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Operating conditions have become increasingly challenging for companies in the heavy machinery and manufacturing space, and that has made for a tougher road for Sweden’s Sandvik (OTCPK:SDVKY) (OTCPK:SDVKF). Not only have core mining orders looked more wobbly as mining companies take a more cautious approach to capex, but the end of destocking in cutting tools across many industrial end-markets has been offset by weakening underlying production volumes.
With all of this, Sandvik shares have underperformed since my last update – rising around 7% (for the local shares), but coming in below the roughly 20% appreciation of the broader industrial sector and the nearly 30% gain in the S&P 500.
I was cautious on Sandvik for the near-term when I last wrote about the stock given the uncertain macro environment (but more bullish on the longer-term outlook), and that largely remains the case today. Although I do see improving operating conditions in 2025 and growth opportunities in areas like manufacturing software, mining automation, and additive manufacturing, I don’t really find the valuation all that compelling now.
Manufacturing Continues To Bump Along
With August and July PMI reports in hand, operating conditions for Sandvik really haven’t changed all that much since the company reported sluggish results for the fiscal second quarter. Numbers in both the U.S. and the EU continue to bump along at weak levels, with the EU figure stuck below 50 (the breakpoint for expansion/contraction) for over two years running and the U.S. numbers showing a concerning weakness in production in August (44.8%, the weakest reading since May of 2020) on flagging demand.
The earnings and guidance reports from industrial companies for the second quarter weren’t all that bad, but there were quite a few more negative revisions than positive, with most companies pointing to growing uncertainty around end-customer demand and much less willingness to move forward with capex projects ahead of rate cuts and the election. All in all, the environment is one of sluggish demand, increased price sensitivity, and more challenges to operating leverage.
For its part, Sandvik saw 4% order growth in its Machining Solutions (or SMS) in the second quarter, but core cutting tool orders were down about 1% and the growth was driven by newer drivers like software (up double-digits) and additive manufacturing. Revenue declined 1% in the quarter, with margin down almost two points on an 8% core EBITA decline, and management noted weakness across the board outside of aerospace (which is only around 4% of total company revenue).
If there’s good news here, it’s that Sandvik’s efforts to expand into areas like manufacturing software (including CAD/CAM) and metrology (with both hardware and software components) are paying off, giving the company some leverage to automation/digitalization trends. The company has also seen some success in transitioning its core offerings to faster-growing markets like EV battery manufacturing, but not surprisingly that market has weakened of late as companies have started pulling back on their EV launch plans.
I’m also relatively encouraged by what sounds like controlled inventory levels among end-users for core cutting tool offerings. I’m not expecting manufacturing activity to inflect to a stronger level until 2025, but Sandvik at least won’t have sizable channel/customer inventories to chew through when that recovery starts to take hold, and may, in fact, see orders turn up a little ahead of that as customers seem wary of being caught short like they were when demand recovered after the pandemic.
Mining – Softer Now, But The Trends Are Largely In Sandvik’s Favor
Not unlike the manufacturing sector, I’d describe the current state of Sandvik’s mining markets as “mixed”. Copper prices are healthy on a longer-term basis (though off early/midyear highs) and gold prices are at all-time highs, and those two metals cover roughly half of Sandvik’s mining exposures. Other commodities like nickel haven’t been quite as strong, and Sandvik has seen weakness in its infrastructure business (Sandvik sells drills and other related equipment for applications like tunneling).
While copper and gold prices remain robust, large miners have started taking a more cautious approach toward capex and this business has been largely flat for a few quarters now, with management seeing still-healthy demand for automation systems (like the company’s proprietary AutoMine systems) but softer demand for capital equipment like drills.
Mining equipment demand is cyclical and always has been. I’m not really worried about this downturn, as, although I do think capex demand could remain soft into 2025, I expect further expansion in underground mining (versus surface/strip-mining) and further adoption of automation as companies look to reduce labor costs and optimize productivity. Companies like Komatsu (OTCPK:KMTUY) are trying to expand their underground equipment exposure and I won’t claim that Sandvik has the best portfolio (I’d argue Epiroc (OTCPK:EPOKY) is better-positioned), but I think there is enough in the portfolio here to support growth when the next mining capex cycle starts (likely 2026).
The Outlook
End-market and revenue trends have largely developed as I expected when I last wrote about Sandvik. Margins, though, have come in short of my expectations. I’m not overly troubled by evidence of greater volume sensitivity (operational deleverage) nor is it surprising to me that the company continues to see some drag from investing in growth drivers like automation, software, metrology and so on.
It does seem that the margin-improvement efforts that management has been pursuing may have topped out, or at least are more dependent upon further volume growth, than the Street previously expected. That puts management’s 20%-plus adjusted EBITA mid-term margin targets at risk, and that is a concern given that there has long been a pretty tight correlation between industrial company margins and stock multiples.
Between a slightly weaker 2023 and sluggish year-to-date trends, I’ve revised my 2024 revenue expectations lower, and I think management will be hard-pressed to show revenue growth this year. I do expect a rebound in manufacturing activity in 2025, though, and a mining capex rebound in 2026. Over the long term, I expect core revenue growth in the 3% to 4% range, with Sandvik well-placed to leverage growth in mining and manufacturing automation and software, offset by some risk that further expansion in near-net shape forgings will drive weaker core cutting tool demand.
One area of significant modeling uncertainty for me is the extent to which Sandvik can and will augment its core revenue growth with meaningful M&A. Management has talked about a 7% annualized revenue growth target, and while I’m looking for around 4% to 5% core revenue growth over the next three years, adding meaningful revenue through M&A may well be limited by the company’s net debt position (around 1.8x of expected EBITDA) and investor worries about the company expanding too far out of its historical core operating expertise – in other words, I’m not sure Sandvik has the resources or targets to close that growth gap through M&A without taking risks that the Street may well not appreciate.
I’ve cut back my margin expectations, but I still believe that mid-20%’s EBITDA margins are attainable when manufacturing and mining capex activity recover in 2025/2026. A bigger concern is whether the company can drive free cash flow margins back to a sustainable double-digit level. I consider this possible but not assured, and it’s a significant swing factor for long-term valuation.
As is, long-term revenue growth in the 3% to 4% range and FCF growth in the high single-digits isn’t really enough to get me all that excited about the share price. Likewise, while the stock does look undervalued on a margin/return-driven EV/EBITDA basis (around 10% undervalued using an 11.5x multiple on 12-month EBITDA), that’s not a huge undervaluation. Delivering on 20%-plus core margins would support a multiple in the 12’s (and upside closer to 20%), but that could take longer than management has led the Street to expect.
The Bottom Line
I don’t want to get that negative on Sandvik. I think management is doing the right things from a strategic perspective, and it’s sometimes too easy to get caught up in the cyclicality, particularly when business is softer. As I said earlier, I think Sandvik will be fine for the long term.
The “but” is that investors have thousands of options for their investment funds and by definition not all stocks outperform. I’d like a bigger margin of safety than I find here today and if I had to overpay for an industrial stock, I’d prefer to do so for a name like Atlas Copco (OTCPK:ATLKY) or Eaton (ETN) where there are stronger operating track records and/or core growth stories. Should Sandvik continue to lag, it’s a name to revisit, and again I do think it’s a name to consider if you’re more bullish on the timing and scale of a manufacturing recovery, but for now, it’s not a compelling idea to me for a new investment.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
