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If you believe recent economic reports showing a slowdown in the nation's economy are temporary and that the global growth story remains intact, an earnings report released by Hurco Companies (HURC) late last week point to this Indianapolis-based manufacturer of machine tools as worth considering for your portfolio. The report gives good reason to believe that Hurco's business has almost completely healed from the recent financial crisis and that its future prospects continue to be bright as economies continue to industrialize around the globe. A similar earnings report several weeks ago from Hardinge (HDNG), an industry peer based in upstate New York, had hinted at the result. As we'll discuss later, that company offers another bet on the worldwide manufacturing sector, concentrated in the China market. However, we prefer the higher-margin European market and thus Hurco for our own portfolios.

Like other companies it competes with, Hurco has always provided investors with a way to capitalize on the global growth story. They manufacture machines used on factory floors to cut precision metal parts and by specialty shops that do custom metal cutting. Hurco's products are used by companies in a range of industries, including aerospace, defense, medical equipment, energy, automotive, transportation, electronics and computer equipment. As the global economy expands, so does demand for Hurco's products, which are near the base of the supply chain.

Hurco's Numbers

In an earnings report released Friday, June 3, Hurco said it had turned a profit of $2.3 million, or 36 cents a share, during the quarter, up from a loss of $1.5 million, or 24 cents a share, the previous year. Although those earnings figures were certainly worth cheering (it was their second consecutive quarter of profit following the financial crisis), the real good news could be found in the data Hurco released about new orders for its machinery that it logged during the past three months, which shed some light on the company's future profitability.

According to the report, Hurco said new orders booked for its April 30 quarter jumped 127 percent over the previous year to $72.6 million. To put that figure into perspective, those orders exceeded the $58.9 million Hurco booked in the same quarter of 2008, which represented a pre-global financial crisis peak and reflected a 22 percent increase over the previous year's quarter in 2007. (It should be noted however, that Hurco said some of its 2011 increase was helped by customers trying to buy before a price increase took effect.)

Digging down even further into the new order data from this quarter also gave investors a reason to be optimistic about future earnings and margin growth. Hurco's largest market is Europe, where it sells its most profitable and advanced machinery and operating software. Orders in that region jumped a solid 175 percent during the quarter, to $32 million, the data showed. This should further help the company's profit margins, which rose to 30 percent from 19 percent year over year, as its sales increased and its European sales recovered.

Hardinge’s Numbers

A month ago, Hardinge reported its first-quarter earnings of 12 cents a share, versus a loss of 45 cents a share in the year-ago quarter. Sales jumped 70 percent, helping to drive down SG&A (selling, general and administrative expenses) from 33.4 percent of sales to 22.7 percent. This measure of overhead can be volatile at inflection points of the economic cycle, as additional sales past a certain point no longer require massive investments in staff.

Like Hurco, Hardinge enjoyed an explosion of orders: a 98 percent jump to $114 million, outpacing sales of $73 million. Unlike Hurco, however, Hardinge’s strengths lie in Asia, where sales ballooned 133 percent, North America 81 percent, and Europe coming in last at 60 percent.

Because orders may be canceled at any time, they should not lull investors into complacency.

In the first quarter, its gross profit margin was 26 percent, four points lower than Hurco. As mentioned before, this has to do with the different markets in which they possess comparative advantage.

Hurco

Hardinge

Geographic Region

3 mos. ended 4/30/11

% of Total

3 mos. ended 3/31/11

% of Total

North America

9,137

22%

17,214

23%

Europe

27,297

66%

19,815

27%

Asia Pacific

5,142

12%

36,453

50%

Capital Expenditures and Overreliance on Select Measures

Investors can make the mistake of focusing too much on one or two factors when they analyze companies. For a while, Hardinge had a mountain of cash on its books: $36 million at the end of last year, and total current assets of over $201 million. For comparison, its current market capitalization is approximately $119 million. (See Yahoo! Finance.)

But company management has decided to invest in China to prepare for future growth, after an industry-wide shutdown during the recent worldwide economic crisis. Net cash used in capital expenditures jumped to over $7 million in the first quarter, compared to an influx of $3.3 million a year ago. This combined with seasonal effects caused cash flow to drop from $12.75 million in 4Q 2010 to an outflow of $6 million in the 1Q 2011.

Management expects the new factory in China to triple capacity, and combined with a replacement in Switzerland, to lay the groundwork for more spectacular growth. So this drawdown of cash, combined with another $12.6 million expected for the rest of the year related to these two factories, should not be seen as stop signs for investors. However, cash flow will likely be negative for two or three more quarters. Two more quarters at the current rate could reduce cash on hand to the level of long-term debt. Investors who had jumped in purely based on cash levels, perhaps thinking the shares were a safe bet, have suddenly found themselves relying on growth rather than pure value to justify the value of the stock.

Similarly, investors should not be too enamored by Hurco’s practically debt-free status. As small companies, any major construction project could easily impact cash flow and the balance sheet. Of course, being debt-free does provide a buffer for unexpected shocks, and is another reason we feel comfortable with the company.

Market Reactions and Concerns

How good was the news in the recent earnings report? Although Hurco's earnings were released on a day when the Dow Jones fell 97 points or 0.8 percent, the company's stock still managed to close at $30.47 a share, up 3.3 percent from the previous day, and less than 22 cents off its high for the day.

Hardinge’s stock has not fared as well in the month since its most recent earnings release. Shares jumped to $12.50 in the hours after the release but has since fallen about 17%.

Given concerns over a global slowdown that have emerged recently, there are reasons to be wary about investing in a company like Hurco whose fortunes rise and fall with the world economy. Recent economic reports have shown some weakness across the globe, with the U.S. unemployment rate ticking up, German manufacturing expansion slipping to its lowest level in 6 months, and reports showing that brakes that China's leadership has placed on their economy are beginning to temper that nation's rapid economic growth.

However, if you believe, as some analysts have concluded, that recent economic weakness will abate as some recent shocks, such as the Japanese earthquake and tsunami and revolutions in the Middle East, filter their way through the system, then Hurco may be just the kind company to invest in to take advantage of the ongoing industrialization lifting economies around the globe.

Source: Precision Profits From Manufacturers of Machine Tools