Investing in Aglets

“Love supersedes all armies.” – Dick Gregory

The market continues to benefit from positive investor enthusiasm fueled by a combination of factors:

• Strong corporate earnings performance for the first half of the year.
• A weaker dollar has made it easier for U.S. companies to sell their products overseas.
• U.S. wages have improved enough to encourage consumer spending.
• Interest rates remain low, providing continued sources of borrowing capital, and
• Earnings reports for the September quarter are expected to be positive.

On the policy front, the White House has placed the Healthcare initiative on the backburner to fully focus on tax reform which will be less likely to accentuate party divisions and, if approved, will benefit both large and small companies. RBC Capital Markets estimates that a drop in corporate tax rates from their current effective average rate of 27% down to 20% would add a proportional 7% to per share earnings. Smaller companies, which tend to pay a higher effective tax rate, would benefit even more from the tax cut.

With all of this good news, where can things go wrong?

There is a long list of possibilities. Tax reform can be as unsuccessful as Healthcare. Twitter bluster with North Korea can turn into real conflict. And corporate earnings could begin to slow. There is no way to handicap any of the possibilities or to predict when things may turn. But we do know for certain that the market does not always go up. And in the same way you would put your money behind your favorite athlete playing for your favorite professional sports team, we put our money behind the best companies with the best prospects for navigating whatever lies ahead. At Richie Capital Group, our investments typically fall into one of two categories: “Franchise Players” or “Orphans”. Our Franchise Players are industry leaders and market makers. These companies have wide moats to protect them from competitors and an opportunity set much larger than the market is giving the company credit for. The Orphans are often special situations that the market does not understand or the company may be going through a transformation where the end result is not yet clear. These Orphans tend to be priced at valuations so cheap that we can afford to buy shares and wait for the story to evolve and value to be created.

In all cases, we view our investments as part ownership in real companies with a view towards holding our investment for the longer term, ideally, more than 3 years. This longer term thinking forces us to assess the near and longer term prospects for the company while freeing us from concerns about the ups and downs of the market.

One of our clear Franchise Players is a company called Amphenol (APH). We originally purchased our shares in October 2013 for $41/share.

You have probably heard the urban legend about the guy who invented those little plastic caps on the end of your shoelaces. The legend goes that he created a business around the simple, yet boring, product and became famously wealthy. Those caps are called “aglets”. A bit of Googling gives credit to an English inventor named Harvey Kennedy[1], and he is said to have earned $2.5 million from the product back in the 1790s. That is $64.8 million in 2017 dollars!

Amphenol is of a similar mold in that their products are relatively simple (and boring), but immensely valuable to their end customers. Amphenol is a leading designer and manufacturer of electrical, electronic, and fiber optic connectors and interconnect systems and the world’s second-largest producer of coaxial cables for cable TV markets. A connector is a device that connects and disconnects wires or fibers to expand or connect a circuit among electronic devices or subsystems.

Amphenol’s typical products look like this:

You have more than likely come across one of these and never thought twice about it, the same for the aglets on your shoelaces. The company operates more than 100 manufacturing facilities worldwide and serves customers in the communications, aerospace/military, industrial, and automotive markets. Their connectors and cables are immensely critical for ensuring that power is transmitted throughout nearly every application that contains an electronic circuit. Everything from DVRs and microwaves to power grids, drilling rigs and medical catheters; each of these contain a few, if not hundreds of these connectors.

Over the past few years, there has been a proliferation of electronics in multiple end markets including automotive, medical, industrial, and aerospace applications. If you think about the complexity of the navigation and entertainment systems that have evolved in cars (and airplanes), you can begin to imagine the need for increased connector content in these products. Amphenol serves customers in all of these industries which helps shield them from fluctuations in the global economy.  

But there is more to the story than just a simple product. The connector industry remains fragmented and is quickly consolidating, creating opportunities for the strongest players. The top ten connector companies own approximately 58% of market share[2], while the remaining share is divided among more than 2,000 small manufacturers that operate regionally. This represents an attractive feeding ground for Amphenol to acquire these smaller companies, secure their customer relationships, reduce costs and sell products through their low cost supply chain. These acquisitions also provide Amphenol with additional product offerings and open new markets in new geographies. Over the past decade, Amphenol has completed more than 50 acquisitions, which have contributed an average of 4% to annual revenue growth. Amphenol’s management team has a track record of successfully completing acquisitions, extracting synergies, and successfully integrating new client relationships. And they have accomplished this without overburdening the business with debt, which is a headwind for most serial acquirers. Amphenol’s leverage currently stands at ~2.2x EBITDA[3]. For comparison, Apple’s leverage is in the 1.5x EBITDA range, and Amphenol’s closest competitor has 3.0x EBITDA leverage. We would only be concerned if Amphenol’s debt level exceeded the 4.0x EBTIDA range. We will continue to monitor their balance sheet for any signs of stress. In the meantime, there is plenty of liquidity and significant free cash flow to sustain the business.

There are risks to any investment. And in the case of Amphenol, we view the biggest risks as their exposure to the cyclicality of the automotive sector and fluctuations in commodity prices (e.g. gold, silver and copper), which are critical inputs to connector products. A jump in commodity prices would directly impact margins and cash flow.

Looking ahead, we expect Amphenol to continue to outgrow their markets and gain share through a combination of product innovation and small tuck-in acquisitions. 58% of the market is owned by what could be considered “mom and pop” shops that will disappear over time as the market consolidates to what we expect to be a few dozen manufacturers. In this business, relationships matter, but scale is even more important. If you can produce better products more cost effectively, then you can win the game. Amphenol would also benefit significantly from the previously mentioned tax reform or the ability to repatriate their $1.4 Billion in overseas cash through a tax holiday.

We purchased our shares for ~$41/share at a Price/Earnings multiple of 21x earnings. As of this writing, our shares are trading at $86, more than doubling our original investment at a rate of return of 21%+ per year. Shares are now trading at a 28.7x P/E multiple. Certainly more expensive than when we purchased them, but in line with industry peers and not unreasonable for a company that increased earnings per share by over 50% and increased free cash flow by almost 40% over the same time frame. 

When would we sell?

We see a long runway for our investment, but signs that would give us pause include:

• Key management changes – The CEO, Richard Norwitt, is still very young for a CEO at 47 and has been President and CEO since 2007 and 2009 respectively. His team is responsible for the successful growth strategy.
• Significant increase in leverage – Or a corresponding decrease in cash flow.
• Slowdown in industry consolidation – To this point, Amphenol’s acquisition strategy has been driven by interest in specific markets, customers and geographies as opposed to acquisitions driven purely for scale, which often signals that the market is reaching maturation.

Until then, we will continue to watch our franchise player grow!

The Dick Gregory quote had nothing to do with anything discussed in this post but, under the circumstances, it seemed very appropriate…

 

[1] http://www.huffingtonpost.com/entry/what-is-an-aglet_us_576838a6e4b015db1bca2a6d

[2] RBC Capital Markets estimates

[3] EBITDA = Earnings before Interest, Taxes, Depreciation and Amortization