Keyence's Diverse Business Model Continues To Deliver

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About: Keyence Corporation (KYCCF), Includes: CGNX
by: Stephen Simpson, CFA
Summary

Keyence is faring better than many machinery and automation enablers, as demand for machine vision equipment and sensors remains relatively healthier.

A broader macro slowdown is still a threat to Keyence, but longer-term investments in automation should continue to support well above average growth potential.

Keyence gets credit for its exceptional margins, reduced cyclicality, and higher long-term growth potential, but it's hard to call today's price a clear bargain.

From a quality perspective, it’s hard to find many better companies in the automation-enabling space than Japan’s Keyence (OTCPK:KYCCF) (6861.T). A strong player in machine vision, sensors, control systems, and other precision equipment, Keyence is not only a leader in attractive areas like 3D vision and product ID, but it has a long history of “self-obsoleting” and moving out of increasingly competitive markets that are no longer willing to pay for innovation before they become commoditized.

The only problem with Keyence is that its qualities are well-known and typically well-reflected in the share price. I thought the shares were an okay pick back in mid-2018 for longer-term investors wanting a dependable play on automation, but I didn’t think they were particularly undervalued, and the shares have mostly just kept pace with the broader industrial sector, while underperforming Cognex (CGNX) but outperforming a fair few Japanese automation names. I think this recent run in many automation names may be underplaying the risk of further macro deterioration, and while I’d still stand behind Keyence as a long-term holding, I’d wait in the hope of a cheaper entry price.

The Business Is Still Growing … Though Sparse Details Complicate The Analysis

One of the biggest challenges in following and analyzing Keyence is that the company says so little about its operations, and that includes the Japanese language materials available on the website. Management reports results on a quarterly basis, but only breaks out its performance by geography and seldom says much of anything about specific end-market conditions. While it’s certainly possibly to use information from other companies like Cognex, Hexagon (OTCPK:HXGBY) to “triangulate” market conditions for Keyence, there’s always an elevated level of guesswork here.

Be that as it may, Keyence has continued to generate better revenue growth than most of its automation peers – an achievement that I believe ties back to the company’s lower exposure to China (particular smartphone capex) and autos relative to other automation machinery suppliers.

Revenue rose 12% in the December quarter (or 13% in constant currency), continuing a now four quarters long streak of decelerating year-over-year revenue growth (the past five quarters have seen growth of 12%, 15%, 20%, 25%, and 34%). Keyence certainly saw some impact from slower capex spending in China, as sales to Asia were up 8% in the quarter (still a good result relative to many in the sector) while sales to Japan rose 11%, sales to Europe rose 16%, and sales to North/South America were up 21%.

Gross margin improved another 40bp (to 82.6%) and it’s worth mentioning again that Keyence operates as a fabless company, so its operating leverage opportunities are definitely different than those of Cognex or Japanese machinery companies like Yaskawa (OTCPK:YASKY) and Fanuc (OTCPK:FANUY).

Operating income lagged revenue, though, with 9% growth in the quarter and 140bp contraction in margin. This was a modest miss relative to expectations and marked a more significant slowdown in growth relative to revenue, as operating income growth over the last five quarters has come in at 9%, 13%, 21%, 29%, and 41%). Keyence is a good example of a company that runs itself for the long-term, and part of the reason that the company is seeing margin pressure is that it continues to invest in sales engineers.

How Slow Will It Get?

With the slowdown in Japan and Asia in Keyence’s results, I do think the company is seeing some impact from the recent deceleration in capex demand in China for applications like smartphones and cars. Keyence is not as exposed to these end-markets as Cognex (about 40% to 50% of revenue), but it still appears to be having an impact, and with both DMG Mori and the JMTBA (the Japan Machine Tool Builders Association) looking for double-digit declines in machine tool volume in 2019, I believe there’s still some near-term downside risk to Keyence’s Asian business.

On a more positive note, a significant percentage of Keyence’s business consists of products like sensors, measurement tools, and control systems that are not typically paid for out of capex budgets and should be somewhat better-protected from capex cycle worries, particularly as manufacturers in China are still continuing to embrace automation as a means of counteracting labor costs and keeping production in-country. To that end, I would note that Keyence rival/comp Optex Group (6914.T) reported 24% growth in its factory automation business in the fourth quarter, driven by its sensor business, while machine vision lighting sales rose about 5%.

Like Cognex, Keyence is also leveraged to ongoing adoption of automation. Keyence’s 3D vision enables a range of automated functions, including picking robots that are only just starting to be used in areas like factory-based assembly and warehouse/logistics operations. Keyence is likewise placed to sell into a range of reader, measurement, and sensing applications that will play increasingly large roles in factory and warehouse automation, allowing robots and cobots to recognize where they are, grab and handle target materials, and move through a facility with minimal direct oversight or input.

The Outlook

I’m somewhat concerned about Keyence’s exposure to a weaker macroeconomic environment as 2019 develops. Trade peace between the U.S. and China would certainly help, but in the meantime Keyence is facing a macro environment where auto sales are weak (outside the U.S.) and starting to impact capex, semiconductor equipment investment is declining, smartphone capex equipment investment is declining, and where machine tool orders have started to decline (again, outside the U.S.). I do believe this is just a temporary phenomenon, though, and I believe the longer-term outlook for machine vision and other automation and control products is quite good.

I’ve trimmed back my expectations for FY’19 and FY’20 on the revenue side, but I’m still expecting long-term growth above 10%, with the business reaccelerating in FY’21. I do believe there’s still some margin leverage potential here as the company digests and leverages its sales force expansion, and I’m looking for low double-digit FCF growth modestly above revenue growth.

The Bottom Line

It doesn’t surprise me at all that today’s valuation seems robust; Keyence has long been recognized and appreciated for its strong market position, it’s very strong margins/FCF generation, and its above-average growth potential. While I’m not going to argue for shorting the stock, I do think the implied return is too low for me, particularly relative to Cognex, and I’ll be content to stand on the sidelines unless and until the prospective returns improve to at least the high single digits.

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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