Description

SUMMARY THESIS         

Encore Wire (Nasdaq: WIRE or “the Company”) is a vertically integrated manufacturer of copper wires for residential, industrial and commercial applications. The Company is a commodity player in a commodity market and has historically been a net price-taker. WIRE’s spread on copper purchased versus sold has reached astronomical levels and led to a period of massive over-earning. This was driven by recent periods of tight supply and strong end-market demand, both of which are reversing. Management has set expectations for a “gradual abatement” of this dynamic. We no longer see this as the case and believe earnings will decline far more rapidly than expected. WIRE’s share price has meaningfully diverged from the correction in copper since last reporting earnings (WIRE +4% vs Copper -25%). These adverse developments are not being appropriately reflected in the stock. We believe Q2’22 earnings (Monday, 7/25 AMC) and a pending drop in wire pricing (link), should act as a key reset for investor and consensus earnings expectations, supporting our year-end price target of $60 or approximately 50% downside with multiple catalysts. The stock is currently GC.

CATALYSTS

Near-term catalysts include: 1) copper wire price and spread compression resulting in dollar and percent margin reversion; 2) volume declines as demand slows; 3) earnings and guidance revisions; and 4) potential inventory write-downs.

SHORT THESIS

Consensus Estimates Are Stale to Correction in Copper and Softening Demand Outlook

Since WIRE last reported earnings, the macro-outlook has evolved rapidly and copper (as a key economic barometer) is now signaling demand is on the cusp of slowing considerably. Based on (1) of the (2) reporting sell-side analysts for Encore Wire, estimates are assuming $4.40/lb copper versus the current price of $3.31/lb, a 25% difference. Based on the 5-Year chart below, we recognize the high correlation between copper and WIRE and believe the recent divergence should be short lived as expectations are reset closer in line with the current demand picture.

Looming Industry Price Decrease

Southwire is the largest supplier and price setter for the industry, which others, including Encore Wire, have to follow in order to remain competitive. As we have observed, there remains little brand differentiation as products are highly commoditized and inventory is interchangeable. We suspect investors have been slow to react as there have been May and June price increases (link), but no July price decrease as of yet and no indication that the recent price increases have been realized. While we believe investors might find this favorable interim price dynamic reassuring, at least for now, it serves to reason that the first decrease of many is likely looming as demand cools. Buyers at its largest customers, Home Depot and Lowe’s, are acutely aware of the input costs for this product and are almost certainly pushing back on prices after such a large rise since the pandemic. Over the last month, wholesale copper tube prices have dropped 10-20% and can be seen as a signal for where copper wire is heading as well.

Spreads Collapsing Faster Than Anticipated

As shown below, WIRE has been wildly over earning since the early days of the pandemic as its spread on copper hit record levels with EBITDA spiking over 700%. While Management has been candid about this dynamic, as noted, they have also set expectations for a “gradual abatement” of this pricing power. However, as copper prices have dropped sharply over the past month, we suspect this is no longer the case. A development that is clearly not reflected in consensus expectations or the share price.

While additional capacity (15-20% added to the industry since 2020), particularly within residential, has come online in recent years, we see the opportunity for spreads to revert negative, similar to 2019, where higher priced inventory works through at lower price points into softening markets.

“And most of last year, we always said we just didn't know when it would abate. We didn't know if it would be abrupt or gradual. 4 quarters in now, we feel more comfortable with that gradual abatement.” – Encore Wire CFO, Q1’22 Earnings Call

Balance Sheet Not as Strong as Perceived

Bullish investors may be overcapitalizing WIRE’s $466mm net cash position (~23% market cap), overlooking a possible lower cost of market inventory adjustment and likely failing to see the strong possibility for negative free cash flow on the horizon (consensus est. $140mm FCF 2023).

Aggressive Capex Deployments for Capacity Expansion into Softening Demand Outlook

First, Management’s guidance for $150mm to $170mm of capital expenditures in 2023 exceeds Adjusted EBITDA in 2019 of $94mm, which may prove to be the appropriate go-forward earnings level. While Management is pursuing a rather aggressive growth capex plan, margins are normalizing, and demand is slowing. We see this as a dangerous combination for a cyclical business and would worry the fixed cost footprint is being expanded just as that of its customers is being reduced to match fading end-market demand.

Share Buybacks at Cycle Peak Likely Value Destructive

Second, WIRE’s share buyback program, an approximate $170mm authorization, appears equally as ill-timed as its growth capex investments. We see it difficult to create meaningful value, if any, when the shares being purchased themselves are overvalued. In Q1’22, shares were repurchased over $115 with the stock dropping as low as $95 since. We suspect this unfavorable dynamic to only accelerate.

Inventory Write-downs Q3 Catalyst

Lastly, we see a strong possibility for a lower cost of market write-down to inventory in Q3’22. Assuming we see an industrywide price decrease to match the decline in copper, WIRE may be left with overpriced raw materials and finished goods on its balance sheet that will require taking an impairment.

VALUATION

As these factors manifest themselves, we believe WIRE will generate a normalized EBITDA of $100M. Applying its historical 8x multiple (and building products peer multiple) equates to $60-62 per share for a 45-55% return on the short.

RISKS & BULL THESIS 

• Low-cost producer enabled by Encore Wire’s one campus model and vertical integration

• Superior fill rates on deliveries and execution from one-campus model

• Industry pricing appears to have held with Q2’22 nearly 1/3 completed

• Strong balance sheet with $466mm of cash and no debt

• Executing on share buyback program

Catalyst

1) copper wire price and spread compression resulting in dollar and percent margin reversion

2) volume declines as demand slows

3) earnings and guidance revisions

4) potential inventory write-downs