Monday, September 8, 2008

Analysis of Hurco

Hurco (HURC) is a leading manufacturer of computerized machine tools used in metal cutting in a variety of industries that include aerospace, defense, medical equipment, energy, electronics and automotive. They incorporate a proprietary computer control system for use on a PC system that improves the quality of cutting and ease of use. In addition to producing the machinery and control systems, Hurco also provides software upgrades, parts, service and support to customers. Hurco manufactures their cutting machines in Taiwan, and sells their products in Europe, Asia and North America via direct sales and through independent distributors.

Hurco’s competitive advantage appears to be the computer controlled cutting system they have developed. In machine cutting the setup and accuracy of the process greatly affects efficiency and cost. If Hurco is able to decrease setup time and reduce errors via their proprietary software, it would give them an advantage over their competitors such as Hardinge (HDNG) that don’t have the sophistication of the Hurco product. This is reflected in their return on capital of 24.15%, net margins of 11.1% and 5-year sales growth of 22.7%, all of which are higher than any of their peers. In addition, they have $4.50 per share in cash and no long-term debt.

Hurco is not without it’s challenges. According to the most recent 10-Q, approximately 89% of global demand for machine tools comes from outside the United States, and as a result, Hurco’s sales are heavily concentrated in foreign markets, with 73.6% of sales coming from Europe, compared to 20.8% from the United States and 5.6% from Asia. Because of this, the company earnings are sensitive to foreign currency fluctuations, which have a material impact on earnings based on the relative strength of the dollar versus the British Pound and the Euro. In addition, because of the time it takes to manufacture and ship products from Taiwan, Hurco must schedule production based on sales forecasts for 4-5 months in the future. Therefore, they would be slow to respond to a rapid decrease in orders, resulting in excess inventory and a decline in return on equity.

This may be what happened during the last recession in 2001-2002, when cash flow per share dipped from $1.25 in 2000 to -$0.28 in 2001 and -$1.48 in 2002, before rebounding in 2003 and increasing to $3.24 in 2007. In addition to an economic slowdown, rising prices for steel are also a concern, as they may pressure margins for Hurco and its customers. Such conditions have yet to slow growth, as Hurco managed to grow sales by 37% in the first six months of 2008 versus the same period in 2007. Sales in the United States were flat, but sales in Europe and Asia increased 50%, with currency exchanges resulting in a favorable impact of 17% in Europe and 14% in Asia. Sales of machine tools accounted for 89% of revenue with service fees and parts making up the remaining 11%.

The last five years of the falling dollar have benefited Hurco by making its machining tools less expensive abroad, a trend that is at risk of reversing as the European Central Bank and its British equivalent are being pressured to lower interest rates by slowing economies. The prospect of an economic slowdown has hit shares of Hurco, driving them from a high of $60.44 per share in October 2007 to a recent price of $31.00. This has resulted in a trailing P/E of 8, near the low end of its historical range, and an EV/Ebitda multiple of 4.3 for the last 12 months. This is cheap for a company that tripled earnings from $1.04 in 2003 to $3.24 in 2007. The only analyst covering the stock expects 2008 earnings of $3.58 per share with 2009 earnings growing 12% to $4.00 per share. This would result in a forward P/E of 7.87 and an attractive earnings yield of 12%.

Hurco holds an attractive niche in the machine tool market. In a world that will demand lower costs and greater efficiency as emerging markets grow, Hurco stands to benefit as a provider of quality, cost-saving manufacturing tools. Given the cyclical nature of this business, buying opportunities will present themselves on a frequent basis, as investors respond with fear to economic news and earnings calls. While I believe the current price to be a good entry point, a return to the $25-$28 range is not an unreasonable expectation. It would be wise to enter a position in thirds, the better to take advantage of declines in the share price in these uncertain times. Doing so should provide a good return for the long-term investor.

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