Depending on what metrics or indicators you follow, you wouldn’t necessarily think that there’s much to worry about in the economy, and particularly the industrial/manufacturing economy. The S&P 500 is at or near a high and industrial stocks as a group have been cruising along, with the Industrial Select Sector SPDR Fund (XLI) up 23% over the past year and the Vanguard Industrials Index Fund (VIS) up a similar 24%, despite ongoing weakness in indicators like manufacturing PMI both here and in Europe.
I believe underlying conditions aren’t so strong, at least in some sectors, and Hurco’s (NASDAQ:HURC) fiscal second quarter results certainly back that up. Although some of the numbers weren’t much worse than I’d expected, orders remain worryingly weak and when combined with other inputs like Lincoln Electric (LECO) revising growth expectations lower (to mid-single-digit organic revenue decline for FY’24) and Fastenal’s (FAST) sluggish manufacturing sales growth numbers, it doesn’t paint a pretty picture.
Maybe this is as bad as it gets, but “maybe” is a shaky basis for an investment thesis. I can say, though, that this current trough is the worst Hurco has seen in over a decade (excluding pandemic-impacted years) and this cyclical business is still leveraged to trends like “catch up” capex spending in the U.S. and reshoring in major North American and European markets, to say nothing of the more typical cyclical recovery drivers. I will not argue that Hurco is any kind of “must own” stock, and I do still see a risk of industrial stocks derating from here, but I think investors looking for bottom fishing opportunities may want to consider this name as a 2025 rebound idea.
Another Tough Quarter As Macro Indicators Erode
There are more than a few aspects to Hurco that make benchmarking more difficult, including its small size, its somewhat more specialized customer base, and the fact that the company reports on a non-calendar cycle (the fiscal year ends in October). With that, Hurco can sometimes be a leading or lagging indicator, and it looks like the company’s weak performance in fiscal Q1’24 was a prelude to recent weaker macro indicators. Given weak results again in fiscal Q2, that’s not great news.
Revenue declined 16% year over year and increased slightly on a sequential basis. That the business may be stabilizing, perhaps indicating a bottoming out process, is the best news from the results. Revenue declined 8% in North America (up slightly qoq) and 24% in Europe (down slightly qoq), while currency-adjusted revenue in Asia rose 3% (down slightly qoq).
Gross margin declined more than I expected, falling 560bp year over year and 370bp quarter over quarter to 17.8%. I was concerned about the ramifications of the inventory build seen in the last quarter, and indeed management did blame price cuts to move inventory for the weaker gross margin (as well as a less robust product mix). With what hopefully will prove to be cycle-low revenue and gross margin, operating results have slipped into the red for a second straight quarter ($3.4M versus $1.8M in the prior quarter).
The company ended the quarter with about $5.82/share in net cash, but inventory only declined about $1M and is still equal to about 1.1 years of annualized COGS.
Orders declined 27% year over year and 12% quarter over quarter (with a book-to-bill just under 1.0) and that sequential slide does concern me some as far as calling a cyclical bottom goes. U.S. orders declined 23% yoy and 18% qoq (a book-to-bill of 1.01x), while European orders fell 28% yoy but rose 23% qoq with a 1.27x book-to-bill. Asia-Pacific orders were weak (down 33% yoy and 44% qoq, with a 0.6x book-to-bill), but I’ve found order trends less predictive for this part of the business.
A Look Around The Neighborhood Isn’t Encouraging
I can’t rule out the risk that Hurco is losing to larger rivals like DMG Mori, Yamazaki Mazak, and Okuma (and head-to-head revenue comparisons are misleading), but looking at other metrics and indicators, Hurco isn’t on an island all by itself where weak underlying market demand is concerned.
The numbers for U.S. cutting tool consumption are regrettably always late in arriving, but March showed a downturn (down 5.8% yoy) after two months of improvement and MSC Industrial’s (MSM) most recent earnings report and guidance weren’t fantastic (MSC is a leading distributor of cutting tools). Likewise, U.S. machine tool orders declined about 4% in January, then 27% in February, and 21% in March, while German machine tool orders were down 24% in the first quarter.
Looking at the numbers provided by the Japanese Machine Tool Builders Association (which are prompter and more detailed), overall orders declined 9% yoy in April, with U.S. orders down 23%, German orders down 23%, Italian orders down 11%, and U.K. orders down 36% (Italy and the U.K. are also significant Hurco markets).
Turning to PMI, after a brief spurt above 50 in March, manufacturing PMI has declined in two straight months (49.2 in April and 48.7 in May), while Germany (a major Hurco market) has seen some improvement from 41.9 in March to 42.5 in April and 45.4 in May.
Last and not least, anecdotal data points from other industrials suggests ongoing pressure. In addition to the weak data from MSC, Fastenal has been reporting slowing growth from its manufacturing customers (+2% from heavy manufacturing in March, followed by +1.9% in April, and +1.5% in May) and Lincoln Electric recently revised its fiscal 2024 revenue growth forecast from low-to-mid single-digit growth to mid-single-digit decline citing “weakening industrial activity and capital investment”.
Looking at some of the major machine tool markets, auto companies have definitely pulled back some on capital spending for EV projects, semiconductor spending is still cautious, machinery spending is weakening, and die & mold activity is also slowing. That’s about 60% of the machine tool market, and I suspect the uncertain political climate in the U.S. could lead to spending pauses until the election results are in.
The Outlook
Some readers may take issue with the idea that just because Hurco’s business has bounced back in the past, it will do so again, but I don’t think anything has changed here on a fundamental level.
It’s certainly fair to complain about an overall lack of long-term growth and question whether Hurco can stay competitive with companies like DMG Mori and newer technologies like additive manufacturing, but I don’t think the basic cyclicality of machine tools has changed much. Add in some tailwinds from long-delayed capex spending among industrial customers and a reshoring of manufacturing in many major Hurco markets, and I think there are drivers for an eventual recovery. I don’t know if that recovery will start materializing in the next quarter or two, or whether results could bump along the bottom until 2025 (though orders should pick up earlier).
I’ve made some modifications to my model, mostly on the order of pushing out some revenue from FY’24 into FY’25 and FY’26. It lowers my FY’24 revenue estimate by about 6%, but the longer-term revenue and growth rates don’t change, and I’m still looking for close to 3% long-term revenue growth. Margins will likely see more pressure in FY’24 than I’d expected, but can rebound as revenue improves, and I think Hurco can still generate 3% to 4% long-term FCF margins.
Between discounted cash flow and margin/return-driven EV/EBITDA, Hurco shares look modestly undervalued below the high-teens to low-$20’s.
The Bottom Line
Hurco is not a good candidate for buy-and-hold investors; there hasn’t been much growth over the years, and metrics like return on invested capital aren’t good either. Counter-intuitive as it may sound, though, lower-quality cyclical companies can often outperform in cyclical recoveries and Hurco does have some merit as an investment idea on that basis.
These shares haven’t done well since my last write-up, and investors need to appreciate the risk that the U.S. goes into an actual recession and/or that Hurco’s issues are more company-specific. Even so, it does have some promise as a short-cycle cyclical industrial turnaround story for 2025.
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