Hurco Treading Water As The Cycle Turns (NASDAQ:HURC)

The last few months have done little to dispel concerns that short-cycle industrial demand is slowing, and that certainly hasn’t helped small machine tool manufacturer Hurco (NASDAQ:HURC). While the shares have held up okay relative to the broader industrial space and other shorter-cycle names like DMG Mori (OTCPK:MRSKF), Fastenal (FAST), Kennametal (KMT), and Sandvik (OTCPK:SDVKY) (though Kennametal has done better) since my last update, the reality is that the current outlook is not particularly strong for an already-overlooked short-cycle industrial.

In light of the last Hurco earnings report and reports from other companies and third-party information sources (like the Japanese Machine Tool Builders’ Association or JMTBA), I’ve pulled forward my expectations for Hurco’s cyclical correction. The shares do still look undervalued and positioned for a double-digit long-term annualized return, but it’s hard to see investors getting excited about short-cycle names again until mid-2023 at best, as the rate cycle has yet to play out and inflation remains stubborn, while business confidence erodes.

Looking Back At Fiscal Q3 Earnings

Hurco’s fiscal third quarter earnings (reported back in early September) were a mixed bag, with evidence of sales and order erosion, but some positives on the margin side.

Revenue rose 6% as reported, or 14% in constant currency terms, but declined 8% sequentially and management’s commentary suggested that pricing drove a large part of the revenue performance – suggesting even weaker underlying demand on a volume basis. Revenue from North American customers was strong, up 24% yoy and 6% qoq, and EU revenue was up 2% year over year (up 16% constant currency), but down more than 6% sequentially. Revenue from customers in the Asia-Pacific region was down 25% yoy (or 20% in constant currency) and 47% qoq.

Gross margin was better than expected, rising 110bp yoy and 20bp qoq to 25%, as the company’s pricing actions do seem to be offsetting input and logistics cost inflation. Operating income declined 34% yoy, though, as the company incurred greater expenses tied to a major bi-annual industry trade show. Relative to the last time this trade show took place, SG&A expenses were 22% of sales versus 19% in 2018, but absolute dollar spending was down 17% – said more simply, while SG&A did jump this quarter, I expected that jump and I think Hurco is doing a good job of “doing more with less” overall.

Order Trends Aren’t Promising

Hurco reported a 21% yoy decline in orders (down 15% in constant currency) and a 10% sequentially decline, with North American orders down 9% yoy and 11% qoq, while EU orders fell 22% yoy (11% in constant currency) and 5% qoq. Asia-Pacific orders were even weaker, down 46% yoy (41% cc) and 27% qoq.

I’m not overly concerned with the declines in Asia-Pacific, partly due to the fact I expected a sharper downturn here and partly due to the disruptive impact of COVID lockdowns in China earlier this year. Longer term, I remain concerned about competitive pressures from Korean tool companies and improving domestic producers, but this is more of a niche market for Hurco.

Looking at North America, there is definitely evidence of waning business confidence and moderating business activity (as measured by ISM and other metrics). Likewise, companies like Fastenal have reported some deceleration in their U.S. manufacturing customer base. Still, the 9% decline that Hurco saw (and the 0.9x book-to-bill) was worse than the data would otherwise suggest, and I do think this is a leading sign that smaller manufacturing companies are pulling back on capex spending as they catch up with their backlogs and take a more cautious outlook on additional capital investment.

So too with Europe, albeit with the added complication of the impact of Russia’s invasion of Ukraine and the impact of higher energy prices this winter, not to mention the recent political and economic turbulence in the United Kingdom.

DMG Mori reported 12% revenue growth in its June quarter (which overlapped Hurco’s fiscal third quarter for two months) and 18% year-over-year order growth, and management’s commentary was rather bullish for machine tool demand for the remainder of 2022. Management did note some increasing concerns/uncertainty for 2023 but basically characterized demand as healthy.

Here again, I think the differences between Hurco and larger rivals like DMG Mori come into focus. Hurco’s client base is typically smaller, less well-capitalized, and generally produces components for larger OEMs, while DMG Mori, Okuma, Haas, and others supply more of those large OEMs directly. With that, Hurco is often ahead of broader cyclical trends, so while Hurco is seeing order contraction now, DMG Mori and the JMTBA are reporting healthy growth, but Hurco is likely to bottom and recover faster as well.

The Outlook

This is the more challenging part of the cycle to own Hurco, and the near-term outlook does concern me. Current results aren’t that bad, as North American and constant currency EU sales were up nicely on a yoy comp, but I do think the order erosion is a risk, as are other macro factors like rising rates and softening capex investments. Keep an eye on other industrial company earnings reports this cycle for more commentary on the near-term order outlook and particularly with respect to equipment (as opposed to parts/consumables).

I’ve lowered my FY’22 and FY’23 revenue estimates again but also increased my FY’24, FY’25, and FY’26 estimates as I believe the cycle is coming in faster than I’d previously modeled. Longer term, nothing really changes as I expect low single-digit revenue growth from Hurco that’s a bit ahead of my expectation for GDP and capital investment growth in Hurco’s core markets.

I’ve raised my gross margin assumption slightly, as Hurco has been doing better than I expected here, but I think it will take a couple of years for gross margin leverage to really normalize in a meaningful way. I haven’t changed my SG&A expenses all that meaningfully at this point. Long term, I expect low single-digit to mid-single-digit FCF margins, with peak years in the high-single digits to low-double digits.

The Bottom Line

Between discounted long-term free cash flow and margin/return-driven EV/EBITDA, I believe that Hurco is priced for a long-term annualized return in the double-digits, but the weaker near-term outlook does weigh more on my short-term valuation outlook. I do think that Hurco is undervalued below $30, but I also don’t expect investors to be clamoring to get into an unfollowed industrial micro-cap with short-cycle exposure. I expect sentiment to clear up in the second half of calendar 2023, but investors will have to be patient in the meantime.