Liuhsihsiang
It's been a tough few months for shareholders of Hurco (NASDAQ:HURC), as the shares of this small industrial capex company (machine tools) have lost more than 20% of their value since my last update. That's considerably worse than the performance of the broader industrial space, to say nothing of a broadly-defined comp group that includes other machine tool companies like DMG Mori (GIL.DE) (6141.T), Fastenal (FAST), Kennametal (KMT), and Lincoln Electric (LECO). In particular, it would seem as though investors really didn't like the more tempered guidance that many large industrial companies gave for the second half of the year, as the shares weakened considerably through the April reporting season.
At this point, I believe Hurco is a name for more risk-tolerant investors to consider. I do believe manufacturing activity will slow in the second half of this year (calendar 2023), but Hurco's core customers often make decisions in anticipation of the cycle, and I believe orders may have already troughed. This isn't an easy stock to own, and investors shouldn't expect dynamic acyclical growth, but I do see upside at today's price.
Looking Back At A Mixed Fiscal Q2
Hurco's fiscal second quarter included a mix of good and bad news. Relative to my expectations (and there is no sell-side coverage, so no "consensus" expectations), revenue was basically in line and orders were better, but margins were frustratingly weak.
Challenging Current Results
Revenue declined 14% as reported (and 12% in constant currency) from the prior year and fell about 2% from the prior quarter. Sales were weakest in North America, declining 18% yoy and 17% qoq, but stronger in Europe (up 1% yoy and 5% qoq) on strength in the U.K. and Germany markets. Sales to the Asia-Pacific region declined 38% yoy, but improved 34% sequentially.
Gross margin declined 140bp yoy and 10bp qoq to 23.4%, worse than I'd expected. Margins were hurt by lower volumes in the U.S., as well as a mix shift away from higher-value machines. Although SG&A declined from the year-ago period and was basically flat sequentially, operating income declined about 68% yoy and 18% qoq, with margin falling to 1.8% from 4.9% last year and 2.3% last quarter.
There are a couple of relevant drivers for margins to keep in mind. First, Hurco should be near a cyclical low in revenue, so there are overhead absorption issues. Second, management is actively continuing to build the business, including increased investment in the key European business (particularly in automation and control technologies).
More Encouragement In Orders
The order story was considerably more positive, but I do want to reiterate a warning that Hurco's core customer base is made up of smaller businesses and this has led in the past to more volatility. So while things do look as though they're coming off the bottom, readers need to appreciate that this is an "at risk" sort of statement.
Orders rose 5% yoy in constant currency terms and improved 13% qoq, with a book-to-bill of 1.1x (versus just below 1.0 in the prior quarter). North American orders fell 9% yoy but improved 13% sequentially and the book-to-bill was 1.2x. European orders rose 23% yoy and 10% qoq, with a book-to-bill of 1.1x, while Asia-Pacific orders were down 19% yoy and up 35% qoq, with a book-to-bill of 0.9x. As a reminder, orders from Asia-Pacific tend to be less predictive (it seems to be a shorter-cycle business).
Uncertainty Remains The Theme
There are abundant signs of slowing business activity, particularly in the manufacturing space, but there's a lot of uncertainty in the economic outlook. Businesses seem to be taking a "hope for the best, plan for the worst" stance with conservative guidance but without large-scale decreases in capacity (perhaps fearing a repeat of the post-pandemic crunch as orders surged).
Hurco is always difficult to benchmark, as its core business opportunities are not the typical opportunities for larger machine tool companies, or larger industrial capex suppliers in general. That said, it's not as vulnerable to near-term downturns in production volumes relative to longer-term capex expansion and planning. With more and more evidence of meaningful reshoring/near-shoring activity (returning more manufacturing and supply sourcing to domestic markets or nearby markets), the capex outlook is more positive and that could explain some decent momentum in orders (off a modest base).
Industrial distributors like Fastenal have been seeing slowing manufacturing activity (with May manufacturing sales up 10% for Fastenal after 13% growth in April and 11% growth in March), but again this current production and not as closely tied to capex spending. While European orders are picking up, macro indicators like business confidence have been mixed, with a significant recent drop in Germany (particularly in manufacturing), stable-ish results in France and Italy, and a little improvement in the U.K.
I do still see Hurco as a beneficiary of a capex cycle that should be more evident again in calendar 2024 and beyond, driven in part by re-/near-shoring as well as investment in areas like aerospace, electrification, renewable energy and so on. I also see potential upside from market share growth in the U.S. and Europe, particularly if Hurco can leverage past investments and capabilities in automation.
The Outlook
I've adjusted my gross margin expectations lower but left my other estimates largely intact. I do expect Hurco to see improved mix in the coming quarters (more investments in more capable machines), but I don't see the point in getting too far ahead of the numbers. I'm still looking for revenue declines in FY'23 and FY'24, but I see upside to my FY'24 numbers if these order trends accelerate. Longer term, I'm still looking for mid-single-digit free cash flow margin and EBITDA margins that trough in the 4%'s and peak above 10%.
Between discounted free cash flow and margin/return-driven EV/EBITDA (using a more normalized EBITDA number in FY'25 and an 8.5x multiple, discounted back) I believe these shares are undervalued below $30.
The Bottom Line
I believe Hurco has interesting potential as a "buy the trough" opportunity to leverage future growth in North American and EU manufacturing capacity and capital equipment renewal. As companies like Lincoln have pointed out, there have been years of underinvestment and this next cycle could be significant. That said, this is a tiny and unfollowed company and while it seems like the worst may be over, a worse downturn over the next 6-12 months could invalidate that thesis. Still, on a risk/reward basis I think this is a name to consider.
