Description

Woodward (WWD) is a compelling bottoms up investment in Aerospace.  I previously wrote up Boeing (BA) in November 2016 and continue to like BA despite its significant run.  Like BA back in Nov 2016, market is too overly focused on the short-term and missing the obvious value that lies ahead, which isn’t all that far away.  In short, I see 37% upside to year-end and a near double within 3 years, with the story staying strong even beyond that time frame.  The upside is primarily driven by significantly increased content on the new planes vs. the old planes which is allowing WWD to grow significantly faster than overall production.  The longer-term story transitions from OE to aftermarket as installed base doubles from 2017 to 2022.  There are also a number of other ways to win on top of the organic growth story. 

At a $4.5bn cap and coverage by only one large bank, WWD is a relatively under the radar stock.  It has never been written up previously on VIC.   Recently, the stock has gained more visibility as the WSJ in February noted that BA was looking to buy WWD, which WWD immediately denied. 

Note that the fiscal year is September end, and I make reference to both FY and CY numbers below. 

Background

Woodward supplies components to civil aerospace, defense aerospace, power generation and engine markets.  Its Aerospace segment contributes approximately 75% of segment EBIT and is the growth driver.  Key customers include the military and civil OEMs, the Engine OEMs and Tier 1 suppliers including UTX.  Key competitors include Eaton, Honeywell, Parker Hannifin and UTX.  Its key products include Propulsion Systems (Fuel, oil and air mgmt., engine actuation, fuel injection), Flight Deck Control including throttles and flap levers and other Actuation systems including hydraulics and sensors.  These are highly engineered products that go through rigorous certification requirements not only by the OEMs, but also by regulatory authorities to meet safety regulations.  Woodward invests significantly in R&D (6% of total sales mainly going to Aero segment).  As an example of WWD’s technology, in 2016, WWD received $250mm from GE to set up a JV to supply fuel engine management systems to its large engines like the new GE9x where they still retained a 50% share of the earnings.  Given the few number of OE units built globally and limited competitive set, WWD is often sole sourced or dual sourced on their products.  Aftermarket is 41% of revenues. 

In its Industrial segment, which I model generally flat, WWD provides components into large gas turbines (GE/Siemens), reciprocating engines (CAT/Cummins) and renewables (Wind turbines).  Their products help control flow (fuel, gas systems), motion (actuation), combustion (fuel injection) and systems.  EBIT in this segment has fallen 34% from 2014 peak and is expected to marginally improve over time, primarily due to cost savings.  WWD’s guidance fully incorporates GE’s dismal guidance on the large gas turbine business.  Checks indicate some risk in the reciprocating engine business particularly with Weichai as Weichai may go direct to Bosch and displace WWD as a supplier; however, the recent China IV control system win starting in 2020 alleviates some of those concerns.  Overall, Industrial segment is clearly at a trough in FY9/18, though I model tepid revenue growth and management missing the 14-16% margin target for FY19 (13.5% marign) as no clear signs on when trends improve off the bottom. 

Story

WWD is well-positioned in the Aerospace industry.  First, WWD has substantially more content on the new planes and engines.  For example, WWD has $275k content on the 737MAX vs. $125k on the 737NG, $230k on a 320NEO vs. $80k on the 320CEO and $430k on the 777x vs. $285k on the 777.  As Boeing and Airbus transition to the new models, WWD’s civil aerospace growth will substantially outperform overall production.  WWD went through a capex cycle from 2013 to 2016 and will have limited further capital needs to execute this growth; PP&E rose to $922mm over 4 years by FY17 from just $350mm in FY13.  The military business will benefit from strong content on F-35 and KC-46 as those programs ramp. 

Second, WWD is strategically positioned as a high value supplier (20% Aerospace margin, high R&D content, high barriers to entry, often sole sourced) in niche product areas (within the engine, flight deck controls and actuation).  As the Aerospace industry continues to consolidate, a larger Tier I may look to add WWD’s capabilities and leverage overhead to generate synergies.  There’s a potential $1bn value opportunity in cutting half of WWD’s SG&A (12x multiple on half of WWD’s $177mm SG&A load.  WWD can also leverage their strategic products to form JVs, like the one they formed with GE on engine fuel systems.  BA has openly discussed having a stronger internal actuation capability and WWD could be a natural JV partner.  Given its high value position, growth runway, and synergy potential, an activist can get involved here to try to push for a sale process, particularly given the stock movement around the BA rumors.  On the other hand, WWD itself can be a consolidator with significant FCF and balance sheet capacity, which would be accretive to earnings.  WWD is levered only at 1.5x trailing net debt/EBITDA, which will decline significantly as FCF accelerates and EBITDA declines.  I model 100% of FCF going to dividend or buyback, but even then, Net Debt/EBITDA declines to 1.1x by FY20 with growth in EBITDA.  For example, it’s possible UTX/COL merger may require some assets to be sold.  In either scenario, there is significant strategic optionality, particularly with Aerospace getting close to 80% of EBIT and more in value. 

Third, WWD benefits from a razor/razor blade approach (59% OE and 41% aftermarket in Aerospace segment).  While many OEM-exposed suppliers will benefit from the ramp, WWD will have strong growth beyond the current multi-year ramp as its installed base of commercial components will double over 5 years, which makes the story as good 5 years from now that it is today, which should allow WWD to sustain a high multiple. 

On an organic basis, the company will be able to compound EPS around 20% a year on average through organic sales growth, high operating leverage and capital allocation.  Sales growth is primarily driven by increased share on new-gen platforms as well as production rate increases. 

ROIC is improving as the company grows into the previous capital spent to prepare for the new plane production ramp.  I estimate ROIC approaching high teens compared to managements 15% target.  Normalized incremental margins are high at 50%, but I am modeling 35% as management has cautioned against using the full 50% as they may invest upside in further growth.

Upside

Valuation is compelling for its growth at 14x CY19 FCF, estimated around $5/share.  On 12-month forward EPS, stock is trading at a small premium to its 7-year history despite very high visibility into growth.  P/E is in line with 5-year history on my numbers.  Earnings accelerate into FY19 and FY20, so stock is much cheaper on outer year numbers relative to comparable companies.  While many may view this story or valuation as growth name, I view it as value or fairer yet, GARP, as the “growth” is locked in.  The capital is already in the ground and the contracts are awarded, but they are just not producing much in earnings on a FY9/18 basis.  The capital and cash flow simply mature when 737MAX, 320NEO and F-35 production hit normalized production rates.  Both OE and aftermarket growth is visible and so I expect the company to sustain a high multiple in the future, which is further justified by comparable multiples over 20x in the space.  Further, there are a number of strategic levers to release further value (take-out for obvious overhead synergies, use of balance sheet for accretive M&A or JV with BA).    

Valuation has had a short-term dislocation due to an earnings miss in FY1Q18 where street expectations were simply too elevated; the miss has no impact to my valuation or FY18 earnings/guidance/growth trajectory.  Given potential takeout optionality, strong FCF ($220mm in 2018, $300mm in 2019), strong balance sheet, I estimate low downside at current levels.  There is substantial upside if company returns to 20x+ multiple that it had before the earnings miss (further supported by improved comparable valuations in Aerospace and Defense given moves in BA, LMT, UTX, GD, etc. which are justified by strong outlook for civil aerospace production and defense spending) combined with earnings rolling to FY19 where I estimate EPS growth of 30%.  Valuation has further strategic levers (take-out target, balance sheet deployment, and BA JV potential). 

At 20x CY19 EPS, I estimate stock is worth $95 or upside of 37% by year-end.  Note, I’m at $4.52 EPS for FY9/19 vs. street at $4.11.  At 20x CY21 EPS, I estimate stock is worth $136 or nearly 100% over 3 years.  If the company is able to deploy its balance sheet (even with 100% FCF going to buyback stock in my model, I get company delevering to 1.1x EBITDA), there could be further upside. 

Catalyst

Potential take-out; accretive M&A; JV with BA