SNYYF - Komatsu: Soft Near-Term Prospects But Cautiously Optimistic Medium Term

2023-06-21 23:18:57 ET

Summary

• Komatsu faces near-term challenges due to weak demand in the construction and mining sectors, particularly in North America and Europe.
• Medium-term prospects are more optimistic, with infrastructure investments and growth in underground mining equipment driving potential growth.
• Competitive risks from Chinese manufacturers, notably Sany Heavy Industries, could dampen Komatsu's prospects in high-growth markets.

Japanese heavy machinery and equipment manufacturer Komatsu ( OTCPK:KMTUY )( OTCPK:KMTUF ) is trading below its historic multiple, but near term headwinds from a weakening demand environment in the construction and mining equipment space amid macro challenges don't make it a convincing buy. The company's medium-term prospects are cautiously optimistic, however, and longer term investors may see it as a hold.

FY 2022: robust revenue and profit growth, but FCF impacted by inventory stockpiling

For FY 2022 (fiscal year ended March 2023), Komatsu reported revenues of JPY3.5 trillion, a 26.4% YoY increase. For comparison, American rival Caterpillar ( CAT ) reported sales growth of 16.6% YoY for the year ended December 2022 while Chinese rival Sany Heavy Equipment ( OTCPK:SNYYF ) reported revenue growth of 52.4% YoY for the year ended December 2022.

Komatsu’s operating profit rose 54.8% YoY to JPY490 billion and their return on equity improved 280 basis points to 13.7%.

FY 2022 free cash flows dropped nearly two thirds, however, largely as a result of an increase in inventories to counter supply chain disruptions in key markets like Japan and Europe.

Near-term prospects are soft. Komatsu’s Construction, Mining, & Utility Equipment segment, its biggest revenue and profit generator (accounting for over 90% of revenues and nearly 90% of profits), is likely to see a weak demand environment impacting 2023 financial performance.

Further price hikes this year could expand margins and support near term sales performance (estimated JPY100 billion windfall) but any positive impact to sales could be offset by volume declines due to a softening mining sector worldwide and a sagging construction market in two of Komatsu’s biggest traditional markets i.e., North America and Europe, which collectively account for 36% of revenues.

Construction activity in North America’s residential sector got off to a weak start , a trend not expected to reverse this year as mortgage costs remain elevated. U.S. construction output is expected to contract 5% this year, largely driven by a slump in residential construction.

Western Europe, which is projected to have seen very slow construction activity last year (estimated at low single digits), could see further deceleration as ECB rate hikes, and soaring inflation impact construction activity. IHS Market expects construction output to increase just 0.4% this year in the region.

Japan is the only bright spot, with construction activity expected to increase 4.6% this year.

However, Japan accounts for about 12% of construction and mining equipment segment revenues and so strong performance in this market may not sufficiently offset weakness in Komatsu’s top two markets i.e., North America and Europe.

Meanwhile, decelerating economic growth worldwide could pose headwinds to the mining sector this year, potentially leading to a reduction in capex investments on exploration projects.

Overall, Komatsu management expects revenues to drop 4.6% YoY in FY2023, while operating profits are largely unchanged. Return on equity is expected to decline 200 basis points to 11%.

Medium-term prospects could be better, however.

Public investments on infrastructure development to support construction activity

Despite challenges to near term construction activity, medium-term prospects in some of Komatsu’s key markets are intact and could offset expected medium weakness in Europe which accounts for about 10% of construction and mining equipment segment revenues (Europe’s construction sector is expected to decline marginally this year, and remain unchanged in 2024 due to the war in Ukraine, and inflationary pressures).

Japan's construction output is projected to increase in the low single digits over the coming year and in the U.S., construction output is expected to recover next year, increasing 4.4% helped by America’s infrastructure investment bill.

Meanwhile, in India, a multi-year government capex cycle is gathering momentum and the country's construction sector is forecast to grow in the high single digits over the coming years. Komatsu is well positioned to benefit from this opportunity – together with its Indian JV partner Larsen & Toubro, Komatsu commands a 30% market share in India's construction and mining equipment market.

Increasing focus on underground mining equipment industry

Global demand for metals and minerals is on the rise due to electrification and decarbonization trends, but underground mining in particular is emerging as a growth opportunity as growing resource demands drive investment in the more costly (and less popular) underground mining. Unlike coal, which is more likely to be found on the earth’s surface, a number of rare-earth minerals that are necessary for the production of batteries etc. are found deeper below the earth’s surface.

Already positioned to benefit with its portfolio of underground mining equipment, Komatsu is further expanding its offering and capabilities to capitalize on the growth opportunity. Komatsu acquired Australian underground mining technology solutions company Mine Site Technologies last June, and then scooped up German underground mining equipment company GHH Group GmbH last December. GHH Group would help expand their underground mining equipment portfolio and while Mine Site Technologies is not expected to have a significant impact on Komatsu’s financials, the newly acquired company’s technology could support Komatsu’s product innovation efforts, particularly around automation and teleoperation of underground mining equipment, for which demand on an uptrend in the underground mining space.

Risks

Competitive risks

Competitive risks from Chinese manufacturers, notably Sany Heavy Industries, could dampen prospects. Sany Heavy Industries overtook Komatsu to become the world’s third-biggest construction machinery maker by shipments with an 8.4% market share, compared with 7.5% for Komatsu. The duo trail American construction machinery giant Caterpillar with a 20.7% market share, followed by fellow Chinese rival Xuzhou Construction Machinery Group with a 17.8% market share.

Sany Heavy could take further market share as the company works on its international expansion ambitions, and notably could present significant competitive pressures in high growth markets like Asia and Africa which Komatsu is aiming to grow its presence as part of its mid-term management plan.

Upside risk from improving macro conditions

Any dramatic improvement in near term macro conditions (such as a material decline in interest rates and inflation, and/or an end to the Russia-Ukraine conflict) could have a significantly positive impact on Komatsu's share price. Inflation is moderating and China just cut benchmark rates with more stimulus expected, but it remains to be seen whether these measures would sufficiently revive economic conditions near term. Despite China's recent rate cuts, stocks were pummeled, amid investors saw the move as insufficient to reignite sagging demand.

Conclusion

Analysts are mostly bullish on the stock.

Komatsu is currently trading below its historical multiple, which suggests some upside potential, particularly in the event of unforeseen improvements in macro conditions. Some may view the stock as a buy.

As of now however, near term headwinds are likely, and could last over the next few quarters and the stock's multiple, although cheap relative to its historical average, is not materially cheap to make it a convincing buy. Considering cautiously optimistic medium-term prospects, the stock may be viewed as a hold for now.

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