Alan_Lagadu
It seems at times that Woodward (NASDAQ:WWD) just can’t get a break. Long a leader in complex control systems and components that play essential roles in aviation propulsion and actuation, Woodward invested meaningful sums between 2013 and 2019 to add capacity in anticipation of a significant commercial aerospace ramp… only to get kicked in the head by the COVID-19 pandemic and the temporary collapse of the commercial aviation market. Then, more recently, as commercial aviation has started to recover, Woodward has found itself hamstrung by component and labor issues, as well as component/production difficulties at other suppliers that have led to some disappointments in commercial build-rates.
I look at Woodward’s leverage to the aviation recovery, and I think management has a fairly realistic (if not conservative) view on how build-rates will reaccelerate. I like the company’s industrial business in general, though the near-term outlook is shakier given ongoing issues in China. Trading at close to $100, I don’t see tremendous fundamental undervaluation, but I do acknowledge that this is a stock that could rerate more strongly as aviation builds accelerate and margins expand.
Mixed Results And Guidance Par For The Course Recently
Woodward didn’t have a bad fiscal fourth quarter (calendar September quarter), but guidance was mixed and there still remains significant uncertainty about the pace of the commercial aerospace recovery and when Woodward will see margin leverage on that growth.
Revenue rose 12% in the quarter, beating expectations by about 2%. Aerospace revenue rose 8% on healthy commercial activity (original equipment up 24%, aftermarket up 34%), while defense was notably weak (original equipment down 18% and aftermarket down 7%). Broadly speaking, this was very much in line with what companies like Honeywell (HON) have been seeing. Industrial revenue rose 20%, with management noting healthy demand for power generation in Asia and for data center backup, strong marine demand, and strong oil/gas demand.
Gross margin declined 230bp yoy and 60bp qoq to 21.2%, as the company continues to get stung by input cost inflation and production challenges (higher-cost labor, inadequate labor, and supplier disruptions). EBITDA declined 5% (with a margin of 15%) and GAAAP operating income declined 18%, with margin down 320bp to 8.7%, but still managed to beat by about 5%. At the segment level, profits declined 3%, with Aerospace down 5% (margin down about two points to 15.5%) and Industrial flat (margin down 170bp to 9.0%).
Guidance was… interesting. The revenue guide was 3% ahead of expectations at the midpoint, with strong underlying aerospace trends (projected up 14% to 19% in FY’23) and weaker industrial trends (flat to up 5%). The EPS guide, though, was about 6% below expectations on sustained pressures from supply chain and production challenges. Given a higher mix of what should be higher-margin aerospace revenue, this is disappointing, if understandable and transitory.
Aerospace May Be “When, Not If”, But The “When” Still Matters
As I’ve written in other recent pieces (including one on Spirit AeroSystems (SPR)), aerospace suppliers have been frustrated by a slower and more volatile than expected ramp in commercial aerospace builds, particularly high-value programs like the 737 MAX and A320neo. Boeing (BA) and Airbus (OTCPK:EADSY) would like to ramp up production more than they have, but the reality is that the ability of suppliers to meet their needs remains inconsistent at best (which challenges the engine supply and cast parts that go into those engines and other components), and the OEMs are holding back production to what they are reasonably sure they can achieve.
There’s really not much that Woodward can do about this. While Woodward is a valued supplier of critical components like fuel injection systems, ignition systems, engine actuation, sensors, and electromechanical and hydraulic actuation, they’re at the mercy of OEM production schedules and, by extension, the ability of other suppliers to meet their orders and keep the supply chain running smoothly.
I do expect that this situation will start improving in the second half of calendar 2023, allowing Boeing and Airbus to more meaningfully accelerate their build-rates and driving more revenue growth and margin expansion opportunities for Woodward – the company has about $275K of content on each 737 MAX and about $225K on each A320neo, as well as meaningful content on 777’s and 787’s.
At the same time, though, there are uncertainties in other parts of the business. With the global economy looking weaker next year, a moderation in the recovery of air travel is a risk, and that could slow some of the recovery momentum in the high-margin aftermarket business. Likewise, Woodward is still dealing with its own internal production issues, and efforts like insourcing more supplier work and hiring more labor won’t produce immediate margin leverage.
Defense, too, is a tricky market to figure out. Weakness in defense this quarter was driven again by weaker orders tied to guided weaponry (missiles), but with the war in Ukraine, I would think demand could pick up next year depending upon what happens with respect to U.S. policy toward supporting Ukraine and/or whether European allies decide to increase their military spending.
Industrial Is Not Any Clearer
Woodward has a history of leveraging its core aerospace technology into other markets, and that has created a reasonably large (about one-third of revenue) business supplying control products and other fluid and motion components to end-markets like trucking, power generation, and oil/gas for use in reciprocating or turbine engines. Here, too, there is meaningful uncertainty looking into 2023.
Woodward has a significant business (around 20% of segment sales) supplying combustion controls and other products to the LNG heavy duty truck market in China. While this is a growing market, the government wants to double the mix of heavy trucks using LNG from around 20% to 25% today to 50% by 2030, the market has been hit hard by China’s zero-COVID policy and the outlook for 2023 is uncertain at best.
Power generation has been relatively healthy, but I do expect data center spending to slow next year, which could well translate into lower demand for back-up power systems. Likewise, while the long-term outlook for power generation growth is positive, the near-term outlook is weakening given worsening trends across many industrial markets (many industrial customers make use of distributed or back-up generation).
I’m certainly feeling relatively better about the oil/gas business, and I think this market should be fairly strong in 2023. Likewise with the marine business, with the company noting that ferry and cruise ship activity has returned to pre-pandemic levels.
The Outlook
I’m not worried about the aerospace part of Woodward’s business. Yes, there is significant short-term uncertainty as to how and when narrowbody build-rates will accelerate and when the widebody recovery will come, but I think this is a “when, not if” recovery story. In the meantime, I think management is starting a process of addressing multiple areas of inefficiency, including significant variability in efficiency from site to site and a portfolio that likely needs to be pruned of some lower-margin products.
With the industrial side of the business, the Chinese LNG truck situation is what it is and I can’t pretend to have insight into when conditions in China will stabilize. Longer term, while I do see some risk that Woodward loses some business from the electrification of more transportation markets, the company also has opportunities to grow with the use of alternative fuels like hydrogen and I believe many of the company’s core markets will be slow to electrify, thus providing a longer runway of business for combustion control and related products.
My modeling assumptions, including double-digit aerospace growth over the next five years and low-to-mid single-digit industrial growth, ultimately drive a long-term revenue growth rate of around 7%. I do expect meaningful margin leverage from the aerospace recovery, as well as leverage from slower growth in the industrial business and internal self-help efforts. I think EBITDA margins could be stuck at 15% to 16% for a couple of years due to the ongoing supply and labor challenges, but I also believe 18%-plus EBITDA margins in FY25 are possible. Likewise, I think free cash flow margins could be a little choppy in the near term, but the company isn’t looking at major capex needs and free cash flow margins should grow toward the mid-teens over time, driving low double-digit normalized growth.
While not part of the outlook per se, I would note that Woodward previously was going to merge with Hexcel (HXL) before the pandemic blew up that deal. Then there were rumors that a merger with Meggitt could be a possibility (Parker Hannifin (PH) ultimately acquired Meggitt). I do think that Woodward could be a buyout target, whether from a company with a meaningful existing aerospace business or a sizable conglomerate looking to add aerospace exposure.
The Bottom Line
I like Woodward’s conservatism and I like the self-help opportunities (though I’m not so happy that they’re there in the first place). I also like the leverage here to commercial aerospace and alternative fuels like LNG and hydrogen. Discounted cash flow suggests a potential high single-digit long-term annualized return (around 9%), while an adjusted EV/EBITDA approach (using FY’25 numbers and discounting back) supports a fair value around $105.
I’m ambivalent about the shares. The prospective return isn’t bad, and I wouldn’t be surprised if these shares rerated higher once the aerospace recovery really gets going and margins expand – it’s not rare for stocks to trade below fair value in the tougher times and overcorrect during the good times. All in all, I lean positive, but investors considering the shares need to be prepared to exercise a little patience as the company navigates production and margin challenges and the industry navigates meaningful supply chain turbulence.
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