2023-05-08 05:54:38 ET
Summary
- Woodward designs, develops, and manufactures solutions for the aerospace and industrial markets.
- Recent strategic initiatives to reduce complexity and increase efficiency will likely drive FCF growth up.
- Among the assumptions that I made for the next decade, I included the successful deepening of the relationship with customers.
Woodward, Inc. ( WWD ) recently delivered better guidance for 2023, which included better 2023 sales, lower effective tax, and more sales growth in the industrial business unit. With the new guidance, I redesigned my DCF model, and I now believe that WWD is undervalued. In my view, further development of relationships with existing clients, efficiency improvement, and restructuring could lead to a stock price valuation close to $151 per share. I did identify several risks from low client diversification and new climate change frameworks, however I do believe that the stock could trade at higher marks.
Woodward Revised Its Guidance
Woodward designs, develops, and manufactures solutions for the aerospace and industrial markets. These solutions are mostly energy supply or mobility systems, with the aim of offering their customers cleaner and more sustainable ways of accessing these types of services. These customers are often original equipment manufacturers, in the United States and around the world, as the company has production facilities internationally and domestically.
Woodward is fully dedicated to developing and manufacturing energy optimization systems, which include fluid energy, combustion energy, and electrical energy, which are also in growing demand in the markets in which the company participates, forecasting growth in customers and sales in the short term.
For this, the company manages its operations in two operating segments that bear the same name as the market they serve: the aerospace segment and the industrial segment. In the aerospace segment, the company supplies power and control systems and components to both the defense and commercial aviation markets. Although there are different components, within its product offering, that serve to optimize mobility systems with wings and rotors, or even military solutions for defense aircraft, the central core of the company's operations in this segment is based on the propulsion systems and the operation of the turbines.
In the industrial segment, on the other hand, the company's focus and services are placed on machinery that produces conventional or alternative energy, offering energy flow control systems or combustion control solutions, with oil or gas, in large industrial facilities.
In terms of net sales, the aerospace business unit is more relevant than the industrial business unit. However, in terms of profit margins, I believe that both segments have approximately the same efficiency. The numbers reported for the quarter ended March 31, 2023 are shown below.
Source: Quarterly Earnings Report
With that about the past figures, I believe that Woodward is a good read mainly because management recently revised its guidance. The adjusted effective tax rate expected for the year 2023 is a bit smaller than what was initially expected. Sales expectations also increased to $2.7-$2.8 billion, with sales growth of 14%-19% in both the aerospace and the industrial business unit.
I believe that the recent increase in the stock price could be explained by the most recent guidance given. Note that the stock price increased from less than $100 per share to more than $113 per share. My financial model indicated that there may exist an upside potential in the stock price.
Source: Seeking Alpha
Competitors
Competition in all markets is based on the technological and design differential that the products can offer. The barriers to enter and compete in these markets are diverse, and they deserve a large initial capital and infrastructure to sustain operations. In this sense, it is difficult to believe that a new project breaks into the market breaking the current relationships between competitors.
For the aviation segment, the competitors are other companies dedicated to the control of the primary functions of machinery, such as fuel, drive shafts, and the operation of turbines. These companies are Eaton ( ETN ), Honeywell ( HON ), Moog (MOG.A), Parker-Hannifin ( PH ), and Raytheon Technologies (RTX). Some of their clients are potentially in a position to develop their own management systems.
Regarding the industrial segment, the competitors are also companies dedicated to engineering systems and control of energy flow. We found a more varied environment, more subject to local regulations and with just as steep barriers to entry. Competitors to highlight in this regard are Emerson ( EMR ), EControls, Heinzmann GmbH & CoHoerbiger, Meggitt, Robert Bosch AG and Triconix. There are some other clients such as Caterpillar ( CAT ) or Weichai ( OTCPK:WEICF ), which may develop their own management systems.
I Believe That Market Estimates Are Way Better Than That Of Management
I believe that overall the figures reported by external financial analysts are a bit better than the expectations of Woodward. The figures include 2025 net sales of $3.083 billion, with 2025 EBITDA of $528 million, EBIT of $392 million, 2025 net income of $294 million, and free cash flow close to $327 million. It is also worth noting that the FCF margin is expected to grow from 2023 to 2025.
The Balance Sheet Appears Quite Solid With A Small Amount Of Debt
In the last report, cash and cash equivalents stood at $129 million, with accounts receivable close to $663 million and inventories of $567 million. It is worth noting that total current assets were a bit larger than what Woodward reported in September 2022. Total current assets are a bit larger than the total amount of current liabilities, which appears quite ideal.
Non-current assets reported include property, plant, and equipment of $919 million, goodwill close to $799 million, intangible assets of $483 million, and deferred income tax assets of around $25 million. Finally, total assets were equal to $4.011 billion, about two times the total amount of total liabilities.
Source: Quarterly Earnings Report
Woodward also reported short-term debt close to $130 million, with the current portion of long-term debt of $75 million and accounts payable of $220 million. Total current liabilities were equal to $666 million. Also, with long-term debt of $652 million and deferred income tax liabilities of around $138 million, total liabilities were equal to $1999 million. Considering my FCF expectations and FCF expectations from other analysts, I believe that the total amount of debt does not seem worrying. In my view, bankers would most likely offer financing if new deals or projects are presented to them.
Source: Quarterly Earnings Report
Further Development Of Relationships With Clients, Cost Management, Improvement Of FCF Margins, Efficiency, R&D Efforts, And Restructuring Could Lead To $151 Per Share
Among the assumptions that I made for the next decade, I included successful deepening of the relationship with customers in order to become a fundamental part of their production and operation chain. In my view, the company has been experiencing recovery and growth in all the markets in which it participates except in China, where it obviously competes with local companies supported and managed by the central government.
In any case, most of Woodward's current efforts are focused on reducing production and labor costs, and managing price variations that affect all of its operations. Under my financial model, I assumed that management will successfully continue to enhance FCF margins, which may push the stock valuation up. Considering the recent guidance given by other market analysts, we could see further FCF margin improvement in 2023.
I also believe that recent increases in research and development costs as well as restructuring costs could bring new products and enhancement of the cash flow statement. Note that the company did not deliver restructuring charges in the six months ended March 31, 2022.
Source: Quarterly Earnings Report
Finally, I also assumed that the recent sales growth seen in the last quarter will continue. Besides, recent strategic initiatives to reduce complexity and increase efficiency will likely drive FCF growth up. In this regard, I believe that investors will do good by having a look at the recent comments made by management in the last report.
We delivered strong sales growth in the second quarter driven by robust demand for our products and services across aerospace and industrial markets. We also increased output enabled in part by strategic investments made to mitigate supply chain risk, reduce complexity, and increase efficiency. Source: Quarterly Report
My cash flow model included net income growth from 2023 to 2033 and CFO growth. Some of the adjustments that I had to include were increased deferred income taxes, decreases in trade accounts receivable, decreases in inventories, and more income taxes. I also assumed that some items would not change the FCF, like impairment of assets sold, net gain from changes in currency interest rate swaps, and retirement benefit obligations. I believe that these items are not really part of the regular operations of Woodward.
My financial figures for the future year 2033 included net earnings of $601 million, depreciation and amortization of around $66 million, stock-based compensation of $6 million, and deferred income taxes of -$146 million. My figure also included trade accounts receivable of -$219 million, costs to fulfill contracts close to $33 million, and changes in inventories of -$980 million.
Finally, with changes in accounts payable and accrued liabilities close to $1480 million, contract liabilities of -$57 million, and income taxes of $355 million, I obtained CFO close to $714 million and capex close to -$86 million. 2033 FCF would stand at $628 million.
If we assume an EV/ FCF ratio of 29x and a WACC of 9.4%, the sum of future FCF discounted would be close to $9.99 billion. If we include cash and cash equivalents close to -$130 million, short-term debt of -$131 million, current portion of long-term debt of -$76 million, and long-term debt of $653 million, equity valuation would be close to $9 billion. I finally obtained an implied valuation of $151 per share.
With regards to the current price mark, I believe that the Board of Directors assumed that the stock could be worth much more. The company organized a stock repurchase program in 2022, and bought $26 million in equity in fiscal 2023. I believe that companies do not buy their own stock when the price is expensive.
Source: Investor Presentation Source: Ycharts
Concentration Of Clients And The JV Agreement With General Electric Are Relevant Risks
In my view, Woodward reports low client diversification. Only 5 of the clients account for almost half of the company's annual sales. 43% of sales during 2022 were for its five main clients. Sales for its largest client, General Electric ( GE ), accounted for 11% of sales last year, a similar percentage to previous years. The same is true for Raytheon Technologies, its second largest customer, which accounts for 10% of sales on average in recent years. Some clients have the potential ability to develop their own energy control and management systems. This is certainly a primary risk factor to consider.
In addition, the company declares, among its risks, that the recent JV agreements with General Electric may reduce the productive capacity of Woodward. In this regard, I believe that investors need to have a look at the following words from management.
In January 2016, Woodward and GE, acting through its GE Aerospace business unit, consummated the formation of a strategic joint venture between Woodward and GE (the "JV"). The JV agreement does not restrict Woodward from entering into any market; however, consolidation in the aircraft engine market is increasingly prevalent, resulting in fewer engine manufacturers, and thus it may become more difficult for Woodward to secure new business with GE competitors on similar product applications both within and outside the specific JV market space. Source: 10-k
In addition, Woodward's operations are at risk due to fuel price fluctuations and other factors inherent to international operations such as exchange rates and interest rates. In this regard, climate change regulations are a potential risk factor, not only because of current legislation but also because of those that may be approved in the future.
Conclusion
Woodward delivered better guidance for 2023, which included lower effective tax, more sales growth, and more 2023 sales growth in the industrial business unit. I redesigned my financial model with new figures, and now I believe that Woodward is undervalued. In my view, further development of relationships with clients, efforts to enhance efficiency, R&D efforts, and restructuring could lead to a valuation of close to $151 per share. I also saw some risks from low client diversification, the JV agreement with GE, or new regulations with regard to the climate change law framework in the United States or abroad. With that, I believe that the stock could trade at higher marks.
For further details see:
Woodward: Better Guidance And Efficiency Improvements Lead To Undervaluation