Description

Note: this is a very simple idea – buy a good quality business at a really cheap price – so I’m going to hold back a lot of the nitty gritty details and keep this writeup focused on the context, key points, and under 1,500 words.  All of the company-specific details you need to make an investment decision are in the links below and on the investor relations page: http://www.ntl-naigai.co.jp/ir/

QUICK PITCH:

This is a recommendation to buy shares of Naigai Trans Lines (9384 JP), a low profile owner-operated Japanese freight forwarder from Osaka.  Naigai trades at just 6.4x 2012 PE or 0.9x 2012 EV/EBITDA despite achieving world class industry profitability metrics, posting 22% average EBIT/equity (or 87% average EBIT/ex-cash equity) since going public, and increasing dividends steadily over time (both absolute DPS and the payout ratio).

Naigai deserves a higher multiple because of its unique competitive advantage in less-than-container-load “LCL” export sea freight on intra-Asian routes.  These are niches with good/defensive economics (sticky/diversified clients with some pricing power and high ex-cash ROEs), growth potential (long-term beneficiary of intra-Asian trade growth), and upside in the face of possible long-term yen depreciation (see FY11 presentation page 34 https://www.xj-serve.com/ir2/users/naigaitrans/docs/32ki_kessansetumeikaisiryou.pdf, each 1 yen depreciation vs. USD increases revenue by JPY 50m and gross profit by JPY 15m).  There is no other listed freight forwarder in the world that is as pure a play on these niches as Naigai is.  

According to a Bloomberg screen done minutes ago (http://db.tt/2G2IMIht) Naigai is one of only 8 listed companies in Japan (out of over 3,700 total in the entire country) trading at single digit PEs with double digit ROEs, high single digit EBITDA margins, 20%+ dividend payout ratios, sub-0.4x EV/market caps.

For reference, European/American peers trade at 16x 2012 P/E and 8-9x 2012 EV/EBITDA (see page 20 http://db.tt/NidxBlU8).  Japanese peers routinely trade at mid-teens 2012 P/E’s and +5x 2012 EV/EBITDA (see page 8 http://db.tt/R5LDXplr).  Naigai’s closest Asia-ex Japan peer is Malaysian-listed Freight Management Holdings Bhd, a microcap that trades at 4.6x 2012 EV/EBITDA despite 1) LCL represents just 31% of revenue (43% of gross profit) and 2) management is shifting away from lower risk / asset-light forwarding towards higher risk / asset-heavy warehousing.  

Naigai’s consolidated results (JPY):

2011:   revenue = 12.5b,  GP = 4.0b,  EBIT = 1.1b,  equity = 5.0b,  ex-cash equity = 1.4b

2010:   revenue = 11.4b,  GP = 3.7b,  EBIT = 1.0b,  equity = 4.7b,  ex-cash equity = 1.1b

2009:   revenue = 8.7b,  GP = 3.2b,  EBIT = 0.6b,  equity = 4.2b,  ex-cash equity = 1.0

2008:   revenue = 11.9b,  GP = 4.0b,  EBIT = 1.1b,  equity = 3.9b,  ex-cash equity = 0.9b

BASIC BACKGROUND:

Naigai is an NVOCC (non-vessel operating common carrier) sea freight forwarder.  NVOCC sea freight forwarders act as consolidating agents for containerized cargo lines – a nice gig.  NVOCC’s do not own any fixed assets but they do own the customer base so they can funnel shipment orders to big container lines for a fee (i.e. a gross margin between what an NVOCC pays for container space and what it sells that same space to clients for).  Hence NVOCC’s are asset light cash cows that occupy the best niche in global logistics as measured by profitability and returns on capital (see this primer http://db.tt/xZbAat0d for more background, especially the chart on page 4).

Incredibly, Naigai occupies the two best niches within the NVOCC niche: higher margin less-than-container-load “LCL” freight forwarding (76% of revenue and 89% of gross profit) and higher growth intra-Asian trade routes (83% of revenue, as follows: 53% HK/China/Taiwan/Singapore/Korea, 30% ASEAN).

The LCL niche:

Less-than-container-load LCL freight forwarding caters to small import/export clients that, by themselves, would not be able to fill a single twenty-food shipping container (TEU) or justify the absolute cost.  These small-fry clients typically look to an LCL forwarder to consolidate their shipment with other small-fry clients until a single container fills up.  The upshot: small clients each get to ship less than a full container of stuff for a much lower cost on an absolute value basis, and LCL forwarders get a fat gross margin markup on a per unit of volume basis for the hassle/expertise of consolidating these micro shipments for large container lines.  Though it takes many years to establish, this is a sweet niche to be in because it normally involves serving a highly diversified pool of small/sticky clients that are otherwise ignored by larger freight forwarders.  If other freight forwarders are in the LCL business, they’re almost never solely focused on it because the absolute market size is tiny; as an example, LCL sea freight represented just USD 19 billion of the entire USD 250 billion in global freight forwarding industry revenues (see PDF page 20 here http://db.tt/JOauu56a).

Naigai dominates the LCL niche in Japan with over 15,000 clients, most of which are SME businesses.  According to a trade publication (http://db.tt/yr8Ljood page 2 bottom-left chart) citing data from the Japan International Freight Forwarders Association (JIFFA), in 2009 Naigai occupied a 20% share of Japan’s total LCL exports (up from 8% in 1998) and a 25% share of Japan’s Asian LCL exports (up from 15% in 1998).  Naigai’s dominance of Japanse LCL means a few things:

A)    Naigai earns a superior gross profit per container TEU shipped: according to industry data (http://db.tt/JOauu56a and http://db.tt/Gw4Dsd37) the best European freight forwarders like DSV, Panalpina, and Kuehne+Nagel earned a gross profit per TEU in the USD 300-600 range from 2009-2011.  By contrast, Naigai’s LCL export segment (which generates vast majority of profit) consistently earned a gross profit per TEU of USD 900+ over the same period.

B)     Naigai earns a superior EBITDA margin: the big 3 Euro forwarders above earned EBITDA margins in the 2-6% range from 2005-2010.  Naigai earned a 10% EBITDA margin from 2006-2011 with the exception of 2008 (trough margin of 8%).

The intra-Asian routes niche:

            Since they started out in 1980, Naigai was a pioneer in intra-Asian routes and today they represent the bulk of revenues.  Going long Asian ex-Japan demand has been a great move so far (i.e. steady market share gains since 1998), and continues to make sense long-term if you believe more and more stuff produced in Asia will get consumed in Asia (instead of Europe/North America).  According to a lengthy Deutsche Bank report on this topic (page 47 http://db.tt/Uso22ZwT), intra-Asian freight forwarding volume is expected to grow 10% per annum for at least the next three years, faster than any other region. Also noted in the report is that most listed European/American freight forwarders are way behind the curve on the intra-Asian growth trend (none of them derive a meaningful % of revenues/profits from this).  Just a few weeks ago Panalpina, a sizable European freight forwarder, announced that they are finally starting LCL routes from Japan to Singapore/SE Asia www.panalpina.com/www/global/en/home/news_media/latest_news/12_07_10.html.

            Likewise, western shipping lines have also been late to the intra-Asian routes party and as a result they don’t have as much pricing power on those routes like they do elsewhere because of intense competition from regional competitors.  According to Naigai management, gross margins have been (and still are) comfortably higher on intra-Asian routes because of continuous shipping liner competition and strong final demand in places like China (at the end of the day, nothing does more to sustain Naigai’s margins than filling up a container to max capacity, and growing economies make that task so much easier).

2009 RESULTS EXPLAINED:

            As you can see, Naigai suffered a steep revenue drop between 2008 and 2009 due to the global financial crisis.  Interestingly, gross profit margins expanded from 33% to 37% over this period, and the reason has to do with the unique pricing power that leading LCL forwarders have over their diversified base of small-fry clients (most of whom are only big enough to rely on a single freight forwarder).

            Naigai’s COGS are determined by container shipping freight rates and its revenues are determined by what their clients are willing to pay.  Though freight rates can be really volatile, the prices Naigai charges are less so.  In other words, when freight rates drop like a rock, Naigai can take its sweet time passing on those lower rates to clients and (briefly) earn a super-normal margin – a nice defensive buffer.  This is exactly what happened in 2009, Naigai’s peak year gross margin-wise.

            Yes, EBIT declined a lot in 2009 – but it didn’t have to.  The reason it did had more to do with Naigai’s family-oriented culture.  Whereas many global forwarders rely on variable bonus compensation cultures, Naigai prefers to skew its pay towards fixed salaries so staff can feel more secure in relatively tough times like 2009.  According to Naigai management, preserving short-term EBIT margins back then would’ve required destabilizing pay cuts / layoffs and ruined their corporate culture.  Since they had excess cash in the bank, management focused instead on restoring the top line back to the pre-crisis peak, which was achieved in just 2 years despite the strong post-Lehman yen.

Major risks:

-        further yen appreciation causes further hollowing-out of Japan Inc manufacturers/exporters, eroding Naigai’s LCL customer base

-        management (they control over 70% of the shares) does something crazy to shareholders in terms of cash management

Catalyst