Denso: What doesn’t kill you makes you stronger

by SR on June 1, 2012

Denso posted record profits in Q4 – if you adjust for currency

Denso operating profit margins - previous record high vs most recent quarter and most recent quarter adjusted for forex

  • Conclusion: What doesn’t kill you makes you stronger. The global financial crisis. The meltdown of the auto market in most markets. The Toyota recall problems. The Northern Japan earthquake. The Thailand floods. Japan’s parts suppliers have had a very tough four years. And yet despite everything Denso has not only survived, but has emerged as a leaner, more muscular competitor than it was in 2008. In this post I’m going to show you how the stronger yen has disguised Denso’s high record operating profit margins and reiterate my view that Denso will easily surpass both management guidance and consensus forecast for the March 2013 financial year. This stock is well worth your time.

Denso quarterly sales and operating profit

Denso: King, or queen, of the auto parts industry

There are two dominant specialists in global auto parts. One is unlisted Bosch, a formidable outfit whose power base is in Europe but which has spread around the globe. The other is Japan’s Denso. Denso is younger than Bosch and has grown more rapidly over the past few decades. Denso had tie-ups with Bosch in the 1950s and 1960s; indeed, Bosch was then de facto Denso’s mentor and Denso clearly still has a healthy respect for its former ‘guide’.

The two firms are roughly equal in size – the yen-Euro rate affects comparisons more than anything else – and have similar product lines. Both are experts in electrical and electronic systems, but also supply engine components and a variety of other parts. Each has strengths and weaknesses. Denso dominates the global market for automotive air conditioners and related products. Bosch on the other hand is stronger in diesel engine components than Denso, although people tend to forget that Denso supplied the world’s first high-pressure common-rail diesel system. What it boils down to is that you have two global giants who supply the world’s best auto OEMs, who operate at the cutting edge of technology and who should be able to survive anything the industry throws at them. But you can’t invest in Bosch…

On the face of it, profits have been hit hard

Denso’s highest ever annual operating profit and operating profit margin was recorded in the March 2008 financial year, which came at the end of a glorious 5-year run of rising profits as the Japanese auto makers bit deeply into the US auto market. At Y348.6bn, operating profit in FY3/08 represented an operating margin of 8.7%.

Denso annual operating profit margin (%)

Denso annual sales and operating profits (billion yen)

On a quarterly basis, Denso posted an OP margin of 10.1% in the December 2007 quarter (Y104.1bn), which to my mind is more representative of sustainable performance than the actual peak margin, which was the 10.7% recorded in the December 2005 quarter on OP of Y86.2bn.

Denso quarterly operating profit margin (%)

Part of the problem is production volume, which is still lower than the peak levels of 2007 and 2008. Still, that is not the only issue. The chart below shows Denso’s revenues for each quarter as a percentage of the previous highest revenue reported. That is, for the highest quarter, the value is 100%. Operating profit is shown in the same way. What pops out from this chart is that revenue in the most recent quarter has climbed back to about 90% of the highest ever level. By contrast, operating profit has recovered to only 75% of the previous peak. That’s a pretty big gap and seems to suggest that Denso’s profitability has deteriorated, perhaps structurally.

Denso sales and operating profit as a percentage of the previous highest reported value

The stronger yen has a significant impact

The reality is that Denso’s core profitability has never been higher. The problem is the stronger yen, which obscures Denso’s tremendous bounce-back in margins. Let’s go back and take that highest ever (I say “highest ever”, but that really means “highest since Denso began disclosing quarterly accounts in 2004”) reported operating profit margin of 10.7% and measure the impact of the stronger yen. We are fortunate in that Denso itself offers some guidance as to the impact of a 1-yen change in the foreign exchange rate between the yen and the other major currencies. While probably not 100% accurate, it is the best thing we have – attempting to gauge the impact without the information that the management team has would be impossible. (And even company managements are struggling: one Japanese tyre company recently stopped providing this kind of information to analysts because it felt that the complexities of producing, buying and selling in several different currencies could no longer be reliably transformed to a simple figure.)

For example, according to the most recent information I have a 1-yen move in the yen-dollar rate affects Denso’s operating profit by Y3bn and its sales by Y5.4bn every year. In other words, if the average for the whole of 2010 was 80 yen to the US dollar and the average for 2011 was 81 yen (these are made-up numbers), that one-yen difference would lead to an increase in operating profit of Y3bn. If the yen had gotten stronger and risen to 79 yen in 2011, operating profit would have fallen by Y3bn, all other things being equal. Unfortunately for Denso, the yen has strengthened against all the major currencies used by Denso, especially the Euro and the US dollar.

Denso foreign exchange rates by quarter

How the yen has strengthened

The chart above shows the fluctuations in the US dollar, the Euro and the Thailand Baht against the Japanese yen on an end-of-quarter basis for the past seven years. The chart below shows the cumulative change for each of those three currencies since Denso posted that record high quarterly operating profit margin in the October-December 2005 quarter. The Thai Baht hasn’t moved much at all, on a net basis. On the other hand the yen has strengthened against the US dollar with hardly any backtracking and is now higher by 35 yen. The Euro, like the Baht, has moved around somewhat but against that too the yen has become stronger by 29 yen.

Denso change in foreign exchange rates since previous peak profits

Ouch, that’s going to leave a mark

Obviously, this has been detrimental to Denso’s earnings. The chart below shows the impact on operating profit of the stronger yen compared to the quarter of peak margin in October – December 2005. You need to be cautious about interpreting this chart: take only the value for the most recent data. That is because the sensitivity of operating profit to exchange rate does itself change over time. Denso doesn’t offer a formal time series of this data on a quarterly basis, so I just use it for the most recent quarter. As you can see the main impact has come from the US dollar, then the Euro, with the Thai Baht effect being very small.

Denso impact of forex on operating profit since previous peak operating profit

Adding back the lost profits and sales

If I go through the same exercise with sales – Denso is unusual in that they provide an estimate for sensitivity of revenues to forex fluctuations as well as operating profit – I end up with a figure of about 65bn in total negative impact on revenue for the January – March 2012 quarter compared to the October – December 2005 quarter. So, adjusted sales should be Y1,005bn and adjusted operating profit about Y110.7bn, for an operating margin of 11%. That’s higher than any reported previous margin.

Denso operating profit, operating profit margin and sales after adding back portion eroded by forex

But reported profits ARE still below peak!

Some readers are probably thinking at this point “Okay, so it’s forex that is depressing profits, but it IS still depressing profits isn’t it? Quantifying it doesn’t make it go away, right?”. This is true: reported profits or a close derivation of those profits is our base for valuation, though we may tweak that in some valuation methodologies to remove the effect of certain accounting conventions. As I am not a forex speculator it would be unwise for me to assume that the Japanese yen will either weaken or strengthen significantly from the current levels, so I cannot make the argument that the yen will go to 90 or 70 to the US dollar. If that were to happen operating profit at the same level of volume would soar or crash, respectively.

With the above caveat in mind, this brief examination of the impact of forex has value because it allows us to confirm a few things.

  • Management still has its act together. Important, this. In my experience, blindly buying “quality companies” in Japan will end up in you getting carried out on a door. “Quality” alone does not guarantee returns, but it is important because those stocks that are seen as not having competent management may be excluded from consideration altogether. In the case of Denso, the forex-adusted results show that management and employees have absorbed or deflected everything that has been thrown at them over the past few years, except the one element that no company can control, which is forex. There is no reason not to have Denso in your universe of investable stocks.
  • The business model survives. After the volatility of the past four years, it seems that almost every week we get some pundit (I guess that’s somebody a bit like me) or journalist questioning or outright dismissing Toyota’s business model and by implication those suppliers affiliated with Toyota. I would say that Toyota has had a tremendous run of bad luck and I understand the temptation to view sustained bad luck as being in some way deserved. I reject that temptation and point to the excellent progress being made by Toyota now that the effects of the recalls, the quake and the Thai floods have been put behind it. Equally, some observers have argued that Toyota is changing its practises to put more pressure on its suppliers. Let’s be very clear about this: Toyota’s major auto parts suppliers already sweat blood; Toyota has never been a soft touch. However, Denso’s record core margins demonstrate that any additional pressure from customers has been small enough to more than offset with higher efficiences.
  • The best is yet to come. One day Denso will regain the level of output it reached back in 2008. That’s a promissory statement and in published research I would not be allowed to say that; compliance requires that I say “in my opinion” or something similar. But I am certain that the day will come when Denso posts record volumes and it will probably sooner rather than later. When that happens, Denso’s bottom line will benefit from the operating leverage associated with those higher volumes and on a like-for-like basis should easily surpass its previous highest ever profit. Exactly what level is and when it is likely to be achieved is something we will cover in our next post on Denso.

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