WWD - Woodward Seeing Aero Ramp But Industrial Is Lagging And Margins Remain Challenging

Summary

• Woodward did fine on revenue in the December quarter, but margins were substantially weaker than expected, including very underwhelming performance in Industrial.
• Management is taking an active hand in restructuring Industrial, including combining units and looking to rationalize the portfolio.
• Aerospace demand is on a good path, and Woodward is executing at the top line, but persistent supply/labor cost issues are a watch item.
• Woodward should still be leveraged to an ongoing aero recovery story, but the valuation isn't as compelling now.

A few months since my last piece , and I’m not exactly sure what to think of Woodward ( WWD ). The shares are up about 12% since that generally bullish write-up, beating the market, but other names with aero exposure like Spirit AeroSystems ( SPR ), General Electric ( GE ), and Hexcel ( HXL ) have done better … though I could also list other aero names that have done worse. Suffice it to say, I think the “Woodward is leveraged to the aero recovery” story is playing out.

The company’s miss in the fiscal first quarter, as well as the weaker margins and ongoing challenges in the Industrial segment, do concern me some, as I’m worried that a prolonged period of challenges could temper some of the upside from the aero recovery. With the move in the shares, I see the stock as more fairly valued now. I do think management will work through the overall cost/labor challenges and the Industrial-specific challenges, and I still see upside tied to the ongoing aero recovery, but for me now this name is more “okay” than, “hey, you really need to check this out now”.

Unimpressive Results To Start The Fiscal Year

Woodward’s first quarter results certainly weren’t a disaster, but they do make it clearer to me that there’s still work for management to do. Management themselves acknowledge this, as they’ve postponed the anticipated Investor Day to give them more time to stabilize the Industrial segment. For first quarter results, margins were quite a bit weaker than I’d expected, though full-year guidance hasn’t changed and I take that as a positive.

Revenue rose 14% as reported, and 18% in constant currency terms, and that was good for a 3% beat. Aerospace revenue rose 18%, with commercial aerospace growing strongly (original equipment up 32%, aftermarket up 47%). This was partly offset by weaker defense results which included a 15% decline in original equipment (weaker precision munitions) and flat aftermarket. Industrial sales were up 9%.

Gross margin continues to weaken, falling another 220bp yoy and 80bp qoq to 20.4%. EBITDA fell 5%, and operating income declined 11% (with margin down 150bp yoy and 320bp qoq to 5.5%), missing the Street by a wide margin (close to 30%). Significantly lower than expected taxes helped mitigate the damage and reduce the EPS miss to $0.13 ($0.49 versus $0.62).

Segment profits were also down 11%, with margin down 310bp to 10.7%. Aero profits improved 8%, with margin down 120bp to 14%, while Industrial profits plunged 54% with margin down 640bp to 5.1%.

Multiple Challenges Left To Address

It’s not surprising that inflation remains a headwind; of the industrial companies I’ve investigated more closely in this reporting cycle, pretty much all of them have said that conditions have stabilized more than improved.

Still, I’m a little surprised that Woodward hasn’t managed this better, with management citing a whopping $95M headwind from supply and labor issues. Pricing actions aren’t as simple here as for industrials where there are multiple small buyers with weaker bargaining power, but other companies have found a way ( Crane ’s ( CR ) Aerospace & Electronics business saw 750bp yoy improvement in segment margin to 20.6%, while Hexcel improved operating margin by 380bp yoy to 10.8%) and I’m curious as to why the company is lagging to this extent.

The Industrial business is going to be getting a lot more attention now, with management deciding to consolidate the Engine Systems and Turbomachinery Systems units and rationalize the portfolio (including reducing the number of SKUs).

What’s somewhat troubling to me is that underlying demand conditions aren’t bad right now, apart from the supply/labor cost pressures (which aren’t trivial, I’ll grant). Demand for power generation turbomachinery is healthy, and datacenter backup power demand has remained steady. Demand from oil/gas customers is solid, as is shipbuilding and commercial marine (ferry and cruise activity has recovered beyond pre-pandemic levels).

The only problem area at present is the Chinese natural gas truck business (where Woodward sells combustion control products), and this accounts for about 20% of the segment’s business. With an adverse spread between natural gas and diesel at present, there’s just not as much demand and it’s unclear when this will resolve (though the Chinese government continues to incentivize natural gas trucks over diesel).

Meanwhile, In Aerospace…

Not unlike the Industrial business, my concerns in Aerospace here are more about leveraging profit opportunities during this recovery as opposed to actual sales growth. Relative to aerospace industrials that have reported, there was nothing wrong with Woodward’s growth this quarter (it was better than Crane’s and GE’s). I do believe the supply and labor cost pressures will ease, and again I’d note that while FQ1 results came up short on margins, management did reiterate its full-year targets for revenue and EPS.

I continue to see upside for commercial aerospace suppliers, though at a more moderate pace. Both Airbus ( EADSY ) and Boeing ( BA ) have confirmed near-term production targets for their narrowbody programs (including 31 737s a month), and widebody production should pick up later this year. In the meantime, global air travel continues to recover, though a global slowdown in 2023 will likely challenge that a bit (but I don’t see it impacting aircraft orders).

Honestly, as boring as it may be to read, there’s nothing Woodward needs to really do here beyond resolving the labor and supply chain issues. The product portfolios are solid and Woodward addresses a lot of OEM and operator concerns like fuel consumption, emissions, and operating costs.

The Outlook

I haven’t changed my revenue assumptions to any meaningful degree, though I admit to being tempted to slightly boost them on what I think is actually a better outlook for most of Woodward’s industrial businesses (Chinese nat gas trucks excepted). I have decided to lower my operating margin estimate by half a point for FY’23 and a quarter-point for FY’24. I’ve also trimmed back my FY’23, FY’24, and FY’25 EBITDA assumptions a bit (FY’23 much more than FY’24 or FY’25).

At this point, I’m still looking for long-term revenue growth of over 7%, driven by the aerospace recovery, with EBITDA margin improving to the high teens over the next three years and helping pull free cash flow margins back into the double-digits. Long term, I’m expecting normalized FCF growth in the high single-digits.

The Bottom Line

None of those changes impacted my fair value estimates all that much (by about 1% to the worse). The “issue” is that the shares have risen since my last update only a couple of months ago, and the prospective returns have shrunk. At the same time, I’m not seeing the beat-and-raise quarters that I’d like in order to justify a meaningfully higher fair value.

I’m not really worried about management figuring out the challenges from cost and labor pressure, nor the restructuring efforts in Industrial – I regard these as “when”, not “if”, challenges, and I think there’s still room for aero names to run, particularly as short-cycle industrials weaken. Valuation is the hang-up, though, and while I can understand holding aero names on the assumption that the trend is your friend and will continue, this is a name where I’d wait for a pullback at this point (but wouldn’t rush to sell).

For further details see: