HURC - Hurco Sees Another Downturn In Orders As Manufacturers Batten Down The Hatches

2023-09-10 00:55:21 ET

Summary

• Hurco's fiscal Q3 results were fairly stable relative to Q2, but the outlook is weaker, with a sharp decline in orders and a need to reduce inventories and realign production.
• Macro indicators in Hurco's major markets, such as manufacturing PMI and machine tool orders for the U.S. and Germany, are not good, indicating a weakening market.
• Despite the challenges, Hurco has the cash to weather the uncertainty and should benefit from reshoring-driven manufacturing capex investments in the future.

I’ve said many times over the years that calling a turn in any economic cycle isn’t exactly easy, as it’s not uncommon to see a few “false dawns”. That’s even more true with a company like Hurco (HURC) where the company’s focus on more high-spec systems for smaller customers can create larger divergences between the company’s quarter-to-quarter (and even year-to-year) performances relative to macro indicators and larger peers.

Such would seem to be the case again this quarter. While fiscal second quarter results were better than I had expected and included a nice sequential uptick in orders, fiscal third quarter results were significantly weaker (particularly in orders), and management called out softening markets almost across the board and a need to focus on reducing inventories, generating more cash, and realigning production to apparent near-term demand.

Macro indicators like manufacturing PMI and machine tool orders aren’t good in any of Hurco’s major markets and do stand out next to what was still relatively positive guidance and outlooks from U.S. industrials in the second quarter reporting cycle. I still have real concerns about more quarters of “bumping along the bottom,” but Hurco has the cash to weather this uncertainty I do believe the company can still benefit from reshoring-driven capex investments on the other side of this downturn.

A Significant Step Back

Reported financials for the fiscal third quarter weren’t too bad, nor much different than my expectations (gross margin was actually better), but orders were very weak and management warned about significant weakness across major end-markets, as well as the need to reduce inventories and readjust production in light of weakening demand.

Revenue declined about 9% year over year in constant currency terms and about 1% sequentially. Sales in North America declined 23% yoy and came in flat sequentially, while sales in Europe rose 6% yoy and 4% qoq with stronger sales in France and Italy offsetting weaker results in Germany and the U.K. I thought it was notable that the company also pointed to strength in the Milltronics business, a business that focuses on lower-ASP products. Business was very weak in the Asia-Pacific region – down 21% yoy and 31% qoq.

Gross margin actually improved 30bp yoy and almost two points qoq to 25.3%. Operating income declined about 42% from the year-ago period and came in about flat sequentially, with the operating margin down 110bp yoy and up 10bp qoq to 1.9%.

Orders declined 22% yoy in constant currency terms and 30% qoq in reported terms, driving the book-to-bill to 0.79 from 1.1 in the prior quarter. Orders were weak everywhere, with North American orders down 33% yoy and 35% qoq (B2B of 0.8), European orders down 10% yoy and 16% qoq (B2B of 0.79), and Asia-Pacific orders down 43% yoy and 46% qoq (B2B of 0.71).

Inventories increased about $3M sequentially on a <$1M decline in revenue

Weakening Macro Indicators Are A Worry

I feel as though there’s been a growing divergence between macro indicators and corporate sentiment as 2023 has developed. I’ve been expecting a mild recession starting in the second half of 2023 (or around now, in other words), but while there were meaningful declines in orders and backlogs for many industrial companies in the calendar second quarter, guidance was still relatively upbeat.

Looking at manufacturing PMIs, pretty much every market of consequence is now below 50 (meaning contraction). The last two U.S. PMI readings were 47.9 in August and 49 in July, while Germany saw 39.9 in August after 38.8 in July and 41.0 in June; the July reading being the third-worst result in 15 years (the two worse readings occurred during the global financial crisis and the pandemic). In Italy, the numbers have hovered in the mid-40s for five months now, though the last two months have seen sequential increases, while the UK’s number has been below 50 for some time now and August’s 43 reading was the worst since May of 2020.

Not surprisingly, other metrics of business activity aren’t any better. U.S. machine tool orders declined 2% yoy in June (the July release is due shortly) after a 17% decline in May, and the release noted even weaker numbers for job shops – the sort of small-to-medium businesses that make up a large part of Hurco’s business (unlike DMG Mori , Haas , and Okuma , Hurco doesn’t do that much business with large multinationals).

Up-to-date data for Germany is harder to get, but orders were down 11% in the second quarter and the August PMI release noted a sharp drop in new orders (the steepest decline since the pandemic). Likewise, the Japan Machine Builders Trade Association (or JMBTA) reported a 17% yoy decline in orders coming from outside Japan, including a 31% decline in orders from Asia, a 5% decline from North America, and a 3% decline from Europe, with sharper declines from Italy (down 9%), Germany (down 11%), and the UK (down 31%).

I could go on, talking about recent trends in manufacturing sales at Fastenal (FAST) and commentary from short-cycle metalworking companies, but I think I’ve gotten the main point across – just about anywhere I look, the numbers are not encouraging.

The Outlook

I’d love to have a definitive answer as to how much worse it will get for Hurco, but as I said in the open (and many times in prior articles over the years), this company’s size and different product and customer profile makes it harder to benchmark to these macro indicators. Said differently, I’m expecting a few more “bumping along the bottom” quarters and while I do think Hurco’s business could turn up before the macro indicators flip, I also still think there’s a risk of an even uglier quarter or two before then.

I’ve taken what I hope will prove to be a conservative route with modeling, lowering my FY’23 and FY’24 revenue estimates again. I haven’t changed my FY’25 and beyond numbers as much, as my current thinking is that the timing of the downturn/recovery process has changed more than the magnitude. With that, I still think Hurco offers some leverage to ongoing reshoring efforts on the other side of this downturn, and I’d also note that U.S. and EU companies have been underinvesting in capex for some time; I believe with the renewed emphasis on shorter, more secure supply and production lines some of that underinvestment will reverse and machine tool companies like Hurco will benefit.

With weaker near-term revenue and a stated goal of running down inventories and adjusting production levels, I expect weaker gross margins over the next few quarters, but my longer-term outlook hasn’t changed.

All of that works out to a long-term revenue growth rate of around 2% (unchanged from before), but a mid-teens three-year growth rate off of my FY’23 estimate. My long-term FCF margins likewise don’t change that much – I expect peaks in the high-single digits and a long-term average on the low end of the mid-single digits (around 4%).

The Bottom Line

Between discounted cash flow and margin/return-driven EV/EBITDA I believe Hurco shares are still undervalued and offer double-digit upside from here (with a 12-month fair value in the mid-to-high $20’s). The shares of industrials like Hurco will often move a couple of quarters ahead of turns in the actual reported financials (the market bids them up in anticipation of the turn), but I do still see a lot of uncertainty out there so that upturn doesn’t seem likely until the first half of calendar 2024 unless these macro indicators suddenly turn.

Is a Hurco a good play on that eventual short-cycle turnaround? I think the upside potential is there, but the risk is still elevated and this isn’t an easy stock to own. More aggressive investors looking to make early plays on a rebound cycle should take a look, but this isn’t exactly a “sleep well at night” type of stock.

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