Catalysts Should Overpower The Risks That Woodward Will Face

Investment Thesis

Woodward, Inc. (WWD) is currently trading around $45. This is what appears to be quite a fair price for the company. But considering the growth prospects, catalysts, and limited risks, it seems that Woodward's stock is embedded with great potential for serious capital gains.

Company Overview

Woodward was founded way back in 1870 and is headquartered in Fort Collins, Colorado. The company, which has nearly 7,000 full time employees, provides energy control and optimization solutions across the globe for companies in the aerospace and energy markets. It helps people to operate equipment for effectively and efficiently. Woodward has a number of products to offer, including fuel pumps, air valves, actuators, power converters, ignition systems, and much more.

Competitive and Financial Analysis

The chart below shows the net income of the past ten years for Woodward.

WWD Net Income (Annual) data by YCharts

As you can see, growth has been steady and consistent, with only one small bump along the way. As Woodward continues to innovate and provide high quality products to customers, they have found exceptional success. With businesses always looking to get a slight edge over the competition, Woodward has always had a significant amount of customers to address. Their products are used by companies all over the world to lower costs and increase efficiency. As a result, the addressable markets are quite large.

The energy optimization market itself is also quite fragmented. There are a number of companies involved in it. They all serve different customers in different industries and have varying portions of how much of their business energy optimization actually accounts for. On top of this, many of Woodward's competitors are also their customers. Let's take a look at a comparison between Woodward and a few similar companies:

	Woodward	Parker-Hannifin (PH)	Moog Inc.(MOG-A)	ABB Ltd. (ABB)	Siemens (SI)
Competes In	N/A	Aerospace	Aerospace	Energy	Energy
Revenue Growth (Quarterly, yoy)	6%	0%	7%	8%	-1%
Gross Margin	29%	23%	30%	29%	27%
Operating Margin	12%	11%	10%	11%	7%
Net Income	$145.94M	$953M	$120.5M	$2.88B	$5.29B

As you can see, Woodward is competing in an effective manner. Growth is moving at a decent level and in a consistent fashion. Margins are impressive, and they even have the highest operating margin of the five companies mentioned. As long as Woodward is able to continue providing high quality products and customer service in a way that allows them to profit, the company should continue down the road to growth and success.

So far, the company's balance sheet displays great financial health. They have $50 million in cash on hand, and have a debt/equity ratio of 0.48. Cash flows are impressive as well. Since 2011, free cash flow has been rising slowly and steadily. In fiscal 2013, it was $59 million.

Risks

First, I'll address what could possibly go wrong with Woodward's strategy, as I analyze what I would consider the three key risks:

1. There are a few customers that Woodward relies quite heavily on. If these customers reduced business with Woodward or if they experience financial struggles, that could be seriously problematic for Woodward. For the aerospace segment, each of the following companies accounted for 10% or more of Woodward's sales in fiscal 2013: Boeing (BA), General Electric (GE), and United Technologies (UTX). And for the energy segment: General Electric and Weichai Westport. Luckily, all of these companies are at least somewhat reliable and consistent in nature. Even Weichai Westport, the smallest of the bunch, has Westport Innovations to fall back on.


2. There is always the threat that the global economy could take a turn for the worse. Whether or not this will actually happen should be left to PhDs who spend their days analyzing the macroeconomic fate of our planet. But if for some reason it actually did, I believe that Woodward would be able to tolerate the struggles. We saw that in the last recession, Woodward took a bit of a hit and struggled for a year or two. But within just a few years, the company is back on its feet and better than ever. High quality companies have the type of resilience needed to bounce back after a struggle, and Woodward has already proven itself to be of this caliber.


3. There is the threat of competition. I have already addressed what the company's current competitive position is, and I found it rather impressive. The financial position of the company gives it room to work with and expand. In terms of new entrants to the industry, they shouldn't pose much of a threat. Barriers to entry are high when selling to markets that are as heavily regulated as aerospace and energy. Also, significant R&D expenses make for sunk costs that most people would not want to get involved with if their efforts didn't work out for them.

Catalysts To Drive The Business And The Stock

As you can see, the risks that Woodward faces are limited. The catalysts, though, are extensive. First of all, the demand for and use of energy is continually growing, as shown by the chart below (taken from an Analyst/Investor Presentation).

With energy usage expanding rapidly, and power generation and industry leading the way, Woodward has multitudinous customers to address. Everyone is trying to be more and more efficient to get an edge, and Woodward allows them to do that.

Another exciting opportunity for Woodward is renewables. With energy independence constantly being glorified, and politics being largely in favor of them, renewables should have a bright future. Woodward's recent realignment of the renewable energy business to more directly address wind power has already benefited them. If they continue to expand their customer base and improve their technology, Woodward should find great success in this market. On top of this, Woodward should continue to appreciate significant sales from the oil and gas business as availability and demand have their effects. Gas demand, in particular should be an area for Woodward to focus on.

(click to enlarge)

Next, we have the aerospace segment. As the population of the Earth continues to explode, so does the amount of travel done by plane. According to the investor presentation, air traffic doubles about every 15 years. As aging fleets are coming to need repairs and replacements, companies look toward Woodward to provide them. There is a large and growing market for Woodward to address here.

Overall, Woodward will continue to find success in both the aftermarket and OEM areas of their aerospace segment, as long as they continue to aggressively invest in R&D, create leading technologies, and maintain long term relationships with customers. Also, the company will focus on a number of things to improve profitability. New product platforms should result in higher margins. Also, Woodward is always looking to improve labor and supply chain productivity. Management at Woodward has traditionally done a tremendous job at finding ways to cut costs and increase margins one step at a time, while significantly increasing overall growth.

Valuation

Here is a comparison of Woodward and the aforementioned competitors:

	WWD	PH	MOG-A	ABB	SI
P/E	21.44	20.03	25.98	20.90	20.86
P/S	1.57	1.45	1.17	1.43	1,15
P/B	2.66	3.09	1.98	3.36	3.11
EV/EBITDA	11.78	11.46	9.97	10.95	12.75

Of these five companies, all statistics are in close proximity to each other. There is no one or two companies that are clearly overvalued or undervalued. With this fact considered, Woodward looks like an especially attractive investment that is available at a fair price.

For the next five years, analysts expect Woodward to grow at a rate of 10% per annum. This is only slightly above the expected growth rate of the S&P. I believe that this is an underestimate. The company has a multitude of areas to address within the aerospace and energy markets. I believe they are perfectly capable of capitalizing on these opportunities, and that they will do so. If if it turned out that they didn't beat these estimates, I believe that Woodward is a top candidate for achieving the steady and consistent growth rate that they have in past years.

So, why am I so quick to disagree with the analysts? There are a few reasons. Let's begin with comparable growth. First of all, as I mentioned, the estimate of 10% is only slightly above that of the S&P, which is estimated to grow at 9.67%. Clearly, though, this doesn't account for the fact that Woodward has much more room to grow than most S&P components, which are almost all very established companies in established industries. Woodward, though, is still relatively small despite the fact that it has been around for a while. On top of this, the industry (Aerospace/Defense Products and Services) is expected to grow at 13%, and the sector (industrial goods) at 14%. As the previously shown charts indicate, the energy sector is also expected grow rapidly as demand for gas and other energy sources increase and people continue to look toward renewables. Also, the markets that Woodward engages in are quite fragmented. With the high margins and impressive balance sheet that Woodward has, it puts them in a good position to capitalize on both growth and consolidation in the markets they address. Investments both internally and externally can lead them to a larger market share, and therefore they will be able to capture more growth.

It might be unclear why I believe Woodward will increase its growth rates in the near future, considering the fact that the average growth in the past five years has been 8%.

WWD Revenue (Annual YoY Growth) data by YCharts

This chart shows that 20% range is not unachievable. But in the past, it was more of a "spike up for a year and then come back down" kind of thing. I think growth rates of 12-15% will be here to stay this time, starting sometime within the next couple of years. Gas demand is increasing rapidly, and renewables are establishing a reputation in today's world. As the market becomes less fragmented, Woodward will capture some market share with their high quality products. Also, growth in the aerospace segment should continue to be significant. Net sales from this segment in fiscal 2013 increased 18.5%, largely in part to the acquisition of GE's hydraulic thrust reverser actuation systems business. Also, I previously mentioned that the company is trying to raise prices in this segment through differentiation and lower costs through productivity. All of this growth and improved margins should lead to greater cash flow and a stronger balance sheet, allowing Woodward to further capitalize on strategic acquisitions. Through this cycle of continued organic improvements that open up room for acquisitions, I believe Woodward will be able to beat the 10% estimates in coming years. As growth rates increase, investors should realize this and be willing to pay for it with a true growth stock premium, which could put the PE closer to 25 or higher.

Concluding Insights

Woodward is currently available at a fair price. And any rational investor knows that buying a wonderful company at a fair price is a good idea. Throughout this article, I have shown you why I believe that Woodward is a wonderful company. The reward seems to significantly outweigh the risk. The reader is always expected to follow through with their own due diligence, but Woodward really seems like a fantastic company to invest in.

Source: Catalysts Should Overpower The Risks That Woodward Will Face

Disclosure: I 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. (More...)

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