|Shares Out. (in M):||51||P/E||16.4x||12.7x|
|Market Cap (in $M):||3,781||P/FCF||14.3x||12.9x|
|Net Debt (in $M):||1,831||EBIT||373||504|
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Wesco International, Inc. (WCC) is a well managed wholesale electrical distributor that serves industrial, non-residential construction, utility and institutional (including government) end markets primarily in North America. WCC’s size and national footprint give it favorable competitive advantages relative to a fragmented and consolidating industry. Evidence of the business quality can be seen via the company’s history of consistently expanding margins and the 20%-25% returns on tangible invested capital. Further, WCC is levered to an improving US economy and stands to meaningfully benefit from an eventual improvement in non residential construction end markets.
Shortly after the stock hit is recession lows, Samba834 wrote up WCC in December 2008 (still worth the read)—since that time, the stock is up nearly 4x. While it will be difficult match that kind of performance, WCC is likely to continue to compound intrinsic equity value at 20% or greater over the medium to long term.
The North American electrical distribution wholesale market grows in line with nominal GDP. The market is highly fragmented with the top 4 suppliers (WCC, Sonepar, Graybar & Rexel) accounting for only ~25% of the market—WCC & Sonepar are the largest with 7%-8% each. Electrical distribution is estimated to be a $90bn segment within the larger $500bn general supply market. Larger, national distributors are slowly taking organic share from smaller local distributors because they are better able to service customers’ national footprints, their size (and balance sheet) allows them to supply a greater number of SKUs and their scale allows for greater purchasing power.
The North American market is gradually consolidating—WCC is a leader in this effort and stands to benefit from the continued trend. Consolidated markets have more rational pricing and structurally higher margins than seen in North America with Europe & Canada being prime examples. The top 3 distributors in Europe have ~50% market share and Rexel’s 2012 operating margins were 7% in Europe vs. 5% in North America. Canada is similarly consolidated (WCC now has ~25% market share) and margins are also structurally higher—WCC recently acquired EECOL, a leading Canadian distributor and that business had operating margins of 11% vs. WCC’s 6% in 2012.
Relative to the other full line North American distributors, WCC has a number of advantages. Rexel & Sonepar are part of larger French companies who entered the North American market via acquisitions; in the past they have struggled with integration issues (Rexel in particular) and on the margin this can make WCC a more attractive acquirer. Graybar is employee owned and is run as such (much lower operating margins, very little acquisition activity).
Today, WCC’s Industrial, Construction, Utility and Institutional segments make up 44%, 32%, 12% and 12% of revenue respectively with the US and Canada accounting for 69% and 25% respectively of revenue.
WCC’s end markets grow roughly in line with nominal GDP. Over the last 19 years, WCC has grown revenue at an 8% CAGR driven roughly 50/50 by organic & acquired growth. Over the long term, we anticipate WCC will grow at similar rates as they continue to participate in end market growth, slowly take organic share and via further acquisitions. Near to medium term growth will likely exceed 8% for a number of reasons: 1) on an organic basis, WCC revenue is still 3% below peak 2008 levels 2) The recent EECOL acquisition is their largest to date (adding 14% to revenue) and most importantly 3) The Architectural Billings Index suggests non residential construction should begin to grow y/y in 2014.
The non residential construction segment provides a good example of WCC share gains. Since the peak of 2008, US non residential construction put in place is currently down 19% as measured by the US Census Bureau; over the same time, WCC’s non residential segment is up 3% organically. Some of this is due to mix and better end markets; nevertheless, WCC appears to have taken share in the downturn.
A key, and potentially underestimated, source of earnings growth for WCC is their ability to consistently improve margins. WCC claims they are the #1 customer for all their top 10 suppliers—this allows the company to get better pricing (usually through incentive and volume rebates) vs. small competitors and creates a virtuous cycle of better prices driving more volume driving more purchasing power.
In addition to the organic margin improvement, WCC’s strategy has been to upgrade its margin profile via the acquisition of better businesses. Since the peak of 2007/2008, WCC has acquired $1.5bn (25% of peak levels) of higher margin revenue. These businesses have operating margins in the high single to low double digits vs. WCC’s 5.7% in 2012 and 6.9% at the peak suggesting management’s 2013 guide of 6.2%+ is still far from what we should expect to see at the next peak.
One other thing to note on margins—40%-45% of WCC’s business is direct ship, these are generally custom built or large bulky items that are shipped directly from the supplier. Direct ship items usually have lower gross margins but require less opex and result in similar operating margins. A pick up in large construction projects would mean a moderate mix shift to more direct ship. Over the last decade the mix has remained relatively stable.
Through scale, purchasing power and the acquisition of better businesses WCC has grown gross margins from 16.0% of revenue to 20.2% over the last 19 years. As the GM drops to the operating income line, WCC has been able to consistently increase operating margins. Operating margins have improved from 1.3% in 1994 to 5.7% today (23 bps per year on average); evidence of structural margin improvement can be seen in the 2009 trough operating margins of 3.9% as compared to the previous recession low of 2.3% in 2002 (also an average improvement of 23 bps per year).
Recent acquisitions have taken WCC’s estimated proforma debt to trailing EBITDA to roughly 4x (net debt is $1.8bn). We view this as positive for equity holders—the company went through 2 LBOs during the 1990s and the business has demonstrated its ability to support a modest amount of leverage. Further, management anticipates that by the end of 2013 they will be close to the high end of their normal debt to EBITDA range of 2.0x-3.5x. The debt consists primarily of a term loan facility, an A/R facility and a revolver. Unfortunately, there is a recession era convert that has increased the diluted share count by ~15%; it’s callable in 2016 and accounts for most, if not all, of the short interest in the stock. The AR and revolving facilities come due in 2014 and 2016 respectively; the $1.2bn term loan facility isn’t due until 2019. The weighted average cost of debt is ~4%.
Inflation. A modest amount of inflation is generally good for WCC. As suppliers raise prices, smaller competitors have to raise prices or eat the increases but WCC can push back (more than industry) via rebates. Inventory holding gains in inflationary periods aren’t a huge issue—copper is the biggest driver here and only ~9% of WCC’s sales are of copper related products; additionally, much of this product is direct shipped meaning WCC never holds the inventory. Finally, the nice part about modest inflation is that WCC will usually see the top line impact before they get wage inflation. High inflation could be a problem to the extent that it weakens the economy and dampens end market demand.
Cash flow and capital allocation. Management’s stated target is for cash flow to be 80%-90% of reported net income and in reality it’s been better (110%-120% over the last decade). Reported net income includes non cash intangible asset amortization, stock based compensation, non cash interest costs and higher GAAP taxes which all benefit FCF. As the business grows, increased working capital (usually 14%-15% of revenue) is a bit of a drag on FCF but the higher than target FCF/net income is likely to continue for the next few years primarily as a result of intangible asset amortization from the EECOL acquisition. Regarding capital allocation, management has a stated bias towards acquisitions because of the benefits of a consolidated market (discussed above) and because they believe that larger distributors get better technical support from suppliers and that size creates an advantage in attracting talent. Because of the evidence in the European and Canadian markets and WCC’s strong acquisition track record, we are generally supportive of the company’s efforts to lead industry consolidation.
WCC should compound intrinsic equity value at 20% over the long term; over the medium term the compounding should be meaningfully higher as the company stands to benefit from recent higher margin acquisitions, leverage and any improvement in non residential construction.
The basic long term compounding math is as follows: organic revenue growth of 4% (driven by nominal GDP and slight share gains) and operating margins improving 20-25 bps annually (vs. management’s long term guide of 40-60 bps—theirs includes improvement from acquisitions) should drive operating income growth of ~8% annually. Debt to EV is currently 33% and at a constant EV/operating income multiple, that organic 8% operating income growth translates to 12% returns to equity holders; add to that the 8% forward FCF yield and that implies 20% returns to equity holders. The sizable EECOL acquisition and improving non residential construction end markets should drive even greater medium term equity compounding.
Rexel is probably the best publicly traded comp and despite Rexel’s meaningful exposure to struggling European end markets, the two currently trade roughly in line. WCC’s 2013/2014 P/E of 13x/11x, and EV/EBITDA of 10x/8x is reasonably attractive considering the compounding.
The biggest risk to WCC is a downturn in the North American economy.
Supplier consolidation. WCC’s largest supplier, Eaton Electric recently acquired Cooper Industries and about a year ago ABB acquired Thomas & Betts. Combined, ETN is probably a 14-15% WCC supplier and no other supplier accounts for more than 5%. The risk from supplier consolidation is that WCC is less able to push back on pricing/rebates. Again, because of their relative position in the market, higher pricing is generally good for WCC vs. competitors. Also, we believe WCC was the largest customer for both ETN and Cooper’s electrical businesses and that these businesses will largely be run separately.
EECOL. WCC recently completed the $1.1bn acquisition of EECOL Electric, a leading Canadian electrical distributor. The positives of the deal are that EECOL has higher margins, exposure to fast growing Western Canadian markets and it should be ~17% accretive to 2013 EPS. Additionally, the acquisition gives WCC ~25% share of the Canadian market. WCC intends to continue to operate the business under the EECOL brand and won’t merge their Canadian operations; nevertheless there are integration risks and WCC took on a lot of debt to do the deal (it was their largest ever). Further, the Canadian exposure makes WCC more exposed to oil & gas volatility.
Amazon Supply. One concern that has come up is the threat from Amazon Supply; if it gains traction, we view this as a potential threat to the more retail, ad hoc focused distributors like Grainger and Fastenal. WCC’s business is focused on large projects (40%-45% direct ship) and long term integrated supply arrangements that are top down, consultative sales vs. the small bottoms up discretionary spend that Amazon is going after.
We believe an improving macro economy, modest market share gains, continued margin improvement, operating leverage, strong free cash flow and further accretive acquisitions should drive equity compounding of 20% over the long term. Over the medium term, improving non residential construction end markets and the sizable EECOL acquisition should drive intrinsic equity compounding of 25% or better.
Disclaimer: will579 had long exposure to WCC at the time of publication 3/26/13. will579 has no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. will579 makes no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained in this presentation. will579 expressly disclaims all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this presentation.
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