Industrial Distributors--The Strong Get Stronger

After navigating the rough waters of 2008 and 2009, industrial distributors are harnessing their competitive strengths to chart a course of higher revenue and earnings. However, we find few bargains in this sector, and most stocks in our coverage list are trading near our fair value estimates.

All Is Well with Industrial Manufacturing
Industrial distributors are broadly exposed to the manufacturing output of the United States. The strength in U.S. manufacturing is measured by the ISM Manufacturing Index, with a score above 50 signifying expansion. After contracting for the 14 consecutive months beginning in June 2008, this metric finally turned positive in August 2009. The latest ISM manufacturing index came in 56.9, indicating that U.S. manufacturing is likely to continue to expand, benefiting all distributors. Even distributors with exposure to currently weak sectors like construction have started to enjoy rising revenue. For example,  Fastenal (FAST) derives 20%-25% of its sales from nonresidential construction, and during the four quarters of 2009 revenue from this segment declined 6.4%, 19.6%, 25.3%, and 24.8% year over year, respectively. In 2010, nonresidential sales declined 14.7% in the first quarter before improving 0.5% in the second and 6.3% in the third quarter. We expect these upward trends to continue in the short to medium term, boosting the top line at Fastenal and at its competitors.

Sustaining Record Operating Margins
Even as distributors reported higher revenue during the third quarter of 2010, operating margins climbed even higher due to operating leverage. Specifically,  Grainger (GWW) increased third-quarter operating margins by 148 basis points, Fastenal by 438 basis points,  Wesco (WCC) by 60 basis points,  MSC Industrial (MSM) by 400 basis points, and  Anixter   by 90 basis points. We expect distributors to continue maintaining strong margins as gross margins improve due to higher volume rebates from suppliers. Furthermore, we do not expect employee costs to rise significantly higher since the current unemployment level mutes labor inflation. Finally, as volumes improve, firms will continue leveraging their fixed costs to post higher operating margins.

Earnings per Share Growth
On the strength of higher sales and rebounding operating margins, distributors will demonstrate earnings per share growth. Share repurchase activity aids EPS growth at Grainger and others. Meanwhile, leveraged firms like Anixter and Wesco benefit from lower interest expense as borrowing costs trend lower in a low-yield environment. Thus, higher sales, better operating margins, share buybacks, and lower financing costs should lead to continued EPS growth.

The Strong Get Stronger?
We think large, well-capitalized firms have emerged stronger from the recession. In addition to enjoying greater bargaining power, large players also manage their inventory effectively. In times of slow business demand, inventory reduction can yield better operating cash flow, but too much of a cutback will hamper customer satisfaction. Thus, striking the right balance is important. Inventory management over hundreds of thousands of stock keeping units is complicated and requires sophisticated information systems to provide management with adequate information. In this regard, we think historical investment in information technology enabled larger distributors to make better inventory decisions. Large distributors also tend to have a more diversified customer base and a wider geographical presence. This breadth of revenue translates into better protection against economic downswings. Though the distribution industry is largely fragmented, it is slowly but steadily concentrating around the largest players, implying greater competitive strength for the biggest distributors.

Poor Margin of Safety
Although rising earnings and an improving competitive position bodes well for stock performance, at current prices we do not think the stocks allow investing at an adequate margin of safety. Over the last year, share prices improved 32% at Grainger, 51% at Fastenal, 33% at MSC Industrial, 34% at Anixter, and 73% at Wesco, bringing the stocks near or beyond our fair value estimates. While the fundamentals of the firms we cover are improving, the share prices have recovered to the level we currently believe to be justified by fundamentals. At this point, we would watch market dips to check for any bargains from time to time.