From today on I will increase my long position in shares of Houston Wire & Cable (HWCC) to 4% of the portfolio with a limit price of USD 6 per share.
For a detailed discussion of this business, I recommend to you reading the initial investment case.
The reasoning behind this transaction is the following:
30% to 50% of HWCC’s revenue depend directly / indirectly on US oil and gas. After the oil price shock, the US upstream oil & gas industry reduced rig count by 79% from 1,920 to 404 during the period from December 2014 to May 2016. Since May total rig count has increased by 41% from 404 to 568 as of November 11, 2016. A rebound in US oil and gas production will ultimately lead to increased demand for HWCC’s maintenance and repair products.
With the recent election of Donald Trump as President of the United States, the implementation of a fiscal investment program with the goal to improve the country’s infrastructure has become a likely consequence. HWCC should benefit from more investment in the country’s infrastructure as the company delivers its products to wastewater, transportation, mass transit and shipping facilities / projects throughout the US.
Price movements in metal prices including copper, nickel, steel and aluminum have a significant effect on revenues, cost of sales and therefore gross margins. For instance, in the first nine months 2016 sales were down 19%. Adjusted for metal prices the decline was 800 bps lower at 11% compared to the first nine months of 2015. Hence, after years of metal price deflation any prolonged upswing will have a significantly positive effect on profitability.
In October 2016, HWCC acquired Vertex from DXP Enterprises. Vertex generates roughly USD 30 m in sales which is roughly 10% of HWCC’s size. While Vertex’s products and customers are different from HWCC, the business model itself is very similar. Consequently, HWCC can leverage its existing distribution platform to enhance the availability of Vertex specialty fasteners throughout the US. In addition, the Vertex acquisition should be accretive to HWCC’s profitability and return on capital. According to management Vertex currently earns a 38% gross margins (compared to approx. 20% in the case of HWCC) and has a similar balance sheet structure with most of the capital invested in working capital.
Debt as of September 30, 2016 stood at roughly USD 29 m. This has been the lowest level since 2010. Debt reduction has been funded with a significant reduction in working capital during the downturn. Cost of debt is quite attractive at 1.7% year to date. The company has a revolving credit facility of max. USD 100 m in place to finance the company’s capital needs – so far mostly working capital. The credit facility matures in September 2020. Now management is using the undrawn debt to fund the Vertex acquisition. The deal increases debt by roughly USD 33 m. At the end of last quarter and before the deal closing, HWCC had additional available borrowing capacity of USD 45 m (borrowing capacity depends on the amount of inventory and accounts receivables). So there should be still enough room to maneuver through the ongoing recession. At the same time, management might have made a value accretive acquisition by putting cheap capital to work.
Recently, the company suspended the dividend, but is still conducting share repurchases. The board authorized a stock repurchase program of USD 25 m in March 2014. Since then, the share count has been reduced by roughly 9%. The share repurchase program has still USD 9.4 m outstanding. Given the current market cap of roughly USD 85 m, a significant reduction in share count can be achieved in the near term at what I believe is a very attractive price.
Historically, earnings quality has been good. Over the last ten years, HWCC generated USD 158 m in net income and USD 167 m in free cash flow to equity holders.
From a valuation perspective, the market is discounting the current recession in the US industrial sector. The expectation of a secular decline in demand for specialty wire and cable is getting obvious by looking at past performance. This business generated annual net profit ranging from USD 15 m to USD 20 m from 2011 to 2014 (USD 5.5 m in 2015 and a forecasted operating loss of USD 1.8 m in 2016). Based on a modest ten times multiple (historically shares traded at a 15 times trailing price earnings ratio) and a current market cap of USD 90 m, this implies earnings potential of USD 9 m for the legacy business ignoring any positive impact from the Vertex acquisition. That is roughly 25% below historic mid cycle earnings. I believe that an investment – even at this depressed level of potentially new normalized earnings – is attractive. This is due to the company’s good earnings quality, an extremely experienced and shareholder oriented management team and HWCC’s strong position within its industry.
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