Analyst Note | Oct 16, 2020
The short-cycle nature of narrow-moat Sandvik’s products saw demand highly correlated to the depressed levels of global manufacturing activity. Investors can take comfort from Sandvik’s healthy balance sheet, an astute management team in delivering cost savings, and a diversified earnings stream with a growing portion of uncorrelated earnings attributable to niche mining equipment and services. We expect many of the cost-saving measures to translate into permanent savings and thus justify higher margins during the subsequent recovery. As such, we raise our fair value estimate to SEK 146 per share from SEK 138. The shares appear fairly valued.
Successful execution of cost savings and active portfolio management have helped Sandvik’s operating margins and cash flow hold up better than in previous downcycles. The cash balance is currently sufficient to cover all outstanding debt and net pension liabilities.
The short-cycle machining solutions segment (41% of sales) was the main contributor to the group’s 11% organic sales decline during the third quarter. The segment, which is heavily exposed to automotive and aerospace manufacturing, reported a sales drop of 21% during the quarter and is down 22% year to date. While the trend is improving, order intake was in the negative midteens during September, leading us to believe the recovery for the segment will be prolonged.
Sandvik’s mining equipment and services segment (44% of sales) benefited from higher commodity prices, resulting in strong order intake for capital equipment. However, weaker aftermarket sales more than offset the segment’s growth due to limitations on the number of people able to visit a mine. We believe the decline will be temporary as maintenance can only be postponed for a brief period.
Sandvik intends to proceed with the separation of the margin-dilutive material technology segment, which will help raise the profitability profile of the group following the targeted listing in 2022.
Business Strategy and Outlook | Oct 16, 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, which focuses 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 noncore and lower-margin operations. These actions, along with successfully executing cost-saving initiatives, helped protect Sandvik's profitability during depressed levels of global manufacturing activity as a result of the coronavirus pandemic.
Given the consumable and cyclical nature of many of Sandvik’s products, we applaud the speed at which management lowered the company's cost base without cutting research and development spending. 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.
Sandvik has used strong free cash flow generation and proceeds from divestments to degear the balance sheet, allowing it to successfully navigate a period of lower sales volume.
The 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. In the machining solutions segment, the midmarket category remains highly fragmented with many specialized local players that appear ripe for greater industry consolidation.
Economic Moat | Oct 16, 2020
We believe Sandvik has been able to carve out an economic moat primarily from its strong market position in niche applications in its mining and 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 think this business does not significantly detract from the company’s attractive returns on invested capital. Recent divestments of low-margin/no-moat businesses that historically formed part of the mining division should raise the segment's 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 those of peers such as Kennametal and Iscar. 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 record of 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 record of 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 record of 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 deter not only 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 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, but spare parts and services are mostly proprietary, which low-cost competitors would be unable to replicate.
We attribute the historical margin differential between Epiroc and Sandvik to be due to Sandvik’s product mix. Sandvik has had a more extensive product range that includes lower-margin offerings such as crushing and screening, coal cutting, and the oil and gas business (which is 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 subscale to competitors such as Nippon Steel and Sumitomo Metal. 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 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.
Fair Value and Profit Drivers | Oct 16, 2020
We raise our fair value estimate to SEK 146 per share from SEK 138 to reflect higher profitability as a result of cost-saving initiatives, which will translate into higher profit margins during a subsequent recovery. We forecast medium-term operating margins to be 19%, a 300-basis-point improvement from our 2020 forecast.
The benefits of a diversified portfolio have helped Sandvik limit the impact from a sharp drop in volume in its machining solutions segment (41% of sales). Higher commodity prices during 2020 have led to an increase in demand for Sandvik's mining equipment and services, which account for 44% of group sales.
We expect a prolonged recovery for the machining solutions segments with sales returning to 2019 levels during 2023. The segment is highly exposed to the aerospace, automotive, and energy sector.
Successful execution of cost savings and active portfolio management have helped Sandvik’s operating margins and cash flow hold up better than previous downturns. We expect these actions and the benefits of operating leverage to translate into structurally higher profit margins once volume picks up.
Risk and Uncertainty | Oct 16, 2020
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 affected by global industrial production, which is dependent on the global economic environment. Furthermore, the segment is largely exposed to the automotive industry, which is exposed to general economic conditions as well as structural changes in the industry. This limits Sandvik’s ability to plan for the long term and provides limited visibility on 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 in its mining division.
There is also a new leadership team at Sandvik, with the CEO, president of Sandvik Mining, and president of machining solutions all having announced their departure in 2019. Stefan Widing took over as CEO position in 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 record of lean operations and high profitability. It is uncertain how much low-hanging fruit is still available in terms of cost-cutting initiatives.
Stewardship | Oct 16, 2020
We have a Standard stewardship rating for Sandvik. Historically, management has allocated capital effectively, reinvesting in the company and generating growth through acquisitions and product development, which ultimately rewarded shareholders via an approximately 50% dividend payout ratio. We 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 businesses outside Sandvik’s core machining and mining operations to focus on 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 exposure to energy prices when the oil price was above $100; the company recently announced its decision to divest 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 shifted to small tuck-in acquisitions to enhance its product portfolio, which exhibit lower integration risk than large transformational deals. Sandvik has 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 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 segments are also under new leadership since 2019. Widing previously worked under Sandvik’s chairman at Assa Abloy, and we don’t expect a material shift in our stewardship rating.
