TE Connectivity Stock: Strengthening Fundamentals, Higher Multiples Justify Re-Rating

Investment update

Following my November ’22 publication on TE Connectivity Ltd. (NYSE:NYSE:TEL) the stock is +19% with ~1% of dividend yield realized by investors. My view on TEL hadn’t changed from my original thesis on the company. Economics are superb. The market share is huge. Customer advantages in its brand and networks. Highly cash-generative with a long stream of dividend growth. The perks are all there. However, I’m really looking for long-term compounders which have 1) the propensity to reinvest cash flows at an advantage to compound earnings [ideally >12%], and 2) are priced such that asymmetrical risk/reward is on offer.

Figure 1.

Based on my latest examination of the company’s updates my sentiment has gradually drifted. A few things have changed– 1) it’s a more difficult market, where true fundamentals are being bought [with the exception of tech/AI], which makes TEL shine out, 2) TE’s advantages are beginning to shine [high post-tax margins, stable + high ROIC’s on such a large capital base, ~$2Bn in FCF to play with each 12 months], 3) its fundamentals are strengthening on this, and 4) valuations now supportive to ~$172/share.

I’d stress this isn’t based on a newfound wave of value-creation in TE’s investment runway – rather, my view is the market might be underappreciating its economic strengths mentioned above and certain industry tailwinds in electric vehicles (“EVs”). On my FY’24–’26E numbers [see: Appendix 1], that bake in <1% sales growth, ~21% pre-tax margins, and ~$0.92 of investment required to produce $1 of incremental sales, so the valuation is ~17x FY’24–’26E NOPAT, supporting a revised buy rating.

Reasons behind updated thesis

Several investment facts have updated since my last coverage. First, the repricing from FY’23 lows was 1) earnings driven [EBIT is +$0.15Bn since Q3 ’23] and 2) multiples expansion [EV/EBIT is +1.4x in the same time – see: Figure 2]. Investors value the growth more highly and TE deserves to trade ~17x in my view [this is in line with 3yr averages anyway]. Fundamentals are strengthening and this can’t be overlooked.

Figure 2.

In addition to the market’s view:

• I’d remind readers this is a firm running on ~8% trailing ‘owner earnings’ yield, which is normal [yields were ~12% across ’22–’23]. This is FCF/share + all dividends + buybacks paid up. You’re getting this c.8% running yield as TE throws off ~$2-$3Bn in FCF every rolling 12 months which is superb. This 1) funds dividend growth, 2) allows for extensive buybacks, and 3) is opportunistic for investment opportunities. Moreover, the stock is priced ~12.5x these owner earnings today.
• Post-tax margins are also +60bps since FY’21 with 0.04x higher capital turns, adding ~100bps to ROICs since then. This is relevant as its higher ROICs and economic profits (“EPs”) above our 12% hurdle rate appear relevant. Investors respond to this uptick, re-rating the stock from 1.8x EV/IC to ~2.2x with 2 quarters of EP (Figure 4). So we have 1) higher returns on invested assets, driven by 2) more economic leverage form this capital, resulting in 3) a highly favourable setup that looks to ensure >$2Bn in FCF each 12 months. To me this is reasonably attractive and investors may not be appreciating this at this stage.

Figure 3.

Figure 4.

Q2 earnings exhibit stronger runway

Several takeouts from its Q2 numbers corroborate a stronger runway of business ahead:

1. It booked quarterly sales of $3.97Bn (-460bps YoY), but given its high-quality mode left the quarter with record OCF (+30% YoY) and ~$1.1Bn in quarterly FCF – basically 100% conversion. Management sees ~500bps adj. EPS growth to ~$1.85/share in Q3 [below consensus] but Wall Street sees ~10-11% bottom-line growth from FY’24–’26E.
2. It left Q2 with a book-to-bill >1x [this is desired] with sequential growth in each segment. Orders were +6% sequentially to $4Bn, the split was transportation flat, industrials +7% and communications +30% [thanks to AI/data centre momentum]. Critically, the China transport business was “double-digits” per management, but the segment was flat from US + EU weakness.
3. EV demand is also a tailwind, with the CEO’s comments on the Q2 call cementing in this point (emphasis added):

“EV and hybrid production are both expected to increase by 24% this fiscal year, and we’ll continue to see declines in internal combustion engine production…

…The increase in the electrified powertrain autos will be driven by increased production in Asia, which is our largest sales region and where our auto team has a strong position. And just to give you a reminder, our content per vehicle is 1.5x higher on a hybrid, and 2x higher on a full electric EV versus internal combustion platforms. We have established a global leadership position across all vehicle platforms at all major OEMs and start ups and continue to expect long-term content growth above production of 4 to 6 points.”

These factors can’t be overlooked and in my view TE is well positioned to benefit from this demand. “AI-related” revenues are expected to 2x next year to $400mm and management expects ~$1Bn in sales moving forward with 20% operating margins.

Potentially undervalued

TE is valued ~2.2x EV/IC and ~17x NOPAT. This range is fair and is where the market values it since FY’21 [give or take a few points with ST market cycles]. Management’s investments have created >$11 for every $1 put back into the business – so my point on investors discounting its FCF less + valuing its earnings higher is cemented here. Why the uptick? In my view 1) the +100bps in ROICs since FY’21, and 2) the total market’s outlook in FY’22 was bleak, allowing for the expansion.

Figure 5.

• At ~17x NOPAT I get to ~$172/share implied market value on my FY’24 numbers [see: Appendix 1] – but the risk is in a small contraction to ~16x which says it is worth ~$157/share, where it trades today. The question is, how likely is a contraction? One way to assess this is to create a commodity multiple that assumes no value-add or destruction [in our eyes this is a firm earning ~12% ROIC + the multiple = 8.3x]. Analyzing 1) the recent growth in its ROICs, 2) margin + capital turnover growth, and 3) stable FCFs with >95% conversion, my view is the value of its future growth opportunities is worth a ~0.3x multiple. That’s perfectly acceptable because I don’t expect TE to grow anyway – just to throw off piles of cash, and incrementally ratchet higher at the same c.17x multiple. In that vein, the propensity for contraction <17x is low in my view.

Figure 6.

• Further these are reasonably conservative valuations that are in synch with 3yr history + consistent with this range – they also imply ~2.4x EV/IC fading down to ~2.3x by FY’26E. The hurdle is not high to trade at ~$170/share with my forward assumptions and the propensity for contraction is low in my opinion, as mentioned earlier, leading me to believe the market will appreciate TEL at ~17x NOPAT in FY’24. This is ~10% upside from current rage. Including dividend at the forecast yield of ~1-2% this is ~11-12% total return which appears fair in this name.

Figure 7.

Risks

Downside risks are 1) the major risk is contraction below 16x NOPAT which suggests TEL is fairly valued today, 2) <10% earnings growth will see this happen in my view, 3) major selloff in the large indices due to either harsher inflation data, unforeseen rate hikes, or GDP slowdowns. These are negative to corporate earnings and could see situations (1) and (2) play out.

In short

I’ve revised my rating on TEL to a buy on valuation given 1) stronger fundamentals, 2) excellent cash productivity, 3) improving ROICs. These factors corroborate a more valuable company, which the market has begun to realize. My view is that TEL is worth ~$172/share or ~17x my FY’24 NOPAT estimates. Net-net, revise to buy.

Appendix 1.