Description

Wesco is a leading distributor of electrical and industrial maintenance, repair and operating (MRO) supplies and construction materials.  The company currently operates more than 400 full service branch locations and seven distribution centers (five in the US and two in Canada).  Most of Wesco’s sales originate in the US but it does sell a small amount (10% of sales) into the Canadian market.  Wesco’s 2008 product mix is broken down as follows: 34% general supplies, 20% wire/cable & conduit, 13% distribution equipment, 12% datacom (voice and data communications, access control, security surveillance, and building automation), 11% control & motors, and 10% lighting/controls.  Wesco’s customer mix is 40% industrial, 38% construction, 16% utility, and 6% commercial, institution, and government. 

Wesco operates a highly respected, cost efficient electrical and industrial MRO distribution business.  Its national reach provides substantial barriers to entry and additional market share taking opportunities from local mom & pops.  This allows for growth above attractive historical industry rates of GDP + 2-3%.  Wesco’s business is not capital intensive and free cash generation is significant, and the company should benefit from an infrastructure focused economic stimulus plan.  Despite having a reasonable degree of financial leverage (3x debt/ebitda), we believe the company should have adequate liquidity to cover its debt repayment obligations even in a very negative economic scenario.  Trading for around 3.5 x trailing EPS, we believe Wesco is worth $30 a share based on a 10x multiple of 2010 trough earnings of $3, offering a 60% return from current levels.  Wesco has historically traded at a mid teens earnings multiple.

Investment Thesis:

1)             Good business quality

2)             Inexpensive on projected trough earnings

3)             Improved business going into this cycle downturn

Risks:

1)             Leverage with near-term maturities

2)             Slowdown greater than anticipated

Good business quality.  Wesco operates in an industry that has grown at GDP plus 2-3% for the past 20 years.  The industry is fragmented with the top 5 competitors possessing 25% of the market, and Wesco has consistently gained share from its competition.  Wesco’s scale advantages are substantial, and the company offers integrated supply solutions to its customers (outsourcing of purchasing, stocking, and administrative processes for products used in maintenance and repair of facilities).  The company and management have an excellent reputation within the industry; the management team has a long tenure with the company (CEO 14 yrs, CFO 11 yrs, COO 4 yrs) and management owns 8% of the company.  While Wesco will not be immune from the economic slowdown, the company should be able to maintain margins above previous cyclical lows given an improved business mix and pro-active steps that management has taken in recent years on cost management.   

Inexpensive on projected trough earnings.  Wesco trades for 3.6x and 4.9x trailing EPS and EBITDA, respectively.  We expect 2009 earnings to be close to $4.00 per share and 2010 trough earnings to be north of $3.00 a share as the company partially offsets the effects of negative operating leverage with SG&A cost savings.  Though we expect earnings to decline as end demand weakens significantly, earnings conversion to free cash flow is high and the free cash generation increases with working capital benefits during down-cycles.  The table below summarizes Wesco’s historical and projected financials.  Our projections for 2010 earnings assume a cumulative drop in sales of 12% from 2008 levels and an EBITDA margin of 4.7% (versus EBITDA margins of 7.2% and 6.2% in 2007 and 2008, respectively).    

Capitalization

Stock Px                 $18.75

Shares                        43.1

Mkt Cap                      808

Debt                         1,176

Cash                            103

EV                             1,881

Financials

                                2005       2006       2007       LTM       2008P    2009P    2010P

Revenue                                4,421       5,321       6,004       6,170       6,178       5,762       5,330

% Growth                                                                               2.9%       (4.4%)*   (7.5%)

EBITDA 228          394          431          394          382          312          253

% Margin               5.2%       7.4%       7.2%       6.4%       6.2%       5.4%       4.7%

Net Income            104          217          241          232          219          169          133

% Margin               2.3%       4.1%       4.0%       3.8%       3.5%       2.9%       2.5%

EPS                         $2.10       $4.14       $4.99       $5.26       $5.09       $3.93       $3.09

*Decline figure is core business decline and adjusts for copper related revenue declines – unadjusted decline is 6.7%.

Wesco has acquired approximately $1.1 billion in revenue since June 2005.  Two of the largest acquisitions were (a) Communications Supply – acquired in late 2006 for $525 million ($600 million revenues, $55 million EBITDA), and (b)                Carlton Bates – acquired in late 2005 for $250 million ($292 million revenues, $27 million EBITDA).  At the time of announcement, these two acquisitions were each expected to add close to $0.40 in EPS.

Improved business going into this cycle downturn.  We believe that analysts and the market are focusing on the trough margins of the last cycle and have misunderstood the evolution of Wesco’s business.  In the 2001-2003 downturn, operating margins declined from a peak of 3.9% in September 1999 to 2.3% from September 2002 through June 2003, a decline of ~40%.  Wesco’s LTM operating margin of 5.9% is much higher than peak levels seen in the last cycle.  We estimate that over half of this improvement is the result of cost containment and acquisitions (Carlton Bates and Communications Supply added a combined $900 million in sales at better than 9% EBITDA margins).  Since Wesco is starting from much higher margin levels and has changed its business mix significantly with a focus on driving costs out of the business, we believe margin deterioration during this downturn could be equivalent to the 2001-2003 period in aggregate but will be far less in percentage terms.  Wesco’s business today is more diversified and better run resulting in higher margins.  Acquisitions made by the company since June 2005 have added more than $1.1 billion in sales and $1.00 of EPS.  The acquired companies typically have had higher margins and strengthened or diversified an industry position.  Construction as a percentage of sales has been reduced from 37% to 25%, primarily as a result of the 2006 Communications Supply acquisition which currently represents ~13% of sales and was not previously a primary end market for the company. 

Risks:

Leverage with near-term maturities.  Wesco’s debt/EBITDA is nearly 3x.  Near-term maturities include the $500 million under the A/R securitization facility in May 2010, an October 2010 put date for the $150 million 2025 converts, and the November 2011 put date for the $300 million 2026 converts.  These three maturities provide refinancing obligations of almost $1 billion through the end of 2011.  Though a large refinancing burden like this could be seen as worrisome, management is proactively negotiating the A/R facility and we believe the free cash and credit availability under the revolver afford adequate liquidity to repay its convert obligations.

Though the financing markets are in turmoil, we believe that the A/R securitization is likely to be refinanced and management is currently in discussions with interested parties.  It is likely that the facility extension will be negotiated with a higher interest rate and lower facility size, but this is a secure financing that is unlikely to disappear.  In our analysis, we have focused more of our attention to the $450 million in convert obligations.  The company currently has $350 million in liquidity (credit facility does not expire until 2013).  With cash flow generation of ~$250 million in the last twelve months and projected earnings of over $300 million in 2009 and 2010, we believe the potential $450 million in obligations over the next three years is very manageable.  The only covenant that Wesco is subject to is a fixed charge ratio of 1.1x which the Company should have no trouble covering.

Slowdown greater than anticipated.  If the industry slowdown were to prove to be very long lasting, it is possible that some of the operating leverage inherent in the business could be reflected in persistently low margins.  Management has identified cost cutting contingency plans to implement when a slowdown in the business occurs.  In our discussions with the company, while management has yet to see signs of a slowdown, they anticipate being able to maintain margins by reducing headcount in line with volume declines.  In studying the 2001-2003 period, Wesco was able to reduce SG&A spend by $30 million from approximately $525 million in 2000 to $495 million in 2002.  Wesco sales decreased 6%, 9%, 1% in 2001-2003.  Wesco cut costs at a rate of -2%, -4%, 1% in these years.  We model cost savings in 2009 and 2010 that on a cumulative basic cut costs by $72 million or 9%, which is below the 12% sales decline that we assume. 

Catalyst