Will a Bigger Wesco Be Better?

Brian Bernard: Big changes are afoot for Wesco International, which is an industrial distributor with particular strength in the electrical distribution submarket. The narrow-moat-rated firm expects to complete its acquisition of close peer Anixter International during the second or third quarter of 2020.

Wesco's stock currently trades at over a 50% discount to our fair value estimate, but we think sentiment will become more favorable for Wesco as the market begins to realize the growth, earnings power, and free cash flow generation potential of the combined entity. While large-scale combinations like this can be a bumpy ride for investors over the near term as integration efforts often lead to uneven financial performance, we think patient investors will be rewarded.

At over $17 billion in sales, the combined entity will dwarf W.W. Grainger as the largest industrial distributor in the United States. Given how similar these firms are, Wesco's $200 million cost synergy target seems like a very achievable goal that could push pro forma adjusted operating margins north of 6.0%, compared to the 4.0% to 4.5% margins that stand-alone Anixter and Wesco currently generate. We also see opportunities to achieve revenue synergies (from cross-selling and enhanced pricing power) and improve capital efficiency as digitalization efforts promote a shorter cash conversion cycle. Based on our math, the combined entity's pro forma earnings power could exceed $9 per share, assuming $200 million of run-rate cost synergies and excluding one-time transaction and integration costs.

We estimate the combined entity will have a net debt/EBITDA ratio of 4.5, which is higher than we'd like to see for an industrial distributor; however, Wesco's management expects to reduce the combined firm's leverage ratio to its long-term targeted leverage ratio of 2.0 to 3.5 within 24 months. Both Anixter and Wesco enjoy stable, countercyclical free cash flow generation, so we're not concerned about the combined entity's ability to reduce its debt load, even if end-market demand weakens. That said, we'd expect to see transient cash outflows related to integration activities (for example, severance expense) during the first year as a combined entity.