Our Long-Term View of Wesco Remains Intact, Despite Near-Term Pressure

Equity Analyst

Dawit Woldemariam

In 1994, Westinghouse Electrical sold its electrical distribution business, Westinghouse Electric Supply, or Wesco, to a private equity firm. Wesco went public in 1999. Since its separation from Westinghouse, Wesco has used most of its cumulative free cash flow on acquisitions, which have expanded its scale, diversified revenue, and fueled a meaningful portion of the company’s growth. Once squarely focused on construction end markets, Wesco now serves a much broader array of customers across industrial, construction, utility, commercial, institutional, and government markets.

Wesco operates in very fragmented markets, but its large scale, global footprint, expansive product portfolio and supplier base, and service offerings differentiate it from smaller local and regional competitors. Service offerings, such as vendor-managed inventory, efficiency assessments, product repairs, and training, generate a meaningful portion of Wesco’s sales and are key components of the company’s value proposition to customers. Wesco’s size is also an important competitive advantage because the company has the scale to serve large, multinational clients anywhere in the world.

Wesco doubled in size after it completed its acquisition of close peer Anixter in June 2020. We expect the merger to be value-accretive to Wesco's shareholders. Management is targeting $315 million of cost synergies and $2 billion of cross-sales synergies by 2023, which we think is achievable.

As the U.S. economy recovers from the COVID-19 pandemic, we believe a combination of factors, including normalizing industrial demand and pricing, the Anixter acquisition, and a continued trend of customers consolidating their spending with larger distributors, will provide ample opportunity for Wesco to gain market share and grow faster than its end markets. As Wesco expands its top line, we expect operating margins will improve as it realizes operating leverage and synergies from the Anixter acquisition. Improving gross profit margin performance due to price increases and internal initiatives should also support better profit margins.

Business Strategy & Outlook

We assign Wesco a narrow economic moat rating because we believe the firm's competitive positioning will allow it to generate excess returns over the next decade. Our confidence is rooted in Wesco’s ability to fend off competitive pressures from both new and existing players in the electrical distribution, network and security, and utility power markets.

Wesco has a long history of being a trusted partner in capital projects (accounts for about half of sales). Construction contractors can count on Wesco to provide the products and services needed to drive efficiency throughout the project life cycle, including the design phase. For contractors, a project starts with a request-for-proposal, where contractors request specific products or services from suppliers and then move into a pricing discussion. It’s in contractors’ best interest to keep project costs as low as possible, which creates a competitive bidding process for distributors like Wesco to win the right to supply and service a given capital project. This explains Wesco’s lower margin profile as compared with more MRO-focused distributors, such as Grainger. While competitive bidding limits Wesco’s ability to charge higher prices, the company drives profitability through its cost advantage. Wesco’s size allows it to operate at a lower per unit cost compared with smaller distributors, largely due to the volume rebates it secures from suppliers. We believe it’s important to note that Wesco can charge higher prices for its inventory management services than transaction-only distributors (do not provide services). In capital projects, Wesco delivers and stages products, handles material, manages cables, and provides job trailers to store items until they’re needed on contractors’ job sites. These services help cut down on project costs, improve productivity and allow contractors to complete projects on schedule. Even though the company’s services promote some level of pricing power, we think these capabilities are replicable by other players and do not establish a moat source. 

Wesco’s economies of scale have led to strong returns on invested capital, or ROICs, historically, averaging approximately 18% on average (excluding goodwill) over the past two decades. Throughout its history as a public company, Wesco has also turned to acquisitions as a key growth driver. The company hasn’t recorded any goodwill impairments but ROICs have been constrained when goodwill is considered (11% on average since 1998). That said, we think Wesco’s acquisition of Anixter (global leader in network and security solutions) was a good move (acquired the business for less than its fair value) and will help improve its scale and present opportunities to cross-sell products. On a pro forma basis, we estimate the combined business holds approximately 10% market share in network and security and utility power markets, respectively. In electrical distribution, Wesco holds about 1% share of the much larger and fragmented market based on our estimates. Wesco’s strong presence in these markets and high-touch model sets it apart from both smaller industrial distributors and online players like Amazon Business, and its vendor managed inventory programs separate it from other large distributors.

The North American industrial distribution market is highly fragmented, with the largest players primarily benefiting from scale-driven cost advantages over smaller competitors that lack both scale and a global reach. We think Wesco’s operating margins have historically been at least 200 basis points higher than small electrical distributors. As a large industrial distributor in North America, Wesco benefits from volume-based rebates (lower per unit cost) and other sales incentives that would be unavailable to smaller distributors. Furthermore, we believe Wesco often receives preferential treatment from suppliers in the form of marketing support and product training, which, in turn, help Wesco more cost-efficiently promote its products and provide customer support.

The company’s efficient global sourcing and distribution network is another source of scale-driven cost advantages. The firm has approximately 800 branches and 43 distribution centers. Wesco’s scalable distribution network and centralized order fulfillment centers allow the company to cost-effectively serve its customer base, including multi-national customers that require consistent product availability and service quality around the globe. We believe Wesco’s technological capabilities, including its e-commerce sales channel, integrated customer purchasing and supply chain solutions, and warehouse automation, drive distribution efficiencies that would be difficult for smaller competitors to replicate. 

We believe the company’s leadership position in numerous markets and supply chain solutions increase its value proposition with customers. The company offers customers a wide variety of inventory management solutions, which help strategic source products, replenish inventory online, and place dedicated inventory at customers’ job sites. Wesco’s project management systems allow customers to move through the capital project life cycle efficiently. These inventory management programs are tailored for customers with planned inventory spending. We think Wesco will be able to land more planned spend customers and expand its wallet share. 

An increasing number of companies have been consolidating their spending with large national distributors. Vendor consolidation allows customers to simplify their procurement processes and leverage their buying power. Because Wesco has national scale, a global reach, and a robust portfolio of products and inventory management services, the company is well positioned to capitalize on this trend and take share from smaller local and regional distributors that do not have the scale to profitably service these customers. Although national accounts can generate lower gross profit margins, they also generate much higher volumes, which Wesco can leverage to improve operating margins. 

The Amazon Business threat to industrial distributors is less of a concern for us today than it was a few years ago. The company has certainly grown over the past decade, but not at the expense of Wesco. Amazon does not have any experience bidding on capital projects, and we do not expect Amazon to enter this market anytime soon. Furthermore, we believe it would be difficult for Amazon to upend Wesco’s entrenched position in numerous markets, given its strong relationships with customers. Amazon Business primarily serves small businesses, while Wesco’s high-touch model caters to the needs of large enterprises. Moreover, Wesco provides its customers supply chain solutions, as opposed to Amazon Business, which primarily focuses on online order fulfillment. Additionally, Amazon Business has experienced strong growth in the highly fragmented MRO market without having to make significant incremental investments into building out a high-touch business. We believe Amazon’s strategy will be focused on growing its endless assortment businesses (selling MRO products online), rather than trying to compete with Wesco in high-touch sales (integrated supply services) in several markets. 

In our view, Wesco does not have environmental, social, and governance risks that could result in material value destruction. The most significant ESG risk the firm faces is human capital risk--that is, the risk that Wesco is unable to adequately recruit, train, and retain the talent needed to sell its products and services and manage its supply chain, which could lead to lost market share. While a tight labor market remains a challenge for many companies, including Wesco, we think the firm has adequately managed this risk. We think human capital risk is a greater challenge for some of Wesco's smaller competitors that have fewer resources to manage this risk.

Narrow

Economic Moat

WESCO

WESCO International, Inc. is a holding company, which engages in the provision of electrical, industrial, communications maintenance, repair and operating, and original equipment manufacturers products. It also offers construction materials, and supply chain management and logistics services. Its product categories include general supplies, wire, cable and conduit, communications and security, electrical distribution and controls, lighting and sustainability, and automation, controls, and motors. The company operates through the following segments: Electrical & Electronic, Communications & Security, and Utility & Broadband Solutions. The Electrical & Electronic Solutions segment supplies a broad range of products and supply chain solutions primarily to the construction, industrial and original equipment manufacturer markets. The Communications & Security Solutions segment supplies products and customized supply chain solutions to customers in a diverse range of industries including technology, finance, telecommunications service providers, transportation, education, government, healthcare, and retail. The Utility & Broadband Solutions segment supplies electrical transmission and distribution products, power plant maintenance, repair and operations supplies and smart-grid products, and arranges materials management and procurement outsourcing for the power generation, power transmission and electricity distribution industries. The company was founded in 1993 and is headquartered in Pittsburgh, PA.

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WESCO International, Inc. is a holding company, which engages in the provision of electrical, industrial, communications maintenance, repair and operating, and original equipment manufacturer products. It also offers construction materials, and supply chain management and logistics services. Its product categories include general supplies, wire, cable and conduit, communications and security, electrical distribution and controls, lighting and sustainability, and automation, controls, and motors. The company operates through the following segments: Electrical & Electronic, Communications & Security, and Utility & Broadband Solutions. The Electrical & Electronic Solutions segment supplies a broad range of products and supply chain solutions primarily to the construction, industrial and original equipment manufacturer markets. The Communications & Security Solutions segment offers products and customized supply chain solutions to customers in a diverse range of industries including technology, finance, telecommunications service providers, transportation, education, government, healthcare, and retail. The Utility & Broadband Solutions segment provides electrical transmission and distribution products, power plant maintenance, repair and operations supplies, and smart-grid products, and arranges materials management and procurement outsourcing for the power generation, power transmission and electricity distribution industries. The company was founded in 1993 and is headquartered in Pittsburgh, PA.

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