TRG | The Bottom Line – 4/18

As the DataTrek team reminded readers in this week’s newsletter, “Volatile capital markets like now remind us of Leo Tolstoy’s opening line in Anna Karenina: “ All happy families are alike; each unhappy family is unhappy in its own way.” Volatile markets have been a challenge for investors and companies alike. But could there be any winners in this uncertain environment? If inflation is here for many years, which TRG continues to maintain that it will, who in the construction and industrial work could be a relative winner? Drawing a loose analogy from the market makers of the finance world to the market makers of the industrial world (a.k.a. the distributors), market makers in these volatile times could outperform. TRG’s noted in our note this week, Assessing Distributors in Today’s Environment, bank earnings say it all (CNBC headlines): 1) JPMorgan Chase on Friday reported results that topped estimates on higher-than-expected revenue, helped by booming equity trading activity; 2) Morgan Stanley tops quarterly estimates as equity trading revenue surges 45%; 3) Goldman Sachs tops estimates on boom in equities trading revenue; 4) Citigroup results exceed analysts’ estimates on gains in fixed income and equities trading. Ultimately, we view distributors better positioned relative to manufacturers in today’s uncertain tariff and pricing environment based on historical performance, margin estimates, inventory arbitrage opportunities, and direct impact of price increases. Distributors as a group saw an average margin expansion of 340 bps in 2021 (240 bps excluding outlier) due to the tandem effect of strong end market demand and price increases. The margin expansion was ~100-200 bps higher than a group of manufacturers who also saw similar market tailwinds. Tariffs would likely see the benefit of higher pricing (good for distributors) at the expense of reduced demand (bad for everyone). If pricing is a bigger contributor than reduced demand is an inhibitor, then we see upside to distributor margins relative to consensus and relative to manufacturer estimates. TRG remains focused on asset-light, high cash flow business models as superior investments in the wake of COVID, and distributors clearly check these boxes. With that in mind, we also view the typical distributor characteristics of asset light model, FCF generation, inventory purchasing arbitrage, and ability to execute bolt on M&A through a down cycle as incremental positives to the group especially in the current volatile cycle with the outlook growing more unclear.