Description

SK Kaken is currently one of the cheapest paint stocks in the world, and yet is simultaneously top decile for business quality measures (high and stable returns on capital and profit margins) and also top decile in terms of insider ownership.  The company enjoys a dominant market share in the niche of Japanese architectural coatings, as well as growth opportunities throughout Asia, which have combined to deliver excellent returns on capital (25 year ave. total pre-tax ROC: 29.4%) though sales growth has moderated (1.5% CAGR past 5 years, 4.5% past 10 years).  The business possesses sustainable competitive advantages such as economies of scale in distribution (accentuated due to the high weight/cost ratio of paint), and high switching costs (commercial real estate managers who choose shoddy paint pay dearly, after the purchase) and continues to benefit from historic R&D sunk costs (evidenced in product developments such as anti-bacterial and stone effect paints).  Although analyzing Japanese companies can be frustrating and rarely leads to even 50% of the level of detail that one would routinely expect in a US investment, at the current valuation discount combined with significant insider alignment (reducing the chances of buying a lemon) this stock looks attractive despite being located in Japan.

(Copy and paste from 10 years ago, reasons explained in Introduction.)

Introduction

Preppers got a bad rap for years, until a pandemic made geniuses of them all. The equivalent in Japanese public companies is SK Kaken.  A good business is hidden deep beneath layers of net cash, making the stock a safe place to hide during the pandemic and its economic fallout of unknowable duration. Unlike an unappealing doomsday bunker somewhere in North America where no sane person would choose to live, however, once you get inside you realize how beautiful the business is. Double digit FCF yields combined with the security of net cash supporting 87% of market price might even tempt a few to stay around for while.

This month is the 10 year anniversary of my previous write-up on this company.  Much of the investment thesis still holds true, which I illustrate by copying and pasting the original with updates highlighted. TL;DR: market share now>50% in great niche, ROC higher, sales growth moderated, cash piled up.  Hundreds of others’ recommendations have outperformed its 11.5% total annualized return over that decade.    But not many arrive at such a low risk current valuation, combined with a decent business that holds promise for future returns.  VIC rules state that submitting the same idea - even after a 10 year gap - means that this write-up counts for nothing.  So if you want to show solidarity to a respectful request to qualify long-term shareholders for a second write-up after 10 years, feel free to rate this a 10! 

Business quality

The business has been consistently profitable for at least the past 25 years, throughout a daunting Japanese economy and recent global challenges, delivering operating margins of 8.0-14.0% annually, often beating the relevant segment margins of global peers.  Despite selling essentially a mixture of chemicals and other commodities that fluctuate in price significantly, the business has demonstrated sufficient pricing power to maintain gross margins in a relatively narrow band of 28.1-33.8% since 1995.  Average pre-tax returns on capital (EBIT/net working capital plus PP&E) were 33.1% over the past 15 years.  This is not a commodity or cyclical business.

In contrast to the falling sales experienced by many Japanese businesses, a function of relentless price deflation overlaid and poor demographics, SK Kaken probably just completed its 5th unbroken year of positive top line growth in domestic sales (FY Mar 2020 results due next month).  Domestic Japan Sales CAGRs have been 2.7%-4.6% for the past 5, 10 and 15 years.  This is not a typical superficially cheap Japanese company suffering declining sales and patchy profitability.

SK Kaken manufactures and distributes paints and decorative materials.   The following examples from SK Kaken’s current product line should illustrate:

https://www.sk-kaken.co.jp/product/exterior-finish-materials/graniterior-ex/

https://www.sk-kaken.co.jp/product/overcoat-materials/premium-silicone/

https://www.sk-kaken.co.jp/product/interior-finish-materials/sk-limetailor-in/

https://www.sk-kaken.co.jp/product/interior-finish-materials/sandelegante-in/

https://www.sk-kaken.co.jp/product/interior-finish-materials/finefr-in/

https://www.sk-kaken.co.jp/product/interior-finish-materials/lenacoat/

https://fai.sk-kaken.co.jp/tighca_coat

https://www.sk-kaken.co.jp/product/interior-finish-materials/granitailor-in/

The company is dominant in architectural coatings in their home base of Japan.  They have struggled to achieve the same economics in other Asian countries, and although they still possess a presence in many, I expect their recent single-minded focus on their highest-return products and geographic niche to continue.  

SK Kaken’s Architectural Coatings business in Japan is an attractive business.  End customers who need to paint a building select a product based on quality, durability, availability and cost.  SK Kaken’s sustainable competitive advantages include high switching costs (commercial building managers who choose inferior paint risk quicker re-paints and other logistical headaches, evidenced in SK Kaken’s increasing proportion of sales coming from Paint Replacement – 75% - rather than new construction – 25%) and two forms of economies of scale, in R&D (by consistently re-investing 0.9% of sales in R&D, which represents almost one tenth of pre-tax profits, the company has successfully developed thousands of new products in the past 65 years) and economies of scale in distribution, especially relevant due to the high weight/price ratio of paint (SK Kaken’s 51 sales offices located throughout Japan dominate all other domestic companies with the exception of Nippon Paint who has the next largest market share at around 25%).

These competitive advantages have translated into healthy growth in market share over the past 25 years:

Source: Building Industry Association of Japan finishing materials

New product development has changed the architectural coatings industry in recent years.  It seems clear that companies that can develop new paints with added value are those with the brightest future.  World-class Japanese environmental standards and technology really can translate into a better society (healthier, less environmentally damaging, higher productivity), but the opportunity to make money from all this should also be clear.  At the crucial moment of the purchase decision by the client, price often comes a long way down the list of deciding factors, which suggests an attractive business.  

In the global architectural coatings industry, SK Kaken qualifies to keep playing, with international patents and a demonstrated track record of developing good new products.

Economies of scale will continue to drive consolidation in a still somewhat fragmented industry.  Global paint companies (Akzo Nobel, PPG, Sherwin-Williams, Nippon Paint) should pursue horizontal growth organically and through acquisition, then re-invest excess profits from dominant market positions into strengthening their distribution networks, marketing to specifiers, training of applicators, and more R&D, in the pursuit of widening their moats.  This strategy seems the most likely one to be adopted by the industry in coming years, which would make smaller companies such as SK Kaken, with attractive geographic niches and portfolios of intellectual property, attractive acquisition targets (see catalysts).

One final observation from analyzing business quality in Japan: Western analysts often consider many typical traits of Japanese companies as irredeemably negative. Lifetime employment and loyalty to one company, for example, might be unheard of in the US, but reduced job-hopping and seepage of ideas between competitors can carry significant advantages in an industry such as this one.

On various measures, this business looks of better than average quality.  It is understandable and predictable due to sustainable competitive advantages.  Capital earns an attractive return for the risk. For this above average business, however, the market is currently charging a well below average price.

Valuation

Given all the difficulties of investing in Japan, significant valuation discounts are not sufficient on their own to create a big margin of safety, but they are a useful start:

0.89x P/TBV

1.2x EV/EBIT TTM

1.3x EV/EBIT trailing ten years’ average

13.7x P/E TTM and 10.2x P/FCF TTM with an additional 87% of market cap in cash thrown in for free.  In 2011 I commented about another high quality Japanese business wedded to a massively underleveraged balance sheet: “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.”  Since then, many commentators have wailed and ranted at Japanese conservatism but now, during unforeseen pandemic lock-downs, shareholders can finally have the security of knowing that their equity would not be diluted even after 27 months of zero revenues.

Whichever way you look at it, this just seems cheap.

 Capital allocation

This is often cited as the dominant explanatory factor behind the “Japanese discount” – companies with a very wide definition of their stakeholders adopt a mission to serve the community, employees, pensioners, and maybe as an afterthought shareholders.  This often results in over-investment in under-performing business assets, hence Buffett’s observation of typically low ROEs found in Japan (see original appendix). 

True to the culture, SK Kaken used to re-invest a lot in the business: in the decade prior to the original write-up, capex ran at double D&A and 13% of cumulative CFO was re-invested in accounts receivables.  However, the crucial difference is that this business enjoyed much higher returns on capital than many Japanese businesses: pre-tax ROC ranged 23-26% during that decade.  And contrary to a typical Western approach of relentlessly shrinking working capital, extending generous payment terms to customers did not just serve the community by helping them manage their own cash flow cycle, but also built market share by embedding finance in the purchase decision.  The result was that pre-tax ROC improved yet further to 33-43% range in the past decade. Not for the first time a Japanese management technique initially misconstrued as foolish, instead in hindsight looks astute.

That reinvestment phase has now achieved a dominant market share, relieving the business of heavy cash requirements.  The past decade has seen only 7% of CFO reinvested. Even without adjusting for all the excess cash currently earning zero, a decade average ROE of 9.8% is quite respectable by Japanese standards, and could obviously be instantly more than doubled by a simple capital structure change: returning excess cash.

17% of cash from operations over the past decade has been returned to shareholders (dividends 10% and buybacks 7%).  The company has been value-minded and aggressive on buybacks in the past, buying back 6% of shares outstanding between June and October 2008. 

The rest has been left to accumulate on the balance sheet.  Not a very imaginative use of capital, obviously, but it should make the stock now financially safe as well as cheap.

How will capital get allocated in the next decade?  Reinvestment rates should continue to be very light, at less than 10% of CFO.  The dividend takes only another 10%.  I expect the worst case to be that the remaining 80% of CFO continues to be accumulated on the balance sheet, providing safety and the potential for a catalyst, but failing to meet Principle 5.2 of Japan's Corporate Governance Code which requires companies to adopt "targets for...capital efficiency after accurately identifying the company's cost of capital".

Otherwise, I hope that the founder’s motto: “create something out of nothing” does not get reversed by reckless business ventures or other foolish spending. So far nothing indicates this as likely.

M&A or even minority stakes should not be completely ruled out, especially during a crisis if valuations prove attractive.  For example, Axalta only recently gave up trying to sell itself. A startling illustration of fire power is that SK Kaken could acquire Berkshire Hathaway’s 10% AXTA stake, twice over, using their current cash of $839 million.  In this light, SK Kaken’s entire market cap of just $932 million seems ridiculously cheap if you consider that it purchases not only a predictable annual post-tax cash flow of $85 million but also the chance to acquire a 20% stake in such a large global coatings business as Axalta.  I am realistic about the probability of this particular transaction happening though. 

Buybacks: Since the founder retired in 2017 and his son became president, buybacks have been notably absent. But they should remain a tool that management considers into the pandemic-led price decline, even if they have not featured recently. Management has a fiduciary responsibility to all shareholders, as demonstrated in Principle 1.6 of the Code, and with such abundant cash resources, any repurchases of stock at the current valuation would clearly be powerful in the creation of mid to long-term corporate value for the benefit of all stakeholders, not just shareholders.  A huge valuation discount to both local and global peers brings no benefit to any of the company's various stakeholders. The current market valuation does not correspond to the quality and reputation of this business.

However, statistical cheapness alone is insufficient to compensate for the risks of large liabilities lying undiscovered in the Japanese footnotes, or any other discovery that would make an apparently cheap stock in fact expensive.   Akerlof (1970) described such faulty logic in his “market for lemons”. So we must look for credible signals that people who don’t suffer from the same informational asymmetries that we do, can corroborate the investment thesis. The simplest way I know of to do that is to check what senior management does with their own cash.

Alignment with management

Founder and President Minoru Fujii, aged 87, worked in the business since he was 22 years old, he currently owns 3.5% of the shares outstanding.   

Mitsuhiro Fujii, son aged 53, joined the business aged 28, has been President for three years, and owns 3.5% of shares outstanding.

Kunhiro Fujii, son aged 51, joined aged 22 and is now General Manager of Sales, owns 3.5% of shares outstanding.

In addition the family’s investment holding company owns 30.8% of shares outstanding.

Several long-standing employees combined own a few percent of shares outstanding.

Thus several individuals, each independently wealthy and knowledgeable about business prospects, remain invested and at work in the business. 

Controlling shareholders present obvious risks.  So far there is no evidence of abuse of minorities and shareholders are not diluted through recurring equity issuance.  However, with management directly and indirectly owning 41% of the company valued at $380 million, and for whom SK Kaken dividends are a significant portion of their total compensation, this is a long way from agency management and represents the kind of entrepreneurial equity ownership that should augur well for future alignment of interests between shareholders and management.

Why is it cheap?  Micro

SK Kaken is a small cap stock with a large cap minimum trading size (minimum lot: 100 shares ~$34,000).  This leads to poor liquidity and a bid-ask spread that can be 5-10% wide.  (N.B. ask price used in this report).

Risks 

1. We do not know what we do not know.  Significant informational & cultural barriers exist.  Management is hard to communicate with, but executives do meet with investors.

2. Uncertain pandemic outcomes.

3. Environmental liabilities (common in the industry).

4. Japan earthquake risk was stress tested by 2011’s disasters, which led to new construction and paint demand.

5. Substantial shareholder risk – the dark side of management alignment through insider ownership.

All figures in JPY.  This is not investment advice.  Sources where not attributed: Bloomberg, company filings.

Catalyst