Description

I am recommending a long position in Houston Wire & Cable (“HWCC” or the “Company”) with the potential for a return of 50% or more in two years or less.  

As a micro-cap, HWCC is of course subject to higher volatility than is typical of more liquid positions as evidenced by the 19% move on Friday from peak-to-trough coupled with the 12.5% peak-to-trough move on the preceding day.  On no specific Company news during the past three trading days, HWCC has moved from peak-to-trough by almost 30%.  A 50% move higher would take the stock back to where HWCC closed on July 5^th.  There is clearly at least one fund which wants out of this equity but for those investors having requisite patience and comfortable with both the volatility and illiquidity of a microcap operating in a cyclical industry, I think HWCC, now trading at more than a 15% discount to tangible book value, is an attractive risk/reward.  

On an LTM basis, HWCC is trading at ~12% FCF yield, 7.9x EPS, 7.7x EBITDA, and 10.2x EBIT. The Company’s business performance has recently decelerated as is being witnessed by most industrials but the longer-term business opportunity at HWCC is not impaired and the CEO called out trends that were improving this quarter as described more below.  Leverage is 4.2x EBITDA but FCF is likely to improve, as is typical of most distribution business models, if business continues to decelerate and also given elevated DSIs this past quarter as management sought to build inventories in advance of tariffs.  The balance sheet is not a concern with the revolver having recently been extended to March 2024 and the magnitude of debt on a lower trajectory.  This past quarter, the Company’s borrowing rate was just 3.7%.  During the past decade, the Company’s EBIT has been negative only once and such was primarily driven by the collapse of crude oil from a peak of $108 in 2014 to $26 in 2016. It’s important to emphasize that while EBIT declined from $25.4M in 2014 to a negative $3.3M in 2016, the Company generated its peak-decade FCF during 2015 of $28.7M and then an additional $15.9M in 2016. Based on peak financial performance during the past decade in 2011, HWCC is trading at 3.3x EPS, 3.7x EBITDA and 4x EBIT.  HWCC’s FCF has been negative only twice during the past decade and has averaged close to $11M per annum, or ~18% FCF yield.  

Management continues to assert, as evidenced historically, that the business model can generate over $1 of EPS when its target end markets are performing well. During the past decade, the Company achieved an average ROE of ~10% and EPS of $0.49.  HWCC’s tangible book value at $4.35 is likely understated since the Company owns three facilities in Houston and two facilities in Louisiana. Although TBV has not proven to be “downside protection” for the stock, I believe the recent dislocation is an attractive opportunity at a discount of more than 15%.  For some context, on a TBV basis peers AXE, MSM, FAST, and GWW trade at multiples ranging from 4-14x of TBV although peer WCC is also trading below TBV, at 0.9x.  Based on consensus EPS for 2019, the peer group (which also includes both BDC and MRC which have negative TBV) trades at an average and median 13x (a 65% premium to HWCC’s LTM EPS multiple).  HWCC’s closest competitor, privately-held Omni Cable, was acquired at the end of July by Dot Family Holdings; I have not yet resourced any valuation data to share.     

It is notable that the Company’s revenue was just 10% below the 2011 peak but EBIT was 58% less in 2018 versus 2011.  Part of the explanation is metal pricing, particularly copper, which comprises ~30% of cost of goods sold.  Other key metals include nickel, aluminum, and steel.  During 2011, the average price of copper was more than 36% higher than in 2018.  Another key variable that is more driven by management is operating expenses which was just 14% of sales in 2011, some benefit from higher sales of course, and 20% in 2018 although much improved by 270 basis points since 2016.  This is an area where management is keenly focused on achieving ongoing improvement although it did notably increase by 140 basis points this past quarter.  Based on my interaction with management, I believe they are highly capable of positioning their business for longer-term improvement and improving their cost structure. The company will continue to be influenced by its end markets which have recently incurred some setbacks but the stock seems to discount that the deceleration is a permanent situation and in spite of management having communicated some evidence of improving trends.        

I won’t allocate too much of the reader’s bandwidth to a description of the business as I think VIC member vbs214 did a very good job (note other VIC members agree given the quality rating of 6.6) framing the Company and its business in his/her long recommendation of HWCC on February 14, 2018 when the stock was $6.85.  I encourage those interested in this long recommendation to review that submission for valuable context.  It’s worth noting that from the time of that submission, insiders have purchased almost $1.8M of stock at an average $7.11 (96% higher than the most recent close) at prices ranging from $5.17-8.20.

Below I share some observations regarding the Company from primary research.

1.    Strong organization tailored to sales and services; “always goes above and beyond my expectations” 

2.    Confident of their fulfillment of customer needs even when customer’s order is “last minute;” “highly reliable”, “100% responsive to my needs”

3.    Services such as custom cutting, cable coiling, and custom slings and harness are valuable versus some savings from going direct

4.    Of the customers I was able to contact, over 70% cited a preference for ordering from HWCC versus the Company’s most direct competitor Omni Cable; “more reliable,” “more comprehensive inventory,” “more relationship-oriented”

It’s worth noting that the largest shareholder Nierenberg Investment Management raised its interest in HWCC to 9.9% at the end of last year and both David Nierenberg and his colleague Damon Benedict have been the only vocal participants in each of the last six quarterly earnings calls.  During each of those quarterly calls and consistent with their filing made during December of last year and also during March of this year, the Nierenberg team has communicated a positive perspective regarding management’s approach towards operating the business.  I highlight some of those comments below.

·     “You did a nice job protecting profitability in the second quarter as the quarter went along and the trade war dispute hurt business confidence.” (Q2‘19, August 2019)

·     “Growing revenue at a faster rate than the industry along with an increase in both gross margin and operating expense control is a tough thing to do…The stock market might not recognize your progress yet, but we are certainly appreciative of everything you’re doing as large shareholders.” (Q4’18, March 2019)

·     “Another great quarter…recovery of the economy, recovery of the commodities…we talk about infrastructure investment would create an opportunity overtime for this company to get their quarterly revenues back above $100M and overtime drive earnings per share back above $1 which is where you guys were in the several years in the last up cycle.” (Q2 ’18, August 2018)

·     “Your cash flow dynamics provide downside support:  in the last downturn, HWCC generated enough free cash flow to more than halve debt to under $30M, while repurchasing nearly 10% of shares.” (December 2018 letter)

·     “The insiders have not been stupid buying so many shares in the past 16 months!” (December 2018 letter)

·     “We believe HWCC either should pursue a long term rapid growth strategy which could appeal to the public market or pursue slower organic growth while taking advantage of stock market neglect to repurchase shares, in size, for an extended time and then sell itself to a strategic buyer…we prefer the latter.” (December 2018 letter)

Given their ~10% position in HWCC, it would be very difficult for Nierenberg to exit the position without severely dislocating their exposure.  Nierenberg’s last disclosure of shares purchased, which increased the fund’s stake in HWCC to ~10%, were completed at prices ranging from $7.47-7.92.  Nierenberg has sought Board representation across selected investments in the past.  With regards to HWCC, the fund principals have been vocally supportive of HWCC without having yet communicated an interest for Board representation.  The main areas of stated discontent by Nierenberg have been for the Board to be more aggressive towards repurchasing shares, for management to be more proactive at articulating its longer-term strategy, and that “HWCC’s being a public company adds little value.”  

As described in their filing from December, Nierenberg believed that HWCC could earn $1.76 in five years and a mid-teen earnings multiple.  The letter specifically noted that “through free cash flow, shrewd asset monetization, and repurchase, we believe that HWCC could, over time and with good execution, more than quadruple its current share price.” I am not so bold to envision that outcome; I will be happy with the 50% or more I am targeting in two years or less which, at $5.45, is notably well-below Nierenberg’s $8.63 cost basis. Given the fund’s track record with selected investments I’ve evaluated, I view Nierenberg’s alignment as positive and it would not be surprising to see another filing by them in an effort to raise the visibility of HWCC as an attractive investment.  Their last filing during March highlighted the principals’ interaction with HWCC’s Board to reinforce suggestions Nierenberg made in their December filing.  This included a recommendation to increase the portion of free cash flow allocated to repurchasing shares so that HWCC might ultimately repurchase as much as one third of all shares.  

Concurrent with its most recent earnings announcement, the Company announced its intent to repurchase stock, after having suspended its buyback program in November of 2016.  Although we don’t know if Nierenberg’s call for the buyback is what influenced the Board, it’s clear that the members of the Board agree with the stock being undervalued based on all non-employee Directors, except the most-recently appointed Director in May, purchasing shares much higher.  In regards to reinstating the share repurchase program (with $9.2M currently authorized), David Nierenberg said, “So I hope that you will use all means to take advantage of the gift which Mr. Market is making to you by pricing the stock as low as it is right now and that you will manage your working capital down to more normal seasonal levels both in terms of DSOs and inventory to use that free cash flow both to continue paying down debt and to seize the gift which Mr. Market is giving to you…one gift that the market does give you from time to time is a severely mispriced share price and you’ve got it now and carpe diem.”    

HWCC released its Q2 earnings recently and although there is no sell-side coverage to benchmark results relative to street estimates, the 9% decline in sales was not consistent with the more optimistic tone that had been communicated by management during the few months that preceded earnings nor the consistent trajectory of sales growth that was generated during the nine preceding quarters. Despite the Company having released earnings a week ago that were less than expected, HWCC was up 9.4% on its earnings report and notably on a day when the Russell was down over 1.2%. However, the stock declined by almost 25% since earnings this past week.  I think one can ascribe some of the stock’s initial relative strength to the reactivation of the buyback coupled with the positive tone of management as described below but there is obviously at least one fund that is no longer bullish about HWCC and influencing the stock’s decline which closed near the low of the day (in fact a ten-year low) on significant volume which was ~10x average and the second highest during the past year.

During the recent earnings call, we heard that industrial demand was down and this was primarily ascribed to the supply chain disruptions being caused by the trade war coupled with lower demand from oil and gas-related customers.  But the CEO said “conditions are slowly improving and we expect better sales performance in the second half.”  Although both June and July were down, he noted that “July looked and felt a lot like June, but really started to improve towards the latter part of the month and August has been quite good.”  In response to a question from Nierenberg, the CEO said, “We’ve experienced a little bit of a summer doldrum, which is not uncommon…The outlook for the next five years remains positive.  Our book-to-bill ratio is positive.  And to your question about pipeline, that’s growing as well.”

For some context regarding the last time HWCC confronted a significant deceleration in its business, one has to go back to a period of time that many characterized as an “industrial recession,” when manufacturing production disappeared in 2015 and 2016 and manufacturing production did not exceed the July 2014 level until October 2017. It is possible that the current period, when manufacturing output has declined in five of the last seven months, will also be characterized as an “industrial recession.”  Research from Barclays has already declared “we are in an industrial recession.”  The recent weakness is well-documented and very much ascribed to the ongoing trade war which is likely to get resolved eventually as political motivations influence some compromise.  

During 2014-2016, when the Company confronted a significant deceleration in its business, HWCC’s stock declined from a peak of ~$14 in 2014 to ~$5 in 2016.  It is notable that from the initial trough during 2016, the market gave investors an approximate 50% gain twice within roughly twelve months.  And for some additional context, it is worth highlighting that the average price of copper has ranged from 19-136% each year (averaging 46%), from peak-to-trough, during the past decade.  The point is simply (and perhaps to cite the obvious) that investing in cyclicals comes with large drawdowns from time to time as market participants envision that a cyclical company’s business will be permanently reduced when industry-related drivers are headed in the wrong direction.  But those same industry-related drivers will often eventually become tailwinds as capital spending normalizes and also catches up from deferred maintenance.  Those companies that can successfully manage through a deceleration are best equipped to capitalize when the recovery eventually materializes.

It is not certain whether revenue at the Company will head much lower in the near-term. The recent one quarter decline is not yet a trend.  In fact, the CEO’s commentary was positive about the last several weeks having improved. However, it is clear to me from my research that the Company is equipped to generate lots of FCF in the near-term if its end markets decline precipitously but otherwise there is a scenario for the Company to drive towards $1 of EPS over time if its end markets improve.  HWCC’s business mix is mostly derived from MRO drivers that are inherently more stable as well as longer-dated projects that are not likely to be eliminated.  The last “industrial recession” was primarily driven by the severity of the decline in crude oil and the latest set of industrial challenges can partially be ascribed to a trade war that is likely to be resolved at some point for political-driven aspirations.  It’s a tough environment for almost any industrial to navigate but I believe HWCC won’t be permanently impaired if we are on the cusp of an industrial recession and the Company is well-positioned to improve its financial performance as end markets improve.

As for risks to my long recommendation, it’s important again to reinforce that with illiquidity comes higher volatility and for some that is a risk.  I recognize the softness from the Company’s most recent results but I am not yet convinced that a severe decline in revenue and profitability is looming.  To the extent revenue were to decline by 33% akin to 2014-2016, the timing of my recommendation will likely need to be extended some but I believe the current price is already discounting a lot of potential bad news as reflected by the ~60% decline in price from a year ago and the Company’s lowest historical multiple of TBV. To the extent we enter a deep industrial recession that endures for years and causes numerous longer-term customer projects to get cancelled and for the MRO customers to suffer relative to what were perceived as safe credits but instead get entangled by a deep recession, then this idea won’t likely work anytime soon.  However, as someone with numerous shorts, I am confident that in such a scenario my short exposure will do better than I anticipated and therefore hedge some of this long exposure which I view having more downside protection from the current discount to TBV coupled with the cash flow generation that benefits the Company if management has to retrench from growing its working capital.  

Catalyst

Catalysts

·     Ongoing pricing discipline to avoid gross margin degradation

·     Free cash flow generation coupled with buyback and compounded by improving business trends

·     Resolution of trade dispute drives normalized capital spending pattern as industrial production capacity utilization improves and drives HWCC’s MRO business mix

·     Energy-related capital spending improves from recent trough levels

·     Infrastructure investment accelerates

·     Metals inflation  

·     Insiders assert confidence again with open market purchases

·     Nierenberg’s standstill (from March) ends and the fund accumulates additional shares while concurrently raising visibility of under-the-radar opportunity

·     Acquired for significant control premium