Description

This is something of a special situation with limited downside (16% downside assuming it falls as low as 0 enterprise value) and upside of 16-84% if shareholder pressure results in a significant change in payout policy. It could be the next Mitsuboshi Belting or Nitto Kogyo.

The company trades at a 1x EBIT multiple and is being pressured to raise its dividend. A shareholder proposal for 100% payout failed at the June AGM, but received 38% support, the highest among such proposals for companies with June AGMs that I could find. Institutional ownership is still limited, but the relative success of the shareholder proposal may act as an enticement to get others involved. 

If a similar payout proposal succeeds at the June 2023 AGM, the dividend should reach 124 yen or higher, equivalent to a 7.8% yield. Subsequently, the stock would likely trade up to around a 5% dividend yield (2,480 yen, +56%) as that is around the high end for Japanese companies. At a minimum, it would likely trade at a 6.5% yield (+16%). If earnings overshoot guidance, similar to prior years, to 150 yen of EPS and the stock trades at a 5% yield, 84% upside could be achieved. 

Why Does This Opportunity Exist

Techno Medica is a fabless maker of medical devices with highly recurring consumables revenues. Despite a business model that generates lots of free cash flow with no outlet for investment, management has been hoarding cash. 

Over the last 10 years, after-tax operating cash flow has averaged 1.26b yen. Dividends and buybacks averaged 0.43b, and capex averaged 0.1b. Thus, the company retained 0.7b annually, or 7b in total.

The Japanese market does not give companies credit for cash and financial assets, using the generally correct assumption these will not be used for the benefit of shareholders. As a result, the enterprise value has steadily dropped. 

In addition to poor capital allocation, OP has been in decline. OP peaked at 2.3b yen in the March 2014 fiscal year on sales of 8.9b (26% OPM).  The current president took the helm in June of 2014 and has overseen a more or less continuous decline in profitability. The company forecasts OP of 1.5b on sales of 10b (15% OPM) for F3/23.   

The combination of these 2 has led to a drop in ROE from 15% in F3/14 to 8.4% last year and a projected level of 6.7% for this year. 

A 100% payout ratio would only stop the decline of ROE for the company and should be regarded as a necessary first step. In reality, a business model like this could easily be leveraged and run with a small balance sheet. The company could probably take on 5b in debt and pay out 10b to shareholders as a special dividend and still operate normally. 

Valuation

At the current stock price of 1,621 yen, the company has a market cap of 13.6b. With cash of 11.3b, and no debt, the enterprise value comes to 2.3b. The company has averaged 1.5b in OP over the last 5 years and is expecting 1.5b for this year, EV/EBIT comes to approximately 1.5 times. 

Sadly, I don’t think we can expect substantial growth under the current management. The company has a long-term vision of raising sales from the 9b level of fiscal 2020 to 15b in FY 2030 and OP to 3b (20% OPM). Of course, this would be a welcome development for shareholders,  but the company has not outlined any concrete measures that would lead to such growth. Their plan relies on “new products,” “growth in the existing business,” and “overseas growth.” They have not been able to come up with substantial new products as long as the current management has been in place, so it seems unlikely that will dramatically change now. Profitability in the core business has been in decline, so it is unclear how that will change. And overseas growth is generally low margin due to the lack of consumables revenues. 

I think it is safer to assume no growth going forward. If a change in management were to occur, I would reassess this view. 

For a no-growth, fabless manufacturer, a 6x multiple seems conservatively appropriate as a listed company, while in a takeover situation it could certainly be worth 10x or more. Based on that, I see a fair market cap in the range of 20.3b ~ 26.3b, or 2400~3100 yen per share, for upside of 50-95%. A buyout would be the best possible outcome and I think the company would be of interest to quite a few mid-size private equity funds or medical device companies such as Sysmex (6869). 

More important than a theoretical discussion of value is where the stock is likely to trade in the event the payout ratio is increased to 100% as proposed at the AGM this year. Below are a few case studies of companies that switched to 100% payouts starting this fiscal year. 

Mitsuboshi Belting (5192) was trading around a 3.3% dividend yield for most of 2020-21 when it paid out 1/3 of profit. In May, it shifted to a 100% payout ratio, prompting a 65% increase in the share price so far. The stock currently yields 6.8%. 

Nitto Kogyo (6651) changed from a 30% payout to 100% from May. The stock had traded around a 3.3% dividend yield for 2020-21. Since changing the dividend policy, the stock has appreciated 58% and currently trades at a 6.8% dividend yield. 

Piolax (5988) traded around a 2.5% yield in 2020-21 and moved from 1/3 payout to 100% payout in May. The shares appreciated 50% since then. The stock now trades at a 6.3% dividend yield. 

It has been three months since each of these companies switched to a 100% payout policy and their stock prices are still trending higher. I think the dividend yield will compress a bit more before they stabilize. 

Techno Medica has traded around a 3.2% dividend yield on a 35-40% payout rate for the last 2 years.  With a 100% payout of 124 yen, the dividend yield would jump to 7.6%.  If we assume R&D spending undershoots once again, the actual EPS could reach 150 yen or so, equating to a 9.1% yield.  In a conservative case, the stock would likely rally to a 6.5% yield, or 1900~2300 (+16~41%). I think it is likely to settle at closer to a 5% yield considering the higher quality of the business relative to auto parts companies like Mitsuboshi and Piolax. In that case, the shares could reach 2480~3000 (+52-85%). 

Business Description

Techno Medica is a fabless maker of blood sample tube labelers. These are sold to clinics or hospitals and are especially useful for high-volume sample collections at annual physical checkups.  The machine prints a label with the patient’s information and a barcode and applies it to the test tube.  This is somewhat difficult as the glass tubes are quite delicate, so applying the label without breaking the tube is challenging. 

Their labelers are installed in about 2,250 hospitals and clinics throughout Japan, and they have 90% market share. The only other competitor is Kobayashi Create, whose main business is recording paper for medical devices (like EKGs), and for whom this is a small side business.  

The machines are sold at quite low gross margins, while the company makes its profits from its “Consumables” business, I believe.   

Consumables consists mainly of the adhesive labels, ink, and other parts for the printers. They used to sell glass tubes as well, but stopped from this fiscal year due to the low margins. Consumables made up 55% of total sales in F3/22, while machines were 39% and the rest was for blood gas analyzers (similar to what Radiometer makes).

The Consumables business is attractive, generating steady and growing sales as the number of installed machines gradually increases. 

A few years ago, the company introduced RFID based machines and labels. These allow the clinics and testing facilities to use a scanner to instantly confirm a batch of tubes, rather than having nurses check each tube individually by sight. However, the RFID labels with a chip are maybe 5-10x more expensive than a standard paper label (I guess 20 yen instead of 2 yen) and so the rollout of these units has been slow, at only 116 hospitals so far. It is also questionable if changing to this new format will be net positive for Techno Medica since hospitals will put more pressure to cut costs on the Consumables when it is so expensive. On the other hand, the shortage in health care workers has intensified due to COVID-19, and an RFID-based system should be a welcome labor-saver for many hospitals. 

Accounting Fraud

An accounting scandal was revealed in 2016 and earnings were restated from 2011 to 2015, mainly lower.  They were doing channel stuffing to meet very aggressive growth targets set by the founder / chairman. The third-party committee of lawyers formed to investigate the scandal concluded that the President was unaware of the activity and therefore not held responsible, while his father, the founder, was forced out of the company along with a few other executives. 

If President Saneyoshi was unaware of the fraud, he is of course not guilty of misconduct. On the other hand, a president who is unaware of such activity demonstrates a lack of understanding of company operations, raising the question of suitability for leadership. In spite of this, Saneyoshi has continued in his role for 8 years and overseen the gradual decline of profits, with no apparent plan for a turnaround.

To be fair, the exit of the founder may help to explain the decline in profitability over the last few years. The founder was known for his extreme frugality.  For example, employees had to buy their own pens. Perhaps it is natural that margins should decline as a more normal corporate structure takes hold. However, that does not explain the terrible track record on capital allocation or growth under the current management.  

Revenues

Revenues grew steadily until about 2014, but have stagnated since then. However, the mix has improved as the weight of consumables has grown from 43% in 2006 to 55% currently.  

Profit

Despite the increasing weight of high-margin consumables, operating profit peaked out in 2014 at 2.3b and is expected to fall to 1.5b this year. The company has said they receive pressure to cut prices on consumables every year, and they largely comply.  I think this represents a failed opportunity to exercise pricing power as the dominant industry player. 

Growth

The company's long-term vision targets a 6b increase in sales with 3b coming from growth of existing businesses, 1b from new products, and 2b coming from overseas expansion.  There are no details beyond this. 

In my estimate, it is certainly possible for the company to grow revenue for its existing business by expanding the number of hospitals using the high-end RFID labeling machines and expensive labels. However, I am skeptical that this will lead to higher profit as I don’t think the company can make a decent margin off RFID labels at this time. That may change in the future if they are able to bring costs down.  

As for overseas sales, they have not been able to replicate the consumable business overseas because of the high cost of “Made in Japan” labels for their mainly Asian customers. Thus, growing machine sales without the consumables business adds sales, but does not lead to increased profit.  On the other hand, under different management, local consumable OEM procurement contracts and more effective selling of machines seem like achievable goals. 

One attractive area for growth could be from price increases on consumables in an attempt to return to historical margins on these products. 

Estimates

The company is forecasting a decline in operating income from 1.85b to 1.5b this year. This is premised on an increase in R&D spending from 0.4b to 0.7b. However, the company consistently fails to fully spend its R&D budget. In F20 and F21 they also forecast 0.7b of R&D spending and only spent 0.4b in both years. It seems entirely possible the company will underspend on R&D once again, achieving OP of 1.8b or so, thus generating 150 yen of EPS. 

However, I do not think we should cheer this kind of profit overshoot. The fact that they have been unable to spend on R&D and develop new products is also a factor why the company has been unable to grow sales in recent years.  

Management

President Saneyoshi is the son of the founder, which appears to be his main qualification for leading the company. His tenure since 2014 has been marked by scandal, stagnation and a falling stock price. This track record is reflected in his low support rate from shareholders at the AGM at 74%. 

Risks

It has all the classic characteristics of a value trap.  If shareholders are unable to force some change, it seems unlikely that investors will generate a reasonable return. 

Disclaimer

The information contained in this VIC writeup is strictly for informational purposes only and is not a recommendation to buy or sell the securities noted in this article (the “Security”). The information has been obtained from or is based upon sources believed to be reliable but is not guaranteed as to its accuracy, adequacy, or completeness.  Liability for errors or omissions is expressly disclaimed. The information is provided without obligation and on the understanding that any person or entity who acts upon it does so entirely at their own risk. The author or his or her respective employer or employer’s clients, affiliates, officers, managers and directors, may or may not hold positions in the Security. These parties may trade the Security at any time and may exercise its voting rights and other rights as shareholders in its sole discretion, without notification to this community, and will not disclose this information to this community.

Catalyst

Significant change is unlikely under with the current management team. However, at the AGM this year the company received a shareholder proposal from United Managers Japan calling for a 100% dividend as a way to stem the decline in ROE. The company opposed the proposal, but it received 38% support from shareholders. ISS also supported the proposal (I am not sure how Glass Lewis recommended.) 

This is the highest level of support among proposals related to increased shareholder returns for June AGMs that I could find. Others include Nissan Shatai (7222) at 36%, Iwasaki Electric (6924) at 35%, Miyaji Engineering (3431) at 31%, Faith (4295) at 30% and Bank of Kyoto (8369) at 25%. Meanwhile, President Saneyoshi received only 74% support at the AGM, putting him in the bottom 1% of support rates among Japanese managers (95%+ is pretty much the rule). 

These encouraging results may entice other investors to get involved in the stock, raising the probability of a successful proposal next year. 

Additionally, it seems there is a good probability that existing non-allegiant shareholders will be increasingly dissatisfied with how management is running the company as ROE and the stock price declines.  Anyone who bought after 2013 is now sitting on a loss. 

Shareholder composition as of March 2022, according to the annual report and large shareholder filings, is summarized below:

Allegiant shareholders include 

Shigeyuki Saneyoshi (76)  15.6% / 1,314,500 shares – the founder of the company, now retired

Autonics 11.5% / 967,200 shares – a key manufacturing partner of the company

Masatomo Saneyoshi 2.3% / 191,000 shares – son of the founder and current President 

For a total of 29.4%

Institutional investors include

Fidelity 978,618 /11.6% 

United Managers Japan 479,800 / 5.7% 

Varecs Partners 463,400 / 5.5% 

For a total of 22.8%

Meanwhile, 4000 individuals own a total of 2.4mn shares, or 29% of the total.  Individuals tend not to vote at AGMs.  If institutional ownership approaches 40%, the probability of success of a shareholder proposal seems quite high.