Description

Short Thesis

WD-40 is a very good business with strong competitive advantages.  The company’s Multi-Use Product is a staple in American households and is very unlikely to be replaced by even a much cheaper product.  The company has stable and growing earnings, a great balance sheet and has paid a dividend since at least 1977.  It also uses free cash flow to repurchase stock.  WD-40 is a company any value investor would love to own at 8x EBIT.  However, these characteristics have caused yield-seekers in search of quality businesses to bid up the stock to absurd levels.  In the 21-year period ended 12/31/2011, WD-40 returned 9.9% annually including dividends.  Since then the annualized return is a whopping 24%.  

While WDFC’s financials show solid historical growth that one could argue support the current valuation, this growth has been largely due to aggressive pricing actions combined with significantly lower input costs.  WDFC will experience input cost pressures in coming quarters that are unlikely to be offset by further price hikes, which will pressure earnings and likely result in margins well below current guidance and consensus estimates.  I expect the stock to trade down to the high-end of historical multiples, which would result in the shares changing hands at $75 per share.  While reaching this valuation would only result in a 32% gain on the short position (offset by the $1.96 per share dividend), we believe shorting WDFC is a lower risk way to bet against yield seeking while retaining exposure to a potential short-term catalyst.  A buyout is unlikely to occur at significantly higher multiples, and the lack of financial leverage lessens the risk of the stock trading significantly higher in the near term.

Company Description

WD-40 sells maintenance and household products in more than 176 countries around the world.  It is best known for its WD-40 Multi-Use Product (MUP), which was the company’s only product for more than 40 years.  The firm now sells other products, but WD-40 MUP still accounted for 77% ($291 million) of the firm’s sales in 2015.  The WD-40 MUP formula is not patented.  It is a closely-kept secret like the Coca-Cola mixture.  The formula has remained essentially the same since its invention.  Most WD-40 innovations have involved the delivery method, including a permanently attached straw (now included on most standard-sized cans in developed markets), wide spray nozzle, and the latest EZ-REACH bendable straw.  Consumers have found thousands of uses for the product beyond just oiling the squeaky hinge.  Its usefulness around the house is often compared to duct tape – “If it moves and shouldn’t, use duct tape.  If it doesn’t move and should, use WD-40.”  The product has significant brand equity in the U.S, and to a lesser extent in other countries.  The company estimates that a can is found in 80% of U.S. households.  

In 1995 the company expanded the product line via the acquisition of 3-IN-ONE oil from Reckitt & Coleman.  WD-40 continued to be involved in M&A into the early 2000s with the purchases of several household brands.  These brands consist of X-14, 2000 Flushes, Carpet Fresh, Spot Shot, 1001, and Lava.  The company has been evaluating strategic alternatives for the household products business since 2013, and has operated the brands as cash cows with minimal investment.  The consolidation of customers has pressured household sales, which have declined from $96 million in 2006 to just $41 million in the fiscal year ended August 31, 2016.  Household products accounted for 12% of total sales in fiscal 2015.

WD-40 expanded the maintenance product line in 2011 and 2012 through the creation of WD-40 Specialist and WD-40 Bike.  The WD-40 Specialist line consists of maintenance chemicals with more specific purposes than the original WD-40, such as lubricants, degreasers, and penetrants.  The Specialist products were introduced to expand WD-40s offerings to professionals and more experienced DIYers who would typically not use WD-40 Multi-Use Product outside of routine tasks.  This space had been mostly filled by Blaster, Liquid Wrench, and off-brand products.  Specialist products are being sold through the same distribution channels as WD-40 MUP.  Specialist products contributed just 5% of sales in 2015 ($19 million), according to the investor presentation, but management is focused on growing the product line.  Note that the product lines presented here do not add up to 100% (MUP: 77%; household: 12%; Specialist: 5%).  It isn’t clear what the remaining 6% consists of, but it’s probably 3-IN-ONE, GT85 (a recently acquired bike product), and the WD-40 Bike product line.  WD-40 Bike products consist of chain lubes, degreasers, and bike wash for avid cyclists.  The line was launched in 2013 in the U.S. and has expanded to Europe and Asia.

Most of the company’s products are sold worldwide.  The firm has three operating segments based on geographical presence: Americas (U.S., Canada, and Latin America), EMEA (Europe, Middle East and Africa), and Asia-Pacific (China, Australia, and other).  The firm breaks down sales within each segment into maintenance products and homecare/cleaning products.  More than 75% of last year’s sales were generated in Americas and EMEA maintenance products.

Business Analysis

If a conservative analyst were to value WD-40 a decade ago, he probably would have pegged the sales growth quite accurately.  The company’s ten-year annualized sales growth rate is just 2.9%.  The 15-year CAGR appears much better at 5.8%, but this period commences just prior to the $72 million acquisition of Global Household Brands (X-14, Carpet Fresh, 2000 Flushes).  Household products have shrunk meaningfully over the years and will eventually be sold or discontinued.  Solid growth in maintenance products has been overshadowed by household, as shown in the chart below.  

The table below shows the annualized sales growth of maintenance products in each segment (excluding Q117).  The longest period is 14 years because 2002 was the first year the company broke out each product line by segment.  Growth is impressive in the longer-term at above 6%, but has trailed off recently.  Management has expanded distribution internationally, which is evident by the higher than average growth rates over longer periods.  Americas has also grown nicely, but the pace has been slower as the U.S. is the predominant contributor to the segment, which has been a mature market for many years.  The table does not depict the fact that WD-40 has been a huge beneficiary of higher commodity prices via its strong pricing power.  In fact, we believe a significant portion of the growth presented below is due to pricing.  This is important because future growth via pricing is likely to be much more limited due to the significant decline in commodity prices over the last two years and the large price gap between WD-40 and competing products.  The gap between selling prices and input costs has also benefited gross margins meaningfully, which are currently at the highest level in 15 years (since promotional spend accounting was changed).

In 2009, Wired Magazine had WD-40 analyzed via gas chromatography and mass spectroscopy.  They discovered that most of the can is simply mineral oil.  The remainder is a bunch of various alkanes and CO2.  Very little of the product’s cost is related to manufacturing.  In 2015, only 12% of a can’s cost was related to manufacturing fees.  COGS is highly exposed to raw material costs, with petroleum-based chemicals and the can itself each accounting for roughly one-third of a typical WD-40 MUP can.  Plastic represents another 20% of a can’s total cost.  The company claims that only a small portion of the specialty petroleum-based inputs are correlated with the price of oil, but this isn’t entirely accurate.  Some of the specialty inputs lag the price of oil.  The plastic components are also correlated with oil prices, but again are not immediately impacted by oil price volatility.  Aerosol cans are made of steel and tinplate, and at times have been an even larger headwind than oil.  Similar to petroleum-based inputs, can prices lag changes in steel and tinplate prices.  Can costs typically take the longest time to adjust as the prices are negotiated annually in January, but it is possible more frequent adjustments are made if metal prices are particularly volatile.  

Oil and steel prices began to rise meaningfully in the early 2000s and continued almost unabated until the credit crisis.  Starting in 2004, WD-40 took pricing in almost every year through 2009.  For years, analysts have been trying (mostly unsuccessfully), to get management to disclose quarterly or even annual price and volume changes.  On a few occasions they have disclosed the magnitude of a recent price increase for WD-40, but for the most part analysts are left to guess the impact of such price increases on sales.  The company has provided the gross margin impact due solely to pricing actions on a quarterly basis.  We reconstructed the contribution of pricing to total sales.  It isn’t possible to accurately pinpoint pricing actions for WD-40 because the company at times raised prices only for specific geographies and also for other products, including 3-IN-ONE oil and household products, but we can guesstimate.  Management disclosed in Q106 and Q109 that it had raised wholesale prices of WD-40 by 7% and 10-11%, respectively.  Judging by the subsequent margin disclosures, we estimate high-single-digit pricing actions were taken in 2005, 2006, 2008, and 2009.  

In the later 2000s, sales also benefited from the conversion of all standard-sized U.S. WD-40 containers to a new delivery system called Smart Straw, where the little red straw is a permanent part of the spraying system and folds away if necessary.  The wholesale and retail prices of Smart Straw cans were 30% higher than the old can.  The impact on sales is apparent in Q207 and Q307, when U.S. WD-40 sales rose 25% and 14%.  The Smart Straw rollout was completed in the U.S. in 2008.  Despite high-single-digit price increases in both early 2008 and 2009, combined with the benefit of Smart Straw, U.S. WD-40 sales declined 3% in 2008 and rose just 4% in 2009.  We are not surprised the company would experience significant volume pressure during an economic downturn.  Management has said on numerous occasions that its products are impulse buys, which is why you see WD-40 displays in several areas of a typical hardware store.  In order for a user to engage in an impulse buy, he or she must of course make a trip to the store.  Additionally, sales to trade professionals and industrial workers undoubtedly slowed during this period, but the extent is unknowable.  We suspect worldwide maintenance product volumes were quite a bit lower in 2008 and 2009, and probably grew in the low to mid-single digits in the years preceding the recession.  This helps frame how growth might trend in the future when pricing may not be a viable strategy.  

WDFC did not take pricing after Q109 and Q209, at least not at a material level like it had done since 2004.  The 2009 pricing actions rolled off as 2010 progressed, and WDFC experienced strong sales growth as the credit crisis subsided and volumes rebounded.  U.S. WD-40 growth was 13% in fiscal 2010, and maintenance product volumes increased similarly in all geographies.  Sales benefited in the early 2010s from the expansion of the Smart Straw to other geographies.  Input costs rebounded and rose significantly beginning in 2011, and the company was able to take pricing again in mid-2011, 2012, and 2013 to offset higher costs.  Despite oil rising from $20 early in the 2000s to well over $100 for a sustained period, and aerosol can prices at least doubling, WDFC was able to support flat gross margins at around 50%.  This clearly speaks volumes to the strength of the brand, but it also masks a period of weaker volumes, disguises the business as abnormally recession resistant, skews longer-term annualized growth figures, and led to the abnormal expansion of gross margins that occurred when commodity prices collapsed.  

Sales growth has been lackluster for the last few years in the absence of pricing actions.  This performance is despite the introduction of WD-40 Specialist and Bike product lines and the new EZ-REACH delivery system, as well as continued expansion of Smart Straw to international markets.  Foreign exchange rates have been a headwind, but maintenance product growth has likely still been below historical levels.  We visited local Home Depot stores to check out the pricing and competing products.  The standard eight ounce can is the dominant product in terms of shelf space, but it appears Home Depot is pricing the product below where it might have a few years ago.  Perhaps this is the beginning of pricing pressure.  WDFC has discussed retail pricing on conference calls in the past.  In 2008, it stated that Smart Straw cans sold for about $4.30 per can.  Home Depot is selling cans for $3.97 currently.  Blaster makes a competing multi-purpose product that sells for $1.97, which we don’t recall existing until recently.  Blaster is well known among DIYers for its PB Blaster penetrating spray.  It’s possible the wide price gap is causing some consumers to purchase the Blaster product instead.

Management is looking to the WD-40 Specialist line to drive sales growth.  The product line grew 14% in FY16, but the business is still quite small at just $21.5 million in sales last year.  Management’s stretch goal is $125 million in sales by 2025.  In our opinion, WDFC is going to have a difficult time translating the WD-40 brand name into other products.  The foundation for this belief is that the professionals these products are aimed at are not as impressionable as the typical consumer.  Professionals seek products that work at competitive prices.  Pricing and effectiveness are more important than brand to the professional user due to much more frequent usage.  Additionally, WD-40 is not creating the market; it will have to take share from established competitors.  There is precedent here.  The company introduced an industrial line of products in late 2009 called Blue Works.  It was marketed to professional users and not sold in retail stores.  While management seemed to be happy with the initial response, the product line never got traction and was effectively shut down in 2013.  Management claims Blue Works became the Specialist line.  At Home Depot, shelf space is shared almost evenly with Blaster specialist products.  Inventory checks on Home Depot’s website shows roughly the same number of cans in stock of various Blaster and WD-40 products.  WD-40’s products were generally priced about 50% higher than Blaster products.  

Financial Performance

WD-40’s gross margins are on the higher end of the larger branded household products businesses like P&G, Clorox, Energizer, and Coty, which range from 45%-60%.   Management has done an admiral job improving the company’s margin profile over the last few years via operating efficiencies, but lower input prices, combined with pricing actions taken since 2004, are the primary reason gross margins have improved from 49% to 56% in the last five years.  WDFC appears to have been able to sustain the pricing actions, even as input costs have sunk.  Gross margins were last at this level in 2002 and prior, but these levels do not reflect the change in accounting that was implemented in 2002.  The company was forced to change the way it accounts for promotions, which reduced gross margins by roughly 300-500 basis points in the early 2000s. WD-40’s current gross margins are essentially around 500 basis points higher than the highest levels achieved in the last 20 years.  Input costs take 90-120 days to be reflected in earnings, so WDFC’s financials probably reflect the maximum benefit.  

We believe WD-40’s gross margins will compress back to historical levels.  This will be the result of higher commodity prices or pressure from customers to reduce prices and/or increase promotional spending (effectively a price reduction).  The bargaining power of retailers has increased over the last decade.  Contrary to what investors might believe, there are several competitors that charge significantly less than WD-40.  While WD-40 deserves to sell for a premium price, the price gap cannot widen infinitely.  If commodity prices return to the levels seen three years ago, we do not believe the company will be able to pass through its input costs.  In addition to higher oil prices, the company will likely experience higher aerosol can prices.  One of the world’s leading can suppliers is Ball Corp (BLL), which just merged with another leader, Rexam.  Now that Ball/Rexam commands a massive market share, it has pledged to price its products for profit rather than volume.  The lack of ability to increase prices will limit WD-40’s top line growth to the low-single-digits AND pressure margins.  The current valuation is simply not sustainable based on normalized sales growth and margin assumptions.

Operating expenses are significant as they are with other household consumables businesses.  WD-40 spent 36% of sales in 2016 on what it refers to as “cost of doing business.”  When the company last provided a breakdown of the costs of doing business in January, about half was related to personnel expenses.  Freight accounts for about 10%, advertising and promotions about 17%, and other costs 25%.  D&A is limited as third parties manufacture most of the firm’s products.  Operating margins have fluctuated in the mid-to-high teens for the last 15 years, and last year were at the highest level since 2003 at 19.5%.  

The rest of the P&L is simple.  The company pays $1-2 million on its revolver.  It has had a bit over $100 million drawn for the last few quarters.  This is partially offset by interest income earned on cash and investments.  The company’s tax rate was 28% last year, and has slowly declined over the last few years as growth has been stronger in jurisdictions with lower taxes.  Cash flows from operations, excluding working capital changes, have historically mirrored net income fairly closely.  The only material differences are related to stock compensation and D&A.  In 2016, WD-40 earned $52.6 million in net income and generated $60.6 million in cash flow from operations.  Working capital was a small source of cash last year, but historically has been fairly lumpy.  Changes in working capital can significantly impact CFO due to raw material volatility and capital required for growth/new products.  Capital spending is generally 1-2% of sales, and in 2016 was at the low end at 1.1%.  WDFC generated record free cash flow in FY16 that topped the previous high in 2010, which benefited from a large working capital release.  Free cash flow to equity was $56.3 million last year, up from $49.3 million in 2015.  WDFC’s free cash flow yield is 2.8% using 2016 FCF (TTM capex is elevated due to new headquarters).

WD-40 has very low capital requirements.  It uses third-parties to manufacture almost all of its products.  It has spent only $25.7 million on capex in the current decade (through FY16).  Excess cash is used almost exclusively to pay dividends and buy back stock.  The company has paid a dividend since at least 1977, which is when Bloomberg begins reporting dividends.  Up to 2001, the firm’s payout ratio was nearly 100% of net income.  It was cut from $1.28 per share to $0.80 per share to free up cash to finance the acquisitions of various household brands.  The dividend was increased on a few occasions in the 2000s up to $1 per share.  Since 2010 the company has regularly increased the dividend to its current $1.96 per share.  The actual dividend payout has grown in the mid- to high-single-digits, and this has been magnified by the share repurchases.  The most recent annualized dividend equates to 12.2% growth over the prior year.  Even with the dividend growth, the share price has so massively outpaced the company’s earnings that the yield is only 1.6%.  We aren’t thrilled about eating the payment in order to short the company, but the yield is quite low now, and we much prefer high-priced buybacks to the 100% payout ratio.  

Why is WD-40 a Good Short?

WD-40 is a very good business.  It has a very strong brand that has been around for decades and is highly identifiable by Americans as the representative product of its category.  WD-40 is in the company of Kleenex, Band-Aid, and Neosporin.  WD-40 generates high returns on capital.  It has grown sales and earnings at a decent clip for many years.  It appears to be recession resistant and operationally stable.  It has a good balance sheet.  It pays a dividend and buys back shares with excess cash.  It has not been overly acquisitive.  The company’s corporate presentation includes a Buffett quote!  Bruce Greenwald even wrote an entire chapter on WD-40 in his 2001 book “Value Investing: From Graham to Buffett and Beyond.”  Greenwald describes the value of the franchise by analyzing how a competitor might try to take market share by offering a similar product for a lower price.  He argues that a competitor would have a very difficult time getting customers to switch to another brand simply by pricing the competing product at a slight discount.  A can of WD-40 is so cheap that customers probably aren’t willing to switch to save 30 cents and run the risk that the product doesn’t work as well.  He concludes that this gives WD-40 pricing power.  We agree.  The company has clearly demonstrated its pricing power (which we believe is not sustainable).  Greenwald concludes the chapter with his own valuation of WD-40.  He valued the stock at $25.60.   

WD-40 is a company that any value investor would be thrilled to own at the right price.  However, these characteristics have led to the short opportunity.  We believe investors are reaching for yield in quality businesses because they are afraid they will get burned in the alternatives, say a high-yield bond or long-dated investment grade corporate.  Income producing companies, such as REITs, are trading at ridiculous levels.  While the sector likely has many short opportunities, we prefer WD-40 because it is easier to value.  The debt levels of most U.S. REITs introduce additional risks to a short position.  WD-40 is a solid short in a period where short sellers have had their faces ripped off, with the potential catalyst of weaker than expected margins.

WD-40 is trading at record high valuations based on almost any metric.  Cash flows tend to be volatile due to working capital, so EV/EBITDA and EV/EBIT are the most useful multiples.  Bloomberg has quarterly financials on WD-40 going back more than 25 years to 1990.  The financials appear fairly clean.  The company has not had any material divestitures.  The only material events were the discontinuance of goodwill amortization and the change in accounting for promotions in 2002.  The EV/EBIT chart below uses trailing-twelve-month EBIT starting with fiscal year 1990.  From 1990 to 2013, WD-40’s stock traded at a median EV/EBIT multiple of 11.6x, with a range of about 8x to 15x.  Since mid-2013 the multiple has increased from 14x to over 22x, while operating income has compounded at only about 4% annually.

WD-40 reported earnings last month (we were short before the report).  Despite results that missed, with every primary metric coming in below consensus expectation (admittedly only three EPS estimates), the firm reiterated guidance for fiscal 2017.  The stock had run up considerably since the election, nearly regaining the all-time high of $122, but sold off considerably after the report.  The results were not horrible, but the lofty stock price simply could not support anything less than perfection.  Management expects sales to grow 4-6% and gross margins to slip slightly to 56%.  This margin level is above management’s long-term stretch goal of 55%.  As discussed, we think WD-40 will have trouble maintaining this margin profile.  We believe earnings growth will be more difficult to come by in future years.  If so, the company simply should not be valued at current multiples.  We believe a 15x EBIT multiple is a reasonable target.  This is in line with historical peaks and makes sense with realistic inputs in a justified EBIT multiple model (8% cost of capital, 4% growth).  Using 2016’s $72 million in operating income (2017 will be close if guidance is hit) results in an enterprise value of $1.08 billion.  The current EV is $1.6 billion.  The shares would trade at $75 if the multiple hit 15x.  Bumping the growth rate up to 5% results in an 18x justified multiple, which would put the shares at $90.  There would be considerably more downside if earnings become pressured by commodity input costs.  

There are multiple ways to win shorting WD-40.  A broad market selloff would result in multiple repricing, probably falling well below the average multiple and potentially reaching the historic trough around 8x.  This would likely occur in conjunction with an economic downturn, and would result in the largest potential gain on the short.  A standard repricing of the multiple back to even historical peak levels would be a solid win for the shorts.  We think this is outcome is likely regardless of what the broader markets do.  

Risks

One of the primary risks, particularly in the current period of super-low borrowing costs, is a buyout at a significantly higher price.  This does not concern us.  We believe the lofty multiple and mature nature of the business would make it difficult to justify a buyout much higher than the current stock price.  Nearly all strategic buyers are trading at multiples well below WD-40, and the IRR on an LBO would not be attractive enough to command a much higher price.  The biggest risks to shorting WD-40 are probably company-specific.  The shares would likely trade higher if management returned to a near-100% payout ratio.  Acquirers have also been rewarded in the current market.  While the company has not completed significant deals recently, M&A remains a part of the strategy.  However, we don’t believe these events would be devastating to the shorts.  

In our opinion, the biggest risk to short sellers is that the stock never reprices to historical levels, combined with steady progress towards management’s 2025 stretch goals.  Management is striving to more than double Multi-Use Product sales to $600 million and grow WD-40 Specialist sales to $125 million.  Additionally, its profitability goal is 55% gross margins, 30% cost of doing business, and 25% EBITDA margins.  It has already achieved the 55% goal due to the drop in input costs.  It expects to bring the cost of doing business down to 30% in the next five years by growing sales.  While we believe such growth is unlikely (MUP sales only grew 50% over the last ten years even with significant pricing actions), modeling in the assumptions results in an enterprise value above $2 billion.  This would increase as time passes assuming the terminal date stays fixed.  We are comfortable enough with the risk-reward trade-off to recommend the short.  

RECOMMENDATION: SHORT 

Catalyst

- Input cost pressure

- Inability to take price

- margin compression