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Equipped to Succeed: Three Electronic Equipment Stocks for Your Portfolio
Posted by: Damian Illia (IP Logged)
Date: September 12, 2013 10:57AM

In the electronics equipment industry, big-cap companies enjoy considerable scale advantages, not only related to lower costs, but also to the availability of funds to remain innovative. Either diversified or specialized, successful firms in this segment usually rely on high switching costs and high-quality products that allow them to charge substantial price premiums to their clients. In this article I will look into TE Connectivity (TEL), Emerson Electric (EMR) and Ametek (AME) in order to find out if they stand as good long-term investment opportunities.

Niche Businesses and Price Premiums

Ametek is an electronic instruments and electromechanical products manufacturer that focuses on niche businesses. The firm holds a wide product portfolio that includes monitoring, testing, calibration and display devices, as well as air-moving electric motors. By staying innovative, the company can charge considerable premiums for its products. This has helped it keep its margins above most of its peers´ (currently, its operating margin stands at 22.6%, versus the 10.7% industry average) and continuous top-line growth (EPS grew by almost 20% in average over the last five years).

The firm's main growth strategy over the past years has relied on acquisitions. In order to further diversify its operations, Ametek usually purchases niche businesses – which either lead their market segments or manufacture differentiated products that can be sold at substantial price premiums – [size=13px; ] for under $100 million. This way, it spreads acquisition and integration risks among several small companies. The firm's management has certainly proven successful in expanding its base of niche businesses and moving away from cost-focused businesses, thus making me feel confident about future acquisitions.[/size]

Going forward, its “robust pipeline of acquisitions should boost top-line growth even through a recessionary environment, and the firm's diversification across end markets mutes the cyclicality that otherwise would be problematic” (Morningstar).

Although Ametek´s stock trades slightly above industry average valuations, analysts expect it to deliver EPS growth rates considerably above those of its peers over the next five years. Holding a wide niche businesses portfolio which allows it to charge high premiums for its products; benefiting from operating in markets with substantial switching costs and high barriers to entry; offering great international exposure (especially to emerging economies like Russia, China, and the Middle Eastern countries) and a management with an impressive track record; and even paying out dividends, this is certainly a stock to buy and hold. Several renowned investors seem to think this way too: Jim Simons (Renaissance Technologies LLC), Joel Greenblat (Gotham Capital), and Ray Dalio (Bridgewater Associates) have recently started positions in the company.

Wise Connections

TE Connectivity is the largest connector producer in the world and a leading manufacturer of other various electronic components. Formerly known as Tyco Electronics, this $21 billion company has been undergoing a serious restructuring over the last few years. It now offers its clients the broadest portfolio in the market, with over 500,000 products. This characteristic has helped the firm hold a leading position in almost every segment where it competes, from the computing to the auto industries – [size=13px; ]especially within consumer markets.[/size]

Profitability doesn’t seem to be an issue for TE. The company usually retrieves margins above industry averages, on the back of its low cost structure (supported by producing in low-labor-cost countries) and its considerable pricing power (given the low prices of its products and the willingness of its clients to pay a premium for quality goods).

After divesting underperforming segments and acquiring specialized companies that have proven to increase synergies, the firm seems poised to deliver strong growth figures over the upcoming years. Moreover, the restructuring plan started some years ago, and still on track, should help it widen its margins and returns.

Going forward, I expect TE to benefit not only from its competitive advantages, mainly related to its scale and wide product offering, but also from secular trends, including the expanding use of electronics worldwide and the integration of electronic pieces to products that didn’t use them before (like cars).

Even though Jim Simons recently sold out, I would opt to follow other investment gurus like Seven Cohen, at SAC Capital Advisors, Joel Greenblatt, at Gotham Capital, and the Fidelity Management and Research Company, all of which have been buying TE’s stock lately. Trading at 17.5 times its earnings, at about a 20% discount to the industry average, while offering a projected dividend yield of 1.9% of the current stock price, this looks like a stock worth adding to your long-term portfolio.

The Problems of Cyclicality

Emerson Electric is even bigger than TE in terms of market cap, with more than $45 billion. It is also more diversified, manufacturing a wide range of products, from motors to switches, and has presence in over 150 countries. However, its growth prospects are not as appealing. After a disappointing third quarter, its overvaluation became evident. Currently trading at 31 times its earnings, at almost a 50% premium to its peers´ average, and almost double the industry mean in relation to its book values, now doesn´t seem like a good time to invest in Emerson. Even in spite of its attractive dividend yield and history of returning about 80% of free cash flows to shareholders, the price is just too high.

My main concerns revolve around a few subjects. First, the company´s high exposure to considerably cyclical end-markets, combined with its high operating leverage derived from the nature of its manufacturing activities, makes its margins and general profitability highly dependent of the overall performance of the economy. In addition, the international reach of the firm makes it particularly susceptible to currency fluctuations and political stability, which affects both production and sales.

On account of its considerable overvaluation, its history of reporting low EPS growth rates (over the last five years), an overly optimistic guidance for the upcoming five and an uncertain future in overseas markets, I would stay away from Emerson at this time. Apparently, I am not the only one that has noticed this: Jim Simons, Paul Tudor Jones (The Tudor Group) and Ray Dalio have sold out their stakes in the company recently.

Bottom Line

In an industry where scale seems to be the most important competitive advantage, Emerson (the largest among the companies above analyzed) proves that there is more to success. Ametek and TE Connectivity are considerably smaller yet their growth prospects look more promising. But why? The key seems to be in diversification and high switching costs, which allow them to charge hefty premiums for their products while retaining, and even gaining, clients. With great potential for development and even paying out dividends, these are two companies to add to your long-term portfolio.

Disclosure: Damian Illia holds no position in any stocks mentioned

Guru Discussed: Jim Simons: Current Portfolio, Stock Picks
Ray Dalio: Current Portfolio, Stock Picks
Stocks Discussed: TEL, AME, EMR,
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