|Shares Out. (in M):||23||P/E||10.4x||10.4x|
|Market Cap (in $M):||141||P/FCF||10.4x||10.4x|
|Net Debt (in $M):||-89||EBIT||24||24|
|TEV (in $M):||52||TEV/EBIT||1.9x||1.6x|
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We believe the following idea offers investors a unique combination of a very cheap valuation underpinned by a strong balance sheet, a consistently profitable asset-light and high-margin business, and alignment with a Western corporate controlling shareholder taking steps to unlock shareholder value.
BP Castrol K.K. (5015:JP) is a listed subsidiary of BP plc engaged primarily in the marketing and distribution of BP and Castrol branded motor oil in Japan. This is an asset-light, high-margin, branded consumer goods business with leading share in a mature market. The shares are glaringly cheap, given the following metrics (all numbers in JPY, as of 3/31/14):
Current Market Cap: 14.44B at ¥629/share
Net Cash and Cash Equivalents: 9.1B (including additional ~500m from sale of BP Air)
Net Tangible Assets: 10.47B
TTM Operating Income: 2.43B (17.8% margin)
TTM Net Income: 1.39B
TTM P/E: 10.3x
TTM EV/EBIT: 2.2x
TTM EV/E: 3.8x
TTM Pre-tax ROIC: 130%
The excess cash on the balance sheet covers roughly 65% of the market cap and continues to accumulate, providing significant downside protection for investors at the current share price. We estimate that the upside to fair value today is at least 75%, which is likely to be realized relatively quickly as the Company ramps up cash distributions to shareholders.
BP Castrol K.K. in its current form is the result of a number of corporate actions over the past several decades. In 1978, BP appointed Petrolub, a local company, as the sole agent of BP branded motor oil and lubricants in Japan. Petrolub was listed in 1995, at which point BP held a 33% stake in the company. In 2001, BP merged with Castrol and subsequently created a subsidiary solely focused on the marketing and distribution of Castrol motor oil and lubricants in Japan. In 2005, the Castrol subsidiary was merged with the listed Petrolub to become BP Castrol K.K. After purchasing Petrolub’s founder’s stake, BP controlled roughly 64% of the listed entity, which is now the sole agent for distribution and marketing of BP and Castrol branded motor oils and lubricants in the Japanese market.
Products (Best viewed in Chrome browser, which will automatically translate):
Cost of goods sold primarily consists of licensed manufacturing costs. Over 90% of the marketed products are manufactured by 3rd parties in Japan, and the remainder is imported. Given the strength of its brands, the Company is generally able to pass on rising input costs to maintain gross margins around 50%, although this can fluctuate due to exchange rate movements, input cost fluctuations, timing of selling price increases, and changes in sales mix. Gross margins expanded significantly from 2008 to 2009 due to a price hike followed by a collapse in oil prices, after which selling prices remained stable. Gross margins have drifted lower since 2009 as input costs have risen due to rising crude oil prices and a weakening yen without further selling price hikes.
SG&A expenses include employee salaries and bonuses, commissions to dealers, sales promotions, transportation and warehousing, and royalty fees. The key factor in the decline of SG&A expenses from 2005 to 2008 was a reduction in annual sales promotion expense by roughly 50%; operating expenses have since remained relatively flat. Royalty fees to the parent are fixed based on sales volume; they have ranged between 4.4% and 4.6% of revenues since 2009. The risk that the royalty agreement is amended in a way that would hurt BP Castrol’s margins appears to be low; in 2007 the agreement was actually adjusted downward for two years in the midst of soaring oil prices.
The Company estimates its market share at about 4% of the total Japanese automotive lubricant market. While the overall market is mature and has been declining by about 1-2% annually for the past five years, the Company’s sales have grown slightly due to the strength of its brand (managed at the parent level) and distribution channels, as well as the introduction of new products such as low viscosity oil for hybrid vehicles.
The Company sells through two channels, direct through dealerships and to consumers, which account for 47% and 53% of revenues respectively. The Company sells through approximately 15% of domestic dealerships (Honda, Toyota, Nissan) and 70% of foreign dealerships (BMW, Mercedes, etc.). The biggest competitors are actually the domestic automotive brands themselves, which all offer their own automotive lubricants. However, BP Castrol is able to maintain steady business with dealers, who benefit from higher profit margins by selling BP and Castrol branded lubricants. Consumer sales are maintained with promotions such as the current World Cup campaign, where the parent is managing the branding at the event and BP Castrol is offering small gifts with their products.
The factors discussed above have resulted in a relatively stable, highly profitable business. The numbers tell a similar story (all numbers in JPY millions):
Year Revenue EBIT Net Income
2009 12,189 2,326 1,268
2010 13,177 2,881 1,631
2011 13,479 2,869 1,600
2012 12,989 2,803 1,574
2013 13,377 2,566 1,460
According to Mr. Koishi, the Company President, who answered questions from investors at the last AGM in May, only ¥1,500m of working capital is required to maintain current business operations as the Company does not own any fixed manufacturing, distribution, or warehousing assets. The business is therefore generating post-tax returns on invested capital of about 100%.
Most listed subsidiaries of Western multinational corporations that we have come across in Asia with these characteristics (stable or growing market share, asset-light, consistently profitable, no prospect of acquisition or significant capital outlay) generally pay out a substantial portion of their net income as dividends and periodically pay special dividends if cash reserves grow too large. In fact, BP’s listed subsidiary in India, which is operationally very similar to BP Castrol, does precisely that, maintaining a regular dividend payout ratio over 75% in addition to distributing a special dividend in 2010. However, BP Castrol has been behaving more like a typical Japanese corporation, maintaining a pitifully low payout ratio while cash continues to pile up on the balance sheet for no apparent reason, dragging down return on equity:
Year Dividend (¥ mil.) Payout Ratio Net Cash (¥ mil.) ROE
2009 367 28.9% 5,114 23.8%
2010 367 22.5% 6,194 25.2%
2011 367 22.9% 7,527 20.7%
2012 367 23.3% 8,392 17.6%
2013 527 36.1% 8,500 14.5%
To make matters worse, most of this cash is held in BP’s corporate treasury, denominated in yen and earning a meager 0.3% annual interest. Whether BP Castrol management realized this was poor corporate governance or not, BP (parent) has essentially been receiving dirt cheap financing at the expense of minority shareholders for a decade.
We suspect there are several reasons why this issue was not previously addressed and the shares have remained so cheap for so long. For one, the minority shareholder base mainly consists of Japanese retail investors. Secondly, it is easy for prospective foreign investors to miss: not only is this a sub-$150m market cap company, but a large part of the balance sheet is lost in translation. What we discovered to actually be a cash deposit of ¥8.5 billion is held on the balance sheet as a “Loan Receivable.” This would normally be an obvious red flag upon first glance at the financial statements, with all excess cash flow going into this mysterious line item year after year. On top of this, Bloomberg is actually missing all financial data after 2010 in its database, so there is no way for this to come up in an automated screen.
Following our initial investment, we raised the following points to the Board:
As a result, upon announcing their 2013 annual results in February, the Company also announced their first final dividend increase since 2009 with the stated intention to increase the dividend progressively over time.
In May, BP Castrol announced the sale and transfer of its previously unmentioned subsidiary engaged in the import and distribution of aviation turbine oils to a Japanese subsidiary of Eastman Chemical Company, in connection with the sale of BP’s global Aviation Turbine Oils business at the start of the year. The business was apparently fully integrated into BP Castrol, and as such segmental revenues and earnings were not previously reported. The sales price was ¥806m, equivalent to 6.3x TTM EBIT.
As this additional windfall came shortly after the Company started hinting at returning more cash to shareholders, we think that the next logical step is for the Company to announce a special dividend at least as large as the Air BP divestment along with another increase in the regular interim dividend on July 30th, when they announce their H1 results.
With the downside substantially protected by cash and cash flow and the controlling shareholder apparently taking steps to unlocking value, the only question remains, how high can it go?
Bear Case: For the next five years, the current level of profitability and dividends remain the same, and the stock still trades at 2x EV/EBIT at the end of year 5. Given the Company’s stated intention to increase dividends and the subsequent rerating already in progress, we think this scenario is unlikely. IRR: 8.5% annualized over 5 years.
Takeover Offer: BP decides it would rather keep the cash where it is and extends a takeover offer to minority shareholders. Seeing as how they just sold a similar business for 6.3x TTM EBIT, they could make a similar offer to minority shareholders by the end of this year. However, the announced decision to increase dividends over the next five years suggests that BP may be committed to keeping BP Castrol public. IRR: 73% in 6-12 months.
Optimized Capital Allocation: BP brings its subsidiary’s capital allocation more in line with the parent’s focus on total shareholder returns by paying a large special dividend of ¥5B (bringing the ROE back above 25%) and increasing the regular payout ratio to 80-90%; after which the stock trades up to a 5% dividend yield. In this scenario, the shares could trade up to ¥1,000 in addition to a special dividend of ¥200. IRR: ~100% over 1-2 years with substantial upfront return of capital.
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