To start with, I think Komatsu (OTCPK:KMTUY) is one of the better-run heavy machinery companies in the world, and I think the company's strategy to differentiate itself with technological innovation (particularly in automation) is a very good move. That said, the stock has notably lagged Caterpillar (NYSE:CAT), Joy Global (NYSE:JOY), Terex (NYSE:TEX), and Atlas Copco (OTCPK:ATLKY) over the past year, and I don't necessarily think that Komatsu is a great catch-up trade today.
One of the things that concern me about Komatsu relative to Caterpillar et al is the business mix. Specifically, Caterpillar gets more than a third of its revenue from North America (Joy Global gets more than 40%, and Terex gets more than a quarter), while Komatsu gets less than 20% of its revenue from North America. Instead, Komatsu generates more than 20% of its revenue in Japan, and demand there for construction equipment is expected to decline by 15% or more this fiscal year on weak housing starts and sluggish civil demand. That's going to sting a little more for Komatsu, as growing construction equipment demand in North America supports better performance for Caterpillar, Terex, and others.
Komatsu is also pretty close to a pure play on construction and mining equipment. Caterpillar generates a substantial portion of its earnings from its power gen and transportation businesses, Terex gets about 45% of its business from outside construction and quarrying, and Atlas Copco has its compressor and industrial power tools businesses.
Has Mining Hit Rock-Bottom?
When Komatsu gave guidance for fiscal 2015 a few months ago, management estimated that the global mining equipment market was going to shrink to about 2,000 units - below 2003/2004 levels, and down about 70% from the peak. That broadly corroborates the peak-to-trough guidance given by Atlas Copco and Sandvik, and like these other companies, Komatsu is not looking for a sharp rebound in equipment demand, even though replacement demand (machinery lives run about six-to-eight years) should start to pick up.
This is a very tough period, but I still like the Komatsu mining business. About 70% of revenue comes from parts and service, and that should support revenue going forward, unless mining output starts to decline. Komatsu also seems to be in tune with the evolving needs of its mining clients - the company has invested considerable resources into hybrid engine technologies and automation, including remote-controlled trucks and bulldozers, and larger miners are increasingly looking to automation to reduce costs.
I am also cautiously optimistic on Komatsu's end-market exposures. Where Joy Global is heavily exposed to coal, Komatsu generates about half of its mining business with copper miners and another 30% from iron ore miners. I have some concerns about iron ore, but I'm bullish on copper over the next three-to-five years, so I think Komatsu's exposure will be a positive in its recovery efforts.
Construction Looking At A Slow Build
When it comes to Komatsu's construction business, it is even more exposed to Japan (almost 30%), with Asia (16%), China (12%), and North America (18%) also figuring prominently. Unfortunately, the news for the first three of those has been generally poor.
I already addressed the weak outlook for Japanese construction equipment, but Chinese demand has so far underwhelmed this year, with May excavator unit volume down 21% (though still better than the market as a whole, which declined 31%). Komatsu has around 10% share of the Chinese market, just ahead of Caterpillar, and close to 20% share of foreign sales, but growing domestic sales remain a threat. An even bigger threat in the present is the credit market in China, where local governments are struggling to finance projects.
Asia, ex-China and Japan, is also pretty uninspiring. Komatsu has a good position in the Indonesian market, but activity has slowed. Thailand, too, has slowed due to the recent political unrest, though Komatsu is doing better than United Tractors in terms of unit volumes.
Demand recovery in China and Asia should be a "when, not if" situation, but Wall Street isn't famous for waiting patiently for markets to recover. In the meanwhile, Komatsu is looking to increase its presence in the U.S. construction market, but it is going to face significant competition from established players like Caterpillar that need to drive their own earnings recoveries.
Estimating Growth And Value
I expect both Komatsu and Caterpillar to generate long-term revenue growth in the neighborhood of 4%, with FCF margins in the mid-high single digits. I do think Komatsu has an edge in terms of its market positioning in China, Indonesia, and other Asian markets, as well as an edge from its technology investments, but Caterpillar also has better diversification outside of mining and construction. All of that said, I'm not a big fan of discounted cash flow analysis with these highly cyclical companies - full-cycle analysis can get you in the ballpark, but the specifics will always be harder to pin down.
EV/EBITDA has the downside of only considering the next year out, but sometimes, that's about all you can reasonably forecast in highly cyclical businesses. Komatsu has traded at a forward EBITDA of 9.5x over the last five years, and shaving a half-point from that still suggests a fair value of $25 on the ADRs. The company's ROE (both recent history and projected for the next 12 months) likewise suggests double-digit undervaluation on the shares.
The Bottom Line
Given the greater exposure to North America for Caterpillar and Joy Global, and the greater diversification at Terex and Atlas Copco, I'm not surprised that they have outperformed Komatsu over the past year. I don't believe that this underperformance is unfair given the challenges in China, Japan, and other Asian countries, and so I don't expect Komatsu to quickly close that gap unless conditions in those areas change fairly significantly.
While I think Komatsu's underperformance is reasonable, that doesn't mean I'm completely down on the shares. I do think the shares trade a little too cheaply today, and I think the company is a good way to play a more bullish outlook on mining and/or construction activity in Japan and China.
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