Wesco Aircraft: How To Turn Nuts & Bolts Into A Wide-Moat Business

Wesco Logo

Business

Wesco Aircraft (NYSE: WAIR) is according to its latest 10-K:

“…one of the world’s largest distributors and providers of comprehensive supply chain management services to the global aerospace industry on an annual sales basis. Our services range from traditional distribution to the management of supplier relationships, quality assurance, kitting, just-in-time, or JIT, delivery and point-of-use inventory management. We supply approximately 525,000 different stock keeping units, or SKUs, including hardware, bearings, tools and more recently, electronic components and machined parts.

In fiscal 2013, sales of hardware represented 83% of our net sales, with highly engineered fasteners constituting 80% of that amount. We serve our customers under three types of arrangements: JIT contracts, which govern comprehensive outsourced supply chain management services; long term agreements, or LTAs, which set prices for specific parts; and ad hoc sales. JIT contracts and LTAs, which together comprised approximately 60% of our fiscal 2013 net sales, are multi-year arrangements that provide us with significant visibility into our future sales.

Founded in 1953 by the father of our current Chief Executive Officer, or CEO, Wesco has grown to serve over 7,400 customers in the commercial, military and general aviation sectors, including the leading OEMs and their subcontractors, through which we support nearly all major Western aircraft programs. We have grown our net sales at a 15.6% compound annual growth rate, or CAGR, over the past 20 years to $901.6 million in fiscal 2013. We serve a large and growing global market, and believe that with more than 1,300 employees across 42 locations in 12 countries, we are well positioned to continue our track record of strong long-term growth and profitability.

In simpler words the company manages its customers’ inventory for the following product categories:Product Categories

Wesco’s customer are in the aerospace industry and are major OEMs and their subcontractors:Key CustomersHere are some aircraft types that are serviced by Wesco:

Main Aircrafts ServicedWesco works essentially as a big “warehouse” that receives parts in a cost-effective manner (big and/or planned orders) from suppliers and provides them in a timely and as-needed basis to its customers. It also performs quality control on behalf of its customers helping their operations to run as smoothly as possible.

Customers benefit from Wesco in three major ways:

  • They don’t need to concern themselves with inventory management and quality inspection.
  • They free up a big proportion of their working capital since they don’t have to keep inventory of the parts Wesco supplies.
  • Most of the time they get their parts cheaper through Wesco than they would get them directly from the suppliers. This is because Wesco buys parts for many companies and thus achieves greater volume discounts than any one customer would get for themselves.

Suppliers also benefit in three major ways:

  • They can access the 8,500 customers Wesco serves with minimal sales, marketing, administrative and distribution costs.
  • They keep less inventory as Wesco serves as the buffer between them and their customers.
  • They have greater demand and production visibility which helps them to plan their production accordingly increasing efficiency and lowering manufacturing costs.

Here is a slide from Wesco’s latest investor presentation that shows the benefits customers and suppliers enjoy:Wesco's Win-Win For Customers & Suppliers

Moat

Wesco enjoys two powerful competitive advantages that protect its current business and allows it to grow in a multitude of ways.

The first and more visible one is scale. As said earlier, Wesco can buy larger quantities of parts than any of its customers would on a standalone basis and thus can offer lower prices to its customers. Suppliers benefit also as they have greater sales visibility and can better streamline their production, increasing production efficiency.

Scale is a significant barrier of entry for new competitors and contributes to Wesco’s second competitive advantage which is switching costs. Wesco gains customers in two major ways. It either replaces a competitor that failed to service adequately a customer’s needs or it “convinces” a manufacturer to outsource its in-house inventory for parts that Wesco provides.

In the former case the newly acquired customer has already experienced what bad service feels like and will be extremely reluctant to leave the safety and peace of mind that Wesco offers. Furthermore a customer that contemplates performing Wesco’s job in-house faces two key issues. First, it will have to tie up a significant amount of working capital to build up an adequate inventory of the parts Wesco supplied.

Second, it will have to create an inventory management function that deals with constant quality testing of incoming parts (in order to be compliant to aerospace regulations) and the management of tens or hundreds of different SKUs. In an era where businesses strive to reduce bureaucracy and free-up working capital this approach is a big no-no.

Global Presence

Growth Prospects

Wesco grows organically and through acquisitions. Its organic growth is fueled by two secular industry trends:

  • The increasing growth of the aerospace industry both in size and aircraft complexity. As aerospace technology improves and the world’s middle class increases in size, air travel for cargo or passengers as well as space projects are only going to increase in volume. Especially as aircraft fuel efficiency and safety improves over time.
  • The increasing popularity of outsourcing solutions as manufacturers constantly strive to become leaner and more efficient in their operations. This is a direct effect of globalization which has made competition tougher for aerospace OEMs and because of countries like China who subsidize the creation of their own domestic aerospace industry increasing the number of players in the industry.

Acquisition growth is especially suitable to Wesco’s business model because it can leverage its distribution network to market the acquired company’s products and create cross-selling synergies that deepen its relationship with its existing customers and generate additional high margin revenue. A good example is its latest acquisition of Haas. This acquisition expanded the company’s product offerings, its distribution network, creates new revenue from existing customers and deepens its customers switching costs in one move.

For Haas Wesco paid a reasonable price valuing it at 12.5 times EBITDA (Wesco paid $550 million for Haas’ $596 million of revenue and $44 million of adjusted EBITDA).  Haas AcquisitionHaas Acquisition 2Haas Acquisition 3

Risks

Of course every investment comes with its own set of risks and uncertainties. For Wesco the risks (that I could identify) are the following:

  • The cyclicality of the aerospace industry.
  • Although management has been sensible about acquiring companies this may change.
  • Carlyle group is selling down its stake and when it stops participating in the board management may become less shareholder friendly.
  • Wesco depends on Precision Castparts (NYSE: PCP) and Alcoa Fastening Systems (NYSE: AA) for 39% of its inventory. This may prove to be a problem since it is not clear (to me at least) which party has the upper hand (i.e. pricing power)

In general I don’t see anything that could serve as a “catastrophe” risk for the company except excessive acquisition-driven debt. However the company isn’t over-leveraged (operating earnings are 5 to 6 times its interest expense)and management seems focused (for the time being at least) in quickly paying down any debt incurred by the Haas acquisition and generally keeping the company’s debt levels low.

Valuation

The company is currently valued at $18.94 per share and has a market cap of $1.84 billion. This is around 15.5 times its 2013 adjusted earnings of $1.22/share and 14 times its estimated 2014 earnings of $1.35/share (keep in mind that Wesco’s FY closes on September 30th).

Wesco has been growing its net sales (according to its 2013 10-K) at a 15.6% CAGR for the last 20 years and it’s actually accelerating since this figure was at 14.8% in its 2012 10-K, 13.5% in its 2011 10-K and 13.4% for 2010 according to its IPO S-1 filling.

Given Wesco’s business model and its competitive strengths I believe that it is reasonable to assume that Wesco’s average CAGR for the next 10 years (from 2014 and beyond) will be between 10% and 15%. Applying a 5% discount rate  and a “perpetual” 10X multiple for the years after the first 10, we find that the company is worth between $30 and $44 per share which is a 58%-130% potential gain.

This may seem like a very wide range but the goal here isn’t to be precise but to get a feel about the company’s worth. And given the quality of its business and its competitive strengths I think that Wesco is worth at least $30/share giving us a large margin of safety for buying at these levels.

Of course this is just my opinion, you should always do your own due diligence.

And… I would really appreciate it if you let me know if I missed anything, through email or in the comments below.

 

Full disclosure: I am long WAIR

Liquidity Services: A Case Of An Illusory Network-Type Moat

One of the things that are permanently on my to-do list is to constantly look for companies with a durable competitive advantage (aka “moat”) to add to my watch-list or even better to my portfolio if I’m lucky and find one on the cheap.

One company that looked quite promising was Liquidity Services Inc which trades on NASDAQ under the symbol “LQDT“. Here what LQDT does as it was reported in its 2013 10-K:

“We operate leading online auction marketplaces for surplus and salvage assets. We enable buyers and sellers to transact in an efficient, online auction environment offering over 500 product categories. Our marketplaces provide professional buyers access to a global, organized supply of surplus and salvage assets presented with customer focused information including digital images and other relevant product information along with services to efficiently complete the transaction. Additionally, we enable our corporate and government sellers to enhance their financial return on excess assets by providing liquid marketplaces and value-added services that integrate sales and marketing, logistics and transaction settlement into a single offering. We organize our products into categories across major industry verticals such as consumer electronics, general merchandise, apparel, scientific equipment, aerospace parts and equipment, technology hardware, energy equipment, industrial capital assets, fleet and transportation equipment, and specialty equipment. Our online auction marketplaces are  http://www.liquidation.com, http://www.govliquidation.com, http://www.govdeals.com, http://www.networkintl.com, http://www.truckcenter.com, http://www.secondipity.com, and http://www.go-dove.com.”

What essentially LQDT does is being a “market maker” in the surplus & salvage assets market. It makes it easy for big companies that neither have nor want to operate a reverse supply chain for their surplus & salvage assets. LQDT does it for them. It picks up the goods, stores them and makes sure to find a willing buyer to sell them to.

At first glance LQDT seems to benefit from a classic network-type moat. The more asset sellers it serves the more asset buyers it attracts and the more asset buyers it attracts the more asset sellers are attracted to its services. And the virtual cycle goes on and on..

Furthermore this qualitative analysis seems to be backed by the company’s extraordinary performance. It has compounded its revenue at 24% for the last decade and its net income at 31%. It has no debt and has negative working capital (excluding cash) that suggest the existence of float, and thus a competitive advantage.

(For more on the relation between moats and floats read this excellent series by Sanjay Bakshi at the “Fundoo Professor“)

However, the image of a big sturdy moat around LQDT’s business collapsed when I reached the Management discussion segment, where the company clarifies how it makes its money. LQDT generates income from three transaction models. Asset sellers are free to choose which one they want:

  • The profit-sharing model: Under this model LQDT buys inventory from the asset sellers and sells it, sharing a portion of the profit with the original seller. This model accounts for 13.5% of the company’s revenue and 7% of its gross merchandise volume or GMV.
  • The consignment model (fee revenue): Under this model LQDT receives a commission fee for matching asset sellers with the buyers of the surplus & salvage goods. The fee is a percentage of the price the assets are sold. This model accounts for just 20.1% of the company’s revenue despite the fact it covers 59.1% of the company’s GMV.
  • The purchase model: Under this model LQDT offers asset sellers a fixed amount for their assets or the option to share a portion of the revenue generated by the assets’ sale. This model accounts for 66.5% of the company’s revenue although it covers only 33.9% of its GMV.

The only part of LQDT’s business that has a network-type moat is the consignment segment where LQDT is the facilitator of the transactions in a model similar to eBay’s. However under the other two models, LQDT is nothing more than a wholesaler/reseller of surplus and salvage assets. It may have some cost advantages due to its scale but nothing more.

The way I arrived at this conclusion was by trying to answer the following question:

“What would happen if Amazon and/or eBay (which are the eventual selling places of many surplus and salvage goods) decide that they want a piece of LQDT’s business?”

Well they would probably try to steal asset sellers from LQDT by offering a bigger portion of sales profits/revenue or by buying their assets for a higher price. And thus they would target LQDT’s most profitable models. Would they succeed? Probably yes, because they both have the necessary distribution networks to sell the surplus/salvage assets and they can afford to do it with smaller profit margins compared to LQDT. And they would satisfy both asset sellers (with greater profit/revenue returns) and asset buyers (with lower selling prices).

“Would LQDT’s customers have any trouble or hesitation to abandon LQDT or to split their business between LQDT and LQDT’s competitors?”

And the answer here is… no. LQDT’s clients on both sides of the transaction are mostly businesses who are targeting consumers one way or another and that constantly working on razor-thin margins. They wouldn’t miss an opportunity to be the low-cost seller or increase their margins for a tiny-bit even if it’s temporary.

So it seems perfectly clear that LQDT faces a big catastrophe risk down the road. Competition from the likes of Amazon or eBay has the potential to wipe out 80% of the company’s revenue and thus putting it in existential risk.

HOWEVER, what I’m not saying above is that if LQDT continues to operate competitor-free as it has so far, I believe that it will continue to grow at a breakneck pace and would probably be a multi-bagger for the next decade or so.

Nevertheless, I’m a hard-core Buffett fan and cloner and I can’t bring myself to violate the first step in Buffett’s investment process. And the first step is (as it was artfully demonstrated by Alice Schroeder in the video below) to always check every potential investment for catastrophe risk, which is the possibility of the investment going to zero. If the investment has even a small chance of catastrophe risk the investor should stop thinking and just reject the idea.

And (at least in my eyes) LQDT certainly seems to face some degree of catastrophe risk…

Disclosure: I have no position in LQDT and as of this writing I don’t plan to initiate any long or short position on the company.

FTD Companies: A fairly valued company with a strong moat but low growth potential.

Overview

FTD (NASDAQ: FTD) is a floral and gifting company. It connects consumers with local florists and gift shops from all over the world. A typical order for FTD goes like this:

A customer orders some flowers of his choosing, online or over the phone, to be delivered at a specific address. FTD redirects the order to one of the florists that belong to its network and is closest to the delivery address. The florist prepares the order and delivers it to the specified address either the same day or the day that the customer specified.

From this transaction FTD gains two-fold. It receives a part of the order as a fee for connecting the customer and the florist, and it receives an annual subscription fee from the florist in order to include his business in its network.

FTD - Brands

FTD’s Brands

FTD is a recent spinoff from United Online (NASDAQ: UNTD) and is again a public company since November 1, 2013. I say “again” because FTD has entered and exited the stock market many times over the last 14 years, as you can see below.

FTD's History


A slide with FTD’s history as shown in its investor presentation on December 3, 2013.

Moat

This company is interesting because it seems to have a very wide moat. The moat is its network of 40,000 floral shops worldwide, which is a huge network if we consider that the US floral market consists of approximately 15,000 retail florists. In the floral network business the more locations a network covers the more orders it gets, and the more orders it gets the more florists want to join in adding new locations.

This virtuous cycle is a huge barrier of entry which keeps potential entrants out and limits the competition between the incumbent companies such as 1-800-FLOWERS, Proflowers and Teleflora. FTD also faces indirect competition from mass retailers like ASDA, Marks & Spencer and Amazon that sell and ship boxed flowers to customers.

Besides the qualitative evidence of a moat FTD’s numbers tell a similar story as well. The company operates on a negative working capital basis (excluding cash and short-term debt) which implies some short of float.  Furthermore it has a stable 37% gross profit margin indicating some pricing power.

Unfortunately FTD’s tumultuous history of takeovers and IPOs seems to have created big amounts of long-term debt and goodwill that heavily distort the business’s performance and we can’t use ROE or ROA to evaluate the business.

However the business’ strength becomes evident when we examine it on a free cash flow basis. It has generated $50 million of FCF on average over the last 3 years and is expected to generate about $60 million in 2013. This is a 20% cash return on equity and a 10% cash return on assets, with both numbers being strong enough to indicate a potential moat.

Valuation

Given that the company historically had a very slow growth rate of about 5% over the past 15 years or so, the company is currently worth at best 10x its FCF or about $500 to $600 million or about $27 to $32 per share (the company has 18.5 million share outstanding). And this is the base case scenario.

However in this case capital allocation can change the company’s value by a wide margin.

Scenario 1: Reducing share count by 2% to 3% annually.

If management pursues such a strategy we can essentially increase the company’s future EPS growth rate from 5% to 7% or 8%. At these rates the company would worth between 11x and 12x its FCF or between $30 (11x $50 mil FCF) and $39 (12x $60 mil FCF) per share.

Scenario 2: Paying a 50% to 80% of free cash flow as dividend.

In this case the company would become a pure dividend play and it could pay a dividend somewhere between $25 million (50% x $50 mln FCF) to $48 million (80% x $60 mln FCF). This is a $1.35 – $2.60 per share dividend. So, assuming a fair value at a 4% dividend yield the company could trade from $34 to $65 per share.

Scenario 3: Extinguishing debt by December 31, 2018 and then one of the other options.

If FTD used all its free cash flow to pay down debt it would be debt free in 3 years time, and at that point its free cash flow would rise to $70 million or about $3.8/share annually.

At 10x FCF the company would worth $38 or about 20% higher than its current price. Furthermore the company could also decide to annually return some of its FCF to shareholders, boosting its value even more.

Scenario 4: Using cash to make acquisitions

The company could use its FCF to acquire other companies and thus boost its revenue growth going forward.

In this case I believe the company could worth about 9x to 10x FCF or about $24 to $32/share. The reason I’m so pessimistic in this case is that management’s tend to overpay when acquire new revenue. Thus, I prefer to err on the side of caution than to assume a superb management team and be disappointed.

Scenario 5: Piling up cash

The company could just hoard the cash and wait for some extraordinary opportunity down the road. In this case the company’s value would just increase every year by $2.7-$3.2 per share depending how much cash it generated that year.

In this case I would still value the company not more than 11x FCF or $30 – $35.

Conclusion – Calculating Probabilities

Concluding I’ll try to roughly estimate the odds of each scenario happening. We aren’t completely blind in this process as there are some hints on management’s attitude for investors.

The first hint is the following question and answer from the investor relations Q&A page.

FTD - Dividend Question

The second hint comes from the framework for management incentives insiders currently own insignificant amounts of the companies shares. If they want to maximize their compensation they should give themselves plenty of options and simultaneously decrease the number of shares outstanding in order to give themselves as big a piece of the company as possible.

FTD - Shareholders

So without further delay here are the odds (as I see them of course) of each scenario materializing:

Scenario 1: FTD just buys back shares. Fair value $30 to $39. – 15% probability.

Scenario 2: FTD pays a hefty dividend. Fair value $34 to $65. – 5% probability.

Scenario 3: FTD extinguishes debt immediately. Fair value $38 or more. – 5% probability.

Scenario 4: FTD grows through acquisitions. Fair value $24 to $32. – 20% probability.

Scenario 5: FTD simply hoards its cash. Fair value $30 to $35. - 5% probability.

Combination of scenarios 1,3 and 4. – 35% probability.

Some other combination of outcomes or something else completely – 15% probability.

Given that most probabilities are for a fair value between $30 and $40, the stock isn’t a buy at its currents price of $32. However I added it in my watch-list and I will probably act on one of the following conditions:

-The company clarifies its plans for the future and decides to return some cash to shareholders. In this case I will reevaluate the company and if the price is favorable I’ll buy.

-The company’s shares fall to $20 or lower. At this price I would be a strong buyer (up to 25% of my portfolio) because the stock would have a big margin of safety and big potential returns (up to 100%).

Collectors Universe: A Low Risk, High Uncertainty Investment

Recently I came across a write-up of Collectors universe (NASDAQ: CLCT) on Investing Sidekick.com, an excellent value investing blog I follow. Collectors Universe is a wide-moat business that pays an 8% dividend yield because Mr. Market is expecting the dividend to be cut sooner or later. I disagree strongly with Mr. Market’s view and below I’ll try to explain why.

I won’t talk a lot about the business and the company’s financials as they were thoroughly discussed on the Investment Sidekick. However here are some basics.

Business Overview

Collector’s business is a simple and straightforward one. They provide authenticity certification for collectible items like coins, cards, autographs and others. The company gets 65% of its revenues and 73% of its operating income from its coin authentication segment, which is not only its main business, but also the one with the most growth potential.

It is the second biggest coin grading company and has graded cumulatively 27 million coins over its history. Its main competitor is NGC (Numismatic Guaranty Corporation) which has cumulatively graded 28 million coins. Both of these companies are the most trusted coin graders by a wide margin. However, Collectors is constantly closing the gap with NGC and sooner or later will be the one with the greater number of authenticated coins in the market.

In case you’re wondering, I’m using the “cumulative” number of coins graded to compare these companies for a reason. This number represents not only the market share of these companies but also the strength of their moats. You see the coin grading business is a business build in reputation. The more graded coins one has in the market the more trusted his name becomes attracting more customers.

Furthermore the collectibles that are graded by such a trusted grader (like Collectors) get premium pricing in the market over non-graded ones or ones graded by less trusted companies. This is because fraud is rampant in the market for coins and other collectibles. Verification of authenticity is extremely important for collectors, especially nowadays where a large part of the collectibles market has migrated online.

Finally, despite the great economics of the grading business, it is virtually impossible for any new or existing grading business to compete with either Collectors Universe or NGC. This is because their brands are so widespread and so entrenched in their markets that a competitor would have to struggle for decades before experiencing any significant market share gain.

Financials

The economics of the grading business are really wonderful. Collectors Universe operates with a 63% gross profit margin and a net income margin of 11.5%. Furthermore since Collectors’ customers usually pay in advance for the grading of their collectibles the company has negative working capital, which means that it’s operations are mostly funded by the cost-free float customers are providing.

It doesn’t come as a surprise then, that the company generates returns on assets (excluding surplus cash) north of 30%. It has also increased its FCF at an average 20% over the past three years.

Furthermore according to the company only 10% of the US collectable coins market has been graded leaving enormous potential for the future. Moreover CLCT has just opened offices in mainland China which is the oldest and bigger coin market on the planet.

Mr. Market’s Take

The opportunity in this stock exists in the form of its $1.30/share dividend which at its current $16.2 price represents an annual yield of 8%.

The reason this opportunity exists is that the dividend surpasses both the company’s income and its free cash flow. As a result Mr. Market believes that it will be cut sooner or later. This opinion is reinforced by the fact that some income tax reliefs the company enjoyed over the last few years (due to losses carried forward) have come to an end.

Possible Outcomes

I believe that Mr. Market is overwhelmed by the uncertainty surrounding the dividend and has gone too low in pricing CLCT. Let’s take a look at the potential outcomes for this situation to figure out if Mr. Market is right or wrong:

Outcome 1: Collectors Universe decides to keep this $11 mil dividend for as long as possible and subsequently cut it to 80% of its $8 mil free cash flow. I assume no material change in current business.

In this scenario Collectors has enough money ($17.5 million as of Sep 30, 2013) to fund its $3 million cash flow deficit for at least five years. After that the dividend will fall from $11 mil to $6.4 mil or from $1.3/share to $0.75/share.

So we will receive $6.5 of cumulative payments over the next five years and after the dividend is cut an annual payment of $0.75. The discounted cash flows (I use a 5% discount rate) over the next ten years will have a present value of $8.58 and we will still own the stock which will trade around $19 (assuming CLCT trades at a 4% yield on its $0.75 dividend).

Concluding, in scenario 1 we pay $16.2 for an asset that’s worth $27.58 or 70% more.

Outcome 2: In this scenario let’s assume that CLCT cuts its dividend immediately to 80% of its $8 mil free cash flow.

In this case CLCT will pay out a $0.75 and will probably trade around a 4% yield or $19/share. It will also have a cash hoard of $17.5 million or $2 per share and thus it will ultimately worth around $21/share.

In scenario 2 we pay $16.2  for an asset worth $21 or 30% more.

Outcome 3: In this scenario let’s assume that Collectors Universe China investment goes well and the company continues to grow its FCF at 20% at least for the next two or three years.

In this scenario CLCT’s free cash flow will exceed its dividend needs within the next two years and thus the $1.3 dividend will be fully funded. And the company will have at least $10 million left in its coffins. In this case CLCT will probably trade around a 4% dividend valuation or $32.5/share.

In scenario 3 we pay $16.2 for an asset worth $32.5 or 100% more.

Outcome 4: The company blows it, China is a complete failure, domestic cash flow falls 30% to $5.6 million and the company cuts its dividend by 50% to $0.65/share.

In this scenario CLCT will have a fully funded dividend of $0.65 and will probably trade around a 4% yield valuation or around $16. The cash hoard of $2/share though, will remain intact and thus the whole company will worth around $18.

In scenario 4 we pay $16.2 for an asset worth $18 or 12% more.

Conclusion

Some notes before we calculate the odds for the four outcomes:

  1. The CEO has stated in the Q4, 2013 earnings call that they intend to keep paying the dividend for the foreseeable future.
  2. The first signs from the Chinese market are pretty good.
  3. For my calculations I use the latest number of shares outstanding which is 8.5 mil.
  4. I assume that a 4% dividend yield is a reasonable return for investors given the current economic environment and the quality of the business (wide moat).

Now let’s put some approximate odds on our 4 scenarios.

  • Outcome 1: 40% probability
  • Outcome 2: 10% probability
  • Outcome 3: 30% probability
  • Outcome 4: 20% probability

So, we’ve got an investment that has a 70% probability for a 70% to 100% return, and a 30% probability for a 12% to 30% return. The possibility for a permanent  loss of capital if we buy at these prices is essentially zero!

For me this is the perfect investment opportunity. What do you think?

Disclosure: I am long CLCT for my personal account