Business Strategy and Outlook | 11 Mar 2020
The short cycle nature of Sandvik’s products that are used by cyclical industries has seen the company become a bellwether for the health of global manufacturing and mineral processing. We are impressed by Sandvik’s strategy that focusses on creating a more stable and profitable business throughout the economic cycle. Key enablers of this have been investing in more efficient manufacturing methods and divesting in noncore and lower margin operations, while maintaining consistent product innovation through R&D spend and long-standing customer relationships. A major theme of Sandvik’s former CEO (who left in February 2020 to serve as CEO of ABB) tenure was successfully establishing a decentralized business that allowed the company to be a more focused organization with better profitability. We believe these actions should structurally change Sandvik’s profitability, which we expect to also be more resilient in a downturn.
Given the consumable nature of many of Sandvik’s products, we applaud the company’s efforts to constantly innovate both on product development and manufacturing efficiencies. A large chunk of product innovation is fostered through close relationships that Sandvik has built with its customers, which has been achieved through its direct sales market model and global presence. While the company intends to continue its cost-cutting strategy, we think the low-hanging fruit has been executed and that margin expansion will primarily be due to favorable sales mix and operating leverage.
Strong free cash flow generation and proceeds from divestments have been utilized to degear Sandvik’s balance sheet. This has positioned the company to continue with its top priority for capital allocation, which is to reinvest into the company and generate growth both organically and through acquisitions.
Sandvik’s strong balance sheet allows for bolt-on M&A to continue to be a theme, which enables Sandvik to enhance its product portfolio and expand into growth areas. Within the Machining Solutions segment, the mid-market category remains highly fragmented with many specialized local players that appear ripe for greater industry consolidation.
Fair Value & Profit Drivers | 07 Apr 2020
We revise our forecasts for Sandvik to account for the impact of a recession during 2020, with a slight change in our fair value estimate from SEK 140 to SEK 138. Sandvik's machining solutions segment is expected to be most affected, which sees demand for its products being driven by global manufacturing activity. The segment's significant exposure to the automotive and aerospace sectors is expected to negatively affect sales and operating profits during the current financial year. We update our forecasts for fiscal 2020 to reflect a more bearish double-digit sales decline, with profitability showing a larger decrease due to operating leverage. Both short-term and long-term actions have been taken to limit the impact on profitability and cash flow. This includes suspending its dividend as a precautionary measure. We expect Sandvik to return to growth and reinstate their dividend policy during fiscal 2021. A solid balance sheet will allow Sandvik to navigate through a recession and eventually return to performing bolt-on acquisitions to enhance its growth trajectory.
Scenario Analysis | 07 Apr 2020
Our uncertainty rating for Sandvik is high due to the cyclical nature and low visibility into demand for Sandvik’s products.
Our bear-case scenario accounts for a recessionary environment that would result in a further decline in sales across the Machining Solutions segment. Successful cost-saving initiatives have kept the segment's profitability strong, with operating margins above 20% despite a 6% decline in organic orders during fiscal-year 2019. The company has stated that production rates are now correct for the demand environment; however, we expect that a further decline in sales would likely have an adverse impact on profitability. We model a further 5% decline in sales for fiscal-year 2020 followed by low-single-digit declines through to 2022. Our bear-case scenario for the mining segment is for new equipment spending to remain curtailed with declining mid-single-digit declines but for the demand for aftermarket services to stay flat. Consumable products within the aftermarket business is likely to experience the largest margin pressure in this type of scenario. Under this scenario, our Group EBIT margin would decline from a midcycle margin of 19% to 15%, well below the company’s target trough EBIT margin of 16%. These assumptions which are pessimistic compared with our base-case scenario would reduce our fair value estimate to SEK 97.
In a more optimistic scenario, with continued expansion in manufacturing activity and mining expenditure, our fair value estimate would increase to SEK 189. This would require a turnaround in automotive production within Machining Solutions and for the Mining segment to maintain mid- to low-single-digit growth, driven by strong aftermarket sales growth. Sandvik would also need to utilize its strong balance sheet to contribute to an additional 2.5% in top-line growth.
Economic Moat™
We believe Sandvik has been able to carve out an economic moat primarily from its strong market position in niche applications within its Mining & Rock Technology segment. While we are reluctant to award Sandvik’s Machining Solutions segment with a moat despite its strong presence in the metal cutting market, we feel that this business does not significantly detract from the company’s attractive ROIC profile. Recent divestments of low margin/no-moat businesses that historically formed part of the mining division, should raise the segments profitability closer in line with its most direct competitor, Epiroc. This has helped contribute to Sandvik’s current ROIC of 20%, well above its weighted average cost of capital of 8.9%.
We fail to award Sandvik’s Machining Solutions business a moat despite its leading market position. Sandvik’s tools are consumable in nature and are ISO standard products, which therefore exhibit no positive differentiation versus its peers such as Kennametal (not covered) and Iscar (not listed). Customers tend to exhibit little brand loyalty and thus there is no pricing power, with all premium players’ tools typically being present at their customers manufacturing sites. The company’s track record for regular product innovation and R&D through the cycle is impressive; however, the short operating life of tools coupled with an innovation cycle of around six years provides enough time for competitors to replicate its characteristics once future restocking decisions are required. Furthermore, new developments do not tend to be groundbreaking enough that they can enjoy long-lasting pricing power.
We acknowledge that Sandvik has led Kennametal in terms of production methods and supply chain optimization, resulting in industry-leading margins. However, Kennametal has subsequently begun to follow suit, reducing any temporary cost advantage Sandvik may have enjoyed. Kennametal’s operating margin is expected to catch up to Sandvik’s through spending approximately $300 million over three years, indication that any cost advantages through self-help or manufacturing innovation is unlikely to be sustained for a significant duration of time.
We assign a narrow moat to the Mining and Rock Technology business where the company commands pricing power in many of its niche applications such as hard rock mining. Customers, which include the world’s largest mining companies, are willing to pay a premium for Sandvik’s track record for reliability as well as the regular availability of spare parts and services resulting in a lower total cost of ownership. This is achieved through Sandvik’s worldwide service network stretching across 160 countries of its own employees who are often situated in remote locations, which helps reduce the significant cost of equipment downtime. Sandvik’s on-the-ground presence, often permanently located on its customers' operations, also provides the company with a learning curve advantage for future product innovation. Given that much of Sandvik’s equipment is operated underground and is thus subject to large degrees of wear and tear, customers also place a greater emphasis on quality and safety in order to protect reputational damage. This track record for reliability stretches back many decades with customers, which has resulted in Sandvik and Epiroc enjoying dominant positions in niche applications such as: surface drilling, underground drilling, and underground loaders with combined market shares in certain niche segments at approximately 80%.
We think the above-mentioned barriers to entry would not only deter new entrants but also larger mining equipment suppliers that operate in other areas of the mining value chain. We view it to be unlikely for these companies to allocate large sums of capital into R&D and upskilling its existing sales and service network, given the relatively small market size compared with their existing end markets. Sandvik has also followed a direct sales method, which has resulted in intimate client relationships that would be difficult for new entrants to break especially given the risk-averse nature of mining customers.
The business has also increased its proportion of outsourced production, which is expected to the allow the company to maintain strong profitability when commodity prices drop and demand for new equipment falls. In addition, aftermarket participation rates of approximately 50% on its installed base indicates characteristics of switching costs helping to protect profitability. We acknowledge that certain consumables may lack pricing power in a market downturn, however, both spare parts and services are mostly proprietary, which low-cost competitors would be unable to replicate.
We attribute the historic margin differential between Epiroc and Sandvik to be due to Sandvik’s product mix where Sandvik has had a more extensive product range that includes lower-margin offerings such as crushing and screening, coal cutting, and their oil & gas business (which is in the process of being divested). The margin differential has narrowed since Sandvik has divested several noncore operations focusing only on markets where it has or can see itself as having a leading or number two market position with better profitability. We expect this to help contribute to Sandvik’s excess economic returns.
We view the Material Technology segment as a no-moat business. Sandvik is currently sub-scale to competitors such as Nippon Steel & Sumitomo Metal which operate at a significantly larger scale. The segment also faces fierce competition from low-cost producers in China, making it difficult for the business to command any cost advantage. The uncertain nature of oil prices also limits Sandvik’s ability to command any pricing power on its products. This business is currently being internally separated from Sandvik, with the possibility of a separate listing.
Moat Trend
We view Sandvik’s moat trend to be stable. We expect the company to maintain its strong relationships with clients via its direct sales network and regular product innovation, which helps its customers become more profitable. There is unlikely to be a shift in this approach despite a new CEO at the helm, who has previously worked under Sandvik’s chairman at Assa Abloy.
Self-help initiatives that have successfully contributed to improving margins and ROIC may continue in the short term but are unlikely to change Sandvik’s competitive position in its core segments.
One area we believe exhibits the characteristics of a moat is within autonomous mining and connectivity solutions. We expect these products and solutions could command pricing power and be more integrated, which would likely to create switching costs. Sandvik has high ambitions in this area but the slow-moving nature of the mining industry in adopting these technologies means we do not expect this to materialize significantly within the next five years and thus does not impact our moat trend rating.
Risk & Uncertainty
Our uncertainty rating for Sandvik is high. Sandvik’s customers operate in markets that are either affected by general economic conditions or face a high degree of cyclicality. Approximately 44% of Sandvik’s revenue is attributable to the mining industry whose capital expenditure is based on the uncertain nature of commodity prices. Demand for products from Sandvik’s Machining Solutions segment is directly impacted by global industrial production, which is dependent on the global economic environment. Furthermore, the segment is largely exposed to the automotive industry that is both exposed to general economic conditions as well as structural changes within the industry. This limits Sandvik’s ability to plan for the long term and therefore provides limited visibility in Sandvik’s financial performance. This has been a key reason behind Sandvik’s efforts to reduce its manufacturing footprint, have more flexible production methods, and place a greater emphasis on aftermarket parts and services within its mining division.
There is also a new leadership team taking over at Sandvik with the CEO, president of Sandvik Mining, and president of Machining Solutions all having announced their departure from Sandvik in 2019. Stefan Widing takes over the CEO position from 1 February 2020 succeeding Bjorn Rosengren. Rosengren joined Sandvik in 2015 and established the decentralized business model for the company, which has been successfully implemented. Rosengren helped make the organization more focused, a feature that was most likely observed during his time at Atlas Copco, which has had a track record of lean operations and high profitability. It is uncertain how much low-hanging fruit is still available in terms of cost-cutting initiatives.
Financial Strength
Sandvik’s financial position is currently in a very healthy state. Earnings growth, improved working capital management, and proceeds from divestments have assisted the company to degear its balance sheet and increase cash generation. Debt levels have decreased from SEK 40.8 billion in 2015 to below SEK 30 billion during the most recent fiscal year, bringing Sandvik’s net debt to EBITDA ratio to a comfortable 0.6 times. The company’s net debt to equity is 0.2 times, currently exceeding with its target of 0.5 providing the company with headroom for future M&A. This enables Sandvik to utilize free cash flow generated toward dividend payments and M&A without the overhang of debt repayments.
Over 85% of Sandvik’s debt is long term in nature and any near-term maturities are well covered by its cash pile. This provides Sandvik with a decent cushion in the event of a possible economic downturn and provides the company with a sizable war chest to continue its M&A strategy. Sandvik’s dividend and continued investment in R&D are also not at risk. The strong balance sheet also provides a buffer should there be an untimely scenario of any potential goodwill impairment, which, along with other intangibles assets, total SEK 20.1 billion, or 19% of group sales.
Sandvik’s balance sheet is in a more comfortable position than some of its American peers such as Kennametal and Caterpillar, and on par with its European mining equipment peers such Epiroc and Metso. We cannot fault a conservative balance sheet in a highly cyclical and working capital intensive industry.
Stewardship | 07 Apr 2020
We have a Standard stewardship rating for Sandvik. Historically, it has allocated capital effectively, re-investing into the company and generating growth through acquisitions and product development, which ultimately rewarded shareholders via an approximately 50% dividend payout ratio. We also remain impressed by management’s response to weak periods of demand by adjusting production to ensure profitability and cash flow generation remains strong throughout the cycle. Insignificant alignment with minority shareholders and a new management team are the primary reasons behind our standard rating.
Under Bjorn Rosengren’s leadership (2015-20) management made capital allocations that were well considered accounting for the economic cycle. This included divesting of businesses outside of Sandvik’s core machining and mining operations to focus on its core operations, despite having paid significant amounts for under prior leadership. The Varel acquisition in 2014 (one of Sandvik’s largest M&A transactions) increased its exposure to energy prices when the oil price was above $100, with the company recently announcing its decision to divest in this business resulting in an impairment of SEK 3.9 billion being recorded. Nevertheless, we expect these divestments to boost midcycle profitability and have also placed Sandvik’s balance sheet in a strong position. Sandvik’s acquisition strategy has also shifted to small tuck-in acquisitions to enhance its product portfolio which exhibit lower integration risk than large transformational deals. Sandvik has also prioritized reducing its leverage, a decision we applaud given the cyclical and short-cycle nature of the business.
Sandvik has targeted a 50% dividend payout ratio through the cycle, which appears sustainable since debt no longer needs to be reduced and the company’s net debt is covered by the company’s free cash flow. M&A can therefore be used to enhance Sandvik’s growth profile, with the company aiming for a 2%-3% impact on sales growth. We also place a positive mark next to management’s decision to focus on production efficiencies and working capital management despite periods of strong growth. This includes successfully executing cost-cutting measures at the first sign of slowdown in sales, which has allowed Sandvik’s Machining Solutions segment to maintain an adjusted operating margin above 20% despite four consecutive quarters of top-line decline.
Sandvik has new leadership with Stefan Widing taking over as CEO in February 2020, joining from Assa Abloy. The Machining Solutions and Mining and Rock Technology are also under new leadership since 2019. The new CEO, Stefan Widing, had previously worked under Sandvik’s chairman at Assa Abloy, and we don’t expect a material shift in our stewardship rating.
