2023-03-26 07:41:27 ET
Summary
- Shimano initiated FY2023 guidance in its latest earnings release for the 4th quarter of FY2022.
- The part of my initial thesis regarding possible currency tailwinds played out as expected and there should be more room for currency tailwinds left.
- Even when considering that Shimano has been guiding too low since 2020, the FY2023 guidance is worse than I expected.
- My updated DCF valuation indicates that Shimano is currently overvalued.
- I downgrade my rating on Shimano from "buy" to "hold".
Introduction
This will be an update to my initial article on Shimano Inc. (SHMDF) (SMNNY). Please refer to my initial article for an overview of the business and my expectations for the bicycle components market.
As for the structure of this update article, I will first briefly lay out my initial investment case. Next, I will go over the FY2022 results and especially the FY2023 guidance before finishing with an updated valuation and conclusion.
Initial Investment Case
My initial investment case at the time of my last article was three-fold:
(a) Shimano operates in a growing market (bicycle components) and is the market leader by a wide margin. The bicycle market should benefit from the global trend of urbanization.
This part hasn't changed at all. Please refer to my initial article.
(b) The market sold off Shimano aggressively since late 2021 because it expected the pandemic boost in sales to be a one-time event. Meanwhile, FY2022 results were still strong.
This will be addressed in this article. Especially the FY2023 guidance.
(c) The USD's strength and the YEN's weakness offered a favorable time for US investors to initiate a position.
This will also be addressed in this article.
Performance since my last article
So how has Shimano performed since my last article? Back then, it traded for ¥22,690 on the Tokyo Stock Exchange. As I am writing this, the stock price stands at ¥21,970, a 3% decline on a local currency basis. As can be seen in the snippet from my last article below, the stock rose by 5% on a USD basis.
The ADR traded at $15.42 back then while it trades at $16.73 now. This is a result of the currency effect that was part of my investment case. Here is the chart for the exchange rate since my last article:
I still think there is more room to go. Throughout the past 5 years, the exchange rate hovered around 110 YEN per USD. Fellow SA contributors (that probably know a lot more about currency investing than I do) also continue to be bullish on the YEN. In conclusion, the currency effect part of my initial investment case is still intact.
Operating Performance and FY2023 Guidance
As I outlined in my initial article, we need to adjust Shimano's earnings to factor out currency-related fluctuations. Below is my updated chart for the currency-adjusted earnings (EBT adjusted for foreign exchange gains/losses with a 23% tax rate):
FY | 2019 | 2020 | 2021 | 2022 |
EBT | 71,393 | 84,820 | 153,728 | 174,112 |
f(x) adjustment | 2,463 | 2,372 | -3,386 | -3,323 |
23% Tax-rate | -16,987 | -20,054 | -34,579 | -39,281 |
Net Income | 56,869 | 67,138 | 115,763 | 131,508 |
As the sell-off since late 2021 was caused by concerns over the pandemic effects on the bicycle market, the FY2023 guidance is way more important than the FY2022 performance. The snippet below shows the company's FY2023 guidance as of the 4th quarter FY2022 earnings release :
I will focus on the operating income since this excludes currency effects. In my initial article, I was far more bullish and assumed an FY2023 operating income of ¥147,150 million, a 10% decline YoY. Shimano now guides for ¥105,000 million.
Now Shimano has shown problems with giving proper guidance since the pandemic, so I decided to look at the FY guidance at the start of each year compared with the actual performance reported at the end of each year. This resulted in the following chart:
We can see that Shimano was pretty good at giving guidance but started to guide too low in FY2020. I assume that FY2023 is no exception. Shimano seems to tend to guide low when external factors hinder them from gauging the operating performance of the upcoming year. While I think my last assumption of ¥147,150 million is too high, I guess Shimano will be able to deliver better results than ¥105,000 million. I will just assume an FY2023 operating income of ¥120,000 million.
Updated valuation
As I did in my last article, I will use the operating income (which excludes exchange rate gains/losses) and apply a 23% tax rate. With Shimano's big net cash position that earns interest (which is excluded from operating income) this is a rather conservative approach.
At the end of FY2022, Shimano's net cash position stands at ¥428,278 million. With 90,629,066 shares outstanding, net cash per share stands at ¥4,726 ($3.60 per ADR).
With the expected operating income of ¥120,000 million and ¥319,526 million capital employed at the end of FY2022, the return on capital employed ((ROCE)) for FY2023 should come in at around 37.5%. As I outlined in my initial article I expected Shimano to grow in line with the bicycle components market at a CAGR of 6%. To generate 6% growth off of ROCE of 37.5%, Shimano would need to reinvest 16% of earnings back into the business. This would result in a cash conversion of 84%. With these numbers, we can calculate an expected free cash flow ((FCF)) for FY 2023:
(1) ¥120,000 million operating income x 77% (23% tax rate) = ¥92,400 million net income
(2) ¥92,400 million net income x 84% cash conversion = ¥77,616 million FCF
The enterprise value stands at ¥1.563 trillion ($11.9 billion). By dividing the expected FY2023 FCF of ¥77,616 million ($591 million) by the enterprise value, the FCF yield would come in at around 5%.
The total return of any stock should be the sum of the long-term growth and the FCF yield, in this case, 6% (growth) + 5% (FCF yield) = 11%. This is 100 basis points below my last estimate. The decline is solely attributable to the fact that I had to cut my FY2023 FCF estimate from ¥98,500 million to ¥77,616 million. Remember that this is the long-term return expectation under the assumption that there will be no changes in valuation .
Updated DCF-valuation
To evaluate possible effects from valuation (multiple) changes, I use a DCF valuation as a supplement. With my FY2023 expectations, FCF per share should come in at ¥856 ($0.65 per ADR). I assume a 6% growth rate in line with the bicycle components market and a 3% terminal growth rate. I upped my terminal growth rate assumption from 2% because Shimano has been able to generate high ROCE over the past. This indicates a wide moat and I think a perpetual growth rate in line with inflation seems too low. Here is the result:
Shimano should be worth around ¥15,718 per share ($11.97 per ADR). After deducting the net cash per share of ¥4,726 ($3.60 per ADR) from the current price of ¥21,970 ($16.73 per ADR), the actual price to pay for the business stands at ¥17,244 per share ($13.13 per ADR). In conclusion, Shimano looks overvalued at the current price.
Review of risks
Besides potential market share losses, I highlighted a bigger drop in earnings as a normalizing effect after the pandemic as one of the potential risks to my initial thesis. Here is what I stated back then:
Regarding the risk of a bigger drop in earnings, I already laid out my thoughts and the reasons for those in this article. However, I am relying on official estimates for the overall bike and bike-components market, so a much larger drop can't be ruled out. This would result in Shimano being actually a bit overvalued at the current price, since the FCF-basis for FY2023 used in the DCF-valuation would need to be adjusted to the downside.
Source: Initial article - Risks
This is what happened now. I will refrain from stating risks again here because I will have to change my stance on Shimano from "buy" to "neutral" (which is expressed with my "hold"-rating). This leads me to my conclusion.
Conclusion
I still think that Shimano may be able to deliver 11% long-term total returns. My DCF valuation shows that Shimano is probably overvalued at the current price. While there can be cases where I give a "buy" rating despite assumed overvaluation (like I did in my initial article on Costco Wholesale (NASDAQ: COST )), this isn't one of them. The long-term total return prospects assuming no changes in valuation are not high enough and the business isn't predictable enough (unlike Costco).
My investment case of potential currency tailwinds is still intact. This could counter some of the potential valuation headwinds indicated by my DCF valuation. However, as I laid out at the beginning of this article, a part of this currency tailwind already played out since my past article.
In conclusion, I downgrade my rating on Shimano to "hold" from "buy". I will keep covering the company and probably write an update article sometime in the second half of this year. Ongoing guidance will be the major catalyst to look out for in the upcoming quarters.
For further details see:
Shimano: FY2023 Guidance Is Worse Than I Expected