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Morningstar | Wesco's 1Q Gross Margin Improves, but Sales Slump on a Tough Comparison; 2019 Guidance Maintained

Shares of Wesco International traded lower on May 2 after the narrow-moat-rated industrial distributor reported first-quarter sales and earnings that missed consensus expectations. Reported sales declined just over 1.5% year over year to $1.96 billion, which missed the consensus estimate by about 2%. However, organic sales growth, which excludes the Sylvania acquisition and adjusts for unfavorable currency translation and one less selling day, increased 1% compared with the prior year. While 1% organic growth seems lackluster on the surface, in all fairness, Wesco did face a tough prior-year comparison of 11% organic growth.

We were pleased to see a 40-basis-point improvement in the firm's gross profit margin to 19.5%. However, Wesco's operating margin contracted 10 basis points year over year to 3.6% as selling, general, and administrative expenses grew 2% on lower revenue, due in part to the Sylvania acquisition. Pretax income was about flat year over year, and a higher tax rate offset a lower share count. As such, GAAP EPS of $0.93 was unchanged from the year-ago quarter but missed consensus by $0.03.

While Wesco's first-quarter performance was mixed, management maintained its full-year 2019 guidance of 3% to 6% sales growth, 6% to 18% EPS growth, and 90% free cash flow conversion. We cut our 2019 sales growth assumption to about 4% from 5.5% previously, but we maintained our $5.48 EPS estimate ($5.10 to $5.70 guidance) due to our slightly higher operating margin and lower effective tax rate assumption. We've reduced our fair value estimate by about 1% to $87 per share because of the compounding effect of our lowered 2019 sales assumption.

Although Wesco's first-quarter performance was unexceptional, we still like the firm's long-term prospects. We also continue to view Wesco's stock as significantly undervalued, and the firm's proven through-cycle free cash flow stability supports our conviction in this 5-star-rated stock.

We suspect Wesco's May 2 sell-off was at least partially fueled by the fact that its sales growth substantially underperformed its closest publicly traded peer, Anixter International, which reported 8% organic growth during its first quarter. However, Anixter faced a much easier prior-year period (first-quarter 2018 organic sales were up about 2%), so we think the comparison is somewhat unfair. On a two-year stack basis (that is, comparing first-quarter 2019 sales to first-quarter 2017), Wesco achieved almost 12% organic sales growth compared with Anixter's 9% growth.

In terms of Wesco's end market performance, approximately 2% organic sales growth in both its construction and commercial, institutional, and government end markets was partially offset by slight (less than 0.5%) organic sales contraction in the firm's industrial and utility end markets. However, management said that consolidated sales growth picked up in March and that momentum continued into April. Furthermore, management's outlook remains favorable across its four end markets.

Wesco's first-quarter free cash flow declined 60% year over year to $18.1 million, representing a 43% free cash flow conversion ratio compared with 105% during the year-ago quarter. The steep year-over-year decline was due to net working capital outflows almost doubling to over $49 million due to increased billing in March amid a material uptick in sales and an inventory build to support sales growth in 2019. Still, management expects full-year free cash flow to approximate 90% of net income.

Management still expects to spend at least $75 million on share repurchases by the end of June, representing a cumulative $200 million spent on a $400 million authorization since 2018. Given that Wesco's stock is currently trading at a substantial discount to our estimate of its intrinsic value, we view share repurchases as a prudent use of shareholder capital.