Tag: Compounder

Candle in the Tailwinds: Bath & Body is “Secret SaaS” in Plain Sight $BBWI

Reading Time: 7 minutes

L Brands officially spun off Victoria Secret and now Bath & Body Works (BBWI) is an independent company. This is great news to me as I think BBWI is a “Secret SaaS” business, a topic which I discussed before and will get into here.

Why do I like BBWI?

  • High margin category with growth tailwinds (beauty, fragrance)
  • Fragrance has difficulty translating to online without trust – Brands matter
  • BBWI has high customer loyalty – leaning into that loyalty even more; “Secret” razor, razor-blade model in fragrance
  • Like many other brick-and-mortar retail (B&M) businesses, discovered the power of omni-channel during COVID – I believe it will structurally benefit the business
    • Many focus on LTV / CAC as well as gross profit return on sales and marketing for SaaS and DTC businesses – the thinking being because it is a more variable cost business and you can tie the two
    • But strong B&M brands have high initial upfront investment (e.g. the stores), and then serves the customer and drives loyalty with more limited incremental spend. We shouldn’t forget this.
  • Business has been “trapped” inside L Brands
    • Not sure analysts gave BBWI its full consideration when it attached to VS – a brand that is facing significant competitive pressure and heavily dependent on malls.
  • Not as impacted by supply chain issues, but the “baby could get thrown out with the bathwater”
    • BBWI sources most products from their facility in Ohio, not China. 80% sourced from US. Broader sell-off in retail could create an opportunity

As an aside, the Victoria Secret spin may end up being like Joel Greenblatt spin-off: the market hates VS so much that it gets to an extremely attractive price as people sell the spin. Time will tell. Don’t get me wrong, I would probably be one of those dumping VS if I received it.


Business has been “trapped” inside L Brands

I’m going to start with the last point first because it is quick. If you listen to the latest BBWI call, it is clear to hear analysts are still a bit confused how to model BBWI – it hasn’t been standalone before. Things like normalized capex, SG&A, and others were frequently brought up. I had to do some digging to find long-term gross margins for BBWI. All this is to say – you have to do some work to learn the most you can about BBWI standalone.

Second, BBWI and VS fortunes have been the complete opposite. As such, if you just looked at L Brands as a whole, you might miss the success story within occurring at BBWI shown below:


High margin category with growth tailwinds (beauty, fragrance); Fragrance has difficulty translating to online without trust – Brands matter

BBWI has 28% operating income margins, which both shocked and didn’t shock me.

Granted, this is LTM, where they benefitted from more of a “DTC” model during COVID and less promotions, though their physical stores were closed for 90 days in 2020.

On one hand, the margins are top quartile. On the other, fragrance and beauty are notoriously high margin categories.

Why is fragrance a high margin category? The packaging and everything involved with fragrance related products are usually a small cost. What drives the sale is the actual smell – and that takes technical know-how that is hard to replicate.

It’s analogous to beauty – beauty products are high margin because it tends to be a tough category to replicate, it is tough to get good distribution, and there is a degree of customer trust and loyalty (“hey this worked for me, you should try it”) which is hard to break into. Oh – and obviously consumers will pay up for these products if they “work”.

BBWI is at the center of some of these trends. Clearly, you can see their growth in the numbers I posted previously as well.


BBWI has high customer loyalty – leaning into that loyalty even more; “Secret” razor, razor-blade model in fragrance

I like the simple “razor, razor-blade” model from BBWI. They have “wallflowers” which consumers plug into the wall and dispenses the fragrance. These plugins can be simple or decorative, like seasonal ones shown below.

They  aren’t too cheap, as a razor is for the blade, but the scents offered are consistently refreshed and tend to be “optically” cheap. For example, 5 refills for $24 tends to be a consistent sale.

Compare that to one Yankee candle which is more than that for just one candle (which will burn longer, but the optics to a customer aren’t the same. I could dwell on this point, but to me, I don’t think consumers do that math).

I hate anec-data, but my wife and mother are consistent buyers here (thank you Peter Lynch for recognizing this investment thesis!).

Management has several slides that show they are thinking about this the right way. Find ways to increase retention rates and drive value.


If this is Secret SaaS, can we look at BBWI metrics with the lens of SaaS?

This isn’t perfectly accurate, but I think it is instructive. If you assume 15% of SG&A is for attracting incremental customers, then the company has a ~3 year payback. Again, that is just a fixed assumption and hard to get a direct feedback response for a legacy B&M player.

However, this is extremely difficult to determine for B&M retail. Especially one where we have limited stand-alone detail… But as noted before, the investment in SG&A comes upfront and to some degree, it is a “build it so they come” model.

But Warby Parker put it well in their S-1:

“While we have the ability to track where our customers transact, we’re channel agnostic to where the transaction takes place and find that many of our customers engage with us across both digital and physical channels; for example, many customers who check out online visit a store throughout their customer journey, while others choose to browse online before visiting one of our stores.”

To me, it is clearly the other way around for fragrance. Once you get comfortable that BBWI isn’t going to sell you something awful in their fragrance line up, you are likely to buy online from them (and perhaps, not from a brand you don’t trust). Or, you find several fragrances you really like and consistently re-order them.

I think they are just too interlinked to derive anything useful from this analysis. Instead, we can just focus on margins and FCF to get a sense of health.

Omni-channel

On that B&M note, the company is 35% mall (says 99% are cash flow positive), 31% are off-mall (i.e. stand-alone stores, all cash flow positive) and 31% digital – super-enabled by COVID. They also have a small, international franchise business making up the balance.

I see a similar set-up longer term as Big Lots, which I wrote about how they can pivot their footprint. You can see in the table below that off-mall stores and Class A and B malls are clearly worth keeping. Class C and D? Less… And the Class D malls have the shortest lease terms remaining.

BBWI specifically called out closing stores in non-viable declining malls and remodeling others for an sales uplift.


BBWI Driving More Loyalty

While I’ve already stated why I think BBWI has a loyal customer base, BBWI is doing more. It makes sense – to create value from their existing customers, they need either more trips or for them to spend more in stores per trip.

Loyalty programs typically achieve this. For example, offering a 25% off coupon to loyal members typically gets them to either start an order they might not have done previously, or add one more thing… this incremental sale drives a lot of value for the retailer.

BBWI is testing that now: customers in the loyalty program spend 30% more than non-loyalty members.


A Quick Word on Value

BBWI is expected to generate $5.2BN in FCF between 2022-2025, or 30% of market cap. I even think that could be conservative. The company is returning significant amounts of cash to shareholders (continued the L Brands dividend, doing a $1.5BN share buyback) and I think the valuation is very reasonable at around 10x EBITDA.

However, they are earning high margins lapping a COVID bump. Essentially, the company saw a significant increase in sales, especially online, despite their stores being closed for 90 days during the pandemic. In the 2H of 2020, they were able to pull back on promotions which boosted margins.

I am not too concerned. This is a wide gap, but management targets $10BN in revenue (from $6.4BN in 2020) over the next 3-5 years. They assume some of this margin will be given back and EBIT margins will be in the low to mid-twenties. The stock is currently trading at 10x EV/EBIT on this forward number. Not too cheap, but not overly expensive given the business model either.

If I take the $6.4BN of revenue they did in 2020, apply a 22.5% margin to it I get $1.4BN of EBIT instead of $1.8BN. Based on their PF balance sheet for the spin, I calculate ~$910MM of tangible invested capital. This is true for most successful retailers thanks to leases (which can be a double edged sword), but that ROIC is fantastic.

Bottom line, I think BBWI deserves a premium multiple.

 

Entegris: Picks & Shovels on Secular Semiconductor Growth $ENTG

Reading Time: 5 minutes

I have a picks-and-shovels play on semiconductors. While it may not look “optically” cheap, I think Entegris can compound earnings at a very fast rate thanks to the secular growth in semiconductors as well as changes in semiconductor technology that will require more products from Entegris.

While I say Entegris stock is a “play” on semiconductors, I would underline that this isn’t a short-term trade for me. I am going to lock this name up in my coffee can portfolio and throw away the key. There actually is a second player as well I am reviewing, but haven’t gotten fully comfortable yet.


Why Entegris?

  • Picks-and-shovel plays on semi growth (internet of things “IoT”) which should grow well in excess of GDP
  • Semiconductors are notoriously cyclical; there is a capex-exposed portion of the business (30%), but large chunk benefits from recurring revenue (70% of products are consumed in wafer production)
  • Best-in-class technology which sets them up well in changing landscape
  • Underfollowed name, but center of several long-term trends
  • Dry powder: <1x levered, $400MM of cash on hand to make M&A or investments

While semiconductor manufacturing is complex, I want this write-up to be simple. I think once you just understand the basics, it is easy to see how Entegris can be a winner for the long-run.

So I’m going to put the main drivers of why Entegris is a winner right here:

  • The number of production steps in semiconductors is increasing…increasing demand for Entegris’ materials
  • As the steps increase, yields tend to decline…also increasing the need for materials to improve yield (which Entegris provides)
  • Lastly, Entegris’ materials improve device performance. Performance demands are also increasing in smaller structures

Overview:

Entegris is a chemical / materials company that helps with the production of semiconductors.

Semiconductor production requires hundreds of highly complex and sensitive manufacturing steps. You’ve probably seen videos of semiconductor fabs where people need to dress in full radioactive-like suits to avoid contamination in the process.

Silicon wafers are the core building block for semiconductors, and during the manufacturing process, a variety of materials are applied to silicon wafer to build integrated circuits on the wafer surface.

I snagged this picture from an ASML page. If you don’t know ASML, they also are a picks-and-shovels play on semiconductor growth, particularly high value-add. But I thought this chart showed the processes well.

EUV beginners

Entegris is one of the companies providing these materials in each step. Here are some examples:

  • Etching
  • Deposition
  • Photolithography
  • Ion Implant
  • Chemical Mechanical Planarization (CMP)

I’m not going to explain each one to keep it simple, so please go read the 10-K for that (which I link to above).

Wafers are consuming more materials as the production process becomes more complex. Nodes in semiconductors are getting smaller, which requires more processes and yields potentially go down with each step. This requires new materials of increasing purity, quality, and stability to maximize yields.

For example, in memory chips, the industry is migrating to 3D NAND which requires 128 layers from 64 layers previously. In logic devices, there is a shift to 7 nanometer (nm) from 28nm. In both of these cases, there has been a 2x increase in material spending.

Fabs must reduce defects at each individual step in order to achieve the same final yield. I got this chart from this website which breaks down why the steps are increasing, but this reduction of the situation helps me understand it clearly.

Entegris noted, “by 2022, approximately 25% of the wafer produced in logic fabs will be at 20-nanometer technology or below. And in that same time frame, we expect almost all 90% of the 3D NAND chips to have 96 layers or more” – so that is very positive for Entegris.

Additionally, these materials play a role in performance of the chip. As the Entegris explains:

New materials have played a significant role in enabling improved device performance, and we expect this trend to continue. As dimensions get smaller, new materials will be required to enable transistor connectivity. For example, leading-edge semiconductor manufacturers are moving towards atomic layer scale, where the precision of the manufacturing process and purity of the materials used is vital to maintain device integrity. These materials need to be supplied and delivered at ever-increasing levels of purity and control, from point-of-production to point-of-dispense on the wafer.

So again, the boiled down, simple thesis:

  • The number of production steps is increasing, increasing demand for Entegris’ materials.
  • However, as the steps increase, yields tend to decline – also increasing the need for materials to improve yield.
  • Lastly, these materials also help improve device performance. Performance demands are also increasing in smaller and smaller structures

All of this paints the picture of Entegris compounding at a multiple of whatever semiconductor growth is.

Historically – you can see that is the case:


Quick Word on Value

Entegris valuation isn’t for the faint of heart (neither is ASML mentioned earlier), but the I think the dynamics outlined here, as well as M&A opportunities, makes me think the company can grow FCF/Share at double digits for a long-period of time.

The stock trades at 37x 2022 FCF, or <3% yield. So to get a 15% IRR, I somewhat need to expect a double-digit growth rate.

But here’s the thing that gives me comfort: a lot of capital is being put in to build new semiconductors.

  • TSMC: Investing $100 billion over next 3 years to boost production capacity and R&D on advanced nodes and specialty technology equipment
  • Intel: Announced two new factories in Arizona at $20 billion
  • Samsung: Not disclosed, but analysts expect $37 billion in capex annually in 2021-2023, up from $32 billion in 2020

The current shortage in 2021 is going to leave a lasting impression on the industry and capital is cheap to add strategic capacity. Frankly, odds are several years down the road, we might be oversupplied (a classic cycle).

But the shortage today is here, giving companies comfort in putting new capital in the ground. And countries are looking at their production as increasingly strategic (US vs. China) which may lead to duplicative, but localized capacity. Bottom line: I think that might add even more capacity in the long run.

Again, Entegris is mostly tied to units sold. Semi fabs need to run at high utilization rates (because they are high fixed cost businesses) so maybe that pressure prices down the road, but I can comfortably bet more units will shipped than today.

I recently saw JPM estimate wafer shipments at growing double-digits in 2022, but then moderating to GDP-like growth in 2023+. That seems too conservative to me, but again, Entegris can likely outgrow this due to the factors mentioned previously.

LGI is a Buy $LGIH

Reading Time: 6 minutes

I think LGIH stock is potential multi-bagger. Well, it already has been one, but I think it can do it again. When you add in solid growth, good demand fundamentals and a high ROIC business model, it spells opportunity for long-term investors.

Take a look at some of its growth metrics over time. It does around $480MM of EBITDA now, which is about 2.2x from 2 years ago, and 4.0x from 4 years ago. Also… it was the only homebuilder among the 200 largest U.S. homebuilders to report closings & revenue growth from 2006 to 2008 when the housing market experienced a significant decline. So management clearly is focused on growth.

LGIH did $12.8 in EPS for 2020, but I see the path to $23.3 in EPS by the end of 2023 (discussed more below). Therefore, shares are trading at just ~7.25x my 2023 estimates.

LGIH is interesting too because they provide monthly home closing cadence. The May 2021 was up 42% Y/Y and YTD is up 44%. On one hand, easy comps with April/May, but on the other hand, I think they will keep this strong cadence going for a decent period of time.

Let me break it down.


Perhaps by now you know of NVR, a homebuilder with a “unique” business model which I break down here and how the stock has actually outperformed Microsoft (at the time of writing). It is asset light, relying more on options than buying and developing lots, which in turn means less capital tied up, they have high inventory turns, and high ROIC.

LGIH also generates a really strong ROIC, but it doesn’t rely solely on options, as you can see below (controlled = options). It’s split ~55% owned / 45% optioned.

As you can see, LGIH’s ROIC not only is solid for any company, it is improving with scale.

LGIH ROIC

So how has LGIH stock done versus NVR’s? LGIH stock is now officially crushing NVR

LIGH stock vs. NVR stock

However, LGIH still has a unique model. Let’s break it down:

  • Very sales focused:
    • Whereas NVR focuses on the land strategy (a big thing for builders, no doubt), LGIH’s core competency comes from focus on sales and marketing
    • A sales office typically has 2-5 people in it with one loan officer.
    • LGIH trains its sales staff for 100 days
    • The main goal is to convert renters to buyers. They even send direct mailers to apartment complexes pitching renters on buying a home.
    • Now, in talking to some folks about LGIH’s process, it’s clear some people think LGIH is akin to a used-car salesperson (i.e. pushy). However, as we’ll discuss more, the model appears to work really well. Consumer reviews are also pretty solid.
  • Spec homes – big contrast from other builders
    • LGIH is 100% spec homes. Almost the opposite of NVR
      • “Spec” means they build the home without the buyer already secured. NVR only builds on the optioned land once it has the buyer.
      • Everything is typically included, so there are not specific options that each buyer needs to select. They have 4 to 5 home plans in each community that allows LGIH to build and sell faster and drive on.
      • Now, clearly LGIH seems more risky, though in a tight inventory market, the market needs spec homes. Its model is also still low cost.
      • Also, LGIH was the only top 200 builder to grow from 2006-2008
  • Focused on entry-level:
    • Average price point is around $250k, which is square in the entry level price point (meaning first time home buyers).
    • Given lots are expensive these days, LGIH is typically acquiring lots outside of city centers, but also targets areas where there is some retail anchors to attract consumers.
    • This segment of the market should have demand for years to come, given millennials deferred purchasing homes post-GFC and have been renting for longer.
  • Still earns strong returns
    • The average & median builder earns around a 12% EBIT margin, with DR Horton and Lennar near the top given their massive scale (16.1% and 15.5% respectively) and the smaller builders near the bottom, such as Beazer and Taylor Morrison around 10%
    • LGIH earned a 18.3% EBIT margin
    • Another interesting thing to note, going back to strategy, is LGIH’s absorptions blow competitors out of the water. Again, 4 is the average absorption rate per month in 2020. LGIH is around 7. The gap was even wider pre-COVID (i.e. before the buying boom).
    • This means LGIH is selling almost double the amount of homes in a period of time as competitors.

So what drives LGIH’s high returns on capital?

Dupont formula: profit margins (high for LGIH), asset turns (high for LGIH), and leverage (actually low for LGIH).

As LGIH gains size, I think ROIC will continue to grind higher. Now, they’ve gotten pricing, which helps ROIC and margins, but look at ROIC as size has scaled.

LGIH ROIC

As a quick aside, it’s funny to contrast everything we’ve talked about so far with New Home, a luxury builder I wrote about a few months ago that still trades below book value. New Home is small, so its EBIT margins are low. It’s also a luxury builder which just given the nature of the product is slower moving. However, I still think it’s cheap and it’s likely a take-out candidate in a market thirsty for inventory.


Ok – back to LGIH. To my knowledge, only a couple firms cover LGIH. I only could find JP Morgan and BTIG.

Here lies the opportunity. I think LGIH will be a long-term compounder and it’s relatively undercovered. Based on my estimates, I think LGIH will do about $23 in EPS in 3 years (from ~$15 LTM). So with the stock trading at 7.4x that forward EPS today, that seems too cheap to me.

LGIH projections

Sure, I’m looking 3 years out on a cyclical business, but I’d rather have LGIH stock than buy a questionable SAAS name for 20x sales.


The risk to the thesis is, can they keep up the growth? Well, 2020 will definitely be a tough comp. Right now, we are still lapping the easier part of 2020.

However, the risk to LGIH’s growth is not the same as NVR for example.

Recall, NVR uses solely options on lots and those don’t exist in every market. LGIH’s risk is acquiring lots at attractive prices and selling them in high demand areas – lot prices are going up, but so is entry level demand. I think LGIH will just pass that through.

There are other obvious risks to homebuilders. Interest rates, the economy, etc. etc. But I think this cycle is going to last awhile. Sure, we could have a buyers’ strike like the end of 2018 as rates were rising, but I think we actually need several years of housing starts >2MM (vs. new cycle high of 1.5MM right now) to sustain demand.


I watch the builder stocks from time to time. In some ways, they’re HODL’ers. They are so volatile. But a few are worth grabbing on to and just taking along for the ride.

So bottom line: LGIH stock may not be a straight path up, but I think it will compound earnings for a long period of time.

WD-40 Stock: Breaking Down the Bull Case and Valuation $WDFC

Reading Time: 10 minutes

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 vs. be 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, 40th 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 their 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:

 

Masco: No Credit for Portfolio Transformation & Improved ROIC $MAS

Reading Time: 5 minutesMasco is a leading building products company. If you own a home, there is a decent chance you’ve bought their products at some point. Products range from Behr and Kilz paint to plumbing products such as the Delta brand, among many others. Masco has undergone a significant portfolio shift overtime, and meaningfully improved the ROIC,  but I don’t think the market is giving them enough credit.


Masco set out on a divestiture plan a few years ago, divesting their cabinets and windows business lines. These were highly cyclical businesses with low-to-average ROICs. Now that they’ve sold those segments, they have meaningfully improved the ROIC (to top-quartile), they have a much more resilient business, and they have more cash on the balance sheet than ever.

Despite this, Masco trades at 14.8x 2022 EPS, or ~13.5x when you exclude cash. Compare this to Sherwin Williams trading at 24x or even the more industrial-exposed PPG trading at 17x. Home Depot also trades at ~20x.

Personally, I think Masco should trade at 20x EPS given how resilient / how high a ROIC business it is, which would put it at ~$74/share – nearly 40% higher than where it trades today.

Re-rating is tough to bank on, but I think a business that earns a 40-50% ROIC that is growing well should trade at least at the market level (the S&P trades at 22x forward EPS).


Background

I won’t go into the full background of Masco, but if we rewind to pre-financial crisis, Masco was made up of 5 segments:

  • Plumbing Products: Faucets, plumbing products, valves, tubs, showers, etc.
  • Cabinets: Kitchen & bath cabinets
  • Installation & Other Services: installed building products like gutters, fireplaces, garage doors and insulation products
  • Decorative Architectural Products: Mainly paint, under the Behr name
  • Windows & Other Specialty Products: Windows and window frame components

Several of these business are not what I would view as “high quality” and some were very cyclical.

For example, in a recession, how inclined are you to change your cabinets? If income is tight and you might not feel good about the equity in your home, then you might not replace them until they fall off the wall.

Cabinets are highly exposed to new build construction or remodel projects. Same goes for windows, some plumbing products and the installation products mentioned. With the benefit of hindsight, we know how many of these segments performed: Cabinets, windows, and installation each went operating profit negative at some point during the great financial crisis:

Here is a chart of the earnings of the main segments. As you can see, the more cyclical businesses got crushed and never really recovered. Plumbing and pant just kept on chugging.

Masco's segment performance varied wildly in the last recession

Plumbing and paint really kept profitability and they are great businesses.


Paint is a great business, as many people have figured out by investing in Sherwin Williams. People love to paint their home for a general refresh, or they may paint it before they sell their home. When a new buyer comes in, they often paint right over it again. It’s a relatively cheap remodel project that can really make your home feel upgraded.

It’s also a really consolidated industry, the housing crisis really showed how resilient the business was, and also showed the industry had pricing power.

Masco essentially competes with Sherwin Williams and PPG (note, Sherwin Williams beat out PPG for Lowe’s exclusive retail business, whereas Masco’s Behr paint has Home Depot’s business. I’d prefer to have Home Depot, for what it is worth.) Sherwin Williams also has its own stores where it mainly sells to the pro paint contractors.

The housing crisis really caused the industry to re-rate. Mainly because the competitors demonstrated such resilient performance, but also when oil spiked in 2008, they were able to raise praise and maintain margin. The industry realized that they could bank on pretty consistent price increases and not crimp demand.

You can see SHW and PPG traded around 8x EBITDA pre-crisis and clearly re-rated since then.

Note, I exclude Masco here because the chart gets messy since some of their segments (now divested) went EBITDA negative. Even though these segments are gone, Masco trades at a 2x discount to PPG and 7x discount to SHW today.


Masco’s paint segment is ~20% EBITDA margin and essentially takes no capital to grow (e.g. the company spent $25MM in capex for $620MM of EBITDA).

Plumbing is similar, albeit it will be more cyclical and more competitive (though its hard to even tell compared to the other segments in the chart above). It too earns really high margins — around 20% and 2% of sales for capex.

Lo and behold, that is the portfolio that Masco has today and those metrics point to really high ROIC. They are clearly solid businesses, as demonstrated by prior performance.

And here is a chart of Masco’s Return on Invested Capital (ROIC) over time and what I expect going forward:

Masco ROIC has improved meaningfully


I personally believe this housing cycle has legs, driven by the limited supply additions post-crisis and tight inventory, which I’ve discussed in the past. However, it’s hard to predict cycles.

Management gets 5 stars from me for divesting these lower margin, more cyclical business lines at arguably the best time possible (maybe not absolute peak earnings, but closer to peak than trough and selling for near peak valuations).


Why Do I Think Masco Is Discounted?

My guess is people think there was a pull-forward of demand in 2020, which is possible, though it’s not as if 2020 was a “gangbusters” year. Sales were up 7% and operating profit increased 19%. Q4 sales were up 13% as the housing market had really strong turnover. I expect this will actually be a multi-year cycle for Masco, as it appears more homebuyers are entering the market.

Masco’s brands, like Behr paint, is more focused on the Do It Yourself (DIY) market, whereas Sherwin Williams is “Do It For Me” (DIFM). The trend is in favor of DIFM right now. Painting is “tough”, or at least time consuming, and it looks as though millennials would rather hire someone to do it than paint themselves (a broad generalization).

I think this DIFM trend is overplayed. Investors / sell-side seems so focused on it, it’s like they are saying Masco’s business will shrink in the long run. If DIFM continues and gets more expensive over time, I think we start to cycle back to DIY, especially has home costs have become more expensive in general. Not hiring someone to paint for you is a quick way to save some money. At the end of the day, I think there will always be a sector of the market that is DIY to save money and to have fun with their own project.

Masco’s paint segment grew 12% top line in 2020 – do I think it will continue at that rate? Probably not. But at the end of the day, Masco is a super high ROIC business that even if it grows at GDP, I think it is worth a lot more than the market is assigning right now.


With a healthy balance sheet and $1.3BN in cash, they can buy back a lot of stock to “help the market realize the right valuation.”