This company has a strong position in a niche of the electrical distribution market in the US. Post-recession demand from customers has been choppy. With the decline in commodities (in this case mostly oil and copper), the company is currently facing additional headwinds. However, the market seems to have overreacted as the company is currently trading at a 50% discount based on mid cycle earnings and historic multiples. At the same time management is very experienced, the balance sheet looks pretty stable and the company is producing ample free cash flow with most of that being returned to shareholders.
Houston Wire & Cable (HWCC) is a distributor of wires, cables, and mechanical wire rope in the U.S. With a market cap of USD 110 m, annual revenues below USD 400 m and a market share of 0.4% in the electrical distribution market the company seems to be small fry. However, this only holds true at first glance.
What is a specialty wire and cable distributor doing?
HWCC is actually part of a small sub-industry of the electrical distribution market. The company focuses on specialty wire and cable serving the needs of large full-line electrical distributors or so called channel partners. To put it simply, HWCC stocks and distributes what distributors use infrequently, don’t want to inventory, is very expensive to inventory or is hard to handle.
The greater the need for customization and high service levels, the more likely the transaction will involve a specialty wire and cable distributor such as HWCC. The goods HWCC distributes are not shelf goods to the customer. In contrast, the company is distributing highly engineered special products. These specialty cables and wires represent only a fraction of HWCC’s channel partner’s revenues. Specialty wire and cable make up about 7% of the typical electrical distributor’s revenues. For the large distributors it does not make economic sense to sell these specialty products given the large numbers of items resulting in high costs of inventory and a low return profile.
For instance, HWCC is offering custom cut wires and cables for one off applications. As a result of this service, remnants are usually left. For the conventional distributor it would be costly to stock those remnants and resell them to the market. In contrast, HWCC has a large client database with 65,000 different specialty cable and wire types giving the company a greater opportunity to sell those remnants.
As a consequence, the large electrical distributors including Rexel, Graybar, Wesco and Sonepar are outsourcing this smaller part of their business to companies like HWCC as they find it difficult to inventory HWCC’s product range themselves.
HWCC is offering a wide range of services in a highly fragmented and competitive industry
Since 1975 HWCC has expanded its business from the original location in Houston, Texas to 22 locations nationwide. The strategically located distribution centres generally allow for ground delivery nationwide within 24 hours of shipment. In the markets that they serve, competition is primarily based on product line breadth, quality, product availability, service capabilities, and price. To be successful in this market, a company needs the right product mix and a broad customer base to maximize its inventory investment. Apart from that, HWCC offers a number of services to differentiate itself including custom fabrication and cutting wire to length, stock oddball lengths, bundle cables for specific job applications, offer dependable 24-hour delivery of so called B and C items so distributors can invest in more inventory of the fast-moving A items and cable management services.
Another aspect of HWCC’s business model is that it sales account for only a small percentage of the final value of its customers’ projects. However, these products would cost the customers many times more if these items were mis-handled or delayed in delivery. Thus, customers focus on reliable distributors leading to relatively sticky customer relationships.
According to management, HWCC primarily competes with over 200 mostly smaller specialty wire and cable distributors in North America on a regional and local basis. Many of those specialize in a narrow range of wire and cable products. Relatively large competitors with a nationwide footprint include Anixter, Omni Cable and Priority Wire & Cable. However, Anixter for instance does not focus on full-line electrical distributors as a primary customer segment like HWCC does, but markets its products directly to the end-customer.
During 2014, HWCC served 6,300 customers, shipping approximately 42,000 SKU’s (stock-keeping units) to 10,500 customer locations nationwide. No customer represented 10% or more of sales.
Cutting out the middleman – a potential threat to HWCC?
HWCC’s market segment is highly competitive. However, from my perspective HWCC’s business model itself seems to be somehow protected as HWCC’s wide product selection and specialized services support the company’s position in the supply chain between wire and cable manufacturers and the customer:
The breadth and depth of wire and cable and related hardware that HWCC offers, requires significant warehousing resources and a large number of SKU’s. While manufacturers may have the space and capabilities to maintain a large supply of inventory, management believes that there is no manufacturer that has the breadth and depth of product that HWCC is offering. More importantly, manufacturers historically have not offered HWCC’s services and do not have multiple distribution centres across the country. While manufacturers are also selling specialty wire and cable directly to the end-user, most of the time these transactions include bulk volume of wire and cable, involving little or no customized services requiring long lead times between order and delivery.
More frequently, an electrical distributor serves as the sales channel directly between the manufacturer and the contractor or end-user. The typical sale by an electrical distributor may involve a commonly purchased item that is specifically designated by the end-user and shipped from stock along with a variety of other electrical products.
However, for customers requiring highly specialized wire and cable and additional services electrical distributors will generally source products from a specialty wire and cable distributor simply due to the fact that this has a positive effect on their return on capital. Apart from that, management expects the increasing complexity of specialty wire and cable specifications and the growing need for just-in-time delivery and logistics to spur further growth in purchases through specialty wire and cable distributors.
HWCC obtains roughly 54% of inventory from five suppliers (incl Belden Inc., General Cable Corporation, Lake Cable LLC, Nexans Energy USA, Inc. and Southwire Company). This approach maximizes purchasing efficiencies and vendor rebates. For a distributor this is a relatively high supplier concentration. So, as far as I understand, this is part of the difference to the classic distributor model, where the distributor collects a large number of different products from a large number of suppliers to sell them to a large number of customers to justify its existence. In HWCC’s case it is more about an efficient inventory management and offering additional services creating additional value for customers.
Large exposure to the US oil and gas industry
HWCC satisfies the cable and wire needs of several industries focusing mainly in the utility, industrial, infrastructure, and environmental compliance markets. For instance, in the utility sector the company sells many products used in the construction of a power plant/ upgrading of existing power plants and the related pollution control equipment. In the industrial sector the company serves a wide variety of products specifically designed for use in manufacturing, metal/mineral, and oil and gas markets. In 2014 oil and gas made up roughly 30% of overall revenue. Hence, the decline in oil and gas prices has an immediate effect on the company’s operations. For the first two quarters of 2015 management estimates that lower order intake from the oil and gas industry reduced revenues by 10% y-o-y.
It is important to note that the most immediate impact felt in the industry has been in the upstream space where the company according to management is not very active. Most of HWCC’s daily activity occurs in midstream. In the downstream sector management sees great opportunities over the long term as a combined project work with a value of USD 80 bn has been approved in the Houston area, where the company has secured a large market share.
Project revenues for the construction of large capital asset lead to short term volatility
Roughly two third of revenue comes from products sold for use in the repair and replacement work (MRO). The transactions occur on a daily basis for unexpected demand. Project work contributes the remainder of revenue which is usually very volatile due to small numbers of large orders. For instance, in the first half of 2015 a large project was suspended leading to a substantial overall sales decline. The project segment addresses customers’ growing requirement for efficient just-in-time product management for large capital projects. HWCC stores dedicated inventory so that customers have immediate product availability for the duration of their project. Advantages of this program for customers include extra pre-allocated safety stock, firm pricing, zero cable surplus and just-in-time delivery. Generally speaking, MRO is more profitable than project works.
Stable gross margins during market downturns
The company operates in a cyclical industry as the following graph shows:
HWCC recovered from the recession relatively late in Q3 2010. However, the large rebound in revenues is partly influenced by the USD 50 m acquisition of Southwest Wire Rope in June 2010. Excluding the effect from the acquisition, HWCC wasn’t able to increase revenues above pre-recession levels over the last years.
Revenues are not only a function of the amount of shipping orders but also depend on the movement in metal prices (mostly copper). The company accounts for inventory with the average cost accounting method. This means that the value of inventory slowly moves down over time with copper deflation and slowly moves up over time with copper inflation. Hence, during periods of falling prices the income statement will benefit from this accounting method if compared to the more common first-in-first-out method. Nevertheless, short term metal price fluctuation can have a strong influence on the value of inventory and sales as price fluctuations in metals are passed directly on to customers.
As purchase price fluctuations in the prices of goods sold can be passed on to customers, HWCC’s gross margins have been relatively stable. Between Q4 2008 and Q2 2015 the average gross margin was 21.6% reaching a high of 23.1% in Q4 2014 and a low of 19.4% in Q3 2010. Nevertheless, the company has traditionally experienced greater gross margin pressure in periods of amplified metals deflation similar to what we are experiencing today.
However, it is also noteworthy that the company has not been able to reach pre-recession gross margins so far. Post-recession gross margins decreased by roughly 500 bps compared to the 2006/2007 period. Both lower revenues and gross margins indicate that HWCC’s target markets were not able to fully recover after the financial crisis.
During the latest downturn revenue has fallen by 24% when comparing Q2 2014 with Q2 2015. According to management, the recent y-o-y drop in revenues can be explained by the lower spending in the oil and gas segment (10%), the suspension of large projects in other industries (7%), the fall in cooper prices (5%) and the balance being others.
Profits have not reached the pre-recession level
The company’s business can also be characterized by high operating leverage and a relatively strong cash generation:
As already outlined gross margins have not reached pre-recession level yet. In addition, while metal price deflation has only a short term effect on gross margins, the absolute dollar value of income is declining. Apart from that, operating expenses increased by roughly 40% after the acquisition of Southwest Wire Rope in June 2010.
As a consequence, average quarterly EBITDA decreased by roughly USD 5 m comparing the period from Q3 2010 until Q2 2014 with Q1 2006 until Q3 2008. Over the same period average net profit was more than 50% lower. Net profit in the table above does not include two goodwill impairments in Q3 2013 and Q2 2015 totalling USD 11 m.
Strong cash generation, clean balance sheet and shareholder friendly allocation of free cash flow
Over the last 9.5 years the company generated in total USD 139 m of free cash flow to shareholders before changes in debt and acquisitions (FCFE). That is 81% of net profit before impairments over the same period. Out of this amount USD 50 m was allocated to external growth, USD 56 m was paid as dividends to shareholders with the reminder used for debt repayment and share repurchases.
Except for USD 25 m of goodwill and intangibles representing 15% of total assets, the balance sheet looks pretty clean. With currently USD 41 m net debt representing 0.4 times book value, financial leverage is close to the lower end of the historic range. The bulk of capital is employed in working capital with roughly 34 cents needed to generate one USD of revenue.
Over the last years management continuously increased the dividend to shareholders. At the current run rate, the company pays annual dividends of roughly USD 8 m. In addition to that, the company has a share repurchase program of USD 25 m in place which started in 2014. The bulk of this amount has not been spent yet.
During the latest conference call management was asked whether the dividend might be reduced as the current level of business would suggest more than 100% payout on earnings. Management replied that they have the capacity due to the strong balance sheet to keep the dividend stable during a period where performance is less than expected. In addition to that, cash generation is particularly high during a downturn given that management is actively reducing working capital. Hence, this should enable management to keep the dividend stable for a couple of quarters. However, in case the current downturn lasts for a longer period of time payments to shareholders might be reduced leading to an outflow of income oriented investors.
Experienced management team
The current CEO started his career at HWCC as an account manager in 1987. The same applies to the CFO who joined the company in 1984 as a controller. So the management has weathered a number of market cycles and should be well prepared to handle the current difficult market environment. Together they are holding 1.6% in the company. Last year’s total CEO/CFO compensation of USD 0.9 m incl USD 0.2 m of stock option awards seems reasonable to me.
Since HWCC’s IPO in 2006, the stock traded at an average one year forward P/E ratio of 16.2x. Assuming that the last cycle started in Q4 2008 and ended in Q2 2014 the company traded at an average one year forward P/E ratio of 17.0x.
Over this cycle annual mid cycle net profit was USD 13.7 m and an annual mid cycle FCFE was USD 13.5 m. So, based on the current market cap the company’s value as a multiple of a normalized P/E is 8.0x and 8.2x taking normalized free cash flow into account.
I believe that the business case for HWCC is still intact as customers should continue to focus on reducing working capital investments for the types of high-risk specialty items the company supplies.
HWCC’s greatest exposure from a geographical perspective is the Houston area with its relatively strong dependence on the oil and gas industry. About 20% of Texas State GDP is a function of oil and gas. Management communicates that the overall company revenues as a function of oil and gas are about 30%.
Over the last year the share price declined by almost 50%. I assume that this is mostly due to the company’s exposure to natural resources. That decline is about the same what the S&P Commodity Producers Oil & Gas Exploration & Production Index lost over the same period. Still most of the index components are highly leveraged upstream companies.
From my perspective the market has been overreacting due to the following reasons:
- Revenues from oil & gas sector will not fully blow apart, due to MRO business;
- Low exposure to upstream oil & gas;
- 70% of revenue comes from ex-oil and gas sector which might profit from the US recovery (EDIT: Correction, 30% of revenue are directly related to oil&gas and another 20% are indirectly influenced by demand for crude oil);
- The company is in a strong financial position;
- The company is a major player in an important niche market within the supply chain;
- Based on mid cycle earnings shares trade at a historic low.
After last week’s post I accumulated a 3% position on September 23/24 at an average entry price of USD 6.68 per share.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!