Accelerating orders and recovery in the Energy business support FY12/27 earnings expansion; Goldman Sachs maintains Buy rating on Ebara

Overview

This report summarizes Goldman Sachs's August 21 conference call with Ebara's investor relations team, focusing on demand and margins in the Precision Machinery business and the earnings outlook for the Energy business. Goldman Sachs believes the recent share-price weakness, partly due to the lack of an increase in full-year operating profit guidance, overlooks the support that stronger orders and easing issues at the US plant provide for an FY12/27 earnings recovery, leaving the stock undervalued.

Core views

Goldman Sachs first notes that demand momentum in Ebara's Precision Machinery business is stronger than it was three months ago. 1H orders significantly exceeded initial guidance, prompting the company to raise its full-year order guidance substantially; the improvement in demand is not limited to a single application or region. Before FY12/25, orders were driven mainly by logic chip and foundry customers, but demand from DRAM and NAND memory customers has now also begun to strengthen. Asia accounts for most of the business's sales, with strong demand in Taiwan, South Korea, and mainland China, indicating that the sources of growth are broadening. The growth in orders will not be fully reflected in FY12/26 sales immediately. System products have a production lead time of approximately six months, so the increase in full-year sales guidance is notably smaller than the increase in order guidance. For the China business, management expects sales to account for slightly less than 20% of FY12/26 sales and orders to account for slightly more than 20% of FY12/26 orders. Although sales in China have remained broadly flat since FY12/24, FY12/26 order value is expected to increase significantly. Chinese domestic manufacturers continue to gain market share with support from national policies, but the company believes Ebara retains a competitive advantage in advanced process technologies. The Precision Machinery business's near-term profit sensitivity is weaker than its order and sales growth, primarily because of the product and project mix. First, system products have higher margins than components, but the latest guidance increase is driven more by components. Second, margins vary across projects and customers, and lower-margin projects represent a relatively high share of projects scheduled for revenue recognition in FY12/26. Third, the share of relatively low-margin evaluation projects, whose primary purpose is development, has temporarily increased within the systems business. These three factors explain why the increase in full-year operating profit guidance is relatively limited compared with the increase in sales guidance. The company expects order profitability and margins to improve from FY12/27. Specific measures include passing component and raw-material costs through to selling prices at appropriate times and reflecting greater added value in pricing based on product attributes such as energy efficiency and a smaller footprint. For system products, even without launching an entirely new platform or product, the company can offer options that improve planarity and throughput as customers adopt new chip layer structures and manufacturing processes, thereby increasing the added value and profitability of each project. In the Energy business, the reduction in FY12/26 operating profit guidance is related to operating losses at the US Jeannette plant. Insufficient proficiency during the plant's modernization process, including automation, caused processing losses and supply-chain disruptions. Ebara has introduced expertise from its Japanese facilities in ramping up similar equipment and processes at the US plant. Production disruptions are currently being resolved as planned, and the company assumes they will not affect 2H earnings. The revised guidance still projects year-on-year growth in 2H operating profit, although this is mainly because the situation in the Middle East delayed some S&S sales originally scheduled for recognition in 1H until 2H. Management also notes that high-margin S&S sales are typically concentrated in 2H due to seasonality and therefore believes the current guidance is achievable. Overall, Goldman Sachs believes the recovery in Precision Machinery orders, potential margin improvement in FY12/27, and the resolution of production issues in the Energy business could collectively drive significant earnings expansion in FY12/27. The report also believes there is room for further valuation improvement as a broader group of investors becomes familiar with the stock. Its 12-month target price of ¥7,900 is derived from the relationship between P/B and FY12/27E ROE and corresponds to an FY12/27E P/E of 25X and P/B of 5.6X; Goldman Sachs therefore maintains its Buy rating.

Analysis framework

Goldman Sachs first used a conference call with the company's investor relations team to verify orders and demand by region and application. It then analyzed how production lead times affect the conversion of orders into sales and explained the difference between sales and profit guidance through the product, project, and customer mix. The report subsequently assessed the Precision Machinery business's paths to price increases and greater added value, as well as progress in resolving issues at the Energy business's US plant, before deriving a 12-month target price based on the relationship between FY12/27E ROE and P/B.

Methodology notes

• Valuation MethodologyPB valuation

  Valuation based on the relationship between P/B and FY12/27E ROE

  The report determines the 12-month target price of ¥7,900 based on the relationship between expected return on equity and P/B, with an FY12/27E P/E of 25X and P/B of 5.6X as the corresponding valuation outcomes.

• Industry/Sector Analysis FrameworkSupply-demand framework

  Analyzing semiconductor equipment demand by application and region

  The report breaks down order demand across logic chips, foundries, DRAM, NAND, and markets including Taiwan, South Korea, and mainland China to assess whether stronger demand is broad-based and sustainable.

• Corporate Fundamentals and Financial Framework

  Order-sales-operating profit bridge and mix analysis

  The report uses the approximately six-month production lead time to explain the timing gap between orders and sales recognition, then examines systems versus components, different projects and customers, and the share of evaluation projects to explain why sales growth has not translated proportionately into operating profit.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Ebara (6361.T)

  Growth in Precision Machinery orders, the potential for margin improvement in FY12/27, and the recovery of the Energy business are the primary reasons for the report's maintained Buy rating.

  Strengths

  Demand from DRAM, NAND, logic chip, and foundry customers is strengthening; the company retains a competitive advantage in advanced process technologies in China; and it can increase product added value through energy efficiency, miniaturization, and performance-enhancing options.

  Weaknesses

  FY12/26 sales recognition is constrained by an approximately six-month production lead time, while a relatively high share of components, lower-margin projects, and evaluation projects limits near-term operating profit sensitivity.

  Comparison

  The report notes that Chinese domestic CMP system manufacturers are gaining market share with policy support, but Ebara retains a competitive advantage in advanced technologies.

  Risks

  A downturn in semiconductor capital expenditure, improving competitiveness among Chinese CMP system manufacturers, slow adoption of new technologies, and declines in crude oil/LNG prices and refining and petrochemical margins.

Key data

• Conference call dateMorning of August 21Goldman Sachs held a conference call with Ebara's investor relations team.
• 1H order performanceSignificantly above initial guidanceThe company subsequently raised its full-year order guidance substantially.
• System product production lead timeApproximately six monthsThis resulted in a smaller increase in FY12/26 sales guidance than in order guidance.
• China business's share of FY12/26 salesSlightly less than 20%Management estimate.
• China business's share of FY12/26 ordersSlightly more than 20%Order value is expected to increase significantly compared with sales, which have remained broadly flat since FY12/24.
• Energy business 2H operating profitExpected to increase year on yearSome S&S sales were delayed from 1H to 2H due to the situation in the Middle East, while high-margin S&S sales are typically seasonally weighted toward 2H.
• 12-month target price¥7,900Based on the relationship between P/B and FY12/27E ROE.
• Target price-implied FY12/27E P/E25XValuation multiple corresponding to the target price.
• Target price-implied FY12/27E P/B5.6XValuation multiple corresponding to the target price.

Impact & implications

The report believes stronger FY12/26 orders have not yet been fully reflected in sales and profit due to production lead times and an unfavorable project mix, but the conversion of these orders, value-added product pricing, and the recovery of the US plant are expected to make a more visible contribution to earnings in FY12/27. If a broader group of investors gradually recognizes this earnings trajectory, Goldman Sachs believes Ebara's valuation still has room to expand.

Risks

• A downturn in semiconductor capital expenditure could weaken demand for Precision Machinery equipment.
• Improving competitiveness among Chinese CMP system manufacturers could intensify market-share pressure.
• Slower-than-expected adoption of new technologies in semiconductor devices could affect demand for high-value-added equipment.
• Declines in crude oil and LNG prices could affect demand and profitability in the Energy business.
• Declining refining and petrochemical margins could constrain project investment by relevant customers.

What to watch

• Monitor whether FY12/26 orders convert smoothly into sales after the approximately six-month production lead time.
• Monitor whether cost pass-through and high-value-added pricing can improve Precision Machinery margins from FY12/27.
• Monitor whether production disruptions at the US Jeannette plant are resolved as planned without affecting 2H earnings.
• Monitor whether S&S sales delayed by the situation in the Middle East are recognized in 2H.
• Monitor whether strong orders from DRAM, NAND, Taiwan, South Korea, and mainland China are sustained.