CommScope’s Strengthening Competitive Position
CommScope Holding Company, Inc. (COMM) is a fairly straight forward business. The company is one of the largest global suppliers of cabling structures that form the physical transport layer of data networks. CommScope is also the largest U.S.-based supplier of macro cellular antennas that transmit and receive wireless data traffic. There is a good chance that the next movie you stream at home has traveled digitally, at least in part, over data network cabling components sold by CommScope. Moreover, look up to the top of a few nearby cell towers, and you are apt to see an antenna manufactured by CommScope.
From an investment perspective, however, understanding CommScope requires some effort. On the one hand, the industries in which CommScope operates are challenging. End market demand is volatile and annual revenue growth is, therefore, not predictable. Additionally, a significant portion of CommScope’s sales is derived from large telecom and cable operators. These customers are tough on suppliers, pressing for price concessions while showing little patience for supply delays or product defects.
On the other hand, CommScope has steadily strengthened its competitive position over the past 15 years through organic investment and acquisitions. Although CommScope’s financial results vary significantly from year to year, the firm’s steady improvements become clearer when viewed over longer time periods. The table below shows gross margins, operating margins, free cash flow, and return on invested capital over trailing five-year periods, using our 2016 estimates. Through this lens, CommScope’s business has clearly improved over the past decade. Throughout these rolling time periods, the company has increased average annual gross profit sevenfold, increased average annual operating profit more than tenfold, and more than tripled average annual free cash flow to equity holders.
Given enough capital, any company can grow, and ill-conceived growth initiatives can drive down returns on invested capital to unacceptably low levels. However, as shown in the table below, CommScope’s returns have improved as the company has grown in size. From 2001 through 2005, return on invested capital averaged about 6%. During the trailing five-year period ending September 30, 2016, CommScope’s returns averaged approximately 10%. In our view, CommScope’s long-term improvement in return on invested capital is a result of the firm’s greater scale, closer relationships with its end customers and key channel partners, ownership of a much broader portfolio of valuable intellectual property, management’s focus on profit growth over revenue growth, and improving execution.
We believe return on invested capital should approach 11% in 2016, and we expect annual returns on capital to average 12% over the next five years. So what’s driving the strength this year, and why are we optimistic that returns will sustain at even higher levels over the next five years?
In early 2015, CommScope announced its intent to acquire TE Connectivity’s Broadband Network Solutions (BNS) business for about $3 billion in cash. The strategic benefits of the deal appeared clear to us. CommScope’s strengths included selling cellular antenna systems to wireless telecom operators, structured coaxial cabling to cable operators, and structured cabling products to traditional enterprises. BNS’s strengths included selling fiber optic structured cabling to telecom service providers and large scale data center operators. The combined company would offer a broader product portfolio that could better meet the requirements of large customers in nearly any region of the world. Once the BNS acquisition closed, CommScope’s annual revenue run-rate would be roughly $5 billion, and we believed the firm would enjoy greater advantages over many of its competitors as a result of increased scale and product breadth.
The financial potential was also apparent to us. The two companies were direct competitors in the structured cabling industry with many similar products, manufacturing capabilities, and channels to market. CommScope’s management expected to eventually realize at least $150 million in annual cost savings by consolidating manufacturing and distribution facilities, streamlining BNS’s product line, and eliminating redundant corporate functions. After more than a decade of steady industry consolidation, this combination would further reduce the number of North American structured cabling suppliers to five significant competitors. We believed that CommScope’s negotiating position within its value net should improve moderately as a result of the combined firm’s greater scale and the industry’s smaller number of competitors.
CommScope’s previous two large acquisitions – Avaya’s enterprise cabling business in 2004 and antenna manufacturer Andrew Wireless in 2007 – eventually led to significant financial improvements. After evaluating the potential of CommScope’s acquisition of BNS, we expected meaningful improvements this time as well, including our expectation for annual free cash flow to eventually surpass $500 million.
Our intrinsic value estimate for CommScope and the investment margin of safety are approximately the same today as they were when we made our initial purchase more than a year ago. However, our conviction has increased for three primary reasons. First, the BNS integration is tracking ahead of initial expectations, and management has raised its long-term annual cost synergy target from $150 million initially to greater than $200 million currently. Encouragingly, gross margins are now tracking above our long-term expectations, which we believe is largely a result of BNS’s high margin product portfolio and merger-related cost savings generating more margin lift than we originally expected. CommScope’s gross margins, operating margins, free cash flow, and returns on capital have all improved since the BNS acquisition closed during the third quarter of 2015, despite flattish revenue.
Throughout the remainder of this year and into next, the firm will work through the significant integration project of consolidating multiple enterprise resource planning systems. While this process introduces some near-term risk, it is also a necessary step toward fully realizing the long-term benefits of the merger. We expect margins and returns on capital will increase over time.
The second factor behind our optimism is that CommScope’s management is utilizing excess free cash flow to pay down debt, and the firm has voluntarily repaid $537 million in debt so far this year. We expect CommScope will exit 2016 with net leverage at less than four times trailing twelve-month EBITDA (earnings before interest, taxes, depreciation and amortization), compared to a pro forma net leverage ratio of five times at the end of last year. Management has also stated its intent to repay approximately $500 million in additional debt by the end of 2017. If management meets its objective, we estimate CommScope’s net leverage ratio will improve substantially to about three times trailing EBITDA at the end of next year. All else equal, a lower level of debt translates to higher annual free cash flow and lower business risk.
Finally, CommScope benefits from long-term demand drivers. Clearly, data traffic will increase over the coming years, and operators will continue to invest in their networks to meet customers’ higher service level expectations. Currently, telecom and cable operators are building denser fiber optic networks that increasingly extend all the way inside their customers’ buildings. Large scale data center operators such as Amazon, Google, and Microsoft are building out additional data center capacity to capture growing demand for cloud computing services. Fiber optics cabling is the physical transport medium in these large data centers. The newly acquired BNS fiber optics cabling portfolio, combined with CommScope’s existing portfolio, strengthens the firm’s competitive position as a supplier to these large customers.
Although antenna demand is currently tepid, we are confident that wireless operators will continue to invest in their wireless networks over time to accommodate growing wireless data traffic. This investment will come in the form of new cellular antennas being placed at traditional cellular towers; smaller cellular antennas being placed at less traditional sites such as city street lamps and outdoor venues; indoor cellular wireless systems; and structured fiber optic cabling used to backhaul traffic from cellular antennas to wireless operators’ network aggregation points. Additionally, we anticipate elevated investment to begin sometime around 2020 as forward-leaning carriers begin to promote 5G services as a way to differentiate themselves.
2020 may sound far away; however, it is only five years from the date of our initial purchase of CommScope’s shares and less than four years from today. This strikes us as a reasonable holding period over which to evaluate an investment. We are content to be patient given CommScope’s strengthening competitive position, improving financial health, and undemanding valuation.
Originally published on October 18, 2016
The views expressed are those of the research analyst as of October 2016, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.