Description

Investment Overview:

Distribution Solutions Group (DSGR) has been written up on VIC under its previous ticker (LAWS) just after the consummation of the reverse merger, since then there has been significant change at the Company and incremental evidence supporting the thesis warranting an update. The previous write up discusses the transaction in detail and the near term mispricing that resulted. Since then, DSGR has announced a potential home run acquisition (Hisco) that was previously an ESOP starved of profitability and hosted a fantastic Investor Day introducing the broader investor community to this compelling long term story. Hisco is a quintessential example of why the logic of the DSGR platform is compelling and helps build scale in a best-in-class specialty distributor with numerous opportunities to drive revenue synergies across the three verticals, increase margins and layer on new geographies and adjacencies while tapping into Luther King Capital Management's deep sector expertise and relationships. Given the complexity, relatively young life as a public company and a controlling shareholder, DSGR is misunderstood trading at a discount to other specialty distributors. 

Trading at 10x NTM EBITDA has potential to be a long term compounder through steady organic growth, margin expansion and accretive M&A. DSGR is a $1.8B revenue, $195M EBITDA/$100M FCF specialty distribution company with a $1.4B market cap focused primarily on selling “class C” parts and other consumables to a wide variety of industrial and manufacturing customers through a high touch, value added service model. It has a little something for everyone: aligned owner operator, special situation, organic growth story and opportunistic M&A. Formerly Lawson Products (LAWS), the firm was merged with two other synergistic distribution companies by private equity manager LKCM ($24B AUM in Fort Worth, TX) to create a public platform. LKCM owns ~77% of shares out. The company has a long runway for mid to high single digit organic growth, margin expansion, and accretive acquisitions.

Segment Overview: 

Lawson (~30% of revenues and ~36% of adj. EBITDA) provides vendor managed inventory (VMI) services and distributes class C parts (fasteners, washers, cutting & abrasives, specialty chemicals and aftermarket automotive supplies) to small maintenance, repair and operation (MRO) shops in various end markets such as industrial (21% of Lawson sales), automotive (14%) and aerospace and defense (13%). Lawson has a footprint primarily in North America (U.S., Canada and now expanding into Mexico after the Hisco acquisition). Lawson goes to market through their high touch, high value added service VMI which separates them from larger broadline distributors while taking advantage of DSGR’s scale advantage compared to small local players. VMI is essentially an outsourced supply chain/procurement staff where a Lawson sales rep will visit a repair shop mechanic every few days or weekly replenishing inventory bins with screws and other forgettable but mission critical parts (URI is large customer who would suffer if a multi millionaire dollar excavator had to sit idle because of a missing fastener) with an ASP of $0.90. If Lawson is doing their job properly, the owner of an auto repair shop never has to pick up the phone and order new parts. The VMI go to market is heavily service and relationship-focused which confers 90% customer retention and 50-60% gross margins with a large degree of trust built over time between rep and customer. Lawson sources from ~2,400 suppliers with no single supplier accounting for more than 6% of purchases. 

Gexpro Services (~23% of revenue and ~28% of adj. EBITDA) has a similar offering to Lawson (VMI GTM selling fasteners, machine parts, pipes, valves, fittings, labels and adhesives) but targeting OEMs (GE is 20% of segment sales, top 20 customers are ~63%). Customer concentration is much greater at Gexpro compared to Lawson (~2,000 customers vs ~90,000 for Lawson), but because of their more complex/specialty operations (at the Investor Day they disclosed that 70% of products at Gexpro are custom designed/engineered for their customers) and products getting spec’ed into the design process customer retention is also higher at 98%. 80% of Gexpro sales essentially become “embedded in the assembly line” who’s primary value add is providing 25-30% procurement savings for customers through supplier rationalization, labor productivity, global sourcing etc. ~65% of revenues in 2022 were from customers under long-term agreement which we take to be greater than 1 year. Source from 2,700 suppliers ( largest ~2% of purchases, while the top 10 suppliers represented ~15%) 

TestEquity (~47% of revenues and~36% of adj. EBITDA) provides test and measurement equipment distribution to the aerospace and defense, industrial electronics and manufacturing, semiconductor production, education and medical markets in North America, Central America, UK and Western Europe. Operates through 6 brands: TestEquity, TEquipment, Techni-Tool, Jensen Tools, Instrumex and now Hisco serving over 30,000 customers sourcing from 1,000 suppliers.  TestEquity sources from suppliers such as Keysight (10% of purchases), Tektronix and Rohde & Schwarz (top 5 suppliers make up ~50% of purchases) is more capital cycle exposed than Gexpro and Lawson as TestEquity sells $100,000+ capital equipment (new environmental test chambers, test & measurement instrumentation et accounts for 16% of segment revenue). Through the recent acquisition of Hisco ($400m of sales), TestEquity bulked up their VMI offering layering in more consumables sales (labeling & printing, solder). 2/3rds of segment sales are now driven by low ASP consumables/value added-services that reduces the revenue lumpiness of the segment. Through Hisco, TestEquity growing its service focus (a stickier offering due routine calibration revenues) and decreased supplier concentration: Keysight has fallen from 20% to 10% from ‘21-’22 this business has undergone a step function change in quality over the last 3 years. 

This all ties to 500,000 distinct SKUs from 7,000 suppliers (none more than 9% of purchases) to 170,000 customers for overall DSGR.  Despite serving multinational companies such as Apple, Boeing, Lockheed and Broadcom, we estimate that no customer makes up more than 5% of their $1.8B revenue. 

The overall thesis for DSGR is to emphasize VMI specialty distribution across strong, diverse end markets. Our conversations with Bryan King (CEO) and the Investor Day presentation demonstrate focus and understanding of the compounding characteristics embedded in specialty distribution. Through his experience running a commoditized broadline distributor and two decades of distribution experience Bryan wanted to put a substantial portion of his private equity firm’s capital (30-35% of LKCM capital) into a best in class specialty distributor.  Large manufacturers have tried to go direct in the past, but have failed due to a lack of inventory and not offering a service component indicating that in the test and measurement side of the business technical expertise is important. At the recent Investor Day Russ Frazee, the CEO of TestEquity attested to this, “People underestimate the value of  the labor component. Manufacturers are trying to offload that onto others that do it better than they do and so that's a big component on the selling proposition for all these guys.”  

Thesis:

VMI GTM is an underappreciated differentiator delineating DSGR as a specialty distributor (not a broadline) that has high customer stickiness. 

• Due to DSGR’s short life as a public company and therefore limited data to draw conclusions from, the market has not yet categorized it with specialty distribution peers, instead valuing the company as a broadline distributor (which we define as player who sells a high volume of products towards lower end of price range such as MSM or GWW), a hard business with limited margin expansion as cost efficiencies extracted are captured by customers (each player is effectively standing on tip toe to compete with one another.) In reality, DSGR has a high touch, value added VMI offering that 1) sources rare parts 2) provides sales reps with domain knowledge and expertise and 3) has high service levels that saves time and money for skilled workers.  

• DSGR (I’ll draw examples from Lawson but this holds true for Gexpro and Hisco as well) leads with their large, in-field sales force serving small MRO shops where the average invoice size is $688. The small $ size of customers when combined with the time it takes a sales rep to mature (generally 3-5 years for sales reps to hit $450k in sales) means that DSGR benefits from economies of scale and route density that would take time for a new entrant to replicate. This services-oriented GTM allows reps to focus on building strong relationships with higher switching costs (both a convenience and opportunity cost factor to switching which increases with wallet share), while broadline distributors chase lower margin, higher turnover ecommerce offerings.  Lawson used to disclose sales rep productivity when it was standalone so we know that customer relationships strengthen/spend concentrates over time which contributes to the high retention rates 90%+ which makes sense: if you have a sales rep visiting your shop multiple times a week you might as well get everything on the shopping list from them while they are here. 

• As noted, leading with VMI comes with greater profitability. Lawson bundles the price of the VMI service in with the products they sell which leads to low 50% gross margins vs broadlines MSM and GWW at high 30s/low 40s so there is clearly value add to the services. The productivity gains that a mechanic realizes from one-stop shopping DSGR more than offsets the somewhat higher costs that they charge on parts, costs that are just passed on to the end customer anyways. A time series of LAWS/DSGR and FAST gross margins since 2010 vs GWW and MSM clearly reveal this. These multi-million SKU ecommerce offerings like GWW’s “big book” compete on selection and price, catering to large customers. DSGR’s service focus has allowed them to better serve the small and mid sized business segment while preserving margins. The offering still has tons of value for the procurement department of large customers as well: a single provider that can reach your entire region or country makes sense, it could quickly become a headache tracking all the orders from dozens of different distributors for class C parts that sell for less than a dollar. 

  • An old Goldman note estimated that Fastenal products have a 60% premium to the prices found on Amazon, while W.W. Grainger’s online platform, Zoro, only has a 9% premium. W.W. Grainger cut prices the most in 2018, while Fastenal was able to raise prices in FY18 by 0.7%-0.8% and in FY19 by 0.9%-1%.

• DSGR competes along a different vector than both large broadlines that provide selection/low price and mom and pops who can’t reinvest at the same scale in technology and salesforce to provide best in class service. Most of the products sold by DSGR's operating companies are mission critical (the OEM and MRO shops can’t run their business without these parts), but are an afterthought. Beyond price as it is usually not a big enough cost line to be worth negotiating over, customers care about the distributor having an item in-stock for immediate delivery and reducing downtime of skilled labor. Good service makes for sticky customers – why switch your distributor who has the parts you need and risk something going wrong? Scale economies have allowed DSGR to take share from the long tail of local mom & pop through greater route density which lowers costs to serve per customer and provides procurement benefits. While barriers to entry are low, mom & pop distribution businesses often do not have the workforce to roll out as deep a service offering which forces them to operate at structurally lower margins indicating that barriers to scale are high. DSGR’s scale allows them to have a separate procurement and service function which allows sales reps to focus on specific verticals and get a feel for local market dynamics that a mom and pop servicing only a handful of customers can’t. 

• While Lawson’s products are less cyclical due to their consumable nature (Since they sell consumables “opex, not capex”, they tend to be relatively insulated from macroeconomic headwinds), they are still tied to industrial demand (if you use the machines less, you consume fewer parts). In 2015, despite oil and gas headwinds sales only fell 4% in the segment and EBITDA margins were flat. The same is true from 2019 to 2020 when sales fell 5% and EBITDA margins expanded 40bps.During Q2-Q3 2020, Lawson sales declined 15% but EBITDA margins only dropped 70bps showing some ability to protect margins with cost cutting in a very weak demand environment

LKCM are best in class operators that are highly aligned 

• On the surface, an inorganic growth story, where a private equity sponsor took a public business that they controlled and combined it with two private businesses they controlled is a huge red flag, however there have been enough behavioral data points that put these concerns to rest. 

  • LKCM took zero cash out of the transaction (rolled 100% of their equity in the reverse merger) and fully subscribed to the Hisco rights offering and fully exercised their oversubscription rights. Even the rights offering itself is instructive: while they could have done Hisco with all debt, that would have left them at >4x net debt/ EBITDA (above their stated 3.0-3.5x target), therefore, management chose to issue some equity – but rather than issuing it into the public market at a low multiple to new shareholders, they conducted a rights offering to existing shareholders. We judge this as a partnership mentality.

  • This is a massive position for both Bryan personally (~$60M of his net worth) and LKCM as a whole. 30-35% of LKCM capital is in DSGR. Bryan is taking zero cash comp/board fees and only gets paid through his family’s 20% ownership of the business. 1/3 of LKCM Headwater's $2B in capital came from the investment team, affiliates and related parties.

  • LKCM is taking zero management/advisory fees and is contributing their M&A, corp dev and operations team to help source and integrate deals

  • Gexpro and TestEquity CEOs are compensated out of LKCM waterfall, not minority shareholders. 

• LKCM is experienced and has been successful in the distribution space having spent the last two decades and 35-40% of their capital executing ~100 transactions averaging ~10x MOIC on sold business and 4x on ones they still hold. Our conversations with management and formers reveals that DSGR would not have gotten Hisco and Lawson would not have gotten Partsmaster without access to Bryan’s network

  • To illustrate, Bryan has mentioned that he had been following Hisco for “16-17 years” and started conversations in 2017 to buy it. Gexpro was a carve out from Rexel that amounted to 3% of the latters revenue that he had been following for 10+ years. LKCM was the largest customer of Lawson before taking a position and had been able to look under the hood. The normal buyer/seller information asymmetry does not exist when Bryan is the buyer of a distribution business. 

  • LKCM were former owners of IDG, Rawson, GSMS and Bearcom and currently own Building Controls & Solutions and Relevant outside of the DSGR entity and have been in the space for 20+ years. 

  • Operating subsidiary heads are compensated on Sale $, EBITDA $ and NWC as % of sales. Management and director compensation is tied to adj. EBITDA (60%), Net Sales (30%) and Net Sales from Acquisitions (10%) which prioritizes growth and margins at the operating level. Long-term equity incentives are a mix of RSUs (20%), PAs (40%) and MSUs (40%). The options vest in equal increments over four years, with a seven year expiry with some strikes in the $70s.

  • Few quotes from the investor day 

    • “We have spent the last 20 years focused on specialty distribution and building scale there and knowledge, we've been able to attract a really resilient ecosystem of operators and coaches who are investors in DSG. We have over 100 former CEOs and C-suite executives most of those have been specialty distribution executives and they are all limited partners in helping us try and unlock value very thoughtfully, and it ultimately build the business that we are talking to you about today.”

      • One of their LPs was an executive coach to the #2 at Hisco

    • “IDG, we alluded to earlier, a great example of a business that was under 5% operating [$8mn EBITDA] margins that we took to close to 10% [$53mn EBITDA]. We did six accretive acquisitions. Bryan may have been critical about that business, but we ultimately made 10x our money for our partners on that. We're a land and mobile radio distribution company where we owned for 4.5 years, over tripled EBITDA through 13 acquisitions and organic strategies and made over 8x money for partners.”

    • “Our jump shot is specially distribution. That's reason why it's 35% 40% or more of all of the capital we put to work. We've built 16 or 17 platforms, we just consolidated 3 of them. We've sold 6 or 7 out of them. That they've unlocked 10x our money, or 9.92x. And it's -- and we obviously had an opportunity to sell these three platforms or to run them separately. But for the fact that we saw so much opportunity over a long cycle to create a tremendously more valuable franchise for all of us as shareholders”
      
      

Why the three legs of the stool should be together: sourcing advantages, cross selling and best practices 

• Management has been clear that while there are vendor consolidation/cost synergies with the acquisitions they are only buying assets with “commercial logic” i.e. cross selling ability. On the cost side, efficiencies come from higher asset utilization (Hisco had a labeling machine which was significantly underutilized that Gexpro could use where they were previously outsourcing which drove a  20%+ lift, test chambers that TestEquity used to outsource are now being produced in house by Gexpros SIS division. While this may not sound like a big deal, on the LDD to teens EBITDA margins they target these cost savings have real impact), geographic overlap (DSGR has an overlapping geographic footprint with the companies it acquires, allowing it to consolidate distribution centers and increase route density (both accretive to margins). Take Hisco for example, they had a space in El Paso and Juarez that they were able to consolidate) By plugging in smaller acquisitions into the DSGR platform they get better access to suppliers as well. TEquipment gained access to Keysight T&M equipment after it was bought by TestEquity where it previously couldn’t. These two also had complementary customer bases where TEquipment served small/medium customers and TestEquity was primarily focused on large accounts. DSGR is effectively the rightful owner of these small assets because they can do more with them together than anyone individually. 

• Management has laid out a path to increasing gross margins by 25-50 bps/yr through 2028 highlighting private label mix shift (20% GM for branded vs 40% for private label), labeling/kitting and shifting low gross profit $ customers to the inside salesforce.

• Each of these businesses on their own had solid niches but were individually subscale the best example of this can be seen in Lawson EBITDA margins before and after acquisition 

  • Lawson's MRO business has grown its third quarter revenue over third quarter 2021 prior to the merger by 22%, and its EBITDA by 112%, taking EBITDA margins from 8.4% to 14.5% in less than two years.

  • Overall DSGR was operating at EBITDA margins 8% pre merger and now at 10.7% 

• Revenue side: DSGR has talked about a number of growth elements M&A brings to the table that we bucket as 1) cross-selling and 2) the introduction of new adjacencies. Management identified 250 cross sell/wallet share opportunities that give line of sight to $50mn in revenue synergies over time and there were helpful slides from the investor day that show where these opportunities will come from. In route density businesses disciplined incremental expansion into adjacent product and geographic space can sum to significant competitive advantages over time and DSGR through Hisco is exhibiting this. Hisco has dominant scale in Mexico which is allowing Lawson to enter that market with pre-existing cost advantages/route density. DSGR is also taking products from their TestEquity website and making them available on all Hisco websites and test chambers are being cross sold into Lawson and Gexpro. 

  • As the operating group head of Gexpro said at the Investor Day: “When I told you about the 250 opportunities, 40% of those opportunities are Gexpro services pulling Lawson through to our OEMs.So if you walk away with one thing, there's a huge install base that we can mine collectively together.”

  • “We struggled a lot with Fastenal would come into our VMI's and offer things that we couldn't as TestEquity, and the funny part was they would come in and win because the customer wanted to deal with one supplier. They bought all the stuff from us that we normally put in there but now we can hold them at bay because we just we go in with Cesar [Lawson], and we can actually deliver the full package when they can't.”

• The CEO of Gexpro gave the example of Gepxor’s OEM focus overlapping well with Lawson’s MRO customers where they become completely embedded in the customer lifecycle “so they never have to go anywhere else, but through Gexpro Services to get to Lawson or TestEquity”

  • “And the best benefit, which I have to tell you that what the biggest learning lesson for me with Hisco coming on board, part of the TestEquity Group is I had no idea how close and entrenched they are with their largest OEMs.And they're in the same common verticals that I am, but they brought me to customers”

• Hisco ($269M purchase price/9.4x EBITDA ex-synergies) was previously ESOP owned and Bryan has said that “They've done a very good job growing their top line, growing their volume. They have not had the focus on VMI that they should in getting paid for the value. And that's a mentality of revenue growth without EBITDA margin discipline, candidly.” There were instances where Hisco and TestEquity would compete with the same SKU and same customer where there was a  1,200 basis points difference in margin. 

• DSGR can also extract “big company” benefits such as end market diversification allowing them to put more leverage on the platform, find more reinvestment opportunities, “firing” the 5% of Lawson customers that were uneconomic, invest in CRM and ERP implementation hiding some incremental expense easier.  

• Investor Day metrics and targets demonstrated long term potential

  • DSGR hosted an Investor Day last September where they laid out a roadmap to achieve 13.5% EBITDA margins in 5 years through a combination of 25-50 bps of annual GM % expansion and 50+bps of annual SG&A as a % of sales improvement from wallet share gains, cross-selling, private label mix shift, integrating Hisco and G&A leverage with mid to high single digit organic topline growth leading to $3.3B revenue and $450M EBITDA (20% CAGR). We think these targets are achievable, but won’t happen in a linear fashion for the below reasons:

• 1) Synergy potential with Hisco higher than street believes 

  • Management was intimately familiar with Hisco as a standalone asset (studied it for over 15 years). Gexpro and Lawson were similar businesses that had imminent/obvious low hanging fruit (cross sell to OEM and MRO within multinationals through existing VMI). TestEquity was the least synergistic that management viewed as a “tip of the spear” to win customer leads. The Hisco acquisition solves this and  braces TestEquity to the other parts of the stool. Hisco sells consumables to TestEquity’s end markets, but has a similar GTM VMI focus as Lawson/Gexpro. 

    • “We knew when we bought Hisco, it was going to dilute us because we were fully prepared for what they were bringing. But the upside of what they bring with their customer base, their stickiness and their product lines that we bring all together, we will be able to move quickly back to our double-digit EBITDA.”

  • Management originally put out a $6mn synergy target within 12 months of close (which would take Hisco from $29m of EBITDA/ 7% margins to $35m/8.6% margins). Implying a 7.5x post synergy multiple (1.5 turns of synergies). At the Investor Day management revised this estimate up to $10m of run rate cost synergies and $39M EBITDA implying  ~6.7x EBITDA or 10% margins. However, management has not quantified future revenue synergies which we believe are significant. By comparing Hisco’s operating performance with that of Gexpro and Lawson post acquisition and assuming similar performance we estimate that management can add $5-10M of incremental EBITDA on top of the already announced $10m to TestEquity performance through Hisco margin rationalization and cross selling over the next few years. 

• 2) Salesforce efficiency at Lawson results in conservative guide

  • The opportunity in this bucket is threefold. As a standalone, Lawson had underinvested in technology and salesforce efficiency which is now being remedied through a combination of 1) better gross margins management 2) lowering rep turnover 3) CRM rollout in Q1’24. The salespeople are the real asset here, if Lawson can drive down rep turnover they will be able increase revenue retention (the real driver of the 90% retention rate vs Gexpro at 98% is rep/relationship turnover). We can expect ~$20mm in savings over time from transferring unprofitable accounts to the digital channel

  • 1) Lawson’s historic MO has been more sales reps=more EBITDA dollars because incremental EBITDA margins range from 20-30%. Recently though there has been a mentality to shift to wringing out productivity from these seasoned reps through focusing on gross profit $/unit of sales rep time. As mentioned earlier, the average invoice size at Lawson is $688 and there were 19-20k accounts that did ~$20M in combined annual rev ($1k/account annually). Management estimates that they were losing ~$20M of EBITDA on this $20M (5%) of sales by overserving these small accounts (weekly runs/calls to accounts that were $500 of gross profit dollars or less/year). In response, Lawson has been moving these small accounts away from the field sales team to the inside salesforce (place orders digitally/on phone) which increases gross margins and opens up the sales rep capacity these accounts took up (we estimate to be 30-40% of their time) which can be redirected to hunting for new accounts that Gexpro/TestEquity are introducing an increasing /wallet share existing large accounts. This is already starting to bear fruit as GM% was up 500bps from Q1’22 to Q3’23. The additional margins have been reinvested back into the organization: this time last year Lawson had 5-6 inside sales reps now they have 45, they have doubled their strategic account manager team from 10 to 20 (now 35% of sales) and  2x’d the number of sales service reps (the individuals who do the physical part of putting product away within customer base)

    • “Our inside sales team are actually touching those customers more frequently, but over the phone, right? And then our customers actually benefit from this because now they have resources from us that are spending more time with them. And for us as a company, we've taken those unprofitable sales and allocated that into the right cost to serve model”

  • 2) Management believes that by freeing sales reps of these uneconomic accounts and giving them more capacity to hunt, reps will be able to increase compensation which will drive down turnover. Again, there is early evidence of this success as strategic account revenue was up 23% over last year

    • “It [Street accounts] has been an area where we've tried to drive efficiency or drive sensitivity out of our salespeople in terms of how much time they're spending at a site and making sure that they're hunting to try and grow their revenue because we want them to make more money. We think that their compensation or the opportunity that they've got to drive their compensation higher through being more efficient and growing their productivity and us helping them on that, and then us looking at ways to make sure that they can be rewarded more by their productivity growth is going to slow down that turnover  [Management has told us they think they can drive comp ~20% higher for these reps]. And that turnover is something that we've said publicly before. Historically, for the last five years or so, on our side, we've done a lot of work around the cost of the turnover. And we think it's still $20 plus million a year. It's a real cost to the business of having excessive turnover out of salesforce”

  • 3) Lawson is rolling out a CRM in Q1’24 to help track sales rep efficiency and investing in digital capabilities to help reps on order entry process (bins scanning etc). In combination with the two previous initiatives they believe that this can drive a doubling of sales rep efficiency over the next 2 years and disclosed an 18% sales rep productivity increase last quarter. We have already seen average sales per rep increase from $450k to $700k (other distributors are at ~$1.5M/rep), but now the focus turns to driving margins. Management believes that at $800k/seller they can drive FAST level EBITDA margins at Lawson. 

• 3) Underappreciated M&A function through LKCM network and HOPS team 

  • DSGR is getting access to LKCM’s operations and M&A team at no fee. DSGR’s in-house corp dev team is headed by Matt Boyce former Director of Corp Dev at Carlisle (CSL) at FP&A Director at IDG when it was owned by LKCM and Melanie Nix (PE associate at LKCM) both of whom intimately familiar with LKCM’s operations. DSGR (including back when it was LAWS) had done 14 total acquisitions since 2017 (avg purchase price is 2/3rds of sales), 10 over the last 2 and 5 over the last year. 2022 acquisitions were done at an average of 7.7x EBITDA and have  averaged ~6.3x post synergies. Management has publicly talked about ~8x average acquisition multiple that can be cheapened to 6x after year 1 and to 4x through longer term revenue synergies after 2 years. Acquisitions must have strategic rationale in expanding A) geographic coverage B) product offering or C) end markets or enhancing platform value through D) value added services or E) technology/sales channel

    • A) Example of expanding product offering would be Lawson's acquisition in 2020 of Partsmaster, who brought a private label cutting tool and abrasive line.

    • B) Geographic expansion and coverage: Using M&A as a tool to accelerate how quickly  DSGR can get into a region. Ex: Hisco, with their strong Mexico footprint.

    • C) End markets: Acquired Resolux to dip their toe into the renewable energy space.

    • D) Value-added services and capabilities: Hisco  added label printing and precision converting capabilities that helped liftGM as Gepxro 

    • E) Technology and sales: TEquipment served small/medium customers channel that TestEquity didn’t

  • There are enough data points to gain confidence in their M&A/integration abilities to be positively surprised.  Owned companies on the Gexpro side have doubled EBITDA while revenue has grown over 40% over the last 2 years. TEquipment was bought for 7.2x EBITDA of $7.7M (6.8% margins) and is now run-rating at $12.7M EBITDA (9.5% margins) implying a post synergy multiple of 4.3x after product expansion and digital expansion.. Resolux was bought for 9.4 EBITDA of $3.8M (12.0% margins) and is now run-rating at $6.6M EBITDA (14.0% margins) implying a post synergy multiple of 5.5x after cross-selling, working capital optimization and repricing SKUs while providing expansion into Europe, Asia & South Africa.

  • No doubt that Bryan and his long standing reputation in the distribution industry have been a key reason for sourcing deals, but what we found most interesting is that at the Investor Day Matt mentioned, “When I first started, all I was doing was making outbound calls for the last, we'll call it 12 months. Just turn our bound calls. But now that, we've met some acquisitions the DSG name is getting out there in the marketplace, it's pretty nice. We're starting to get inbound calls where business owners are out there saying, hey, we see what you're doing, we like what you're doing, we want to be a part of it. And so that's been a fund little shift in our world of seeing companies out there that we know, reputable, that are calling on us to be a part of what we're building.” and Bryan reaffirmed this on the Q3 call “there's been a lot of interest that's been inbound, which has been quite interesting about wanting to be a part of what we're building. And there's some businesses that are out there and there's some assets that are out there that really do fit very well with what we're trying to accomplish. It would be real jewels to add to our business and would be very financially and commercially valuable to accelerating us being able to get to some of our objectives long term.”

Valuation Gap 

• Despite the attractive qualities of DSGR’s underlying business (scale economies, high touch VMI), DSGR’s current valuation of  10x NTM EBITDA stands in contrast to a mix of peers that trade in the low-teens or higher. The best, although dated private market transaction is Barnes Class C business that was acquired by MSC Industrial at 13x in 2013.  Although we do not use these aspirational multiples in our base case for valuation, we do believe that as the Company continues to execute prove its platform value it could trade at 10-13x. Public peers that we use and their NTM EBITDA valuation below:

  • FAST: 19.8x

  • GWW: 14.5x

  • MSM: 9.6x

  • POOL:18.2x

  • WSO: 18.5x

  • AIT: 11.9x

  • WCC: 7.3x

  • HLMN: 10.7x

    • Median: 13.2x

  • DSGR: 10.3x

Valuation

Management is guiding towards $450M EBITDA in 5 years (FY’28) on $3.3B of sales (~13.5% margin) and in our base case we believe DSGR can grow EBITDA by ~20%/year. There are 3 sell side analysts covering DSGR (really 2, one analyst didn't show up to the investor day) with consensus EBITDA of $192M for 2024. We think is clearly too low and are projecting $195-200M of EBITDA in FY24 pro forma for the Hisco acquisition.  General outline of our assumptions over a 5-year projection period:

• DSGR organically grows topline at 6%. This is a GDP+ grower through its large tie manufacturing activity. The MRO market is massive and growing 2-3%/year, tailwinds from VMI outsourcing, vendor consolidation, cross selling and reshoring will add low to mid single digit growth on top of GDP. (5-8% organic growth is a reasonable range)

• An additional ~$800M of acquired revenue for 7x post synergy EBITDA ($125M) for a total topline CAGR of ~12-13% 

• While margin expansion won’t be linear we are confident that over time DSGR can achieve gross margin expansion of 25-50bps on average driven by private label and digital acceleration and 50bps of SG&A improvement on average per year  through fixed cost leverage and the simple fact that TE and Hisco are no longer knife fighting on margins 

• EBITDA margins slightly surpass management's guidance of 13.5%, compounding EBITDA at ~13-14% organically and ~20% inorganically off the pro forma ‘24 base of $195-200M

• 11.0x exit EBITDA multiple 

• Capex 1% of sales in line with historic %. (~$16-20M in 2024) 

• Working capital at ~26% of sales 

  • management has disclosed to generate an incremental dollar of sales they need 20-25c of incremental working capital 

  • Built up lots of WC over the last 2 years because of supply chain issues. Lawson can run at ~22% of sales (currently at 23%), TestEquity at ~20% (currently at mid 20s) and Gexpro at 30% (currently at mid 30s) 

We are ahead of street estimates of 5% organic growth and incorporate M&A in our projection. (timing will be unpredictable but they have a proven playbook of sourcing and integrating smaller assets and driving better returns through scale/cross-selling). As noted, DSGR has lots of low hanging fruit to cross sell and has demonstrated an ability to do so (identified 250 opportunities summing to $50M of revenue synergies)   

• Price taken in 2022 has been sticky and lead to margin accretion Again, this stickiness ties back to DSGR high touch VMI and the low cost to value proposition of an outsourced supply chain partner ensuring that assembly lines are not shut down as a result of a dollar part

• Although margins for FY22 will likely come in around 10.2-10.3% (down from 10.9% in 2020 and 10.5% in 2021), we have seen solid quarterly improvement from 1Q of this year (8.7%) as 2Q and 3Q run-rate margins were already at 10.7%. Guidance for the full year implies ~10.9% margins in 4Q

• Management is targeting 13.5% EBITDA margins in 5 years. Just last quarter, Lawson achieved 14% EBITDA margins and Gexpro 11.5%. While Hisco will be exiting 2024 at 10% and has a very similar cost structure at Gexpro/Lawson.  Best-in-class distributors like Fastenal and Grainger have EBITDA margins in the teens to 20% range so we do not view 13.5% as a heroic assumption.

• Current ROIC ~16% (in line with fully synergized acquisition multiples of 6.3x) with line of sight to 20% once sales force efficiency is worked out, Hisco is integrated and working capital normalizes 

Note that there is only one analyst with a 2025 target on BBG, displaying that the investor community has not woken up to the DSGR story. 

Looking at a 12/31/2027 exit we value the Company on $450M of NTM EBITDA at an 11.0x multiple for a total enterprise value of ~$4.95B, an equity value of $3.6B after deducting 3x leverage, and FDSO of ~47mm for a target price of ~$76.50 and an IRR of ~26%. 

As Bryan has said on previous calls: 

“We are constantly informed about the private value of our business and that a scarcity exists for exceptional specialty distributors with our size and line of sight around growth of revenue and earnings by strategic suitors as well as large private equity firms. It is not surprising the interest in DSG by those with the benefit of time as leading specialty distributors continue to be tremendous long-term compounding engines, which is why I have loved the space as much as I have for the last 30 years. 

And so much so that I don't want to sell this business prematurely that we have such tremendous line of sight on how to compound. If the marketplace offers an unnatural price with us generating strong cash earnings, the Board and I believe we should have the flexibility to buy back stock and think about ways to improve the value for the shareholders that want to continue to be partners with us on this journey.”

The idea here boils down to the fact this is a specialty distributor trading cheap at 10x EBITDA because of complexity. Specialty distributors have historically been compounding machines and LKCM are absolute killers in the space.  

Risks: 

TE lumpiness leads to margin/growth lumpiness  

Stock overhang from controlling shareholder owning 77%+ of shares out 

Hisco and other M&A integration more difficult than anticipated 

Catalyst

Catalysts: 

Successful Hisco integration will result in revenue synergies that should drive accelerated top-line growth while enabling deleveraging and margin improvement 

Street mismodeling value capture from Hisco/impact on overall platform and organic growth 

Wider investor awareness