EUR 850.00 For Business Accounts Only

Morningstar | Improving Profitability Shines Through in Wesco's 3Q; Growth Continues Despite Tough Comparisons

Margin expansion was the highlight of Wesco's third-quarter results, in our view. The narrow-moat-rated industrial distributor increased its operating margin 30 basis points year over year to 4.7%, mainly driven by better operating leverage as selling, general, and administrative expenses as a percentage of sales declined 30 basis points to 13.7%. Wesco's steady gross profit margin, which has hovered around 19% over the last six quarters, improved 20 basis points sequentially to 19.2%. We view this improved gross margin performance as a sign that the firm's differentiated value proposition is supporting stronger price realization. Wesco's strong operating margin performance, along with a lower effective tax rate, resulted in a 26% year-over-year increase in EPS to $1.41, which beat the consensus estimate by $0.05.

Reported revenue grew over 3% year over year to $2.07 billion (4% organic growth), about 2% below the consensus estimate. While 4% organic sales growth represents a marked deceleration relative to last quarter (9% organic growth) and the first quarter of 2018 (11% organic growth), this was the first quarter that Wesco had to overcome tough prior-year sales comparisons. Indeed, organic revenue during the third quarter of 2017 was up almost 9%. Management now expects full-year 2018 sales growth of 6%-8% versus its prior guidance of 6%-9%. Management also unveiled its sales growth guidance for 2019, which sees Wesco's top line growing 3%-6% year over year. We are leaving our 2019 forecast for 5% revenue growth intact.

After updating our valuation model, we have increased our fair value estimate about 1% to $87 per share. Our higher fair value estimate is mainly due to the time value of money since our last update. We continue to expect Wesco's top line to grow at about a 5% pace over the next five years with operating margins improving to 5%; based on recent results, this seems very much achievable, in our view.

Like other distributors, Wesco's business model generates strong and consistent free cash flows. Historically, Wesco has used more than two thirds of its cash to fund acquisitions, and we've long commented that we'd like to see a more balanced capital-allocation strategy. It looks like we might get our wish. Management said the share-repurchase authorization was increased to $400 million and the company plans on accelerating the pace of its buybacks. CEO John Engel said during the earnings call that the company plans on spending $175 million on share repurchases through the first half of 2019. As we wrote in our Aug. 2 analyst note, activist Blue Harbour has taken an ownership stake in Wesco. We can't help but wonder if the activist influenced Wesco to allocate more of its capital to share repurchases, especially when the stock is trading near 52-week lows. In our view, Wesco's stock is deeply undervalued, so we think share repurchases are a prudent use of shareholder capital.