WD-40: A Wonderful Small-Cap Trading At A Steep Overvaluation

seekingalpha11-20 16:35

WD-40 Company is a highly profitable small-cap business with a strong brand image, providing a narrow economic moat and pricing power.Management's strategic execution and cost control have expanded ...

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Nariman Safarov  Investment Thesis The WD-40 Company (NASDAQ:WDFC) is a superbly profitable and successful small-cap business. A robust brand image as a household name in the multipurpose sprays sector provides the firm with a narrow economic moat. This allows for pricing power and the ability to realise outstanding earnings from what is ultimately a simple business. The management team continues to apply diligent cost control to operations and has expanded the gross and operating margins successfully in 2024. Indeed, the full-year results were a success for the firm, with revenues and returns increasing at the company. Perhaps my only concern with the business comes from their premium valuation. A DCF calculation reveals that the stock may be up to 24% overvalued, which limits upside potential should there be any slowdown in earnings. As a result, I rate the firm a Hold at present time and welcome you to read my in-depth analysis into the workings of this otherwise wonderful business. Business Overview & Economic Moat WD-40 Company is an interesting small-cap business. The firm is best known for their WD-40 line of core maintenance products and sprays, which make-up approximately 95% of their entire sales profile. The firm also has a select offering of Homecare and Cleaning products which are targeted at specific market niches and geographic regions. WD-40 themselves maintains that their Maintenance Products segment is the core focus of the business, and that they are open to selling the homecare and cleaning portfolio. WDFC FY24 Earnings Presentation While most people know WD-40 as an all-purpose degreasing spray, the company has developed a host of specialty products under the WD-40 banner, ranging from chain oils to dry lube and even penetrating fluids. WDFC FY24 Earnings Presentation By expanding the range of specialty maintenance products, WD-40 is able to target more customers and more accurately fill the needs with particular niches. In turn, the firm is able to retain more pricing power for these special products, which allows the company to generate greater returns and have a larger margin on sales. A stellar brand reputation combined with massive market awareness generates real moatiness for WDFC’s operations, as it would be (and actively is) incredibly difficult for competitors to garner an equivalent brand image. WD-40’s status as a true household name provides the firm with an unrivalled degree of pricing power for their product, as consumers are willing to pay more for a product that they know works. However, given the overall homogenous nature of degreaser and lubricants (except of course for the aforementioned brand reputation), I do not think WDFC would hold any manufacturing price advantage especially compared to companies that produce their products in cheaper regions than say the United States. Therefore, I assign a narrow economic moat to WDFC’s operations and believe the key to their outstanding ROIC and ROA lies in the powerful brand image the firm has both curated and been able to maintain. While WD-40 may not be a particularly universal range of products, I believe their dominance in their respective market niche is a beautiful representation of the earnings power even a small yet stellar franchise can provide a company. I also highly rate the management team at WDFC, with Steve Brass continuing to lead the organisation as CEO. Brass has been with the firm since 1991 and has managed WDFC through a period of superb growth, brand maintenance and strategic execution. Hearing the entire management team speak on earnings calls is a refreshing change compared to the often monotonous and tediously corporate jargon present in the meetings of some corporations. Indeed, it is their transparency surrounding both the organisation’s pathways to growth and any current challenges that pleases me most. Fiscal Analysis The WD-40 Company appears to be a very profitable firm, capable of generating significant value from their operations. Five-year average ROA, ROE and ROIC currently rest around 16%, 36% and 22%, respectively. Comparing the ROIC to their current estimated WACC of approximately 5.95% we can observe that the firm out-earns their cost of capital by about 16%. This significant margin illustrates that for every dollar of capital invested into operations, WDFC is able to generate 16% excess returns, suggesting that any further growth in the company would create value rather than destroy it. The firm also has robust average five-year gross, operating, and net margins of 53%, 16% and 11% respectively, which illustrates how fundamentally profitable the WDFC currently is. Considering that the company essentially sells a homogenous core product, these wonderful margins are supportive of the thesis that WD-40’s strong franchise reputation is the key to the entire firm’s pricing power. WDFC’s most recent Q4 and full-year 2024 results echo these robust historic results, with the firm generating strong revenue growth and margin expansion. WDFC FY24 10K Net sales for the full-year increased 10% YoY on the back of strong sales of their core WD-40 range of products. The team at WDFC noted on the earnings call that prioritisation of growth in key geographic regions such as EIMEA has been executed successfully in the fiscal year, with sales in the segment growing 16% YoY: the fastest of any geographic area. Expansion into relatively underserved markets is much easier for such a robust brand like WD-40 than it would be for other competitors, as most consumers have at least heard of the products' merits before. Once again, WD-40’s superb image provides real moatiness for WDFC in markets that otherwise are congested and homogenous. The company has also been executing on their “few things, many places, bigger impact” strategy which involves minimisation and simplification of unnecessarily complex business activities in the name of realising real cost efficiencies. WDFC FY24 Earnings Presentation Cost savings have been realised massively in FY24, with the firm’s gross profit margin expanding 2pp YoY to 53% thanks to supply chain improvements and a slight easing in supply side inflation. WDFC FY24 10K Importantly, WDFC’s operating expenses have only increased 4pp to 37% of revenues as the management team has aimed to combat rising SG&A expenses. This has allowed operating income to expand 7.5% to $96.4 million and the operating margin to remain stable at just shy of 17%. I always like to calculate the working capital turnover ratio for a business in order to understand how much capital is required to enact $1 additional dollar of revenue growth. In the case of WDFC and their FY24 results, by dividing net sales by their average working capital we find out that for every dollar in capital invested into the business, the firm is able to produce $3.88 in revenues. It can therefore be said that for every $0.26 cents invested into the business (1 divided by $3.88), WDFC is able to create one additional dollar in revenues. This is a superb capital conversion rate for the company and illustrates how well WD-40 is able to generate value from their operations. Looking to 2025 and beyond, I believe their “four-by-four” strategy of growing WD-40 sales through geographic expansion, premiumisation of specialty products and a greater digital presence will allow the firm to hit their forecasts of around 10-12% annualised revenue growth. EPS growth should logically rest a couple percentage points higher as the firm rewards shareholders through buybacks and dividends. Seeking Alpha | WDFC | Profitability Seeking Alpha’s Quant provides a “B” profitability rating for WDFC, which, I believe, is a little pessimistic given the underlying economics at work in the business. Most likely, the relatively low cash from operations figure is dragging down the grade as well as the business being compared against the entire consumer staples sector, which may be excessively broad for a niche company such as WDFC. Turning to the balance sheet, I was very pleased with the capital allocation structure at the WD-40 Company. With a quick ratio of 1.59x and a current ratio of 2.47x, it is clear the firm is on superb financial underpinnings and holds a high level of current liquidity. Furthermore, the firm’s debt/equity ratio is just 0.45x, most due to the firm holding just $86 million in long-term debentures. Total assets of $449 million appear to be accurately accounted for, with goodwill only comprising $97 million of this figure. Considering that the brand image is the biggest boon for the company’s moat, I find it refreshing to see so little intangible and often excessive goodwill on their balance sheets. Thanks to their well-managed levels of long-term debt and the $46.7 million in cash resting in the firm’s coffers, WDFC has a net debt position of just $56 million. WDFC FY24 10K Given that most notes are on sub-3.4% fixed-rates and not maturing until 2027 at the earliest, I see no reason for the company to pay off these debentures, especially as their own capital is more expensive to employ (and more efficient being reinvested into the business). Overall, I believe the WD-40 Company to be one of the most efficient and profitable businesses currently in operation. The firm has superb underlying business economics underpinning their operations, with the narrow economic moat supported by WD-40’s stellar reputation allowing for sustained pricing power. Valuation Seeking Alpha | WDFC | Valuation Seeking Alpha’s Quant assigns WDFC a \"D-\", a valuation grade, which appears relatively correct given what are some pretty steep ratios. With a GAAP TTM P/E ratio of 54.53x, it is fair to say that the market is pricing in what I suspect to be a real premium considering the earnings being produced by WDFC. The most likely explanation is that others too have noticed the fundamentally superb business that is being run in San Diego by the team at WD-40. This phenomenon is replicated in practically every single valuation metric. To emphasise how premium of a valuation is currently held by the stock, I direct one’s attention to the P/S TTM ratio of 6.40x. According to the market, WDFC stock is worth over six times the net sales achieved in the TTM. Despite my utmost admiration for the company’s business and economics, such a valuation often begins to make some assumptions about future growth and earnings. Seeking Alpha | WDFC | 1Y Advanced Chart A look at WDFC’s 1Y advanced chart against the popular SPDR S&P 500 ETF Trust (SPY) illustrates how the company’s stock has underperformed the market over the TTM. Seeking Alpha | WDFC | 5Y Advanced Chart This underperformance is further illustrated by the 5Y chart, where WDFC has delivered only 55% of the gains of the wider U.S. equities market. Such a gap in returns can often materialise for high-quality yet expensively valued stocks, as the lofty valuations decrease the actual gains investors make from underlying profitability improvements. Future growth in the company is being priced in excessively, resulting in shareholders not benefitting from the actual earnings growth being achieved by the firm. I conducted a DCF calculation to understand what the intrinsic value per share may be, as calculated by discounting all cash flows from now until judgement day to their present value. The Value Corner I sourced my FCF data and balance sheet items from Seeking Alpha’s incredibly handy Financials tab for WDFC. The average growth rate of 12.14% is quite appropriate to use as the projected growth rate given the regional and product opportunities present at the firm. For my terminal growth rate I picked 3% which I suspect will largely be in-line with the organic growth (inflation) that will occur at the firm. Finally, my discount rate remains at 7.98% which reflects the annualised average of the last 92-years of returns produced by the S&P500. Using these inputs, my IV came out to $233 per share, which implies a present overvaluation of 24%. As a result of this overvaluation, I find it prudent to consider that any underperformance by the company in their next Q1 FY25 quarterly report could place real downward pressure on shares in the short-term (1-12 months). Nevertheless, I suspect that not with counting any sudden macroeconomic shocks, WDFC is poised to continue doing great quality business and thus rewarding shareholders handsomely in the long-term (1-10 years). WD-40 Company Risk Profile The WD-40 company primarily faces risk from market cyclicality and competitive pressures. Despite the firm’s wonderful business economics, a deterioration in demand as witnessed in FY20 can lead to significantly reduced profitability and revenues at the company. While the requirement for lubricants and degreasers such as WD-40 is quite robust, it is still to be expected that consumers will reduce demand for such a product should their income be particularly strained in times of economic hardship. Therefore, the company can expect some cyclicality in revenues and growth, although I, personally, believe (based-off historic earnings reports) this to be less than say a chocolate company or toy manufacturer. WDFC is also at real risk of franchise fade, which tends to happen to even the most reputable and well-established brands. Due to the outsized returns being earned by companies such as WD-40, competitors are encouraged to enter the market in hopes of achieving similar profits. While replication of the brand may be near impossible in the short-term, sustained efforts by rivals can result in incumbent firms realising a drop in pricing power and their ability to generate returns from their business. At present time, I do not believe WDFC has a competitor capable of dethroning it from the top step of the multiapplication spray market. Nevertheless, it is important to consider this reality, particularly if investing with a long-term outlook. With these risks in mind, I rate the WD-40 Company as having a medium risk profile and of course encourage all readers to conduct their own extensive research into the matter should it be of concern to them. Summary In my opinion, WDFC is one of the most wonderful small-cap businesses currently trading on public markets. Their narrow yet robust moat allows for superb business economics and profitability to be achieved, all the while diligent cost and debt control has led to an excellent capital allocation structure. The ability for WD-40 to generate value from their operations is impressive and illustrative of the great job management has done over the last twenty years. I can only hope that a similar attitude to business and sustainable growth is applied in the coming two decades. However, the hair in the soup for me is the valuation. A real premium is being applied to the stock price, most likely as a result of the anticipated growth to be realised at the company. While I fully understand that high-quality growth companies tend to harbour a premium valuation, the situation at WDFC is quite exaggerated in my opinion, with my DCF suggesting a 24% overvaluation at present time. As a result, I am unable to advocate for a buy-oriented rating and rate the firm a Hold at present time.  I will patiently look for a more attractive entry price closer to the firm’s IV, which would make the stock a much more attractive GARP opportunity.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.2","shortVersion":"4.29.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2484169024"}