Description

Ichigo Inc (2337) is a Japanese commercial real estate company controlled by one of the best capital allocators that few have heard of - hedge fund manager Scott Callon.  Callon has lived in Japan for 28 years and runs Ichigo Asset Management, a concentrated and long-term value investing firm with several billion of assets that has one of the best track records in Japan.  Through his fund, Callon took control of Ichigo Inc during the financial crisis, a stake that is worth over $750 million and is his fund’s largest position today.  Ichigo is a best in-class operator in an inefficient pocket of the market - small and mid-sized real estate in Japan – that has compounded book value and earnings per share at 69% and 26%, respectively, over the past five years.  Despite this, the company trades at 12x this year’s earnings and at a modest premium to adjusted book value, despite having built additional earnings streams into the business.  We believe Ichigo is a long-term compounding machine trading at an attractive valuation and the management team, which just bought back shares for the first time in several years, appears to agree.      

History

We believe Scott Callon is one of the very best investors – perhaps the best - in Japan.  He moved to Japan in 1989 and was the Head of Equities at Morgan Stanley Japan before launching Ichigo Asset Management in 2006.  His fund invests in a concentrated portfolio of Japanese equities on behalf of endowments, foundations and other clients, a roster which includes several of the largest and top performing Ivy League endowments.  According to our research his fund has compounded in the low double digits (net of hedge fund-like fees and in USD) during a period when the overall Japanese market was slightly down.  Callon is a true value investor and described his approach in an interview a few years ago:

“We are high-commitment value investors.  We believe that valuation ultimately is the single most important determinant of investment merit and ultimately returns.  We seek to be shareholders of outstanding companies that have demonstrated their excellence over many years and yet trade at substantial discounts to their fundamental value”

The entire interview with additional details and background is here: https://www.manualofideas.com/files/content/protected/moi201104_japan_scott-callon_interview.pdf

To further verify the Fund’s track record we went back to 2011 and gathered all the Fund’s ownership fillings in Japan, where most of its positions are disclosed, and performed a back test of those disclosed positions.  As you can see below, the performance of Ichigo Asset Management’s holdings has been excellent on both an absolute and relative basis:

Through his Fund, Callon took over what is now Ichigo Inc (2337) during the financial crisis when it was in distress and spent several years selling off non-core assets and improving the company’s balance sheet. Since the turnaround was completed the company has been firing on all cylinders, as you can see from its financial results in the table below.

Company Overview

Ichigo Inc.’s core competency is buying and improving real estate in Japan.   The company buys underperforming properties utilizing low-cost, long-term debt, collects rent while making improvements to the assets, and then sells the improved properties for a profit. Ichigo has a focus on small and mid-sized properties, particularly in the office and hotel markets. This is a very inefficient space where a bit of capital and years of expertise can significantly improve the economics of a building.  Some of this is basic blocking and tackling - for example buying a small hotel, removing a restaurant that loses money and adding extra rooms in its place – but can dramatically improve an asset’s cash flow and intrinsic value.  

Below is an example of the economics on their deals, translated back to USD.  In this example Ichigo puts down $5 million to buy a $20 million building with a 5.5% cap rate, borrowing the rest at 1.5%.  This translates into a 14% yield on the $5 million in equity, before any enhancements are made.  The company than spends $500 K and three years of time improving the building, which enables it to sell the building three years later at a 15% cumulative gain.  If they sell at the same cap rate that they bought, they more than double their upfront investment and achieve a 30% IRR.

Part of the attractiveness of Ichigo’s strategy today is the incredibly low cost of debt in Japan.  While we consider ourselves averse to debt in general, this is a rare exception of a company that we think is utilizing leverage in a smart and reasonable manner.  Interest rates in Japan are incredibly low right now – you can lend money to the Japanese government for 5 years at -0.07% or for 10 years at 0.07% (to be clear, we would not recommend this!) - and that means that high quality companies like Ichigo can borrow at very low rates as well. The company has been steadily decreasing the interest rate it pays while at the same time extending the maturity of its debt – Ichigo is currently borrowing at close to 1% for loans with a weighted average term of over 10 years. In addition, a portion of the loans are at the asset level and therefore are non-recourse to the parent company:

Here is Callon in his own words discussing interest rates and the current real estate market:

“I believe it is an extraordinary time to own Japanese real estate… this gap between Japanese real estate fundamentals, which are extraordinarily positive, and sentiment, which is very cautious, is the biggest I have seen in my career…It has literally never been a better time to be a borrower, in my view. I believe the right way to take advantage of the current low-interest-rate environment is to work with the banks to lock in the low rates…By the way, when I say we have one of the best operating environments in the history of Japanese real estate, it is not just low funding costs. It is also that rents are going up.”

Source: https://www.wisdomtree.com/blog/who-benefits-from-japans-negative-rate-policies

Another important piece of the Ichigo story has been the company’s creation in recent years of three additional listed companies that can buy and hold the stable properties once the parent company has improved them – Ichigo Office REIT (8975), Ichigo Hotel REIT (3463) and Ichigo Green Infrastructure (9282). In addition to serving as an attractive sales channel, Ichigo also earns an ongoing fee for managing the assets once they are sold.  While Ichigo has generated attractive returns from buying and selling real estate over the years, these long-lasting management fees from the affiliated REITs can supercharge the IRR’s the company generates from buying and selling properties.  

The REITs have steadily grown in recent years as they have performed well and been able to issue additional equity at premiums to book value.  Today the REITs are trading below book value and the company is not including any equity raises in its current year forecasts.  Chewy recently wrote up Ichigo Office REIT which I would recommend for more background on the largest and most important of the three REITs: https://www.valueinvestorsclub.com/idea/Ichigo_Office_REIT_/140493

While only appropriate for small funds due to its small market cap ($45 mm USD), we think the recently listed Ichigo Green Infrastructure (9282) is particularly interesting here as well.  The company sells solar energy to large Japanese utilities through Japan’s “Feed in Tariff” (FIT) program that guarantees the sale price on the electricity for 20 years.  9282 has very little overheard, solar output is stable with no input price risk, and the entity pays out its earnings in dividends, with a current distribution yield of close to 8%.  Due to accelerated depreciation, a chunk of the payout is shielded from taxes as well, although various data providers under report the payout as a result (e.g. FactSet currently says it’s 3.7%).  

A few months ago, on a conference call Callon called 9282 “…an extraordinarily compelling product.  It is one of the single best investment opportunities I have seen in my career”.  Callon’s fund owns over 20% of 9282 and bought additional shares on the open market after it was listed late last year.  He also just became Chairman of that entity and appears to be highly focused on unlocking the value of the REITs going forward.  For example, 9282 just issued a 10-year earnings forecast – this was the first time the Tokyo Stock Exchange has allowed a company to do this but it makes sense given the rock-solid nature of its future earnings.  In a country where government bonds offer zero return we don’t think a safe, tax advantaged 8% yield will last forever.  

The company’s IR is responsive, they have financial statements and conference calls in both Japanese and English, and it breaks out its real estate portfolio in detail on slides 35-41 of this presentation, including forecast IRRs and equity multiples: http://www.ichigo.gr.jp/wp/wp-content/uploads/2017/07/Ichigo_20170713_Corporate_Presentation_FY2018Q1_ENG4.pdf

Competitive Advantage

Ichigo’s competitive advantage comes from a mix of its experience, unique model, strong capital allocation, and sweet spot in size that allows it to take advantage of an attractive market opportunity.  The team has been successfully deploying capital into small and mid-sized real estate in Japan for many years and has expertise in sourcing assets, strong relationships with banks to borrow money, as well as in-house engineering talent.   It’s focus on value add, rather than on full scale development projects, decreases the risks at the project level while also increasing IRR’s due to the limited amount of capital required once an asset is purchased.  Ichigo’s affiliated REITs are another key advantage given they are a natural pipeline for assets to be sold into (to be clear Ichigo sells some assets to other groups and the REITs buy from others as well, but a fair amount of Ichigo’s assets end up at the REITs).  

Strong capital allocation is hard to find in Japan and having Callon in charge at Ichigo is a large competitive advantage.  We have tracked the company for many years and have watched it consistently act in a rational and shareholder friendly manner.  They borrow long-term debt at low rates when it makes sense, recently hedged a good portion of their interest rate exposure, and just bought back shares for the first time in many years.  Finally, Ichigo’s focus on small and mid-size properties leaves it with limited institutional competition and a large market opportunity to exploit.  A Macquarie report a few years ago analyzed Ichigo’s opportunity set and found over 10,000 office buildings in Tokyo alone in the size range which it operates.  By contrast the listed J-REITs held just over 3,000 buildings throughout Japan at that time.  We think it’s rare to find a company controlled by a world class investor that is operating in such an inefficient asset class.  

Valuation

There are a few different ways to think about valuation.  As a company that owns real estate, price/book is obviously important, although the company’s book value is consistently below intrinsic value since the properties it buys are held at cost until they are sold, despite the company using its capital and expertise to increase their value.  On a simple price/book the company trades around 2.1x book value, although using the value assigned to its asset by a third-party appraiser, the price/book is closer to 1.5x.  While the appraisers value the assets 21% higher than cost, those estimates are likely overly conservative as well – for example the company just sold an asset this month for 14 billion Yen that the appraisers had valued at 7 billion Yen.  If you assume there is an additional 20% of value above what the appraisers believe, the price/book gets down to just over 1.1x.  

We do believe a premium to book value is warranted given the company’s consistently high ROE as well as the growing earnings it generates from managing the assets in the REITs.  It’s average price/book over the past five years has been 3.3x and the current level of 2.1x is just above the lows over that period.  

I should also note that Ichigo recently ran through a significant tax shield which is part of the reason why net income is not expected to increase in line with operating profit in the near future.    

Since Ichigo actively adds value to its properties, churns its portfolio faster than most real estate companies and has built additional earnings streams into its business model, P/E is also useful to look at.  The current valuation of 12x this year’s earnings is at the low end of where the stock has traded historically – on average it has traded at 18x NTM earnings over the past five years.    

We have followed Callon for a long time - unlike many CEO’s we do not find him to be overly promotional and, if anything, he has a long history of under promising and over delivering.  The company has consistently blown through its previous forecasts, as shown in the table below:

In addition to its conservatism making forecasts, we believe management will continue to do smart things that add value over time – that may be hard to model in a spreadsheet but we have a lot of conviction in this over the long-term.  They recently created an advisory business where they can help manage assets owned by third parties for example, which could be a high margin business going forward.  They also just entered the self-storage space, which while small initially they are very excited about.  In late 2013 when the stock was at very high multiples of book value and earnings they raised new equity and as mentioned, they just executed a buyback in recent months. While small (1% of outstanding shares at 324/share) we think it’s a step in the right direction and are confident the company would buy back more shares if the stock fell further.  

“We announced a buyback today.  It’s pretty simple…The stock has come in enormously.  We’re very happy to buy at these levels and so we are…We look at both earnings yield…and we look at ROE.  So, it’s trading at 2x book.  Our ROE is running at 20% and we think we are comfortably above 15% through the cycle.  We have a very durable franchise.  We think we have global standards of governance so if you attach a normal Japanese cost of shareholder equity - that could be 6%, that could be on the high side 7%, that could be 5%...at 2x book that implies a 10-14% ROE and we’re currently running at 20% and while it may come in a bit this year we think we its’ very durably above 15%.  We always compare buying the stock vs new investment opportunities and frankly new investment opportunities beat the stock, which is to say we’re finding places to put money at 20%+ returns.  The issue is we can do both – we are so cash generative we can buy back the stock and invest in new opportunities.  And so, we are – we will do both this year.”  

- Scott Callon, 04/09/2017 conference call

Risks

• Ichigo Asset Management Stake Decreasing – Callon’s fund has decreased its stake from 80% to 50% in recent years and has guided that we should expect them to sell 5% a year going forward.  The fund bought its initial stake almost a decade ago and had to side pocket the investment because it grew to be such a large and illiquid position during 2013 when it rose almost 10x in less than a year.  Since it is side pocketed the fund’s investors won’t see that capital back and the team won’t crystalize the large embedded incentive fee unless it is eventually sold.  It’s similar to a private equity fund where eventually an asset simply must be sold, no matter how attractive it is.  While this isn’t ideal we think the fund and management team have acted rationally and the alignment of interest remains strong looking forward.  Callon has his entire net worth invested in the fund and doesn’t take any salary or compensation from the company itself.  Ichigo is the fund’s largest position today and Callon has told us that on a look through basis he is the largest investor in the company.  Overall Ichigo will remain an important investment that Callon cares deeply about even if his fund gradually sells the investment over the next 10 years.    

• Size – Historically Ichigo has largely stuck to buying assets in the $10-50 million range but recently has put money to work in larger deals.  It’s possible that given its growth the company has been forced to play in a more efficient and competitive space.  For example, they recently bought a $300 million office building, by far the largest deal they have made.  We’ve walked through that purchase with management and believe they simply found an attractive deal that happened to be large and acted in a rational manner.  Now that they have control of the asset they expect it to be the most profitable deal they have ever made with an expected IRR of 43.5%.  While Ichigo might be forced to focus on slightly larger deals over time, we think there remains plenty of opportunity in Japanese real estate for a disciplined investor.  

• Overall Japan Risk – Ichigo owns real estate in Japan so it is exposed to both the overall economy as well as interest rates in Japan.  For a large portion of its revenue and earnings it depends on a reasonably healthy real estate market to exist in which it can sell assets and realize gains from the properties it has improved, so an increase in interest rates and/or a severe economic downturn in Japan would hurt the company’s earnings.  We view these risks as easily hedgable depending on what you are particularly worried about.  We’ve hedged our exposure to the Yen for example, and we’re comforted by the fact that the company itself has hedged most of the interest rate risk on its debt.  We also believe that the company will hold up well in any sort of mild slowdown or increase in rates – Callon recently said he hopes that cap rates will go up given they have lots of liquidity and could deploy capital at higher rates going forward.  There clearly is exposure to Japan tail risk though but once again you can hedge that based on your own view.    

• Related Entities – Ichigo and its affiliated REITs regularly transact with one another and structures like this in the past have sometimes led to issues – see the “Bill Erbey complex” for a particularly bad example.  In this case we find Callon and the management team to be highly ethical and rational and we’re comfortable with the processes they have put in place to avoid any issues.  While one could argue that Callon is incentivized to favor Ichigo over the REITs, in the long-term the company’s success is dependent upon the REITs performing well and we think there are good reasons why the structure has been set up like this.  It’s also a risk that the REITs will continue to trade below book value and Ichigo’s asset management fees will not grow, although we think this is unlikely over a multi-year period.       

Catalyst

• Continued deployment of capital at high IRR's
• Growth in management fees from the affiliated REITs over time
• Continued value add from disciplined capital allocation