Encore Wire is the third largest domestic manufacturer of copper electrical building wire. It has excellent management, but operates in a mediocre industry, and while that often translates into pedestrian returns for shareholders, I don’t think that’ll be the case here. The stock has a market cap of $137 million, and trades for 15x relatively depressed earnings and 1.3x book value.
Last year, WIRE reported $281 million in revenues, with $16 million in EBIT (5.7%), and $0.60 in earnings per share. CEO Vincent Rego founded the company back in 1989 after selling another wire firm (for the second time), and he owns 10% of the company. A venture capital firm that backed him still owns 18%, so the trading liquidity not great. Rego claims to have never lost money in his fifty years in the building wire business, except one year in which he tried to hedge/speculate in copper – quite a feat considering the competitive and cyclical nature of the business.
WIRE’s products are sold through wholesalers, who sell to the contractors and builders that actually install the wires in residential and commercial buildings. Even with the tough last couple of years, the company has still averaged 17% returns on equity and 25% annual sales growth over the past decade with moderate debt levels. The pace of growth is obviously unsustainable given their much higher base, but the performance has been remarkable given an industry that grows no faster than 1-2x GDP, and in aggregate probably has not earned its cost of capital in years.
Unlike its other major competitors, who all have multiple plants and warehouses, WIRE operates only one manufacturing plant (in Texas) and one warehouse (attached to its plant). This straightforward configuration gives WIRE an advantage in two crucial areas – cost and delivery. Having only one site leverages the manufacturing process and keeps the logistics of delivery very simple. Since most orders for building wire are somewhat time-sensitive and involve several SKUs (out of 5000+ that WIRE carries), it makes shipping an order much more efficient if all the SKUs come from one location. WIRE’s 99.9% fill rate is the best in the industry, probably by a wide margin – they actually advertise it prominently on their website. I’ve heard an estimate of a sub-90% fill rate for the industry, and I would guess that 90% is definitely high after talking to some wholesalers and contractors.
WIRE’s low-cost status, by the way, doesn’t just derive from its one-location structure. Management is stingy on the overhead, and generous in the plant – just the right combination needed to remain low-cost in a commodity manufacturing business. In this recent downturn, the two other competitors with public financials were losing money, while WIRE earned 6% operating margins. WIRE states in its June quarter press release that it is the only profitable building wire operation it knows of in this environment.
Management’s razor-like focus on costs and service has allowed it to gain market share consistently since its founding. Unit volume growth has averaged over 15% for the past seven years (versus at best mid-single-digit industry growth), and WIRE now has around 7-9% market share compared to industry leader Southwire’s 15-20% share. The building wire market is currently down 15-20% from a year ago, while WIRE reported flattish volume in the quarter ended June. With the industry in a slump, the weaker competitors are beginning to disappear, and WIRE is a beneficiary. Late last year, the assets of the previous #3 player were bought by Southwire, and the current #2 is Essex Wire, a subsidiary of Superior Telecom, a public company that has had its stock recently delisted from the NYSE due to financial distress. I expect further industry dislocation.
WIRE’s current annualized earnings per share of $0.60 is half its peak level from a few years ago, due to declining copper prices, the weak commercial building market, and the resulting competitive pricing pressure. Copper is effectively a pass-through cost, and tends to be around two-thirds of cost of goods sold. Thus, the price of copper is a significant factor influencing the profitability of the firm, so if you are really bearish on copper long-term, this is probably not a great idea. The ideal situation for WIRE is a modestly rising copper price environment where WIRE can capture higher gross profits per unit sold.
On first glance, the stock is not that cheap, at 15x run rate earnings. But with a depressed market and historically low copper prices, normalized earnings are probably a better way to value the shares. Applying WIRE’s average margins (~7.5% EBIT margin) and average revenues per pound over the past seven years, and assuming 10% volume growth per year (after a flat FY02e), WIRE’s normalized earnings three years out would be about $1.40 per share. At a reasonable 13x P/E, the stock would be at $18, a double from here. My cynical bent prevents me from getting too optimistic, but when things are going WIRE’s way, it’s not inconceivable that the company will earn much more and/or the stock will get a higher multiple. The shares have historically received over a 15x P/E pretty consistently. And the normalized 7.5% EBIT margin I use is still closer to the currently depressed 6% than it is to the 12%+ margins they did in the good times in 1997-1998. Think about it this way – Encore earned $1.23 a share when it sold about 130 million pounds of copper wire in 1997, and the stock traded in the low $20s. Now it sells over 200 million pounds and the stock trades for $9. Imagine what that EPS figure could be if industry conditions were to ever approach the 1997-1998 levels, which I don’t see as unattainable, given that neither the industry nor copper prices were that inflated, a la the tech bubble. In fact, with the market consolidation occurring, industry conditions should be better at the next peak. [By the way, the earnings and margin figures I mention might not match the reported figures exactly since I‘ve adjusted them for LIFO and LCM inventory accounting.]
The company is spending some money this year to expand capacity ($21 million in capex the last three quarters), so 2002 free cash flow will be in the red by as much as $10 million. As the spending is pretty much over now, a multi-year period of low capex should begin, with next year likely seeing capex under $5 million. If WIRE has a flat year next year, they should throw off around $20 million in cash from operations, resulting in $15mil in free cash flow. Coming at the valuation from another angle, when Southwire bought the assets (basically the machinery) of the #3 player, it paid about 1x book. Encore trades under 1.3x book as a going concern, with newer machines, a better business model, all the goodwill, etc.
The main risks are the fate of copper prices and building activity. This buy recommendation is based on an agnostic stance on both, but I wouldn’t be surprised if the building market continues to remain weak or even worsens for a while. And there isn’t really any good news on the copper front, except that current prices are probably close to the industry break-even point; inventories are high and worldwide economic trends aren’t that good. The way I look at it, WIRE will bump along here earning about half a buck, with very strong cash flow, as long as the building market is soft and copper prices are at historical lows and distressed competitors are hurting pricing. But eventually, enough competitors will exit, or the market or copper prices will turn, or Encore will have enough market share to lead in pricing, and earnings should shoot through the roof.
Commercial building market turnaround.
Copper price increases.
Continued market share gains.
Entering period of low capex.