THK Struggles To Translate A Great Business Into Great Financials

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About: THK Co., Ltd. ADR (THKLY)
by: Stephen Simpson, CFA
Summary

THK is a world leader in components that are critical for producing precise and consistent motion in machinery like robots and semiconductor tools.

The company's expansion into automotive components opens up much larger end markets, but the margins and long-term returns for component manufacturers are not generally attractive on a long-term basis.

THK shares don't seem overpriced, but the 60% move seems to reflect a lot of the expected end-market improvement and the company's margins and ROICs don't inspire tremendous confidence.

In a lot of meaningful ways, Japan's THK (OTCPK:THKLY) is a great company. The company's linear motion systems are mission-critical components for machinery like robots, machine tools, and semiconductor tools that demand precision and reliability, and the company still enjoys roughly 50% global share. On the other hand, THK has struggled to translate that leadership into attractive margins, growth, or returns on capital, and in many cases, customers like DMG Mori (OTCPK:MRSKY) and Applied Materials (NASDAQ:AMAT) have been the better choice for investors.

I'm not optimistic that there will be a profound change for the better on the way. While THK should see an improvement in the machine tool and machinery end markets, competition is rising from component manufacturers in China, Taiwan, and other countries. What's more, I don't think the company's diversification into auto components is likely to build upon the margins and cash flow generation capabilities. THK shares don't seem unreasonably priced on an EV/EBITDA basis, but the cash flow valuation is not compelling and the 60% move from the lows of the past year seems like adequate compensation for the improving end market outlooks.

Well-Established In A Mission-Critical Space

THK is the established and entrenched leader in liner motion guides, which establish the positioning accuracy of the device or system they're in. In machine tools, linear motion guides move the cutting tool. In injection molding machines, linear motion guides position the dies. In robots, linear motion guides allow for precise and consistent movement of the robotic arm(s), and they also provide guidance for measuring equipment. In addition to linear motion guides, THK manufactures related products and components like actuators, ball screws, ball splines, and so on.

There are a range of products and end markets that need such precision, and the market THK serves seems to be worth around $3 billion a year. Machine tools make up around 20% to 25% of the market, and "general machinery" accounts for another 30% or so. Electronics contributes another quarter or so of this segment's sales, with linear motion products featured in many semiconductor and flat panel tool systems. There are additional markets that THK serves, including aerospace, and finding new market opportunities outside its core machine tool/machinery markets has been on management to-do list for over five years.

THK's product quality has allowed it to establish a very strong market presence. THK has roughly 50% market share, and 70% share in Japan. NSK (OTCPK:NPSKY) is a credible rival with around 15% share in Japan and the world as a whole, while Nippon Thompson and SKF (OTCPK:SKFRY) are more limited as head-to-head competitors. Taiwan's Hiwin has been on the way up, and already has established double-digit share in part by offering competitive products at meaningfully lower price points.

That price/performance trade-off is becoming a more pressing issue as China rises as a more significant player in machine tools and precision equipment. The percentage of revenue that THK generates in Asia has grown close to 10% over the past five years or so, but the company has had some share challenges in China due to competition from lower-end products that customers are deeming "good enough". THK is trying to expand its range of lower-cost standardized product to regain some momentum, but it is also worth noting that as Chinese businesses try to compete more on a head-to-head basis with Japanese, American, and European rivals, they are increasingly willing to use higher-end components, or at least for export markets where precision and reliability is a more important competitive factor.

Auto Components Is Less Attractive In Some Respects

THK has acquired its way into a meaningful presence in auto components with a revenue contribution around 40%. In many cases, THK has sought out component businesses that play to its corporate focus on higher-end, precise components that can't fail. With that, the company plays in areas like tie rods, steering linkages, ball joints, stabilizer conrods, linkage load sensing valves and so on.

I think THK has bought credible businesses, but it is not as though auto components offer non-cyclical growth or consistently attractive margins and returns. It's a competitive cyclical business and one where OEMs tend to serially pound and pressure component suppliers for concessions. All told, I find it an odd and questionable use of capital that THK went in the direction of auto components instead of adding other highly-engineered industrial machinery components.

The Opportunity

The biggest near-term opportunities for THK are in market recoveries in semiconductors/flat panels and machine tools. Orders in Japan recently showed growth for the first quarter in about two years, while growth was strong (in local currency) in China, Taiwan, and the Americas. Much of this growth is being driven by the semiconductor/flat panel market, where fabs are buying new tools and OLED manufactures are ramping up production capacity. In the Americas, at least, THK is also seeing good demand in the medical space (where linear motion products are used in applications like imaging).

The machine tool market seems to be bottoming in markets like Japan, the U.S., and Europe, but it's not really recovering yet. Machine tool demand is picking up in Asia, though, largely in response to anticipated smartphone production demands.

A broader industrial recovery should support better growth in the machine tool and machinery markets in the coming years. That said, I think THK's ability to find new business/markets will be balanced by ongoing competitive pressure from component manufacturers in markets like China. Likewise, while I think machine tools and machinery will recover, I don't think the long-term growth outlook is likely to be much above 3% to 4%. All told, I think THK can generate mid single-digit long-term revenue growth and improve upon its FCF margins sufficient to support double-digit growth. That said, the company has struggled to establish any real upward trajectory in operating margins or returns on capital and I don't see that changing.

The Bottom Line

THK could still have some upside on the basis of forward EV/EBITDA valuation, but the free cash flow outlook is less encouraging. I don't think the shares are dangerously overpriced, but I think the move from the lows already reflects the improving market outlook(s) and I have real questions about management's ability to drive sustained improvement in margins, ROIC, and cash flow, as well as its priorities for allocating capital. With that, I think this is a case where the company and its products are more interesting than the stock. For those investors who are more interested in THK, the U.S. ADRs are reasonably liquid, but, of course, the domestic shares offer even better volume (albeit with the added inconvenience that goes with trading on foreign exchanges).

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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