A stock for the future: Electronics, Appliances and Automation

In addition to this supportive cyclical backdrop in Industrial Automation, we think a large part of ME’s portfolio of businesses should also benefit from several structural tailwinds set to play out over the next few years.

As one of the world’s largest manufacturers of air conditioning units, ME will play a leading role in supplying some of the most energy efficient units to help drive down global GHG emissions. To demonstrate its commitment to reducing GHG emissions, ME has announced a net zero GHG target by 2050. As one of the world’s largest suppliers of electrical components to the transport industry, ME will also be front and centre in the electrification of various transport modes around the world. Additionally, ME should benefit from the likely increased demand for automation solutions as the world faces major demographic headwinds and shrinking labour pools. In addition ME screens very favourably in the ‘Social’ and ‘Environmental’ pillar of our ESG framework given the immense societal benefit of ME’s products and services, particularly as global economies begin transitioning to ‘new normals’.

Governance shortcomings and response

Typical of most diversified enterprises, one of the inherent risks and challenges ME faces is ensuring proper oversight of often far-flung local operating units. This became very apparent when the company announced that fraudulent product testing had been identified at some facilities within the Electronic & Energy segment.

While clearly disappointing from a Governance standpoint, ME has at least acknowledged the severity of these incidents and demonstrated a commitment to improving its internal risk management protocols. For example, both the CEO and Chairman have resigned, with the Chair to be replaced by an independent external candidate. The Board has also appointed an externally chaired committee to investigate each of ME’s 22 facilities (findings due in April 2022) and established a ‘Governance Review Committee’ to identify control improvements. Finally, ME has flagged US$260m in IT upgrades and the creation of a new ‘Quality Assurance Division’ to be led by a direct report into the CEO to enhance group oversight.

It is still early days, but we also take some comfort in the fact that these incidents have largely been confined to the Electronic & Energy segment and don’t yet appear to be widespread. Furthermore, while management have yet to quantify the financial impact of these internal control failures, we don’t think they will likely be material. In any case, ME has the balance sheet flexibility to fund any large potential liability with ~JPY500bn of net cash on hand (~US$4bn).

After the share price weakness, ME is now trading on an EV/Invested Capital multiple of ~1x, which is a level the stock has rarely traded below. The combination of decent valuation support and a strong balance sheet caps a lot of the downside potential from here.

Longer-term financial targets

Management have set a March 2026 EBIT target of JPY500bn. This solves for a Return on Capital of more than 15%, which would result in a share price around 2,600 range, if the market capitalises those returns on a multiple of ~1.5x EV/Invested Capital. 

Source: Talaria, Company Reports