Description

WD-40 Company (WDFC) - Short
$156.33/share

Summary: WD-40 is a low-growth business that trades at an extremely high valuation. While the company has a good legacy brand that is strong in its industry, the stock is simply materially overpriced. The current CEO and management team, after presiding over a period of failed acquisitions in the early 2000’s, improved performance somewhat by focusing on international expansion of the core WD-40 brand, driving modest ensuing growth. That said, recent results have been lackluster, at best. We believe WDFC is an attractive short based on its (1) very high valuation at 35x FY2019 P/E and 27x EBIT, (2) demonstrated low rate of sales growth, (3) potential exposure to decreased profitability in the face of shifting commodity prices, and (4) limited upside business potential.

Business Description

WD-40 produces the well-known lubricant sold in the blue and yellow can that is widely used both in the home and at construction sites. WD-40 is a well-known consumer brand, but the underlying product is a chemical compound used in manufacturing, repair work and construction jobs. Beginning in the 1990s, the company began to acquire other products, which now form the basis for its segments:

·         Maintenance Products (91% of 2018A sales): The flagship WD-40 multi-use product, and the “WD-40 Specialist” line of water-resistant silicone sprays make up the vast majority of this segment which also includes the brands WD-40 Bike, 3-in-One, and Blue Works

·         Homecare and Cleaning Products (9% of 2018A sales): No-name cleaning brands that have seen sales decline ~8% per annum since 2008. Brands include X-14 (liquid mildew stain removers); 2000 Flushes (automatic toilet bowl cleaners); Carpet Fresh (room and rug deodorizers); Spot Shot (aerosol carpet stain removers); 1001 (carpet and household cleaners); and Lava and Solvol (rug and room deodorizers and heavy duty hand cleaner products in bar soap and liquid form)

Generic competitors to the core WD-40 brand exist at lower price points. However, consumers tend to go with the trusted brand given the low purchase price of a can of WD-40. Management likely overstates somewhat the power of the brand equity, with grand language around the “positive lasting memories” consumers associate with the product. Nonetheless, it remains true that there are few credible competitors offering the same type of “multi-use product” with anywhere near WD-40’s brand recognition.

WD-40’s business model is very asset light, as it outsources all manufacturing (apart from mixing the concentrate formula). Annual capital expenditures ranges from 1-2% of sales. While the business is not very cyclical, it does maintain exposure to some industrial applications, meaning revenue could take a hit in an economic downturn.

Key Short Thesis Points

EITR210’s write-up from February 2017 provides a good overview of other aspects of the company’s history and competitive dynamics. We agree with much of the characterization of the situation. We would like to emphasize the following points around why we feel WD-40 is now a timely and attractive short.

Growth at WD-40 has slowed and is unlikely to re-accelerate.

A key piece of WD-40’s success over the past 15 years has been the expansion of WD-40’s business outside of the US. In 2006, 65% of WD-40’s sales came from the Americas segment – that percentage has decreased over time to 47%. Management’s strategy to expand WD-40’s global reach clearly makes sense, and we expect that international markets will continue to grow faster for them relative to the US. However, a significant portion of the easy wins have already been had internationally, leading to lower realized growth over the past five years. We expect this dynamic to continue on a go-forward basis.

WD-40 has released a very hard to reach set of long-term revenue targets that call for the company to grow to $700mm of sales by 2025:

Reaching $700mm of sales by 2025 would require the company to grow top line at a CAGR of 8%, higher than the company has grown any year since 2010. The segment-level assumptions necessary to justify this target show that it is quite a stretch. To reach $700m in revenue, the company projects a 2%-5% annual Americas segment revenue CAGR (vs. 1% over the past 5 years), an 8%-10% EMEA CAGR (vs. 2%), and a 10%-12% APAC CAGR (vs. 5%).

We anticipate that WD-40 will continue to grow at rates in-line with global GDP over time, well below the company’s stretch goals for 2025.

Pricing power for WD-40 is surprisingly limited and could lead to continued decreases in gross margin.

Over a long period of time, WD-40 has been able to offset the impact of increases to commodity prices (primarily petroleum-based specialty chemicals) by implementing price increases slightly in excess of the commodity impact. This dynamic, along with weak commodity prices from 2014-2016, has allowed the company to expand gross margins from 47% in 2008 to an all-time high of 56% in 2016. More recently, we have seen signs that WD-40 has pushed its pricing too far and will have a tougher time offsetting commodity increases in the future.

The company’s recent price hikes have hindered near-term sales volumes in the Americas, and additional price hikes are unlikely in 2019.  CEO Garry Ridge spoke to this issue on the conference call for Q2 2019, explaining why backlash to WD-40’s pricing actions by an important US customer caused them to miss on sales estimates (with sales flat y/y):

What happened is that when we went last year with our price rise, as you well know, customers don't always open their arms and welcome us gladly with a price rise. So they do what [a] great company should do, they try to do with the best they can for their end-user and good for them to do that. In one particular customer, they decided that they would help us understand more their discomfort with us doing a price rise, hoping that we would not do the price rise by suggesting that if we did rise our price that it would be unlikely that they would be as enthusiastic as they have been in the past around promoting our product for a period of time. One may call that punishment, but anyhow. So -- although, we weren't at anyway delisted from this customer, they decided that they were [not] going to engage in a normal level of promotion. So there was not as much of our product in their store.

Over the past two and a half years, WD-40’s gross margin progression has reversed, as the company has not been able to increase prices fast enough to offset increases in WTI and other related commodities:

Using the information management has provided on the gross margin impact of pricing, we have been able to estimate the blended annual price/input cost increases WDFC has experienced over time. Over the past two and a half years, WD-40 has had a much more difficult time than usual increasing price to offset commodity price inflation:

While it is difficult to quantify exactly what the impact of the price/input cost dynamic will be going forward, the weakness the business has shown more recently gives us more confidence that gross margins are unlikely to expand meaningfully beyond 55%. This removes a substantial piece of the historical level of profit growth WDFC has enjoyed for the past decade.

There is very limited risk from M&A or other strategic actions the company could take.

Over the past several years, WD-40 has spent 100% of its FCF on dividends and buybacks, in roughly 50/50 proportions. In our view, the company will likely continue buybacks no matter the market conditions/stock price.

WD-40 spent ~$130mm on acquisitions from 1999-2004 with little to show for it – some of what they acquired now forms the terminally-declining Homecare and Cleaning products segment. Apart from a ~$4mm acquisition of GT85 (UK-based bike maintenance product), the company has done no M&A since 2004. They may do future M&A, but it is likely to be more tuck-in in nature (not needle-moving).

Management does not see Homecare and Cleaning as a core product segment, and they would likely be a seller if they were able get the right multiple for this segment. However, the segment is small, declining, and poorly positioned competitively, so it is unlikely that proceeds from any deal would be meaningful.

In our view, it would be difficult for WD-40 to engineer a sale of the full company. There is not likely significant opportunity to cut costs, and the stock’s high valuation is likely enough to ward off potential acquirors.

Valuation/Financials

WD-40 currently trades at 35x FY2019 P/E and a 2% FCF yield. This is a very high valuation for a company that is likely to grow sales in the very low-single digits and EPS mid-single digits annually. Shorting WDFC could prove very attractive if growth continues to slow, the company faces operational difficulties related to pricing or commodity price inputs, or if industry competition emerges in a meaningful way. And should the business performance suffer, even temporarily, we will likely make good money on our short as the multiple may contract significantly and quickly.

Notably, NTM P/E and TEV/EBITDA multiples for WDFC are near all-time highs:

Risks

·         Smart capital allocation or M&A. This risk is somewhat limited given management’s stated philosophy on M&A.

·         More aggressive approach on pricing or expense management. It is possible that WD-40 could be run more aggressively, either in terms of taking price or managing headcount. Reported results from recent years suggest that the opposite is more likely, but it is necessary to monitor whether there is any change of management tone or philosophy. It is also worth noting that CEO Garry Ridge and his key lieutenants are unlikely to retire in the near future.

·         Significant decline in WDFC’s commodity input costs. WD-40 has benefitted from past periods of commodity price deflation, and likely would going forward.

Catalyst

Catalysts

·         Input cost pressure

·         Intensifying competition

·         Continued declines in sales growth