AGB 2023.9 - Amphenol Corp (APH)
Benefiting from Electrification of Everything
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“Now the underpinning of that strategy is really what I like to call the electronics revolution and what that means by revolution is electronics, creating new functionalities, creating new capabilities, new applications across really every aspect of society and around the world. In earthmoving equipment, in mining equipment, in data centers, in more devices that we hold in our hands and wear on our wrists, you have revolutions every day. And what revolution entails is unpredictable. You don't know when that next new design is going to come, that next new application, that next big hit that may come about. And so it's up to us to remain poised to capitalize on that regardless of where that revolution comes and you see here whether that's getting more efficient and cleaner, whether that's being more mobile, connected higher speeds, there's so many aspects of that electronics revolution and it's our job to enable it and we do that really across the broadest and most balanced array of markets in our industry.” – Chief Executive Officer, Richard Norwitt, at the 2019 Baird Global Industrial Conference
Amphenol is one of the leading designers and manufacturers of electronic connectors and sensors. The company started as a manufacturer of sockets for cathode ray tubes used in radios in the 1930s. Since then, the company has expanded to make connectors and components for many different types of applications across most industrial, auto, technology, communications, aerospace and military end markets. No industry vertical is greater than 25% of revenues and this diversification allows the company to gain expertise across different technologies and experience less volatility from the various market cycles.
Similar to a Roper, Amphenol operates a decentralized organizational structure. The company has 130 business units, each led by a general manager who has autonomy over almost every aspect of the business including R&D, engineering, sales, marketing, quality control, manufacturing, sourcing, and back-office functions like HR, finance and IT. Each of these business units even operate their own ERP system, which could be viewed as inefficient. But it works for Amphenol because these general managers have accountability for each of those decisions. This autonomy also allows the general managers to adjust quickly during sudden demand shifts in their end markets.
The company recently changed its reporting segments into three groups - Harsh Environment (25% of revenues), Communications Solutions (45%), and Interconnect and Sensor Systems (30%). With that change, Amphenol promoted three division presidents that each oversee a group of business units. The division presidents report to the CEO. The company jokes that the CEO and division presidents mainly act as an intermediary between the general managers that are doing the real work and shareholders.
The interconnect and sensor market was estimated to be $235B in 2022, implying Amphenol’s share at just 5.4%. Each industry vertical is different but in general most are fragmented. The top 20 companies can account for as much as 88% of a market such as automotive, but as little as 58% in aerospace & defense. Amphenol’s highest market share is in aerospace & defense at 34% but the company only commands 2% of the consumer and automotive verticals. A lot of this has to do with customer concentration, regulatory requirements, and industry wide competition. Certain verticals also require certification and once a company is considered a qualified supplier, they tend to stay as a supplier.
Looking at data from 2020, Amphenol leads across the industrial, aerospace & defense and telecom verticals. The company competes with public competitors like Aptiv, TE Connectivity and Luxshare Precision as well as private competitors like Molex, Yazaki and others.
Customers choose Amphenol vs. the competition because of its technology innovation, product quality and price. The company tries to work with customers to design value added products which require much more customization and longer lead times. Amphenol especially shows its value when customers need to make last minutes re-designs, which also require a new interconnect system. The company makes adjustments quickly (the company gave an example of a 5 day turn around on its 2Q 2021 earnings call) to accommodate the new designs.
Amphenol’s growth engine is fueled by both organic reinvestment and acquisitions. Over the past 10 years, organic revenue growth has averaged +7.1% and acquisitions have contributed +4.5%. This implies roughly a 60%/40% split. The company aims to achieve a 67%/33% split, so the last decade was relatively close to internal targets. We have to remember that organic revenue growth calculations can be overstated because starting in the 2nd year, growth of acquired companies is counted as organic. Given that Amphenol generally acquires much smaller companies, its superior distribution and manufacturing capabilities should naturally increase production and selling capabilities for many of the acquired assets. This is all to say that Amphenol’s organic revenue growth number is benefitted by its acquisition strategy.
Of Amphenol’s eight verticals, automotive has been one of its main growth areas over the past 10 years. A lot of Amphenol’s growth in this area can be attributed to the electrification and increased complexity of passenger and commercial vehicles. Over the years, luxury car manufacturers have increasingly loaded their cars with more options, which tend to have higher connector content. And lower-end car manufacturers have also adopted more of these features. The automotive vertical accounted for just 5% of revenues in 2008. This has increased to 21% in 2022.
Amphenol manages the company to operating margins targets because each business unit has a different gross margin profile and capital investment requirement. Acquisitions sometimes have a dilutive impact to margins and the company is mindful of that when setting targets, especially since the general managers make capital allocation decisions at the business unit level. The incremental margin target is 25% for organic revenue growth.
Why is it a good business?
As a leading provider of electronics connectors and sensors, Amphenol benefits from its customers’ switching costs. The company works closely with its customers to design leading products for new electronic applications. As a customer’s designs go into the production phase, it becomes more difficult for these customers to switch to another provider. The risk of failure is a high compared to the relatively small cost of the component vs. the final product. This plays to Amphenol’s strengths in quality control and quick on-time deliveries. This is especially true for certain verticals like aerospace & defense, industrial and auto where the cost of failure is not just about the potential financial losses.
Amphenol is highly integrated with its customers’ design process, often working as partners to buildout a new product. The company often moves a team of engineers onsite to a customer once awarded the contract to a project. These integrations make switching more difficult for customers over time, especially as both parties familiarize themselves with the process, systems and technologies required to bring a product to market. The use of customized components that require expertise also contribute to increasing switching costs.
While the company doesn’t benefit from significant scale economies at the business unit level, the company does benefit from its size at the corporate level. Remember that each business unit runs almost independently, allowing few cost synergies among business units. But the scale of the company does help with its M&A efforts. Potential acquisition targets know Amphenol to be an acquirer of choice. This matters more for sellers that want to stay on to manage the business. Some of Amphenol’s recent acquisitions have allowed the sellers to retain a small portion of the equity.
Diversification of the company’s end markets also benefits Amphenol. This helps dampen the volatility of the overall company’s growth rates and margins, since tailwinds and headwinds occur in different industries at different times. Compared to TE Connectivity and Sensata, Amphenol’s end market exposure is more evenly spread out, with no industry vertical accounting for more than 25% of revenues. Both Senata and TE Connectivity are much more dependent on the trends of the automotive industry.
Geographic diversification also helps the company to benefit from lower cost manufacturing. This allows the company to be price competitive in many regions and provide customers with lower lead times for its products. There is also the benefit of being less impacted by potential geopolitical risks since manufacturing is less concentrated to a specific region.
Returns on incremental capital?
Over the past 10 years, Amphenol has spent 23% of its capital on capex, 19% on R&D and 58% on acquisitions. Capex is mainly related to the company’s manufacturing capacity. Amphenol has a global manufacturing presence, which helps the company to be price competitive due to the lower manufacturing costs in many regions.
R&D is related to the development of new interconnect and sensor products. Amphenol aims to focus its R&D investments on products that can be used for similar applications across industry verticals. Remember that R&D efforts are still led by each business unit, so leveraging the R&D from one business unit to sell to another business unit’s customers is efficient. Amphenol aims to bring these new products to market to achieve significant sales in a 1-3 year period after launch.
M&A is the largest component of Amphenol’s capital allocation. Over the past decade, the company has spent over $6.4B in capital across 40+ acquisitions. Many of these acquisitions are smaller tuck-ins that average close to $50M in deal size. The company recognizes that the average deal size has to get larger over time for the acquisition engine to contribute to growth in the same way as it has in the past. The number of deals have remained relatively consistent over the past decade, ranging from 2-7/year on average.
Amphenol consistently improves the operations of its acquisition targets. The company reduces cost by leveraging its global supply chain and manufacturing capabilities. And Amphenol increases revenues with cross-selling opportunities with other business units. Acquired targets typically have low-teens operating margins and they are quickly brought up to company average in the first 6 to 12 months. The uplift in margins implies a reduction in the acquisition multiple, which improves the return on capital of acquisitions.
There have been a couple of large deals in Amphenol’s recent history. In 2021, the company acquired MTS, a leading supplier of precision sensors, test systems and motion simulators for $1.7B or 21X EBITDA. MTS’s sensor unit was complementary to Amphenol’s portfolio of Harsh Environment sensors. MTS sensors include position sensors that are used for a wide range of industrial applications, test sensors used in the auto and aerospace & defense industries, and industrial sensors for the heavy industrial and energy + power verticals.
MTS was the first public company that Amphenol acquired. The company quickly divested the test and simulation division to Illinois Tool Works for $750M. The sensor division is what Amphenol wanted, which was actually the smaller but more profitable business unit. Net of the divestiture, Amphenol paid $950M for the MTS sensor business, or 14x EBITDA. Assuming that the company improved MTS’ operating margins close to the corporate average of 20.5%, we get close to a high single digit EBITDA multiple.
The 2nd large acquisition was FCI Asia Pte, which Amphenol acquired in 2016 for $1.2B. FCI was a leading interconnect solution provider for the communications and wireless networks verticals. FCI was owned by private equity at the time, but it was reported that FCI had revenues of $600M and EBITDA of $120M, implying a purchase price of 10x EBITDA. Amphenol quickly brought FCI operating margins up to the company average in the first six months, implying an even lower acquisition multiple. FCI is based out of Singapore, which meant the company could use off-shore cash to acquire the business. This was just prior to the Tax Cuts and Jobs Act that made the tax differences of off-shore/on-shore cash less relevant.
We estimate that Amphenol has generated returns on incremental capital between 9%-21% over the past 5 years. The large acquisitions create some volatility in annual returns, due to the higher multiples paid vs. the smaller tuck-ins. Capex and R&D investments are fairly consistent averaging between 3%-4% of revenues for capex and 2%-3% for R&D.
Amphenol estimates that the global connector and sensor market was $245B in 2022, which implies the company’s market share to be 5.4%. Amphenol’s estimate of its TAM has increased +7.4% annually since 2014, when the first estimate was given. In 2014, the company’s market share was 4%. Amphenol increased its revenues annually by +11.3% since 2014, resulting in almost 4% of out performance vs. the market.
In each of its end market verticals, Amphenol is benefiting from the electrification of products. Over the past decade, most of the outsized growth has come from autos (adoption of EVs + more electronics in ICE vehicles) and industrial verticals (factory automation, alternative energy, commercial vehicles, etc). Looking ahead over the next decade, the end market vertical that may benefit the most from industry tailwinds is military/aerospace & defense.
Military accounts for just 9% of revenues, down from 12% in 2013. This is understandable because the U.S. defense budget peaked in 2010/2012 and trended lower until 2016. Amphenol’s exposure to the Department of Defense’s budget is mainly correlated to procurement and research & development, which together account for more than 1/3 of the total budget. This segment of the budget has historically grown faster than the remaining 2/3. The last procurement cycle started in 2016 and lasted until 2020. During that period, Amphenol’s revenues from the military vertical outpaced the market’s growth by 6% annually.
Amphenol could benefit the most from an increase in the DoD budget in the upcoming years since they are the market leader in this vertical at 34% market share. The company has more than double the share of #2 player, Johnson Electric at 15% share. TE Connectivity is the #3 player with 3% share. And because the aerospace & defense vertical tends to be highly regulated and have much longer product cycles, incumbent connector suppliers tend to retain or gain market share.
The recently signed Fiscal 2023 National Defense Authorization Act allotted $816B to the U.S. DoD. More than 1/3 of that budget was assigned to procurement, and many analysts are predicting that procurement will become a larger part of the budget in future years.
With a reinvestment rate between 60%-80% and a return on incremental capital between 9%-21%, we estimate that Amphenol has increased its intrinsic value between 7%-12% over the past 5 years. The large acquisitions put downward pressure on returns on capital but also increase the reinvestment rate, so the intrinsic value growth is relatively consistent. And because these acquisition are self-funded, the returns are relatively simple to calculate. Looking ahead, Amphenol should continue to make larger acquisitions so that they are meaningful to the company’s growth going forward.
What else is important?
Amphenol During Recessions
Similar to most component suppliers, Amphenol is not immune to economic downturns. Customers that cancel or delay new product launches and/or reduce production of existing products will lead to lower demand for connectors and sensors. But because Amphenol is more diversified among its end market verticals, down cycles in one industry doesn’t have as large of a negative impact. The general managers of each business unit act quickly to reduce costs to adjust to the new demand environment. And when demand resumes, the company is also quick to reinvest to capture that growth.
Going back to the 2008/2009 recession, Amphenol did have a pullback in customer demand but recovered quickly in 2010. Revenues of $2.8B in 2009 was only down -12.5% from 2008, which rebounded quickly to $3.6B (+28.5%) in 2010. Operating margins only came down a couple of percentage points in 2009 and also rebounded in 2010.
Connectors vs. Semiconductors
When studying connectors and sensors, one may consider that the market dynamics are similar to that of semiconductors. The similarities are that both connectors and semiconductors are critical to many products across industries and are usually designed purposely for specific end market applications. And that design process is usually in done in concert with the end customer so that the component can be customized specifically for the product.
The main differences are that the design and production of semiconductors is very capital intensive in terms of both R&D and capex. The manufacturing process of semiconductors is also very complex and require massive fabs to be able to produce them at a yield that is cost efficient. And because of this, many semiconductors are produced in just a handful of fabs around the world, usually in lower cost geographies. Amphenol’s products are manufactured around the world at the company’s 250+ facilities.
The main source of optionality for Amphenol will be through M&A. But even then, given that Amphenol is already diversified across geographies and end markets, any one acquisition will likely not move the needle much. Sometimes optionality for a company may be limited and long standing consistency is enough.
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