The Fanuc Stock Story Is Getting More Interesting (OTCMKTS:FANUY)

Japan’s Fanuc (OTCPK:FANUY) has long been a major player in automation, with leading share in CNC equipment for machine tools, as well as strong share in robots and machine tools like tapping centers. Despite that leadership, I’ve been less than positive on the company at many points due to what I’ve seen as excessive investor enthusiasm and questionable choices in the past regarding R&D investments and capital allocation.

Since my last update, the shares have slid another 10% or so, underperforming the S&P 500, but more or less matching the broader industrial space and good enough for a “middle of the road” performance versus other automation plays like ABB (ABB), Schneider (OTCPK:SBGSY), Siemens (OTCPK:SIEGY), and Yaskawa (OTCPK:YASKY). I still have many concerns about Fanuc, including a possible near-term order peak, increasing competition from Chinese rivals, and underinvestment in growth areas like cobots, but the valuation is more reasonable now than it has been in a while, and that’s with what I don’t believe are “heroic” growth assumptions.

Automation Demand Is Booming

Between catch-up spending that was deferred during the pandemic (and before, at least for more developed markets) and expanding opportunities in areas like electric vehicles, these are good times for automation capex providers like Fanuc and Yaskawa, with strong order flows and improving margins on improving operating leverage.

Revenue was comfortably ahead of expectations (by around 7%, though different services reported different average estimates) in Fanuc’s fiscal third quarter, growing 30% year over year and 14% quarter over quarter. Factory automation (or FA) revenue rose 59% yoy and 16%, while Robot revenue rose 39% yoy and 23%. Robomachine revenue declined 10% yoy and improved 1% qoq, and Service revenue rose 17% yoy and declined slightly on a sequential basis.

Gross margin improved about 70bp annually and declined 150bp sequentially – a result that I’d argue is quite strong relative to the ongoing supply challenges shared by virtually all industrial companies. Operating income rose 40% yoy and 10% qoq, good for an 8% beat after a sizable miss in the fiscal second quarter. Operating margin improved to a quite-healthy 24.4% (from 22.7% a year earlier), and declined modestly from 25.2% in the prior quarter.

On the back of healthy results and strong order flow, management raised its full-year operating income target by 5% – bringing it in-line with the prior sell-side average estimate.

Orders – Jam Today, But Still Jam Tomorrow?

Orders rose 27% yoy and 6% qoq in the fiscal third quarter, good for a modest 2% beat versus expectations, but with some notable dispersion in the components – namely, very strong FA and Robot orders, offset by weaker Robomachine orders.

FA orders rose 44% yoy and declined 5% qoq, and management indicated that orders would have likely been stronger if not for supply chain issues (both with the company and its customers). This fits with the strong orders seen at Yaskawa and for the Japanese machine tool sector as a whole (up 41% yoy in December), as well as the small pure-play tool company Hurco (HURC).

Machine tool orders have been strong almost across the board, apart from aerospace, with some improving demand in autos despite other supply chain issues (chips, mainly) and strong demand in “general industrial”. I do have some concerns about the overall likelihood of a further run in orders from here, but I would note that there was meaningful under-investment in developed country capex going into the pandemic-driven downturn, and reshoring/near-shoring could drive a more prolonged recovery.

Robotics orders rose 34% yoy and 17% qoq to JPY 90.9B, blowing away the old record of JPY 78.6B, as demand remains robust – particularly in the auto sector in North America and Europe as OEMs tool up for future EV launches. A key concern of mine going forward is whether Fanuc can continue to hold on to historical market share in industrial (non-auto) robots, as Fanuc has underinvested in areas like cobots. With many new automation adopters turning to these safer, more mobile, more flexible platforms, companies like Teradyne (TER) have benefited considerably, and it remains to be seen if Fanuc can keep up with the evolving needs of industrial robots.

Robomachine orders declined 17% yoy and rose 9% qoq. I expect this to remain a “consistently inconsistent” business for Fanuc, but one where I am concerned. Customers like Apple (AAPL) have been relentless in pushing suppliers for lower costs, and Fanuc’s tapping centers have traditionally been around 15% to 20% more expensive than alternatives from Korea, and even more expensive relative to machine tool offerings from Chinese rivals. Management is refocusing on more productive, more efficient tools across its range (including tapping centers, injection molding, and cutting), and Fanuc could perhaps benefit from rival Chinese toolmakers buying their CNC systems, but it still bears watching.

The Outlook

Regular readers of mine know that I’ve made no secret of my bullishness on factory automation and electrification over the next five to 10 years, as companies look to automation to address manufacturing costs and flexibility. As a major provider, Fanuc should stand to benefit, but “should” is a tricky word here.

As I’ve said in the past, I’m concerned about share loss in CNC equipment outside of Japan, with increasing competition from open source alternatives. I’m likewise concerned in robotics, where I see Fanuc vulnerable to share loss in its historical “core” robotics portfolio, as well as a shift in demand as new robot customers look more towards cobots for their automation needs. Last and not least are the concerns that Fanuc will see its Robomachine customers turn to cheaper alternatives from Korea and China.

On the positive side, the multiyear capex binge of FY16 to FY20 is well behind the company, and while there will always be some need to add or renovate capacity here or there, it won’t be on the same magnitude. High fixed costs do remain an issue, though, and while the company has gotten more efficient about R&D spending, I do still have some concerns about what R&D projects they’re prioritizing.

I have been more conservative on my modeling for Fanuc, and so despite the big fiscal Q2 miss, the better results in Q3 lead me to slightly higher numbers. Longer term, I’m still expecting high single-digit annualized revenue growth; while I have concerns about Fanuc’s leadership in automation, I do still believe there will be strong secular tailwinds for the company.

I do expect better margins as the company becomes more focused on operating efficiency after a significant multiyear investment cycle, though again I do think more reinvestment is needed in areas like cobots. FCF margins have historically swung pretty wildly here, but I think we’ll see a move from the mid-teens (on average) toward the low 20%s over the next three to five years.

The Bottom Line

I value stocks like Fanuc with multiple approaches; I almost always use a discounted cash flow model, supplemented with a margin/returns-driven model. In the case of Japanese industrials, there is a strong historical relationship between ROEs and P/BV, and that is one of the metrics I use. Between these two approaches, I believe Fanuc could be more than 15% undervalued today and could offer a better annualized total return (in the mid-to-high single-digits) than it has in some time.

Obviously I’m not unreservedly bullish on Fanuc. Assuming that old champions will remain a force in the future can lead to disappointment (I say this as a fan of the Chicago Blackhawks and Dallas Cowboys…), and I do think Fanuc needs to rethink some of its portfolio. That said, I think we’ve already seen the worst of the “end of the cycle” sell-off, and at this point I see more upside than downside.