Nitto Kohki (JP:6151) - Decent Compounder Trading around Liquidation Value

Company Overview

Nitto Kohki, founded in 1956 and headquartered in Tokyo, Japan is a well established Japanese manufacturer of components, tools and machines. Nitto Kohki's products fulfill vital roles in fields ranging from applications in the construction industry, automotive industry, medical device manufacturing and high-tech engineering.

Its mainstay products are quick connecting couplings to join fluid pipes. Customers are mainly found in the field of semiconductors manufacturing and housing construction.

Products of the machine tool segment are mainly steel drilling machines and die machining tools to produce automobiles.

In the segment pumping systems, the company mainly offers linear motor driven pumps with a wide range of applications. Among others in medical equipment and for wastewater treatment systems.

The company has sales subsidiaries in the U.S, U.K, Germany, Shanghai and Australia.

General Valuation

Apart from price metrics in relation to book value, Nitto Kohki does not appear being deeply discounted.

Stated EPS for FY ended March 2020 came in at 133 Yen leading to an actual P/E ratio of 13.

Stated average EPS for the last 18 Years was 114 Yen leading to an average P/E ratio of 16.

Moderate P/E ratios appear justifiable given that Nitto Kohki has been showing subpar rentability over an extended period. Over the last 18 Years Return on Equity (ROE) averaged out around 6%.

But P/E ratios and return metrics can be misleading. Especially in corporate Japan with its high cash balances, big investment portfolios and low financial gearing. They often do not reveal the attractive valuation of a company!

To adjust for the overly conservative financing of the company EV/ Ebit and EV/ Ebitda ratios are used. The Enterprise Value (EV) of the company stands at 6’700 Mios. of Yen. If Nitto Kohki’s investment portfolio is excluded, which consists of highly liquid assets, which are marked to market, the EV at current market price is only 4’000 Mios. of Yen.

In the FY ended March 2020 Nitto Kohki reported an Ebit of 4'000 Mios. of Yen and Ebitda of 5’400 Mios. of Yen. Thus, EV/Ebit and EV/ Ebitda ratios (incl. Investments) are a meager 0,94 and 0,7 respectively.

Overview of Operations

Nitto Kohki is operating in a cyclical segment of the economy. Sales suffered significantly during the Great Financial Crisis (GFC) and have never recovered to pre- crisis levels.

In addition, the last FY already indicated a margin compression due to the cooling down of the Japanese economy. Finally, recent quarterly reports indicating a severe adverse impact of the Covid 19 crisis on Nitto Kohki’s business and operational performance.

The short- term impact of economic contractions on sales and operating margins can be severe. Nevertheless, in the last 18 Years the company has always been profitable. And for the current FY the guidance does not indicate a deficit.

Furthermore, average operating metrics over a full cycle are more than decent.  The 18 Year average of stated operating and net- income margins are 16% and 10%. Worth noting is the stable nature of gross profit margins. Although, operating and net income margins contracted almost 14% and 8% during the GFC, gross margins barely budged (hovering around 50%).

Due to overcapitalization of the balance sheet and the absence of financial gearing (see analysis of balance sheet), decent operating margins do not translate into decent return metrics. Average ROE over the last 18 Years was only 6%, barely matching Nitto Kohki’s estimated cost of capital.

Interesting to note is the huge discrepancy between ROE and Return on Invested Capital (ROIC). When adjusting for the conservative financing of the company average return metrics almost double!

Analysis of Cash Flow

Over time Nitto Kohki generates significant and stable Operating Cash- flow (OCF). More importantly, due to limited Capex requirement the company is constantly generating Free Cash- flow (FCF). In the last 18 years the company reported only one FY with FCF being negative. At current market price the average FCF yield is roughly 7%.

Contraction of OCF in 2012 and 2013 was mainly attributable to increasing working capital requirements.

The relatively high and stable nature of OCF and FCF over time allows inferences about a high quality of reported earnings!

Interim Conclusion: A well-established Japanese manufacturing company that operates in a cyclical business segment. Scrutinizing operating and return metrics over an extended period, the company appears to be more resilient to fluctuations in the business cycle. The company’s ROIC is significantly higher than ROE.

Relatively high ROIC, high and stable gross margins in combination with high OCF and FCF over time pointing to a company with a certain degree of moat and/or competitive advantage.

Analysis of Balance Sheet

Nitto Kohki’s interest-bearing debt on its balance sheet is negligible.   

Stated overall Net Assets per share have been increasing moderately by approximately 4% p.a. The equity ratio for FY 2020 stands at a staggering 88%.

During the last 18 years cash holdings more than tripled. Since 2014 the trend has gained momentum, albeit moderating lately. Including the investment portfolio roughly 80% of the market capitalization is covered by net cash.

Asset composition has been seeing a transformation over time, away from fixed assets towards more liquid assets. As for the latest FY asset composition is highly favorable. Cash, receivables, and the investment portfolio make up for roughly 68% of total assets. Goodwill and intangibles are negligible.

Nitto Kohki’s current share price of 1’763 Yen matches roughly its Net Current Asset Value (NCAV) of 1’785 Yen per share. If the investment portfolio was included (130 Yen per share) the company is trading at a tiny discount to NCAV. In relation to its liquidation value the stock is trading at a tiny premium.

The trend of NCAV over time is highly favorable.

 

The same holds true for the liquidation value.

Intrinsic Value/ Margin of Safety

In the last 18 years the discrepancy between share price and intrinsic value has never been more pronounced as of today. Based on a conservative valuation model incorporating the Graham growth value, discounted dividend value, earning- and asset power value the company is roughly 40% undervalued.

Interim Conclusion: Company carries almost no financial debt on its balance sheet. The balance sheet is severely overcapitalized. Overall business is cash generative and company is cash rich. Company is trading around its liquidation value. Trends in NCAV and liquidation value are highly favorable. Company appears severely undervalued not only on an EV basis, but also on a valuation model based on Graham growth value, discounted dividend value, earning- and asset power value.

Analysis of Shareholder Returns

Generally, management targets a pay- out ratio to net income of roughly 40%. For FY 2020 the company paid a dividend of 52 Yen per share. Due to the Covid- 19 crisis the company reduced the dividend significantly to a meager 21 Yen per share for the current fiscal year.

The stated average payout ratio over the last 18 years was 48%.

Every now and then the company buys back its own shares. When it does, buybacks are significant and executed at favorable terms for remaining shareholders. The last buyback program was initiated in the last FY and was terminated in the current one.

Corporate Governance

The company has no takeover defense measure in place. But that is not necessary, given the founder, who died September 2020, and his family having a firm grip on the company. They own roughly the blocking minority. Thus, engagement of a shareholder activist cannot be expected!

The company used to have a generous shareholder benefit program in place (“Yuutai-plan”). “Yuutai plans” are shareholder perks given only to Japanese retail investors. Those plans can yield a significant amount and are highly popular among individual Japanese investors.

The management abolished the plan in 2016/2017 citing concerns regarding equality to all shareholders. At the same time management increased the dividend significantly and bought back own shares. The action is laudable and noteworthy and stands in stark contrast to the increasing trend of Japanese companies introducing such shareholder benefit plans.

Given the number of outstanding shares owned by the founder and his family the action should not be viewed as altruistic. Nevertheless, is it in the best interest to all shareholders.

A drop of bitterness is the severe dividend cut in the current FY. Given the significant overcapitalization of the balance sheet it was unnecessary and value destructive.

The best measure management could take to mend the severe undervaluation of the company in a timely manner is adopting a shareholder return policy based on dividend on equity (DOE). Basically, paying out a certain rate in relation to net assets in form of dividends and/ or share buybacks.

Conclusion

Nitto Kohki is a well-established Japanese manufacturing company that operates in a cyclical business segment of the economy. Scrutinizing operating and return metrics over an extended period, the company appears to be more resilient to fluctuations in the business cycle.

The current market capitalization is almost entirely backed by cash and liquid investments net of total liabilities. Trends in NCAV and liquidation value are highly favorable. Company appears severely undervalued not only on an EV basis, but also on a conservative valuation model based on Graham growth value, discounted dividend value, earning- and asset power value.

Adjusting for the insanely conservative financing of the company return metrics over a full business cycle appear decent.

Relatively high ROIC, high and stable gross margins in combination with high OCF and FCF over time pointing to a company with a certain degree of moat and/or competitive advantage.

Drop of bitterness is a highly conservative pay- out policy. Given the severe overcapitalization a change is warranted away from a policy based on net income towards one that is based on equity/ net assets.

Disclosure: Long Nitto Kohki (JP:6151)