WDFC - WD-40 Company: We Were Wrong

2023-07-11 13:14:35 ET

Summary

• Earlier this year, we suggested a short-term sell of WD-40 Company due to sky-high valuation and what looked like a weakening macro situation.
• WDFC stock has been perennially overvalued, so maybe the market is fine with that in perpetuity.
• WD-40's fiscal Q3 earnings were exceptional relative to the usual slow growth of the company.
• No one gets hurt taking a profit, but we left money on the table.

We have long owned WD-40 Company ( WDFC ) stock. This is actually our senior analyst's longest holding. It has been a generational hold. In fact, in the words of our senior analyst, "my grandfather always said 'put a little WD' on it." A cure-all for all things stuck, rusted, or needing a little bit of grease.

In April, after the last earnings report, which was poor, in conjunction with the sky-high valuation , we applied a short-term sell on WDFC stock and dumped 20% of the position. In retrospect, that was a mistake. We had thought the market was going to revalue the name lower on what looked like a rather so-so outlook for the rest of the fiscal year, and that the valuation was so high, with very little dividend support or growth behind it. Well, the valuation has been stretched for years. Maybe for whatever reason that is the valuation the market is comfortable with, because for many years it's been trading at 30-40X. Yes, the stock is simply overvalued. But we got that call WRONG. And when we are wrong, and thankfully that is far less than we are correct, we own it. So we own being wrong on this one.

Now, we return to cover the stock not just to say we got this wrong, but to talk about the much better-than-expected performance the stock just put out. Yes, all of our complaints about valuation, low growth, and low dividends remain. We would never sell the whole position but are regretting the sell a few months ago as shares are up a good 20% from there. That is a lot to leave on the table. In fact, 20% gains are our targets on all of the BAD BEAT Investing trades we make. So this one missed the mark, while WD-40 nailed the mark in its just-reported quarter. Thankfully, we kept the bulk of the position. No one gets hurt taking a profit, but it "hurts" in that this is a generational stock that Dr. Davis (senior analyst) hadn't sold a share of the company since Feb 2021, when it was ridiculously expensive. At that point, no regrets. And before that, 2007!

So, WDFC stock will remain a holding, the growth outlook will simply continue to be slow and stable, and the stock will remain expensive. Frankly, with markets having risen so much, and with so many macro headwinds brewing, it is wise to be selling stocks in this environment with high valuations. WD-40, we suppose, is a hold. Buy low sell high, hold in the middle. We are at hold levels.

While WD-40 products are largely insulated from a recession, they are not immune, so there is some risk still. The performance of the company does not justify the premium on earnings in our opinion, but the market thinks otherwise. WDFC stock has been priced for rapid growth for years now, and growth has been slow and steady. Margins have been preserved thanks to inflation allowing price increases, and some cost-cutting. The just-reported earnings were upbeat and much better than expected. In this column, we discuss the strengths and weaknesses of the fiscal third quarter.

WDFC's topline growth continues

The company is regularly increasing sales. In fiscal Q3 , on an absolute basis, sales for the fiscal third quarter were $141.7 million, up 14.6% from the $130.2 million last year. We were expecting sales of around $396.8 million, so this was actually an upside surprise. This also surpassed consensus by $3.3 million . We thought sales would be up single-digit, so this was a big upside surprise.

Sales up in all regions

WD-40 Company has expanded its business internationally, and the gains have been impressive. Long term, there are many more markets that can be penetrated. If we look at the sales on a constant dollar basis, net sales for the quarter were much higher. Controlling for currency, sales were up to $145.6 million overall. Overall, net sales by location for the quarter were 50% in the Americas, 37% in EMEA, and 13% in the Asia-Pacific region.

Sales in the Americas increased 16%, driven by 21% higher sales of maintenance products in the U.S. versus last year. The increase was entirely driven by the impact of price increases, which was partially offset by slightly lower demand, which resulted in decreased sales volume. Sales were down 23% in Canada, and they increased 18% in Latin America. This was strong growth, and the company was both promotional while also increasing their prices.

Net sales in EMEA rose 6%, which was primarily due to price increases across all direct and distributor markets. If we control for the dollar, sales would have been up 13%. Volumes were down, but direct market sales were up 2%. In Asia-Pacific, sales were up 42% from last year due to much easier shipping conditions as the COVID pandemic restrictions were lifted. There was a 151% increase in maintenance products sold in the Asia-Pacific distributor markets and 13% increase in China sales have remained constant which was surprising with the country reopening for business. Thankfully, price increases not only boosted the top line above expectations, but they helped margins a bit too.

Margins improved

WD-40 Company has a long-term 55% gross margin target. For quarter after quarter, it seemed that there were simply too many increasing expenses, including labor, input costs, and administrative costs, for this to be attained. However, margins are moving in the right direction year-over-year. That said, Q2 gross margin was 50.6% compared to 47.7% in the prior year fiscal quarter. That is a huge swing. Year-to-date gross margin was 50.9% compared to 49.7% in the prior year fiscal period.

The work to reduce expenses has started to have an impact. Selling, general, and administrative expenses were up 14% in the quarter to $38.2 million compared to the prior year fiscal quarter. We would like to see better cost controls here, but there is labor inflation and input cost inflation to deal with. Advertising was stepped up as well in the quarter to move product, with a 23% increase here to $7.7 million.

Net income was $18.9 million, an increase of 30% from the prior year fiscal quarter. EPS rose to $1.38 from $1.07 a year ago and beat estimates by $0.16 per share. This was a strong turnaround to be sure, as the previous fiscal Q2 was abysmal, and in part, drove our decision to slap a sell call.

Looking ahead

The market liked what it saw and has sent shares higher. Guidance was reiterated for the year. EPS is forecast to be $4.90 at the midpoint for this fiscal year. This is now over 40X FWD EPS. Yes, overvalued, but, it has been for many years. Sales should rise in the single-digit this year, and the company is repurchasing shares. Just two weeks ago, the board approved a new share repurchase plan. Under this new plan starting on September 1, 2023, the company is authorized to acquire and retire up to $50.0 million of its outstanding shares through August 31, 2025. The dividend is still being paid, but the yield is a paltry 1.5%. In conclusion, the price action may not make sense fundamentally, but WD-40 Company is indeed a slow and stable grower over time. We will hold the remaining stock, despite the valuation.

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