February 10, 2005
Company Watch: WD-40 Company
By Brady Willett & Hope Trites

WD-40 – which is the abbreviation for ‘Water Displacement perfected on the 40th try’ - was invented by three chemists in 1953. Following the commercial success of WD-40, the Rocket Chemical Company was renamed to ‘WD-40 Company’ in 1969, and went public in 1973. The rest as they say is history. 

WD-40 Company is an attractive company because of the solid returns its best known product(s) generate.  Contrarily, WD-40 is an unattractive company because its stock valuations are at historically high levels, and also because the company’s future is less predictable because of the adoption of many new brands. WDFC has been added to the ‘Watch List’ with an initial price target of $25/share. 

Company Overview

Over the last decade WD-40 (the company) has spent $16.89 million in total capital expenditures and paid out over $195 million in dividends. Ordinarily these numbers would be switched (companies usually spend more on PP&E type investments rather than dividends).  However, at WD-40 constant product reinvention/machinery retooling is not required: the manufacturing of WD-40’s products is outsourced to contract packagers, and - beyond changing the packaging - the WD-40 formula that was created 50+ years ago remains much the same today (less some VOCs). 

Since WD-40 outsources its production needs the year-to-year cost configuration of the business is better tracked by following SG&A related expenses instead of capital expenditures. Over the long-term these expenses – which include everything from freight costs to currency gains/losses - are a good indicator of how efficiently WDFC is operating.


That expenses reached an all-time high (as a percentage of sales) in 2004 suggests - and the company confirms - that inflationary pressures are developing. To combat rising commodity prices WD-40 plans to raise prices in 2005.

Another reason for the increase in expenses is that the company has launched/maintained numerous new products since expanding beyond it founding product in 1995. These new products have been supported by increases in R&D, promotion, freight costs, etc.



The costs of maintaining brands and rising commodity prices are not the only things threatening WDFC’s bottom line.  Rather, new product lines not only required greater capital, but also generate smaller returns (compared to WD-40 line).  For that matter, some new product initiatives (T.A.Z. in 1997 and the Lava U.K. launch in 2001) have failed to generate any positive returns. To better highlight the trend of diminishing returns one chart will suffice. To note: while commodity prices are currently a drag, they were not at all responsible for the plunge in net margins from 2000-2002.



Whether intentional or not, the company’s ‘fortress of brands’ strategy is all about sacrificing margins and dividends for top line growth.

The Lubricating King Has Quietly Been Taken Down a Notch

WDFC’s stock price is near an all-time high. WD-40 Company recently released strong 1Q05 financial results and maintained its optimistic outlook for 2005 and beyond. With these things in mind why has the ‘King’ been taken down a notch? Because the takeovers have made WD-40 a significantly less potent enterprise.

Since the takeover of 3-IN-ONE in 1995 goodwill/intangible assets have arrived on the balance sheet and have continued to increase with each new acquisition.  Moreover, the returns since 1995 have not evenly spread out. For example, revenues have more than doubled since 1995 (above chart in red), while earnings have only increased by 25%.
 

With the exception of 3-IN-ONE - which broadened WD-40’s distribution channels and made the company even more competitive in lubricants - other acquisitions have been an expensive grab for revenues.  Obviously Garry Ridge (CEO) and others would disagree: management is quick to tout the growth benefits of 1001 (the latest acquisition), and that products like SpotShot are expected to grow in 2005. However, what management fails to mention is that growth has not come easy.  To be sure, interest expense has gone from nil in 1999 to more than $6 million in 2004, Return on Equity is in freefall, dividends have been cut, and working capital has been drawn down.  Suffice to say, the company likes to point out that it is growing, yet the long-term stockholder cannot help but wonder at what cost.


Valuations Rich

The valuations story on WD-40 follows the pre and post 2000 stock market mania to perfection.

Pre-Crash: ‘Old economy’ stock WD-40 is ignored by investors. Company has attractive dividend yield and stable growth prospects.

Post-Crash: After 2000 WD-40’s dividend yield starts to decline as 1) U.S. interest rates decline, 2) Investors become more attracted to dividend paying companies, and 3) WD-40 begins to focus on long-term growth instead of increasing shareholder wealth (via dividends). As for WDFC’s stock price: from its lows in 2001 to its highs in 2003 WDFC stock more than doubles. 


Currently the company has a dividend yield of 2.39% (versus a 4% 10-year Treasury yield).  At the height of the stock market mania the company traded at a P/E ratio of 15 and had a dividend yield of 6.29%. The average 10-year Treasury yield for the year 2000 was 6.01%.

Conclusions and Investment Opinion

WD-40 is one of the most remarkable product stories of all time. There are cheaper, equally effective products on the market, but none of them have the brand power of WD-40.  When purchasing WD-40 you not only get a lubricant that can be used for more than 2000 different jobs, but you also get a conversation piece.  By way of contrast, Lava soap cleans your hands.

Since 1995 the WD-40 Company has purchased and developed brands that have a strong market presence, but none of these new products have the long-term appeal of WD-40. In fact, some products – Carpet Fresh and X-14 to name two – will probably need to be constantly updated and promoted to simply remain viable products in the competitive household products category.  Suffice to say, acquisitions have not only transformed the company into a less potent enterprise, but have also diluted the exposure the investor gets from the WD-40 product alone. 

There are items of interest - including broker concerns/old lawsuits, product counterfeiting in China, unexpensed stock options, and potential class action suits (toilet cleaner issues) - that the investor should be aware of when analyzing WD-40. Moreover, the investor needs to be aware that WD-40 management has been infected with acquisitions-bug; that future financial success/failure will be tied more to how acquisitions pan out and not to how well the world’s most popular lubricant performs (the WD-40 pen looks like it will be a great success in 2005!).  That being said, before attempting to draw any final conclusions it is worth remembering that WD-40 trades at 27 times free cash flow, more than 20 times earnings, and yields only 2.39%.  These rich valuations mean that WDFC and its brands are only worth serious consideration should its financial performance and/or stock price hit a road block.  At $25 WDFC would be trading at 20-times free cash flow (diluted) and its dividend yield would be 3.3%. At $25 a share WD-40 Company warrants, at minimum, another test drive.

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