FANUF - Fanuc Corporation Has A Balanced Risk-Reward Profile (Rating Upgrade)

Summary

• The key positives for Fanuc Corporation are its attractive valuations and the favorable change in analyst sentiment.
• Fanuc's key negatives relate to its modest pricing power and the challenges in cross-selling its products.
• My rating for Fanuc is a Hold, as I view the risk-reward for the stock to be balanced.

Elevator Pitch

I think that Fanuc Corporation's ( FANUY ) [6954:JP] shares are worthy of a Hold rating.

I touched on Fanuc's below-expectations financial results for the second quarter of fiscal 2022 (year ended March 31, 2023) in my earlier article for the company written on November 2, 2022.

My investment rating for Fanuc is upgraded from a Sell previously to a Hold now, after taking into account both the positives and negatives relating to the stock. I like the fact that Fanuc's valuations are sufficiently appealing and the sell-side sentiment for the stock is turning slightly more favorable, so it shouldn't deserve a Sell rating. On the other hand, I have a negative view of Fanuc's pricing power and cross-selling potential, and this means that it doesn't warrant a Buy rating.

Share Price And Valuations

Fanuc's stock price performance has been poor in the past couple of years. In the last one year, FANUY's shares have corrected back by -21.9% as compared to a milder -14.2% pullback for the S&P 500 Index (SP500) in the same time frame. Fanuc's stock price also fell by -44.6% in the past five years, while the S&P 500 rose by +42.7% over the same period.

As a result of its share price underperformance in recent years, Fanuc's current valuations are substantially below historical averages based on financial data taken from S&P Capital IQ .

Fanuc's current consensus forward next twelve months' normalized EV/EBITDA multiple of 14.1 times is -24% lower than its five-year mean EV/EBITDA ratio of 18.6 times. The stock is now trading at 25.0 times trailing twelve months' P/E, which is -32% below its five-year average P/E metric of 36.9 times. Similarly, Fanuc's current trailing P/B multiple of 2.49 times represents a -16% discount as compared to the stock's five-year mean P/B of 2.95 times.

Fanuc's undemanding valuations are also validated by its significant share buybacks, which typically are done in consideration of the undervaluation of its stock. The company has initiated a share buyback plan to repurchase 2.5 million shares or 1.3% of its shares outstanding in March 2022, and it had already competed around 40% of its share repurchase program by the end of November last year.

In a nutshell, Fanuc's stock price weakness and valuation derating have already priced in the company's disappointing Q2 FY 2022 financial performance to a considerable extent.

Analyst Sentiment Is Improving

There are indicators suggesting that the sell-side analysts are becoming more positive on Fanuc.

One indicator is the change in the consensus sell-side price target for Fanuc. According to S&P Capital IQ data, the average analyst target price for Fanuc was cut by -18.8% in 2022. In the fourth quarter of last year alone, Fanuc's mean price target was reduced by -7.3%. But Fanuc's mean sell-side target price was increased by +0.6% in the first one and half months since the beginning of 2023. Although the average analyst price target of +0.6% appears to be marginal, it could mark the end of sell-side target price cuts for Fanuc.

Another indicator is the change to the market's consensus financial forecasts for FANUY as per S&P Capital IQ data. In the past two months, the sell-side analysts didn't cut Fanuc's current fiscal year bottom line projections. In fact, Fanuc's consensus FY 2022 earnings per share or EPS estimate was increased from JPY854.6 as of December 9, 2022 to JPY855.5 as of January 13, 2022. In other words, we might have already seen the worst of analysts' earnings downgrades for the stock.

On the flip side, takeaways from Fanuc's 1H 2022 earnings briefing suggest the company's mid-to-long term outlook isn't favorable considering its pricing power and cross-selling potential. I touch on these two key points in the subsequent sections of this article.

Limited Pricing Power

Fanuc's EBITDA margin contracted by -710 basis points from 46.0% in fiscal 2017 to 37.9% for FY 2021. The consensus financial numbers obtained from S&P Capital IQ imply that the sell-side analysts don't expect Fanuc's EBITDA margin to recover in the next few years. Specifically, the market consensus sees Fanuc registering lower EBITDA margins of 28.8%, 30.6%, and 32.2% for FY 2022, FY 2023, and FY 2024, respectively.

I believe that Fanuc's limited pricing power is the key reason for its profitability decline.

During the company's 1H 2022 earnings call , Fanuc noted that it is "doing our best to persuade our customers to purchase at a reasonable price," when it was questioned about the possibility of passing on the higher expenses to clients in the form of price hikes. This seems to suggest that Fanuc doesn't find it easy to raise the selling prices of its products.

Potential For Cross-Selling Isn't Significant

For industrial conglomerates, synergies between the various businesses tend to be a key driver of revenue growth through cross-selling or integrated product offerings. This doesn't appear to be the case for Fanuc.

Fanuc was asked about whether it had "considered selling servo motors as a single product in order to develop your FA (Factory Automation) business" at the company's recent 1H 2022 results briefing. In response, Fanuc acknowledged that its clients in the factory automation segment "wish to make good use of their software assets that they have developed." In other words, it has always been tough for Fanuc to cross-sell its controllers to its factory automation customers who buy FANUY's amplifiers and motors.

The difficulty of leveraging on cross-selling efforts to grow its top line seems to be reflected in Fanuc's consensus financial estimates. Analysts see Fanuc expanding its revenue by a modest CAGR of +5.1% for the FY 2023-2025 period.

Concluding Thoughts

A Hold rating for Fanuc Corporation is appropriate in my opinion. FANUY's valuations are already pretty depressed based on a historical comparison, but its limited pricing power suggests that Fanuc Corporation doesn't have the ability to expand its future profit margins with substantial price increases.

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