TE Connectivity - An Industrial Tech Story With Favorable Exposure To Long-Term Secular Trends, All At A Below-Market Multiple

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About: TE Connectivity Ltd. (TEL)
by: Nicholas Coppola, CFA
Summary

TE Connectivity expected to benefit from long-term secular trends with growing technological content in a variety of product categories (i.e., cars, trucks, airplanes, industrial equipment).

For better or worse, the business is exposed to the global industrial cycle. That said, we expect content growth to enable the company to outperform its end-markets for many years.

Despite the strong runway for growth, the stock is trading at ~15.5x forward earnings, which is about two and a half turns below the S&P 500.

At Kays Financial, we like to purchase businesses that benefit from long-term structural trends, so long as said businesses can be acquired at attractive prices. We think TE Connectivity (TEL) fits this bill reasonably well. TE Connectivity is a global industrial tech company that over a period of years should benefit from trends, including 1) a shift towards electric (and eventually autonomous) cars and trucks, 2) the use of automation and robotics in factories, 3) growth in the healthcare industry with a focus on minimally invasive interventional medical devices, and 4) the internet of things as the world becomes more connected.

To get a bit more specific, TE Connectivity makes a wide array of connectors and sensors that serve a variety of end-markets. At the risk of over-simplifying, connectors serve things that need power, data or signal, and sensors serve things that sense pressure, vibration, humidity, temperature, or position. As a common theme, their products are utilized in ‘harsh environments’ where failure is not an option. This importantly helps to steer the company towards areas where they are compensated for their engineering expertise, and away from more commoditized parts of the market. The company employs ~7,000 engineers across the world and closely partners with their customers throughout the design process, creating custom solutions. The company maintains leadership positions and differentiates themselves through their innovation and global presence.

Some additional geographic and segment data may help shed a bit more light on the company. TE Connectivity generated ~$13B of revenue last year, approximately evenly split between the Americas, Asia-Pacific, and Europe, Middle East & Africa (EMEA). At the segment level, Transportation made up ~58% of revenues, Industrial made up ~29% of revenues and Communications made up ~14% of revenues, adjusted for the expected sale of the Subsea business. Working down to the sub-segment level, Transportation was ~74% automotive, ~14% commercial and ~12% sensors. Industrial was ~50% industrial equipment, ~31% aerospace, defense, oil & gas, and ~19% energy. Communications was ~60% data & devices and ~40% appliances, again, adjusted for the expected sale of the Subsea business.

With that brief description out of the way, we’ll dive into what gets us most excited about the investment, which is the content growth story. For better or worse, TE Connectivity is exposed to the global industrial cycle and each aforementioned end-market. However, with their components becoming more and more prominent in smarter cars, smarter trucks, smarter airplanes, smarter factories, and smarter homes, the company should be able to grow their average dollar value of content per unit for many years into the future.

Automotive is their largest sub-segment at ~43% of sales and illustrates the opportunity ahead. The headline is that more connected cars with greater safety and efficiency translates to greater revenue per vehicle. As a recent example, last quarter, with global auto production growing at ~4%, TE Connectivity’s core auto revenues managed to grow ~10% year-over-year, excluding acquisitions. The content growth story here is particularly massive for electric and autonomous cars. To put some numbers around this, management indicates that as you move from an internal combustion engine to a hybrid, content increases on average ~50%. And when you go fully electric, it’s closer to a ~100%.

Encouragingly, TE Connectivity also has favorable exposure to China, which management believes will be the first big mover in electric vehicles. So why is China currently positioned to be successful in the electric vehicle space? Reasons include government incentives, different user requirements in terms of driving range, and an acute focus on reducing pollution (which anyone who has visited China will tell you is a pressing issue). TE Connectivity sells into every leading manufacturer in China and management reports a high degree of confidence they will participate in this growth. As one exceptional example, TE Connectivity is selling more than $500 of content into the NIO New Energy vehicle in China vs. their current global average of ~$62 per vehicle. And then as we think about the shift towards autonomous vehicles (which contrary to the popular view exists on a spectrum from simple cruise control to fully autonomous), the need for reliable high speed connectivity and data moves stair steps higher. Looking across the rest of TE Connectivity’s businesses, similar stories can be told about increasing technology leading to greater revenue opportunities (i.e., smarter trucks, airplanes, factories, homes). And despite this strong long-term growth story, the stock looks cheap relative to the broader market.

In terms of valuation, the stock is trading at ~15.5x next twelve months projected earnings. As a matter of comparison, the S&P 500 is trading about two and a half turns higher. And we would argue this is a better than average company on a better than average earnings trajectory. So why is the stock cheap right now? There is certainly concern among investors regarding the North American auto cycle. That said, the Americas make up only ~15% of auto sales for TE Connectivity, and trends in Asia and EMEA should be much more impactful (however those are also question marks with some particular concern regarding China). As an aside, one memorable quote from the Berkshire Hathaway annual shareholder meeting in 2016 that stuck with me was from Charlie Munger, who said “microeconomics is what we do, and macroeconomics is what we put up with.” Well, we like the micro story for TE Connectivity and filtering through the shorter-term macro noise, with a long enough time horizon, auto production should only move higher as the world develops. There is also concern out there regarding trade, but management has indicated a large portion of their manufacturing is already strategically in local markets. Somewhat related to this discussion, we view the recently announced divestiture of their Subsea Communications business as a positive, since the Subsea business carried lower profitability and had recently encountered project delays that were an overhang on the stock.

We also think there is ample opportunity for the company to exceed expectations. Management at their investor day last December provided their long-term financial outlook, calling for organic revenue to grow ~4-6% annually, with an additional ~1% or more from acquisitions. Operating margins are expected to expand ~30 – 80 bps annually, in part benefiting from improved efficiencies as well as fixed cost leverage, and EPS is expected to grow in the double digits. Given the content growth story and the potential for new technologies to be adopted at an exponential rate, we think there is an opportunity to outperform investor expectations. In terms of capital allocation, over a cycle, ~1/3 of cash flow is expected to be directed towards strategic M&A and ~2/3rds to share repurchases and dividends. Their ROIC target is in the mid-teens. Note that the $325MM of proceeds from the recently announced SubCom sale is expected to fund share buy-backs, which we view as an additional positive given our bullish outlook for the stock.

All in, while we acknowledge uncertainty regarding the global industrial cycle, we believe that TE Connectivity is well positioned to grow its top and bottom line at an above-market rate as structural trends play out over the longer-term. Despite this, the stock is currently trading at lower than the market multiple, and in our view, is meaningfully undervalued.

Disclosure: I am/we are long TEL. 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.