The Bull Case For CSW Industrials Inc.

With Quiver Quantitative’s recent institutional holdings data, we can see that hedge funds and asset managers have been increasing their holdings in CSW Industrials Inc. CSWI. Firms such as Vanguard, Wasatch Advisors, and Two Sigma Advisers have all recently added to their CSWI positions. Most notably, Wasatch Advisors increased shares held by a whopping 733% (as filed on 9/30), bringing their total CSWI holdings to 504,699 shares worth around $102.7 million dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on CSW Industrials Inc.

In November, CSW Industrials posted earnings results for the second quarter of fiscal year 2024. The results were very positive, with the business posting record revenue, EBITDA, and EPS metrics for the second quarter and the first half of the fiscal year. Total revenue came out to a record of $203.7 million dollars (7% increase), with net income coming out to $30.1 million dollars (24% increase). Diluted EPS came out to a record of $1.93/share, a 23% increase. Additionally, cash flow from operations came out to $44.7 million dollars (a whopping 47% increase), with the business paying down $37 million dollars worth of debt during the quarter, further improving the balance sheet. CEO Joseph Armes commented on the quarter, “Our team continues to outperform the markets we serve, as exhibited in the record fiscal second quarter results delivered against strong prior year period results. Our second quarter and fiscal first half results demonstrate our ability to leverage our strong distributor relationships, drive operational execution, and carefully manage expenses.”. As we can see, the business is rapidly expanding and compounding earnings through organic growth and acquisitions, while paying down debt and improving the balance sheet. With these earnings results in mind, we believe that CSW Industrials is a compelling investment opportunity, trading at a very fair valuation (which we will discuss later).

CSW Industrials is a diversified industrial company operating in three main segments: Contractor Solutions, Engineered Building Solutions, and Specialized Reliability Solutions. The company focuses on niche, value-added products in various end markets including HVAC/R, architecturally-specified building products, plumbing, industrial, energy, rail transportation, and mining. With a strong emphasis on innovation and quality, CSW Industrials offers a range of products such as HVAC/R mechanical products, plumbing products, building safety solutions, and specialty lubricants and sealants. The company generates revenue through both direct sales to end-users and distribution channels in over 100 countries, leveraging a robust wholesale distribution network. CSW Industrials drives profitability by combining organic growth with strategic acquisitions to expand its diverse portfolio, catering to the evolving needs of its customers across its specialized end markets.

CSW Industrials operates within the competitive industrial products industry, facing varied competition from global, regional, and local companies, including major players like Exxon-Mobil, Fuchs, Kleuber, Shell, and South Coast Products. The company sets itself apart primarily through product differentiation, superior performance, and quality, along with a customer-centric service approach. Unlike many commodity consumables, CSW Industrials focuses on long sales cycles where product performance is a key buying decision factor, rather than price. Their Specialized Reliability Solutions products are primarily sold through value-added distribution partners, as well as maintenance and repair operations or catalog channels. The company's customer base is diverse, encompassing petrochemical facilities, industrial manufacturers, construction companies, utilities, and operators in the rail and mining sectors, with a business strategy that combines 'pull' demand from end-users and 'push' demand towards distributor partners.

CSW Industrials boasts a variety of competitive strengths, highlighted by a broad portfolio of leading products and solutions in their targeted markets. They have achieved strong organic revenue growth by focusing on markets with growth trends and leveraging a loyal, diverse customer base. Key to their success is a continuous improvement culture aimed at optimizing manufacturing processes, evident in initiatives like consolidating manufacturing to enhance efficiency and product quality. Additionally, CSW Industrials utilizes diverse sales and distribution channels, including an international network of sales representatives and wholesale distribution partners, to reach niche markets and support both organic and acquisition-driven growth. Their proven track record in successful acquisitions further underscores their competitive edge, adding value through strategic product-line expansions that complement their existing distribution and manufacturing capabilities.

Management is solid, and their capital allocation priorities do a great job of creating shareholder value. CSW Industrials' Board of Directors authorized a new $100 million share repurchase program on December 16, 2022, replacing a similar program from 2020. Under the previous program, the company repurchased 336,347 shares for $35.7 million, contributing to a total of 462,462 shares bought back for $50.1 million. As of March 31, 2023, no shares have been repurchased under the current program, which is set to expire on December 31, 2024, with future repurchases contingent upon the company's financial health and other factors. While we believe that it would be sensible for management to repurchase shares at current valuations, it's great to see that management likes to return value to shareholders via repurchases, and it seems like they do a great job of efficiently repurchasing shares when share prices are below intrinsic value. Outside of repurchases, the business also offers dividends (albeit small). Dividends of $10.6 and $9.5 million dollars were paid out in FY23 and FY22, respectively. Since 2019 (when the business’ dividend program commenced), dividends have routinely increased YoY.

In terms of incentives, management is incentivized well, with a compensation structure that does a great job of aligning shareholder and management interests. The compensation structure includes a base salary, an annual cash based incentive, and long-term equity incentives that are paid out in the form of performance shares (PSUs) and restricted shares (RSUs). During FY23, 82% of the CEO’s compensation was at-risk, with 68% at-risk for all other NEOs’ compensation. The annual incentive program is based on EBITDA and semi-annual operating cash flow (OCF) goals, while the long-term equity incentive is based on total shareholder return relative to businesses in the Russell 2000 index. This long-term equity incentive does a great job of aligning shareholder and management interests, as management is incentivized to maximize shareholder returns while building equity in the business, which further helps to align management and shareholder interests. A famous quote “Show me the incentive, and I'll show you the result” plays out nicely here, considering that CSW Industrials is consistently in the 75th percentile or above when it comes to TSR (total shareholder return) in the Russell 2000 index. As we can see, management’s compensation structure incentivizes maximizing shareholder returns, handsomely rewarding shareholders over the long run.

CSW Industrials is a very efficient business. The business currently operates at a LTM ROE of 18.8% and a LTM ROIC of 18.2%. With the business currently operating at a WACC of 7.8%, CSW Industrials currently operates at a ROIC to WACC ratio of 2.33x. This indicates that the business is able to generate returns on capital far greater than the business’ weighted average cost of capital, showcasing the business’ efficiency with its capital. Businesses that are able to generate high returns on capital are known as compounders, businesses that are able to rapidly compound intrinsic value over the long run. These businesses often outpace the S&P 500 and other market indices, making them solid investment opportunities that handsomely reward shareholders over the long-term. In addition to the business’ high returns on capital and equity, the margin profile of the business is stellar, showcasing the business’ operational efficiency and ability to generate a high percentage of earnings from revenue. EBIT margins have hovered around 16 - 19% over the last decade, with incremental margin expansion in that same time frame. A stellar margin profile and expanding margins show that CSW Industrials is a high quality business with high levels of operational efficiency.

Analyzing CSW Industrials’ income statement, we can see some stellar sustained growth in revenue, gross profit, and earnings within the last decade. Since 2014, CSW Industrials has grown revenue at a CAGR of 12.6%, with gross profit growing at a CAGR of 11% in that same time period. Since 2014, revenues have never seen a YoY downturn, showcasing that the business sells products with sticky demand. In terms of earnings, CSW Industrials has grown EBITDA at a CAGR of 13.7% since 2014, with EPS growing at a CAGR of 14.6% in that same time period.

Looking at CSW Industrials’ balance sheet, we can see that the business operates in solid financial health. The business currently has $15.4 million dollars worth of cash and equivalents on the balance sheet, paired with $173 million dollars worth of long-term debt. More broadly, the business operates at a net debt of $203.7 million dollars. While this low cash to debt ratio may be a red flag for some investors, we don’t believe that it should be a cause for any concern. CSW Industrials operates in a capital intensive industry, and they spend money on acquisitions and other reinvestments back into the business that benefit shareholders. Arguably, this is a much better use of capital than letting it sit on the balance sheet, and it is evident that management likes to put its money to work to rapidly expand the business. In case you were still worried about solvency issues, the business currently operates at an interest coverage ratio of 9.6x, meaning that the business generates $9.60 in EBIT for every dollar of interest expense incurred by the business’ debt obligations. The business has plenty of runway to cover its debt expenses, and we are happy to see that cash is being put to work to expand the business.

Analyzing CSW Industrials’ cash flow statement, we can see some stellar sustained growth in net income and free cash flow within the last decade, showcasing the business’ increased operational efficiency. Since 2014, the business has grown net income at a CAGR of 14.6%, while free cash flow has grown at a CAGR of 32.2% in that same time frame. The massive growth in free cash flow can be attributed to rapidly expanding free cash flow margins, along with healthy top-line revenue growth. In 2014, the business operated at a free cash flow margin of 2.8% of revenue, compared to today where the business operates at a free cash flow margin of 19.6% of revenue. This free cash flow margin expansion acts as a major catalyst for the business’ expansion. As the business is able to generate more and more cash, along with healthy top-line revenue growth, it can continue to put that cash to work to expand the business, either organically or through acquisitions. CSW Industrials is a high quality compounding business, and this free cash flow margin expansion acts as a strong catalyst for the business’ continued growth and compounding of intrinsic value.

After conducting a reverse discounted cash flow analysis, we can see that CSW Industrials is trading at share prices that imply a 2.94% growth rate (CAGR) in free cash flow over the next decade, using a discount rate of 7.8% (CSW Industrial’s WACC) and a perpetuity growth rate of 3% (largely in line with US GDP growth). We believe this growth rate is extremely cheap, especially given CSW Industrial’s free cash flow growth rate and free cash flow margin expansion within the last decade. While past performance is not indicative of future results, since 2014, CSW Industrials has grown free cash flow at a CAGR of 32.2% on massive free cash flow margin expansions (2.8% of revenue in 2014 compared to 19.6% of revenue today). We find it very unlikely that this growth will regress all the way down to a 3% CAGR in free cash flow, especially given the business’ solid and predictable revenue growth on its products that evidently have sticky demand. A more conservative free cash flow growth rate is 8%, which implies a share price of $289 and a 42.7% upside. Oftentimes, quality compounding businesses like CSW Industrials trade at high premiums, however, this is a great opportunity to own a quality compounding business at a cheap valuation, an outlier. These valuations are completely based on our proprietary models, and we encourage all investors to do their own due diligence to arrive at their own valuations, which may lead to differing opinions on what a “fair” valuation may be.

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This article is from an external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.