Sandvik Stock: Medium To Long-Term Outlook Remains Fundamentally Sound (OTCMKTS:SDVKY)

Summary

Readers may find my previous coverage via this link. My previous rating was a buy, as I believed Sandvik’s (OTCPK:SDVKY) share price was undervalued given the order strength reported in 1Q23 and the performance in its mining business back then. I am reiterating my buy rating for SDVKY as I believe the medium-to-long-term outlook remains fundamentally strong given the visible tailwinds.

Financials/valuation

SDVKY saw its revenue grow organically by 1% to SEK31.8 billion in 4Q23, which was in line with consensus estimates. Looking at the segments, SMM (Sandvik Manufacturing and Machining Solutions) saw an organic decline of 1%, while SMR (Sandvik Mining & Rock Solutions) grew 5% organically, and SRP (Sandvik Rock Processing Solutions) saw an organic revenue decline of 13%. SDVKY also saw an EBITA of SEK6.2 billion, which translates to a margin of 19.5%. When adjusted for FX impact, EBITA would be around 20.6% (FX impact was SEK 323 million, dilutive to the margin by 110 bps).

Putting up a model this time, I believe SDVKY should see its revenue accelerate to 6% over the foreseeable future. I expect FY24 to be a soft year, following the trend from 4Q23 and taking in the uncertainties from the China economy’s performance and the potential disruptions from the restructuring programs. In FY25 and FY26, growth should accelerate, ultimately reaching the past 5-year average growth rate of ~6%. EBITDA should expand in FY25 and FY26 as the restructuring program benefits kick in as well as operating leverage due to a larger revenue base. I used 25% as a benchmark for FY26, as margins should surpass recent high (FY21) levels of 25% due to the lower cost base. I assumed FY24 margins to be flat as the restructuring cost offsets any savings benefits. For valuation, I expect it to trend back to its through-cycle multiple of 10x EBITDA (its average), which I believe is the right way to value cyclical companies.

Comments

While the share price has been largely flat since my last update, I continue to think that there is upside to the stock as the fundamentals remain sound and the valuation is not demanding. In terms of the SMR segment in particular, I am optimistic about the outlook because demand is strong and the environment is showing no signs of change. Though some junior miners are facing greater financial difficulties, which could cause delays, management indicated that surface progress will continue to be bolstered by additional investment. As the aftermarket is still being propelled by customers destocking ground tools after building their inventory, SDVKY’s visibility into growth is favorable. As a point of reference, this aftermarket accounts for approximately SEK10 billion in yearly sales, which is a substantial amount when compared to the total number of SMR orders (around 15%). Although visibility is great, I would warn that until the destocking process is complete, this might put pressure on performance in the near term. As such, I don’t disagree that there might be some near-term muted performance. However, I think the medium-to-long-term outlook remains favorable as the industry tailwinds from automation, mine planning and operations management software, and BEV (battery electric vehicles) will drive more investments on the supply side of the equation as each of these tailwinds enables faster ramp-up times and load cycle times. SDVKY is in a position to take advantage of these tailwinds. In automation, SDVKY is the leading player with more than 65% of the global installed fleet of autonomous and teleremote underground load and haul units and is the only OEM for large-scale advanced systems (>5 units).

As for BEV (i.e., electrification), SDVKY is also a leading player with a strong market share winning streak (more than 75% of load and haul BEV orders are won by SDVKY). In my opinion, this electrification trend is going to be a massive tailwind for the industry, as it is a win-win situation. Customers that use BEV can find themselves saving up to 17% in total cost of ownership [TCO] as they experience lower carbon, cooling, and ventilation costs. The terminal value of BEV is also much higher, which further contributes to the lower TCO as BEV has a 65% higher lifecycle revenue potential. From a P&L perspective, SMR margin has touched 20.8%, and with these industry tailwinds driving growth for the medium-to-long term, I believe it can eventually reach the management target of 30%.

Similar positive sentiment was echoed in the SMM segment, where 4Q23 performance was mostly supported by strength in aero, auto, and stable general industrial. The debate for FY24 performance is whether performance in China will continue to see strength following the momentum of high double-digit annual growth in 4Q23, as the Chinese economy outlook is not very positive at the moment. I cannot predict what the Chinese government will do to support the economy in the near term, but my take is that when push comes to shove, the government has to step in to support the economy one way or another. Longer-term, the debate becomes whether the growing shift towards EVs (electric vehicles) is a threat to the segment. I think this threat is real, but it is more of a very-long-term risk that is not going to impact valuations today. First of all, EV adoption has been slowing due to affordability, charging, and range concerns. Secondly, the adoption of EVs also meant that there would be an increase in demand for aluminum (for electric motors, battery housing, reduction gear boxes, etc.), which is positive for SDVKY. Thirdly, compared to light vehicles, the business is more exposed to the medium-heavy commercial vehicle segment, which has a machine intensity ratio five times higher. Viewed from a more holistic point of view, I believe the threat of EV adoption is actually overestimated today.

For the SRP segment, I acknowledge that the results were weak, mostly stemming from infrastructure. With dealers’ inventory levels high and customers selling off their surplus due to weaker end-market demand, the future does not appear bright either. However, SRP only accounts for 7% of adjusted EBITA, so I doubt it will have much of an impact.

Finally, another positive takeaway from the results was that management is implementing a restructuring programme, which is expected to generate annual savings of around SEK 1.2 billion (which is around 5% of adjusted EBITA). Decentralization of production units and organizational optimization are key to the program. More specifically, 85% of the projects are addressing structural issues, while 15% are addressing volume-related issues. In terms of timeframe, management anticipates reaching 80% of total yearly savings by the end of 2024 and 100% by the end of 2025.

Risk & conclusion

I think the big risk here is that the Chinese economy slows down much more than expected as the government chooses to continue waiting on the sidelines. They have shown their will to wait longer than the market expected, and they certainly could do it again. If that happens, the near-term performance of SMM might be further impacted. SMM is around 42% of adjusted EBITA; as such, the drag on headline numbers could be huge.

Overall, I reiterate my buy rating for SDVKY. Despite a flat share price since the last update, the fundamentals remain strong, and the valuation is reasonable. While near-term challenges may arise, particularly in the SMM segment due to potential economic slowdown in China, the overall positive trajectory is underpinned by industry tailwinds like automation, BEV adoption, and strong market positions in key segments. The ongoing restructuring program adds to the positive narrative.

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