Margin Challenges And Growing Cyclical Worries Have Dimmed Rexel

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About: Rexel SA ADR (RXEEY), Includes: ABB, ETN, ROK, SBGSY, WCC
by: Stephen Simpson, CFA
Summary

Rexel shares have underperformed as margin leverage has been slow to develop and concerns mount about the health of industrial and construction markets.

Rexel's efforts to improve its U.S. operations are largely independent of macro drivers, but still a few years away from delivering meaningful better contributions.

Rexel shares look undervalued, but management has to prove that it can deliver the promised margin improvements.

The performance of industrial distributor stocks on a year-to-date basis really covers the map. Grainger (GWW) has been performing exceptionally well, Ferguson (OTCQX:FERGY) has done alright, HD Supply (HDS) is more or less flat, but the electrical distributors Wesco (WCC) and Rexel (OTCPK:RXEEY) are each down about 15%. Although some of Rexel’s trouble can be attributed to frustration and disappointment in the pace of margin improvement, I also believe growing worries about the industrial cycle are playing a role.

I like the value in Rexel shares, but there are risks with both execution and macro factors – it is tough to hold a good/improving company when investors are selling out of the sector. I’m bullish on the prospects for construction in Europe and ongoing improvements in the U.S. business, but if discrete manufacturing is slowing down, it will be harder for management to hit its margin improvement targets.

An Underwhelming Start

Rexel’s first quarter didn’t look quite bad enough to explain the sharp negative reaction when it reported (down around 7%), but that has been par for the course during this earnings season – investors are jittery about industrial companies and selling the stocks on almost any signs of weakness.

Rexel’s revenue rose about 4% on an organic basis, or about 3% on an “ex-days” basis that also strips out copper price increases. Within that 3%, Rexel saw pricing growth of more than 1% - short of Wesco’s 2%, but not bad on a relative basis compared to other distributors.

Revenue rose a little less than 3% in Europe, with growth in France decelerating noticeably on a QoQ basis due to poor weather. There was also noticeable deceleration in Scandinavia, while the U.K. remains weak (down almost 6%) due to both market (weaker construction) and company-specific issues.

Sales in North America rose more than 3% and U.S. sales were boosted by mid single-digit growth in commercial construction, double-digit growth in residential, and double-digit growth in oil/gas, while weaker project revenue and a sharp decline in sales to General Electric (GE) (down 34%) pushed the other way. Sales in Asia were up almost 13%, but contribute less than 10% of the total.

Although Wesco did far better than Rexel in revenue growth terms (due in part to different product/market mixes), Rexel did a little better on gross margin with flat performance (Wesco was down 60bp). Gross margin improved in the U.S., but it is still about three points below the gross margin of the European business and two points below the company average.

Adjusted earnings fell 6%, with margin contracting about 10bp and the company missing sell-side expectations by about 6%. While revenue was a little lighter than expected (due to weather in Europe), the bigger issue was simply that management moved ahead with expense-boosting initiatives designed to improve long-term growth (including investments in IT/digital platforms).

Sticking To The Plan

While management did not sound especially pleased by the results in the first quarter, they are sticking with their overall strategic plans for the company. A big part of that plan is to improve the company’s performance in the U.S., where its market share (around 5%) is far lower than in much of Europe (10% in Germany to 20%-25% in the U.K. to 30% in France). Management has already completed several projects designed to improve the company’s logistics, but there is still more that can be done and the company continues to look to expand its branch footprint while also investing in its digital/online capabilities.

Some of Rexel’s U.S. performance is also out of its hands. GE's Industrial Solutions business has long been a major part of Rexel’s U.S. business, but the business suffered from neglect and under-investment in recent years. ABB (ABB) is committed to turning this business around, including a significant refresh of the product lineup, but that will take time and Rexel will find it hard to replace that business in the interim.

Rexel also remains committed to meaningful investments in its online/digital capabilities. Only about 14% of the company’s total sales were handled through digital means in 2017 (and half that in the U.S.), but management is looking to build that to 35% to 40% in the coming years.

Will End-Market Demand Stay Healthy?

Low-voltage electrical equipment, which includes a range of products like fuses, couplers, controls, actuators, and sensors, makes up more than 40% of Rexel’s revenue base. Unfortunately, neither ABB nor Eaton (ETN) are seeing booming demand here, though Schneider (OTCPK:SBGSY), a large Rexel supplier, is doing a little better, and Rockwell’s (ROK) first quarter revenue growth was likewise in the low-single digits on an organic basis.

Low-voltage products are used in the electrification of buildings, factories, and other infrastructure, as well as renewable energy installations, and encompass everything from lighting to uninterruptible power systems to automation. Through suppliers/partners like Rockwell and Schneider, Rexel works with customers to support installation and maintenance of new systems aimed at improving energy efficiency, safety, and/or productivity.

With that, there’s a split between lackluster demand for core electrification, but still-healthy demand for discrete automation products, as seen in the results from ABB and Schneider (both in reported revenue and bookings/orders).

The Bottom Line

With weaker-than-expected core electrification growth from companies like Eaton and some concerns about deceleration in automation spending, I’ve cut back my growth expectations a bit for Rexel. I still believe the company is leveraged to a healthy European commercial construction market and a recovering oil/gas market, but the overall outlook for industrial growth seems to be drifting lower. I’ve also toned down my expectations for margin improvement at Rexel – I do believe the company will drive operating margins off this recent trough around 4%, but it will take some time to do it.

I’m still looking for revenue growth to be around 2% to 3% over the long term (a little lower than what I expect from OEMs like Eaton, ABB, and Schneider), but I’m still expecting improved margins to drive double-digit long-term FCF growth.

The Bottom Line

I believe Rexel’s ADRs should trade closer to $20, offering healthy double-digit annualized return potential, but I also recognize that Rexel has earned its spot in the market’s doghouse and has to start delivering the goods in terms of healthy organic revenue growth and margin expansion. I believe they can and will, but there are execution risks to consider here, as well as larger concerns about the overall health of industrial spending/investment.

Disclosure: I am/we are long ABB. 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.

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