Co-produced with Preferred Stock Trader
Wesco International (WCC) was founded almost 100 years ago and is a large distributor of a very broad variety of electrical products. The following is from Yahoo Finance:
The company distributes electrical, industrial, and communications maintenance, repair, and operating (‘MRO’) and original equipment manufacturers products and construction materials in North America and internationally. The company sells general supplies, such as wiring devices, fuses, terminals, connectors, boxes, enclosures, fittings, lugs, terminations, wraps, splicing and marking equipment, tools and testers, safety, personal protection, sealants, cutting tools, adhesives, consumables, fasteners, janitorial, and other MRO supplies; communication and metering devices, and racking systems; and solar modules, connectors, and storage batteries. It also distributes wires, cables, raceways, metallic and non-metallic conduits, and coupling and fittings; and communications and security products, including structured cabling systems, broadband products, low voltage specialty systems, specialty wire and cable products, equipment racks and cabinets, access controls, alarms, cameras, and paging and voice solutions.
In addition, the company sells electrical distribution and controls comprising circuit breakers, transformers, switchboards, panel boards, metering products, and busway products; lamps, fixtures, ballasts, and lighting control products; and motor control devices, drives, relays, timers, pushbuttons, operator interfaces, switches, interconnects, programmable controllers, industrial computers and network, and surge and power protection products. Further, it provides supply chain management and logistics services; and value-added services in the areas of construction, e-commerce, energy and sustainability, engineering, production support, safety and security, supply chain optimization, training, and working capital. It serves industrial firms, electrical and data communications contractors, utilities, commercial organizations, institutions, and governmental entities.
Merger With Anixter International
WCC recently completed a merger of equals with Anixter International. Prior to the merger, WCC was ranked 379th on the Fortune 500 list and Anixter was ranked 359th, but with the merger, WCC has now doubled in size. The merger was paid for with cash, WCC common stock and shares of the newly created WCC-A preferred stock.
The positives from the merger are:
- Removal of a leading competitor in Anixter
- Anixter has a larger international presence than WCC, so WCC will gain new international channels for selling its products
- The merger makes WCC the largest electronics distributor in North America, making it the place to go for customers who want one stop shopping
- Like any merger within the same sector, WCC should see cross-selling opportunities
- WCC expects to achieve annualized run-rate cost synergies of over $200 million by the end of year three after the merger.
The negative from the merger is:
- A significant increase in debt.
Wesco International Preferred Stock
As part of the merger with Anixter, Anixter shareholders received 21.6 million shares of Wesco International Series A Reset-Rate preferred stock, symbol WCC-A. Here are the details of WCC-A (as of 9/18/2020).
- Initial Dividend Rate of 10.625% = Annual Dividend $2.656 ($0.664 quarterly)
- Current Yield 9.5%
- Par $25
- Yield-To-Call 7.8%
- Cumulative: Yes
- Call/Reset-Rate Date 6/22/2025
- Reset Rate is the 5-Year Treasury Rate plus 10.325%
- Qualified Dividends: Yes
- Note: As is typical for a new issue, the initial dividend period wasn’t exactly three months. In the case of WCC-A the first dividend covered 100 days and was a prorated amount of $0.73. Be aware that some data providers will annualize that amount and provide an incorrect yield calculation. Our computation is based on the $0.664 quarterly dividend shown above.
Thoughts on WCC-A Yield Metrics
The average analyst’s earnings estimate for WCC for 2021 are $6.05 per share. For such a profitable Fortune 500 company, the 9.5% current yield is incredibly generous. But what’s even more striking is the floating/reset rate of the five-year T-note rate plus 10.325% for the preferred stock.
The floating rate floor of WCC-A is remarkable:
- It is 34% higher than the next highest floater of Targa Resources (NGLS) preferred stocks NGLS-A (NGLS.PA), with its 7.71% plus LIBOR floating-rate.
- It’s more than triple that of some other fixed-to-floaters like Region Financial’s (RF) preferred stock RF-C (RF.PC) with its floating rate of 3.15% plus LIBOR.
Given the very high current fixed-rate as well as the extraordinarily high reset-rate, WCC-A is an all-weather preferred that will provide a great yield should interest rates stay low, but also provides some of the best protection you will find should rates rise significantly in the future – as many fear.
Since dividends on common and preferred stocks issued by corporations are qualified for a lower tax rate, we believe that WCC-A dividends should be qualified. Both Quantumonline and Wesco investor relations department have indicated that WCC-A dividends are expected to be “qualified.”
Fortunately, the yield metrics are so high on WCC-A that we believe it’s a great bargain regardless of the tax status, but we recommend that these be purchased in taxable accounts for those who have a choice. In a taxable account, many will get an after-tax equivalent current yield of near 11% and an after-tax equivalent reset rate of 15% should the five-year T-note be at 2% in 5 years. This is relative to after-tax yield you would get from a “non-qualified” dividend (like that of NGLS-A) or from a bond.
The best way to analyze a preferred stock is to have a look at the bond yields of the issuer. WCC issued $1.5 billion of 7.125% bonds (CUSIP 95081QAN4) to raise cash for the buyout of Anixter. In the three months since the bond issuance, these bonds have traded significantly higher and the yield has dropped enormously to 3.9% according to Finra. This yield reported by FINRA, is the yield-to-call (‘YTC’).
Using the 3.9% YTC, the yield on the bonds has dropped 45% from their par yield in a very short amount of time. However, the YTC on the preferred stock has only dropped 27% from its yield at par. We believe that the superb action in the WCC bonds is very bullish for WCC-A and that it still has price upside to catch up to the bond action.
Safety of WCC
From a balance sheet perspective, WCC carries a fair amount of leverage. WCC has an enterprise value of around $7.35 billion while carrying $5.07 billion of long-term debt. Thus, debt makes up about 69% of enterprise value. That’s not great but not troublesome. Distributors must carry a huge inventory of products, so having low leverage is unusual in this sector.
From a liquidity perspective, things look quite good. In their second quarter 10-Q filing, WCC reports $5.00 per share in cash as well as a solid current ratio 2.6 (current assets divided by current liabilities). Here’s a slide from the WCC second quarter conference call.
This slide shows that the company has access to $819 million of cash, has no debt covenant issues, and doesn’t have any bank credit maturing until 2023. Additionally, with regard to the bonds issued by WCC, there’s only one maturity before 2024, and that is in December 2021. The 2021 bond is a $500 million issuance which is less than their current liquidity.
Source: WESCO Q2 2020 Presentation
Where WCC shines is in their interest and preferred dividend coverage. With analysts expecting earnings of $6.05 in 2021, earnings before preferred dividends should be around $360 million with preferred dividends amounting to $57 million annually. That is more than six times coverage. If we look at EBITDA, coverage is even better. Using the $1 billion EBITDA number from the above slide, preferred dividends are covered 17 times while interest plus preferred dividend coverage is estimated by us to be close to three times.
Even excluding the Anixter business, WCC reported a record order backlog on their very bullish second quarter conference call. They also announced that sales have been increasing each month since the COVID-19 lows in April.
Improving Future Dividend/Interest Coverage
WCC reported $140 million in free cash flow in just the second quarter. This kind of free cash flow generation should allow WCC to pay down debt rather quickly, and once the $200 million annual cost synergies kick in, we would expect even much higher free cash flow. WCC has targeted a 50% cut in leverage in three years.
Another very bullish sign for WCC is the large drop in WCC’s bond yields. Not only is this a strong sign from the markets that WCC is a strong company with minimal risk, but it provides opportunities for WCC to refinance their higher yielding bonds and cut interest expense further. If it wasn’t for the callability of their bonds, they would likely trade at YTMs of around 4.5%. Currently they have a bond outstanding of more than $1 billion with a 7.25% coupon. This bond is callable in June 2023. They should be able to save quite a bit by refinancing this bond as it currently yields less than 4.5% according to FINRA. Additionally, the $1.5 billion bond just issued at 7.125% is callable in 2022 and this could provide another opportunity for WCC to cut their interest costs by refinancing this bond. So the future presents some strong additional opportunities to cut costs outside of just the synergies from the merger and the large free cash flow.
Fair Value For WCC-A
We would estimate fair value at $30. At $30, WCC-A would still carry a current stripped yield of 8.9% with a YTC of 5.8%. The 8.9% is still extremely good vs. the 5.0% YTM on their 2025 bond. And the 5.8% YTC is still attractive versus the 3.9% YTC on the 2025 bond. If held in a taxable account, with the distributions on WCC-A having “qualified dividend” status, then fair market would be even higher.
We believe that our fair market value for WCC-A is actually a conservative fair value because the enormous reset-rate provided by WCC-A is not even factored in to our fair value, and having this kind of inflation / interest-rate protection is definitely worth a lot.
WCC-A is a fairly new reset-rate preferred stock that was issued as a result of the merger of two Fortune 500 companies which created the leading electrical distribution company in North America. Although WCC took on significant debt as a result of this merger, their free cash flow generation is very strong and the company is projected to report very strong profits of $6.05 per share in 2021. WCC expects to cut leverage in half over the next three years. Additionally, their preferred and interest rate coverage is very strong as is their liquidity. This is reflected in the huge rally in WCC bonds since the merger which should allow WCC to refinance a large part of their debt at lower rates in the future.
What makes WCC-A special is the enormous 9.5% current yield as well as having, by far, the best fixed-to-floating rate of any preferred stock. WCC-A’s reset rate, of the five-year T-note rate plus 10.325%, is double the typical floating-rate of other fixed-to-floating rate preferred stocks. Additionally, the current yield on WCC-A is far superior to the yield on WCC’s bond. In fact the preferred shares of WCC yield almost double that of their bonds which clearly shows mis-pricing.
Our fair value for WCC-A is $30 per share and that gives no weighting to the great hedge WCC-A provides against higher interest rates. WCC-A is the perfect stock for achieving a high yield should interest rates stay low and, at the same time, provides the best floating-rate in the market should rates rise over the coming years. It’s the perfect all-weather preferred stock.
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Disclosure: I am/we are long WCC.PA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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