Description

Executive Summary

WESCO International (WCC), an industrial distributor, is scheduled to close the acquisition of Anixter International Inc. (AXE), also a distributor, during 2Q20 or 3Q20.  This is a transformative acquisition for WCC as it will more than double the Company’s Revenues and EBITDA, based on 2019 financials for both parties.  On 5/14/20, WCC’s stock closed at $25.09.  In a base case scenario, described below, the pro forma entity generates $344mm in FCF in 2023 and trades at a 10% FCF yield, equating to a stock price ~$69 or ~175% upside from current levels.  In an upside scenario, also described below, the pro forma entity generates $600mm in FCF in 2023 (management’s guidance) and trades at a 10% FCF yield, equating to a stock price ~$120 or ~380% upside from current levels.  The biggest risk associated with owning WCC stock is the high level of leverage (~9.7x net debt/2020E EBITDA) the pro forma entity will have immediately after acquisition closure.  With the unlikely but possible downside scenario of $0/share in a bankruptcy and an upside scenario of $120/share, the risk/reward profile appears quite favorable, making this an attractive investment opportunity.  Please note that this investment thesis will take time (~3 years) to play out.

Description of WCC

WCC is primarily a distributor of products sold to the electrical, industrial and communications maintenance, repair and operating (“MRO”) markets and to original equipment manufacturers (“OEM’s”).  The Company serves ~70,000 active customers globally through ~500 branches primarily located in North America, with operations in 16 additional countries and 11 distribution centers located in the United States and Canada.  WCC distributes over 1,000,000 products, grouped into six categories:

·         General Supplies (41% of 2019 Revenues) – Wiring devices, fuses, terminals, connectors, boxes, enclosures, fittings, lugs, terminations, wrap, splicing and marking equipment, tools and testers, safety, personal protection, sealants, cutting tools, adhesives, consumables, fasteners, janitorial and other MRO supplies, solar modules, solar connectors, communication and metering devices, racking systems, and storage batteries

·         Wire, Cable and Conduit (14% of 2019 Revenues) - Wire, cable, raceway, metallic and non-metallic conduit, coupling and fittings

·         Communications and Security (16% of 2019 Revenues) - Structured cabling systems, broadband products, low voltage specialty systems, specialty wire and cable products, equipment racks and cabinets, access control, alarms, cameras, paging and voice solutions

·         Electrical Distribution and Controls (10% of 2019 Revenues) - Circuit breakers, transformers, switchboards, panel boards, metering products and busway products

·         Lighting and Sustainability (11% of 2019 Revenues) - Lamps, fixtures, lighting poles, ballasts and lighting control products

·         Automation, Controls and Motors (8% of 2019 Revenues) - Motor control devices, drives, surge and power protection, relays, timers, pushbuttons, operator interfaces, switches, sensors, programmable controllers, industrial computers and network, and interconnects

WCC sells its products into the following end markets:

·         Industrial (36% of 2019 Revenues) - Industrial product categories include a broad range of electrical equipment and supplies as well as lubricants, pipe, valves, fittings, fasteners, cutting tools, power transmission, and safety products. In addition, OEM customers require a reliable supply of assemblies and components to incorporate into their own products as well as value-added services such as supplier consolidation, design and technical support, just-in-time supply and electronic commerce, and supply chain management.

·         Construction (33% of 2019 Revenues) - Customers include a wide array of contractors, and engineering, procurement and construction firms for industrial, infrastructure, commercial, and data and broadband communications projects. Specific applications include projects for refineries, railways, wastewater treatment facilities, data centers, security installations, offices, and modular and mobile homes. In addition to a wide array of electrical products, WCC offers communications products for projects related to IT/network modernization, physical security upgrades, broadband deployments, network security, and disaster recovery.

·         Utility (16% of 2019 Revenues) - Customers include investor-owned utilities, rural electric cooperatives, municipal power authorities and contractors that serve these customers.  WCC provides utility customers with products and services to support the construction and maintenance of their generation, transmission and distribution systems along with an extensive range of products that meet their power plant MRO and capital projects needs.

·         Commercial, Institutional and Government (“CIG”) (15% of 2019 Revenues) - Customers include schools, hospitals, property management firms, retailers and federal, state and local government agencies of all types, including federal contractors.

Description of AXE

AXE is a distributor which provides over 100,000 customers access to nearly 600,000 products through 309 warehouses/branch locations in over 300 cities and ~50 countries.  Customers are international, national, regional and local businesses, covering a diverse set of industry groups including manufacturing, resource extraction, telecommunications, service providers, finance, education, healthcare, retail, transportation, utilities, defense and government.  Customers include contractors, installers, system integrators, value-added resellers, architects, engineers and wholesale distributors.  No single customer accounts for more than 3% of revenues.  AXE has three business segments:

·         Network Security Solutions (53% of 2019 Revenues) – Supplies a broad portfolio of products which includes copper and fiber optic cable and connectivity, access control, video surveillance, intrusion and fire/life safety, cabinets, power, cable management, wireless, professional audio/video, voice and networking switches and other ancillary products.  The segment supplies to the following industries: technology, telecommunication service providers, transportation, education, government, healthcare and retail.

·         Electrical & Electronic Solutions (27% of 2019 Revenues) – Supplies a broad range of wire and cable, control, power/gear, lighting and core electrical products and customized supply chain solutions.    The segment supplies products for the transmission of power and signals in industrial applications to customers in key markets including oil, gas and petrochemicals, alternative energy, utility, power generation and distribution, transportation, and wastewater treatment.  The segment also sells products used in the manufacturing of automotive, industrial, medical, transportation, marine, military and communications equipment.

·         Utility Power Solutions (20% of 2019 Revenues) – Supplies electrical transmission and distribution products, power plant maintenance, repair and operations supplies, as well as smart-grid products.  Products include conductors such as wire and cable, transformers, overhead transmission and distribution hardware, switches, protective devices and underground distribution, and connectors used in electricity transmission and distribution infrastructure.  The segment serves the utility end market.

Covid-19

Both WCC and AXE are deemed “essential businesses” by government regulations.  WCC noted in reporting its 1Q20 earnings that all of its branches remain operational.

AXE and WCC Transaction

·         Background - WCC and AXE signed a definitive merger agreement on 1/10/20 and subsequently announced the merger in a press release on 1/13/20.  WCC prevailed in a bidding war for AXE over private equity buyer Clayton, Dublier & Rice, LLC (“CD&R”).  As detailed in the finalized merger proxy filed on 3/11/20, AXE had been in takeover discussions since May 2019.  As the bidding ensued over many months, the AXE board eventually determined that the eighth and final proposal from WCC was superior to effectively the fifth and final proposal from CD&R.  During this time the price of AXE stock rose from ~$63 in the beginning of May 2019 to ~$98 in January 2020 after the definitive agreement was announced.

·         Consideration – Through the acquisition, shareholders of AXE will receive the following consideration for their stock:

o   $70.00 per share in cash (this cash portion is subject to a maximum adjusted increase of $2.82, as provide in the “downside protection” clauses in the merger agreement.  The adjustment language in in the S-4 under “Adjustments to Merger Consideration”).

o   0.2397 shares of WCC stock

o   $15.89 per share in WCC preferred stock

At the time of the signing of the definitive agreement, the total consideration had a value of ~$100 per share, based on the cash and preferred portions as well as the common stock portion valued at ~$13.94 per share based on WCC’s 1/10/20 closing price of $58.14.  Currently, the total consideration has a value of $94.72 per share, based on an adjusted cash portion of $72.82, $15.89 in preferred stock, and $6.01 in WCC common stock based on WCC’s 5/14/20 closing price of $25.09.

·         Financing - WCC originally intended to finance the transaction through raising debt and issuing equity.  However, the selloff in WCC’s stock due to Covid-19 caused management to alter the financing plan.  As described in a press release on 3/9/20, WCC has chosen to fund the acquisition solely with debt and cash-on-hand.

·         Approvals – The acquisition of AXE by WCC has already been approved under the antitrust laws of the US, Russia, Turkey and, most recently, Mexico.  The transaction still needs regulatory clearance from Canada as well as Chile, although the receipt of approval in Chile is not a condition to the closing of the merger.

·         Timing – When WCC announced that they had received regulatory approval in Mexico (5/4/20), they reiterated that they expect to complete the merger in the second or third calendar quarter of 2020.

Select Balance Sheet Items and Share Count

Below is a quick summary of the estimated cash, debt and preferred stock amounts as well as the share count of the pro forma entity.  All items are based on figures contained in the companies’ 3/31/20 10-Q’s.

Pro Forma Entity

Below are summary financials for the pro forma entity.  Key points include:

·         Timing – The model assumes that WCC completes the acquisition at the end of 3Q20.  The transaction will likely be completed more quickly, but the model uses this timing as a conservative assumption.

·         Revenues – For both AXE and WCC the model projects the following y-o-y revenue declines for 2Q20, 3Q30, 4Q20 and 1Q21: (20%), (15%), (10%), and (5%), respectively.  The estimated declines are due to the impact of Covid-19.  On their 1Q20 earnings call WCC management provided some commentary on the trends that they are seeing thus far in 2Q20 and the impact Covid-19 is having on their business.  They noted that through 4/28/20 MTD revenues were down (16%) and that gross margins were holding at levels “consistent with 1Q20”.  The model projects a (20%) decline in revenues in 2Q20 and is thus reasonably conservative.  Because of the pending transaction with WCC, AXE did not host an earnings call, so the model projects that the impact of Covid-19 on AXE’s business is the same as on WCC’s.  The model then assumes that both businesses recover post the trough in 2Q20, as shown.  There’s considerable debate in the investment community about what the shape of an overall global economic recovery from Covid-19 will look like (“V”, “W”, “U”, Nike swoosh, “L”, etc.).  Anyone can incorporate their own projections into a model, accordingly.

·         EBITDA – The model assumes decremental/incremental margins of ~20% for both WCC and AXE.  This is reasonable as the gross margins for both companies are in the 19-20% range.  Of note, on their 1Q20 earnings call WCC management emphasized that they are taking a series of cost reduction actions which will amount to $50mm in savings in 2020.  Management noted that some of these cost reduction actions won’t be fully implemented until the beginning of 3Q20 and so investors won’t see the full effect of them until that quarter is reported.  To be conservative, the model does NOT assume any benefit from these actions and they present additional upside to the figures presented below.

·         Synergies – The model assumes that management achieves their pro forma cost synergy targets of $68mm in Year 1 and $140mm in Year 2 (see 3/3/20 merger presentation, slide 9).  Of note, management’s goal is to achieve $200mm in cost synergies by Year 3 with “significant upside” from there.

Of note, the EBITDA projections for both WCC and AXE are significantly below the projections detailed in the S-4 filed on 3/9/20 (see “Certain Unaudited Prospective Financial Information”, pages 94 and 95).  Just to provide a sense, for WCC the summary model projects stand-alone 2022E EBITDA of $340.5mm vs. $522.6mm in the S-4.  For AXE the summary model projects stand-alone 2022E EBITDA of $436.6mm vs. $608.0mm in the S-4.

Pro Forma Free Cash Flow

The summary model above projects estimated EBITDA for the pro forma entity of $767.0mm and $887.2mm for 2021E and 2022E, respectively.  Projecting another ~3% EBITDA growth from there equates to ~$915mm in EBITDA in 2023 or “Year 3” post merger.  Also, capital expenditures for both WCC and AXE have been ~$40mm/year for the past 3 years, so projecting out $90mm for the combined entity by 2023 appears reasonable.

Based on these figures, below is a build from EBITDA to FCF for 2023E:

2023E

EBITDA - $915mm

Working Capital – (50)mm

Capital Expenditures – (90)mm

Cash Interest – (291)mm

Cash Taxes – (90)mm

Preferred Dividends – (50)mm

FCF - $344mm

Valuation and Risk/Reward Profile

According to Bloomberg data, WCC has historically traded at an average PE multiple of 13.5x 1-Year forward earnings.  According to Company data, WCC has averaged 103% FCF conversion from Net Income for the past 10 years.  Therefore, WCC has historically traded at an average FCF yield of 7.6%.  To be conservative, projecting that WCC trades at a 10% FCF appears appropriate.

In a worst-case scenario, the entire Covid-19 situation is much worse than expected, and the pro forma WCC files for bankruptcy and equity holders receive $0/share.

In a base case scenario, the pro forma WCC generates $344mm in FCF as shown above.  If WCC’s stock eventually trades at a 10% FCF yield on the above projections, this would equate to a market capitalization of $3,440mm.  With 50mm shares out, this equals a share price of ~$69, or ~175% upside from current levels.

In an upside scenario, the pro forma WCC generates $600mm in 2023E FCF.  This is what management emphasized on the 1Q20 earnings call in terms of what they believe the pro forma entity can generate.  They noted that historically WCC and AXE have generated a combined $400mm of FCF as separate companies.  After adding in the synergies, management believes the pro forma entity can generate $600mm in FCF in 2023.  If WCC’s stock trades at a 10% FCF yield on management’s projections, this would equate to a market capitalization of $6,000mm.  With 50mm shares out, this equals a share price of $120.00, or ~380% upside from current levels.

Based on the above, the risk/reward profile for WCC stock is highly skewed to the upside.

Key Risk: Leverage

The biggest risk to investing in WCC’s stock is the high leverage of the pro forma entity.  As shown in the “Select Balance Sheet Items and Share Count” table above, the pro forma entity will have a total debt balance of ~$5.4bn and a net debt balance of $4.7bn immediately after the transaction is completed.  The financials for the pro forma entity detailed above project that WCC will generate 2020E EBITDA of $208.7mm and that AXE will generate 2020E EBITDA of $276.8mm.  Combined and without any synergy benefits, this equates to $485.5mm.  Accordingly, immediately after the transaction and with a net debt balance of $4.7bn, the pro forma WCC will be leveraged ~9.7x 2020E EBITDA.

While this level of leverage is quite high, it should rapidly decline as EBITDA increases and FCF is used to pay down debt.  Assuming WCC achieves the $915mm in EBITDA in 2023 detailed above, and that the pro forma entity generates ~$500mm in cumulative FCF during 2021-2022 which it directs toward debt pay down, by the end of 2022 the pro forma entity’s net debt / 2023E EBITDA should decline to 4.6x.

It’s particularly important to note that distributors tend of have FCF which is counter-cyclical nature.  For distributors in general, FCF tends to increase during recessions/economic contractions as working capital gets released from the balance sheet.  Illustrating this is Slide 7 from WCC’s 1Q20 earnings presentation (below).  The absolute dollar amount of FCF as well as the FCF conversion from net income actually increased in 2009 as well as during the 2015-2016 timeframe as working capital was reduced.  As the economy slows down due to Covid-19, both WCC and AXE should experience is similar increase in FCF, helping them pay down debt.

On their 1Q20 earnings call, WCC management emphasized that their debt structure is very “covenant light”.  Specifically, they noted that they don’t have a maximum leverage covenant.  While the financing for the acquisition of AXE is in progress, WCC management expects terms will be similar to what they have currently have in place.

Catalyst

The main catalyst is WCC's completion of its acquisition of AXE, scheduled during 2Q20 or 3Q20.  This will cause sell-side analysts to update their WCC earnings estimates to include the contribution from AXE.

Another potential, secondary catalyst is the return of C,D&R who could potentially bid on the pro forma entity.  C,D&R was obviously interested enough in AXE that they progressively increased their bid price for the Company.  It is possible that they return and make a bid for the combined company.