Companies appear to be opening their wallets for capital investment once again, and that has been very good news for DMG Mori (OTCPK:MRSKY) ((6141.TO)). This Japanese (and German) leader in the machine tool space has seen its share price almost triple from its early 2016 lows and rise almost 80% in the last year as the company starts to leverage its strengths into an improving order cycle.
With 2017 being the first year of growth off a trough, DMG Mori ought to be looking forward to at least a few more years of solid order growth, fueled by underlying drivers that include a need to replace aging machinery, a need to automate to remain cost-competitive and deal with a skilled worker shortage, and new technologies. Even so, the strong run in the shares has already captured a sizable chunk of the value, and I would note that analysts don't seem ready to believe that this cycle will be as strong as past cycles.
DMG Mori is more richly-valued than Hurco (HURC) (which I own), and there are valid reasons why it should be - it's the largest player in the field, and it has exceptional scale and operating leverage, among other reasons. What's more, there would seem to be room for analysts to raise their expectations in the future if this cycle matches prior upswings. That said, a lot here is riding on the overall health and growth of global manufacturing, so the current spread between the share price and fair value isn't as robust as I'd like.
I would also warn U.S. investors that the ADRs for DMG Mori are not liquid at all. The Japanese shares, however, have no such problem and are a better option for those investors able and willing to go to the added trouble.
Ready To Run
The past few years have not been easy ones for the machine tool industry. While some sectors, namely auto, continued to invest in new equipment, others like aerospace, energy, and "general industrial" cut back sharply on their tool orders. That didn't hit DMG Mori as hard as others (the company's orders grew in 2016 versus an industry decline), but it still made for a challenging operating environment.
Now that order trends have turned positive, if not sharply positive in recent months, in the U.S., Germany, and Japan, DMG Mori should be looking at its first real opportunity to flex its new strengths in the market.
DMG Mori is the combination of Mori Seiki (a Japanese leader in lathes and multi-axis tools) and Gildemeister (a German leader in metal-cutting machines, especially in multi-axis machines). The process of consolidating Gildemeister has taken time, but the end result is the world's largest tool maker, with a focus on high-end machinery and broad exposure to Japan, Germany, and the U.S. (roughly half of the business).
Combining these two businesses has allowed DMG Mori to focus on "the best of the best" that each company can over, which is saying quite a bit given the strengths of the two companies prior to the deal. It has also allowed the company to streamline - the combined company has gone from offering around 300 models to less than 200, and will likely get into the 150-100 range soon. This has simplified procurement and manufacturing, as well as reduced the overall level of marketing support needed by the business.
Now that order growth has really picked up (up 37% in the last quarter alone), the synergy benefits are starting to show themselves as well - operating income returned to the black in the third quarter, with 17% sequential growth off a second quarter that saw over 300% yoy growth. As orders flow in, DMG Mori should see more gross margin benefits from its more streamlined product offerings and better leverage its sizable sales overhead; selling more advanced 5-axis and multi-axis tools requires a more active and engaged sales effort and it is hard to scale that down when order activity declines.
Opportunities To Grow
I do not believe that DMG Mori is just a cyclical machinery story, although the company is well-placed to benefit from this cyclical recovery. About a quarter of the company's business is "general manufacturing", and DMG Mori should also benefit from the growth that is coming out of the aerospace sector as major OEMs work to meet their order books. As the largest player, DMG Mori has relationships with some of the largest manufacturing companies out there, so when major machinery companies are investing, DMG Mori should benefit.
Beyond the cyclical story, there are other trends to consider. First, more and more companies are automating and making increasing use of more and more sophisticated machine tools. Some of this is driven by cost and productivity, but a lot is also driven by the simple fact that skilled machinists are getting harder and harder to find - 5-axis and/or multi-axis machines can make up for a lot of machinists. As 5-axis tools are still under-penetrated in Japan (and somewhat underpenetrated in the U.S. as well), driving wider adoption of these more sophisticated tools can be a significant growth driver. DMG Mori is also leveraging emerging opportunities like IoT and designing tools that can be better controlled and integrated into comprehensive automated factory systems.
DMG Mori is also moving aggressively on additive manufacturing. Many machine tool companies have added additive manufacturing capabilities (including Hurco, Mazak, and Okuma), but DMG Mori has been assembling multiple technologies (including nozzle-style powder technology and bed-style selective melting) to offer a wider array of additive manufacturing options. Given how quickly some companies in sectors like aerospace and medical devices are moving towards additive manufacturing (versus traditional machining), I believe these investments will pay off for DMG Mori as customers look for machine tools that provide both efficiency and flexibility.
I also look for DMG Mori to leverage its scale on the service and marketing side. About 30% of the company's revenue already comes from services and that is not trivial to me. The sales effort for advanced tools is considerably more involved than for basic lathes or simple machining centers, and smaller companies in many cases simply cannot afford the same level of sales and service detail. I would note that Mori Seiki and Gildemeister (prior to becoming DMG Mori) were both able to charge very healthy prices for their tools - not only because they were good, but because of the strong service backing them. To that end, the company has been increasing its focus on direct sales and I believe leveraging more of its marketing muscle will produce benefits for the company down the line.
There are certainly risks to consider. First is the overall health of the global economy - machine tool orders have rebounded nicely, but there are no guarantees when it comes to the multiyear outlook for global growth. Past trough-to-peak cycles in the tool industry have typically lasted four to six years, but that is a trend, not a promise. If there were to be a shock to the global economy (most likely political/military issues leading to an oil price spike), you can forget about past history as a useful guide.
There are also industry-specific risks in play. Chinese and Korean companies continue to try to build their presence in the machine tool space; while they historically have not been competitive at the high end, that can change quickly (as companies in a range of industries have learned). The industry is also looking at a significant future headwind in the auto sector (a major customer for machine tool companies) - the switch from internal combustion engines to EVs will take away a lot of tooling work (engine blocks, bearings, transmission parts, etc.) that won't be offset by demand for electric motors and dies/molds. That's likely a seven-to-ten year risk, but it is a risk all the same.
The next couple of years should be healthy ones for DMG Mori, after which the question of whether this is a shorter recovery cycle or a longer one becomes much more pressing. I'm modeling long-term revenue growth of around 4%, but it's definitely important to keep an eye on those order trends as these stocks don't trade on long-term growth targets. On the margin side, I expect significant margin leverage over the next three years as the company really sees the benefits of its combination and the synergy moves it has made. While FCF margins could peak in the high single-digits in good years, I expect a long-term run-rate more in the mid-single-digits.
The Bottom Line
Valuation is not everything you could hope for. The shares look a little undervalued on discounted cash flow and a little pricey on EV/EBITDA (the opposite of what I find with Hurco). The difference is not large, though, and I think there's a little upside (around 5% to 10%) even if this recovery cycle is on the short end of historical averages. I do think I'm using relatively conservative assumptions, though, so if manufacturing activity in Japan, Germany, and the U.S. grows more than I expect and DMG Mori executes better than I currently model, there is definitely room for upgraded expectations. With that, while DMG Mori has already had a very good run on renewed enthusiasm for manufacturing, there could still be a few laps left before it is time to head to the sidelines.
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Disclosure: I am/we are long HURC.
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