VLEEF - Hammered By Input And Launch Costs Nidec Is Worth Another Look

Summary

• Nidec has been hit hard by input cost inflation and launch costs in its electric vehicle operations, as well as the decline in demand for HDDs for PCs and datacenters.
• The initial costs of building the EV business are worthwhile; Nidec has staked out a lead among third-party e-axle suppliers in China and stands to benefit from future OEM out-sourcing.
• HDD demand isn't likely to rebound quickly and appliances/HVAC motor demand will be pressured in 2023, setting up a more challenging near-term outlook for the established businesses.
• Nidec isn't conventionally cheap and future growth/margins in EVs and other growth markets may never come, but the long-term risk/reward balance still looks interesting.

The last year and a half has been a brutal one for Nidec ( NJDCY ) (6594.T), with the local shares down more than a third and the ADRs down closer to 50% since my last update . Nidec has been hit hard not only by a downturn in high-margin spindle motors for hard disk drives (or HDDs), but also much higher input costs and launch costs for its emerging EV auto business (e-axles). If that wasn’t bad enough, a weaker outlook for motors used in appliances and HVAC systems is also weighing on sentiment.

The investment case for Nidec used to be more of a battle about the right multiple to pay, as Nidec shares historically traded at rich multiples. While the sharp pullback has helped the longer-term valuation argument, the shares still remain pricey on more conventional short-term multiples-based approaches. While I do like Nidec’s leverage to vehicle electrification, a weaker market for consumer electronics could persist and Nidec has significant sentiment headwinds to overcome.

HDDs – PCs May Be Near A Bottom, But The Market Is Weak

According to Techno Systems Research, October HDD shipments declined 55% year over year, with HDDs meant for PCs (2.5” and 3.5”) down 58% yoy and near-line HDDs for data center applications down 49%.

Hard drive shipments have been weakening for about 18 months, undermining an important source of profits for Nidec. HDD motor sales declined 19% in the last quarter (the fiscal second quarter or calendar third quarter), outperforming global shipments, but still representing an ongoing erosion in this once-key business with revenue now about 70% below a pandemic-fueled peak in FQ2’20. With the HDD motor business historically generating operating margins well above company averages (sometimes as high as the low-30%’s), this is not a trivial concern.

While there was a month-over-month rebound in HDD shipments for PCs (up 21%), it seems premature to call a recovery, particularly with many consumer electronics companies pointing to weak demand trends. I do believe this business has more or less bottomed, but weakness in data center HDDs is likely to get worse and I think it could be a slower recovery in PCs given how the pandemic likely pulled demand forward.

The Auto Business Is Accelerating, But Profitability Remains Challenging

The biggest part of the bull thesis on Nidec has been, and remains, the company’s ability to leverage its expertise in high-quality electric motors to participate in the electrification of transportation, and particularly passenger vehicles.

Through strong R&D and engineering, Nidec developed one of the most competitive first-gen e-drive units (in terms of power-to-weight), competitive with both Valeo ( VLEEY ) and Tesla ( TSLA ) and well ahead of many would-be rivals in the space. The company has recently launched production of its second-gen e-axle, and the company currently enjoys about 9% share of the Chinese e-axle market, with 27% share among third-party suppliers (and a market-leading position equal to the #2 and #3 players combined) and major wins with Guangzhou Automobile Group (or GAC) ( GNZUF ) and Geely Automobile ( GELYY ) (and its parent company).

China is an attractive growth market for EVs already, and Nidec’s latest offerings are built with both performance (power/weight, et al) and cost in mind, including lower-cost IGBTs and other components. With underlying sales of EVs containing Nidec e-axles up 188% in the second quarter, management’s target of more than doubling shipments from 220K to 550K between FY’22 and FY’23 doesn’t seem unreachable.

The Chinese market is large, but Nidec isn’t restricting itself to China. The company has also been working with American, European, and Japanese OEMs, and the company has a joint venture with the PSA segment of Stellantis ( STLA ) to produce e-axles in Europe. While many Western OEMs have proclaimed their intention to insource EV powertrain production, my expectation has always been that they’d try that initially, but that some would fail and then turn to outside vendors like Nidec. To that end, Nidec announced with fiscal second quarter results that they received an inquiry from a “major European OEM” that had initially opted to insource its electric motor/e-axle needs.

The production ramp and initial model/design wins for Nidec’s automotive business have gone well, but I can’t say the same for profitability, as the business still generates low single-digit operating margins. The board has clearly been frustrated with this, bringing the Chairman (and former CEO) back into the CEO role and reassigning the then-CEO Jun Seki to the COO position was an explicit mandate to improve the profitability of the auto business.

I believe patience will pay off here. While Nidec doesn’t have the same historical scale in auto parts as other EV powertrain rivals like BorgWarner ( BWA ), Valeo and Vitesco ( VTSCY ), the company has a long-standing business in a range of auto motors (power steering, dual clutch systems, pump motors, and starters/alternators) and isn’t exactly a stranger or newcomer to auto OEMs. It’s true that the startup costs for the e-axle business have been significant, and the business has been hit hard by inflationary pressures (electrical steel especially), but I believe this is money well-spent over the long term.

Near-Term Pressures Likely In Appliances, But Nidec Is Expanding Its Addressable Markets

Nidec has significant exposure to the appliance, HVAC, and non-residential markets, as the company is a leading supplier of motors and inverters for refrigerators, washing machines, air conditioners, and elevators. While backlogs for U.S. residential HVAC businesses are strong, the business is likely to weaken noticeably in 2023, and I’m not expecting much strength in consumer appliances nor in non-residential construction (HVAC and elevators) in 2023.

Longer term, the company is still leveraged to growing adoption of inverters in household appliances, as well as growing global adoption of air conditioning. Beyond that, though, the company is also pushing into new areas like EV charging and battery storage, which in many cases repurposes and builds upon existing technological/product capabilities.

The Outlook

Although 2.5M shipments of e-axles in FY’25 is still a possibility, I’ve pulled in my assumptions for the EV business given more challenging economic conditions in China and some delays in launch schedules among U.S. and European OEMs. I’ve also cut back my estimates on a weaker outlook for PCs, data center storage spending (as seen, too, with Marvell ’s ( MRVL ) recent guidance), consumer appliances, and industrial capex (the “Machinery” segment).

“Cut back” is somewhat relative, though, as I’m still looking for double-digit growth over the next five years (versus high-teens previously). Likewise, my revenue estimates drive a long-term revenue growth rate of 11% that is still quite high, though below the prior 14% growth rate.

Nidec has been hit hard by inflationary pressures and start-up/launch costs in the EV business that have proven worse than expected. I still believe that low double-digit free cash flow margins are possible over time (driving high-teens FCF growth), but it’s going to take longer to get there, and EBITDA margins seem likely to be stuck in the 13%-15% range for the next three to five years.

For valuation purposes, Nidec is in a tough spot. I do believe the company is under-earning today to build up future growth drivers, but the reality is that it’s tough to call the shares a bargain based on near-term multiples-based approaches like EV/EBITDA or P/E. While discounted cash flow suggests a solid long-term return potential at today’s price, the reality is that modeling visibility is low – not only for uptake in areas like e-axles, but for the long-term margins of that business.

The Bottom Line

There are definitely bearish arguments to make here – the stock is not conventionally cheap, valuation is dependent upon future revenue and margin growth that may never materialize, and major sources of present-day earnings (HDD spindle motors, appliance motors/inverters, et al) are under real pressure.

I am still bullish on the stock, however, as I think the company has an underappreciated track record of reapplying core technologies to new growth markets, and I think that will hold true with the company’s EV ambitions (conventional EVs, two-wheel EVs, charging, storage, et al). I may well be doubling down on a bad call, but this is still a name that I think is worth a closer look.

For further details see: