Summary

With the Japanese market up more than 65% since mid-November, finding value in Japan is getting more difficult. However, we think we have found a deep-value small cap gem with improving fundamentals. The company is Hitachi Zosen Fukui (“H&F” is the trade name) and the stock has a slightly negative enterprise value due to a cash rich balance sheet. Despite the inefficient balance sheet, the stock trades at a single digit P/E and a 3.2% dividend yield. The company sells automated press machines and factory automation equipment to Japanese auto OEMs and parts makers. While the company is not a direct beneficiary of the weak yen (they price products in yen not dollars), we think they indirectly benefit from the currency boon their customers are enjoying. The order book is rising and we expect the company to benefit from increased capacity investment by Japanese auto makers.

Description

H&F is a 53.6%-owned subsidiary of Hitachi Zosen Corp (7004 JP) and is based in Fukui prefecture on the Sea of Japan. The company dates back to 1964 with the founding of Fukui Machinery which was acquired by Hitachi Zosen in 1999. In November 2006, the company listed on the JASDAQ. H&F’s business is building very large automated presses and related factory automation equipment for Japanese auto makers. These are primarily used for shaping exterior panels for cars (see diagram below). The company designs and manufactures all of the equipment in-house. H&F also provides after sales service and repair for the equipment. In a normal year, 40-50% of sales is press machinery, 25-30% is factory automation equipment, and 20-25% is after-sales service and repair.

Sales are pretty diversified across the top 6 Japanese OEMs. The sales breakdown by customer over the past 5 years through FY11 is 24% Honda, 19% Toyota, 10% Nissan, 9% Mazda, 9% Suzuki, and 8% Mitsubishi. H&F supplies all of the Japanese OEMs but has slightly higher market share at Honda, Mitsubishi, and Mazda.

Although H&F predominantly supplies Japanese customers, the destination of their equipment is very global and increasingly in emerging markets. The destination of H&F’s equipment over the past 5 years was 49% in Asia ex-Japan, 34% in Japan, 6% in Mexico, and 11% in North America, US, and other. The major destinations in Asia are Thailand, China, Indonesia, and India.

Competition

H&F’s two primary competitors are Aida Engineering (6118 JP) and a division of Komatsu (6301 JP).  The three companies are the only suppliers in Japan and they primarily serve the Japanese OEMs and related parts makers. H&F has slightly lower share, typically in the range of 20-30%, with Aida and Komatsu each commanding 30-40%. Schuler of Germany is the major overseas competitor with high market share with European and US automakers, but the Japanese OEMs generally only source from the Japanese suppliers except for Nissan. H&F’s competitors are more diversified and also make smaller presses for other applications and end markets. The market is pretty consolidated and the competitive intensity seems moderate, especially in a strong demand environment.

Demand Environment

Demand for large auto presses is unsurprisingly driven by auto capacity expansion and the outlook for Japanese OEM capacity additions appears to be very good. The Big 6 Japanese OEMs are expected to add nearly 3.0m units of overseas capacity in 2013-14 up from about 2.2m in 2011-12 and about 2.1m in the previous peak of 2007-08.

H&F’s order book has been rising and we expect this to continue. Order intake in FY3/13 was 28.1 billion yen up from 24.9 billion in FY3/12 (+13%). Similarly the order book increased by 25% y/y through March 2013. Management is guiding for 5% sales growth in FY3/14 but we expect this could prove conservative. Results exceeded management’s initial sales guidance by 6-7% in each of the past two years. Additionally, H&F’s competitors have given positive guidance for this year. Aida forecasts auto press order intake to increase +7% and sales to increase +16%. Komatsu commented that “sales of presses and machine tools should increase firmly.”

The weak yen is also an important factor to consider. As mentioned, H&F prices in yen so the yen depreciation won’t directly impact their reported sales or margins. However, Japanese OEMs margins and cash flows are experiencing a considerable boost from the weak yen. They are likely to continue and possibly accelerate overseas capacity investments because although they are generating decent margins on exports now, they have not forgotten the pain they suffered from the strong yen and they want to better align the geography of production and sales.

Guidance / Thai Flood Impact

Management issued a disappointing forecast for FY3/14 in mid-May which caused the stock to drop 17% in a single day. The guidance is for sales to increase +5% but operating profit to decline by 37% and net income to decline by 34%.

One important factor in the negative guidance was an abnormal profit generated in the June 2012 quarter due to the Thai floods. The floods had a heavy impact on H&F’s customers in Thailand and led to significant high-margin service revenue to repair equipment that had been submerged and damaged by the floods. Management estimates that they generated an extra 1.0 billion yen of operating profit from the floods (out of a total FY3/12 operating profit of 2.7 billion). However, last year also included an extraordinary 841 million yen pension charge which is not expected to recur. We believe a normalized EPS excluding these two factors for last year is approximately 106 yen per share. Therefore management’s guidance implies flat earnings this year which seems too conservative in light of competitor guidance and the aforementioned demand environment. In the past two years, operating profit exceeded management’s initial guidance by 200% and 65%. Stripping out the Thai flood profits, operating margin was about 7.6% last year compared to a peak margin of 10.3% in FY3/08. It appears management is being characteristically conservative again and there is scope for guidance to be raised later in the year.

Balance Sheet / Valuation / Dividends

H&F has 8,660 million yen of net cash and 629 million of securities, which are primarily government bonds according to management. This compares to the market cap of 9,210 million which implies a slightly negative EV. There is a pension liability of 1,085 million yen so adjusting for this the EV is not negative but still very low.

H&F is trading at 5.8x trailing earnings or 8.8x excluding the Thai flood profit (note that these are not cash adjusted earnings multiples). Peers trade at an average of 16x trailing and 12x forward earnings estimates. H&F has low capex requirements and generates significant cash flow. The trailing FCF yield to market cap is approximately 30%.

We don’t expect management to aggressively return this cash to shareholders but they did double the dividend last year to a record 30 yen per share. Management also indicated to us that they will continue to increase the dividend if results improve so perhaps there is upside to the guidance of a flat dividend this year. A more progressive shareholder return policy would be nice to see, but the Japanese market has increasingly started to reward latent balance sheet value lately so we think the balance sheet could gain further recognition even without a hard catalyst.

Risks

Weakening of the global auto industry
Market reaction to a difficult comp for June-13 quarter due to the Thai flood last year
Strengthening of the yen
Market share loss

Other

The company has an English website and presentations which is helpful (http://www.h-f.co.jp/english/publics/index/52/). The President is conversant in English if you want to arrange a call. You can also read Aida and Schuler’s English websites and annual reports for more industry background