WESCO (NYSE:WCC) has been doing its best to continue growing in recent years, despite the fact that key markets making up nearly half of sales have yet to really recover in a big way. Given the value that WESCO adds as a distributor, the fragmented nature of its electrical distribution industry and the opportunity for future growth coupled with better margins, WESCO is a name that I wouldn't want to be short for the long term.
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Filling a Key Role in a Big Market
WESCO is a significant distributor of electrical, industrial and communications products in North America, selling nearly 1 million different products from 18,000 suppliers to more than 65,000 customers. Although it's one of the largest players in this approximately $100 billion market, WESCO has just 6% share or so - highlighting just how fragmented the industry is.
Distributors often get a bad rap for their weak margins and thin free cash flow, but industrial distribution is a somewhat different animal. Companies like WESCO, Grainger (NYSE:GWW) and Fastenal (Nasdaq:FAST) actually serve key intermediary roles between suppliers and customers and the value they add supports respectable margins and returns on capital.
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What's the value? Well, suppliers like Eaton (NYSE:ETN), Rockwell Automation (NYSE:ROK) and Belden (NYSE:BDC) really don't want to serve all of those 65,000+ WESCO customers individually. WESCO basically aggregates the demand and allows the suppliers to operate at more efficient production rates and inventory levels, and that enables lower final prices for everybody while companies like WESCO still collect their cut.
Still Waiting for Healthier Markets
Construction and utility customers have traditionally been large customers for WESCO, and they still make up nearly half of the company's sales. That's been problematic, as it is well known that the construction industry has not been very healthy outside of a few select categories like oil and gas infrastructure. Likewise, the long-awaited refurbishment or replacement cycle in utility infrastructure still hasn't really developed.
On the other hand, WESCO has been enjoying good growth in its industrial business, while also growing that business through acquisitions. So, now part of the question for WESCO investors is just how healthy the North American industrial market is - investors are clearly worried about a slowdown, though WESCO pointed to 9% organic growth in the month of July during a recent analyst day.
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If you believe that North American industrial growth has paused (as opposed to peaked), you can probably look forward to a resumption of growth at WESCO. On top of that, there is the prospect of an eventual recovery in the aforementioned construction and utility markets.
Those aren't WESCO's only growth opportunities, though. WESCO has been an active acquirer for many years and while the individual deals usually aren't huge, they're quite often accretive from the get-go. At the same time, WESCO is expanding its business in areas like broadband/communications and security products, adding billions to its addressable market opportunity.
The Bottom Line
There isn't an abundance of cheap industrial distribution stocks today, and companies like Grainger and Fastenal do boast better margins and growth, respectively. At the same time, there remains a huge amount of distribution business out there in the hands of small players; companies that will find it increasingly difficult to make money against larger companies like WESCO, Sonepar and Anixter (NYSE:AXE) that enjoy significant economies of scale. That suggests to me that WESCO can look forward to many years of organic growth and acquisition opportunities.
Valuation is problematic. Even assuming 15% free cash flow growth (a combination of mid-single digit sales growth and improving margins), fair value on WESCO would seem to be in the neighborhood of the high $60s. That would encourage me to hold on if I was already a shareholder, but I'd want a bigger margin of safety if I were a newcomer to the stock.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.