Description

CommScope is a turnaround situation with multiple industry tailwinds and an aggressive new CEO recently installed by Carlyle, the company’s largest shareholder. In my analysis, it has about 90% upside to fair value, which appears attractive even relative to the company’s risks due to leverage, technological change, and execution.

Description:

CommScope is a leading physical infrastructure provider to the cable and wireless communications industries. It makes copper and fiber optic cabling for cable companies, datacenters, and office buildings; antennas, cables, and housings for cell phone towers; core infrastructure and software for cable companies; enterprise wifi systems for large buildings; and modems, wifi routers, and video set-top boxes for home networking applications.

The business is organized into four segments:

• Broadband Networks -- mostly cable network infrastructure
• Home Networks -- mostly the set-top box market, and in rapid decline
• Venue & Campus networks -- mostly enterprise wifi from the Ruckus brand
• Outdoor Wireless -- mostly antenna and cable solutions for wireless applications

Background:
The business has had a rough few years. Copper connectivity products have been in long-term decline. A wave of infrastructure investment by the cable and wireless companies, in response to the perceived threat of Google Fiber, led to overbuilding in 2016, and was followed by several years of reduced industry capital investment after Google retreated from the market in 2017. Then, in early 2019, CommScope levered up massively to purchase ARRIS to expand its product portfolio and cross-selling abilities and missed the fact that the set-top box market was in freefall due to cord-cutting and the shift to streaming, and that the cable infrastructure business was facing the same headwinds from lack of carrier investment as CommScope’s own wireless segment was also facing. Meanwhile, the promise of a renewed investment cycle from 5G remained a mirage on the horizon. These headwinds led to a series of major earnings and guidance disappointments from the summer of 2017 through the beginning of 2020. The stock price has reflected these disappointments and is down 65% from its peak in early 2017 to today.

While it’s fair to criticize the company for execution missteps, including being terrible at giving guidance and for making an ill-timed acquisition, the underlying quality of most of the business has remained. COMM has maintained its market share during this weak industry environment and remains the leader in most of its categories. Gross margins have remained attractive, at around 33%, in-line with the company’s long-term average. Operating and EBITDA margins took a hit over the last few years, and fell from an average of ~20% down to 15% (on EBITDA) last year, but should rebound as volume returns, and as mix shifts to the company’s three growth segments and away from the dying Home Networks business. Returns on tangible invested capital -- my preferred measure of quality -- remains highly attractive, at over 30%, though down from a longer-term average of 45%. And, critically, long-term trends are favorable, as demand for bandwidth through both cable and wireless continues to grow with no end in sight.

The tide is turning:

Many of the trends in the industry environment are now finally beginning to turn positive for the company, which should drive a return to revenue growth for all but CommScope’s Home Networks segments. While overbuilding due to Google’s threat led to a few years of flat carrier investment, spectrum auctions from last year ($4.5 bn for CBRS) and much more importantly, this year ($81 bn for C-band), along with the completion of the T-Mobile/Sprint merger, are, at last pointing to a resumption of investment from the large cable and mobile carriers. Industry experts have told me multiple times that spectrum is the lifeblood of the industry and now, at last, there’s major new spectrum available for all the major carriers, and this spectrum should  spur the first real wave of investment in 5G.

Next, COVID has driven significantly increased loads on cable networks through work- and learn-from-home, especially for uplink, and as a result, COMM’s Broadband Networks segment saw sales go up 22% last year (all other segments declined). This increased load is likely to persist and sustain long-term investments in capacity. 

In addition, the US has launched the $20 bn Rural Digital Opportunity Fund to invest in providing internet access to ~160 mm Americans who lack access to broadband internet access over the next decade. CommScope expects the RDOF to drive significant revenues for them beginning this year. 

A turnaround expert is brought in:

While the industry environment is changing, and alone should drive a resumption in growth, the board has recognized the execution challenges at the company over the last few years and hired a proven turnaround CEO, Chuck Treadway, last summer. Treadway has led or been involved in six company turnarounds, generating significant wins for his private equity backers. He was brought in by Carlyle, which had previously hired him as CEO of Accudyne Industries. At Accudyne, Chuck was able to both grow revenue and cut costs at the same time, more than doubling EBITDA in three years. 

Paragon Research initiated a buy recommendation for CommScope in February based on Chuck’s hiring, saying, “New CEO Chuck Treadway is an operationally-focused turnaround specialist who will de-lever CommScope while reaccelerating growth through customer collaboration and a greater software focus. Treadway will restructure ARRIS and sell off its Customer Premise Equipment business. Streamlining the remaining businesses’ operational processes will restore margins to pre-ARRIS acquisition levels while sale proceeds will reduce leverage and interest expense.” Paragon argues that Chuck will drive 60-94% earnings growth through 2022, which is 10-44% above consensus (and also represents upside to my estimates).

I spoke with Chuck and was impressed with his no-nonsense approach, his domain expertise in electrical engineering, his prior record of turnaround success, and his action orientation. While he believes there remain significant synergies that can be captured from the massive ARRIS acquisition, beyond what the company has already achieved, he is not planning to gut the firm, and plans to increase investment in technology leadership, growth categories, and in go-to-market strategies, especially in pursuing more international markets where the company has not previously been active and has much lower market share than in North America. It seems likely that he will divest or run-for-cash the Home Networks segment. At prior companies he has achieved about half his EBITDA improvements from top-line growth, and half from cost cutting. The board has given him until Q3 of this year to deliver his full review of the CommScope portfolio and long-term plan, but with the Q1 report he already announced the outline of his plan. While we do not yet know the details of his plan for the company, he inspires confidence that he will be able to find the right strategy, and will execute quickly.

Valuation:

I model the company returning to low single-digit growth in each segment except for Home Networks, which I expect to decline at 15% per year. The company believes their TAM is growing at 2-3% per year, and that they have an opportunity to add another 200-300 bps of annual growth from entering new international markets, so there may be upside to my topline estimates. From my conversation with Chuck, I believe the company can rebound from 15% to 17-18% EBITDA margins as mix improves, but I’m not projecting the company returns to the 20% EBITDA margins it historically enjoyed. With these assumptions, earnings power in five years is over $3/share. The company currently trades at less than $15, so less than 5x five-year forward earnings. Structurally, COMM is a relatively good business, and I believe the company merits a five-year forward multiple of at least 9x, which is roughly where the broad market has historically traded on five-year forward earnings (right now, the market is trading far above this historical average). A 9x multiple on 5-year forward earnings results in a fair value estimate of around $27, or almost 90% upside to current levels.

Risks:

•  Leverage: The company has over $9 bn of net debt from its ARRIS acquisition, and trades at 7.1x forward net-debt-to-EBITDA. However, the company has no maturities until 2024, when just $1.2 bn is due. With EBITDA of $1.3 bn and higher expected for each of the coming years, the company should easily be able to handle its debt obligations. It’s committed to paying back its debt as soon as possible, and with expected cash flow over the next few years should be able cut leverage to the 4x range by then.

• Virtualization: This technology trend is relevant to both the wireless and cable segments. For wireless, companies like DISH, Jio, and Rakuten are pursuing a new technology architecture called Open Radio Access Networks (O-RAN), which is disruptive to many wireless infrastructure players like Nokia or Ericsson, but the components that COMM makes are not directly affected. For cable, virtualization could be a larger threat, with companies like Harmonic making inroads with some cable carriers with software-based cable modem termination systems (CMTS) and converged cable access platforms (CCAP). CommScope has #1 market share in CCAP products, and was slightly behind in delivering a virtual product to the marketplace, but COVID drove carriers to delay trials of virtual solutions last year, and gave the company time to catch up. Third-party experts believe that as long as COMM chooses to invest in this technology, and it has, it is strongly favored to maintain its market leadership. 

• Execution: The company is complicated, with 17 business units, and operates in a space with very powerful customers, the largest telecom carriers. As experienced as the new CEO seems, getting COMM on firm footing will be challenging.

Catalyst

• Carrier investment following recent spectrum auctions.
• Announcement of full turnaround plan in next two quarters.
• Likely divestiture of the Home Network segment.
• Corporate execution on new CEO's turnaround plan.