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Something different today – I’m going to make a counter argument on a battleground stock. WD-40 stock is one of those names that easily is discarded by analysts for trading at too high of a multiple (myself included, typically). But comparing multiples is not valuation.

For context, WD-40 multiple can be defined as high – currently trades at 35x EV / LTM EBITDA and ~52x price to LTM EPS – and it has expanded significantly over time, too.

Again, this is not valuation. In fact, as I try to lay out in this next chart, you could argue that WD-40 stock has been consistently undervalued by the market. Obviously hindsight 20/20 with a share price going up.

But the red line shows the price where you could buy the stock versus the orange dashed line which is where you would need to buy to realize a 10% IRR (ex-dividends).

Therefore, I’m going to try to look at WD-40 stock with fresh eyes.

I do have biases, so I am going to lay those out upfront. However, I will not cling to any of those biases in my model.

Here is my assumptions about WD-40 stock and why it trades so rich:

• Interest rates are very low. WD-40 is a high quality company, has little debt, and probably grows at GDP+.
• If I’m a large diversified asset manager, such as a pension fund, and I need to invest in something for 30 years, I can either pick a ~1-2% bond or a high ROIC company that has staying power and will grow earnings above GDP.
  • The choice obviously isn’t that simple, but bear with me.
• WD-40 stock also has a 0.85% dividend yield at the time of writing, which will probably grow, as opposed to being fixed with a bond
• As such, as rates have continued to decline over time, the multiple paid for WD-40’s earnings have gone up
• In essence, this is a classic “bond proxy” stock. And investors will get punished severely if rates rise.

Again, that’s just my bias as I look at WD-40 stock and I think previously, that would have caused me to do zero work.

Here is a waterfall chart outlining the source of WD-40 stock returns. As you can see, most of the shareholder returns come from multiple expansion (used to trade at 20.5x LTM EPS in 2006 and now trades at ~60.0x:

So I’m going to ignore this narrative for now and ignore the valuation and just plug into (i) the business, first and (ii) what management is saying that could drive the stock higher.

First and foremost, here are some of my initial takeaways (some obvious):

• WD-40’s name comes from “Water Displacement, 40^th attempt”. Basically a secretive lubricant.
  • There are some other facts, myths, and legends on their website, including a bus driver used WD-40 to remove a python from their undercarriage.
• WD-40 is an excellent company.
  • Highly recognizable brand is worth something that is hard to quantify
  • Earn extremely high returns on invested capital (ROIC) – I estimate ~65% pre-tax in TTM
  • High ROIC is also demonstrated by high margins, low capex: they have 24% EBITDA margins and spend 1.5%-2.0% of sales in capex.
• LT target is to operate under the 55/30/25, which is 55% gross margins, 30% cost of business, and that implies 25% EBITDA margins. They are already pretty close to these metrics.
• Management is pretty conservative and leverage is consistently low (0.5x net debt to EBITDA)
  • Management lays out their multi-year initiatives and harps on those initiatives. Every… single… call…
  • Management has also been consistent… like, the people themselves. Garry Ridge has been CEO since 1997.

Some other things I learned after further work:

• I expected WD-40 to be a big emerging markets play. It kinda is, but not the way I thought.
  • Yes, 65% of revenues come from outside the US, but a lot of that is developed or developing Europe, LATAM, or Australia.
  • China is $15MM of sales in the TTM, which is just ~3.5% of total sales. India is also small.
  • If you think they can win emerging Asia – that growth is still on the come. If WD-40 can be as successful there as it is here in the US, then there is a long runway for growth.
  • Over the long run, they expect to grow APAC 10-13% annually.
• WD-40 sells through distributors in new regions and slowly moves into direct sales model
  • If I were an investor, I’d actually be frustrated with how slow China growth for WD-40 seems to be.
  • One benefit of WD-40 though, as mentioned, is that they’ve had the same CEO for 2 decades and he’s remarkably consistent.
  • Here are his thoughts from a 2006 earnings call when they first entered China:

• • You can actually see this play out in the employee count. However, I wouldn’t really call it a “success” so far. They aren’t really getting better and better leverage on employee costs.
  • Sales per employee (blue line) is consistently going down, which is counter to what I would have thought.

• • Ridge, the CEO, knows China is key as he said in an interview in 2015 and the commentary makes total sense to me.
  • For context, he brings up factories because an average household consumer maybe uses $0.40 of WD-40 per year. Someone in a workshop may use $40-$70 per year.

• This is a small company. They do just $435MM in revenue and $106MM in EBITDA.
  • Seems like a conscious decision. Whereas Rust-Oleum owner, RPM, uses cash to buy other brands, WD-40 basically said it doesn’t want to do that – it doesn’t want to di-“worse”-ify.
  • Instead, they are focused more on “specialist” brands, such as a silicone lubricant, bike chain lube, or marine grade products, among many others.
  • It is unclear whether that’s really the best approach, but I can’t argue with their shareholder returns so far.
• Growth has been… just OK. Sales have grown at a 3% CAGR for 14.25 years and EBITDA has grown at 5%. Excluding the run-off products discussed below, sales have grown at a 5% CAGR, too.
  • I will say this is basically all organic. And if we go back to “bond-proxy” status, earnings held up pretty well in the GFC (were down 15% from peak, but snapped back fast) so the reliability of those slow earnings is rock solid.
  • If all companies earned the same ROIC, then growth would be the only differentiating factor between investments. And WD-40 clearly is top quartile for ROIC.
  • But back to China / EM, I feel like management hasn’t pushed growth there enough. They do discuss it a lot on calls, but would expect sales to be much, much higher than current or even projected. They would drive so much more value given their ROIC if they pushed growth here.
• WD-40 owns some home cleaning brands, but they are essentially in run-off and management expressly says they just harvest the businesses for cash (see how orange bars have shrunk)

• The company (maybe not too unsurprisingly) spends little in advertising. It spends about the same each year in advertising as it did in 2006, yet gross profit is +60% higher
• Capital allocation: investor in 2006 would have gotten all his cash back from FCF
  • In 2006, WDFC traded at 11.6x EBITDA, 20.5x EPS and ~23x FCF.
  • Not “cheap” by any means… The market cap was ~$576MM
  • As shown below, an investor then would have received more than the market cap through dividends and share buybacks since then.
  • Obviously left with a much more valuable piece as well

What type of Moat Business is WD-40?

Connor Leonard did a guest post on Saber Capital’s blog back in 2016, (Saber is run by John Huber and I highly recommend you check out his posts or twitter). In that, Connor outlined four different types of businesses: No moat, Legacy Moat, Legacy Moat with “Outsider” Management and Reinvestment Moat.

It seems to me that WD-40 could fall into one of the last three buckets. The brand value of WD-40 is clearly a legacy moat, but the question is whether or not there are really reinvestment opportunities.

I don’t really consider management here to be “outsiders” but it is hard to argue that earnings have been allocated poorly. The CEO also hasn’t succumbed to debt or M&A pressures by the market. So they haven’t been allocating dumb-ly.

As Connor says,

“[It is] the rare company that has all of the benefits of a Legacy Moat along with ample opportunities to deploy incremental capital at high rates within the current business. In my opinion this business is superior to the “Legacy Moat – Outsider Management” because it removes the variable of capital allocation: at the end of each year the profits are simply plowed right back into growing the existing business.”

WD-40 has plenty of opportunity to reinvest in China and India, but I also still think the capital required to grow there will be pretty limited.

And there lies the point of his post – introducing a fifth model of “capital light compounders.” Those that can grow earnings with very little capital. Instead of reinvesting into the business with long-runway, they systematically repurchase shares.

In my view, you are essentially creating a scarce asset. The powerful business is acquiring itself each year, and crowding out other purchasers of the shares each year.

Expectations Investing

I did a deep dive on WDFC and built projections on that. Frankly, I did them a bit more aggressively than I normally do, but I was using mgmt’s LT targets as a guide (they are shooting for $700MM of sales by 2025).

Frankly, that may be pretty hard target and I actually don’t have them hitting their sales target. Just look at their performance pre-COVID. It wasn’t on-track. However, I do have WDFC expanding margins as they leverage their costs better and beating the 25% EBITDA margin target. It seems to me they already have the infrastructure in place to grow Asia significantly.

I have them using their FCF to repurchase shares and pay their dividend.

While capex might look low, they’ve actually been overspending recently (the big bump in 2017 was building a new office building; in 2020 it was building capacity for their Smart Straw product). At the end of the day, that’s essentially what high ROIC means – they can grow FCF with limited incremental capital invested.

They can’t really buyback too much of the market cap each year at these levels.

DCF

I did a DCF which I don’t normally do, because they can be overly precise and subject to wide swings based on small assumption changes, but I wanted to back into a “what do you need to believe” case.

Firms create value when they’re returns on capital are higher than their cost of capital. The cost of capital, or WACC, is the return offered for the risk that the projected cash flows don’t occur as planned. If future cash flows are more uncertain, investors require higher rates of return for the risk.

For example, here’s the value of a firm under different ROIC vs. growth assumptions with a 10% WACC. If the firm earns < 10%, they are destroying value even if they grow. The important thing is that an already high ROIC business gains more value by growing faster, not by increasing ROIC a bit more (though a low ROIC business will do better by increasing ROIC). This furthers my frustration that China growth has been so slow.

WD-40 cash flows are highly certain (implying a low WACC) and given their ROIC is around 65%, there is a huge spread between this cost of capital and ROIC.

As you can see below, we get in the ballpark of the current stock price using a 5.5% discount rate and assuming the stock grows 3% into perpetuity. Cross checking that with the implied terminal EBITDA multiple, pretty interesting to see it is very high (~29x).

If WACC moved higher (to a not-even-high number), the stock could get crushed.

If you are saying this discount rate is too low… theoretically… it isn’t. Just theory and I’ll touch on this at the very end. Again going back to the stability of WD-40 cash flows, it results in a really low cost of equity. Debt is super cheap right now too, but they barely have any.

The other factor where this DCF is weak is the terminal value: the terminal value math implies a company’s ROIC will equal its WACC in the terminal period (because of competition) and growth steps down. It’s interesting that if I just stretch my DCF out 2 more years, I get a $350 share price (assumes 5.5% WACC and 3% LT growth rate) as WD-40 still earns more than their cost of capital.

Bottom line:

I think WD-40 is a great company and they will continue to compound earnings. I think I have a lot more appreciation for why it is valued like it is valued and hope readers do as well.

Will I be adding it to my portfolio? No.

The company is clearly earning high returns on capital… but I care about returns on my capital. And my opportunity cost is higher.

If a business could invest $1,000 in a factory and earn $400 in dividends, that’s a 40% return on capital for the initial investor. But if someone buys those shares for $4,000, they’ll only receive a 10% return on capital. Price matters.

But I will be looking for other names that are viewed as “too expensive” with perhaps faster growth and similar reinvestment runways.

March 28, 2021 Update: It has come to my attention that Greenwald dedicated part of his book to WD-40. Definitely worth a read:

 

Re $WDFC, Bruce Greenwald has an interesting chapter dedicated to its unique situation in his book, Value Investing pic.twitter.com/42l8x5KWVX

— Lawrence Hamtil (@lhamtil) September 21, 2020