SDVKF - Sandvik: Strong Q1 Results Should Support Valuation

2023-04-24 17:27:37 ET

Summary

• SDVKY had a solid 1Q23, with strong organic growth and demand leading to higher-than-expected orders, particularly in the short-cycle division.
• Revenue in the mining industry performed well, and I expect it to receive greater.
• Management has put significant effort into managing leverage and reducing volatility over the course of the cycle, which should have a positive impact on valuations.

Summary

Sandvik ( SDVKY ) designs, produces, and sells metalworking tools, rock excavation machinery and equipment, stainless steel goods, special alloys, and resistance heating materials and process systems, among other things. One phrase describes all of 1Q23's profits perfectly: a Solid 1Q. The short-cycle division played a significant role in the unexpectedly high volume of orders. Importantly, the quarter ended with management reporting strong demand in Europe and a recovery in China. Results-wise, revenue growth in the mining industry has been running 4% ahead of projections. As for adj EBITA margin, it came in weaker than expected. But I do not think this is structural because it was mostly driven by the revaluation of balance sheet items.

Overall, I think the stock is underpriced and recommend a buy rating. It is promising to see order strength in this business in 1Q23, given that the high-quality mining businesses contribute the bulk of the group's earnings. Despite this, the stock price seems to be mainly driven by news flow rather than business fundamentals - something that I believe will continuously provide buying opportunities, albeit increasing share price volatility. I anticipate that the mining business to receive greater acknowledgement by the market as it consistently perform well throughout the economic cycle. I also think the SMM forecast isn't as bad as people are making it out to be. With auto, aero, and energy exposure still not recovered, volume risk is concentrated in General Engineering, mitigating potential losses. In terms of non-organic growth, I also think that the management's proactive strategy of repositioning SMM and investing in mining assets can generate shareholder value. Management also noted that daily order intake for machining was slightly up compared to 1Q23 levels in the first two weeks of April, suggesting that we may see better-than-expected earnings in the coming quarter.

1Q23 results

Strong organic growth and underlying demand led to Group-level orders that were 5% higher than expected. To be more specific, organic growth was 2% overall and 5% when excluding Russia. Currency effects on the revaluation of some balance sheet items contributed to a 100bps decline in margin performance. If we take out the effects of these one-time revaluation adjustments, the currency was a tailwind of 110bps.

The organic increase in SMM order intake of 5% was significantly better than the consensus expectation of negative growth. North American demand was robust, and there were signs of a turnaround in China by the quarter's end. The overall engineering order intake was positive, and the Aerospace and Energy sectors both saw expansion of DD%. Underlying orders for SMR were up 1% y/y, but if we exclude three large orders totaling SKR1.15 billion, organic order growth was 2%, 100bps higher. Surprisingly robust aftermarket activity was also present, growing organically by 15%. Equipment, on the other hand, fell by -17% y/y, Among everything, I think it's noteworthy that regionally, order intake increased by a total of 57% across Europe, 28% across South America, and 11% across Africa and the Middle East. Finally, SRP order intake was down 9% organically, with aftermarket growth of 1% and a 19% organic decline in equipment orders. Profit margins dropped by 140bps y/y due to SP Mining-related integration and carve-out expenses and the impact of currency revaluation.

Margin

Management believes that there is a greater opportunity for leverage from volume growth than price growth across the board. At present, SDVKY leverage is the result of a higher pricing component; however, I anticipate this to have less of an effect in the long run as growth becomes once again volume-driven. However, management did note that significant effort has been put into managing leverage and lowering leverage relative to volumes in SMM. I find this is critical because it cushions the blow of any potential setbacks and allows for more maneuverability, both of which reduce volatility over the course of the cycle. This should also have a positive impact on valuations as the business will be a lot less volatile, thereby improving investors' ability to value this with high confidence. However, this strategy has the unintended side effect of reducing the beneficial leverage effect at higher volumes.

Industry Read Through

What I've learned about the industry as a whole from SDVKY's earnings is that the SMR order beat is good news for the other mining equipment players. In particular, the 15% increase in the SDVKY mining aftermarket in the face of tough comp stands out as exceptional. Machining demand in April was up slightly from 1Q23, and I anticipate that this news will be well received by other market participants. However, it should be borne in mind that SDVKY machining division had an easier comp due to exposure to Auto and Aero, and that demand has never really recovered compared to pre-COVID levels. Therefore, the growth rate here must be modified before being compared.

Conclusion

In conclusion, SDVKY 1Q23 results were impressive, with strong organic growth and demand leading to higher-than-expected orders. Despite a weaker-than-expected adj EBITA margin, which was mostly driven by the revaluation of balance sheet items, I believe the stock is underpriced and recommend a buy rating. The mining business, which contributes the bulk of the group's earnings, has been performing well, and I anticipate it to receive greater recognition from the market. Additionally, with machining demand slightly up compared to 1Q23 levels in the first two weeks of April, we may see better-than-expected earnings in 2Q23.

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