Description

Nagano Keiki (7715)

Thesis:

Nagano Keiki is a small-cap Japanese manufacturer of pressure measurement instruments. Although a small cap, Nagano has a solid competitive position as one of the largest pressure gauge manufacturers in the world with very strong brand names. The business has proven resilient through past economic cycles and is receiving a material tailwind from recent Yen depreciation with ~50% of sales coming from outside of Japan. Despite demonstrated business resiliency and strong recent results, Nagano trades at ~5.6x run rate EBIT (~4x run rate EBITDA). These multiples compare favorably with Nagano’s annual average TEV/EBIT multiple since 2016 which has fluctuated between 5.8x and 11.2x with an average of 7.6x. Nagano’s strong competitive position, resilient underlying business, currency tailwinds, and modest multiple expansion to closer to its average TEV/EBIT multiple of 7.6x will drive >30% upside to fair value by year end 2023.

Note: liquidity is fairly thin at ~$400k/day so this idea is only appropriate for small funds and PA’s.

Business Overview:

Nagano is a leading manufacturer of pressure measurement instruments (pressure gauges and pressure sensors). Founded in 1896, they have a storied history and have established strong brand names and customer history. Nagano focuses on higher specification applications where performance is often critical. Their instruments typically have <=1% accuracy specifications (many times much less). End Users of their products (e.g. refineries, petchem plants, automobile OEMs, semiconductor fabs, water treatment plants, etc.) create accepted manufacturer lists (AML) for pressure gauges / sensors for brands that have demonstrated their reliability and suitability for the application. It is not an easy thing for competing manufacturers to get on an AML. In addition to AMLs, customer history / preference plays a large role in product selection. Engineers with a long history of successfully using Nagano’s products continue to specify them in new projects because pressure instruments constitute a very small portion of the overall project cost and reliable, accurate measurement is important. In addition, Nagano’s large installed base creates built in MRO (maintenance, repair, and operations) demand for their products. When a pressure gauge or sensor has reached the end of its useful life, the maintenance engineer will almost always order a drop-in replacement from the same manufacturer unless there was a performance issue. Their incentives typically do not encourage potentially jeopardizing process reliability in order to save small amounts of money.

Nagano does not provide a breakdown of their business between MRO sales and new project sales, but we can surmise based on the stability of their revenues that there is a large chunk of relatively stable MRO based revenue. Looking back to the great financial crisis, peak to trough revenue decline was ~25%. During peak Covid year (12 months ending 3/31/21), revenues declined 9%. During both those time periods, Nagano remained solidly FCF positive.

Nagano’s business is not a high growth business. Total revenue has CAGR’d at 2% since 2008 and 3% since 2016. However, EBIT has done much better growing at 9% since 2008 and 11% since 2016 due to gross margin expansion from ~23% in 2008 to ~28% in 2022.

Despite many attractive business characteristics, Nagano is still an overcapitalized Japanese company. ROIC has averaged ~6% since 2016 and ROE has averaged ~8%. While I do believe there is meaningful room to improve these numbers, my thesis does not count on significant changes in operational or financial strategy.

Note: unless otherwise noted, all figures in tables below are in millions of Yen.

Industry Exposures:

Pressure measurement instruments are used in a huge number of industries. Some of the larger industry exposures include Upstream, midstream, and downstream O&G (with downstream being the largest), petchem, water & wastewater, semiconductor fabs, automobile OEMs, power generation, pharmaceutical / biotech, food and beverage plants, pulp and paper mills, and large HVAC systems. These industries vary widely in their cyclicality as well as their MRO vs project-based demand split; however, we do know that Nagano’s overall revenue stream has remained fairly stable through recent economic gyrations.

Below is the industry split Nagano provides:

It is easy to note the 23% exposure to automotive products, 12% exposure to semiconductors, and 4% exposure to HVAC systems. Oil & Gas and petchem sales would undoubtedly be included in the 40% constituted by the Industrial Machinery and Process Products segment, along with water & wastewater, power gen, and other process plant type applications.

Segment Breakout:

The table below lays out the segment revenue streams Nagano breaks out. Pressure gauges account for about half of their revenue, pressure sensors account for another third. Both of these segments have CAGR’d at ~4% since 2018. In the most recent quarter ending 9/30/22, strong oil & gas demand in the USA, good demand across most sectors in Japan, and currency tailwinds drove solid y/y pressure gauge revenue growth of 22%. Pressure sensor demand was also solid across all fronts, but sales were hindered by continued shortages of electronic components (chips). Pressure sensor sales in quarter ending 9/30/22 were up only 6% y/y. As those shortages resolve, I expect pressure sensor sales growth to accelerate in line with pressure gauge sales, but I am not modelling that benefit.

Measurement Control Equipment, Die-Cast, and Others segments are all driven in large part by the Japanese automotive industry. They posted decent results in the most recent quarter, and their results should track the Japanese automotive industry in the future, but they do not benefit from currency tailwinds like the pressure gauges and pressure sensors segments.  

Geographic Split / Currency Tailwind:

About half of Nagano’s revenue is generated in Japan, 22% in the USA, 15% in Asia (mostly China), 9% in Europe, and 3% elsewhere. The recent ~25% depreciation of the Yen/USD is a large boon to Nagano’s business. Depreciation vs the Chinese Yuan (~20%) and the Euro (~7%) have been somewhat smaller, but still a solid tailwind. Not only does this depreciation mean more Yen for every dollar/Yuan/euro of sales immediately, but it improves Nagano’s competitiveness going forward as 2/3 of their PP&E is located in Japan (20% in USA and balance in China).

It is worth highlighting here as well that revenue growth is being driven by Asia, Europe, and Others. Japan has stagnated since 2018. USA is only up 1%. It is likely that USA revenue in 2018 was benefitting from greater O&G activity than occurred in the year ending 3/31/22.

Run Rate Earnings + Downside Case:

In the table below I lay out my forecast for the year ending 3/31/23 assuming that the business performs in the final two quarters exactly how it performed in the quarter ending 9/30/22 adjusted for current exchange rates. In reality there will likely be some additional revenue growth due to higher oil and gas activity; however, that additional revenue may be offset by the slowing global economy. “Run Rate” annualizes the most recent quarter’s results at current exchange rates. “RR – 25%” is the downside GFC case where I haircut the Run Rate Case Revenue by 25% (similar peak to trough decline seen during GFC) and decrease Cash Opex by 10% as well (similar to GFC as well).

TEV and Valuation:

Nagano has a net cash position that is roughly offset by a net pension liability.

Since 2016 Nagano’s TEV/EBITDA multiple has fluctuated between 5.8x and 11.2x with an average of 7.6x. The current market price implies 5.6x. Mean reversion to 7.6x would imply well north of 30% upside to fair value.

Risks and Mitigants:

Risk 1:

Nagano is overearning relative to their current mid cycle earnings power. Global economy goes into a recession hurting Nagano’s cash flows making it only optically cheap.

Mitigant 1:

Nagano currently trades at a reasonable 9x EBITDA in my GFC stress test scenario.  During the real GFC, Nagano traded at >15x trough EBITDA implying a large margin of safety today.

Risk 2:

My returns are measured in USD not Yen. The yen may continue to depreciate and impair the dollar value of my investment as 50% of Nagano’s revenue is generated in Japan.

Mitigant 2:

I don’t have a strong view on the future trajectory of the Yen, but this is a risk that can be hedged.

Risk 3:

Japanese capital allocation is poor. Nagano has piled up cash and investments on its balance sheet over the past 15+ years. When will I see my money?

Mitigant 3:

There is a paltry dividend, but this is a real risk. The good news is that they have not destroyed capital with large acquisitions. The only semi-mitigant to this risk is the extremely depressed valuation. 

Catalyst

Continued solid financial results driven by currency tailwinds, strong competitive positioning, and oil & gas activity