Description

* P/E above is "traditional P/E". Ex-cash P/E according to my calculations are 16x for 2019 (year-end December) and 14x for 2020.

Hoshizaki is a worldwide leader in commercial refrigeration & kitchen appliance, and is also Japan's largest ice-cube machine manufacturer (70% share in Japan, 25% worldwide). Hoshizaki is a stalwart: it enjoys a leading position in most of its markets, a wide recognition for product quality, a solid financial profile & relative resilience to the macro cycle. It’s at an early stage of internationalization with potential for continued growth and fits the framework of “the good quality business whose price dropped for temporary reasons”.

Today we can buy Hoshizaki at a cheap 16x ex-cash PE, paying the same multiples as in 2014, before the stock becomes known as a growth stock. The main reason we're offered this price is that there was an accounting issue at a subsidiary, which I believe is a non material, and which forced some investors to sell. As concerns disappear, I expect Hoshizaki's price to increase.

In the short-term, their results have been rather sluggish, hit by exceptional investigation costs linked to the scandal and lower restaurant capex (half of sales are to the restaurant sector). However not all is bad:

- Japan and US abolition of R22 refrigerant in 2020 should help drive demand for new products

- the launch of new products in all geographies will help, it’s worth noting some are targeting adjacent markets (e.g. warming appliances like steam convection ovens).

The scandal has drawn scrutiny on the company and it is now forced to review some of its former practices, including internal controls, incentives, poor disclosure and bloated balance sheet (net cash & securities are worth â…“ of the market cap).

After their latest results, they published for the first time English financials and earnings slides on their website. Management has admitted they must do something about the balance sheet, and I believe an increase in the shareholder payout is next (Hoshizaki is one of the last firms in the Topix 500 having never done a buyback).

I - Brief history of the firm

II - Business fundamentals (Japan, overseas, gas regulation)

III - Why it got cheap: the accounting scandal

IV - Some details on M&A

V - Governance & incentives

VI - Valuation

I - Brief history of the firm

The firm was founded after WWII in Japan by Mr. Sakamoto, the father of the current Chairman. They didn't find their way immediately, first they started making car horns (!). In 1965 (18 years after founding), they developped the first fully automatic ice-making machine, which laid the foundation for today's business. Afterwards, the firm continued it's expansion as a commercial kitchen equipment manufacturer:

- 197x: Extended line-up to beer dispensers + commercial refrigerators + commercial dishwashers

- 1981: USA entry

- 1992: Europe entry

- 2004: China entry

- 2005: Son of founder took over as CEO/Chairman

- 2006: First acquisition, in the US (Lancer)

- 2008: IPO, Gram acquisition in Denmark

- 2010: Taiwan / HK entry

- 2013: India / Korea / Brazil entry

- 2014: Indonesia entry

- 2017: President change, the son of the founder became Chairman and left Mr. Kobayashi as President

II - Business fundamentals

The commercial kitchen equipment market is growing mid-single digit and is characterized by:

- relatively short replacement cycles compared to other machineries (7 years on average)

- an important need for reliability and service, especially in the restaurant business where downtime is not an option

- following from the first two points above, a small second-hand market for products

- a willingness from clients to pay for value-added (notably low-energy consumption products, which represent 10-15% of a restaurant energy use)

- some regulation, notably linked to the use of refrigerants which cause pollution

Lately, providing full kitchen solutions to clients has become more & more important, which is why you can notice several of the following happening in the sector:

- M&A transctions

- partnerships with other firms (Hoshizaki buys the product it does not have like kitchen sinks from 3rd parties)

- launch of new products lines (main domestic competitor Daiwa Industries launched a new convection oven, it was before only working with cold technology)

Hoshizaki's strategy focuses on (mostly) local production, outsourcing non-core tasks like financing solutions to local partners. Its clients are 100% professional, and roughly 50% of them are in the restaurant sector. This mix has been evolving very slowly over the last 10 years, with the share of non-restaurant clients evolving to reach above 50% now. Several other sectors in which Hoshizaki is active are the hospitality sector (hotels etc), the health sector and the mining sector. It seems that in these sectors some specific expertise is required, for instance blood storage must answer to norms and requires a flat and constant temperature.

Hoshizaki has become a dominant player by doing in-house production of core parts and outsourcing parts where they didn't add value (compressors etc). They have kept a strong focus on product quality and their products are unanimously appreciated by clients:

a) Japan (â…” of sales & EBITA)

Japan is a mature market, although it was still growing recently at a 3-5% pace, thanks to new restaurant opening, strong demand from CVS and strong demand for energy-saving products following the 2011 earthquake. In Japan, Hoshizaki has a leading & stable market share on all product categories, a direct contact with clients unlike most competitors, and a very strong local presence due to the biggest marketing and service team by far. It is almost impossible, visiting Tokyo, not to see Hoshizaki’s products in restaurants.

On a "consolidated basis", Hoshizaki's market share would be 30-40%, by product they have 70% share for ice-makers, 65% for beer dispensers 45% share for commercial refrigerator, 45% share for commercial dishwashers, so they usually are number 1 in all their main categories. The main competitors are Fukushima Industries, Daiwa Industries, Panasonic, Nittoku Engineering. It's important to note that only Daiwa Industries follows a direct sales model as well (and also get the profitable maintenance). Fukushima has minimal direct sales and instead go through distributors, because they originated as a kitchen OEM. It's harder for them to get client feedback and improve products rapidly. Over the last 10 years, market shares have been very stable, and we have seen no new entrants. As I learnt from Daiwa Industries, this is in part due to the fact that products have special sizes and are not standardized unlike in Europe, hence why foreign competitors do not come in.

Experts and competitors are unanimous: what makes Hoshizaki so dominant is their "very strong sales force", in Japan they employ 3,000+ sales people and 2,500+ maintenance people, who keep a close contact with customers and generate new business opportunities during visits. They have ~450 sales offices in the country, >2x more than Daiwa Industries. This very wide coverage of the country, combined with a 24/7 call center, allows an extremely fast repair in the whole country (between 1-3h), at a fee lower than competitors. Many Japanese taverns ("izakaya") are open very late or all night, hence the 24/7 service. Hoshizaki also has approx. 100 in-house food experts, this helps them with product development and providing service for full kitchens. Finally, one notable feature which may be unexpected for a manufacturer: given client advances and their direct sales model, Hoshizaki Japan has a large negative working capital in Japan (-10% sales) which is not the case abroad. This explains in part their high ROCE (>100%).

--> Coupled with their strong competitive advantages, it makes this unit an excellent business, highly cash-generative, and n°1 domestically for decades.

Regarding growth expectations for this business, firms in the sector are rather optimistic until 2020, due to several factors:

- as dietary habits change, we see more space for fridges within convenience stores (increase in pre-cooked meals, more old people and working women)

- the aging society increase the needs for hospitals and nurseries, which use refrigerators

- the phase out of refrigerant R22 in Japan in 2020 will be beneficial from this year

In the long-run however, I expect a stable / declining market. Regarding margins, I see no reason for change and expect them to be stable (12-13% OPM). The increase you notice from 05-06 levels is due to Mr. Sakamoto taking over the company and implementing better production practices. 

b) Overseas

Hoshizaki has entered overseas in the 80s and has since developped this part of the business as well. Nowadays it presents 1/3 of consolidated sales, and the midterm goal is to bring this to 50%. The main country is the US, followed by India and then Europe / APAC. Abroad, the model uses both direct sales & distributors, and faces competition from cheaper products manufactured in China & Malaysia mostly. It's therefore structurally less "solid" than in Japan but with more growth. They benefit from their relations with Japanese firms when they expand abroad (convenience stores or restaurants), a strategy also used by competitor Fukushima with AEON to develop in SE Asia.  

USA (23% sales, 26% EBIT): they entered via their own subsidiary in the 80s and started local production. They acquired Lancer in 06, their first acquisition, which are specialists of drinks dispensers, notably for the fast-food industry and gave them access to the large fast-food chains. Lancer was a 130M$ sales company at the time. Today it surpassed 200M$ in sales according to MS. They also acquired Jackson, a professional dishwasher manufacturer, whose quality is praised by competitors.

Nowadays the US business is mostly focused on the ice-making machines, with ~30% market share and growing. Other businesses like refrigerators etc are smaller, it seems that they are only dominant in the ice-maker category for now. Margins on the ice-maker category are >20% and it seems other product lines like refrigerator are not very profitable and the firm could increase margins by reviewing its product mix.

The Hoshizaki America entity, which excludes acquisitions like Lancer, is generating 13-15% net profit margin. It has also been growing organically between 6-10% over the last few years. The trend in the US is positive. On another note, Glassdoor reviews say the company is "great" or "excellent" as well as the products, but there's too much executive turnover and the management style is "too Japanese".

Europe / Asia (11% of sales, 7% of EBIT: According to my calculations, the first business in this segment is actually India, with the acquisition of Western Refrigeration in 2013. They own 83% of the business and have been increasing their stake - the rest was left to promoters. It would represent 1/3 of the segment, but still tiny vs consolidated sales (3-4% of sales). Western Refrigeration is focused on lower quality refrigerators. They seem to be doing well as sales have grown between 5 -18% per year in local currency in the last 3 years, their debt rating has also been upgraded due to strengthening of the market position of key products. They have good relations with some fast-food firms like Coca-Cola to whom they provide products.

Switching to Europe, Hoshizaki is mainly present due to its acquisition of Gram in 08, a Danish company. The product line-up of the company seems great, notably they are also diversified towards product for the health sector, however since acquisition performance has not been so great. It has taken time for them to integrate the business. They recently did efforts restructuring their European operations, which included merging distribution branches and giving more power to European managers. These efforts are seemingly starting to pay off.

In China, they have a business and factories, and they are launching a new dishwasher product this April. Like Europe, it's very small in the consolidated financials.

c) Gas regulations

Gas regulations are pushing the sector to innovate. Basically, we have been manufacturing gases to use as refrigerant, however we later found these gases were harmful, mostly to the ozone layer. With the Montreal Protocol in the 80s, countries got together and the gases used at the time (CFCs) started to be phased out and be replaced by other gases which hurt the ozone layer less, but are still potent greenhouse gases and therefore contribute strongly to global warming (HCFCs). In other words, we found a "temporary solution" to save the ozone layer at the expense of global warming. Then, HCFCs were in part replaced by HFCs, similar gazes which contribute less to global warming, and above all, do not deplete at all the ozone layer. It seems that the shift from HCFCs to HFCs happened mostly in Europe, as in other parts of the world, HFCFs are still used as well.

To understand the big difference in pollution impact, one must look at the global warming potential of the gases (GWP), which compares how much heat a certain gas retains in the atmosphere compared to CO². According to Linde Gases' website, R404A has a GWP of 3,922, which means that 1kg of R404A leaked into the atmosphere does the same effect to global warming than 3,9 tons of CO² ! Still according to Linde's websites, new solutions include "HCs" and "Natural refrigerants" which are found in nature, contrarily to before, and whose GWP is close to zero, so the difference between current and future gases is important. 

Regarding Hoshizaki, they don't seem particularly "in advance" regarding these topics, but it doesn't seem like they are neglecting them either:

- Hoshizaki UK announced the phasing-out of HFC ice-machines from 2019, so that their portfolio of ice-machines will be HFC-free by 2020

- their acquisition of Gram Commercial A/S in 2008 as brought them access to new products and expertise. Gram has been commercializing HFC-free products since 2002 (using propane)

- in India, their second biggest overseas market after the US, it seems the country is currently phasing out HCFCs, but HFCs will be phased-out over a very long period of time (> 2040)

--> the striking point is that with the current shift, the improvement in GWP is huge ! From the data above we can reasonably expect this to be a tailwind for some time to come. 

--> we can see Europe as a leading indicator for the rest of the world as they are clearly in advance, followed by the US & Japan, then emerging countries. 

III - Why it got cheap: the accounting scandal

End of October 2018, a scandal was revealed by Hoshizaki. Several sales people (~100) of one domestic sales subsidiary, Hoshizaki Tokai (HT), were involved in incorrect order taking. This included booking sales before sending the products, and booking fake orders to hide the fact that some product sold to distributors where sold at lower than official prices. This was the only subsidiary concerned by the irregularities, out of 16 domestic sales subsidiaries. This subsidiary as a whole has 650+ employees, and accounts for ~6% of consolidated sales, ~3% of consolidated EBIT.

Before reading the facts, keep in mind:

- part of the irregularities where committed using distributors, which is a very small distribution channel domestically

- Hoshizaki has a decentralized structure, they have 1 head office & different sales offices. The sales offices operate independently with differing cultures & way of working . This was stated by the investigation committee, but it was also confirmed to me by former employees.

a) Timeline

End of June 2018, the stock was at an all-time high of ~11,700 and brokers had buy ratings on the stock. At the beginning of October the share price was ~11,000 and fell a lot during the month suggesting the news about the inappropriate transactions leaked very early. Date and share price in parenthesis:

- 30/10/2018 - (9,634): Release of inappropriate transaction + postponment of Q3 earnings release

- 01/11/2018 - (8,883): Investigation commitee formed with lawyers

- 13/11/2018 - (8,724): Firm announced to postpone deadline of quarterly report to 14/12, as investigation would take roughly 1 month

- 06/12/2018 - (8,774): Investigation report published, at HT, giving conclusions about the sales reps being involved. The report (in Japanese only) was very detailed, and included textual analysis of the subsidiaries directors’ cellphones and emails.

- 10/12/2018 - (8,883): Whistleblower told an accounting auditor that a senior part-time employee gave instructions to employees nationwide about how to answer to investigations. Additional investigations were needed thus there was no possibility to release earnings by the 14 as originally planned. The employee was over 60 and too old to manage, he acted as a "senior advisor" (senior people who stay employed by the firm after retirement)

- 14/12/2018 - (7,312): First press conference: the facts about the senior advisor were disclosed and the stock was designated as "Security under supervision"

- 27/12/2018 - (7,640): Deadline for delisting. The firm published its Q3 security report approved by Tohmatsu (Deloitte) & trading resumed

- 13/02/2019 - (7,010): Annual results were supposed to be published, the firm instead announced they would be delayed as improper transactions continued into November while the first commitee's investigation used data up to the month of October. There was also an additional whistleblowing report made to Hoshizaki USA which required investigation by an external lawyer.

- 25/02/2019 - (7,850): The new third party committee was announced with only outside members. They rechecked the previous investigation data and analyzed new data up to December 2018

b) Result of the inquiries

- The misstatements were immaterial, only affecting HT and no other subsidiary (the maximum profit impact is 100M JPY on a FY basis at the net income level, or less than 1M€)

- A charge of 200M JPY will be booked in Q4 related to legal cost. In total, 1,100M JPY expenses have been booked related to this accident.

- As the impact is not material, the firm will not restate former financials. They also did not change their yearly guidance.

- The root cause of the problem was a lack of communication between the subsidiary and the HQ, and an aggressive sales culture at HT, where the “sales team” is everything. These problems are being resolved, and are not unique in corporate Japan.

c) "Security under supervision" status 

On December 14 2018, Hoshizaki was designated as "Security Under Supervision" by the TSE. This caused the stock to drop by 30%. This status basically requires the firm to publish their financial report by the 27th of the same month, otherwise they would be delisted. The interesting point to note is that many Japanese pension funds & life insurance firms can't invest in securities with such a status, creating forced selling. 

d) Corrective measures taken end of December

- End of December 2018, Hoshizaki announced that they fired the president and the general manager of HT

- Hoshizaki's top execs, including the president, announced voluntary returns of salary: between 10-30% of their compensation for a period between 1-5 months depending on seniority

- A review of the evaluation system for the marketing teams, even though the exact details were not communicated

e) Thoughts about Japanese frauds

In Hoshizaki, we don't have the signs of the several types of fraud we saw in Japan in the past:

- until now, there was no claim against product falsification or similar hidden problem. We're unlikely to have to face any product recall or potential lawsuit as in the case of KYB, Kobe Steel, Toray.

- profitability and growth over the last few years are not completely out of line with the sector, growth is within a reasonable range, profitability has been stable and is lower than some comparables. The contrary was a clear sign of problems at Suruga Bank.

- the accounting is clean: no segment change, no working capital problem, no suspicious increase of non-operating assets on the balance sheet, great FCF generation every year, decent and growing cash distributions every year, stable gross margin, strong net cash position. 

--> This makes me comfortable with the hypothesis that Hoshizaki is a solid company with one subsidiary that is a "rotten apple" (with some degree bad office practices as in old-style Japanese firms) but not an outright fraud.

IV - Some details on M&A

Hoshizaki's M&A strategy started in 06, and was orchestrated by Mr. Sakamoto, the son of the founder once he took over. Before that, market entry was made directly, like Hoshizaki America for instance. According to one person who worked with him: "Mr. Sakamoto is a unique person. He doesn't believe in Japan. He said even if Japan finishes the company must survive, that's his policy. He wants to make his company global. That's why Hoshizaki acquired many companies to survive."

Overall the track record has been great, making roughly one acquisition every 2 years, bringing sales between 5-150M€. They did not have any big issues related to their acquisitions, and did not appear to have overpaid any of them. They usually pay up to 10x EBITDA. And after they leave the management of the acquired company in place to do his job. 

In my numbers I do not expect any M&A soon, but it is still part of the strategy. They will likely continue small acquisitions once every few years. 

V - Governance & incentives

Governance & incentives seem ok with potential for improvement.

The firm's first shareholder is the Sakamoto family, which is the founding family. The founder was President until 2004 (!), then left his son at the helm. This really gave a new impulsion to the company with improvement in manufacturing practices and the start of the M&A strategy. Today the 2 first owners are the Sakamoto Foundation (8.6%) and the Hoshizaki Green Foundation (8%). Employees own 3.7% through an ESOP, down from 5.2% in 2014. I think this amount is non-significant, it represents in total 7,700€ average selling per employee over 5 years. Some insiders own 1-2% and the rest is owned by institutionals. Foreign ownership as been between 20-30% over the last 5 years. 

In 2017, Sakamoto made Mr. Kobayashi President of the company. He's the second President who is not from the founding famiy, after Mr. Suzuki in 2011-2013. I see this as positive. Mr. Kobayashi was working at a consulting firm and joined Hoshizaki in 2008. Again according to my source,  "Sakamoto has the vision, he employed smart people and hired Kobayashi, he was the brain for Sakamoto".

The firm has no poison pill. Regarding incentives, directors have a base pay + variable salary linked to achievement levels of yearly objectives. For sales people, after the scandal, they said they reviewed the incentives package without giving more details yet.

VI - Valuation

I take a few approaches. In several cases Hoshizaki's valuation appears too low to me.

First, what is into the share price ? A DCF with no growth and stable 13% operating margins gives no upside, in essence, the stock is available at a no-growth price. I think this is too pessimistic. The Japanese market is not supposed to grow much from here although we can expect small growth from the non-restaurant sector. However, Hoshizaki has proven their success abroad and this represents now more than 1/3rd of the business. Also, the M&A potential should be taken into account to some extent, and they have a huge cash pile to do it.

Secondly, we can look at the stock valuation compared to its historical values:

- on a P/B basis, Hoshizaki is trading at 2.5x, value it was trading at in 2014, vs an all-time high of ~4.5 in 2016

- on an EV/Sales basis, Hoshizaki is trading at 1.4x, value it was trading at end of 2014, vs an all-time high of ~2.2 in 2016 

- on a P/E ex-cash basis, the firm is trading at 16x, inexpensive taking into account the quality of the business

Arguably, there are stocks out there with a larger upside. I like the fact that expectations about Hoshizaki came down a lot, and I think the margin of safety is great at this price. 

Catalyst

- Improvement in shareholder returns

- Improvement in communication / IR activities

- Renewed focus on M&A strategy