RXEEY - Rexel S.A.: Slowing Industrial Demand Is A Risk But Expectations Are Low

2023-09-07 11:26:42 ET

Summary

• Rexel S.A. has continued to outperform expectations, as strong growth in new electrification markets like automation, EV infrastructure, and renewable energy have continued to ramp up.
• The company's core markets are looking weaker, with industrial end-markets slowing, housing prices falling across its major markets, and commercial real estate seeing weakness as well.
• Self-help remains an underappreciated lever, as the company continues to execute on its digitalization initiatives while also gaining share in key markets and broadening its portfolio of offerings.
• I see near-term risks from slowing industrial and property markets, but the long-term outlook is positive and the shares appear meaningfully undervalued on low-to-mid single-digit growth expectations.

Shares of Rexel S.A. (RXLSF) (RXEEY) [RXL.PA] have delivered mixed performance since my last update . While the shares of this international distributor of electrical products has outperformed the larger industrial sector and some of its key suppliers since then, more diverse distributors like Grainger ( GWW ) and WESCO ( WCC ) have done even better, as I believe Rexel has been held back by investor concerns over its market exposures, and particularly its European markets.

Rexel has continued to outperform both Street expectations and its own guidance and goals, and I don’t believe that is fully reflected in the share price. Even allowing for weaker industrial markets later this year and into 2024, Rexel is still well-leveraged to attractive growth trends in electrification like automation, electric vehicles, HVAC, and renewable energy, and likewise still has positive internal drivers like growing digitalization and market share gains. Low-to-mid single-digit growth can still support an attractive return from today’s level.

Weakening Core Markets Are A Risk

I don’t want to minimize the near-term risks to many of Rexel’s core markets. Macro indicators like PMI have slipped below 50 in virtually all of the company’s key markets, and I do still see a weaker outlook for many industrial markets over the next 12 months (even if economies like the U.S. avoid a recession). Suppliers in categories like automation have already reported significant slowdowns in their order books and uncertain demand outlooks, and I do expect cautious commentary through third and fourth quarter reports.

Commercial and residential markets are likewise shaky. After eight years of strong house price growth in the EU, the last two quarters have seen declines, bringing the overall index down about 3% from the high water mark. While there has been meaningful variation from market to market, with Sweden having one of the weaker performances, housing has still been weaker in important markets like France, Germany, and the UK, not to mention the U.S.

Commercial real estate has likewise been shaky, with well-reported issues in segments like office properties. While renovation and retrofit activity has helped offset this (more on this in a moment), the reality is that new-build market for commercial real estate isn’t particularly strong in any of Rexel’s major markets.

Electrification Has Underpinned Growth, And Can Continue To Do So

Offsetting some of the weakness in Rexel’s core legacy markets has been strong demand tied to new electrification projects including industrial automation, electrical vehicle infrastructure expansion, HVAC renovation, and renewable energy capacity growth.

While overall growth in the second quarter of 2023 came in at around 6% (with over 3% volume growth), these electrification categories grew at a 16% rate for Rexel, with 31% growth in the EU region. Rexel continues to report strong investments in solar across many of its EU markets, and I believe we are still in the early years of government-subsidized investments into EV infrastructure (charging stations and the like), as well as commercial HVAC renovation/retrofit projects, and industrial automation.

As a reminder, the EU is looking to subsidize projects to both reduce emissions and reduce the reliance of the EU on imported natural gas, and that includes investments both on the production side (large-scale solar projects) and the usage side (more efficient commercial HVAC, converting to electrical heating options like heat pumps in residential, and so on).

In past articles on companies like ABB (ABBNY), Eaton (ETN), Hubbell (HUBB), Schneider ( SBGSY ) I’ve made no secret of the fact that I believe electrification will be a strong multiyear secular growth opportunity for these electrical products manufacturers, as I expect significant ongoing investments in factory automation (part of meaningful reshoring efforts), renewable energy capacity, grid reliability, building automation, vehicle electrification, and HVAC retrofits. As a key distributor with national scale in many markets, Rexel will be a facilitator of this growth, as manufacturers are typically not well-suited to deal directly with customers.

I do believe that further investment into M&A will be a part of Rexel’s growth strategy here. The company acquired another industrial automation distributor in the U.S. last year (Horizon Solutions, which works largely with Rockwell (ROK)), and I believe there is room to acquire across these growth markets. I’d also like to see Rexel add more capabilities in the data center space – management doesn’t often talk specifically about this market all that often, but I believe ongoing investments in high-power functions like AI/machine learning will continue to support a healthy growth opportunity in this sub-market.

The Outlook

Apart from the normal cyclicality of the electrical products markets that Rexel serves, I am not really concerned with Rexel’s positioning, nor its ability to meet or exceed the growth and margin targets it laid out last year as part of its “Power Up 2025” strategy. Although distribution is a tough, low-margin business in general, the growing sophistication of electrification projects provides more value-add opportunities for large distributors like Rexel. Likewise, I still see room for more margin leverage from the company’s ongoing digitalization efforts – more than a third of the company’s EU business is now handled digitally (35% in Q2’23) and penetration continues to grow in North America (up almost 5% in Q2 to 16.7%).

Given that I believe major electrification trends (automation, EVs, solar, et al) can support long-term growth in the neighborhood of 4% to 5%, while more traditional markets are likely to grow closer to 2%, I don’t think my long-term revenue growth target of 3% is particularly ambitious.

Rexel has outperformed my margin improvement expectations for some time, and my EBITDA margin target for 2025 has moved from a little under 8% to over 8.5%. I don’t want to get too far ahead of the progress, though, as I do think significant competition among major distributors will still cap margin expansion opportunities. With that, I think free cash flow margins can improve by around a point over the next decade (on average) and possibly reach 4% (versus a long-term average in the 2%’s), turning that 3% revenue growth into 6%-7% annualized FCF growth.

Between discounted free cash flow and margin/return-driven EV/EBITDA, I believe Rexel is undervalued, with 30% or better long-term upside from this level. Even with a 15% discount to what would normally be a “fair” multiple based on Rexel’s margins and returns (ROIC, et al), the shares look more than a third undervalued today.

The Bottom Line

I do think Rexel could see more weakness in its legacy industrial, commercial, and residential markets before these businesses reaccelerate. I do expect ongoing investments into advanced electrification projects to paper over this weakness to some extent, but the market is clearly concerned about the risk of a downturn in core electrification demand. I don’t want to downplay the sentiment headwinds that Rexel could face over the next six to 12 months from that, but I think the long-term opportunities tied to electrification and self-improvement are such that these shares are still worth a look.

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