Will Supply-Chain Disruptions and Delayed Capital Spending Be Material?

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Supply-side disruptions are a significant risk amid the coronavirus pandemic. The entire supply chain is at risk of shutdowns and slowdowns, from raw material production to shipping, distribution, and end-point sales.

We observe three general types of supply-chain scenarios facing manufacturers, customers, and retailers, each resulting in myriad knock-on effects. However, we expect supply-chain disruptions to gradually dissipate as the coronavirus crisis is overcome.

First, we envision cases of product oversupply meeting soft demand. As Chinese factories ramp up production again, worries about supply-chain disruptions are probably easing. However, the tables have turned, and manufacturers could overproduce while offshore demand weakens. This oversupply could cause retail prices to deflate; combined with lower near-term consumer spending, this would be a double whammy for retailer revenue. For example, with large global auto manufacturers ceasing production at various sites, the auto-supply industry is likely to curtail production to prevent this oversupply.

At this point, it would be premature for us to forecast the full impact of COVID-19 on 2020 automotive sector fundamentals. Demand and supply-chain disruptions will be ongoing until the virus is contained. So far, European automakers have had varying degrees of demand and supply impact. Renault RNO and Peugeot UG both have facilities in Wuhan, China, which were slated to resume production. BMW BMW/BMWYY, Daimler DAI/DDAIF, and Volkswagen VOW3/VWAGY as well as all of our auto-parts suppliers have Chinese facilities that saw extended shutdowns after the lunar holiday. Jaguar Land Rover was airlifting some components from China to keep operating in Europe. Fiat Chrysler FCA/FCAU also had a supply problem for one European facility but managed a workaround. Given Italy’s containment measures, Fiat Chrysler said it would temporarily close Italian facilities where necessary. We do not envision any scenario where COVID-19 affects our midcycle assumptions, and we do not expect any substantial changes to our auto sector fair value estimates.

Second, we see situations where supply-chain disruption can cause lower stock availability but still meet, or partially meet, lower demand. For instance, apparel retailers facing lower consumer demand are likely to be less affected by lower stock availability.

Third, significantly higher demand has caused supply-chain stress in some categories, especially supermarkets. Panic buying for food and sanitary products has been widespread, boosting grocers’ revenue lines, but we expect it is also introducing more costs such as labor cost per carton or higher waste. Efficient, low-cost supermarket supply chains rely on well-planned deliveries and streamlined stock handling at warehouses and in stores.

Despite these significant short-term disruptions, we don’t predict any long-lasting changes to companies’ supply-chain structures. Some businesses might consider decentralized manufacturing. It is not a difficult decision for retailers that outsource their production, as they are naturally inclined to engage multiple manufacturers to avoid overly relying on one supplier. However, retailers who manufacture products in house must weigh the risk of disruptions against additional capital expenditures and production costs. Also, the coronavirus crisis is unlikely to increase inventory levels in the long term. At face value, this could prepare companies better for major disruptions. However, events of this magnitude are rare and unlikely to justify the higher cash intensity of such a switch in a normalized environment.

Capital Spending Returns More Gradually Capital equipment demand will probably take some time to recover, but the long-term outlook for industrial robotic demand gets a boost. Capital expenditure plans that have been delayed will not immediately return and instead will likely resume more gradually. Projects in the earlier stages may be deferred until businesses restore normal operations and confidence increases to resume investing in growth. While we have been expecting cyclical headwinds arising from the U.S.-China trade friction and reduced global capital spending to have an impact on companies until the first half of fiscal 2020 (ending in August-September), we believe the market is expecting that the effects of the coronavirus will lead to a prolonged decline in growth in the factory automation sector after 2020 as well. The increased uncertainty from the pandemic is likely to delay capital spending by the automobile manufacturers over the next six months (as we are seeing temporary production shutdowns in the United States). However, we believe we have already accounted for the near-term year-on-year reduction in capital spending by automobile manufacturers in our fair value estimates.

Lessons from the pandemic could include seeing the benefits of Industry 4.0 software for remote plant management and the deployment of robotics to improve manufacturing capacity flexibility. Our base scenario is that global economic activity normalizes by the end of 2020. However, we expect the pandemic’s knock-on effect to spread over two years for some companies.

In 2020, we expect short-cycle product revenue to decline. These are mainly robotics with concentrated end markets in automotive and consumer electronics, as well as the electrical and automation component categories, that might take one to two quarters to deliver.

These are categories that have seen deep declines in volume in past periods of economic uncertainty but equally see a bounce-back in demand within a year. Hence, we assume most of the additional loss in 2020 from the pandemic will rebound in 2021 due to pent-up demand, as we are convinced that more companies will have a sense of urgency and consider making factory automation investments so that their production can continue to run even in times of difficulties with labor constraints.

We think this strengthens Japanese factory automation companies’ long-term growth potential. We continue to believe that these companies are well positioned for long-term, secular factory automation growth due to factors like aging population, increasing wage costs, and the increased need for production efficiencies in key markets such as Japan and Asia. In the near term, we assume that an increase in semiconductor and 5G-related investments will serve as the initial catalyst to a cyclical recovery in the factory automation market this fiscal year; however, we now expect much of this recovery will be delayed from the beginning of fiscal 2020 to around the second and third quarters, assuming the pandemic is contained within the first half of fiscal 2020.

We believe Yaskawa Electric 6506 is best positioned for these investments, since 25% of its motion control sales (its largest business segment) comes from sales related to semiconductors and electric components. We do not see any material capital constraints or supply-side issues over the near term as a result of the pandemic. With consecutive positive free cash flow for over the past five years, as well as lack of any interest-bearing debt for Fanuc 6954/FANUY and Keyence 6861 and a low net debt/EBITDA ratio of 0.09 times, we believe Japanese factory automation companies would be able to withstand any potential material impact from the coronavirus. Further, we believe that having the majority of the production based in Japan will mitigate supply-side risks in case the pandemic affects production facilities in China. While there is more risk related to parts procurement with Fanuc’s and Yaskawa’s industrial robot segments, considering that both companies produce their own key components such as servo motors for the robots, we do not believe either one would face serious capacity constraints where they would not be able to meet demand in a worst-case scenario.

Denise Molina and Jason Kondo contributed to this article.