Description

Distributors – Value in Plain Sight

Higher-quality companies and businesses exposed to secular trends in renewable energy are trading at expensive valuations. But, you can still buy Wesco at a bargain bin price. 

Wesco is an electrical equipment distribution company. Before I go into Wesco, a few thoughts on distribution companies.

Distributors are sneaky-good businesses. They benefit from both economies of scale and scope, protecting them from new entrants or disruption. They play a key role in supply chains, across most industries. They act as a sales and marketing arm for suppliers to reach a fragmented customer base. They generate healthy double-digit returns on invested capital. And in periods of economic weakness, when sales decline, they produce countercyclical cash flows.

And Wesco is in an industry where the next decade should be brighter than the past decade.

I’ve been investing in distributors for the past 15 years and have written up three on VIC in the past six years (Tech Data in 2018, Arrow Electronics in 2019, and Rexel in 2022). In addition, I’ve owned Synnex, Univar, and Ingram Micro. They have all been successful investments: compounders, available at reasonable prices. They’re not the highest growth companies in the world, but they’re consistent. They tend to be available at attractive entry points. And they wind up catching a higher multiple along the way (sometimes aided by private equity interest – i.e. Univar, Ingram Micro, and Tech Data).

Thesis

Wesco is the largest electrical products distributor in North America, selling about 1.5 million items to 150,000 customers through 800 branches. For manufacturers, Wesco acts as an outsourced sales and distribution partner reaching a fragmented customer base. For customers, Wesco provides logistics, value added services, financing, and purchasing discounts. 88% of sales come from North America with the remainder split between Asia and Europe. The company generates 41% of revenues from Electrical & Electronics Solutions, where Wesco serves the non-residential construction, industrial, and manufacturing end markets. The remaining 59% is split between Communications & Security Solutions and Utility & Broadband where Wesco supplies electrical solutions to data center, utility, and telecommunication customers.

Wesco is a high-quality business that has generated an average return on capital of 20% over the past decade, aided by an asset-light business model with capex requirements of just 0.5% of revenue. As the largest scale player in electrical distribution, Wesco spends more than $22 billion acquiring products each year, making it one of the largest customers for each of its suppliers and a preferred partner. Wesco’s scale also allows it to offer a greater breadth of products to its customers, on a timelier basis. These scale advantages are especially important in a highly fragmented distributor market, where the top four companies capture just 30% of revenues.

Wesco is a resilient business that generates more cash in a downturn. In recent years, the company has reduced its exposure to cyclical end markets. While some of Wesco’s end markets are cyclical, the company’s working capital needs and free cash flows are counter-cyclical. If overall sales decline, Wesco can reduce its purchasing and run down its inventory balance, resulting in significant cash savings. In 2009, revenues fell 25%, but free cash flow grew 6%. Moreover, after merging with Anixter in 2020, Wesco’s exposure shifted away from cyclical end markets, such as construction, and into more stable markets like Utility and Broadband. In fact, Wesco’s direct exposure to construction customers now only accounts for 16% of revenues compared to 33% before the merger. In addition, Wesco is exposed to secular trends, including electrification, automation/IoT, and onshoring, which provide stability should other areas of the economy weaken.

The Anixter merger provided additional scale benefits and significant cost synergies, leading to structurally higher earnings for Wesco. I believe the financial benefits of this merger added around $10 per share of earnings compared to pre-merger Wesco earnings of $5.20 in 2019. Going forward, I expect the company to achieve its target organic sales growth of two-to-three percentage points above GDP.

Key Questions

1.       Are Wesco’s margins above normal (2023 EBITDA margin was 7.6% versus 5.7% pre-Anixter deal average)?

• Yes, 2023 EBITDA margin was above normal, but synergies should keep margins close to this level. 

• Both companies did around 6.5% EBITDA margins from 2011-2014 (above the 5.1% pro-forma in 2019).

• From 2009-2019, the average pro-forma EBITDA margin for the combined company was 5.7%.

•  Cost synergies add 150bps.

• To value the company, I use a 6.75% EBIT margin longer-term (or 7.25% EBITDA margin including 0.5% of Depreciation). This results in about $20 of EPS for 2026.

2.       EPS increased from $5 in 2020 to $14.50 in 2023. That has to be above normal – Value Trap!

• No, earnings are structurally higher than 2019 because of the Anixter deal.

• This deal was incredibly accretive (about 100% accretive, including synergies).

• As you can see in the table below, if we give credit for synergies, 4% underlying growth (from 2019), $2.2b of cross-sell opportunities, and the current capital structure, they should earn $14.50. 

3.       We’re heading into a recession and this is not what you want to own in that environment.

No, they should be resilient.

• It’s a distributor, so they generate countercyclical cash flows.

• Wesco is priced as a legacy construction play, but there are secular opportunities they will benefit from including infrastructure spending, reshoring, and energy transition. For example, United Rentals frames the opportunity by comparing non-res construction spend versus the various stimulus measures announced. The non-res market is $900 billion annually. There has been $2 trillion of stimulus announced. Assuming the spending is spread over 10 years, that’s a >20% lift to construction activity per year.

• Construction is a lower part of the business than in the past (see below).

• Industrial Production still at 2014 levels. 

4.      EPS was flat from 2013 to 2019. What’s wrong with this business?

• In 2013 & 2014 WCC was over-earning.  The Shale boom and strength in Canada’s economy created a very favorable margin environment for WCC. These margin benefits are shown in the table above.  Oil crashed in 2015 and high margin sales went away. 

• China also began to slow in 2015 and the industrial economy faced a recession.  There was a mini upcycle in 2017-18, then the trade war created another Industrial slowdown.

• The future demand environment is healthy, as you can see below.

Recent Issues related to Inventory

When Wesco reported 4Q23 earnings earlier this year, they missed expectations and inventories did not decline as much as expected. The stock was down 31%. This was disappointing, but I think the market overreacted, while management didn’t help with poor communication.

Since then, the stock has effectively recovered all its losses, as the facts became more clear.

Most of the excess inventory is in larger projects, where project delays are forcing them to hold inventory longer than expected. This is not necessarily a bad thing, as the revenue will ultimately get recognized. As supply chain continues to normalize, they expect inventory days to as well (in their CSS segment, the supply chain is back to normal as are their inventory days). And in their traditional “stock and flow business”, inventory is roughly normal.

Conclusion

This short-term noise and volatility creates an opportunity for longer-term oriented investors to benefit from a secularly exposed business, trading at 11.5x EPS.

Going forward, I think EPS should grow around 10%+ per year and that the shares are worth 50% above the current price.

Catalyst

continued earnings growth