Analyst Note | Oct 23, 2020
Narrow-moat Epiroc benefited from higher commodity prices and pent-up demand for its niche mining equipment and services in the third quarter. Demand for aftermarket services continues to provide a degree of resilience as equipment maintenance and upgrades can’t be postponed indefinitely. We believe Epiroc’s significant contribution of profits (69% of sales), derived from resilient aftermarket activities, warrants reducing our systematic risk rating to average from above average. The adjustment lowers our WACC to 8% and drives a moderate increase in our FVE to SEK 100 per share from SEK 83. Our narrow moat rating remains intact. Shares are currently trading at elevated valuation multiples to historical averages and are fully valued.
A combination of higher commodity prices and six consecutive quarters of declining order growth helped Epiroc print a 10% increase in orders year over year. Order intake was stronger at the end of the quarter and thus did not fully translate into sales during the third quarter. Organic sales declined 3% year on year. We adjusted our 2020 forecast to reflect the uptick in new orders, which has been more than offset by currency headwinds, translating into estimated sales declines of 13% from 11%. The outlook for the rest of our forecast period is unchanged. Cost-savings implemented earlier in 2020 helped increase EBIT margins by 40 basis points to 21.7%, limiting the decline in EBIT to negative 12%.
We attribute the growth in new orders to pent-up demand and maintain mining customers will continue to prolong the life of existing machines through rebuilds rather than big-ticket equipment purchases. A book/bill ratio of 1.07 times, provides visibility of a stable sales outlook for the rest of 2020 although no guidance was provided.
A larger installed base and penetration rates of 50% on existing fleet provide runway for Epiroc in the long term. A net cash position allowed Epiroc to maintain its full-year dividend of SEK 2.40 per share.
Business Strategy and Outlook | Mar 30, 2020
Demand for Epiroc’s products are driven by uncontrollable and cyclical factors such as commodity prices and general economic activity. Therefore, Epiroc’s strategy has focused on areas that it can influence such as lowering its production costs and increasing its sales penetration in more profitable areas of the business, such as the aftermarket segment. While these actions are replicable and have resulted in the margin differential with its closest rival Sandvik narrow, Epiroc (and its previous parent company Atlas Copco) have historically been successful in quickly executing these initiatives before others.
Epiroc has successfully used its strong aftermarket position to further develop the company’s relationships with its customers by having staff on its customers production sites and frequently involving them in the product development process. This provides Epiroc with firsthand insight into understanding its customers’ future product requirements, which they are able to satisfy without having to outspend its competitors on R&D. This helps protect Epiroc’s market position, which in many segments such as hard rock drilling, is a duopoly between them and Sandvik.
Unlike certain other mining segments within the mining value chain, equipment suppliers compete on product quality and the consistent availability of servicing and spare parts. This is due to these products being used in harsh environments which have significant maintenance requirements, highlighting the importance of Epiroc’s global aftermarket business. The company currently enjoy a 50% attachment rate on its installed base, which Epiroc aim to grow by utilizing their proprietary insight into equipment usage resulting from the increasing number of its installed base of equipment with digital connectivity capabilities.
The Morningstar view is for large scale equipment additions to be largely behind us, with a greater focus on finding efficiencies to extend existing equipment life. This should provide a tailwind for Epiroc’s aftermarket business. In addition, the company’s wide range of underground mining applications stand to benefit from the ongoing decline in ore grades.
Economic Moat | Mar 30, 2020
We assign a narrow moat to Epiroc resulting from intangible assets. Epiroc’s sales and service footprint in over 150 countries provides its multinational mining customers with peace of mind that support is available as required and that the severe cost of equipment downtime is kept to a minimum. Customers are willing to pay a premium for this assurance given that the upfront costs of equipment represent a fraction of the total cost of ownership over the life of equipment, which can last over 10 years. Epiroc’s focus is on niche equipment within the mining value chain, which represents a low proportion of a customer's total expenditure but where performance is critical, and results in price being an unlikely source of differentiation given that each moment of nonproduction results in lost income. This has enabled Epiroc to generate excess economic profits through the cycle, with the company’s return on invested capital, or ROIC, currently at 21.3% significantly above our WACC of 8.9%.
Epiroc is often viewed as a partner for many of its customers, providing on-site support and services via its extensive aftermarket network of over 10,000 employees (70% of its workforce) in remote locations across the world. Service personnel can also be permanently stationed to a customer’s production facility. Its global presence is a result of a customer's decision to expand, requiring a supplier with global sales and service footprints for its niche products. These relationships, which stretch back decades, provide the company with a clear competitive advantage over any potential new entrants especially in an industry which is risk averse and hesitant to change. This is evident through the duopoly market structure, where Epiroc and Sandvik have a combined market share of approximately 80% in underground hard rock mining equipment. A dominant market share, long-standing client relationships with major miners and on-site global presence provides the company with a clear learning curve advantage into its customer’s future equipment requirements. This helps facilitate future product innovation making it even more difficult for new entrants to erode profitability from Epiroc.
Epiroc operates in selected niche applications of the mining value chain such as surface and underground rock drilling, which requires greater technological know-how, places a greater emphasis on quality and represents a limited share of a customer’s total capital and operational expenditure compared with other products within the mining equipment market. These products are subject to greater abrasiveness and thus require significant maintenance requirements and regular spare parts. This further emphasizes the need for a global service network and points to why Epiroc has managed to achieve industry leading margins and profitability. Given the low relative cost to its customers’ total expenditure, optimized equipment lifecycle and thus lower total cost of ownership through minimised downtime, we don’t expect profitability to erode through increasing competition in the next 10 years. We also view the barriers to entry to be too high for larger mining equipment suppliers such as Caterpillar and Komatsu Mining, whose primary focus is in other areas of the mining value chain. These companies would have to commit large sums of capital into R&D and upskilling its existing sales and service network to potentially enter a relatively small market, compared with its existing end markets. Epiroc has also followed a direct sales method, unlike Caterpillar and Komatsu who utilize dealer networks. This has resulted in intimate client relationships, which would be difficult for new entrants to break, especially given the risk-averse nature of mining customers. Transformational acquisitions in the past within the mining equipment industry, with questionable success by both Caterpillar (Bucyrus) and Komatsu Mining (Joy Global), also makes it unlikely that these players would risk allocating capital to enter new niche applications with a limited potential return on investment.
The aftermarket. which consists of services and sales of spare parts and consumables, is likely to be more resilient in the event of curtailed expansionary capital spending. We acknowledge the highly cyclical nature of demand for Epiroc’s equipment. However, the company outsources approximately 75% of production costs, which enables the company to generate returns above its cost of capital throughout the cycle through flexible manufacturing methods. A low commodity price environment may result in demand for new equipment falling but will also require the need for greater investment in efficiency and productivity benefitting the capital light aftermarket business. We acknowledge that certain consumables may lack pricing power, especially in a commodity downcycle. However, both spare parts and services are mostly proprietary; which includes dedicated software, specialized spare parts and in-depth inspection; which low-cost providers are unable to replicate. This enabled the company to maintain attractive and relatively stable margins during 2015/16 when capital spending troughed in the mining industry. The company is also expected to benefit from its higher exposure to underground mining due to depleting ore grades and its relatively large exposure to copper (17% of sales), which stands to benefit from increased consumption as a result of greater adoption rates of electric vehicles.
The company’s aftermarket business also exhibits characteristics of switching costs based on participation rates of 50% on its installed base. We expect these rates to grow as the company climbs the service ladder, a result of the growing shift to automation and connectivity solutions in the next 10 years. The shift to automation lowers the cost of production for miners, which would create a greater margin of safety between the marginal cost of production and the volatile nature of commodity prices. Mining companies would be willing to pay a premium for such an offering, which would typically have more pervasive switching costs. Epiroc’s current offering includes automated drilling products both above and below ground in 16 countries and delivered approximately 3,500 machines with connectivity capabilities during 2019.
We do not assign a moat to Epiroc’s tools and attachment, which forms part of Epiroc’s aftermarket business, due to the consumable nature of products with limited product differentiation of certain products. These products include hydraulics and drill bits, which exhibit lower barriers to entry and are subject to more competition than other applications that Epiroc competes in. This segment represents 27% of group sales.
Fair Value and Profit Drivers | Oct 23, 2020
We raise our fair value estimate for Epiroc to SEK 100. We believe Epiroc’s significant contribution of profits, that are derived from resilient aftermarket activities, warrants lowering our systematic risk rating to average from above average. The adjustment lowers our weighted average cost of capital, WACC, to 8% and drives a moderate increase in our fair value estimate to SEK 100 per share from SEK 83. Aftermarket sales are exposed to customer’s operating expenditure rather than more volatile capital expenditures and thus exhibit greater cyclical resilience.
Higher commodity prices in 2020 has resulted in a return to growth in new equipment orders for Epiroc’s niche mining and construction equipment during third-quarter 2020, after six consecutive quarters of double-digit declines. However, much of this growth was from emerging markets where currency weakness has more than offset our upward revision in new equipment demand. We lower our fiscal 2020 sales forecast to reflect a decline of 13% down from negative 11%. The outlook for the remainder of our forecast period is unchanged.
We attribute the increase in new orders to pent-up demand and maintain our view that mining customers will continue to prolong the life of existing machines through rebuilds rather than big-ticket equipment purchases. In addition, a growing installed base and penetration rates of 50% on the existing fleet are the basis for service growth, which should be the main source of growth for Epiroc.
We expect cost-saving actions implemented during the start of the coronavirus pandemic and a largely outsourced new equipment manufacturing business model should keep margins relatively stable. Our forecasts reflect midterm operating margins of 21%, in line with that achieved in 2019.
Risk and Uncertainty | Mar 30, 2020
Our uncertainty rating for Epiroc is high. The company is exposed to the mining and infrastructure markets, which are affected by general economic conditions and the cyclical nature of commodity prices. Both of these factors influence Epiroc’s customers investment plans and production levels, which can change materially.
This limits the company’s ability to plan for the long term and therefore provides limited visibility into the company’s financial performance. This has been a key reason behind the Epiroc’s efforts to outsource a large share of its production and thus it can quickly adapt to changes in volume, protecting profitability.
The demand for new equipment is determined by the investment plans of the mining industry. Mining companies tend to expand and invest in equipment during periods of high commodity prices and typically reduce investments and place a greater emphasis on cost-savings when commodity prices are low. The length of these different periods can vary greatly. China’s rapid urbanization is also expected to moderate as well as its consumption of key commodities, which could place downward pressure on demand for infrastructure and mining equipment. While demand for aftermarket parts and services is driven by operational expenditure and therefore tends to be more resilient, certain customers may decide to acquire consumables from low-cost producers or in-source certain servicing functions during periods of distress.
Stewardship | Mar 30, 2020
We have assigned a Standard stewardship rating to Epiroc. Its short history, during which time the company has operated as a standalone business, restricts our ability to assign an exemplary rating, despite promising signs of excellent stewardship that we have seen since listing in 2018. We have given an Exemplary stewardship rating to Epiroc’s previous parent company, Atlas Copco, due to its disciplined capital structure and strong track record of value-enhancing acquisitions.
We have been impressed with the conservative levels of debt that Epiroc has taken on since listing. This is likely to reflect the company’s approach to leverage in a highly cyclical industry, which we would expect to continue. Further, the company’s requirements for mergers and acquisitions, or M&A, also adheres to what we look for in capital allocation, which focuses on profitable growth, as opposed to purely sales growth, and thus shareholder value creation. Future acquisitions will typically be performed without deviating from its core business and tend to be of interest to its existing customer base.
Epiroc’s target payout ratio is 50% of its net profit through the cycle. This is in line with its closest competitor, Sandvik’s dividend policy.
Epiroc is currently under new leadership, with Helena Hedblom taking over as president and CEO since March 2020. Hedblom is a long-tenured employee of Epiroc with vast experience, having joined Atlas Copco in 2000. Therefore, we expect the business to follow Atlas Copco with best-in-class capital allocation.
We also note that the company’s largest shareholder is Swedish investment holding company, Investor AB, which holds a 23% interest in Epiroc. Investor AB has historically exercised its influence in the best interests of minority shareholders.
