Description

Executive summary

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 both reasonable returns on capital (15 year ave. total pre-tax ROC: 28.2%) and positive sales growth (6.7% CAGR past 5 and 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.

Business quality

The business has been consistently profitable for at least the past 15 years, throughout a daunting Japanese economy and recent global challenges, delivering operating margins of 8.0-12.8% 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 28.2% 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 11^th unbroken year of positive top line growth (FY Mar 2010 results due next month).  Sales CAGRs have been 4.8%-6.8% 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.   The following examples from SK Kaken’s current product line should illustrate the cost and time that can be saved by spraying on stone/gold/wood effect finishing, and how anti-bacterial coatings are used in hospitals:

http://www.skk.com.sg/products_stone_coating_granipastel.php

http://www.skk.com.sg/job_references/index.php?album=governmental&image=governmental_01.jpg

http://www.skk.com.sg/job_references/index.php?album=others&image=others_03.jpg

http://www.skk.com.sg/products_functional_coating_eco_fresh_clean_anti_bacteria_paint.php

The company is dominant in architectural coatings in their home base of Japan.  Beyond architectural coatings the company sells paints for diverse uses: vehicles, ships, metal products, machinery, woodworking and road marking, both in Japan and throughout Asia.

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 1.2-1.5% of sales in R&D, which represents one tenth of pre-tax profits, the company has successfully developed 260 new products in the past 35 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 the 64 other companies who constitute the remaining 55% of the market).

These competitive advantages have translated into healthy growth in market share over the past 15 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. 

The increasing relevance of R&D for the architectural coatings industry suggests two conclusions:

1. SK Kaken qualifies to keep playing, with international patents and a demonstrated track record of developing good new products.
2. Economies of scale in R&D will continue to drive consolidation in a still somewhat fragmented industry.  Global paint companies (Akzo Nobel, PPG, Henkel, Shewin-Williams, Dupont, BASF) should pursue horizontal growth organically and through acquisition, then re-invest excess profits from dominant market positions into 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 analysing 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:

0.76x P/BV

1.9x EV/EBIT TTM

2.4x EV/EBIT trailing ten years’ average

9.1x P/E TTM and 6.7x P/FCF TTM with an additional 66% of market cap in cash thrown in for free.  One of the reasons that has probably contributed to management holding so much cash is the generous payment terms offered to customers and the associated credit risk.  However, even in the event that every single Account Receivable defaults with zero recovery, net cash would still be 21% of mkt cap.

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 appendix). 

True to the culture, SK Kaken does re-invest a lot in the business; in fact over the past ten years, half of CFO has been re-invested.  However, the crucial difference is that this business enjoys much higher returns on capital than many Japanese businesses: pre-tax ROC ranged 23-28.5% during the past decade.  Even without adjusting for all the excess cash currently earning zero, a decade average ROE of 8.9% is quite respectable by Japanese standards, and could obviously be instantly doubled by a simple capital structure change: returning excess cash.

One quarter of cash from operations over the past decade has been returned to shareholders already (dividends 13% and buybacks 12%).  The company has been value-minded and aggressive on buybacks in the past, buying back 6% of shares outstanding between June and October 2008 at an average of ¥2491 per share. 

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.

So half of CFO creates value by re-investment in a growing business that generates returns above the cost of capital.  One quarter gets returned to shareholders.  And one quarter accumulates on the balance sheet, providing safety and the potential for a catalyst.

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 77, has worked in the business since he was 22 years old, remaining active and invested, he currently owns 5.4% of the shares outstanding.   

Mitsuhiro Fujii, son aged 43, joined the business aged 28, has been Managing Director since 2003, and owns 5.4% of shares outstanding.

Kunhiro Fujii, son aged 41, joined aged 22 and is now General Manager of Sales, owns 5.2% of shares outstanding.

Masahide Sakamoto, not a family relative, aged 58, has been the Senior Managing Director since 1995 and has worked at the company for the past 33 years.  He owns $3.9 million of stock (0.9% o/s). 

In addition it appears (but I cannot yet confirm) that the family controls a real estate company, Shikoku Kosan YK (SK Kaken’s original name in 1955 was Shikoku Chemical Industry), which owns 21.4% of shares outstanding.

Employees own a further 3.9% of shares outstanding.

Thus several individuals, each independently wealthy and knowledgeable about business prospects, remain invested and at work in the business.  There were no insider sales from management during the past few years.  Instead, despite clearly being extremely conservative in their financial management, the company repurchased 1.035 million shares (out of 15.3 million then outstanding) between December 2007 and October 2008 as the stock price declined, thus increasing management’s percentage holding 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 apparently owning about 42% of the company valued at $180 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.

The second body of evidence relied upon to reduce the chances of buying a lemon is the abundance of understandable reasons which would make this stock cheap in the absence of company spe cific problems such as fraud, undeclared liabilities etc.  Understanding the macro reasons why this stock might be cheap can help reduce the chances of adverse selection.

Why is it cheap?  Macro

Local despondency has combined with the informational asymmetries faced by Gaijin, to produce a truly bombed-out investment landscape in Japan, where it is sometimes hard to believe that life still lurks below these valuations.  On the one hand, locals should be best placed to analyze Japanese stocks, yet few can muster the confidence after a 5 and 20 year bear market in stocks, two decades of economic stagnation and price deflation, and the psychological impact of a soon-to-be shrinking population.  It should therefore really be no surprise that behavioral effects dominate objective valuation analysis among locals.

For example, a popular current investment for Japanese pensioners is Brazilian fixed income yielding 8.75% with full currency risk, despite some good and understandable local businesses in Japan being available at 20%+ earnings yields with zero currency risk.  The lack of local confirmation that genuine opportunities exist among a few Japanese stocks hardly instills confidence in foreign investors, who have every reason to be paranoid due to significant informational asymmetries. 

Even among non-Japanese investors who feel comfortable tackling the informational asymmetries of all foreign markets, JISC (Japanese, Illiquid, Small Cap) is the very distant and ugly cousin of the glowing and beautiful BRIC. 

Unfashionable and unfathomable: the basic reasons why one can find a few genuinely super-cheap stocks in Japan, amidst quite a lot of dross.

Why is it cheap?  Micro

SK Kaken is a small cap stock with a large cap minimum trading size (minimum lot: 1000 shares ~$29,000).  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

• We do not know what we do not know.  Significant informational & cultural barriers exist.  Management is hard to communicate with.  Basic operational facts considered sine qua non for a US investment are hard to discover.  Q&A might be frustratingly brief.
• Asian real estate crash, causing customer credit defaults to erode the company’s net cash position (days receivable has been reduced from a heady 118 in 2004 to the current 95 days which is still enough to keep my pulse racing given the customer base: commercial property owners, developers etc.)  However, AR currently represents two thirds of net cash meaning that this threat is serious, but should not be fatal.
• Environmental liabilities (common in the industry).
• Japan earthquake risk (though would presumably ultimately also lead to new construction and paint demand).
• 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.

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Appendix – Buffett’s approach to Japanese stocks

Warren Buffett 

Lecture at the University of Florida School of Business 

October 15, 1998

“Question: What about Japan?  Your thoughts about Japan? 

Buffett:  My thoughts about Japan?  I am not a macro guy.  Now I say to myself Berkshire Hathaway can borrow money in Japan for 10 years at one percent. One percent! I say gee, I took Graham's class 45 years ago and I have been working hard at this all my life maybe I can earn more than 1% annually, it doesn't seem impossible.  I wouldn't want to get involved in currency risk, so it would have to be Yen-denominated. I would have to be in Japanese Real Estate or Japanese companies or something of the sort and all I have to do is beat one percent. That is all the money is going to cost me and I can get it for 10 years.  So far I haven't found anything.  It is kind of interesting.  The Japanese businesses earn very low returns on equity - 4% to 5% - 6% on equity and it is very hard to earn a lot as an investor when the business you are in doesn't earn very much money.  

Now some people do it.  In fact, I have a friend, Walter Schloss, who worked at Graham at the same time I did. And it was the first way I went at stocks to buy stocks selling way below working capital.  A very cheap, quantitative approach to stocks.  I call it the cigar butt approach to investing.  You walk down the street and you look around for a cigar butt someplace.  Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it.  So you pick it up and the puff is free--it is a cigar butt stock.  You get one free puff on it and then you throw it away and try another one.  It is not elegant. But it works.  Those are low return businesses.   

But time is the friend of the wonderful business; it is the enemy of the lousy business. 

If you are in a lousy business for a long time, you will get a lousy result even if you buy it cheap.  If you are in a wonderful business for a long time, even if you pay a little bit too much going in you will get a wonderful result if you stay in a long time.   

I find very few wonderful businesses in Japan at present.  They may change the culture in some way so that management gets more share holder responsive over there and stock returns are higher.  At the present time you will find a lot of low return businesses and that was true even when the Japanese economy was booming.  It is amazing; they had an incredible market without incredible companies.  They were incredible in terms of doing a lot of business, but they were not incredible in terms of the return on equity that they achieved and that has finally caught up with them.  So we have so far done nothing there.  But as long as money is 1% there, we will keep looking.” 

http://www.intelligentinvestorclub.com/downloads/Warren-Buffett-Florida-Speech.pdf

Warren Buffett on buying extremely cheap South Korean stocks

“A couple of years ago I got this investment guide on Korean stocks. I began looking through it. It felt like 1974 all over again…In 4 hours I had found 20 companies like this. The point is nobody is going to tell you about these companies. There are no broker reports on Dae Han Flour Company. When you invest like this, you will make money. Sure 1 or 2 companies may turn out to be poor choices, but the others will more than make up for any losses. Not all of them will be good, but some will and those will make you rich.”

http://www.investorwords.com/tips/789/lesson-from-a-korean-flour-company.html

Catalyst

• Change of control.  Acquisitive global paint competitors have demonstrated a desire to expand in architectural coatings, attracted by “the strong and stable cash flow that is customary with architectural paint businesses.”  SK Kaken is ranked 27^th by size among Global International Coatings Companies. In a fragmented industry still early in its global consolidation, cheap and doable deals should be on many companies’ radars.
• Public to private transaction.
• Share buybacks.