Fukuda Denshi (JP:6960): The Three Bagger Stock That Still Is a Bargain

Introduction

Fukuda Denshi was first presented on the blog in 2012. Since mentioning the company the stock price has more than trippled.

In this post I will make the case that Fukuda Denshi is a wonderful company that, irrespectively of the significant share price appreciation,  is still a bargain issue.

Company and Market Overview

Company Overview

Fukuda Denshi Co, Ltd. is a manufacturer of medical electronics equipment, having strengths in those related to the cardiovascular system. The company was founded in 1948 and developed the first electrocardiograph in Japan.

Fukuda Denshi is mainly focused on the Japanese medical device market and has little international presence. It offers a wide range of medical equipment products. Among other products, like software and ultrasound paper, it offers defibrillators, patient monitoring - (central and bedside), vascular screening -, ultrasound -, stress test - and respiratory systems. In addition, the company provides therapeutic instruments for sleep apnea syndrome and sells AED (automated external defibrillators) made by Philips for cardiopulmonary resuscitation.

Lately, the company is making efforts on expanding its lineup for rental medical equipment for home care, including oxygen concentrator devices.

 Market Overview

The medical device market is a segment of the Japanese economy that has been showing satisfactory organic growth in recent years. Due to the aging society it is expected to continue to expand in the foreseeable future.

But the growth of the medical device market segment in Japan is not as spectacular as in other regions, like the USA. The main driver of the subdued trend is the strict cost control the Japanese adhere to when it comes to healthcare spending. It manifest itself in a relatively small health expenditure per capita (see graph), as well as in relation to the GDP. In 2011, for example, Japan’s expenditure for the healthcare system was roughly 9% of its GDP. Just a fraction of the 18 % recorded in the USA.

 Analysis of Operation, Cash Flow and Balance Sheet

 Analysis of Operation

Over a time frame of 17 years Fukuda Denshi was able to grow its turnover by roughly 3, 6% p.a., and thus, can be viewed as moderately growing.

The financial crisis of 2008/2009 had no negative influence on Fukuda’s turnover and/ or operating margins. Neither did the fragile state of the Japanese economy in the aftermath.

This operational stability in turbulent times shows impressively the defensive nature of the market segment in which Fukuda Denshi operates. In addition, does it exemplify that the company is shielded from the vagaries of the Forex market. On one hand, because Fukuda Denshi is almost exclusively focused on the domestic market. On the other hand, because the company running a division that is dependent on imports of third party products from overseas suppliers. Hence, a rising yen lowers procurement costs and contributes positively to operating margins.

The stable/ expanding operating margins of the post crisis years stand in stark contrast to severe pressure on them in the pre- crisis era. The margin pressure between 2001-2005 was mainly due to an increasingly conservative accounting policy in combination with a weaker yen. Whereas, the outright collapse between 2005/ 2006 was induced by a disposal and extraordinary write down on a wholly owned subsidiary (Kontron SAS). It had been purchased in 2005 and was already disposed of in 2006 at a significant loss.

The EPS growth has outpaced the expansion of operating metrics by a wide margin. This is mainly due to significant share repurchases between 2010 and 2014 at extremely favorable terms (see pay- out policy). Return metrics expanded significantly too. But, in recent years it has not been able to keep pace with the EPS expansion, mainly due to BPS increasing faster than EPS.

Analysis of Cash Flow

The significant earnings growth is backed by the company’s ability to generate high operating cash flow, as well as free cash- flow. Actually, generation of operating- and free cash- flow has to be seen as Fukuda’s strong suit. In the last 17 years Fukuda Denshi has shown the capability to structurally increase those metrics. Especially, since the aftermath of the financial crisis operating–, as well as free- cash- flow appear to have established a permanently higher plateau.

Not only does the ability of generating substantial cash- flow point to an extremely high earning’s quality, it also can be assumed that the company has a strong competitive advantage within Japan.

The ability to generate an ever increasing amount of FCF is impressive.  Especially, against the background that Fukuda Denshi has been constantly increasing investment in growth capex, which is not even considered in this FCF examination.

Analysis of Balance Sheet

 

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Fukuda Denshi exhibits a rock solid balance sheet. It does not carry any interest bearing debt and has a shareholder equity ratio in excess of 70%. Furthermore, are shareholder equity and retained earnings expanding consistently and significantly over time. In the last 17 years net assets have risen around 5% p.a.

The growth in BPS was with 5,5% p.a. slightly higher than growth in net assets.

Fukuda’s asset composition is highly favorable, as the company does carry little intangibles on its balance sheet and the majority of tangible assets are highly liquid.

Actually, the company has to be regarded as overcapitalized. It manifests itself in an ever increasing net- liquid position.

 Interim Conclusion:

• Long established medical device company
• Operates in a market segment of the Japanese economy that is showing organic growth due to the aging society
• Company is modestly growing in terms of sales
• Modest sales growth translates into disproportionately high economic efficiency in terms of margin and EPS expansion and, most importantly, into the ability of generating large sums of FCF
• Balance Sheet is rock solid. Actually, the company has to be regarded as overcapitalized

Valuation

General Valuation

The stated actual P/ E and P/C ratio (14 and 8) for FY 2016 appear modest. Cyclically adjusted ratios are significantly higher (29 And 14). Mainly due to the fact of a  run up in the company’s stock price in recent years in combination with subdued operational efficiency in former years.

As noted above, stated operating margins and return metrics are satisfactory, especially when keeping in mind dealing with a Japanese company. The structural increase of Fukuda Denshi’s operational efficiency in recent years becomes apparent when comparing them to the average operating margins and return metrics. The company’s average ROE and net operating margins are 6% and 5% compared to actual readings for the FY 2016 of 8,3% and 7,2%.

At current market capitalization Fukuda Denshi’s stated P/B ratio is slightly above 1.

All the above mentioned valuation metrics on price basis make up for a company that is modestly valued, but not a steal. So where is the beef?

On the flaws of Price Ratios

Well, it is to be found in the fact that price metrics can be very misleading valuation metrics indeed, especially in Japan.

Because standard price ratios do not give away the "true" state of a companies’ valuation granted by the market.

In many instances P/ OCF and P/E overstate or understate the valuation of a company by a wide margin. Although, widely followed and eagerly marketed by the financial media and financial community, price metrics, at best, do not deserve the prominent position they are granted by market pundits. At worst they are detrimental to your wealth.

Especially the P/E ratio is the most overhyped and flawed ratio, and dangerous as hell when taken at face value. Unlike the P/OCF ratio, which is mainly distorted through the numerator (P), the P/E ratio can be so by the numerator and denominator.

The distortion of the numerator mainly comes into play when not taking into account differences in the capital structure of a company, e.g. debt vs. equity financing. The denominator is distorted by different accounting standards and accounting assumptions.

Making the Case for Enterprise Value

 

The concept of enterprise value (EV), earnings before interest and taxes (Ebit) and earnings before interest, taxes, depreciation and amortization (Ebitda) adjusts for those flaws found in pure price metrics.

In the case for EV, the market capitalization is adjusted for the interest bearing debt on the balance sheet (e.g. added to the market cap) and the companies’ cash balance (e.g. subtracted from the market cap). Basically, the EV is the money a potential buyer has to put up for acquiring the whole company at prevailing market prices.

In Fukuda Denshi’s case the following valuation picture emerges following the analytical concept of EV.

With an EV/Ebit ratio of 7 and EV/OCF of 6 it becomes apparent that the company is not only moderately valued by the market, but rather cheap.

In addition, if we excluded Fukuda’s investment portfolio from our EV calculation, which is highly liquid and marked to market, the Company becomes an outright steal.

Comparative Valuation: Fukuda Denshi vs. Nihon Kohden

Fukuda Denshi’s main competitor on the Japanese market is the company Nihon Kohden. Thus, it lend itself to perform a comparative analysis of these two companies.

Already when comparing the price metrics and operating margins of those two companies, the value discrepancy becomes apparent. Although exhibiting almost the same operational efficiency, Fukuda Denshi is trading at a significant discount to Nihon. In addition, does Fukuda Denshi offer a significant better dividend yield.

But how steep Fukuda Denshi’s relative discount really is becomes only apparent with a comparative analysis on EV basis.

Whatever EV ratio you take into account, they all show that Fukuda Denshi trades only at a fraction of Nihon Kohden. And this for the company that has the higher Roic (ex. Cash and marketable securities) and FCF yield!

In addition, when taking Fukuda Denshi’s significant investment portfolio into account the valuation discrepancy of those two companies become outright obscene.

Intrinsic Value

Certainly, Fukuda Denshi is not such a deep value bargain issue like in 2012 when I first mentioned the stock on this blog at around 2500 Yen,

Nevertheless, it is my conviction that Fukuda Denshi still offers a lot of intrinsic value in relation to the prevailing market price on several counts.

Fukuda’s NCAV stands at roughly 5000 Yen per share and is increasing significantly over time. Thus, at the time of writing one pays only 1,6 times the NCAV. For such a high quality stock I would regard the NCAV value the floor in the absolute worst case scenario in case of a full blown market meltdown.

Concentrating solely on the asset power value, and discounting the actual dividend into the infinite future leads to the conservative assumption concerning Fukuda Denshi’s intrinsic value. Here the model indicates a fair and moderately rising valuation.

The more aggressive assumption concerning Fukuda Denshi’s intrinsic value focuses more on its earning power. This model indicates a significantly rising intrinsic value over time and deep undervaluation of the stock.

The total intrinsic value in the aggressive case is composed of the following components:

Interim Conclusion:

• Price ratios do reveal the attractive valuation Fukuda Denshi is been traded at only partially
• EV analysis in combination with Ebit/ Ebitda paramount when analyzing Japanese companies, due to high net liquid asset position and conservative accounting policy
• Only EV analysis reveals attractiveness of Fukuda Denshi at current market price
• Comparative Analysis with Fukuda’s main competitor reveals the cheapness not only on an absolut basis, but also on a relative basis
• Depending on focus , i.e. assets and dividend vs. assets and earning power, Fukuda Denshi is trading around its intrinsic value or significantly below it
• Intrinsic Value is in both cases rising over time

Analysis of Pay- Out Policy

Fukuda Denshi is actually paying a dividend of 160 Yen p.a. leading to a dividend yield of roughly 2% and a stated dividend payout ratio of 25% for FY 2016.

The dividend per share doubled in the last several years. But this was not due to a significant increase in the absolute amounts of profits returned to the shareholders, but rather an aggressive share buy- back program decreasing the outstanding shares significantly.

At the peak of the buyback program in 2014 outstanding shares were reduced by almost 30%. The disposal of treasury shares in 2015 were a result of making Atomic Sankyo a wholly owned subsidiary (see corporate governance).

The buybacks between 2010 and 2015 were conducted at incredibly favorable terms. That is around or significantly below book value.

Corporate Governance

When I first mentioned the stock on this blog in 2012, corporate governance was an issue for me.

Although, the company still has a takeover defense measure in place, a lot has changed to the positive since I first mentioned the company on the blog in 2012.

Mainly, because the ownership structure has become much more transparent. As it turned out two entities close to the founder’s family, which were major shareholders in the company, got dismantled.

The first one was Tokyo Enterprise Co.Ltd. It sold its 7,5% stake into the off- market share repurchase programs the company executed. The shares could be purchased by the company at incredible low valuations.

More importantly though, Atomic Sankyo was turned into a wholly owned subsidiary in 2015. Atomic Sankyo was a major shareholder of the company with a 14% stake and 100% controlled by the founder’s family. It had business relationships with Fukuda Denshi selling electrocardiogram recording paper and renting out office space. Although, I am not aware of any improper transactions between Fukuda Denshi and Atomic Sankyo, it is very comforting to see that the company and Fukuda-San seemed to be aware of the intransparency of this interconnectedness and the potential for abuse. Apparently, Atomic Sankyo was taken over at favorable terms as negative goodwill was reported on the transaction.

The transaction was financed by giving treasury shares to Fukuda- San. Kotaro Fukuda is now the largest shareholder of the company holding 17,7% of the outstanding shares.

Conclusion

• Company engaged in an attractive segment of the Japanese economy that can be expected to keep on showing organic growth in the future
• Fukuda is a mildly growing, but hugely cash generative company that is attractively valued in terms of assets, earnings and, most importantly, free cash- flow.
• Fukuda Denshi’s attractive valuation is not apparent at plain sight, i.e. by scrutinizing stated price ratios. Only when the market cap is adjusted for high cash holdings and the high investment portfolio, i.e. a valuation on enterprise value basis is conducted, does its undervaluation become apparent.
• Fukuda Denshi is also very attractively valued in comparison to its main competitor Nihon Kohden
• Given the limited international presence of the company, it must be viewed as a domestic value play.
• Pay- out policy is satisfactory. Especially the significant share repurchases between 2010-2014 at very attractive terms were value accretive on the long-run. Still, given the ability of generating significant free cash- flow and an ever increasing net liquid position in the balance sheet, in combination with an attractive valuation of the stock, more action is warranted
• Good Corporate governance is evolving, as the ownership structure has become more transparent, and the potential of conflicts of interests was mended by making Atomic Sankyo a wholly owned subsidiary

Disclaimer: Long Fukuda Denshi