Denso: estimating the guidance beat for FY3/13

by SR on June 22, 2012

A significant overshoot is on the cards

  • Conclusion: you can quantify “a good year” – here’s how. We explore a few things in this post, including the reasoning for regarding Denso’s most recent quarter as its best ever, the structure of the company’s fixed and variable cost base, the effect of operating leverage and a fully worked out forecast for operating profit in FY3/13 that suggests that consensus is 10% too low. Our estimate is for EPS of Y245 in FY3/13, putting the world’s largest auto parts stock, and a prime beneficiary of the Toyota resurgence, on 10.3x earnings.

Revisiting the impact of currency

Over the past few years, the yen has appreciated significantly against the US dollar and the Euro, which has had a correspondingly significant and negative impact on Denso’s sales and operating profit. Let’s put that impact into figures, starting with reported sales and operating profit.
Denso annual sales and operating profit (billion yen)

Denso recorded its highest ever annual operating margin of 8.7% in FY3/08 (recall that Denso’s financial year end, like that of most Japanese companies, ends in March, not December). For that financial year, Denso used an average yen-US dollar rate of 116 and a rate of 160 yen to the Euro. For the FY3/12 year, Denso used an average rate versus the US dollar of 79 yen and a rate of 109 yen to the Euro.

Denso annual operating margin (%)

On an annual basis, what would FY3/12 operating profit have looked like had the yen remained at the levels of FY3/08? As I explain in detail in my previous post, Denso gives us sensitivity figures that allow us to estimate the impact of the stronger yen on its sales and operating profit. Specifically, a 1-yen move in the rate versus the US dollar affects sales by Y5.4bn annually and its OP by Y3bn annually. The equivalent figures for the Euro are Y2.4bn and Y0.8bn respectively. The change in the forex rate from FY3/08 to FY3/12 was 79 – 116 = -37 for the US dollar and 109 – 160 = -51 for the Euro. The impact on sales is therefore (-37 x 5.4) + (-51 x 2.4) = -199.8 and -122.4 for a total impact on sales of negative Y322.2bn. The impact on operating profit is (-37 x 3.0) + (-51 x 0.8) = -111 and -40.8 for a total impact on operating profit of negative Y70.2bn.

If we add back to FY3/12 sales and operating profit the amounts eroded by the stronger yen, we see that sales increase from the reported Y3,154.6bn in FY3/12 to Y3,476.8bn. Operating profit rises from the reported Y160.7bn for FY3/12 to Y230.9bn, for an operating profit margin of 6.6%. That is of course better than the reported margin of 5.1% but still way adrift of FY3/08’s level of 8.7%. At first glance, even accounting for the negative effects of forex, that looks disappointing.

The ‘vehicles supplied’ metric and how to approach it

Forex, however, is not the whole story. Denso is a classic industrial company: it buys in raw materials and parts, creates a new product in its own factories – in doing so adding value – and sells this product on to a third party. A decent fraction of Denso’s cost base (certain types of labour, various other costs, depreciation up to a point) is fixed or changes only very slowly. My rule of thumb for Denso is that 35% of total costs are fixed in nature. This means that when sales rise, costs rise more slowly than sales, leading to an exaggerated impact on profits. This is what operating leverage is all about. In brief, profits will vary with volumes.
As it happens, there is a reasonable proxy for production volume at Denso. To help the investment community track its performance, Denso’s management discloses a “car production” number every quarter. This metric, which I am going to call the ‘vehicles supplied’ figure, reflects the number of cars manufactured for which Denso supplied product. This data needs to be treated with some caution because it includes only the vehicles manufactured by Japanese OEMs in Japan and overseas. It does not include production by the non-Japanese manufacturers (GM, Fiat, Hyundai/Kia, Ford etc) and together these customers make up at least 13% of Denso’s revenue and possibly several percentage points more.

Denso vehicles supplied, million units

Nevertheless, although there will be transfers of market share back and forth among individual customers, Denso is so large that I think it’s reasonable to assume that the number of cars to which it supplies components will move closely with the global auto market and that the total number of vehicles moves in a similar way to the reported figure described above, which is somewhat smaller. Incidentally, there is no mystery about the provenance of this data: it is disclosed in Denso’s presentation material on the company web site.

From this we know that Denso supplied product to 24.33 million vehicles in FY3/08 and that it therefore generated about 165,400 yen per vehicle in revenue and 14,330 yen in operating profit. Based on reported sales and profits in FY3/12, the equivalent figures are 133,000 yen and 6,780 respectively. If we use our forex-adjusted figures for sales and profit in FY3/12 the figures come to sales per unit of 146,600 yen and 9,730 yen respectively. On an annual basis, that’s still not very impressive compared to the peak values of FY3/08.

We shouldn’t be surprised. Although on an annual basis Denso’s ‘vehicles supplied’ unit figure of 23.71 million came to 97% of the 24.33m units achieved in FY3/08, the picture of a quarterly basis looks very different. In the April-June 2011 and July-September 2011 quarters Toyota and its suppliers, including Denso, were struggling to deal with the disruption to production caused by the Northern Japan earthquake of March 2011. The following chart shows a quarterly version of the vehicles supplied data and illustrates how badly affected output was by the earthquake.

Denso vehicles supplied by quarter, million units

January-March 2012 results for Denso were stellar

Above I go through the forex impact on an annual basis. In my previous post I discussed the stronger yen and quantified the effect it had on sales and operating profit in the January-March 2012 quarter. I demonstrated that if you were to adjust for the effects of currency relative to the quarter in which Denso reported its highest-ever operating margin, the operating profit margin in January-March 2012 would have been 11%. That would have exceeded not only the previous record operating margin of 10.7% set in the October-December 2005 quarter (which frankly looks a bit anomalous) but also the 10.1% OP margin recorded in the October-December 2007. So although we concluded above that Denso’s sales and operating profit in FY3/12 looked unimpressive for the year as a whole, results for the fourth (January-March) quarter of FY3/12 were stellar. Here are reported sales and operating profit by quarter.

Denso sales and operating profit by quarter (billion yen)

Now operating margin by quarter.

Denso operating profit margin by quarter (%)

And finally here is operating profit margin adjusted for forex in the most recent quarter.

Denso operating profit margin (%) adjusted for forex impact

Extrapolating from Q4: risky but fun

In the financial year to March 2013, Denso expects to ship product to 25.6 million cars, an increase of 8.4% YoY. (If we assume roughly 82 million cars sold in 2012, with production somewhat higher than sales – call it 85m for the sake of argument – then 3 out of every 10 cars contain Denso product. I would rephrase that at least 3 out 10 as the real figure is probably more like 3.3 or 3.5 vehicles out of every 10.)

In the January-March 2012 quarter Denso supplied parts for 6.77m units. If we multiply that by 4, we get 27.1m units, a figure about 5% higher than the 25.6m cars just mentioned. As a rule, multiplying any quarter by 4 (or any month by 12) is bad practise due to seasonal effects, which can be quite pronounced in the auto market. 27.1m units would be an increase of 14.3% YoY in vehicles, which is pretty significant for a company the size of Denso. But is it reasonable, especially compared to the 8.4% YoY figure being forecast by management? Let’s put Denso firmly back in the context of its largest customer, Toyota.

Toyota’s global production in FY3/12 was about 7.5m units. The exact definition will vary depending on whether you include Toyota’s partnerships in China and so on. Looking at recent trends in Toyota’s production and walking forward monthly output, I would expect (using the same counting basis) a little more than 9m units in FY3/13, an increase of 20% YoY. So take Denso’s 3,154bn yen in revenue for last year and grow the Toyota group portion of that (49.1%, or 1,549bn yen) at 20% YoY; that gives 1,858bn yen. If we assume the remaining 1,605bn yen grows at 5% YoY (more or less what I expect for global auto sales) then we end up with 1,685bn + 1,858bn = 3,544bn vs management guidance of 3,420bn. Of that, Toyota accounts for 1,858/3,544 = 52.4%.

In answer to the question we posed above, we can reasonably expect growth in revenues – before any of the tweaks we apply below – of about 12.4%, two solid percentage points less than the 14.3% YoY growth we mention above. This is reassuring rather than disappointing. Common sense dictates that in a seasonal market you shouldn’t expect reliable forecasts from taking any one quarter and multiplying it by four.

Costs, fixed and variable

As for profits, well, this is a moveable feast indeed. Let’s start out with last year’s cost of goods sold, which came to Y2,720bn in FY3/12. That’s not all the expenses we have to deal with though. sales, general & administrative costs (SG&A) added another Y274bn. Combining these gives a “total costs” figure of Y2,994bn. Depreciation was Y180.6bn. I estimate that labour costs, while higher than in FY3/09 – because salary and bonus cuts have been mostly reversed – have probably not climbed much, as management has been very focused on doing more with fewer people. For the same reasons I expect other sundry expenses to be much lower than they were in FY3/09 as these were cut aggressively in FY3/10 and have rebounded only a little. All in all, I estimate about 32% of Denso’s total costs were fixed or semi-fixed in FY3/12. In other words, about Y960bn in fixed costs and Y2,033bn in variable costs.

Let’s assume that variable costs rise pretty much in line with volumes, which is 12.4% given our rough calculation above. Variable costs should therefore rise from Y2,033bn to Y2,285bn. Fixed costs should be roughly the same, but we know that depreciation will rise by Y6.4bn to Y187bn in FY3/13, so let’s add that to the Y960bn in fixed costs posted in FY3/12. This gives us Y2,285 + 966.4 = Y3,251.4bn. Now, as we just said we assume that revenues rose by 12.4% from Y3,154.6bn to Y3,544bn, which implies operating profit of Y3,544 less total costs of Y3,251.4bn = 292.6bn in operating profit.

The second pass: refining the model

Have we missed anything? Sure, several things.

For one thing, we need to reflect price cuts given by Denso to its customers. If we assume a net 1% decline in average selling prices, revenues would be Y3,544bn less Y35.4bn, giving Y3,509bn. What does that mean for operating profit? Well, we should knock Y35.4bn from OP as well, because a price cut is a reduction in income without a corresponding reduction in costs. So our operating profit outlook goes from Y292.6bn to Y257.2bn.

The concept of higher volumes generating higher profit is already incorporated into our forecast but we have not yet considered the subject of cost cutting. Typically Denso manages to cut costs by a few tens of billions of yen every year. For example in FY3/09 the company reduced costs through various means, by Y40bn. In FY3/10 the equivalent was Y48.3bn, for FY3/11 it was Y35.6bn and in FY3/12 it was Y19bn. The last two years look like a big step down, but FY3/12 was hit hard by both the Northern Japan earthquake and the Thailand floods. It’s hard, as any manufacturer to tell you, to work on steadily cutting costs when you have a lot of volatility in the loading of your factories. Because I expect FY3/13 to be a year of sustained high output, I’m going to assume that Denso can generate roughly Y30bn in efficiency gains. If we reduce costs by this much we effectively raise operating profit by Y30bn, leading to an OP forecast of Y257.2bn + Y30bn = Y287.2bn.

But there’s another factor to take into account, which is the one-off (non-recurring) impact on operating profit of the natural disasters of FY3/12 (quake and floods). This reduced operating profit by Y16.5bn, which is lower than previous estimates by management, which had suggested something like Y25bn. Perhaps they’re being a little cautious here. Anyway, let’s take Y16.5bn as the correct figure and add this back. That gives us Y287.2 + Y16.5 = Y303.7bn in operating profit compared to management guidance for FY3/13 of Y205bn. This Y303.7bn represents a Y143bn increase over FY3/12 OP of Y160.7bn. We expect revenue to grow by 355bn in FY3/13, so the implied incremental operating margin is 143 / 354 = 40.4%.

More tweaks

Having made these changes, the incremental margin of 40% seems too high to me. It is not impossible for a large company to achieve that level in short bursts if volumes are growing at an exceptionally rapid rate. Still, 40% seems like a stretch based on empirical observation of Denso’s history. Remember however that the Y143bn increase includes that Y16.5bn caused by disaster-related costs incurred in FY3/12 not reappearing in FY3/13. If we exclude that Y16.5bn figure the ‘real’ incremental margin is 35.7% (143 – 16.5) / 354), which is easier to stomach but perhaps still a little high.

Where else might we be a little optimistic? Management suggests that the impact of “product mix” will be Y23.8bn in FY3/13. Now although there is an element of product mix at work here, this is mostly an euphemism for “price cuts”. In my experience the company has good visibility on this item but always errs on the side of caution, so our assumption that prices will fall by Y35.4bn starts to look pessimistic. Let’s lighten our assumption from negative Y35.4bn to negative Y24bn, a change of Y11.4bn.

Impact: operating profit increases from our previous forecast of Y303.7bn to Y315.1bn.

Conversely, management is suggesting that labour costs will rise by Y15bn and that other sundry costs will rise by Y27bn. While I would expect the company to use the worst-case scenario for both of these items, it’s unlikely that they are pulling two such fairly substantial items out of thin air. Moreover, production is supposed to rise this year, so it is logical to expect some upward creep. Let’s assume a Y22bn increase in other costs and a Y12bn increase in labour costs, or Y34bn. That’s 80% of the Y42bn in downward pressure on profits that management is forecasting.

Impact: operating profit decreases from our previous forecast of Y315.1bn to Y281.1bn.

I will assume that the impact of forex is neutral, although management expects Y4bn positive impact. Management also expects the impact of higher raw material prices to hit profits by Y6bn. Given commodity prices seem to be getting softer I think this is a little pessimistic, so I will tweak this down to Y5bn in negative impact. So, zero from forex and negative Y5bn from rawmats.

Impact: operating profit decreases from our previous forecast of Y281.1bn to Y276.1bn.

Our revenue forecast also changes slightly because we reduced our assumption for the negative impact of price cuts from Y35.4bn to Y24bn, a change of Y11.4bn.

Impact: revenues rise from our previous forecast of Y3,509bn to Y3,520bn.

We are now predicting an increase in revenues of Y366bn (that is, Y3,520bn minus FY3/12 sales of Y3,154bn) and an increase in operating profit of Y115.4bn, although this latter figure includes the impact from one-off costs posted in FY3/12 not recurring in FY3/13, which comes to Y16.5bn as noted above. So the organic change in operating profit is Y115.4bn less Y16.5bn = Y98.9bn. Our incremental margin is therefore Y98.9bn divided by the increase in revenues of Y365.4bn, which comes to 27%. That’s a lot more comfortable than the 35.7% incremental margin we mentioned a few minutes ago.

Let’s take a few seconds to tabulate the adjustments we just made to revenue, costs and profits.

Denso FY3/13 earning forecast revisions
Billion yen           Sales  Variable costs     Fixed costs     Total costs       Operating profit
FY3/12 results         3,154.6         2,033.0           960.0         2,994.0                  160.7
FY3/13 provisional forecast         3,544.0         2,285.0           966.4         3,251.4                  292.6
Price cuts of 1%           -35.4            +0.0            +0.0            +0.0                  -35.4
FY3/13 revision 1         3,508.6         2,285.0           966.4         3,251.4                  257.2
Efficiency gains            +0.0           -30.0            +0.0           -30.0                  -30.0
FY3/13 revision 2         3,508.6         2,255.0           966.4         3,221.4                  287.2
One-off costs disappear            +0.0            +0.0           -16.5           -16.5                  +16.5
FY3/13 revision 3         3,508.6         2,255.0           949.9         3,204.9                  303.7
Price cuts impact adjustment           +11.4            +0.0            +0.0            +0.0                  +11.4
FY3/13 revision 4         3,520.0         2,255.0           949.9         3,204.9                  315.1
Higher labour and Other costs            +0.0            +0.0           +34.0           +34.0                  -34.0
FY3/13 revision 5         3,520.0         2,255.0           983.9         3,238.9                  281.1
Higher raw material costs            +0.0            +5.0            +0.0            +5.0                   -5.0
FY3/13 revision final         3,520.0         2,260.0           983.9         3,243.9                  276.1

The outlook for FY3/13

Before summarising our forecast, let’s once again state the obvious: this is a forecast. It is very likely that our forecast will diverge from reality; the real question is by how much. We are not aiming for extreme precision, because we are working with imprecise inputs. We are not aiming for extreme granularity – in sales, for example – because the law of diminishing returns sets in very quickly.

For example, we can take a view on global auto production in half an hour, or less if there is a friendly auto sector analyst nearby. On the other hand it would take many hours to forecast each individual customer for Denso and the rewards are pitiful. It makes sense to estimate revenues for Toyota (44.7% of revenues) but Denso’s next largest customer (Honda) only accounts for 6.2% of total revenues. From Denso’s perspective, the difference between Honda’s revenues growing at 10% YoY and growing at 5% YoY is 0.3% of revenues. It’s not worth spending time on this when you could instead be thinking about investment ideas or generating new ones. We take a view and we move on.

You should revise a forecast as often as needed to reflect material changes in the environment or the fortunes of the company. I expect to have to change mine several times over the next 12 months. Don’t be surprised if I have to hack 20% off my estimates, or conversely add 20% to them. Actually, I regard these forecasts as aggressive and so I am more likely to cut them than raise them, in my opinion. But I might be pleasantly surprised.

Note also that we are simplifiying many other issues not mentioned above. For example, “fixed” costs aren’t really fixed. “Variable” costs do not vary in a nice linear fashion with sales. Accounting treatments, exchange rates and one-off events all distort earnings. Forecasting at this level has an unavoidable tendency towards complexity: we need to reduce that complexity to a manageable level. We need to thin out the trees so that we can see the shape of the forest. It’s not necessary to count every tree. We’re also not forecasting the balance sheet at all, which in a professional capacity would be absolutely necessary. Having said that, the balance sheet for a major Japanese tends to be pretty stable. For better or worse, such companies usually have a decent cushion in terms of cash and other liquid assets, which many investors would argue is a mis-use of assets.

With that little lecture out of the way, let’s dash through the lower half of the P&L. Assume that the non-operating account i.e. recurring profit minus operating profit is positive to the tune of Y10bn (unusually low for Denso by the way, which usually has Y20bn or so), which is Y286.1bn. Let’s further assume that net profit is about 70% of recurring profit, which is what management is implying. That gives us net profit of Y197.4bn and earnings per share of Y245. Yes, by rushing this bit we are doing violence to the bit on which the financial media seems to be fixated, namely the EPS but it’s irrelevant. EPS, particularly under Japanese GAAP, is subject to all kinds of distortions that have nothing to with core performance. For this kind of company I far prefer to use operating profit as a guide to the company’s ability to generate earnings. Feel free to go through the above as an exercise and refine the EPS figure with a more explicit forecast for taxes and so on.

Incidentally, IFIS has a consensus recurring profit forecast of Y258.8bn for FY3/13, which suggests operating profit of Y248bn. We’re galloping 10% ahead of that at nearly Y280bn. Japan market analysts tend to be conservative forecasters; it’s not a culture in which risk-taking is recognised. Analyst estimates tend to cluster together and fairly close to those of the management. My hunch is that we’re more aggressive both on sales and on the amount of operating leverage that can be generated. If our assumptions are accurate and if our understanding of the mechanics of the costs is correct, we could get a pretty substantial overshoot vs not only management forecasts (OP of Y205bn – come on guys!) but also consensus.

Denso results and earning forecasts
Billion yen                             FY3/11          FY3/12      FY3/13 Est      FY3/14 Est
Toyota group sales                     1,548.5         1,549.4         1,844.5         1,941.0
Other sales                            1,583.0         1,605.2         1,675.5         1,746.6
Total sales                            3,131.5         3,154.6         3,520.0         3,687.6
Variable costs (estimated)             1,992.4         2,033.0         2,260.0         2,354.3
Fixed costs (estimated)                  950.8           960.0           983.9         1,008.9
Total costs                            2,943.2         2,994.0         3,243.9         3,363.2
Operating profit                         188.3           160.7           276.1           324.4
Recurring profit                         207.2           180.8           286.1           339.4
Net profit                               143.0            89.3           197.4           220.6
EPS (yen)                                177.5           110.8           245.0           273.7


From what I can see investors are having difficulty looking out more than a few weeks at the moment, so I don’t want to spend too much time on the outlook for FY3/14, but for what it’s worth, here’s my view. Growth rate in sales to fall to 4.8% YoY. More upward creep in both fixed and variable costs, but nothing major. OP of Y324.4bn, close to the previous record of Y348.7bn posted in FY3/08. Based on a larger non-operating account of Y15bn and net profit at 65% EPS of sales, we get EPS of Y273.7. That puts the stock on a forward PE multiple of just over 9x FY3/14 earnings. Not bad for the world’s largest auto parts stock, especially one that’s on a bit of a charge.

But what does the market think? That’s what really matters. In our next post we’ll think about the share price, valuation and all that jazz.

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