Woodward (NASDAQ:WWD) is a relatively small industrial and aerospace business that is not that well-known to many investors. Over the past decade, Woodward has created quite a strong track record of growth accompanied by strong and stable margins. While cash flow generation has come under pressure in recent years, the outlook for cash generation is good following a recent investment spree, combined with some bolt-on dealmaking. The trouble is that the market has picked up on these defensive qualities so far this year, making shares of this quality play expensive both on an absolute and a relative basis.
Woodward develops control systems and components for both aerospace and energy markets. The company generates $2 billion in sales each year doing so, split pretty evenly across these two end markets. The company's control systems focus on flow, combustion, electrical and motion systems, allowing customers to get more clean and reliable output. In both industrial and aerospace markets the company is well-positioned, certainly as the world is looking to improve efficiency and reduce emissions.
To defend its position, Woodward has strong ties with many OEMs and it invests heavily in R&D to fortify its position in markets being "protected" by certification and long sales cycles. Another appealing item is the servicing of the installed base, creating more stable cash flow streams rather than through outright installments itself.
The aerospace segment focuses both on airframes, as the company is a key supplier to Boeing (NYSE:BA) and Airbus (OTCPK:EADSY), as well as engines. GE (NYSE:GE) and Rolls Royce (OTCPK:RYCEY) are key customers in the latter segment. Roughly 60% of aerospace revenues are derived from deliveries to OEMs. The more stable aftermarket sales business makes up roughly 40% of sales. Roughly two-thirds of revenues in the industrial segment are generated from power generation clients, with oil and gas as well as machinery clients making up the remainder of sales.
The popularity of the products has in part been driven by market share gains, which on their turn results from continued elevated investments into R&D. This growth has a downside, namely that it hurts free cash flow generation in the short run. Capital spending related to new facilities was peaking at $200-$300 million a year between 2014 and 2016, only to fall back to an anticipated $100 million thereafter.
A Look At Past, Steady Growers
Woodward's niche position across two long-term growing segments has been beneficial for the company in the past. The company has more than doubled its sales from $850 million in 2006 toward $2 billion at the moment. The margin profile has been very stable, with operating margins ranging between 10% and 13% of sales, being another key attraction for investors. While organic growth played a major role in these achievements, Woodward has engaged for a total of roughly $1 billion in acquisitions as well.
Besides more than doubling top-line sales, Woodward has managed to buy back 10% of its outstanding shares over the same period of time. That allowed revenues per share to increase by roughly 150% in that period of time. These are pretty encouraging results, and have been closely matched by the share price development.
After temporarily dipping toward $10 in the midst of the crisis, shares have gradually risen, mostly trading in the $30-$50 range. Shares have been on fire already this year as the market recognizes the defensive qualities of the company, with shares trading 35% higher compared to levels in early January.
Upcoming Free Cash Flow Bonanza
To facilitate recent growth and upcoming growth, Woodward has invested heavily in organic expansion, pressuring free cash flow. Total free cash flow generation was just $300 million in the period between 2011 and 2015, as the completion of these projects should boost cash flow generation going forward while reducing capital spending needs. Therefore free cash flow generation is seen at $1.5 billion between 2016 and 2020.
The company just finished its fiscal year of 2016. While full-year sales were flat at $2.02 billion, headwinds in the industrial business were offset by continued resilience in aerospace. With headwinds starting to alleviate into the industrial segment, fourth-quarter revenue growth accelerated toward 5%, an encouraging development.
As the industrial segment is anticipated to stabilize, 2017 revenues are seen up by 4%-6%, allowing for earnings of $2.95-$3.25 per share, vs. the $2.85 per share reported this year. The 35% run-up in the share price so far in 2016 left shares trading at elevated multiples, with shares now exchanging hands at 21-22 times forward earnings.
Cash flow generation is key in the coming years, expected to surpass anticipated earnings. Holding $81 million in cash, Woodward operates with nearly $650 million in net debt. Note that operating earnings totaled $253 million in 2016. After adding back a combined $69 million in deprecation and amortization charges, EBITDA came in at $322 million, for a 2 times leverage ratio. The forward ratio will, however, fall below 2 times given deleveraging and increased earnings.
Final Remarks - Great Business Has Become Pricey
Woodward is a great business, but it is simply a bit too expensive for my taste. While 2016 was a flat year, as continued progress in aerospace was offset by poor industrial performance, growth is set to resume in the coming year. That is the only bright spot, however, for investors as valuation multiples have increased a lot with shares up 35%, while the underlying performance has been flattish.
At 22 times forward earnings, and being leveraged around 2 times, the valuation is simply a bit too steep. This is despite a stellar track record and the fact that the company has made a lot of capital investments already in order to support future growth. While continued aerospace growth and a rebound in the economy might aid profit growth, the valuation multiples are a bit too steep.
By applying a market multiple to earnings of $3.10 per share, I end up with a fair value calculation in the mid-$50s, levels that we saw days before the election. At an all-time high of $67, I have no interest in buying shares at this point in time. That said, I will place the company on my watch list given the great positioning, stable margins and very good track record.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.