WESCO International

Wesco reported second-quarter organic sales growth of 13% year over year driven by around 45% growth in data center equipment sales. Management raised full-year guidance, and shares traded up over 10% the morning of July 30.

Why it matters: All three of Wesco's segments experienced accelerating sales growth on the heels of unprecedented US construction spending. Wesco's backlog grew 60% year over year, signaling that sales momentum is likely to unfold over many quarters. Consolidated operating margin grew 20 basis points year over year to 5.7%. We believe this is mainly a mix shift; Wesco's CSS segment, which houses its data center business, is both the fastest-growing and highest-incremental-margin segment. It now represents around 40% of sales. Additionally, Wesco continues to purchase service-led businesses with attractive margins. Its $136 million purchase of Newark Engineering, which provides engineered cooling solutions and lifecycle services for data centers, closed on July 1.

The bottom line: We raise our fair value estimate for narrow-moat Wesco to $275 per share, up from $240 to reflect our more bullish margin expectations. We believe a revenue mix shift, operating leverage, and higher-margin acquisitions should lift Wesco's operating margin around 100 basis points over the next five years. We continue to believe Wesco's intrinsic value has positive optionality if management can deliver on its 10% adjusted EBITDA margin goal. Nevertheless, the market seems to be extrapolating Wesco's supercharged organic sales volume growth too far into the future. We reiterate that Wesco primarily distributes capital equipment; if construction spending wanes, Wesco's growth would likely nosedive.

We raise narrow-moat Wesco's fair value to $275 per share, up from $240, to reflect our more bullish margin expectations. The value of Wesco is underpinned by its narrow economic moat rating, which we believe enables the firm to outearn its cost of capital over the next 10 years. Wesco’s fair value estimate equates to about 16 times our estimate of 2026 adjusted earnings.

We model mid-single-digit annual sales growth over our explicit five-year forecast. Of all the industrial distributors we cover, Wesco has the greatest exposure to new construction markets, positioning the firm to capitalize on rising infrastructure spending and reshoring trends in the US, as well as the data center buildout. Wesco's data center business has increased by more than 50% in the last year, and the end market now accounts for more than 20% of consolidated revenue.

At Wesco's 2024 investor day, management laid out a road map to achieve 10%-plus EBITDA margins. Wesco’s team sees numerous margin-improvement drivers, including cost efficiencies from its digital transformation, ongoing cross-sale synergies, operating leverage from volume growth, and margin-enhancing acquisitions. Still, this target strikes us as optimistic, and we're maintaining our more conservative profit margin outlook for now. That said, if management can deliver stronger profit margins, we see upside to our fair value estimate. We continue to model a moderation in Wesco's midcycle margin to account for a potential economic downturn.

We assign Wesco a Morningstar Economic Moat Rating of narrow, from a significant cost advantage over smaller peers. The firm generates average returns on invested capital, inclusive of goodwill, in the low teens, in line with its largest public peer, Rexel. Wesco’s returns fell below its cost of capital during the last two global economic crises in 2009 and 2020. However, the firm still outearned its cost of capital over the business cycle, and we have confidence it can do so over the next decade. Wesco distributes a wide array of capital and maintenance equipment, primarily focusing on electrical, networking, security, and utility components. It reports through three business segments, but our analysis considers the company as a whole, given the similarities and significant interactions among the segments.

A McKinsey survey revealed that top-performing distributors tend to have superior scale, product breadth, value-added services, and digital tools to improve the customer experience. We think Wesco has each, helping explain how it can generate returns above its cost of capital in a fragmented, cutthroat market. Although it is a highly uncertain exercise to estimate the size of the capital equipment distribution market, we believe Wesco is likely the largest global player and holds a single-digit market share.

Wesco has a long history of being a trusted partner in capital projects, accounting for about half of the firm’s sales. For construction contractors, a project starts with a request for proposal, in which contractors request specific products and services from suppliers, then move into a pricing discussion. It is 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. In our view, Wesco’s unparalleled breadth of top-tier capital equipment helps minimize construction delays and gives the firm an edge over smaller peers in bidding. The competitive bidding process does, however, result in a lower margin profile for capital equipment distributors compared with distributors like Grainger and Fastenal that primarily focus on maintenance, repair, and operations, or MRO, supplies.

While competitive bidding limits Wesco’s ability to charge higher prices, the distributor achieves profitability through its scale-driven cost advantage. Wesco aggregates demand from its 150,000-plus customers to drive economies of scale and achieve lower per-unit costs with tens of thousands of suppliers. In other words, Wesco’s size allows it to offer competitive pricing on a broader array of products compared with smaller distributors largely due to the volume rebates it secures from suppliers that drive down its cost of goods sold. We estimate that Wesco’s operating margins have historically been at least 200 basis points higher than smaller local and regional distributors, which represent the vast majority of competition. Wesco’s largest capital equipment distribution peers, Rexel and Graybar, earn similar superior operating margins in the niches they inhabit.

The company’s dense, wide-reaching distribution network is another source of scale-driven cost advantage. Wesco has hundreds of branches and distribution centers in North America—its strongest market—and formidable operations in foreign countries. Global sourcing, proximity to its customers, and centralized order fulfillment capabilities allow Wesco to cost-effectively serve customers, including multinational corporations that require consistent product availability and service quality around the globe. Over the past few decades, an increasing number of companies have worked to consolidate their spending with large national distributors that offer value-added services. Vendor consolidation allows customers to simplify their procurement processes and leverage their buying power. Because Wesco has national scale, it has increased its wallet share of national accounts, taking share from smaller competitors that cannot profitably service such customers.

Wesco also offers value-added services for its suppliers and customers. Suppliers can reduce selling costs by outsourcing their sales, marketing, and logistics activities to the distributor. Value-added services for customers include efficiency and safety assessments; engineering and installation; product sourcing, prefabrication, customization, and kitting; vendor-managed inventory; planned and emergency repair services; and training. Although we think many of these services are replicable and do not establish a moat source, they are an important component of Wesco’s value proposition and help fend off low-touch providers like Amazon.com. Customers tend to lack the expertise to evaluate and select from the large assortment of stock-keeping units that Wesco sources from a highly fragmented supplier base, nor do they have the scale to cost-effectively manage their supply chains. Wesco's services and technical expertise simplify customers’ product procurement processes, lower their working capital needs, and drive cost and risk out of their supply chains. As such, we believe Wesco’s broad offering of value-added services provides some degree of pricing power.

Countercyclical cash generation supports a flexible leverage strategy and enables Wesco to make acquisitions during periods when companies are most likely to be distressed and sold at a discount.

Wesco’s global footprint and wide array of inventory management services help the firm take market share from smaller distributors and support pricing power.

Through the acquisition of Anixter, Wesco effectively doubled its scale, the key driver of its cost advantage.

Wesco’s acquisition strategy has potentially diluted returns but fueled much of its past growth.

The firm maintains above-average leverage, which can put a handbrake on the business during periods of weak cash flow generation.

Continued customer and supplier consolidation could put pressure on Wesco’s bargaining power.