EUR 850.00 For Business Accounts Only

Morningstar | We've Tempered Anixter's Near-Term Margin Expansion to Account for ERP Spending; FVE to $98

During Anixter's fourth-quarter earnings call, management disclosed that an enterprise resource planning system upgrade was a component of the firm's "innovation and business transformation" plan. Management noted that they expect the transformation to provide $40 million to $60 million of run-rate cost savings by 2023. The firm provided more details about the ERP implementation in its February investor presentation. Anixter will begin moving from the firm's current antiquated homegrown mainframe-based ERP system to an Oracle cloud-based system in 2020, and the implementation is expected to conclude in 2023. Management expects to fund the project with incremental gross margin improvements and to begin realizing net cost savings by the second half of 2021.

While Anixter's ERP implementation could go smoothly, it's not without risk and could lead to business disruption and earnings volatility, especially given that properly functioning ERP systems are critical for distributors. Furthermore, Anixter doesn't have an established track record of gross margin expansion over the last five years. If management's gross margin expansion goals fail to materialize, ERP-related costs will have a larger impact on the company's bottom line. We now believe our prior operating margin forecast between 2019 and 2021 was too aggressive considering ERP-related expenditures and potential operating risks. We're now modeling Anixter's operating margin to remain about flat over the next three years versus our previous forecast that projected 60 basis points of margin improvement over the same time horizon. However, we still believe a near-5% operating margin is a reasonable estimate for Anixter's normalized, sustainable operating margin, which we model in the final year of our valuation model (2023). Our tempered near-term operating margin forecast caused our per share fair value estimate to decline about 8% to $98. Still, we think Anixter's stock is significantly undervalued.

Anixter's gross profit margins have been on a downward trend since 2013 due in part to a prolonged industrial production contraction in 2015 (it took more than three years for the industrial production index to return to 2014 levels) as well as increased competition. However, Anixter's gross margins may have hit an inflection point during the fourth quarter of 2018, when its gross margin improved 50 basis points year over year to 20.3% (full-year 2018 gross margin contracted 10 basis points to 19.7%). Management's 2019 guidance projects a 20 to 40 basis point gross margin improvement along with 3% to 6% organic top line growth. If Anixter achieves the midpoint of its 2019 sales growth and gross margin goals, the firm will generate approximately $100 million of incremental gross profit in 2019 that could be used to fund the ERP implementation.

In our view, our moderated near-term operating margin expectations bake in heightened operational risk related to the ERP implementation into our valuation, and we therefore don't believe it necessary to change our medium fair value uncertainty rating, especially given Anixter's consistent and counter-cyclical free cash flow profile. As a distributor, Anixter has lower fixed costs and capital expenditure requirements compared with many other non-distributor industrial firms, and the firm is able to decrease its working capital needs when end market demand slows. Case in point, Anixter generated a record $419 million of free cash flow in 2009 despite sales declining 19% year over year. Anixter has generated free cash flow every year since 2007, and we don't expect that trend to change even if the firm encounters unexpected cost headwinds related to its ERP implementation.