Description

Katakura Industries (“3001 JP”) is a small-cap Japanese conglomerate trading at a 9% free cash flow yield with five business divisions: (i) real estate; (ii) textiles; (iii) pharmaceutical; (iv) machinery; and (v) other.  This is an update to our 2018 write-up that provides more background on 3001 JP’s businesses.  Since our write-up there have been several positive developments that make 3001 JP a more compelling investment today.  We believe that near-term earnings momentum, combined with management’s increased focus on returns of capital, will drive a re-rating of the shares.  With a market value of ¥50 billion, despite having a real estate portfolio worth ¥127.8 billion and proportional net cash and investments worth ¥45.8 billion, there is 243% upside from 3001 JP’s close.  Downside is protected as 3001 JP’s proportional net cash and investment portfolio covers 90% of the current market value. 

Historically, 3001 JP’s growing, and profitable real estate business, has been masked by its other businesses that were mostly loss making due to typical Japanese mismanagement.  Additionally, 3001 JP has had poor disclosure around its real estate value and, in true Japanese fashion, has operated with far too much excess capital on its balance sheet.  All of this resulted in an undervalued and underfollowed stock.  This is changing as 3001 JP’s current largest shareholder, Oasis Management (who recently increased their ownership to 10%) started an activist campaign in 2017 pushing for improvement in both profitability and capital efficiency.  While it has taken longer than expected, this has actually led to several transformative changes to 3001 JP’s business in the last few years:

1. 3001 JP underwent a structural reform and exited all of its loss-making businesses.  3001 JP achieved its target of positive EBIT for all segments by 2020 despite C19.
2. 3001 JP cut a significant amount of costs by reducing its employee headcount by 21%.  This was primarily through two rounds of early retirement incentive programs.
3. 3001 JP appointed a new outside CEO and three new independent directors.
4. 3001 JP initiated a share repurchase program in April 2020 and has acquired 4% of shares outstanding as of the end of May 2021.  We expect repurchases to continue as the program is ongoing.

As result of new management and the structural cost reduction program, 3001 JP’s non-real estate businesses have gone from consistently losing money to making money:

Concurrent with its cost reduction programs, 3001 JP has improved its capital allocation.  Since 2019, the company has sold ¥1.8 billion of stock it held in other public companies, and we expect continued progress to convert a portion of its remaining ¥36.2 billion investment holdings into cash.  Additionally, 3001 JP announced its first ever stock buyback program, and has bought back 4% of its outstanding shares since the program began in April 2020.  The company is actively buying in the market and is on track to complete the current program (additional 1.4% of outstanding shares) before the end of 2021.  We expect them to refresh the program and to continue repurchasing stock.

Considering a structurally improved business and improved capital allocation, we also believe 3001 JP’s current 2021 EBIT guidance overly conservative – making now an ideal time to invest in 3001 JP. 3001 JP generated ¥1.6 billion of EBIT in 1Q2021 alone, and while there is some seasonality, we expect 2021 EBIT will far exceed guidance of ¥3 billion.  The real estate business will drive further earnings upside beyond 2021 as the country rebounds post-C19 - 3001 JP’s main property, Cocoon City shopping center, was materially impacted by C19 and is not expected to fully recover this year.  Cocoon City is by far the company’s most important property, and its success has resulted in 3001 JP beating its real estate segment forecast every single year for the last ten years.  3001 JP also achieved its previous mid-term 2021 EBIT target of ¥4 billion for the real estate segment two years early which we believe highlights how effective new management has been.  We expect the segment will return to ¥4 billion EBIT which is an incremental ¥300 million EBIT upside not in our 2021 estimates.  Additionally, 3001 JP has been contemplating the next phase of development for Cocoon City and its surrounding owned real estate.  This was put on hold due to the pandemic, but the company has indicated it will likely present the next major real estate development plan in the upcoming new mid-term plan which could be released as early as fall 2021.  The prior Cocoon City development was completed in 2015 and took the real estate segment’s EBIT from ¥2.2 billion to ¥4.1 billion.

Given 243% upside and 90% of its market value in net cash with an increasing focus on capital efficiency (including active buyback program), we believe an investment in 3001 JP is a compelling and asymmetric risk-reward.

Catalyst

 2021 guidance upward revision

Continued share repurchases

Potential announcement of next real estate development project to drive multi-year growth