Woodward Q1 2023 Earnings: Avoiding This Stock Until 2H23 (NASDAQ:WWD)

Investment thesis

If you were to look at Woodward (NASDAQ:WWD) share price post the earnings without reading it, you would think the results are bad. You are right, it is. Woodward 1Q23 results saw further margin downside, following results below expectations in most of FY22. The more glaring margin deterioration is the Industrial segment where margin stands fell nearly 800bps from 2 years ago. It is even laughable when you consider the long-term margin target of 16%. Even Aerospace margin missed and the worse is it is down despite growing revenue – which means reducing incremental margin.

Now the good news is WWD reiterating FY23 guidance, which implies very strong recovery over the remaining FY23. Can WWD do it? Maybe. However, I am not sure if it is worth it to undertake this risk, as such I think it is best to stay away from the stock until we have more clarity on business recovery.

Financial results

Overall revenue for WWD came in at $619 million, an increase of 14% from their previous reporting period. Aerospace saw an 18% increase in sales, to $396 million, thanks to increased volumes from both the Commercial OEM and aftermarket segments. Industrial sales increased by 9% to $223 million on the back of increased marine sales and robust turbomachinery sales.

Operating margin for the segment was 10.8%, down 300 bps from the previous year. Aerospace’s EBIT margin fell 120 bps within this context, to 14.0 percent, largely due to inflationary effects on materials and wages, and increased manufacturing costs from supply chain disruptions and labor inefficiencies. The same story applies to Industrials, along with major FX headwinds, where it saw a decline of 640 bps in margin, bringing it down to 5.1%.

Commercial aftermarket in focus

The continued upswing in domestic and international air traffic, combined with higher fleet utilization and the fact that the newest aircraft have far more aftermarket content than older ones, were the primary factors driving Commercial Aftermarket growth in 1Q23. In addition, WWD’s primary platforms are the A320neo and 737, two newer narrowbodies that have seen higher utilization rates than their larger widebody counterparts.

As OE rates increase and planes are put back into service to meet airlines’ capacity demands, initial provisioning may become a material driver again moving forward. I expect initial provisioning, which accounts for roughly 10% of Commercial Aftermarket sales, to continue ramping up over the near-term. However, revenue growth should be lumpy given it is tired to the number of new airlines are taking delivery of the aircraft. Management has stated that while initial provisioning on the narrowbody side was not exceptionally strong, the reopening of China could serve as a catalyst in the coming years.

Overall, I expect that the narrowbody aircraft sector, especially in the Commercial Aftermarket, will drive the growth of WWD in the coming years. This is because, as the aerospace industry recovers, there will be a rise in the number of maintenance visits for crucial engine platforms like LEAP.

Supply chain and labor impact on Aerospace

As per guidance, there will be an increase in Aerospace margin of between 150 and 200bps, or to 16.7% -17.2%. Given the effects of material and labor inflation and the return of annual incentive comp in FY23, I expect WWD to be lower than the low end of the guidance range. Despite a slight improvement from 4Q22, I believe the effects of delayed shipments due to supply chain and labor disruptions will remain for the foreseeable future. The negative effects of these factors were evident in 1Q23, when the Aerospace segment’s margins dropped by 120bps.

What is also implied from this guide is that Aerospace needs to finish the remaining of the fiscal year with a blended margin of 17.8%, in order to meet the guided margin midpoint. For this to occur, supply chain and labor disruptions needs begin to abate during the second half of CY23, and that WWD needs to begin production after installing its rapid complex machining centers in 2Q23. In addition to streamlining the supply chain, adopting contract rollover pricing may contribute to meeting this target. In particular, management stressed the potential for price increases in the high-IP portion of the engine.

Industrial orders impacted

WWD Industrial segment growth is heavily dependent on the introduction of clean fuels, new infrastructure, and flexible energy systems, all of which are essential to the success of the global energy transition. 1Q23 revenue increased by 9% to $223 million on the backs of higher marine sales thanks to the ongoing use of the in-service fleet and robust industrial turbomachinery sales to back up rising demand in the power generation and process industries. Seeing as how management is still getting strong demand signals from customers, I expect Industrial to continue growing in the high single digits organically. After taking into account the mid-single digits in FX headwind, my estimate would be roughly in line with guidance on a reported basis.

CAPEX

In 1Q23, capex was $24m, or 30% of the FY23 guidance. WWD had already opened up new facilities to accommodate the rising demand for commercial aerospace and industrial products just before the pandemic. With that, I expect WWD to have sufficient capacity for production over the next few years without investing in capacity, despite the impact of COVID-19 on commercial production rates. WWD should also enjoy high incremental margin from the operating leverage that comes with this installed capacity.

Guidance

Management has not changed their EPS forecast for FY23 from $3.15 to $3.60. The driver behind this maintained guidance is the increase revenue guide of $2.60 to $2.75 billion (midpoint growth of 12%). Importantly, this guide presupposes that supply chain and labor disruptions will begin to abate in 2H23 and that price will be realized at a rate of 5%. In terms of market segments, management guided to 14%-19% growth in the aerospace sector, and 0%-5% growth in the industrial sector. In the aerospace industry, margins are expected to hit 17.0 percent, an increase of 150 basis points to 200 basis points from the previous year. Margin projections for the industrial sector are unaltered at 9.6%.

Conclusion

While WWD has re-affirmed its FY23 guidance, suggesting a strong recovery over the remaining fiscal year, it is uncertain if this can be achieved. Given the uncertainty, it may be wise to avoid investing in the stock until there is more clarity on the business recovery.