Value-Added Approach Sets Anixter Apart

While we anticipate 2016 will be a challenging year for

Anixter is a value-added industrial distributor of power utility, communications infrastructure, wire, and security products. It is the nation's third-largest electrical distributor. Most of its customers do not have the scale to evaluate and select from the 450,000 SKUs that Anixter sources from thousands of vendors. Similarly, most of its suppliers do not have salesforces that can handle end users' irregular and infrequent product requests.

Following a busy year of mergers and acquisitions in 2015, we expect 50% of Anixter's sales to come from enterprise cabling and security solutions, 26% from electrical and electronic wire and cable, and 24% from utility power solutions. The electrical and electronic wire and cable segment is similar to a traditional distributor as it sources, stocks, and distributes products through 230 sales offices around the world. The enterprise cabling and security division uses these offices to create custom product displays for customers and demonstrate a working system before it is deployed. The utility power solutions segment provides wire, transformers, transmission and distribution hardware, and switches to the power utility industry. A customer can order cable and security cameras from several different suppliers, but for the past decade Anixter has been the only distributor that can assemble a comprehensive security or computer system and test the integrated solution in a UL-certified lab. Additionally, Anixter independently tests many components in its inventory to provide product performance information beyond what the manufacturer can offer.

As a large distributor, Anixter generates superior returns from its network effects and its cost advantage. Unlike the general industrial distributors, Anixter sells some components that are competitively sourced by customers, which pressures pricing power. Although the market is more price competitive, we believe Anixter has generated an 11% average return on invested capital over the past 10 years (16% excluding goodwill) because of its value-added services that make it stand out from competitors.

Network Effect Provides a Moat We believe Anixter has a narrow economic moat stemming from its ability to capitalize on network effects and a cost advantage. Industrial distributors can pursue several primary network effect strategies: supply chain services, value-additive information, and services and convenient store locations. Anixter is focused on the first and second strategies. As a key middleman between a fragmented customer base and a large number of vendors, it is an important source of information and products to its customers. Exposure to numerous suppliers means that it can provide comparative product insights to customers. Additionally, Anixter's independent product testing allows it to generate information that the manufacturer does not disclose. Suppliers appreciate Anixter's ability to stock channel inventory as well as provide feedback on how products are satisfying customer needs. Serving as an intermediary is more efficient for manufacturers and customers than a direct relationship.

Traditionally, we believe a distributor's cost advantages have four sources: volume rebates, direct product sourcing, private-label products, and an efficient logistics supply chain. We think Anixter's cost advantage stems from volume rebates and an efficient logistics supply chain. We believe it has a cost advantage relative to independent systems assemblers and integrators because the company is also involved in systems integration and assembly. In general, higher workforce utilization, better-utilized assembly sites, and established assembly processes allow the company to implement this value-additive service more cost-efficiently than customers can do it and more cost-effectively than independent systems integrators.

Combined, these moat sources have allowed Anixter to generate an 11% average annual ROIC for the past 10 years. Excluding goodwill, Anixter's ROIC has averaged 16% as the company has been forced to create goodwill allowances for the high-quality businesses it has acquired over the past several decades. Going forward, we project a 10%-11% ROIC relative to Anixter's 7.5% weighted average cost of capital.

Consolidation, Competition Could Pose Risks Anixter has a medium uncertainty rating. The company is highly dependent on security system- and telecom-related spending. Any major changes in enterprise IT capital spending patterns would probably have an impact on the company. Approximately 35% of Anixter's sales are in foreign currency (predominantly euros and Canadian dollars). Hedging is used on a limited basis, and any dramatic fluctuations could have a negative impact on Anixter.

If suppliers continue to consolidate, that would raise disintermediation risk. Anixter's five largest suppliers currently provide 29% of dollar volume purchases and probably pressure margins. This vendor concentration and a long sales cycle that allows customers to competitively bid distributors against each other reduce Anixter's bargaining power and its margins.

Although we believe Anixter's significant scale is an advantage, new online competition and supply chain consolidation are trends to monitor. Google GOOG and Amazon AMZN have launched industrial distribution websites and highlight that the Internet is a source of new competition and potential disintermediation. Amazon Supply is an online-only industrial distributor. In contrast, Google directly connects end consumers and product manufacturers. Both Google and Amazon will gain sales, but we believe their decisions to hold low inventory or no inventory as well as an inability to provide authoritative advice on products will slow their market share gains against Anixter. Additionally, Anixter's focus on value-additive solutions, including product and system integration as well as independent component testing, are not incredibly common in the industrial distribution industry. Amazon and Google will develop their strategies in the coming years, but we think it is highly unlikely that they will go through the process of establishing their own UL-certified labs and assuming system assembly and integration services.