TDK: Record-High Capex And R&D Spend Are Negative For The Shares

Summary

• TDK is embarking on a product diversification strategy for its successful battery business involving record-high levels of capex and R&D.
• Although this has potential benefits for the long term, we believe this strategy will lead to negative free cash flow and limited earnings upside.
• Guidance implies the shares are trading on PER FY3/2022 18.8x and 1.3% dividend yield. Whilst undemanding, we are sellers of the shares.

Photo by Poravute/iStock Editorial via Getty Images

Investment thesis

TDK (OTCPK:TTDKY) is embarking on a product diversification strategy for its successful battery business. This will involve record-high levels of capex and increasing R&D, resulting in a significant negative free cash flow profile in FY3/2022. Valuations are currently undemanding but with this backdrop we are sellers of the shares.

Quick primer

Founded in 1935 TDK stands for 'Tokyo Denki Kagaku' (translated as Tokyo electric science) and manufactures a broad range of electronic components such as ceramic capacitors and rechargeable batteries for consumer electronics. The core business driver is batteries (classified as the Energy applications segment), contributing 52% of FY3/2021 sales and the majority of total operating profits. The company has exposure to areas of secular decline such as magnetic applications for HDD heads, and the sensor business is loss-making with no current timeline for turning profitable.

FY3/2021 sales by segment

Source: Company, created by author

FY3/2021 operating profit and margins by segment

Source: Company, created by author

FY3/2021 sales split by end-markets

Source: Company, created by author

Our objectives

In this piece we want to assess the following:

• the outlook for the energy application business, which has been the core earnings driver for the last 5 years.
• expectations over free cash flow as the company highlighted a significant ramp in capex into FY3/2022.

We will take each one in turn.

Power cell developments

TDK's competitive edge in battery manufacturing stems from coating technology expertise developed in legacy audio cassette production. The company believes that it has the highest market share in consumer electronic rechargeable batteries (around 40% globally), and this has been a stable earnings driver. FY3/2021 results were above consensus driven by digital transformation demand for laptops, PCs and smartphones, but company guidance for FY3/2022 was 8% below consensus for operating profit which was a negative surprise - JPY150 billion versus JPY163.5 billion.

Management highlighted that it expects battery sales in FY3/2022 to grow 8% to 11% YoY driven by smartphones and laptop demand, doubling sales of power cells, semiconductor power supply demand and EV charging components. However, in terms of segmental profit no growth is expected YoY due to increasing power cell-related development costs. We can clearly see planned total R&D expense rising 10% YoY for FY3/2022, versus total sales growth planned at 8% YoY.

R&D spend trend

Source: Company, created by author

Battery demand for consumer electronics will still remain a major contributor to earnings for the medium term, but TDK is looking to product diversification as tablets and smartphones reach market saturation. The aim is to boost production of batteries in new markets such as electric motorcycles, scooters and residential power storage systems with a geographic focus on Asia.

In the longer term, TDK's diversification strategy may result in renewed growth in the battery operation. However, the business currently needs investment and those costs will dampen earnings growth in the short to medium term. The company is also aiming to grow manufacturing capacity outside of China, pointing to further investment costs.

We surmise that the battery business has limited scope for profitability enhancement in the short term due to upfront investments.

Next we look at free cash flow, as this is directly related to TDK's battery investment plans.

Capex hike to come

TDK's shares listed in Japan hit an all-time high in January 2021, but has fallen after the Nikkei newspaper revealed a 3-year JPY520 billion capex drive to boost battery production. Management last week confirmed plans for capex spend of JPY300 billion for FY3/2022, a major increase of 41% YoY. TDK has averaged capex of around 12% of sales over the last 10 years, but guidance for FY3/2022 points to capex at 19% of sales which is at an all-time high.

Annual capex trend

Source: Company, created by author

The major concern is that for FY3/2022, TDK will return to negative free cash flow territory. The company does not have a reliable track record of sustained free cash flow generation. With a medium term plan to launch new power cell products and to build manufacturing capacity in India, the outlook for free cash flow generation is negative. We estimate negative free cash flow of JPY100 billion in FY3/2022.

Annual free cash flow trend

Source: Company, created by author

Despite opportunities for growth longer term, we think a significant cash-burn profile in FY3/2022 poses downside risk to the shares.

Balance sheet

In FY3/2021 TDK's balance sheet had a small net debt position of JPY37 billion and sufficient liquidity with a current ratio of 1.2x. Financing for future capex plans does not require dilutive equity issuance in our view, with the company in a position to borrow with a satisfactory Baa1 rating from Moody's.

Shareholder returns

Company guidance for FY3/2022 implies a dividend of JPY190 per share, an increase of JPY10 YoY. The payout ratio is 24% which is a decline from 29% in FY3/2021 and 39% in FY3/2020 which comes as a small disappointment. The large capex plan explains the limited distribution, but with no share buyback plan in place we believe that existing shareholders have little reason to hold the stock in the short term.

Valuation

Company guidance implies the shares are trading on PER FY3/2022 18.8x, with a prospective dividend yield of 1.3%. These multiples in isolation do not look particularly expensive. However, taking into account the miss to FY3/2022 consensus estimates and negative free cash flow being a likely scenario, valuations do not present themselves to be at an attractive discount.

Risks

Management are planning to unveil a new medium term plan on 24th May 2021. The shares may react positively to targets for improving profitability once the investment phase is complete for the battery business. There is also growing expectation of a concrete timeline to illustrate when and how the sensor business will turn profitable.

New targets may be unveiled in terms of total shareholder returns. Although short term there may be little change, management may indicate future targeted returns which may encourage investors to stay the course.

New technological breakthroughs in batteries may provide positive sentiment for the shares. TDK is working on new products such as all-ceramic solid state batteries and commercialization may provide a positive catalyst.

Conclusion

We believe TDK's product diversification strategy is positive for its battery operation as the consumer electronics market reaches saturation. Expanding manufacturing capacity outside of China also sounds like a positive development. However, in the short to medium term significant investment costs will result in limited earnings growth, as well as a likely negative free cash flow profile in FY3/2022. Whilst valuations for FY3/2022 are not demanding, given this negative backdrop we are sellers of the shares.

Analyst’s 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.

Comments

[Jop88]

Good call - the market is agreeing with you. About 6 months ago, I had targeted ~$125 as an entry point for TDK, but I am now dropping it from my prospect list..