Maybe it's a glandular issue, or maybe I'm not getting enough sunshine, but I've been struggling the past few months to find any investments I'm willing to sink my hard-earned money into. Over the past several years, I've found myself trending away from the small unheard of stocks that I did so well with, and towards the big names that everyone happens to be covering.
However, when I run my screener, I find that it is dominated by unexciting companies specializing in mundane markets such as semi conductors and fertilizer. Unlike many others, I believe that free cash flow is one of the most important indicators on long-term prospects of a company -- not an exciting story.
A recent screening of stocks, followed by some cursory examinations of their prospects, turned up nine stocks that peaked my interest. Since I am not a huge fan of list articles, I thought I'd choose one to look at.
Assuming you read the title of this article, you already know we are going to discuss TE Connectivity Ltd. (TEL). TE Connectivity builds electrical components, such as relays, circuit protection devices, wiring, heat sensors, touch screens and antennas. The company is divided into three segments: Transportation Solutions, Communications and Industrial Solutions, and Network Solutions. Customers served span over 150 countries and a variety of industries, such as automotive, consumer electronics, telecommunications, aerospace, defense, medical, energy, and lighting.
Free Cash Flow Calculation
As stated above, valuation screeners are just a start for me, and I prefer to invest in companies that have positive free cash flow. Furthermore, I prefer to pay significantly below fair value, as indicated by my discount free cash flow analysis.
DCF analysis tends to lend the air of an exact science. Unfortunately, much of what goes into the analysis is educated (or sometimes uneducated) estimates. I tend to use very conservative numbers, at the risk of missing opportunities that turn out to be lucrative. However, I find that when an opportunity is truly mispriced by the market because it is under-covered, too boring, and its negatives over-emphasized, it tends to be drastically so.
Before I present my results, I'll explain my assumptions. Instead of the company's WACC, I use 10% (my required return) to discount future returns. My 2012 numbers used are simply the 2011 numbers reduced by 7%. I chose a 7% reduction because analysts estimated a 6.3% reduction in earnings, and I wanted a small buffer to account for negative surprises.
Next, I assumed an 8% growth rate for the next five years, and a 3% growth rate in perpetuity beyond that. Analysts estimate 9.16% growth for the next five years. As analysts tend to be overly optimistic, I cut the growth estimate by a bit over 10%. Here are my numbers, open to critique:
Income Statement ($ thousands)
Cost Of Goods Sold
Selling, general & administrative
Balance sheet ($ thousands)
Total operating current assets
Total operating assets
Total operating current liabilities
Free Cash Flow Calculations ($ thousands)
Tax on Operating Income
Net Operating WC
Net Operating Long Term Assets
Total Net Operating Assets
Investment in net operating assets
Free Cash Flow
free cash flow
growth rate in free cash flow
WACC/ or required rate of return
Value of operations
Value of investments
Total value of firm
value of all preferred stock
Value of equity
Number of shares (millions)
Estimated Share Price
Buy Under price!
My calculations estimate a fair share price of $45.86. Because of the great reliance on estimates, I prefer to include an additional buffer, or value moat, as many greater than I have termed it. Generally, I stick with 20-25%, depending how I feel about the general market. In this case, I've calculated a "buy under" price with a 25% buffer, giving me a target of $34.40 or less. As I write this, TEL sits at $33.40. Despite a run-up today, it still sits under my buy price.
Before I commit to a position, I'd like to see what kind of growth TEL requires to justify its current price in the mid-$33s. It turns out that current prices assume an 1.1% growth rate in my model. So if your due diligence on market circumstances leads you to believe that TEL cannot grow at 1.1% or better, then you should avoid investing in the company.
To get some idea of whether our guesstimated growth rate has any basis in reality, let's look at TE Connectivity's metrics in relation to its competition. Roughly, I'm looking at growth, efficiency, financial health, and overall valuation:
Return on Investment (5 yr avg)
Return on Equity (5 yr avg)
Net profit margin (5 yr avg)
Sales - 5 yr growth rate
Earnings per share - 5 yr growth rate
P/E ratio (TTM)
Price to tangible Book
Price to Free Cash Flow
Several things jump out at me when comparing TE to industry numbers. TE seems to hold up poorly on all fronts compared to the industry averages. Both ROI and ROE are much lower than supposed industry averages, growth rates are lower, sustainability is lower (as measured with current and debt/equity ratio), and share price is more expensive when compared to industry Price/Book and P/FCF ratio. But industry is an unknown quantity. Since these numbers come from Reuters, and I don't know how Reuters defines industry, I find it much more productive to compare the results against three defined competitors.
Of the three competitors, Corning (GLW) seems to be the strongest, and Alcatel-Lucent (ALU) looks weakest (I may have to examine Corning further). TE lags in areas of profitability, growth, and financial health when compared to its rivals Corning and Molex (MOLX). ROI and ROE look particularly bleak when compared to these two competitors. However, it's important to point out that TE had substantial nonrecurring expenses in 2009 that significantly dampen its results in any category that takes a five-year average. Its ROI and ROE are significantly higher now, and competitive with Molex, and they even exceed Corning's current ROI and ROE.
My greatest concern lies in two areas. First, TE's current ratio and debt to equity ratio are significantly worse than its two healthy competitors. While there is nothing wrong with a current ratio over 1.0, particularly if global recovery continues, its higher debt, combined with its lower ability to meet short-term financial obligations could be a significant hindrance should the world economy sour over the next few years. The industry itself is reliant on global growth, but from these ratios alone, it would appear that TE may suffer relative to Corning and Molex.
Next, TE's earnings have declined over the past five quarters, and could indicate that the company will have difficulty meeting analyst growth expectations in the future. The company has room to improve its profitability, and will need to show signs of doing so in the future to warrant continued investment.
The "So What" Moment
All of that being taken into consideration, I consider TE's price to be attractive, despite the risk. I believe that a purchase at $34 or below (I've sold $30 puts) will most likely result in long-term profits, and that the potential upsides far outweigh the potential downsides.
Personally, I would consider selling puts for entry points below $34. I personally sold puts at $30, and plan to reevaluate should those positions finish out of the money.
This Just In...
Since TE just released fourth quarter earnings as I was getting ready to submit this article, I thought I would comment on them. The company finally reported an increase in profits, after three quarters in a year of reporting "year over year" profit losses. Revenues fell by around 10%.
This is both positive and negative. First, falling revenues are never great. One of my concerns however, was decreasing profits, and perhaps TE is focusing on increasing efficiency to squeeze more profits out of revenue. If it can address revenue losses, as the economy improves, increased efficiency will pay off enormously.
Analyst expectations for future earnings are growing increasingly negative (first quarter earnings expectations have dropped from .79 to .77), but we already factored in lower growth rates than analysts expected, and the vast majority of TEL's quarters beat the analyst expectations.
All in all, this evening's earnings release does not change my outlook on TE Connectivity.
Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not currently long TEL directly, but I have sold several put contracts short. Currently they are out of the money, but should TEL's price drop, and the options be exercised, I could be long TEL within 72 hours.