Japanese automation leader Fanuc (OTCPK:FANUY) (6954.T) has a loyal shareholder base that can lean toward the fanatical, but the last couple of quarters underline that for all of Fanuc’s quality, it’s not immune to macro-driven cyclicality. What’s worse, competition has ramped up in many of the company’s businesses and management’s projections that conditions won’t get significantly worse may prove too optimistic.
From where I sit, the argument that Fanuc is too cheap now only works if you expect a pretty dramatic reversal (basically a V-shaped recovery) in recent machine tool and automation demand trends in China and a quick return to double-digit ROEs. I don’t believe that’s going to happen, and I think Fanuc has more vulnerability to traditional rivals like ABB (ABB) and Yaskawa (OTCPK:YASKY), non-traditional rivals like Teradyne (TER) and local Chinese automation companies, and shifting market trends than its more bullish supporters acknowledge.
A Tough Situation Gets Ugly
Fanuc was already showing some cracks back in the summer of 2018, and that was before machine tool industry order numbers went definitively and dramatically negative. Now those cracks are quite a bit wider and the question has shifted to how much worse things will get before Fanuc recovers.
Revenue fell 20% in the fiscal third quarter (the December quarter) after falling 9% in the second quarter, driven by a 48% decline in the robomachine business and a 23% decline in the automation business (largely CNC systems for machine tools). The robot business was relatively stronger, with revenue down just 3% yoy and up about 5% qoq.
Sales to China were down 56% yoy in the third quarter, and the company has been hammered by the weakness in smartphone capex demand. Unit sales (volume, that is) of robodrills are now running about 10% of where they were in mid-2017, and a host of Japanese machine tool companies (including DMG Mori Seiki and Misumi) have cut their guidance largely due to much weaker demand in China (with some concerning emerging weakness in Germany and Italy too).
Fanuc enjoys very strong operating leverage in the good times, but that leverage cuts the other way when volumes drop. Gross margin fell five points from last year, and operating income tumbled more than 40% as operating margin contracted by about nine points. Analysts had been revising down their expectations for Fanuc (seemingly with every update on Japanese machine tool sales), so the final result was only about 2% below sell-side expectations, but it was about 25% below where analysts expected it to be back in the summer of 2018.
No Joy In The Order Book, Either
Nothing in the order book suggests a quick turnaround for Fanuc.
Orders fell 30% yoy and 6% qoq in the third quarter, with robomachine orders down 55% yoy and 8% qoq. Factory automation orders dropped 29% yoy and 5% qoq, while robot orders fell 24% yoy and 11%. All told, orders missed expectations by around 5% to 10% (there’s no good data source for sell-side order estimates for Japanese companies).
There are several parts of this that concern me. First, while I’m sure inventory de-stocking is occurring in China, weakness in Chinese machine tool demand is creeping beyond smartphone and auto industries into other manufacturing segments and the government is actively promoting local brands as alternatives. I’d also note that the robot business is weak despite what the company called healthy overall orders in Japan and the EU; weakness in the EU auto sector seems to be getting worse, not better, and I’d be concerned about more vulnerability here.
I’m also concerned that the 5G handset wave could be more of a threat to Fanuc than the market currently expects. Although not much has been finalized and things could certainly change between now and then, it looks like more OEMs are contemplating switching from aluminum cases to glass or hybrid materials. Siemens (OTCPK:SIEGY) has a leg up on Fanuc in China with glass processing equipment and local CNC companies in China have been gearing up for this switch and could be a bigger threat to Fanuc than they were in recent years. Last and not least is history – down-cycles in this sector lasted about 18 months from peak-to-trough, suggesting orders could keep declining through the end of calendar 2019.
Fanuc always has its defenders, and I can respect that to a point – the company has seen increasing competition in CNC equipment from Siemens and Mitsubishi Electric (OTCPK:MIELY) and increased competition from Yaskawa and ABB in robotics (as well as Teradyne and its cobots), but it still holds strong share in these markets and has strong internal R&D and engineering capabilities.
Even so, the defenses can get a little stretched at times. I have to admit laughing when I read a recent upgrade piece on Fanuc from Goldman Sachs that was predicated on Fanuc trading at a multiyear low for the price/book multiple … but that made no mention of the significant drop in ROE (ROE and P/B correlate fairly well for Japanese industrials).
I’d probably be more bullish on Fanuc if I saw management looking to reduce or shift its high fixed cost base and respond more proactively to the cobot threat. As is, my expectations really haven’t changed all that much despite this sharp near-term turndown. I thought conditions were going to get pretty ugly, and the last couple of quarters haven’t really surprised me. To that end, I’m still looking for long-term revenue growth around 5% (versus a trailing 10yr average of about 7%) and long-term FCF growth in the low double-digits.
Unfortunately, those cash flows don’t support a bullish fair value today. Likewise with a margin and ROIC/ROA-driven EV/EBITDA approach, where the near-term decline in EBITDA has had a more pronounced impact on my fair value than in my DCF model. I’d also note that while Fanuc’s P/B ratio has indeed declined significantly (from around 4.25x to around 2.5x), the ROE has fallen from about 12.5% to around 8%, and the shares are no better than fairly priced based on the long-term relationship between ROE and P/B.
The Bottom Line
Fanuc isn’t alone – Yaskawa, ABB, and KUKA have all underperformed since the summer, as have others in the automation “family” like Omron and THK. Keyence has done better, but that’s more of an outlier. As it stands now, I’d rather own Yaskawa or ABB (which I do own) than Fanuc, though I’ll freely admit that Fanuc should do well when the sector comes back in favor. Keyence is probably a safer bet in the short term given its different end-market exposures (and ABB with its electrification and process automation businesses), but this looks like a tough sector to make money in for the short term.
Disclosure: I am/we are long ABB. 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.