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Worthington Industries: Sufficient Margin Of Safety Despite Being Cyclical (NYSE:WOR)


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Investment thesis

Worthington Industries (NYSE:WOR) achieved an extraordinary result for 2021. Furthermore, 2022 will be one with record revenue. But do not be misled by these results. The 2021 performance was due to a one-off gain from 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 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.

I would argue that there are also other items that can be considered as a margin of safety. These are its investments, its share buyback program, and even the immediate EPS.

Rationale

  1. WOR is a fundamentally sound company. I have already shown this in my article last year. The inclusion of the 2021 and YTD 2022 results would not change this picture. The key issue is whether there is a margin of safety. Valuation is key.
  2. WOR LTM and last year’s performances were extraordinary and should not be used to represent the long-term performance.
  3. WOR is in the steel sector. The steel sector is cyclical. Any valuation of WOR should then be based on its performance over the cycle.
  4. WOR has substantial investments and to “wash out” these impacts, I looked at the operating margins over the past 12 years. I considered 2 valuation scenarios – based on 2021 revenue and LTM revenue to represent the long-term performance.

Fundamentally sound

In my 2021 Seeking Alpha article on WOR, I had shown that WOR is fundamentally sound. There is no reason to change my assessment given the current good performance. My bases are:

  • It has a D / (D + E) ratio of 0.35. While high compared to the steel sector ratio of 0.25 (Source: Damodaran’s Jan 2022 dataset), WOR has USD 225 m cash. On a net Debt basis, the ratio is 0.28.
  • It had been able to generate cash flow from operations yearly for the past 12 years. On average it generated 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.

Comparing WOR ROA with those of its peers

Peer Returns – From SEC Filings (Author)

Extraordinary run

Over the past 2 years, WOR had an extraordinary run.

  • It had a record net income of USD 741 m for 2021.
  • The LTM revenue for 2022 is a record of USD 4.1 billion.

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.

Revenue trends by products

Revenue by Products – From SEC Filings (Author)

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. But the main reason for the extraordinary performance was the USD 655 m gain from the sale of its investments (Nikola Corp). This was a one-off corporate exercise.

At the same time, the current LTM revenue for WOR is about 29 % higher than the 2021 revenue. Based on WOR LTM data, I estimated that the LTM average selling price for steel is 1/3 higher than that for 2021.

Steel prices are currently on an uptrend. The following in a July 2021 Fortune article exemplifies the steel price situation.

“I don’t think we’ve hit the peak for steel prices. Most people in the market see strength through the third quarter, and some don’t see it getting better on the buying side until 2022 sometime,” Thorsten Schier, a metals expert at Fastmarkets.

Steel prices are cyclical and while I do not know how long the current high price will last, I am sure that it will eventually decline.

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. There is further growth in 2022. Based on the LTM results, WOR will achieve record revenue for 2022.

Compares WOR revenue with a number of economic drivers

WOR Revenue vs Economic Indicators – From SEC Filings (Author)

WOR revenue growth is a combination of volume growth and price growth. The chart below tracked the physical units shipped and 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 products selling price in 2021 is 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 is 88 % higher than that in 2010. This is about a 5.9 % CAGR from 2010 to 2021.

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

Segment volume and price trends

Segment trends – From SEC Filings (Author)

Cyclical performance

Apart from the operating assets, WOR had USD 225 m cash and USD 291 m of investments in unconsolidated affiliates. Over the past 12 years, these generated 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 thus focused on the metric, operating return = 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 below. 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 volatile.

DuPont trend analysis

DuPont analysis – From SEC Filings (Author)

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

WOR 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 operating profit margin

Tax = 21.3 % based on the 2019 to 2021 average

Reinvestment rate = growth / operating return

Operating profit margin = 6.4 % based on the past 12 years’ average as per its SEC Filings.

Under the FCFF model, to derive the value of equity, we have to add the value of the non-operating assets and deduct Debt and Minority interests. For these values, I used the Nov 2021 unaudited values.

I considered 2 revenue scenarios – based on 2021 revenue and based on the current LTM revenue.

The results of the valuation are tabulated below.

various valuation metrics of WOR

Valuation summary (Author)

You can see that there is only a margin of safety based on the Earnings value with growth.

Margin of Safety

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 Nov 2021, the investments in the unconsolidated affiliates amounted to USD 291 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 the 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 about 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.

Finally, you could also view the LTM EPS of USD 8 as another margin of safety. If the steel price continues to remain high till the end of 2022, the FYE 2023 EPS could also be another margin of safety. Note that this is on top of the computed intrinsic value as the computed one is based on a cyclical performance.

Conclusion

My focus is on the valuation as I believe that WOR is fundamentally sound. Thus the challenge is to see whether you could buy it at a discount. If you agree that my assumptions reflect reality, then you should see the current price as an investment opportunity.

What are the investment risks? It is not so much the business fundamentals but rather the valuation assumptions. There are two basic issues here – the Revenue and the discount rate.

I have used two revenue scenarios. Note that even if you take the past 12 years’ average it would only be 7 % less than that for Scenario 1. As such I like to think that I am being conservative for the revenue assumptions.

But the discount rate is based on Damodaran’s Jan 2022 dataset which reflects the situation in 2021. You could argue that due to the current Ukraine situation, the risk is higher and thus the risk free rate and Beta would be higher. This would result in a higher cost of funds which in turn reduces the margin of safety. But I hoped that the other sources of the margin of safety helps to mitigate this.



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