Denso: despite headwinds, 3Q profit flat YoY

by SR on February 6, 2012

Denso reported its third-quarter results on Friday 3 February (recall that like most Japanese companies its financial year ends in March and thus the third quarter is October-December).
You know what? I thought they were impressive.

Headline figures: sales up 4.8% year-on-year to Y805.2bn (+3.4% quarter-on-quarter), operating profit flat year-on-year at Y50.2bn (+38.7% QoQ).


Flat OP despite forex. I estimate the impact of the stronger yen relative to the dollar and the euro, which I estimated knocked Y5bn off quarterly OP. Operating profit margin of 6.2% in this 3Q FY3/12 would have been 6.8% excluding currency effects, higher than 3Q the previous year. That’s despite the damage caused by the Tohoku earthquake and the Thai floods.


Regions and products. By geographical region, the contribution of Asia to sales and operating profit sank relative to the previous quarter (note that this was the July to September quarter for that region and thus reflected disruption from the earthquake) but Japan and the Americas surged, more than offsetting this. I’m not sure that we have enough granularity on the product lines to be able to say anything of importance on a quarterly basis, but for the record, Electronics and Safety & Information products accounted for 70% of the Y26.3bn incremental gain over the previous quarter.

Outlook for 4Q. Management cut revenue guidance from Y3,170bn to Y3,110bn but left OP guidance unchanged at Y135bn, suggesting that they already had a substantial “buffer” built into their OP forecast. The implied 4Q sales guidance is Y895.6bn and Y52.9bn in OP.

Conservative guidance, as usual. Sales are slated to rise Y90.4bn while OP is seen rising only Y2.6bn. Management no doubt will offer reasons for this, but these are usually a smoke-screen for conservative forecasts. Given Denso’s cost structure, I would usually expect an the margin on incremental sales to be about 30%, which would suggest a Y30bn uplift in profits in the fourth quarter. However, if we look over at depreciation, it looks like it’s due to rise Y10.6bn in the final quarter, which is likely a genuine headwind. So call it Y20bn, roughly Y70bn for the quarter.

For the full year FY3/12 that suggests to me Y3,110bn or so in sales and Y155bn in OP. Costs related to the earthquake for the whole year of FY3/12 are estimated at negative Y18bn, so excluding that item, ‘real’ OP would be about Y173bn in FY3/12. IFIS says consensus for recurring profit is Y162.8bn, and the non-operating account should be about positive Y14bn this year, so the implied OP consensus for FY3/12 162.8 – 14 = 148.8bn. So, consensus is a bit short of what I think is likely for FY3/12 but not massively adrift. Probably a bit academic at this stage, as eyes will be turning to FY3/13.

The outlook for FY3/13

Well, just back of the envelope, say Toyota grows its global production by 10% YoY as it recovers from the truly horrendous past two years. Let’s also assume that the remainder of Denso’s customers grow sales (and production) by 5% YoY. Given that Toyota is 47.5% of sales, we can guesstimate 3110bn x 47.5% = Y1,477.3bn, growing to Y1,625bn, with the remainder growing from Y1,632bn to Y1,714bn for blended sales growth of 7.4%, total of Y3,340bn in FY3/13.

I have to think that with all the cost-cutting the company has done over the past couple of years, they can squeeze out 30% incremental margins, so for FY3/13 add Y68.8bn in profit to the Y155bn I think they’ll achieve in FY3/12. Add another Y18bn for the one-off earthquake costs that (I very much hope) will not recur in FY3/13. That gives Y241.8bn in OP (+49.6% YoY), Y256.9bn in RP, Y168.9bn in net profit, Y209.6 in EPS, putting the stock on 11.1x FY3/13 earnings, probably about 9.5x for FY3/14, for the biggest auto parts company in the world and one that’s just been through two really, really horrible years and is due a little mean reversion.

The key issue is whether you believe Denso can ever return to the glory days of 2007-2008. If you adjust their profits per vehicle for forex, in terms of operating margins they already surpassed the peaks of 2007-2008 in 2010, but since then the headwinds have been severe. Personally I’m optimistic that if they can just get some volume growth their margins will improve rapidly.

Let’s go into a bit more detail on those difficulties that Toyota and by extension Denso have faced. Take a look at this next chart, which shows Toyota’s global production in relation to those three big headwinds. The Toyota recall crisis that began in January 2010; the Tohoku earthquake of March 2011; the Thailand floods of October 2011.


You can see production tooks some big hits. Notice how, after the recall crisis, production effectively moves sideways for the whole of 2011. That’s partly because of inventory. While the chart below only shows inventory days in the US, you can see the way US inventory rose sharply in early 2010 and resulted in a cut to production as Toyota tried to work down stocks. You can also see how inventory plummets after the earthquake and how it only really starts to get back to normal in December 2011.


Note also the way that production in the first of these two charts nosedives after the earthquake and then again after the floods in Thailand. If you can’t make it you can’t sell it, right? This all matters a great deal to the auto parts stocks like Denso: it is auto production, not auto sales, that drives their revenue in the short-term. And while Toyota only accounts for 47.5% of Denso’s revenues, it is still 47.5% of revenues.

I think Toyota’s going to have a relatively good 12 months. For the first time in 2 years, it has something like a level playing field compared to Nissan, Honda and Hyundai. And it has some interesting new models coming out in its major markets. Yes, Toyota has a long way to go but the direction, for the first time in a while, looks to be upward rather than down.

Will investors agree with me? I think they need more proof. Toyota has become a “show me the money” stock. After two years of bad luck, many investors suspect something more worrying that bad luck is involved. Is it management incompetence? I think not, but until Toyota starts posting solid improvements in its margins (or gives the impression to the financial community that it is likely) investors will not in my view be flocking to Toyota. But Denso might get a little more love. Better margin recovery, exposed to a Toyota recovery but with some diversification there to reduce risk, solid emerging markets strategy – it’s worth a look.


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