DFKCY - Daifuku Is Muddling Through A Rough Patch Ahead Of Long-Term Automation Capex Growth

2023-09-08 09:14:26 ET

Summary

• Daifuku, a leader in warehouse automation, has faced recent challenges in revenue growth, margin leverage, and expanding its business outside of Japan.
• The company's recent earnings report showed weak revenue growth and a decline in operating income, as customers in the warehouse and cleanroom automation markets pull back on capex.
• The warehouse automation market is still expected to grow, but Daifuku needs to step up efforts to grow outside of Japan and consider acquisitions to build scale and relationships.
• Daifuku looks modestly undervalued and remains a leader in what I expect to be a secular growth market, but less aggressive investors may want to wait for a little more clarity on end-market capex plans later this year.

The warehouse and e-commerce automation has definitely had its ups and downs over the last few years. A gold rush-style scramble into the relatively limited number of publicly-traded names inflated valuations during the pandemic, and investors have since had to contend with a sharp slowdown in orders as would-be customers absorb newly-build capacity and try to figure out their needs amidst an uncertain demand outlook. Along the way investors have also had to content with weaker than expected margin leverage and higher capex needs as the automation providers themselves scramble to scale up to meet demand.

Writing about Japan’s Daifuku ( DAIUF )(DFJCY)(6838.T) in 2019, I liked this automation provider for its strong position in warehouse automation (“Intralogistics”), as well as the potential in expanding the business from its historical core in Japan. The shares have since risen about 48%, better than the average industrial over that time, though not on a U.S. dollar basis, and likewise not quite as good as the performance from other automation names like Jungheinrich ( JGHHY )( JGHAF )( JUN3.DE ) or Toyota Industries ( TYIDF ) (though better than KION ( KIGRY )).

At this point I think Daifuku has to win back some investor trust and benefit of the doubt. Revenue growth has progressed a little better than I’d forecast, but margin and EBITDA evolution has been less impressive, with the latter trending about 10% below my expectations. The company has also made less progress than I’d hoped in building its business outside of Japan. I do expect better days ahead and the valuation isn’t terrible, but I also don’t see it as an obvious bargain today.

Weak Orders And Profitability Have Driven A Recent Decline

Daifuku didn’t exactly impress investors with its last earnings report, and the lack of detailed commentary forces investors into an uncomfortable “trust us” position relative to management’s guidance for the remainder of the year.

Revenue rose just 3% year over year in the last quarter (closer to flat excluding currency), while operating income fell 20%, with operating margin down 180bp to 6.1%. The latter number, operating income, missed expectations by close to 30%, but management reiterated guidance for the full year of JPY 54.5B. To hit that figure, there’s going to have to be a significant ramp in the coming quarters (relative to JPY 8.2B in first quarter profits).

Management also noted a 38% decline in orders. Unfortunately, the company does not break out orders in an especially useful way, forcing investors to dig deep and make some assumptions to arrive at estimates for the core Intralogistics and Cleanroom businesses. Intralogistics orders appear to have declined about 37% on a significant decline in the Japanese market, while Cleanroom orders were down a sharp 60%.

Compounding investor concern, the company more recently made a surprising issuance of JPY 60B in convertible zero coupon euroyen bonds. Two-thirds of the funds are earmarked for capex in Japan, the U.S., and India, with the remainder going to fund a buyback equivalent to around 2% of the current market cap. While neither the capex nor the buyback are “bad”, the markets are already nervous about the outlook for warehouse/logistics automation in 2023 and 2024 and the lack of prior notice doesn’t help.

Warehouse Automation Still A “When, Not If”

Warehouse automation was already a growth market before the pandemic, but the shift toward e-commerce significantly accelerated interest in automation across a number of industries. While Amazon ( AMZN ) has led the way in automating its distribution centers, other retailers have been forced to upgrade simply to stay competitive.

With the heavy investments made over the last four or five years, I have seen some third-party estimates that warehouse automation penetration has roughly doubled or tripled to around 20%. I would advise taking these numbers with a grain of salt, as there’s a lot of “wiggle room” in what various third parties count as “automation” and how they separate out areas like traditional warehouse / distribution centers and in-plant warehousing/storage.

In any case, the last few years have seen a significant increase in capex spending to automate warehouse, logistics, and distribution functions. Those investments have been largest in the retailing sector, though there has also been meaningful growth in industries like biopharma and food/beverage. More recently, though, companies like Amazon have slammed on the brakes, looking to drive increased absorption and utilization of the capacity they added in recent years and holding off on further investments amidst an uncertain demand environment.

Daifuku remains a leader in warehouse automation, including conveyor, racking, storage/retrieval, and sorting/picking systems, and the company has been a leader in system integration – working newer technologies like cobots into systems so that they work seamlessly with more traditional technologies (like conveyors).

Given the nature of the Japanese labor market and the retail culture in the country (where home or site delivery is not only an expected service, but expected within pretty precise time windows), Daifuku has been pushed to deliver high-performance systems that appeal to a range of industries. Still, the company hasn’t made the progress I’d hoped to see in moving outside of Japan – North America is still about one-quarter of the sales base and not as profitable as it should be.

I do think that management needs to step up its efforts to grow outside of Japan, and this upcoming cycle of internal capex should help. That said, looking at some of the acquisitions that companies (like Jungheinrich) have made to improve their go-to-market capabilities in markets like the U.S., I think management should seriously consider some select acquisitions to build scale and relationships with both customers and suppliers. The good news is that there’s still ample time – if that estimate that warehouses are roughly 20% automated is accurate, that means there is still substantial growth ahead and I believe the endless prioritization of incremental margin improvement among publicly-traded companies will drive further investment into automation in the coming decade.

Cleanroom And Auto Sectors Are More Challenging

Around a third of Daifuku’s revenue comes from its core warehouse/logistics automation business (and about 60% of operating profits). Another significant piece (about a third of revenue and 20% of operating income) comes from the company’s Cleanroom business, with another 15% and 10% coming from its Automobile segment.

The Cleanroom business primarily focuses on providing automated material handling systems for semiconductor clean rooms (around 80% of the business) as well as flat panel clean rooms (around 20%). Automating these functions is practically mandatory to avoid contamination and ensure smooth operations, but semiconductor capital equipment/investment has always been cyclical. I do like the company’s decision to focus on growing its back-end process equipment business and I also like the long-term outlook for semiconductor capex, but this business will likely never rival the Intralogics business in terms of profitability and it will always be cyclical.

I’m not as bullish on the Auto segment. It’s true that auto companies have been stepping up capex to accommodate increased EV production, but Daifuku has relatively less leverage here. While robotics companies like Yaskawa ( YASKY ) are seeing robotic systems added to production stages for EVs where they’re not used for internal combustion vehicle, that’s been less true for Daifuku and it has been more common to simply see Daifuku systems repurposed to EV lines. In other words, the addressable market hasn’t really been expanding that much due to the shift to EV production, and Daifuku is more tied to overall net capex trends.

The Outlook

As retail and e-commerce customers digest past warehouse automation investments and semiconductor capex sorts itself out, I expect a challenging period over the next 12-18 months for Daifuku in terms of reported revenue growth. I still believe in the long-term drivers here, and I expect long-term revenue growth in the range of 5% to 6% over the long term, but there could be a couple of below-trend years (and perhaps even contraction) if the global economy slows further and companies cut back even more on capex projects.

Given the challenges in the Cleanroom business and ongoing challenges to build profitable scale in new markets like the U.S., I’m not expecting a lot of margin leverage in the near term. I think EBITDA margin will likely hang out in the 10%’s for a little while, though I do expect improvement toward the mid-teens over a five-year period. Likewise, capex investments will likely limit free cash flow leverage in the near term, but I still think long-term FCF margins in the 7%-8% range are attainable, driving mid-to-high single-digit annualized FCF growth.

If those estimates are in the ballpark, Daifuku is modestly undervalued today on a discounted cash flow basis. Valuing the company on a multiples-based approach takes a little more work. I believe it’s reasonable to drive a “fair” EBITDA multiple on the basis of margins and returns (ROIC, et al), but I also think near-term results are likely to be less representative of the true earnings power of the business. If I skip ahead a couple of years and use FY’26 numbers (discounted back), I can support a fair value at least 10% above today’s price, but there are always risks in using this sort of approach.

The Bottom Line

Daifuku shares have benefited in the past from scarcity value – there aren’t all that many accessible publicly-traded companies with relatively clean exposure to warehouse automation, so when investors want to own the theme, these stocks can run. That may well happen again, I am after all a believer in automation over the long term, but the outlook over the next few quarters is more challenging. Patient investors could certainly consider this name now, but I’m more inclined to wait a bit and see what industrial and retail companies have to say about their demand and capex outlooks in the third and maybe fourth quarters of this year.

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