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Lowering Harmonic Drive’s FVE but Still See Upside Potential; Wide Moat Remains Intact

We note that our revised expectation of margin expansion is still higher than management’s plan and we currently see upside potential in the low- to mid-teens percent. Throughout calendar 2020, the company’s share price grew significantly as a result of high growth expectations for HDS’ strain wave reduction gears, which serve as vital components for high precision machinery like industrial robots and semiconductor equipment. However, since reaching its peak of around JPY 9,200 at the end of 2020, HDS’ share price has fallen year to date, as the market’s excessively high growth expectations have been corrected.

The medium-term plan, ending in fiscal 2023, implies that operating margin will return to normalized levels in fiscal 2023–at 21.4%, from 2.3% in 2020. We believe the plan is conservative, but we also take this into account for our downward revision to our projection. Further, we consider the potential impact of pricing, as management commented that a domestic industrial robot manufacturer (HDS’ customer) hopes to eventually adopt a “two company” supplier policy for small-size reduction gears. At the moment, compared with other manufacturers’ gears, there is a significant pricing premium on HDS’ strain wave reduction gears due to hurdles by other companies in replicating the quality of HDS’ high-end gears. We note that this impact would not be immediate and that despite the likelihood of reduced pricing over the medium/long term, HDS’ wide moat remains intact, as the high-end strain wave gear market is not a “winner take all” market and will likely continue to have high barriers to entry.

Over the medium term, we assume margins will increase from 22% to 25.5% between fiscal 2022 and 2025, compared to 25% to 28% in our previous projection during the same year. Further, we maintain our fiscal 2021 operating margin of 18%, which is also higher than management guidance of 12.7% margin for the same year. We think this is possible, based on higher sales assumptions compared to guidance and after considering its high contribution margin of about 50%. We note that our assumption still implies operating margin of 5 percentage points lower compared to fiscal 2017 levels despite similar companywide revenue levels. We attribute this margin gap between 2017 and our 2021 projection to: 1) higher production-related costs, including increased expenses related to the operations of its new factories in Japan and North America as well as record D&A levels as a result of peak capital investments in 2018 and 2019; 2) increased R&D spending as part of its medium-term plan; and 3) near term rise in costs related to packaging and shipping.

For the current fiscal year, we assume 47% top-line year-on-year growth, which is higher than both guidance and our previous projection (40% and 37% year-on-year growth, respectively), as we expect stronger top-line recovery in Japan/Asia and Europe segments. We attribute this to order improvement in the fourth quarter, which exceeded our previous expectations, and likelihood of further increases in orders/sales throughout the fiscal year from industrial robot and collaborative robot, or cobot, manufacturers in these regions, as factory automation investments in the automobile industry pick up. Fourth-quarter consolidated orders in the Japan/Asia segment more than doubled year on year, and order growth in the Europe segment also turned positive in the fourth quarter with 12% year-on-year growth, after two consecutive declines from same periods of the previous year. We expect these factors will also contribute to margin expansion going forward.

The company’s fiscal 2020 year-end results, ending in March, were in line with our expectations, as companywide revenue remained flat year on year, while operating margin remained low at 2.3%–though this is an improvement from minus 0.5% in 2019. Margins have been impacted by high fixed costs from its newly constructed factories in Japan and North America, where HDS spent in excess of JPY 30 billion or 30% of sales collectively in 2018 and 2019. While the parent entity’s standalone operating margin improved by about 8 percentage points to 10.6%, from strong sales to Japanese industrial robot makers, other key group companies in North America and Europe realized declining operating income from lower sales for mainly non-industrial robot applications (such as for medical, amusement, and service robot industries).

Harmonic Drive Systems Inc Company Profile

Harmonic Drive Systems Inc., or HDS, manufactures and sells precision control equipment and components worldwide. It offers high-precision reduction gears (speed reducers) under the Harmonic Drive brand as well as other mechatronics products such as rotary actuators, linear actuators, and AC servo motors. The company also provides planetary-gear speed reducers under the Accu Drive and Harmonic Planetary brands. Its products are used in industrial robots, semiconductor manufacturing equipment, and other high precision equipment. HDS was founded in 1970 and is headquartered in Tokyo, Japan.

Source: Morningstar

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Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

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Ramsay Health Care Ltd

Ramsay’s offer of GBP 2.40 per Spire share represents an enterprise value of GBP 2 billion or EV/EBITDA multiple of 10.9 on pre coronavirus fiscal 2019 earnings. Post-acquisition, our EPS for fiscal years 2023 to 2025 increases by an average of 11%, slightly ahead of the high-single-digit EPS accretion management guided for fiscal 2024. However, we still view the transaction price as fair, with shares still screening as overvalued.

We expect Spire’s revenue to grow at a low-single-digit percent and operating margin to largely be maintained at 10%. In addition, we factor in GBP 26 million in annualised cost synergies from fiscal 2024 through procurement benefits, capacity utilisation and a reduction in administrative costs. The scheme is first subject to a Spire shareholder vote expected in July 2021, followed by a likely 12-month review process by the U.K. Competition Market Authority, or CMA. Ramsay’s 8% market share combined with Spire’s 17% would create the largest independent hospital operator in the U.K., but at most we anticipate CMA may require Ramsay to divest certain hospitals or clinics. Accordingly, we forecast full integration and control in fiscal 2023 and full realization of synergies in fiscal 2024.

We view the acquisition as strategically sound, in addition to extending Ramsay’s geographic reach. Spire provides more exposure to private revenue streams and higher acuity inpatient admissions. This complements and balances Ramsay’s U.K. case mix, which is dominated by day patients and revenue sourced from the National Health Service. We anticipate Ramsay to fund the deal through existing debt facilities and still afford a 50% dividend payout ratio. However, Ramsay indicated potential capital management initiatives or asset sales to deleverage its balance sheet if needed.

Profile.

Ramsay Health Care is the fifth-largest global private hospital operator with approximately 480 locations in 11 countries. The key markets in which it operates are Australia, France, the U.K., Sweden and Norway. It is the largest private hospital group in each of these markets other than Norway where it is number two and the U.K. where it ranks fourth. Ramsay Health Care has a history of acquisitive growth, with the most recent acquisition being that of Stockholm-listed Capio AB in November 2018. 51%-owned Ramsay General de Sante is listed on Euro next Paris. Ramsay Health Care undertakes both private and publicly funded healthcare.

Source:Morningstar

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General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

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Global stocks Shares

Xiaomi Produces Record Smartphone Sales and Gross Margins; FVE Raised to HKD 20.70

The smartphone gross margin of 12.9% was up 480 basis points on the previous corresponding period. Up until third-quarter 2020 Xiaomi’s smartphone gross margins averaged 7.5% and never rose above 9% in any quarter. Fourth quarter last year these margins increased to 10.5% and then jumped to 12.9% in the first quarter. The smartphone performance drove consolidated operating profit (less investment gains) up 161% with an 8% consolidated operating margin, much better than its previous best quarterly operating margin of 6.1% in second-quarter 2019. Huawei’s retreat seems to have lifted margins across the industry with Samsung’s smartphone business and Apple’s consolidated business also reporting their best operating profit margins since 2016. We lift our fair value estimate to HKD 20.70 from HKD 16.30 previously due mainly to increased gross margin forecasts in the smartphone business as well as increased smartphone revenue growth forecasts in 2021, with the lift in the value of Xiaomi’s investment portfolio over the quarter and a slightly stronger CNY also helping. Our no-moat rating is retained as we believe Xiaomi is predominantly an electronics hardware supplier with limited switching costs with its internet services business not yet well enough developed to assign a moat to. On our estimates Xiaomi currently trades on a 2021 price/earnings ratio of 31 times. Despite Xiaomi’s growing Internet of Things and lifestyle services business revenue giving it some differentiation from other consumer electronics peers, we believe this multiple is still above what could be reasonably justified.

Xiaomi’s smartphone segment had another strong quarter with Xiaomi’s total number of smartphones sold globally rising by 69% and smartphone revenue increasing by 70% from the previous year. Smartphone gross profit was up 170% with gross profit margin increasing to 12.9% from 8.1% in first-quarter 2020. Until the third quarter of 2020, the average smartphone gross margin for the previous 15 quarters had been 7.5% with a range of 3.3% to 9%. The margin then jumped to 10.5% in fourth-quarter 2020 and 12.9% in first-quarter 2021. Given Xiaomi generates around two thirds of its revenue from smartphone, its valuation is very sensitive to the smartphone gross margin assumption. If we double the smartphone gross margin assumption from 7.5% to (say) 15%, holding all other assumptions equal, Xiaomi’s valuation nearly doubles. Xiaomi pointed toward the shift in product mix toward higher end smartphones and reduced marketing and promotion spend given tightness in the semiconductor supply chain as the key drivers for the margin increase.

We estimate that reduced competitive intensity from Huawei has probably also helped smartphone industry margins and there may also be some premium attached to 5G phones. In the first-quarter 2021, key competitor, Samsung, reported its highest quarterly smartphone operating margin since the second quarter of 2016. The first quarter also saw Apple reporting its highest quarterly company operating margin since first quarter of 2016.

Xiaomi admitted that gross margin expansion had not been its main focus nor does it expect it to be in the near future as it is quite rightly focused on increasing market share, particularly in the mid-high end phone segment. It expects future growth to come from increased penetration into the offline segment in China as it is currently expanding its store footprint with a target of around 10,000 stores by the end of 2021. We forecast Xiaomi to grow its smartphone revenue by 44% in 2021 and at an average of 18% per year thereafter out to 2025 and assume its smartphone gross profit margin increases from 11.0% in 2021 to 11.4% in 2025 having lifted these assumptions by around 200 basis points following this result.

Revenue from the Internet of Things and lifestyle products segment increased by 41% year over year in the first quarter after growing by 8.6% in 2020. We note that the prior period was negatively impacted by COVID-19. Gross margin increased to 14.5%, which was also a quarterly record. Management had previously indicated that it had proactively reduced the number of stocks keeping units in this division to focus more on those products that interworked with the smartphone ecosystem. The company indicated that global shipments of its smart TVs were down 4% to 2.6 million for the first quarter. Larger television competitor, TCL, reported global TV sales volumes up 33% for the first quarter with TV sales in China up 8.3% and non-China sales up 43%. We forecast that Xiaomi can grow its Internet of Things and lifestyle products revenue by an average of 15.1% per year out to 2025 with gross margins averaging 12.0%.

Revenue from internet services was below expectations, increasing by 11.4% year over year in the first quarter after growing at 20% in 2020. Monthly active users, or MAUs, of its Mi User Interface increased to 425 million at the end of March from 396 million at the end of December 2020 and were up 29% year on year. However, average revenue per user was down 13% to CNY 5.3 per month. Advertising revenue was strong growing by 20% to CNY 3.6 billion and making up 58% of total internet services revenue. This is mainly driven by smartphone sales with the improved mix of higher end smartphones helping Xiaomi to grow the preinstalled app revenue. The high percentage of advertising revenue and improved margins from the fintech business drove internet services gross margin to 68.4% for the quarter. We believe the dominance of advertising in this revenue stream speaks to the difficulties Xiaomi has faced in building non-hardware-related internet revenue streams. We forecast internet services revenue growth of 20% per year to 2025 noting that growth in first-quarter 2021, internet services revenue was slower because of the very high gaming revenue in first-quarter 2020 due to the pandemic.

Source: Morningstar

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Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

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Change Healthcare Inc

UnitedHealth still plans to purchase Change for $25.75 per share, which is our fair value estimate. However, in March, U.S. antitrust regulators announced an extension of that merger’s review period, and if the deal doesn’t close because of regulatory concerns, we would reduce the value of Change to our stand-alone fair value estimate of $16.50.

In the quarter, Change beat consensus on both the top and bottom lines. Revenue grew 1% to $855 million, above FactSet consensus of $846 million. With cost controls likely due to rightsizing before the pending acquisition, Change turned that slight revenue beat into a bigger profit beat. The company turned in adjusted EBITDA of $272 million (above consensus of $254 million) and adjusted EPS of $0.42 (above consensus of $0.36).

On the pending merger with UnitedHealth, both the acquirer and the target look committed to the deal, but regulators have thrown a wrench into the process. Based on recent commentary from UnitedHealth, there appears to be no major financing concerns or red flags from the perspective of the potential acquirer, and Change shareholders voted to approve the merger in April, as well. However, the Department of Justice announced an extended antitrust review on the combination in March after receiving a letter from the American Hospital Association about the combination, citing concerns about sensitive healthcare data shifting hands from Change (a neutral third party) to UnitedHealth’s Optum segment (a subsidiary of the largest U.S. health insurer and a large caregiver, too). The AHA suggested that the shift could give UnitedHealth an unfair advantage in its legacy businesses by seeing competitive claims processed in Change’s clearinghouse business. Concerns like that add uncertainty about whether the deal will close.

Profile

Change Healthcare is a spin-off of various healthcare processing and consulting services acquired by McKesson over numerous years. Recently, these processing assets were contributed to a joint venture and in June 2019 public shares were issued with McKesson retaining the majority interest. As of the end of the March 2020 quarter, McKesson distributed all its interest in the public processor. Core services consist of insurance (healthcare) claim clearinghouse for healthcare payers in addition to administrative and consulting services to assist healthcare providers improve reimbursement coding, billing, and collections.

Source:Morningstar

Disclaimer

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.