Consider WESCO International For A Turnaround - WESCO International, Inc. (NYSE:WCC)

WESCO International (WCC) distributes products and provides advanced supply chain management and logistics services to the industrial, construction, utility, and commercial, institutional and government customers. I think the company’s long-term growth drivers are robust. Expect the stock price to stay steady in the short-term, and a rebound in the medium-to-long term.

WCC is faced with diverging forces in the industry. While there is a deceleration in MRO and OEM sales for industrial products, we notice a healthy construction activity and an improving utility sector sales. The company’s strength lies in cashing in on cross-selling opportunities in the electrical and communications products and project management expertise. In Q1 2019, it received a five-year contract with estimated total revenues of $350 million. Its cost minimizing initiatives have already reflected in improving its gross margin in the past couple of quarters.

The LED light bulb business across the world can be the growth catalyst the company is looking for. To bolster its effort, it has recently acquired the assets of a company which offers lighting upgrade, retrofit, and renovation solutions. The company’s cash flow shrunk significantly in Q1 and may increase the near-term financial risks. At the current level, the stock can be relatively under-valued.

WESCO International’s growth parameters are closely tied to industrial production and other key economic indicators. According to the U.S. Federal Reserve Statistical Release in June 2019, the industrial production growth has been muted in 2019, although it did show signs of improvement in May compared to the previous month. Month-over-month, the U.S. industrial production was up by 0.4% in May. While the utility sector was relatively stable (2.1% up) in May, the indexes for manufacturing and mining were muted (0.2% and 0.1% up, respectively).

According to tradingeconomics.com, Industrial Production in the U.S. averaged 3.73% from 1920 until 2019. So, the current growth rate is lower than its historical average. In Q1 2019, the company’s revenues from the U.S. declined by 1.5% year-over-year, while revenues from Canada decreased by 3.5% during the same period. Lower sales in the utility sector in Canada primarily pulled the company's Canada performance lower. While revenues from U.S. utilities increased (3% up), it crashed in Canada (38% down) year-over-year. In Canada, the company decided to discontinue a significant contract as a result of inadequate margin.

Such divergence, however, did not affect the industrial sector, where sales were uniformly flat in the U.S. and Canada. The company’s management is quite optimistic about the industrial sector demand. The positive momentum would continue to take sales in petrochemical, metals, and mining, and food processing industry forward, while it would decline for the OEM (other equipment manufacturers) customers.

The growth in non-residential construction projects, which represent WCC’s primary end-market in the construction category, has attracted investments in recent times. According to data provided by the U.S. Census Bureau, from March until May (latest reports available), the housing market has been resilient. According to edzarenski.com, non-residential buildings construction spending can remain steady in 2019 (down 0.2%), while the pace is likely to pick up in 2020 (up by 8.9%). Similarly, the residential construction spending is expected to stay flat in 2019 and then pace up next year.

Although the number of units declined in 2019 so far, sales in the Commercial, Institutional, and Government (or CIG) segment increased by 2% in Q1 2019 compared to a year ago. The growth was driven by LED lighting renovation and retrofit applications, broadband build-outs, fiber-to-the-x deployments, and network and security solutions.

WCC’s gross margin was 19.5% in Q1 2019, which was 0.4% higher than a year ago and 0.1% up versus Q4 2018. The improvement was notable because, by the end of 2018, the company witnessed input cost inflation and supplier price increases. The use of LEAN continuous improvement initiatives has led to improved productivity. WCC has extended its LEAN efforts and project management expertise to capitalize on new non-residential construction opportunities. As a result, the company’s gross margin in Q1 represents the third consecutive quarter of improvements.

However, the Q1 margin improvement benefited from the improved gross margin in the SLS acquisition. In March 2019, WCC acquired certain assets of Sylvania Lighting Services Corp. (or SLS), which offers lighting upgrade, retrofit, and renovation solutions. The acquisition was WCC’s second purchase in the lighting section (in 2015, the company acquired Aelux/Lumigent). According to the management, LED lighting is its priority category, which presented a significant growth opportunity. However, some legacy lamp business continues to be a part of its portfolio. The legacy bulb business if fast losing margin, with more than 15% declines every quarter. There is, however, no denying of the attractiveness of the overall market size. The LED bulb business is estimated to be ~$300 billion, plus the business opportunity for the base installation.

As I discussed earlier, the utility business was one of the primary drivers for growth in the U.S. The company has been able to increase its utility business in the past seven years until 2018. In Q3 2018, WCC received three major annual renewals worth triple-digit millions. In Q4, it won two more contracts. In Q1 2019, it received a five-year contract with estimated total revenues of $350 million to provide electrical generation, T&D materials, lighting, and MRO supplies. The company is primarily dealing with large public power customers across the U.S. and Canada. Although 2019 has not been very prolific so far because of the decline in Canada, the company believes that it can recover a lot of the lost ground in the latter half of the year.

In the metals and mining sector, the company renewed a five-year contract to support capital projects and provide electrical and MRO materials. The deal will yield an estimated total revenue of ~$250 million, which would be 15% higher than the current contract value with that customer. As the business momentum improved in both the U.S. and Canada in recent months, WCC’s management expects moderate growth in the non-residential construction market in 2019.

WCC targets customers in the construction industry who need project management and construction services solutions. It targets customer groups which have been facing a tight skilled labor market, cost inflations, and tariff-related price pressures, which added up to higher costs for their projects. The company aims to reduce the supply chain complexity and add value by increasing construction job site productivity. As a result, it received the multimillion-dollar contract in Western Canada, as I have already discussed in the article.

Given the nature of the industry, the company primarily focuses on public power and utility contractor customers. Due to the secular growth in some of these industries, including the construction market, industrial output, grid hardening, reliability projects, and renewable energy, the company expects long-term growth to accelerate.

In FY2019, WCC’s management expects revenues to increase by 3% to 6% compared to FY2018. For FY2019, the operating margin can vary between 4.3% and 4.7%, which would be in line with its higher than the current performance (Q1 2019 operating margin was 3.6%). Compared to FY2018, diluted EPS can increase by 12% to a range between $5.10 and $5.70.

WCC’s management also expects the Q2 2019 results to improve compared to Q1. While the quarterly revenues are expected to increase by 3% to 6%, the operating margin may improve by 0.35% to 4.6% compared to Q2 2018. However, the positive bearing from the year-over-year margin expansion would look less attractive when you consider the fact in Q2 2018; its operating margin was adversely affected by a bad-debt charge related to a Canadian customer. Nonetheless, the operating margin would still be an improvement over Q1 2019 when it was 3.6%.

In Q1 2019, WCC’s cash flow from operations (or CFO) decreased by 46% compared to a year ago. On top of a 2% decline in year-over-year revenues, an increase in trade accounts receivable, rising inventories, and higher management incentive payments led to the CFO deterioration in Q1 2019. In FY2019, its capex is likely to remain unchanged compared to FY2018.

Its liquidity totaled $781 million as of March 31. The company has set a target financial leverage ratio of between 2x to 3.5x EBITDA which is consistent with its current leverage of 3.0x. Its debt-to-equity ratio (0.59x) is lower than its competitors (0.81x), including DXP Enterprises (DXPE), Fastenal Company (FAST), and HD Supply Holdings (HDS).

In October 2018, it initiated a $400 million share repurchase program that is set to expire in 2020. It plans to repurchase $75 million worth of shares by June 2019. WCC’s contractual obligation involves repaying $826 million of debt between 2019 and 2020, followed by $350 million debt repayment in 2023 and after. With the available liquidity, and at the current cash-flow-generation-run-rate, it can face a tight situation in managing the capex and share repurchase programs.

WCC is currently trading at an EV-to-adjusted EBITDA multiple of ~8.3x. Based on sell-side analyst estimates, WCC’s forward EV/EBITDA multiple is lower, which implies higher EBITDA in the next four quarters. Between FY2013 and FY2018, the EV/EBITDA multiple was 9.8x. So, it is currently trading at a discount to its past six-year average.

Its forward EV-to-EBITDA multiple contraction versus the adjusted trailing 12-month EV/EBITDA is marginally steeper than the industry peers’ average multiple compression because the sell-side analysts expect the company’s EBITDA to improve more sharply compared to the peers in the next four quarters, which would typically result in a higher EV/EBITDA multiple. However, the stock’s EV/EBITDA multiple is lower than its peers’ (HDS, DXPE, and FAST) average of 11.9x. So, the stock can be relatively under-valued at the current level. I have used estimates provided by Thomson Reuters for the table above.

According to data provided by Seeking Alpha, six sell-side analysts rated WCC a “buy” in June (includes “outperform”), while 11 of the analysts rated it a “hold”. None of the analysts rated a “sell”. The consensus target price is $65.9, which at its current price yields ~31% returns.

However, according to Seeking Alpha’s Quant Rating, the stock receives a “Bullish” rating. Although its ratings are high-to-moderate on value and EPS revisions, the ratings are moderate-to-poor on growth, momentum, and profitability. I agree with Seeking Alpha’s rating on value because the stock can be relatively under-valued, as I discussed earlier in the article. I also agree with the assertion on growth and profitability, because the company’s revenue and profit growth rate, as well as profit as a percentage of revenue, have been lower than many of its peers.

WCC is faced with diverging forces in the industry. While there is a deceleration in MRO and OEM sales for industrial products, we notice a healthy construction activity and an improving utility sector sales. The company’s strength lies in cashing in on cross-selling opportunities in the electrical and communications products and project management expertise. Its cost minimizing initiatives have already reflected in improving its gross margin in the past couple of quarters.

The LED light bulb business, which according to the company's estimates is a $300 billion business worldwide, can transform WCC's outlook. To cash in on the opportunity, it has made a couple of acquisitions, one of which was recently (March 2019). I expect the integration of the electrical equipment and construction business will improve its margin, going forward. At the current level, the stock can be relatively undervalued. I think the company’s long-term growth drivers are robust. Expect the stock price to stay steady in the short-term and rebound in the medium-to-long term.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Seekingalpha.com

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