With all likelihood, this is the final post on Kawasumi Laboratories, a longtime holding of mine that was mentioned on my blog two times in the past.
Friday the 31st of July Sumitomo Bakelite announced its intention to takeover Kawasumi Laboratories at a price of 1'700 Yen. An offer which would result in a performance of 318% (incl. dividends before tax) over a period of almost exactly 8 years. And my first Japanese stock where I made the serious money basically within three days.
I have not tendered my shares to Sumitome Bakelite or sold them on the market yet. Before doing so it is time to contemplate. Writing to myself a brief presentation of my initial investment case, a recap of my rather long and wearisome journey in this “deep value” sphere of stock market investment and finally, an in depth analysis of the takeover offer, reasoning if it is attractive or not and if there is any chance of a significantly bettered offer.
Recap of My Initial Investment Thesis
I first mentioned the stock in October 2012 at a price of 434 Yen. In addition, I received dividends on a per share basis of 116,5 Yen. Thus, the performance of my engagement without dividends is 292 %. Including dividends, the performance is 318% over a period of roughly 8 years.
The investment case brought forth in 2012 was mainly based on quantitative valuation metrics concerning the company’s asset and earning power in relation to the prevailing market price.
Already stated valuation metrics appeared very compelling, with a P/B ratio of 0,32, P/ OCF ratio of 2 and a FCF Yield of 21,8 %.
Adjusting for the high balance of liquid assets revealed a company that was abstrusely undervalued by Mr. Market. Basically, when the investment portfolio was excluded the market valued the company at negative enterprise value.
And this even though the company never had delivered a single year of negative operating cash flow over a time span of 14 Years, and the FCF generation was very favorable.
In 2012 Kawasumi Laboratories was a classic Graham and Dodd net- net stock that was debt free. The discount to the liquidation value (incl. Investments) was roughly 15%. In addition, liquidation value showed a rising trend over time.
The discount to NCAV (incl. Investments) was 42%. Thus, the minimal upside potential according to the Graham and Dodd philosophy was roughly 82%.
The intrinsic value model based on earning and asset power value, Graham growth value and discounted dividend value indicated a fair value of 1’231 Yen. According to this model at a prevailing market price of 434 Yen the company was undervalued by 65%. Thus, the stock had an upside potential of 183%.
Why Was Kawasumi Laboratories So Dirt Cheap?
Firstly, it was a Japanese company. In 2012 the Japanese stock market was completely ignored, not only by international investors, but also Japanese investors showed no interest at all.
Secondly, the stock had no analyst coverage, so even within Japan very few investors were aware of the company’s existence.
Furthermore, the stock was very illiquid. No institutional investor was able to build up a meaningful position.
Finally, the elephant in the room: The Management. They were almost hostile against the shareholders of the company. They not only were indifferent concerning the severely undervalued share price, but actively engaged keeping the stock price at depressed levels for almost an eternity by introducing poison pills, keeping the real pay- out ratio extremely low, not buying back shares at extremely value accreditive terms, and even diluting existing shareholders on extremely unfavorable terms.
The Journey
The ride on this “deep value vehicle” was quite an interesting one. Fundamentally, it was smooth and encouraging. Year in and year out quantitative metrics were improving. Not so much on the sales and earning side, but on a free cash- flow basis. Operating business, although not growing, nevertheless delivered handsomely, which led to a significant increase in the liquidation value, and thus, the margin of safety.
Price wise it was a different story. Calling the experience a roller coaster ride would be an understatement. The price went all over the place in short periods of time. The only encouragement was that the stock never fell below the initial acquisition price. Still the price action drove me nuts! Always when it looked like the lift off is imminent it crashed back to mother earth. Although the crashes stopped at higher low levels, valuation levels not seldom undercut previous lows. Most insane was the revaluation in 2019, which enticed me to write a follow up on my initial investment case.
Firstly, it was a Japanese company. In 2012 the Japanese stock market was completely ignored, not only by international investors, but also Japanese investors showed no interest at all.
Secondly, the stock had no analyst coverage, so even within Japan very few investors were aware of the company’s existence.
Furthermore, the stock was very illiquid. No institutional investor was able to build up a meaningful position.
Finally, the elephant in the room: The Management. They were almost hostile against the shareholders of the company. They not only were indifferent concerning the severely undervalued share price, but actively engaged keeping the stock price at depressed levels for almost an eternity by introducing poison pills, keeping the real pay- out ratio extremely low, not buying back shares at extremely value accreditive terms, and even diluting existing shareholders on extremely unfavorable terms.
The Journey
The ride on this “deep value vehicle” was quite an interesting one. Fundamentally, it was smooth and encouraging. Year in and year out quantitative metrics were improving. Not so much on the sales and earning side, but on a free cash- flow basis. Operating business, although not growing, nevertheless delivered handsomely, which led to a significant increase in the liquidation value, and thus, the margin of safety.
Price wise it was a different story. Calling the experience a roller coaster ride would be an understatement. The price went all over the place in short periods of time. The only encouragement was that the stock never fell below the initial acquisition price. Still the price action drove me nuts! Always when it looked like the lift off is imminent it crashed back to mother earth. Although the crashes stopped at higher low levels, valuation levels not seldom undercut previous lows. Most insane was the revaluation in 2019, which enticed me to write a follow up on my initial investment case.
Management and corporate governance wise nothing really changed. The management only mended what it was obliged to fix. They nominated two independent directors. They bought back 10% of the shares, but not because it was the right thing to do, but rather because the dismantling of cross shareholdings forced them to do so. Due to the poison pill and docile (corporate) shareholders management was fully entrenched and did not care for the shareholders at all!
The Outcome
Let us get to the nitty gritty: Abovementioned the TOB came in on Friday the 31st of July after market closure with an offer price of 1`700 Yen. The stock closed that day at 785 Yen. Thus, Sumitomo Bakelite is offering a premium of roughly 117%.
Furthermore, the simple average closing price for the-month of July was 840 Yen. Hence, Sumitomo Bakelite is offering a premium of 102% to the prior month simple average stock price.
According to Statista (December 2018) average premiums paid in the Japanese healthcare sector on simple monthly average were 32 %. Based on price premium metrics the offer looks very generous.
But what about putting the offer price into context to Kawasumie’s intrinsic value?
According to Statista (December 2018) average premiums paid in the Japanese healthcare sector on simple monthly average were 32 %. Based on price premium metrics the offer looks very generous.
But what about putting the offer price into context to Kawasumie’s intrinsic value?
On stated price to operating metrics the offer appears to be OK but not great. What is striking though, is the offer price being 10% below stated book value, And, that for a company that is debt free and owns a vast amount of valuable liquid assets.
Subtracting those liquid assets from the market cap at 1’700 yen (==> Enterprise Value) and putting the adjusted market cap into relation to operating metrics the offer appears significantly less attractive!
Paying an EV/ Ebit, EV/ Ebitda and EV/ OCF of just 6, 3 and 5 times for a viable and highly cash generative business is quite pathetic!
Analysis of Kawasumi’s Fair Asset Value
For FY 2019, which ended in March 2020, Kawasumi reported a net cash balance (cash – total liabilities) of 748 Yen. If the investment portfolio was to be included (consisting of liquid Japanese stocks, which are marked to market) the net cash position would increase to 919 Yen. Thus, Sumitomo Bakelite is offering a premium of only 85% over net cash (incl. Investments). Or put differently, they are paying only 781 Yen for the operating business.
A conservative estimation of liquidation Value (incl. Investments) comes in at 1'198 Yen, thus the premium shrinks further to only 42%.
NCAV (incl. Investments) is 1’407 Yen. The premium shrinks to a meager 28%.
Thus, Bakelite pays only 28% of NCAV to get a grip on the assets they are most interested in, namely the PP&E account. It is stated on the books at 441 Yen per share. But mainly due to excess depreciation this account is artificially depressed. Still a highly conservative assumption of depreciation over gross income and depreciation over PP&E of 15% (already a very high number indeed) would still lead to excess depreciation on the PP&E account accumulated over a time span of 22 years of roughly 450 Yen per share. Hence, the real value of the PP&E account is closer to 900 Yen per share.
Fair Value (1) Kawasumi (Asset Basis) = Liquidation Value (incl. Investments) + Adjusted PP&E = 1’198 Yen + 900 Yen = 2’098 Yen.
Fair Value (2) Kawasumi (Asset Basis) = NCAV (incl. Investments) + Adjusted PP&E = 1’407 Yen + 900 Yen = 2’307 Yen.
Fair value range (Asset Basis): 2’100 – 2’300 Yen
Thus, the offer price (1700 Yen) is roughly 22 % below the company’s fair value on an asset basis!
Interestingly, Daiwa Securities estimation for a fair value on a DCF basis comes in at a range of JPY 1’513 to JPY 2,358 per target share. Hence, my high range of the fair value on an asset basis is close to the high range of Daiwa’s estimation on a DCF basis. So, let us have a look at the valuation ratios at an offer price at the high range of my fair value assumption.
On a price to operating metrics an offer price of 2300 Yen would appear rich.
But on an enterprise value basis, especially EV/ Ebitda and EV/ OCF basis, the fair value price on an asset basis of 2’300 Yen looks more than reasonable at a ratio of roughly 7 and 10. Other relevant metrics also look attractive for Sumitomo Bakelite. At a price of 2'300 yen Sumitomo Bakelite still would get a more than decent company that is relative cheaply valued.
Unfortunately, given that Kawasumi’s management unsurprisingly recommends accepting Sumitomo Bakelite’s inadequate offer, and an unfavorable major shareholder composition, the chance of any bettered offer has to be seen as extremely remote.
Disclosure: Long Kawasumi Laboratories
Source:
http://www.kawasumi.jp/e/pdf/PR200731-1.pdf
https://www.statista.com/statistics/978607/average-premiums-in-japan-by-industry/
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