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LONG: Namura Shipbuilding

Namura Shipbuilding, a Japanese shipbuilder, is one of the cheapest stocks in the world at .4x EV/EBIT. This is a stock for the Ben Graham in you. The Warren Buffett in you will hate it. 

Ben Graham was a deep value investor, which is to say he was a bottom feeder, and I say that with the utmost pride. Only the most base, vile bottom feeder could be interested in a stock like Namura Shipbuilding, which will probably never earn more than the historical stock market return on its invested capital and therefore according to capital budgeting theory, ought to liquidate and become an index fund.  

Equally repulsive, Namura has just completed a dilutive acquisition of Sasebo Heavy Industries. To acquire a business which hasn’t made any money in years, Namura gave away 20% of itself in the form of stock. It gets worse. Macro factors have formed a sort of perfect storm for Namura. Worries over the potential collapse of the Japanese economy taint all Japanese securities, as does the fact that Namura’s record profitability over the last few years came from the almost-violent depreciation of the yen. Piling on, rock-bottom oil prices have come along and kicked shipbuilders in the teeth, and finally there is even according to the shipbuilding companies themselves a massive amount of overcapacity in the industry. Some say there is double the supply of ships that there should be relative to demand.

2015 will be a terrible year for Namura. And that’s why I like it. The wonderful thing about being thrown from a moving car and left for dead is that you’ve already been thrown from a moving car and left for dead. In this case, the bad news is already priced in, and the emotional pain for holding this is extreme. That’s the time to act.

I believe Namura offers the patient investor a 70% return at some point over the next two years. For the less patient investor, I think Namura offers an opportunity for some appreciation in the next quarter, as the drawdown in shipbuilding stocks comes to seem like an over-correction.

Some background

Namura was founded in 1911 and went public on the Osaka Exchange in 1949. Until 1999, Japan produced most of the world’s ships, but now its share of global shipbuilding has fallen to 16%. Meanwhile South Korea’s share is 34%, and China’s has grown to 39%.

Shipbuilding in Japan is a stagnant industry without any prayer for growth. The number of workers involved in shipbuilding in Japan has been flat for years.

Source: OECD.

From 2002 to 2012, of the Japanese shipyards that produced ships over 10,000 GT, 8 closed or downsized, and only 2 opened a new shipyard or expanded. Bottom line: this is a commoditized, rather hopeless industry where you have to break your back just to stay in place.

That said, innovation in the industry is slow, and Namura operates in a…I hesitate to say unique…but at least a somewhat less commoditized space with in it. Of the top global firms located in Japan, Namura has one of the largest shipyards and thus has a somewhat less-common capacity to produce some of the largest ships (VLCC oil tankers, WOZMAX ore carriers, etc.). I would consider this a very mild “plus.”

Some have said that shipbuilding in Japan would be dead if it weren’t for the government, but I haven’t really seen evidence of that. While the Japanese government seems to have several initiatives to help the shipbuilders and has taken steps to help lower their cost of capital a little, all of the government’s efforts seem vague and marginal at best. When I started researching this, I was hoping there’d be something in Japan similar to the Jones Act in the U.S. The Jones Act requires that goods moved between U.S. ports be transported on U.S.-built ships, something that essentially is the reason there are any shipbuilding companies at all in U.S., where high labor costs would otherwise prove prohibitive. Unfortunately Japan has no such protectionism.

Nonetheless the fact that Namura has been able not only to survive the rise of cheap shipbuilding capability in China and also consistently turn a profit speaks well of its staying power. Namura’s profitability is unique among Japanese shipbuilders (granted a falling yen has augmented that profit nicely). 

This is from the company website, and is one of the few helpful things on there. It’s in yen, but for reference the smallest pre-tax profit, which was ¥6041 in 2011, works out to $70MM using the 2011 year-end JPY/USD exchange rate (at today’s exchange rate, it would be $50MM). The biggest pre-tax profit, which was in 2014, works out to $200MM at the current exchange rate. Though 2014 profitability will likely never happen again anytime soon, the thesis here doesn’t remotely depend on it. Even the 2011 level of profitability of $70MM is wonderful for a company with an enterprise value of $31MM.

Current valuation

Using TTM financials and company guidance, below are the valuation metrics for Namura:

Price/book: .72

Price/sales: .47

EV/EBIT TTM: .13

EV/EBIT for FY 2015: .4

Notice the huge difference between EV/EBIT forward versus TTM. Namura had a great year last year, and now it is guiding to a 66% drop in earnings. Moreover this drop in earnings is the “new normal” for the company and the industry as a whole for at least the next year. Investors have gone from bored to scared.

But so what?

When you account for its cash hoard, Namura  meets the definition of “stupid cheap.” .4x EV/EBIT is a multiple for a company that’s distressed or within the zone of insolvency. Namura, however, isn’t either, not even close. It’s choking on cash. It’s consistently profitable, though at this price it doesn’t need to be in order to have a lot of appeal. Really what’s going on is that Namura is in a sleepy, low-growth, low-margin industry which is projected to have an absolutely awful year. And as usual the “macro” prophets are predicting things will be this way forever.

One point about the Sasebo acquisition: though it isn’t accretive to earnings, it was still a good acquisition. First of all Namura didn’t pay that much for Sasebo—a little less than 1x Sales—but the combined entity will have something most Japanese shipbuilders lack, and that’s the ability to manage large orders. For LNG carriers (which haul liquefied natural gas), shippers prefer Japanese and South Korean shipbuilders to the Chinese, and even between the Japanese and South Koreans, the Japanese companies are viewed as having an edge in safety technology. But they frequently lose out to South Korean companies because they can’t fulfill a large-scale order. In these circumstances, a consolidation like the one between Namura and Sasebo could be valuable in the long-run. 

Why this opportunity exists

Namura or any shipbuilder is probably never going to trade at a glamour multiple. These businesses simply aren’t high-growth or high-quality enough to support that. But there are several things that have come along and turned this ordinary unhappiness into hysterical misery: 

(1) overcapacity in the industry

(2) low oil prices

(3) macro fears about Japan

(4) Shipbuilding is a low return on capital business

Overcapacity

According to one CEO of a Korean shipbuilder, the global supply of oil tankers and bulkers and oil carriers is twice demand. Now some shipyards are preemptively reducing their working hours for 2015 by 10-15%. I own it right away: that’s an absolutely terrible sign. When we look at the Baltic Dry Index, which measures shipping rates for major raw materials, we can see why these companies are so concerned.  

Source: ZeroHedge.com.

The index, as measured annually each January above, is at the cheapest point since 1986. Yes, that’s right, 1986. 30 years ago. The simple concept of supply and demand tells us what this means for shipbuilders like Namura who make ore carriers and bulkers. The shipping rate is so low that it won’t encourage industry participants to build new ships to meet demand. This doesn’t auger well for Namura. That said, the shipping rate is already at a historic low. It’s not likely to go much lower. 

You might be thinking, well how can you know that? First of all, I don’t know it for certain. Second of all, nobody else does either. What I do know though is that most of the opportunities we come across arise from people’s overconfidence about an industry’s demise—or at least it’s long-suffering future. And outside of cases involving technological obsolescence, this is an extremely, extremely difficult thing to predict. What I’m saying here is bet on price, which is certain, and not on industry predictions, which aren’t.

Returning to the shipping rate, notice how low rates have been each January since 2009. Despite this massive headwind for the industry, Namura has continued to be well into the black over this period. I think if Namura can be profitable in this environment as it has shown it can, then it’s likely enough that it will continue to do so.

Cheap oil

Record-low oil prices are terrible for shipbuilders in general. The thinking goes: their customers are going to have to delay CapEx and orders for capital goods in order to survive the environment of low to no profitability. This was why Korean shipbuilders, which along with China are Japanese shipbuilder’s biggest competition, fell 50% in 2014.

Namura is in a different boat (ha, pun). Many other shipbuilding companies make drill ships and offshore production vessels. But Namura focuses on tankers. Some analysts have said that low oil actually increases demand for tankers in particular because low oil prices boosts oil and gas shipments. I don’t really know if this is true, but frankly I don’t really care. All that matters is that low oil prices don’t portend a complete collapse in Namura’s long-term earnings power.

The point here isn’t to get into the weeds on vagaries of shipbuilding industry analysis or predictions about oil. That’s just too hard. The point is to highlight that low oil prices don’t represent an existential threat to Namura’s business. They may hurt it a bit or they may not hurt it all. They may even help it. But either way, demand for Namura’s tanker products is probably unchanged long-term.

The Macro picture

Namura is a Japanese company, which means at least on the surface its fate is affected by the broader Japanese economy. Japan is undergoing demographic collapse, and despite what everyone thinks, its supposed financial crises aren’t financial in origin at all. They’re demographic. The fact is Japan’s population is aging at a scary rate, and it has utterly failed for the last 30 years to produce enough young people to pay for older dependents. As sad as this is for Japanese culture and the Japanese people, this is neither here nor there for the shipbuilding industry in Japan, which exports the vast majority of its ships. The endgame that Kyle Bass and scores of other hedge funds are predicting could play out, and Namura would be fine.

In fact the weakening of the yen, brought on by an increasingly desperate Japanese central bank, has been a huge bonus for the shipbuilders. As you can see, the yen has depreciated quite a bit since 2012 against the U.S. dollar.

As mentioned earlier, this has augmented earnings for exporters like Namura. That said, it’s not a repeatable source of earnings, and so the thesis doesn’t really hinge on Japan’s currency doing one thing or another.

Flat earnings maybe forever

Namura isn’t a compounder, and it will never become one. Its return on invested capital is anemic. Below is a model once used by Buffett to determine intrinsic value. Buffett would take the return on invested capital and then divide it by some sort of discount rate (I think he used a 10-year Treasury rate, but here we use the historical nominal return on equities). Once he’d done that he had a valuation multiple which he’d multiply times the company’s invested capital to get intrinsic value.

According to commonsense capital budgeting, this $1.1 billion of invested capital never should have been invested in Namura’s business in the first place. Instead investors should have taken their billion+ and stuck it in the market, earning 9% nominally a year. That said, the invested capital in this business is so large that even though the company has a tiny ROIC, it still has a decent amount of intrinsic value.

Shipbuilding is not a “good” business. Full stop. What does that mean for us here? Well, there are some no-growth businesses which provide investors with hope (though not results), but shipbuilding isn’t one of them, and so we can’t rely on the greater fool theory to make this investment appreciate above intrinsic value. But fortunately Namura is so cheap we don’t have to.

Our valuation is below. We’re more conservative than the Buffett model above because Buffett accounts for “quality” and as bottom feeders, talk like that just makes us angry. 

Intrinsic value

Because Namura is essentially a $600MM pile of net cash with a business currently valued at  $31MM attached, any valuation needs to use enterprise value instead of market cap. We like Ben Graham’s P/E measure and have altered it for our purposes here.

Graham’s measure of intrinsic value:

Value = Earnings x (8.5 + (2 x growth rate))

Graham believed that a company with zero earnings growth deserved to trade at an 8.5x multiple, and any growth beyond that should be multiplied by 2 and added to the 8.5. Interestingly Graham hit the nail on the head with this. The average earnings growth rate for the S&P 500 since 1870 is 4% or so nominal. Plugging this into his equation gives you an earnings multiple of 16.5. And what do you know? That’s average P/E for the stock market since 1870. Yet another thing Graham got right.

We prefer operating earnings to net earnings, so we use EV/EBIT instead of P/E. We have looked at historical financials for the market and determined that a 6x multiple is appropriate for a company with zero earnings growth.

Here’s what we get when we plug Namura’s numbers into our model. Note the stock currently trades at $9.04.

We think Namura’s shares offer 70% upside, using some pretty undemanding assumptions, such as that earnings never again grow for the foreseeable future. Now let’s assume the opposite, that operating income hasn’t bottomed at $80MM and it falls to $40MM. Not the worst-case scenario, but certainly pretty bad.

If earnings halve, the stock would still be 34% undervalued. There is some margin of safety provided by this company’s steep discount, and it’s good to know that some deterioration of the company’s fundamentals over the next year isn’t even remotely a doomsday scenario (to say nothing of all the company’s cash).

Disclaimer: Nothing the author writes should be construed as investment advice or a recommendation to buy or sell specific securities. Please do your own research. While everything the author writes is factually correct to the best of the author’s knowledge, a lot of this is guesswork and is far more subjective and far more prone of error than it may seem. You are encouraged to notify the author of any mistakes or oversights in the comments section, but the author assumes no liability whatsoever for the accuracy of the information herein. Moreover the author undertakes no duty to update the information contained in this write-up. Do not rely on the information set forth in this write-up as the basis upon which to make an investment decision.

Catalyst

• ·       Oil prices stabilizing, if not going back up to a sustainable price

• ·       General investor sentiment that the sky is in fact not falling for shipbuilders long-term.

       Really these are pretty weak catalysts, but frankly this isn’t an event-driven idea, and I don’t want to try to make it one. I think this is a mediocre company trading at a fire-sale price, and frankly the lack of catalyst on the horizon is the reason the opportunity exists in the first place. As Howard Marks has said, you have to catch the falling knife; if you wait until the dust settles, there’ll be no bargains left.