Description

Nippon Kanryu Industry (1771:JP) is a deep value Japanese nanocap that is surging due to the emerging coronavirus crisis and subsequent scramble for infection control supplies.  The stock is still exceptionally cheap at 1x EV/EBIT, 5.8x P/E and 0.6x P/B with 75% of the market cap covered by net cash and 94% of the market cap covered by net-net current assets.  Despite the company’s tiny market cap of less than $35m, a surge in trading volume to over $1m/day has made it possible for small funds or private investors to consider a position as a hedge against a worst-case scenario in the region.  Over the next decade or so, the company should also be a beneficiary of a structural labor shortage in the Japanese construction industry.  The company’s ownership structure, with no controlling shareholder and the largest shareholder at only 5.6%, may attract a tender offer for control amidst an increasingly active market for M&A in Japan.  This write-up will be brief as the clock is ticking.

The company has three segments: Disaster Prevention and Security, Construction, and Chemicals.

Disaster Prevention and Security

While this segment only contributes about 15% of total sales and operating profit before corporate costs, it has clearly captured the attention of the market due to a surging demand in Asia for protective masks, clothing, and hand sanitizer. 

https://www.foxbusiness.com/money/3m-honeywell-respond-to-coronavirus-mask-shortage

Nippon Kanryu offers a full range of infection control supplies, including masks, clothing, goggles, gloves, foot covers, and hand sanitizer.   

http://www.kanryu.co.jp/safety/infection/index.html

Mask products include their own line of masks for children, N95 masks with 95%+ particle collection (pictures of 3M N95 masks suggest they are a contract manufacturer for 3M), and higher efficiency masks with 98.4%+ particle collection.  

http://www.kanryu.co.jp/safety/infection/maskkids.html

http://www.kanryu.co.jp/safety/infection/mask.html

In Hong Kong, you better believe I am just hanging out at home, and luckily I live on a less densely populated outlying island.  When I have ventured out to buy beer, I would estimate that maybe 80% of the people I see, typically visitors day tripping to the island for a hike, are wearing masks.  Friends on the main island and Kowloon report that it is nearly impossible to find a shop with hand sanitizer in stock.  When masks are in stock, the lines are long and the price is marked up.  @tomgrundy, editor of the Hong Kong Free Press, has been documenting some of this on twitter.  Here he found boxes of 3M N95 masks, 20 pieces for US$90, which rose to US$321 48 hours later:

https://twitter.com/tomgrundy/status/1221381267221925888

https://twitter.com/tomgrundy/status/1222119757849055232

While a contract manufacturer obviously would not directly benefit from price gouging at Kowloon pharmacies, it is a sign of a serious supply shortage in China (most of these pharmacy’s customers are visiting Mainlanders).  The supply chain is already adjusting to meet the sharp increase in demand, and vendors like 3M should be leaning heavily on their partners in the region to ramp up production.

Hong Kongers are being particularly cautious due to the memory of SARS in 2003, which resulted in nearly 300 deaths in the city.  Only 10 cases have been reported in the city of 7 million, but the government has already declared a state of emergency, cross border traffic is being drastically reduced, several popular tourist attractions have been shut down, and schools are closed for the next three weeks.  The HK government has suggested they are preparing for a crisis that could last up to six months.  The quarantine zone in China has a population 7x that of Hong Kong, and more cases are being reported across Asia.

https://www.scmp.com/comment/opinion/article/3047359/after-sars-hong-kong-prepared-another-deadly-coronavirus-outbreak

https://www.latimes.com/science/story/2020-01-28/wuhan-chinas-coronavirus-50-million-people-quarantined

It is difficult to make any estimates here with precision, but if a weeklong state of panic was enough to cause a severe shortage and all indicators point to this heightened caution becoming a way of life for the next several months, 2020 should be an above average year for manufacturers of infection control supplies.  Leading up to this event, this segment has generated the most consistent growth and profitability of the group.

Construction

The largest contributor to revenue and profit is the construction segment, which is engaged in engineering works related to traffic safety such as those for signs and safety barriers.

http://www.kanryu.co.jp/construction/index.html

Results in this segment seem to have benefited from demand for repair works in the years following two major earthquakes, Tohoku in 2011 and Kumamoto in 2016.  Japan is located along the most active earthquake belt in the world and accounts for 20% of the world’s 6.0+ earthquakes.  Tremors of smaller intensity occur almost daily.  Once I was in a mall in Tokyo looking at kittens in a pet store window when an earthquake shook the whole building, which was quite large.  The kitten I was looking at lost its footing and toppled over, and I ran out the nearest exit.  Pretty soon I realized that I was the only person who had run out, and when I walked back in everybody seemed to be carrying on about their business like nothing happened.  The point I’m trying to make is that earthquakes are a fact of life in Japan, and there will always be some road repair or slope reinforcement work to be done outside of the big earthquakes that make the global news.

Another certainty is that much of the infrastructure built in the boomtimes of the 1970s and 1980s will continue to age, which is the more important long-term driver underpinning demand in the Japanese construction industry.  The company has developed environmentally friendly methods to repair and reinforce slopes, tunnels, bridges, waterways, drainage, and steel pipe columns such as lighting poles and signposts.  A browse through the company’s construction-related offerings will give you a general sense of what they do; there are a couple dozen different kinds of projects they feature.

http://www.kanryu.co.jp/construction/structure/index.html

Despite this boom in demand to upgrade the bulk of the country’s infrastructure, which is expected to last through the next decade, the labor pool has continued to shrink.  The number of construction workers has declined by 27% over the past two decades.  25% of the industry’s skilled workers are over 60, compared to just 10% under 30.  The industry is struggling to attract new workers, who have a plethora of career opportunities to choose from with unemployment around 2% and the job opening to applicant ratio at its highest in 45 years.

https://www.japantimes.co.jp/news/2019/11/06/business/economy-business/labor-shortage-japan-construction-economic-boost/#.XjGWfGgzaUk

I believe structural drivers are underpinning a sustained margin expansion for contractors, rather than another cyclical boom and bust.  On the one hand, project prices are rising as it is difficult to add capacity to the labor market. One-offs like construction related to the Tokyo Olympics or major earthquake repair works are quite small as a percentage of industry revenue, perhaps 1-2%, and given the declining supply amidst rising redevelopment and repair demand, these events have simply delayed other planned projects. Workers would seem to have the upper hand to demand higher wages, as the industry has proven very difficult or expensive to automate thus far, and immigration is tightly controlled.  However, workers are still very loyal to their employers, particularly older workers who have bought into the system of lifetime employment, so hopping from one company to the next is rare and employee turnover is low.  At the same time, there was a lack of consolidation by industry participants during the lean years unless forced by bankruptcy to merge, and even the tiniest no-brainer buyout targets like Nippon Kanryu have managed to remain independent by squeezing out a profit every year.  Therefore there are not as many “synergies” being extracted as you might see in the same situation in other markets, which over the long run would free up much needed labor.  Finally, not specific to the construction industry, Abenomics has failed to spark wage growth even as unemployment has fallen, as Japan tries to wrest itself from a deflationary mindset that has lasted thirty years.

The following charts from Tokai Tokyo Research show construction investment in Japan over the past 60 years leading to the expected rebound in demand over the next two decades, the labor shortage over the past 8 years, and the subsequent increase in operating margins at the major and mid-size contractors:

Chemicals

This segment is primarily sales of environmentally friendly weed control material.  “Weed Attack S” is a pavement soil derived from bamboo fiber.  This has been a nice cash cow for the company, although sales and margins have declined in recent years.  There is one additional product in this segment, insoluble sulfur, which is used as a rubber vulcanizing agent.  It is unclear if one or both products are contributing to the recent deterioration in the financial results.

http://www.kanryu.co.jp/chemical/bousoudo1.html

http://www.kanryu.co.jp/chemical/iou.html

Consolidated Financials

The Company records about JPY500 million of annual expenses at the corporate level.  The Company also consistently records an additional JPY50 million of non-operating income; about half comes from dividend and rental income and the other half comes from “commissions” and “miscellaneous.”

In addition to the JPY3,465 million of net-net current assets, which includes JPY2,784 million cash and zero debt, the Company has JPY738 million of investment securities and about JPY2 billion of PP&E, which is mostly land held at cost and depreciated real estate assets.  The current market cap of JPY3,684 million implies little to no value for the operating businesses, which have generated an average EBIT of JPY625 million over the past ten years.  This puts average pre-tax ROIC at about 23%.

With the release of their FY 2019 results in November, management guided for lower revenue (-4.8%) and operating profit (-52.9%) in FY2020, primarily due to expected weakness in the construction segment.  At first glance their explanation for the dismal expectations sounds plausible, as they have just finished a relatively large project related to the Kumamoto Earthquake in 2016.  However, they also cite soaring construction material and labor costs, which doesn’t quite gel with reality.  On closer inspection, this Company has a habit of massively under promising, having exceeded their revenue guidance in 8 out of 10 years by an average of 5.3%, their EBIT guidance in 9 out of 10 years by an average of 84%, and their net income guidance in 9 out of 10 years by a whopping average of 107%:

I learned from a Japanese construction industry analyst recently that this is an industry-wide phenomenon, and that there is a good explanation for it.  Recall again the charts showing the average EBIT margins for the major and mid-size contractors.  (CE) stands for Company Estimate from the beginning of the year.  While margins were steadily increasing from 2015 to 2018, the companies were guiding extremely conservatively and beating their original EBIT targets by 50%.

There are two reasons for this.  One, contractors tend to book revenue conservatively earlier in the fiscal year and then catch up with reality at the end of the fiscal year (ending March), which is also when corporate Japan tends to settle their books and pay taxes, etc.  The second reason is that the contractors are actively bidding on projects and negotiating with their workforce, so it is advantageous in dealing with both parties to look like you are suffering.  Given the sharp downturns of the past, it’s almost believable.  Nippon Kanryu is a little strange in that its FY ends in September, so the first half can be more profitable than the full year, with the most profits booked in Q2 (most of Japan’s Q4).  This chart shows how EBIT margins trend up for the industry over the FY:

Another funky thing about Nippon Kanryu is that it trades on the Fukuoka stock exchange, which you may not have immediate access to depending on your set-up.  If you are a retail investor, check out Boom Securities for access:

https://the-international-investor.com/brokers/boom-securities

http://www.boom.com/en/why_boom/multi_market/

Capital Allocation

I’m not actually a fan of companies that have tiny payout ratios while they hoard cash, run low margin businesses in cyclical industries, and hold stocks with no apparent investment strategy (probably related companies like customers or suppliers).  This company is guilty of all these things.  For somebody out there quick enough, brave enough, and liquid enough, this could be an opportunity to take control through open market purchases.  I have seen this happen before on the Japanese market, and I will perhaps share the name in another write-up one day.  A small cap, very good business with a pile of cash that had never paid a dividend.  The founder was AWOL and there was no controlling shareholder.  Another company in a similar line of business used borrowed money to buy as many shares as it could.  The share price tripled in a month on huge volume, and when the dust settled, this other company reported a 45% stake, up from 5%.  Speaking to management later on, they told me that so many shareholders had been holding on for so long with no dividend, that they just sold into the spike, and there was enough on offer to almost buy control before they even had to report the change in their position.  There was initially some management resistance to certain proposals such as the initiation of a regular dividend, but they put their heads down and did as they were told as soon as the other company bumped their stake from 45% to 50%, giving them the power to replace the board and management.

In the meantime, they are running their operating businesses efficiently enough that I wouldn’t hesitate to give them full credit for their net cash position, something for their investments and maybe 3-4x EBIT at a minimum for the rest of it, making this appear to be a very low risk way to hedge against the coronavirus infecting the rest of your portfolio:

Market Cap: 3.68B

Net Cash: 2.78B

Investments (50% Discount): 370m

Average EBIT: 625m

4x EV/EBIT: 5.65B

Upside: 53%

Downside: Nil. In another year or two, the market cap will be covered by net cash again.  Hard to envision having to take a permanent loss here.

Catalyst

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