Komatsu Acting Like The Worst Is Over

| About: Komatsu Ltd. (KMTUY)
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In acquiring Joy Global for nearly $4 billion in cash and assumed debt, Komatsu would seem to be signaling its faith that the worst is over in the mining sector.

Joy greatly expands Komatsu's mining product range, offering new exposure to underground mining, complementary above-ground assets, and significant potential for automation and integration.

KOMTRAX data has been surprisingly positive in China this year, suggesting the worst may be over in the Chinese construction market.

My base-case scenario has the Joy deal adding almost $3/ADR to Komatsu's fair value, but the next few quarters will be rough and the real gains are years away.

Shares of Japanese construction and mining equipment giant Komatsu (OTCPK:KMTUY) have been stronger over the past six months than I would have expected. While I thought the shares were worth around $17 to $19 back in January, I thought prolonged fretting about the health of China's construction sector and the global mining industry would have been a bigger headwind.

As it turned out, China has shown signs of a turnaround in construction equipment demand, and that is a significant swing factor for sentiment on Komatsu. What's more, there had been some signs of stability in some of the larger end-market materials for the company's mining business despite the company's repeated outlook that results likely wouldn't start improving (and even then, slowly) until 2017.

The biggest confidence-boosting move, though, may be the most recent. Last week, Komatsu announced an acquisition that had been long in the making - bidding nearly $4 billion to acquire American mining company Joy Global (NYSE:JOY). While an acquisition like this is certainly no guarantee that the mining sector demand will improve, it is a mark of confidence on the part of Komatsu management and it does open the door to meaningful product and financial synergy. If Joy Global's recovery can bring in $3 billion or more of revenue in 2020/2021 at double-digit margins, I believe this deal adds nearly $3/ADR in fair value, while the "no recovery" scenario would put about $2 of value at risk.

A Marriage Long In The Making

Komatsu and Joy Global have been a "will they or won't they?" story for close to five years, with Komatsu having acknowledged interest back in 2012 but electing not to go forward. Ever since, and particularly as the mining equipment correction gained steam, there have been periodic rumors and speculation as to whether Komatsu would take another look at a deal that would greatly expand Komatsu's strong, but limited, mining equipment portfolio into rope shovels, draglines, and a host of underground equipment.

Komatsu announced an all-cash bid for Joy Global last week, valuing the stock at $28.30. That was a 20% premium to the prior day's close and a roughly 50% premium to the 90-day average during which a lot of mining and construction-related stocks have been pretty strong. While there has been some speculation that there could be resistance to the bid from institutional investors who would still be underwater at the bid price, I don't think a rival bid is particularly likely so those investors will have to decide whether they really want to agitate for a go-it-alone strategy and more of a boom-or-bust return prospect.

How Komatsu Benefits From The Deal

To Joy Global's credit, the company has been running itself pretty well through this downturn - free cash flow has stayed positive and it looked as though operating income (excluding restructuring costs) could have bottomed without going into the red as well. What's more, the company has been expanding into new lines of business - expanding its hard rock mining capabilities and targeting India as a growth market.

For its part, Komatsu is getting a market leader in underground mining equipment - an area of mining that Komatsu had no exposure to previously. While underground mining is capital-intensive and costly, it is still a significant part of the mining industry (50% or more for some resource types) and it can be very cost-effective when done right. Although Komatsu will still be primarily an above-ground mining equipment company, it can now compete with Caterpillar (NYSE:CAT) (and to a lesser extent companies like Atlas Copco (OTCPK:ATLKY) and Sandvik (OTCPK:SDVKY).

Komatsu will now also have the opportunity to integrate and drive synergies between the two companies' product and technology capabilities. As Komatsu highlighted in its presentation, there's a good overlap between Joy's wheel loaders and shovels and Komatsu's trucks. Komatsu is also no doubt interested in what it can do from an automation perspective.

A pilot automation project with Rio Tinto (NYSE:RIO) delivered a double-digit reduction in crash-related costs, and Komatsu has been using IoT deployments to significantly reduce on-site fuel costs for above-ground customers. Given that Joy's customer base skews toward high-cost producers, the potential cost savings from Komatsu's automation solutions could be significant.

Komatsu also benefits from not seeing another rival get Joy. I don't think Atlas or Sandvik was ever going to bid for Joy, but a Chinese mining equipment company could have and would have no doubt looked to leverage Joy's established international distribution. With Joy taken off the board, Komatsu likely reduces the prospects of a Chinese-based company becoming a bigger global competitive threat.

Of course, the deal also carries risks for Komatsu. Assuming the deal goes through, there is still the fact that nearly 40% of Joy's business comes from thermal coal and another 20% from met coal. While met coal may be bottoming (and so too copper, which is about 20% of Joy's business mix), thermal coal may be looking at long-term struggles, even as it still represents a large portion of the energy generation of both the U.S. and China. Moreover, synergies are not always easily obtained and it could take several years for Komatsu to develop integrated automation solutions suited for Joy's underground business.

Some Signs Of Life

Even without the Joy deal, there were some signs of market improvement that were boosting sentiment around Komatsu. The June KOMTRAX numbers (a measure of equipment time in service) was up 1%, with China up over 10%. The China KOMTRAX numbers have been positive all but one month this year (January), and that's an encouraging sign for excavator demand. To that point, Komatsu has been seeing double-digit excavator sales growth in recent months, albeit off a greatly reduced base. To be fair, both Caterpillar and Hitachi Construction Machinery are also seeing the turnaround, so it's not unique to Komatsu.

Knowing exactly what's going on in China is never easy. For its part, Komatsu spoke earlier this year (in late March) about a significant decline in building permits and customers stretching out equipment service lives (in some cases to double previous levels). Management has also talked of its expectation that mining equipment demand won't really start to recover until next year and that this current fiscal year is likely to see the first single-digit operating margin in over six years.

On the other hand, the company's automation-driven fuel efficiency efforts are resonating with mining customers (that are desperate to cut operating costs) and there are some signs that copper may be stabilizing.

For my part, I think this is a case where the market is already anticipating and pricing in the bottom. The numbers themselves are still going to get worse before they get better, but Wall Street generally looks ahead. I would also note, though, that the KOMTRAX data for Japan and North America have been consistently negative this year (Europe has bounced between negative and positive), so I think it is premature to say that Komatsu (and Caterpillar) is out of the woods yet.

The Opportunity

If Joy Global can reach $3.5 billion to $4 billion in revenue in 2020-2022 with double-digit margins, I see this deal adding about $4 to Komatsu's fair value. On the other hand, if Joy's sales continue to bump along around $2.4 billion, the deal would strip away about $2/ADR of value. My base case is that Joy Global gets back to $3 billion around 2021, but that Komatsu does a good job of driving cost synergies and over time is able to use automation and integration to boost sales further and gain share.

That scenario adds just under $3 to my fair value, bringing the range up to around $20 to $21.50. This scenario assumes nearly 6% long-term growth (spiked by the deal) and a similar level of free cash flow growth, along with a low double-digit long-term ROE.

The Bottom Line

Up about a third since my last piece, Komatsu shares have already done pretty well (and CAT has done just as well). There still seems to be some upside here, but I do wonder if there will be a point where optimism about a recovery in China is outweighed by the ongoing struggles in Japan and North America.

Komatsu looks okay as a long-term holding today, but the next few quarters of financials could be underwhelming and there is that commodity price risk to consider. A pullback closer to $18 would be a more exciting entry point, but I don't know that we're going to see that soon if China remains on an improving trajectory and commodities don't roll over.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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