Doosan Infracore (042670)

Transcription

1 Company Report / Machinery September 2, M rating BUY (Reinstate) 12M TP W16, Up/downside +33% Stock Data KOSPI (Sep 1, pt) 2,68 Stock price (Sep 1, KRW) 12, Market cap (USD mn) 2,427 Shares outstanding (mn) Week high/low (KRW) 16,9/11,4 6M avg. daily turnover (USD mn) 15.2 Free float / Foreign ownership (%) 63.5/22.6 Major shareholders (%) DooSan Heavy Industry & Construction Co.,Ltd and 8 others 36.5 NPS Fund 5.1 EPS revision (KIS estimates, KRW) Previous Revised (%) 214F F F - 1,36 - Performance 1M 6M 12M Absolute (%) (9.4) (1.8) (11.4) Relative to KOSPI (%p) (9.2) (15.2) (18.8) 12MF PB trend (X). Oct-9 Oct-1 Oct-11 Oct-12 Oct-13 Source: WISEfn consensus 12MF PER (L) price (R) Chulhee Cho chulhee.cho@truefriend.com (KRW) 35, 3, 25, 2, 15, 1, 5, Power of a balanced portfolio Take new angle and focus on OP growth after four-year fall We reinstate coverage of Doosan Infracore (DI) with BUY and a TP of W16, (target 1.x 12MF PB). OP that had been shrinking since 211 should end a fouryear slide and grow 25% YoY in 214F and 22%YoY in 215F. This would be better than the Kospi 2 constituents OP growth of 6.1% and 16.8% over the same period. DI s OP should rise as 1) profits at Doosan Infracore Bobcat Holdings (DIBH, an intermediary holding company that owns US-based Bobcat, Doosan Infracore International or DII, and Europe-based Bobcat, Doosan Holdings Europe Limited or DHEL) continue to improve and 2) profits in emerging markets such as China have stopped shrinking. As such, we are closely monitoring the OP rise stemming from a well-balanced portfolio rather than the disappointment surrounding the China excavator business (only 13% sales weighting in 1H14) that has already lost much of its ability to contribute to earnings. Started making money to pay down debt; DIBH s IPO is the last piece of the puzzle for financial restructuring DI will likely use cash from operations to cut net debt from 214. Thanks to better earnings, 214F EBITDA should reach W748bn and exceed annual cash outflow of W616bn (facility investment W28bn, interest expenses W273bn, corporate taxes ~W5bn, hybrid bond dividends W18bn). Also, DIBH s IPO should be completed by 216. According to a scenario analysis, a successful IPO would help cut the net debt from ~W4.8tn at present to as low as ~W3tn at end-216, thereby considerably improving financials that have been the biggest hurdle for a share price rebound. Robust divisions to stay healthy, weak to get better DIBH and the machine tools division are still enjoying healthy industry conditions. As of 1H14, DIBH accounted for 47% and 53% of DI s overall sales and OP, respectively, settling in as the biggest sales contributor for the company. With the US Environmental Protection Agency (EPA) introducing Tier 4 Final standards (regulations on exhaust emissions from non-road diesel engines), products that meet the requirement should enjoy a higher ASP in future and firmly support the company. We also anticipate better earnings for the machine tools (33% of DI s OP) and engines unit on greater sales of new products (G2) and for the China excavator after restructuring efforts in A 213A 214F 215F 216F Sales (W bn) 8,158 7,737 7,772 8,34 8,653 OP (W bn) EBT (W bn) (22) (57) NP (W bn) 34 (12) EBITDA (W bn) Net debt (W bn) 5,376 4,836 4,757 4,583 4,392 OP margin (%) ROE (%) 15.8 (3.7) Dividend yield (%) EPS (KRW) 2,18 (596) ,42 chg. (% YoY) 14.1 NM NM BPS (KRW) 14,569 14,398 15,8 15,812 16,769 DPS (KRW) PE (x) 8.4 NM PB (x) EV/EBITDA (x) Analysts who prepared this report are registered as research analysts in Korea but not in anyother jurisdiction, including the U.S. PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES & DISCLAIMERS AT THE END OF THIS REPORT.

2 Sector report focus What is the report about? Analyze industry conditions of each business and estimate future earnings Examine improvements to the financial structure via issuance of hybrid bonds and global depository receipts (GDR) and the massive refinancing of debt (W1.72bn) related to DIBH; Provide reasons why financial-related risks should fade Present a growth story where all divisions become profitable backed by stable cash cows in the mid to long-term instead of focusing on near-term issues such as quarterly earnings and monthly unit sales Key assumptions and valuation Profit estimates: DIBH s US business to see product ASP rise 5% YoY; China excavator market s overall sales to fall 1% YoY to ~94, units; DI s market share to rise.7%p YoY to 8.5% Valuation: Applied 1x PB; Two risks that prevented share price rebound to ease; 214 OP to grow for the first time in four years and free cash flow (FCF) to be used to reduce net debt; Applying a valuation multiple based on the book value is justified given DIBH s IPO is an effective option to improve financials China excavator market: 214 sales to decrease 1% YpY (units) (%) 24, China market sales (L) YoY chg. (R) 1 21, 18, 15, 12, 9, 6, 3, F Source:Korea Investment & Securities Sensitivity & scenario analysis Based on net foreign currency debt (USD-denominated) of USD8mn as of end-2q14, every W1 drop in the year-average KRW/USD would translate into FX-translated gains of W8bn Risks/opportunities If China s excavator market remains sluggish in 2H14 and DI s annual sales fall below 7,5 units, the China business could have trouble improving earnings (2) (4) (6) Sector highlights 1) (Past-present) Shares sensitive to China excavator sales In the past, DI shares reacted sensitively to excavator sales in China; Accordingly, shares spiked when the Chinese market was booming through 211 But since sales in China s excavator market started shrinking, shares have weakened as well China excavator sales chg. vs. DI shares/market cap (5) (%) Excavator sales YoY chg. (L) (W bn) Market cap (R) (1) Jan-9 Jan-1 Jan-11 Jan-12 Jan-13 Jan-14 Source:Korea Investment & Securities 2) (Present-future) Sharp drop in China excavator weighting; Focus on better fundamentals With DI s excavator business in China becoming less important, DIBH, the machine tools division and the engines unit have seen steady earnings improvement; We believe DI should no longer be viewed as a stock with extreme volatility depending on monthly excavator sales in China and thus, we suggest focusing on the company s better fundamentals as the share price rise would be driven by gradually improving earnings In 1H14 (peak-demand season), the China excavator business accounted for 13% of sales, down sharply from 3% in 211 While machine tools and engines emerge as cash cows, DIBH has become the biggest earnings contributor, accounting for 46.3% and 76.8% of DI s overall sales and OP, respectively, in 213 backed by brisk earnings Peer comparison 5,5 5, 4,5 4, 3,5 3, 2,5 2, 1,5 Due to a low ROE, DI trades at a discount to peers averaging 1.6x PB See global peer comparison on pg.3

3 Contents I. Valuation & investment points Investment points 2. Valuation II. Balanced portfolio, first OP growth in four years OP and shares move in the same direction 2. Sales portfolio is well-balanced by region and business 3. DIBH and engines unit s OP growth to lead earnings improvement III. Started making money to pay down debt; Hope for DIBH s IPO in Net debt to gradually narrow from 214 thanks to better earnings 2. Last puzzle piece for DI s financial restructuring: DIBH s IPO in Step-by-step IPO preparation 4. Scenario analysis: How much debt will reduce with DIBH s IPO in 216? IV. Outlook by division DIBH reborn as a main growth engine 2. Non-DIBH construction machinery; Power of restructuring 3. Machine tool business to remain healthy 4. Engines: Time to reap harvest V. Earnings outlook Growth achievable even without Chinese market recovery 2. Better operations to lead to positive cash flow Appendix. Doosan Group ownership structure Glossary... 25

4 I. Valuation & investment points 1. Investment points Sluggish China business offset by other divisions; First OP growth in four years 1) Well-balanced sales portfolio; Focus on the direction of overall OP DI s OP that had been shrinking since 211 should end a four-year slide and grow 25% YoY in 214F and 22% YoY in 215F as profits are rising in advanced markets and have stopped shrinking in emerging markets such as China. Thanks to the company s well-balanced regional sales portfolio, the sluggish performance of one market is being offset by the healthy performance in another region. Thus, we are closely monitoring the direction of OP that should deliver full-fledged growth from 214. As profits grow, shares would naturally pick up as well. Figure 1. OP to grow in earnest from 214 after a trough in 213 (W bn) 8 OP (2) (4) (6) F 215F 216F Source: Korea Investment & Securities Net debt to shrink from 214; DIBH s IPO is an effective option to improve financials Businesses that did well to stay healthy and those that struggled to get better from 214 2) Started making money to pay down debt; Hope for DIBH s IPO in 216 Backed by better earnings, the 214F EBITDA should reach W748bn and exceed the annual cash outflow of W616bn (facility investment W28bn, interest expenses W27bn, corporate taxes ~W45bn, hybrid bond dividends W18bn, etc.). DI will likely use the FCF to reduce debt. But to slash the debt on a structural basis, DI must recoup investment via DIBH s IPO that is expected to be completed by 216. If the IPO is successful, it would help cut the net debt from ~W4.8tn at present to as low as ~W3tn at end-216. Moreover, net annual interest expenses that reached ~W28bn in 213 could shrink to ~W15bn from 216 and onward. 3) Business overview: Robust divisions to stay healthy, weak to get better DIBH (Bobcat) and the machine tools division are still enjoying healthy industry conditions. DIBH has settled in as the biggest sales achiever and should continue to deliver steady earnings. With the US EPA introducing Tier 4 Final standards, products should enjoy a higher ASP in future and firmly support the company. The cash cow machine tools division s OPM should remain solid at the 1% level. We also anticipate better earnings for the engines unit on greater sales of new products (G2) and for the China excavator business after restructuring efforts in

5 2. Valuation Focus on 1) OP growth and 2) better financials via DIBH s IPO Figure 2. PB band Our TP W16, equals 1.x PB Our TP of W16, equals a target 1.x 12MF PB. The stock currently trades at.7x 12MF PB that is less than the book value. However, concerns about sluggish earnings and financials (caused by excessive debt) that prevented shares from rebounding in the past have started to fade. The company s OP should grow for the first time in four years by 25% YoY in 214F and 22% YoY in 215F. This would be better than the Kospi 2 constituent s OP growth of 6.1% and 16.8% over the same period. Moreover, controlling interest NP stripping out the one-off gain from 212 (deferred tax assets of W4bn) should turn upward for the first time since 211. Better earnings would also help reduce net debt from 214. Of note, DI has an ace in the hole in the form of DIBH s IPO to improve financials. According to a scenario analysis, a successful IPO would immediately cut the net debt by more than W1tn. Thus, we believe a 1.x PB for the TP calculation is not overblown. Figure 3. PE band 4, (KRW) (KRW) 4, 35, 2.3x 35, 3, 1.9x 3, 25, 1.5x 25, 3x 2, 15, 1.1x 2, 15, 26x 22x 18x 1,.7x 1, 14x 5, 5, Jan-6 Jan-8 Jan-1 Jan-12 Jan-14 Jan-6 Jan-8 Jan-1 Jan-12 Jan-14 Source: Bloomberg, Korea Investment & Securities Source:Korea Investment & Securities Table 1. Global peer comparison (local currency, %, x) Company Sales OPM PE PB EV/EBITDA ROE F 215F 13 14F 15F 13 14F 15F 13 14F 15F 13 14F 15F 13 14F 15F Sany Heavy 37,95 34,527 35, Caterpillar Inc. 55,656 55,269 58, Volvo Ab-B Shs 272, , , Komatsu Ltd. 1,953,657 1,894,42 1,959, Hitachi 82, , , Construction machinery maker avg Mori Seiki 16, ,6 178, Fanuc Corp. 45, ,67 565, Toshiba Machine 113,62 125,1 131, THK Co. 185,466 29, , NSK Ltd. 871, , , Machine tool maker avg. Source: August 22 closing prices Source: Bloomberg, Korea Investment & Securities 3

6 II. Balanced portfolio, first OP growth in four years 1. OP and shares move in the same direction OP growth means shares will rise as well; Suggest taking advantage of profit growth DI s OP that had been shrinking since 211 should start growing from 214. Historically, DI shares have moved in the same direction as OP. As DI faced many non-operating issues that were unpredictable, the stock s direction was determined by the extent of the value created by the company s own business activities. But it is a different story in 214 as shares remain deflated even though OP has been on the rise. This is due to 1) disappointment surrounding the delayed Chinese market recovery and 2) shareholders becoming more concerned about group affiliates considering whether to raise funds. However, we believe it is more reasonable to focus on DI s overall OP resuming growth from 214 rather than hope for a market recovery in a specific region. When the ongoing funding issue related to group affiliates dissipates, shares should pick up again. Figure 4. As OP rises from 214 after a low in 213, shares to pick up as well 1, (2) (4) (6) (8) (W bn) (W bn) Others (excl. non-dibh construction machinery) OP (L) Market cap (R) F 215F 216F Non-DIBH construction machinery Others Combined Market cap DI OP (R) Non-DII construction machinery OP (L) 5, 4,5 4, 3,5 3, 2,5 2, 1,5 1, 5 Source: Korea Investment & Securities 2. Sales portfolio is well-balanced by region and business Well-balanced portfolio with non-dibh construction machinery segment s woes being offset by other businesses Looking at the sales breakdown below, we can see DI s sales portfolio is wellbalanced by region and business. In 211 when China s construction machinery market was booming, businesses in emerging markets such as China accounted for 46% of overall sales while DIBH that focuses on North America and Europe accounted for 34%. But afterward as China s construction machinery market continued to slump, the sales weighting shrank for China and increased for DIBH and thus, advanced markets now represent a bigger sales portion than emerging markets. Accordingly, DI s business portfolio took a more balanced form in line with global economic trends, creating a structure in which the sluggish performance of one market is being offset by the robust performance of another. For example, while the non-dibh construction machinery segment (businesses in China, Korea, emerging countries) was performing poorly, other divisions enjoyed a sharp rise in OP. In particular, DIBH s OP spiked from 211 after making losses through 21 in the aftermath of the global financial crisis, and this very much helped slow the pace of DI s overall earnings erosion. 4

7 Figure 5. DI s annual excavator sales: Flat since 212 Figure 6. Sales weighting by major business/region: China construction machinery weighting narrowed 25, (units) DI excavator sales in China 1 (%) C/M DIBH Machine tools Engine C/M APEM C/M China 2, , , 4 3 5, F 215F 1H11 1H13 1H14 Source: Korea Investment & Securities 3. DIBH and engines unit s OP growth to lead earnings improvement Profit growth by DIBH and engines unit to drive up shares DI s overall OP should move in a different direction from 214. The non-dibh construction machinery segment s OP should no longer spill red ink and reach the break-even point in 214. In a conservative assumption that the non-dibh construction machinery division will continue to break even, the direction of DI s overall earnings and shares will hinge on how other divisions perform. We believe shares will receive a considerable boost from emerging growth drivers such as 1) DIBH whose product ASP should go up on the US EPA introducing Tier 4 Final standards, 2) the machine tools business with a steady order inflow and 3) the engines unit making a sharp turnaround. Figure 7. Non-DIBH construction machinery OP downturn weighed on shares Figure 8. Other divisions have enjoyed better earnings since (W bn) (W bn) 5, Non-DIBH construction machinery OP (L) Market cap (R) 4,5 4, (W bn) (W bn) 8 Others (excl. Non-DIBH construction machinery) OP (L) 5, Market cap (R) 6 4,5 4 4, F 215F 3, F 215F 3,5 (2) 3, (2) 3, (4) (4) (6) 2,5 (6) 2,5 (8) 2, (8) 2, Source: Korea Investment & Securities Source: Korea Investment & Securities 5

8 III. Started making money to pay down debt; Hope for DIBH s IPO in Net debt to gradually narrow from 214 thanks to better earnings FCF should be used to reduce debt As of end-213, DI s consolidated net debt stood at ~W4.8tn, of which ~W1.7tn belongs to DIBH and ~W3.1tn to other divisions including the parent company. We believe DI s FCF will continue to grow over the next three years backed by better earnings from operations. On a consolidated basis, the FCF is mostly generated by DIBH. Assuming most of this FCF is used to pay down debt, DIBH s net debt should narrow to as little as ~W1tn through 216 and DI s consolidated net debt to ~W4.4tn. That is, pure business operations would help reduce the debt by W4bn over the next three years. This W4bn decrease could translate into a ~W2bn drop in annual interest expenses. Table 2. DI FCF outlook (W bn) Item F 215F 216F Net debt DI (consolidated) 4,836 4,757 4,586 4,395 DIBH (Bobcat) 1,7 1,473 1, Non-DIBH 3,136 3,284 3,349 3,451 OP 1 DI (consolidated) DIBH (Bobcat) Non-DIBH Depreciation 2 DI (consolidated) DIBH (Bobcat) Non-DIBH EBITDA 3 = 1+2 DI (consolidated) DIBH (Bobcat) Non-DIBH Net interest costs 4 DI (consolidated) (incl. hybrid DIBH (Bobcat) bond dividends) Non-DIBH Capex 5 DI (consolidated) DIBH (Bobcat) Non-DIBH Corporate tax 6 DI (consolidated) DIBH (Bobcat) Non-DIBH FCF 7 = DI (consolidated) DIBH (Bobcat) Non-DIBH (148) (14) (28) 12 Note: 1. Interest expenses reflect hybrid bond dividends of W18bn p.a. but not net chg. in working capital 2. As DIBH s corporate tax recognizes deferred tax assets of W4bn, there is no actual cash outflow Source: Korea Investment & Securities Figure 9. DI FCF and net debt (W bn) (W bn) 5, Net debt (L) FCF (R) 4 4,8 32 4,6 24 4,4 16 4,2 8 4, F 215F 216F Source: Korea Investment & Securities 6

9 2. Last puzzle piece for DI s financial restructuring: DIBH s IPO in 216 DI needs DIBH s stock market debut for a massive reduction of net debt; IPO likely in 216 DIBH s earnings to get on a normal trajectory Preemptive financing is required in 216 before a large debt payment schedule arrives in 217 Although DI has turned into a company that can generate a positive cash flow via operations, it would face limitations to reduce massive debt in a short time only from operations. As such, the company plans an IPO for DIBH to trim its net debt. A detailed timeline and methods have not been decided but we expect the IPO will be pushed ahead with a goal of being completed in 216 for the following reasons. First, DIBH s profit growth will peak in 216 and slow after the year. While its KRWdenominated sales remain flat YoY in 214, sales in USD are growing due to the falling KRW/USD. Sales and OP growth should be remarkable in 215 and 216 backed by a higher ASP as all non-road diesel engines are subject to the Tier 4 Final standards from 215 and the European market will likely recover. But the momentum for overall market growth seems limited as DIBH s core products compact track loaders (CTL) and skid-steer loaders (SSL) are mainly used in advanced markets with limited growth potential. Following the full adoption of the Tier 4 regulation, it would be hard to expect fast growth momentum. Meanwhile, in 216, DIBH is likely to exceed DII s EBITDA peak of W43bn touched in 25 and 27. With earnings getting on a normal trajectory, 216 would be a perfect timing to go public. Second, the payment schedule for large debt would come in 217. DI has made steady efforts to improve its financial structure by issuing hybrid bonds (hybrid bonds) worth W5bn and GDR worth W42bn in 212. In particular, DI preemptively refinanced DIBH-related debt worth USD1.72bn in May 214. With the refinancing, it would not face any large debt payment obligation through 216. But the debt pay-down issue may surface in 217 again given the scheduled payment of W65bn in corporate bonds and W5bn in hybrid bonds that year. Although hybrid bonds have a long 3-year maturity, DI is expected to exercise its call option for the bonds (early redemption before maturity) as the rate is set to be lifted by 5%p (currently 3.25%) in 217, the fifth year from the bond issue. For a company that would face a payment obligation for more than W1tn, an IPO-backed financing could be a major option. Figure 1. DI hybrid bond issue structure Figure 11. Maturity for DI corporate bonds and hybrid bonds (separate basis) DI hybrid bond issue structure 1,4 (W bn) Corporate bonds Hybrid bonds ㆍ Grant call option to DI after five years ㆍ If call option is not exercised, include a clause with a step-up of 5bp ㆍ SPC is not connected to DI s account book Issue hybrid bonds DI Investor SPC Make payment Sell put option Sign agreement for credit issuance 4% 4% 2% Credit issuing bank Bank 1 Bank 2 Bank 3 1,2 1, Trustee DI bond management SPC Admin Provide main services on behalf of SPC Pay commitme nt fees SPC Admin Source: News reports, Korea Investment & Securities Source: Bondweb, Korea Investment & Securities 7

10 3. Step-by-step IPO preparation Preparation of IPO underway; Single entity for an IPO and financing Figure 12. DIBH earnings With the recent refinancing, DIBH has adjusted the payment schedule to after 221 from the initial timeline of Accordingly, DI has more leeway to proceed with DIBH s IPO. That is, DI has a choice to proceed with the IPO plan according to market conditions without facing a financing burden to pay down debt over the short-term. The establishment of DIBH that owns 88.4% of DII and 78.3% of DHEL is intended to efficiently conduct administrative work for the IPO over the mid/long-term by making a single entity that will go public and play a financing role. Figure 13. DIBH ownership structure 4,2 (W bn) DIBH sales (L) (%) 12. DIBH OPM (R) 3,5 9. DI DI 2,8 6. 1% 2,1 3. DIBH 1, % 78.27% 88.41% 78.27% 7 (3.) DII (US-based Bobcat) DHEL (Europe-based Bobcat) DII (US-based Bobcat) DHEL (Europe-based Bobcat) F 215F 216F (6.) 4. Scenario analysis: How much debt will reduce with DIBH s IPO in 216? Key assumptions: 1) DI would own 5% of listed DIBH, 2) Doosan Engine would sell 16% stake, 3) 1x EV/EBITDA for DIBH The most critical variables to determine the extent of possible net debt reduction via the IPO would be the size of new shares issue and the DIBH stake that DI would put up for sale. We expect DI to maintain more than 5% ownership in the listed DIBH for managerial rights. With this assumption, we estimate a likely reduction of net debt depending on the weighting of new shares issue/existing shares sale. We derive an estimated market cap of the listed DIBH by using EV/EBITDA and apply the three-year trailing EV/EBITDA of US Nasdaq industrials as a fair multiple. Backed by its superior product competitiveness, DIBH leads the CTL and SSL segments in the US construction equipment market ahead of Caterpillar. As such, we believe 1x EV/EBITDA can be justified. 8

11 Table 3. Scenario analysis for post-ipo debt changes (DI 5% shares) (W bn, x) Item Note F 215F 216F EBITDA EV/EBITDA multiple EV 3 = 1 x 2 3,86 3,864 4,273 4,551 Net debt 4 1,7 1,473 1, Market cap 5 = 3-4 2,16 2,39 3,36 3,66 Net debt (no IPO) DI (consolidated) 4,836 4,757 4,586 4,395 DIBH 1,7 1,473 1, Non-DIBH 3,136 3,284 3,349 3,451 Case 1) Net debt DI (consolidated) 4,836 4,757 4,586 3,151 New shares % DIBH 1,7 1,473 1, Non-DIBH 3,136 3,284 3,349 2,26 Case 2) Net debt DI (consolidated) 4,836 4,757 4,586 3,95 New shares 1% DIBH 1,7 1,473 1, Non-DIBH 3,136 3,284 3,349 2,511 Case 3) Net debt DI (consolidated) 4,836 4,757 4,586 3,4 New shares 2% DIBH 1,7 1,473 1, Non-DIBH 3,136 3,284 3,349 2,816 Case 4) Net debt DI (consolidated) 4,836 4,757 4,586 2,984 New shares 3% DIBH 1,7 1,473 1,236 (137) Non-DIBH 3,136 3,284 3,349 3,121 Note: 1. Applied 1x EV/EBITDA is the three-year avg. of Nasdaq industrials; 2. Assuming DI will hold a 84.5% stake in DII and DHEP via DIBH Source: Korea Investment & Securities Successful IPO would help cut DI s net debt from W4.8tn at present to as low as W3tn at end-216 We expect DI to proceed with the IPO by maximizing the sale weighting of existing shares. Backed by healthy earnings, DIBH has ample room to reduce debt via its own operations. Thus, DIBH would make efforts to ease DI s debt-servicing burden by prioritizing the parent company s debt payment. As such, the IPO will likely follow case 1 or 2. If the IPO goes ahead as expected, annual net interest expenses of ~W29bn (incl. W18bn in hybrid bond dividends) in 214 would considerably fall to ~W17bn from

12 IV. Outlook by division 1. DIBH reborn as a main growth engine DIBH a flagship for DI; US business continues to roll and Europe strives to get better Figure 14. DIBH earnings DIBH is a flagship business for DI with 46.3% revenue and 76.7% OP contributions as of 213. Major products break down to compact equipment (SSL, CTL, mini excavators or MEX, etc.) and heavy products (midsize/large excavators). Production plants are located in the US (Gwinner, North Dakota, with annual capacity of 43, units) and Europe (Dobris, Czech Rep., 16,). The US market has entered a mature phase and it is hard to expect a sharp rise for sales volume. But with the Tier 4 standards in place, a higher ASP should materialize in 214 and 215. The sales volume of heavy products is growing fast with a widening sales area coverage in the US and Europe. Figure 15. CTL and SSL manufactured by DIBH 4,2 (W bn) DIBH sales (L) (%) 12. DIBH OPM (R) 3,5 9. 2,8 6. 2,1 3. 1,4. 7 (3.) F 215F 216F (6.) Note: Regional adjustment reflected from 212 with Middle East sales excluded and Russia sales added 1

13 Full compliance with Tier 4 Final starting in 215 to push up DIBH s ASP in earnest 1) Tier 4 regulation to boost DIBH s top and bottom line Since October 213, the Tier 4 Final regulation 1 has been applied to non-road diesel engines installed in CTLs and SSLs with less than 74h.p. (DIBH s core products). After a one-year grace period, the installation of compliant engines would become mandatory for all DIBH products from end-214. With better engine performance, the ASP for CTLs and SSLs should go up 1-2% compared to existing products by 215. During the grace period, the company is mounting environment-friendly engines only on some models for fear of reduced sales stemming from price resistance. The company has not yet fully passed the higher cost on to the ASP. But with the full execution of the emissions mandate for all products from 215, the company is planning to raise its ASP in earnest, which will boost its sales and profitability. Table 4. Tier 4 regulation schedule: Some products under the mandate since 213 and one-year grace period is granted before compliance for all products KW HP >56 >751 Phases Tier 2 Tier 3 Tier 4 Interim Tier 4 Final Source: EPA, DI, Korea Investment & Securities Table 5. DIBH product lineup Type Model no. H.P. Applied regulation S Tier 4 S13 49 Tier 4Interim S51 49 Tier 4 S53 49 Tier 4 S55 61 Tier 4 SSL S57 61 Tier 4 S59 66 Tier 4 S63 74 Tier 4 S65 74 Tier 4 S75 85 Tier 4 Interim S77 92 Tier 4 Interim S85 92 Tier 4 Interim T55 66 Tier 4 T59 66 Tier 4 CTL T63 74 Tier 4 T65 74 Tier 4 T75 85 Tier 4 Interim Source: DIBH, Korea Investment & Securities 1 Tier 4 regulation: The rule to reduce particulate matter (PM) and NOx emissions from off-road diesel engines set by the US Environmental Protection Agency (EPA); In particular, the Tier 4 Final, called new-source performance standards (NSPS) and set to be applied to all equipment from 215, is the most stringent emissions mandate 11

14 Sharp rise of heavy product sales to lead DIBH s sales growth irrespective of market conditions 2) Fast-growing heavy product sales; Buyout synergies fully unleashed The most expected synergy for DI s takeover of DIBH in 27 was the expansion of heavy product sales in Europe. DI intended to expand its construction equipment portfolio in advanced markets by adding heavy equipment (its core products) to DIBH s compact lineup. DIBH s main CTLs and SSLs have already penetrated advanced regions by commanding 3.7% and 43.1% of the North American market (six-month moving avg.) at end-1q14. As such, DIBH s mid/longterm sales growth would hinge on the penetration by its heavy products. The efforts are bearing fruit beginning in 214. The sales trend of heavy products in 2Q14 shows that DIBH achieved 37% YoY sales volume growth in North America while the market itself grew only 4-5% YoY. In Europe, DIBH also delivered 3% YoY sales volume growth, well above the market s 1% YoY growth. Given its ongoing efforts to reinforce the dealership network and establish a marketing strategy, DIBH s heavy product sales rise should continue to outpace the overall market s growth. Figure 16. Compact product sales volume in EMEA: Up 13% YoY Figure 17. Heavy product sales volume in EMEA: Up 24% YoY 3,5 (unit) Compact (unit) 1, Heavy 3, 9 8 2,5 7 2, 6 5 1,5 4 1, Q13 2Q14 2Q13 2Q14 Note: EMEA refers to Europe, Middle East and Africa Note: EMEA refers to Europe, Middle East and Africa 3) US: Favorable market continues but still uncertain housing indicators DIBH s US sales have been cruising since 213. The sales volume has steadily ballooned for both the compact and heavy lines, and led the solid overall earnings in 1H14. Market conditions are friendly given biggest rival Caterpillar also achieved steady YoY sales volume growth in North America in 1H14. DIBH products are targeted at developed countries and their customers are wide-ranging. Thus, the company s outlook cannot be determined solely by housing market indicators. Still, the fact that homebuilder sentiment measured by the Housing Needs Index (HNI) recently resumed an upswing is a plus for the firm. 4) Europe: YoY sales volume up in a sluggish market Despite slow market conditions in Europe, sales at DIBH are swelling YoY. Although DIBH s capacity in Europe is a mere one-third of the US plant, higher utilization in the region is definitely a plus. The rise in sales is centered on excavators in the heavy line rather than the compact range including CTL, SSL and MEX. Heavy products are exported in complete knock-down form by the US head office to Belgium, which handles the final assembly and sales in Europe. 12

15 Figure 18. US HNI Figure 19. US new home sales and building permits (index) HNI 2,5 2, (') New housing construction starts New housing construction permits 5 1, , Jan-5 Jan-7 Jan-9 Jan-11 Jan-13 Source: Bloomberg, Korea Investment & Securities Jan-5 Jan-7 Jan-9 Jan-11 Jan-13 Source: US Department of Commerce Bureau of Economic Analysis, Korea Investment & Securities Figure 2. DI construction machinery sales: US Figure 21. DI construction machinery sales: EMEA 7 6 (W bn) Construction machinery sales in North America (L) (%) 5 YoY chg. (R) (W bn) (%) Construction machinery sales in EMEA (L) 2 YoY chg. (R) (5) 2 1 (1) 1 (1) 5 (15) 1Q11 3Q11 1Q12 3Q12 1Q13 3Q13 1Q14 (2) 1Q12 3Q12 1Q13 3Q13 1Q14 (2) Note: EMEA stands for Europe, Middle East and Africa Figure 22. Caterpillar machinery sales volume in NA turned upward Figure 23. DI sales volume by product: Shifted to profitable machinery (%) 7 Monthly N. American machinery sales YoY chg (1) (2) (3) Jan-11 Jan-12 Jan-13 Jan-14 (%) SSL CTL MEX 1H12 1H13 1H14 13

16 2. Non-DIBH construction machinery; Power of restructuring 214 China market sales down 1% YoY Growth more likely toward year-end given policy expectations in 2H14 1) No growth hopes for China s excavator market in 214 In 214, a recovery is still unlikely for China s excavator market. As of YTD end- July, excavator sales volume in the country stood at 62,324, down 11.5% YoY. Since 1H is a typical high season, it has become difficult to hope for an increase in the annual sales volume with a YoY drop in the 1H14 figure. In 214, China s excavator sales volume should fall 1% YoY to 94,333. Although sluggish sales volume should continue into 3Q14, monthly sales would turn upward YoY toward the year-end. The seasonal aspect of China s excavator market, characterized as brisk 1H and slow 2H, has gradually faded since the peak in 211. In China s excavator market, the sales volume typically swelled after the Lunar New Year holiday through 1H and then sharply dwindled in 2H. But recently, as Beijing implemented policies to make up for the slow 1H, related effects appeared in 2H and gradually diluted the market s seasonal features. Also this year, Beijing unveiled a mini stimulus package in April. Since the measures include boosters for construction machinery demand, such as building rail lines and new homes, the sales volume should expand at the related firms. Another plus is an array of additional policy support (e.g., lower reserve requirement ratio) provided by the People s Bank of China. Figure 24. China excavator sales: 214 sales volume likely to drop YoY 24, 21, 18, 15, 12, 9, 6, 3, (units) (%) China market sales (L) YoY chg. (R) (2) (4) F (6) Source: Chinese Construction Machinery Association, Korea Investment & Securities Figure 25. China monthly cumulative excavator sales volume Figure 26. China construction starts area: Slow in 1H14 but recovery ongoing (' units) F (% YoY) YoY chg. in floor area for new building permits in China (2) (4) 1Q5 1Q6 1Q7 1Q8 1Q9 1Q1 1Q11 1Q12 1Q13 1Q14 Source: Chinese Construction Machinery Association, Korea Investment & Securities Source: Chinese Construction Machinery Association, Korea Investment & Securities 14

17 Figure 27. M2 growth: Rebounding since April Figure 28. China excavator sales volume: % in 1H vs. 2H 28 (% YoY) China M2 YoY growth 1% 1H 2H 26 9% 24 8% 22 7% Jan-1 Jan-11 Jan-12 Jan-13 Jan-14 6% 5% 4% 3% 2% 1% % F Source: Chinese Construction Machinery Association, Korea Investment & Securities Source: Chinese Construction Machinery Association, Korea Investment & Securities Table 6. Chinese government mini stimulus Major plans Accelerate the rail project Improve housing conditions for low-income families Offer tax breaks to small and midsize firms Description - Build YoY 18% more rail lines in the Midwest - Issue bonds worth CNY15bn - Secure CNY2bn-3bn from the private sector - Issue bonds dedicated to housing finance to improve housing conditions of 4.7mn shantytown households in Extend the 5% income tax cut until end Announced the possibility of a lift in the taxation limit Source: Media reports, Korea Investment & Securities Four mid-term growth engines China urbanizing at a breakneck pace To build 36mn social housing units in Stepped up water treatment project a new growth driver for the excavator market 2) Solid mid/long-term demand pool; Limited fall in sales volume likely Although a sharp YoY expansion is unlikely for the 214 sales volume, the excavator market has solid mid-term growth engines given Beijing s policy blueprint. The following four variables should act as the growth engines. Urbanization: As of 211, China s urbanization reached ~5.6%, up ~24%p over the past two decades. Since the level is still less than other developing and developed countries, urbanization should continue under Beijing s target of balanced development to address the gap between the rich and poor. The project should place stable orders in the construction industry and feed the excavator market for the long-term. Social housing: The Chinese government announced a plan to build 36mn social housing units for low-income households in its 12 th five-year plan ( ). Social housing is among the large projects that lead China s excavator demand. Indeed, the excavator market was bullish when such housing starts peaked in 211. Social housing starts totaled 2.49mn through 213 and the project will continue in 214 and 215 as well. In particular, the People s Bank of China s liquidity supply policy adds support for social housing development. The policy is in fact Beijing s ultimate scheme to revive the real estate market. Environmental projects: Among projects introduced in the 12 th five-year plan, some measures will stimulate excavator demand and environmental infrastructure projects are among them. A massive investment (CNY2tn or ~KRW328tn) should go to a water quality improvement project which includes excavation work and road building, etc. Thus, the project is an important mid-term growth driver for the construction machinery market, especially the excavator segment. 15

18 Creates base demand: Annual 6,-7, excavators to be replaced Replacement cycle arrives: Since 2, more than 1mn excavators have been sold and the replacement cycle has arrived. Considering excavators have an average lifespan of 1-15 years, annual replacement demand for 6,-7, excavators should arise if the current level of demand continues. Figure 29. China urbanization rate Figure 3. Urbanization rate in major countries 1 (%) China urbanization rate 1 (%) Urbanization rate More developed avg. (77.7) World avg. (52.1) Less developed avg. (46.5) F 24F World India China Japan UK Canada US Korea France Source: UN (211), Korea Investment & Securities Source: UN (211), Korea Investment & Securities Figure 31. China social housing project plan (mn units) 12 Construction starts (target) Construction starts (actual) Completed 1 Figure 32. China fixed asset investments (CNY tn) (%) 49 China fixed asset investments (L) 35 YoY chg. (R) F 215F Source: China Ministry of Housing & Urban-Rural Development, Korea Investment & Securities Note: YTD June for 214 data and YoY growth for 214 is compared with YTD June 213 Source: CEIC, Korea Investment & Securities 16

19 Market share growing with new models released Fundamentals strengthened by restructuring in 213 3) DI earnings improved despite the slow market Although the overall YTD July sales volume slid 11.5% YoY, DI outperformed the market with its figure down 7.3% YoY. The company bolstered the large product range by releasing new models for the 42-tonne and 5-tonne lines in 213. In 1Q14, the firm further sharpened its competitive edge by rolling out new small (7.5- tonne and 12-tonne) products. The company grew market share by restructuring its sales agents offering full support for blue-chip agents and closing or slimming down poor performers. Although the company posts 213-level excavator sales in China, the performance by the non-dibh construction machinery division should improve. That is because DI s fundamentals have been strengthened thanks to the large-scale restructuring in China in 213. DI reduced capacity by temporarily halting operation of the small excavator plant in Suzhou and using it as a logistics warehouse. The firm also implemented sizable human resources restructuring. Thanks to reduced fixed costs, the firm lowered the OP break-even point to 7,5-8, units p.a. Thus, assuming the market sales volume remains similar to 213 and DI maintains current market share through 2H14, then the non-dibh construction machinery division could avoid an operating loss in 214. Table 7. Major company 1H14 excavator sales volume in China Ranking Company YTD 214 sales volume Market share (%) 213 sales volume Market share (%) 1 Sany 7, , Caterpillar 5, , Komatsu 5, , Doosan 4, , Kobelco 4, , Hitachi 4, , Volvo 3, , Hyundai 2, , SDLG 2, , Liugong 1, , Source: Chinese Construction Machinery Association, Korea Investment & Securities Figure 33. Quarterly YoY excavator sales volume chg. Figure 34. DI market share since 211 (%) 2 DI quarterly sales YoY chg. China market quarterly sales YoY chg Q9 2Q1 2Q11 2Q12 2Q13 2Q14 (5) 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % 26.5% 27.2% 3.3% 4.7% 47.6% 45.6% 44.7% 4.2% 6.6% 7.% 8.4% 6.5% 3.3% 3.6% 6.3% 6.8% 8.2% 4.6% 11.3% 9.% 6.5% 12.7% 12.9% 13.7% 13.6% 12.1% 5.5% 6.7% 8.6% 1.1% 1.7% 7.5% 6.3% 6.5% 5.8% 15.3% 15.8% 8.8% 6.7% 7.4% 14.5% 8.5% 7.7% 11.% 11.6% 8.% 8.3% 1.8% 11.3% 8.5% 8.9% 9.2% 1.% 7.9% 7.2% 16.5% 4.9% 15.6% 13.3% 9.6% 8.5% 7.8% 8.6% H14 Doosan Hyundai Komatsu Hitachi Kobelco Volvo Caterpillar Sany Others Source: Chinese Construction Machinery Association, Korea Investment & Securities Source: Chinese Construction Machinery Association, Korea Investment & Securities 17

20 3. Machine tool business to remain healthy Sales to grow backed by ample orders backlog 1) Sound orders drive up earnings The machine tool division is poised to enjoy earnings momentum. Sales should increase for the remainder of the year backed by an ample orders backlog. Monthly orders have picked up after touching a bottom in 3Q13. In particular, monthly orders exceeded 1, units, matching the peak-season level, during 1Q- 2Q14 (avg. 1,123 per month in 2Q14). As it generally takes three months from order receipt to sales recognition, we see a bright earnings outlook in 2H14. Figure 35. Machine tool earnings: 1%+ OPM sustained Figure 36. Quarterly machine tool sales and orders 2, (W bn) (%) Machine tools sales (L) 15. Machine tools OPM (R) 4, (units) Machine tools sales (R) Machine tools orders (L) (W bn) 5 1, , ,2 3 1, 6. 2, , F. 2, 1Q12 3Q12 1Q13 3Q13 1Q14 3Q14F Figure 37. Monthly machine tool orders: 1,+ units sustained Figure 38. Machine tool sales by region 1,4 1,2 1, 8 (units) Machine tools orders (%) Domestic NA Europe China Others Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 1Q11 1Q12 1Q13 1Q14 18

21 2) Domestic sales and exports a good ensemble Europe (improvement): The most promising market in 2H14. The Purchasing Managers Index (PMI) is above the 5 mark, which is indicative of an expanding economy, and the manufacturing sector s average utilization is trending upward. The capex environment will turn for the better, mainly in major manufacturing countries such as Germany, given likely key interest rate cuts and the introduction of liquidity-boosting measures amid deflation concerns in the euro area. As orders from developed countries are for high-end products, greater sales to the region will help drive up ASP and profitability. US (gradual improvement): US manufacturing PMI stays high and facility utilization is on an upward slope, albeit not steep. Facing intense competition from Japanese makers, DI is unlikely to enjoy the full benefits of the US market recovery. US-bound sales should gradually improve. Domestic sales (status quo): The outlook is not rosy for the machine tool market at home. Various leading indicators suggest a dismal picture for industrial order growth in 2H14. But domestic auto parts and IT manufacturers are putting up sound sales figures. In particular, the auto parts makers are enjoying brisk exports. Figure 39. Manufacturing PMI: Sentiment indicator staying above the 5 mark in most countries Figure 4. Manufacturing utilization avg.: Rising capex demand 6 58 (pt) US Germany Korea Europe China 1 95 (%) US Germany Europe Korea Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Source: Bloomberg, Korea Investment & Securities Q3 1Q4 1Q5 1Q6 1Q7 1Q8 1Q9 1Q1 1Q11 1Q12 1Q13 1Q14 Source: Bloomberg, Korea Investment & Securities Figure 41. Korean machine tool orders Figure 42. US: Greater manufacturing utilization but low inventory; Capex demand to rise (W bn) (%) Overseas orders (L) Domestic orders (L) Domestic orders YoY chg. (R) Overseas orders YoY chg. (R) (x) Manufacturing inventory (5) 1.6 Jan-1 Jan-11 Jan-12 Jan-13 Jan-14 (1) 1.5 Sep- Sep-2 Sep-4 Sep-6 Sep-8 Sep-1 Sep-12 Source: Korea Investment & Securities Source: Bloomberg, Korea Investment & Securities 19

22 Figure 43. Auto parts exports remain robust Figure 44. Electrical/electronic sector machine tool order growth 2,5, (USD') Auto parts exports (L) (%) 4 YoY chg. (R) 3 (%) Electric/electronic orders YoY chg. 2,, ,5, ,, 1 5 5, (5) Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 (1) (1) Jan-8 Jan-9 Jan-1 Jan-11 Jan-12 Jan-13 Jan-14 Source: KITA, Korea Investment & Securities Source: 한국공작기계협회, Korea Investment & Securities Figure 45. Global machine tool makers competitiveness by downstream industry Source: The Economic Research Institute, Japan Society for the Promotion of Machine Industry, JMTBA, Korea Investment & Securities 2

23 4. Engines: Time to reap harvest After two years of losses, engine division will turn to profit in 214 thanks to the G2 1) Turn profitable in 214 with completed G2 engine development After two years of loss-making operations, the engine division is emerging as a cash cow with a likely positive OP starting in 214. Development of the G2 engine commenced in 28 to allow internal procurement for DIBH products. The G2 will replace Japan s Kubota engine in DIBH products with its cheaper manufacturing costs and better functionality. In particular, the G2 meets Tier 4 exhaust regulations in developed markets without requiring a costly diesel particulate filter (DPF). The G2 has been mounted on DIBH products after testing since October 213. DI aims to lift the G2 installation rate in DIBH products from 15% in 213 to 5% in 214 and 85% in 215. Exploring external customers while meeting captive demand 2) Engines a cash cow alongside machine tools; Exploring outside customers while meeting captive demand The engine division s earnings should spike in 214. As the G2 for DIBH products will enter volume production in earnest, the division should report a positive OP of W29.9bn in 214F compared to a W5.7bn operating loss in 213. The division OP will increase to W8bn in 215F. The yearly G2 production capacity is 5, at present, which is enough to cover captive demand including DIBH products and DI s forklift trucks. In addition to meeting internal demand, DI is working to secure outside buyers. Aimed at growing the engine business into a reliable cash cow alongside machine tools, DI plans to expand the capacity to 1, units by 217. Figure 46. DI engines OP after G2 supply Figure 47. G2 engine sizes 9 (W bn) Engines OP Installment rate 85% DI's G2 installment rate for Bobcat products reached 15% Installment rate 5% (1) (3) Loss due to massive R&D spending to develop G F 215F Source: Korea Investment & Securities 21

24 V. Earnings outlook 1. Growth achievable even without Chinese market recovery We set sales at W7.78tn and OP at W462bn, up.4% YoY and 25% YoY, respectively, in 214F. The OPM should gain 1.1%p YoY to 5.9%. The construction equipment division s earnings will likely improve even as its Chinese excavator business witnesses flat sales YoY. We are upbeat as 1) the Chinese business earnings should improve, albeit slightly, thanks to lower break-even points (by no. of excavators sold) after restructuring and 2) DIBH s earnings are steadily picking up. The machine tool division should remain a cash cow with more than 1% OPM annually. Earnings growth is fastest at the engine division, which will clearly turn profitable thanks to the G2 being mounted in more models in 214. Table 8. Earnings by division (W bn, %) 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14F 4Q14F F 215F Sales 1,789 2,182 1,88 1,887 1,89 2,113 1,915 1,934 7,737 7,772 8,32 Construction equipment 1,368 1,661 1,392 1,332 1,377 1,588 1,378 1,379 5,753 5,721 6,28 Non-DIBH ,171 2,71 2,155 DIBH , ,583 3,65 4,53 Machine tools ,347 1,41 1,443 Engines Chg. YoY (18.3) (6.5) (3.1) (5.2) Construction equipment (19.2) (6.7) (4.4) (1.1) 3.5 (6.2) (.6) 8.5 Non-DIBH (25.9) (9.2) (6.3) (17.4) (5.) 7.6 (11.7) (4.6) 4.1 DIBH (14.) (4.7) (.2) (2.5) Machine tools (27.9) (12.4) (1.) (8.5) Engines (2.8) OP Construction equipment Non-DIBH 12 8 (13) (61) 32 (4) (18) (21) (54) (1) 11 DIBH Machine tools Engines (4) 5 (6) (4) 3 8 OPM Construction equipment Non-DIBH (2.7) (13.4) 5.8 (.7) (4.) (4.3) (2.5) (.5).5 DIBH Machine tools Engines (3.) 2.7 (3.7) (.6)