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Morningstar | Higher Investments and Nonrecurring Costs Weigh on Denso’s Profitability; Cutting FVE to JPY 5,900

Narrow-moat auto parts manufacturer Denso posted a 22% decline in operating profit for the fiscal 2019 that was worse than our expectation. Revenue was in line, up 5% from last year, but substantial investments for research and development and new production facilities coupled with additional provision and impairment costs struck the profitability significantly, with operating margin down 2 percentage points to 5.9%. Stripping out the nonrecurring items, operating profit went down by 14%, still lower than we expected.

We’re cutting our fair value estimate for Denso to JPY 5,900 from JPY 6,500, after taking account into worse-than-expected fiscal 2019 profits and lower profits assumptions for the next five years. Although management expects its revenue and operating profit in fiscal 2020 to grow 2.6% and 20% year on year, respectively, to JPY 5,500 billion and JPY 380 billion, the forecast numbers are still below our previous estimates. The shares are undervalued at current levels, trading in 4-star territory.

Denso’s margins reached new low since fiscal 2013. However, we think the company will gradually improve in the medium term, after significant investments for future growth. We anticipate its gross margin to rise from 15.5% to an average of 16.4%, as the production costs per unit will decrease due to improvement of its production efficiency and larger economies of scale. As the operating expense ratio will be stabilized, operating margin will also advance to 7.1% in average over fiscal 2020-24, but will be lower than the average of 7.5% over the past five years.

Geographically, sales from European only rose 1% from prior year, while sales from Japan, North America, and Asia increased moderately at 6%, 5%, and 8% year on year, respectively. On the product front, the sales from the mobility systems, up 29% (including Denso Ten), was the primary growth driver, while the largest business, thermal systems, saw revenue declines of 0.9%. We expect the growth driver will come from the electrification and safety related products.