Description

Chugoku Marine Paints (CMP) is a worldwide leader in a boring oligopolistic niche business: antifouling paint manufacturing. It is also the only listed pure-player worldwide. Anti-fouling is a specific type of paint which is used on a ship’s hull to protect it from living organisms and to improve fuel efficiency. Due to a recent drop in orders from shipbuilders, Chugoku Marine Paints has seen sales fall, but I believe the company is an attractive investment with low downside, which will deliver as volumes recover. I like that the stock has been a consistent FCF generator (which has helped its balance sheet go from net debt to net cash over the last decade), is trading at a discount to global paint peers, has no serious sell-side coverage and has a rational, transparent management team.

A) The product

The anti-fouling paint represents 80% of CMP’s sales and is an attractive business for 3 reasons:

a)       It has strong barriers to entry:

- Anti-fouling is a niche market, it represents roughly 2% of global coatings volume, which makes it out of reach for some large paint players and deters potential entrants.

- Developing an anti-fouling paint requires high intellectual property and knowledge. The copying of a coating products requires several years of research. Furthermore, there is a long lead-time to test and prove the efficacy of a new product to clients.

- Some scale is still required as one needs to have multiple bases worldwide to be able to develop relationships with and service shipowners and shipbuilders.

b)      It is a critical product for clients:

- anti-fouling coating is a technological coating which allows fuel savings of more than 8% compared to traditional coatings, by preventing living organisms to stick to a ship’s hull by making it smoother.

- without the anti-fouling, fuel consumption increases exponentially as time passes by. This makes the cost of the product small compared to the savings it brings to the client. A 2010 study estimates the cost for the Navy’s fleet: “the results indicate that the primary cost associated with fouling is due to increased fuel consumption attributable to increased frictional drag. The costs related to hull cleaning and painting are much lower than the fuel costs. The overall coast associated with hull fouling for the Navy’s present coating, cleaning and fouling level is estimated to be $56M per year for the entire DDG-51 class or $1B over 15 years. The results of this study provide guidance as to the amount of money that can be reasonably spent for research, development, acquisition, and implementation of new technologies or management strategies to combat hull fouling.”

- the buying decision for new ships is a no-brainer as the anti-fouling cost represent less than 1% of the ship’s price: anti-fouling has a relatively low price elasticity.

c)       It has a structural recurrence:

- as the boats navigate at sea, the coating wears off and ships must be repainted every 3-5 years, during the dry-docking process. This is necessary to keep the fuel costs low.

- therefore, 45% of Chugoku's sales are replacement demand, vs 55% for new orders.

B) The company

CMP is competing in this oligopolistic market against International Paint (subsidiary of Akzo Nobel) and Jotun (Orkla Group). These 3 companies divide equally 70% of the market and have comparable high-quality products. Hempel has 10% market share and lower quality products; the rest of the market being split among minor manufacturers. CMP is a worldwide business with sales in Japan (40%), HK/China (30%), Korea (15%), Europe/US (15) and the remainder in South-East Asia. It has been doing well in all these locations:

-          In Japan, its market share has increased from 42% in 1996 to 62% in 2016. This has been possible by gradually taking market share from International Paint (which left the market) and Jotun.

-          In Korea, its market share oscillated between 10-20% and is now at 16%.

-          In China, its market share reached a peak of 30% in 2010 and is now around 15%, due to the management not willing to lower its prices to compete with the lower quality products of Hempel.

Except in China, the business has always been profitable and generating comfortable FCF. Note that in the filings, you will see Europe with a negative EBIT: this is because it is a cost center as most clients are in Europe. The costs related to the higher sales force in Europe are reimbursed by other subsidiaries under the EBIT line, so at the net income level the company is actually structurally profitable in every region.

Furthermore, CMP also sells paint for containers in China (10% of sales), where they own 25% market share in China, and sells paint for wooden floors (10% of sales as well), where they own 50% market share in Japan.

Recent results have been disappointing with sales dropping 28% in 2016, which brings back sales to levels not seen since 2009 and 2012. This has happened due to lackluster shipbuilding demand and due to heavy competition in the Chinese container paint market. I see now as a good time to invest waiting for the tide to turn with a low risk:

- Our downside is protected with half of sales coming from maintenance demand and a solid balance sheet

- The market has shown signs of bottoming out, notably in China and South-East Asia

Management’s response to the current market conditions seems rational:

- They have been unwilling to lower prices against competitors such as Hempel

- They have instead focused on cost-cutting and NWC improvement

- Notably, they kept on investing in the industrial tool and just delivered a European fully-automated factory able to produce 1K ton of paint per month.

- They also increased their dividends and bought back 1% of shares in FY2016.

C) Market perception and valuation

CMP is not a market darling. I believe investors do not like the shipbuilding exposure and recent poor results. However:

- Japan, which generates most of the profits, is doing OK with shipbuilders having a full order book for 2018.

- Korea’s shipbuilders are until now supported by the Korean government and CMP’s receivables there are only around 2B JPY.

- The China business has roughly 13B JPY receivables, where payment delays have been stable. They have lost share by only dealing with credit-worthy customers, unlike Hempel. The company believes Hempel is going to have trouble collecting some payments.

- Dayrates are at historically low levels and recent rebound is positive for CMP’s clients. Ultimately, ship orders cancellations will stop and the tide will turn.

We are paid a growing dividend while waiting, and own a business throwing a comfortable FCF good year bad year, with close to 20% of its market cap in cash (our EV is adjusted for cross-shareholdings and consolidated cash belonging to non-controlling interests). Management is rational and increasing shareholder returns. Ultimately, I believe I am paying under 7x normalized EV/EBIT for an attractive niche business, when global paint peers routinely trade at double this valuation or more (one can look at the valuations of Akzo Nobel, Nippon Paint, etc).

Catalyst

- Dayrates recovery and pick-up in shipbuilders' orders
- Increased returns to shareholders and continued share-buybacks
- Acquisition/consolidation