I can't really complain about the post-election performance of Hurco (NASDAQ:HURC), as this small manufacturer of machine tools has seen its shares rise almost a third since the election. That's not out of line with what many smaller industrial-focused names have seen, as fellow machine tool company Hardinge (NASDAQ:HDNG) is up close to 30% since that time and welding equipment manufacturer Lincoln Electric (NASDAQ:LECO) is up more than 20% while the much larger (and less U.S.-focused) DMG Mori (OTCPK:MRSKY) is up around 15%.
I believe Hurco can still look forward to stronger economic conditions in both the U.S. and Germany, and the company should start to see even more benefits from its 2015 acquisitions of Milltronics and Takumi now that it has used a recent industry trade show to reintroduce and relaunch the brands. I'm not expecting Hurco to get back to the pre-2008 experience of gross margins in the mid-to-high 30%'s and operating margins in the mid teens, but I do expect the company to modestly outgrow its sector and generate solid consistent performance, supporting a fair value closer to $40 today.
A Solid End To A Challenging Year
Hurco seemed to get more of a bump from the International Manufacturing Technology Show this year than I'd expected, as sales in the Americas region (which is largely the U.S.) rose 8% to over $27 million. That helped offset weaker results in Europe (down 2%, and about 10% lower than I'd expected) and allowed the company to post 3% constant-currency revenue growth for its fiscal fourth quarter.
Gross margin was slightly better than I'd expected, and up about half a point, but a little disappointing to me relative to the revenue beat. Operating income was down about 24% from the year-ago period, with a 250bp drop in operating margin, largely due to higher spending tied to that major trade show.
While the company has not published its 10-K or a full cash flow statement, it would seem that it posted modestly negative free cash flow for the year (as I expected).
Will 2017 See The Start Of A Meaningful Upturn?
A lot of investors are already placing their bets on a significant improvement in industrial end markets in 2017, and that would certainly be good news for Hurco. While Hurco's more specialized focus relative to DMG Mori and Hardinge makes it a bit tougher to benchmark and forecast vis-a-vis macroeconomic indicators, the fact remains that a healthier industrial economy is a net positive for the company's outlook.
Orders were up 11% in constant currency for the fourth quarter, but order levels are only modestly predictive of future results. Orders jumped in the Americas, up 32%, which I attribute partially to pent-up demand going into the IMTS show (customers didn't want to order until they saw the new products on offer), but also at least in part to stabilizing markets in the U.S. and good customer response to new products from Hurco. Orders in Europe were down 10%, which bothers me a bit, while orders soared (up over 100% in constant currency) in Asia.
Conditions in the U.S. continue to be choppy. Quoting and order activity in the metalworking space seems to be improving, with aerospace and medical looking pretty healthy, oil/gas looking more stable (if not somewhat better), and ag and mining still in rough shape. Auto is also looking pretty healthy, which is key for the machine tool space as it is a major end market. All of that said, machine tool orders were down in November (down 1.3% yoy), Gardner's metalworking index has spent September through November hovering just below 50, and some contacts have attributed rising orders post-IMTS to more aggressive pricing concessions from tool companies.
Europe is likewise a mix of good and bad. While the German manufacturing PMI was at its highest level in 35 months in December (55.6), third-quarter domestic machine tool orders were still down 14%. Overall, though, it looks like manufacturing is in decent shape in Germany, and there's more optimism in markets like Italy as well.
All of this gives only a hazy sense of Hurco's near-term prospects. Unlike Hardinge and DMG Mori, Hurco is more focused on short-run, high-spec production (including things like prototypes) that doesn't always correlate well with overall trends. Still, I think the arrow is starting to turn up. What's more, the company was busy at the IMTS show. The company made an official release of Takumi CNC machines for the North American market (using Fanuc controls) and relaunched the Milltronics brand with new models featuring new controls. That's not a trivial detail, as superior controls and software is a big selling point for Hurco.
The company also featured some newer products like its BX40i double-column CNC machine, its VC600i cantilever machine, and its 3D print head adapter. I don't think 3D printing will revolutionize Hurco's prospects, but the idea of being able to do 3D printing with existing machine tools is pretty cool and an incremental opportunity for the company as 3D printing becomes more commonplace on factory floors.
I continue to look for Hurco to slightly outgrow its served markets and gain share with its focus on high-quality specialized systems. The machine tool market is extremely fragmented, and it won't surprise me if Hurco uses its healthy balance sheet to make additional deals in the future - acquiring its way into specific end-markets or geographies, or buying another tool cool with specialty capabilities (like machining harder specialty alloys).
On its own, I'm still looking for mid-single-digit revenue growth from Hurco, around 1% to 2% above the underlying market growth rate, with high-single-digit growth in the upcoming recovery years. I don't really expect major improvement in margins from here, as I think the lower-margin mix of Takumi and Milltronics will weigh down overall margins (and will not be entirely improvable), but I do believe the company can produce double-digit operating margins in the coming years and mid to "mid-high" single-digit FCF margins.
Discounted back, those cash flows work out to a fair value of about $38, even when using a low-double-digit discount rate to reflect the risks from cyclicality, competition, and a heavy skew of sales to markets outside the U.S. Looking at EV/EBITDA, I use an 8x multiple on my 2017 EBITDA estimate (to reflect my expectations of high-single-digit EBITDA growth from 2017 on), and that drives a fair value in the low $40s.
The Bottom Line
There's room for Hurco to exceed these projections, as cyclical recoveries can certainly overshoot expectations on both the high and low sides of the ledger. Likewise, Hurco could have more success than I presently expect with its margin improvements and operating efficiency, though machine tool companies do typically have to keep a meaningful working capital investment in inventory to serve client orders. In any case, Hurco is still an appealing holding for me as a play on better conditions in the industrial sector. While Hardinge may offer more upside, I think Hurco is the better-run company, and I think it has a better long-term plan with its focus on high-spec/low-volume markets.
Disclosure: I am/we are long HURC.
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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