Denso: upward revision to guidance supports our thesis

by SR on August 2, 2012

Denso guidance revision

Conclusion: auto parts a relative safe haven

Back in June I walked you through a detailed forecast for Denso, concluding that “a significant overshoot is on the cards”. While I prefer not to contribute to the noise of earnings season, I will admit that I was happy to see Denso posting a significant upward revision to March 2013 financial year guidance when it announced its April-June quarter results earlier this week. The Denso revision is shown in the table above and was driven by higher than expected volumes and a powerful operating leverage effect. I believe that this revised guidance will also be beaten (see the section below on the figures for details).

Equally important from a tactical investment perspective has been the contrast with the weak results that have come companies such as construction machinery vendor Komatsu and bearing specialist NTN. In theory this bad news should not have been news – I and no doubt many others have been flagging the weakness in machinery orders for months – but the share prices of both Komatsu and NTN plunged the next trading day. As I said in a recent post, the argument that demand for machinery cannot deteriorate much further is a sensible one, unless China implodes completely. Normally, you would buy these cyclicals before the bad news is still flowing but after the share price has stopped reacting to that negative news flow. Normally, if you wait for concrete, unambiguous good news to come out before buying cyclicals, you will find that the share price train has already left the station. Unfortunately the market is so nervous this year that any failures, shortfalls or transgressions are being punished severely. And that’s what happened to Komatsu, NTN and Sumitomo Heavy.

One more point: although the auto parts suppliers affiliated with the Toyota group generally posted strong figures, the same cannot be said for the Honda group suppliers. Those with more exposure to the motorcycle business appear to have been hard-hit by slowing demand in Indonesia and Brazil and Keihin and Musashi Seimitsu both revised down their full-year guidance.

Denso quarterly sales and operating profit (billion yen)

The figures in brief

As shown in the chart above (click on the chart for a larger image) Denso reported sales of 882.4 billion yen (down slightly compared to the previous quarter) and flat operating profit of 78.2 billion yen. The year-on-year change is meaningless as in Q1 last year the earthquake in Northern Japan caused havoc with production and profits. The operating margin for the quarter came to 8.9%, the highest since the beginning of the global financial crisis in 2008, as you can see from the table below. (Click on the chart for a larger image.)

Denso operating profit margin (%)

While that 8.9% is still below the 9-10% that the company regularly posted between 2005 and 2008, the yen is significantly stronger now at around 80 yen to the dollar rather than the 110-120 range of 2005-2007. In this post on Denso’s margins I show how forex alone has knocked more than 30 billion yen off Denso’s quarterly operating profit compared to the highest ever margin of 10.7% recorded in the October-December 2005 quarter. Here’s a different way of looking at the operating margin over time.

Denso operating profit margin (%)

Guidance is still a bit cautious

Let’s finish with a look at the revised guidance for FY3/13, put in the context of annual sales and profits over the past few years. The implied operating profit margin is 7.2%. There’s plenty of room for improvement there, in my view. For one thing, I expect the full year revenue forecast to be bumped up slightly between now and the end of the year. Secondly, the existing guidance effectively calls for a 20 billion yen decline in profit on flat sales in the second half of the year, that is, in the October to March 6-month period. Well, I can understand that depreciation is back-loaded to the second half and so on, but this still smells of lowballing to me. I’m sticking to my FY3/13 forecast of 3,520 billion yen in sales and 276.1 billion yen in operating profit.

One final point: Denso raised its guidance for capital expenditures by 18.1%, depreciation (very slightly) and research and development expenses by 8.8%. That last point is especially interesting as it is an indicator of new model program activity at customers like Toyota. So, the future still looks pretty bright for this company. If it hits our forecast EPS of 245 yen, the stock would be trading on 10.3x this year’s earnings – not bad for the world’s largest listed auto parts supplier.

Denso annual sales and operating profit (billion yen)

Denso annual operating profit margin (%)

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