2023-09-14 10:54:49 ET
Summary
- TDK Corporation's stock has been on an upward trend, but its value at current prices is uncertain.
- The company's Q1 FY'24 results showed a decrease in operating profit on a modest decrease in net sales.
- TDK's return on capital employed is low, making it difficult to justify investing in the company at the current point in time.
- Net-net, rate hold.
Investment briefing
TDK Corporation (TTDKY) had caught a reasonable bid off '22 lows before topping at the end of H1 FY'23. It has now tracked higher with a series of tight closes the last 6 weeks and has crossed the 50DMA in doing so [Figure 1]. The question that now needs to be answered—what's the value on offer at these prices.
This report will unpack all of TTDKY's value drivers to guide investors in developing an informed investment opinion. Based on the economic performance of the company, and headwinds in its core markets, I rate TTDKY a hold, and will discuss the reasons why here. Its HDD business continues to be a drag on profitability, and market dynamics in its ICT arm have crimped business growth this year. The stock trades at relatively cheap multiples but it's difficult to vote for the company with an allocation with subpar returns on capital and tightening sales growth. Net-net, I rate TTDKY a hold.
Importantly: TTDKY reports in JPY. But in this report, all numbers will be quoted in USD, at the USD/JPY cross rate, where 1 USD = 147.36 JPY at the time of writing.
Figure 1.
Critical investment facts to hold thesis
1. Q1 FY'24 insights
TTDKY put up Q1 FY'24 sales of $3.41Bn, a modest decrease of 140bps YoY [note: TTDKY reported its Q1 results for its fiscal '24, corresponding to Q2 CY2022. For consistency and simplicity, I'll talk in terms of Q1 from hereon in, unless otherwise stated]. It wasn't as modest an impact down the P&L, however. Operating profit was down 41% YoY to $178.4mm, and pre-tax earnings were at $142mm on after-tax earnings of $0.26/share. Given these circumstances, management adjusted its full-year FY'24 projections. The revised outlook anticipates net sales of $13.4Bn, operating income of $1Bn, and net income of $704mm.
Segment-wise, there were interesting contrasts in sales and profitability. To name a few:
- Sales of passive components tallied $953.5mm, a marginal 1.1% YoY contraction. Whereas declines in its information and communication technology ("ICT") snipped profitability by 42.3%. Despite this, management said sales of aluminium and film capacitors were robust, especially in the automotive and renewable energy sectors. My estimation is these are secular trends that align with structural changes in the economy.
- In the sensor application products ("SAP") division, sales were stable at $263mm, but clipped a 77% YoY decline in operating profit of $4.1mm. Growth was observed in temperature and pressure sensors, attributed to high-end sales in the automotive industry.
- Its magnetics and applied products business did $259.1mm in sales, down 30.7% YoY on an operating loss of $65.9mm . Critically, its hard disk drive ("HDD") head and suspension business booked sharp declines in volumes. Management said this stemmed from a 31% YoY drop in overall HDD demand—quite concerning to the company in my view, but not entirely unexpected. This is a consequence of reduced investments in data centres resulting from 1) economic slowdowns and prolonged HDD inventory adjustments. In fact, the HDD market is undergoing a rapid transformation of its own. Unsurprisingly, cloud service providers ("CSPs") have intensified their CapEx allocation toward AI-related projects in 2023, whilst the renewal cycle for general-purpose servers and storage systems has lengthened. These trends ultimately put a halt to HDD production volumes due to slower HDD inventory consumption and order volumes.
- Finally, there was a reprieve from its energy application segment. It did $1.86Bn of business, a 5.7% increase, with an operating profit of $218.4mm, up 17.7% YoY.
It was obviously a mixed quarter for TTDKY, and the revised outlook should be factored in as well. To me, this is a fairly neutral assessment.
2. Economic factors and earnings rate on capital employed
TTDK is a capital-intensive business. Required reinvestment rates are high and earnings produced on these investments have been waning. Around $11.7Bn of total capital is required to run the business and to maintain its competitive position. But it has been reinvesting ~20–30% of NOPAT each quarter with no incremental profit growth to show for it.
The $11.7Bn produced $570mm in post-tax earnings last period (TTM values), otherwise, $1.51/share in earnings produced on $31/share of investment, a paltry 4.8% rate of return. This comes from just 4.2% post-tax margins on 1.14x capital turnover. Problem is, this isn't out of synch with TTDKY's historical numbers.
Step back for a second, and think in first principles. When you're buying part of a business, you're buying part of (i) the capital employed to run that business, and (ii) the cash flows, or earnings power, these assets can produce going forward. You then compare/discount this to/at a required rate of return. In fact, the value of any asset is the cash flows that can be drawn from it over a horizon, compared to a hurdle rate.
Take the stock market and stock price out of it for a second (the stock price is what you're asked to pay, not the value). In this vein, you're buying (i) and (ii) from above.
In reality, the value of (i) doesn't matter as much as the value of (ii), the earnings power. Capital/assets are worthless if they don't produce anything. Here, it's a simple calculus of return on investment—what kind of earnings are produced on what level of capital employed to grow the business. Size has no bearing here. You'd much rather buy a business with $10mm of capital employed producing a 20% return, than a $100mm business doing 5%. Why so? Because the higher the ROIC, it means neither growth or FCF's are jeopardized by one another. A firm can grow and throw off piles of cash to shareholders at the same time. We want FCF + growth—and as much of possible of each. A low ROIC? It's either growth or FCF, not both, or, it's neither. This is where growth can be destructive to value. If the returns on capital invested are low, 1) FCFs to shareholders are limited, 2) growth comes at the expense of FCF, or 3) there's no growth, and no FCF. Either way, intrinsic value will be stagnant.
Equally as important is the reinvestment runway to redeploy surplus cash flows to incrementally grow earnings. Indeed, you want to own companies that are drowning in cash, and have more FCF than they can possibly reinvest. But if there are no places to reinvest in the first place, difficult to grow the business, and therefore grow intrinsic value.
With these points in mind:
- For TTDKY, a 4.8% return on the capital we are theoretically part owners of is unacceptable, especially if you take a 12% hurdle rate (in line with long-term market averages).
- Even with the 2-year average ROIC of 6%, funds for reinvestment are limited, and growing the business will likely hurt FCFs + shareholder value, all for a tight rate of return.
- Alas, you're paying a high value for (i); but receiving poor value on (ii).
Figure 3 shows what it needed to produce in NOPAT over the last 2.5 years to beat the 12% hurdle rate. Over the testing period, it hasn't met the basic requirements. For example, in Q2, it needed to produce $1.4Bn in TTM NOPAT to meet the criteria. It did $570mm. In Q1, it was $1.4Bn, but did $778mm, respectively. This is certainly a neutral posture in my view.
3. Value drivers and steady-state forecasts
The above analysis shows what the company has been doing and serves as the bedrock for assumptions downstream.
More critical is what TTDKY can offer moving forward. Figure 4 captures the company's value drivers over the last 3 years (call this the steady-state). Operating and investment drivers are noted, as they both contribute to FCF, the lifeblood of corporate value. Sales are down 1% on aggregate, operating margins have been relatively stable and averaged 7.6%.
More importantly—for every new $1 in sales, an additional $1.09 in NWC was required. Interestingly enough, intangibles and fixed asset intensity were down $0.17 and $0.1 on the dollar, respectively.
Figure 5 projects the outlook for TTDKY should it remain in the steady-state numbers above, albeit with a 1% sales growth rate. Granted, this is low. But the company hasn't exactly proven otherwise this year.
At the projections, out to FY'24:
- FCFs would grow to $617mm, with NWC density growing ~$150mm each quarter.
- Around $12.3Bn in capital would be required to run the business and it would need to reinvest ~19% of earnings to maintain a competitive position.
- But it would still be spinning off ~6% returns on capital invested, well below our 12% required rate of return. The negative 6% spread results in an economic loss of this amount.
- So you'd have a $712mm incremental investment growing NOPAT by $29.8mm, just 4.1% incremental rate of return.
4. Valuation
The stock sells at 16x forward earnings and 13.4x forward EBIT, and is priced at 24x forward NOPAT as I write (13,740/571 = 24x). My basic assumptions have TTDKT to do ~4% growth in NOPAT in the next 12 months, as mentioned. At the same 24x multiple, this gets you to $14.2Bn in market value (571x1.04 = $593; 24x593 = $14,242) and just 3.7% value gap at the time of writing.
These findings are supported in the DCF built on the steady-state assumptions looking out to FY'28. Cash flows are projected and the company's stock price is compounded at the rate of its forecast ROIC and reinvestment rates. The average of both outputs gets you to $33/share, with a range of $27–$38/share. This supports a hold rating.
In short, there are a number of factors to reflect on with TTDKY. Its end markets are choppy, sales are lumpy, and the economics are soft compared to other investment opportunities. The premise of this analysis was to think of TTDKY's ability to compound its intrinsic value in first principles. So, think about it in first principles again. The company would theoretically need to invest another $712mm, 6% of its current capital base, to generate 6% ROIC going forward. The question is—could you invest 6% of your net worth, and get >6% return on investment? My firm estimate is yes, with more selective opportunities. This—and the other factors raised here today—supports a hold rating in my view, and I've priced TTDKT at $33/share.
For further details see:
TDK Corporation: Dividends Don't Offset Soft Value Drivers, Economic Performance, Rate Hold