As often happens with companies that serve deeply cyclical end-markets, the timing and magnitude of the swings in Komatsu's (OTCPK:KMTUY) end-markets have defied expectations. While improving construction and mining markets have been part of the Komatsu story for a while now, the strength of the recoveries (especially in mining) has exceeded expectations, as has Komatsu's operating leverage and execution.
With major mining companies only starting to reinvest in equipment and plenty of room to grow in automation-driven investments, I believe Komatsu could still offer some upside from here. The shares aren't cheap on a free cash flow basis, but that's not all that unusual and a forward multiple in line with long-term averages suggests 10% more upside from here with the possibility of further upward revisions.
Mining Getting Better And Better
The strength of the mining recovery at Komatsu continues to surprise to the good, with overall revenue up 53% in the last quarter and 50% organic growth in the underground mining operations (the former Joy Global operations), and even stronger growth in original equipment sales. Profitability is also coming along nicely, with double-digit margins in the mining business and ongoing volume-driven leverage.
The strongest recovery market so far has been the coal market, with Indonesia and Australia particularly strong as China's appetite for commodities returns. Gold mining, too, has been strong in areas like the U.S. and Russia. Equipment orders for copper mining appear to be just starting to recover, while demand tied to iron ore remains sluggish.
All of that is fine and broadly consistent with what other players like Caterpillar (CAT), Atlas Copco (OTCPK:ATLKY), and FLSmidth (OTCPK:FLIDY) have been saying. Given the size of the copper market, I believe the signs of recovery here are very encouraging for Komatsu's near-term prospects. I'd likewise note that most companies supplying the mining industry have been saying that the major international operators are only just starting to open up the purse strings for new equipment, suggesting that this recovery cycle could still have some room to run.
The Automation Story Still Matters
Automation has been an important part of Komatsu's outlook for some time, and that is not about to change. If anything, the drive toward automation is one of the key components to Komatsu today.
First, I think it is important to understand that Komatsu is both a provider of automation and a beneficiary. The company uses its KOMTRAX operating hour tracking capabilities to dynamically adjust production schedules for its construction equipment, making its lines and plants more efficient and better matching supply with anticipated demand.
Komatsu has also been adopting industrial IoT technologies to run its plants more efficiently. By better coordinating production, Komatsu needs less production equipment and management believes that this will ultimately lead to reductions of 30% to 50% in the volume of machine tools and robots it needs to run its production lines. This is an aspect of industrial IoT adoption that hasn't gotten nearly as much attention and it's certainly a data point to consider when evaluating companies like Fanuc and DMG Mori in the future.
On the customer-facing side, Komatsu's automation efforts are driving more and more deliverable improvements for customers. Autonomous trucks (and other equipment types) have been around for a little while now, but the LANDLOG and TRUCK VISION opportunities are just emerging on the construction side. LANDLOG collects data throughout the survey, design, construction, and maintenance stages from all kinds of sources (survey equipment, drones, construction machinery, etc.) to help create real-time plans and reports, allowing engineering and construction firms to maximize the machinery they have, minimize down time, and better coordinate the entire process (including scheduling deliveries of supplies/components).
As time goes on, I expect automation to become more and more important in both Komatsu's construction and mining businesses. Japan is already suffering from a shortage of trained and experienced construction workers and automated systems can help compensate for those labor deficits. Likewise with mining - experienced miners are aging out and labor costs are rising significantly, making automated equipment and more coordinated planning increasingly important to the bottom line.
In The Meantime…
In addition to the aforementioned recovery in mining, Komatsu's construction equipment business seems to be on an improving trajectory. The monthly KOMTRAX numbers jump around a lot, but operating hours have been trending higher across the company's major markets. Japan is likely to see ongoing healthy demand in the lead up to the Olympics, while China's commercial and residential property markets seem to be healthier and the country seems to be accelerating investments into infrastructure projects. Local competition, not to mention competition with Caterpillar and Hitachi Construction Machinery, is still a factor, but Komatsu still holds a mid-teens share of China's excavator market and markets like Indonesia continue to offer attractive growth.
New Growth Opportunities
Komatsu management is also targeting new growth opportunities to expand the business. Forestry is currently a small business for Komatsu (less than 5% of sales), but it is a sizable market (around $5 billion a year) with decent growth characteristics and where management thinks it can grow its 15% market share. Deere (DE) is the biggest publicly-listed competitor, but Komatsu could at some point consider a bid for a smaller company like Tigercat - Komatsu doesn't do that many deals, but they are willing to go that route to acquire technology and/or improve its sales network.
The Opportunity
With the mining recovery coming on faster and stronger than expected, not only have the shares done well over the past year, but the sell-side has been playing catch-up. Revenue expectations for fiscal 2018 (which ends in 22 days) have risen about 25% over the past year and the average sell-side price target has roughly doubled.
For my part, the strong results in the last few quarters have led me to pull my revenue growth and margin leverage assumptions forward (I too thought the mining recovery would be "lower for longer" relative to what has taken shape), lifting my DCF and EV/EBITDA-based fair values. My long-term revenue growth expectations haven't changed that much (up slightly, but still in the grey area between "mid-single-digit" and "high single-digit" growth), but I have increased my margin assumptions, particularly given the extent to which management has spelled out its leverage to automation within its own plants and the impact that has on capacity utilization and margins.
Although I do expect double-digit annualized FCF growth over the next decade, that doesn't support an especially attractive fair value today. That is no surprise to me at all, as companies like Komatsu generally only look attractive on the basis of discounted cash flow when the cycle is in its weakest periods.
I am surprised, though, that an EV/EBITDA approach suggests some additional upside. Over the long-term, Komatsu shares have typically traded at a forward multiple of 7x to 10x. Using the midpoint (8.5x) on my 12-month EBITDA estimate gives me a fair value of $37.50, or about 10% above today's price. Crank the multiple up to 10x and my fair value moves into the mid-$40's.
The Bottom Line
Although the recovery in construction and mining equipment is well underway, I'm not convinced we're past the point where expectations can still go higher. With that, I think Komatsu offers enough undervaluation today to be worth a look, with the added kicker of potential upward revisions to estimates. This party won't last forever, but I believe Komatsu has positioned itself as a long-term leader in its markets, and I believe automation adoption can continue to drive healthy sales growth. Accordingly, I'd at least give these shares a closer look.
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