WOR is still one of the better NYSE stocks

Value Investing Case Study 16-3. I last covered Worthington Industries in July 2021. This is an updated analysis incorporating the Q3 2022 results. Note that the FYE is May.

WOR is still one of the better NYSE stocks

I have previously covered Worthington Industries (WOR or the Group) in my blog as well as in my Seeking Alpha articles. Refer to:

The various articles concluded that WOR is fundamentally sound with a good run over the past 2 years. The issue is whether the current price provides a sufficient margin of safety.

WOR is in a cyclical sector and any valuation should be based on its performance over the cycle. 

Join me as I provide an updated valuation of WOR based on such a cyclical lens. I will show that there is a margin of safety based on such a cyclical model. But this requires you to view WOR as a cyclical company with a growth component. This is not unrealistic. 

As such I would conclude that WOR is one of the better NYSE stocks to invest in.

Should you go and buy it? Well, read my Disclaimer.

Contents

  • Investment thesis
  • Rationale
  • Fundamentally sound
  • Extraordinary past 2 years
  • Cyclical sector
  • Operating income
  • Valuation
  • Conclusion
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Investment thesis

WOR achieved an extraordinary result for FYE 2021 and FYE 2022 will be one with record revenue. Its YTD revenue for Q3 2022 (as of end Feb 2022) is 70% higher than that for 2021. But do not be misled. The 2021 performance was due to a one-off gain from the sale of its investments. And the 2022 performance is due to an extraordinary steel price situation.

There is no question that WOR is fundamentally sound. But you make money by investing in sound companies with a margin of safety. The steel sector is cyclical and WOR’s operating performance and valuation should be based on its performance over the cycle. On such a basis, there is a margin of safety based on the Earnings value with 4 % growth.

But I would argue that there are other margins of safety - its investments and the share buyback program.

Rationale

  • WOR is a fundamentally sound company. I have already shown this in my article last year. The inclusion of 2021 and 2022 YTD results would not change this picture. The key issue is whether there is a margin of safety. Valuation is key. 
  • WOR Feb YTD 2022 and last year’s performances were extraordinary and should not be used to represent the long-term performance. 
  • WOR has two main businesses - steel processing and pressure cylinders. The former accounted for about 2/3 of the Group revenue. The steel sector is cyclical. Any valuation of WOR should then be based on its performance over the steel cycle. 
  • WOR has substantial investments and to wash out the impact, I looked at operating margins over the past 12 years. 

Fundamentally sound

In my 2021 article, I had shown that WOR is fundamentally sound. There is no reason to change that assessment:
  • As of Feb 2022, it has a D / (D + E) ratio of 0.36. 
  • It had been able to generate cash flow from operations yearly from 2010 to 2021. On average it generates about USD 242 m per year compared to its average net income of USD 178 m.
  • It achieved an average ROA of 4.5 % for the past 12 years. It is a reasonable performance compared to its peers.

WOR Peer ROA
Table 1: Peer ROA

Refer to my previous articles for a more detailed comparison.

Extraordinary past 2 years

Over the past 2 years, WOR had an extraordinary run.
  • It had a record net income of USD 741 m for FYE 2021, equal to about an EPS of 13.42 cents.
  • The Q3 YTD revenue for 2022 at USD 3.7 billion is 70 % higher than that for 2021.

The chart below shows the revenue trend for WOR over the past 12 years. WOR has two major products - steel processing and pressure cylinders. Steel processing accounted for about 2/3 of the Group revenue.

WOR Revenue profile
Chart 1: Revenue Profile

Despite the lower revenue in 2021 compared to that of 2019, WOR achieved a net income of USD 741 m in 2021 compared to USD 163 m in 2019. No doubt the gross profit margin in 2021 at 20 % was higher than the 13 % in 2019. The main difference for the 2021 extraordinary performance was the USD 655 m gain from the sale of its investments in Nikola Corporation. This was a one-off corporate exercise.

At the same time, the Q3 YTD 2022 revenue for WOR is about 70 % higher than that for the corresponding period in 2021. Based on WOR Q3 YTD steel processing data, I estimated that the average selling price for steel is 90 % higher than that for 2021.

Steel prices are cyclical and there are signs that prices have peaked. For example, WOR reported that the hot rolled steel price for the 3 months ended Feb 2022 was USD 1421 per ton compared to the USD 1690 for the 9 months ended Fed 2022.

My main point is that using the current or past year’s performance to represent WOR performance will result in misleading valuations.

Cyclical sector

WOR is in a cyclical sector and over the past 12 years, it had gone through at least 2 price cycles as shown in the chart below. Compare WOR revenue pattern with that for the hot-rolled steel to see what I meant.

While cyclical, there is also a growth component to WOR revenue. From 2010 to 2021, WOR revenue grew at a 4.6 % CAGR. Based on the YTD Q3 2022 results, WOR will achieve record revenue for 2022. 

WOR Performance relative to economic indicators
Chart 2: WOR Performance c/w Economic Indicators

WOR revenue growth is a combination of volume growth and price growth. The chart below tracked the physical units shipped and the average selling price for the 2 product categories:
  • Steel physical shipment (tons shipped) grew at a 6.4 % CAGR from 2010 to 2021.
  • The average steel selling price in 2021 was only about 5 % higher than the 2010 average selling price. This is about a 0.5 % CAGR from 2010 to 2021.
  • The number of pressure cylinders shipped grew at a 4.2 % CAGR from 2010 to 2021.
  • The average selling price for pressure cylinders in 2021 was 88 % higher than that in 2010. This is about a 5.9 % CAGR from 2010 to 2021.

WOR segment trends
Chart 3: Segment Trends

Any valuation of WOR should incorporate the cyclical feature as well as the growth trends.

Operating income

Apart from the operating assets, WOR had USD 44 m cash and USD 303 m of investments in unconsolidated affiliates as of the end of Feb 2022. Over the past 12 years, these generate about an average annual income of USD 98 m. This income does not appear to be cyclical.

Because of the investment income, it is more appropriate to look at the operating income when looking at the cyclical performance of WOR. This operating income excluded interests, investment gains, and other non-operating income/expenses.  I then had the operating return metric = operating income/equity

Over the past 12 years, WOR had an average operating return of 21%. It had increased from 17 % in 2010 to 30% in 2021.

I also carried out a DuPont analysis of the operating return as shown in the Chart 4. In 2021 the operating return was 75 % higher than that in 2010 contributed by the following:
  • The operating margin was 110 % higher.
  • Asset turnover was 26 % lower.
  • Leverage was 13 % higher.

The biggest driver for the improved operating return was the operating margin.  But as can be seen from the chart, the operating return and operating margin are cyclical.

WOR DuPont Trends
Chart 4: DuPont Analysis

To represent the long-term performance of WOR, it is more meaningful to look at the operating margins over the cycle. 

Valuation

I valued WOR based on a single-stage free cash flow to the firm (FCFF) model.

Value = FCFF X (1 + g) / (r - g) 

FCFF = Operating profit X (1- tax) - Reinvestment

g = growth rate. I assumed 4 % based on the long-term US GDP growth rate. This 4 % is lower than the historical steel tonnage shipment growth or the pressure cylinder shipment growth.

r = WACC. This was derived based on the Damodaran Jan 2022 dataset with 1.51 % as the risk-free rate, and a Beta of 0.98 for the steel sector.

Operating profit = (Revenue X gross profit margin) - SGA

SGA = Revenue X SGA margin

Reinvestment rate = growth / operating return

The various assumptions used in my valuation are shown in the following table.

WOR valuation assumptions
Table 2: Valuation assumptions
Notes
(a) This is used to derive the TCE required to determine the Operating return that is defined as EBIT(1-t) / TCE

The results of the valuation are illustrated in the following chart.

WOR valuation
Chart 5: Valuation

With the current market price at USD 48.62 (as of 26 Apr 2022) you can see that there is a margin of safety based on the Earnings value with growth.

Case Notes

While the valuation model is based on a single-stage formula of FCFF X (1 + g) / (r - g), different analysts will come to different conclusions about the value as there will differences in the following:
  • The Free Cash Flow (FCFF).
  • The growth rate (g).
  • The discount rate (r).

The key point is that each of the variables above is not a single-point estimate. There is a range of values. To get around this problem Damodaran suggests using a probabilistic approach. One way is to do a Monte Carlo simulation with some assumed distribution of the key variables.

If you use a Monte Carlo simulation, you will then have a distribution of intrinsic values. How this will look can be seen from the chart below. It is a simulation of Amgen as reported by Damodaran. You can see that the intrinsic value is not a single number but a range of values. There is a probability distribution and you can get a sense of the risks associated with the margin of safety you adopted.

Simulation example

As a retail investor, you may not have access to such simulation models. I personally don’t do such simulations. One way round it is to try to get different perspectives from other investors. A good example of  where you can get such views is Seeking Alpha.* Click the link for some free stock valuation examples. If you subscribe to their services, you can tap into their business analysis and valuation.




Conclusion

The analysis showed that for any margin of safety, you have to view WOR as a stock that can continue to grow its revenue from the current base. This is not impossible as historically WOR had been able to achieve a 4.6 % CAGR in revenue. There was volume growth for both product categories.

Secondly, the FCFF valuation model focus on its operating assets. To derive the value of equity, I then added cash and investments and subtracted the Debt and Minority interests.

I have taken WOR cash and investments at their book values.

As of Feb 2022, the investments in the unconsolidated affiliates amounted to USD 303 m.
  • Over the past 12 years, WOR had an average annual gain or income of USD 98 m from its investments (this is even excluding the Nikola gain).
  • I have not gone into details of the investments. But the Book Value may not reflect the earnings value of the investments. I don’t expect another Nikola but the investments could be another margin of safety.

The other plus point is that the business generated an average of USD 242 m cash flow from operations annually. About half of this had been used to buy back shares. The share buyback will boost share prices and if WOR continues with this practice, it will be another margin of safety.

What are the investment risks? It is not so much the business fundamentals but rather the valuation assumptions. If you agree that my assumptions reflect reality, then you should see the current price as an investment opportunity.

The only concern I have is that the parameters used to derive the cost of funds were based on Damodaran's Jan 2022 datasets. These probably reflected the situation before the Ukraine invasion. It also did not expect the high inflation rate. 

Damodaran do not have an updated datasets based on these negative outlook. But even without these numbers, I am sure that any updated cost of funds would be higher than that estimated above. There is higher risks than that reflected in the cost of funds used in my valuation.

To get around this, we can either arbitrarily increase the WACC or rely on the margin of safety to account for the higher risk. 

I am relying on the margin of safety. I am confident that the share buyback programme and the investments in the non-operating assets will provide the additional margin of safety.

As such you can understand why I consider WOR as one of the better NYSE stocks to invest in. 


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Disclaimer & Disclosure
I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you.




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