HURC - Hurco Closes The Fiscal Year Strong But Not Quite In The Clear Yet

Summary

• Hurco reported both year-over-year and sequential growth in constant currency terms, with strong margin leverage on improved overhead absorption.
• Orders declined 14% yoy in constant currency, book-to-bill is <1.0 in major markets, and many macro indicators are suggesting more pain ahead for short-cycle industrial and capex demand.
• Hurco shares look undervalued, but this is an illiquid cyclical small-cap manufacturing company with significant near-term market uncertainty and very lackluster long-term return history.

The industrial sector has been a more interesting place of late. While there are still troubling signs for 2023, including higher rates, contracting manufacturing PMI, and weakening business confidence, the market has been more willing to look for "buy the dip" opportunities and the sector has done well over the last three months. That said, there has still been a gap between the broader industrial space and sub-sectors like metalworking where there are still risks about short-cycle weakness and where Hurco (HURC) has modestly underperformed the sector since my last update (up around 4% versus 11% for industrials) while beating the S&P 500 and other machine tool companies like DMG Mori (MRSKF) and Okuma (OKUMF) and metal tools company Kennametal (KMT).

Hurco's better-than-expected fourth quarter results are encouraging, but I'm not willing to sound the "all clear" at this point given increasing pressures on smaller manufacturers. That said, I do think the reshoring trend still has legs and I believe management has the company in good shape to weather whatever remains of this downturn. I do still see double-digit annualized return potential from here, but I would again remind investors of the risk of a worse-than-expected short-cycle slowdown in 2023, particularly with numerous quarterly reports and 2023 guidance calls on the way in this sector over the next six weeks.

A Nice Upturn To End The Fiscal Year

I was relatively bearish on Hurco going into this quarter given weaker order trends and macro challenges like higher rates, weaker incoming orders, and more caution on capex spending going into 2023. Hurco surprised me with a stronger quarter.

Revenue declined 8% in reported terms and rose 1% in constant currency, while rising 10% sequentially in reported terms. That was a major beat (around 20%) relative to my expectations, and it was balanced across the company's geographic reporting areas. Sales in North America rose 7% yoy (and 9% qoq), sales in Europe fell 11% (up 4% constant currency) and rose 11% sequentially, and sales in Asia-Pacific fell 38% (down 31% in constant currency) and rose 10% sequentially.

With meaningfully better overhead absorption, Hurco reaped good margin leverage in the quarter. Gross margin improved 320bp yoy and 270bp qoq to 27.7%, though operating income was still down 13% yoy (and up 54% qoq) on higher spending tied to the International Manufacturing Technology Show (or IMTS), a major machine tool tradeshow). Operating margin declined a modest 25bp yoy and improved 125bp qoq to 4.25%.

Although Hurco did outperform my expectations, the business is still showing relative deceleration. For the three months that made up Hurco's fiscal fourth quarter, MSC Industrial ( MSM ), a leading distributor of metalworking tools, reported average daily growth of 13% to 15% versus the 7% growth in North American sales at Hurco, and Fastenal ( FAST ) likewise reported healthy growth (20%-plus) among its manufacturing customer base.

It Seems Too Early To Call The Bottom

It's always worth mentioning that Hurco is a tough company to benchmark. Not only are there really no direct comps (DMG Mori and Okuma are far larger companies with much different customer makeups), but the company's customer base of smaller manufacturing companies tends to lead to more volatile results that can often diverge from macro indicators like manufacturing PMI.

Despite a stronger end to the year, I don't think Hurco is in the clear just yet. Orders still declined 14% in constant currency, with a 16% yoy and 14% yoy constant currency decline in North American and European orders, respectively. In both cases the book-to-bills were below 1.0x (0.93 and 0.86) and there is ongoing evidence of deceleration in its markets - U.S. manufacturing PMI has contracted for two straight months, MSC saw average daily sales growth slow to 9% in December (and is looking for 5% to 9% growth in fiscal 2023), and German manufacturing PMI has been below 50.0 (indicating contraction) for six straight months, though it has improved in each of the last two months.

I've written in the past that Hurco typically sees 30% to 50% peak-to-trough declines in orders across its cycles. Orders did fall 30% from FQ4'21 to FQ3'22, but that's an unusually short correction cycle (it typically takes 18-24 months), and I think there is risk of further weakness in the first half of 2023.

In addition to the aforementioned macro indicators like manufacturing PMI, numerous banks have reported declining interest in business lending and many companies were already reported declines in orders with third quarter earnings and sufficient inventory restocking. In the short term, I think this could all mean relatively lower willingness on the part of smaller manufacturers to invest in new capex (including machine tools). I do think that there are positive longer-term drivers, including reshoring manufacturing away from China and other far-flung locations (in both the U.S. and Europe), but I believe many manufacturing customers will pause spending and see how 2023 develops before adding more capacity.

The Outlook

Before discussing my modeling assumptions, I'd note that the company did announce that the board has approved a $25 million buyback. While I think returning more capital to shareholders is a good thing and buybacks offer more flexibility than dividends (given that American investors tend to react very poorly to dividend cuts), I'd note that Hurco is already well below the investability threshold of many institutional investors with only about $250K in average daily volume.

Further reducing the float could make the shares even less liquid, and I'd frankly prefer to see management save up the company's cash with an eye toward taking it private. Now is not the time to lever up and make such a transaction, but it's something I'd consider on the other side of this cyclical correction.

I'm still expecting a low-teens contraction in revenue next year ahead of a meaningful recovery in FY'25 - at this point I believe FY'24 revenue could decline too, but I'm not sure yet if we'll see a sharper, shorter correction in short-cycle markets in FY'23, or a shallower, stretched out correction. Long term, I'm still only expecting core adjusted revenue growth in the neighborhood of 2%-3%.

I expect weaker volume and higher input costs to pressure margins in FY'23 and FY'24, but I do expect a meaningful recovery in FY'25 and a double-digit operating margin could be possible again in FY'26. Long term, I expect average free cash flow margin in the 4%'s, driving healthy but cyclical FCF growth.

Discounting those cash flows back, I believe Hurco is still priced for a double-digit long-term annualized return. I typically like to use a margin and return-driven EBITDA multiple as an alternative valuation approach for industrials, but in the case of Hurco I have to make some adjustments to account for the company's cyclicality. Specifically, I'm using my estimates for FY'25 margins, returns (ROIC, et al), and EBITDA and then discounting the result back two years at a double-digit discount rate. Doing so gives me an adjusted near-term fair value around $31.

The Bottom Line

It is certainly possible that the U.S. economy will avoid a recession, and I well may be too conservative or bearish on my outlook for short-cycle industrials, particularly with relatively healthy demand in important metalworking markets like aerospace, autos, and energy. Still, I've seen a fair numbers of cycles and I don't like what I'm seeing today across a range of indicators. Hurco will get through this cycle and enjoy better days, but the upside I see in the shares over the longer term is tempered both by elevated near-term risks and the reality that the long-term (10 year-plus) returns haven't been very good.

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