Nittoku: EV Mobility Play But Limited Upside

Investment summary

Nittoku (OTC:NKUEF) gains attention as a beneficiary of scaling EV adoption, with its winding machines used in the production of electric motors. With limited order visibility, low operating leverage, and a mixed track record as a conservative and non-dynamic business, we rate the shares as neutral.

Quick primer

Established in 1972 and based in Saitama in Japan, Nittoku develops, manufactures, and sells automatic winding machines and related machinery. Over 90% of sales are made up of winding systems and mechatronics, with the remainder coming from RFID cards and tags (using copper wiring). In Q2 FY3/2023, domestic sales made up about 35% of the total, with nearly 50% coming from Asia and 15% from Europe. In terms of market sectors, current order growth is coming from mobility (primarily EVs), followed by information technology (such as smartphone-related component demand).

Key peers include ABB (ABB), thyssenkrupp (OTCPK:TKAMY), and Odawara Engineering (OTC:OWECF). Odawara supplies its winding machines to Tesla (TSLA).

Key financials with consensus forecasts

Our objectives

Nittoku's business is geared towards the increasing adoption of electric motors in mobility, as their winding machines are used for placing the copper coils in the stators (the stationary component of electromagnetic circuits) of a motor. There is growing secular market demand, and engineering advances are also rising with the need to increase the fill factor (level of power conversion), better thermal performance as well as reduce manufacturing costs.

Motors have different winding processes for various applications. Recent manufacturing developments have led to the widespread adoption of hairpin windings for EV motors (as opposed to traditional random-wound winding), used in the 4th generation Toyota (TM) Prius. However, Nittoku has developed a new cassette method which is said to be a next-generation approach, improving higher fill factor.

We want to assess the outlook for Nittoku's earnings, given their exposure to the EV megatrend. The secular growth theme of EV adoption has been talked about for the last 5 years, but Nittoku's shares have fallen over 50% in that period.

Order outlook is positive, but FY guidance lowered

Q1-2 FY3/2023 results were ahead of expectations, driven by demand for winding machines from the mobility and telecommunications sectors. Sales from Asia (from China, Taiwan, and Korea) were robust, growing 64% YoY (page 4). Mobility demand is primarily driven by motor production, but there is also sizable demand for coil production used in common mode inductors, power inductors, and sensors.

At the parent level, order visibility was fair with Q2 FY3/2023 orders growing 19.2% YoY (page 6), driven by mobility which saw orders grow 29% YoY. However, the 12-month average book-to-bill ratio (ratio of new orders to completed sales) fell to 0.88x, which was a negative surprise. The company saw business earmarked for H2 being brought forwards into Q1-2, hence partly explaining the strong reported figures as sales grew 51% YoY. However, the company also lowered FY guidance significantly, with sales down 9% and operating profit down 21% from the original guidance (page 10).

What is damaging is the company's explanation for its downgrade, pinning it on general macro issues that are affecting all businesses worldwide. Supply chain challenges and inflationary costs are certain headwinds, but our impression is that the business has limited earnings visibility and is not skilled at managing market expectations.

Longer-term outlook

The company has ambitions to grow the business, aiming for at least JPY50 billion/USD385 million in sales by FY3/2026 (page 18). The plan involves a combination of increasing its presence overseas in Europe and the Americas, raising exposure into factory automation, and scaling its profitable services business whilst growing the mainstay winding machine volumes via production capacity hikes.

Whilst we believe that mobility-led demand will continue to increase, consensus forecasts (see Key financials table above) illustrate a fairly slow pace of growth, with a volatile actual growth profile as seen over the last 2 years.

What appears to be an inherent problem with Nittoku's business model is a relatively directionless earnings profile despite visible secular themes - sales volume recently peaked in FY3/2019 pre-pandemic and is yet to return to that level. Profitability has averaged a 10.4% operating margin over the last 5 years, but there is limited gearing with any rise in sales volume.

The company has a high level of specialist engineering expertise which should add value to its customers. Unfortunately, it does not appear to be either a large-scale or a margin-enhancing opportunity.

Valuation

On consensus forecasts, the shares are trading on PER FY3/2024 16.8x but with expectations of high capex, the free cash flow yield is a low 1.8%. This highlights that the company occasionally undergoes episodes of high upfront investment costs to increase its production capacity. Inevitably, the quality of earnings is not high.

Risks

Upside risk comes from a major hike in orders, driven by mobility demand. We note that US demand has been low during FY3/2023, and successful expansion activities here could be a trigger for a re-rating.

With a net cash balance sheet, the company could conduct a large one-off buyback. Current net cash makes up about 30% of market capitalization.

Downside risk comes from a poorer than anticipated performance in H2 FY3/2023, as guidance is lowered again with limited visibility.

Although partly expected, the company does not look to be in a position to grow its sales volume to JPY50 billion by FY3/2026, prompting the market to lower expectations further.

Conclusion

Nittoku is a market leader in winding machines, and its application in mobility should result in the company enjoying relatively high order visibility. However, its position as a niche precision machinery supplier to large auto OEMs is challenging, given limited bargaining power and internal resources (the company only has around 900 employees). With only a finite level of output it can achieve, the shares look fairly priced for a relatively static operator. We rate the shares as neutral.

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