Description

Sumitomo Densetsu

Sumitomo Densetsu (1949 JP) is a US$580 million cap market leader in the Japanese electrical engineering contract industry with a track record of stable revenues and a focus on increased profitability. With a core Return on Equity (ROE) of 40% excluding excess cash on its balance sheet and only 10% of its revenue tied up in working capital, the company operates an asset-light and stable business model.

We believe the company’s shares are significantly undervalued when considering the amount of cash deposited at its parent company, Sumitomo Electric (5802 JP), which is currently not visible to investors. An ongoing soft activist campaign is underway to unlock excess cash on the balance sheet and improve capital allocation going forward.

Cash Deposited at the Parent Company

Based on our experience with BP Castrol K.K. (5015 JP), a similar situation we published on VIC in June 2014, we believe corrective actions by Sumitomo Densetsu to address its overcapitalized balance sheet could lead to a rerating of its shares upwards from 80% to 170% from their current price.

Unlike BP Castrol K.K. which only had a US$100 million market cap at the time (it currently stands at US$315 million), Sumitomo Densetsu sports a larger capitalization, making it accessible to a wider range of investors at this initial value stage. The much-publicized updated version of the Japanese Corporate Governance Code released in June 2018, with its focus on transparency, equal treatment of shareholders and constructive dialogue with them, meaningfully increases the likelihood of a positive outcome for shareholders once the situation gathers more interest.

Before delving into the company’s business and competitive situation, let’s first deal with the financial data provided on Sumitomo Densetsu’s assets on the balance sheet.

The table below recaps what can be seen in Bloomberg or Capital IQ:

Following our 2013 investment in BP Castrol K.K. we have made a point of asking detailed questions surrounding the nature of receivables when meeting investment candidates in Japan, especially when talking to subsidiaries of larger parent companies as is the case here. Similar to our experience with BP Castrol K.K., we found a meaningful part of the Receivables to be in fact a Loan Receivable, which represents cash deposited at the parent company, Sumitomo Electric, a US$12.5 billion market cap power equipment manufacturer.

The table below recaps the corrected balance sheet and more accurate valuation of Sumitomo Densetsu.

The cash deposited at the parent company represents 33% of Sumitomo Densetsu’s equity and makes it the 10th largest depositor of cash to its parent in Japan on that metrics. Together with the cash left on its own balance sheet, it depresses its core ROE from 40% to its reported ROE of 10%. It is interesting to note that another Sumitomo Electric’s subsidiary, Nissin Electric (6641 JP), also has 20% of its equity in cash deposited with it, placing it in the top 20 of the largest depositors to their parents in Japan.

In addition to the 33% of the company’s equity kept in cash at the parent level and 22% in cash on its balance sheet, Sumitomo Densetsu keeps another 30% of its equity in Long Term Securities Investments. As Sumitomo Densetsu is trading at 1x book value, 85% of its market cap is therefore covered by cash and listed securities. In a period of high asset valuation and increased volatility, Sumitomo Densetsu has its downside well covered!

Business Overview

Sumitomo Densetsu is a leading Japanese Electric Engineering EPC (Engineering and Project Company) whose team of 700 engineers plans, designs, organise procurement and construct electrical installations in the power generation and distribution and office and factories construction sectors. The company is primarily active in Japan (86% of revenues) but also supports its Japanese customers expanding their manufacturing or logistics bases throughout the rest of Asia (14% of revenue), with a focus on Southeast Asia.

Sumitomo Densetsu is subcontracted by Japanese construction companies on projects ranging from work for the electrical utilities for high voltage power distribution systems improvements, electrical storage and connection to the grid for new solar farms, electrical wiring and management of data centers and general electrical and IT needs for new office construction or renovation projects. As such, it does not take on financial project risks itself.

The Japanese construction industry has consolidated over the past eight years and benefits from two tailwinds: a healthy need for renovation projects in major cities and a dearth of engineers and construction workers, leading to much healthier margins across the industry. The upcoming Olympics of 2020 in Tokyo is also marginally adding to demand.

Higher focus on profitability and a generally more profitable construction industry has lifted Sumitomo Densetsu’s operating margins from 3.8% to 6.7% from 2011 to 2018. Fiscal year 2018, which ended in March 2018, was a stellar year with revenue increasing 7% and operating income increasing almost 20%.

There has been no bad debt to speak of historically as electrical and IT equipment is only ordered once a specific project has been approved. As a result, their limited working capital is mainly tied up in receivables rather than inventory.

The only two negative issues that we could find are a continuous increase in working capital which has negatively impacted their cash conversion ratio over the past four years and an over-invoicing fraud discovered at their Indonesian subsidiary in 2016 which lead to a charge to operating income totalling JPY1.76 billion (US$16 million) covering the 2014, 2015 and 2016 fiscal years. The financials outlined below were restated to take the later into account.

Sumitomo Densetsu’s Financial Highlights

The company has forecasted a slightly lower operating margin for fiscal year 2018-19, however, historically the company is known to be more conservative in its annual forecasting exercise. For example, fiscal year 2017-18 operating income outperformed its forecasts by 12%.

The first quarter of fiscal year 2018-19 results which was released in July 2018 displayed an operating profit decline of 6.8% on slightly higher revenue due to a reduced percentage of contracts being completed compared to last year. These results outperformed their own half-year forecasts. More importantly for their full-year results, the revenue backlog grew by 12% year-on-year.

Sumitomo Densetsu is controlled by Sumitomo Electric, which owns more than 50% of its shares. Less than 10% of Sumitomo Densetsu’s revenues are contributed to its parent company and it seems that the company is operationally independent from it, although all its Board members have either worked for one or both companies.

Competitive Situation

Sumitomo Densetsu’s business quality as expressed by its Return on Invested Capital (ROIC) stands out among its peers. In the graph below, we have included the cash on its balance sheet, but subtracted cash accumulated at the Parent Company from its Invested Capital.

Paradoxically, Sumitomo Densetsu has a much lower valuation than its lower-quality peers which can be seen from the table below mapping out its valuation and capital structure against its competitors.

Shares Rerating

It should be clear from the table above that the company’s valuation would significantly improve if all or some of the three corrective actions were taken:

1.   Cash deposited at the parent company is repatriated to its balance sheet and becomes visible to all investors in order to bring Sumitomo Densetsu in line with its peers, none of which deposit cash at their parent companies.

2.   A special dividend is paid in order to bring Sumitomo Densetsu’s cash to equity ratio at least in line with its peers.

3.   The dividend payout ratio is brought to a reasonable level more in line with its assets-light business model. For instance, if Sumitomo Densetsu were to increase its payout ratio from 26% to 100%, the dividend would jump from the current 2.7% to 10%.

We have outlined below the increase in valuation under different scenarios:

Rerating to Peers Valuation Level

If the market valued Sumitomo Densetsu at the average multiple of its peers, the share price would increase by 76%.

Rerating to Parent Company Valuation Level

Despite having a lower ROIC, Sumitomo Electric currently trades at 10.8x EV/EBIT. We see no reason for Sumitomo Densetsu to trade at a lower multiple than its parent. Should Sumitomo Densetsu trade at the same valuation multiple of its parent company, the share price would then increase by 109%.

Rerating to Japanese Market-Derived Valuation Level

If the market would value Sumitomo Densetsu at the average multiple of companies of similar business quality, its share price would rise by 172%.

For example, BP Castrol K.K. shares rerated from JPY 650 to JPY 1,300 after paying a special dividend and increasing its dividend payout ratio in 2014. Today, BP Castrol K.K. pays 100% of its earnings, equalling to a 4.3% dividend yield even after having rerated 285% from our initial investment in mid-2013. Interestingly, the company still has US$100 million deposited at its parent, BP, showing that not all corrective actions need to be taken for shares to rerate meaningfully.

Risks

Although the company is stable and operates a very asset-light business model, it is dependent on sustained demand for improvements to the power network and general construction and renovation projects in Japan as well new industrial plants and logistical centers in its overseas business. In case of a slowdown in domestic and foreign markets, margins could suffer.

A mitigating factor is the scarcity of engineers in Japan and our understanding that Sumitomo Densetsu is currently turning away lower-margin business because of its focus on margins and its own limited capacity.

Catalyst

With Abenomics in place for five years now, a quality Japanese company sporting a US$580M market cap with an asset-light model powering earnings growth that could pay a special dividend in addition to a regular 9% dividend should not be trading at less than half the market valuation.  

The catalyst of making stakeholders aware of the true overcapitalization of the company balance sheet and its impact on ROE public should be self-fulfilling. Making this information public and having investors query Sumitomo Densetsu and Sumitomo Electric should prod both companies to take corrective actions over the next few quarters, yielding good returns with very limited risks over that period of time.