Ambitious Goals for Worthington Industries Require Caution

Diversified metal processor  Worthington Industries (WOR) has spent the past several years reducing its exposure to the anemic construction markets while expanding its product offerings, acquiring higher-margin businesses, and implementing a transformation plan to generate greater efficiency and sustainably improve returns. While we commend management's call to action, we see a few hurdles in achieving margin and growth targets, particularly as the landscape of the company looks quite different today following plant closures and divestitures alongside numerous acquisitions in the past few years.

Acquisitions, Transformation Efforts Fundamental to Earnings Growth Strategy
Worthington launched its transformation plan in 2008 to produce cost reduction, higher asset efficiency, and process improvement, with the ultimate goal of increasing margins over the long term. On a plant-by-plant basis, the transformation plan involved identifying areas with room for performance improvement and implementing solutions, as well as methods to track and measure performance from inventory management to operating processes to sales channels. Steel processing has completed the transformation, while the process is under way in pressure cylinders and just launched in engineered cabs (acquired in January).

Margins have improved in steel processing since transformation began, even after adjusting for the effects of rising steel prices. However, we think the improvement is only slightly due to the transformation plan. The recovery in North American steel demand---particularly in automotive, which represents roughly 50% of Worthington's steel processing volume--is probably a major contributor to the higher returns. It is difficult to estimate the efficiency gains achieved through transformation until the company has been through a full economic cycle. Worthington has incurred more than $70 million in restructuring charges as the result of the transformation effort and it is too soon to say whether this investment will be successful, in our view. We believe the margin gains in steel processing are sustainable in our explicit forecast, but this is largely due to our positive outlook for North American steel consumption and automotive demand in particular, which we view as the largest earnings catalyst for this segment.

The automotive industry consumes roughly one third of Worthington's sales, mainly in steel processing, where tons shipped in fiscal 2012 were still down 12% from fiscal 2008. Pressure cylinders adds exposure to the retail, industrial, and alternative fuel markets and is the most geographically diverse after completing eight acquisitions since 2009. The company seeks target companies that already generate higher margins than Worthington's current portfolio in the relevant business segment. We think this strategy has yet to drive higher returns on capital. We wonder whether seeking underperforming businesses for a cheaper price may produce even higher returns, particularly as the transformation plan might enable the company to better identify targets that have the potential for meaningful efficiency gains by implementing Worthington's newly evolving best practices.

While pressure cylinders is not the only area management targets for acquisitions, it has been by far the most active and is likely to see a large share of merger and acquisition activity relative to the other segments. There are no closely comparable companies to assess the performance of this business, and the returns are muddled by mix shifts because of the wide range of selling prices and margins across the product portfolio. This segment as a whole enjoys higher margins than either steel processing or engineered cabs, and the transformation effort is still in the early innings. An emphasis on product innovation and the growing exposure to alternative fuels could also drive better returns ahead. Still, we don't think there is clear evidence that an aggressive growth strategy including further acquisitions--in pressure cylinders or elsewhere--is the path to value creation. There may be some synergy value in acquiring new business segments in related industries, such as between the newly acquired engineered cabs segment and the legacy steel processing business. But the combination of diverse business segments is unlikely to generate meaningful competitive advantages.

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Joint Ventures Contribute the Most Income, but Value Is the Most Difficult to Forecast
WAVE, the largest of the nine joint ventures, is a global provider of ceiling suspension systems, mainly to the renovation markets. This business consistently enjoys EBITDA margins in excess of 30% and represents more than two thirds of the total equity income generated by the joint ventures. After transitioning the bleeding metal framing business to a joint venture in 2011, Worthington has greatly reduced its exposure to the construction markets and increased the prominence of joint ventures in its portfolio.

Following automotive, the next-largest end markets for Worthington are construction (14%), leisure/recreation (12%), and industrial gas (9%). A diversified range of end markets mitigates earnings volatility while still providing ample exposure to the automotive sector, which was a key goal for the company. We question whether restructuring a portfolio to reduce earnings volatility actually drives value for shareholders. The lack of control and reduced disclosure requirements for the joint ventures also cloud the long-term forecast for their earnings contribution. Still, the joint ventures have yielded impressive earnings with less capital and management attention required, in our view, and we expect this segment to continue its strong performance.

Doubling Each Business Segment Every Five Years Could Be Optimistic
Total sales peaked at $3 billion in fiscal 2008 and remain down 17% from that level as a result of the elimination of metal framing from the top line. The specific goal for each business unit to double the top line may be higher or lower than the five-year target, depending on each segment's focus on M&A versus organic growth as well as prospects for the relevant end markets, but each business currently has a plan in place to grow by 100% in a "reasonable" amount of time. While we think this is feasible, given the company's experience in executing M&A transactions, and the balance sheet has ample room for greater leverage, with total debt/EBITDA currently at about 2 times, this growth could come at a lofty price, in our view. Management's primary focus is on higher-margin targets, but each business unit is also given the objective to produce returns on capital in excess of 10%. We think adhering to these two goals will make it difficult for the company to grow at that pace. We project organic growth of about 6% per year for the next five years from improving end markets and company initiatives to expand capabilities to reach new customers. We believe any excess growth is likely to require a higher capital cost and would be value-neutral for the company.

Shares Look Overvalued
The stock has risen 31% year to date, vastly outperforming the other metal processors we cover--Reliance Steel & Aluminum (RS) (up 14%) and Olympic Steel (ZEUS) (down 22%). This also compares with a 5.5% decline in the Market Vectors Steel Index. Most of the price strength occurred in the early summer, and we don't think this movement was justified by a meaningful improvement in market fundamentals for any of the company's key end markets.

We project higher long-term EBITDA margins (175 basis points above fiscal 2012) and rising returns on invested capital in our explicit forecast. There may be further upside potential to our estimates, particularly to the top line, but at a higher cost of capital. Rapid changes in the business in recent years combined with aggressive revenue goals require caution, in our view.