Two net nets with mild-to-moderate manginess

by admin on October 28, 2012

Ryoden is a company that I have heard mentioned many times by foreign investors, but Japanese people seem to know of it as a “perennial value stock”.  The fact that it is a trading company, and is involved in semiconductors (hold nose) has kept me away, because trading companies are largely impenetrable, and change the business they are in every so often.  Also, I don’t, in practical terms at least, know what a semiconductor is (other than something related to a box full of wires).

Ryoyo is also a semiconductor trading company, and it came to my attention through Monish Pabrai.

 

Let’s start with Ryoden.

Ryoden is a bit doggy-looking – CAGR of EPS from 2004 to 2012 = ZERO!

Ryoden net income & assets per share Ryoden net income, something like op inc,  assets per share

However, there is one thing about Ryoden that caught my attention, and I started looking into it.

In 2010, they set up a 3-year plan which involved “contributing to society through a profitable growth strategy”. Now, if they were not contributing to society before that time, I really don’t know what they were up to, because their profits were not great. They bottomed out in 2010 at around 25 yen per share, and are expected to be around 71 yen per share for fiscal 2013.

So that seems that the plan has been working, which is obviously good news.

You can see the plan here (in Japanese): http://www.ryoden.co.jp/ir/pdf/cp2012.pdf

The highlights are that basically they decided to focus on growth outside Japan (I can hear you saying “duh” – please be more polite) and on “environmental” products, which means energy-saving electronics.

(By the way, this company is a net-net – so the first question I asked myself was not about valuation, but rather: “Will I be able to understand the business model?”, followed by: “Is the company any good”)

Now, although they are a trading company, their business model is a little bit more transparent than those of other trading companies.

They explain their business model on this page: http://www.ryoden.co.jp/power.html

Although it is in Japanese, the graphic is quite helpful, I think.

Ryoden Ryoden

Basically, Japanese manufacturers of electronic goods are not very good at getting through to customers, apparently. Also, customers are not very good at approaching vendors. Ryoden is a middleman, but more than a warehouse – they are more like consultants. They get involved in talking about improving technology, supply chain management, and improving product purchasing with their clients. I know that this can be pretty hard to understand for people who are not familiar with Japan, but basically Japanese customers will always pay a bigger premium than you might expect to have things explained to them or arranged for them by middlemen. This gives rise to the phenomena, for example, of Japanese consumers loving package tours more so than those in other countries, Japanese restaurant customers very frequently going for set menus, and a surprising array of Japanese businesses offering “sets” of services and products in a single package as standard.  I just typed in to the Japanese version of Google the phrase “Buy it in a set” (in Japanese), and the top hits were:

Servers and CPUs

Land with a new building

Bathroom wear for men

Buying a set of seals (i.e. used to stamp official documents)

 

Anyway, there is an inherent demand for this kind of hand-holding service, particularly in new areas (when Japanese companies want to grow overseas).  Also, you need to know that Japanese companies have relationships with customers and suppliers that sometimes are incestuous when compared with Western “arms-length” criteria.

You can view it as a technology consulting company that gets paid through product re-sales and is directly involved in buying from manufacturers and reselling to clients, as well as in developing technology that they might need together with manufacturers. They are deeply entrenched with both the manufacturers and the clients, so this is a real barrier to entry, in my opinion.  The one snag is that being an agent of a large electronics company may make it difficult to ever expand margins meaningfully. But then again, you could view their margins as a function of the profitability of their electronics suppliers, which is increasing.

 

Since 2010, they have been increasingly focused on expanding in China. This may be a slight concern to those worried about politics recently (many Japanese factories in China are running on low production runs and many expats have come back to Japan from China – if you are not aware of this, you need to get with the program and read the news). However, their growth strategy relies on using local partners, who presumably will protect them from any direct pressure from angry consumers boycotting Japanese goods, although the indirect pressure will most likely still be there.

So the fundamental driver for this business is, in fact, not getting involved in any and all manner of business which seems profitable at the time (which some trading companies do – or, worse, they can get involved in businesses for political reasons), but rather it is the expansion of Japanese companies overseas.

Largest counterparty: Panasonic (27 billion yen of sales in FY12; 13.6%)

Geographical split:

Ryoden geographical revenue split Ryoden geographical revenue split

As you can see, their Japanese sales have been falling, but this has been made up for with growth overseas. You can view this as a play on “kudoka” (industrial hollowing out of the manufacturing base in Japan).

Unfortunately their segments were reorganized in FY2011, but here is the last two years of data (B Yen):

Ryoden segment results Ryoden segment results

Factory automation (which actually includes cooling/heating machines and systems for buildings such as elevators) is the area which they are trying to grow in, because it has good margins, whereas the electronic/communications part is the older part of the business. They were impacted by the Thai floods as well as the earthquake. If Chinese capital investment in factories grinds to a halt, then this will be a problem. However, note that private capital investment in Chinese factories is not the same thing as government overinvestment in civil engineering projects. When the Chinese economy eventually does rebalance, factories will find their labor becoming more expensive (see M. Pettis for an explanation on this), logically leading to investment in greater factory efficiency, even within a background of declining overall capital spending. However, note that it is difficult to say what the impact on Ryoden will be, because the other parts of their factory automation segment may be sensitive to other things.

Note about investments: Do not trust the “investments” number on their balance sheet at all – it is essentially marked to whim for securities, and is stuffed full of junk such as related company shares, restructuring bonds, etc.

Note about creditworthiness: Ryoden is a member of the Mitsubishi club, so it will not really ever worry about going broke.

Although Mitsubishi companies account for at least 7.5 B yen of accounts receivable, the haircut for these should be minimal, because there is just no way they could ever not pay, and to say that Mitsubishi is too big to fail is like saying that Goldman Sachs has political connections. The haircut for Panasonic should be higher, and the haircut for the rest (unknown counterparties) should be quite high, in my opinion – e.g. 35%. I only discounted short-term bills by 10%.

Btw – they had an outstanding Q1. Net inc. up to 457 M yen from 170 M yen in the prior year – it was all down to factory automation, which just went ballistic with margins exploding.

Valuation:

How much would I pay for the company? Well, I guess the balance sheet might be worth a lot less than reported, especially if you take down the products (boxes of wires, I think) down by 90% (who wants an old box of wires?):

Ryoden balance sheet Ryoden balance sheet

But the cashflow stream is worth something too.

With an average of 2.4 B yen in income over the last five years plus the one year forecast ahead, and with DD&A greater than capex on average, then you can call it 2.4 B yen of FCF per year. Obviously this is not a capital-heavy business, but that capex seems to be going into expansion overseas, which is good.

How much would you pay for this? The key is in the eye of the beholder, because if you think this business is a secular growth story (which it gives the impression of being – i.e. the kudoka thing), then in Japan this could sell for 10x FCF or more in a private transaction (net of balance sheet). I choose to assign it 7.5x. I would go for 5x normally due to their long track record of stunning mediocrity, but I have to say that I am swayed by their impressive recent earnings (which the stock market is yawning at).  The discount reflects my guess of the probability of the combined events of: a. China’s political situation (vis a vis Japan) will be a significant near term upset; b. China will have a growth crisis which will impact factory automation spending; and c. Japanese electronics companies retrench from overseas for any other reason.

So 7.5 x 2.4 = 18 B yen. Add that to my cut-down estimate of their balance sheet and you get c. 27 B yen vs. a market cap of 19.9 B yen – good, but not that good.

Return of cash: Dividends were cut in 2010 (just one case of many such unnecessary hair-shirts in Japan) from 22 to 18 y/sh, and are going up to 20 y/sh in FY13 (c. 4%) – not bad.  Last two FYs show repurchases of 2M yen (not meaningful).

Basically, in order to get extremely excited about this company you need to either have a strong view on their balance sheet – you could argue that my cut to the receivables is too aggressive, for instance; or, you need to believe that they will grow, which I kind of do, but although the first-pass “optics” of the valuation are fantastic, I just feel that the long-term appreciation potential depends on factors which could be constrained by Chinese headwinds – and this lack of clarity itself is a danger sign. The dividend is nice, but I believe that if the thesis does not slap you across the face, you should abandon it.

 

Ryoyo:

This company appears to be on the same line of business as Ryoden.

Is more internationally diversified in terms of revenues, but is probably a poor guide to the international split of op inc.:

Ryoyo Geo Revenue Split Ryoyo Geo Revenue Split

Also while Ryoden has found the area of relative prosperity that is factory automation, it seems that Ryoyo is stuck in more traditional electronics.

They try to explain their strategy here: http://www.ryoyo.co.jp/library/file/jp/ir/2012Q2_Result-Briefing.pdf

But honestly, they do a very poor job of this.

Their “strategy” is to become a total service company by building this, developing that, and accelerating global something.  Clearly, they are trying to “add value”, but they’re having trouble in putting that into a concrete form.  At present, it looks like a management consulting presentation gone wrong. Everything is being strengthened and accelerated, without specifying what precisely. However, they do allude to new areas of business, so potentially they could follow in the footsteps of Ryoden and get into higher margin areas.

Judging by the fact that Ryoyo has made a loss in the past few years, while Ryoden was relatively more resistant during the downturn last time, and given that Ryoden’s margins are higher than those of Ryoyo, it is reasonable to assume that Ryoden is a better business for whatever reason – either due to its specialization or the way it is run. However, I have a feeling that it is because Ryoden is in a better line of products.

Update: the company lost a major customer in ’08.

Ryoyo net income & assets per share Ryoyo net income & assets per share

Average FCF per year has been about 1.2 B yen.

Return of cash: Management reduced dividends from 40 y/sh to 30 y/sh in FY10, but increased them in the following year. Current yield is 3.6%. But… they spent about as much on repurchases as on dividend payouts, so the real return is about double that… quite tasty. Dividend policy: They will think about it when stuff changes.

Current asset treatment: same as with Ryoden. The “Ryo” means “bishi”, as in “Mitsubishi” in both names, and they are both under the umbrella.

Major counterparties: Toshiba-Mitsubishi Electric, Ryoyo Hong Kong, Fujitsu, Ricoh Electronics, Japan Hewlett Packard

Cut rest by 35%, cut bills by 10%.

Investments seem to mostly be bank bonds – and most of them were redeemed in the last quarter, so clearly they are real investments, and not political ones. Discount by 20%.

Ryoyo balance sheet Ryoyo balance sheet

So this company could be worth something like 37.2 B yen for the balance sheet and maybe 3x FCF, given its feeble track record relative to Ryoden, and no apparent growth (although that does mean there is room for growth, just to catch up), i.e. 40.8 B yen, which is significantly better than the market cap of 23.67 B yen. The lack of a no visible catalyst and the greater exposure to China than Ryoden are issues. But that return of cash of over 7% does make it tasty.

 

 

****UPDATE****

Additional info prompted thanks to comments from readers:

General method of journalizing liabilities: Straight line, allocating part of the next ten (Ryoyo) or twelve (Ryoden) years’ liabilities to arise for each employee into each future year’s P&L

Surpluses in any given year are given in the “Other” field on the balance sheet, while deficits in any given year are expensed in the following year.

Retirement liability stats (M Yen, except staff):

Ryoden:

No. of staff: 928

Average age: 40.4

Average no. of years at the company: 14.9

Average salary: 6.4 M Yen

Balance sheet:

Headline net retirement liability (2012 / 2011): 1726 / 1654

Retirement liabilities (2012 / 2011): 10,338/ 9,482

Retirement assets (2012 / 2011): 6,262 / 6,217

(Most of the difference between the net of these figures and the headline number on the balance sheet is actuarial differences, which were 2771 in 2012)

P&L: retirement expense (2012/ 2011): 605 / 620

(This is not anything useful, but just “friction” from the point of view of a shareholder – just getting ripped off by guys in suits, in my opinion)

 

Ryoyo:

No. of staff: 447

Average age: 41.3

Average no. of years at the company: 15.8

Average salary: 5.8 M Yen

Balance sheet:

Headline net retirement liability (2012 / 2011): 890 / 903

Retirement liabilities (2012 / 2011): 2738 / 2705

Retirement assets (2012 / 2011): 1940 / 1928

(These won’t net out to the total because they also have actuarial differences and prepayments, but the net of these numbers is still fairly close)

P&L: retirement obl. expense (2012/ 2011): 206 / 222

 

I do not think that the retirement situation in Ryoyo is a major concern because increasing the liabilities or reducing the assets by 50% would change the net liability by 1.4 B or 0.97 B yen, respectively.  With Ryoden, the same exercise just using the liabilities net of actuarial adjustments and assets gives you variance of 3.8B and 3.1B yen, so that is a significantly greater relative concern.

However, in general, care should be taken with some companies which are members of pension unions with peers from the same industry.  There have been quite a few cases where one company is struggling and the others need to bail them out. These two companies do not mention such arrangements in their annual reports, so they are most likely not members.

{ 10 comments… read them below or add one }

o-tone October 28, 2012 at 2:20 am

Nice post Jan.

“Judging by the fact that Ryoyo has made losses in the past few years….”

Hm. It had a tiny loss in- net income only once (2008) and a tiny one in operating income (but not net-income in 2009). Apart from those two years it was always profitable (at least the last 10 years), which is not too bad when one considers that they lost one of there most important customers (mitsubishi electric) in 2008. That’s also the reason why sales decreased so dramatically.

The trading sector has seen quite significant consolidation going on. I think their used to be over 20 of them at the beginning of 2000 and this number is under 10 by now (not 100% sure, if those numbers are right; can remember reading it somewhere)

Comparing the pay-out politics of those two companies would be of interest too. In the case of Ryoyo I know that they bought back around 7% of outstanding shares (that’s quite a significant amount) end of last year and canelled all of them (thats what should be done with repurchased shares).

Anyway, Have a nice weekend and keep on the good work.

Reply

admin October 28, 2012 at 9:32 am

O-tone – you are right.

It’s not such a big deal with the small loss – I guess it is only a heuristic of mine.

And – the return of cash is really a major part of the attraction to Ryoyo, so I added that in.

Thanks for keeping me on my toes – I wrote the whole thing late last night, and woke up thinking that it must be full of nonesense.

Also, it sounds like you know the sector well – I occasionally look at trading companies, but generally find them too messy. It sounds like you could make a really interesting write-up about it.

Do you think this consolidation is over?

Reply

Feuerball October 29, 2012 at 6:16 am

Interesting post. I agree that Ryoden looks better. I also looked at those japanese trading companies as value traps but it looks like those 2nd tier ones are way more attractive than the large Keirutsu companies like Itochu and Mitsubishi. I always wondered what these companies are actually doing and your post clarifies that to some extend. I have some experience with Hakuto, which looks quite attractive based on dividend yield alone and very sold looking balance sheet.

Reply

admin October 29, 2012 at 8:04 am

Ryoden only looks better operationally – whereas, Ryoyo, although crapper in various ways, seems better as an investment.

What is your thesis on Hakuto?

JP

Reply

Feuerball October 29, 2012 at 1:55 pm

Re Hakuto – i don’t have a these yet but i deal with them at work. For a japanese company, they are quite reasonable to deal with and seem to be technically competent.

So I started to look at the stock. Hakuto is cheap like many other japanese stocks but what caught my attention is the high and rising dividend yield and the strong FCF, which goes into paying back the little debt they have.
While Hakuto is no net net, I think they begin to run their business more efficiently and a 4.8% dividend is nothing to sneeze at.

Reply

admin October 29, 2012 at 9:00 pm

Feuerball – thanks for the idea. Hakuto looks interesting – especially since their guidance is so high. I wonder why the market is just ignoring it so badly.

I will have to look into it.

Reply

William October 29, 2012 at 5:41 pm

As a non Japanese speaker Ryoyo is interesting just because it is one of the few Japanese net nets which translates its financials into English.

However, one major concern I have over Ryoyo is that they have a defined benefit pension scheme. The liability on the balance sheet is actually for a fairly small amount – 890M Yen, but it is quite possible that this small number is the difference between two large numbers – the pension scheme assets and liabilities. I cannot see the pension scheme assets and liabilities in their English financials. Also they do not give any information about their acturial assumptions, or assumed growth rate of the pension assets. Are smaller Japanese companies generally considered to use reasonable actuarial assumptions? Anyway, for me Ryoyo is uninvestable without knowing more about their pension scheme in particular and Japanese pension schemes in general.

Reply

admin October 29, 2012 at 8:12 pm

William,

You are completely correct to be worried about that.

I added the data into the post based on your comment – thanks.

JP

Reply

o-tone October 29, 2012 at 11:26 pm

Well,

if you mention the possibility for offloading liabilities into off-balance sheet arrangements under JGAAP, you should also say something about the hidden reserves in the balance sheet of corporate Japan, which JGAAP allows to build up.

Also the effective tax shield created by the aggressive (or conservative; as you want to see it) depreciation (most japanese companies use acellerated methods) would be of interest.

greetings

Reply

admin October 31, 2012 at 9:07 pm

O-tone,

You are right to say this is an issue, particularly as the standard is effective control – another classical example of bendy rules in Japan.

The depreciation thing is carte blanche in theory, but in reality, even if I try to mess around with that kind of legally-ok accounting idea in my little firm, my accountant will squirm so badly that I won’t be able to do it, in the end. Sure, if someone want to mess with it they will, and there are bad apples in every country, but I haven’t seen any examples of really bad exploitation of the flexibility with depreciation, or at least I may have not been paying enough attention to it.

JP

Reply

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