Seeking Small-Cap Moats: WD-40 Company

This article is part of Todd's monthly series "Seeking Small Caps With Moats." The introductory article can be found here. New articles in the series are published on the fourth Wednesday of every month.

Since November, we've looked at seven small-cap companies that, at least in my opinion, possess economic moats--that is, they should be able to generate economic profits for at least 10 years.

Even though these companies generate economic profits, potential investors still need to consider a stock's valuation before buying. A good company doesn't necessarily imply a good stock. Price always matters. 

In bullish markets like this one, finding high-quality companies trading at material discounts to their fair value is a challenge. Small caps in particular have had a very strong run over the past five years. 

Five-Year Annualized U.S. Market Returns (%) by Market Cap and Style
	Value	Core	Growth
Large Cap	16.0	18.6	18.9
Mid Cap	22.4	22.5	19.9
Small Cap	22.9	20.5	20.0
Source: Morningstar. Data as of May 31, 2014.

Indeed, at the time of publication, none of the seven stocks we've previously mentioned (listed below) appeared to be bargains based on certain valuation metrics. Although this has been an understandable point of criticism from some readers--hey, I like immediately actionable ideas, too--the purpose of this article series is to highlight lesser-known, moatworthy small caps. These small caps may be overvalued, fairly valued, or undervalued at time of publication, but they're all worthy to include in your watchlist. 

With a bit of patience, a well-stocked watchlist can provide plenty of buying opportunities in the event of a market downturn. 

A Unique Household Brand
Anyone who's spent time in a garage, made repairs around the house, or worked on bicycles is familiar with this month's small-cap idea--WD-40 Company (WDFC).

Below are some quick facts about WD-40:

• Founded: 1953
• Market cap: $1.1 billion (as of June 23)
• Headquarters: San Diego, California
• Number of sell-side analysts covering: 4

The vast majority of the company's revenue is based on the original WD-40 formula (WD-40 stands for "Water Displacement perfected on the 40th try") that we're all familiar with. The company also owns a number of related consumer and industrial cleaning products such as Lava soap and X-14 mildew stain remover. Its products are sold in 188 countries, so the company already has a wide geographic reach (about 40% of sales are generated within the U.S.).

Moat
Though Morningstar doesn't currently cover WD-40, and the company hasn't been vetted by our moat committee to produce an official Morningstar Economic Moat Rating, I'm of the opinion that WD-40 possesses at least a narrow economic moat.

For starters, the WD-40 brand name is extremely valuable, and the company likely enjoys an intangible-asset advantage. It's a trusted brand and there are few (if any) substitutes for the original secret formula, so the company can charge a premium price. Fans of the WD-40 product even have their own website, showing more than 2,000 uses for the product. There's not much a can of WD-40 and a roll of duct tape can't fix.

Beyond the brand, the company's ability to leverage a single formula and create multiple products from it is an example of economies of scope. This results in a cost advantage that potential market entrants would struggle to match if they attempted to go head-to-head with WD-40 on a certain product line.

The company's ability to consistently generate double-digit returns on capital and equity is another indication that an economic moat is likely present. Since fiscal year 2004, returns on capital and equity haven't fallen below 10.8% and 15.6%, respectively.

Finally, WD-40 consistently generates about $1 million in revenue per employee. As a rule of thumb, I like to see at least $250,000 in revenue per employee, so this is definitely a sign of an efficiently run business. It's hard to believe that such a global brand has only 375 employees (manufacturing is outsourced).

WD-40's "50/30/20 Rule" provides a North Star for driving efficiency--deliver over 50% gross margins, keep the cost of doing business (i.e., overhead) below 30%, and generate EBITDA margins above 20%. Make no mistake that these are, in fact, bold targets, as the company has failed to achieve the 30% and 20% objectives in recent years. If the company were able to hit on all three targets, this would help drive strong earnings growth, and I see no reason why WD-40 couldn't achieve this given its considerable competitive advantages and efficient operations.

WD-40 Profitability Metrics (%)
	2011	2012	2013	TTM
Gross Margin	50	49	51	52
Cost of Doing Business	33	33	35	34
EBITDA Margin	17	16	17	18
Source: Morningstar, WD-40 presentations

Stewardship
There's a lot to like about WD-40's management team, including meaningful insider ownership (directors and executives own about 7% of shares outstanding) and the fact that all seven corporate officers have been with the company for more than 15 years. These factors should promote long-term thinking and cultural continuity, and should align shareholder interests with management's interests.

CEO Garry Ridge has been with WD-40 since 1987 and has been CEO since 1997. During his time as CEO, the stock has gone up 356% on a cumulative basis, or about 9.5% annualized, compared with a 170% gain, or 6.2% annualized, for the S&P 500. The stock has also outperformed the S&P 500 and Russell 2000 by about 50 percentage points over the past five years. All this is to say that long-term shareholders should be fairly happy with the way the company has performed under Ridge's leadership.

When I asked Ridge about the company's capital allocation strategy, here's what he had to say:

"Our capital allocation strategy is fairly straightforward. We focus on both return of capital to shareholders and investing in the future. Our first priority is our regular dividend; we target a dividend payout ratio of 50% of net income. Next we look at opportunities to invest in future growth; this can be either internal growth or by acquisition. The balance is returned to shareholders through our share repurchase program."

Striking a balance between future growth and current returns is always tricky, and the company ran into that issue last decade when WD-40 reduced its very generous dividend to allocate more capital toward growth initiatives. With the benefit of hindsight, that turned out to be the right call for long-term shareholders. Going forward, keeping the dividend payout ratio around 50% of net income should help WD-40 balance growth and returns.

Risk and Valuation
If I have one major criticism of WD-40, it's the company's focus on EBITDA as an incentive metric. EBITDA is one of my least favorite financial metrics because interest, taxes, and depreciation are natural and recurring shareholder expenses that shouldn't be ignored. I'd much prefer to see WD-40's incentives based more firmly on shareholder-focused incentive metrics such as net income, free cash flow, or economic value added (EVA).

The biggest risk for WD-40 is a potentially limited growth runway. With its products already in 188 countries and a sizable portfolio of products already built around the WD-40 brand, the company might be challenged to drive revenue growth. Of course, this criticism has been frequently voiced for over a decade, yet the company has consistently outperformed these expectations by expanding into new end markets and further penetrating into new geographies.

WD-40 Valuation Metrics
	WDFC	S&P 500	Industry Average	WDFC 5-Yr Average
Price/Earnings	28.5	18.3	18.4	21.3
Price/Cash flow (*)	3.0	1.7	1.7	2.3
Dividend Yield (%)	1.8	2.3	1.5	2.5
Source: Morningstar, as of June 22, 2014. (*) Price/cash flow uses 3-year average for all columns except final column.

As much as I'd like to make this an immediately actionable article, I think WD-40 is best kept on your watchlist at current prices near $74 per share. Rarely does the stock look cheap, but these multiples look particularly lofty at the moment. In the event of a market pullback, however, WD-40 will be on my shortlist for new buys, as I think it's one of the highest-quality companies in the small-cap universe.

Other stocks highlighted in this series:

• Raven Industries
• Sun Hydraulics
• John Bean Technologies
• Exponent
• Culp Inc.
• Badger Meter
• US Ecology

Todd owns shares of Sun Hydraulics. You can follow him on Twitter at @toddwenning.