WESCO: High-growth tech will overcome pressure on margins and cash flow (NYSE: WCC)
WCC drivers look to strengthen
WESCO International (NYSE: COE) would be hampered by the negative effect of supply chain constraints and one of the shifts of utility customers from a full revenue model to a fee-for-service model. Free cash flow dried up in fiscal 2021, putting pressure on an already leveraged balance sheet.
Nonetheless, given its reasonably balanced valuation, investors might want to hold the stock expecting modest returns in the short to medium term. WCC should benefit from its cross-selling initiatives and secular growth trends. The current industrial environment has facilitated the company’s strategy to focus on building conference room infrastructure, automation and IoT-related technologies. It also increased its synergy target from the commercial integration of Anixter.
Overview of strategic growth
WCC management believes that in 2022, the company will benefit from secular growth in the industry, which will lead to increased investment in network modernization, rural broadband and data center development. Along with the industry trend, the company will seek to turn supply chain obstacles into business opportunities. WESCO develops digital solutions for data-driven decisions to increase operational efficiency and provide increased flexibility to its customers. It will benefit from the growth of automation and IoT (Internet of Things) and high-growth technologies, such as 5G and cloud computing.
Earlier in 2022, it launched a new A/V conference room as a service line to support the growing hybrid work environment. The overall solution includes conference room infrastructure, new applications, predictive maintenance, and advanced automation and analytics.
Cross-selling and synergies
WCC acquired Anixter in June 2020, as I discussed in my previous article, which enabled cross-selling synergies through complementary products and services. In 2021, it increased the sales synergies target to $500 million by 2023. However, it increased the target again to $600 million following a larger cross-sell opportunity and faster revenue generation. At the end of 2021, it recorded $365 million in cross-selling synergies. Much of the gains were in the EES business, where it expanded its relationship with an integrated multinational energy company.
Looking further into the deal’s $315 million cost synergy opportunity, the company has already realized estimated overhead savings of $45 million. However, the remaining synergies remain in the supply chain and field operations, which can take a long time to materialize.
The inflated order backlog level also speaks volumes about improving revenue visibility. In Q4 2021, its backlog increased by 14% compared to Q3 and even more strongly than a year ago. With increased demand, the company’s sales rose a few decades in January, off to a promising start.
FY2022 Estimates and Near-Term Challenges
Based on the recovery in the energy sector and WCC’s ability to drive the cross-selling program, its management expects fiscal year 2022 sales to exceed industry sales by 200 basis points to 300 basis points, which translates to revenue growth of 5% to 8%. It expects to achieve an EBITDA margin of 6.7% to 7%. It posted an adjusted EBITDA margin of 6.5% in fiscal 2021. It also expects adjusted EPS of $11 to $12 from $9.98 in fiscal 2021.
However, the company’s efforts will be partially offset by the negative effect of supply chain constraints and commodity price inflation. On top of that, one of his contracts related to a utility customer would be affected by the customer moving from a full revenue model to a fee-for-service model, which would reduce sales growth by 0, 5 percentage points. Additionally, the company’s short-term compensation tied to a target payout can alter its cost structure. An increase in transportation and logistics costs may reduce the FY2022 margin by 20 basis points. Depreciation and amortization costs, however, may decrease.
Industry and economic activities
The ISM Manufacturing Price Index improved in February 2022 from the previous month, driven by growth in new orders and production as the COVID-19 effect waned. In February, unemployment in the United States (3.8%) was below the 2021 average. The drop in the unemployment rate is positive for the COE’s short-term growth trajectory.
Construction activity stabilizes
New homes for individuals fell slightly (by 1.8%) in February 2022 compared to a month ago. It is still above the 2021 average, indicating possible consolidation in the housing market. According to Edzarenski.com, the pandemic has slowed non-residential construction spending over the past two years and could carry into 2022 and 2023. Most of the gains in 2021 spending over 2020 were due to a substantial increase residential buildings.
End market performance
The Electrical and Electronic Solutions segment accounted for 41% of its sales in the fourth quarter of 2021 and increased by 19.6% compared to the previous year. Continued growth in construction sales and positive momentum in industrial and OEM businesses drove segment revenue growth. Communications & Security Solutions (or CSS) segment grew 10.6% in the fourth quarter (YOY) due to the addition of network infrastructure, increase in cloud-based applications and AV installations professionals.
The Utility & Broadband Solutions (or UBS) segment accounted for 28% of its sales in the fourth quarter. In this segment, sales increased by 23% in Q4 2021 due to storm recovery sales and strong demand for data and broadband connectivity.
A margin analysis
Wesco’s gross profit and EBITDA margins contracted in Q4 compared to Q3. The unfavorable sales mix in the UBS segment and the mix of shipping types (higher percentage of lower gross margin drop-ship products) led to the gross margin deterioration. Its EBITDA margin also deflated due to security equipment write-downs and higher average inventory costs.
Cash flow and debt
In fiscal 2021, WCC’s cash flow from operations (or CFO) decreased significantly (down 88%) compared to the prior year. Despite a 48% increase in revenue over the past year, its working capital has increased following increased inventory purchases, increased other liabilities, and increased payroll and benefits expenses. social. Compared to fiscal 2020, the company’s free cash flow (or FCF) plummeted (down 97%) in fiscal 2021. Despite this, management expects all adjusted net income converts to free cash flow in 2022.
The company’s cash was $664 million as of December 31, 2021. Its leverage ratio (1.25x) is significantly higher than the average of its competitors (HDS, DXPE and FAST) of 0.55x. A decline in free cash flow generation would make it difficult to improve leverage despite debt repayments.
Forecast based on linear regression
Based on a regression equation on industry indicators and WCC’s reported revenue over the past seven years and previous four quarters, I expect revenue to remain virtually unchanged over the two next few years and decline the following year.
Based on the model using expected average revenues, I expect its EBITDA to grow over the next two years. However, over the next 12 months (or NTM) of 2023, I expect EBITDA to decline.
Relative valuation and target price
The stock’s return potential using the price forecast based on the forward multiple (8.9x) is lower (6% down) than the return potential using the past average multiple (16% up). Wall Street analysts’ estimates suggest a modest 13% increase.
WCC’s forward EV/EBITDA multiple compression from current EV/EBITDA is less pronounced than its peers, which generally results in a lower EV/EBITDA multiple than its peers. The share’s EV/EBITDA multiple (10.3x) is lower than the average of its peers (MSM, DXPE and FAST) of 18.5x. Thus, it is reasonably valued compared to its peers.
What’s the take on WCC?
WCC should benefit from its cross-selling initiatives following the acquisition of Anixter. EES has recently expanded its relationship with an integrated multinational energy company. In its most recent efforts, it plans to focus on high-growth technologies. A higher backlog by the end of 2021 also speaks volumes for improved revenue visibility. Thus, its share price has outperformed the SPDR S&P 500 Trust ETF (SPY) over the past year.
However, I see short-term operating margin concerns triggered by supply chain constraints and commodity price inflation. Cash flow also weakened sharply in fiscal 2021, which may be concerning given an overleveraged balance sheet. Nonetheless, I think the positives may outweigh the negatives, and the stock has room for modest price upside in the short to medium term.