Description

C. Uyemura & Co., Ltd. (TSE:4966), a Japanese cash cow operating in the disciplined electroplating chemicals industry, stands out as a safe harbor for investors: 64% and 88% of its market cap is covered by cash and cash + real estate + equity investments, respectively. Maybe we should thank the extremely low trading volume at the 2nd Section of Tokyo Stock Exchange for giving us the opportunity to buy a company that has been consistently profitable in the past two decades at merely 2.7x EV/(EBITDA-Capex) and 4.0x ex.cash P/E. Theoretically, if I were a private equity fund, I could acquire the company for free by offering ~70% premium to current share price while funding the transaction with 5x Reported LTM EBITDA leverage – when l exit in a few years, I could make at least half a billion USD and achieve the highest IRR ever (because I could get it for free)!

I do not have any special insights for the company, nor am I an expert on Japanese companies and their culture; but just based on public information, this investment opportunity is rare, straight forward and has enough margin of safety (hard to find these days).

Electroplating chemicals industry

Electroplating chemicals is an attractive niche within the surface treatment industry. Although the industry growth is limited to single-digit, a number of factors have made every player in this industry a cash cow:

• Electroplating chemicals is a mission-critical component in producing PCBs, auto parts surface treatments, semiconductors, and other surface treatments, yet only yields a small portion of the overall manufacturing cost base. Electroplating chemicals players are unlikely to experience significant pricing pressure – even during the financial crisis, majority of the industry remained profitable.

• Structurally growing downstream as we consume more and more PCBs (smartphone, car electronics, wearables) and increase usage of functional plating on cars (plating chemicals on plastics to make them look like metal).

• No new entries for several decades due to product complexity, R&D knowledge and customer services capability required, high switching costs to customers, and brand equity.

• Concentrated market with three global players Platform Specialty Products (US-listed, Pershing Square owns 18% stake), Atotech (under Total SA) and Rohm & Hass (under Dow Chemical) commanding ~60% global market share; and four Japanese players (Uyemura, JCU, MEC, Okuno) taking the other ~20% share.

• Asset light, high customer retention, high margin, limited Capex / R&D / working capital investments required.

On top of abovementioned merits, another great news is that the industry is consolidating and the top 2 players are facing changing dynamics, in a way that would benefit smaller players like Uyemura, in my view.

• Platform Specialty Products (“PAH”): similar to Valeant, PAH is built upon a roll-up strategy fueled by debt. PAH built its electroplating chemicals business (roughly half of the total revenue) by consolidating MacDermid (~10x EBITDA) in 2013, OM Group electroplating assets (~13x EBITDA) in 2015, and Alent (~13x EBITDA) in 2015. However, since the announcement of acquisition of Alent in July 2015, its share price has fallen from ~$28 then to ~$9 now. PAH is highly levered to >7x forward EBITDA (similar to the Valeant story).

• Atotech: Total SA announced in May 2016 to divest Atotech. According to the latest update from Bloomberg, it seemed that one of three private equity players could end up as the new owner and the divestment could be announced as early as this September / October.

• I view the changing dynamics at PAH and Atotech as a positive development to the industry and more favorable to smaller players like Uyemura. Simply assume that PAH and Atotech would need to 1) raise price and/or 2) cut Capex / R&D to be able to generate growth and pay down debt. Smaller players could tag along with the price increase, and/or become more competitive over the long run by maintaining the adequate Capex / R&D investments.

Background of the opportunity

Uyemura is a pure play in electroplating chemicals and is the largest out of the four Japanese players. Globally, Uyemura would rank no.4 or no.5 (with a high single digit market share), after the big global players. The Uyemura family owns 25% stake in the company, Schroder Investment Management is the 2nd largest shareholder with a 13% stake. Uyemura is headquartered in Osaka, Japan, established in 1848, incorporated in 1933 and went IPO in 1997.

Uyemura has been profitable (in both bottom line and operating cash flow) ever since its 1997 IPO and has grown in line with the overall industry. At the moment, it has a market cap of JPY 40.3bn and EV of JPY 14.8bn, including net cash balance of JPY 25.8bn, or 64% of its market cap. The company is trading at only 0.83x to its tangible book value. In the past decade, the company’s current assets (ex. net cash) were always higher than its total liabilities in any given year. Hidden under Uyemura’s non-current assets were the company’s JPY 8.1bn office / residential real estate for rental (fair value, also justified by a 20x price-to-rental ratio) and JPY 1.5bn investments in listed equity securities (here together defined as “realizable non-current assets”). If we were to assign fair value to such realizable non-current assets, together with the cash balance, we would have 88% of the market cap covered, without assigning any value to the company’s PP&E. I’m confident that within a year, the company’s incremental cash flow could close the remaining 12% gap.

As shown in below table, company has stable financials with moderate growth (topline number is affected by the company’s metal & chemicals trading business, which has little impact to profitability). EBITDA was JPY 7.1bn for FY 2014A, JPY 8.2bn for FY 2015A, JPY 8.8bn for FY2016A and JPY 9.3bn for FY 2017E (forecasted by management). Adj. EBITDA was JPY 4.2bn for FY 2014A, JPY 6.4bn for FY 2015A, JPY 6.2bn for FY2016A and JPY 5.4bn for FY 2017E (forecasted by management). Net income was JPY 1.7bn for FY 2014A (affected by one-off income taxes), JPY 3.8bn for FY 2015A, JPY 4.3bn for FY2016A and JPY 4.0bn for FY 2017E (forecasted by management). Adj. net income was JPY 1.4bn for FY 2014A (affected by one-off income taxes), JPY 3.5bn for FY 2015A, JPY 3.9bn for FY2016A and JPY 3.6bn for FY 2017E (forecasted by management). Note that management forecast is lower than current sellside analyst forecasts – being conservative here.

Adj. EBITDA is defined as EBITDA minus rental income and Capex to proximate core business cash flow. Adj. NI is defined as net income minus rental income and net interest income adjusted for tax (assuming tax rate of 35%). Uyemura is trading (FY2017) at 2.7x EV / Adj. EBITDA, and 1.0x EV / Adj. EBITDA (if we recognize the value of realizable non-current assets in arriving EV). Similarly, the company is trading (FY2017) at 11.2x P / Adj. NI, 4.0x P / Adj. NI (ex. net cash), and 1.3x P / Adj. NI (ex. net cash and recognize the value of realizable non-current assets in arriving market cap).

Thoughts on valuation

Without doubt, Uyemura is trading at a valuation that’s typically seen in distressed situations, but ironically, it is a solid company in a disciplined industry where precedent transactions were priced at 10-13x EBITDA (refer to PAH’s acquisitions). Could it be a Japan specific issue? Uyemura is trading at significant discount even to its Japanese peers JCU and MEC. Based on public info, I have made two observations that could help explain the discount.

Observation 1: Low liquidity / trading volume and slow historical growth (although similar forecasted growth)

Observation 2: Family ownership / limited incentive to promote share price

• JCU went through MBO in 2003 with relatively small management stakes remained in the business, and there is no legacy family ownership.

• MEC recently rolled out ESOP for its management and started buying back shares – its share price nearly doubled in the past 12 months.

• Uyemura, on the other hand, is currently headed by Mr. Hiroya Uyemura, who holds a 25% stake in the business. The company’s last major share buyback was in FY2010, when the business went into a low year due to the financial crisis. I suspect that Mr. Hiroya Uyemura lacks the incentives to promote share prices (which could easily be done through share repurchases or increase of dividends). In addition, Uyemura did not try to move from the 2nd Section to the 1st Section of Tokyo Stock Exchange, which JCU and MEC both did years ago.

Uyemura is cheap, and it may continue to stay cheap if the management has no incentive to distribute value to shareholders but instead just piling up cash on its balance sheet. Nonetheless, the value is there. Sooner or later, it will be realized. At current price level, I do not see any downside potential, unless you are worried that Uyemura could be traded below its cash balance + realizable non-current assets value + one year cash inflow, considering:

• Some cash may be trapped in overseas entities (mainly China and Taiwan) and cannot be bought back without WHT leakages

• FX impact (subject to further diligence, FX shouldn’t impact value too much in Uyemura’s case)

• If USD appreciates against JPY: Assuming the company’s cash are all in JPY (subject to further diligence on the exact currency split of the companies’ cash), the more USD appreciates, the more valuable the company’s existing cash balance are (again, cash accounts for 64% of market cap)

• If USD depreciates against JPY: the company has 60% of its revenue generated outside Japan – USD depreciation should help drive up the company’s bottom line – resulting in a lower P/E

• Fraud? (I think the chances are extremely small, two reputable funds invested large stakes)

I view entering Uyemura now as a defensive play, as the global equity markets continuously move to higher and higher multiples. I personally think there might be a correction soon or later, and I planned to hold cash until seeing it through. Then I found Uyemura, which I believe is better than holding cash and is as safe as holding cash (while getting a 2.7% dividend yield). Maybe the upside is limited and the timing of upside is uncertain, but given the absence of downside risks, I believe I could sleep well at night for parking my cash there, until I find better investment opportunities.

Final words

Uyemura’s value on the table is too obvious, has anyone else noticed? Yes. Schroder Investment Management has been buying Uyemura shares almost every year since 2004, and increased its stake from 0.9% to 13%. Similarly, Polar Capital entered the position in 2009 with 1.7% and increased to 5.4% in 2015.

Japan market is known to have cheap, profitable companies trading below book value, typically low growth companies in borning industries. To confirm that Uyemura is a cheap, high quality stock even within the Japanese market, I ran a quick screening setting criteria as: Tokyo Stock Exchange, dividend yield > 2%, EV/LTM EBITDA < 3x, P/ LTM EPS < 15x, P/tangible book < 1x, Net cash > 50% of market cap, EBITDA margin > 10%. From the 46 companies emerged from the screening, I believe Uyemura has: one of the highest EBITDA margin (indicates strong pricing power, non-commodity type industry); Best industry dynamics; Most stable financials (vs. most other cyclical businesses); One of the fastest book value per share growth (real value gained for shareholders).

Catalyst

• MBO

• Uyemura moves to 1st Section of Tokyo Stock Exchange and/or increased trading volume

• Dividend increase and/or share buyback

• Industry consolidation, merger of Japanese players or Japanese players getting acquired by global players

• Potential cash flow / debt problems at PAH and/or Atotech sold to a private equity buyer instead of a corporate