Trying to call a bottom in the machine tool space is a good way to look foolish, but I think we’re finally there – based not only on the commentary of companies like DMG Mori (OTCPK:MRSKY) and the results posted by Hurco (HURC) today but also looking at other trends and commentary in the industrial space. With this quarter, Hurco’s orders have spent two quarters at close to 50% below the prior peak, and I believe the company will see sequential revenue growth in the next quarter and quite possibly a return to order growth.
Although this downturn has been brutal in its suddenness, which does create some challenges in managing costs, it hasn’t been all that different in terms of magnitude relative to past downturns. Looking ahead, I expect healthy double-digit growth from Hurco over the next couple of years, with improving operating leverage as well. With the shares have meaningfully underperformed since my last update (when I turned neutral the near-term outlook), I think today’s valuation offers an attractive upside to a short-cycle industrial recovery in 2021 at a very reasonable price.
Still Rough, But A Few Bright Spots
Relative to my expectations, Hurco did better than I expected this quarter. While I thought the last quarter could be the bottom for revenue, I wasn’t completely convinced. This quarter, Hurco did report a 22% year-over-year decline in revenue, but a 22% sequential improvement, and the overall results were about 15% better than I’d expected, with stronger recoveries in Europe and Asia.
Revenue from North American customers fell 15% yoy and rose 5% qoq, while revenue from Europe fell 36% and rose 33%. Revenue from Asia improved 12% yoy and 40% qoq. Hurco’s business in Asia is small and volatile, so I’m cautious about reading too much into it, but there has been some definite improvement in machine tool demand in Asia – the Japan Machine Tool Builders Association reported 8% yoy and 14% month-over-month growth in demand in Asia in July (and Hurco’s fiscal quarter ended July 31).
Gross margin declined five points from the prior year but improved six points from the prior quarter. The company has not filed its 10-Q as of this writing, but I expect that the negative mix will still be a factor in the gross margin weakness, but I believe overhead under-absorption is more of an issue, helped by the company having a little more time to adjust expenses/capacity. Operating income fell 69% from the year-ago period but did improve on the quarter-ago loss, with margin recovering to a little over 3% (versus 8% last year).
Orders Haven’t Turned Yet
Hurco reported a 32% yoy and 1.5% qoq decline in orders, and you really want to see sequential improvement before feeling more confident in calling a bottom. Within the totals, orders from North America were down 17% yoy and up more than 2% qoq, while European orders fell 48% yoy and 9% qoq, and Asia-Pacific orders fell 9% yoy and rose 10% qoq.
The recovery in Asia makes sense and would seem to fit the reported trends from the JMTBA numbers, as well as customs data from Japan for companies like Fanuc (OTCPK:FANUY) and Brother (OTCPK:BRTHY). DMG Mori had a much more negative report, with orders from China falling 33%, but DMG Mori’s quarter ended in June, and not having that month of July might have really mattered in the comparison.
DMG Mori management also said that they believe orders have bottomed (globally) and that Chinese orders would be positive in the next quarter. I’ll mention my boilerplate warning once again, though, that comparing DMG Mori, or any of the large publicly-traded machine tool companies, to Hurco is tricky given the sheer difference in scale and customer bases – DMG Mori has major multinationals in its customer base, while Hurco generally sells to smaller companies.
I do believe that Hurco has likely seen the bottom in North America. Orders improved modestly on a sequential basis, and most indicators continue to support a sequential improvement in business activity calendar third quarter. I’d be careful about expecting a sharp V-shaped recovery in either of the next two quarters, though, as there are still significant demand uncertainties, and companies are still being quite cautious about ramping up capacity and capex.
Europe is a tougher call. This is the second quarter in a row where North American orders were larger than European orders, and that’s quite unusual on a historical basis. Granted, Hurco has been trying to build up its North American business, but Germany and Italy are still critical markets for the company.
I was happy to see the ifo Business Climate Index for Germany improve again in August – from 90.4 in July to 92.6 in August – but the index for manufacturing is still below 0, even though it has improved sharply over the last few months. Order intake for machine tools in Germany is still low, but overall business confidence in Europe does seem to be improving.
Looking at end-markets, the auto market still seems pretty soft with respect to capex spending, but there does seem to be improving demand in hydraulic machinery, and medical remains pretty healthy. I would expect improving demand from “general manufacturing”, but I do believe that most participants in most sectors are going to be very cautious with their near-term capex spending.
At this point, I’m expecting a roughly 10% sequential revenue improvement for Hurco in the next quarter, with some room for improvement in gross margin and operating margin. I expect the recovery to begin in earnest next year, driving mid-teens post-FY’20 three-year growth.
For the long term, I still expect low single-digit growth a bit ahead of underlying GDP, as I see opportunities for Hurco to gain share (particularly in the U.S.), partly offset by a turn away from machine tooling in favor of additive manufacturing among some customers – given Hurco’s historical focus on systems designed for high-spec, low-volume production, I do believe additive manufacturing is a threat here, though the company has introduced systems that combine additive manufacturing capabilities with more traditional machine tool functionality.
As revenue recovers, so too should margins as the company regains positive operating leverage. Once FCFs normalize, I expect mid-single-digit long-term growth. One item to watch on free cash flow is working capital – Hurco’s kept a higher level of inventory than I had expected, pressuring current year FCF, but perhaps setting the stage for a little upside in the year or two ahead.
The Bottom Line
Between discounted cash flow and margin/return-driven EV/EBITDA, I believe Hurco is more meaningfully undervalued now. Priced to generate a low-to-mid-teens annualized total return, I believe investors are getting more than adequate compensation for the risk that the recovery may be delayed, and/or that the recovery in 2021-2022 may be flatter than currently expected. Hurco is unfollowed and not particularly liquid, and carries meaningful risks as a capex supplier to cyclical end-markets, but I believe the risk/reward balance skews positive today.
Disclosure: I am/we are long HURC. 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.