Introduction
Distribution Solutions Group’s (NASDAQ:DSGR) share price has remained largely stable since their Q2 earnings release, running in that low-to-mid-$30/share range, although between Q1 and Q2 earnings, prices have ranged from high-$20/share to high-$30/share, leaving investors opportunity to pick up shares at a more attractive price. Fundamentally, I thought Q2 was a positive quarter with demand largely tracking where I expected. There are still some macro pressures today, but with stabilization seemingly being realized plus internal margin growth opportunities over time, I continue to think investors can earn decent returns going forward.
Lawson: Stabilizing
Lawson posted ~$121M in sales, up just under 2% from ~$119M posted in the prior year, and up 2.5% from the $118M posted in Q1. For those who may be less familiar with Lawson, the segment consists of MRO parts sold through various brands – think fasteners, chemicals, etc. – to various verticals such as auto repair shops, manufacturers, etc. Sales range from the U.S. to Canada, of which the latter was just expanded via a post-quarter acquisition which I’ll touch on later.
Going through this sales trend, there are a few things to unpack. I talked about this last time, but price has gotten down to what I think is an immaterial impact. Thinking through the broader trend here, consistent with the inflationary period, Lawson was pushing through the price increases in 2022. But then product cost inflation slowed, and so fast forward to today, Lawson isn’t still pushing through material price increases. Bryan actually seemingly confirmed that Lawson’s last price increase was mid-2023, so there may be some benefits year-0ver-year, but it’s not huge.
Thus, the sales growth for both periods is largely a reflection of volume changes and not price. With respect to volume, this is partly influenced by M&A tailwinds – DSGR acquired ESS in January for which I estimate they probably contributed just under $3M in sales in Q2. They contributed $2.3M in sales in Q1, but I’m assuming there’s some positive seasonality here. They also acquired S&S in May, which added another $7.3M in quarterly sales to Q2. So, assuming a full quarter for S&S, they probably post a normalized quarterly sales level of ~$10-11M once you factor in another month to the fiscal quarter (April).
What this amounts to though is that minus M&A, sales were down 4.2% year-over-year on an organic basis, reflecting a different reality than the reported growth. And again, this is more or less a reflection of volume changes. Now, to be perfectly comparable, their per day sales were up 8%, and this is obviously a better metric for comparability to adjust for the differences in total days – excluding M&A, sales declined ~1% organically. Either way, we can see that sales have declined.
Much of this trend is reflective of what I discussed last time. Broken out, their military vertical declined year-over-year. Because of how niche-y this demand is, it’s hard to get a read from other businesses and frankly, it is partially concerning given the general stability of military spend. What they claim is that governments, apparently every 5-7 years, change their “order entry program” which is “disruptive for all of us that sell into the government.” What that means precisely, I don’t know, but I’m fine taking their word for it given their history. They claim to not have lost any customers – i.e., market share – but either way, this is part of the year-over-year decline that they’ve seen.
While they don’t specifically confirm the other verticals that are down in Q2, we can infer that this is likely the case. When discussing their Lawson business as a whole, they noted that they’ve “seen some softening across most of those segments.” With that in mind, and the sequential trend, we can probably infer that their Core business was lower. They confirmed that Core sales were lower in Q4 and Q1, so without material demand changes since, that’s likely the case today too.
Behind this could be some market-related declines. Their customer base is going to a collection of different end-markets, so we can think of them as having general GDP exposure – there are “tens of thousands” of customers they sell to, which are inherently smaller businesses. Thus, given general business trends since the early part of 2023, it’s not unreasonable to believe that part of the declines were indeed market-driven. To use an industrial proxy, the PMI, for instance, has been running at sub-50 for nearly a year now.
However, we know that this isn’t the full story to their decline. While it’s hard to parse out quantitatively, as discussed last time, the reduction in their salesforce is obviously having a negative impact on sales as customers are deprioritized – if not abandoned – ultimately leading some customers to go to competitors. I wrote more on this decision in my Q4 2023 article, but summarily, they decided to scale back the number of outside sales reps and focus on building an internal support team. The net result was a decrease in total reps, for which, while they never explicitly suggested this was the case, is likely contributing to some market share loss.
On the other hand, if we dig a little deeper, their internal organizational/personnel changes are also likely contributing to some share gains in certain areas. That is, while it’s probably the case that their Kent Auto business and Strategic accounts have seen net organic declines as well, it’s not necessarily the case. For instance, both their Kent Auto and Strategic sales grew organically in Q1, so it’s not inconceivable to think they grew in Q2 as well. They did note that they “continue to see a strong pipeline in new strategic customer agreements, but these have a longer implementation cycle, so the associated revenues are not yet being realized.”
Either way, there’s very likely a tailwind from share gains here. While they’ve been deprioritizing reps for their Core (Street) customers, they’ve been prioritizing reps for this part of the business, hence their strategy of focusing on more profitable (larger) customers. This is reflected by their inside sales team growth, which is likely north of the 40 people staffed in Q1, but both higher than the non-existent department in 2023. It’s a little difficult confirming share gains given the widespread customer base, but if we look at a more concentrated pocket with Kent Auto which sells MRO parts to a host of auto repair shops, the growth they’ve seen from Q4 and potentially up until today is counter to the organic declines that LKQ is posting, for instance.
Putting it together, I’m expecting sales trends to improve as today’s macro pressures shouldn’t persist, nor should the share losses. As for the potential share gains they’re seeing – or benefits of expanded inside sales team – newly hired reps should continue ramping to a more mature productivity level and furthermore, management claims that they “need to hire at least another 70 reps” by the end of the year. So, coupled with general market growth and the outlook for Lawson as a whole is positive, in my opinion – assuming otherwise would necessitate that some of today’s softness is a result of structural share loss.
Quantitatively, the $121M in sales they posted for the quarter is not quite normalized. First, we need to add in ~$3M for a full quarter of S&S to get to ~$124. And then they acquired Source Atlantic post-quarter, who apparently does ~$185M in annual sales. So, taking that $124M figure, this likely amounts to ~$480M in annual sales using Lawson’s 2019 seasonality – adding $185M on top of that gets me to total Lawson segment sales of $665M.
Margin-wise, they had a solid quarter. Segment EBITDA margins came in at 13.6% which were more or less flat with the 13.5% posted in last year’s Q2, although these margins are up materially from the 11.4% posted in Q1. Like I noted earlier, price is probably down to an immaterial impact and this would be consistent with what appears to be a stable cost profile. Thus, there’s understandable stability from this angle.
There is some operating deleverage though from the organic sales decline of 4.2% (need to look at it on a reported basis). How much is difficult to say, but we know there’s some. Now, on the other hand, there should be some net reductions in SG&A from the net sales rep decline. However, in Q4 2023, they posited that while “there’s been a little bit of compression in the number of field reps that we’ve got,” there’s “not been any compression in terms of the total spend.” So, cost savings are maybe fairly marginal, all considered, such that on a net basis, there was indeed some operating deleverage.
There was a mix tailwind. It wasn’t confirmed on any of the calls, but they did note that at the time of the acquisition, ESS’s margins were “expected to be accretive to DSG’s adjusted EBITDA margins,” which would implicitly mean higher than 10%. So, we can infer that they’re in the territory of Lawson’s existing margin profile. S&S is less clear because they don’t break it out. However, while part of the gross margin headwinds for Lawson for the first six months came from “lower gross profit margins on revenue generated by the 2024 acquisitions with lower margins,” they specifically called out “acquisitions” as a gross margin tailwind in Q2.
To this end, the positive margin performance is more apparent when we consider trends on a sequential basis, for which they called out 3 contributors. The first was acquisitions – potentially referring to S&S specifically – although this only improved margins by 11 bps, suggesting the margin profile for those businesses were already in line with the existing Lawson business. Then they called out two and three being “organic gross margin improvements and related cost controls.”
Frankly, I’m not sure what the explanation behind this is because they didn’t offer much explanation. We talked earlier about how price is not really a contributor, thus suggesting that the gross margin growth is perhaps mix-driven. That is, perhaps their Kent business does better margins than their government/military business where such mix shift in Q2 was margin positive – I’m not sure. Then, with respect to the cost side, the only explanation was savings from fewer reps as they’re nothing else really going on to have a material impact. Part of me suggests this wasn’t the case as they noted that attrition slowed; however, they also noted that hiring was taken “down as we were refining some of the process.” So, perhaps the number of reps did decline to drive this.
Anyways, zooming out for a second, they’re understandably excited to drive higher margins for the segment. They’ve got a handful of new businesses in the mix that they have yet to fully tap into their potential synergies. With Source now onboard, they “expect to drive both Source Atlantic and our total Canadian opportunity to higher structural margins via scale and synergies” such that “[o]ver the next 12 to 18 months, we target EBITDA margins for the combined Bolt Source Atlantic in the low double-digit range” and for “Source Atlantic margins on a run rate basis to be accretive to the consolidated DSG EBITDA margins by the end of 2025.”
What they get to precisely, I don’t know. But starting with today’s 13.6% margins, perhaps something like 13-to-13.5% is more normalized on today’s quarterly sales rate of $124M (calculated earlier) – on $480M in sales ($120M quarterly), I’m fine assuming 13%, or ~$63M. Toss in Source at 10% margins – given their desire to get to the “low double-digit range” – and that would imply an additional $18.5M of EBITDA for a total of $81.5M on $665M in sales, or ~12.3% margins.
It could be the case that some of today’s macro pressures continue into year end such that normalized sales decline. However, looking out a few years, with new reps coming on board, existing reps maturing, and cross-selling and cost synergies from with today’s underlying businesses, it’s hard to not think they’re going to be a bigger business by FY26, say. 5% growth on $665M gets me to ~$733M – at 20% incremental margins, which is certainly doable, that’s EBITDA of ~$95M, or margins of ~13%.
Gexpro Services: Signs Pointing Up
Gexpro had a fine quarter, achieving ~$107M in sales in Q2, down 1.2% from the ~$108M posted in Q2 last year. Sequentially, however, they grew 8.5% from the ~$99M earned in Q1. As another reminder, sales consist of class-C parts sold to various manufacturers and related businesses around the world. Key verticals include renewable energy – think wind blade manufacturers – power generation equipment manufacturers, aero and defense, and then various other industrial businesses. GE, for context, is around 20% of their sales here.
Relative to Lawson, Gexpro is probably benefiting from more price versus last year. I noted this last time, but they “reset” contract terms at year-end 2023 to adjust for cost inflation – as pricing is only adjustable when the contract expires – so that obviously is going to result in a tailwind. How much of a benefit this was, I don’t know, but it’s not unreasonable in my opinion to think that perhaps they passed through low-single-digit increases. Inflation slowed materially in 2023 so it’s reasonable to conclude these weren’t outsized increases, but likely bigger than what Lawson experienced.
What that then means is that their volumes were probably down something like 3-4% year-over-year – something in the low-to-mid-single-digit territory. From my perspective, what’s seemingly going on are simply various macro pressures that have flowed through over the past 12 months. Per the 10-Q – and call – sales across their renewable customers (apparently project work) and industrial verticals declined while these declines were only partly offset by sales growth in A&D and their auto customers.
A lot of this is confirmable market-related declines. For one, I think the softness that Lawson’s Core business is seeing is likely comparable to their industrial verticals here, thus confirming that trend. The overlap is unlikely to be exactly the same in terms of customer or vertical, but the broader trend is indicative of the landscape as a whole. Or we can merely look at the aforementioned PMI data which reflects this trend more broadly, for which I don’t see any reason why Gexpro’s customers would necessarily be countering this trend, net.
On the renewables side, the dynamic is similar. For context, DSGR scooped up exposure to renewables manufacturing when they acquired Resolux who had various relationships with existing “wind OEMs”, and then they acquired Frontier as well who actually manufactures fabricated components themselves for renewable energy customers. So, they’re exposed to both new production and R&R. Behind the sales declines, it’s well documented that OEMs are seeing less demand themselves as reported here. While maybe not a perfect representation of the industry, TPI Composites (TPIC) reported a 17% sales decline in Q2. So, this is not a DSGR issue specifically, but a market-related one. Management’s take is that it’s been interest rate related specifically:
“We thought that the renewables end market would start accelerating after the Inflation Reduction Act or the production tax credit was renewed. There were a lot of projects in the queue that we were aware of and our market share there is very high. So, we were going to get to enjoy those. As interest rates rose and cost of capital went up, it fought some of the economic benefits of the production tax credit because those projects are largely project financed. And so, there’s been certainly some delays associated with those projects, but there’s a lot of pressure to get them started.”
The semi softness is a little different – this is more end-market demand softness than project economics driven, something we’ve seen more broadly correlating with consumer softness. Countering both semi and renewable softness, however, has been growth in A&D, which is slightly unexpected actually considering the softness that Lawson is seeing with government/military. Perhaps some of this is market-related – Knowles (KN) is seeing growth in defense – but they’ve talked about winning new clients and increasing spend from enhanced e-commerce capabilities, so perhaps some of it has been market share gains too.
The interesting angle here is that trends across the board appear to be improving. Sales increased 8.5% sequentially, for which some of this might be seasonality-driven as Q2 and Q3 are stronger quarters for DSGR collectively. From the call, however, KPIs point upwards, consistent with their commentary in Q1.
“Aerospace and defense and technology continue to be a bright spot with year-over-year growth as well as sequential increases through the first half of 2024.
In addition, the renewables end markets were strong, with double-digit growth this quarter and double-digit growth in the second quarter versus the first quarter of 2024, and they show the promise we expected for the back half of the year. The Frontier and Resolux acquisitions continue to present expanded opportunities as we evolve them into successfully collaborating versus competing with these great businesses that we acquired.”
So, the sequential trend may indeed be a reflection of improved demand trends beyond seasonality. Thus, we can likely assume that we’re nearing the bottom of sales declines for Gexpro and model them accordingly. Between cross-selling opportunities for Resolux and Frontier coupled with what should be growing markets, we can reasonably model in sales growth. For right now, Q2’s $107M in sales amounts to around $410M in annual sales – maybe higher, maybe lower, but I’m assuming a lower Q4 per seasonality.
Margin-wise, they posted 11.9% margins, down 20 bps from the 12.1% posted in the prior year Q2. I don’t contextualize this to be at all a reflection of lower contributions margins. As I talked about earlier, they’ve raised prices recently and mostly likely to the point of fully offsetting the cost inflation they’ve incurred. Consistent with this too, if we look at the margin growth on a sequential basis, nothing indicates that this isn’t the case, or that they’re seeing pricing (contribution margin) degradation.
Now, one variable that was an additional tailwind on a sequential basis, but a headwind on a year-over-year basis, was operating leverage. On a year-over-year basis, the impact here wouldn’t be anything huge considering the marginal sales decline, but on a sequential basis, it’d obviously be more impactful with sales up nearly $10M. Gexpro’s a distributor similar to Lawson, but the customer concentration is much greater here (their top-20 customers represent ~75% of sales). As such, costs are materially more concentrated, so a mere decline in sales per customer doesn’t allow for Gexpro to really do much with their channel-related costs. Furthermore, given their manufacturing operation with Frontier, that too is going to make them less cost flexible than Lawson.
In any event, the effects of fixed cost leverage were minimal on a year-over-year basis given the minimal change in sales. However, offsetting the tailwind of price is the headwind of mix. It’s been documented that technology (SEMI) is their highest margin vertical, so with the decline in sales here, that’s then going to bring down Gexpro’s margins. It hasn’t been stated that renewables are higher margin too, but older filings suggest so. When they reported pro-forma financials for Resolux and Frontier which we know comprises their renewables exposure, we can see that GAAP EBIT margins were low-to-upper-teens for Resolux and Frontier, while mid-single-digit for legacy Gexpro. So, it’s probably true that the decline in renewables sales was also a margin headwind.
This is also a helpful contextual point for their sequential trend. While we know that operating leverage was a tailwind here, all of their verticals seemed to have grown similarly – i.e., it wasn’t seemingly the case that one outpaced the others by a material margin. So, given that, we can tie this back to my earlier assumption that price indeed has been stable to growing, consistent with their comments.
Added up, it appears to me that today’s ~12% margins are normalized at this sales level. If true, per my prior model, assuming they can take today’s ~$410M in annual sales and grow that by ~4% annually to get to ~$440M in FY26, margins should grow too. On $110M in quarterly sales, we’re looking at ~12% margins actually, which would imply a segment EBITDA of ~$53M. Maybe there are some synergies they can extract cost-wise with the continued integration of Resolux and Frontier, but this is conservative.
TestEquity: Also Stabilizing
TestEquity’s (TE) sales came in at just under $198M, which amounts to growth of ~38% from the ~$136M posted in last year’s Q2. Sequentially, sales nearly 6% from $187M in Q1. For regular context reminders, the vast majority of sales are in the U.S. where they’re reselling various capital assets used for test and measurement needs including items like “benchtop and handheld test and measurement products from top manufacturers like Keysight, Textronix, FLIR, Fluke”. And they also sell their own line of environmental test chambers, which are now being manufactured by the Gexpro team.
From a year-over-year perspective, we need to remove the impact of the Hisco acquisition in early 2023, a “specialty adhesives, chemical and industrial products distributor that services the growing industrial technology market.” Management helpfully tells us that minus Hisco, sales were down 9.2% organically, which obviously paints a different picture. Implicitly, organic sales declined from ~$136M last year to just over $123M, or a decline of nearly $13M. Hisco then is posting around $74M in quarterly sales.
Unpacking that organic sales decline, it’s a mix of both market and competitive dynamics driving those lost sales. And to note, sales declines across both chambers and T&M parts and equipment, not just one, which then goes to support the idea of market losses. (TestEquity sells both with the chambers manufactured internally, and they complement this by offering calibration and related services.)
From a market perspective, most of their customers here are what they refer to as electronics manufacturing, which essentially refers to either internal teams within manufacturers or whomever that company is outsourcing T&M services too. Either way, they’re ultimately levered to all things electronics for which, of course, some portion of that is tied directly to consumer demand. As we’ve hinted at with respect to Gexpro’s semiconductor exposure, there are evident declines here to support the idea that demand has declined for almost everyone. And TestEquity too will sell directly to semi producers, so this would have a more direct impact to sales.
I’m basically arguing that it’s a macro-driven decline for some of their losses, and to this end, this would then support the data point of both chambers and T&M equipment declining. Notably, the softness they’ve seen on the aero and defense side would contrast with the growth they’ve seen within Gexpro, however the discretionary nature of the product – class-C versus capital investment – creates this dichotomy, which management noted:
“Aerospace and Defense, which has been a real strength for Gexpro Services on the MRO side has been a real soft area for TestEquity. And we know that our customers there are healthy. We know that they’ve got capital spending needs that they are deferring on Test & Measurement equipment. But given their businesses are obviously the macro environment globally is causing their businesses to be strong but deferred some purchasing on the capital side.”
We know, however, that the sales declines weren’t purely macro-related. As I talked about in my prior write-up, excess industry inventory has caused discounting by a few of their competitors, resulting in some customers picking up equipment at those (superior) prices. This, obviously, results in some share loss, but as I explained last time, this should be temporary. I.e., Once inventory normalizes, market share should then remain more stable.
To this end, sales are up nearly 6% on a sequential basis. I suppose there may be some positive seasonality similar to what I discussed surrounding Gexpro’s trends, but broadly speaking, this is obviously a positive trend. Sales, for instance, were down 16% organically in Q1, so with sales down ~9% today, that’s an obvious improvement. Consistent with this quantitative positivity is qualitative positivity – from the call:
“As we’ve discussed on previous calls and similar to Gexpro Services, we started to see some recovery in various end markets in Q1 that continued through Q2.
For example, the test and measurement business is still down nearly 3% from a year ago quarter, but was up nearly 18% sequentially over the first quarter. Additionally, Chambers, albeit a smaller piece of our business, had soft sales in late 2023 and the first quarter of 2024, but was up nearly 40% sequentially as we improved our stocking position of these units.”
Should this then materialize to a continuously stable-to-up remainder of the year, we can think about modeling today’s sales on a stable basis. I.e., Today’s ~$198M in Q2 sales likely translates into an annualized sales level of ~$770M thereabouts. A la Gexpro and Lawson, fewer selling days in the fourth quarter results in the other quarters representing more of their annual sales, but $770M seems like a fine estimate for now. This is higher than the $750M I was modeling last time.
Margin-wise, they ended up posting 7.8% segment EBITDA margins in the quarter, which are 80 bps higher than the 7% posted last year, and they’re 160 bps higher than the 6.2% margins posted last quarter (Q1). Compared to last year, I postulated last time that there could have been some slight price degradation. They commented that they didn’t take down price as much as their competitors did – hence the share loss – but there certainly could have been some price reduction, thus resulting in lower product margins. Evidently, however, the impact of this wasn’t overly huge.
In addition, though, to any headwinds from reduced prices was the headwind of operating deleverage resulting from the ~9% reduction in organic sales. The dynamic here is similar to Gexpro in that, versus a business like Lawson, sales are more concentrated in a smaller number of customers. So, when we think about the nature of the sales decline, we’re really talking about reduced sales per customer from lower volumes. Thus, there’s not really an opportunity to reduce many of their costs as their channel costs – e.g., sales and support reps – must remain to support the customer over time.
Additionally, Hisco is a margin headwind on a year-over-year basis. When they acquired Hisco, they reported historical financials showing a GAAP EBIT loss in FY22, however they were reporting positive EBIT going into 2023, so the FY22 period might have not been normalized. Either way, we can see from prior comments that Hisco was a mix headwind, thus reducing their segment EBITDA margins to the tune of 50 bps in FY23 and 35 bps in Q4 2023. We can probably think about Hisco then having a similar impact to Q2 margins despite not being explicitly noted.
With the above in mind – i.e., headwinds from mix, operating deleverage, and potentially price – what then contributed to the margin growth year-over-year? For one, as I noted in my prior write-up, they’ve been doing a lot of work rationalizing (reducing) their cost profile since last year. As I wrote:
“On the call, they discussed their efforts consolidating facilities in Mexico (4) and removing “duplicate warehouse headcount”. And then they also noted another 5 facilities have been consolidated across the U.S. and Mexico, collectively amounting $1.2M in annualized savings, or ~$300K quarterly, or a ~15 bps improvement.”
But this evidently isn’t enough to fully support the margin growth. However, I don’t think this is totally accurate – as noted on the Q2 call, they talked about taking a “step in the right direction” in realizing “$15M” in savings for TestEquity in 2024 (from the integration of TestEquity and Hisco), or ~$3.75M quarterly which amounts to nearly 200 bps of margin. Perhaps, then, they were about to capture something like half of those in the quarter, thus offsetting the above headwinds. And indeed, if we look at this on a sequential basis, they definitely captured the benefit of operating leverage, but it’s seemingly the case that the outsized sequential margin growth was partly driven by this variable too.
There should be some offset from reduced product costs. As I noted earlier, they’ve switched from having a third-party manufacture their own test chambers to now having Gexpro’s team manufacture it for them. As such, they’re effectively taking out the margin previously being charged which in turn saves them money – hence their claim on this. How much this benefited them, I’m not sure, but it’s not going to be a huge benefit – i.e., it’s not going to offset the negative impacts of operating deleverage.
Their goal is to get TestEquity’s segment EBITDA margins to “double-digits” for which, if they execute on the aforementioned cost savings they’ve laid out, can get them to just under 10%. If this is realized, they’re going to materially increase the intrinsic value here. In other words, should sales grow – let’s just say at 4% as they have cross-selling opportunities, so it should be market plus – to ~$830M by FY26, 10% margins would equate to $83M in segment EBITDA, well above the low-$60M they’re posting today. And that doesn’t fully include the benefits of operating leverage, so all considered, the 10% mark isn’t an inconceivable figure which I’m modeling myself. This is higher than the high-single-digit figure I was modeling last time to update for the expected cost savings.
Valuation: Closer To Fair Value
As I noted, they acquired Source Atlantic post-quarter. What they acquired them for, we don’t know yet because it hasn’t been disclosed, but considering that the business does ~$185M in annual sales per management, something around $200M seems reasonable. Comparable MRO vendor ESS was acquired by DSGR for just under 1x sales as a point of reference.
Either way, it’s clear that they’re still focused on doing M&A having now done 3 deals YTD, spending ~$95M on the first and probably another $200M for this one. This doesn’t overly concern me. I talked about this last time, but they’ve been paying fair multiples for businesses for which, coupled with their ability to cross-sell into their existing brands/salesforce and customer base, the deals carry strategic value.
Source Atlantic should fit that profile too. Management gave a lot of helpful context on the call, noting how Source’s Canadian presence will complement their Lawson Canada and Bolt Supply House operations in Canada by allowing them to cross-sell customers of which the overlap is apparently “minimal.” This, in turn, is what’s giving them the confidence for margin expansion.
The only element worth watching is that they’re funding these deals with more and more debt for which there’s nothing inherently wrong with that, particularly as they acquire the businesses at attractive IRRs. However, it nonetheless continues to add to their leverage profile – at the end of Q2, they had net debt of $560M thereabouts, for which they’ll add another $200M to that for source to get them to $760M. Now, distributors can handle more debt given the relative demand stability, and currently, I don’t think they’re in dangerous territory – while GAAP EBIT to interest expense is close to 1x, once you add back amortization expense that should justifiably be added back, DSGR is now doing something like $25M, amounting to over 2x. So, they’re not in terribly concerning territory, but something to watch for as they keep doing deals.
Adding it all up, at today’s price of $37/share with 46.757M basic S/O, they’re trading at a ~$498M market cap. Net of ~$46.8M of cash and ~$605M of total debt, that’s an EV of ~$468M.
Per my assumptions from earlier, they’d be posting FY26 sales/EBITDA of $2B/$231M. This is higher than what I modeled last as I’ve updated my sales estimates to be higher plus am now modeling in more margin growth for TestEquity. Either way, adding in another $4M of corporate EBITDA, and subtracting SBC at 0.6% of sales ($12M), D&A at 4% ($80M), $63M in interest expense (adding another $14M for Source Atlantic debt), 25% tax rate, and capex at 1.25% of sales ($25M), I get a free-cash-flow figure of ~$115M.
Like I wrote last time, I’d value this business at around 20x free-cash-flow. Their organic growth should remain in that mid-single-digit territory with their internal margin prospects, and over time too as they capture operating leverage and accretive capital allocation. Using a 20x multiple, that would imply an FY26 market cap of ~$2.3B thereabouts – assuming cash generated in the interim of ~$150M, that’s an adjusted market cap of $2.45, or ~$52/share. Discounted back 2.5 years to today gets me to a fair value of ~$40/share, slightly higher than the $37 price today.
Given this setup, DSGR represents a situation where I sort of struggle. On the one hand, I think they have a solid fundamental future between natural organic growth, some internal margin initiatives, and good capital allocation. On the other hand though, the price is now getting to a level I’d deem as decently expensive, prompting an urge to reallocate dollars elsewhere. However, given the capital allocation angle specifically, this is a situation where I’m holding on to more shares than what my typical approach suggest.
Conclusion
Summarily, Distribution Solutions is a fine business to own, although I wouldn’t necessarily fault anyone for passing on them to invest in other businesses that may have better IRR prospects given DSGR’s price today. Nonetheless, I think the fundamental outlook for DSGR is positive that’ll likely be rewarded positively by investors. The management team has demonstrated a focus on building shareholder value and they have various internally controllable initiatives to increase intrinsic value, so there’s a lot to like about their future, although the macro situation can certainly reduce their valuation in the interim.
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