Encore Wire Investment Thesis
Encore Wire Corporation (NASDAQ:WIRE) is a well-run business with a strong balance sheet that is underpriced due to being caught up in the crossfire of shorts betting on copper prices dropping in the short-term, which ignores the mid-term and long-term tailwinds for both copper and the business itself. Demand for copper is expected to increase dramatically over the next decade due to its increased use in a transition to more renewable energy and an increase in the number of electric vehicles produced.
The result is an excellent opportunity for value investors to get a great price on a company that could have a significant growth runway in front of it.
Value Investing Fundamentals for WIRE
Let’s start off with the earnings, since any debate on Encore Wire is likely to hinge on whether earnings have peaked at what is going to be a unique all-time high due to the impact of inflation on spreads, are currently in a cyclical peak, or can continue growing. On a trailing 12 months basis, WIRE’s earnings are $30.76 per share, which gives us a price-to-earnings ratio of 5.77 based on the closing price of $177.44 on September 20, 2023.
That gives it an attractive earnings yield of more than 17% and earnings growth over the last decade is impressive overall, but has not been consistent – which does lead to some concerns over whether or not this is a one-off as opposed to actual growth in the company. We’ll dissect that more going forward.
WIRE has an extremely strong balance sheet with no debt, and a current ratio of more than 8, so there are no concerns whatsoever in those areas. The tangible book value is $107.09 per share, with $39.80 being in cash and short-term investments and an additional $29.14 in receivables.
Further, they’ve been aggressively returning capital to shareholders. On the June 2022 filing, WIRE had 19.1 million shares outstanding. As of the June 2023 filing, they’ve reduced that number to 16.8 million. That’s a 12% reduction in shares in a year.
While the company does pay a small dividend, the overwhelming majority of the capital return is through buybacks. As pointed out on their most recent earnings call, the Board of Directors has authorized the repurchase of up to two million shares by March 31, 2024 and Executive Vice President and Chief Financial Officer Bret Eckert expects the pace of buybacks to continue.
Well, we’ve been, if nothing else, consistent. The buyback was $126.7 million in the second quarter and $127.1 million in the first. That was not planned, but definitely pretty consistent between the two, north of 700,000 shares. So, I think you can take that — you’d expect to take from the Board coming out and refilling that bucket back up to full 2 million.
It’s consistent with what we did in August of last year. And so, second year in a row where we bought back really just short of 1.5 — we did about 1.1 million in the first 6 months of last year, almost 1.5 million in the first 6 months of this year. Looking at the price of the stock today, we remain undervalued, so.
Last but not least, WIRE has a net-net value of $94.41 based on their most recent balance sheet. I certainly don’t expect this company to be liquidated anytime soon, but a net current asset value that high relative to the share price for a profitable business indicates a strong margin of safety.
Encore Wire Risks and Headwinds
Copper prices surged during the inflationary period of the last few years, and are now coming back down to earth, impacting spreads and directly threatening WIRE’s profit margins. A recent analysis called, “The Shorts are Offside,” by Courage & Conviction Investing went in depth on this thesis and offered views that are more or less aligned with mine, so I’ll avoid too much redundancy.
There is also a significant concern that elevated interest rates are going to slow down new housing starts, which make up a lot of the demand for copper wire. That’s true, however this is a short-term headwind. Over the long run, there is a significant housing shortage in the United States and construction will have to crank back up sooner or later.
I believe the stock is priced as if the negative thesis is a near certainty, while there are several potential catalysts for significant upside. Suffice it to say, I think there’s a reasonable chance that WIRE avoids a worst case scenario that’s already mostly priced in, which makes this a tremendous asymmetrical opportunity.
Let me break down why I think the worst case scenario is already baked in. The low earnings estimate for 2024 on Seeking Alpha is $17.11. As you can see on the chart below, WIRE traded at a PE ratio between roughly 12 and 28 prior to the pandemic. So even if the analysts are off by about 50% and the earnings drop to $11.40 per share, that’s a range of $137 to $319 per share at historical multiples.
WIRE is pretty close to the bottom of that range already, and it’s also worth noting that the company has seen an influx of cash due to the windfall from higher copper spreads. As the share count has continued to decrease, the earnings per share can be expected to increase even if the topline numbers do not.
Potential Catalysts for Encore Wire
While a high likelihood of headwinds appears to be baked into the current price, I believe there are several potential tailwinds that could lead to significant upside for investors.
Encore Wire Will Reap Rewards of Transition to Renewable Energy
WIRE is a stock that stands to benefit from the transition to renewable energy, as there is a significant projected increase in copper usage. Encore Wire also can be expected to profit off of an increase in production of electric vehicles.
According to S&P Global, copper demand is going to skyrocket over the next decade or so in order to meet the carbon targets to reduce the impact of climate change.
Copper demand is projected to grow from 25 million metric tons (MMT) today to about 50 MMt by 2035, a record-high level that will be sustained and continue to grow to 53 MMt by 2050. Power and automotive applications will have to be deployed at scale by 2035 in order to meet the 2050 net-zero targets
They project a “chronic gap between worldwide copper supply and demand,” starting in the middle of the 2020s, and they project a gap both in the most optimistic and pessimistic scenarios for the scaling of copper mining.
They are not alone in this projection, as Bloomberg also projects a drastic increase in copper demand and copper supply deficits.
The chart on the right above is particularly interesting to me, as it shows deficits barely dropping off from levels that have driven the current surge in profits for WIRE, and in fact getting significantly deeper in seven to 10 years.
This increase in demand means that the potential will be there for Encore Wire to sell about as much copper as it can scale up to produce at prices that should continue to increase towards the second half of this decade. Supply constraints will likely be the limiting factor, but Encore’s vertical integration allows them to input copper cathode, recycled copper, or copper scrap on site and output copper rod that they can turn into wire. For more on this process, see page six in their Shareholder Value Presentation from March 2023.
This also provides a counter-argument to the bear thesis that declining copper spreads mean WIRE is overvalued or fairly valued at current prices. Not only is there an increase in demand going forward, Encore Wire has experienced strong year over year growth in volume shipped. They shipped 7.9% more copper in 2022 than 2021 per their earnings release, after a 10.8% increase in 2021 over 2020 per their earnings call after the fourth quarter of 2021. That helps reduce the impact of temporarily narrowing margins.
Currently High Capex Is Set to Decrease Soon
Capital expenditure is also expected to decrease over the next couple of years, from $160 to $180 million in 2023 down to $150 to $170 million in 2024 and $80 to $100 million in 2025, according to the most recent earnings call. The 2025 numbers are projected to be $60 to $100 million lower than 2023, which will reduce annual expenses by about $3.50 to $6 per share.
So, even if topline revenue decreases somewhat significantly, profit margins might not be slashed quite as much as some bears expect.
It was already touched on in a previous analysis, but the Inflation Reduction Act should continue to lead to increased infrastructure spending, which will also drive increased copper demand and higher volumes – which can help to overcome lower margins as spreads tighten.
Encore Wire is Likely to Continue Aggressive Buybacks
As we’ve already touched on, there should be plenty of room for buybacks going forward as WIRE continues to remain profitable and show a dedication to returning capital to shareholders via buybacks at reasonable prices.
As you can see, from 2013 through 2019, WIRE was not reducing its share count. In fact, it really wasn’t starting in earnest until 2021. As you can see below, this coincides with Encore Wire’s PE ratio dipping significantly versus historical trends, and the buybacks have been most pronounced when the multiple is below 15.
Of course there are other factors, such as available uses of capital on expansion and vertical integration. Also there are many metrics management could be using to decide what their price point for share repurchases should be, and the PE ratio is just a simple way to gauge whether they’re buying back shares indiscriminately. However, the fact that the repurchases seem to be made based on some measure of the value proposition is important, and gives me confidence that management agrees with my assessment that their stock is undervalued.
That also makes it a catalyst for value realization, as I expect the company to continue repurchasing shares until the stock aligns with their view on a proper valuation.
In this section I always like to point out that I am more focused on profitable investing strategies than nailing an exact valuation on a company. My goal is to get in well below fair value and exit positions when they start to get into a broad range of my projected fair value, while considering what catalysts remain.
With that in mind, I am always looking for a stock to hit on seven of my value indicators, and aim to be able to achieve a ballpark of 50% upside on those investments. WIRE meets seven of my criteria up to a price point of $184.55, which means a conservative target price would fall somewhere in the neighborhood of $277 per share.
Earnings estimates for 2024 are in the range of $17 to $20, and based on the historical trends for WIRE (see above charts) and general value investing guidelines, I think a multiple of 15 is a reasonable ballpark estimate. That would mean a fair value range of $255 to $300 per share in fiscal year 2024.
Finally, we’ve seen Encore Wire mostly trade at a price-to-book ratio between approximately 1.5 and 2.0. With a current book value of $107, and projected earnings the rest of this year of nearly $9, followed by projected 2024 earnings of $17 to $20, we can project a book value of approximately at the end of the 2024 fiscal year of about $132 to $135. This method would give us a range of about $198 to $264.
All of these numbers are based on short-term projections and metrics, and one of the reasons I am bullish on Encore Wire is the expected market for copper in the back half of this decade. As a result, barring any bearish developments, I think the fair value of WIRE looking towards 2024 is more towards the high end of these ranges, so let’s call it $260 to $300.
Obviously WIRE is currently trading well below those prices, and while there could be some turbulence based on copper prices in the short term that may allow for a lower entry point, I think the margin of safety on this stock over the next two years is strong. With a combination of a solid margin of safety, compelling long-term growth catalysts, and great value investing metrics, I believe Encore Wire is a buy. I opened a position recently at $165.20 per share, and would continue to add shares if it dips in the short term.