Description

CommScope (COMM) $31.04

Summary

CommScope (COMM) is a leading provider of connectivity solutions for wired and wireless networks. On January 28, 2015, COMM announced its intent to acquire the Broadband Network Solutions business of TE Connectivity (TEL) for $3.1b. This transformative deal will increase COMM’s revenue base by 50%. From an investment perspective, pro forma COMM has the characteristics of an attractive spin off but with a lower risk profile owing to an experienced management team at COMM which has already proven their ability to successfully manage M&A integration risk, delivering cost synergies in excess of expectations and aggressively deleveraging the business. The pro forma CommScope is an earnings growth story powered by cost reduction and deleveraging which should benefit from the secular tailwind of rising demand for broadband capacity.

Background

CommScope is a global leader in each of its three operating segments: Wireless, Enterprise and Broadband. The Wireless segment provides ‘everything but the radio’ for cell sites. The Enterprise Segment provides structured cabling solutions, connectivity and intelligence software for businesses and data centers. Broadband provides fiber and coaxial cable and communications equipment for cable networks.

TE Connectivity’s Broadband Network Solutions business is a leader in fiber optic connectivity in wireline and wireless networks and is an excellent complement to CommScope’s strength in wireless. This business operates in three segments: Telecom, Enterprise and Wireless. Telecom provides fiber connectivity solutions to telecom providers; Wireless focuses on fiber connectivity to businesses and data centers and Wireless offers distributed antenna solutions to carriers and building owners.

The combined entity will be a global leader in both fiber and wireless connectivity – the fundamental building blocks of future broadband networks.

The Opportunity

The Broadband Network Solutions (BNS) business has likely suffered from lack of attention from its current parent, TE Connectivity. TE Connectivity is the former Tyco Electronics business which was comprised as a roll up of several businesses. TE Connectivity’s crown jewel is its automotive connector and sensor business with BNS representing only 13% of LTM revenues. There are several qualitative indicators that the business offers room for margin improvement such as running more than six ERP systems currently versus a single system for CommScope. Management has targeted $150MM in run rate cost synergies starting in year three with over $50MM in cost synergies expected in the first year. Consensus is that management should be able to exceed this target. In 2007, CommScope acquired Andrew to enter the wireless business. At the time, Andrew was slightly larger than the BNS business is today. Current management was able to exceed the cost synergy target by over 30% and increase operating margins by over 400bps.

The current deal will substantially increase CommScope’s leverage, but current management has proven its ability to execute and rapidly deleverage twice in recent history. First, in 2007 with the Andrew acquisition and again in 2010 when the Carlyle Group took COMM private. In both cases, Debt/EBITDA jumped to 4.5x – 5.0x and was reduced to under 3.0x three years hence driven by both margin improvement and debt reduction. The debt markets recognized this accomplishment by pricing $2.75MM in combined debt offerings to finance the acquisition at attractive rates in June.

Many spinoffs have similar characteristics: an orphaned division within a large company gets carved out as a standalone business. It is often saddled with significant debt incurred to pay a parting dividend to its former parent. Management is typically unproven at running a standalone public entity and must quickly prove their ability to rationalize the business while simultaneously investing for growth and deleveraging the business. If it all comes together, the rewards to the equity holder are substantial, but management ability is often the swing factor. Pro forma CommScope exhibits several of these characteristics but with two important distinctions: first, management’s ability has already been demonstrated – significantly de-risking the opportunity. Second, the combined business will benefit from secular demand tailwinds. While the capex spend of carriers and enterprises to increase broadband capacity will continue to be lumpy, the trajectory is assuredly up and to the right.

Analysis

The purchase price of the BNS business is $3.1b, which will be financed by roughly $250MM cash on hand and $2.75b in additional debt at approximately 6%. COMM expects that roughly half of the purchase price can be allocated to intangible assets that will create a tax shield of $100MM/year over the next 15 years. This cash tax savings of $25MM - $35MM is worth roughly $280MM in present value.

In addition, the low end of cost synergies is forecast as: greater than $50MM in year 1, greater than $70MM in year 2 and greater than $150MM in year 3. I believe that ultimately the run rate cost synergies could be closer to $200MM.

Mentioned but not quantified is revenue synergies that will likely occur. These businesses are extremely complementary with respect to customers and geographies. CommScope has focused on providing solutions instead of being a commodity component manufacturer. The ability to bring that approach to the BNS business as well as offering enhanced solutions that combine technologies from both businesses (namely fiber and wireless) should add to revenue growth. Offsetting this benefit is that CommScope manages for profitability not revenue growth. In the past, it has pruned unprofitable revenue products from its portfolio and is likely to do so going forward. In the absence of additional detail as to the scope of the revenue synergies and the revenue pruning, for now I am making the cowardly assumption that they simply cancel each other out.

The acquisition is economically attractive on an unlevered basis and offers exceptional returns when levered.

Adjusting for the value of the tax shield on the intangibles and the expected cost synergies and the unlevered returns are attractive at roughly 15%. The low cost debt financing boosts return on equity above 50%.

The reduction in leverage over the next few years transfers enterprise value from creditors to shareholders. While not explicitly modeled, the reduced risk profile that accompanies the debt reduction should be rewarded with a higher multiple.

As a baseline, looking at pro forma LTM (3/15) results and assuming no revenue growth and modeling the low end of the cost synergies against the expected cost of the synergies ($150MM) and clearly the EPS growth accelerates on the synergies and debt reduction alone. Under this exceptionally conservative scenario, CommScope should be able to delever by $1.9b combined over the first four years, boosting EPS by 75%. Note that I’m using a more conservative EPS definition than the company’s ‘adjusted’ definition.

Adding in modest revenue growth of 2.5% and increased expectations for cost synergies only improves the thesis. Margin expansion and the resulting increase in debt reduction drive additional EPS growth of 94% over the next four years.

The earnings growth combined with deleveraging should provide for a commensurate growth in the valuation of the business. Note again that I am using more conservative numbers than the company’s adjusted figures which makes the resulting multiples look inflated. Relative to current trading and recent transactional comps, the multiples are more reasonable than they might initially appear.

There is likely valuation support to deliver 15% returns per annum over the next few years.

Conclusion

I believe that CommScope offers an attractive risk-reward opportunity given the established management team and this transformational acquisition. As the Company integrates the BNS businesses, margins should expand and debt reduction should drive accelerated earnings growth providing compounded returns of roughly 15% per annum on average over the next few years.

Catalyst

The catalyst is the pending acquisition of TE Connectivity's Broadband Network Solutions business which should close by the end of 2015 which increases COMM's revenue base by 50% and financed with cash and debt. The integration of this business by a proven management team should result in substantial margin growth and accelerated debt reduction, which will combine to drive earnings growth and support a rerating of the stock price.