Komatsu: Focus On Valuations And Capital Allocation (OTCMKTS:KMTUY)

Elevator Pitch

Komatsu Ltd. (OTCPK:KMTUY) [6301:JP] stock is awarded a Buy rating.

I evaluated KMTUY’s above-expectations third quarter performance in my January 31, 2024 article. My bullish view of Komatsu stays intact with this update, as I think that the company can leverage on value-accretive capital allocation initiatives to command higher valuations.

The three-month average daily trading value of Komatsu’s Over-The-Counter shares is decent at $3 million as per S&P Capital IQ data. Investors also have the choice in dealing in the company’s relatively more liquid Japan-listed shares (three-month mean daily trading value of $100 million) with US stockbrokers like Interactive Brokers.

Valuations

In an investor meeting in March 2024, Komatsu’s CEO Hiroyuki Ogawa and board director Takeshi Kunibe commented on the stock’s valuations. Specifically, the company noted that its shares’ “PBR (Price-to-Book Ratio) should be higher” and also drew comparisons with the higher P/B valuations for its peer and rival Caterpillar (CAT).

According to valuation data sourced from S&P Capital IQ, Komatsu currently trades at a trailing P/B multiple of 1.47 times and a consensus forward P/E metric of 10.7 times. In contrast, Caterpillar is now valued by the market at trailing P/B and consensus forward P/E ratios of 9.2 times and 16.9 times, respectively. As such, I think that KMTUY is justified in thinking that the stock should trade at more demanding valuations which are closer to that of the company’s key peer, CAT.

Komatsu’s and Caterpillar’s actual trailing twelve months’ ROAs (Return on Assets) were 7.4% and 11.8%, respectively. KMTUY’s inferior ROA is most probably the main reason for the company’s substantial valuation discount as compared to Caterpillar. Komatsu revealed at the investor meeting in the previous month that the company is now “analyzing the difference in PBRs between Komatsu and CAT” and considering various actions “to raise the PBR.”

In my opinion, capital allocation will be a critical tool that allows KMTUY to generate a superior ROA for the future and narrow the peer valuation gap (between Komatsu and Caterpillar) in time to come. This is the topic for the subsequent section of the article.

Capital Allocation

KMTUY touched on the company’s inorganic growth strategy and shareholder capital return approach, which are key components of its capital allocation in the recent March 2024 investor meeting.

At its investor meeting held last month, Komatsu shared that it is keen on allocating capital to Mergers & Acquisitions or M&A “as a way to map out strategies and acquire the missing pieces” in certain business areas.

As an example, KMTUY concluded the takeover of “Detroit-based battery manufacturer, American Battery Solutions or ABS” at the end of the prior year as per its December 2, 2023 announcement. In this disclosure, Komatsu highlighted that the M&A deal’s purpose is to “leverage ABS batteries to power Komatsu mining equipment in North and South America, where demand for electrification has been increasing.”

The recent ABS acquisition should enable Komatsu to sell higher-margin mining equipment that clients are interested in buying. It is likely that KMTUY will continue to set aside capital for acquisitions that can boost the company’s future ROA via top line expansion and profitability improvement.

Separately, there is the potential for Komatsu to distribute a bigger proportion of the company’s earnings and excess capital to its shareholders going forward.

KMTUY’s current dividend policy is to pay out at least 40% of its net profit as dividends, which is slightly higher than the average Japanese company’s dividend payout ratio of around 36%. It isn’t far-fetched to think that there is a good chance of Komatsu raising its dividend payout ratio sometime in the future.

More importantly, it seems likely that Komatsu could initiate a new share repurchase program in the near term. KMTUY’s board director Takeshi Kunibe specifically mentioned at the March investor meeting that “my personal opinion is that it is time for the Board of Directors to discuss the merits of share buybacks in addition to the committed dividend.”

Shrinking the company’s asset base by reducing excess cash via dividends and buybacks will also enhance Komatsu’s future ROA, on top of value-accretive inorganic growth initiatives.

Results Preview

April 26, 2024 is the expected date for Komatsu’s upcoming financial results release.

The market has a bearish opinion of KMTUY’s Q4 FY 2023 (YE March 31, 2024) financial performance. In specific terms, the sell side forecasts that the company’s revenue (in JPY terms) will decline by -0.3% YoY for Q4 FY 2023 as compared to a +5.6% YoY growth in Q3 FY 2023. Also the analysts see Komatsu’s EBIT growth moderating from +15.9% YoY for Q3 FY 2023 to +2.1% in Q4 FY 2023. These estimates are sourced from S&P Capital IQ.

At the company’s Q3 FY 2023 results briefing at the end of January this year, Komatsu drew attention to near-term headwinds like the negative impact of high “energy prices” on “construction equipment demand” in Europe, and the “sluggish real estate market conditions” for China. These unfavorable factors are likely to have hurt KMTUY’s financial performance in the most recent quarter.

My view is that Komatsu’s fourth quarter results disclosure in late-April won’t be a positive surprise. I expect KMTUY’s actual Q4 FY 2023 financials to be either in line or below the market’s expectations.

Variant View

Capital allocation is a double-edged sword. There is potential downside for Komatsu’s shares, if the company allocates capital in a manner that hurts the interests of shareholders.

One key risk is buying businesses of poor quality at demanding valuations. It is always tricky to assess potential acquisition targets and have the discipline to avoid overpaying for businesses or assets.

The other key risk is the reduction in the amount of capital set aside for shareholder capital return. A cut in the dividend payout ratio or holding back on a new share buyback plan will likely be perceived in a negative way by investors.

Final Thoughts

I think that Komatsu can trade at higher valuations, assuming that it is successful in enhancing shareholder value with the right capital allocation moves. As such, I stick with my Buy rating for KMTUY.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.