Description

CommScope was written up in June by aquicap, when the stock was at $31.  It is a thoughtful writeup which I encourage you to read.  Since then, the company closed on a transformative acquisition, and the stock has fallen to $26 subsequent to Q3 2015 earnings.  Not much has to happen to make money at these levels.  We feel that today’s intrinsic value is $38 (~45% higher), and that value should grow over time.  The stock was as high as $34 in late Q3.     

Company Overview

CommScope is a leading provider of connectivity and essential infrastructure solutions for wireless, business enterprise, and residential broadband networks.  It helps companies around the world design, build, and manage their wired and wireless networks by providing critical radio frequency (RF) solutions, intelligent connectivity and cabling platforms, data center and intelligent building infrastructure, and broadband access solutions.  Demand for the company’s offerings is driven by the rapid growth of data traffic and need for bandwidth for the continued adoption of smartphones, tablets, machine-to-machine communication, and the proliferation of data centers, big data, cloud-based services, and streaming media content. Global telecom carriers are pushing video and over-the-top services while fixed-line over-the-top providers continue to expand.

History

The company was founded in 1976 and has made 3 transformational acquisitions in the last 11 years.  

In 2004, it acquired Avaya Connectivity Solutions for $263 million.  Up until then, CommScope manufactured cables, but not cable components.  Connectivity Solutions manufactures structured cabling for businesses and telecommunications service providers.  Avaya sold the business so that it could focus on the IP telephony market.  This acquisition led to CommScope’s enterprise segment.  

In 2007, CommScope acquired Andrew for $3 billion.  This provided the base for the company’s wireless segment.  

Carlye purchased CommScope for $3.9 billion in Q1 early 2011.  Carlyle took the company public in October 2013 and still owns about 32% of the equity.  Since the IPO, stock was sold at $30.75 in March 2015 and $30.80 in June 2015.  Carlyle’s stake at today’s prices is worth $1.6 billion, making CommScope the second largest public holding of Carlyle.          

In August of 2015, the company acquired the Broadband Network Solutions (BNS) division of TE Connectivity for $3 billion BNS is a leader in fiber optic connectivity for wireline and wireless networks.    

Segment overview (wireless, enterprise, broadband, BNS)

In the wireless segment (39% of LTM Sep 2015 sales, 21% EBITDA margins), CommScope is #1 in merchant RF connectivity solutions and small cell DAS (distributed antenna systems).  The wireless segment sells many products but has a focus on antenna systems.  It offers 3 primary antenna systems: base station, DAS, and point-to-point microwave.  The DAS products add spot coverage in high-traffic areas as well as difficult-to-cover areas such as tall office buildings, parking garages, stadiums, airports, and shopping malls.        

In the enterprise segment (17% of sales, 25% EBITDA margins), CommScope is #1 in physical layer connectivity solutions for data centers and commercial buildings.  It targets the high end of the market with differentiated technology, premium features, and performance.       

The broadband business (10% of sales, 13% EBITDA margins) is #1 in cables for hybrid fiber coaxial networks for broadband service providers.    

The newly acquired BNS segment (34% of sales, 15% EBITDA margins) is a world leader in fiber connectivity for wireline and wireless networks.  Pro forma for the $150 million of synergies, the pro forma price was under 7x EBITDA.  Like CommScope, BNS has low capex requirements.  This was a highly accretive acquisition with strong strategic rationale, which is why the stock rallied earlier in the year upon announcement of the deal.  BNS has leading fiber technology which expands CommScope’s solutions set and allows it to offer a broader range of services.  What is so special about having a strong fiber portfolio?  Growth in video, the internet of things, and the cloud are driving increased demand for broadband and connectivity – optical fiber is the medium of choice in backbone, transmission, and increasingly in data center networks, due to its unparalleled bandwidth capacity.  Even at 100Gbps, a fraction of fiber’s total capacity is used.  Fiber is used with many applications, the most well-known  being FTTH (fiber to the home).  But it also used for several other applications including xDSL (which can deploy fiber to the distribution point), cable TV (hybrid fiber coax networks where cable operators deploy fiber as part of the solution), fiber-based mobile systems (fiber is used between the base station on the ground and the antennas at the top of the cell tower, resulting in lower electrical losses and higher wireless output power).  Wireless operators strive to have heterogeneous networks comprised of 4G macrocells, DAS, small cells, and WiFi hotspots for maximum coverage and capacity – fiber is a key part of the solution. The acquisition of BNS should slightly dampen the volatility.                    

Recent stock drop

The company’s stock price took a large hit upon releasing Q3 earnings primarily because investors were hoping to hear about a recovery in the company’s wireless segment.  The management team is very conservative and said that the recovery would not happen in Q4, but most likely in the 2H of 2016.  This caused many investors to lose patience and sell the stock.  Demand for the company’s products and services is lumpy, but grows over time.  This last point is key yet labor-intensive to verify because the company has limited historical figures and the acquisitions make things less clear.  By speaking with former employees, consultants, competitors, the telcos, and cell tower companies, we were able to gain conviction that long term this is a growth business. Based on our diligence, we feel that we will start to see a wireless recovery in 1H 2016. The management team has cautiously said recently it is beginning to see some improvement.

We gained an understanding of how deployment of CommScope products works with initial buildout of networks (going from 3G to 4G for example), how CommScope products are used post-network buildout in order to densify networks, and also how the replacement cycle works.  The replacement cycle for many of their products has shortened as technology evolves and performance requirements become more stringent.  Although many parts of the world have gone past 3G, most of their wireless sales in 2015 were tied to 3G, which again bodes well for the company.            

Wall Street analysts have 1-year price targets of $30-$35 based on applying a low P/E multiple to 2016 earnings.  We feel this is misguided for several reasons: (1) the full run-rate of synergies will not be achieved until 2018, (2) management has a history of being very conservative and the synergies are likely to be higher than the stated $150 million, (3) the business has a very strong market position and competitive advantages which are not appreciated, (4) the company has high EBITDA margins and low capital expenditures, leading to substantial debt reduction over time, and (5) the team has a history of good capital allocation, although no large acquisitions will happen soon.  

CommScope did an excellent job with its last two large acquisitions, and has a track record of achieving synergies higher than the original targets. Both with Avaya Connectivity Solutions and Andrew Corporation, the company drove significant cost reduction and margin expansion.              

Competition

CommScope has strenghtened its market position over time. In wireless, they are the undisputed market leader. There is a decent Germany competitor Kathrein, but CommScope leads in technology evolution, R&D, and reputation. CommScope comes across Huawei from time to time - but CommScope again has better technology and U.S. telcos do not want to use a Chinese supplier for security reasons. In fact, CommScope has won bids in price-sensitive emerging markets since the total cost of ownership can be cheaper due to quality and durability. Our customer calls have confirmed that CommScope can justify its price through its quality and also its ability to provide comprehensive solutions. Ericsson came out with an antenna product called Ericsson air which had severe quality issues - the cost of failure is high and telcos stopped using the product. The point is that the technology is not trivial.

Corning had better fiber offerings than CommScope pre-BNS deal, but now we are on par with Corning and larger. In the broadband/FTTH business, CommScope is the leader. CommScope's scale and IP are a huge advantage - it serves all 200 major telco carriers and is a critical supplier.

In enterprise, COMM has 400--500 salespeople on the street generating demand, which is also unique in the marketplace. This coupled with strong technology is a real advantage.

Financial Summary

Below is a financial summary – you can see how I am layering in the synergies.  

The 4%, 3%, 2%, and 2% growth rates used for the wireless, enterprise, broadband, and BNS segments, respectively, are based on our work on the smooth-lined long term trends.  The growth rates will of course exhibit more volatility than shown.  In the aggregate, we are forecasting modest growth below 4% annually.  

Valuation

We value the stock several ways, but reach a fair value today of around $38 in all cases.  Below we apply 11x EBITDA less capex multiple to pro forma EBITDA less capex – pro forma for synergies.  We also assume modest growth of $100M in base EBITDA as EBITDA today is depressed.  

Management is guiding to at least $500 million of free cash flow in 2017.  However, 2017 is likely to include only $100M of the $150M in total synergies.  On a pro forma basis, 2017 free cash flow is closer to $600 million when taking into account the $150M of synergies as well as backing out the $50M in cash required in 2016 towards creating the synergies.  Applying a 15x FCF multiple to that, we arrive at a $47 price target for year-end 2017, over 75% higher than today’s valuation.  We were not at the Robin Hood conference when Lee Ainslie pitched the idea, but his target was around $45.  That being said, if anyone was there it would be great to have a recap of his thesis.  Ainslie actually owned COMM before it was taken private by Carlyle, so this is not his first time to be involved.  As the company demonstrates synergy realization in 2016 and throughout 2017, investors should start giving them full credit for their synergy targets.  We believe that total synergies will come closer to $200 million.  

My FCF schedule above assumes all the free cash flow will go towards debt reduction - in reality the management team will either do another accretive acquisition or buyback stock.

While this is a recommendation for the stock, I will note that the COMM bonds trade at a 6.5% yield which is a decent spread (500 basis points) for paper maturing in June 2020.  Net debt to total enterprise value is 50%, and the company is 5x levered, but closer to 4x when you give them full credit for synergy realization.  The company spends a significant amount in R&D, but otherwise will be quickly de-levering the balance sheet over time.  There is certainly a lot of HY paper with higher yields, but COMM is a market leader across its businesses, is not exposed to energy, is not capital intensive, de-levers quickly, and the paper matures in 4.5 years.    

Risks

Leverage is not light here, but it is prudent.  The management team dealt with more leverage during the Carlyle LBO.  

The stock can be volatile - if the wireless markets are slow to recover, the stock could languish.  At the same time, the company will be creating equity value via debt paydown.  

Catalyst

1. Executing on synergies, sell-side giving COMM credit for synergies.  

2. Recovery in wireless markets in 2016 so that stock is no longer priced as a 0% grower.

3. Analyst Day mid-2016. 

4. People having a better understanding of the market and the replacement cycle.  Even if you have LTE everywhere, you are not done, you keep tweaking it and buying the latest & greatest antennas.