Investment Thesis
While WESCO International, Inc. (NYSE:WCC) has seen a slowdown in growth in the last few quarters, its revenues should return to growth in the coming quarters thanks to the easing comparisons and stable demand trends. Further, increased spending on infrastructure, electrification, broadband expansion, grid modernization, and data centers should result in good end-market demand and contribute to revenue growth in the medium to long term. Additionally, the company has a good track record of outpacing its distribution peers and publicly listed suppliers in sales growth thanks to its good execution, which I expect to continue helping the company drive above-market growth. Apart from organic growth, the company’s reasonable net leverage of 2.6x should also enable it to pursue its bolt-on acquisition strategy which should complement its organic growth.
On the margin front, I expect sequential margin expansion driven by benefits from cost reduction actions in the recent quarters, operating leverage from improving sales outlook, and divestiture of low-margin Wesco Integrated Supply business in the Utility & Broadband Solutions segment. The longer-term margin outlook is also favorable, with continued benefits from productivity improvements, and the adoption of digital solutions. Coming to valuation, the company is trading at a discount to its peer distributors and as the company continues its good execution, I believe its P/E multiple can see a re-rating. Hence, I am upgrading my rating to a buy.
Revenue Analysis and Outlook
I last covered WCC in December 2023, where I discussed my concerns about sales growth given the declining backlog and moderating demand trends. The company has reported its Q4 2023 and Q1 2024 results since then and similar dynamics were seen there.
In the first quarter of 2024, the company’s sales declined 3.1% Y/Y to $5.35 billion. Excluding a 0.1% favorable FX impact, organic sales declined by 3.2% Y/Y due to volume declines across all segments, partially offset by a 1% contribution from pricing increases.
Segment-wise, the Electrical & Electronic Solutions [EES] segment’s sales decreased by 1.7% Y/Y and 1.8% Y/Y organically due to a decline in OEM sales. The organic sales decline was partially mitigated by increased industrial sales resulting from growth in automation, electrical equipment upgrades, and strength in oil and gas markets. Construction sales were flat Y/Y as growth from large project shipments and strength in Canada was offset by continued weakness in solar due to difficult Y/Y comparisons.
In the Communications & Security Solutions (CSS) segment, sales were down 3.6% Y/Y on a reported basis and 3.7% Y/Y on an organic basis. The continued weakness in the service provider market resulted in lower Enterprise network infrastructure sales. The security sales were down high single digits due to difficult Y/Y comparisons. However, these negatives were partially offset by increased data center sales attributed to growth in hyperscale solutions.
In the Utility & Broadband Solutions [UBS] segment, sales fell by 4.5% Y/Y and 4.6% Y/Y on an organic basis mainly due to a decline in Broadband and Utility sales.
Looking forward, the company’s revenue growth outlook is positive. The first quarter had the toughest comparison with 10.8% Y/Y organic revenue growth in Q1 2023. In Q2 2023 and Q3 2023, organic growth slowed to low single digits, while in Q4 2023 it turned negative. So, the comparisons are easing as the year progresses. The company’s backlog was also flattish sequentially indicating stable demand trends, and management indicated solid quoting and bidding activity. An easing comp coupled with a stable demand trend indicated improvement in the coming quarters.
In the medium to long term, the company is poised to benefit from electrification, broadband expansion, infrastructure build and data center demand, and increased investment in grid hardening by utilities.
The company’s net leverage is also at a reasonable 2.6x after the last couple of years of deleveraging. So, I believe the company will again become active in the M&A market and bolt-on acquisitions should add to organic growth from FY25 onward. Wesco, as a large multinational player, with a broader product offering and better access to capital has better competitive advantages compared to smaller players and can act as a consolidator in the space.
The company has a good track record of growing sales above its peer group and even outpaces the growth of its publicly listed suppliers.
So, the company has done a good job in terms of gaining share, and I expect the good execution should continue to help Wesco deliver above-market growth.
Margin Analysis and Outlook
In Q1 2024, the company’s margins were adversely impacted by lower supplier volume rebates and unfavorable inventory adjustments. This more than offsets benefits from cost reduction actions taken in 2023. As a result, the gross margin contracted by 60 bps Y/Y to 21.3% and the adjusted EBITDA margin declined by 120 bps Y/Y to 6.4%.
On a segment basis, the adjusted EBITDA margin declined by 70 bps Y/Y in the EES, 140 bps Y/Y in the CSS, and 60 bps Y/Y in the UBS segments.
Looking forward, the company’s margins should sequentially improve in the coming quarters. The Y/Y gross margin comparisons are also getting easier as the year progresses. Management has guided for between 7.5% and 7.9% adjusted EBITDA margin for the full year versus 6.4% in Q1 2024 indicating sequential improvement as the year progresses. The company’s margin should benefit from operating leverage from improving sales outlook, and benefit from cost reduction action in 2023 and Q1 2024 should also help. In addition, the recent divestiture of lower-margin Wesco Integrated Supply should be margin accretive to the company’s UBS (Utility & Broadband Solutions) segment. Partially offsetting these positives should be the restarting of performance-based incentive compensation which was paused for the last few quarters.
In the longer run, the margin should benefit from improved productivity, continued adoption of digital solutions, leverage from higher sales, and continued realization of synergies from the Anixter acquisition. Management has shared its target of ~10% EBITDA margin for the company in the longer run indicating meaningful runaway for margin improvements in the coming years.
Valuation
Wesco is trading at 12.99x FY24 consensus EPS estimates of $14.25 and 11.13x FY25 consensus EPS estimates of $16.63. This is a significant discount versus other distributors;
Peers Current Fiscal P/E Next Fiscal P/E Fastenal (FAST) 31.62 28.88 MSC Industrial Direct (MSM) 15.91 14.24 W.W. Grainger (GWW) 24.04 21.94 Applied Industrial Technologies (AIT) 20.52 19.42 Core & Main (CNM) 24.06 21.47
Source: Seeking Alpha Consensus Estimates
The company also compares favorably on EV/EBITDA versus the sector median. The company is trading at an EV/EBITDA of 9.32x and EV/EBITDA (FWD) of 8.52x versus the sector median of 13.12x and 11.37x respectively.
Most of the stock linked with megatrends like electrification, data center demand, and investment in grid hardening have seen a good re-rating in recent times. I believe once Wesco starts seeing benefits from these trends over the next couple of years, its stock is also likely to re-rate. Further, the company has a solid track record of execution and has created a good amount of shareholder value post Anixter acquisition by outperforming expectations. As the company continue to execute well, I believe investors should warm up to the story.
When I last covered the stock with a neutral rating in Dec 2023, I was worried about near-term moderation in backlog and demand trends. That has already played out with stock price seeing a significant decline post disappointing Q4 results and then a subsequent recovery going into Q1 earnings. With backlog sequentially flat, demand stable, and easing comps ahead, the company is poised to return to growth in the coming quarters and the stock can see good upside. Even if the stock trades at low teens P/E (lower end of the publicly listed distribution peers mentioned above), it can see a good upside. Applying 13x P/E to FY25 consensus EPS estimates of $16.63, we get a one-year forward target price of $216, which implies a 16.7% upside from the current levels. Hence, I am upgrading the stock to a buy.
Risks
The company has a good track record of growing through M&As. However, inorganic growth is relatively riskier compared to organic growth and there are always risks related to integration missteps, overpaying for an acquisition, and the leverage a company takes to make an acquisition. In case any future acquisition goes wrong, it may negatively impact stock price.
The company faces risks from the current macroeconomic environment, like high interest rates. If the macro situation worsens, it could impact the company’s end market demand and could delay the anticipated revenue recovery.
Takeaway
The company is poised to return to revenue growth in the coming quarters due to easing comparisons and stable demand trends. The medium to long-term outlook remains positive, supported by strong end-market demand from electrification, broadband expansion, infrastructure development, data center demand, and grid hardening investments. Market share gains and inorganic growth opportunities should further drive revenue growth. Margins should also expand from current levels, driven by operating leverage, cost reduction benefits, divestiture of low-margin business in the UBS segment, productivity improvements, and continued synergies from the Anixter acquisition. The valuation is also discounted compared to its peer distributors and as the company continues with its good execution, I believe the stock can see a good upside. Therefore, I am upgrading my rating to a buy on WCC stock.
GS Analytics
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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
This article is written by Gayatri S.
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