2023-07-10 09:42:15 ET
Summary
- CommScope is expected to benefit from market tailwinds such as the rollout of 5G networks, expansion of broadband access, and the convergence of Wi-Fi and cellular in the enterprise space.
- The company's Network Cable & Connectivity segment has a growing order backlog, indicating strong customer demand, while its Outdoor Wireless Networks segment is navigating challenges from reduced North American capital expenditures.
- Despite reporting a negative net income in FY2022, CommScope has positive free cash flow due to non-cash expenses and changes in working capital, and is expected to overcome margin challenges.
CommScope ( COMM ) is a buy as it seeks to benefit from the explosive growth of 5G networks across the globe.
My thesis is centered around the continued growth of its Connectivity and Cable operating segment ((CCS)). The CCS segment has an order backlog of approximately $1.1 billion, which rose from $800 million at the end of 2021. This suggests significant customer demand.
I feel that COMM is able to navigate the risk and opportunities associated with this segment, which will lead to a higher share price in the future. A higher share price will be buoyed primarily by the global roll out of 5G, as well as increased fiber broadband connectivity in the United States and abroad.
CommScope Overview
CommScope is a global leader in network infrastructure solutions that play a crucial role in how operators create and evolve their networks. The company's range of end-to-end infrastructure solutions includes everything from broadband and enterprise network cables to wireless and enterprise antennas. CommScope has various operating segments including CCS, Outdoor Wireless Networks ((OWN)), Intelligent Cellular and Security Solutions ((NICS)), Access Network Solutions ((ANS)) and Home Networks ((HOME)).
The CCS operating segment is the company's primary focus , as it represented 41% of the company's net sales in FY2022, bringing in $3.8 billion.
The CCS segment saw a significant increase in operating income from $138.5 million in 2021 to $438.2 million in 2022, representing a 216.4% increase. The adjusted EBITDA also increased from $448.9 million in 2021 to $643.6 million in 2022, a 43.4% increase.
So while CommScope saw improvements in some segments, it faced significant challenges in others, particularly in ANS. The company's overall operating income turned negative, but its adjusted EBITDA, which excludes non-operating items, showed an increase. This suggests that while the company faced operational challenges, its core business operations remained profitable.
Indeed, due to these challenges in some of its segments, such as ANS and OWN, COMM stock is down 14.69% year to date, and down 0.63% over the past year.
Most recently the company missed its quarterly revenue target by $160M, while its EPS target of $0.35 was in-line with analyst targets.
This year's first quarter revenue miss of $160M was anticipated by management, due to a mix of factors that included "seasonality, customer inventory adjustments and lower demand." A small amount its backlog was also trimmed due to cancelled orders amid recessionary concerns and higher prices due to inflation, but these were not deemed to be significant.
However, I feel that these are temporary setbacks, and that management will continue to unlock further growth in the OWN operating segment moving forward.
Part of this is because CommScope serves customers across the globe, with around 40% of its sales coming from outside of the United States year-to-year. In 2022 international regions accounted for 38% of its total net sales.
CommScope annual report
The company's reach will allow it to tap into the global growth of the 5G, broadband, and enterprise Wi-Fi space, which is set for explosive growth moving forward. Its international positioning also benefits shareholders through catering to a wider total addressable market than the U.S alone.
Strong Market Tailwinds in 5G
Some experts believe that the global 5G ecosystem will be worth $8 trillion in 2030, providing the backbone for technologies like AI and internet of things (IoT) to unleash a new age for human convenience and productivity.
CommScope is uniquely positioned in the 5G space for several reasons. For one, the company has been providing infrastructure solutions for wireless networks for several decades, and its products have evolved along with the industry's technological advancements. Established in 1976, the brand started with the rollout of 2G, and successfully provided antennas, base station components, and fiber optic infrastructure that were crucial for the build-out of networks in the 4G/LTE era. The company therefore has a deep understanding of the technical and logistical challenges involved in rolling out a new network technology, and positions it well to help its customers navigate the transition to 5G.
CommScope also has an advantage in 5G that could help it give itself an edge over its many competitors. The company developed its Mosaic base station and antenna solution. The device helps customers transition to 5G while also keeping their 4G networks online as it supports both within the same footprint. This means that its customers can gradually shift to 5G without having to completely replace their existing network infrastructure, which eliminates a key objection to the transition. The Mosaic station also allows rollouts to be conducted faster and with greater ease and accessibility, to help it attain greater market share.
Its other advantage is that over time, industrial Wi-Fi and cellular data are expected to converge in terms of their capabilities. New standards like Wi-Fi 7 are being worked on to match the speed and reliability of cellular networks such as 5G. CommScope's solution is to add additional radio frequencies in Wi-Fi to increase the amount of data that can be transmitted. For Wi-Fi, this is the 6GHz band accessible to Wi-Fi 6E and Wi-Fi 7 which basically quadruples throughput. For private LTE and 5G cellular networks in the United States, it’s the addition of the Citizens Broadband Radio Service (CBRS) 3.5GHz band which adds 150MHz of spectrum.
The implication of this is that CommScope is well-positioned to capitalize on the convergence of industrial Wi-Fi and cellular data. As these two technologies become more similar in terms of capabilities, there will be increased demand for solutions that can seamlessly integrate and manage both, and CommScope has a portfolio of products in the works that will allow them to do so.
There's also already some strong evidence that CommScope will be successful in unlocking value from this segment, as well as others due to the amount of backlogged revenue that sits on its order books. According to the Q1'23 earnings call , backlogged orders sit at $2.4 billion in revenue for its core segments. With this backlog in mind, management gave guidance of a $1.35 billion to $1.5 billion adjusted EBITDA for this year.
Other tailwinds for the stock is that its customers have little choice but to upgrade to 5G. Global data consumption is ramping up at an unprecedented rate in a 'J' curve-like fashion. This is driven by trends in video streaming, cloud computing and Internet of Things (IoT).
Newer technologies require faster speeds and higher bandwidths to function effectively, if at all. Therefore, customers that want or need these technologies in their enterprise stacks would first look to upgrade their networks as the natural first step in the process.
It's apparent that CommScope is barely putting its toes in the water when it comes to the long-term potential for the rollout of 5G and its main operating segment on the whole. Looking ahead, the company said it's also aggressively investing in its internal capacity to handle the expected future demand. This will be a key driver in turning those backlogged orders into profits for shareholders.
Fiber broadband rollout
A peripheral yet important tailwind in conjunction to harnessing to 5G is the roll out of broadband fiber connections to underserved and rural areas in the United States. This rollout is fully supported by the U.S government, of which billions of dollars in subsidies are being offered to companies like CommScope to produce fiber on home soil. The company received a $47 million investment to create fiber at its plant located in North Carolina, with U.S. Secretary of Commerce Gina Raimondo stating:
As we've seen, we can produce materials needed for broadband deployment right here in America. With today's announcement of a $47 million investment CommScope is demonstrating its commitment to our once in a generation infrastructure movement.
Investments such as these by the United States Department of Commerce have allowed it to develop technologies such as the HeliARC fiber optic cable, which are essentially smaller and lighter versions of previous versions. This in turn allows fiber networks to be deployed faster and have a lower cost of deployment.
Although fiber has been around for many years, there is still much more room to grow. S&P Global predicts that fiber penetration will reach a 62% market share of connected homes worldwide by 2025.
S&P Global
Interestingly, the North American segment has some of the lowest fiber adoption levels in the world. This is driven by the comparatively higher speeds of cable internet, as well as a previous lack of fiber connection targets set by the U.S Government.
S&P Global
However, these numbers are to change. Although cable internet in the United States can technically reach download speeds of 1 gbps (which is comparable to fiber), its upload speeds are slower. Fiber is symmetrical, offering both high upload and download speeds. Fiber is also a more efficient means of sending and receiving data, which means its more reliable, as well as less prone to slowdowns due to peak usage times. The advantage is therefore clear to remove the old copper coaxial cable connections and replace them with fiber if America wants a competitive internet infrastructure.
The White House seems to view it this way too, as President Joe Biden announced a $40 billion package last month to roll out fiber broadband to rural and underserved areas in the United States.
These trends mean that CommScope is in a great position which will be fully reflected in its financials moving forward.
Financials
One of the biggest concerns that investors have about CommScope are its margins and net income losses. However, CommScope has positive free cash flow. This is despite reporting a negative net income in FY2022. It was able to generate positive free cash flow due to the non-cash expenses and changes in working capital that increased its cash flow from operations and its capital expenditures that were lower than its operating cash flow.
A large part of the reason why its net income was positive can be chalked up to its depreciation and amortization (D&A) line item. This is not included in the free cash flow equation, but is used when calculating net income. D&A stood at $696.1 million in 2022.
CommScope had also a negative change in working capital of $287.7 million, which increased its operating cash flow. Finally, free cash flow is calculated as cash flow from operations minus capital expenditures. If a company's capital expenditures are lower than its operating cash flow, it can generate positive free cash flow even with negative net income. In 2022, CommScope's capital expenditures were $101.3 million, which were lower than its operating cash flow of $190 million, resulting in a positive free cash flow of $88.7 million.
Still, margin challenges persist for the company. Specifically for its operating and net profit margins. All are well beyond industry means when compared to its peer group.
One of the main reasons I'm bullish on CommScope is that this issue has already been addressed with its CommScope Next initiative. This is basically a restructuring plan to trim the fat off its business model and get its margins on par with its competitors. The plan was put into place at the start of 2021 under the leadership of CommScope's new CEO, Chuck Treadway. Delivering on such a transformation takes time, and we might not have enough quarters of financial data to say definitively whether this approach is working, or not.
In the earnings call, Treadway also pointed to the fact that much of the margin issues the company faces is from continued congestion in the global supply chain. The congestion has given the business limited room to negotiate on direct materials costs. Some good news is that the supply chain problems were said to be "loosening and moderating" by Treadway.
Getting margins under control therefore seems to be a core priority of the business, which is great news for investors. There's some evidence that these changes have already started to lead to material impacts. Although correlation is not causation, the NICS operating segment increased by $72 million in adjusted EBITDA thanks largely due to its cost initiatives led by CommScope NEXT.
CommScope's revenue has been on an upward trend over the past three years. In 2020, the company reported revenue of $8.4359 billion. This increased slightly in 2021 to $8.5867 billion, representing a growth of approximately 1.8%.
Author supplied
The growth was more pronounced in 2022, with the company reporting revenue of $9.2281 billion. This represents a year-over-year increase of approximately 7.5% from 2021.
This consistent growth in revenue suggests that CommScope has been successful in increasing its sales and generating higher income from its operations.
The more substantial growth in 2022 could be indicative of the company's strategies and initiatives, such as CommScope Next, beginning to bear additional fruit.
Furthermore, the company's operating expenses have decreased from $2.50 billion in 2020 to $2.34 billion in 2022, which is a positive sign as it indicates improved operational efficiency. All of this leads me to think that the company is headed in the right direction and will continue to do so.
Valuation
Here's what I feel is that juiciest part of the thesis. CommScope is undervalued compared with the median of its industry peers on all the main valuation ratios.
This could be because the market is not fully pricing in its future potential, or putting too much weight on its paper financials such as net income while free cash flow is in fact positive.
Its poor margins under previous leadership is undeniably a factor here too, but a revamp of its business model is already in the works. The company has plenty of cash on its books to help ride out its transformation, namely $398 million. It's also in a very healthy financial position despite its margin compression. It has a current ratio of 1.76 and a debt ratio of 0.81.
In terms of whether or not it's worth it to buy today? I'd say yes. The company is trading well below the 200-day SMA. On a recent historical basis, using the P/FCF ratio it's also undervalued. It traded for $9.21 on 06/30/2022 while its trailing twelve months cash flow per share was a negative $1.48. Today the share price is lower while also reporting a positive free cash flow last financial year.
Risks
Despite management's best efforts and focus to improve margins, we currently don't have enough data to say whether their approach is working or not. And since much of the stock's criticism can be chalked up to margin compression, its future as a potential investment remains uncertain.
The biggest risk is that the company's backlog and future growth catalysts don't matter if it can't convert these into earnings and a consistent FCF for investors.
Providing services like 5G and broadband is also becoming increasingly commodified. A long lasting competitive advantage for a company like CommScope may be difficult to successfully carve out. The competition in these industries is intense, and will surely become savage as the rollout continues.
Much of the company's future is then heavily dependent on management's ability to navigate it, more so than other types of companies. Although it has a depth of experience in navigating previous iterations of mobile and Wi-Fi networks, mistakes can and do happen. Buying the stock is as much about as buying into management's track record, competency and future projections. This then leaves much room for unsuccessful speculation on behalf of investors as well as those who are at the helm of CommScope.
Conclusion
In conclusion, CommScope, presents a compelling investment opportunity, particularly for those who believe in the potential of 5G and fiber broadband connectivity. The company's significant backlog in its Connectivity and Cable operating segment suggests strong customer demand and potential for growth. Despite the challenges faced in other segments, the company's global reach, innovative product portfolio, and strategic initiatives such as CommScope Next position it well to capitalize on the ongoing technological shifts in the industry.
While the stock has faced pressure due to operational challenges, the company's positive free cash flow and undervaluation compared to industry peers suggest significant investment potential. However, it's crucial for potential investors to monitor the company's performance and the execution of its strategies closely. For these reasons, I rate CommScope as a buy.
For further details see:
CommScope: Navigating 5G Market Trends For Growth