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Wipro’s Q3 Aided by Inorganic Growth, but EPS Falls Short; Maintaining INR 495 FVE

Business Strategy and Outlook

Wipro is a leading global IT services provider with the typical menu of offerings, from software implementation to digital transformation consulting to servicing entire business operations teams. Wipro benefits from switching costs and intangible assets, although Morningstar analyst also see it benefiting from a cost advantage. Forays into the higher-value realm of industrial engineering will help ensure that Wipro does not miss out on substantial growth trends in the overall IT services industry.

In many regards, there’s uncanny resemblance between Wipro and its Indian IT services competitors, Infosys and TCS, such as in its offerings, offshore leverage mix (near 75%), or attrition rates (near 15%). However, Wipro has pockets of solutions where it distinguishes itself. 

Wipro isn’t unusual for being an IT services provider with switching costs and intangible assets. These are founded on the intense disruption that customers would experience when changing their IT services provider as well as Wipro’s specialized knowledge of the industry verticals it caters to and the distinct knowledge of its customers’ web of IT piping. But besides these two moat sources, Morningstar analyst think Wipro benefits more from a cost advantage (which we only allot to Indian IT services companies) based on its labor arbitrage model. Morningstar analyst also thinks that benefits from such a cost advantage will diminish over time as the gap between Indian wage growth and GDP growth in primary markets narrows, analyst view that Wipro’s moat is secure as the company’s foray into higher-value offerings and increasingly automated solutions offsets this trend.

Wipro’s Q3 Aided by Inorganic Growth, but EPS Falls Short; Maintaining INR 495 FVE

Wipro gave guidance of 2%-4% sequential revenue growth in its IT services segment for the quarter ahead. All in all, Morningstar analyst maintaining  INR 495 fair value estimate for Wipro and  believe Wipro is overvalued even with shares down 8% upon results–much like other Indian IT services giants Tata Consultancy Services and Infosys.

Third-quarter revenue grew 30% year over year to INR 203 billion due to year-over-year growth in all seven of its sectors led by 50% year-over-year revenue growth in its largest sector, banking, financial services, and insurance, indicating continued strong results from its previous Capco acquisition. Wipro continues to see a large portion of revenue growth stemming from inorganic acquisitions completed earlier in 2021. . Still, IFRS EPS came in at INR 5.42 which missed our expectations of INR 5.64 due to salary increases and additional headcount.

Financial Strength 

Wipro’s financial health is in good shape. Wipro had INR 350 billion in cash and cash equivalents as of March 2021 with debt totalling INR 83 billion. Morningstar analyst expect that Wipro’s cash cushion will remain healthy, as it is expected that free cash flow to grow to INR 118 billion by fiscal 2026. This should allow for continued share buybacks and acquisitions. Morningstar analyst expect that share buybacks over the next five years will average INR 50 billion each year and forecast that acquisitions over the next four years following fiscal 2022 will average INR 9 billion each year. While analyst don’t explicitly forecast dividend increases over the near term, and think Wipro will have more than enough of a cash cushion to undergo any dividend raises as desired without needing to take on debt.

Bulls Say

  • Wipro could benefit from greater margin expansion than expected in our base case as more automated tech solutions decrease the variable costs associated with each incremental sale.
  • Wipro should profit from a wave of demand for more flexible IT infrastructures following the COVID-19 pandemic, as more companies seek to be prepared for similar events. 
  • As European firms become more comfortable with outsourcing their IT workloads offshore, Wipro should expand its market share in the growing geography

Company Profile

Wipro is a leading global IT services provider, with 175,000 employees. Based in Bengaluru, the Indian IT services firm leverages its offshore outsourcing model to derive over half of its revenue (57%) from North America. The company offers traditional IT services offerings: consulting, managed services, and cloud infrastructure services as well as business process outsourcing as a service.

 (Source: Morningstar)

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

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Ferguson’s coverage to the RMI market enhanced from 31% to 60%

Business Strategy and Outlook

In the United States, Ferguson primarily serves three major end markets: repair, maintenance, and improvement, new construction, and civil infrastructure. Between 2008 and 2020, Ferguson’s exposure to the RMI market increased from 31% to 60%, while new construction decreased from 58% to 32%. Increased exposure to the U.S. RMI market will benefit the company because elevated demand for repair and remodel services due in part to aging housing stock. While the repair and remodel market are less cyclical than new construction, it still tracks housing construction activity. It is projected total housing starts to average approximately 1.6 million units annually this decade, which is above the historical long-run average. 

Ferguson has built leading positions in many different end markets through its roll-up acquisition strategy. The company typically acquires local competitors, gaining access to new brands, suppliers, regions, and customers. Ferguson is projected to continue this strategy, which should augment its scale-driven competitive advantage. Ferguson’s pricing strategy has transformed from being primarily localized to more standardized across the group over the past decade. In the past, branch managers had more discretion over pricing to react to local competitive dynamics. Today, the company employs a more disciplined approach to pricing, allowing it to take better advantage of its economies of scale. 

Ferguson sold its Wolseley U.K. business for approximately $420 million in February 2021. This business struggled to generate value for the group despite being one of the largest distributors in the United Kingdom. There were very few synergies between geographies and little overlap in suppliers. Ferguson’s strategic shift to the United States will be a tailwind for the firm’s prospects, and the listing on the New York Stock Exchange (shares began trading in March 2021) could increase interest from U.S. investors. Shareholders will vote on a U.S. primary listing in spring 2022.

Financial Strength

Ferguson set out to clean up its balance sheet following the great financial crisis, and it improved net debt/EBITDA from 3.5 times before the 2008 crisis to 0.6 times as of Oct. 31, 2021. Net debt at the end of the first quarter of fiscal 2022 (October 2021) was $1.4 billion. Ferguson’s strong balance sheet gives management the financial flexibility to run a balanced capital allocation strategy that augments growth with acquisitions but also returns cash to shareholders. In terms of liquidity, the company can meet its near-term debt obligations, given its strong cash balance. Its cash position at the end of the first quarter of fiscal 2022 stood at $2.2 billion. Ferguson’s ability to tap available lines of credit to meet any short-term needs is making the scenario comforting. The countercyclical nature of industrial distributors’ free cash flow generation, which results from the ability to drawdown inventory during times of economic malaise is also encouraging. Ferguson generated over $1 billion of free cash flow during the great financial crisis, and we expect current economic weakness to push free cash flow levels materially higher as working capital requirements ease. In our view, Ferguson enjoys a strong financial position supported by a clean balance sheet and strong free cash flow prospects.

Bulls Say’s

  • Ferguson’s roll-up strategy in the U.S. should lead to market share gains, boosting revenue growth more than the market average. 
  • Ferguson’s strategic shift to the U.S. away from international markets has strengthened group operating margins. 
  • Ferguson generates strong free cash flow throughout the economic cycle despite serving cyclical end markets

Company Profile 

Ferguson distributes plumbing and HVAC products primarily to repair, maintenance, and improvement, new construction, and civil infrastructure markets. It serves over 1 million customers and sources products from 34,000 suppliers. Ferguson engages customers through approximately 1,600 North American branches, over the phone, online, and in residential showrooms. In fiscal 2021, Ferguson derived 94% of its nearly $23 billion of sales in the U.S. According to Modern Distribution Management, Ferguson is the largest industrial and construction distributor in North America. The firm sold its U.K. business in 2021 and is now solely focused on the North American Market.

(Source: MorningStar)

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Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

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Fastenal Co.: To fund a shareholder-friendly capital allocation strategy

Business Strategy and Outlook

Since opening its first fasteners store in 1967, Fastenal has built one of the largest industrial distribution businesses in the United States. For many years, Fastenal’s growth story was driven by its branch count, which now stands at approximately 1,900. While this expansive footprint is still an important component of Fastenal’s business model, other strategies–including expanding its product portfolio, its vending and inventory management services, and most recently, its on-site program–have become increasingly important growth drivers. 

The benefits of Fastenal’s vending, inventory management, and on-site services are twofold: Not only do these services drive incremental revenue, but they also embed Fastenal in its customers’ procurement processes, which supports higher retention rates and pricing power. Fastenal has a first-mover advantage in both vending and on-site services, introducing the former in 2008 and the latter in 1992 (although the on-site strategy did not become a focused strategy until the past few years), and we see long growth runways for both offerings. In addition to growth through its vending and on-site initiatives, Fastenal is well positioned to benefit from customer consolidation trends. In recent years, customers have been consolidating their maintenance, repair, and operations, or MRO, spending with large distributors to leverage their purchasing power and increase operational efficiency. With its national scale, broad product portfolio, and inventory management services, Fastenal can capitalize on this trend and take market share from smaller and less capable distributors. 

Because Fastenal’s sales mix is increasingly skewing more toward large national accounts, on-site programs, and more price-competitive MRO products, the company’s gross margins are likely to come under pressure. However, the combination of higher sales volume and containment of selling, general, and administrative costs provide Fastenal the opportunity to realize strong operating leverage and expand operating margins. It is forecasted Fastenal’s operating margin to reach 21% by our midcycle year.

Financial Strength

Fastenal has an outstanding debt balance of approximately $405 million. It is leveraged at only 0.3 times 2021 EBITDA, which is very conservative relative to the other industrial distributors. Fastenal’s earnings provide substantial headroom to service debt obligations. During fiscal 2020, Fastenal incurred only about $10 million of interest expense and generated about $1.3 billion of EBITDA, which equates to an extremely comfortable interest coverage ratio. Even with its expansive store footprint and cyclical end markets, Fastenal has a proven ability to generate free cash flow (defined as operating cash flow less capital expenditures) throughout the cycle. Indeed, it has generated positive free cash flow every year since 2003. Given its conservative balance sheet and consistent free cash flow generation, we believe Fastenal’s financial health is satisfactory.

Bulls Say’s

  • Vending and on-site programs should provide a long growth runway for Fastenal. 
  • Fastenal can capitalize on its national scale, broad product portfolio, and inventory-management services to take market share from smaller and less capable distributors. 
  • Despite serving cyclical end markets, Fastenal’s business model generates strong free cash flow throughout the cycle. Fastenal is likely to continue to use its cash flow to fund a shareholder-friendly capital allocation strategy.

Company Profile 

Fastenal opened its first fastener store in 1967 in Winona, Minnesota. Since then, Fastenal has greatly expanded its footprint as well as its products and services. Today, Fastenal serves its 400,000 active customers through approximately 1,900 branches, over 1,300 on-site locations, and 14 distribution centers. Since 1993, the company has added other product categories, but fasteners remain its largest category at about 30%-35% of sales. Fastenal also offers customers supply-chain solutions, such as vending and vendor-managed inventory.

(Source: MorningStar)

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Japan Market Outlook – 14 January 2022

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Although Las Vegas Remains the Core Presence, MGM’s Macao Assets Should Benefit From a 2022 Recovery

Business Strategy and Outlook

No-moat MGM Resorts is facing material near-term headwinds from COVID-19 as well as elevated operational risk in Macao from government plans to increase supervision of casinos. Still, we think MGM has a healthy liquidity profile to see it through this turmoil and remains positioned for the attractive long-term growth opportunities in Macao (22% of pre-pandemic 2019 EBITDAR), U.S. sports betting, and Japan (accounting for an estimated 10% of 2027 EBITDAR, the first year of likely operation). 

We see solid Macao industry visitation over the next 10 years, as key infrastructure projects that alleviate Macao’s congested traffic (Pac on terminal expansion and Hong Kong Bridge in 2018, light-rail transit at the end of 2019, and reclaimed land in 2020-25) come on line, which will expand the region’s constrained carrying capacity and add attractions, thereby driving higher visitation and spending levels. As MGM holds one of only six gaming licenses, it stands to benefit from this growth. Further, MGM Resorts has expanded its room share in Macao to 8% from 3% with its Cotai property, which opened in February 2018. That said, the Macao market is highly regulated, and as a result, the pace and timing of growth are at the discretion of the government.

In the U.S. (78% of pre-pandemic 2019 EBITDA), MGM’s casinos are positioned to benefit from a multi-billion-dollar sports betting market, generating an estimated mid-single-digit percentage of the company’s 2024 sales. That said, the U.S. doesn’t offer the long-term growth potential or regulatory barriers of Macao; thus, we do not believe the region contributes a moat to MGM. Still, there have been very minimal industry supply additions this decade, and this should support solid industry Strip occupancy, which stood at around 90% in pre-pandemic 2019.

We expect MGM to be awarded one of only two urban gaming licenses in Japan, with a resort opening in 2027, generating attractive returns on invested capital in the teens.

Financial Strength

MGM entered 2020 in its strongest financial health of the past 10 years, in our view. This was illustrated by its 3.7 times debt/adjusted EBITDA in 2019 versus 13 times and 5.7 times in 2010 and 2015, respectively. It was also buoyed by MGM having recently exited an investment cycle, where the company spent $1.6 billion on average annually during 2015-19 to construct and renovate U.S. and Macao resorts versus the $271 million it spent on capital expenditure in 2020. We believe MGM has sufficient liquidity to remain a going concern even with zero revenue for a few years. The recent sales of underlying casino assets (Bellagio in November 2019, Circus Circus in December 2019, and MGM Grand/Mandalay Bay in February 2020) provided it with around $6.9 billion in cash. The company recently entered into leaseback asset sales of Aria, Vdara, and Springfield, raising over $4 billion in cash in 2021. Also, MGM is set to receive $4.4 billion in cash for its ownership in MGM Growth Properties, which is scheduled to be acquired by Vici in the first half of 2022. The firm has taken further action to lift its liquidity profile by reining in expenses, tapping its $1.5 billion credit facility (which has since been paid), suspending dividends and repurchases (which have since been reinstated), and raising debt. MGM has $1 billion of debt scheduled to mature in 2022.

Bulls Say’s

  • We expect MGM to be awarded one of only two urban Japanese gaming concessions due to its strong experience operating leading resorts in Las Vegas and its successful record of working with partners 
  • MGM is positioned to participate in Macao’s long-term growth opportunity (22% of pre-pandemic 2019 EBITDAR) and has seen its room share expand (to 8% from 3%) with the opening of its Cotai casino in February 2018.
  • MGM’s U.S. properties are positioned to benefit from the expansion of the multi-billion-dollar domestic sports betting market

Company Profile 

MGM Resorts is the largest resort operator on the Las Vegas Strip with 35,000 guest rooms and suites, representing about one fourth of all units in the market. The company’s Vegas properties include MGM Grand, Mandalay Bay, Mirage, Luxor, New York-New York, and CityCenter. The Strip contributed approximately 49% of total EBITDAR in the pre-pandemic year of 2019. MGM also owns U.S. regional assets, which represented 29% of 2019 EBITDAR. We estimate MGM’s U.S. sports and iGaming operations will be a mid-single-digit percentage of its total revenue by 2024. The company also operates the 56%-owned MGM Macau casinos with a new property that opened on the Cotai Strip in early 2018. Further, we estimate MGM will open a resort in Japan in 2027.

(Source: Morningstar)

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Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

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Australian Market Outlook – 14 January 2022

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