Encore Wire: Ride The Energy Transition With A Boring Business

1 month ago 23
Production of copper wire, cable in reels at factory. Cable factory.

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Investment Thesis

Encore Wire (NASDAQ:WIRE) is a low-cost manufacturer of electrical building wire and cable. They are a significant supplier of building wire (copper and aluminum) for commercial, industrial, and residential buildings. Thanks to their vertically integrated business model and efficient manufacturing processes, they hold an industry-leading fill rate and have been meeting the rising demand for electric wire. Many industries (data center, renewables, EV charging, and healthcare) are driving this trend, and I believe Encore is an excellent investment choice for the long-term investor. The following are the main reasons:

  • Demand for electrical wire will continue to substantially increase, driven by a multitude of sources (data center, renewable, healthcare, residential, and EV infrastructure).
  • Encore's business model and manufacturing efficiency is enabling them to meet the strong demand, while still managing costs very effectively.
  • A superb balance sheet with zero long term debt provides stability and a competitive edge during an environment of high interest rates.

Multifaceted Demand Drivers

As we all know, the demand for electricity has been steadily rising, and that trend brings a relentlessly rising demand for electric wire. On top of growth from traditional commercial, industrial, and residential building applications, several new trends are boosting demand even further.

The proliferation of data centers is a recent trend that contributes to rising demand for wire. Many companies now appreciate the power of large data and artificial intelligence, and are building out powerful data centers. These data centers consume a great deal of energy, requiring a large amount of electrical wire. Also, renewable energy sources such as solar and wind require substantial electric wirings, and the Senate's recent bill will further fuel the construction of renewable energy plants. Additionally, the ongoing EV transition demands wires for its infrastructure (EV charging stations, larger distribution capacity, and battery storage). All of these sources will contribute to long-lasting growth for Encore Wire.

Demand Drivers for Encore

Demand Drivers for Encore (Encore Investor Relations)

Energy Usage in Information and Communication Technology Sector

Energy Usage in Information and Communication Technology Sector (AKCP)

Strong Cost Control

Encore has a vertically integrated business model, which means they own most of their supply chain from raw material to delivery, along with a highly efficient manufacturing site. These two factors have contributed to a superb gross margin throughout their history, and have been accentuated over the past couple of years.

The sharply rising demand, along with constraints in the supply chain, have caused prices on both raw materials and finished electrical wires to increase significantly in the past couple of years. While many of Encore's competitors have struggled, Encore has actually thrived in this environment. Their strong logistics, supply chain, and operations not only allowed them to control costs, but also enhanced their gross margin. With several planned CAPEX investments (new service center, expansion of manufacturing capacity, and modernization of facilities) on the horizon, I expect Encore to maintain these competitive advantages.

Gross margin of Encore

Gross margin of Encore (Encore Investor Relations)

Strong Balance Sheet

To fight inflation, the Federal Reserve has been raising interest rates. This environment typically brings challenges for companies with weak financial security. Interest payments increase and chew on the profit margin. Meanwhile, a recessionary environment causes the availability of capital on the market to shrink.

Encore Wire won't have these challenges because they carry zero long-term debt and $469 M cash on hand. Also, their revolving line of credit remains untapped. Therefore, rising interest rates won't reduce their profit margin, so Encore shouldn't run into issues in executing their CAPEX plan.

Intrinsic Value Estimation

Since my last article, Encore's business grew substantially, and their cash flow has improved. I updated my DCF model to estimate a new intrinsic value. For the estimation, I utilized the free cash flow ($368 M) and current WACC of 8.0% as the discount rate. For the base case, I assumed free cash flow growth of 10% (long term EPS growth expectation) for the next 5 years and zero growth afterwards (zero terminal growth). For the bullish and very bullish case, I assumed operating cash flow growth of 12% and 14%, respectively, for the next 5 years and zero growth afterwards.

The estimation showed that the current stock is severely undervalued. With multifaceted growth drivers, a strong balance sheet, and superb business model, I expect Wire to achieve a great upside in the long run.

Price Target

Upside

Base Case

$253.89

107%

Bullish Case

$273.28

122%

Very Bullish Case

$294.00

139%

The assumptions and data used for the price target estimation are summarized below:

  • WACC: 8.0%
  • Cash Flow Growth Rate: 10% (Base Case), 12% (Bullish Case), 14% (Very Bullish Case)
  • Current Free Cash Flow: $368 M
  • Current Stock Price: $122.89 (08/08/2022)
  • Tax rate: 20%

Separately, I performed a downside calculation based on Encore's beta (1.27) using S&P 500's standard deviation (~6%, past 12 month). This calculation suggests a potential downside of -16% (with 95% confidence level). The take home is that the potential upside here is much greater than the potential downside.

Cappuccino Stock Rating

Weighting WIRE
Economic Moat Strength 30% 4
Financial Strength 30% 5
Growth Rate vs. Sector 15% 4
Margin of Safety 15% 5
Sector Outlook 10% 4
Overall 4.5

Economic Moat Strength (4/5)

Encore has a very well-defined economic moat. The vertically integrated business model and manufacturing efficiency give them strong cost advantages over competitors. Strong relationships with raw material providers also provide a competitive advantage, especially in an environment of constrained supply chains.

Financial Strength (5/5)

Balance sheet is superb. They have zero long-term debt with an ample amount of cash to support growth. Encore has always been a financially disciplined company, delivering strong cash flow throughout their history. However, in the past couple of years, a higher spread on copper wire has boosted their operating cash flow. I expect their financial strength will keep gaining in the future.

Growth Rate vs. Sector (4/5)

Encore's growth rate has been superb in the past several years, mirroring the growing demand for electric wire. The 5-year average revenue growth rate (23% per year) is a solid number, and I expect growth to remain high for a while. Multifaceted growth drivers will bring further tailwinds to Encore.

Margin of Safety (5/5)

Based on the intrinsic value calculation, Encore is severely undervalued. The current stock price is only about a half of the intrinsic value of the business. With a strong balance sheet and high operating cash flow, I believe Encore is a safe bet for the future.

Sector Outlook (4/5)

The electrical wire industry is projected to grow at a solid pace (8% CAGR). Increasing demand from data centers, renewables, and EV infrastructure will contribute to an even higher growth rate in the future than in the past.

Risk

To fight high inflation, the Federal Reserve has been raising the interest rate, and this hawkish monetary policy could lead to a recession. Even though I don't expect a severe recession, slower economic activity may be inevitable. The demand for electrical wire is highly correlated to economic activity and CAPEX level of corporations. Therefore, investors should monitor the demand level for electrical wire.

So far, the political environment has been favorable towards the EV transition and renewables. The senate just passed a bill to support these industries with subsidies and tax credits. However, this political environment could certainly change, which could have a negative impact on Encore's growth trajectory. Especially given the upcoming mid-term election, a shifting political environment could alter the demand for electrical wires in the future.

Conclusion

Encore Wire has been a great investment option for a long time (outpacing Russell 2000 index for a couple of decades). A strong outlook for electrical wiring, superb business model, and clean balance sheet will serve Encore well in the future. They will continue to grow and return value to their shareholders. Slowing economic activity and less favorable political environment could certainly challenge growth, but Encore has built up a cushion of resources that will help them handle these scenarios. Their stock price is severely undervalued at this point, and I wouldn't be surprised if the stock price more than doubles in the long run.

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Visit me at Cappuccino Finance, I share my top picks (Value, Growth, Dividend & Growth), market outlook, and interesting ideas from super investors, based on my 12 years of experience and knowledge in stock investment and in real estate. I, Justin J. Lee, believe in fundamental analysis and disciplined market research. I have strong quant background with a Ph.D. (University of California, Santa Barbara) in model predictive control and an MBA (Jones School of Business, Rice University). My primary focus is to identify 1) small cap companies with strong fundamentals and growth potential, 2) large cap companies going through temporary set-backs, and 3) stable companies with solid dividend yields and growth potential.

Disclosure: I/we have a beneficial long position in the shares of WIRE either through stock ownership, options, or other derivatives. 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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