Wesco Air (WAIR) surfaced on my radar following a large negative reaction in the wake of a downgrade released by analysts at Jefferies.
Shares of Wesco have been a huge disappointment for investors who participated in the IPO back in 2011. Ever since, shares have fallen from $15 to $13, with no dividend payouts to make up for the capital losses over this five year time window.
Given the structural growth in the wider aerospace business, this is a highly disappointing results and warrants an investigation.
A Troubled Past, A Look At "Base 2011"
Wesco Air has been a very established business which has changed ownership quite a few times in its corporate history. Before the latest IPO of the company's shares in 2011, the company was in private hands of the Carlyle Group.
Back in 2011 Wesco was still a $710 million distribution business to the aerospace industry. The vast majority of sales were derived from OEM's as revenues have been split pretty evenly between military and commercial use. The company was very profitable as operating profits of $161 million translated into margins of over 22%.
There were 93 million shares outstanding at the time, giving the company an equity valuation of $1.4 billion at the IPO price. Including a net debt load of $500 million, Wesco was valued at $1.9 billion at the time, equivalent to roughly 2.7 times sales and nearly 12 times operating profits.
A Lot Has Changed Since 2011
Since 2011, Wesco made two important acquisitions. It all started with the $132 million purchase of Interfast in 2012. This was followed by the $561 million purchase of Haas in 2014. The revenue contribution of Interfast has not been specified at the time, but Wesco acquired Haas at a purchase price being similar to the annual revenues being generated by the business.
It therefore seems safe to say that these two deals roughly doubled the 2011 revenue base of $700 million to some $1.4 billion on a pro-forma basis. Given that revenues approached $1.5 billion in 2015, it is safe to say that organic growth has been fairly limited in recent years. The wider aerospace market has been faring pretty well, but Wesco has been troubled given the underperformance of the acquired Haas business as well as relative large exposure to the defense industry.
While the sales developments have been relatively solid, margin developments have been terrible. Operating profits rose from $161 million in 2011 to merely $184 million by 2014. This marks just 15% growth in actual operating profits, even as acquisitions doubled the revenue base. A further deterioration of the (Haas) business triggered a huge $267 million impairment charge. Excluding that charge, operating profits fell to just $56 million in 2015. It should be said that Wesco took a $95 million charge related to excess and obsolete inventories as well. If we generously exclude that charge as well, operating profits would have come in at around $150 million.
By adding back $27 million in depreciation and amortization charges, I end up with EBITDA of $177 million as the company itself `manufactured´ an adjusted EBITDA figure of $192 million for the year. The trouble is that despite a lack of dividend payouts and large capital expenditure requirements, leverage has been on the increase. Net debt stood at $870 million by the end of 2015, nearly doubling compared to 2011 following the acquisitions. Even if we use the optimistic EBITDA metrics provided by the company itself, leverage ratios are very high at 4.5 times.
The start of 2016 does not give a lot of reasons to be optimistic. First quarter sales were down by 4%, and fell by 2% in constant currency terms. The fall in topline sales hurt the profitability of the business as well, with adjusted EBITDA falling to little over $45 million.
The second quarter results were not impressive either, although sales fell by less than 1% in constant currency terms. While sales and EBITDA are down for the first six months, management has remained committed to the full year outlook. The company continues to believe that full year sales will increase and EBITDA margins will improve by a full percent point.
The guidance for sales growth seems optimistic with sales being down by $23 million to $736 million for the first six months of 2016. If management is correct, sales are projected to surpass $1.5 billion in 2015.
Cost savings of $25-30 million should support a full point improvement in terms of EBITDA margins compared to 2015. The trouble is that EBITDA margins fell by half a percentage point to 13.1% of sales in the first half of 2016. To report a 1 percentage point increase in margins, margins would need to increase by 250 basis points in the second half of the year. This simply looks too optimistic in my eyes. With interest rates ´eating´ most of the modest profits, net debt has only been reduced by $10 million in the first six months of 2016.
Remember that in 2015, Wesco posted adjusted EBITDA of $192 million on sales just shy of $1.5 billion. Those margins of 12.8% should improve by a point according the company itself on slightly positive sales. That suggests that EBITDA should at a minimum approach $210 million in 2016, which seems to optimistic. Even in this optimistic scenario, leverage ratios come in around 4 times EBITDA. The only comforting notion is that depreciation and amortization charges exceed maintenance capital spending, boosting the free cash flow generation of the business.
Opportunity — But Risks As Well
The combination of the huge fall in margins, defense spending cuts and leverage is creating a huge overhang on the stock of Wesco. These concerns and poor operational performance have resulted in a massive underperformance versus the wider industry which has fared relatively well. Despite the fact that current problems are not new, leverage and other issues continue to create an overhang on the business.
That does not necessarily mean that an investors should not consider a company which faces real challenges.
Before the purchase of Haas, Wesco was a near $1 billion business with operating margins of 20%. If we assume no profit contribution from Haas following a failed integration process, operating profits of $200 million on sales of $1.5 billion translate into potential operating margins of 13-14% of sales. A recovery in margins, reduction in leverage and refinancing of debt could lower interest costs to $30 million in such a scenario. If we assume a 30% tax rate, after-tax earnings could come in around $120 million, or at roughly $1.20-$1.30 per share. With shares currently trading at $13, Wesco's shares would certainly look cheap in such a scenario.
Operating earnings came in at $78 million for the first six months of 2016, down by roughly $5 million compared to the year before. That is equivalent to roughly 80% of the reported adjusted EBITDA of $96 million for this time period. Assuming that the $210 million guidance for full year EBITDA might be reliable, a 80% conversion might result in operating profits of $160-$170 million. That results in projected after-tax profits of $90 million in 2016, equivalent to roughly $0.90 per share, for a 15 times earnings multiple.
The real kicker has to come from further cost savings, a return to growth and reduction in leverage and lower financing cost. In that scenario, earnings can indeed come in at $1.25 per share and combined with optimism and some multiple inflation, shares could hit $20 in such a scenario. That being said, achieving this outcome is uncertain and will probably require a lot of hard work and some luck as well.
Real potential has to come from a scenario in which margins approach 20% of sales gain, potentially resulting in earnings per share north of $1.50 per share. The issue is that the shift towards contract distribution has structurally impaired the margin profile potential of the business, although it improves visibility as well.
The other case in which potential can be revealed is the divestiture of the troubled Haas unit. While a sale would `lock-in` shareholder value destruction, it could solve the leverage concerns and create a much more focused and profitable business.
Avoid For Now
While I recognize the value of aerospace distributors I have two key reasons to avoid Wesco at the moment. The highly leveraged balance sheet and notably the optimistic 2016 projections leave potential for a downside surprise. Even after the latest sell-off shares still trade 30% above the January/February lows, as equity is not trading at fire sale prices. The structural underperformance of the business, troubles at Haas and leverage employed all create a continued overhang for the business.
While there is certainly upside in a rosy scenario (there always is if you use a lot of debt), I do not think that the potential rewards in a realistic scenario are sufficient to cover the real risks which are out there as well. As a result, I will closely monitor the situation going forward, but avoid investing at the moment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.