Komatsu Looks Like A Winner, But Valuation Is Tricky

By Stephen D. Simpson, CFA | July 11, 2013 AAA

Most American readers will be well aware of the significant share and scale that Caterpillar (NYSE:CAT) enjoys in the construction and mining industries. What may be less appreciated is that Japan's Komatsu (Nasdaq:KMTUY) enjoys similar scale on a global basis, and has done quite well for itself in markets like China and Indonesia. What's more, Komatsu has made considerable investments in a variety of automation technologies that could set its equipment apart in the coming years. Valuation here isn't a simple exercise, but a multi-metric analysis suggests that Komatsu may well be cheap enough to merit serious investment consideration. Leading The Way With InnovationKomatsu isn't the only heavy off-road machinery company to make R&D and innovation a priority – Deere (NYSE: DE) has done quite well for itself that way in the ag sector, and other mining and construction companies like Caterpillar and Volvo (Nasdaq:VOLVY) have had their own advances. I'd argue that Komatsu has led the way, though, and particularly in the area of automation. When Komatsu acknowledged that it had considered an acquisition of Joy Global (NYSE:JOY) only to decide against it, part of the rationale was management's belief that it could accomplish more by investing a portion of the same capital into developing better automation technology and building for a future where construction and mining companies looked to replace labor with automation (machines don't go on strike, don't need pensions, and don't have families that sue after accidents).SEE: CAT Suffers Sixth-Straight Sales Fall Komatsu is incorporating its Information and Communication Technology (ICT) into more and more machinery types, including remote-controlled dump trucks that are currently in operation with Rio Tinto (NYSE:RIO). Later this year, the company intends to introduce a remote-controlled bulldozer in the U.S. and Europe and a remote-controlled excavator in Europe.  Mining Still Going To Get UglierWhile mining was about one-third of Komatsu's business in fiscal 2013, it looks like this business is about to get much worse before it gets better. Komatsu is looking for another 25% drop in mining equipment, and that's even with the fact that Komatsu is relatively better leveraged towards iron ore and copper versus coal. After The Correction, What Will Chinese Demand Look Like?One of the bigger issues for Komatsu is figuring out how the Chinese market is going to look in the near future. A significant decline in construction activity and over-building by local manufacturers like Sany basically flooded the market, and some larger rivals like Caterpillar and Kobelco chose to compete very aggressively on price to work off excess inventory.Dealer inventory figures suggest that a lot of the excess has been taken up, but that doesn't seem to clarify the situation all that much (other than to say it probably won't get much worse). There is still a lot of modernization and building that needs to occur in China, but it's unlikely that demand is going to match the frenetic pace of recent memory. If there's a bright spot for Komatsu, it's that despite its reputation as a China play, it actually has meaningful leverage to markets like North America, South America, and Indonesia. In fact, Indonesia accounts for about half of Asian construction equipment demand and Komatsu enjoys a good reputation there. The Bottom LineOperationally and strategically, Komatsu looks like an interesting play on eventual recoveries in the U.S. and emerging markets in construction and a long-term trend in mining towards automation. In the present, though, valuation is tricky. The stock doesn't look appealing from a cash flow basis, which is not very surprising as Japanese stocks often incorporate what I consider to be absurdly low discount rates. It's a different story with EV/EBITDA and price/book, though. An EV/EBITDA approach suggests a fair value of around $26 (based on a 8x multiple), while looking at historical price/book trends suggests that the stock could be as much as 30% to 40% undervalued today. Although I'm a big believer in discounted cash flow, I'm willing to look past it in certain circumstances, and Komatsu is one of those. While there are risks that North American construction takes longer to recover and/or that China doesn't bounce back as much as expected, I'd say valuation and strategy make Komatsu a name to consider.

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