Komatsu Beating Estimates And Raising Guidance, But Going Nowhere Fast

In my last article on Komatsu (OTCPK:KMTUY), I noted a growing rift between the performance of Komatsu as a company and the performance of its shares. Since then, the company has continued to execute well, handily beating expectations, but the shares have arguably still lagged what that performance should have earned. Komatsu’s local shares are up about 8%, while the ADRs are down about 8%, versus a 15% move in Caterpillar (CAT) shares, 3% moves at Deere (DE) and Terex (TEX), and a much weaker performance at Volvo (OTCPK:VLVLY) and Hitachi Construction Machinery (OTCPK:HTCMY).

I believe Komatsu is undervalued relative to what the market has typically paid for peak earnings, but I’m also concerned that demand for construction machinery in markets like North America isn’t likely to get much better, and that demand in Indonesia and across the mining sector could likewise soften from here. I see a trading opportunity here, but I’d be careful about not overstaying my welcome.

Strong Results Continue To Roll In

There wasn’t much that I could fault in Komatsu’s fiscal second quarter results (the September quarter), as the company once again posted healthy, balanced revenue growth and profit growth that exceeded sell-side expectations despite ongoing weakness in the major Chinese market.

Revenue rose 33% as reported, or around 14% in constant currency terms. The construction and mining business posted 34% reported revenue growth and around 14% constant currency growth. Construction revenue was up 31% (reported), with equipment up 30% and parts up 37%, while Mining was up 37% with 24% growth in equipment sales, 49% growth in parts, and 38% growth in service revenue. Industrial Machinery revenue rose 20%, with Komatsu once again seeing strong demand for semiconductor-related products (light sources and lasers) and weaker demand for presses and machine tools used in auto manufacturing.

Komatsu has been active on pricing (contributing close to half of adjusted growth this quarter), and margins have held up well, with gross margin up 70bp to 29.6%. Operating income rose 58%, with operating margin up 220bp to 13.8%, beating by 28%. Segment profits rose 60% (margin up 230bp to 13.8%), with the construction and mining segment up 60%, and margin up 220bp to 13.2%.

Mixed Demand In Construction, And Mining Is Still Strong

Komatsu’s market performance and commentary indicated still-strong demand in most of its key growth markets.

North American sales rose 55% as reported, with the company noting ongoing strength in construction and infrastructure end-markets and improving energy and rental fleet demand. For its top 7 products, demand accelerated year over year and sequentially from the prior quarter, with year-over-year demand improving to +7% from +4% and growing 2% sequentially.

Demand also remains strong in Asian markets (excluding China and Japan), with strong demand in Indonesia and Malaysia, among other markets. Sales rose 104% in the second quarter, while underlying demand in the top 7 products increased 31% yoy (after increasing 22% yoy in the prior quarter) and 3% qoq.

China remains challenging. Sales were up 9% in the quarter, but underlying demand declined 33% yoy (down 60% yoy in the prior quarter) and improved 18% qoq. At this point, demand for excavators is trending at the lowest level in more than five years, as China continues to see the impact of its zero-COVID policy and broader problems in the property sector.

Komatsu reported a 35% yoy improvement in demand for its mining equipment, up from 18% yoy growth in the prior quarter.

Comparisons to other companies are never apples-to-apples, but I’d say that Komatsu is holding its own. Caterpillar reported 19% yoy growth in its construction business and 30% growth in its resource businesses this last quarter, while Terex reported 20% growth in its Materials Processing business. Epiroc (OTCPK:EPOKY) reported 12% organic revenue growth, while Hitachi Construction Machinery reported 22% revenue growth.

The Outlook

I would note that management did meaningfully boost guidance for the full year with fiscal second quarter earnings – boosting its revenue target by 15% (implying 23% yoy growth) and its operating profit target by 28%, or about 13% above the prior sell-side target.

At the same time, though, management sounded some cautious notes – guiding to minimal construction equipment demand growth in Japan (with recent average operating hours down 5% to 7% yoy), single-digit growth in North America (hours up about 4% to 5% recently), a 30%-plus decline in China (hours have been improving from double-digit declines to low single-digit declines), over 20% growth in Southeast Asia (hours up mid-single-digits), and flat yoy results in mining.

To my thinking, that signals peaking demand that is likely to lead to weaker growth next year and a possible contraction a year or two beyond that. To that end, while the longer-term outlook for construction in the U.S. is healthy, I think there could be some weakness tied to higher rates, and I’m concerned that a weaker global economy could slow investments in new equipment even though the mining fleet remains overaged.

Longer term, I remain impressed with Komatsu’s investments into autonomous equipment (it now has almost 600 autonomous mining trucks in operation) and new powertrains (hydrogen combustion, battery electrification, and fuel cells). I also am encouraged by the company’s efforts to catch up in underground/hard rock mining – the company recently announced a trial with Codelco for a mining tunnel boring machine.

I’ve boosted my near-term revenue expectations for Komatsu given the stronger-than-expected results, but I’m still expecting long-term growth around 4%. Management has been actively working toward sustained improvement in margins and FCF generation, and if they can execute and maintain mid-to-high single-digit FCF margins, a high single-digit FCF growth rate is possible.

The Bottom Line

Komatsu looks undervalued on both discounted cash flow and margin/return-based multiples valuation. Discounted cash flow is always tricky with cyclical companies, but I do find it can be useful as a broader signal of under/overvalued. With the multiples approaches, a 12% ROE in this fiscal year should support a price/book above 1.75x (currently 1.2x), while the company’s margins and historical trading range should support a forward EBITDA multiple of at least 8.5x (around $30/ADR), if not 9.5x.

Are Komatsu’s major markets at or near near-term peaks? That’s entirely possible. But I do think the company still has better financials on the way, and a “near-term peak” doesn’t guarantee a sharp fall in the near future. I would approach these shares with some caution given the global macro outlook, but today’s valuation does look appealing for a catch-up trade.