Sterne Agee CRT Initiates Coverage On Distribution Group Amid 'Extremely Low' Expectations

Sterne Agee CRT’s Hamzah Mazar initiated coverage of the Distribution Group, saying that expectations remained “extremely low” since forecasts reflected both secular and cyclical gross margin headwinds. The Group may be helped by operating margin offsets, balance sheet catalysts due to under-levered balance sheets, and easier comps in the back half of 2016.

Op Margin Offsets Matter

There was further gross margin weakness in 4Q15, and expectations remain low for 2016 and 2017. “We prefer distributors that can offset gross margin headwinds on the operating and cash flow line through share gains and balance sheet driven catalysts (prudent M&A, opportunistic buybacks, divestiture of non-core assets, etc.),” analyst Hamzah Mazar wrote.

Share Gains Could Accelerate Longer Term

On average, share gains represent about 50 percent of total organic growth. Mazar noted, “Although investment spend can hurt operating leverage especially if sales growth is declining, most management teams can cut back or push out spend to rightsize the cost structure with the demand environment.”

The analyst expects ecommerce, vending, on-site solutions and other channel investments to gain “critical mass over next few years,” which would drive share gain potential and improve operating margin profile.

Ratings

• W W Grainger Inc GWW – Rated Buy
• HD Supply Holdings Inc HDS – Rated Buy
• Fastenal Company FAST – Rated Neutral
• MSC Industrial Direct Co Inc MSM – Rated Neutral
• WESCO International, Inc. WCC – Rated Neutral

Citing the outperformance in certain names, such as Fastenal, MSC Industrial Direct and WESCO International, Mazar recommend companies with low expectations, like W W Grainger, and balance sheet and end market catalysts, like HD Supply Holdings.