Brief Industrials: SMC (6273 JP): Profit Decline Accelerates and more

In this briefing:

1. SMC (6273 JP): Profit Decline Accelerates
2. China Tower Results Confirm Lower Capex Outlook, but Were Otherwise Mixed
3. Versum Materials – Merck KGaA Not Going Away (Part II)
4. MINT’s First Post-Acquisition Update
5. Polycab IPO: Largest Cables Player, Asset-Heavy Low ROE Model = Vulnerable to Govt Capex Slowdown

1. SMC (6273 JP): Profit Decline Accelerates

Downturns in the semiconductor, auto and other user industries have caught up with SMC. Sales were down 4.0% year-on-year in the three months to December (the first decline in more than two years) and the decline in profits accelerated, with gross profit down 5.4%, operating profit down 10.6% and net profit down 18.8%. Year-on-year comparisons are likely to remain difficult for at least another two quarters.

In December, we wrote: “Management reports that semiconductor-related demand is down in all markets and that auto-related demand is down in the U.S. Auto sales are also declining in China.” (SMC (6273 JP): Profits Start to Decline ) Last week, WSTS reported the first decline in semiconductor sales in 30 months and the Nikkei newspaper reported that “Japanese chipmaker Renesas Electronics will temporarily halt work at 13 of the company’s 14 production facilities, including all nine domestic plants, due to high inventory levels and possible impact as Chinese demand for automotive and machinery tools plummets.” On Friday, March 8, SMC’s share price dropped by 3%. 

SMC has left FY Mar-19 guidance unchanged, implying a 4.1% decline in sales and a 2.9% decline in operating profit in 4Q. In view of current trends, this looks over-optimistic. The shares are now selling at 17.8x our EPS estimate for FY Mar-19 and 18.6x our estimate for FY Mar-20. These multiples compare with a 5-year historical P/E range of 13.8x – 28.5x. 

2. China Tower Results Confirm Lower Capex Outlook, but Were Otherwise Mixed

China Tower (788 HK) reported 4Q18 results that looks slightly disappointing. However, they did deliver strong net profit, confirmation that capex is likely to materially undershoot guidance, and the first dividend for the company. However, while that is positive, there were areas of disappointment, with weaker revenue growth and EBITDA.

Our view remains that China Tower’s shares are relatively undervalued and expect share prices to continue to move higher over time, as the stock reflects its inflecting ROIC. It remains our favored name in China given the risks of policy driven over-investment into 5G (see Chinese Telcos: Rising 5G Capex Risk Leads to Another Downgrade).

3. Versum Materials – Merck KGaA Not Going Away (Part II)

Since my initial report on Versum Materials (VSM US)  last week, Versum Materials – Entegris Beaten to the Punch by Merck KGaA , I’ve dug deeper and feel even more confident that Merck KGaA (MRK GR) is intent on seeing its proposal to acquire Versum to a successful conclusion, with or without a recommendation from the Versum board.

In this follow-up note I provide an update of events since last week, look at VSM’s corporate governance documents, review relevant landmark Delaware takeover case law, and elaborate on a possible path to control of Versum for Merck KGaA.

4. MINT’s First Post-Acquisition Update

We caught up with MINT and Bangkok Dec-Con today. Some highlights from the meeting:

• MINT has gained international presence following the acquisition of NH Hotels in Spain, but the first benefits is mainly coming from the top line side (34% revenue growth) rather than profit level at this stage. Having said that, NH itself has turned around significantly.
• Synergies expected through branding, loyalty programs, and cross-selling, though perhaps not all at once. 
• Leverage reduction. Much has already been achieved by asset revaluation, but the next step involves sales of some selected Tivoli assets and issuance of new warrants entailing a maximum dilution of 20%.
• Bangkok Dec-Con acquired a 40% stake in Phuket water concessionaire Gold Shores in December for Bt600m. A sizable diversification, eventhough they are really growing their profits like crazy in 2018.  

5. Polycab IPO: Largest Cables Player, Asset-Heavy Low ROE Model = Vulnerable to Govt Capex Slowdown

• Polycab India (POLY IN) is the largest wires and cables manufacturer in India almost 2x the size of its next largest competitor. It is also present in electrical consumer durables and EPC projects.
• Company’s 14% revenue Cagr over FY14-18 was aided by government’s increased capex in rural and railway electrification.
• Despite large B2B exposure, company managed to defend gross margins over FY15-18 by passing on input cost variations to its customers. Operating margins have also been steady on the back of improving margins in the key wires and cables segment.
• High B2B nature of business results in 90+days of working capital cycle. Business is capex heavy (annual run rate Rs2.4bn over FY15-18). Company has the lowest asset turnover among its listed peers. It also generates the lowest amount of free cashflows among its peers.
• Investing most of the operating cash in the business would have been great if company was generating healthy ROE. But company’s ROE is in the sub 15% range and it would fall further after the planned Rs5bn primary issue.
• The asset-heavy and low ROE model makes Polycab more dependent on earnings growth to drive stock performance. This, in turn, makes it more vulnerable to any slowdown in government capex in electrification compared to peers.