R&I Rating Methodology by Sector

Transcription

1 R&I Rating Methodology by Sector Construction Machinery May 8, 2015 R&I applies its rating methodology for construction machinery to firms whose principal business is the manufacture and sale of construction machinery used mainly for earthmoving and construction, such as hydraulic excavators, bulldozers and construction cranes. Most of the entities rated by R&I are manufacturers that are developing a broad product lineup, including high-end equipment, on a global scale. While construction machinery for earthmoving and construction and construction cranes differ in terms of their market size and competitive conditions, R&I judges it reasonable to regard them as having identical industry risk because they are used for the same purposes, such as urban development and infrastructure construction, and their demand is highly synchronized. I. Evaluation of Business Risk 1. View of industry risk Demand for new construction machinery is predicated on construction investment primarily for urban development and infrastructure upgrades. In developed markets where the construction of social infrastructure is well advanced, relatively stable demand is envisaged, but significant growth cannot be anticipated. Emerging countries, on the other hand, have vigorous demand mainly from infrastructure construction. Medium-term growth potential is large, albeit highly volatile. Viewed globally, demand for construction machinery should continue to expand in the medium to long term. Because construction machinery is a capital good, however, demand is easily affected by the external environment, and fluctuations are fairly large. There are only a limited number of players who are developing their construction machinery business globally by offering quality products and a well-developed service network. They maintain and raise new machinery prices through such efforts as delivering collective cost benefits to users. Parts and service businesses that can capitalize on the past sales of new machinery also contribute to profits. Moreover, companies enjoy comparatively flexible revenue and expenditure structures as a result of having worked to lower their fixed costs. this website or any other information included in this website belong to Rating and Investment Information, Inc. ("R&I"). None of the information, etc. may be used, in whole or in part, (including without limitation reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), or stored for subsequent use without R&I's prior written permission. 1/9

2 Based on the fact that companies have created revenue and expenditure structures corresponding to large swings in demand, as well as the competitive environment and market growth expected to continue over the medium to long term, R&I judges the construction machinery business to have a medium degree of industry risk. (1) Market size, market growth potential and market volatility According to the Japan Construction Equipment Manufacturers Association, the value of construction machinery shipments in fiscal 2014 is projected to have exceeded two trillion yen. When foreign manufacturers are taken into account, the global construction machinery market is believed to have a decent scale. Although the construction machinery market in advanced countries has considerable demand, the market has matured, and high growth is difficult to envisage. In emerging countries whose economies continue to grow, on the other hand, infrastructure construction creates vigorous demand. To meet the demand for the resources needed for such infrastructure construction, large construction machinery is sought for mining development. Viewed over the medium to long term, R&I believes that the construction machinery market will continue to expand. Being a capital good, however, construction machinery is highly susceptible to the external environment, including trends in the economy, public works investment and capital investment. Demand for new machinery can therefore experience large swings. (2) Industry structure (competitive environment) The number of manufacturers developing their construction machinery business globally is limited. For high-end products and mining machinery in particular, the number of firms is even more limited. Construction machinery production is not mere procurement and assembly of components. Accumulating technology is necessary to design and manufacture products. To produce a high value-added product, a company has to develop vital components in house or establish a system to procure them stably. Efforts to prevent the flow of technology outside the company also form a barrier to entry. The establishment of a sales network is another factor limiting the number of global players because of the considerable time required. (3) Customer continuity and stability There is a wide gap in the product quality of the leading global manufacturers and local niche manufacturers. Among the leading global manufacturers, on the other hand, major product quality 2/9

3 differences are unlikely to arise, in R&I's view, partly because of their obligations to achieve a certain level of quality to comply with exhaust emissions regulations, for example. Unique services and some features contributing to total cost reductions work positively for customer retention and business continuation. In their mother markets, however, each company boasts strong brand power as well as a high market share. In many cases, relationships with customers are stronger than in other operating regions, and R&I believes there is a certain amount of customer continuity. Even after selling new machinery, a company has opportunities to generate earnings through parts sales and maintenance services. Profit margins on these businesses are comparatively robust and help to boost profitability. Enhancing a service network is also a key point for increased customer continuity and stability. (4) Capital and inventory investment cycle In construction machinery production, capital investment does not constitute an unduly heavy burden if limited to assembly plants. Production is relatively labor intensive, and the obsolescence risk of production facilities stemming from model changes and other factors is low. A commensurate amount of capital investment is made if a company builds a new facility for production of components that demand precision manufacturing processes. Even so, components are not significantly modified upon every model change. The capital investment burden is thus comparatively light when viewed overall. The ability to control inventory is important. In an industry with large fluctuations in demand, a manufacturer can be left holding surplus stock during a phase of suddenly contracting demand, or oppositely find itself facing inventory shortages. Excessive inventory, in particular, may lead to fire sales and will also make the working capital burden heavier. A manufacturer needs to control production and inventory levels appropriately by making sophisticated demand forecasts with an understanding of to what extent the construction machinery it sold is used, for instance. (5) Protection, regulations and public aspects While every country in the world is moving in the direction of tightening exhaust emissions regulations on diesel engines for construction machinery, this is not a significant concern for the leading manufacturers from a technical aspect. Overall, there are no protections or regulations that will affect creditworthiness. In China, however, firms cannot undertake proprietary development because construction 3/9

4 cranes are classified together with trucks and investment by a foreign company for a more than 50% stake is not approved. This has become a factor behind the slow market development in China, and is one reason firms are not capturing vigorous demand. (6) Cost structure Earnings of construction machinery manufacturers are easily affected by the external environment including economic trends and exchange rate fluctuations. Each company has therefore made efforts to lower their fixed costs. Even during the period when demand slumped following the collapse of Lehman Brothers, they did not report substantial losses thanks to such measures as reflecting higher costs in product prices. Relatively stable sales expected from highly profitable parts and service businesses are also an advantage. As the leading construction machinery manufacturers are able to maintain and raise new machinery prices partly because of their quality products, R&I can evaluate their revenue and expenditure structure to be comparatively flexible. 2. View of individual firm risk In contrast to industry risk, which highlights the standard risks of the industry of which the subject firms are a part, the business risk of each company will differ depending on the individual firm risk as explained below. (1) Geographical diversification Construction machinery demand is susceptible to changes in the external environment such as economic conditions, government policy and public investment trends in each operating region. Earnings are more likely to fluctuate if highly dependent on a specific region. A company with a geographically diversified earnings base is able to reduce earnings volatility risk. R&I evaluates the extensiveness of a global sales and service network. Operating regions are broadly divided into advanced countries and emerging countries. Advanced countries enjoy relatively stable demand, but lack growth potential. Emerging markets, on the other hand, have large medium-term capacity to grow thanks partly to substantial demand for infrastructure construction, though demand volatility is high. With respect to large construction machinery used for mining development in resource-producing countries, demand is affected by not only economic trends in emerging countries but also resource prices. Accordingly, short-term demand volatility warrants attention. 4/9

5 (2) Product lineup A broad product lineup helps mitigate earnings volatility risk. Even when looking at hydraulic excavators, one of the most typical types of construction machinery, there is an array of models ranging from small-scale machines used for urban construction such as housing to medium and large-size machines used for road and other infrastructure construction, and huge machines for mining. Their demand characteristics are all different. R&I favorably views an extensive product lineup because it leads to diverse sources of earnings. Moreover, several types of construction machinery are used at many construction sites where construction machinery is deployed. Having a lineup with a variety of models in order to meet all kinds of needs helps strengthen relationships with customers. (3) Product competitiveness Added value contributing to total cost reductions or other benefits gives a price advantage at the time of new machinery sales. With this advantage, a company does not have to resort to desperate measures for sales expansion and is able to achieve appropriate profits more easily. Whether a company can differentiate its product quality and performance is a key factor for evaluation. A company that has built a close relationship with a customer when selling new machinery can benefit from the relationship later in its parts and service businesses. R&I also evaluates product competitiveness by looking at the company's global market shares, as it believes that such shares reflect the company's comprehensive competitiveness. In the short term, it is unlikely that major manufacturers will lose their competitive advantage in product quality. If they are caught up with by low-price manufacturers in quality or other terms, however, price competition should intensify in the entire industry. The keys to enhancing future product competitiveness include fuel efficiency, unattended operation and the utilization of information communications technology, in addition to basic research and development (R&D) capabilities to address exhaust emissions regulations and other challenges. (4) Ability to control inventory and production Because the construction machinery industry is subject to large swings in demand, whether a manufacturer is capable of controlling production and inventory based on sophisticated demand forecasts is highlighted in R&I's evaluation. If a manufacturer fails to control production volume as a result of poor forecasts at the time of demand contraction, inventory will pile up. In contrast, it will lose business opportunities should it be unable to respond to growing demand. R&I examines 5/9

6 whether the manufacturer is successfully controlling production and inventory by making demand forecasts based on the information gathered on how the construction machinery it sold is used, and confirms the quality and track record of such control. In general, the larger the construction machinery is, the longer it takes from manufacture to sale, and this makes supply chain management including parts procurement even more important. Mitigating a burden of goods in progress and other inventory allows the manufacturer to reduce working capital and the size of its balance sheet. (5) Businesses other than new machinery sales Having earnings sources that do not depend on demand for new machinery helps mitigate earnings volatility risk. Parts and service businesses are a typical example of non-new machinery businesses. These businesses are viewed positively if they make great contributions to overall profits. In general, they generate strong profits and become a means of boosting profitability. Demand is also stable compared to new machinery sales thanks to the past sales of new machinery. A rapid expansion of these businesses is difficult, however, because it is indispensable to appropriately understand and analyze how the construction machinery sold is used and to enhance a sales and service network. The sales finance business is expected to help new machinery sales, and a manufacturer can also envisage earnings from this business. II. Evaluation of Financial Risk In addition to looking at various financial indicators, R&I evaluates qualitative factors, such as a firm's financial management policy and liquidity risk, in its analysis of financial risk. For the construction machinery industry, R&I emphasizes the following financial indicators in view of its business characteristics. Because differences in asset size and the level of debt can arise easily depending on the size of the sales finance business, if any, R&I examines these both on a "consolidated basis" and based on "manufacturing and sales operations excluding the sales finance business." (1) Earning capacity EBITDA (earnings before interest, taxes, depreciation and amortization) margin, EBITDA/average total assets, operating margin R&I emphasizes EBITDA and operating margins on sales as indicators of overall competitiveness and profitability. A company capable of providing users with high value-added 6/9

7 products and services can achieve high profit margins more easily. The EBITDA margin is highlighted when comparing a company with other firms in the same industry or making an evaluation excluding fluctuations stemming from the timing of investment. Given the susceptibility of sales to changes in the external environment, another important factor is to what extent a company can withstand a fall in new machinery sales by establishing a flexible revenue and expenditure structure that can accommodate such fluctuations. When evaluating a company's earning capacity relative to total assets, R&I excludes its sales finance business. (2) Scale and investment capacity EBITDA, equity capital R&D and capital investment for differentiating product quality, among others, and the strengthening and expansion of a sales and service network are indispensable for construction machinery manufacturers. Investment capacity that enables them to fund these activities is therefore an important factor in rating evaluation. Another focus is on equity capital as a buffer for absorbing losses when a company reports deficits. When evaluating scale and investment capacity, R&I uses consolidated basis values, including the sales finance business. The reason is the profitability of the sales finance business, and the equity capital as a financial buffer for this business, are also important. (3) Debt redemption period Net debt to EBITDA ratio, net debt to operating cash flow ratio Because the level of debt varies substantially depending on the size of the sales finance business, R&I evaluates debt excluding this business. The risk that sales finance receivables might deteriorate is limited, and the collection of sales finance receivables is not a major concern. R&I thus compares debt by excluding the sales finance business. To judge how well working capital is managed, attention is also paid to the balance between net debt and operating cash flow. When assessing the debt redemption period in manufacturing and sales operations, R&I looks at the model changeover cycle as a reference. 7/9

8 (4) Financial profile Equity ratio, net D/E ratio (ratio of net debt to equity capital) Construction machinery is a business in which swings in earnings tend to be large owing to their susceptibility to the influence of the external environment. In addition to the amount of equity capital as a financial buffer, R&I therefore focuses on the equity ratio and net D/E ratio. Because the scale of assets will vary depending on the development of the sales finance business, R&I looks at each indicator excluding this business. (5) Liquidity risk The capacity to maintain stable capital is an important checkpoint. When companies manage their sales finance business by themselves, the capacity to raise funds takes on greater importance. R&I confirms a company's relationships with banks and other financial institutions, and evaluates what efforts a company has made to diversify its channels for raising funds. III. Rating for Construction Machinery Industry Issuer Rating Individual Firm Risk Financial Risk Importance Base Indicator Importance Geographical diversification Earning capacity C EBITDA margin Product lineup E EBITDA/average total assets Product competitiveness C Operating margin Ability to control inv entory and production Scale and investment C EBITDA Businesses other than new machinery sales capacity C Equity capital Debt redemption period E Net debt to EBITDA ratio E Net debt to operating cash f low ratio Financial profile E Equity ratio E Net D/E ratio C: Consolidated E: Excluding sales f inance business Industry Risk: Medium Note) Importance is indicated by : extremely important, : important, or relatively important. 8/9

9 * This report replaces all previous versions that have been released to date. The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited without R&I's prior written permission. Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese the information written in Japanese will take precedence. 9/9