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Nov. 26, 2019, 6:06 a.m. EST



The following discussion and analysis is intended to help the reader understand our business, financial condition, results of operations, liquidity and capital resources. You should read this discussion in conjunction with our consolidated financial statements and the related notes contained elsewhere in this Annual Report on Form 10-K.

The statements in this discussion regarding industry trends, our expectations regarding our future performance, liquidity and capital resources and other non-historical statements are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in Part I, Item 1A. "Risk Factors" and "Cautionary Note Regarding Forward-Looking Statements." Our actual results may differ materially from those contained in or implied by any forward-looking statements.

Agreement and Plan of Merger

On August 8, 2019, the Company entered into an Agreement and Plan of Merger (the Merger Agreement) with Wolverine Intermediate Holding II Corporation, a Delaware corporation (Parent), and Wolverine Merger Corporation, a Delaware corporation and a direct wholly owned subsidiary of Parent (Merger Sub), pursuant to which Parent will acquire the Company for $11.05 per share through the merger of Merger Sub with and into the Company, with the Company surviving as a wholly owned subsidiary of Parent (the "Merger"). Parent and Merger Sub are affiliates of Platinum Equity Advisors, LLC, a U.S.-based private equity firm. The closing of the Merger is subject to customary closing conditions, including the receipt of requisite competition and merger control approvals in the United Kingdom. See Note 1 of the Notes to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K for further discussion about the Merger.

Industry Trends Affecting Our Business

We rely on demand for new commercial and military aircraft for a significant portion of our sales. Commercial aircraft demand is driven by many factors, including the global economy, industry passenger volumes and capacity utilization, airline profitability, introduction of new models and the lifecycle of current fleets. Demand for business jets is closely correlated to regional economic conditions and corporate profits, but also influenced by new models and changes in ownership dynamics. Military aircraft demand is primarily driven by government spending, the timing of orders and evolving U.S. Department of Defense strategies and policies.

Aftermarket demand is affected by many of the same trends as those in OEM channels, as well as requirements to maintain aging aircraft and the cost of fuel, which can lead to greater utilization of existing planes. Demand in the military aftermarket is further driven by changes in overall fleet size and the level of U.S. military operational activity domestically and overseas.

Supply chain service providers and distributors have been aided by these trends along with an increase in outsourcing activities, as OEMs and their suppliers focus on reducing their capital commitments and operating costs.

Commercial Aerospace Market

Over the past three years, major airlines have ordered new aircraft at a robust pace, aided by strong profits and increasing passenger volumes. At the same time, volatile fuel prices have led to greater demand for fuel-efficient models and new engine options for existing aircraft designs. The rise of emerging markets has added to the growth in overall demand at a stronger pace than seen historically. Large commercial OEMs have indicated that they expect a high level of deliveries, with the exception of the Boeing Company's 737 MAX aircraft impact, primarily due to continued demand and their unprecedented level of backlogs. The pause in deliveries and reduced production rate of the 737 MAX aircraft by the Boeing company has negatively affected total large commercial aircraft deliveries. The impact is dependent upon when the aircraft returns to service, which will be determined by factors such as certification by the FAA and other regulatory authorities, when the OEM resumes deliveries and returns to its previous production schedule and whether or not the delay creates disruptions to the related supply chain.

Business aviation has lagged the larger commercial market, reflecting a deeper downturn in the last recession, changes in corporate spending patterns and an uncertain economic outlook. However, production has increased for new models, and the market for certain pre-owned aircraft remains tight. Whether these conditions lead to increased deliveries in the future remains uncertain.

Military Aerospace Market

Military production has fluctuated for many aircraft programs in the past few years. Increases in the U.S. Department of Defense budget for fiscal years 2018 and 2019 have supported greater production of certain military programs. In particular, we believe the services we provide the Joint Strike Fighter program will benefit our business as production for that program increases. We believe increased sales from other established programs that directly benefit from these changes also will benefit our business.

U.S. Department of Defense spending continues to be uncertain for fiscal years 2020 through 2023, given that the limits imposed upon U.S. government discretionary spending by the Budget Control Act and the Bipartisan Budget Act of 2013 remain in effect for these fiscal years, unless Congress acts to raise the spending limits or repeal or suspend the provisions of these laws. Future budget cuts or changes in spending priorities could result in existing program delays, changes or cancellations.

Equity Method Investment

We apply the equity method of accounting for investments in which we have significant influence but not a controlling interest. Our APAC reporting unit has an equity investment in a joint venture in China, the carrying value of which was $7.1 million and $10.4 million as of September 30, 2019 and 2018, respectively, and was included in "Other assets" in the unaudited Consolidated Balance Sheets. During the three months ended June 30, 2019, we recorded an impairment charge of $3.0 million resulting from a decline in value below the carrying amount of our equity method investment, which we determined was other than temporary in nature. The remaining $0.3 million decrease was due to foreign currency translation loss. As of September 30, 2019, we did not identify any events or circumstances which would indicate a further decline in the fair value of our equity method investment that is other than temporary.

Other Factors Affecting Our Financial Results

Fluctuations in Revenue

There are many factors, such as changes in customer aircraft build rates, customer plant shut downs, variation in customer working days, changes in selling prices, the amount of new customers' consigned inventory and increases or decreases in customer inventory levels, that can cause fluctuations in our financial results from quarter to quarter. To normalize for short-term fluctuations, we tend to look at our performance over several quarters or years of activity rather than discrete short-term periods. As such, it can be difficult to determine longer-term trends in our business based on quarterly comparisons. Ad hoc business tends to vary based on the amount of disruption in the market due to changes in aircraft build rates, new aircraft introduction, customer or site consolidations, and other factors. Fluctuations in our ad hoc business tend to be partially offset by our Contract business as a majority of our ad hoc revenue comes from our Contract customers.

We will continue our strategy of seeking to expand our relationships with existing ad hoc customers by transitioning them to Contracts, as well as expanding relationships with our existing Contract customers to include additional customer sites, additional SKUs and additional levels of service. New Contract customers and expansion of existing Contract customers to additional sites and SKUs sometimes leads to a corresponding decrease in ad hoc sales as a portion of the SKUs sold under Contracts were previously sold to the same customer as ad hoc sales. We believe this strategy serves to mitigate some of the fluctuations in our net sales. Our sales to Contract customers may fail to meet our expectations for a variety of reasons, in particular if industry build rates are lower than expected or, for certain newer JIT customers, if their consigned inventory, which must be exhausted before corresponding products are purchased directly from us, is greater than we expected.

If any of our customers are acquired or controlled by a company that elects not to utilize our services, or attempt to implement in-sourcing initiatives, it could have a negative effect on our strategy to mitigate fluctuations in our net sales. Additionally, although we derive a significant portion of our net sales from the building of new commercial and military aircraft, we have not typically experienced extreme fluctuations in our net sales when sales for an individual aircraft program decrease, which we believe is attributable to our diverse base of customers and programs.

Fluctuations in Margins

Our gross margins are impacted by changes in product mix, pricing and product costing. Generally, our hardware products have higher gross profit margins than chemicals and electronic components.

We also believe that our strategy of growing our Contract sales and converting ad hoc customers into Contract customers could negatively affect our gross profit margins, as gross profit margins tend to be higher on ad hoc sales than they are on Contract-related sales. However, we believe any potential adverse impact on our gross profit margins would be outweighed by the benefits of a more stable long-term revenue stream attributable to Contract customers.

Our Contracts generally provide for fixed prices, which can expose us to risks if prices we pay to our suppliers rise due to increased raw material or other costs. However, we believe our expansive product offerings and inventories, our ad hoc sales and, where possible, our longer-term agreements with suppliers have enabled us to mitigate this risk. Some of our Contracts are denominated in foreign currencies and fixed prices in these Contracts can expose us to fluctuations in foreign currency exchange rates with the U.S. dollar.

Fluctuations in Cash Flow

Our cash flows are principally affected by fluctuations in our inventory. When we are awarded new programs, we generally increase our inventory to prepare for expected sales related to the new programs, which often take time to materialize, and to achieve minimum stock requirements, if any. As a result, if certain programs for which we have procured inventory are delayed or if certain newer JIT customers' consigned inventory is larger than we expected, we may experience a more sustained inventory increase.

Inventory fluctuations may also be attributable to general industry trends. Factors that may contribute to fluctuations in inventory levels in the future could include (1) purchases to take advantage of favorable pricing,

Our accounts receivable balance as a percentage of net sales may fluctuate from quarter to quarter. These fluctuations are primarily driven by changes, from quarter to quarter, in the timing of sales within the quarter and variation in the time required to collect the payments. The completion of customer Contracts with varied payment terms can also contribute to these quarter to quarter fluctuations. Similarly, our accounts payable may fluctuate from quarter to quarter, which is primarily driven by the timing of purchases or payments made to our suppliers.

Segment Presentation

We conduct our business through three reportable segments: the Americas, EMEA (Europe, Middle East and Africa) and APAC (Asia Pacific). We evaluate segment performance based primarily on segment income or loss from operations. Each segment reports its results of operations and makes requests for capital expenditures and working capital needs to our chief operating decision maker (CODM). Our Chief Executive Officer serves as our CODM.

Key Components of Our Results of Operations

The following is a discussion of the key line items included in our financial statements for the periods presented below under the heading "Results of Operations." These are the measures that management utilizes to assess our results of operations, anticipate future trends and evaluate risks in our business.

Net Sales

Our net sales include sales of hardware, chemicals, electronic components, bearings, tools and machined parts, and eliminate all intercompany sales. We also provide certain services to our customers, including quality assurance, kitting, JIT delivery, CMS, 3PL or 4PL programs and point-of-use inventory management. However, these services are provided by us contemporaneously with the delivery of the product, and as such, once the product is delivered, we do not have a post-delivery obligation to provide services to the customer. Accordingly, the price of such services is generally included in the price of the products delivered to the customer, and revenue is recognized upon delivery of the product, at which point, we have satisfied our obligations to the customer. We do not account for these services as a separate element, as the services generally do not have stand-alone value and cannot be separated from the product element of the arrangement.

We serve our customers under Contracts, which include JIT contracts and LTAs, and with ad hoc sales. Under JIT contracts, customers typically commit to purchase specified products from us at a fixed price, on an as needed basis, and we are

responsible for maintaining stock availability of those products. LTAs are typically negotiated price lists for customers or individual customer sites that cover a range of pre-determined products, purchased on an as-needed basis. Ad hoc purchases are made by customers on an as-needed basis and are generally supplied out of our existing inventory. Contract customers often purchase products that are not captured under their Contract on an ad hoc basis.

Income (Loss) from Operations

Income (loss) from operations is the result of subtracting the cost of sales and selling, general, and administrative expenses and other costs from net sales, and is used primarily to evaluate our performance and profitability.

The principal component of our cost of sales is product cost, which was 94.3% of our total cost of sales for the year ended September 30, 2019. Product cost is determined by the current weighted average cost of each inventory item, except for chemical parts for which the first-in, first-out method is used. The remaining components are freight and expediting fees, import duties, tooling repair charges, packaging supplies, excess and obsolete (E&O) inventory and other inventory related charges, which collectively were 5.7% of our total cost of sales for the year ended September 30, 2019. Depreciation related to cost of sales, if any, was immaterial and not included in cost of sales.

The E&O inventory provision is calculated to write down inventory to its net realizable value. We review inventory for excess quantities and obsolescence monthly. For a description of our E&O provision policy, see "-Critical Accounting Policies and Estimates-Inventories." Net adjustments to cost of sales related to E&O inventory related activities were $2.7 million, $16.8 million and $12.9 million during the years ended September 30, 2019, 2018 and 2017, respectively. We believe that these amounts appropriately reflect the risk of E&O inventory inherent in our business and the proper net realizable value of inventories. For a more detailed description of the E&O provision, see Note 5 of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K. Other inventory related charges are typically for shrinkage and spoilage that occurs in the warehouses. The total shrinkage and spoilage cost was $24.2 million, $7.9 million and $15.6 million for the years ended September 30, 2019. 2018 and 2017, respectively. These charges typically are recorded as a normal part of our business. However, $13.0 million of the total charge recorded in 2019 resulted from the Wesco 2020 initiative focused on warehouse consolidation.

The principal components of our selling, general and administrative expenses are salaries, wages, benefits and bonuses paid to our employees; stock-based compensation; warehouse and related costs, commissions paid to outside sales representatives; travel and other business expenses; training and recruitment costs; marketing, advertising and promotional event costs; rent; bad debt expense; professional services fees (including legal, audit and tax); and ordinary day-to-day business expenses. Depreciation and amortization expense is also included in selling, general and administrative expenses, and consists primarily of scheduled depreciation for leasehold improvements, machinery and equipment, vehicles, computers, software and furniture and fixtures. Depreciation and amortization also includes intangible asset amortization expense.

Other Expenses

Interest Expense, Net. Interest expense, net consists of the interest we pay on our long-term debt, interest and fees on our revolving facility (as defined below under "-Liquidity and Capital Resources-Credit Facilities"), capital lease interest and our line-of-credit and deferred debt issuance costs, net of interest income.

Other (Expense) Income, Net. Other (expense) income, net is primarily comprised of foreign exchange gain or loss associated with transactions denominated in currencies other than the respective functional currency of the reporting subsidiary.

Critical Accounting Policies and Estimates

The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our financial statements. We base our estimates on historical experience and on assumptions that we believe to be reasonable under the circumstances. Our experience and assumptions form the basis for our judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and judgments on an on-going basis and may revise our estimates and judgments as circumstances change. Actual results may materially differ from what we anticipate, and different assumptions or estimates about the future could materially change our reported results. We believe the following accounting policies are the most critical in that they significantly affect our financial statements, and they require our most significant estimates and complex judgments.


Our inventory is comprised solely of finished goods. Inventories are stated at the lower of cost or net realizable value (LCNRV). The method by which amounts are removed from inventory are weighted average cost for all inventory, except for chemical parts and supplies for which the first-in, first-out method is used.

Our inventory is impacted by shrinkage and spoilage as a normal course of operations, largely due to the high volume of purchases and sales and large quantities of small parts, which can be impacted by fluctuations in warehouse activity and operating efficiency. We will provide for shrinkage and spoilage on a periodic basis along with making provisions as required based upon operational activity.

We charge cost of sales for inventory provisions to write down our inventory to the LCNRV. Inventory provisions relate to the write-down of excess quantities of products, based on our inventory levels compared to assumptions about future demand and market conditions. Once inventory has been written down, it creates a new cost basis for the inventory that is not subsequently written up. The process for evaluating E&O inventory often requires us to make subjective judgments and estimates concerning forecasted demand, including quantities and prices at which such inventories will be able to be sold in the normal course of business.

The components of our inventory are subject to different risks of excess quantities or obsolescence. Our chemical inventory becomes obsolete when it has aged past its shelf life, cannot be recertified and is no longer usable or able to be sold, or the inventory has been damaged on-site or in-transit. In such instances, the value of such inventory is reduced to zero.

Our hardware inventory, which largely does not expire or have a pre-determined shelf life, bears a higher risk of our having excess quantities than risk of becoming obsolete or spoiled. We continually assess and refine our methodology for evaluating E&O inventory based on current facts and circumstances. Our hardware inventory E&O assessment requires the use of subjective judgments and estimates including the forecasted demand for each part. The forecasted demand considers a number of factors, including historical sales trends, current and forecasted customer demand, customer purchase obligations based on contractual provisions, available sales channels and the time horizon over which we expect the hardware part to be sold.

Demand for our products can fluctuate significantly. Our estimates of future product demand and selling prices may prove to be inaccurate, in which case we may have understated or overstated the write-down required for E&O inventories. In the future, if the net realizable value of our inventories is determined to be lower than the carrying value of our inventories, we will be required to reduce the carrying value of such inventories to the net realizable value and recognize the differences in our cost of goods sold at the time of such determination. However, if LCNRV is later determined to be higher than the carrying value of our inventories due to change in circumstances, we will not be allowed to recognize a reduction of cost of goods sold for such difference even when the difference resulted from previously recorded write-down of those inventories. For a more detailed description of the E&O provision, see Note 5 of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K.

Goodwill and Indefinite-Lived Intangible Assets

Goodwill represents the excess of the consideration paid over the fair value of the net assets acquired in a business combination. Goodwill and indefinite-lived intangible assets acquired in a business combination are not amortized, but instead tested for impairment at least annually or more frequently should an event or circumstances indicate that the carrying amount may be impaired. Such events or circumstances may be a significant change in business climate, economic and industry trends, legal factors, negative operating performance indicators, significant competition, changes in strategy, or disposition of a reporting unit or a portion thereof. Goodwill and indefinite lived intangibles impairment testing is performed at the reporting unit level on July 1 of each year, as well as when events or circumstances might indicate impairment. We have one reporting unit under each of the three operating segments, Americas, EMEA and APAC.

We test goodwill for impairment by performing a qualitative assessment process, or using a two-step quantitative assessment process. If we choose to perform a qualitative assessment process and determine it is more likely than not (that is, a likelihood of more than 50 percent) that the carrying value of the net assets is more than the fair value of the reporting unit, the two-step quantitative assessment process is then performed; otherwise, no further testing is required. Factors utilized in the qualitative assessment include the following: macroeconomic conditions; industry and market considerations; cost factors; overall financial performance; Wesco entity specific operating results and other relevant Wesco entity specific events. We may elect not to perform the qualitative assessment process and, instead, proceed directly to the two-step quantitative assessment process.

The first step identifies potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill. The fair value of our reporting units is determined using a combination of a discounted cash flow analysis (income approach) and market earnings multiples (market approach). These fair value approaches require significant management judgment and estimate. The determination of fair value using a discounted cash flow analysis requires the use of key judgments, estimates and assumptions including revenue growth rates, projected operating margins, changes in working capital, terminal values, and discount rates. We develop these key estimates and assumptions by considering our recent financial performance and trends, industry growth projections, and current sales pipeline based on existing customer contracts and the timing and amount of future contract renewals. The determination of fair value using market earnings multiples also requires the use of key judgments, estimates and assumptions related to projected earnings and applying those amounts to earnings multiples using appropriate peer companies. We develop our projected earnings using the same judgments, estimates, and assumptions used in the discounted cash flow analysis. If the fair value exceeds the carrying value of a reporting unit, goodwill is not considered impaired and the second step of the test is unnecessary. If the carrying amount of a reporting unit's goodwill exceeds the fair value of a reporting unit, the second step measures the impairment loss, if any.

The second step compares the implied fair value of goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. The implied fair value of the reporting unit's goodwill is calculated by creating a hypothetical balance sheet as if the reporting unit had just been acquired. This balance sheet contains all assets and liabilities recorded at fair value (including any intangible assets that may not have any corresponding carrying value in our balance sheet). The implied value of the reporting unit's goodwill is calculated by subtracting the fair value of the net assets from the fair value of the reporting unit. If the carrying amount of goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.

As of July 1, 2019, we performed our Step 1 goodwill impairment tests on our three new reporting units, Americas, EMEA and APAC. The results of these tests indicated that the estimated fair values of our reporting units exceeded their carrying values. For the Americas, EMEA and APAC reporting units, the fair value was in excess of carrying value by 29%, 10% and 85%, respectively. The EMEA reporting unit had goodwill of $51.2 million as of September 30, 2019. We determined the estimated fair value of the EMEA reporting unit based on several . . .

Nov 26, 2019

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