2023-12-20 20:42:46 ET
Summary
- WWD reported strong Q4 2023 results with 21% organic revenue growth, driven by growth in Aerospace and Industrial segments.
- Management revised its long-term outlook, projecting 7-9% organic growth, earnings growth twice the pace of revenue, and free cash flow conversion of over 100%.
- More content in Aerospace and the shift towards dual fuel engines in the Industrial segment are expected to drive above-market growth for Woodward.
Overview
My recommendation for Woodward ( WWD ) is a buy rating, as 1Q24 margin performance was better than I expected and the growth outlook is now much better. The content gains in both segments should help to achieve the long-term growth outlook set out by management. Note that I previously rated a hold rating for WWD as I was unsure about how the margin performance was going to be in the near term.
Recent results & updates
WWD reported total 4Q23 revenue of $777 million, showing 21% organic growth. The strong growth was driven by 11% growth in Aerospace revenue to $455 million and industrial revenue growth of 39% to $322 million. The margin concern that I had previously appeared to not be a big issue, apparently. Segment operating margin came in at 17.1%, an increase of 390 bps vs. last year. Both Aerospace and Industrial EBIT margins improved y/y as well, with Aerospace up 170 bps and Industrial up 790 bps on a y/y basis. Overall, performance was pretty great, and with management revising its long-term financial target at its analyst day , I am now much more positive about the outlook.
Touching first on the revised long-term outlook. Management guidance now includes:
- 7 to 9% organic growth CAGR through FY26. Using 8% as the midpoint, it implies that WWD will be able to achieve around $3.7 billion in revenue.
- Earnings to grow at twice the pace of revenue, implying 14 to 18% growth (excluding inorganic contributions).
- Free cash flow conversion of more than 100% (implying more than 4% FCF yield at the current valuation)
The focus for WWD is its Aerospace segment, which management has targeted to grow at an 8–10% CAGR through FY26. Aerospace margin target was also raised slightly to 20 to >22% from the >20% target previously. In my view, after reviewing the recent performance and management comments, I am positive that this guidance can be achieved. The most important factor would be the increase in WWD content for the newest generation of narrowbody aircraft compared to the previous generation. Those improvements, in my opinion, would improve WWD's commercial aftermarket growth rate in the long run. In particular, management pointed out that items with a stronger aftermarket presence were the primary focus of the shipset content increase. This means that the engines used by the A320neo and 737MAX have a much higher aftermarket service value (5x vs. prior generations), even though the shipset value is 3x higher than earlier generations. In my opinion, this sizable multiplier should more than sustain above-market growth for the foreseeable future. Management projected a 12% growth rate for the commercial aftermarket between 2023 and 2031, exceeding the industry average of 6% growth. Keep in mind that management is being cautious with the LEAP aftermarket ramp, so growth is expected to accelerate starting in FY26. As such, the aftermarket growth rate should be accelerated by the multiple effects beyond 2026.
On the other hand, WWD’s Industrial segment should also drive growth, especially with the shift toward more dual fuel engines which should offer a tailwind. Management provided an example of the possible impact by stating that the content's value for these engines could be more than 50% greater than for an engine that uses just one fuel source. As the proportion of marine engines powered by dual fuel engines continues to rise , I anticipate that this enormous increase in potential demand will propel Industrial to experience above-market growth in the years ahead. Given the relative technical complexity of these dual fuel products, I also think their pricing and margins could be higher. This has the potential to boost Industrial's profit margins even further.
Valuation and risk
According to my model, WWD is valued at ~$170 in FY25, representing a 24% increase over 2 years. This target price is based on management earnings growth guidance through FY26, which I believe is achievable given the growing content penetration in both the Aerospace and Industrial segments. With the improved growth outlook, I believe WWD’s current 27x forward PE multiple is much more justifiable when compared to its 5-year trading history. Over the past 5 years, WWD revenue grew at a CAGR of 5% and was trading at a high 20+ forward PE. Now that the growth outlook is much better, I believe it deserves to trade in the same range.
The extended time it takes for engine shops to complete repairs is a big problem for WWD's aftermarket business since it delays the demand pull for WWD's parts. The impact on revenue and earnings has been negative, and it's possible that this will remain so in 2024.
Summary
I am now recommending a buy rating for WWD as management's revised long-term guidance indicates a positive growth trajectory through FY26. The main driver is Aerospace growth, particularly in content for newer aircraft generations. Also, the growth in dual fuel engines should also drive above-market growth for the Industrial segment. My valuation model has a target price of $170, driven by WWD enhanced growth prospects and a forward PE multiple of 27x.
For further details see:
Woodward: Growth Outlook Through FY 2026 Is Positive ( Rating Upgrade)