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Japan Keyence (OTCPK:KYCCF) (6861.T) is a remarkable company in many ways. This leader in automation and automation technologies has generated double-digit revenue growth and free cash flow growth of approximately 15% over the past decade, generating incredible margins while reinvesting in the company and continues to innovate. It is also one of the most opaque and difficult companies to follow, and if you don’t read Japanese, I think it will be difficult to follow the quarterly results.
Keyence has also been seen as an exceptional company, which has long been one of my main problems (I speak/read Japanese, so the lack of English information is less limiting). Despite this, the shares are still up about 45% in local currency since then my last update (down 10% in US dollar terms for ADRs, however), outperforming Omron (OTCPK:OMRNY) (6645.T) (down 28%) and hexagon (OTCPK:HXGBY) (up 18%), while lagging behind ABB (OTCPK:ABBNY) (up 138%) and Siemens (OTCPK:SIEGIE) (up 75%).
At this point, I view Keyence as a “it is what it is” investment. End markets like automotive and machine tools aren’t doing so well right now, and markets like chemicals are slowing, but electronics and semiconductors are doing better, and I remain very bullish on the long-term outlook for automation as countries like Japan face persistent labor shortages. Valuation simply doesn’t work according to the approaches I’m using, but I have no reason to believe Keyence won’t remain a growth leader in sectors like machine vision, metrology, security, sensing, and control.
Slow sales and lower margins
Like other companies in the automation and precision machinery sector (ABB, Emerson (DME), part of Honeywell (Honor), Rockwell (Republic of Korea), Siemens, et al), Keyence has seen a slowdown in business as companies across various end markets cut capital spending in the face of greater macroeconomic uncertainty.
The latest quarter (fiscal fourth quarter) saw reported revenue growth of over 7%, but underlying growth was closer to flat, with sales down 1% in Japan, up 2% in Asia in local currency, up 2% in Europe in local currency and up 6% in the Americas in local currency. These figures were, however, better than the prior quarter, with all regions except Europe seeing acceleration on a sequential basis, driven by stronger demand in the semiconductor and electronics sectors.
Gross margins remain quite strong, up another 200bps to 83.7% in the latest quarter. No, that’s not a misprint. Keyence uses an outsourced manufacturing system as Atlas Copco (OTCPK:ATLKY), but goes even further, and this generates exceptional gross margins.
Operating income increased 4% on a reported basis (but declined 3% in constant currency), with operating margin down 160bps to 52.1%. An operating margin above 50% is a fantasy for most industrial companies (even if Keyence is more of a design and engineering company in some respects), but despite this, Keyence has now had eight consecutive quarters of decline, largely due to significant hiring activity, with the company increasing its headcount by 16% in FY2024 after an 18% increase in FY2023.
It is also worth noting that the company continues to accumulate cash on its balance sheet. The company increased its dividend by 50% in FY2023 (to JPY300/share), but the payout remains at around 20% of free cash flow and there is now around JPY4,671/share in cash and short-term securities on the balance sheet (versus a recent price of around JPY75,580).
Many opportunities throughout the company
While many industries have recently cut back on capital expenditures, the overall outlook for automation and precision equipment remains quite healthy for Keyence and the company’s broad product portfolio gives them a potentially large share of the portfolio with significant automation projects.
While U.S. investors tend to view Keyence in terms of its machine vision business (where it competes with Cognex (CGNX)), this represents only about 10 to 15% of the business. The most important activities are in sensing and measurement, where it competes with companies like Omron, Honeywell and SICKand probably generates about 25-30% of revenue, automation (PLC, HMI, security, etc.), where it competes with companies like ABB, Emerson, Honeywell and Siemens and probably generates about 30% of revenue, and other businesses like marking/printing (where it competes with companies like Dover (DOV) And Danaher (HRD)) and metrology.
As companies look to increase automation and implement industrial IoT with smarter devices, sensing/measurement products and control systems will only become more important. Similarly, machine vision remains a growing market, not only as standalone systems for applications such as warehouse automation, but also as vision systems for robotic systems.
It’s also worth noting that Keyence places an uncommon emphasis on product development and customer service. While the company typically makes standardized products, I don’t know of any other company of its size that delivers high-end products in such short time frames, and the company consistently seeks to maintain a high percentage of sales of products launched in the last two or three years. I wish I had the numbers to prove it, but it’s a point management has repeatedly made over the years in its earnings presentations.
Overall, Keyence is a leading supplier of automation equipment and I think this will be a great area to be in for the next decade. Given that I believe that precision – whether it’s measurement or motion – is going to be a key technology, Keyence’s capabilities in sensing, control and measurement seem to be a great fit for the evolution of many of its markets.
Perspectives
I still see risks to the near-term outlook due to weakness in some key markets like autos and machine tools, as well as weak demand in the logistics sector and uncertain demand in the food and pharmaceutical markets. Semiconductors and electronics are picking up, however, and I think non-chemical process markets are still healthy (and I think chemicals are simply taking a breather as Western companies reinvest in sustainability and Chinese companies invest in capacity).
I think Keyence can generate revenue growth of about 6% to 7% this year, and I wouldn’t rule out 10% growth if short-cycle industrial markets pick up toward the end of this calendar year. In the long term, I think 9% revenue growth is achievable, and given Keyence’s track record, that number may be conservative.
On the margin side, I think the company is probably near the end of its hiring expansion phase and lower operating leverage due to slowing sales. I think FY25 EBITDA margin could still be down about two or three percentage points from a year ago (to around 50%), but I expect expansion in the coming years. On free cash flow margins, I see no reason why the company could not continue to generate free cash flow margins in the 30% range over the long term; I am not sure that 30% or 40% margins are sustainable given the current optimization of the company. In this environment, I expect single-digit free cash flow growth.
Valuation is a topic that seems almost pointless, because Keyence almost never looks cheap. Discounted cash flow? You either have to expect free cash flow growth in the 15% range over the next decade, or use a single-digit discount rate, or a combination of both. Similarly, with margin/yield-based approaches, Keyence is trading well beyond any kind of normal valuation metrics, and the stock is trading at about 45 times FY2025 earnings.
The essential
I’m not saying that Keyence can’t go higher from here, especially since Keyence’s business model is very different from other comparable companies. However, you have to accept the valuation and the lack of information (even if you can read Japanese, the level of disclosure is not very good) and believe that the growth in global demand for automation will continue to fuel opportunities for Keyence to continue to outperform its peers. This combination doesn’t really suit me, but I recognize the excellence I see here.
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