Big player in Japanese medical device import and repair business is almost a net-net

IMI is a near net-net which has been growing and has somewhat of an economic moat.

They import artificial respirators anaesthesia devices, percutaneous gas monitors, brain function monitors, infrared oxygen monitors, and various other types of related equipment, and rent it out and provide maintenance for it (that is the bit I like). You can see a list of their products here: http://www.imimed.co.jp/rental/summary.html – It is in Japanese, but it is all single noun phrases, which Google translate can handle well. They are the largest player in the Japanese artificial respirator market.

Growth

The company basically has three divisions: Products, Rental, Maintenance, as well as Legacy Sales, which do nothing for income but are just pass-through sales. In the last release with an update (the annual report), artificial respirator sales were down 13% on the year (1.4B yen), monitors were up 16% (0.49B yen), and other products were up 17% (1.9B yen). Rental was artificially inflated a few years ago due to increased respirators sales with the fear of H1N1, so it is moderating.  Maintenance is falling despite an increase in the number of maintenance contracts, because hospitals are saving money by not getting IMI to do maintenance for other companies products – sounds bad, but growth in IMI products now is likely to lead to growth in maintenance in the future. As mentioned, the legacy products are basically pass-through sales, and generate almost no income.

So, how have they managed to grow while the rest of the Japanese hospital market is in so much pain?

The answer is basically that their sales to university hospitals (about 20% of total sales) have made up the slack, growing at 28% in 2011. Also, only 28.5% of their sales are to publicly owned hospitals, which are the worst affected by public spending, and the balance (about half of revenues) is from privately owned hospitals.

 

Pricing

A major reason why many people are worried about medical device makers is the mandated price decreases from the central government. Essentially, the amount of money available to spend on medical care depends on how much the government wants to spend on it (insert your own joke about the profligacy of the government here). Every two years they review the amount to be spent, and they have been some pretty sharp price cuts in certain areas (pharmaceuticals come to mind). Due to the inability of most companies to raise prices, there is an unusual amount of product innovation within Japan, as bringing out a new product is the only way that companies can ever get to raise their prices. However, it is clear that there is a struggle between the ministries (which are a little bit like gods on Mount Olympus, or perhaps like Stalin – unaccountable, dictatorial, etc.), with one wanting fiscal prudence, and another wanting innovation. Add to the mix large groups of doctors, dentists, pharmacists and nurses organised into organisations which lobby ministries, as well as companies doing the same, and you can easily see that the whole thing is like six head chefs in a kitchen.

But the interesting thing is that in the most recent price diktat, there was an overall increase in prices for the first time in 10 years (of 0.004%), and prices went up for doctors, dentists and pharmacists, and down for drugs and materials. Within this there were some changes positive for IMI, such as the increase in the allocation for home nursing, surgery and specialist technologies, but we still have not had one quarter with the effect of this change. The company says that they expect this to increase demand for medical devices at ER departments, but that the effect will be small, and that “fierce” price and service competition will continue. NB: “fierce” competition in most Japanese markets is equivalent to “average” in the US or Europe – IMI has 34% operating margins for its product import business.

It is definitely worth paying attention to changes in government policy, because Japan is, after all, capitalist in name only and basically a quasi-socialist country (if you don’t believe me, try to sue anyone in government or in a big business).

Benefiting from the yen’s strength

The strong yen is a tailwind for importers (obviously), and IMI had about 108 out of 1655 million yen in 2011 operating earnings from currency effects.

 

Good attitude

I like the fact that they have taken a hit for restructuring and disposing of low-margin subsidiaries (related to artificial respirator cleaning and drying equipment, as well as defibrillators.) This is rare for Japanese companies. The CEO owns over half the company.

 

Dividend policy

The policy is for a payout ratio of 30%. The dividend has been stuck at 60 yen (4%), while the ratio has been falling and is now just above 30%.

 

Valuation

With a market cap of under 8 billion yen, current assets of 9 billion (of which 6.4 billion is cash, 0.7 billion is inventory, and 1.2 billion is receivables), and total liabilities of 2.1 billion yen, if this were anywhere outside Japan, the market would be telling you to expect a bankruptcy filing to be somewhat likely. However, with net margins of 11 – 12%, net income last year of 0.9 billion yen, and free cash flow (after capex) of comfortably over 1 billion yen, this is basically a steal.

 

The downside case

We know that healthcare prices in Japan are constrained. What if there is increased competition, or if hospitals group together to import equipment directly? Hospital mergers are happening, but this is a mature market with no significant new entrants, just a managed decline for now. The age structure of the country means that there will be more spending overall on healthcare but prices may be forced down by the government, which any economist can tell you will lead to shortages. The distortions are complex and interesting – while nursing wages are not rising at all, advertising rates for nurses have been rising a lot and nurse staffing agencies are making a killing right now.

What about a worst-case scenario? What if, say, one third of their clients defaulted on their payables to IMI, and then suddenly competition drove margins on product sales down by half (it should not go to zero because importers can always make margins by buying in bulk, and importing medical devices is not like importing a sack of potatoes or a roulande of cheese – it is harder to do, particularly in the red-tape paradise that is Japan, and this blocks out some competition.)

Well, in that case, taking the product import and servicing (maintenance and repair) markets as separate and only applying the discount to the product sales part, you would knock down the cash flow by about a quarter, and add 0.6 billion to the enterprise value – and it would still be cheap at that level.

Another way to look at this is how much lower to the shares need to go for the company to be trading as a net-net, and that is less than 10%. Would you buy this 10% above bankruptcy value? I think Ben Graham would be OK with this one, despite the loose approach to the current assets.