SDVKY - Sandvik: Sandwiched Between Positive Company Drivers And Elevated End-Market Uncertainty

2023-10-10 16:47:21 ET

Summary

• Sandvik's shares have performed well over the last year on strength in aerospace, auto, mining, and oil/gas, but short-cycle industrial markets have been showing more signs of weakness lately.
• Industrial stocks have largely held up despite weak global PMIs, higher rates, and geopolitical risks, but commentary on end-market order and inventory trends will be key in Q3'23 earnings.
• Sandvik's Mining & Rock business has experienced double-digit growth but new equipment orders are likely to slow in the near term; long-term trends remain positive, particularly with automation/digitalization.
• Sandvik shares look modestly undervalued now and short-cycle markets will recover at some point, but sentiment could be a risk through Q3 earnings.

Despite ample uncertainty around the outlook for industrial end-markets for the remainder of the year and 2024, Sandvik ( SDVKY )(SDVKF)(SAND.ST) hasn’t performed too badly of late. The shares are up about 30% over the last year, outperforming the average industrial and carving out something of a middle road between names like Epiroc (EPOKY), SKF (SKFRY), Atlas Copco (ATLKY), and Lincoln Electric ( LECO ) as investors try to weigh out the relative prospects of stronger markets like auto, aero, mining, and oil/gas against weaker industrial markets and concerns about China.

I do still see risk to multiple end-markets over the next 6-12 months, but I think Sandvik’s leverage to markets like aerospace, auto, mining, and oil/gas can help offset some of that pressure. I also expect Sandvik to continue to benefit from cost improvement initiatives in its Machining business, as well as accretive M&A. Still, a tight credit cycle, weak PMIs, and ongoing destocking are all challenges for sentiment and overall industrial stock valuations are still a little elevated. I do like Sandvik on valuation and as an early-cycle recovery story, but if we see more conservative guidance and commentary from industrial companies in this upcoming reporting cycle that won’t make it any easier for the shares.

A Lot Of Moving Parts Within Machining

Simply by virtue of the company’s end-market mix there’s always a lot going on within the Machining Solutions (or SMS or “Machining”) business at Sandvik. In the relatively recent past, for instance, the company’s leverage to slower-to-recover aerospace, auto, and oil/gas markets were a headwind, but now the company is seeing underlying strength in these markets helping to offset emerging weakness in the broader “general industrial” market.

I’ve discussed this a few times in articles on other industrial/manufacturing companies, but the current global environment is not an easy one – credit has tightened up, orders have started to contract, and many companies have reported customer destocking. To that end, Fanuc (FANUY), Sandvik, Siemens’ ( SIEGY ) Digital business, and Rockwell ( ROK ) all reported weaker than expected orders, and there is ample evidence that the markets for cutting tools and machine tools are still heading toward a bottom.

The real question is how much further this destocking cycle has to go and how much of this recent weakness is normalization and how much is tied to weakening end-user demand. While PMI numbers are weak (sub-50) and have been for some time, employment and output numbers haven’t been so bad. Moreover, this destocking cycle is coming off an aberrant period where companies were holding surplus inventory to offset the risk of supply shocks and shortages.

The good news for Sandvik is that there are some meaningful markets still seeing underlying strength. Aerospace is well into what should be a multiyear recovery cycle, and the only issue here is that it’s a relatively small part of Sandvik’s overall customer/business mix (around 3%-5%). The auto market is about twice as large as a percentage of sales, and business has been strong here as companies retool to support hybrid and EV launches. Oil/gas has likewise been strong overall (though Sandvik seems to be underperforming some here), and with oil prices continuing to support production, I don’t expect a near-term downturn.

I do think there are a couple more quarters (at least) of destocking and order pressure, but I do expect Sandvik to start seeing improving general industrial conditions in 2024 (Sandvik tends to be an early mover). I likewise expect aerospace and oil/gas markets to remain healthy, though I could see auto softening some. Other markets like non-resi construction are a tough call into 2024, but I’m more bullish on areas like rail and infrastructure.

I’d also note that Sandvik remains leveraged to some longer-term growth trends that should support and grow the SMS business. Sandvik has strong share in the U.S. with tools and inserts and reshoring should continue to help this business. The company also continues to invest in growth markets like metrology and additive manufacturing, and I expect the company’s fairly aggressive M&A program to include a lot of technology-driven bolt-on deals for this segment.

Mining At A Good Cruising Altitude

When I last wrote about Sandvik , companies like Epiroc, Metso (OUKPY), and Sandvik were still looking to benefit from increased capex as companies refurbished their equipment fleets and moved ahead with new projects. That process has played out, driving multiple quarters of double-digit growth in Sandvik’s Mining & Rock business, but orders have slowed some of late.

In the near term, I don’t expect a lot of strength in new equipment orders. I think major miners are going to be more cautious now given credit costs and weakness in multiple markets (though metal prices have generally held up well), and I think most mining companies have done what they needed to do to get their fleets back in order (average ages are still elevated, but I expect a more measured approach to fleet renewal now). At the same time, permitting of new projects has slowed in many countries and there’s more of a skew toward brownfield expansions rather than greenfield starts.

Longer term, I’m generally bullish on this business. The electrification cycle I expect over the next decade (not just passenger vehicles, but with factory automation, commercial buildings, and so on) will require metals like copper and nickel, and I don’t see a lot of open-pit projects on the horizon, so more underground-focused companies like Epiroc and Sandvik should stand to benefit.

There are also internal improvement opportunities to consider. Management has executed on a multiyear project of pruning away lower-margin/lower-return businesses and continues to build up the aftermarket/services business – Sandvik’s historical attachment rate has been around 50%, but management still believes that 70% is a viable target. The company also continues to invest in automation and digitalization, which I see as key offerings in the coming years as mining companies look to work around heightened environmental and worker safety standards while also leveraging automation and digital tools to reduce production costs.

The Outlook

Obviously I’m very interested in what Sandvik will say in its upcoming third quarter earnings release and conference call. I see a definite chance of below-consensus orders (and revenue) in the Machining business, and I expect to hear of ongoing deterioration in many “general industrial” end-markets, while aerospace, auto, and oil/gas remaining comparatively healthy. Were management to talk about “green shoots” in the diverse general engineering category, that would of course be a positive for Sandvik and the sector as a whole. I’m not expecting much drama in the Mining & Rock business, though I expect some commentary about aftermarkets demand and customer inventory levels.

Given my relatively bearish outlook for shorter-cycle industrial markets, I do expect 2024 to be a relatively lackluster year for Sandvik, with low single-digit revenue growth after what should be low double-digit growth in 2023. Longer term, I’m expecting a little more than 4% revenue growth, though M&A (which I don’t explicitly model here) should drive some upside.

On margins, I’m not looking for a lot of leverage from 2023 to 2024, as I think the company will be limited on pricing and cost reduction tailwinds may underwhelm. Moreover, if end-user demand does in fact weaken, that won’t help operating leverage. In any case, I’m expecting mid-20%’s EBITDA margins for a couple of years with a more pronounced (50bp+) improvement in 2025 as demand ramps up again. Longer term, I’m still looking for mid-teens FCF margins and double-digit FCF growth.

Between discounted cash flow and margin/return-driven EV/EBITDA, I do believe Sandvik is undervalued but arguably not dramatically so. Discounted cash flow suggests a high single-digit long-term annualized potential return – not bad for a quality industrial but not compelling either. My EV/EBITDA approach is more forgiving and suggests upwards of 20%-25% undervaluation, but I’d note that companies exposed to mining (close to half of the revenue base) tend to trade at a discount to what would otherwise be a “fair” EBITDA multiple on the basis of drivers like operating margin, ROIC, and so on.

The Bottom Line

I do think there’s a risk that it’s too early to buy Sandvik. Past inventory correction cycles have taken around a year to work out and there are certainly negative drivers in play now (interest rates, wars, a weak China, and the upcoming election in the U.S.), though this inventory correction cycle is also different in that the starting point was inflated by unusual supply shortages (so the adjustment process may not be as severe). Said differently, there are a lot of unknowns in the short-term outlook for Sandvik and that creates some risks.

All of that said, I believe Sandvik is a well-run company with positive drivers over the short, medium, and long term. I do think those industrial end-markets will recover in time and Sandvik’s current undervaluation may offer some “cushion” even if the timing of those recoveries turns out to be a little later than currently expected.

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