jebmo’s posthaven

If you like fundamentally boring businesses, Encore Wire (NASDAQ:WIRE) should be up your alley. While there's actually a lot that goes into making and maintaining a top business in the space, electrical wiring for residential, commercial, and industrial construction isn't the sort of business that is going to get a lot of attention. Nevertheless, Encore Wire has managed to blend strict operational discipline with a surprising amount of innovation into a solid company within this overlooked sector.

As is the case with so many stocks now, the post-election rally has made this a problematic stock from a valuation perspective. Even my more aggressive methodologies top out in the mid-$40s for fair value, making this an iffy prospect for serious outperformance. That said, I really admire how management runs this company, and if you can live with the volatility of a business tied to the cyclical construction market(s) and commodity input prices, it is a name worth considering at a better price.

Simple, But Then Again, Not So Simple

Encore is a vertically-integrated producer of a variety of wiring types used primarily in residential, commercial, and industrial construction. While the company reports in relatively simplistic terms (copper wiring and aluminum wiring), there are numerous types and varieties of wire that it produces, including NM-B cable (principally for residential interior), UF-B cable (used mostly for outdoor lighting), SE cable, THHN/THWN2 (used in commercial and industrial), and metal-clad and armored cables used in commercial and industrial applications.

The vertical integration at Encore is actually a pretty big part of the story, as the company buys raw materials like PVC and copper cathode and takes care of all of the other steps (including casting, drawing, stranding, insulating, and jacketing) in-house. Encore is one of the few wire manufacturers with on-site rod mill operations, which allows the company to process copper cathode into cable. At the risk of over-simplification, the more tasks you can efficiently handle on-site, the better your margins (since you have to pay other suppliers to do those tasks and they're not likely to do it on a not-for-profit basis).

Likewise, Encore is able to save on scrap costs through its integration - because of the facilities Encore has, it can reprocess most of its own scrap. Competitors without those facilities have to sell the scrap, usually below (and sometimes well below) the spot price of the copper or aluminum; by re-using this scrap in-house, Encore avoids those scrapping losses.

Vertical integration also supports one of the company's biggest selling points - its ability to fill 99% or more of orders within a week. While it may be basically true that "wire is wire", contractors want what they need when they need it, and they don't want the hassle of juggling multiple orders and deliveries. With a highly concentrated and consolidated manufacturing footprint (one site), Encore can be more responsive than its rivals. It also does create a risk, though; Texas is tornado-prone, and while the odds of a natural disaster hitting any particular plot of land are small, the consequences to Encore would be severe.

Encore is also a little more innovative than you might think. The company doesn't spend a lot on R&D, but it does spend some, and it has led to 10 patents and 29 patents pending. Some of Encore's innovations seem obvious in retrospect (and those are often the best kind), like color-coded cabling that is faster and safer for workers to install, and others less so like the MC-LED product made from soft-drawn copper and wrapped with flame-retardant paper.

A Consolidating Market Should Add Stability

As far as I can tell, the U.S. building wiring market is worth about $6 billion a year, with Encore holding a low 20%s market share. Southwire is the largest player in the space, and also the most active on M&A. Southwire has bought multiple rivals over the last decade, and most recently acquired the third or fourth-largest competitor United Copper in September of this year. I would estimate then that Southwire now has something on the order of 40% share of the market, and Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) Cerro Wire is a distant third place. Atkore's (Pending:ATKR) subsidiary AFC Cable boasts strong share in the armored cable space (claiming the #1 spot with 39% share), but this company doesn't really look to compete head-to-head with Encore or Southwire (it considers itself a rival with the likes of Eaton (NYSE:ETN) in electrical raceways).

Less competition should support more rational behavior in the future. Encore has seen some near-term hits to copper and aluminum spreads due to Southwire's acquisition, as well as a struggling rival in the aluminum wire space. In fact, struggling competitors have disrupted the market on multiple occasions in the past, but the effects pass and Encore keeps on keeping on. A newly enlarged Southwire has no incentive to ruin the market with irresponsible pricing, though, and fewer viable competitors should give distributors less ability to play off suppliers and try to time the market. On the other hand, with more power in Southwire's hands, Encore could find it harder to make future price increases stick if Southwire doesn't increase prices by similar amounts.

The Opportunity

Encore has historically generated the large majority of its sales from the commercial/industrial construction space, and I would expect that to continue. To that end, the recent improvement in the Architecture Billings Index (from 48.4 in September to 50.8 in October) is encouraging, though the decline in design contracts is less so. Non-residential construction spending was up 2.6% yoy in October and residential building permits have been growing pretty well.

Growth is not just about the number of buildings going up, though. On a quarter-to-quarter basis, the spreads for copper and aluminum make a meaningful difference. Revenue at Encore was down 6% in the second quarter of this year and then down 10% in the third quarter despite ongoing growth in unit volume for both copper and aluminum wire. Most of the trouble seems related to the aforementioned market disturbances (a major acquisition and a struggling rival) and should fade. Nevertheless, it is important to remember that Encore's short-term results don't always track the trends in construction over the same period(s).

Looking ahead, I think Encore can continue to grow its business through the ups and downs of the cycle. For instance, while revenue was down 10% in the third quarter and operating income was down 59%, per-share book value was up 6%. I'm looking for long-term revenue growth in the low-to-mid single digits and long-term FCF growth in the high-single digits, along with returns on equity/capital in the low teens. Using an excess returns model leads me to a fair value in the mid-$40s, but I would note that this tends to be a more "aggressive" model relative to a more plain vanilla discounted cash flow analysis.

Encore has never been interested in M&A, and I don't see that changing. At most, I think all it'd ever buy would be IP. On the flip side, if a company like General Cable (NYSE:BGC), Nexans (OTC:NEXNY), or Prysmian (OTCPK:PRYMY) decided it wanted to compete in a meaningful way in construction/building wiring, Encore would be a pretty attractive target.

The Bottom Line

As I said in the open, Encore is yet another stock that has been lofted higher in this post-election rally. I'm not so confident that this rally has long legs, and Encore is not the kind of business I'm inclined to chase after. I like the prospects for Southwire's ongoing acquisitiveness to lend more stability to the market, and I'm generally bullish on ongoing growth in non-residential (and residential) construction, but I'm really not keen to buy above the low $40s.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.