WCC - WESCO International: Wait And See If Margins Are Sustainable

2023-03-22 09:09:49 ET

Summary

• WCC has a strong foothold in the commercial and institutional construction sectors in both the US and Canada.
• The key debate surrounding WCC is whether the company can sustain its current margin or revert back to historical levels.
• I recommend a hold rating, but the bull case is that if WCC can meet consensus estimates, the stock should trade back to historical valuation of 12x.

Description

Electrical products and other industrial maintenance, repair, and operating supplies are distributed by WESCO International ( WCC ). The company has offices and distribution centers in the US, Canada, and other countries to serve its international clientele. In my opinion, WCC has a strong foothold in the commercial and institutional construction sectors in both the United States and Canada. WCC's data communication and utility vertical positions, as well as its international presence, have also been strengthened by the acquisition of Anixter . I believe Wesco can grow market share both organically through cross-selling initiatives for large customers and through continued consolidation with M&A, as WCC still has a relatively low share of the industries it serves. But as I'll explain below, management is under a lot of pressure to deliver results and prove that current margins are sustainable. The stock price could easily plummet if they fail to deliver. Nonetheless, the bull case's potential rewards are enticingly high if the plan succeeds in its execution. In general, I think it's best to be cautious and have a hold rating while we wait for further proof that profit margins can be sustained before making any investments.

4Q22 results

Revenues for WCC's 4Q22 were 3% higher than expected, largely due to a slightly better-than-expected gross margin. Demand is holding steady, and backlog is 44% higher. Preliminary January sales are up roughly 17% from the same time last year, which is also good news. The midpoint of management's revenue forecast for FY23 is $17.55, which is slightly higher than the consensus estimate. FCF conversion is also expected to increase from FY22 levels, with a range of 65-90% of net income being the target. In spite of this, management has admitted that stockpiles are unusually high and won't be reduced until supply chains are stabilized. I believe once we get past this supply chain issue, FCF conversion should start to normalize and get back to the 100% targeted figure set by management.

Growth margin

Upon further examination of the projected growth, it seems that the estimated sales growth of 6-9% for FY23 includes the benefits of pricing from the previous year, without factoring in any additional pricing actions. Given that management has mentioned a good start to the year with continued momentum in February, we can infer that the guidance is factoring in a weaker performance in 2H23. Investors should take this into account when building their models.

In FY23, we should see an increase in gross margin as the Anixter acquisition helps salespeople make better calls on pricing. Also, since much of WCC's business is project-based, the company's margins improve (especially in the current macro climate, where things change rapidly) because prices and profits are locked in at the outset of the process, thereby giving good visibility. As a result, I think a more-than-expected drop in volume is what will really hurt gross margins. Now on the flipside, I believe what is putting investors ‘on-hold’ is that WCC gross margin is at its all-time-high, and I would imagine the bears to expect gross margin to contract sharply in the near-term, which will cause earnings to get decimated. In fact, I think this is the core reason why WCC Is trading at 8x forward earnings as the market is worried about the decline as well. The risk is also present in consensus revising estimates. Currently, consensus are projecting a rather flattish gross margin line (21+% gross margin) over the next 3 years. Suppose management fails to sustain margins, we could see the following happening: WCC misses GM expectations > consensus revise gross margin > thereby revising EPS downwards > negative narrative surrounds the stock that earnings will continue to fall in the near-term > share price falls. This is not an impossible surround to imagine, as such I believe the pressure for management to execute is high.

As for opex, I anticipate that all cost lines, below the gross margin line, will continue to show price increases. While the company will see some positive effects from reduced incentive compensation, I anticipate an increase in labor costs when the company renews contracts for facility leases and freight transportation. However, I'm putting my money on WCC's ability to use operating leverage from the increase in sales to counteract the impact of cost inflation on margins. In my opinion, management anticipates this as well, given their margin projections.

Valuation

Here I set out the bull case valuation for WCC. Supposed WCC can meet consensus estimates in gross margin and revenue over the next 3 years, I believe the market will find itself rewarding WCC for its structurally higher margin relative to history. WCC stock should trade back to historical valuation of 12x if this happens, and the share is worth $244.

Summary

I believe WCC has a strong presence in the commercial and institutional construction sectors in the US and Canada, as well as a solid international presence following its acquisition of Anixter. While the company's 4Q22 results were better than expected, I believe the key debate is whether WCC can sustain its margin or see it revert back to historical levels. The outcome of the stock in the near-term is heavily dependent on management ability to show the market if WCC margin is structurally higher today. I would recommend waiting for more evidence that margins are sustainable before investing.

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