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Morningstar | Anixter Reports Electrifying 3Q Organic Revenue Growth and Raises Full-Year 2018 Revenue Guidance. See Updated Analyst Note from 23 Oct 2018

Anixter International's reported third-quarter revenue grew 8.1% year over year (7.4% organically) to $2.2 billion. Anixter's 7.4% organic growth rate was the highest growth rate the firm achieved since the third quarter of 2011 and was up from 4.9% organic revenue growth last quarter. All three of Anixter's segments reported strong organic sales growth; network and security solutions, or NSS, grew 6.4%, electrical and electronic solutions, or EES, grew 9%, and utility power solutions, or UPS, grew 8.1%. Given the strong top-line growth achieved during the third-quarter, management raised its full-year 2018 organic growth target to 4.5%-5.0%, up from 3.5%-5.0% previously. With the security acquisition, which closed during the second quarter, along with modest tailwinds from foreign currency and copper prices, we project Anixter's full-year 2018 revenue will grow about 6% year over year. After reviewing Anixter's third-quarter results, we've maintained our $107 per share fair value estimate, and we continue to believe that Anixter's stock is deeply undervalued.

Anixter's gross margin has been steady in 2018. Excluding a $2.6 million charge related to the acquisition, Anixter's third-quarter gross margin was approximately 19.6%, in line with the prior two quarters. During the earnings call, CEO Bill Galvin commented that the team is optimistic gross margin can improve in the fourth quarter, which would certainly be a positive development for Anixter. However, given the close eye the investment community keeps on distributors' gross margins, missing this goal next quarter could pressure the stock. GAAP operating expense as a percentage of sales improved 30 basis points year over year to 15.4%, and GAAP operating margin expanded 10 basis points to 4.1%. At the segment level, NSS GAAP operating margin expanded 20 basis points to 6.6%, EES margin improved 90 basis points to 5.7% and UPS margin declined 30 basis points to 4.5%.

We were impressed with the electrical and electronic solutions segment's operating leverage during the quarter--adjusted EBITDA grew over 23% year over year on a 7.6% increase in reported revenue. EES operating margins must continue to improve for Anixter to achieve our midcycle operating margin assumption of approximately 4.8%. EES operating margins are still significantly below the 8% average the segment achieved between 2011 and 2014. We model EES operating margins to improve from 5.8% in 2018 to 6.8% by 2022 as strengthening industrial end market demand drives volume gains and operating leverage.

At the end of the third-quarter, Anixter's debt/capital ratio was 44.7%, which is below management's targeted range of 45% to 50%. Anixter's debt/adjusted EBITDA ratio was 3.1, just above management's targeted range of 2.5-3.0. Now that Anixter's capital structure is about where management wants it, and assuming management views mid-single-digit revenue growth as sustainable, we think there is an increased likelihood of the firm returning cash to shareholders as early as 2019.

We continue to view Anixter's stock as deeply undervalued. Indeed, the stock is currently trading near our bear-case valuation of $65 per share. To warrant such a valuation, we'd have to assume that Anixter can do no better than 2% revenue growth and 3.7% operating margins over the long run. In our view, 2% revenue growth is too low for a company that's exposed to secular growth trends of data center expansion and increased security spending. Furthermore, over the past decade, Anixter's average operating margin was approximately 5.4%. We think the firm's profitability will improve with a growing top line.