Sorry to ask this, but…

*This is an article I wrote for the Japan Summit of Value Conferences. It was very good, and two presentations in particular stood out (Alexander Kinmont and Shuhei Abe).

How much would you pay for Company X?

I want to cut to the chase quickly…

How much would you pay for a freight forwarding company with the following characteristics?

Your guess

Okay, perhaps I have been a little sudden. Perhaps you are not ready to make a decision yet.

But, what do you do, by the way, when you have insufficient information? You discount the information you have – or, rather, that somewhat large error bars around it, to protect yourself.

So what would you pay, given the limited information above?

You might assume that the growth has been good in the past, but will not continue. You might assume that the current assets are full of junk.  However, this company is not full of junk, and is continuing to grow.

The reason why I left out currency units in the table is because Company X is a Japanese company, and this would have biased your reasoning such that you would have assigned is an extremely low multiple.

Let’s look at some more information about this company and see what would be a reasonable price.

Company X is actually AIT, an Osaka-based freight forwarder mainly dealing with sea containers between China and Japan.

They do not own operating assets, but they stand between the shipping companies and the end consumer wanting to ship some products between China and Japan (mainly from China to Japan).

A freight forwarder is basically an office full of people in suits with telephones and faxes, with a few warehouses here and there. The suits get on the telephone and make sure that the goods get to the right place. This is harder than it sounds, because there are all kinds of complications like customs, and customers are fussy.

The value of the company as a living entity (i.e. above the simple value of its balance sheet) lies in main competitive advantage, which is know-how. I know this may be a little bit of a fuzzy concept, however, as an example, shipping brokers such as Clarkson can be fantastic businesses and all they have is know-how (the same applies, in certain conditions, to investment banks). The next good thing about it is that it does not require capital to grow. Further, as it grows in size, its competitive advantage also grows – once you reach a certain size in dealing with shipping companies, you can demand better rates. However, obviously, neither of these will be much help if there is a protracted slowdown in exports to Japan from China. Although there is a huge number of companies involved in the sea freight logistics business between the two countries, including trading companies and manufacturers handling their own operations, the customer-facing aspect of it is quite tricky, which narrows down the competition a lot.

From a foreigner’s point of view, it may seem strange to be betting on Chinese-Japanese trade just when the Chinese boom seems to be losing steam. But remember that trade between Japan and the rest of the world grew a lot while its own bubble-inflated economy was flatlining. However, this might not be a terribly good analogy for the current state of affairs, because Japan was digging itself out of its deflating bubble while America and the rest of the world were generally growing well. Also, AIT’s business depends on imports into Japan, which makes it a bit of a bet on the Japanese economy (but it is more of a bet on the management, I think). You can take a little comfort from the fact that dealing with Japanese customers is difficult, and they have got this buttoned down. They are particularly focused on small products and clothing.

Anyway, the reason why I was attracted to this company in the first place was the surprisingly high frequency of comments in other companies’ management discussion & analysis disclosures featuring plans to expand into China.

The company has offices/ facilities in every major seaport along the coast of China – Shanghai, Hong Kong, Da Lian, Tianjin, Qingdao, Nantong, Suzhou, Ningbo, Xiamen, Shenzhen, and Guangzhou. And, in fact, they have more employees in China (200) than in Japan (179).

So, moving back to the discussion of their valuation… here is some more information:

This is their growth profile (notice margin expansion due to economies of scale):

AIT Growth profile

Could you tell there was a major recession somewhere in this period?

Well, there was, and trade between China and Japan looked like this (in red below; blue = US-Japan trade).

AIT J-C Trade

Source: http://www2.ttcn.ne.jp/honkawa/5050.html

The company does report geographical segments (with Japan accounting for c. 87% of operating income). However, these do not tell us a great deal about what its prospects might be like, so I have omitted them here.

Growth:

They are building a logistics center in China, but basically they are growing through adding staff. The first reason why I like this company is that does not require capital to grow. It has already got most of the facilities it needs, and it only needs to hire some people in suits and set them in front of telephones (with training, etc.) to increase their capacity. And, they also have economies of scale, so the incremental benefit of doing this is fairly good on a cash flow basis. I also like the fact that the company has a good track record of executing on its promises.

Balance sheet:

After cutting various suspicious items such as prepayments and advances within the current assets by half, and removing altogether things like deferred tax assets, I arrived at an adjusted current asset value of 3.37 B Yen, not a huge reduction from the current asset book value of 3.7 B Yen – this is because a lot of this is cash. I only cut accounts receivable by 15% because their receivable days are just 13.7, and their largest accounts receivable debtor accounts for less than 8% of the total amount. (Note: You can only get the full breakdown in the annual filing, so these estimates are using extrapolations of those numbers with the last quarterly filing).

They have about 450 M Yen of investments, however, only 100 M Yen of this is in securities – the rest is in things like related company shares and deferred tax assets.  I assigned a value of 50 M Yen to these securities, and after netting of the 1.34 B Yen of total liabilities, I get a value for the company as a dead entity of 2.1 B Yen.

So here are some ideas for what you might pay for this company:

AIT Valuation table

*Note: the multiples for the peer companies are just their p/e ratios for last year with earnings multiplied by an assumed growth rate of 10% for each.

Concerns:

Now, the actual market cap of the AIT is 5.5 B Yen, which is about 8 times next year’s earnings, but I think it makes more sense to see it as an adjusted enterprise value (using the market cap minus the above adjusted net current asset value) of just under 5 times next year’s earnings.

This company appears to be able to grow despite adverse conditions. Even though imports from China to Japan peaked in 2007, at 15 T Yen, bottomed in 2009, at 11.4 T Yen, and have been rebounding gradually since, the company has been growing as if nothing happened.

Therefore, the market must be concerned about something, and you may have noticed the forecast decline in margins in the above table. I think the concern is better illustrated by this chart, which seems to get at the core of the business:

AIT Op inc vs staff to 2013

There is a potential issue over the apparent decrease in efficiency (operating income per staff). This may be valid, but you also need to consider that: 1. they are increasing the number of staff in China, and this will dilute the efficiency per employee but not damage the value of the company, and 2. there is a lag between increasing staff and increasing operating income.

And… this looks very similar to what happened in the years up to 2009:

AIT Op inc vs staff to 2009

The only way in which the valuation of this company can make sense at present is if imports from China into Japan collapse*. This may of course happen – they would have to collapse and not come back for your investment to be seriously impaired – some people might view buying this stock to be like selling insurance on the China-Japan trade flow.

*Or if there is a flood of new competition – but stealing market share in Japan is difficult

But the way I see it is that the probabilities are in your favor. You do not have to bet that this company will be valued like EXPD.

By buying this stock you are betting that imports from China to Japan will be mediocre or better for the next few years.  If a calamity does not occur, then you will likely be paid out in the form of the shares rising to a more realistic multiple, e.g. 9 times earnings (net of balance sheet). That would be around 8.3 B Yen (+ 50%) using FY13 forecast numbers, but by the time the market stops being so pessimistic the earnings themselves may well be better.

You can think of this situation by taking the same concerns about adding staff that are not immediately productive to be good for you as an investor – this means that you can buy the growth at a discount, since the market’s view is that the extra staff will just be deadweight costs and will produce nothing, but this is not likely (leaving the macro situation aside). Further, this discounting should work the other way – if the company stops growing its staff, there will be a one-off positive effect on earnings (macro situation being equal). If the market is excessively discounting growth in the above way, then it would excessively reward one-off earnings spurt. I know this sounds a bit silly, but it does happen more than a reasonable person would expect, and at least you are getting something of an insurance policy in that scenario.

Perhaps all of this is a very roundabout way of saying “this is cheap growth, folks”. And you get 4.8% while waiting.