|Shares Out. (in M):||6||P/E||9.2x||9.2x|
|Market Cap (in $M):||562||P/FCF||11.1x||10.0x|
|Net Debt (in $M):||-183||EBIT||91||91|
Company and industry history
The electric-powered dentist's drill (now more euphemistically described as a "dental handpiece") was invented in Bavaria, Germany in 1887 by the predecessors of the publicly traded Sirona Dental Systems. Only very few precision engineering companies have successfully entered the industry at various stages of its technological development, so it is now dominated by a few entrenched companies: the W&H Group (founded in Austria in 1890, still a private family business); KaVo (founded in Germany in 1909, purchased in 2004 by publicly traded Danaher Corp); Bien-Air (founded in Switzerland in 1959, still a private family business) and Nakanishi (founded in Japan in 1930, still managed and 24% owned by the founder's family, public for the past 11 years). Design and manufacture for each of these companies has never moved far from their founding locations nevertheless their various owners appear to have done quite well.
High and stable returns on capital (over the past decade, pre-tax ROC has averaged 70% and always exceeded 50%, ROE averaged 15.6% with a minimum of 14.8% despite significant excess cash) demonstrate that this has historically been a high quality business. The company's competitive advantages suggest it would not be a stretch to extrapolate past performance into the future:
We have all probably heard too much about the global emerging middle class. However, since most people suffer tooth decay, most people don't like it, and despite the odd blip average living standards globally are improving, long-term dental instrument demand should be in pretty good shape.
Innovation for dental instruments has spin-off applications for industrial instruments, applying the ultra-precise high-speed rotation technology to micro-precision machining such as lathes and polishers. This only represents 12% of sales, and personally I am less convinced that returns will ever approach those of the dental instruments business simply because the competitive advantages are weaker and new entrants can more easily compete away any initial advantage gained from innovation. Still, to the extent that this business makes use of sunk R&D costs and might even have some feedback loops back into dental instruments innovation, it is a nice to have.
Clearly the biggest impediment to growth has been the unwelcome Yen strength over the past four years, which has put Nakanishi at a significant cost disadvantage to its European based competitors. Management is gingerly experimenting with lower cost production centers, recently investing in Vietnam, but for now almost all of the many thousands of precision parts are designed, manufactured and assembled in-house in Japan. European competition includes the Swiss (Bien-Air), who have been suffering from currency strength of their own. The key takeaways from currency sensitivity and industry structure are that despite an ownership base of the key players which is a mix of private and public, US, European and Japanese, all companies retain manufacturing in-house, in high cost centers of high skill but rigid labor markets (Japan, Switzerland, Austria and Germany) because these deliver a high quality product and the accumulated knowledge base powers innovation. US owned KaVo still produces upholstery in beautiful but costly Italy, and its only production location in an emerging market is in Brazil, but this is motivated more by punitive Brazilian import tariffs rather than an inherent cost advantage from localized production. Nakanishi's consistent operating margins north of 30% in spite of a relentlessly appreciating production currency suggests that higher costs can be passed onto customers.
This is already cheapish on a market cap basis, at 9.1x P/E TTM and 11.1x P/FCF TTM, meaning that excess cash alone does not make this cheap. When we adjust for that we get:
EV/EBIT TTM 4.2x
Those worried that stocks in general are expensive on a CAPE/Shiller's trailing ten-year average basis should find solace in the fact that EV/EBIT (trailing 10 years) is only 5.3x. The future needs to look much bleaker than the past for this company to be expensive here.
1.28x Price/Tangible Book Value.
Some Japanese stocks are cheaper. But very few of these are truly global businesses with such attractive economics. Clearly this is trading in the public markets at a major discount to US comps or to private market values even in these uncertain times, and would make an attractive acquisition for many trade buyers at a significant premium to the current price. If the family management ever tire of their jobs and prefer to monetize their stake, I would expect a line of eager buyers to form quickly at their door.
Management and capital allocation
Management has been conservative and undistracted in their capital allocation during their history as a public company. An eyebrow might have been raised at the sale of 10% of shares outstanding by former Chairman & CEO Takasuke Nakanishi back to the company in September 2008. Though others might differ in their conclusions, personally I view this as a perfectly acceptable use of excess corporate cash, executed at an appropriate (and presumably non-compulsory) liquidity discount (10% below then-market). For a 71-year-old owner manager who had worked for the company since aged 18, I think this episode was safely above the global average treatment that minorities could expect.
Otherwise I see nothing to argue against the fact that the family's ongoing 24% ownership of this company is aligned to the interests of minority investors. Eiichi Nakanishi, the US educated President and COO is 47 years old and has significant personal wealth ($45 million) in the stock, and annual cash dividends from his ownership probably exceed his salary. He has been with the business for 21 years, and clearly aims to build on his ancestor's legacy. There is nothing to suggest he will be reckless with shareholder's money typical of "heads I win tails you lose" hired hands management.
Management conservatism shows up in a conservative balance sheet, with one third of market cap in net cash. But hey, this is Japan. And who knows, before this economic cycle is over, maybe we will have all learned a thing or two about net cash vs. net debt capital structures. The point is that even ignoring net cash this is still cheap, and meanwhile it makes the company immune from sovereign debt downgrades or banking crises, and gives the company options. One day I hope they use them.
Apart from this cash hoarding, capital allocation has been extremely sensible. Over the past decade, one fifth of CFO has been reinvested in capex at very attractive rates (see returns on capital), and one third has been returned to shareholders via dividends and buybacks. Organic growth, spending other people's money the same way you do your own, no silly acquisitions, this is what I like to see.
EURJPY and USDJPY go to 50 (29% of sales are to Europe, 19% to North America).
Technological developments rendering dentists and their instruments redundant.
Product recalls on quality problems.
Fukushima nuclear fall-out spreads, preventing production at the company's facilities 100 miles away (always well outside the US evacuation zone even during the peak of the nuclear crisis to date).
Generic and Japanese risks.
This is not investment advice and is not intended to be distributed in any jurisdiction where it would contravene local laws.