By Lee Gyu-sun

We initiate our coverage on Dongyang Mechatronics with a buy rating and a target price of 25,500 won ― up 60 percent from the current price. We derived the target price by applying a target price to earnings ratio (P/E ratio) of 13.5 to our forecast for the 2012 earnings per share of 1,884 won. The current price of 16,250 won corresponds to the P/E ratio of 8.

Our investment recommendation is premised on the following. Firstly, the Chinese construction equipment market is projected to be weak in the first half and strong in the second half. Dongyang’s fundamentals are improving on the restocking of parts by local machinery companies in February.

Secondly, Dongyang emerged as the top hydraulic cylinder maker in China based on its 30-year experience. The company took up the lion’s share ― 30 percent ― of the hydraulic cylinder market in China in 2011 with sales to local companies accounting for 45 percent of the Chinese subsidiary’s revenues.

Thirdly, the large-scale expansion of domestic and overseas production facilities should provide further growth momentum.

Lastly, the company is benefiting from an increase in outsourcing by machinery companies, including Hitachi and Caterpillar.

Leading in China

Established in 1978, Dongyang Mechatronics currently operates three businesses ― hydraulic cylinders, auto parts, and industrial machinery.

The hydraulic cylinder business is specialized in excavator cylinders, and the auto parts business produces wiper modules and direct current motors for windows. The industrial machinery business produces truck cranes, concrete pump trucks, car washing machines and golf carts.

Dongyang takes up over 50 percent of the hydraulic cylinder market in Korea, and is a leading machinery outsourcing company in China with a market share of 30 percent.

The hydraulic cylinder, auto parts, and industrial machinery businesses are projected to generate 53 percent, 36 percent, and 11 percent of consolidated revenues respectively in 2012.

Each business’ contribution to parent-based operating profit came in at 45 percent for hydraulic cylinder, 39 percent for auto parts, and 16 percent for industrial machinery in 2009. Considering that hydraulic cylinder sales generate 60 to 70 percent of the Chinese subsidiary’s revenues every year, the business’ contribution to consolidated operating profit is estimated at 70 percent. As earnings at the hydraulic cylinder business outweigh those from the auto parts business, the company can be classified as a machinery company.



Dongyang’s potential maximum production capacity is estimated at 1.4 trillion won ― 900 billion won for the domestic and 500 billion won for Chinese facilities ― in light of the size of its production sites. As a result of a large-scale capacity expansion in 2011, including the second Chinese hydraulic cylinders plant, the Asan auto parts plant, and the Changwon hydraulic cylinders plant, the company’s actual capacity based on facilities and workforce is projected to have improved to 1 trillion won.

Meanwhile, the first Chinese plant in Yantai was established in 2001 as a wholly-owned subsidiary. The second plant in Jiangyin began operations earlier this year.

Dongyang emerged as the top hydraulic cylinder maker in China on the back of its know-how in heat treatment and precision metal-cutting gained over 30 years.

Given that acquiring such technologies takes a long time, we expect the company’s market power in China to further strengthen.

The company is supplying hydraulic cylinders to eight Chinese companies including Sany and Yuchi. Sales to local companies as a percentage of the Chinese subsidiary’s revenues have steadily improved from 16 percent in 2009 to 34 percent in 2010 and 45 percent in 2011.

Meanwhile, the percentage of sales to its largest customer Doosan Infracore in the subsidiary’s revenues has slid from 72 percent in 2009 to 54 percent in 2010 and to 40 percent in 2011.

Third rally

Dongyang Mechatronics experienced big rallies in 2007 and 2010, both of which were driven by hydraulic cylinders. In 2007, strong sales of hydraulic cylinders in China boosted the Chinese subsidiary’s revenues by 172 percent year on year, despite sluggish auto parts sales. At that time, the contribution of hydraulic cylinders to revenues outpaced that of auto parts, for the first time in the company’s history.

In 2010, the heated Chinese excavator market raised the revenue contribution of hydraulic cylinders to over 50 percent, boosting Dongyang’s consolidated revenues to over 600 billion won.

In addition, expectations of the company’s capacity expansion through the construction of the second Chinese plant and the Asan plant have lifted its shares further. However, the rapid cooling of the Chinese excavator market in the second half of 2011 depressed the company’s earnings and led to the delay in the operation of second Chinese plant. Thus, Dongyang’s shares have been sluggish for about six months since July 2011.

We believe Dongyang Mechatronics will soon stage a third rally. In light of the recovery of the construction equipment market in China and the company’s competitiveness in hydraulic cylinders, Dongyang Mechatronics is expected to generate historic-high earnings in 2012.

We project Dongyang will generate historic-high earnings in 2012, with revenues of 808.9 billion won (up 12 percent), operating profit of 77.4 billion (up 17 percent), and net profit of 59.7 billion won (up 41 percent) under consolidated K-IFRS. Operating profit margin and net margin are also expected to improve to 9.6 percent and 7.4 percent respectively.

The hydraulic cylinder business is anticipated to take off sharply in March in line with the upturn in the Chinese construction equipment market.

In addition, an increase in sales to the Hyundai Motor Group should diversify its customer base and strengthen growth potential.

Furthermore, the company’s investments should bear fruit as the second Chinese plant and the Asan plant are scheduled to commence operations this year.

Lee Gyu-sun is the leader of the small cap team at Daewoo Securities’ research center.