Description

Anchoring and insufficient adjustment is one of the first heuristics you learn about at behavioral finance school.  Here’s one way to make money from it in the wild.  

LONG KANSAI PAINT (“KP”).  

(I use a lot of pictures to tell this story, attempting to illustrate the anchoring effect.)    

Profits have broken to the upside from their recent range, but the stock price has not.

(Note EBIT is more relevant due to NI including exceptional gains referred to below.)

The stock is down 10% YTD 2024 in a Japanese market +15 to +18%.  This leaves KP’s valuation at an 8 year low of 10x EV/EBIT.

So which is the more likely future EV/EBIT multiple for this stock: 10x (2000-2013 average) or 17.5x (2014-2024 average)? 

To answer that question let’s see how this company compares to global paint industry benchmarks.  First, we’ll compare historical stock performances and valuations.  Second, business quality.

10 year stock price CAGRs (ex. divs):

Notice the clear bifurcation: Sherwin Williams and 4612 Nippon Paint delivered solid double digit returns.  PPG, Axalta and Akzo Nobel were pedestrian in comparison at mid single digits.  Historically, KP was in this group.  RPM has started to break out from the also-rans, and is now approaching the two leaders.  Elliot’s involvement starting in 2018 was an important turning point for that family managed firm to become more shareholder focused.  

10 year historic valuations (KP is thick blue): 

Two things to see from historical valuations:

1. The stocks with the highest historical returns (SHW, RPM and 4612 Nippon Paint) also command the highest current valuations of 18-27x EV/EBIT.  Though you could argue this is just the fruits of momentum, instead I think it has more to do with having businesses and management which are higher quality than PPG, AkzoNobel and Axalta.  I would argue that the first three managements demonstrate a commitment to building shareholder value that the others do not.  This translates into better focus and capital allocation.    

2. Despite KP not historically being close to the top in business quality, neither has it been valued as obviously the worst - it has run with the pack for a long time.  Its current cheapness is a recent aberration. 

KP’s recent cheapness seems to me to be a mistake by the crowd.  The stock price is basically unchanged over the past decade, despite enormous improvements in management and capital allocation.  

Business quality 

This is not the highest quality paint group in the world.  Despite market leading positions in Japan and India Auto OEM business (total Auto + Refinish is 35% sales), a further 25% of sales are in highly competitive industrial paints, and 28% in non-dominant architectural paints market shares in India, parts of Africa and Japan.   So operating margins are mid to high single digits rather than the low to mid DD achieved by larger comps.

Nevertheless, there seems to be room for improvement.  As often happens in Japan, change might appear glacial for years, but then happens almost all at once.  A steady upgrading of senior management, including Presidents Kawamori Yuzo (2010-13); Ishino Hiroshi (2013-19); Mori Kunishi (2019-now) and the current CFO Takahara Shigeki have brought this once sleepy management into the 21st century.  Takahara-san was an important external hire in April 2020 who deserves some credit for combining the best of US and Japan practices: ROE ambition achieved through collective effort and attention to detail.  Starting then, “a number of sub-committees for Improvement of Business Performance…comprising a total of 82 members made up mainly of young employees aged in their 20s to 40s, work across business departments to solve common issues” (1), with the explicit goal of improving returns on capital. 

Once KP management succeeded in restoring ROE to its original 10% target, they proceeded to raise it to 13%.

Adjusted ROE: (Net income + Amortization of goodwill) / Shareholders’ equity (Average of the term)

13% ROE became a “must to be achieved by FY 2025.  Execute “share-buybacks” as needed, to achieve the targeted ROE.” (2)

Net shares outstanding (millions)

Mar-21   257 

Jun-21   257 

Sep-21   257 

Dec-21   257 

Mar-22   257 

Jun-22   254 

Sep-22   233 

Dec-22   232 

Mar-23   231 

Jun-23   226 

Sep-23   226 

Dec-23   226 

Mar-24   211 

Net shares have been cut by 18% in just 2 years (12% excluding recent buyback on convertible issuance - see risks).  The average price paid by the company is slightly below current, which I think looks cheap.  

Next came sales of non-core investment assets, whose exceptional gains result in this year’s spike in NI (see first chart) and ROE, neither of which will be sustained.  

Aside from the noise of exceptional gains, operating profits for FYE Mar-24 will genuinely increase by over 50%.  Although accurately forecast by management, and the fruit of management strategies the past several years, I think it still represents a shocking kind of growth number for this Osaka, Japan-based paint company.   

So the evidence for improved business quality has only actually started to materialize in the past two years: higher ROE, better capital allocation, a reduced share count, and now higher earnings.  And yet the stock price is basically unchanged since January 2022.  This anchoring and insufficient adjustment produces an attractive valuation.  

Risks

1. FX.  More than 50% of operating income is ex. Japan.  The company’s Japanese auto manufacturer customers also have significant FX sensitivity.   

2. M&A.  The biggest scope for management error.  The African businesses bought last decade have struggled, losing money six straight years until a sale attempt to AkzoNobel in 2022 which was ultimately blocked on antitrust.  Forced to manage their way out of an inherited problem, profitability has been restored for the second year.  Unfortunately KP has limited experience building a world class deco business in other geographies so despite the demographic promise, I am skeptical they will achieve much in Africa, though someone will build a very decent African deco business over the next few decades and it could be them.  I also struggle to believe in their European acquisitions, worried that most of these small acquisitions frequently made by PPG and Akzo rarely meet disciplined return on capital hurdles.  The one exception seems to have been Nippon Paint’s Australian Dulux acquisition, but that was already an obviously dominant and excellent business when they bought it.   

3. India.  While their auto business looks promising, deco is currently being disrupted by a deep pocketed, ambitious new entrant Aditya Birla group firm Grasim Industries.  This demonstrates the vulnerability of obviously great opportunities and the advantages of restrained competition.  Kansai Nerolac had #3 Indian deco market share before this new entrant.  For non-believers in India, if you subtract KP’s 75% shareholding in Nerolac from KP it implies a 5x EV/EBIT for KP’s non-Indian businesses.

4. Selling of stock by shareholders unwinding cross holdings.  Though there is a (low probability) potential that KP represents an achievable takeover target.

5. Convertible debt.  KP recently issued ¥100 billion of zero-coupon convertible debt maturing 2029 and 2031.  Conversion price is ¥2,771 (+28% from current).  I admit I don’t like this process of issuing so much potentially dilutive debt, especially given the already low yield of ¥ debt.  Header valuation numbers represent this as debt.  

References:

(1) https://www.kansai.com/sustainability/pdf/report/2021_ir_en.pdf

(2) Q4 2020 Starategy update

Catalyst

sustainability of higher operating earnings