Is Worthington Industries a growth trap? (Part 2 of 2)
Value Investing Case Study 16-2: I first covered Worthington Industries in Jun 2021 in Seeking Alpha based on relative fundamental analysis. This post continues the company analysis and valuation along the lines of my normal approach.
As of 4 Jun 2021, Worthington Industries Inc (WOR or the Group) was trading at USD 66.10 per share compared to its Book value of USD 25.16 per share (as of 28 Feb 2021).
This is equal to a Price to Book of 2.6. A high Price Book ratio is commonly associated with a growth stock.
Over the past decade, WOR has spent about USD 1 billion on acquisitions. Compare this with its shareholders' funds of USD 1.3 billion as of March 2021. Is the market thinking that these acquisitions will transform the Group into a growth stock?
Unfortunately, the Group’s track record does not support the growth story. From 2010 to 2020, the Group revenue only grew at a CAGR of 4.6 %. During the same period, net income grew at a 5.1 % CAGR.
These are not the signs of a growth stock. Is WOR a growth trap then?
A growth trap is a stock that is priced as if there is sustainable high growth. But then the growth is illusory. The company is not able to deliver the earnings associated with high growth. The high stock price cannot be justified.
Join me in Part 2 of this series as I show why WOR is a growth trap.
Should you go and short it? Well, read my Disclaimer.
Contents
- Did Top Management Seize Opportunities?
- Is there an Awesome Buying Opportunity?
- Will there be Spectacular Growth in Shareholders’ Value?
- How to Secure Your Investment by Minimizing Risk.
- Pulling it all together
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Did Top Management Seize Opportunities?
WOR is an owner-managed Group as the current Executive Chairman has a 31.9 % stake in the company. He is in fact the son of the founder.
Because of this stake, the Board and senior executives have a 36.6 % stake in the company.
- In 2020, the Board comprises 11 members. They are on average 63 years old and have an average of 18 years of Board tenure.
- Including the Executive Chairman, there were 10 senior executives featured in the 2020 Form 10-K. They are on average 48 years old and have been with the Group for an average of 27 years.
In Sep 2020, Andrew Rose, the President of WOR became the CEO and principal officer of WOR. He has been with the company since 2008. Andrew took over from John McConnel who will continue as Executive Chairman.
I am not familiar with the US, but if this was a Malaysian family-controlled company, I would not expect any major change to the business direction. This is even with the change in the CEO.
This is a Group where the Board and senior executives have served for decades. With such a history, how did they perform from the operations and capital allocation perspectives?
Operations
WOR is a component company in the S&P 1500 Steel Composite Index. In its 2020 Form 10-K, WOR listed 13 steel-related companies from this Index.
For peer comparison, I have shortlisted this to 6. They are companies that have products and services most like those of WOR. They are
- Allegheny Technologies (ATI)
- Cleveland-Cliff (CLF)
- Nucor (NUE)
- Steel Dynamics (STLD)
- United States Steel (X)
- Olympic Steel (ZEUS)
As can be seen from the chart below, WOR is among the best in terms of revenue growth over the period from 2010 to 2020.
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| Chart 1: Peer revenue index |
The companies in the peer group do not have exactly the same products or services as WOR. For example, none have pressure cylinder businesses. As such it is very hard to draw conclusions about the gross profit margins.
All I can say is that WOR gross profit margins are about the peer average. I would not pass any judgment about whether this is good or bad.
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| Table 1: Peer performance |
As there was a substantial amount of share repurchases by WOR and its peers, I looked at Return on Assets when comparing returns. In terms of ROA, WOR performance can be considered average.
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| Chart 2: Peer ROA |
What does the best revenue growth but an average ROA imply? I interpreted it as WOR growth being driven by increasing assets. It was not driven by more productive use of the assets.
The chart below comparing the Revenue Index with the Total Asset Index illustrates the point.
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| Chart 3: Revenue vs Total Assets |
In Part 1, I have mentioned that the Group embarked on a Transformation Plan. This was with the overall goal to improve the sustainable earnings potential, asset utilization, and operational performance.
I looked at a number of metrics to see the progress made - gross profit margins, SGA as % of revenue, EBITDA margins, and Asset Turnover. Refer to the chart below.
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| Chart 4: Transformation Plan |
I am not impressed with the results. I was expecting to see some obvious trends. The only metric that seemed to show some improvement trend was gross profit margins. This grew to 18 % in 2017 compared to 14 % in 2010. However, it dropped back to 14 % in 2020.
Of course, it can be argued that the situation would have been worse if the Group had not undertaken the Transportation Plan.
The Transformation Plan has been highlighted in all WOR Annual Reports since 2008. As such the results have been disappointing.
Capital allocation
From 2010 to 2020, the Group generated USD 2.64 billion cash from operations. During the same period, the Group.
- Paid USD 474 million as dividends. This is equal to a 31 % pay-out ratio with reference to the net income of USD 1.51 billion generated during the same period.
- Spent USD 1.1 billion for its share repurchase programme. This reduced the number of shares from 79.1 million in 2010 to 55 million in 2020.
- Incurred USD 722 million of capital expenditure.
- Incurred net USD 759 million for its acquisitions. Net here refers to expenditure less the amount received for its disposal of businesses.
- Increased its cash by USD 88 million.
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| Chart 5: Deployment of cash |
Note that the amount expensed is greater than the cash flow from operations due to an increase in debt of USD 482 million. The debt included the leases.
As you can see, the Group returned about USD 1.5 billion or almost all of the net income to shareholders during the 2010 to 2020 period in terms of dividends and share buybacks.
At the same time, its Debt Equity ratio increased from 0.3 in 2010 to 0.8 in 2020. But as mentioned in Part 1, the current debt level is still below the industry level.
I would commend management for its capital allocation. This is looking at expenditure relative to the cash flow from operations and net income.
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| Chart 6: Debt to (Equity + MI) |
But not all the capital allocation plans went well.
In Part 1 I have mentioned that WOR had acquired the Engineering Cab business in 2012. Within 6 years, the Group had de-consolidated the business. It does indicate some weakness in the diversification plan.
A significant part of the Group strategy involved annual acquisitions. In view of this, the Group needs to address this poor diversification result.
Is there an Awesome Buying Opportunity?
I generally use two approaches in assessing the intrinsic value.
- Asset Value (AV). This is broken down into NTA and Book Value.
- Earning Value. This is broken down into the Non-Operating Asset component, Earning Power Value (EPV), and Earning Value with growth. For the Earning Value with growth, I have a Conservative one with a growth of 2.0 %.
The key assumptions used in the valuation were:
- I have treated the impairment and gains from divestments as part and parcel of the normal operating expenditure. This is because of the annual acquisitions and divestments. This is in contrast to my normal procedure of considering these as one-off items to be adjusted to profits.
- I took the average 2010 to 2020 performance as representative of the future. This was because of the cyclical nature of the steel industry.
- The cost of equity and cost of debt was based on Damodaran Jan 2021 datasets. This incorporated the 2020 pandemic impacts and has resulted in low values for the cost of funds. In other words, using these costs of funds meant that the derived intrinsic values would be on the high side.
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| Chart 7: Valuation |
As can be seen from the chart,
- The Earning value is greater than the Asset Value. In fact, the EPV is greater than the Asset Value.
- Over the past 5 years, the highest market price has gone above the Earning value with growth.
According to Professor Greenwald, for the EPV to be greater than the AV, there must be some sustainable competitive advantage. But before we interpret this literally, remember that in the case of WOR, the Asset Value has been reduced by the share repurchase programme.
Without the share repurchase from 2010 to 2020:
- There would be an additional USD 1.015 billion to the shareholders. I treated this as additional cash.
- There would be an additional 34.2 million shares.
Adjusting for these 2 factors, the Book value would be USD 27 per share and the EPV would be USD 42 per share. We still have the scenario where the EPV > Asset Value.
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You can see that based on the Conservative Earning Value with 2 % growth, there is hardly any margin of safety at the current market price.
You may argue that I had assumed a 2 % growth rate whereas the Group had a long-term revenue CAGR of 4.6 % and a net income CAGR of 5.1 %. Shouldn’t we use at least a 4.6 % growth rate?
According to Damodaran, the long-term growth rate should be the same as the risk-free rate. The risk-free rate based on Damodaran Jan 2021 datasets was 1.9 %. I had earlier mentioned that the Damodaran dataset took into account the pandemic year where the US interest rate was very low.
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| Table 2: Valuation metrics |
The other argument is that if you assumed a higher growth rate, you should also assume a higher cost of funds.
If you are considering the long-term prospects of WOR, you should look at a risk-free rate that is not affected by the pandemic year. This meant a higher risk-free rate which in turn allows for a higher long-term growth rate.
I had used the following model in my valuation with growth:
Value = [Free Cash Flow X (1 + g)] / [r - g]
Where
r = cost of fund
g = growth rate
If you assumed a higher growth rate due to a higher cost of funds, there is only a small impact on the overall intrinsic value. This is because the factor [r- g] remains the same.
The only other factor that comes into play is then (1 + g). It can be shown that if the growth changes from 2 % to 4.6 %, the overall impact is a 2% increase in intrinsic value. This is insignificant in the context of a 30 % margin of safety.
The issue is not the long-term growth rate of WOR. The question is whether there is some high growth phase. As shown in my Part 1 analysis, there is no justification for such a growth scenario.
I still maintain that there is no margin of safety for investing in WOR. This is supported by the high Acquirers’ Multiple. I normally consider a buying opportunity if this is less than 6.
I hope you can understand why I said that WOR is a growth trap.
Will there be Spectacular Growth in Shareholders’ Value?
If you have been following my blog, you will know that a high-quality company is one that has a good chance of increasing shareholders’ value.
I looked at the following metrics to assess shareholders' value creation.
- Over the period from 2010 to 2020, assuming that no dividend has been distributed, the shareholders’ funds would have increased by a CAGR of 11.8 %. This is almost double the cost of equity of 6.3 %.
- Over the past 11 years, the Group achieved an average 9.1 % return. This return was computed as EBIT(1-t)/TCE assuming a 24 % tax rate. The return is significantly higher than WOR's cost of funds of 5.5 %.
- If a shareholder had bought a share at the start of 2010 and held onto it till the end of 2020, he would have achieved a CAGR of 9.5 %. Compare this with the 6.3 % cost of equity.
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| Table 3: Shareholders' gain |
Based on these 3 metrics, the conclusion is that WOR had been able to create shareholders' value.
There is another perspective of the excess returns especially for the growth in shareholders’ funds and the EBIT(1-t)/TCE. It suggested that WOR must have some sustainable competitive advantages for this to be sustained over the past 11 years.
This competitive edge picture is consistent with the EPV > AV valuation scenario.
The only negative point is that the share repurchase programme seemed to be undertaken at prices greater than the intrinsic values.
As per the table below, only 2 out of the 9 years with share repurchases were carried out at prices less than the intrinsic values. Even on a volume-weighted basis, the shares were bought back at prices greater than intrinsic values.
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| Table 4: Share re-purchase |
In my analysis, I have assumed that the intrinsic value for the respective years is doubled the respective Book Value. This was the ratio based on the current computation and I assumed that this ratio held during the past 11 years.
How to Secure Your Investment by Minimizing Risk
In its 2020 Annual Report, WOR has indicated that a significant part of the Steel Processing segment net sales is tied to 2 sectors:
- 53 % to the automotive market.
- 19 % to the construction market.
The chart below illustrates the relationship between WOR revenue and these markets. It was based on and a number of metrics related to the automotive and construction sectors as well as to the hot roll steel prices.
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| Chart 8: Revenue vs Industry indicators |
Steel is of course a cyclical commodity and WOR has stated that:
“…the market price of hot-rolled steel is one of the most significant factors impacting our selling prices and operating results. When steel prices fall…negatively impacting our results. On the other hand, in a rising price environment, our results are generally favourably impacted.”
However, this steel price risk is something that affects all steel companies and is not something extraordinary.
I have accounted for this risk by taking the average 2010 to 2020 performance to represent the future prospects. During this period, there have been 2 cycles of hot-rolled steel prices.
In its 2020 Form 10-K, WOR has listed the risks related to its business. I do not see anything extraordinary. Rather they are the business risks that would be associated with any business in this sector.
I do not see any challenge - business or technology - that would disrupt WOR business. While the traditional automobile sector is facing the challenges of the electric car, this would not impact the demand for steel in car production.
At the same time, there is no impending disruption to its Pressure Cylinder business.
The main concern would be management's ability to identify ventures outside the Steel Processing and Pressure Cylinder businesses. This is based on WOR's track record in venturing into the Engineering Cab business. The mitigation here is that the Group has been able to generate profits and cash flow to cover for such “mistakes”.
Pulling it all together
The analysis suggested that WOR is a good company.
- It has been profitable over the past 11 years. This covered 2 hot-rolled steel price cycles and the Covid-19 pandemic.
- It is financially sound with a Debt Equity level lower than the industry average. As of Feb 2021, cash represented 29 % of the total capital employed.
- It has a good track record of growing shareholders’ value.
- The sustained excess returns and the EPV > AV scenario suggested that it has a sustainable competitive edge.
- While there may be limited opportunities for high growth in the US, there is a global demand for its Pressure Cylinder segment products.
There are of course some concerns:
- The share repurchases were not carried out at prices that created value for the shareholders.
- The results of the Transformation Plan were not what I expected.
- The acquisition and deconsolidation of the Engineering Cab segment suggested some weaknesses in its diversification plan.
But there is no dispute that WOR is a good company. But is it a good investment?
At the current price, there is no margin of safety from the EPV perspective. I would argue that there is also no margin of safety from a Conservative Earning with a 2 % growth perspective.
For the price to go higher and hence project some justification for buying, you would have to view WOR as a growth stock.
But the analysis did not provide any evidence of a high growth phase. If you invest based on a high growth expectation, it would be investing in a growth trap.
End of Part 2 of 2
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