A Glimpse of Q3? WESCO’s Perspective

As Q3 comes to a close, feedback from distributors and manufacturers is that the quarter has been a financial godsend.

Needless to say, it had to be better than Q2.  The disastrous April is quickly falling into the rear view mirror and with many having had a strong Q1 (at least prior to March 15^th), year to date performance is not too bad. In fact, on the current pace, for some who were in the hardest hit states (i.e. where the market was closed – Boston, New York, Pennsylvania, Michigan, etc) – being down 20-25% for the year is considered a positive.

Aside from work being restarted to finish projects scheduled for April and May, Q3 is traditionally a good construction month. This year the residential sector is especially strong. Further, some are trying to get a head start on projects scheduled for Q4 if they have labor available as they are concerned about the unknown.

 And Q3 performance has been hindered by supply chain issues in the areas of circuit breakers, PVC pipe, EMT and some other areas which could have further added to performance.

Industrial Weak?

Some in the industrial space report that business in this sector remains weak.

WESCO recently presented at an investor conference and shared some goals and performance updates from their first half as well as shared some Q3 to date highlights.

According to an online report from Baird (our notes in italics):

WCC CFO David Schultz spoke at a competitor conference this morning, and the company filed an 8-K with quarter-to-date revenue trends. Through the first 50 days of 3Q20, pro-forma sales are tracking -8% y/y, which implies revenues slightly below our/Street full-quarter expectations.

• QTD revenue trends. Pro-forma revenue is tracking -8% y/y roughly 3/4 of the way through the quarter. This is slightly below our -6.5% estimate for the quarter. Additionally, this is stable with the -8% seen through the first 28 days of the third quarter provided on the 2Q20 call, despite progressively easier comparisons for legacy WCC through the quarter (July 2019 +4%, August +3%, September +2%). If the -8% declines hold over the remainder of the quarter, we estimate pro-forma revenue would be $4.04 billion vs. consensus of $4.07 billion and our $4.10 billion estimate.
• End markets. Utility sales (lowest margin segment) have remained strong, including a benefit from recent storm response. The legacy broadband AXE business (likely the highest margin segment) continues to see solid demand with increased demand for data consumption/bandwidth amid the pandemic. Non-residential construction and industrial continue to see softness. Management does not see an “air pocket” ahead for non-residential construction, noting backlog has continued to grow and strong residential construction could portend better non-residential trends ahead. We are skeptical and maintain our cautious non-residential stance.
  • The non-resi construction and industrial markets are the elements of WESCO that are most applicable to the electrical industry but it should be noted that only 24% of WESCO sales are in the contractor market and, by our estimate, this means that WESCO does about $2.5-3.0 billion of the US commercial construction contractor market. While backlog has grown, the question becomes, is this due to a significantly higher close ratio (more wins) for future business or a delay of existing projects (which is what many have experienced. If these segments are down more than 8%, does that mean the market is down that (and remember, that’s not YoY, that’s WESCO vs WESCO) or is WESCO down more or less than the general market and could this be due to the industrial market performance?
• Gross margin expansion. WCC is looking to apply legacy AXE’s gross margin expansion initiatives across the entire organization. This includes providing greater data visibility to sales reps and leveraging a broad product portfolio with service capabilities to lower total cost of ownership for customers. AXE has had a good track record of gross margin expansion, delivering y/y expansion for the last seven consecutive quarters.
  • The “total cost of ownership” / productivity savings message is being adopted by more and more distributors. Essentially becoming table stakes in their messaging to customers. Manufacturer reps are also using the same messaging as they meet with end-users and some are using in their discussion with distributors as it relates to helping reduce supply chain costs and making their manufacturers “easier to do business with.”
  • The gross margin comment is interesting and highlights one of the takeaways from due diligence – identifying better practices from someone else!

Deleveraging and synergies. CFO Schultz reiterated confidence in deleveraging to 2.0-3.5x within 36 months of close. Management sees the combined company eventually generating $600+ million in free cash flow, with the pro-forma companies averaging $370 million the past five years, coupled with $200+ million of synergies. Management also reiterated confidence in delivering upside to the targeted $200 million of synergies.

• This further highlights the potential in distribution businesses … can be strong cashflow generators.

Lighting a Leading Indicator?

With lighting representing 25-28% or so of industry sales and a higher percent of construction-oriented distributor sales, it can typically be an indicator of industry performance. Early results from our Q3 Pulse of Lighting survey (open till Monday, September 21^st, it takes only 3 minutes to complete and you’ll get a free copy of the results) shows a wide array of responses. The distributor element is typically the most accurate as they represent an array of manufacturers. While the bell curve shows +/-4%, there are still some down 10-20% and some up 10%.

Crystal Ball

So, the question is, is WESCO indicative of Q3 or are you outperforming them? If outperforming them, what segments have rebounded to fuel opportunities.

And then, the next question becomes, what’s your “feelings” for Q4? We’re hearing quotation activity strong. Backlog continuing to rollover but trepidation.  Accurate?