Tuesday, July 11, 2006

WD-40 and the Slippery Slope of Advertising and Sales Promotion

Lots of value investors have admired the brand franchise of WD-40 (WDFC) over the years. In a recent interview with The Wall Street Transcript (subscription required) Bryant Evans of Cozad Asset Management describes the rationale for his holding of WDFC:
"One of the things that we really like about WDFC is that management does a nice job of expanding its product line without losing focus. To some extent, it epitomizes what we're looking for in terms of management skills and marketing within the conservative framework that qualifies a company for our portfolio."

WD-40, known for that little can of lubrication wonder, actually represents nine different leading consumer brands.The lubricants, both WD-40 and 3-In-One represent some 65% of sales, Internationalization is significant as these products are marketed in over 160 countries. Europe represents 29% of sales and Asia-Pacific about 8%.

The stock dropped about 7.4% today despite what seemed to be at least superficially, okay numbers. Let's look a little closer:

Revenue growth was 12.1% reflecting 13.2% growth in lubricants, 12.3% growth in Household Products, and a 16% decline in hand soaps (I may be the last living user of Lava soap!) I thought sales growth looked quite decent reflecting various product extensions that made a lot of sense,,,the WD-40 Smart Straw and No-Mess Pen come to mind. European growth was amazing at over 27% YOY. European sales growth in Household Products was negative at -3%.

Gross margins actually expanded by 50 basis points to 48.5% despite the cost pressures of petroleum based chemical raw materials. But operating income was flat and operating margins were down to about 15% versus some 17% a year ago. The culprit is SG&A which is up to over 25% of sales due to stock options expense and selling and marketing expense. Selling expenses were up to over 8% of sales versus last year's 7% and what historically, had been less than 5%. Management suggested that a range of 7.5% to 9% may be appropriate for the future.

It is easy to lose sight of what advertising and selling expenses represent. In my view, for a brand name company, this is not terribly different than making a capital expenditure that provides you a 100% first year tax write-off. For a brand name company, advertising is an investment in the future. Its effectiveness does not become apparent with immediacy generally, but I do believe that it can be a very worthwhile "investment" rather than "expense."

WDFC management continues to seek acquisition opportunities that meet its ROIC hurdles. Prior to its acuisitions of 1999 and 2000, which brought in the businesses of Lava and Solvol, this was an underlevered firm with ROIC of over 30%. Acquisitions had brought debt to almost 60% of capital by 2001 and the company has steadily improved its balance sheet since then. Debt is down by about $20 million over the last year, down to about $53 million. The company could easily handle a  significant acquisition that employed debt since interest coverage ratios are very high (11 times.) But ROIC is now around 15-16%, slightly above the 13% levels that it reached right after the acquisitions.

The company generates close to $1.00 per share in free cash flow (TTM) at this point and has about $45 million of cash and equivalents on the balance sheet ($2.00 per share.)

The company pays a 22 cent quarterly dividend and has maintained this level since mid-April 2005 having cut its dividend to 20 cents in 2002 from a previous 27 cent level, and as high as 32 cents in 2000. The company has bought back little stock over the years with a net buyback of only $7 million in 2004. Not what I would call being shareholder friendly.

The strategy is somewhat disturbing to long time admirers of the stock. Product extensions are great when they result in sales growth. Geographic expansion is great...imagine every Chinese family with a can of WD-40. Use selling expenses to build your brand...that's great too! But reliance on building a portfolio of consumer brands through acquisitions which have reduced your return on invested capital to just attractive from astounding seems like the wrong approach. The historical acquisition  record, at least in my view, does not create great feelings of warmth and respect. The need to reduce the dividend temporarily was correct and probably required by the indentures related to the borrowings...but let's share the wealth.

From a valuation standpoint, the company is trading at merely 10 times EV/EBIT, a relative "bargoon" to quote Eddie Shack, for a business that produces a 16% ROIC. Superficially, it seems attractive, but the strategy worries me. My conclusion: Statistically attractive, but not with my dough.

Disclaimer: Neither I, nor my family have a current position in WDFC. A number of clients do have a current position in this stock.


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