Illustration by Irena Gajic
Demand for cloud computing, power from renewable sources, and electric vehicles, along with more extreme weather events, mean that electrical infrastructure will need extensive investment for years to come. That’s just one of many reasons to hold shares of Wesco International .
Wesco (ticker: WCC) distributes electrical and communications products. It has 800 locations, 18,000 employees, 30,000 suppliers, 125,000 customers, and 1.5 million products. The Pittsburgh-based company is estimated to have generated about $18 billion in sales in 2021 and is expected to have about $18.9 billion in 2022. It has a roughly 15% share of the U.S. electrical-distribution market. The relatively fragmented nature of such markets gives larger, well-capitalized companies, such as Wesco, a chance to grow by gobbling up smaller, regional players—or by taking market share from them.
Wesco stock, at a recent $119, is down 10% this year, having been punished along with many other small-cap shares. The Russell 2000 index, which covers small-caps, is down 12%. The drop, while painful for shareholders, also provides an attractive entry point.
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Recent declines feel more like a stock-market phenomenon than a problem specific to Wesco or its rivals. Secular electricity trends look positive. Power generation, transmission, and demand are all undergoing significant change. Investors can extrapolate what it all means from a few data points. Utility giant NextEra Energy (NEE) estimates that completely decarbonizing the U.S. economy by 2050 will require up to $4 trillion in investment, or roughly $140 billion a year.
Utilities already maintain and replace power-generating equipment. The Edison Electric Institute estimates that total U.S. spending by investor-owned electric utilities will average about $140 billion annually for the next few years, up from an average of $120 billion over the past few. And Wood Mackenzie projects that tens of billions will be spent each year on distributed energy resources, including battery backup power and solar installations.
There is some overlap and nuance, but the total picture means better growth than in the past for the markets that Wesco serves.
Along with the secular tailwinds, Wesco has a cyclical one. The U.S. industrial economy is growing quickly. The Institute for Supply Management Purchasing Managers’ Index, or PMI, is at about 59. The PMI has averaged almost 61 over the past 12 months, compared with about 52 over the past 40 years. It’s rarely been this good for manufacturers, and more manufacturing means more sales for distributors, including Wesco—though concerns about slowing economic growth could dampen sales in the near term.
Wesco bought another electronics distributor, Anixter International, in mid-2020. As integration continues, it keeps finding new ways to squeeze out costs, boosting profit margins.
“We’ve raised our cost synergy targets through the end of 2023 twice since the merger closed,” said Wesco CEO John Engel at a November conference. Wesco originally expected to cut some $200 million in combined costs when it merged with Anixter. Annualized cost savings should be closer to $300 million, with another $100 million still to be realized by 2023. Management also envisioned roughly $200 million in cross-selling synergies from the deal, as Anixter and Wesco didn’t have a lot of customer overlap.
One negative: The merger raised Wesco’s net debt to about $5.3 billion from $1.5 billion; that figure was $4.4 billion at the end of September. But the company expects to pay down some of it in coming quarters, targeting a debt-to-Ebitda ratio of 2 to 3.5 times, down from a current 4. (Ebitda stands for earnings before interest, taxes, depreciation, and amortization.)
High debt can be a risk for any company, but it can also benefit shareholders. Today, Wesco’s enterprise value—the sum of its debt and its $6 billion market capitalization—is about $11 billion, including preferred shares. As free cash flow is used to pay down obligations, there’s a shift of value from debt to equity. Wesco is expected to generate about $2 billion in free cash flow over the next three years.
Inflation is another risk, but it isn’t such a big deal for distribution businesses. “They don’t make anything,” notes RBC Capital Markets analyst Deane Dray. Distributors essentially buy and sell products, earning a spread. Some degree of inflation can actually benefit them, as inventory becomes a little more valuable over time.
Inventory-inflation arbitrage isn’t a reason to hold the stock for the long run, but the stability of distribution business models is. Wesco hasn’t produced a loss, on an adjusted basis, in any of the past 40 quarters.
Dray calls Wesco one of his top picks for 2022 because of its trifecta of secular, cyclical, and company-specific tailwinds. His target price for the stock is $158. That works out to roughly 13.6 times his 2022 Wesco earnings estimate of about $11.60 a share.
That isn’t a big valuation multiple for many companies. But Wesco has changed hands at an average price/earnings ratio of roughly 12 times over the past few years. That was before the merger, before the potential growth in electricity-related spending, and before the S&P 500 started trading for 20 times estimated 2022 earnings.
If the shares fetch 14 to 15 times earnings, they could hit $170 in 2022, about 43% above their recent $119. And with sales expected to grow at an average annual rate around 3% and bottom-line earnings at nearly 13%, multiple expansion is certainly on the table.
Write to Al Root at email@example.com