Description
SMC (6273 JP); stock price: 10,200Yen; equity market cap: 733bYen; cash/investments: 330bYen
SMC is the largest pneumatic company in the world with 26% global market share (+60% market share in Japan, +40% in fast-growing Asia, 15% in Europe and 12% the U.S.). Festo is global #2 at 12% global market share, Parker Hannifin is #3 with 8%, IMI (Norgren) has 6%, and CKD has 3%. SMC has historically taken about 1ppt of global market share a year. Market is reasonably fragmented with the top 5 players having 55% global market share.
SMC's operating margins are double their competitors (SMC:25% OM, PH 15%, IMI 14%, CKD 11%, Festo is private). SMC’s domestic end markets: 22% semiconductor production equipment, 19% auto, 14% machinery, 9% consumer appliance, 4% food, 2% medical, 30% other. The company has +600,000 SKU's (15,000 discrete SKU’s). Pneumatics is the use of pressurized air to effect mechanical motion. SMC’s primary product lines: directional control values, actuators, air-line equipment, and filters. Their largest customer is Toyota at 1% of sales (very low customer concentration).
Over the last two decades, book value per share has grown at 10.5% CAGR, sales at 8.5% CAGR (all organic), and an average operating margin of 19% (with the peak and trough operating margin levels working higher through the cycles). Current pre-tax ROCE is +30% and after-tax ROCE is +20%.
Company has rich product lineup, huge SG&A and R&D leverage, and shorter lead times (70% of all domestic orders are delivered in 3 days), which all have helped the company take market share over time. As to the impact of SMC's scale, one can look at CKD (6407 JP), which is their top domestic competitor. SMC has 3.7x the revenue of CKD, 5x the SG&A, and 6.7x the R&D. SMC's scale advantage gives the ability to design customized solutions for customers, which they can then standardize and deliver across their sales base profitably as the development cost gets spread much more thinly than their smaller competitors can achieve. Their market share gives them scale up and down the income statement.
SMC’s overseas sales ratio has gone from 17% in 1991 to 53% in 2007. This is not a situation where the company is going to be stuck in a long-term shrinking market (i.e., Japan). They can clearly compete very effectively in the global marketplace. Their most recent quarter is a good indicator of where things are going. Japan represented 47.7% of the total sales and grew 2% y-o-y. Asia was 20% of total sales and grew 29% (China represents 1/3 of Asian sales). Europe was 17% of total sales and grew 19%. North America was 12% of total sales and grew -2%.
SMC's is exposed to a fast-growing end-market as the global pneumatic market has growth at 7% a year over 20 years (roughly 2x GDP growth). Pneumatics have taken share from hydraulics due to pneumatics being cleaner, lighter, lower maintenance, and lower emissions. Demand has risen on the back of computer integrated manufacturing and increased product miniaturization. SMC has been able to outgrow their end-market by 3% a year as they have consistently taken share. SMC’s long-term organic growth rate would put it near the top of global industrials. While the overall growth has been good, SMC also has the advantage of competing in a niche market with annual global pneumatics sales totaling roughly $15bUSD, which makes the market smaller than the global excavator market. SMC does not have to play in the same sandbox with GE or UTC.
Chairman and founder is Yoshiyuki Takada, who is 81 years old. The two founding families own 8% of the company.
SMC’s long-term corporate strategy is guided by the Lanchester Principle. In modern combat with artillery pieces firing at each other from a distance, the guns can attack multiple targets and can receive fire from multiple directions. Lanchester determined that the power of such an army is proportional not to the number of units it has, but to the square of the number of units. This is known as Lanchester's Square Law. Here's why. Suppose the blue army is three times the size of the red army. This means that it is concentrating three times as much firepower on red as red is firing. Just as importantly, red's firepower is diluted over three times as many blue units. The combined effect of these two conditions is that blue is nine times as strong as red although it only has three times as many units. This principle has had a big impact of Japanese corporate strategy by encouraging managers to focus on the attainment of large market shares (Toyota, Fanuc, etc.). Using Lanchester’s math yields 26% market share as the minimum target (where SMC is currently). 42% market share gives control of the market. 74% market share is a monopoly. To implement this strategy, SMC has typically had 3x the sales force of their competition in the markets where they are focused on taking share. SMC is pushing very hard in Europe and N.A. SMC's aggressive push into China has helped them move their market share to 40% from 10% in 1998. With SMC’s 60% market share in Japan, their domestic investment levels have been curtailed as this battle has been won. In the U.S., SMC has expanded their salesforce by 70% over the last 3 years as they have taken share from Parker Hannifin that is much more concerned with its near-term profitability than long-term market dominance. Ten years ago, Parker had 22% of the U.S. pneumatics market, versus only 16% now. SMC’s U.S. share has gone from 5% to 12% over the same period. Parker has recently rolled out a more aggressive strategic pricing initiative that has angered their long-term customer base, which is sending more of them over to SMC. SMC could have raised prices with Parker, but they have kept their prices in the U.S. flat for the last ten years as they would rather take market share long-term than lift profitability in the short-term. SMC truly operates the company in accordance with the Lanchester Principle- it is not just a slide in their roadshow pack (they don’t do roadshows anyhow).
The company is levered to semiconductor production equipment spending and auto capital expenditures. A global slowdown or recession would leave the company very exposed as the company generates little in aftermarket or service sales. SMC's operating profit was down 44% in 1991 recession, 28% in the Asian crisis of 1998, and 63% in the 2001 recession. The 2001 recession was an exaggerated cycle that we don’t think will repeat. The EBIT numbers for the period are: 29bYen (FY’99), 36bYen (FY’00), 61bYen (FY’01), 23bYen (FY’02), 31bYen (FY’03), 56bYen (FY’04). The 63% EBIT decline from FY’01 to FY’02 was exaggerated by the 70% EBIT lift in FY’01. With all the SKU's and short delivery times, SMC has to hold a lot of inventory (inventory days outstanding = 250).
The company started their first ever share repurchase program in the 2nd half of 2007 when they repurchased 4.5% of the equity capital. With 330bYen in cash and investments on the books, we think the company has a lot of room left to repurchase significant amounts of their stock at very depressed valuations. SMC is 50% foreign held, which clearly worries the management team that is much more concerned about long-term world domination of the pneumatics market than what the stock price is doing. The company does not have a poison pill.
The stock is currently trading for 4x EV/FY’08 EBIT (including the net cash position that represents almost 50% of market cap). This valuation represents a 50% discount to our estimate of its private market value. Even if the global economy were to slow sharply and SMC’s EBIT went down 40%, the stock would still trade for 6.5x EV/EBIT. We think the very low valuation on this very high-quality business creates a supremely large margin of safety.
Local sell-side coverage is so poor as to be almost negligent. Besides the fact that the analysts are nitpicking a great industrial at 4x EV/EBIT- they can’t even add the excess cash on the books. Most of them find the stock expensive at 12x ’08 EPS, but that doesn’t include the cash, which is almost 50% of the market cap. Taking the cash out of the calculation, the P/E on FY’08 is 6x. With 15 sell-siders covering the company, there is only one buy-rating (Mizuho). Looking at the cash balance, they are earning just 1.6% on it pre-tax (sub 1% post-tax). Their current dividend yield is 1.2% (with a 14% payout ratio). A large share buyback clearly makes sense on a number of levels. The stock is a 15% FCY.
Catalyst