2024-01-16 15:50:35 ET
Summary
- My dividend growth portfolio focuses on a select few companies. The watchlist plays a crucial role in guiding my investment decisions.
- I recently added Amphenol Corporation to my watchlist due to its strong position in the industrial sector.
- Amphenol Corporation, a leading global player in electronic components, follows a strategy emphasizing market diversification, technology solutions, and global expansion.
- Despite a modest dividend yield, Amphenol Corporation's stellar stock performance, impressive growth rates, and efficient operations make it a compelling long-term investment.
Introduction
As most of my readers will know, I try to keep less than 25 companies in my dividend growth portfolio. While the number of stocks that I believe make good investments is far bigger than that, I like to keep my company count low, as I prefer to go "big" into a few names instead of having low exposure in countless companies.
Hence, my watchlist is one of the most important tools that I use to make investment decisions, as it includes all companies that I believe make good long-term investments.
Once the opportunity arises, I add new positions from that list.
With that said, I just added a new company to my watchlist. A company that operates in a sector that already accounts for more than 50% of my net worth: industrials.
That company is Amphenol Corporation ( APH ) , a $58 billion market cap giant located in Wallingford, Connecticut.
With a 0.9% dividend yield, the company is somewhat of an outlier on my watchlist. However, its low dividend yield comes with high dividend growth and a business model that makes the APH ticker a fantastic wealth compounder.
In this article, I'll walk you through the company and explain why I'm looking to make APH a core position in my portfolio if I get the chance on a potential market correction.
So, let's dive into the details!
A Fantastic Industrial Compounder
Although I have more than 50% industrial exposure, most of it is concentrated in aerospace & defense, machinery, and transportation.
I am not exposed to the electronic components industry, at least not directly.
You probably already guessed it, but that's the industry Amphenol operates in.
Founded in 1932, Amphenol is one of the leading global entities in designing, manufacturing, and marketing electrical, electronic, and fiber optic connectors.
The company's diverse product portfolio also includes antennas, sensors, and coaxial cables.
In 2022, the estimated worldwide sales for interconnect and sensor-related products reached approximately $235 billion, which is a massive total addressable market, or TAM.
In order to effectively service a highly fragmented market that includes industrial, automotive, IT, aerospace, defense, broadband, and mobile network customers, the company operates three business segments.
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Communications Solutions (45% of 2022 Net Sales):
This segment includes a broad range of connector and interconnect systems, including antennas.
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Interconnect and Sensor Systems (30%):
In this segment, the company focuses on designing, manufacturing, and marketing a large portfolio of sensors, sensor-based systems, connectors, and value-added interconnect systems.
- Harsh Environment Solutions (25%):
In this segment, the company designs, manufactures, and markets ruggedized interconnect products.
Like most compounders, Amphenol has a strategy focused on market diversification, development of high-technology solutions, global expansion, cost control, strategic acquisitions, and supporting collaborative, entrepreneurial management.
Or, to put it differently, the company aims to maintain a portfolio of next-gen solutions to support demand. This portfolio supports free cash flow, or FCF, used to acquire new companies, which are then integrated into its business.
I like to compare these companies to someone (successfully) playing Monopoly.
While Monopoly includes a certain degree of luck, once players have a decent portfolio of assets, it's much easier to win, as existing assets fund new investments, accelerating potential income.
Looking at the company's long-term goals, we see that it has a clear hierarchy:
- Making sure that its existing sales portfolio shows outperforming growth rates.
- Growing margins to boost its bottom line.
- Generate strong free cash flow used for reinvestment.
As a result, over the past ten years, the company has grown its revenues by 10% per year. Higher margins paved the way for 12% annual compounding earnings per share growth.
This paved the way for a 20-year stock price CAGR of 18%, which allowed the company to outperform most growth stocks.
Going back to January 2014, APH shares have returned 378%, beating the stellar 215% return of the S&P 500 (SP500) by a wide margin. Industrials returned just 164%.
These returns include its dividend.
The APH Dividend
On top of steady growth, the company has a very healthy balance sheet . This year (2024), it is expected to end up with $2.3 billion in net debt, down from $2.6 billion in 2023E.
This translates to a 0.7x net debt ratio, which is very low. It has a BBB+ credit rating, which is one step below the A range.
As a result, the company does not have to prioritize its balance sheet when it makes capital spending decisions.
Unfortunately, for income-focused investors, the dividend isn't a big priority of the company.
The company is expected to generate $2.0 billion in free cash flow this year.
Compared to its $58 billion market cap, this translates to a 3.4% free cash flow yield, meaning that it could pay a 3.4% dividend after servicing its CapEx needs.
However, after hiking its dividend by 4.8% on October 25, it pays a $0.22 per share per quarter dividend, which translates to a yield of 0.9%.
The five-year dividend CAGR is 14.1%, which is very high. The dividend has been hiked for 12 consecutive years .
This dividend is protected by a 27% cash payout ratio, as the main focus is on acquired growth. After all, that's how the company is generating strong long-term value.
- In 2022, the company paid dividends worth $477 million and bought companies worth $288 million (net of cash acquired).
- In 2021, the company spent roughly $350 million on dividends (not the elevated dividend growth between 2022 and 2021) and acquired companies worth $2.2 billion net of cash acquired.
While APH may very well turn into a high-yield play at some point in the future, for now, the focus is on acquired growth.
Also, and this is very important, the main reason why its yield is low is its massive stock price performance. If the stock hadn't done so well in the past two decades, the yield would be much higher.
This shows that accepting a low yield is often not a bad move, especially if it's backed by a powerful business portfolio.
Recent Events Show Strength Amid Economic Weakness
Amphenol shares are up 20% over the past 12 months, excluding dividends.
That's a mighty performance, considering that industrial demand is not great.
The chart below compares the leading ISM Manufacturing Index (black line) to the distance (in %) APH shares are trading below their all-time high. As we can clearly see, lower economic expectations tend to be a drag on APH's shares, which creates buying opportunities.
The reason why the market doesn't care about this yet is the strong financial performance of APH - relatively strong, I should say.
In the third quarter of 2023 , total sales reached $3.2 billion, reflecting a 3% decrease in U.S. dollars and local currencies compared to the same period in 2022.
Organically, sales experienced a 5% decline. However, sequential sales showed a positive trend, increasing by 5% in U.S. dollars, local currencies, and organically.
Orders came in at $3.2 billion, which is unchanged compared to the priory-ear level. The book-to-bill ratio was 0.99x, which means that new orders were roughly in line with finished work.
While economic pressure weakened sales a bit, the company's operations were highly efficient. Operating cash flow in the third quarter reached $618 million, equivalent to 128% of adjusted net income.
Free cash flow came in at $544 million, representing 112% of adjusted net income, which indicates high-quality earnings.
Moreover, profitability remained strong in the quarter, with adjusted operating margins at 20.8%. This was only a marginal decrease of 20 basis points from the prior year.
Sequentially, the operating margins improved by 40 basis points, which was reflected in its earnings per share numbers.
Adjusted diluted EPS for the quarter was reported at $0.78, a modest 3% decline from the prior year but a robust 8% increase on a sequential basis.
During its Q3 earnings call , the company emphasized its acquisition strategy, having closed three acquisitions since the 2Q23 earnings call: Connor Manufacturing, Q Microwave, and XMA Corporation
Another acquisition, PCTEL, was under a definitive agreement, expected to be finalized by early 2024.
Speaking of its earnings call, the company also acknowledged the uncertain economic environment. Assuming market conditions do not worsen significantly and with constant exchange rates, the fourth-quarter outlook predicted sales in the range of $3.09 billion to $3.15 billion, with adjusted diluted EPS in the range of $0.75 to $0.77.
This would translate to a sales decline of 3% to 5% and an adjusted diluted EPS decline of 1% to 4% compared to the prior year.
Speaking of its earnings, on January 24, the company will report its earnings before the market opens.
Analysts are looking for $0.77 in EPS, which is based on six estimates , including one upgrade over the past four weeks (zero downgrades).
The company has never missed EPS estimates over the past two years.
Nasdaq (APH Earnings Estimates)
I believe that during the next earnings call, the company will comment on new economic developments. I also believe that it will report more demand weakness yet strong results in certain areas like automotive and aviation, which both benefit from post-pandemic tailwinds.
Valuation
Using the data in the chart below:
- APH is expected to see a 2% EPS contraction in 2023.
- 2024 is expected to see 10% EPS growth, followed by 14% growth in 2025 and 20% growth in 2026 (based on just one analyst).
- APH is currently trading at a blended P/E ratio of 32.6x. Its five-year normalized valuation is 29.4x, which I believe fits its growth profile.
- Technically speaking, the mix of its dividend, fair valuation, and expected EPS growth trajectory indicates 11.6% annual returns.
However, while I will give the stock a Buy rating, I am hunting for a correction.
Considering the projected economic weakness according to the ISM index and the market's pricing in of six rate cuts for 2024, the risk/reward ratio for my strategy is currently unfavorable.
This also answers the question of what the biggest risks may be. I believe that cyclical risks are the biggest potential headwinds.
The second-biggest risk seems to be its ability to acquire companies and integrate them into its business. Creating synergies is tough, but APH has shown that it is more than capable of getting the job done.
Over the next few quarters, I hope to move APH from my watchlist into my portfolio, as I am extremely excited about the future of this well-diversified industrial compounder.
Takeaway
Despite its 0.9% dividend yield, Amphenol Corporation stands out as a fantastic wealth compounder in the electronic components industry.
With a clear focus on market diversification, technology solutions, and global expansion, APH boasts a robust business model.
Over the past decade, it has demonstrated impressive growth, achieving a 20-year stock price CAGR of 18%.
While the low dividend yield may raise eyebrows, the company's stellar stock performance validates the move of prioritizing business growth over immediate yield.
As economic uncertainties loom, I anticipate potential buying opportunities and aim to transition APH from my watchlist to a core portfolio position.
For further details see:
Meet Amphenol, The New Super Compounder On My Watchlist