Fitch Ratings has assigned WESCO International, Inc. and WESCO Distribution, Inc. a first-time Issuer Default Rating of ‘BB-’. Fitch has also assigned ratings of ‘BB+’/’RR1′ to the company’s first lien secured ABL facility and ‘BB-’/’RR4′ to the company’s existing $850 million of unsecured notes and proposed issuance of $2.825 billion of new unsecured notes to purchase Anixter International. The Rating Outlook is Stable. Additionally, Fitch also expects to rate WCC’s preferred shares at ‘B (EXP)’/’RR6′ when the instruments are issued at the close of the transaction.
Moody’s Investors Service downgraded WESCO International, Inc.’s Corporate Family Rating to B1 from Ba3, Probability of Default Rating to B1-PD from Ba3-PD, and Speculative Grade Liquidity Rating to SGL-2 from SGL-1. Moody’s also downgraded the rating on the company’s senior unsecured notes at WESCO Distribution, Inc. to B2 from B1. The outlook was revised to stable, from ratings under review. This action concludes the review of the ratings initiated on January 14, 2020.
WESCO’s IDR of ‘BB-’ is driven by the significant increase in leverage that is expected to occur from the issuance and assumption of approximately $3.9 billion of debt to purchase Anixter International, coupled with weak end markets as a result of the coronavirus outbreak and low commodity prices. The company is targeting a net leverage ratio of less than 3.5x within three years; however, this is largely contingent on the full recovery of end markets and the repayment of a significant amount of debt.
Fitch believes the company will be able to de-lever relatively quickly following the close of the transaction as FCF generally remains stable during downturns due to the selloff of working capital, which will allow the company to deploy cash towards reducing revolver balances and repaying upcoming 2021 bond maturities. Supporting factors for the rating include a significant increase in size and scale, and a strengthened market position from the combination of the two businesses.
KEY RATING DRIVERS
High Post-Transaction Leverage: Fitch expects that WCC’s leverage (total debt with equity credit/EBITDA) will be elevated in the mid- to high-7x range on a pro forma basis at YE 2020, due to debt issued to buy Anixter International, including preferred shares, and expected double-digit revenue declines from the impact of coronavirus. The company has a net leverage target of less than 3.5x within three years of close; however, the current economic disruption could delay the anticipated timeline. Fitch expects leverage to decline materially to the mid-4x range by YE 2022 and below 4.0x by YE 2023 as sales recover, cost synergies are realized, and the company uses FCF to repay upcoming bond maturities and ABL revolver balances.
Stable Cash Flow Generation: WESCO has consistently generated strong FCF, which Fitch views as a positive credit driver. Cash generation is typically counter-cyclical for distributors as they have the flexibility to unload inventory while scaling back purchases in periods of downturn. Fitch expects WCC will have FCF margins above 2% in 2020 as the company liquidates working capital. Consolidated FCF will be modestly lower in 2021 and 2022 as the company spends cash on restructuring and capex in order to integrate Anixter and achieve cost synergies. Fitch believes long-term FCF margins will stabilize between 2.5% to 3.0% of annual revenue.
Current Headwinds: Fitch believes that WESCO will experience a moderate impact from the coronavirus outbreak, with sales to industrial and construction end markets likely to be to most effected in the near term. Fitch estimates organic 2020 sales are likely to decline by mid-teen digits before mostly recovering in 2021. This will lead to higher near-term leverage; however, the company’s counter-cyclical cash flow should allow it to maintain financial flexibility and repay debt including $500 million of unsecured notes due December 2021.
Increased Diversification: The merger with Anixter International increases the consolidated company’s diversification, as legacy WCC was somewhat concentrated in the industrial and construction end markets. AXE’s focus on data communications provides a complementary and more stable business. Both companies are well diversified by customer with no customer totalling more than 4% of revenue. The majority (>70%) of the pro forma company’s revenue is generated in the U.S.; however, Anixter’s larger international presence expands legacy WESCO’s geographic footprint which could lead to cross selling opportunities.
Narrow Operating Margins: WCC’s EBITDA margins have averaged about 5% over the last three years, which is relatively weak but in line with industry peers. The merger with Anixter does not fundamentally change the company’s profitability profile; however, management believes it can achieve cost synergies of $200 million or more within three years mainly through supply chain, facility, and administrative consolidation. Through the medium term this should drive EBITDA margins towards 6%, with potential additional upside.
Strong Market Position: Fitch believes WCC’s top market position in the electrical distribution industry is a strong positive factor of the credit profile. The combination with Anixter solidifies the company as the number one electrical and data communication distributor in North America with a market share of approximately 13%. The overall market remains highly fragmented, with few competitors with meaningful market share. Fitch expects that WESCO will resume its acquisitive posture once the integration with Anixter is complete and the company is on track for its leverage reduction targets.
Increased Size and Scale: WCC’s purchase of Anixter effectively doubles the company’s size, which has beneficial impacts on the operating profile. Fitch believes there are modest competitive advantages provided by increased scale, including cost savings from a consolidated supply chain and increased market position defensibility through broad customer and supplier relationships. Aside from the company’s projected cost synergies, there could be additional benefits from revenue synergies that accelerate growth.
WESCO has an operating profile similar to IT focused distributors such as Avnet, Inc. (BBB-/Stable), Ingram Micro Inc. (BBB-/Stable) and Arrow Electronics, Inc. (BBB-/Stable) with EBITDA margins in the mid-single digits and counter-cyclical free cash flow, however post-acquisition leverage is expected to be significantly higher. Compared to more industrial focused distributors such as W.W. Grainger, Inc. (NPR) and HD Supply, Inc. (NPR), WESCO has greater scale, significantly slimmer profitability margins, higher leverage and comparable end-market cyclicality.
Fitch’s Key Assumptions Within its Rating Case for the Issuer
— The merger with Anixter International is completed in late Q2 or Q3 of 2020;
— Organic revenue declines by mid- to high-teen percentage in 2020 due to coronavirus impacts before rebounding mostly in 2021 and resuming growth in mid-single digits by 2022;
— Operating margins decline modestly in 2020 due to lower revenue, but cost synergies are gradually realized with EBITDA margins sustaining above 6% by 2023;
— Working capital reduction provides a cash inflow in 2020 and 2021 as the company unloads inventory and reduces purchases. Working capital is a usage of cash in 2022 and beyond as the company focuses on growth initiatives;
— The company spends approximately $140 million from 2020 to 2022 in order to achieve cost synergies;
— Capex is elevated in 2020 and 2021 in order to facilitate growth efforts, mostly centered around IT investments. Capex returns to approximately 0.5% in 2022;
— WCC repays all upcoming bond maturities with FCF;
— Excess cash flow is used to moderately repay AR and ABL facility borrowings;
— The company’s preferred shares will be sufficiently subordinated to qualify for 50% equity-credit;
— Total debt with equity credit at YE 2020 is approximately $5.4 billion.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
— The company successfully executes on its deleveraging strategy, with leverage (total debt with equity credit/operating EBITDA) sustaining below 4.0x and FFO leverage sustaining below 4.5x;
— EBITDA margins sustain above 6%;
— FCF margins sustain above 3.5%.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
— Leverage sustains above 5.0x;
— FFO Interest coverage sustains below 2.5x;
— FCF margins are consistently below 2%;
— Excess cash is used for share repurchases as opposed to debt repayment.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance.
LIQUIDITY AND DEBT STRUCTURE
Liquidity: As of March 31, 2020, WESCO had sufficient liquidity of $790 million, comprised of $343 million of available cash and $447 million of ABL revolver availability, net of $100 million in borrowings, letters of credit and borrowing base reserves. The company had no available capacity under its AR securitization facility.
Debt Structure: WCC’s capital structure as of March 31, 2020 consisted of $100 million outstanding on a $600 million ABL facility, a fully drawn $600 million AR securitization facility, $850 million of senior unsecured notes, and $39 million of other debt. WCC is issuing an additional $2.825 billion of unsecured bonds in order to fund the Anixter 2023 and 2025 note tender offer and the remaining cash purchase price
WCC expects to upsize its ABL revolver and AR securitization to approximately $1.1 billion and $975 million, respectively, in coordination with the close of the Anixter merger. WCC also anticipates issuing approximately $540 million of perpetual preferred stock, which Fitch expects will qualify for 50% equity-credit.
The highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies).
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.