Description

Elevator Pitch

Lixil is the dominant producer of household interior and exterior products in Japan with the #1 position in 9 out of its 11 product segments and #2/#3 in the two others. Despite its dominant position, it has margins that are 300bp below peers in Japan. Yoshiaki Fujimori became the CEO of Lixil in late 2011 joining from GE with the intention of improving domestic margins and expanding abroad. Fujimori was the highest ranking Japanese executive at GE in its history commanding a number of high profile roles. We believe there is significant potential to improve Japan margins and that Fujimori is the CEO to set the improvement in motion. We believe also that analysts are underestimating how accretive the recent acquisition of Grohe in Europe and American Standard Brands in North America will be. We see the company potentially earning > ¥300 in cash EPS in 03/17 with the stock trading at < 2,400 or < 8x. At a not unthinkable 16x the stock would be a double.

Bull Case

There is significant opportunity to improve Japanese margins

Lixil can cut costs to close the margin gap with peers

According to the research firm Fuji Keizai, Lixil is the number one producer of kitchen systems, bathroom units, dressers, wall units, tile, aluminum sash, doors, gates, and fences in Japan. It is the number two producer of toilets and the number three producer of faucets. It is the only comprehensive provider of building products in Japan. The market is consolidated with the average market share of the top three producers across these segments at 76%. Despite Lixil’s strong position, its margins lag peers. Margins for peers such as (Rinnai, KVK, Toto, YKK, and Takara Standard) average 9% (and range from 7.6% to 11.9%) for the relevant segments versus Lixil at 6%. International companies have even higher margins with Geberit at 23.4% (in bathroom and faucets) and Masco at 12.4% (in Kitchen, bathroom and faucets).

Lixil is a roll-up of various brands. The 1970s incarnation of Lixil was called Toyo Sash, which was mostly focused on exteriors. It later added the Tostem brand in interiors and then merged with Inax in 2001 to bolster this position. Tostem-Inax became JS Group in 2004 after they added Shin Nikkei and Sun Wave. It was not until 2010 that Lixil was born (good LIving and LIfe) and the company started making efforts to really combine all its disparate brands. The 03/12-03/14 cost savings/integration program was called C-30 with the goal of streamlining products and integrating back office functions. The company aimed to save ¥110b offset by ¥55b in expansion costs for net savings of ¥55b on 03/11 operating profit of ~¥40b. The plan pre-dates Fujimori by a few months but he adopted and executed it, achieving the full savings in the company’s estimation.

Calls with former Lixil employees and competitors confirm there is significant opportunity to cut costs. We spoke with employees that were at the company well into the C-30 program and they say there is still ample room, particularly through the integration of production facilities and logistics. Six-Sigma was only first introduced in the 03/13 fiscal year. The feedback on Fujimori has been very positive. He spent 25 years at GE eventually becoming the CEO of GE Plastics in 2001 and then GE Japan in 2008 (along with the Asia consumer lending business). It is worth quoting Immelt and Beccalli (head of GE International) upon Fujimori’s promotion:

Fujimori is a true global growth leader. His extensive background in both the industrial and financial sectors, along with his strong relationships with Japanese partners will ensure that GE is equipped to maximize its growth opportunities in Japan… Fujimori brings a strong international perspective and leadership skills to this role.

So far he has shown he is not the typical Japanese CEO writing a quarterly Executive Column and talking about the need to bring diversity and change to the workforce. In his first annual report he discusses development of a “performance-oriented culture” and mentions that they “implemented new executive performance and compensation practices”. The first stock options pursuant to this were issued in April 2012.Contacts suggest morale is high at the company with employees embracing change.

The new mid-term plan (G-15) consists of a growth plan (MI-16) and a new cost savings plan (BT-16) that aims to save ¥110b in the Japanese new and renovation segment (not inclusive of distribution or real estate) with an estimated ¥33b in leakage. This plan focuses on further simplifying the product assortment but also consolidating production sites for the first time. In our base case we assume that ~¥35b in cost savings flow to operating profit by 03/17 (at current currency levels) and domestic operating margins reach close to 7% (with savings somewhat offset by declines in new housing), still 200bp shy of competitors. In our bull case we assume margins of 8% (100bp below comps) with slightly less cost savings where the improvement is driven by better macro. In the bear case we assume higher cost savings of ~¥60b but a worse macro situation resulting in little improvement in margins (260 bp below peers).

Lixil can improve its domestic mix towards the renovation market

Approximately 25% of Lixil’s Japanese sales for the new and renovation markets are for renovation. Analysts estimate that Toto’s renovation share is > 50% (though VAR suggests that number is inflated and probably closer to 35-40%). The aforementioned Fuji Keizai estimates that ~40-45% of the sales in Lixil’s markets are for renovation. Renovation sales carry ~2x the margin of sales into the new home market. We estimate a 4-5% margin for Lixil’s sales to the Japanese new home market and 9-10% for renovation. Former Lixil sales managers tell us that they were incentivized to drive the topline and that the new home market represented the easiest path to do so. Furthermore, the company does not have as robust a system of showrooms for designers or contractors that work in the renovation market as its competitor Toto.

Focus on the renovation market is one of the core pillars of the G-15 midterm plan. The company estimates the renovation market will grow double digits through 2020 and Lixil “should aim for growth at least twice the rate of the market as a whole.” (from the July 1, 2013 Executive Column “Seizing Opportunities in the Existing Housing Stock Market”). VAR contacts echoed the bullish estimation for renovation growth driven by an aging population with limited availability of senior living facilities, an aging housing stock, efficiency tax credits at a time of high electricity costs, pent-up demand, and housing ill equipped to cope with earthquakes and/or tsunamis. We are not willing to underwrite such a bullish scenario and assume a 4% CAGR for Lixil renovation sales in the base case (2% in the 03/15 fiscal year), 6% in the bull, and 2% in the bear. Coupled with a significant decline in new home sales we have the company getting to a ~33% renovation share in the base and bull cases (36% in the bear). Without any change in sales or sales mix this shift would contribute a 40bp improvement in margins in the base case of the 100bp we assume.

Analysts are underestimating the accretion from recent overseas acquisitions

Lixil’s goal is to reach ¥1t in overseas sales versus close to ¥200b in 03/13. In 2011 Lixil acquired Permasteelisa an Italian designer and installer of large steel exteriors and interiors (think the Guggenheim Bilbao). In 2013 it acquired the North American operations of American Standard Brands (completing the acquisition it began in 2009 when it took the Asia operations). In January 2014 Lixil acquired 43.75% of Grohe, a high-end producer of bathroom and kitchen products. Each of these acquisitions have considerable goodwill and intangible amortization, which Japanese analysts include in their estimates. Lixil plans to move to IFRS in 03/17 at which time only intangible amortization will still run through the P&L. It does highlight an adjusted EPS number ex both items.

Lixil purchased Grohe (and its Chinese subsidiary Joyou) as part of a consortium. Lixil and the Development Bank of Japan (DBJ) bought an 87.5% stake through both preferred shares on which interest is paid and common shares. A third party retained 12.5% of the company, which they are in the process of acquiring. The initial equity injection was reduced by a preferred share investment by several Japanese banks. In 03/15 with a 43.75% share, Lixil runs Grohe through the equity line. After the acquisition of the third party’s 12.5%, they will consolidate the entity (in 03/16). In 03/17 Lixil plans to buyout the preferred shares of DBJ and the banks to own 100%. This purchase faces no hurdles (Lixil has a call option), and our numbers and net debt calculation reflect its completion. Over 50% of the operating profit improvement from 03/14 to 03/17 comes from the acquisition of Grohe. It will be 40% accretive to 03/14 EPS, a fact being masked by the process of consolidation and the amortization of goodwill and intangibles.

Grohe is a high quality asset with mid-teens operating margins. A majority of its sales are in Europe but despite this it has grown sales over the past few years with margins staying between 15% and 17%. VAR confirms that this is a solid asset and that its margins are not out of whack with those seen at other high quality manufacturers (Delta within Masco and Geberit). The company was able to replace Grohe’s debt at an 8% interest rate with debt at 3.5%. On our three year out estimate they paid 10x EBIT for the company. American Standard Brands (ASB) is not as high quality but is much smaller. ASB has been operating with a low single digit margin. Lixil estimates it can extract $35m in synergies off of a 2013 estimated sales base just below $900m and operating profit of ~$50m. It quickly struck a deal with the large US distributor Ferguson that can improve sales (VAR confirmed) by $200m. We expect margins to get to 7.5% from 6%. At that level they will have paid 7x EBIT for the company.

Lixil has other opportunities and the balance sheet to expand outside Japan

The now closed purchased of Grohe of the original stake in Grohe and the impending purchase of the additional 12.5% will take the balance sheet to ~2.5x leverage in 03/15 (after a number of short-term cash generative actions from the sale of receivables and some investments). Part of the G-15 plan targets an improvement in the cash conversion cycle from 90 days to 55 days. We factor in some working capital improvement in the coming years, which should be achievable given our view that overall Japan sales will be down to flat. Given this and generally improving earnings we see the balance sheet ~1.5x levered by 03/17 even with the outlay for 43.75% of Grohe and < 2.0x after 03/15. The company could deploy another ¥150b yen in this timeframe. If they can acquire at 10x EBIT it would add > ¥20 in EPS (assuming debt at 3%). This would enhance our base case by > 7%.

Bear Case

The Japanese housing industry is facing a downturn

The Japanese housing industry faces cyclical and structural headwinds. On the cyclical side, housing starts have been in decline this year to decline due to the April 1, 2014 increase in the consumption tax from 5% to 8%. There was some pull ahead in demand in the 03/14 period due to this impending increase. Starts are expected to be down > 10% this year. The last time the income tax was raised was just after the end of FY 03/97, after which housing experienced a steep downturn after the increase and never really recovered. We assume two years of 10% declines in the base case then flat starts and 15% in the bear case (followed by a 10% decline in 03/17). The more bearish analysts also assume a decline in renovation sales after a 9-10% increase in 03/14.

On the structural side, Japan faces a declining population in an already oversupplied housing market. The Japanese population has been declining since 2008. The number of households is expected to start declining after 2015 and will decline at a 0.2% CAGR through 2030. Currently there are ~50m Japanese households (127m total population) and as of 2008 ~57m homes, implying a vacancy rate of 12%. There is no obvious need for new homes in the country, so the downside to new homes may be lower than the 800k we assume in the base case.

Response

The economic circumstances at the time of the 1997 tax increase were much different. This was the period of the Asia crisis and the persistent deflationary process had only just started in 1995. It is true that the tax increase coincided with a similar effort to restart the economy that we are seeing today. The level of overbuilding also did not look much different than today given around 600k household formations at the time with 1,600k starts. The government has instituted a number of mortgage tax breaks through 2015 to offset the impact of the tax increase (as they did in 1998). The amount of mortgage principal that can be deducted from income taxes will double; the inhabitance tax deduction will increase from 5% to 7% with the maximum increased by 1.4x; and there is a new upfront cash benefit for households earning less than $50k. If you combine these benefits with the tax increase it is actually better to buy after the tax increase for households earning over $60k under most circumstances (it depends on house size and whether it is with or without land). We see the ultimate impact as more a function of the overall macro scenario. We will likely see some downturn but the macro will dictate the degree. In any case, the 20% decline to 800k we assume seems reasonable. The 03/10 trough was 775k units and the absolute monthly low was an annualized 683k in August 2009. Fiscal year to date trends are in-line with a 10% reduction and starting in October homebuilder new orders started to turn positive which generally implies an increase in starts 3-6 months out.

We do not see much risk of a sustained downturn in renovation demand. The four year CAGR is only 4.8% and VAR contacts have been very positive on the backdrop. Plus we should see some lagged demand from new home sales that have averaged 7% growth in recent years. Lixil also has scope to grow beyond the market. But as with new homes, renovation demand will be a function of the overall macro economy. Fiscal year to date renovation demand has been flat to slightly negative with Lixil outpacing the market up 2%. However, recent traffic indicators in showrooms have been very positive suggesting an upturn in activity.

In terms of the structural argument, Japan has a very unusual housing market that maintains activity well above household formation. Every five years the government releases demolition estimates. The last set was released after 03/08 and we are due to receive an update this year or next. In the five year period from 03/03-03/08 ~900k units per year were torn down in Japan. Average starts during that period were ~1,200k. There are a number of academic studies showing that home values in Japan for the physical structure fully depreciate in 30 years (the Japan Housing and Land Survey puts the number at 27 years) and some studies show the number to be as low as 15 (Koo, Richard and Masaya Sasaki, “Obstacles to Affluence: Thoughts on Japanese Housing”, NRI Papers No. 137, Dec. 2008). Half of all homes are torn down before they are 38 years old (Jiro Yoshida of Penn State provides that claim here: http://freakonomics.com/2014/02/27/why-are-japanese-homes-disposable-a-new-freakonomics-radio-podcast-3/) and > 30% of homes are this old (most pre the Japan Building Standards Act of 1981). In the US the life expectancy of a home is 64 years and in England it is 84 years. There is some premium put on new homes in Japan that cannot be completely explained by quality or degree of disaster preparedness (see the Freakonomics link). There are 4x the number of architects per capita in Japan and 2x the number of construction workers than the US. At the same time the second hand market is very small relative to other developed economies. With renovation work growing we may see some additional negative influence on this tear-down phenomenon, but there is some underpinning to new home construction.

The first cost cuts have not shown up in the results

The C-30 program will have saved ~110b in costs in the 03/12-03/14 period. However, operating profit in Japan has gone from ¥46b to ¥72b for total growth of only ¥26b when net savings were expected to be ¥55b. We should be skeptical of any cost savings promises made by management. It may be that the company is simply involved in too many areas across interiors and exteriors with too many brands to affect a proper consolidation.

Response

We have looked at the detailed operating profit bridges for the period and almost all of the delta between the expected and realized savings can be explained by currency and some permanent cost increases from the earthquake/tsunami and then Thai floods. Lixil is negatively impacted by a weak yen. The historical currency sensitivity is ¥1.3b in operating profit for every 1 yen move to the dollar (the current sensitivity is ¥0.5b). The average yen exchange rate in 03/11 was 86 and in 03/14 it was 100. That implies a ¥19b hit to operating profit and the reported Forex hit (using the full year estimate from the Q3 report) has been ¥18b. The company had a plant in Japan shutdown post the earthquake/tsunami and another shutdown due to the Thai floods both in 2011 (the Thai factory is back to full operation). There have been an additional ¥6b in costs added to address vulnerabilities the company saw post those events. Together this largely closes the gap.

Lixil’s integration efforts have weakened its brand positioning and it is losing share

Lixil clearly lost share in the 03/12-03/14 timeframe. New home sales grew 22% during the period while Lixil’s sales grew 10%. Renovation sales for the whole market grew around 10% and Lixil grew a similar amount, but they are supposed to grow much faster than the market. During this time Lixil’s R&D spend as a percentage of sales has been decreasing while Toto’s, its principal competitor, has been increasing.

Response

On an absolute basis Lixil spends roughly the same amount on R&D as Toto, and calls with market participants have not picked up on anything particularly negative on the competitive side for Lixil. The company has been rationalizing SKUs and brands, accounting for some of the share loss. Most of that work is done. We should also not underestimate the impact the Thai floods had on the company. Most of the share loss came in 03/12 when they had to shut the plant and later change their manufacturing base.

A weak yen is negative

Historically a weak yen has been negative for Lixil. It has become less so with overseas acquisitions and some change in sourcing strategy. Presently the sensitivity is roughly ¥0.5b for every 1% move in the Yen/$. A move from the current ¥118/$ to ¥130/$ would erase ¥5b in profitability or 4% of our 03/17 operating profit assumption.

Response

Lixil’s yen sensitivity will continue to decrease as it expands overseas. With the consolidation of Grohe, we see forex sensitivity getting cut by another 30-50%.

Catalyst

-Pick-up in Lixil renovation sales

-Turn in Japanese and Lixil new home sales

-Continued progress on cost cuts

-Full consolidation of Grohe and acquisition of remaining stake