HURC - Hurco: Navigating Elevated Uncertainty And A Short-Cycle Slowdown

2023-03-10 12:03:17 ET

Summary

• Hurco's fiscal first quarter results met my expectations, but did show clear weakness in North American and European sales that was significantly worse than typical industrial reports for the quarter.
• Uncertainty is the word of the day now, with many companies guiding to weaker demand in the second half of 2023 and warning of below-average visibility on customer demand.
• Hurco has been a "first in, first out" company in the past and results could be a sign of worse things to come for the broader group.
• I expect orders and revenue to turn around sooner here than for the larger group, and Hurco has good leverage to further growth in reshoring/near-shoring of manufacturing.
• Hurco shares offer a double-digit return from here, but this is an unfollowed, less-liquid manufacturing company that is far off most investors' radar.

A lot of short-cycle industrials have held up relatively well in recent months, with investors apparently more confident that whatever slowdown may be on the way will be relatively brief and not all that severe. Time will tell if that’s true (I’m more bearish), but in the meantime machine tool manufacturer Hurco ( HURC ) is navigating through a downcycle without a lot of visibility.

Relative to my last update on the shares, the stock has been outperforming the broader industrial space, but lagging metalworking companies like Kennametal ( KMT ) and Lincoln Electric ( LECO ), and the post-earnings reaction has since pushed the shares down slightly relative to the broader group since my last update.

Fiscal first quarter results were basically on target with my model, so I’m not changing much at this point. I do expect Hurco to be a beneficiary of ongoing reshoring and nearshoring trends, but I also do expect to see weaker spending for industrial capex in 2023 and possibly into 2024. I expect long-term core revenue growth to largely match underlying GDP and industrial production growth, and the shares do seem to offer a decent return from here, but they remain illiquid and vulnerable to eroding end-market demand through 2023.

Weaker Results Relative To A Still-Healthy Industrial Sector

As I note in almost every Hurco piece, it’s well worth remembering that this is a small industrial company that largely serves other small industrial (mostly manufacturing) companies with largely higher-spec products. In practical terms, that tends to separate the company from larger macro trends at least to some degree – Hurco isn’t counter-cyclical or acyclical, but it doesn’t follow the group in lock step.

That heterogenicity showed up again in fiscal first quarter results with numbers that were meaningfully weaker than what most industrial companies have reported, and management acknowledged both the elevated volatility and elevated “lack of visibility” (for lack of a more elegant phrase) in the business right now.

Revenue declined 18% year over year as reported (and 14% quarter over quarter) and 13% in constant currency terms in a quarter where the average industrial announced around 10% year-over-year growth and relatively few companies posted year-over-year declines. Revenue performance in North America and Europe were relatively similar, down 8% year-over-year in constant currency, while the sequential declines were 15% and 11%, respectively.

I find this a bit curious given that most management commentaries on the quarter cited weaker results/demand in Europe relative to the U.S., but again refer above to my comment about how in the short term Hurco can zig while others zag.

Results in Asia were quite weak, with revenue down 48% yoy in constant currency and down 25% qoq in reported terms.

Gross margin declined two points from the year-ago period and 440bp qoq, with the business likely hit in part by mix, but also by reduced overhead absorption on lower volumes. Operating income was down 77% year over year, with operating margin down 550bp to 2.3% (and down about two points qoq).

More Pain On The Way

Orders declined by 20% yoy in constant currency terms and 9% qoq. While many industrials have started to report weaker order trends, this is a bigger drop than what has been typical in the industrial group. Orders from North American customers declined 11% yoy and 18% qoq, while EU orders fell 20% and 8% and Asia-Pacific orders fell 51% and 45%. Hurco ended the quarter with a 0.97x book to bill versus 0.92x in the prior quarter, and 1.06x in the year-ago quarter, including a 1.05x book to bill in Europe (versus 0.86x in FQ4’22) and 0.90x book-to-bill in North America (versus 0.93x in the prior quarter).

I do believe there could be another quarter or two of sequential weakness before an upturn, and that’s assuming that I don’t need to fundamentally revisit my expectations for industrial capex in FY’23 and FY’24. I expect the U.S. PMI to worsen from here, and trends like manufacturing sales to decline further – Fastenal ( FAST ) reported that February manufacturing sales were up 15.8% yoy after 17% growth in January and 13.4% growth in December. I also expect weaker trends in Europe, as economies (and major Hurco markets) like Germany seem to be ahead of the U.S. in seeing a slowdown.

I’d also note that companies that sell to machine tool manufacturers (including ABB ( ABB ), Fanuc ( FANUY ), and Yaskawa ( YASKY )) have reported weaker trends of late, though a lot of the latter two’s sales go into Asia and aren’t particularly relevant comps for Hurco. As far as general themes go, “uncertainty” is a word that you see come up a lot, as companies are increasingly nervous about the outlook for capital spending, and this can ultimately become a self-fulfilling prophecy as companies pull back on their own spending in reaction to uncertainty about other companies’ spending.

There are some positives, though. The auto and aerospace markets are meaningful machine tool end-markets, and while aerospace growth will almost certainly outpace auto growth in 2023, auto volumes should still be positive. Longer-cycle markets like oil/gas and mining are also still healthy, and I’m expecting decent or better demand for agriculture and mining equipment, as well as improving heavy construction machinery demand in FY’24 (on U.S. infrastructure spending). So-called “general machinery” is likely to be weaker, though, and I’m likewise not as bullish on the tool/die market at this point.

The Outlook

While the prior quarter was stronger than I’d expected, I didn’t boost my numbers in response and this quarter’s results were much more in line with my model. I’m expecting a 13% revenue decline this year and a small decline in FY’24 before a rebound in FY’25 and FY’26. In past cycles, Hurco has seen 30% to 50% peak-to-trough order declines, with the process taking about 18-24 months. The last peak was in FQ4’21 (15 months) and we’re now down about 30% from that level.

I do believe that machine tool demand will recover in time, and I also see Hurco as a potential beneficiary of both reshoring/near-shoring manufacturing (shortening supply lines and moving production out of China), as well as catch-up spending on meaningful under-investment in capex leading into the pandemic. Offsetting those positive drivers is a risk of market share loss to rivals like DMG Mori, Haas, and so on, and the ongoing growth of additive manufacturing in prototyping and short-run manufacturing. While additive manufacturing does have a long way to go before it seriously threatens machining, it is more of a risk in areas like prototyping that have traditionally been more important to Hurco.

I’m looking for long-term adjusted revenue growth in the range of 2% to 3%, and I’m expecting long-term FCF margins to average out in the 4% to 5% range, driving low-to-mid single-digit adjusted FCF growth.

Between discounted free cash flow and EV/EBITDA, I believe Hurco still offers upside. Discounted cash flow suggests close to 10% annualized return potential, while a 8.5x multiple on my ’25 EBITDA estimate discounted back two years gives me a low-$30s fair value.

The Bottom Line

I do still see a real risk that end-market conditions get worse before they get better, and if I had to guess, I would say there’s a greater chance that I end up revising my FY’23 numbers lower rather than higher. Were that to happen, though, I do think it would be offset by a bigger rebound in the FY’24-26 time period. I also believe that that the market will eventually start looking past the downturn and that Hurco’s shares will likely move before the underlying reported financials improve.

Given low liquidity and low coverage, Hurco is a higher-risk way to play the manufacturing capex cycle. I do still see positives here that argue for the shares, but the long-term returns haven’t been exceptional and investors have a wide range of options to play similar themes.

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