Description

Kansai Paint Co. (4613 JP) – Long, ¥2,500/share 12-24 month target

Market Cap: ¥489b (Last Sale: ¥1,790; Shares Outstanding: 273mm)

TEV: ¥476b (¥13b Net Cash)

3-month Avg Daily Volume: 900k shares/day (¥1.4b)

Investment Type: Value w/ soft catalysts

Investment Horizon: ~12-24 months

Summary

Kansai Paint (Symbol 4613 JP, for this write-up I will use “KP”) is a top 10 global coatings maker that is positioning itself to grow at above market rates for years to come given its increasing presence in emerging markets.  Notably, KP has leading positons in India, including the #1 auto coatings maker (with 55% market share) and the #2 architectural coatings maker.  In the near term, KP is also benefitting from raw material cost deflation and will continue to see gross margin expansion as a result.  Additionally, it appears KP has the ability to increase their dividend payout beyond consensus expectations.  At ~7x FY18 EV/EBITDA, I view the stock as cheap on both an absolute and relative basis.  Overall, my ~12-month target is ¥2,500/share, about 40% above the last sale. 

Why This Opportunity Exists

In my view, KP is trading at a cheaper multiple than global coatings comps because of: a) emerging market worries, and b) concerns that global auto production is at peak.  Year-to-date, the stock is down ~3%, outpacing the decline in the NIKKEI 225 (-10%).

Valuation

Base Case: ¥2,500/share (+39%) – ~10x FY18 (March FY end) EV/EBITDA.  Global comps like PPG, AXTA, SHW are trading at 10x-13x CY17 EV/EBITDA.

Down Case: ¥1,500/share (-12%) – ~8x FY17 (March FY end) EV/EBITDA on my Down Case scenario.

Bull Case: ¥3,500/share (+106%) – ~12x FY18 (March FY end) EV/EBITDA on my Up Case scenario, including M&A.

Thesis

The main tenets of my long case for KP are:

-          1)  KP is exceptionally well positioned in India as its Indian subsidiary, Kansai Nerolac Paints (KP owns 69%) is the top manufacturer of automotive paints and second largest maker of decorative paints in India.  Though only ~20% of KP’s consolidated sales now, India will be the main driver of sales growth for the company over the next several years.  India coatings demand is growing at an exceptional rate:

o   KP has a strong relationship with India’s largest auto maker, Maruti Suzuki, and will benefit from a continued acceleration in auto demand.  Per Goldman Sachs, Indian auto sales will increase 15% and 18% in FY16 and FY17, respectively.

o   On the Deco side, sales are growing at a low-to-mid teens rate (14% in Q3 FY16).

-          2)  Raw material costs will remain a tailwind for coatings makers this year – recent commentary from the like of SHW, AXTA, etc. point to modest (i.e. 2%-4%) reduction in raw material costs in CY 2016.

-          3)  KP is a consistent generator of cash.  In fact, over the last 15 years, KP has only been free cash flow negative once (2012).

-          4)  I believe KP can increase shareholder remuneration, most notably by increasing their payout ratio. 

-          5)  KP has a fortress balance sheet and a well-regarded management team, thus I expect most any M&A transaction to be looked upon favorably.

-          6)  I believe KP is cheap – KP trades at ~7x my estimate of FY18 EBITDA, while global industrial coatings comps like PPG and AXTA are trading at 10x-11x CY17 EBITDA.  I believe the discount is too large for a company I view as of relative quality.

Catalysts

The key events for KP over the next 12-24 months are:

-          -  Potential mid-term plan update in the next several months.  The highlights of such an update could be:

o   Increased payout ratio – given a net cash balance sheet, KP has a high degree of flexibility.  KP’s current payout ratio is 20%.  Goldman Sachs believes KP will raise the payout ratio to 25% in Q3 of FY17 (which would still be below the 33% TOPIX average).

o   Potential for management to layout new 3-year sales targets that are beyond consensus expectations.  Currently, consensus is calling for sales to increase at a 2.9% CAGR through FY19, which seems quite beatable to me.

-          -  M&A – KP has been modestly active in M&A / JV formation over time.  With a strong balance sheet and an inclination to grow its presence in emerging markets I believe KP could very well do bolt-on M&A deals in these markets.

-          -  Earnings evens – again, I believe short/medium term estimates look conservative

Business Description

KP is the ninth largest coatings company in the world in terms of revenues.  KP’s largest end market is automotive, and the company is effectively one of five major coatings suppliers to global auto manufacturers – the others being PPG Industries, Axalta Coating Systems (AXTA), BASF, and Nippon Paint (4612 JP).  In aggregate, these 5 coatings makers comprise >80% of the global auto coatings market.

By region, 44% of KP’s sales are derived from Japan, 20% from India, 20% from the rest of Asia, 11% from South Africa, and the rest from other regions.  By end market, 38% of KP’s sales come from automotive coatings, 27% from decorative paints, 25% from industrial coatings, 6% from marine & protective coatings, and the rest from other coatings-related businesses.  Notably, KP and AXTA operate an auto coatings joint venture in South Africa (named Kansai Plascon).

KP traces its origins to 1918 in the city of Amagasaki City, Hyogo Prefecture in Japan, by Katsujiro Iwai, who is also a founder of Iwai & Corporation (the predecessor of the current Sojitsu Corp).  Iwai established six manufacturing companies by investing profits he created through trading, one of them being KP.  Iwai’s intention was to create a globally competitive Japan-made product in order to

contribute to the nation’s wealth, unlike the trading business which was effectively a processing business.

KP is run by Hiroshi Ishino, who joined Kansai Paint in 2003 from Mitsubishi Corporation.  He is the first President to assume the role without being originally from KP.  He assumed the President role in April 2013.  President Ishino has expanded KP’s business into overseas markets, culminating in the acquisition of Freeworld Coatings in South Africa in April 2011.

Risks

 - The main risks to KP are:

-          -  Decline in global auto production as 38% of KP’s sales are tied to auto

-          -  Downturn in emerging market growth, notably India, South Africa and developing Asian markets

-          -  An increase in raw material costs (including oil-based raw materials and TiO2).

-          -  M&A – while KP has done a decent job at M&A, the risk exists that they make a deal that is too expensive or doesn’t make strategic sense.

-          -  F/X - >50% of KP’s sales are outside of Japan, thus the company is highly exposed to currency fluctuations.

Financial Overview

Catalyst

 -         -  Potential mid-term plan update in the next several months.  The highlights of such an update could be:

o   Increased payout ratio – given a net cash balance sheet, KP has a high degree of flexibility.  KP’s current payout ratio is 20%.  Goldman Sachs believes KP will raise the payout ratio to 25% in Q3 of FY17 (which would still be below the 33% TOPIX average).

o   Potential for management to layout new 3-year sales targets that are beyond consensus expectations.  Currently, consensus is calling for sales to increase at a 2.9% CAGR through FY19, which seems conservative.

-          -  M&A – KP has been modestly active in M&A / JV formation over time.  With a strong balance sheet and an inclination to grow its presence in emerging markets I believe KP could very well do bolt-on M&A deals in these markets.

-          -  Earnings evens – again, I believe short/medium term estimates look conservative