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Stock Strategist

This Stock's Price Is Absurd

Wesco is trading almost 50% below our fair value estimate.

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Wesco’s (WCC) stock sold off after the narrow-moat industrial distributor reported second-quarter sales that missed the consensus estimate and also lowered its full-year outlook. Management had warned during the June 13 investor day that second-quarter sales growth would probably be closer to the low end of its 3%-6% guidance. However, sales grew approximately 2% to $2.15 billion, falling short of both guidance and the consensus estimate of $2.17 billion. Management blamed the top-line miss on softer demand conditions in the United States, especially in April and May. However, sales strengthened in June (total organic sales up 5%) and preliminary July sales are up midsingle digits.

Wesco’s operating margin expanded 30 basis points to 4.6% (we calculate a very solid 14.5% incremental margin) as 2%-plus gross profit growth outpaced a 1% increase in selling, general, and administrative expenses. Wesco’s 19% gross margin was flat with the year-ago quarter because of faster growth from the company’s lower-gross-margin utility business and slowing “short cycle” sales (that is, maintenance, repair, and operations sales), which tend to have higher gross margins. Short-cycle weakness is not unique to Wesco; Ingersoll Rand (IR) called out slowing short-cycle sales as a headwind for its industrial business.

Management now expects 2019 revenue growth of 1%-4% (down from 3%-6%), an operating margin of 4.2%-4.5% (down from 4.3%-4.7%), and earnings per share of $5.00-$5.60 (down from $5.10-$5.70). We project almost 3% sales growth, a 4.4% operating margin, and EPS of $5.42 for 2019.

Our long-term outlook is unchanged, and we’re maintaining our $88 fair value estimate. Given that the stock trades at almost a 50% discount to our fair value estimate, we liked that management repurchased $150 million of its stock this quarter.

Wesco’s second-quarter sales growth looked particularly disappointing compared with close peer Anixter International (AXE), which boasted 6% organic sales growth for the quarter. Anixter has less exposure to the MRO market (short-cycle sales) than Wesco, which probably explains some of its relative outperformance this quarter. However, compared with other industrial distributors such as Grainger (GWW) and MSC Industrial Direct (MSM), Wesco’s 2% sales growth was not unusual; both Grainger and MSC cited slowing end markets and reported 1% and 2% organic growth, respectively.

Management’s full-year sales growth outlook implies accelerating top-line growth over the second half of 2019. At first blush, it’s difficult to comprehend how Wesco could achieve its 2019 sales growth target after reporting about flat top-line growth through the first half of the year. However, we see several factors that support management’s guidance. First, Wesco will face much easier prior-year comparisons during the second half (third-quarter 2018 growth of 3% and fourth-quarter 2018 growth of less than 1% compared with first-quarter 2018 growth of 13% and second-quarter 2018 growth of 10%). Second, Wesco has a very strong construction backlog--the second-highest second-quarter backlog in its history--and its overall pipeline remains healthy. Finally, Wesco’s sales growth picked up considerably (5%) in June, July preliminary data points to mid-single-digit growth, and the company is seeing particular strength from its utility, data communications, and security markets.

We think Wesco’s current valuation is absurd. In fact, the company’s current stock price is more than 20% below our bear-case scenario of $58 per share, which assumes less than 1% compound annual sales growth over the next five years and operating margins that struggle to stay above 4%. Wesco’s 15-year average operating margin is approximately 5% with a high of nearly 7% and a low of 4%. Based on our analysis, to justify Wesco’s current valuation, one would have to believe that the company can neither grow nor earn returns on invested capital above its 8% weighted average cost of capital over the foreseeable future.

While Wesco serves cyclical end markets, it generates free cash flow throughout the business cycle. Indeed, the company has generated positive free cash flow each year since its 1999 initial public offering. As a distributor, Wesco has lower fixed costs and capital expenditure requirements than many other nondistributor industrial companies. Working capital (trade receivables and inventory less trade payables) is the largest component of Wesco’s invested capital. When end-market demand slows, the company can decrease its working capital needs by reducing inventory. As a case in point, Wesco generated a near-record $279 million of free cash flow in 2009 despite sales declining 24% year over year. Given this stable free cash flow, we applaud the company’s decision to initiate a dividend “at some point over the next several years.” Management said it would analyze a dividend when it completes its $400 million share-repurchase authorization that expires in 2020. We think a dividend could attract more investors to Wesco.

Brian Bernard does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.