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Morningstar | MHI’s 3Q Continues Trend of Profit Improvement but Slipping Orders, Remains Fairly Valued

Mitsubishi Heavy Industries’, or MHI’s, third-quarter performance continues the trend seen in the first half of their fiscal 2018 (year ending March 2019) with core operations’ profit improving but with slipping new orders reflecting a continued challenging business environment. The firm's fiscal 2018 profit guidance is unchanged but has unsurprisingly lowered new orders expectations. Since we had already factored in slow revenue growth averaging 1.8% in our five-year projection, our profit forecast is unchanged. We forecast MHI to be free cash flow-negative this fiscal year mainly due a capital injection into Mitsubishi Regional Jet, or MRJ, but in the absence of further such requirements, we expect the company to be free cash flow-positive from fiscal 2019. The company itself continues to target to be free cash flow-positive. Our fair value estimate moves to JPY 4,710 from JPY 4,640 due to the time value of our discounted cash flow. MHI is trading shy of our fair value estimate presently but a larger discount is preferred.

We think the results are benign considering the slowing global demand. Relative to our segmental expectations, power sector revenue is slightly ahead while aircraft & defence is below but the fourth quarter can be lumpy. The operating loss at MRJ increased to JPY 31 billion in the third quarter, which points to a pace that is around 10% worse than guidance. Our current estimate is for MHI to achieve a net profit of JPY 73 billion, which is 10% below guidance of JPY 80 billion.

The key things we’d like to see from MHI are its ability to achieve cost efficiencies and for the MRJ to commence delivery. We presently only expect MHI’s power segment to see average revenue growth of just 1.1% over the next five years so cost management will be key and we expect segment operating profit growth at 6.2% due to cost cuts. We see MHI’s operating margin rising 300 basis points to fiscal 2022 but there is room to lift our fiscal 2019 assumption.

MHI management continues to expect MRJ’s fiscal 2018 operating loss to be around JPY 90 billion and it sounds like they will capitalize some hardware spending. MHI is in an escalating legal wrangle with Bombardier over the MRJ but does not expect this to delay the plane’s delivery starting in 2020. We have forecast for a similar level of operating loss in fiscal 2019 of JPY 90 billion but expect the losses to reduce starting in fiscal 2020. However, we expect slight operating losses to continue through fiscal 2022. The lower MRJ losses will help drive MHI’s five-year EPS CAGR of 16%.

The company lowered its power and industrial segments new orders expectation by JPY 200 billion and JPY 100 billion, respectively. These are driven by cancellations and deferred expansion projects in Japan, the U.S., Southeast Asia, Africa and Europe. MHI has minimal China power segment revenue but its industrials segment has noted sluggishness but no evident need to cut sales expectations so far. While the company has been able to win new orders and its wind-turbine associate company has seen its new orders rise 80%, which are both positive, we think the risk of cancellations remains high for conventional products given slowing global growth.