Description

Kyudenko Thesis

Kyudenko trades at a cigar-butt valuation, but it is a high-quality electrical and HVAC engineering business, with recurring revenues, that has compounded its earnings at a 17% annual rate since 2007. This is not another Japanese junk-box with a lot of cash. Kyudenko is a stable business that is dominant in the Kyushu region, which enjoys better demographics relative to the rest of Japan. And, the company should benefit from a continued shift towards energy efficient buildings and infrastructure.

I think the stock has 70% upside to fair value and minimal downside, given that cash and securities account for nearly 40% of the market cap.

High-Quality Business

Kyudenko is a leading Japanese electrical engineering company. It primarily installs and maintains electrical systems and HVAC for buildings/factories (84% of revenues) and manages and repairs utility power lines (11% of revenues).

Kyudenko operates a simple and predictable business model. Repeat orders from existing customers account for about 70% of sales and more than 40% of operating profit comes from recurring business, like maintenance or remote monitoring. This provides a stable source of demand. Electrical projects tend to be small and short in duration, with a typical project costing Y100m or less (below 1m USD) and last for one year or less. Furthermore, most of Kyudenko’s costs are labor, not materials. These short duration, low-cost projects are easy for Kyudenko to budget, resulting in a strong track record of profitability with double-digit plus returns on operating capital.

To understand the durability of Kyudenko’s business model, consider the company’s performance during Japan’s period of economic crisis referred to as the “Lost Score” from 1991 to 2010. During this period, construction spend in Japan halved, but Kyudenko’s revenues remained flat. And despite the slowdown, EBITDA has been positive each year, going back to 1982. 

Very Cheap on Longer-Term Earnings Power

The business is resilient and held up extremely well during COVID and the company expects healthy growth over the next three years. For the year ending March 2021, sales are expected to be down just 1% year-over-year, with an EPS decline of just 8%.

Management’s mid-term plan (for the year ending March 2024) implies top-line growth of 6% per year and EPS growth of 12% per year to 478 yen per share.

Excluding the value of net cash and investments, the stock is trading for under 5x March 2024 EPS. 

That is insanely cheap for a business of this quality.

Dominant Market Share in a Healthy Region of Japan

Kyudenko is the largest electrical engineering company in the Kyushu region, which has enjoyed stronger population and GDP growth than the rest of Japan because of its proximity to China and other Asian countries. Being the largest company has meaningful advantages. Kyudenko has a dense service network with close proximity to its customers. This results in a cost advantage, compared to peers. Sourcing labor is also challenging in the engineering field and because of this, smaller players are exiting the market. Over the next few decades, the number of contractors is expected to shrink by another 30% from current levels. 

As you can see in the diagram below, Kyudenko’s presence in this region is vast. This is unmatched by competitors.

Impact/ESG Stock

Kyudenko also benefits from secular trends in sustainability. The more services it provides, the more positive impact it has on the environment. I suspect that Kyudenko’s sustainability angle will result in a higher valuation over time.

Japan relies on high-carbon resources for almost all its energy consumption. Japan receives 88% of its energy from coal, oil, and natural gas – all imported from other countries. Japan’s energy self-sufficiency ratio is just 8%, which is amongst the lowest in the world. The country’s goal is to double its reliance on renewable power to 24% of its energy mix by 2030 and to reduce greenhouse gas emissions by 26% by that time, compared to 2013.

Kyudenko is critical to helping Japan achieve its goal of increased energy efficiency and penetration of renewable resources. Japan has already made significant improvements, as its emissions levels dropped by 12% between 2013 and 2018. Kyudenko provides and services technology that will enable the country to continue this improvement and meet its long-term resource reduction goals.

Kyudenko installs and maintains environmentally friendly and energy efficient building systems. This includes the equipment for LEED certified buildings, which consume 25% less energy than commercial buildings, and 11% less water. Its offerings go beyond traditional electrical systems. Kyudenko offers a proprietary energy management system that converts solar or wind power (where output is inconsistent depending on weather conditions) to a stable power resource. This puts less stress on lead storage battery systems and dramatically extends their useful life to about 18 years, from 11 years.

Valuation and Risk-Reward

Even amongst Japanese value equities, Kyudenko’s balance sheet optionality is extreme. As a percent of its current market cap, the company has 40% in net cash and investments. Yes, there are plenty of Japanese companies with juicy net cash balances. But, many of them aren’t great businesses. In this case, even if the cash continues to build, I think you win. And, if the company decides to return cash to shareholders, you win big.

Corporate governance and capital allocation continues to improve in Japan. I also like Kinden, in Japan, which is a similar business to Kyudenko. It too had a large cash balance until it decided to start buying back stock in January 2020. I believe Kyudenko is facing similar pressures from shareholders to return excess capital. 

The stock trades at about 11x consensus 2021 EPS. Adjusted for cash and securities, it trades at just 6x. Longer-term, I think the EPS should grow at around an 8-10% rate (including potential share repurchases). The stock also offers a 2.5% dividend yield.

At 15x 2021 EPS + 1500 yen per share of cash and investments, the stock has approximately 70% upside to fair value. 

That’s pretty darn good, considering the recurring nature of the business and the margin of safety from the balance sheet.

Catalyst

Hitting mid-term targets.

Improved valuation as it is realized to be a sustainable business.