Woodward: Waiting For More Predictable Margins Movement Before Investing

Investment thesis

While Woodward (NASDAQ:WWD) stock has jumped due to a better-than-expected operating results in F2Q23, concentrated in Industrial which had higher revenue and margins. I still believe it is a wise move to avoid investing in the stock due to uncertainties, especially with margins, in my previous post. I like to state upfront that I hold a positive long-term view on the business, but the near-term margin uncertainties are what keep me from initiating a buy rating. The fact that margins could swing so much despite only one quarter ago that segment had surprisingly low margins reinforce my view that the range of outcome is wide here. The bull case here would be that the new management has a plan to improve operations, and the company has solid long-term positions in the aerospace market. The bear case is that results have been fairly lumpy which leaves a degree of limited visibility into forward results. This uncertainty will continue to weigh on the stock as I believe investors are looking for "safe" and "predictable" stocks in the current very uncertain macro environment. Moreover, I don't think the risk/reward is very attractive from a valuation perspective either as WWD stock trades at 15x forward EBITDA, which is near 1 standard deviation above its 5-year average.

Aerospace segment to start improving

Aerospace saw a year-over-year increase in segment margins of 70 basis points in 2Q23, reaching 16.8 percent. In spite of headwinds like net inflationary effects, supply chain-related costs, inefficiencies brought on by new hires, and the reintroduction of annual incentive compensation, I see progress that far exceeds my expectations. As WWD experiences the benefits of price realization, I anticipate margins will improve further. Regarding pricing, remember that most commercial OE contracts are locked into long-term agreements that prevent price changes except during annual January contract rollovers. Management, however, has pointed out areas where prices could be increased, namely the high-demand part of the engine where there is the most intellectual property. Besides better pricing, I anticipate higher volumes for both commercial OE and AM beginning with the start of production in 2H23, made possible by the installation and commissioning of rapid complex machining centers at WWD plants in the coming quarter. Hence, I am pretty confident that WWD can hit its FY23 guidance. According to the guidance, the segment should see a year-over-year increase in margin of 150bps to 200bps. This will result in segment margins of 16.7 percent to 17.2 percent, up from 15.2 percent in FY22. In addition, I anticipate supply chain and labor disruptions to diminish during 2H23, which will further alleviate the cost pressure that WWD has been experiencing thus far.

Industrial turning around?

Mentioned previously in my 1Q23 update post, WWD Industrial segment growth is heavily dependent on the introduction of clean fuels, new infrastructure, and flexible energy systems, all of which are essential to the success of the global energy transition. That's why I have a bright view of the industry overall in the long run.

The results from the most recent quarter were also satisfactory. Strong demand growth across all end markets led to a 31% increase in sales for the segment, which totaled $281 million in 2Q23. Power generation was in high demand due to LNG's widespread use and data centers' perennial need for backup generators. As a result of the recovery of the cruise and ferry industries to their pre-COVID utilization levels, there has been an increase in the demand for replacement parts throughout the global marine sector. A combination of rising commodity prices and robust utilization has led to a surge in demand for oil and gas industry aftermarket products.

Management has also recently implemented a number of strategies that I am optimistic about, which has only solidified my optimistic outlook on this market segment. Firstly, management aims to optimize the segment size. Restructuring charges were incurred during the quarter because WWD is taking active steps to adjust the cost structure to reflect current market conditions. I believe this move will structurally improve the segment margin as WWD becomes more lean and able to target higher margin projects. In continuation of the previous point, the second strategic initiative being implemented will boost margins. The company's management is making concerted efforts to capture prices that more accurately reflect the value it provides. The large price increases from suppliers and internal wage rates are the impetus for these measures. The price realization goal for FY23 has been revealed to be 5%. Finally, WWD has eliminated 5% of the segment's 60,000 SKUs through strategic elimination. In my opinion, this will increase capacity and boost operational efficiency. Take note that this is consistent with the goal of optimization.

Looking at the big picture, the margin improvement should become operational and contribute to earnings growth over time. While I agree that all these initiatives are great for the long-term, I am more worried about how it would impact the short-term margins. Firstly, these initiatives typically involve additional expenses upfront that will impact margins in the near-term (not sure how much restructuring charges will flow through to 3Q23). Secondly, the nature of the projects is lumpy and hard to predict in the short-term. We could see a repeat of 1Q23 where management guided positively in 4Q22 but growth and margins came in weak. Below is a quote from 4Q22 earnings: "Industrial sales are expected to be supported by demand for power generation equipment, rising oil and gas investments and a stable global marine market…", and the outcome in 1Q was weak growth and 390bps decline in margins sequentially. In fact, in the 2Q23 earnings, guidance also implies a slowdown in industrial revenue in 2H23 (due to China lumpy demand profile and also lack of insights into 2H23). If we combine all these together, I am just not confident about the direction of margins in the remaining of FY23.

Conclusion

I remain cautious about investing in the stock. Although there are positive developments in the Aerospace segment with improved margins, the wide range of outcomes and limited visibility into future results dampen my confidence. The current macro environment also favors safer and more predictable stocks. Furthermore, the stock's valuation is not attractive, trading near its 5-year average. However, there is potential for future growth as WWD focuses on optimizing operations and capturing better prices in the Industrial segment. Strong demand across various markets and strategic initiatives are encouraging signs.