Industrial distribution is not the most glamorous industry. However, companies in this sector that have a strong competitive advantage and that are available at an attractive price can offer promising long-term investment opportunities. We believe Wesco Aircraft is one of these businesses. And it has the added benefit of operating in a sector with very favourable growth prospects.
There are pockets of opportunity in the industrial distribution sector
Certain businesses and industries, such as the latest technology start-ups, appear to be very glamorous. However, this does not necessarily mean that they are good investments as they may be too expensive. Other businesses or industries may appear to be dull because of the nature of their operations, but can actually offer very attractive investment opportunities, particularly those with a strong competitive advantage and that are available at attractive valuations. Certain industrial distribution businesses fall into this last category.
Industrial distribution businesses act as the middle man between the manufacturers of industrial parts on the one side and the users of these parts (original equipment manufacturers or maintenance/repair/overhaul operators, known as OEMs or MROs) on the other. In the context of the aircraft industry, Boeing and Airbus, who build planes from various parts, are examples of OEMs. We believe Wesco Aircraft is an example of a distribution company with a significant competitive advantage. Before we get into the detail, let’s start with understanding the nature of a competitive advantage in the distribution sector.
How distribution companies build a sustainable competitive advantage
Successful and profitable distributors typically build a sustainable competitive advantage in three ways:
- growing an extensive network of customers and suppliers,
- offering value-added services that support their customers’ procurement processes, and
- developing efficient logistic and supply chain processes.
Growing an extensive network of customers and suppliers
A network effect exists when the value of a product to the user increases as the number of people using the product increases. In the distribution sector, this realises as follows: as a company serves more customers by offering an extended range of products, the company’s bargaining power with suppliers increases. This enables it to extend its product range even further at lower prices. In the process, the company gradually obtains more and more of the customer’s business, until the customer can obtain all the parts it needs from the company. This also increases the customer’s efficiency, since they have fewer suppliers to deal with.
The greater the number of products supplied to the customer, the more it makes sense for the customer to outsource certain supply chain or procurement functions (such as quality control or warehousing) to the distributor. Again, the customer’s efficiency increases as fewer resources are spent on a non-core business function. This increases the customer’s perception of the value of the products and services they receive.
Ultimately a distributor could potentially bring together thousands of suppliers and customers. Leading distribution business W.W. Grainger, for example, connects 2,700 suppliers and 2 million customers. Without this network of suppliers and customers it would be impossible to offer the range of products and value-added services that they do.
The network effect makes it very difficult for a new competitor to enter the distribution market. To win over customers, such a company would have to offer a vast range of products and demonstrate the ability to provide these products punctually from day one, which is very difficult to do.
Offer value-added services that support the procurement process
Distribution companies can embed themselves in their customers’ procurement process by offering value-added services such as:
- supply chain services, for example quality control and ‘just-in-time’ stock management, and
- convenient ‘store’ locations for stock (often on-site at the customer’s premises) via stock-keeping bins or vending machines.
Develop efficient logistic and supply chain processes
A big network helps a distributor develop efficient logistic and supply chain processes. This enables the company to build a solid track record of dependability, particularly when it comes to stock availability, which is vitally important to manufacturers. For example, the manufacturer of a $150 million aircraft cannot afford to put its assembly line on hold to wait for a $100 fastener.
Once the company has built up a track record of stock availability, punctual delivery and meeting all quality requirements, it is not worthwhile for the customer to switch to another distributor, especially for relatively low-value items. High switching cost is another effective competitive advantage that can give a company pricing power relative to its competitors as well as better-than-average margins. Distributors also require relatively little capital expenditure once they reach a certain scale, which enables them to become strong cash generators.
Two of the giants in the distribution sector have shown remarkable growth over 15 years
Two well-known success stories amongst general industrial distributors are those of W.W. Grainger (which has a market capitalisation of $13.9 billion) and Fastenal (market capitalisation of $12.5 billion).
Figures 1 and 2 show how W.W. Grainger and Fastenal have been able to beat their cost of capital consistently over time by a handsome margin, which enabled them to grow intrinsic value substantially over the 15-year period. As one would expect, their share prices have reflected this – over the period, W.W. Grainger and Fastenal have outperformed the MSCI World Index by 183% and 174% respectively.
Although a smaller market player, we believe Wesco has similar growth potential
We believe Wesco, which has a much smaller market capitalisation of $1.3 billion, has the potential to be the next W.W. Grainger and Fastenal. Wesco was founded by Jack Snyder in 1953 as a dealer of scrap metal and hardware. When Jack’s son, Randy succeeded him in 1977, Wesco started to focus on distributing the small parts and components required to manufacture aircraft. Today, their products include fasteners, bearings, bolts, screws, circuit breakers as well as chemicals such as adhesives, sealants, tapes, lubricants, paints and coatings. Wesco was listed on the New York Stock Exchange in 2011. The Snyder family still owns approximately 10% of the company.
The company is growing its network and distributes to all the main aircraft manufacturers
Today, Wesco is a global company supporting virtually every aircraft manufactured in the US and Europe. It has a network of over 1,200 suppliers and 8,000 customers, including Airbus, Boeing, Lockheed Martin, Gulfstream, Raytheon and United Technologies.
Wesco’s quality control capabilities are a key value-add for their customers
Wesco has a very broad product range of 575,000 stock keeping units (SKUs). Each part has to be certified by aviation regulators, which requires stringent quality testing and certification on every part. This part of the procurement process (quality control) could become very cumbersome and costly for Wesco’s customers. As a result, they rely to a great extent on Wesco’s quality control capabilities – a value-added service that entrenches Wesco in their customers’ procurement process.
The medium- to long-term outlook for new aircraft bodes well for Wesco’s future revenue
Wesco and KLX are the two leading global distributors of aircraft parts – their combined market share is estimated at 33%. Their competitors are small and fragmented, often with a regional or niche focus.
Wesco’s revenue is driven mainly by the number of parts sold, which is a function of the number of aircraft being built. The bright medium- to long-term outlook for new aircraft demand is therefore good news for Wesco’s potential revenue growth. Revenue Passenger Miles (RPMs), an indicator of global commercial air travel traffic, is growing at approximately 5% per year (as shown in Figure 3) and underpins the healthy order books for planes (as shown in Figure 4). At their current production rates it will take Boeing and Airbus almost eight years to meet the orders that are currently on their books. US Defence Force spending has also stabilised after years of budget cuts.
Management’s focus on expanding the product range and reducing debt is a good long-term strategy
As the result of a deliberate strategy to grow the number of SKUs on offer, Wesco has faced a compression in margins in recent years. In general, the SKUs that Wesco added to its product list, for example electronic components and chemicals, generate a lower gross margin than traditional fasteners and bearings. We believe this is the right strategy for the long term and that Wesco is, in fact, “digging a deeper moat”. This speaks to the discussion about the network effect earlier in the article.
Under the previous management team, Wesco stumbled slightly on the acquisition of Haas, a chemicals business. Although the acquisition made strategic sense, they probably overpaid for the business and didn’t extract benefits from the acquisition as quickly as the market expected. The new management team under David Castagnola have made significant progress in recent quarters and are on track to meet their revenue and operating profit targets for 2016. Importantly, the company’s cash generation is strong and they are bringing down the debt used to fund the Haas acquisition to more acceptable levels. Debt reduction will remain management’s main capital allocation priority over the next couple of years.
We believe Wesco is well positioned to offer favourable long-term returns
Our view is that Wesco has all the competitive advantages of a leading distributor and is well positioned to benefit from the increased demand for commercial and military airplanes over the next decade. On our estimates, Wesco currently trades on a multiple of just over 12x of estimated earnings for 2017. We believe the share is undervalued and we therefore remain invested in Wesco on behalf of our investors in the Sanlam Global Best Ideas Fund.