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Morningstar | Organic Revenue Growth Has Become a Welcomed Theme for Wesco; Raising FVE to $86 Per Share

Wesco turned in another solid quarterly performance, in our view. The narrow-moat industrial distributor's second-quarter revenue grew over 10% (9% organic) year over year to $2.1 billion. Excluding a 20-basis-point unfavorable impact from a $2.5 million bad debt charge, operating margin expanded 20 basis points to 4.5% (flat year over year on a GAAP basis). GAAP EPS increased nearly 20% to $1.22, driven by a 10% increase in GAAP operating income, a lower effective tax rate, and a reduced share count versus the year-ago quarter. Wesco's second-quarter EPS missed the consensus estimate by $0.01 on in-line revenue.

We continue to be pleased with Wesco's strong, broad-based organic revenue growth, which has persisted over the last four quarters. In our view, this trend is indicative of both healthy end market demand and Wesco's solid execution. We've increased our fair value estimate to $86 per share from $84 previously due to the time value of money since our last update. Our fair value estimate continues to assume that Wesco's normalized operating margin and return on invested capital (excluding goodwill) is 5% and 15%, respectively, versus a 4.2% operating margin and a 13.4% ROIC (excluding goodwill) in 2017.

In terms of organic revenue growth by end market, utility grew 19% year over year, commercial, institutional, and government grew over 9%, construction grew 8%, and industrial grew 6%. All four of Wesco's end markets have had at least four consecutive quarters of positive organic growth. Based on a strong first-half performance and positive outlook, management raised its full-year revenue growth guidance to 6% to 9% from 5% to 8% previously.

In addition to updating sales growth guidance, management also updated its operating margin guidance to 4.2%-4.5% from 4.2%-4.6% previously and its EPS guidance to $4.60-$5 from $4.50-$5 previously. Based on our modeling, this guidance appears to be reasonable.

Wesco's gross margin was down 20 basis points year over year (down 10 basis points sequentially) to 19%. However, we think Wesco's gross margin has stabilized (it's ranged between 19% to 19.3% over the last five quarters).

Through the first six months of 2018, Wesco has generated approximately $70 million of free cash flow (defined as operating cash flow less capital expenditures), about 24% higher than last year. Free cash flow conversion has been better, too, at 70% of net income versus 65% last year. Management expects to convert more than 90% of its 2018 net income into free cash flow. Wesco's financial position also improved during the quarter; total debt/trailing 12-month EBITDA fell to 3.3 versus 3.5 last quarter. Management's targeted leverage ratio is 2.0 to 3.5.

During the call, management noted that it had a "very robust [merger and acquisitions] pipeline." While we don't take any issue with future bolt-on type acquisitions, we would prefer Wesco return more of its free cash flow to shareholders than it has historically. Wesco has long preferred using free cash flow for acquisitions instead of returning cash to shareholders. The firm has never paid a dividend, and major share repurchases have been relatively infrequent. A more shareholder-friendly capital allocation would better align Wesco with many of its peers, in our view.

On July 2, Blue Harbour Group filed a Schedule 13D filing with the SEC that disclosed that the activist investor had over a 7% ownership stake in Wesco. Given that we see Wesco's stock as materially undervalued under a conservative set of valuation assumptions, we're not surprised that an activist investor has shown interest in the firm. Blue Harbour has long been known as a "friendly" activist that works alongside management to unlock shareholder value. As such, we don't think Blue Harbour will pressure Wesco into a forced sale (we think there are few logical buyers anyways). Given Wesco's balance sheet, we also don't see the firm as a major consolidator either. If anything, we think Blue Harbour will encourage Wesco to establish a more shareholder-friendly capital allocation strategy, which we would like to see as well.