Tag: Equity Analysis

Container Shipping is on Fire: Opportunity in Leasing Stock Triton $TRTN

Reading Time: 6 minutes

As everyone I am sure is aware, container shipping rates right now are astronomical. The re-opening of the economy and associated supply-chain bottlenecks has created a situation where people will pay up just to make sure their items are actually on that boat!

This has caused blow-out earnings for the shipping lines. Maersk reported a 166% increase in EBITDA for Q1’21 for example.

However, I don’t think this is sustainable and no one else does, probably. Shipping is also a fraught industry to invest in – when times are good, capacity is brought online. These ships are long-lived assets so when times aren’t good, the supply is still there.


There’s alternative however, with a much stronger industry structure, ROEs, cash flow, on and on. That is container leasing. Triton is the largest player in the space after it merged with TAL in 2016.

I like Triton stock because:

  • Leader in the market – scale in the leasing industry matters and drives much higher margins + lower cost of capital
  • Fundamentals are in terrific shape
  • They are signing long leases at high rates – abnormally long and abnormally high – which will give strong visibility into cash flows for foreseeable future
  • Can flex capex spend with the market – has a history of shutting of capex and buying back stock + dividend
  •  Triton stock trades for ~6x ’21 EPS, 1.3x ’21 BV – historically generated mid-teens+ ROE in normal times. This should improve

The business historically went something like this:

  • Triton buys containers and places them on lease with shipping companies.
  • Historically, these would be 5 year leases. However, with limited technological obsolescence (just renting a steel box in most cases), the age of the asset didn’t really matter. So they can pretty quickly re-lease the box, but the lease rate may change
  • The assets (boxes) last about 15-20 years with pretty minimal maintenance. Maybe slightly more for a refrigerated box, called a reefer (yes the actually  name), but the lease rates would also be higher. So historically there’d be 3+ leases involved
  • End of life – they sell the box for some residual value, which also helps recoup part of their investment. It used to be they buy a box for $2,000-$2,500 and could sell it for ~$1,000. Right now, they can sell the used box for about $1,500, which is pretty nice.

Why do shipping companies lease instead of owning their own containers? It outsources capex in an already capex-heavy industry. It’s off balance sheet financing for them. The shipping lines do still own their own containers (about half of the market), but that’s been trending down pretty consistently over time. It just makes more sense for them to focus on shipping and flex leases up and down with the market.


Investment Thesis

I don’t think I need to dwell on why fundamentals are good right now or why buying Triton stock at 6x earnings is optically cheap. I’m going to focus on the lease rates and new longer duration contracts being signed right now.

If you are worried about the current conditions being unsustainable, long, contracted lease rates help that. As shown below, Triton is trying to tell investors that not only is it leasing more containers than basically ever….  putting assets to work… the lease durations are now approaching 12-13 years.

If you like SaaS, you’ll *love* container leasing companies.

We’ll have to think about these rolling off in 2031-2033, but meanwhile, the company will be earning above average ROEs.

Here is a chart from their Q1 basically showing lease rates are 1.6x the general average. You can see there was a dip in 2019, but the company pulled back – the size of the bubble indicates how many containers were put on lease (so very few). In a sense, Triton is an asset manager just like a Blackstone – you kind of need to trust that they will be deploying capital when times are good and pulling back when times are bad.


What could go wrong?

I should mention what could go wrong. We have seen this situation before – following the GFC, world trade snapped back and lease rates surged. Unfortunately, they all basically expired in 2015/2016. This was also when we were in a quasi-industrial recession. This was also when steel prices were in the gutter, which makes up most of the price of a box and makes it tough to sell used boxes at a fair price. Hanjin, a major shipping line, also effectively liquidated (in a BK case, most of the time a shipping line will just keep its assets rolling in a Ch. 11 because its a critical asset to operating – Hanjin just disappeared.)

In many ways, 2015/2016 was worse that the GFC. I mean, it actually was worse. The GFC wasn’t actually that bad because global trade remained pretty steady.

Even with a trade war, it’s hard to knock off the secular trend of the western countries importing from Asia. If it isn’t from China, it is from Malaysia, Vietnam, and so on.

Did I strike to buy Triton stock in 2015-2016?? No. I was gun shy as I’ve been following the industry for quite some time and they never seemed to generate real FCF (CFO-Capex). It was an asset gathering game.

But then in 2019-2020, when the market wasn’t particularly great, they actually proved they could shut-off capex. They starting generating a ton of FCF and showing signs to shareholders that they care about the stock (they issued a pref as well to help fund buybacks)

Another sign they care about capital allocation is this fantastic sources and potential uses of cash in their deck:

Basically they are telling you they could buy back 12% of the stock in one year. Share count is down about 15% in 2.5 years, but now I think they’ll be deploying cash into higher ROE opportunities, which is fine by me.


Financing

One thing I should mention is typically Triton finances itself through the ABS market. They get 80-85% LTV against the asset value for very long duration. Happy to answer any questions on this, but I’m not too concerned with the ABS market financing.

Triton issued $2.3 billion of ABS notes during the third quarter at an average interest rate of 2.2%. Most of the proceeds were used to prepay $1.8 billion of higher cost notes, which is expected to reduce interest expense by more than $25 million over the next year

They are also diversifying financing – so they just issued an IG secured bond and have talked about moving up to IG ratings. If their cost of capital goes even lower, I it will be great for the business in the long run.


EPS Estimates

Last thing I’ll say is basically Triton is covered by one company. You’d think modeling it would be easy enough, but we are talking about hundreds of thousands of containers, utilization can change, etc etc. However, I think EPS estimates are probably still too low in the long-run. It’s been that way in the short-run, so far, but we shall see. It’s hard for sell side to model operating leverage + high lease rates + deploying cash into such a significant amount of assets.

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.

Forced Seller + 25% FCF Yield = Interesting Civeo Stock $CVEO

Reading Time: 4 minutes

Today will be a quick idea on Civeo. The bottom line is that CVEO stock trades at ~25% FCF yield, is only ~2.5x levered, and there is a “forced” seller I think is driving down the stock.

Ok – “forced” seller is kinda click bait. The company completed an acquisition a few years ago, giving the seller some stock as consideration. That seller is now blasting out nearly every day, which I get into below.

Background

Civeo provides hospitality services to commodity industries. So think about remote locations where companies are mining precious metals and pumping oil and gas, Civeo provides lodging, food service, and housekeeping for those companies.

Commodity prices generally have been completely bombed for several years now, particularly where the company participates. This includes oil, liquified natural gas, met coal (the coal used to make steel), and iron ore, though demand has still been OK (as I noted in this oil post). The nature of the business also means they typically are in highly commodity driven areas – Australia (given their met coal and other metals help serve the China / Asia demand), Canada (oil sands) and the US E&Ps.

As you can see, the stock has not performed too well in this environment.

The company currently operates around 28 lodges covering 30,000 rooms. They also own a fleet of modular assets that are typically used for short-term stays in the US and Canada.

“Forced Seller”

ANYWAY –  if you were to look at the company’s insider transactions, it would look UGLY. The Torgerson’s have sold 3% of CVEO stock (almost $7MM) in near-daily blocks since August 2020.

That is until you realize the Torgerson family were the sellers of a company Civeo bought, Noralta Lodge, for $165MM. Of the total purchase price, $69MM was issued in equity to the holders of Noralta.

This was a little over 3 years ago at this point, so no surprise following a COVID scare + some time since you’ve sold your business that’d you would just want to move on.

The Torgersons still own 11% of the company, so there is a long way to go, but I can’t call the end of this technical factor.

Nearly 25% FCF Yield

The seller is obviously not selling because the value of the CVEO stock looks too rich.

On the latest call, Civeo management guided to $55MM of FCF. This compares to a market cap of ~$230MM. Previously, the company used FCF to delever (after levering up for Noralta), but now that it is at 2.5x, there is a bit more flexibility. As I’ve talked about, I like these busted balance sheet names as they start to improve, but are still in the penalty box of equity holders.

When a stock trades at 25% FCF yield, the market is saying there is high bankruptcy risk. I don’t think that’s the case here. The term loan and revolver mature in 2023 and they generate plenty of FCF to keep lenders happy.

Fortunately, the COVID snapback has caused commodities to rip. If they stay elevated, who knows, but I think it will at least help the company extend contracts on existing lodging facilities and maybe sign some new ones (that will also help any concerns with credit facilities, but again – I’m not concerned there).

There is a bit of a spat going on between China and Australia over trade, but I think it’ll be sorted out eventually. Either way – this was included in mgmt’s FCF guidance. Secondly, the company announced it renewed several key Australian contracts on its latest call.

Back to the FCF yield guidance – there should be pretty good visibility. You have a set number of rooms available on site, you talk to your customers about need and what they are planning for the year, and you have a general gauge of commodities (are they up or down, is demand up or down) so you can try to win more business. This makes me believe FCF guide is a decent one to bank on.

Last thing I’ll say, the past 3 years the company actually generated $63MM of FCF on average. There was some working capital movements there, but it doesn’t seem unreasonable at all to me.

M&A Target (Seriously)

Using “M&A target” as an investment thesis is weak… yet here we are.

Typically its weak because its like, yeah sure… in SOME scenarios, this COULD get acquired (especially in a deal hungry private equity market), but any time I hear that, it doesn’t come to fruition.

In this case, Target Hospitality received a buyout offer from TDR Capital. Now, it was apparently a really cheap price of $1.50 and now Target Hospitality is trading at $3.40. Target Hospitality currently trades at 7.25x ’21 EBITDA vs. 6.0x for CVEO. HOWEVER, Target is also pretty levered still at 5x EBITDA vs. 2.5x for CVEO. Their cash flow has also been much less consistent. 

I also think the capital markets are supportive and perhaps this company would be better suited as a private company, rather than a $230MM public company. Just saying.  

Different Way to Play Housing: Manufactured $CVCO $SKY

Reading Time: 7 minutes

I did a recent post on Sun Communities, a manufactured housing and RV park manager. I liked the core business and outlook, but returns on capital seemed too low and the the REIT structure made them over reliant on capital markets for growth. I could be wrong on that name, but I think I found where I’d prefer to play: manufactured housing stocks. And there are two stocks in the space: Cavco (CVCO) and Skyline Champion (SKY). The Oracle of Omaha owns the other, biggest player in the space, Clayton Homes.

Why Manufactured Housing?

Bottom line: Manufactured housing has improved considerably over the past 30 years (both from a product perspective and an industry perspective). With home prices moving higher with tight supply vs. demand, I think we will see considerable demand for something more affordable for years to come. I also think these stocks are “off the radar” for most people. COVID also masked a very large build in backlog.


Why is Housing in a Shortage? Following the last downturn, where we clearly overbuilt housing supply, we went too far in the other direction. We’ve been underbuilding arguably since 2010 when the housing market started to bottom.

If you look at the long-term average of construction starts (pictured below), its around 1.5-1.6MM average starts per year. We just got back to that level 11 years after the bottom. So we just got to long term averages. In 2012-2013, we were still building in line with the lows of 1980’s and 1990’s recessions (I’ll add that the average mortgage rate in the 80s was in the teens percent range… not below 4%).

Another simple way I think about it is, if there are 120MM households in the US and that grows 1% per year, we need at least 1.2MM new housing developments each year, and that is before any teardowns or second homes.

In reality, household formations over the past 10 years have been held back. We all remember the stories of millennials moving back in with mom and dad. Well, that is a deferred housing formation. And that is finally starting to unwind as millennials age, get married, and have higher savings.


Another way to look at it is from “months supply of inventory.” Months supply of single-family homes hit a new all time low recently at 1.9 months. This means at the current sales pace, all of the housing inventory available for sale would be sold in less than 2 months – a new record low.

Tight supply + strong demand = increased prices. Econ 101. And that is bearing out. CoreLogic reported home prices increased 10% Y/Y in January 2021. Low interest rates also haven’t hurt to spur demand…

Could housing cycle down again? Yes. Absolutely. In 2018, when rates were rising, people paused their purchases. You can kind of see the surge in months supply of inventory on that last chart in 2018. However, that just deferred demand.


I encourage you to scan your local market for “entry level” homes. There just aren’t any available. Part of that is also because of investors scooping up rental homes, too. We also now have 3 publicly traded REITs that play in the single-family home market that didn’t exist prior to the financial crisis.

All of this tells me that housing will remain unaffordable to a large swath of the population.

Enter: Manufactured Housing

In areas I look at real estate, the $150k entry-level home doesn’t exist anymore. At least, not within an hour’s drive. Heck, even $250k is becoming more scarce.

SKY had an interesting stat from 2018 that noted, 80% of homes sold below $150k are now manufactured homes. The average price SKY sold homes at was ~$63k, so there is a huge disparity between entry-level single family home and buying manufactured housing.

We also can’t forget that ~37% of American’s earn less than $50k per year. One out of four Americans make less than $35k per year. And that’s the market for manufactured housing.

Statistic: Percentage distribution of household income in the U.S. in 2019 | Statista
Find more statistics at Statista

Some Quick History

This might be a good time to explain some history on manufactured housing. In short, MH saw a mini-preview of the Great Financial Crisis in the 1990s. Both consumers AND retailers were able to get ultra-easy financing. When you think about that in relation to supply / demand, it basically meant demand from consumers was artificially propped up AND retailers were able to stockpile inventory cheaply.  This eventually caused the industry to implode and it still hasn’t recovered from a shipments perspective.

Recovery to these levels isn’t my thesis though. It is pretty hard to argue shipments will go back to bubble levels.

The share of manufactured housing as % of housing starts has been pretty constant though over the past 15 years, which I think could improve some in an affordability crisis. I think it could also exceed recent levels because of this. I also think starts will continue to be above long-term averages.

So we may not get to 222k shipments as highlighted in the chart above, but we could come somewhere in between.


As with any downturn, this led to consolidation. Berkshire is the behemoth, followed by Skyline (which merged with Champion) and Cavco. The latter two still roll up any players that come for sale, but its pretty well consolidated at this point.

As pictured at the beginning of this post, the inventory available has really improved. And they come in all shapes and sizes…..


I Like the Business Model

The business is vertically integrated. A SKY or CAVCO typically manufacture the home, but also operate the retail side as well (though there are individual retailers, too).

Need financing? Cavco and Clayton have retail financing arms, too (and they are GSE approved). Both Fannie and Freddie offer financing support, which is relatively new and I personally view as a game-changer. There was a recent WSJ article on this as well. Now consumers can get access to cheap financing with as little as 3-5% down – very helpful to a consumer who may not have a high degree of net worth. I’ll circle back to the limits of this, though (permitting).

How do they transport the homes? They operate trucking businesses, too.

Anyway, I think the manufacturing side of these homes is interesting. Homebuilding is actually moving more and more to these sorts of “off-site construction” given labor constraints and a desire to speed up build times.


Why Permitting is an Issue

A benefit to Sun Communities is a detriment to Cavco and Skyline. Manufactured housing suffers from “NIMBY” or not in my back yard. So permitting for new communities that allow these types of housing is tough and this has clearly been a governor on growth. That is essentially why Sun has to acquire for growth versus anything organic.

However, with improved aesthetics and a broader realization that housing is unaffordable, we could see some changes here on the margin.


Cavco and Skyline are very similar, so I’ll just show CAVCO highlight below. While EBITDA margins are relatively low, capex is too. So for each dollar of EBITDA earned, they actually convert a decent amount of that into unlevered FCF (excl-taxes, excl-interest). It seems pretty clear to me that the company can scale up earnings without needing to invest too much.

For example, Cavco acquired some commercial real estate in 2020. Otherwise capex would have been $8-$10MM. Said another way, they increased EBITDA from 2016 by $42MM, but recurring capex only went up by $4MM…


Backlogs are Big

In March 2020, Cavco had a backlog of ~$124 million. Today… its $472 million. But if you looked at 2020’s results, it doesn’t look like Cavco really benefitted too much. LTM sales are up 1%. But the reason has been manufacturing disruption. So the results are really more on the come.

Skyline is in a similar place: Their backlog before the pandemic hit was $128MM… now its nearly 4x that. 


Valuation

Admittedly, Cavco and Skyline don’t screen as cheap stocks. Each trade around 15.5x March ’22 EBITDA and 25x FCF based on consensus estimates. Number one, I think the higher multiples are warranted as these businesses can generate good FCF and they also are essentially debt-free (kind of like WD40). I also think growth will be above average for years to come.

I also think consensus is way too low.

Again, these are manufacturing businesses with backlogs that are up 4x from pre-COVID and we really haven’t seen that roll through yet. Therefore, consensus estimating sales up 12-15% for CY2021 seems way too low to me. While labor and raw material increases could squeeze margins, if capacity utilization on the plants are running flat out, that fixed cost leverage will improve EBITDA considerably.

Time will tell. I like both Cavco and Skyline and am just playing it via a basket.

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: