De toelichting op onze huidige investeringen in momenteel alleen in het Engels beschikbaar.
Founded in 1964, the company is the world leader for manufacturing precision reduction gears known as harmonic drives. These gears are used to enable precise movement of machinery. Whilst these gears have many applications that require highly accurate manufacturing processes such as in the use of semiconductor manufacturing equipment, it is predominantly used for the joint movement of robotic arms in automated production lines. These gears enable robotic arms to adjust and move their position in precise increments. This gear is what allows a robot to consistently repeat a process at a high accuracy unmatched by a human worker. Since its founding, HDS has focused on making light weight and highly durable small size gears for small robots.
What we like, and especially rare amongst Japanese companies which typically pursue multiple endeavours with conglomerate type structures, is its relentless focus on excelling at one type of activity, in this case production of precision reduction gears. The result of this focus is evident in its market position as a virtual monopoly for small sized gears. Its market share is estimated to be about 85%, making it the industry’s de facto standard. As the only player with decades of experience, HDS has collected unique intellectual property and expertise to produce and test its gears that ensure consistently high quality. Its scale has enabled a production cost advantage, helping it to remain highly profitable.
A key quality factor that is valued highly by customers is its reliability and durability. Customers typically use robots for repetitive and intensive manufacturing. If a robot malfunctions or breaks down as a result of a worn out gear, this could stop the entire production line, resulting in a costly affair for the customer. With this in mind, the level of durability of HDS’ gears is currently unmatched in the market. Given the relatively low cost of HDS’ gears, there is little incentive to try a cheaper, less proven competitor.
The business of gears is cyclical as it is dependent on the level of investments in robots (and consequently gears), which varies on an annual basis. Depending on the market cycle, manufacturers may be less capable of investing in automation from one year to another.
However, we believe HDS is exposed to a robotics sector that is set to grow for many years to come. Despite volatility in annual demand, we expect the overall market for robotics to be much larger 5-10 years down the road.
We also take comfort in the fact that HDS has a rock solid balance sheet, which ensures sustainability and client confidence during a cyclical downturn.
Collectively the chairman and related family members own a total of 5%. Indirectly, the holding company of the chairman's brother (who also sits on the board) currently owns 35% of the company. Thus we believe the management incentives to be in line with minority shareholders like us.
Average management and board tenure is 30 years and has acted as the foundation of stable performance of the company. The CEO has been with the firm for 16 years and has been CEO for the last 5 years. HDS has committed to quality, and refuses to sell cheaper, low quality gears to fast growing Chinese robot manufacturers that make lower quality robots. Rather it chooses to penetrate the Chinese market through high quality robot manufacturers. We believe this is a testament to its focus on quality and on its reputation.
There are several barriers to entry to this business. Some of Harmonic Drive’s patents expired many years ago, yet it has hardly seen new significant entrants except Nidec Shimpo, which we will discuss later.
Firstly, manufacturing the precision reduction gears is a highly complex process, especially if one wants to manufacture them profitably.
Secondly, these gears are typically selected by the robot manufacturers at the design stage of a robot and once designed-in, they won’t be replaced by another supplier during its lifetime. Robot models are changed typically after a three to five year period. Robot manufacturers carefully select a gear supplier based on reliability and track record, which is the third barrier to entry. Given robots have a multi-year life cycle, manufacturers are expected to build robots that rarely break down because, as mentioned earlier, a malfunction of a robot for an industrial user can be costly. Given the relatively low cost of gears and the high risk of switching, there is little incentive for robot manufacturers to try a new gear supplier.
Despite the fact that average robot prices have nearly halved in the last decade, HDS has not seen significant price pressure from its robot manufacturing customers, reflecting its pricing power as a mission critical component.
Robotics and factory automation is a growing market driven by an increasingly tight labour market, rising labour costs, manufacturers’ pursuit of higher efficiency and quality. This is especially the case in China.
Currently, the US and Japan have 189 and 303 robots installed for every 10,000 employees respectively. In China, only 68 robots per 10,000 employees are currently installed. We believe that, as a global manufacturing powerhouse, this figure can at least match that of the US, helped by the Chinese government promoting increased use of robotics.
As prices come down, robots will no longer be only affordable for large corporations. The fastest growing sub-segment in robotics is the market for smaller robots. In particular the number of collaborative robots, which work in tandem with human workers, are expected to grow strongly through 2025. Additionally, as programming of robots become simplified and intuitive, accessibility for smaller businesses increases.
Robots have historically been used mostly by the automotive sector, but this is changing as more industries such as electronics manufacturing and the food and beverage industry embrace automation. We anticipate that robotics will increasingly be used for applications in new fields outside of its traditional end markets, which we believe provides additional long-term growth potential, such as in medical technology and aerospace. In short, a large opportunity lies ahead.
The company obtained ISO 14001 certification for its environmental management systems. This indicates that it has met voluntary guidelines to reduce pollution and industrial waste by implementing an environmental management system. Based on its environmental policy, HDS sets targets for each division and develops a program to reduce CO2 emissions and improve energy efficiency which it reports annually. It is also a certified Sony green partner.
Its gears, through the promotion of robotics, also contribute to health and safety of workers as robots can substitute or assist human workers in hazardous and potentially fatal work environments. Some hazards may be more nuanced where repetitive tasks may lead to chronic health issues.
HDS constantly tests and develops new gears and has now committed to discovering and producing gears for new fields other than robotics. HDS currently owns 103 harmonic drive related patents which is roughly 5 times more than the number 2 player. This reflects its focus on continued development of improved products, which has helped maintain its market leadership.
In further evidence of its commitment to innovation, it has partnered with California-based Stanford Research Institute in an attempt to develop the next big disruptor for the reduction gear market. In particular it is developing a new gear now called Abacus Drive.
HDS has seen a significant decline in its stock price in 2018, driven by two key factors which we believe are unfairly punishing the stock and creating an excellent buying opportunity.
Firstly, the stock prices of all robotics related companies have been under pressure due to declining orders and amid an uncertain automotive sector (a key customer for robotics) further aggravated by the trade war between the US and China, which has put the Chinese economy under clear pressure. HDS also has to deal with slowing order intake after a temporary explosion in orders last year, causing shortages of gears and HDS’ lead time to deliver its product to expand from a typical 1-1.5 months to 11 months. This is now normalising. Investors appear disappointed by a hardly surprising decline in orders, which we believe will prove temporary. Periods of weaker orders are to be expected in a cyclically growing industry such as the one HDS operates in. We believe however that in the coming 3-5 years, which is our investment horizon, HDS will benefit from growing end markets given the opportunities discussed earlier. Non-automotive sectors are becoming more important users of robotics, diversifying its revenue base.
Secondly, reports of a competitor called Nidec Shimpo entering the market has made investors fearing increased competition, especially as it has the backing of a large parent company and its stated intention to sell gears at a 20% discount to HDS.
Clearly, this is a threat we have looked into carefully. We learned that Nidec is selling gears 20% cheaper because it has a very limited track record of product durability and its gears are perceived to be of lower quality so is unable to justify pricing at the same level as HDS. Track record of product quality, even after extensive testing, is something that cannot be replicated quickly. Given that there have been shortages of reduction gears in the market, robot manufacturers may be interested in trying Nidec gears, but we believe this will be on a fairly limited basis. Having spoken to various robot manufacturers, we believe it will take some years before manufacturers will have enough experience with Nidec gears for application in core products. It is simply too much a risk to switch without long duration testing in real production environments. We will closely monitor developments here but currently do not believe Nidec’s entrance hinders HDS’s long-term growth opportunity. Over-the-cycle demand for reduction gears outstrips supply so we believe there is sufficient room for more than one player in the market. Even if Nidec successfully penetrates the market and gains some market share from HDS, we believe this would not meaningfully affect HDS’ top line growth potential. Nidec itself mentioned it aims to be a secondary supplier in the market, acknowledging the difficulty of displacing HDS as the industry standard.
Between its peak in January and when we first purchased the shares in October 2018 HDS’s shares had fallen by 50% creating what we believed to be an excellent entry point for long-term patient investors. Our initial fair value estimate implied approximately 50% upside versus a downside risk of 30%. A further share price decline significantly improved the risk/reward ratio and lead us to increase our holding in December to 2.5% of the portfolio.
With its status as the de facto standard we believe HDS should be able to take advantage of a structural growth opportunity for years to come. We believe that once the temporary weakness in orders passes and sentiment improves from its currently depressed levels, the stock can move up sharply.
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