Description

Precision Tsugami China (PTC) is manufacturer of high-end computer numerical control (CNC) machine tools. PTC was established in 2003 and is 70.8% owned by parent company, Tsugami Corporation (6101-JP) of Japan. PTC’s sales are split 66% China/33% overseas. PTC should be a beneficiary as China upgrades its industrial base to focus on high-end manufacturing. The ratio of CNC machine tool sales to overall machine tool sales in China has increased from 20% in 2011 to 24% in 2014, but this figure still lags far behind the 55% in the United States and ~66% in both Japan and Germany. Sales and net income for 1H’19 increased by 37% and 117% YoY, respectively. The stock trades for 8.3X current year earnings.

Relationship with Tsugami Corporation

Tsugami Corporation was founded in 1937 and has been listed on the Tokyo Stock Exchange for 70 years. The TSUGAMI brand has a long history and excellent reputation in the precision machine tool market. PTC was a wholly-owned subsidiary of Tsugami Corporation focused on China. In September 2017, PTC issued and listed 73.5mm new shares on the Hong Kong Stock Exchange. Tsugami Corporation remains the controlling shareholder with a 70.8% stake. PTC licenses various technologies and trademarks from Tsugami Corporation and pays royalties ranging from 1-5% of sales depending on the machine tool model. Tsugami Corporation is also PTC’s largest customer, accounting for 33% of sales (i.e., all its oversea sales).

Precision Tsugami China

PTC’s major product lines are lathes (59% of sales), turrets (22%), machining centers (9%), thread/form rolling machines (<1%), and grinding machines (5%). The major uses for CNC machine tools include auto manufacturing, consumer electronics, aerospace, and energy equipment. PTC is the leading supplier of precision lathes with over 35% market share. The company seeks to grow in other product areas such as precision turrets where it holds less than 2% market share.

The company has four production plants and is adding capacity to boost its annual machine tool production to 12-14K units (~30% increase). Over 60% of China’s CNC machine tools are imported from Japan and Germany, so there’s ample room for substitution from domestic sources. Along with expanding production capacity, PTC continues to grow its sales network. The company open five new sales centers to expand its geographic footprint in 1H’19. The number of PTC distributors also increased from 209 to 241 YoY.

PTC isn’t some impenetrable wide moat business in the world, but it’s decent. The TSUGAMI brand has a well-deserved premium reputation and PTC has stated it does not compete on price. PTC has been able to pass on component price increases to customers. The company’s vertical integration allows it to win business by offering customers shorter delivery times. Building out a distribution network also requires time and resources. Tsugami Corporation of Japan sells CNC machine tools in the U.S. through a similar distribution network. If you can’t make a trip to China, You can talk to a U.S. Tsugami distributor to get an idea of how PTC’s business works.

Risks

PTC has done a good job of diversifying away from customer concentration risk. The gigantic revenue increase in FY2015 followed by the gigantic revenue decrease in FY2016 was Apple coming and going. However, PTC is still exposed to two industries with capex cycles, auto (35% of sales) and consumer electronics (20%). Autos and smartphones have been horrible, so while we may or may not be at the bottom of the cycle, we certainly aren’t at the top.

The relationship with Tsugami Corporation raises potential conflicts. However, the royalty rates seem reasonable for the value provided and if Tsugami Corporation tries to steal from PTC, they will be 70.3% stealing from themselves. The upside is that as a subsidiary of a Japanese corporation that has been listed for 70 years, the books probably aren’t cooked and there is adquate oversight from a corporate governance perspective.

Summary

PTC probably grows earnings for a long time as China upgrades its manufacturing base, though the path of growth may be cyclical. The balance sheet is debt free and free cash flow is in line with earnings. Management seems competent with the CEO in place since 2005. CEO purchased stock on the open market during the market sell-off last year. PTC returns capital to shareholders through dividends (HK$0.20 interim dividend announced with 1H’19 earnings). A 8.3X P/E is a decent price to pay for a decent business with good growth prospects.

Catalyst

Earnings growth over time.