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Morningstar | Anixter Delivers on Gross Margin Improvement Goal; Sees Growth and Better Gross Margins in 2019

Management was optimistic that Anixter's gross profit margin would improve during the final three months of 2018. So, we were pleased to see that Anixter realized that goal, with fourth-quarter gross margin improving 50 basis points year over year and 80 basis points sequentially to 20.3%. We can't stress enough that this level of gross margin improvement is no small feat. Indeed, most of the other industrial distributors we cover have struggled to maintain gross margins due to inflationary and mix shift pressures and increased competition.

Anixter's fourth-quarter gross margin performance was not just a one-off either.  If management's outlook plays out like they expect, the firm's gross margin should improve another 20 to 40 basis points in 2019. So what's the secret? While Anixter's ability to stay ahead of rising product costs with price increases is likely part of the story, management also attributed gross margin gains to broad-based initiatives that are beginning to bear fruit. We think the read through here is that investments in process improvements, training, and infrastructure are resulting in better-informed pricing and inventory management decisions. Initiatives to improve the customer experience are also likely strengthening Anixter's value proposition to customers, which supports pricing.

Sales remained strong during the fourth quarter, and management expects that trend to continue in 2019. Fourth-quarter revenue grew 5% organically to $2.1 billion as all three of Anixter's segments delivered organic growth during the quarter. Anixter's full-year reported revenue grew 6% (4% organically), and management's 2019 outlook calls for 3% to 6% organic growth. Despite its European business facing challenges amid an uncertain economic environment, Anixter's other businesses are performing well, and the firm has a growing backlog and a healthy pipeline of new business. We've maintained our $107 per share fair value estimate as our thesis remains intact.

Anixter's fourth-quarter adjusted EBITDA margin was 5.1%, which matched last quarter's margin but was 30 basis points lower than the year-ago quarter due to investment spending we discussed above. Anixter's full-year adjusted EBITDA margin was 4.9%, which management expects to improve to at least 5% in 2019. As a result of the previously-discussed business initiatives, management expects to save $40 to $60 million annually by 2023. To put the financial impact of these savings in perspective, reducing Anixter's 2018 cost structure by $50 million (the midpoint of management's goal), would've resulted in a pro forma 5.5% adjusted EBITDA margin in 2018 compared with the 4.9% actual 2018 result and management's long-term adjusted EBITDA margin goal of over 6%.

Given Anixter's fourth-quarter sales and earnings beat, its gross margin improvement that bucked the industry trend, and its bullish 2019 outlook, we had expected Anixter's stock to surge during the Jan. 29 trading day. Unfortunately, that didn't occur. We continue to believe that Anixter is materially undervalued with a wide margin of safety. Furthermore, despite Anixter's exposure to cyclical end markets, similar to other industrial distributors, Anixter's cash flows are countercyclical. Case in point, Anixter generated record-high operating cash flow of $441 million during the last recession (2009). After completing two major acquisitions in 2014 (Tri-Ed) and 2015 (Power Solutions), Anixter has steadily been strengthening its balance sheet, and the firm finally reached management's targeted capital structure in the fourth quarter of 2018 (3.0 debt/adjusted EBITDA ratio versus 2.5 to 3.0 target and 44.4% debt/capital ratio versus 45% to 50% target). Prior to these acquisitions, Anixter had historically returned two thirds of its free cash flow to investors via special dividends and/or share repurchases. Now that Anixter is operating with a stronger balance sheet, we're hopeful that management will consider returning excess cash to shareholders, a practice that is common for industrial distributors that enjoy cash flow stability.

Perhaps Anixter's small market capitalization or its relatively small following by sell-side analysts has kept the market from recognizing Anixter's competitive strengths and prospects. Whatever may be the case, we're hopeful that Anixter's improving fundamentals in 2019 (featuring a gross margin that is moving in the opposite direction of most other distributors) will draw increased investor attention and help close the gap between Anixter's current market price and our estimate of its intrinsic value.