Thursday, May 2, 2013

Will Whirlpool's Drive for Margins Work?

Sometimes when companies outline their strategic thinking the market chooses to ignore them and then be surprised when the results come out in line with the company’s strategy rather than with what the market chose to think. I think there was a bit of this mentality with Whirlpool's (NYSE: WHR) recent results. Revenues were a bit less than market estimates but earnings were ahead. The company told us that its focus was on margin and cost reductions rather than purely revenues and volumes; why don’t we try taking that at face value?

Staring Into a Whirlpool

This is an activity that can produce confusing optics. The periphery may swirl around and signal danger but the center is calm. It’s a nice way to think about these results. Whirlpool declared it was on track to deliver on all its key metric such as profit margins, EPS and an impressive $600-650 million in free cash flow for the year. Most notably omitted from these metrics is revenue, and I suspect the reason is that the company intends on pushing ahead with margin expansion rather than chasing or holding market share. As a consequence there was no change to its full year guidance.

However the revenue numbers got the market worried.  On an adjusted basis sales were flat at $4.3 billion but adjusted operating profits were up 21% to $280 million and free cash flow improved by $139 million to an outflow of $376 million. So margins and cash flow improved but sales didn’t.

Nobody likes companies that aren’t increasing sales, but there is a rationale for it. Whirlpool is trying to achieve margin expansion in an industry that is coming off a historically low base, so the opportunity for leverage is significant. Operating margins rose to 6.6% in the quarter with the longer term aim being to get them up to 8%. I think this strategy makes sense in a rising market but, make no mistake, if the market does turn down again Whirlpool will suffer inordinately compared to its peers.

The stock is very much a directional play on US and Latin American housing. EMEA (nearly 16% of sales) is a significant region, but conditions are tough there and the forecast is for flat revenues in 2013 while Asia is not a significant region (4.4% of sales). Hopes rest on the US and emerging markets, particularly Brazil.

Will it Work?

Whirlpool seems to be of the opinion that promotional activity won’t necessarily increase market share and appear to be jejune to the threat posed by LG and Samsung selling into Home Depot (NYSE: HD) and Lowe’s Companies (NYSE: LOW). Indeed, LG saw some margin erosion in its last quarter. All of which leads to a classic investment proposition. Do you favor a company gaining market share with margin erosion or one like Whirlpool that tends to hold margin but is willing to lose some market share?

As ever there is no immutable answer to these sorts of questions. My feeling is that the latter is a better strategy provided its end markets are doing well and the company invests in innovation in order to keep the perception of value in the brand.The good news is that Whirlpool is doing this. Furthermore let's recall that Whirlpool is acting on behalf of its shareholders rather than trying to establish volume growth for some ulterior motive.

With this in mind it's worth looking at what the industry is saying. I noted that in General Electric’s (NYSE: GE)  recent outlook it gave a positive prognosis for its home and business division. While it is not a big part of GE’s operations it is a significant marker for its view on the consumer market in 2013, particularly the housing related sector. Moreover, GE is similarly positioned to Whirlpool in the market so there isn’t strong evidence to suggest LG and Samsung are set to dominate.

Turning to the home goods stores, Home Depot reported that its pro sales were starting to increase more relative to consumer sales in Q4. This is a sign that the market is starting to turn up definitively and not just relying on replacement sales anymore. Furthermore, Home Depot reported that more of its discretionary elements were starting to outperform and crucially for Whirlpool, it said that kitchens, bath performed positively.  It was a similar story with Lowe’s Companies. It reported that the outperforming categories in the quarter were things like cabinets, counter-tops, home fashion, storage and cleaning. Again this is good news for Whirlpool.

As noted in a previous article we are approaching the 10 year anniversary of the boom years in the housing market where consumers were accelerating their purchases of white goods. Therefore it is reasonable to expect a new replacement cycle to kick in over the next few years. This should benefit all the companies discussed above.

Where Next for Whirlpool?

On balance I think Whirlpool’s mix of exposure to a resurgent housing market plus its margin expansion opportunity makes it an attractive stock to hold. It is forecasting North American growth to come in at 2-3% with Latin America at 3-5%. If it hits these rates and continues to expand margins and cash flow I think the stock will be higher at the end of the year.