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Morningstar | MHI Targets Robust Near-Term Growth, We Are Less Optimistic but FVE is Raised

Mitsubishi Heavy Industry's, or MHI's, strategy briefing revealed robust profit growth targets in all three divisions, led partly by cutting costs, but we are less optimistic about it. MHI is targeting an operating profit of JPY 350 billion in fiscal 2020 (year ending March 2021), a 59% year-over-year jump over fiscal 2019's JPY 220 billion. Much of the increase comes from a margin improvement. We have given MHI some benefit of the doubt but our revised fiscal 2020 operating profit forecast of JPY 269 billion is still 23% below MHI's target. Our fair value estimate is raised to JPY 5,200 from JPY 4,820 and the stock remains fairly valued. The market would still find it difficult to accept MHI's robust targets without specific details about its cost-cutting plans.

Of the three segments, we believe plans for its power systems segment are more probable. MHI expects a pick-up in its nuclear systems and servicing activities, and continued strength in renewables to lift revenue. New nuclear power plant safety measures are being implemented. As a result, it sees revenue growth for this segment rising to 16.4% in fiscal 2020. We view fiscal 2019 and fiscal 2020 growth as very strong because delayed projects are restarting and expect growth to return to low-single-digit pace thereafter. There is less sensitivity to macroeconomic challenges relative to manufacturing spending because of policy and pump priming by governments to boost economic growth, barring currency headwinds.

The industry and infrastructure segment may face challenges meeting its aggressive margin uplift targets. MHI has built in assumptions that struggling businesses will turn around but we think this will be difficult owing to slower global growth. Lastly, MHI sees lower losses in its aircraft, defense and space segment but there is little clarity over the spending plans for its regional jet business to be more optimistic and if this will be achievable to the extent that MHI has planned.

With the revision in our margin assumptions to be midway to MHI's targets, we now expect MHI to achieve robust EPS CAGR of 13.5% over the next five years. However, we have also raised our assumption for capital expenditure to 4% of revenue, from 3.6%, because this is closer to the 4.2% average over the past three years. Because we have not factored in any acquisitions, we believe the higher capital expenditure, or capex, is reasonable because total reinvestment is likely to be sustained owing to MHI's plans to acquire new businesses. So we see free cash flow stabilizing at about JPY 125 billion.

MHI's Power Systems revenue growth will be higher than that of similar businesses at key competitors Siemens, ABB and General Electric. In other words, we are only looking at low- single-digit revenue growth for the industry. Because we believe the jump at MHI reflects recent acquisitions in the nuclear and windfarm segments and restarting previously deferred projects, we think revenue growth will normalize after fiscal 2020. We factor in a slight revenue dip in fiscal 2021.

The industry and infrastructure segment includes competitive consumer electronics businesses, shipbuilding, industrial equipment and turbochargers for the auto industry. The wide range of products limits the transparency for this segment because revenue growth could range from low-single-digit growth for consumer electronics and shipbuilding to high single-digit-growth for turbochargers and material handling equipment. One of the main reasons MHI management has set aggressive profit targets for this segment is because a restructure in 2018 has consolidated the product lines into seven main business groups that should enable management to focus on driving profit. Since Japanese business culture rarely leads to mass job cuts, we think it will take more time for cost savings to materialize. There is also the possibility of impairment charges while stronger growth elsewhere is likely to be hit by the trade war. As a result, we see a more gradual rise in operating profit margin to 6% in fiscal 2021 from 3.7% in fiscal 2018. MHI is targeting to reach 8% in fiscal 2020.

It looks like MHI expects the faster-growing products to make up about 40% of segment revenue with the more competitive products making up the balance in fiscal 2020. While it's difficult to estimate the profitability without the detailed margin breakdown, we still think that a 6% operating margin is more appropriate versus peer group range of 6%-11%, given that MHI has lower margin commercial shipbuilding, and commercial electronics products and EPC services in this mix.

While the aircraft, defense and space segment is the smallest contributor to MHI's operating profit, the losses at its regional jet business have weighed on group profit. These losses should diminish once its aircraft obtain regulatory approvals, which is still anticipated to be in 2020. MHI has rebranded its regional jets to SpaceJets and will produce two main products, the M90 and M100, to seat up to 92 and 88 passengers, respectively. The latter is a redesign to meet United States scope-clause restrictions. While we are less excited by this product segment, the exit by Bombardier from the commercial regional jet segment does give SpaceJet an opportunity to be a key supplier of these aircraft. However, we also see this as a small market, especially given that the current trend indicates a preference by airlines for narrow body jets over regional jets. We think challenges remain as Bombardier also struggled to get new orders for its jets and the target 2023 date for production of the M100 appears to present a delay.

MHI sees an operating loss of JPY 20 billion in fiscal 2019 followed by breakeven in fiscal 2020. We anticipate some delays to hit profits and factor in an operating loss of JPY 39 billion and JPY 10 billion respectively. We also don't expect Boeing 777X deliveries to start meaningfully until fiscal 2021, which may slow sales at MHI for the fuselage that it manufactures for Boeing. We have left our profit assumptions for this segment largely unchanged. The risk would come from further development plans for its SpaceJet series that is likely to lead to additional investment.