Sandvik Dogged By Short-Cycle Concerns As Mining Recovers Strongly

 

I was lukewarm on Sandvik (OTCPK:SDVKY) when I last wrote about the stock in October of 2020, and the shares have basically tracked the performance of the broader industrial space since then, as abundant signs of strength in the mining operations have been offset by disappointments and concerns in the tool business. While Sandvik has outperformed other industrial peers like Kennametal (KMT) and SKF (OTCPK:SKFRY), as well as some mining players like Komatsu (OTCPK:KMTUY) and Weir (OTCPK:WEGRY), Epiroc (OTCPK:EPOKY), at least, has done noticeably better.

While I think underlying demand conditions for the tools business is better than the bears fear, I am concerned about a pretty dicey history of margin performance here (relative to expectations) stretching back before the pandemic. With mining, I think the issue is more whether Sandvik can meet all the demand they are seeing without hurting margins.

The market seems to be cooling on shorter-cycle names, and that’s a sentiment risk for these shares. From a fundamental view, though, the valuation isn’t too bad, with double-digit near-term return potential and a long-term annualized return potential in the high single-digits. If Sandvik can start showing better results from the Manufacturing and Machining business (or SMS), outperformance is possible.

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Sandvik Dogged By Short-Cycle Concerns As Mining Recovers Strongly

Sandvik Outperforms On Margins, But Weak Industrial Orders Are A Concern

If more industrial companies report quarters like Sandvik’s (OTCPK:SDVKY, SAND.ST) third quarter, I’m not sure that the rally in industrial will hold. The stronger-than-expected margins were certainly welcome, and margins are an underappreciated driver of multiples in the sector, but meaningful shortfalls in Machining Solutions (or SMS) orders and revenue highlight that the industrial recovery is not yet on firm footing. Add in the impact of new lockdowns in Europe due to COVID-19 and you do have a good case for some concern about near-term demand in a variety of industrial end-markets.

I liked the better results from Sandvik’s mining operations, and again, the margin performance across the business (including SMS) was certainly worth praising. With Sandvik having underperformed the broader industrial group since my last update, I’m a little more interested in these shares as a short-cycle industrial recovery play, but I’m going to wait to see what other industrials report and what management offers investors at the upcoming November capital markets day in terms of long-term strategic initiatives and targets.

 

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Sandvik Outperforms On Margins, But Weak Industrial Orders Are A Concern

Sandvik Managing A Steep Downturn Relatively Well

One of the very few industrial stocks that I saw as undervalued enough to consider buying a quarter ago, Sandvik (OTCPK:SDVKY) has since appreciated about 40%, outperforming even the mighty Atlas Copco (OTCPK:ATLKY), though not performing quite as well as fellow short-cycle play Parker-Hannifin (PH). Investors have certainly ran the idea of a coming V-shaped recovery in short-cycle industrial markets, but Sandvik's second quarter results offer a reminder that it may not be such an easy play as the market valuations would suggest.

While I do think Sandvik is close to the end of the downturn and has done quite well managing margins through the downcycle, I also think valuation is far more demanding now. I'm not worried about much that is Sandvik-specific, but I do worry that expectations are so high for the recovery now that any bumps along the road could have a disproportionately large impact on valuation.

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Sandvik Managing A Steep Downturn Relatively Well

Fear Has Pushed Sandvik Back To A More Reasonable Valuation

At least as far European industrials are concerned, analysts have moved swiftly to cut estimates in expectation of a serious recession in the wake of Covid-19, and Sandvik (OTCPK:SDVKY) (SAND.ST) is no exception. Although manufacturing data has held up a little better than feared so far, the second quarter is still likely to be ugly and the sell-side seems braced for an ugly stretch of performance.

Sandvik isn’t my favorite name among European industrials from a quality perspective (that would be Atlas Copco (OTCPK:ATLKY)), and I have some concerns about the long-term growth potential of the core cutting tools business. Even so, the shares would seem to offer a double-digit return on the basis of a 2% to 4% growth rate over the next decade, and that looks like a pretty reasonable risk/reward opportunity.

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Fear Has Pushed Sandvik Back To A More Reasonable Valuation

Sandvik Doing Well Through The Slowdown, But The Price Already Reflects A Recovery

Short-cycle stocks by and large did well in the fourth quarter, with investors buying in ahead of an expected return to growth in the second half of 2020. Sandvik (OTCPK:SDVKY) has gone along for that ride, and has also outperformed the broader industrial group since my last article – rising more than 10% and holding that through a fourth quarter earnings report that still showed signs of weakness.

The confidence expressed by Sandvik’s management on the call that short-cycle markets were bottoming certainly won’t hurt the investment case, but I’d keep an eye on economic indicators in Europe and the U.S. all the same – there’s been more weakness than expected to close 2019 and start 2020. While it hasn’t dented the second-half rebound thesis yet, that recovery is already reflected in the multiples.

Sandvik shares already trade near their one-year (and five-year) high, so it’s not like the impending recovery has been ignored in the valuation. I like Sandvik, and I do still see some upside on an EV/EBITDA basis, but the risk/reward doesn’t seem overly skewed in investors’ favor and this would be a name where I’d still rather wait in the hopes of another sector-wide pullback.

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Sandvik Doing Well Through The Slowdown, But The Price Already Reflects A Recovery

Sandvik Barely Makes The Quarter, But Investors Seem Relieved

Maybe the worst is over for multi-industrials. Multiple end markets are still weakening, but investors seem to increasingly have this factored into their outlooks, as Sandvik’s (OTCPK:SDVKY) low-quality beat in the third quarter seems to have gone over fairly well with investors. I think we could still see another downturn in the shares before year-end (with the ADRs retesting the $14-$15 zone from $17 today), and the stock is not particularly cheap on a DCF, but I think the conversation around Sandvik will start to evolve toward the question of when the Machining Solutions business will bottom out and recover in 2020.

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Sandvik Barely Makes The Quarter, But Investors Seem Relieved

Sandvik Knocked Back As Signs Of Slowdown Accumulate

I suppose it’s still early in the second quarter reporting cycle, but I’m pretty much sold on the idea that the industrial economy is most definitely slowing, though in the interests of transparency, that’s been my expectation for a while, so there’s a risk of seeing what I want to see. Specific to Sandvik (OTCPK:SDVKY), shares have fallen more than 10% since my last update on the company, as those signs of slowdown continue to build and a second half rally seems less likely.

I like Sandvik as a business, but it’s tough to get excited about a company with heavy auto and general industrial exposure at this point in the cycle, particularly when past downcycles at Sandvik have lasted a little more than a year. Perhaps stimulus (the market expects the Fed to cut rates) will lead to a shallower, briefer downturn, but I think there could still be too much optimism for a second half rebound in the market. Sandvik shares are now a bit below my fair value estimate, though, so this is a name to keep a closer eye on if the pullback continues from here.

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Sandvik Knocked Back As Signs Of Slowdown Accumulate

"Good Enough" Is Good Enough To Keep The Rally Going At Sandvik

Although I thought Sandvik (OTCPK:SDVKY) (SAND.ST) looked beaten down in late January on mounting worries of a global economic slowdown, particularly in manufacturing end-markets, I didn’t expect the 25% rally in the shares since then – a rally that has seen Sandvik’s share roughly double the average strong move in industrials over that same time. Clearly investors are feeling better about the global economy, and Sandvik’s results would lend support to the idea that the weakness in autos hasn’t really spread all that far yet.

It’s much harder to argue that Sandvik is in any way beaten down or overlooked now. While Sanvik’s results, and those of other industrials and multi-industrials that have reported so far, would suggest a softer landing than I’d expected, these shares are now basically counting on a stronger second half that I think may still be too ambitious.

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"Good Enough" Is Good Enough To Keep The Rally Going At Sandvik

A Sharp Downturn In China Seizing Up Nidec's Growth Engine

Evidence continues to mount that conditions in China, and to a lesser extent other regions around the world, are not good. Nidec (OTCPK:NJDCY) (6594.T) has seen a withering decline in auto business in the last couple of quarters, with weakness spreading beyond autos into consumer appliances and various industrial markets. At the same time, though, Nidec continues to build for its future – globalizing its production capabilities and logging significant inquiries for its electric vehicle traction motors.

Nidec isn’t quite as cheap as I might wish, and I think this macro malaise could linger on a little while longer than the Street presently expects, but I think this is a very good company now trading at a reasonable valuation. In addition to a major opportunity in EV motors, I believe Nidec is leveraged to ongoing growth in brushless motors, robotics, and data centers, and could deliver meaningful operating leverage with this latest efficiency initiative. Looking past the rocky near-term, I think these shares could be 10% undervalued today and that the shares could re-rate meaningfully higher as 2019 moves on if and when the outlook for China improves.

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A Sharp Downturn In China Seizing Up Nidec's Growth Engine

At Sandvik, Cycle, Value, And Self-Help Are In A Battle Royale

These are challenging times to evaluate almost any industrial company, but Sandvik (OTCPK:SDVKY) (SAND.ST) cranks that to “11” right now. In the plus column, Sandvik has done some very strong work with self-help over the past few years (streamlining supply chains, reducing overhead/fixed costs, culling low-margin business), and a lot of that improvement is acyclical. Sandvik is also benefiting from a strong recovery in mining capex, and has options to further remake the company through M&A. In the minus column, the cutting tool business looks to be rolling over and it’s tough to make headway when your largest, most profitable business is starting to struggle.

If a significant global slowdown is in fact underway (let alone a recession), it’s going to be tough for Sandvik to outperform. Still, I think Sandvik will manage some additional margin leverage from here while keeping its ROIC up in the 20% range, making this a very tempting name even now.

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At Sandvik, Cycle, Value, And Self-Help Are In A Battle Royale

Weir Group Poised To Benefit As Natural Resource Companies Get Back To Work

Weir Group (OTCPK:WEGRY) (WEIR.LN) hasn't been badly treated over the past year. As investors have shown renewed enthusiasm for companies leveraged to both oil/gas and mining equipment, Weir Group shares have risen more than 50% - keeping good company with the likes of Metso (OTCQX:MXCYY), FLSmidth (OTCPK:FLIDY), Atlas Copco (OTCPK:ATLKY), and Sandvik (OTCPK:SDVKY). Margins are only just starting to recover, though, and it remains to be seen just how strong the recovery in natural resources capex will be. What's more, Weir Group has issues to address in its seemingly perennially disappointing Flow Control business.

Valuation seems quite healthy, if not generous. Even if I assume that Weir regains its prior peak revenue in 2019, grows in line with historical norms for natural resource capex growth (that is, before the "super-cycle"), and reaches/holds double-digit FCF margins (something it's never done before), I can't get to a compelling DCF-based fair value. On the flip side, if the company can generate three to five years of mid-teens EBITDA growth on the back of this recovery, a fair value 5% to 10% above today's price is arguably in play. Investors considering these shares should consider the London-listed shares if possible, as they offer considerably better liquidity than the ADRs.

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Weir Group Poised To Benefit As Natural Resource Companies Get Back To Work

Early-Stage Recoveries And Rebuilt Optimism Supporting Komatsu

It looks as though the worst has passed in both the mining and heavy construction equipment markets. With that, both Komatsu (OTCPK:KMTUY) and Caterpillar (NYSE:CAT) have been stronger, with the former up about 25% from my last article on the company and not really having given investors that buy-on-the-pullback opportunity I was hoping for. Komatsu has seen consistently better demand for its mining machinery in recent quarters, and although operating hours have been choppy around the world, the situation is quite a bit healthier than it has been over the last two to three years.

Komatsu shares seem to be pricing in a pretty healthy recovery. I don't really have a problem with that, but it does lead me to wonder how much upside remains. Construction equipment demand seems a little muted, though progress on a huge infrastructure stimulus bill in the U.S. could significantly improve the outlook in the United States. With mining, companies are getting back to capex spending again, but thus far, they have been proceeding cautiously. My base-case assumptions for Komatsu haven't changed all that much, and I think the company could deliver high single-digit revenue growth over the next five years with meaningful improvements in cash flow. Priced to deliver a high single-digit return, Komatsu is still arguably a worthwhile idea to consider for a GARP portfolio.

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Early-Stage Recoveries And Rebuilt Optimism Supporting Komatsu

Atlas Copco's Excellence Reflected In The Performance

Sweden's Atlas Copco (OTCPK:ATLKY) is a case in point as to some of the limitations of modeling and model-based valuation. This is an excellent industrial conglomerate by almost any standard and one that is well-respected and generally well-liked. When I last wrote about the company in September of 2016, I liked the company quite a bit but thought that the valuation was already very healthy. Since then, not only have the company's underlying markets come back faster and stronger than expected but so too has investor enthusiasm - pushing these shares up by a third, in line with other strong Swedish plays like SKF (OTCPK:SKFRY) and Sandvik (OTCPK:SDVKY) but well ahead of strong U.S. industrial conglomerates like Fortive (NYSE:FTV) and Illinois Tool Works (NYSE:ITW).

It's hard to connect the dots on the valuation today, unless you think long-term revenue growth will reach the high single-digits, FCF margins will move into the 20%s, and/or you're willing to accept a total return closer to the mid-single digits. I've learned over the years not to bet against Atlas Copco (or at least to do so very carefully), but even the company's announced split and ongoing recoveries in multiple markets can only do so much for a stock that already enjoys quite a bit of esteem.

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Atlas Copco's Excellence Reflected In The Performance

Perpetually Restructuring Kennametal Tries To Recapture Lost Glory

Kennametal (NYSE:KMT) has been in a state of almost perpetual restructuring since 2007, but there's little to show for it as revenue and margins are both lower today than back in 2007. While the shares are up over the last 10 years, they are only by about 10% (versus a greater than 60% gain for the S&P 500) and due in part to the strong run that stocks have enjoyed since the U.S. presidential election.

New management is going about things in a much smarter way, and I think it is reasonable to think that the returns from this latest restructuring program will be more significant. On the other hand, Kennametal has lost a lot of shares (and a lot of credibility with the Street), its end markets are changing, and management's projections may be bold to the point of unrealistic. While I do think recovering end markets and a better strategy can drive above-market growth and double-digit FCF growth, today's valuation already seems to give a pretty hefty benefit of the doubt to the company.

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Perpetually Restructuring Kennametal Tries To Recapture Lost Glory

Atlas Copco Muddling Through, But At A Richer Valuation

As was the case with so many industrial names, investors had a nice buying opportunity with Atlas Copco (OTCPK:ATLKY) early this year. I liked the stock back in January, and the ADRs are up about 40% since then - more or less matching Sandvik (OTCPK:SDVKY), Metso (OTCQX:MXCYY), Eaton (NYSE:ETN) and Caterpillar (NYSE:CAT), but edging out other industrial/tool names like Ingersoll-Rand (NYSE:IR), Stanley Black & Decker (NYSE:SWK), and Graco (NYSE:GGG).

Also, as is the case with so many high-quality names (and I'm thinking of companies like Honeywell (NYSE:HON), 3M (NYSE:MMM), and the like here), the improvement in the share price of Atlas Copco seems to have outpaced the improvement in business outlook. I continue to believe Atlas is an excellent company, and the total returns from here don't look awful, but it comes up short of my 10% total return target, and I'd rather wait on the sidelines in the hope of a better price.

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Atlas Copco Muddling Through, But At A Richer Valuation

Seeking Alpha: Atlas Copco Is Great Everywhere But In Value

Sweden's Atlas Copco (OTCPK:ATLKY) has long been one of my favorite industrial companies, and it remains so today. The shares have done so-so since I last wrote about them for Seeking Alpha; hit by the severe downturn in mining, the shares are up about 20% over that stretch - roughly on par with Caterpillar (CAT) and better than Sandvik (OTCPK:SDVKY), but only about half the returns of Ingersoll-Rand (IR) or the S&P 500.

Even with that underperformance, and even though I like the company, I'm not as bullish on the shares as I wish I could be. Mining likely is troughing, but even an estimate for 10% future annual free cash flow growth only gets me to about par with today's share price. I would definitely keep this name on a watchlist and stay alert for pullbacks (the shares rarely get very cheap and the windows don't stay open for long), but today's valuation seems pretty fair to me.

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Atlas Copco Is Great Everywhere But In Value

Seeking Alpha: Has Joy Global Bottomed Out?

Cyclical stocks have a way of outdoing expectations both for good and bad. That makes it tricky to feel all that confident that Joy Global (JOY) is bottoming out, particularly when there are still long-term issues with the coal market that makes up a large percentage of the company's equipment revenue base. What Joy Global has done, though, is significantly improved its manufacturing process and shifted its capital focus from M&A to returning cash to shareholders. Provided that coal isn't in perpetual decline as a global energy source, these shares could still have some appeal even after a 20% run from recent lows.

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Has Joy Global Bottomed Out?

Investopedia: Caterpillar's Numbers Look Ugly, But That Was Expected

Even though the mining and construction markets stubbornly refuse to get better as quickly as analysts want them to, there's still a “want to believe” trade alive and well in Caterpillar (NYSE:CAT) shares. In other words, investors know that this company is built to withstand the ups and downs of the very cyclical construction, mining, and energy markets, and there's a definite interest in trying to buy low ahead of the recovery. Although the recovery looks a little further away now after the second quarter and Caterpillar shares aren't exactly cheap, they are a quality vehicle for playing those eventual recoveries in construction, energy, and mining.

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Seeking Alpha: Weak Metalworking Corroding MSC Industrial's Growth

When I last wrote on MSC Industrial (MSM) about a month ago, I suggested that the solid average daily sales growth being reported by Grainger (GWW) and Fastenal (FAST) on a monthly basis was threatening to put the company in the penalty box with some investors. See, the challenge for MSC Industrial has long been in proving that it's more than a cyclical industrial supplier and that it can grow consistently, albeit even if not on the same level as Fastenal.

Unfortunately for investors, MSC Industrial's fiscal third quarter earnings were decidedly mediocre in that respect. Although the company did as it said it would in terms of revenue and exceeded its own guidance for operating efficiency, the relatively weak daily growth highlights the challenges of the company's focus on the metalworking industry and puts even more pressure on management to exploit the BNDA acquisition for all its worth in terms of broadening its addressed markets.

The question for investors now is one of time horizon and patience. I do believe the company is making considerable investments today that will underpin above-average growth in the coming years (likely starting around the second half of 2014). I likewise believe that U.S. manufacturing (and particularly metalworking businesses) can and will recover in 2014. So while I continue to find MSC Industrial undervalued on a long-term basis, the exposure to the clearly underperforming metalworking industry could make it harder for these shares to outperform in the meantime.

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Weak Metalworking Corroding MSC Industrial's Growth

Seeking Alpha: Without Emerging Market Growth, FLSmidth Stuck In Cement

China's break-neck infrastructure development over the past decade seriously distorted multiple commodity and resource markets, and now companies are scrambling to figure out what the "new normal" actually is. Companies like Caterpillar (CAT) and Joy Global (JOY) have been fairly circumspect with guidance, and major miners like Rio Tinto (RIO) and BHP Billiton (BHP) have been pulling back on their capex plans.

That brings us to FLSmidth (FLIDY.PK) - a global engineering company that provides an array of equipment and services for the cement and mining industries. Barring a significant re-acceleration in demand for cement, coal, and base/industrial minerals, it's hard to see why this company deserves a higher multiple.

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Without Emerging Market Growth, FLSmidth Stuck In Cement