Despite deteriorating real estate market conditions, Daikin (OTCPK:DKILF) equities held up well and results for the first half of FY3/2023 were positive. In the shorter term, we believe the business will be negatively affected by a slowdown in commercial real estate, and geographically in the European and Asia/Oceania markets. With valuations appearing fair, we classify stocks as neutral.
Daikin is the world’s largest manufacturer of air conditioners, with a global market share of around 12%, followed by its peers Midea Group (000333), Gree Electric (000651), Trane Technologies (TT) and Carrier (CARR). Overseas sales account for over 80% of the total, with the Americas (around 40%) being the most important, followed by Europe (16%) and Japan (15%). It provides HVAC (heating, ventilation, and air conditioning) solutions for residential and commercial properties, and its product strength lies in ducted air conditioners (as opposed to the ductless ones popular in US residences).
According to the International Energy Agency (IEA), in 2050, the demand for air conditioners is expected to more than triple from the current level due to economic growth in emerging countries.
Key financial data with consensus forecasts
FY3/2022 sales broken down by division
Despite challenging conditions with lockdowns in Shanghai affecting manufacturing and supply, Daikin Results H1 FY3/2023 (Q2 FY3/2023 YTD) were ahead of forecast and hit an all-time high. Key demand drivers included heat pump water heaters in Europe, heatwave-related air conditioning demand in Italy and Spain, and a robust US market overall. The published figures were also helped by the depreciation of the Japanese yen (the USDJPY key rate was 115 JPY compared to the current 145 JPY), as well as the increase in price increases to compensate for the increase in the costs of raw materials.
We see Daikin’s prospects as largely dependent on increasing market share in developed markets, followed by an increasingly addressable market in emerging markets over the longer term. As developed economies experience rising financing costs with an ongoing property market downturn, we want to assess Daikin’s earnings outlook over the medium term.
Indications from the real estate sector are negative
HVAC companies benefit from a growing installed base, with initial purchase driving replacement demand further down the line. Switching costs tend to be low in residential but high in commercial, so the latter can generate service charges and more reliable business activity.
The real estate market is currently or is heading towards a slowdown. The general outlook here is negative for Daikin, particularly in Europe, as households are hit hard by rising inflation and rising borrowing costs and Housing starts in the United States begin to weaken. Commercial real estate is seeing rising yields (asset prices are falling) and the concern going forward is the closure of small and medium-sized businesses, which will lead to soaring vacancy rates. Homeowners will therefore have little or no reason to upgrade or replace HVAC units, and new developments will come to a halt.
On a positive note, lockdown conditions are easing in China, where Daikin’s central production is based, and supply constraints will be less of an issue going forward. We consider end demand to be the critical issue, and this will likely be driven more by consumer sentiment than price, technology and availability, which have a greater influence on purchase choice in more economic conditions. standardized.
There are some signs that inflation could be culminating in the United Statesand the IMF spoke of inflation close to its peak. This bodes well for a quicker end to the central bank’s tightening policy, but the damage may already have been done as the combination of rising unemployment and stagflation (sustained inflation but no economic growth ) continues. This is negative for discretionary consumer spending.
A slowdown is expected
Based on consensus forecasts (see table above in Financial Key Figures), the market expects a significant slowdown in sales and earnings growth in fiscal year 3/2024. However, this outlook is highly dependent on exchange rates with Daikin’s significant overseas sales exposure, where the continued weakness of the Japanese yen will be positive for reported year-over-year earnings. If interest rate increases slow, the Japanese yen will strengthen and the benefits of the conversion will diminish.
Shares have only corrected 11% since the start of the year, underscoring that the market has relatively high expectations for the company. The question is whether this is justified or too optimistic. Daikin is a well-run company and should relatively outperform its peer group in a downturn, diligently cutting costs while growing revenue. However, we don’t see much room for operating margins to continue to grow year-over-year (H1 FY3/2023 operating margins increased from 12.4% in the last period at 11.0%), and the real estate market looks extremely negative.
The thematic driver of global warming as well as the need for more energy efficient HVAC systems work in favor of Daikin. However, with the current global economy, demand from developed markets will be tempered and demand from emerging markets is not expected to accelerate significantly.
According to the consensus forecast, the shares are trading on a FY3/2024 PER of 22.4x with a free cash flow yield of 3.8%. These valuations do not signify an overvaluation and, for a top player such as Daikin, they seem relatively low. With a lackluster market outlook and limited opportunity to expand operating margins, we think stocks look fairly priced.
The upside risk comes as Daikin embarks on an M&A campaign to bolster its product portfolio while targeting accretive earnings. Management has indicated that market conditions are currently favorable. With increased environmental monitoring and the introduction of product standards, this puts Daikin as a ‘winner’ in its group to gain market share with compliant products already in production.
The downside risk stems from a significant downturn in the commercial real estate market, which has a higher margin than the residential market, diluting the sales mix. Inventory levels would be high in Asia and Oceania, which could lead to inventory adjustments leading to lower margins.
Daikin’s performance in the first half of FY3/2023 was positive given the circumstances and credit to its management. However, as market conditions continue to deteriorate, we believe the company will be significantly challenged to grow earnings in FY3/2024 – Europe looks high risk, as well as a slowdown in Asia/Oceania. Valuations appear to be fairly assessed for a market leader, and we rate the stocks as neutral.