Wesco International: Transformative M&A Deal Is Highly Accretive To Shareholders

Summary

• The company is set to acquire Anixter International in Q2 or Q3.
• The new entity is also expected to double its EPS growth rate and expand its EBITDA margins by 100 basis points.
• We believe there is an opportunity for long-term growth in the combined entity.
• The market is heavily discounting the new capabilities of Wesco post-acquisition.

We see a long-term opportunity in Wesco (NYSE:WCC) shares. The company is set to acquire Anixter International (AXE) in Q2 or Q3 (pending closing conditions) for what is to be a transformative $4.5B M&A deal.

That said, the market doesn’t seem enthusiastic about the acquisition, as reflected in Wesco’s share price. It is not without merit though, as a big acquisition in times of great uncertainty and economic recession, is not a recipe for optimism.

Wesco is taking on a significant amount of debt to finance the acquisition of Anixter. They are offering a combined $2.82B in senior unsecured notes maturing in 2025 and 2028. A challenging environment adds more risks to a levered balance sheet. On a positive note, Wesco debt covenants are very lenient, with no maximum debt leverage covenant. Therefore, any decreases in EBITDA because of recessionary headwinds, which would balloon their debt to EBITDA ratio, is not going to trigger any rapid amortization measures, giving a lot of breathing room for the company to digest the acquisition.

We believe there is an opportunity for long-term growth in the combined entity. The acquisition makes a lot of sense too, as it would fortify the competitive position of Wesco in an industry that is still very fragmented, yet the market is pricing Wesco at a significant discount to its book value, at only 0.64x. Wesco’s 15-year average price to book ratio is 2.3x. The discount gives us an opportunity to acquire shares in a very well-run business.

The combined entity is going to have approximately 13% of the market share

The electrical distribution industry is very fragmented and is estimated to be a $114B industry. Wesco and Anixter, competitors before the acquisition, had less than 7% of market share each. With the two entities combining, on a pro forma basis, the new Wesco is estimated to generate $17B in sales and $1.1B in EBITDA. Although not a direct competitor but a good proxy, W.W Grainger (GWW) had total sales of $11.4B in 2019. Overnight, Wesco is going to double in size once the acquisition gets completed.

The new entity is also expected to double its EPS growth rate and expand its EBITDA margins by 100 basis points. Although it doesn’t seem as much, a 1% expansion in profit margins is a huge improvement, especially since we are talking about a distributor. The distribution business is by nature a low-profit margin business. Also, we are talking about a new Wesco making $17B in sales. Every improvement in margins should be highly accretive to earnings.

The expansion of EPS after the acquisition is attributed mostly to cost synergies. Management estimates cost synergies of $200M after the acquisition. We don’t like the word cost synergy much, but in this case, we believe it makes sense. The two entities have very similar cost structures:

Source: company filings

However, looking at the above table, we see where Wesco can achieve their cost synergies from. Historically, Anixter has run higher SG&A costs than Wesco. We could say it has been somewhere between 80 to 100 basis points higher. Wesco on the other hand, states their belief in being one of the lowest-cost operators in the industry:

Our competitiveness has been enhanced by our consistent favorable operating cost position, which is based on the use of LEAN, strategically-located distribution centers, and purchasing economies of scale. As a result of these and other factors, we believe our operating costs as a percentage of sales has historically been one of the lowest in our industry. – WCC 2019 10K (emphasis added)

We believe Wesco’s culture can be adopted by the new entity, which would be a big contributor to the cost synergies expected by management. From the $200M in synergies, 45% of that amount is related to duplicative G&A costs:

You may recall that we previously provided a breakdown of the identified cost synergies with approximately 55% generated from supply chain and field operations and 45% coming from corporate and administrative costs. Of the 45% that is corporate and administrative, approximately 2/3 will come from the elimination of duplicative general and administrative costs and 1/3 will come from corporate overhead. - Wesco International Inc & Anixter International Inc Merger Update Call

The opportunity to realize cost synergies also comes from Anixter's product mix, which has been concentrated on selling Network and Security solutions as compared to Wesco’s biggest selling product category of “General Supplies.”

So yes, we believe the new Wesco is going to have better gross margins, not only because of its bigger size which would allow them to get more volume rebates from suppliers, but also because of a better product mix.

The combined entity is going to have top line synergies as well

There is going to be a lot of room for cross-selling opportunities within the new Wesco, which should be a catalyst for revenue growth. As mentioned before, Wesco’s largest selling product category is with what they call “general supplies”:

Source: WCC 2019 10-K

The rest of their product mix accounts for low percentages of revenues. In contrast, Anixter's biggest revenue contribution comes from its network and security solutions with 52% of total sales. Anixter describes their network and security solutions as follows:

NSS has a broad product portfolio that includes copper and fiber optic cable and connectivity, access control, video surveillance, intrusion and fire/life safety, cabinets, power, cable management, wireless, professional audio/video, voice and networking switches and other ancillary products. – AXE 2019 10K

We believe that description falls nicely within Wesco’s wire, communication, and automation product categories. Following the completion of the merger, we should see a stronger product portfolio.

It also should provide Wesco with some industry tailwinds within the telecom sector, as the rollout of 5G infrastructure continues. If we look at the result of Anixter’s network solutions, we find nice and steady growth in sales and EBITDA:

Source: AXE 2019 10-K

So here we have a new entity with very a very compatible product portfolio, something that management explains very well:

WESCO's capabilities in industrial and nonresidential construction are complemented by Anixter's capabilities in network and security solutions. For example, consider a traditional nonresidential construction project where Anixter's [real and real] technology and cable management systems can add significant capabilities to WESCO's construction services, while WESCO's energy services business and lighting renovation and retrofit capabilities can be sold across Anixter's customer base. - Wesco International Inc & Anixter International Inc Merger Update Call

Cash flows in the electrical distribution business are counter-cyclical

Another important point to address is Wesco’s cash flow trends. With a very levered balance sheet after the acquisition is completed, it is important to understand Wesco’s operating cash flow trends.

The biggest use of cash flow comes from the investment in inventory. CAPEX is a minuscule percentage of total sales, and the company's PPE/sales ratio also demonstrates very little need in infrastructure to support sales. Taking into consideration the new accounting treatment for leases, Wesco’s PPE/Sales ratio only stands at 5.5%.

In times of recession, the company can adjust their working capital, so it becomes a source of cash, instead of the use of cash. If we look all the way back to 2004, Wesco has generated positive cash from operations in every year:

Source: company filings and tikr.com

In 2008 and 2009, changes in working capital contributed $31.5M and $145M to cash from operations. Free cash flow has been positive for every year except in 2004, 2006, 2010, and 2012. However, the reason for the negative free cash flows was due to acquisitions.

In a way, the strong cash generation by the company allows them to have a highly levered balance sheet. That said, we can expect the deleveraging of the balance sheet to become a priority if economic conditions remain under pressure. The stated goal is to bring their Debt/EBITDA ratio within 2x to 3.5x in two years of completing the acquisition. We believe they have the capabilities to do so.

Wesco is trading very cheap

We believe the market is giving us this opportunity because COVID-19 brings so much uncertainty. On top of that, we are talking about a transformative $4.5B merger, so we could expect Wesco to find some complications to integrate Anixter into their operations. The company expects restructuring costs of $150M, but more conservative investors should expect a higher number.

Still, we believe the market is heavily discounting the new capabilities of Wesco post-acquisition. Trading at a P/B of 0.6, the market’s forward-looking expectation is signaling, in our simplistic point of view, a new Wesco incapable of generating returns above their cost of capital.

Source: tikr.com

Historically, however, Wesco is trading well below their P/B average ratio of 2.3x and even below the lows in 2008. We believe the market is pricing in the worst possible scenario at this point. Any slight positive news could send share prices higher.

Takeaway

We see Wesco as a long-term investment (3-5 years). The acquisition of Anixter is going to take a while to digest, during which the financials are going to appear messy. The added debt is also a risk, but as we showed, the company has a strong ability to generate cash even in times of economic distress.

The added scale of the new Wesco should allow them a better competitive position and better terms with suppliers, increasing profitability margins along the way. The stock seems very cheap at this point.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in WCC over 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.

Comments

[jimidean]

Good article. Could you speak to the competitive landscape, in particular AMZN, and the potential long term threat it may pose. Thanks

[Value Focus Investing]

Here is what Morningstar said in regards to Amazon. "Some industry observers have speculated that Amazon’s emergence in industrial distribution is the beginning of the end for many incumbent distributors. Although we think the threat from Amazon should not be dismissed, We think Amazon would struggle to replicate Wesco's product expertise and high-touch supply-chain management offerings, which should prevent Amazon from taking meaningful share from Wesco."

I am not sure about this, but also heard similar things concerning AMZN killing drug distributors for years, and they still have not made much headway.

[rcray]

It would be helpful if you had discussed future outstanding debt totals, interest coverage and debt to EBIT ratios. Otherwise it's impossible for anyone to know if this is worthwhile or not.
People also remember Oxy's transformative acquisition, also funded by lots of debt, of Anadarko and how that turned out. The pandemic has made the importance of low or no corporate debt very very obvious.
It looks like Wesco is buying Anixter from a private equity owner, that alone is enough to discourage buying Wesco stock. In addition you say Wesco's culture can be adopted by the new company. Corporate cultures change very slowly and you imply that maybe Anixter has a different culture than Wesco. This could be trouble (remember Penn Central?).

[jimidean]

Anixter was a public company prior to the merger

[Value Focus Investing]

Comparing WCC to OXY is really a ridiculous comparison as OXY is a high decline rate oil producer sitting on the far right end of the global cost curve. The "D" in their EBITDA is a real expense(and a huge expense at that) as production would plunge if they would ever cut capital spending. Distributors can defer capex for years while they right size operations during downturns. Both AXE and WCC were both profitable and cash flow positive during the 2008 and 2009 recession.

The blog above does reference the WCC/AXE combo as having a DEBT/EBITDA in the 4.5 range and expected to be in the 2.0-3.5 range in two years if everything goes to plan. WCC was in the 4.5 range back in 2012 after they completed a rather large acquistion for EECOL, which was another distributor. This and a lot more info is in their most recent presentation

[rcray]

OXY is just a recent example of a disastrous exercise in empire building by corporate management. Several studies have concluded that less than 1/3rd of corporate takeovers add any value to the acquirer, the other 2/3rd's results are somewhere between marginal gains and total disasters. However mergers are great for CEO egos while executive pay is closely related to a company's size. Debt/EBITDA of 4.5 is fairly high; given the upheavals caused by the virus and government response, getting it down substantially seems rather optimistic. There is also no guarantee that the Fed's printing presses can continue to support the debt markets.