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Morningstar | Nabtesco Cuts Guidance, Expects 2019 Recovery; We Still Think Bad News Is Already Reflected

Wide-moat-rated Nabtesco has cut its 2018 revenue and operating profit guidance by 4% and 20%, respectively, following disappointing third-quarter performances in three out of four of its business segments. The reductions imply that net profit for 2018 should be down 25% year over year driven by a drop in demand for precision gears, especially from the auto sector, and increased costs. Third-quarter operating margin slid to 9.1% from 11.3% a year ago and 9.3% in the first quarter, but as we have already factored in a slowdown in sales, there is lesser impact to our post 2018 earnings estimates.

Nonetheless, the knock-on impact of the lower sales in 2018 leads to a cut in our fair value estimate to JPY 3,350 from JPY 3,800 with negative free cash flow in 2018 that should rebound but not to the past five years' average level until 2022. We think Nabtesco's share price already reflects the weaker outlook but concerns will linger over near-term challenges.

We think the next two to three years will remain difficult for the company as it is expanding its precision gear capacity at a time in which auto segment expansion looks to be soft. We believe this adds risk to Nabtesco's near-term performance. Capacity utilization at its Japan-based precision gears plant has dropped from over 150% in the first half to 105% in the third quarter. We think slowing growth in China will dampen demand and lengthen the ramp up of its additional capacity in 2020. Although revenue growth should improve, margins should remain soft relative to historical levels. As a result, we are only expecting operating profit to grow at 2.4% CAGR despite an average 6% revenue growth over the next five years.

The company expects a better cost picture in 2019, however, with reduced technology and marketing costs and the absence of the JPY 5.2 billion asset impairment charge accounted for in the second quarter. As such, net profit could rebound 16% in 2019 before dipping again.

Geographical performance shows that Nabtesco's sales growth is still largely driven by Asian demand. Interestingly, sales in Asia ex-China and Japan were up strongly, growing 29% year over year. We think this could be a bright spark for Nabtesco as we think it implies rising mechanization by manufacturers across Asia. China's sales grew 8% year over year, most probably led by demand for hydraulics gears. Growth for this segment was much stronger than we anticipated and Nabtesco has raised its guidance for this business although it's not enough to offset the drop in sales of precision gears.

At the moment, customer demand in Asia is likely to remain sensitive to trade war sentiment. An alleviation in the U.S.-China trade war impasse could lead to a more promising near-term demand outlook for Nabtesco. However, we don't expect a significant pick up in demand from the auto sector given the longer-term picture of slowing growth in China and the potential rise of rideshare programs.