Fanuc Still Under Pressure From The Automation Slowdown

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Summary

Since my last update on Japanese factory automation specialist Fanuc (OTCPK:FANUY) (6954), the shares have declined about 6% - broadly in line with other Japanese automation plays like Yaskawa (OTCPK:YASKY) and THK (OTCPK:THKLY), but lagging Western players like Rockwell (ROK) and ABB (ABB). Fanuc has also been one of the weaker stocks in the group over the past year, an issue that I believe ties back just as much to the overheated valuation as fundamental deterioration in the business.

I still see a lot of challenges for Fanuc. The company’s extensive investments in capex have created a lot of operating overhead, and it’s no better than unclear to me as to whether significant increases in R&D spending over recent years have really improved product vitality and competitiveness. Worse still, I see more competition eroding the company’s former strength in CNC controls and I haven’t been all that impressed with the company’s leverage to opportunities like cobots or industrial IoT.

Fanuc still enjoys a strong reputation as arguably the go-to name in Japanese automation, and I think that is reflected in the share price. I expect business to pick up significantly in the coming years, and I see significant potential to improve FCF margins, but I can’t make the valuation work.

Not A Great Quarter, But Likely A Relief

I believe part of the issue with the performance of Japanese automation stocks is that, for some reason, the sell-side and investors got really excited about the recovery story around September of 2019. While markets like China probably did bottom in the second half of 2019, I think expectations got ahead of reality and now there’s a reckoning.

Revenue rose 17% in Fanuc’s fiscal third quarter, beating the IBES average estimate by a fractional amount. Factory automation sales (largely CNC controls and servomotors) dropped 31% yoy and 2% qoq, and robomachine sales (machine tools and injection molding tools) followed a similar path, falling 31% yoy and 5% qoq. Robots held up relatively better, falling only 3% yoy and actually rising 5% qoq on good demand within Japan.

Between factory overhead absorption issues, pricing, and mix, gross margins remain weak. Gross margin declined seven points from the year-ago period and about 70bp qoq. Operating income dropped 45%, with operating margin contracting eight points yoy and 60bp qoq. A double-digit cut to R&D spending (down 12%) helped limit the damage. As far as this performance goes relative to expectations, two different sources (Bloomberg and IBES) gave me very different sell-side estimate averages – according to Bloomberg, this was a modest beat, but according to IBES it was a roughly 3% miss.

Weak Orders And A Challenging Outlook

Fanuc reported a 14% yoy drop in orders, missing expectations by about 2%. FA orders fell 21% yoy, but rebounded 15% qoq. To management’s credit, I believe they tried to tamp down excitement related to this, noting it was likely driven by restocking and the timing of the Chinese New Year shutdowns. Robot orders were down slightly yoy and 13% qoq, while robomachine orders were down 29% yoy and 6% qoq.

When Yaskawa reported earlier this month, it told investors that motion control sales (which includes servos) declined 15% yoy and 3% qoq, with motion control orders down 3% yoy and up 3% qoq. Robotics sales were down 18%, with orders down 17% yoy and down about 2% qoq.

Both Fanuc and Yaskawa pointed to challenging trends in key markets like autos; Fanuc noted strength in Japan and stability in the U.S., but weakness in Europe and China. Likewise with general industrial demand. Given that there can be some significant differences driven by customer concentration (large auto OEMs tend to go with one robot provider), I think that largely explains quarter-to-quarter variation between the likes of ABB, Fanuc, and Yaskawa in robotics. Broadly speaking, China and Europe are problematic and the U.S. is dicey.

I don’t expect 2020 to be as bad for auto capex, but spending is still weak. General industrial demand should improve as the year goes on, and I’d note that Maxim (MXIM) recently upgraded guidance for its industrial semiconductor segment on the back of strengthening demand in automation.

Specific to Fanuc, though, I still see some significant challenges.

The company’s once-dominant position in CNC controls is significantly less dominant now, with competitors like Siemens (OTCPK:SIEGY) and Mitsubishi Electric (OTCPK:MIELY) gaining some share, but fiercer competition from Chinese and Taiwanese players as well. Open-source competition has become stiffer, and this business isn’t the fortress for Fanuc that it once was.

I’m also concerned about Fanuc’s position in robotics. Fanuc’s cobot portfolio doesn’t look as impressive as those from ABB, Teradyne (TER), or Yaskawa, and I likewise don’t think Fanuc has been quick enough to adapt to new opportunities in markets like food/beverage and logistics.

Last and by no means least is the cost structure. Fanuc has ratcheted up its R&D spending from around 4% of revenue to 9% to 10%, but there’s not much to show for it in terms of product vitality or gross margins. Fanuc also took the boom in Chinese-driven automation demand as a sign to invest in capex, and capex has expanded from around 3% to 4% of sales to over 20% (up 10x between FY14 and FY19). It takes money to make money, absolutely, but I am concerned that Fanuc has committed itself to too much fixed overhead, pressuring margins on a long-term basis.

The Outlook

Management is trying to be responsive to the spending issues, pledging to take a more controlled approach, but not to allow cost-cutting to impede future growth. That’s fine; that’s what companies should do. Still, I think there is a real risk of under-utilized capacity, as I don’t think Fanuc will see a second demand boom in China, particularly given the growing competitiveness of Chinese automation providers (and the Chinese government’s interest in encouraging/supportive self-sufficiency).

I approach modeling Fanuc with the idea of global capex increasing at a long-term rate of around 3%, but automation capex growing faster (at a 5% to 6% rate). I think Fanuc is going to be a net share loser over time, but I still expect 5%-plus long-term revenue growth. Were the company to develop more impressive internal growth drivers (industrial IoT, software, etc.), there could be some upside.

On margins, I do think that management will rein in R&D and capex spending, and I see that allowing FCF margins to re-expand to 20%-plus. I don’t think the mid-to-high 20%s are attainable again on a sustained long-term basis, as I think the gross margin opportunity is fundamentally different now.

Unfortunately, the resulting mid-to-high-teens FCF growth isn’t enough to drive a compelling fair value today, nor is my margin/return-driven EV/EBITDA approach or a ROE-driven P/BV approach (Japanese stocks, at least in automation, do show a correlation between ROE and P/BV).

The Bottom Line

If the pullback in Fanuc picks up steam, I’ll keep an eye on it. There are a lot of challenges here, but at the right price it would be worth considering (it’s still the leader in CNC controls and robots, after all). I’d also note that sentiment is really bad now, with a net “sell” rating from the sell-side. All in all, though, I just don’t see a compelling argument for owning Fanuc today.

Disclosure: I am/we are long ABB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.