Spruce Point believes that WD-40 (Nasdaq: WDFC or “the Company”) is widely misunderstood and believed to be defensive, but in reality, is facing both long and short-term secular pressures. With the Company recently upsizing and drawing down 100% of its credit facility, a size 1,500% larger than the previous recession in 2008-2009, we believe a massive hole in its balance sheet has been exposed. Our forensic review and channel checks indicate record bloated inventories, and material financial strain. We believe it will have to drastically reduce its optimistic 3-7% sales target and re-set investor expectations meaningfully lower. Trading near all-time highs and at an unprecedented 6x sales and 28x EBITDA, we believe shares are a horrible risk/reward. We see 55% – 60% downside risk ($75-$85/share).
WD-40 relies on a trade secret, and has no patents, to protect itself in the market place from dozens of cheaper all-purpose and specialty lubricants in a variety of saturated retail channels, and user end markets
WD-40’s heaviest users are maintenance and repair specialists, notably in the auto market. A long-term challenge facing it is the electrification of cars, which have fewer moving parts and require less regular maintenance. In addition, WD-40 sells into the bicycle and motorcycle markets. Each of these markets are also under long-term pressure from changing customer preferences, in addition to the electrification of the market. Independent bicycle dealerships are in long-term decline, while children (the next generation of users) are also purchasing fewer bicycles
We believe the product is also coming under increasing regulatory scrutiny. By analyzing changes in its product fact sheet, we see that more disclosures about the hazardous nature of the chemicals contained in the product are being highlighted. Because of these hazards, we believe WD-40 is not well suited to an e-commerce environment. In fact, WD-40 recently added a disclosure statement in its product fact sheet that it does not recommend transporting it by air. The FAA also added WD-40 to its list of products that cannot be carried on, or packed in luggage, by the public when flying commercial air
Late Friday on March 27th, WD-40 drew down the remainder of its $150m credit facility. During the prior crisis, it had a small $10m facility that was never utilized. We believe this gigantic draw down exposes a major hole and problem with its business. WD-40 is levered only 0.7x Net Debt to EBITDA and projected to generate $30m+ of free cash flow. Why would it need to max out its credit line?
In our view, WD-40 has no visibility in an economic recession. It missed FY 2009 sales and EPS estimates by 13% and almost 10% at the mid-points, respectively. In FY 2008 it missed sales and EPS by 5% and 13% and the mid-points, respectively. This time around, the economic crisis is greater, and we expect a much larger miss of its targets.
WD-40’s business has grown much more international today vs. the last financial crisis 10yrs ago. Today: 63% international sales vs. 52% during the last crisis. WD-40 now obscures country-level revenue detail. However, we estimate the U.K is 37% of total revenues vs. 9% during the last crisis. We estimate 75% of WD-40’s cash is in its U.K. subsidiary. First Brexit, and now a coronavirus scare, has sent the Pound to multi-year lows which we believe has compounded WD-40’s challenges.
Working capital strain has materially intensified. Based on our analysis, working capital to sales is currently 16.3% of sales, almost double the 8.6% of sales in 2007. By closely examining the composition of WD-40’s inventory accounts, we observe that Finished Goods make up an increasing percentage of the overall balance, and more than prior to entering the last crisis. Days of Inventory and its Cash Conversion Cycle are near all-time highs. In our opinion, this suggests that inventory is building up and not selling-through to customers.
As a 65+ year old company relying on a core lubricant product, it’s easy to understand that finding new markets and introducing new and successful products can be challenging. We observe that WD-40 is taking actions consistent with a mature company, including investing less and less in R&D every year, and covering-up disclosures about challenged products and ventures (recently WD-40 BIKE). WD-40 continues touting geographic expansion with a $1bn market opportunity. A year ago, it even listed Venezuela and Iran as market opportunities for its products. However, it recently omitted these countries from its latest investor presentation.
By far, WD-40 has been promoting its ambitions in China, once claiming sales would be $100m. Yet, 17 years ago it admitted that 25% of the market was counterfeits. We find evidence that counterfeits continue to plague its growth ambitions there. Asia-Pacific and China have recently become an extreme weak spot for the Company, and while it blames the issue on “formulation changes” and China holidays, we suspect there are more structural issues that will hamper its ability to reach its lofty Chinese goals.
WD-40 is also promoting a new product for the recreational vehicle (RV) industry, but the timing of the introduction is terrible given that nearly all major RV industry players have suspended production, and there’s concern that long-term industry sales have peaked. With respect to channel distribution, we find that WD-40 has already penetrated major categories: mass merchants (WalMart, Target), home improvement stores (Home Depot, Lowes, Ace Hardware), auto repair shops (AutoZone, Advanced Auto, Pep Boys), drug stores (Rite Aid, CVS), and dollar stores (Family Dollar, Dollar General). Our channel checks show some retailers offering their own store brands, like WalMart, and in some cases offering competing products up to 60% lower in price than WD-40’s comparable product. In the home improvement and auto center market, we find that PB Blaster is becoming a formidable competitor, driving more intense price promotion.
WD-40 recently started disclosing reductions to sales for rebates, coupons and cash incentives. The disclosure may have been pushed by the auditor, which recently added rebates and marketing program accruals as a “Critical Audit Matter”. By closely analyzing recent trends, we find that WD-40 gave its largest incentives in Q1 2020. We believe this supports our channel check concerns.
A majority of the executives are 60+ years old, and with a small company of ~500 employees, investors should pay attention to recent management transition plans. Unfortunately, not all are in shareholders’ best interest such as the CEO now assuming the Chairman role. WD-40 recently promoted internally a new Chief Accounting Officer. A background check reveals that during her previous tenure at Cymer (formerly: Nasdaq: CYMI), it disclosed accounting errors and a material weakness related to income tax accounting. It’s noteworthy that WD-40 just disclosed a $0.63 per share reserve for uncertain taxes.
In our view, there is evidence insiders act in their own best interest. Insiders have misdirected 62% of total free cash flow since 2007 towards stock repurchases at increasingly inflated prices. This has allowed insiders to materially reduce their ownership and capital at-risk. Current insiders own a record low 1.9% of total shares. In addition, we see evidence of management making usual adjustment to EBITDA bonus targets by ignoring certain expenses that look ordinary and necessary to execute its business plan. WD-40 would benefit from replacing its auditor PwC, which has audited the Company for so long that no one is even sure when the relationship began. The current audit partner has a self-proclaimed focus on healthcare and biotech, not retail or chemicals
Despite a $2.7 billion dollar market cap, WD-40 is largely under-followed by the sell-side brokerage community. Instead, it appears the CEO has sought endorsement from retail investors through channels such as CNBC’s Mad Money. The two analysts covering it have price targets of $210 and $225, implying approximately 15% of upside on average. Yet, we don’t believe either analyst has conducted a rigorous forensic review and channel checks that indicate significant financial strain and long-term challenges that will cap upside potential. The analysts push the Company narrative that WD-40 is recession resistant, yet don’t point out that during the last crisis WD-40 wildly missed its targets and experienced declining sales and EPS. We believe this time around, the magnitude of the miss will be greater.
Collectively, the analysts still see top line growth this year of 1.3% which will rebound to 6.6% in FY 2021. We view both of these forecasts as wildly optimistic in light of continued long-term challenges, and price increases put though in the recent past which aren’t likely to be repeated. To be clear, we view analysts’ estimates as aggressive even before the recent economic turmoil brought about by the virus. Sell-side analysts also point to the recent plunge in oil as a catalyst to buy the stock. While we acknowledge that 33% of WD-40’s cost to produce a can is petroleum-based specialty chemicals, this benefit comes at the same time as severely depressed economic activity also affects sales. In addition, WD-40’s competitors (already pricing products below WD-40) get the same benefit and can become even more price aggressive to take share.
Furthermore, the magnitude of oil’s decline during the last crisis is comparable to today’s from a percentage decline of approximately 70%. We see that it took until Q3 for the Company to say that oil benefited gross margin by 200bps, and that was a full year after oil peaked over $140/bbl in July 2008. What’s also important to realize is that WD-40 had ~40 days of inventory outstanding then vs. ~80 today. As a result, we believe it will take even longer for it to realize the full benefit of lower oil. WD-40’s valuation relative to its own selected peers set of specialty chemical and auto part distributors exposes its extreme valuation. Its valuation becomes even more expensive once it becomes evident that overly aggressive estimates for 2020-2021 will be difficult to achieve. The multiple has actually expanded during the current crisis to all-time highs, and the bullish analysts’ even think there is more room for valuation expansion. We beg to differ. Only distorted financial logic would argue that WD-40 should experience multiple expansion while an enormous hole in its balance sheet exists.
Currently trading at 6x and 27x 2020E consensus sales and EBITDA, WD-40 is priced beyond perfection. Once investors come to grips with the reality that WD-40 will repeatedly miss aggressive forecasts set by management, and reiterated by analysts, we believe its multiple will compress to more realistic levels in-line with low/no growth consumer product and specialty chemical peers. At a generous 2x and 12x sales and EBITDA multiple on our lower financial forecasts we estimate 55% – 60% downside risk.
For investors holding out hope that WD-40 is a take-over target, we point out that larger companies such as Dupont and Newell Brands have competing products in the space; neither have invested in developing the product category, or made an offer for WD-40. Furthermore, any financial or private equity buyer would struggle to make the math work at its current excessive valuation.