EUR 850.00 For Business Accounts Only

Morningstar | Sandvik's Recent Margin Expansion Should Partly Outlast the Cycle but Not Its Revenue Growth

Sandvik's first half 18.7% EBIT margin positively surprised us relative to our 17.2% margin forecast for the full year. Restructuring efforts and divestitures of low margin businesses have expanded margins greater than we factored into our model. As a result, we have increased our fair value estimate to SEK 111 from SEK 104 for the local shares and to USD 12.60 from USD 11.90 for the ADR. Most of the increase comes from increasing our midterm EBIT margin by 50 basis points to 15.6%. However, we believe the shares are overvalued and that there is increasing risk of a near-term peaking of revenue growth, trending in the double-digits and reflective of the rebound in manufacturing activity.

Sandvik's largest division, Machining, makes tool inserts for metal cutting used across mainly cyclical end markets like autos and manufacturing. The order lead time for the inserts is very short, meaning that a turn in the cycle can hit the division quickly. In the first half of the year, division revenue grew by 10%, well above the 3.5% midcycle range. We believe there is growing risk that the peak cycle revenue growth is behind us or will be in the next quarter or two, as 2018 represents the second year of recovery in orders, while there are indications of the cycle turning. Recent manufacturing indicators, such as the European PMI, have been coming in at progressively lower rates in the past couple of months. We see the risk of a pullback in manufacturing spend due to caution on a potential expansion of the tariff wars.

We also view the current EBIT margin as reflective of peak cycle. However, we expect some lasting effects of around 250 basis points from the recent restructuring program including the divestitures within the Materials division. Therefore in the medium term, we expect the group EBIT margin to settle at a little over 15% on a midcycle basis, higher than the roughly 13% historic midcycle but lower than 18.7% posted in the first half.

In previous cycles, Sandvik's revenue swing has ranged from negative 11% to +15% and its EBIT margin contracted by nearly 500 basis points. For this reason we have a high uncertainty rating on the stock and require a wider margin of safety, or upside, relative to our fair value estimate before recommending the shares.