WD-40 is Well-Oiled for Growth

The lubrication outfit's market position, strong margins, and new products make it a slick choice for investors, according to S&P

From Standard & Poor's Equity Research

WD-40 Co. says it's in the business of eliminating squeaks, smells, and dirt. Fortunately for WD-40 (WDFC; recent price, $32), these daily nuisances are not likely to go away -- and that fact generates consistent demand for the company's products from consumers and trade professionals.

Standard & Poor's 5 STARS (strong buy) opinion on the stock of this nearly $300 million maker of lubricants, household cleaners, and soaps reflects what we see as its solid growth outlook and attractive valuation. WD-40 has nine leading consumer brands and is the dominant leader in household lubricants around the world. We believe wider distribution and new products are likely to sustain sales growth going forward. In addition, we view WD-40 favorably due to its profit margins and free cash flow that are above the level of peers.

We see WD-40's valuation as compelling as well, with the shares trading at a discount to peers on a relative basis and to our 12-month target price of $39. The stock also provides a 2.7% dividend yield, well above the 1.7% average for its peers. Given these attributes, we look for WD-40 to significantly outperform the S&P 500 over the next 12 months.


  For more than four decades, the company sold only one petroleum-based product, known as WD-40. Beginning in 1995, it began to acquire household-product and hand-cleaner businesses in an effort to diversify and grow.

The company's revenues come from three product categories: multipurpose lubricants (66% of sales in the fiscal year ended August, 2005) -- including WD-40 and 3-IN-ONE Oil; household products (31%), including the 2000 Flushes toilet bowl cleaner, X-14 hard-surface cleaner, Carpet Fresh rug & room deodorizers, and Spot Shot brand; and hand cleaning products (3%), including the Lava and Solvol brands. WD-40 believes its products complement one another, providing lubricant and heavy-duty hand-cleaning brands aimed at the do-it-yourself hardware, automotive, and other retail and industrial markets.

Its brands are sold in various locations around the world. In fiscal 2005, the Americas accounted for 67% of sales, Europe 26%, and Asia/Pacific 7%. In fiscal 2005, WD-40 sales to Wal-Mart (WMT) and its affiliates accounted for 13% of sales.


  Over the past four fiscal years, WD-40's sales and earnings have advanced at a compound annual growth rate (CAGR) of 13%, aided by acquisitions and organic growth. Like many of its peers, profitability over the past few years has been stunted by higher raw material costs. Given the easier upcoming cost comparisons and greater operating leverage that we foresee, we believe the company has opportunity for margin improvement.

We believe the companies that perform well in the household-products industry are the ones that possess superior product innovation. This has been evident over the past five years, in our opinion, with industry leaders such as Procter & Gamble (PG; 5 STARS; $57), Colgate-Palmolive (CL: 5 STARS; $57), and Gillette (now owned by P&G) creating new product categories and changing the way consumers tackle daily household tasks.

While we don't believe WD-40 has yet created any revolutionary or "game-changer" type products, the company appears to be on the right track in creating evolutionary products and making a greater commitment to research and development. In fiscal 2005, the company introduced 11 new products, mainly in the lubricant and household-cleaning segments. In fiscal 2005, the company created a unit to focus on product innovation named "Team Tomorrow." The team has started to show some promise already, in our view, with several key innovations introduced in fiscal 2005 and 2006.


  Much of the company's expected growth in fiscal 2006 will likely come from new delivery systems in the lubricants segment. The company saw an opportunity to boost sales in offering the venerable WD-40 lubricant with new packaging. In August, 2005, it introduced the WD-40 No-Mess Pen and the WD-40 Smart Straw. The WD-40 No-Mess Pen stores the WD-40 lubricant in a pen-shaped applicator, providing users with portability and small size so that it can be stored in carrying bags, desks, cars, or toolboxes.

The WD-40 Smart Straw features the lubricant can with a folding straw system that sprays a fine mist when flipped up and provides a wide spray when folded down. These features eliminate the need to insert the often-misplaced straw for precise spraying. (The company found that 80% of regular WD-40 users misplaced the straw.)

In the household-cleaning segment, the company has had recent success with Carpet Fresh No Vacuum carpet refresher.


  We favor companies that can generate attractive earnings growth while still being able to invest in marketing and R&D. In fiscal 2006, WD-40 plans to increase R&D investment by $1.5 million, to $4 million. We believe this investment will fuel the new innovation drive within the company and lead to new products that can enhance and increase the company's portfolio.

WD-40 enjoyed strong growth in international markets in fiscal 2005, with Europe (26% of total sales) leading the way, with a 15% local currency sales increase. The company's strong growth in Western and Eastern European countries, as well as the Middle East, has been driven by a larger sales force and distribution gains. Latin American sales growth in fiscal 2005 was also strong due to strong lubricant sales.

We believe that, like its larger peers, WD-40 will benefit from the growth of economies in developing countries. Not only should the company benefit from greater sales to a burgeoning consumer base for its products but also from the industrial and trade markets, as construction and maintenance needs grow.


  In the fast-growing Russian market, WD-40 expects to increase volume 33% in fiscal 2006, to over 5 million lubricant cans, compared to fiscal 2005. With respect to China, the company already maintains a strong position in the commercial segment and is setting plans to enter the most populous (over 1.3 billion) consumer market in the near future.

Although it operates in more than 160 countries, WD-40 has only recently been building up its direct-sales force. We expect this build-up to continue in the near term, which should result in entrance into more sales channels and ultimately generate more sales, in our view. We also see an opportunity for the sales force to cross promote products among different categories.

One of WD-40's strengths that we deem important to our investment thesis is its level of profitability, specifically its operating margin. The company's operating margin of 18.0% in fiscal 2005 ranked above the average operating margin of 16.1% for our household product universe, and, compared to the 12.8% average for its small and mid-cap peers, the gap was even wider. With strong brands and product innovation on the rise, we believe WD-40 will be able to sustain this advantage for years to come.


  We also view the company's ability to generate strong free cash flow (cash flow from operations less capital expenditures) as a key strength and differentiator among peers. In fiscal 2005, the company generated $28.5 million in free cash flow, representing 10.8% of sales. This compares favorably to the 10.2% average for the household product universe and the 7.6% average for the company's small and mid-cap peers.

We attribute this advantage to WD-40's strong profitability and working capital efficiency as well as a low level of capital-expenditure requirements. The company primarily uses contract manufacturers for its products. In fiscal 2005, its capital expenditures amounted to 1.2% of sales, vs. 3.1% for the household-product universe and 2.8% for small/mid-cap peers. Given that we don't anticipate a fundamental shift in WD-40's operating model, we expect it to continue to generate a strong level of free cash flow.

For fiscal 2006, we project 10% sales growth, driven by new products, distribution gains, and international expansion. WD-40 should continue to face higher raw materials costs in the first half of fiscal 2006, but we expect easier comparisons in the second half. Coupled with anticipated higher marketing costs for new product introductions and stock-option expense of $1.8 million, we project modest margin compression. (Note that $1.2 million in stock option expense was not included in fiscal 2005 costs.)


  We see lower interest expense in fiscal 2006, an effective tax rate of 35.8%, and about a 1% increase in shares outstanding. We project fiscal 2006 EPS will increase 7.2%, to $1.78, from $1.66 in the prior year, and 12% on a Standard & Poor's Core Earnings basis (which includes stock option expense in both years).

In December, 2005, the company set its four-year goals. WD-40 plans to increase sales at a CAGR of between 7.6% and 9.3% and to increase net income at a CAGR between 9.8% and 12.1%. The company said it will continue to focus on developing its existing brand portfolio through innovation and will be looking for brands to acquire. Given the company's strong momentum, favorable growth prospects, and cost structure, we believe these goals are attainable.

Our S&P Core Earnings estimates and our operating EPS estimates for fiscal 2006 and fiscal 2007 are the same, as the company has no post-retirement obligations plan and stock-option expenses are included in our operating-earnings estimates. (New accounting standards now require all employee stock options to be expensed.) We estimate $1.8 million (pretax) in stock options for fiscal 2006, which translates to 7 cents per share on an after-tax basis.


  We view the shares as very attractively valued, recently trading at 15.7 times our calendar 2007 EPS estimate of $2.04, about a 10% discount to peers. WD-40 also trades at a discount to peers on a forward p-e-to-growth basis, at 1.1 times, vs. 1.5 times, based on our calendar 2007 estimates. Furthermore, the shares are at a discount to our $41 intrinsic value calculation, determined by our discounted cash flow analysis model. Our 12-month target price of $39 is derived from a blend of our relative valuation (p-e) and discounted cash flow analysis.

In our opinion, WD-40's corporate-governance policies are sound. Some of the favorable aspects we see are that the board of directors is comprised of a supermajority of independent outsiders, the compensation and audit committees are both comprised solely of independent outside directors, and the chairman and CEO roles are separate. The absence of a poison pill and "related-party" transactions are also plusses, in our opinion.

However, we view negatively that shareholders don't have cumulative voting rights in director elections, the board is authorized to change its size without shareholder approval, and the company is subject to a freeze-out provision.

Risks to our recommendation and target price include increased costs for raw materials (steel- and petroleum-based products); higher fuel costs, which would increase distribution costs; heightened competition; and a low level of consumer acceptance of new products.

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