2023-12-26 13:06:22 ET
Summary
- WESCO International's growth rate is expected to moderate in the near term due to lower backlog levels and moderating demand trends.
- The company's revenue growth has slowed, with organic sales increasing by 2.8% year over year in Q3 2023.
- Margins have been impacted by lower supplier volume rebates and a shift in sales mix, and the outlook remains mixed with a normalizing pricing environment.
Investment Thesis
While WESCO International, Inc. ( WCC ) has shown a good growth rate over the last few years, I expect a moderation in its growth rate in the near term due to lower backlog levels and moderating demand trends. Further, with the three-year integration program with Anixter coming to an end this year, the benefits from the cross-sell synergies should also be modest moving forward. There are some positives like a potential reversal in the interest rate cycle in the back half of FY24, secular tailwinds such as the recent reshoring trend, and increased grid modernization spending which should result in good end-market demand. However, I don't think we will likely see the double-digit organic sales growth that the company saw over the last couple of years (till Q1 2023), anytime soon.
The margins are expected to remain flat sequentially due to the normalizing pricing environment and the fact that most of the cost synergies from the integration of the Anixter acquisition have already been realized over the last three years. Coming to valuation, the stock is trading in line with the historical averages. I have a neutral rating on the stock given moderating growth prospects and in line with historical valuations.
Revenue Analysis and Outlook
Over the past few years, WCC's sales have benefited from good demand trends, price increases, and the execution of the cross-sell program. Further, accretive M&A favorably impacted sales growth. However, the company's sales growth has started to moderate of late.
In the third quarter of 2023, the company reported a 3.6% Y/Y increase in net sales to $5.644 billion. Excluding a 2.4% favorable impact of the Rahi Systems acquisition and a 1.6% negative impact from one less workday in the quarter, organic sales increased by 2.8% Y/Y. Pricing contributed 3% to organic sales, while the contribution from volume growth was flat Y/Y.
In the Electrical & Electronic Solutions ((EES)) segment, net sales declined 2% Y/Y with a 0.2% decline in organic sales. The organic sales decline was attributed to weakness in the construction and manufactured structures businesses, which more than offset the high-single-digit growth in the Industrial business.
The Communications & Security Solutions ((CSS)) segment's net sales grew 11% Y/Y on a reported basis and 4.1% Y/Y on an organic basis. This was attributed to low double-digit growth in network infrastructure, low single-digit growth in security businesses, and double-digit growth in the professional audio/visual installations business. Further, the acquisition of Rahi Systems contributed 8.2% to the sales growth, driven by strong demand from hyperscale customers for Wesco Data Center Solutions.
In the Utility & Broadband Solutions ((UBS)) segment, net sales increased 4.2% Y/Y and 5.8% Y/Y organically due to high single-digit growth in the utility business driven by electrification, green energy, and grid modernization investments. Further, low double-digit growth in Integrated Supply sales driven by new programs and scope expansion with customers added to the overall sales growth. These positives were partially offset by a double-digit sales decline in broadband business as customers continued to work through inventory destocking in the third quarter.
Looking forward, the company's revenue outlook is mixed, with near-term headwinds from lower backlog and moderating cross-selling benefits on the one hand and a long-term secular tailwind from reshoring on the other.
On its last earnings call , management noted that the company's backlog at the end of Q3 2023 was down 6% Y/Y and ~7% sequentially from the end of June. The improving supply chain situation and normalizing lead times have resulted in customers returning to normal ordering patterns and implementing inventory destocking. This is resulting in backlog going back from high levels seen over the last couple of years to more normalized levels. Over the last few quarters as the company burned through its high backlog levels converting it into sales, its growth rate benefitted. However, with a declining backlog, it should be less of a help going forward.
Further, management noted a step-down in demand trends in October on its last earnings call and noted that sales per workday were down ~2% Y/Y in the month. This is what the company's CFO David S. Schulz said on the last earnings call :
As we start the fourth quarter, end market demand trends have moderated versus our prior expectations. We experienced a step-down in demand in October with preliminary reported sales per workday down 2%.
CSS was up low single digits including the benefit from Rahi. EES was down low single digits with growth in industrial offset by declines in construction and OEM. UBS was also down low single digits as we continue to see broadband down double digits, offsetting modest growth in utility and integrated supply."
A step-down in demand trends coupled with a lower backlog doesn't bode well for the company's near-term growth prospects.
Further, over the last few years, the company benefitted greatly from the cross-selling opportunities post-Anixter acquisition. According to targets shared by management, the company is close to realizing cumulative cross-sell synergies of $2.2bn through the end of 2023. These cross-sell synergies have resulted in a good amount of market share gains and outperformance for the company in recent years. However, with the company's three-year integration program with Anixter coming to a close at the end of this year, I believe the majority of the cross-sell synergies have already been realized and the incremental benefit from cross-sell opportunities should be relatively modest moving forward.
On the positive side, the recent reshoring trend catalyzed by the government stimulus from CHIPS and Science Act and Inflation Reduction Act should result in good demand from the company's end markets in the medium term. The company's utility end market should also benefit from increasing grid modernization spending. Further, the upcoming reversal in the interest rate cycle should help start activities in some of the customers' projects that were pushed out due to the high-interest rate environment.
Overall, I expect the next couple of quarters to be tough for Wesco due to lower backlog levels and moderating demand trends. The growth should pick up toward the back half of next year as the interest rate cycle reverses and the company starts benefitting from reshoring-related demand. However, I don't think we will see the double-digit organic growth seen over the past few years (till Q1 2023) anytime soon.
Margin Analysis and Outlook
In Q3 2023, the company's margins were negatively impacted due to lower supplier volume rebates, a shift in sales mix, and higher SG&A. However, this was partially offset by benefits from cost-reduction actions. As a result, the gross margin contracted by 50 bps Y/Y to 21.6%, and the adjusted EBITDA margin contracted by 50 bps Y/Y to 8.1%.
Segment-wise, the EES segment saw its adjusted EBITDA margin decline by 140 bps Y/Y due to lower supplier volume rebates, business mix, and higher SG&A as a percentage of sales. On the other hand, the adjusted EBITDA margin in both CSS and UBS segments expanded by 10 bps Y/Y.
Looking forward, the company's margin outlook remains mixed. Over the last couple of years, the company has seen a strong pricing environment due to supply chain constraints, and its margins have benefited as a result. However, the pricing environment is now normalizing, and I am expecting sequentially flat gross margin levels moving forward.
In recent years, the company's operating margins benefitted from cost synergies from the integration of the Anixter acquisition. According to management, it remains on track to achieve $315mn in cumulative run-rate cost synergies by the end of 2023. However, with the three-year integration program coming to a close, the incremental cost synergy opportunities should be relatively modest moving forward. So, I am expecting a flattish trend for operating margins as well.
Valuation and Conclusion
WCC is currently trading at a 10.42x FY24 consensus EPS estimate of $16.90, which is in line with the Company's 5-year average forward P/E of 10.41x. The company has performed well over the last few years and the execution of Anixter International integration has been a great success. However, the market continues to apply lower multiples to the company as there are long-term risks associated with Amazon ( AMZN ) entering B2B distribution and how it will impact traditional brick-and-mortar distributors. I believe investor perception is unlikely to change in the near term, and this worry should keep valuation multiples from re-rating higher.
I also don't like the company's revenue outlook for the next few quarters, with near-term headwinds from a declining backlog and moderating cross-selling benefits. The margin expansion prospects are also mixed with a normalizing pricing environment and limited incremental cost synergy benefits from the Anixter integration resulting in a flattish margin outlook. Given the company's moderating growth prospects and an in-line valuation versus historical averages, I have a neutral rating on WCC stock.
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WESCO International: Growth Should Moderate In The Near Term