Daikin: Market Leader Looking Fairly Valued (OTCMKTS:DKILF)

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Investment thesis

Despite deteriorating conditions in the real estate market, Daikin’s (OTCPK:DKILF) shares have held up well and H1 FY3/2023 results were positive. In the shorter term, we believe the company will be negatively impacted by a slowdown in commercial real estate, and geographically from the European and Asia/Oceania markets. With valuations looking fairly valued, we rate the shares as neutral.

quick primer

Daikin is the world’s largest manufacturer of air conditioners, with an approximate global market share of 12%, followed by peers Midea Group (000333), Gree Electric (000651), Trane Technologies (TT), and Carrier (CARR). Overseas sales make up over 80% of the total, with the Americas (approximately 40%) being the largest followed by Europe (16%) and Japan (15%). It provides HVAC (heating, ventilation, and air conditioning) solutions for both residential and commercial properties, and its product strength is in ducted air conditioners (as opposed to ductless popular in US residential).

For the residential market, Daikin is viewed as a premium brand compared to peers such as Panasonic (OTCPK:PCRFY), Hisense (OTCPK:HISEF), Haier Smart Home (OTCPK:HRSHF), and Fujitsu (OTCPK:FJTSY).

According to the International Energy Agency (IEA), in 2050, air conditioner demand is projected to more than triple the current level due to the economic growth of emerging countries.

Key financials with consensus forecasts

Key financials with consensus forecasts

Key financials with consensus forecasts (Company, Refinitiv)

FY3/2022 sales split by division

FY3/2022 sales split by division

FY3/2022 sales split by division (company)

Our objectives

Despite challenging conditions with lockdowns in Shanghai affecting manufacturing and supply, Daikin’s H1 FY3/2023 results (Q2 FY3/2023 YTD) were ahead of guidance and reached a historic high. Key demand drivers included heat pump hot water heaters in Europe, heat wave-related aircon demand in Italy and Spain, and a robust market in the US overall. Reported numbers were also helped by a depreciating Japanese yen (guidance USDJPY rate was JPY115 versus current JPY145), as well as increased price hikes to offset increasing raw material costs.

We view Daikin’s outlook as being broadly dependent on increasing market share in the developed markets, followed by an increasingly addressable market in the emerging markets for the longer term. With the developed economies experiencing increasing financing costs with a downturn in the real estate market underway, we want to assess the outlook for Daikin’s earnings for the medium term.

Indications from the real estate sector are negative

HVAC businesses benefit from an increasing installed base, with an initial purchase resulting in replacement demand further down the line. Switching costs tend to be low in residential but high in commercial, hence the latter can generate service fees and more dependable repeat business.

The real estate market is currently in or is heading toward a downturn. The general outlook here is negative for Daikin, particularly in Europe as households are hit hard with rising inflation and borrowing costs and US housing starts are beginning to weaken. Commercial property is experiencing increasing yields (asset prices are falling) and the concern going forwards is the foreclosure of small and medium-sized businesses which will result in a spike in vacancy rates. Landlords will therefore have little or no reason to upgrade or replace HVAC units, and new developments will ground to a halt.

On a positive note, lockdown conditions are being loosened in China where Daikin’s central production is based, and supply constraints will be less of an issue going forwards. We view end demand being the critical issue, and this is likely to be dictated more by consumer sentiment as opposed to pricing, technology, and availability which has greater influence over purchasing choice under more normalized economic conditions.

There are some signs that inflation may be peaking in the US, and the IMF has talked about inflation nearing its peak. This bodes well for a sooner end to tightening central bank policy, but the damage may have already been done as a combination of rising unemployment and stagflation (sustained inflation but no economic growth) continues. This is a negative for consumer discretionary spending.

Slowdown is expected

Looking at consensus forecasts (see table above in Key financials), the market is expecting a significant slowdown in both sales and earnings growth into FY3/2024. However, this outlook is highly dependent on FX rates with Daikin’s large overseas sales exposure where a continued weak Japanese yen will be positive for reported earnings YoY. If interest rate hikes slow, the Japanese yen will strengthen and translation benefits will fall away.

The shares have only corrected 11% YTD, which highlights that the market has relatively high expectations for the business. The question is whether this is justified or too optimistic. Daikin is a well-run business and should relatively outperform its peer group in a downturn, diligently cutting costs whilst increasing the topline. However, we do not see much scope for operating margins to continue increasing YoY (H1 FY3/2023 operating margins dropped from 12.4% last period to 11.0%), and the real estate market looks overwhelmingly negative.

The thematic driver from global warming together with the need for more energy-efficient HVAC systems do play in Daikin’s favor. However, with the current global economy, developed market demand will be tempered and emerging market demand is unlikely to be accelerating significantly.

Valuation

On consensus forecasts, the shares are trading on PER FY3/2024 22.4x with a resultant free cash flow yield of 3.8%. These valuations do not signify overvaluation, and for a premier player such as Daikin appear relatively low. With a subdued market outlook and limited scope to raise operating margins, we believe the shares look fairly valued.

risks

Upside risk comes from Daikin embarking on an M&A drive to boost its product portfolio as well as targeting accretive earnings. Management has commented that market conditions are currently conducting. With increasing environmental scrutiny and product standards being introduced, this places Daikin as a ‘winner’ in its group to gain market share with compliant products already in production.

Downside risk comes from a material slowdown in the commercial real estate market which is high margin than residential, diluting the sales mix. Inventory levels are said to be high in Asia and Oceania, which may result in inventory adjustments incurring lower margins.

conclusion

Daikin’s performance to H1 FY3/2023 has been positive given the circumstances, and credit to their management. However, as market conditions continue to deteriorate, we believe the company will be significantly challenged to grow earnings into FY3/2024 – Europe appears at high risk, as well as a slowdown in Asia/Oceania. Valuations appear to be fairly valued for a market leader, and we rate the shares as neutral.

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