Grainger continues to invest in its supply chain capabilities.
Courtesy of Grainger
One of the key variables for investors, economists, consumers, and policy makers over the past few years has been the rate of inflation. It has been a challenge for some companies’ earnings, while providing a boost to others—perhaps none more so than processors, distributors, and other middlemen. As prices rise, so does their take.
That applies to the likes of
Visa
(V) and
Mastercard
(MA) perhaps most of all, but also to the numerous distributors of goods that bridge the gap between producers and manufacturers and their end customers. Several have been recent Barron’s picks, including Ferguson (ticker: FERG),
PoolCorp.
(POOL), Watsco (WSO), and
Wesco International
(WCC).
The group has done well this year, with most stocks ahead of the market. All four of Barron’s distributor picks are up at least 20% this year.
What comes next? Inflation has slowed meaningfully from 2022 levels. Goods inflation has been particularly weak as supply chain snarls unwound and a hangover followed the pandemic spending glut. Accordingly, the rally in distributors’ stocks has stalled in recent months after a strong start to the year.
At its most basic level, distributors’ business model is typically to take a percentage off the top of every sale. When the ticket price rises, distributors’ profit increases. On top of that, inventory already in distributors’ warehouses becomes more valuable when prices go up.
“Distributors love inflation; it allows them to revalue inventory to match any OEM price increases, providing a strong gross margin tailwind during times of increasing prices,” wrote Jefferies’ Stephen Volkmann in a recent report.
But that cuts both ways. When demand and pricing are weak, margins can contract and inventory on hand may need to be marked down. Distributors’ stocks tend to fall early when the economy tips into a recession, then lead on the way out.
Barron’s compiled the dozen or so stocks of companies with a market value of at least $5 billion whose primary business is distribution of a variety of manufactured products in the U.S. We excluded distributors of energy, chemicals, and raw materials—focusing on those with products further down the supply chain that are less sensitive to swings in commodity prices.
We took a look at today’s valuations and how they compare to each stock’s half-decade average. It’s also worth comparing valuations today to the last time that the manufacturing purchasing managers index was at similar levels—below the expansionary threshold of 50, but not dramatically so, for several months in a row. The manufacturing
PMI
has come in between 45 and 50 in nine of the past 10 months. During the Covid-19 lockdowns, the manufacturing PMI fell to just 36.
A decent parallel was in late 2015 and early 2016, when the broader economy was strong but manufacturing sectors fell into recession. Back then, the manufacturing PMI was in contractionary territory for several months in a row, but never fell below 47.
| Company / Ticker | YTD Return | Past 5 Years EPS Annual Growth | Forward P/E | 5-Year Avg P/E | Early 2016 P/E | Distributor of |
|---|---|---|---|---|---|---|
| Applied Industrial Technologies / AIT | 25.5% | 19.6% | 16.9 | 15.9 | 13.7 | Industrial products and components |
| Beacon Roofing Supply / BECN | 48.4% | 27.6% | 10.7 | 11.4 | 19.4 | Roofing |
| Core & Main / CNM | 54.6% | N.A. | 13.5 | 17.4 | N.A. | Water and fire-protection products |
| Fastenal / FAST | 17.0% | 13.4% | 26.9 | 27.2 | 23.5 | Industrial and construction supplies |
| Ferguson / FERG | 21.3% | 18.6% | 16.6 | 16.3 | 16.7 | HVAC and plumbing |
| Genuine Parts Company / GPC | -13.5% | 14.7% | 15.5 | 17.6 | 18.7 | Auto and truck parts |
| MSC Industrial Direct Co. / MSM | 17.0% | 8.4% | 15.0 | 14.5 | 14.5 | Metalworking tools and supplies |
| Pool Corp. / POOL | 14.5% | 32.9% | 24.3 | 28.9 | 23.3 | Swimming-pool supplies |
| SiteOne Landscape Supply / SITE | 37.9% | 33.0% | 34.8 | 38.6 | N.A. | Landscape supplies |
| W.W. Grainger / GWW | 24.8% | 24.8% | 18.4 | 18.6 | 17.5 | Maintenance, repair, and operating supplies |
| Watsco / WSO | 41.7% | 21.5% | 24.6 | 25.6 | 22.7 | HVAC |
| Wesco International / WCC | 24.7% | 35.3% | 9.5 | 9.7 | 11.5 | Electrical and communications |
Source: FactSet
Three distributor stocks are cheaper today than their five-year average and during the last period of manufacturing PMI weakness:
Beacon Roofing Supply
(BECN),
Genuine Parts
Company (GPC), and Wesco. Others like
Core & Main
(CNM),
SiteOne Landscape Supply
(SITE), and Pool trade for decent discounts to their recent average.
Electrical-and-communications products distributor Wesco has the cheapest valuation of the group at 9.5 times expected earnings over the coming year, compared with its five-year average of 9.7 and a multiple of 11.5 times in early 2016. In our pick last year, Barron’s cited increasing investment in U.S. power generation, transmission, and storage as a tailwind. That’s a secular growth trend on top of Wesco’s usual cyclicality.
Most distributors aren’t far off their average valuation multiples over the past half-decade, meaning the stocks have kept up with the recent earnings growth. The opportunity from here is if the economy hangs in there better than expected, or if goods inflation accelerates. Inventory then becomes more valuable and sales increase.
All in all, valuations are just, well, fine. They aren’t attractive enough for those expecting a recession. A more attractive entry point for the group may lie ahead if the economy appears to stumble and distributor stocks move to reflect greater pessimism.
If you’re in the soft landing, economy-hangs-in-there camp, buy distributor stocks. If you’re certain about a recession on the horizon, wait for the dip.
Write to Nicholas Jasinski at [email protected]
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