“…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:
Wesco 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 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.
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.
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.
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