Kawasumi Laboratories (JP:7703) - The Beauty and The Beast

Introduction


This post will scrutinize the ever increasing cash holdings and corporate governance issues at Kawasumi Laboratories, a deep value J-Net stock and long term holding of mine.

The stock was first mentioned on the blog in 2012 as a deep value idea. Quantitative metrics in 2012 indicated that the company was trading in the Japanese stock market at a significant discount to its intrinsic value.


Although earnings growth and return metrics have been at best paltry since the initial investment, liquid assets in the form of cash holdings have been ever increasing during the holding period. Although the stock appreciated roughly 75% (excl. Dividends) during that time, the combination of significantly increased cash holdings and absence of interest-bearing debt, has pushed the company into obscene valuation territories, seldom seen in my career as a value investor in the spirit of Graham and Dodd.



The massive undervaluation at Kawasumi begs the question of how much of a cash hoard is enough. Also, it lays bare how steep a corporate governance discount can materialize at a Japanese company that continuously acts against the best interest of its shareholders.


Company overview


Kawasumi laboratories, in Japan known as Kawasumi Chemicals, is a well-established Japanese medical device company. Historically it has concentrated its business activities around disposable medical products for hemodialysis, plasmapheresis, blood banking and transfusions.


Lately, it has been reorganizing its business activities. Abandoning those areas it deems low margin businesses, and concentrating R&D and capex investments in the endovascular sphere, mainly Stent Graft systems.


Overview of Operations 


Stated Return metrics and EPS have been under pressure for an extended period of time. 

Stated ROE and ROA for the latest FY came in at a poor 2% and have been poor historically.

Sales were stagnant during the period of 1999 and 2009, and since have been falling steadily.


Stated operating margins and net income margins have been low for a long time. For the FY ended March 2019 a meager 2.5% and 0.77% were reported. Margin compression for the latest FY is attributable to business restructuring. Adjusting for extraordinary charges (restructuring, income from sale of investment securities and excess depreciation) leads to operating income and net income margins of around 5.5%, significantly higher than the stated numbers, but still disappointing.


Interesting to note is the fact that the company is showing stable gross margin readings of 30- 34% for the last 10 years. Not great for a Japanese medical device company, but not bad neither. R&D expenditure alone can’t explain the huge discrepancy between gross, operating and net margin, as it was only around 5% of net sales for the latest FY. 


Analysis of cash flow


Not only with its margins is Kawasumi exhibiting discrepancies, but more importantly so in relation of earnings and generated operating and free cash flow.

At a current market price of 750 Yen and stated average earnings per share of 46 yen for the last 20 years, the stock is trading at an average P/E ratio of 16. Whereas the average P/OCF ratio stands at only 5. 


Furthermore, although average stated ROE is only around 3%, the average FCF yield is more than double of that (roughly 7%).

Interim Conclusion: A well established Japanese medical device company that has been showing low operational and return metrics over an extended period of time. By scrutinizing those stated metrics, discrepancies appear. It appears that the company is misrepresenting its operational efficiency for the worse and underreporting its true earning power.


Analysis of Balance Sheet


Aforementioned discrepancies in stated and adjusted operational metrics over a prolonged period of time, are also reflected in Kawasumies balance sheet.

Although BPS has increased only modestly over time….

… cash holdings are exploding. Especially, in the last 5 years the discrepancy between the evolution of overall book value and those to cash holdings are flabbergasting!


The whole composition of assets has been reshuffled over time. Away from fixed assets, which have been written down aggressively, towards liquid assets like cash and investment holdings. 


At the same time the company has been engaging in a radical deleveraging process. In 2006 total liabilities stood at around 13,000 Million Yen. For the latest FY they had a value of only 5,800 Million Yen.


The implication for NCAV and liquidation value of those asset reshuffling and deleveraging are significant.

Especially, in the last 5 years NCAV is on a significant uptrend. Most striking is the buildup in the net cash position. It stands at 615 yen per share, a staggering 82% of Kawasumi’s present market capitalization. If the marketable security portfolio (207 yen per share) were to be included in the analysis it would lead to 822 yen per share. Thus, roughly 110% of Kawasumi’s market cap is backed by cash + marketable securities (mainly stocks) – all liabilities! 

Including Kawasumi’s investment portfolio the stock has a liquidation value of 1’150 yen per share. Trading at around 750 yen, the stock is trading 34% below its liquidation value. Since investing in the company in 2012 the liquidation value has almost doubled. 


Although the stock has returned roughly 100% (incl. Dividends) during that time spam it has never been cheaper on an Enterprise value (EV) basis.

Excluding the investment portfolio, the companies’ EV is –7,828 Million Yen. And this incredible low valuation granted by the market is for a company that has never exhibited a (real) loss year in the last 20 years!

Interim Conclusion:Company with an insanely overcapitalized balance sheet. Business is cash generative, especially during the last 5 years. EV dipped in negative territory and the negative trend has been accelerating. Company never reported a loss year in the last 20 years, when numbers are adjusted.


Company is a prime example of a company that is rich, and their shareholders are poor!


Corporate Governance


The fundamental analysis of the company conducted so far, begs the question what makes Mr. Market valuing the company as if it was heading for bankruptcy in the not too distant future. The fundamentals presented in this post do not indicate any distress the company might be facing. Quite to the contrary. It is indicating a company that is delivering relatively high owners’ earnings and has been underreporting its earning power significantly over a long period of time and is insanely overcapitalized.


The only sensible explanation for this striking undervaluation is Mr. Market applying a massive corporate governance discount to this company. But is he rightly doing so?


The company had been approached by the activist fund Steel Partners in the mid-2005. Managements response was the introduction of a poison pill to fend off any unfriendly action. Apparently, the management was so afraid of a proxy battle that it did not deem the poison pill to be sufficient. In 2008, under the disguise of a supposed business alliances, it took on board friendly corporate shareholders (Terumo, Kuraray, etc.), partially by offering new shares. It was done at extremely unfavorable terms to existing shareholders. I regard this share offering as the real atrocity the management did to the existing shareholders, with negative implications to the market value of the company existing until today.

Some of the shareholder value destructive actions of 2008 were subsequently mended. The company bought back large blocks of shares from those friendly corporate shareholders. Especially the transaction in FY 2018 was encouraging and signaled to me that the management intends to dismantle the cross shareholdings. Also, it would have partially explained the ever-increasing cash holding in the last 5 years, as the dismantling at a price of 900 – 1000 yen would have cost the company, according to my calculations, around 7,500 Million Yen.


Unfortunately, I underestimated management’s deep rooted animosity toward its existing shareholders. In the final days of the last fiscal year the disposing of shares of old strategic corporate shareholders continued. A bloc of shares (23%) were sold to Sumitomo Bakelite, a Japanese chemical company. Furthermore, Sumitomo Bakelite reported a significant one-time gain on negative goodwill on this transaction in the FY ended March 2019. 


Kawasumi’s management allowed a Japanese company to get richer on the back of existing shareholders (it could have opposed the transaction as it has a poison pill in place). By getting on board another strategic corporate, and not buying those shares back itself (although it had the financial means and the share price was deeply undervalued), the company once again made sure that that the company stays rich and existing shareholders remain poor.


Conclusion


Kawasumi Laboratories is an ok business, that is misrepresenting its operational performance for the worse over an extended period of time. Why it is doing so remains a mystery! 


For a long time, the company has had a balance sheet that had been overcapitalized. In the last 5 years this trend of overcapitalization is accelerating. A valuation only based on the company’s net- cash and net investment position indicates a hugely undervalued security.


On an asset basis the company has been undervalued for a prolonged period of time, but the discount between intrinsic value and the market price has been steepening significantly in the last 5 years.


The main culprit for this steep undervaluation is to be found in the extremely poor decisions concerning capital allocation, and an almost hostile stance of the company’s management towards the best interest of its existing shareholders. Thus, a corporate governance discount is certainly warranted for this company. How steep such a discount should be is anyone’s guess.

Disclosure: Long Kawasumi Laboratories