Description

Company Description / Thesis

Rexel is a global distributor of electrical products based in Paris, which sells about two million items to 650,000 active customers through 1,900 branches. Revenues are split 55% in Europe, 35% in North America, and 10% in Asia.

Rexel is a high-quality business that has generated an average return on capital of 20% over the past decade, helped by very low capital intensity of just 1% capex-to-revenue. Rexel sells low voltage components that are critical to an electrician’s work but represent a small portion of their total project cost. As such, Rexel customers are much more focused on good service and availability—getting the right products on-time—than seeking the lowest price. Rexel’s customers can have their orders delivered on site, within hours, or immediately have access to a full selection of products and expert assistance at a nearby branch. It would be extremely challenging to replicate Rexel’s service business profitably because of its dense local scale. Rexel is the #1 or #2 player in segments comprising 60% of its revenue base.

Rexel’s business is recurring and resilient. About 60% of sales are driven by the “proximity” business through which Rexel supplies everyday components to their customers. More than half of Rexel customers shop with them every business day. While the other 40% of Rexel’s business is more project-based and cyclical, the company’s free cash flow is counter-cyclical. During a downturn, Rexel will sell on-hand inventory and generate excess cash. In 2020, for example, revenues declined 8%, but free cash flow expanded 32%.

I believe the future is bright for Rexel. I expect the company’s organic growth rate to improve from its historic low-single-digit rate, driven by the secular shift to electrification. Rexel’s topline typically grows around the same rate as those of its major suppliers, like Schneider and Legrand. Going forward, those businesses are guiding sales growth around 500bps per year, or roughly double the historical trend. Over time, I expect Rexel to take share as the industry consolidates, which should improve its margin. Many markets remain highly fragmented, yet it is increasingly difficult for small competitors to keep up with digital investments made by major players like Rexel.

Rexel trades for just 8.5x 2022 EPS. I think EPS should grow at a 10%+ rate and that the stock is worth at least 50% above the current price.

Why I Like Distributors

Distributors are good, but often overlooked, businesses. They play a key role in the supply chain, connecting thousand of suppliers with a fragmented customer base. In return, they receive a “commission” and have implicit (or sometimes explicit) return rights with their supply partners, minimizing or even eliminating the possibility of obsolete inventory. That working capital is also variable and as sales decline, distributors throw off cash, resulting in counter-cyclical cash flows.

 Rexel has four key value propositions:

1.      Local, Timely, Delivery – electrical distribution is a local business, with installers needing timely, reliable, product delivery. Rexel is an everyday partner of its customers. On average, over 70% of sales are delivered on site without a customer entering a physical store. In France, for example, 95% of Rexel’s available stored products are shipped for next day delivery. 

2.      Broad Selection – customers want a one-stop shop that can service a wide range of product requirements.

3.      Technical Support – unlike DIY shops, electrical distribution involves a stronger element of technical advice on products, installation, and after-sale services.

4.      Credit Facilitation – distributors generally offer customers credit facilities, effectively passing on the benefits of their balance sheet to customers.

The Future is Brighter than the Past for Rexel

I think Rexel should earn a 6% operating margin, longer-term, above the historical average of ~5% and revenue growth should be healthier than in the past. First, I’ll explain some of the problems that occurred over the past decade. Most of the weakness, predominantly in the early 2010’s, can be attributed to a poor acquisition in the US and economic malaise in Europe.

In the US, Rexel bought GE Supply before the financial crisis, which was a poor acquisition as management didn’t know the business well. At that time, management was short sighted and aggressively closed branches and cut opex to meet earnings targets. During this time, the company closed 1/3 of its network (200 branches), which almost destroyed its business. In Europe, sales declined at a 1.5% rate, annualized, from 2011-2016 because of weak overall economic activity. As a result of these two pressures, operating margins for Rexel declined from 5.7% in 2011 to 4.2% in 2016.

Then, starting in 2016, Rexel began a major turnaround. An activist, Cevian Capital, got involved and brought in new management. The company invested heavily in increased digitalization, improved customer retention, and restored its US business. As a result, Rexel stabilized its market share and began to grow above its end markets. From 2016-2019, sales grew low-single-digits organically and EPS increased at about a 10% annualized rate. Then, despite the initial step-down from COVID, EPS increased an additional 68% by 2021.

Rexel is well positioned to benefit from attractive secular trends, such as growing electricity consumption, increasing energy efficiency, and expanding the number of connected devices. Most electrical suppliers, including Schneider and LeGrand, have increased their long-term growth outlook from historical ~2% to ~5%. I expect Rexel to at least grow in line with these suppliers, as it has since 2014, including above market growth in 2021. In addition, if the world, doubles its electricity consumption by 2050 to lower emissions, it will imply a 30-year growth CAGR of ~2.5%, further supporting an end market growth of at least that much.

Rexel should be able to improve its normalized margin to 6% with further market consolidation, operating leverage and an additional 50bps of margin expansion from portfolio optimization. In fact, Rexel is already above its target margin in several markets. Rexel earns 7%+ operating margins in 33% of its markets. Margins for electrical distributors are highly correlated to market concentration and scale. Digitalization in the industry will further squeeze small and medium distributors as they don’t have the means to invest, and Rexel will likely gain market share. For example, in France, Rexel and Sonepar control 70-80% of the market and Rexel’s margin is well above 7%. In Canada, the top five distributors account for 75% of market share, and Rexel enjoys above company average margins.

Normalizing for Inflation

In an inflationary environment, Rexel benefits in two ways. 1) From the “carry” on inventory prices. Rexel sells goods at today’s prices that it purchased at yesterday’s prices. 2) Higher prices make it easier to capture higher “commissions”. For example, when copper prices rise, distributors tend to keep a bit more profit as part of the transaction.

In 2021, I estimate that these two factors positively impacted margins by about 90bps (roughly ½ from each factor). Adjusted for these two factors, the 2021 operating margin was 5.3%.

Longer-term, I think operating margins should improve to 6%. As revenues grow at a healthier rate, operating margins should improve as Rexel benefits from operating leverage, market consolidation, and portfolio optimization. And, if inflation continues to push component prices up, Rexel should have an additional tailwind to achieving its target margin.

Capital Allocation

The balance sheet is in great shape at 1.4x net-debt-to-EBITDA as of 4Q21, compared to a longer-term target of 2.5x. As a result, Rexel should be able to either make acquisitions (using cash) or repurchase shares.

Risks

Risk of Distributors being Cut Out (Disintermediation) – It’s unlikely that manufacturers will shift small projects to direct sales given the high cost to serve its long-tail customers where orders are small, customers want next day delivery and technical support. In fact, when I asked this question to Schneider, they stressed the importance of distributors in the supply chain.

Amazon risk - Electrical distribution is an extremely localized business. Aftermarket service, technical support, and fast delivery are important for customers. Thus, Amazon is unlikely to take market share away other than in the commoditized categories. In addition, contractors and installers don’t necessarily want the price transparency on Amazon to protect their own margins.

Catalyst

earnings growth and debt paydown