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Financial Analysis of Amphenol

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Financial Analysis of Amphenol - February 18th, 2011

Founded in 1932 and headquartered in Connecticut, U.S., Amphenol Corporation (APH) designs and manufactures connectors and interconnect systems that are used primarily to conduct electrical and optical signals for a wide range of sophisticated electronic applications. The company is one of the leaders in developing interconnect products for factory automation, machine tools, instrumentation, and medical systems. Amphenol Corporation competes in two business segments: Interconnect Products & Assemblies and Cable Products.

Interconnect Products & Assemblies. This business is the core of Amphenol, accounting for 89% of 2006 revenues. Interconnect products include connectors, which when attached to an electronic or fiber optic cable, a printed circuit board or other device, facilitate electronic or fiber optic transmissions. Interconnect assemblies generally consist of a system of cable and connectors for linking electronic and fiber optic equipment. The company produces a broad range of products catering to wireless infrastructure, mobile devices, computers and data storage, automotive, industrial, military and aerospace end-markets.

Cable Products. This business, which accounts for 11% of 2006 revenues, designs, manufactures, and markets coaxial cable primarily for use in the broadband cable television network. The company has also developed a broad line of radio frequency connectors for coaxial cable and fiber optic-interconnect components for full service cable television/telecommunication networks.

There are several positive factors impacting Amphenol including favorable conditions prevailing in the Interconnect Products business. The company's top-line growth is benefiting from improved end-market demand, new product rollouts, and market share gains.

Mobile products and infrastructure and the Datacom end markets offer the highest growth potential followed by improving military/aerospace and automotive markets:

We remain optimistic about Amphenol's long-term growth prospects in the mobile devices business.

Demand for mobile phones remains strong. Third quarter 2007 sales increased 30% on a year-over-year (y-o-y) basis. We are forecasting a 20% y-o-y sales growth in FY07. This is due to the successful launch of product introductions related to new cell phone models, as well as new design wins for new technology products. Obviously, the design wins and its partnership with top suppliers (offering the best-selling models) bode well for APH's continued penetration in the mobile phone market in 2007. Beyond mobile phones, the company continues to expand the use of its products into fast growing sub-markets, such as PDAs, laptops, and desktop computers. Whenever a company expands the use of its product into new markets, the potential for large revenue gains exists.

Even in the mobile infrastructure business, third quarter sales increased 8% on a y-o-y basis. We expect sales to grow further amid continuing subscriber growth, especially in emerging markets such as India, South America, Africa and others increasing data and multi-media traffic, which will require new installations and equipment and a shift to new IP mobile networks.

Datacom and Information Technology market is another driver of Amphenol's sales growth amid strong demand, increasing roll out of next generation interconnect technology products and solutions, and new customer wins geographically. This market now represents the largest market served by APH accounting for about 23% of total third quarter sales.

Apart from these specific end-markets, the military/aerospace and industrial markets also offer growth potential. The military/aerospace division's third quarter sales rose by a strong 40% amid continued rebound in business following the flood in Sydney. Management stated that the FY07 growth story rests on commercial aerospace complementing the existing growth in U.S. defense spending. On the call, management noted the growing opportunities in the commercial aircraft business and stated the 6-month delay of Boeing's 787 Dreamliner will have no material impact on operations. Amphenol plans to launch several new platforms related to defense programs, which should lead to additional order flow down the road. The acceleration in commercial aircraft orders remains important to APH's overall growth rate, since the military/aerospace market represented about 19% of sales in the current quarter. Hence, the rise in U.S. defense spending bodes well for future growth. The Industrial division also continues to perform well reporting a 9% y-o-y increase in Q307 sales, amid sustained growth in medical instrumentation, rail and new power applications, and oil and gas exploration markets. The company's more sophisticated technology in these areas is expected to generate market share gains over smaller and technologically less-advanced companies. These industrial markets require the sophisticated solutions that APH offers.

Even in the automotive market, we were very pleased with sales growth, which exceeded our expectations for the fourth straight quarter. Third quarter 2007 revenue increased 29% on better uptake of new interconnect products designed for safety devices as well as the inclusion of new electronics in lower-end cars (where APH products are found). The company expects further growth in the European market, where most of the automotive business resides. We are pleased to hear that the company remains committed to being a niche player seeking higher margins on the safety side, rather than growing the overall business--most of which is commodity-priced. Essentially, Amphenol did a good job of investing resources into high-growth markets. This factor helps to explain APH's industry leading margins.

Positive trends for Cable:

Outside the strength in the Interconnect Products segment, Amphenol's Cable Products business is being positively impacted by increased capital spending by cable TV operators, price increases, and new product introductions. During the third quarter of 2007, Cable Product sales grew 6.6% to $74.5 million from $69.9 million a year ago. Given the strong growth of new subscribers for broadband services, we expect cable operators to continue network upgrades necessary to provide voice, data, and streaming video for its cable television viewers.

Cable margins on the mend, with more improvement expected in the fourth quarter of FY07:

On a year-over-year basis, third quarter 2007 cable operating margins increased 30 basis points to 12.7%. While APH has done a good job in offsetting the persistent rise in material and freight-related costs with price hikes, the company had to encounter a sharp rise in aluminum prices in the last couple of quarters. Fortunately, we believe the global economy is in the process of slowing down and commodity & energy prices will ease in the fourth quarter of FY07. Assuming that the company manages the price relationship between suppliers and customers favorably and continues to sell a greater mix of higher-margin specialty products, we expect operating margins of 12.9% by the fourth quarter of 2007.

Amphenol has industry leading margins:

Amphenol's company-wide margins are benefiting from higher volumes, price hikes, ongoing development of new higher-margin products, increasing contribution from the TCS acquisition, and cost-reduction initiatives. The Interconnect segment s (largest segment) third quarter margins increased 150 basis points (bps) y-o-y and 20 bps sequentially to 21.9%, benefiting from increased sales, growth and further introduction of higher-margin products, ongoing cost control efforts, and higher TCS margins. On the cost front, while productivity improvements and shifting manufacturing and sourcing to Asia explains part of the recent expansion, management deserves partial credit for boosting operating margins through its reduction of overhead costs. During the third quarter of 2007, APH reported a 60 basis point y-o-y decline in SG&A expenses as a percentage of sales to 13.1% from 13.7% in the comparable quarter of FY06, and a 30 bps decline sequentially. Given our expectation for labor cost reduction as plant expansion occurs in Asia rather than in North America, we project fourth FY07 SG&A expenses to sales ratio to decline another 10 basis points to 13.0%. Overall, company-wide third quarter 2007 operating margin expanded 150 basis points y-o-y and 10 bps sequentially to 19.5%. Further, APH is also investing in the development of new high-margin products for the wireless infrastructure, mobile devices, and the IT and Datacom end-markets all of which are exhibiting extremely positive demand trends.

Acquisition of Teradyne's Connection Systems provides upside to our 2007 EPS forecast:

In December 2005, APH purchased Teradyne's Connection Systems (TCS) for approximately $390 million in cash. This acquisition created the third largest interconnect company in the world. Amphenol seeks to drive sales and earnings growth by exposing TCS's leading high-speed communication products to a broader customer base and low cost manufacturing and materials sourcing. Apart from providing cost-savings, TCS is also a growth business. When APH bought the business, revenue was estimated at $84 million and today it stands at over $100 million. With large investments geared towards new product development and the ability of TCS to leverage its association with APH, we are growing increasingly optimistic of our double-digit, sales growth forecast for 2007 and beyond.

The margin expansion in the TCS segment is also quite impressive. When APH took over TCS, margins were a paltry 7.5%. Through volume gains, sourcing to Asia, cross-selling TCS product to existing APH customers and vice versa, increasing sales of value added products (instead of commoditized products),

and rising demand for a complete interconnect system architecture, the company was able to boost TCS margins to 16% in the third quarter of FY06. Management stated that TCS margins increased this quarter, but failed to provide an exact figure. However, the company did say it expects TCS margins to converge with interconnect margins by FY07. With interconnect margins currently at 21.9% this implies a very large margin expansion this year of nearly 500 basis points. We are still being conservative in calling for a modest 300 basis point margins increase to 19% in FY07 and 21% by FY08. This is due to synergy-related volume gains between TCS and Amphenol, a greater percentage of sourcing to low cost regions (80%-85% in the next couple of years versus 70% currently), increasing sales of value-added product (instead of commoditized products) such as in automotive, and the exit from low-margin businesses.

Given the strength across its entire end markets anticipated over the next couple of quarters, the prospects for further sales and cost synergies from TCS, and the margin recovery in the Cable segment, we reiterate our Buy recommendation on shares of APH and increase our target price to $49.00 per share.
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