Investment Thesis

I recommend holding WEG (OTCPK:WEGZY) shares after the 1Q24 results, released on May 2nd. As I mentioned in my coverage initiation report, the company has a stretched valuation and needs great results to justify it.

On the positive side, the good performance of long-cycle businesses, together with expense control, helped keep the EBITDA margin high, reaching 22%. This expense control once again shows how efficient WEG managers are.

However, revenue grew 5.5% y/y and there is a clear slowdown in almost all geographies and operating segments. With a P/E of 28.9x, it is impossible to make a recommendation to buy the shares.

Review of WEG’s 1Q24 Results

After this brief introduction, let’s analyze the company’s results in more detail.

Revenues – Weak Numbers

WEG reported revenue of $1.6b (5.5% YoY and -9.2% q/q). The highlight of 1Q24 was the relevant slowdowns in almost all geographies and operating segments.

Net Operating Revenue From The External Market By Geographic Region (IR Company)

Now, let’s talk in more detail about each of the segments that make up the company’s revenue:

Industrial Electronic Equipment (IEE):

In the foreign market, fluctuations in demand in Europe and China had harmed the performance of short-cycle equipment, despite the good results in deliveries of long-cycle equipment.

In Brazil, industrial activity contributed positively to the unit’s performance, with short-cycle products showing good demand and good performance in deliveries of long-cycle equipment.

On a consolidated basis, the segment has been showing a negative trend for a few quarters. In my view, this trend should continue to occur, given the trends for capital goods businesses in the US and around the world.

Energy Generation, Transmission, and Distribution (GTD):

This unit had the best result in the quarter, both in Brazil and abroad. In Brazil, projects linked to transmission and distribution network auctions boosted deliveries of large transformers and substations. The delivery of wind turbines also contributed to the quarter.

Abroad, WEG continues to benefit from favorable conditions in several markets, especially those linked to the electrical grid infrastructure in the USA, in addition to good performance in India and Europe.

This segment has been gaining relevance quarter by quarter in the company’s business and I believe that the trend should continue. This is due to the energy transition trends that the world is going through.

Commercial and Appliance Motors (MCA):

This segment was negatively impacted by the drop in demand in the foreign market, mainly Mexico and China, which was partially offset by domestic performance, mainly related to manufacturers of air conditioning and residential motor pumps.

Paints and Varnishes (T&V):

The segment delivered stable results, with demand maintained and few highlights.

But let’s go! What are the prospects for revenue in general? The Brazilian government is considering including energy storage systems in its energy auctions and, if this happens, it would be a good growth opportunity for the company. Furthermore, the growth of AI could exponentially increase the demand for energy storage systems.

However, these possibilities will hardly exceed a 7% share of total revenue. As a result, a structural improvement in revenue growth depends on the capital goods sector, and the prospects are not so encouraging. According to S&P, the sector’s growth will be less than 5% between 2024 and 2025, and this low growth outlook supports my thesis of holding the shares.

Costs and Margins – Excellent Control

Costs grew 5.3% y/y, while total expenses grew 5.1% in the same period:

As a result, the company achieved an EBITDA margin of 22%, stable in the annual comparison. This is one of WEG’s positive points, even in the most adverse competitive scenario, managers have the ability to control costs and expenses well and maintain margin.

Now, let’s look at the profits the company recorded and other highlights.

Net Income – Better Than Expected

Presenting weak revenues but good cost and expense control, WEG reported a net income of $265m (+2.7% YoY and -26% q/q).

It is worth remembering that 1Q24 had fewer working days than 4Q23, which may have impacted the company’s results. But profits came in above expectations, especially due to the tax rate.

In 1Q24, the expectation was for a significant increase in the rate due to the arrival of Transfer Pricing and the exclusion of tax credits resulting from subsidies, with impacts of 250 bps and 50 bps respectively. However, the rate remained stable.

And what are the prospects for the following results? WEG recently acquired assets from Regal Rexnord (RRX), and they will be incorporated into the results in the next quarter. Therefore, business synergies can increase results in the future. However, we need to understand how expensive or cheap we are paying for the company’s assets, and we will do this in the topic below.

The Valuation Is Not Attractive

Next, I will use Koyfin to compare the Price/Earnings of WEG and its peers such as GE (NYSE:GE), Siemens (OTCPK:SIEGY), ABB (OTCPK:ABBNY), Schneider Electric (OTCPK:SBGSF), and Nidec (OTCPK:NJDCY).

If we add the companies’ Price/Earnings multiple and divide by 6, we arrive at a sector average of 25.75x. WEG presents a Price / Earnings of 28.9x, above the sector average, and as we saw in this report, the company presents a small increase in revenues and complex prospects for its sector.

To justify a buy recommendation, the company must grow its revenue well above 5% y/y. For this reason, my recommendation is to hold the company’s shares, and now let’s see what the Quant and Factor Grades tools indicate.

Seeking Alpha Quant Rating and Factor Grades

According to Factor Grades, WEG has excellent revisions and profitability:

However, the tool corroborates the stretched valuation, and also gives a recommendation to hold the company’s shares.

Potential Threats To The Thesis

If the investor chooses to invest in the company, the main risk is the stretched valuation. The company trades at a premium of 12% to the sector average and does not have great growth prospects, so there is no margin of safety.

Another relevant risk concerns the next result, when the company will consolidate the results of Regard Rexnord. The transaction was the largest M&A in the company’s history, and will consequently bring greater challenges to extracting synergies.

Finally, we have the risks of tax rates. Rates abroad have represented around 1/3 of the total tax shield, with the other 2/3 coming from earnings and tax incentives in certain Brazilian regions, which in this specific quarter showed good results in commercial engine operations. However, this situation could change drastically with changes in tax policy and worse results in the aforementioned regions.

The Bottom Line

WEG trades 12% above the Price/Earnings average for its sector. However, recent market research does not indicate strong growth in the capital goods sector within the next two years.

Currently, the company has grown its revenues by just 5%, and this does not justify a valuation of 28.9x earnings. Even with excellent managers who can control costs and expenses, the sectoral scenario does not seem interesting.

Based on this analysis, I again recommend holding the company’s shares. Investors should be aware of the company’s timid growth and its stretched valuation. There is currently no margin of safety for a buy recommendation.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.