THK: rapid return to double-digit OPM looks likely

by SR on February 15, 2012

Related stocks: THK (6481 JP); NSK (6471 JP); NTN (6472 JP); FANUC (6954 JP)

  • Orders and the share price. THK is a global leader in products that allow ultra-precise positioning, such as linear motion bearings. As such its orders are driven by capex. As the chart below shows, in the past THK’s share price has generally moved in line with (and slightly ahead of) its monthly order inflows.
  • Return to normality? Having been hit like most Japanese industrials by the Tohoku earthquake and floods in Thailand, it looks as if THK’s business might be returning to normal, which suggests to me that we could see a return to the 13% OPM level that was posted in the quarter just before the quake.
  • Outlook for FY3/13. If THK can claw its way back to the Y50bn per quarter in revenue level, my view is that annual OP of about Y26bn and EPS of Y140 is on the cards, which suggests a target price of Y2,100. However, for such a volatile stock the upside of ~20% is relatively small unless you have a more bullish view on capex for 2012-2013.

Hiwin monthly sales

Orders and markets

A number of Japanese machinery parts suppliers disclose monthly orders to the market, one of them being THK. THK specialises in products that enable very precise movement and positioning, such as linear motion bearings. I estimate that 30-35% of THK’s revenues come from machine tools and machinery, another 15% plus comes from electronics and semiconductor-related and 15-20% comes from the auto and transportation sector. The remainder comes from the distribution channel and sundry other markets.

Share price leads billings

Take a look at the chart above. What surprises me a little is how closely the share price tracks orders (somebody did tell me this was the case but I chose to suspend judgement until I had taken a look at the data myself). The blue line shows the share price, indexed such that the Y2,240 price from 31 October 2003 is 100. The red line shows total monthly orders, also indexed so that the order value posted in October 2003 is equal to 100. Generally the share price moves up and down with the absolute level of orders. This makes sense, as orders are usually converted to sales and for a manufacturing company like this with a high proportion of fixed costs, higher volumes usually translate to higher margins. At turning points in the cycle, such as in early 2009, the share price also leads orders by several months. Again, this makes sense, as the market should anticipate recovery rather than waiting for the recovery to be revealed as fact.

Divergence shows other factors at work

I said “higher volumes usually translate to higher margins” but there are exceptions. Most noticeably, THK’s share price plunged from the middle of 2007 to the end of 2008. In absolute terms the share price fell from more than Y3,000 to just over Y900, which is a dramatic collapse by anybody’s standards. Notice that this took place well before the Lehman shock of September 2008 crystallised the market’s concerns about the global economy. In fact, THK’s orders remained on a gentle rising trend from mid-2007 all the way through to the mid-2008 before crumbling. So the share price seems to have been out of sync with orders by more than a year.

However, in previous posts (like this one on bearings) I have emphasised that while individual tit-bits of information and specific macro and micro-economic indicators can hold useful clues, you can’t interpret these in isolation. There’s always something else involved. The factor that pushed down THK’s share price in this case was pressure on profits due to higher depreciation caused by the ramp of new facilities and amortisation on goodwill related to the integration to the group of a large subsidiary. Hiwin monthly sales THK’s FY3/08 operating profit fell by Y4.9bn to Y26.9bn. Depreciation rose by Y3.2bn over the same period, accounting for most of this decline in profit. The result was that although sales rose by 19.5% in FY3/08, profits fell. Management had in May 2007 forecast 6.9% YoY growth in operating profit for FY3/08, but when first quarter results were announced in August 2007 it became apparent that the reality of earnings was diverging from management’s script. 1Q FY3/08 operating profit fell by 14.9% YoY and this sparked a sell-off that continued up to and beyond the Lehman bankruptcy. Hiwin monthly sales To put it another way, the share price of THK tends to move with orders unless operating leverage – the positive impact on profits of higher volumes – is seen to be temporarily suspended as it was in the second half of 2007 and beyond. It’s worth noting that after the global financial crisis THK’s orders rebounded to new peak levels, but that operating profits remained well below peak. The main culprit was probably the stronger yen, the effective rate of which for THK was floating between 115 and 120 yen to the US dollar in FY3/07 and FY3/08, but had fallen to 94 yen in FY3/10 and 88 yen in FY3/11.

The view ahead

For FY3/12, the effective yen-dollar rate looks likely to come in at 79, so that is one significant change compared to FY3/11. On the other hand, THK has implemented cost-cutting since 2008 that may well be enough to offset the forex if orders recover (this is what we saw in late CY2010). Forex aside, I feel that the environment for THK today looks similar to that of early 2011, before the Tohoku earthquake struck in early March. One could argue that one difference is that the Greek crisis is now front and centre but in both 2010 and 2011 the power of that issue to hold down the share price proved to be limited (for more discussion, see this post).

More a concern for me is the state of capex in China and Japan; neither looks particularly healthy right now. In 2011 the handling of the auto market by the Chinese authorities showed very clearly that the expansion of one particular market will not always be given the highest priority when competing with other ideas, such as the need to control inflation. This doesn’t give me much hope that China will embark on significant fiscal loosening any time soon. However, fiscal tightening was already a concern in early 2011 and yet THK’s share price rose to more than Y2,200.

I think this was a simple calculation by investors who asked themselves the following question: can THK return “close to peak” profitability, as defined by the Y140 in EPS posted in FY3/08, within a couple of years? Probably investors assumed that it could, given that in 3Q FY3/11 the company kicked out Y50bn in revenue and Y6.5bn a 13% margin , so quadrupling that would give Y200bn and Y26bn in sales and OP respectively. Of course, the impact of seasonality means that multiplying any quarter by four is a bad idea, but those 3Q results did hint that on average THK could hit Y50bn a quarter and Y7bn in a year or so, and that would put us at an annual EPS level of Y140. Hiwin monthly sales As I mentioned above, the environment here in February 2012 does not look significantly dissimilar to that of the environment 12 months ago. That suggests that once the impact on demand and production of the Tohoku earthquake and the floods in Thailand has ebbed, THK should go back to pushing out Y50bn or thereabouts per quarter as described above. If we get a surge in semiconductor capex from Intel and Samsung, which seems increasingly likely, that could happen sooner rather than later.

So, if THK can go back to “close to peak” earnings, how much would investors be prepared to pay for a global niche franchise, with experienced management, sustainable operating margins of 15-20% and exposure to the China automation theme? Going by past experience, I would say a forward PE multiple of 15x. That suggests a target price, based on the Y140 in EPS just mentioned, of Y2,100. Add a bit of speculative froth and a share price of close to Y2,500 starts to look possible (maybe not justifiable, but possible).

Today, the share price is a little below Y1,700, leaving a bit more than 20% upside to the Y2,100 we considered as a theoretical target price a few minutes ago. For a volatile mid-cap like this one, that 20% upside might not be enough to tempt me. But if you have a strong view on demand – whether that be in semi production equipment, machine tools or autos – you might feel that even at these levels the stock is attractive.    

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