Description

Taiwan Sakura is a domestic market leader in appliances with an excellent financial track-record, good return on capital, and high free cash flow which is almost entirely returned to shareholders. A period of tough sales comps in late 2016 and early 2017 caused the stock to de-rate but this has now been lapped and the company just reported record quarterly sales. The stock trades at a low-teens P/E and about half of comparable businesses in Asia, which looks like a rare bargain in today’s market for a company with a defensive business model and a nearly 7.0% dividend yield. Sakura also has strong upside optionality through an unconsolidated JV appliance business in China.

Background

Taiwan Sakura (“Sakura”) is Taiwan’s leading manufacturer of water heaters, gas stoves, range hoods, and kitchen solutions with sales of ~US$190m (see graphic below for a sales breakdown by product). The company was founded in 1978 and is headquartered in Taichung, Taiwan. The current Chairman, Yung-Chieh Chang, is the second generation leader from the founding family. The Chairman and other family members collectively own ~50% of the company. The company has production in Taiwan as well as two plants in China in Jiangsu and Guangdong provinces. Sakura also owns 44.4% of Sakura China, which sells Sakura branded products in mainland China through a JV with Japan’s Noritz.

Taiwan Business

Sakura’s core products are water heaters, gas stoves, range hoods, and dish dryers which are sold under the mid/high-end Sakura brand and the lower-end Topax brand. The company has a #1 market share in each product category, with 53% in water heaters, 43% in gas stoves, and 39% in range hoods. Market share has been stable or increasing in all categories and in aggregate, Sakura’s market share increased from 39% in 2011 to 47% in 2016. The main competitor is Japan’s Rinnai. Products are sold primarily through distributors, hypermarkets, and professional contractor stores. About 12% are sold through 103 self-owned Sakura brand stores. Sakura distributes the Electrolux and Svago brands in Taiwan which accounts for 4% of sales, and exports to the rest-of Asia, Australia, and the Americas which accounts for 8% of sales.

Sakura also has a faster growing Kitchen Solutions business (27% of sales in 2016), which provides custom kitchen design, appliances, cabinets, and installation. Sakura is the market leader in this business too, but the market is still very fragmented. Sakura has around 15% market share and is twice the size of the #2 player. Nearly 70% of this business is with contractors/developers and the rest is through the company’s self-owned retail store network. The company is targeting 25-30% market share in this business so there could be ample room for growth.

Growth and Margins

While the overall market for water heaters and kitchen appliances in Taiwan has been pretty flat at around 1.5 million units per year, we think Sakura can continue growing sales at mid- to high-single digit rates through a combination of modest market share gains in water heaters and kitchen appliances, significant market share gains in Kitchen Solutions, and higher ASP through improving product mix.

In 2012, Sakura began a strategy roadmap to launch new high-end products with smart and eco-friendly features to drive improved product mix with higher ASPs and gross margins. This strategy has been successful and management is optimistic that there is more room to improve gross margins by 1-2ppts per annum. Sakura’s more advanced products typically have prices 2-4x traditional products and gross margins that are 10ppts higher. As an example, a traditional 10L water heater costs NT$7,000 and has a gross margin of 26-30%, but a wireless remote 16L intelligent water heater is NT$19,900 and has a 40-43% gross margin. Management believes there is an additional tailwind for product mix improvement from the increasing trend toward eco-friendly digital water heaters. The mix of digital water heaters has been increasing but was still only 44% in 2016. This compares to 100% in China and 90% in Japan so the penetration of digital water heaters in Taiwan is likely to continue rising. We think Sakura is capable of generating an operating margin of 14-15% and ROE of greater than 20% in the next three years.

Tough Comps Created a Buying Opportunity

The stock sold off more than 30% from the 2016 peak levels because monthly sales turned negative on a y/y basis in Q4 2016, which continued through May 2017. In 2016 the Taiwanese government offered subsidies for purchases of energy-saving water heaters and appliances and this both boosted Sakura’s sales as well as pulled forward some demand. However, we think this high-base effect is now lapping and monthly sales have turned positive again since June 2017 with sales in the last seven months rising more than 22% y/y. Furthermore, the December 2017 quarterly sales reached a new quarterly record. The Taiwanese market tends to be overly focused on monthly sales and we think the sell-off created a great opportunity to buy a very good company at a cheap price.

Strong Cash Flow and Shareholder Returns

One reason we like to invest in Taiwan is that we find many management teams that have a laser-like focus on cash flows and whom return the majority of excess cash flow to shareholders. Sakura fits this description perfectly. With tight management of working capital and efficient use of capital expenditure, Sakura has converted an average 102% of net income into free cash flow if we exclude the equity method income from Sakura China. We think Sakura can continue to do this. Management has also returned 92% of cumulative net income to shareholders over the past five years through dividends and a capital return in 2016, while maintaining a strong net cash balance sheet the whole time. Although the capital return in 2016 was designed to return a large amount of excess cash and we don’t expect this to be repeated in the next few years, management is committed to maintaining a dividend payout ratio of 80%. As a result, we think the stock has a sustainable and growing prospective yield of approximately 7% which we believe is very attractive for the quality of the business.

Sakura China creates Optionality

Sakura entered China in 1994. In 2005, the company sold a 55% stake to a Chinese private-equity firm, Brightcord. In 2013, Japan’s Noritz acquired the 55% stake from Brightcord to increase their exposure to China.

Sakura has a much lower market share in China at around 3%. The main competitors are Haier, Noritz, Rinnai, Midea, AO Smith, and Vanward. Sakura is positioned as a Tier 2 brand in China, with higher prices than most local brands but lower prices than the Japanese and American brands.

Sakura China has had a mixed track-record. They made some mistakes which led to a 33% decline in sales between 2010 and 2012. In particular, they became overly reliant on mass market appliance chains like Gome and Suning where it was easy to grow sales but difficult to generate profitability. They decided to focus more on profitability and exited the relationship with Gome, which caused a big decline in sales. Sales bounced back in 2013 but have been growing slowly for the past three years.

2017 is likely to be a slightly down year for Sakura China as a large price hike of 10-15% taken in Q2 had a short-term negative impact on volumes, but management thinks that the business should return to growth in 2018. The JV has around RMB 300m of net cash and it pays out ~90% of annual net income in dividends to its joint shareholders.

We believe Sakura China provides upside optionality for the stock. The JV has been contributing 10-15% to consolidated profits for the past few years. What is not apparent from looking at Sakura’s income statement, because the JV is not consolidated, is that the China JV is larger than the Taiwan business, with sales of ~US$220. Therefore, very small increases in market share in China and an improvement in the JV’s low margins could have a very material impact on Sakura’s bottom line. We don’t think we are paying almost anything for this call option on the China business at today’s stock price.

Cheap Valuation / High Margin of Safety

We think Sakura is very undervalued, on both an absolute basis and relative to regional and global peers. While we acknowledge that it seems reasonable to assume some level of liquidity discount compared to Sakura’s larger market cap peers, we don’t think the considerable discount that currently exists is warranted. We think the company’s generous dividend policy also creates a strong margin of safety. Furthermore, the stock is trading toward the lower-end of its own historical 10-20x P/E multiple range.

Risks

Cycle: while Taiwan’s appliance market has historically been very stable and is primarily driven by remodeling, a significant slow-down in new construction could negatively impact the business.

Deterioration in Sakura China: Although we believe Sakura China provides for more upside risk than downside risk, if the JV were to lose market share and fall into losses, it could negatively impact consolidated earnings.

Catalyst

Accelerating earnings growth, China JV recovery