Getting the Backbone of Manufacturing at a Discount

One of the most important — yet least widely known — sectors of the global economy is in the beginnings of a rebound.

It’s called the machine tool industry. It’s the backbone of manufacturing. Machine tools cut, grind and shape metal to make components for machines. Machine tools include things like lathes, milling machines and drill presses. These tools make the parts that go into everything from networking equipment to medical devices.

The machine tool industry is a key supplier to manufacturers all over the world. So it tends to be very cyclical. When manufacturing goes down, the market absolutely stomps on these guys. But when manufacturing rebounds, machine tool makers fly.

Right now, the stocks are still way down — 75% off their highs — but a rebound is clearly in the offing. It’s a very contrarian bet, but even if the stocks made up only half the ground they lost, investors would double their money. There is not much downside, because the market expects so little of the stocks and the valuations are already lower than a snake’s belly.

In 2008, spending on machine tools plunged as projects all over the world froze in the icy winds of the financial crisis. Even in booming markets like China, there was a pause in new orders as people tried to wrap their heads around what was happening.

The speed of the decline was unprecedented for the industry. Machine tool orders dropped by half in U.S. In some countries, it was worse. In Japan, machine tool consumption fell 66%. In Taiwan, it fell 59%. The financial crisis mauled the industry like never before.

But things are bouncing back. As I say, that turn is already in the works. The Association for Manufacturing Technology and the American Machine Tool Distributors’ Association said orders for machine tools were up 49.5% in March from a year ago.

And if you look at individual companies involved, you can see it there too. Here are some comments from Richard Simons, the president and CEO of Hardinge, a machine tool firm (emphasis added):

“Looking at the current business environment around the world, we are seeing signs of improvement, which are reflected in our very strong order rates in the first quarter. Business across Asia, not just China, has not only improved dramatically, versus the low first-quarter 2009, but has also improved sequentially from the fourth quarter. That area of the world started off the year immediately with a surge of orders, making the quarter one of the highest ever experienced by Hardinge, surpassed only by the third quarter of 2008, which was before the financial crisis.”

It’s interesting to note where the strength is. It’s in Asia. Machine tool consumption is down the most in the mature markets, like the U.S. And while there is some new activity even in the U.S., it pales compared to the growth in Asia.

You can see this by looking at Japan’s machine tool exports. In 2006, the value of Japan’s exported machine tools were twice as much as what it exported to China. Now it’s reversed. In the first quarter of this year, Japan’s exports to China are more than double that to the U.S. Chalk it up as more evidence of a sad decline in American manufacturing and a weak economy.

Overall, this is not a U.S. story. The U.S. consumes only about 9% of the world’s machine tools. The demand for machine tools is mainly abroad and mostly from emerging markets. China is far and away the biggest consumer of machine tools.

Anecdotally, there are many stories of a developing machine tool shortage. Recently, The Wall Street Journal highlighted the problems companies are having. “For some companies,” the WSJ reports, “tight machine tool supplies are causing production bottlenecks and delivery delays as they gear up to fill new orders or rebuild their inventories.”

The WSJ continues:

“Purchases of machine tools and other types of business equipment are still far below pre-recession levels, particularly in developed countries like the U.S., where the recovery has generally been slower and more fitful than in emerging economies like India and China. But because rehiring workers and restocking warehouses take time, many companies are struggling to meet the recovery in demand, and shortages are arising.”

Companies such as Alcatel-Lucent and Ericsson have both said they’ve had trouble finding components — made by machine tools, of course — to meet customer orders. Fanuc, a company that sells robotic equipment to factories, has had a hard time filling new orders because of a shortage of components. There are stories of other companies waiting months for parts to arrive.

This all goes back to the machine tool guys who make all that stuff. They have more business than they can handle right now. Hardinge’s orders were up 75% in the first quarter compared to a year ago. And that’s typical in this industry.

The other telltale sign that we’re onto something good: Wall Street’s analyst community is not interested. Several of the big Wall Street firms dropped their coverage of these companies as they imploded. The sector doesn’t seem to have much of a following. But investors will come back — as they always do — when the stocks start rising from good results.

Today, you’ve got a chance to get in early when prices are cheap…

Chris Mayer
Whiskey & Gunpowder

July 12, 2010

The Daily Reckoning