R&I Rating Methodology by Sector March 9, 2016
Capital Equipment, etc.
This rating methodology for capital equipment, etc. discusses the firms that offer equipment and related services in the form of so-called B to B transactions, and regularizes its evaluation parameters. R&I envisages the scope of this rating methodology broadly, as enterprises engaged in transactions between firms or with government and municipal offices. When it has prepared a separate rating methodology for an industry, however, R&I will apply that separate rating methodology even if the entity being rated is included within the scope of this capital equipment rating methodology. When judging the applicability of this rating methodology to a firm, R&I looks at whether the firm is a manufacturer that handles capital equipment utilized for production, development or the provision of services, as well as the components and devices necessary for such capital equipment, and whose customers are juridical persons such as firms and government offices. Examples of such firms as categorized using the Nikkei industrial classification are firms and businesses that conduct B to B transactions, in sectors such as machinery, electric machinery, precision instruments and other manufacturing. While firms that focus on a domestic niche market are encompassed as well, R&I bases its rating methodology on the assumption a subject entity operates in a global market.
I. Evaluation of Business Risk 1. View of industry risk Firms classified as part of the capital equipment industry are wide-ranging and face varied risks depending on users, products and business models. Consequently this rating methodology only highlights the industry risks that serve as the common basis to evaluate such firms. Differences that exist because of the industry with which a firm is identified or the products a firm handles are incorporated in the evaluation of the individual firm. Viewed globally, capital equipment markets can vary in size from niche markets worth several tens of billions of yen to product markets in excess of several trillion yen. Despite short-term swings in the volume of orders received, however, every market is projected to enjoy comparatively steady
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growth, driven by emerging countries, for example. Because the customers using capital equipment are professionals in their respective markets, capital equipment products are not goods where a company can win customers by price alone, and continuity of transactions can be anticipated. For many of the firms and businesses in the industry, the mass production model is not suitable, and a comparatively light investment burden can also be cited as one characteristic of such entities. In light of the above, R&I considers the industry of capital equipment, etc. to have a “medium degree” of risk. Specifically, industry risk is assessed based on the points mentioned below.
(1) Market size, market growth potential and market volatility The markets for products that are unrelated to one another cannot be aggregated and viewed as a single market, even though entities employ the same B to B framework. While some manufacturers of capital equipment, etc. target niche markets, some target markets worth several trillion yen. When all capital investment-related products are included, the entire market size will be at least tens of trillions of yen. When viewed over a medium- and long-term timeframe, an upward trend in capital investments has continued in conjunction with growth in the global economy. The products to which R&I applies this rating methodology are diverse, ranging from those with high growth potential to those for which markets have matured. Market volatility is rather high. Users’ investment sentiments are highly susceptible to economic vicissitudes, and even during an economic recovery they will sometimes adopt a prudent stance. As a result, even though orders may drop sharply hand-in-hand with a deterioration of the economy, a resurgence in orders can often lag behind an economic recovery and require a considerable period of time.
(2) Industry structure (competitive environment) In this industry risk evaluation R&I does not assume products or operations that demand large production facilities like those in so-called process industries, or intensive technical innovation. To a certain extent, in-house manufacture by users and market entry by new players are both possible, and R&I judges the competitive environment to be comparatively severe. However, because users set high reliability and durability requirements for capital equipment products compared with consumer products, the barrier to entry somewhat rises when an organization to ensure a certain level of maintenance or repairs, etc. is required. Consequently in
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some cases a firm will evolve toward a near-monopoly position in a niche market, and even in markets of a certain size, an oligopoly can develop. While public works investment partly supports domestic operations, the manufacturers that purchase capital equipment continue to set up operations overseas. One concern is that competition will intensify with the contraction of the domestic market. In overseas markets, new rivals that offer a competitive price or have strength in integrated system solutions are emerging. Although the position of technologically superior manufacturers remains unshaken in products that demand accuracy, users, especially those in emerging countries, exhibit a strong preference for low-priced products. There are instances as well where orders are placed preferentially with local businesses as a national policy. Competition with emerging country manufacturers cannot be avoided through superior product development capabilities alone.
(3) Customer continuity and stability Customer continuity is comparatively high. Users wish to avoid a decline in productivity, and tend to be cautious about substituting capital equipment with another company’s products. A capital equipment manufacturer’s strengths and weaknesses depending on the product also work in the direction of higher customer continuity. Even when markets overlap, this does not necessarily result in competitive relations, and in some cases there is advanced compartmentalization based on areas of expertise. Moreover, there are two business models for capital equipment: one built around transactions that are completed upon product delivery, and one that involves ongoing transactions through the supply of maintenance services and sale of repair parts. The latter case offers additional advantages, such as the ease of making timely new product proposals as renewal periods approach, as well as aiding a next product development project based on a continued understanding of the conditions under which equipment is used. These lessen the possibility that customers will move to another company.
(4) Capital and inventory investment cycles Unlike process industries, mass production of specific products is rare for capital equipment manufacturers, and manual assembly of some capital equipment and components remains. Due partly to the widespread use of outsourcing, firms do not have a very heavy capital investment burden. The working capital requirement, however, tends to be significant. There are cases where equipment is reported as revenue only after the product has been delivered and the customer has completed its inspection, and the accounts receivable collection period can easily be prolonged.
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Another aspect is that not many parts are produced in-house, and maintaining a large stock of purchased components can push up the inventory burden.
(5) Protection, regulations and public aspects Basically, there are no protection or regulation aspects that affect creditworthiness. Users tend to give priority to manufacturers in their own country, which seems to reflect the fact such manufacturers have proven track records based on past business relationships and can offer local designs that are suited to customers’ characteristics. On the user side, there are restrictions requiring the use of lead-free metals, as well as various restraining factors and technical innovations based on energy conservation regulations. Responding to these trends is essential.
(6) Cost structure Without the need for large-scale capital investment in many cases, the burden of fixed costs for production is comparatively light. Because many components are not manufactured in-house, however, products are easily affected by prices for materials and components. Profitability tends to be squeezed when raw materials costs rise. For items supplied for state-of-the-art products with short technical innovation cycles such as semiconductors, the development cost burden can easily increase. R&D spending is a source of future competitiveness, so cutting the spending is not easy for any firm. In the case of firms whose competitiveness can be undermined without continued large R&D investments, their cost structure can easily become inflexible.
2. View of individual firm risk When deciding the business risk of each company, R&I first considers the industry risks common to all manufacturers handling B to B capital equipment and related services and then factors in the risks confronted by the individual firm.
(1) Market size and market share When looking at a company’s competitiveness, R&I places considerable emphasis on market share based on sales. A firm’s comprehensive product competitiveness, including its technological capabilities and marketing and sales skills, is manifest in its market share, helping the firm to occupy a dominant position in price negotiations with upstream and downstream manufacturers.
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Nevertheless, it is also important to scrutinize a relative comparison of market share with a firm’s competitors. Even for firms that have secured a high market share, gaining outstanding price bargaining power is no simple task if competing firms exist and market areas or sectors overlap. Even if an entity has an overwhelming share of its market, there will be limits on the evaluation if the market is a niche, or is limited to just the domestic market. The reason is that it is not easy to increase the ability to generate cash flow and build capital.
(2) Diversification of users Demand for capital equipment, etc. is susceptible to external factors such as economic fluctuations. Even so, if sources of demand (users) are diversified across a number of sectors and areas, earnings volatility risk can be mitigated. Demand can be broadly divided into that from the public sector and that from the private sector. Public demand is easily affected by budgets, but its sensitivity to business conditions is limited. Private demand exhibits differences in sensitivity depending on product applications. A company will be able to mitigate the effects of an industry’s unique business cycle, however, if it has developed its business across several industries. R&I also attaches importance to the diversification of customers within an industry because such diversification can alleviate the risk of a drop in orders stemming from the failure of its purchasers within an industry. Meanwhile, even if a company serves a specific customer, earnings stability can be achieved, provided that the transactions with the customer are primarily those that would generate replacement demand continuously. R&I evaluates geographical diversification based on the location of customers. The diversification of sales territories is considered an important factor in assessing the diversification of users because it can mitigate the effects of economic fluctuations in a specific region.
(3) Continuous, stable earnings sources One positive evaluation factor is a company’s creation of a business model that generates stable earnings because, generally speaking, for the build-and-sell business model that does not involve subsequent maintenance or similar services, users in many cases will defer equipment upgrade investments when the business barometer falls, and it is difficult to mitigate the impact of economic fluctuations. For its evaluation criteria, R&I looks at the proportional breakdown and depth of revenue and income from maintenance/repairs that are secured by contracts or goods such as consumables, which have short product life cycles and require investment that is difficult for
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customers to defer.
(4) Product substitution risk and technological flexibility Although R&I fundamentally considers substitution risk to be low, products such as specialized capital equipment for specific applications are shadowed by the risk a market will disappear through substitution of a user’s final product or the process of technical innovation of the manufacturing method. Achieving high evaluation is difficult when there is significant risk that a market will disappear or that a product will be replaced to a considerable extent because of the emergence of an alternative product. In light of the future substitution risk, R&I also carefully examines what countermeasures a company has taken, including R&D. Despite signs of actualization of a market or product’s substitution risk, R&I may make a comparatively strong positive evaluation if it can judge a company to be in an advantageous position because of the high capability of responding technologically by, for example, obtaining a patent for next-generation technology.
II. Evaluation of Financial Risk In addition to quantitative factors in the form of financial data, R&I also evaluates qualitative factors, such as a firm’s financial management policy and liquidity risk, in its analysis of financial risk. Based on the business characteristics, R&I emphasizes the following financial indicators with regard to the industry of capital equipment, etc.
(1) Earning capacity Operating profit margin EBITDA (earnings before interest, taxes, depreciation and amortization) margin R&I believes that earning capacity succinctly expresses a firm’s comprehensive product competitiveness, including its technological capabilities, marketing and sales skills and price bargaining ability. Because the capital equipment industry experiences somewhat high market volatility, a company, in order to maintain strong creditworthiness, needs to have enough earning capacity to keep cash flow positive even when the business climate has deteriorated and orders have dropped. In its evaluation of earning capacity, R&I attaches the greatest importance to the EBITDA margin. Because capital equipment spans a broad range of business sectors, and costs such as depreciation expense and required working capital differ depending on the product handled,
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cross-comparisons of operating profit margins and ROA are difficult. R&I thus considers the EBITDA margin, which eliminates the effects of an investment burden, to be an appropriate indicator. To examine the capacity for R&D investment, R&I looks at the operating profit margin, because it indicates whether a company is generating sufficient profits after depreciation.
(2) Scale and investment capacity EBITDA Equity capital To maintain and continue to strengthen competitiveness, a certain level of investment is indispensable. R&I therefore looks closely at the amount of EBITDA, which indicates the amount of investment capacity. The reason is the investment burden can be assumed to grow when a company develops its business overseas and expands its business territory, or undertakes large-scale plant construction, even though many of capital equipment products are relatively niche and some products do not necessarily require a heavy investment burden. R&I emphasizes the amount of equity capital as a risk buffer against periods when a company reports losses. The capital equipment market is susceptible to the investment intentions of its users, and volatility is somewhat high. If confronted with a sharp plunge in orders, firms might slip into the red because of a delay in cost reductions and, take asset impairment write-offs on production facilities, inventories and other assets, and in some cases see their equity capital eroded. If maintenance and other after-sale activities are included, transactions with a user extend over a long period. A strong equity capital cushion serves as a buffer when products and services must be supplied continuously even during a downturn.
(3) Debt redemption period Net debt/EBITDA ratio Net debt/operating CF ratio Compared with consumer products, capital equipment has a long product life cycle. Products are replaced with new products only infrequently. For the A rating category, firms do not necessarily have to be substantively debt-free. When a firm has debt that substantially exceeds its ability to generate cash flow, however, this creates a concern it will lose the business management flexibility that could be necessary in the future for capital investment and R&D. Depending on the product handled, the accounts receivable collection period could be long, and the burden of inventories, mainly of materials and components, tends to be heavy. R&I looks closely
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at the ratio of net debt to EBITDA, as well as net debt to operating cash flow, which indicates the funds actually generated from operating activities.
(4) Financial profile Equity ratio Net D/E ratio (ratio of net debt to equity capital) To verify a company's financial leverage is not excessive, R&I emphasizes the equity ratio. Simply because capital equipment is an industry where orders can fall sharply depending on the economy, firms must maintain a debt-equity structure that will enable them to sufficiently absorb temporary losses. A company’s financial profile, including its net D/E ratio, is important for examining its capacity to raise funds. Depending on the business or product characteristics, in some cases the financial profile may fluctuate every quarter because of changes such as an increase/decrease in working capital, which necessitates a certain amount of caution.
III. Rating for the Industry of Capital Equipment, etc.
Issuer Rating
Individual Firm Risk Market size and market share Diversification of users Continuous, stable earnings sources Product substitution risk and technological flexibility
Financial Risk Importance ◎ ◎ ◎
Earning capacity Scale and investment capacity Debt redemption period Financial profile
○
Indicator Operating profit margin EBITDA margin EBITDA Equity capital Net debt/EBITDA ratio Net debt/operating CF ratio Equity ratio Net D/E ratio
Importance ○ ◎ ◎ ○ ◎ △ ◎ ○
Industry Risk: Medium
Note) Importance is indicated by ◎: extremely important, ○: important, or △ relatively important.
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* This report replaces all previous versions that have been released to date.
The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited without R&I's prior written permission. Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese the information written in Japanese will take precedence.
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