2023-10-20 10:14:37 ET
Summary
- Encore Wire is exposed to manufacturing re-shoring, increased adoption of EVs, push to develop renewable energy, and emergence of AI.
- The company is cash rich, has no debt, and trades at just 9x forward earnings.
- The stock offers 30% upside to fair value.
Introduction
Over the past few years, the US government has made a push towards developing the country’s infrastructure and manufacturing base. This industrial policy through subsidies is expensive, but whether you agree with it or not, the bills have been passed and the money will be spent. In addition, consumers and corporations concerned with the environment are putting their dollars to work in moving towards green energy. Finally, the trend du jour of artificial intelligence is energy intensive, and requires physical infrastructure to support it.
Encore Wire ( WIRE ), as its name implies, makes wires. Plain and simple. Wires are a necessary and critical component for most of today’s buildings and applications. Rather than making acquisitions or returning too much capital to shareholders, the company is investing in America by expanding production and vertically integrating. The stock trades at a single digit earnings multiple, has a fifth of its value in cash, and offers substantial upside if it can maintain its profits at the current level.
Company background
Encore Wire is headquartered in McKinney, Texas, north of Dallas. It manufactures low voltage electrical wire (less than 600 volt applications) at this campus. It sells its products to wholesale electrical distributors in the US, who supply end customers like contractors. The company’s manufacturing facility has quick rail access to other parts of the US.
Wire is made from copper cathodes or scrap that are first fashioned into specific rod shapes. These blocks are then extruded into wires of various diameters, after which they are insulated. Such copper wires make up 85% of revenue, with the balance being aluminum wires.
The company does not hedge commodity costs, but rather attempts to pass these on to customers. Periods of increased demand in relation to supply lead to higher margins, while the opposite situation leads to lower margins.
Exposed to favorable long-term trends
The company’s products’ end uses are approximately a quarter in residential construction, and three quarters in non-residential construction. With higher interest rates, residential construction is admittedly challenged. However, the impact has arguably already been felt, and the future path of rates is likely to be flat to down.
It is the non-residential sector in America that has a bright future. The Infrastructure Investment and Jobs Act passed in November 2021 offers increased subsidies for broadband Internet access, electric vehicle charging, and power infrastructure. The CHIPS and Science Act passed in July 2022 mandates big subsidies for building semiconductor plants in the US. The Inflation Reduction Act passed in August 2022 offered further subsidies for green energy and manufacturing.
The last year has seen the emergence of Artificial Intelligence ((AI)) as a hot new trend. To train and run models, servers need to use a lot of power, reportedly 2-3x that required for conventional applications. The increased power requires more cables.
Want to build a chip plant? Be ready to wire it for it to be operational. Want to grab the $7,500 subsidy for an electric vehicle? You’ll need to run a 220V wire to charge it. Want to build a windmill farm to supply clean energy? Wires needed. Want to run a large language model to train your AI application? The data center is going to need a lot of wires to supply the power-hungry servers.
Solid competitive position with barriers to entry
market share information about the low voltage wire sector is not publicly available. Based on information provided in the company’s 10-K (page 4) and our proprietary research, we believe Encore has about a third of the market, and is the near market leader, perhaps a little behind Southwire, a private company. Cerrowire (a division of Marmon, a Berkshire Hathaway company) has about half this market share, and a handful of other competitors like General Cable (part of the Prysmian Group) and AFC Cable Systems (a part of Atkore International) have single digit market shares. It is thus a fairly concentrated market. Encore’s dominant market position gives it scale and preferred customer access for buying raw materials. It is also more vertically integrated than most of its competitors, making copper rods and insulation.
Converting raw materials into wires by melting and shaping them is very energy intensive, using huge furnaces that cannot be easily turned off and on. Thus, it is hard for a new entrant to get into this business without established customer relationships to provide a baseload of demand.
Encore’s supplier and customer relationships, its long operating history of providing quality products in a timely manner, and its existing manufacturing base provide substantial barriers to entry.
Encore financial overview and outlook
For the quarter ending June 2023, the company reported $636 million in revenue and $127 million in operating income. Diluted EPS came in at $6.01, aided by an 11% reduction in the share count YoY. The company ended the quarter with $668 million of cash and no debt. Thus, it had net cash of $38 for each of the 17.4 million diluted shares.
The balance sheet was pristine, with perhaps the only point of concern being PP&E up 11% YTD, as the company spends heavily on capex in excess of depreciation. It is expanding capacity and vertical integration, adding manufacturing for new types of insulation. The company expects capital expenditures to go down in 2025 from the current elevated level.
For 2023, the company is expected to earn $21 per share, going down to $18 per share next year as margins normalize. This should prove to be a steady earnings base for future years.
The company does not pro-forma out costs to report inflated non-GAAP figures. What you see according to GAAP is what you get! It does report an EBITDA figure, but one can safely ignore it.
Balanced capital allocation
Encore does not make acquisitions, period. Thus, it does not waste company resources in looking for, evaluating, and ultimately overpaying using shareholder money.
The weakest point in the company’s capital allocation framework is the $0.02 quarterly dividend . This is not at a level that would be appealing to income investors. The company’s priority is to reinvest its cash flow to expand capacity, lower costs, and improve its competitive position. Finally, the excess is used to repurchase shares, and this has proven to be a sound use of capital as the stock has steadily gone up over the last few years . The company is maintaining a larger than warranted cash balance, which gives it optionality in case the stock goes down due to non-fundamental reasons.
Long tenured management with skin in the game
According to the company’s 10-K (pages 4 and 5), CEO Daniel Jones, has been with the company for 33 years, and has been CEO for the last 18 years. CFO Bret Eckert has been with the company for 4 years, prior to which he was the CFO of another company and a partner at Ernst & Young. The company’s proxy statement details on page 14 that the CEO owns 4% of the company, and the CFO 1%. In addition, page 26 of this statement shows that 58% of the CEO’s 2022 compensation and 64% of the CFO’s was in the form of stock awards.
Why the opportunity?
When looking at an investment, a relevant question to ask is why the opportunity exists. Why do you think there are people taking the other side?
The company got a boost from increased residential construction meeting supply constraints during Covid, resulting in revenue doubling in 2021 from 2020 (and 2019). In its latest 10-K (page 5), the company said that supply chain constraints had positively impacted the prices at which it had sold its products. Some investors focus on reversion to the mean, and in many cases, this works out. However, even assuming some margin degradation, there is a sufficient margin of safety here given the company’s healthy cash balance, new revenue sources and low valuation. Investors could also have a point of view that the economy could weaken to a point where reduced demand would cause revenues and margins to go down a lot.
A reflection of investor skepticism is the fact that short interest is high at 25% of float. If the company continues to deliver, this could provide a boost as the short positions get covered.
WIRE valuation: Fair value of $225
I will apply a 12.5x multiple on 2024 EPS of $18 to value the stock at $225. Thus, the stock offers 30% upside from the current $173 price. I believe a 12.5x multiple, representing an 8% earnings yield, is reasonable given current long-term interest rates at the 5% level . It also compares favorably to the current market multiple of around 20x.
The company’s net cash position, cash generation and reasonable valuation put it in a good position to continue to buy back stock and pay out a special dividend if it chooses to. Much will depend on the path of the economy over the next year.
In a bear case, margins will go down and the company’s earnings could come in much lower. A 40% drop in expected earnings would imply a share price of $135 at the same multiple, for 20% downside.
I am not adding back the cash balance in determining value because with higher interest rates, the cash is contributing to profits, and this is included in the EPS estimates.
WIRE’s competitors are private or a part of larger diversified companies. There are thus no good public market comparables.
I recommend that value investors buy WIRE shares. At a $2.4 billion enterprise value, the company could be a target for a larger industrial player, especially given the investments it is making to secure its market position.
Risks are moderate
In spite of all the positive attributes, an inescapable fact is that the company’s products are commodities. Customers do not seek out a specific brand when they buy wire.
The biggest risk is that the company’s earnings will come in lower than expected due to a reduced demand or margins.
If the company is unable to pass on higher commodity costs in a timely manner, this could cause a hit to profits.
AI could turn out to be more hype than hope, resulting in lower demand from data centers. There is some evidence that demand is weakening. Belden ( BDC ), which provides connectivity solutions among other products, pre-announced that it expects revenues to be 10% lower than expected this quarter.
Shareholders depend on a company’s management being good stewards of their capital. There is a risk that the company is miscalculating the potential returns from its capital investments.
Conclusion
An investment in WIRE offers exposure to favorable trends, and an opportunity for high financial upside, with reasonable risks. The company’s large net cash position offers downside protection.
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Like Infrastructure, Green Energy Or AI? You'll Love Encore Wire