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Industrial Stocks

Industrial-Grade Retail

By Peter Staas, on Jul. 16, 2017

Competition within the retail sector has grown increasingly cutthroat, thanks to the boom in e-commerce and consumers’ ability to compare prices and research products on their smartphones.

Meanwhile, Amazon.com (NSDQ: AMZN) continues to take market share from traditional retailers, hoovering up brick-and-mortar retailers’ profit pools and extending its reach to categories that many analysts and market participants had assumed would prove more resistant to online competition and disruption.

The importance of fit and feel, for example, hasn’t prevented Amazon.com and other online retailers from making their mark in apparel and sporting goods. More recently, Kroger’s (NYSE: KR) stock suffered a double-whammy after the company lowered its guidance and Amazon.com announced a blockbuster deal to acquire Whole Foods Market (NSDQ: WFM), intensifying an already ultra-competitive environment.

In mid-December 2016, we highlighted Manhattan Associates (NSDQ: MANH), a software and business services company that helps brick-and-mortar franchises transition into the brave new world of omnichannel retailing. (See Your Wish Is Our Command.)

The stock has tumbled 8.6 percent over the intervening months, reflecting weakness in the company’s professional services segment that prompted management to lower its revenue guidance. Investors also worry that ongoing pain and restructuring in the retail space could delay customers’ plans to invest in omnichannel capabilities.

Although Manhattan Associated faces near-term headwinds, we continue to believe in the company’s growth story. Prospective investors should ease into this position to take advantage of any additional weakness.

Our background research for that article made us wonder whether any profit pools in retail land can withstand the suction of Amazon.com’s tentacles. Mulling over this question led us to Ollie’s Bargain Outlet (NSDQ: OLLI), a discounter that offers a compelling in-store shopping experience and can grow rapidly over the next several years by opening additional locations.

This pick has fared much better than Manhattan Associates, returning 37.7 percent since we highlighted the stock in the Jan. 19 issue of Capitalist Times Premium. (See This Discount Retailer is No Joke.) We continue to like Ollie’s Bargain Outlet and its growth story, though investors who missed out the first time should wait for the stock to dip below $40.

Industrial Strength

Like Ollie’s Bargain Outlet, WESCO International’s (NYSE: WCC) business should resist disruption by Amazon.com and other e-commerce players eager to raid established profit pools.

The company went public in 1999, when the private-equity outfit that purchased Westinghouse’s electrical distribution business in 1994 sought to monetize its investment.

Over the subsequent decades, WESCO International has built impressive scale, expanded its product lineup and customer base, and diversified its revenue away from its core construction end-markets (now about 34 percent of annual revenue) via bolt-on acquisitions funded primarily with free cash flow.

(Click to enlarge.)

Today, the company acts as a middleman to more than 25,000 suppliers and 75,000 customers that come from the industrial, construction, utility, commercial and institutional markets.

Suppliers value the company’s massive customer base, e-commerce platform and capable sales force. Working with WESCO International effectively shifts some of the burden for sales, marketing, delivery and service to a capable partner that continues to grow its customer base and cross-selling opportunities with each acquisition.

In the highly fragmented North American electrical distribution market, this scale gives WESCO International a huge advantage over local and regional competitors in terms of its ability to procure favorable pricing and win national accounts.

As customers continue to consolidate the number of suppliers they deal with to simplify their operations, WESCO International should take market share. These market dynamics also offer ample opportunity for the distributor to grow via bolt-on acquisitions.

Besides the appeal of working with a single supplier, WESCO International’s scale enables the company to offer competitive prices and access to an inventory of more than 1 million different items. The company’s value proposition also includes supply-chain solutions and technical expertise that add to the value proposition. For example, the company offers safety assessments, engineering services, product prefabrication, inventory management and training.

At WESCO International’s recent investor day, management estimated that 65 to 75 percent of the company’s revenue comes from business tied to services and technical solutions. This service component helps to insulate its business from competition from the likes of Amazon Business and other online-only players.

Although WESCO International’s base business generates about $200 million in free cash flow annually that the company plows into acquisitions, weakness in industrial end-markets and soft pricing have resulted in two consecutive years of declining sales—one of the reasons that the stock trades at a favorable valuation.

During these fallow years, management focused on improving operating efficiency by consolidating branches into larger distribution centers and leveraging its spending across fewer suppliers to improve rebates. The company expects its One WESCO initiatives to deliver at least 20 basis points of margin improvement annually. These efforts should ensure that the bottom line looks even better when business picks up.

Moreover, we continue to see strong upside for WESCO International in coming years from robust capital expenditures in the utility sector, where the transition from coal to natural gas and renewable energy has accelerated. This shift likewise requires investment in grid enhancements and other upgrades that improve efficiency. Management has also highlighted data centers and the ongoing transition to LED lighting as potential upside drivers.

The residential construction market has also picked up, while an infrastructure-focused stimulus could be a major upside driver, given WESCO International’s leverage to major projects. With the stock trading at an undemanding valuation, just the expectation of infrastructure-related fiscal stimulus could catalyze a meaningful rally in the shares.

Even without a big infrastructure build-out, WESCO International’s end-markets should strengthen, while the network effect associated with bolt-on acquisitions should drive steady growth. WESCO International rates a buy up to $60 for patient investors who have an eye for value.

Peter Staas is managing editor of Conrad’s Utility Investor and Energy & Income Advisor.

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