Sediment Capital’s valuation for passive business owners – Jeffrey’s 8 item checklist

1.        Catastrophic Risk and durability of business model  (tell me where I will die and I won’t go there)

-Too much leverage? Easily disrupted space? How will it look a decade from now?

2.        Is this business understandable?   (Are first hand sources written to mislead and confuse?)

-Are there too many segments? Complicated conglomerate?

- Back of the envelope calculations (net quick, inventory, earnings)

3.        Competition, Cash conversion cycle, financial ratios, and industry specific metrics  (What didn’t kill us, just made us weaker)

-          Industry size, how many competitors?

-          efficiency relative to industry

4.        Tangible book value and capital employed to owner’s earnings on a long term basis

Tangible assets, working capital, debt relative to consistent cashflows/owner’s earnings, ROIC

5.        Ethical Management & Efficient Capital Allocators aligned with shareholder’s interests  

 (How can these people screw me over? Who is the pansy?)

-          Is management ethical? How do they deal with tough situations? Look at the lawsuits. Are there interested aligned with ours? Who are the owners? What do suppliers, customers, distributors, and customers say about them?

6.        Sustainable Competitive Advantages (barriers to entry, is first mover advantage relevant? How long will these advantages last?)

7.        Price Paid  (if you pay way too much for a good thing, it makes it bad)

-          Was there a margin of safety? How much growth is expected? Did I adjust the price for additional risk?

-          Inflection point?

8.        Opportunity Costs, concentrated portfolio and when to sell

(Murphy’s law "Anything that can go wrong will go wrong".)

-          What did I miss? Where are my blind spots? With limited diversification, are these industries too similar? Will they be hit by the same type of risk?

-          Friendships- How many true friends do you have? Friend you spend quality time with?

If you’re honest, only a handful.

-          Concentrated Portfolio- How many companies are relatively cheap with quality management that I truly understand? If you’re honest, only a handful, maybe less than 5.

“The information you have is not the information you want.

The information you want is not the information you need.

The information you need is not the information you can obtain.

The information you can obtain costs more than you want to pay”

– Peter Bernstein

When purchasing shares to become a partial, passive business owner, here are the things to look at:

1.     Catastrophic Risk- Will this business last? Will it be here a decade from now?

Is there catastrophic risk? Before thinking how we can succeed, think about how this can go wrong. How can we lose our investor’s money?

A decade from now, will this company still exist? Is there too much debt on the balance sheet? Will it be disrupted by another technology or government regulation? Most companies listed in the Fortune 500 don’t last a few decades. It is important to invert and think about what to avoid before digging deep.

In order to compound, we need a long runway. Cigar-butts are great, but long term compounders give us for more time to think instead of worrying about when to sell. We also pay less taxes and brokerage fees. A real owner of a public company would not go in and out of his holdings frequently, so why should you?

2.     Is this business understandable? Are there too many parts?

Some businesses are understandable but are conglomerates or require a sum of parts analysis. While conglomerates may be underpriced due to unaccounted real estate, etc. additional analysis may make you conclude it is undervalued.

However, conglomerates are sometimes flawed in my view. Why? They lack focus. I talked to a Chinese State Owned Enterprise which helps different countries with power generation through coal, nuclear, hydro-electric, etc. They said General Electric has proprietary technology in steam turbines which is hard to replicate. This is an advantage an America corporation has over other countries. Yet GE is in a mess now and can’t capitalize on this situation because they’ve spread themselves too thin with too many unnecessary projects.

In a conglomerate, even if you have enough capital and funding, your focus is always diverted and management can’t concentrate all human resources on winning the important battles. You can’t answer in a concise manner to your customers the simple question, “what the hell do you do?”

If you fight too many battles you can’t win the war. You have to pick your battles wisely. Some industries are winner take all. If you can’t gain a reasonable market share, you should leave.

What did Steve Jobs do when he returned to Apple? He had to cut out important projects that were interesting but not crucial and reduce the number of products, whether software or hardware, from hundreds to a dozen. When his favorite singer, Paul McCartney of the Beatles asked him what was he most proud of? He said it was the things he decided not to do. As Steve use to say, “People think focus means saying yes to the thing you’ve got to focus on. But that’s not what it means at all. It means saying no to the hundred other good ideas that there are. You have to pick carefully. I’m actually as proud of the things we haven’t done as the things I have done. Innovation is saying ‘no’ to 1,000 things.”

Having 2 or 3 complementary businesses in one holding is mildly acceptable; anything more than that is convoluted. If a business is overly complicated or misleading, it is best to stop reading and look for the next investment opportunity.

3.     What is the industry like? What are the important metrics? Who are the competitors? How big is the entire industry?

For example, in retail, you would like to know the comparable store sales, the terms for rent, whether it is NNN, etc. For manufacturing, you would like to know the utilization rates, cost of each factory, product quality, etc. For insurance, the combined ratio, for banking, the capital adequacy, etc.

Then you want to compare these metrics and with the competitors by reading their annual reports. You’ll quickly see who the leader in the industry is. Sometimes the leader is overpriced. This is where patience and temperament comes in. Don’t buy it until it is the right price. If there’s a temporary blimp or bad news, swing for the fences.

4.     Are the assets inflated/fabricated? What is the capital employed/tangible book value? How can this business be more efficient compared to its peers? What is the capital employed? What is the return on capital? Is cash flow stable over the next few years? If not, when?

Double check if the quick assets were real, what percentage is in cash? Which assets can be liquidated? How much you could reduce the inventory and increase the turnover, and how much you could increase the earnings (or cash flows)?

Check how days payable, inventory and days receivable compare relative to peers.

For capital employed, think in terms of an owner—which is working capital and tangible fixed assets used to generate owner’s earning. Are there hidden assets or real estate which is undervalued? What comprises tangible book value?

Then think about the amount of leveraged used to generate the operating cash flows each year. Once you find out if the company can sustain its return on capital and if it is high, what the company did to accrue these advantages and what it could do to lose it?

What is the capitalization? If it is debt free and does not require capital markets, why is the company issuing more shares?

5.     Is management ethical? Are they aligned with shareholders? Is there a long enough financial track record?

Is it family owned? How much do they own? Who has the controlling vote? Does management have a stake? What are the related party transactions?

Management leaves a paper trail- dig deep into the lawsuits and news articles and employee reviews. How do they deal with things in time of a crisis?

You want management to be good capital allocators who don’t make too many acquisitions and reinvest retained earnings in projects which will create value.

When you go through the entire due diligence process of analyzing a company, you will come to the conclusion that companies which have been listed for 5 years or less won’t give you the necessary history to know about how it deals with mishaps, recessions, or bad fortune, and how the company evolved financially and culturally over time.

6.     Durable Competitive Advantage

Low-cost Provider

-          Economies of Scale (Amazon, Costco, GEICO)

-          disadvantages

Pricing Power

-          Brands(America Express, Coke, Apple, Nike)

-          Product Differentiation

-          Patents, trademarks, etc.

Barriers to Entry

-          Government Regulated (Duke Energy, Waste Management, Shell Gasoline)

-          Network Effects (Facebook, Ebay, Priceline)

o    First mover advantages vs. certain situational disadvantages

-          High Switching Costs (Oracle, SAP, IBM)

-          Distribution (Wal-Mart, Kraft, Gillette)

Low Cost Provider

Economies of scale and efficient operations keeps competition out by being the low cost provider. This can be a significant barrier to entry and can build brand loyalty, as demonstrated by Amazon Prime, which has a huge competitive advantage. Scale over competitors helps drive down costs and pricing, given leverage with purchasing (Walmart), volume production (Samsung), marketing (Coca-Cola), fixed costs (Costco), and partners (AT&T).

Commodity products lacking differentiation such as iron, steel, plastics, rely on lower pricing to gain more customers. In the long term, this strategy may hurt profit margins of the company, especially if there is a rise in raw material prices or operating expenses.

Sometimes as a shareholder you have to worry about a new breakthrough which brings prices further down. Does this new manufacturing technology benefit the customer, or the owner? The manufacturer or shareholder may not benefit if every competitor buys it.

Pricing Power

A company that can increase prices without losing on volume has pricing power. Companies that have pricing power are usually taking advantage of high barriers to entry or have earned a dominant position in their market. Pricing power is created through patents, a strong brand, or product differentiation.

Brands

Strong brands ensure a certain quality from its reputation such as Disney, Apple, Nike, etc. This creates a goodwill with a customer in which a premium can be charged for a product. It takes a large investment in time and marketing costs to build a brand and very little to destroy it. A good brand is invaluable because it causes customers to prefer the brand over competitors such as Coke.

Luxury Brands

For luxury brands, the higher the price charged the more perceived value and quality of the product.

Product Differentiation

A unique product or niche builds customer loyalty and is less likely to lose market share to a competitor than an advantage based on cost. The quality, number of models, flexibility in ordering (i.e. custom orders), and customer service are all aspects that can positively differentiate a product or service.

Companies (such as fast moving consumer goods, food processing, and service based business) that create durable competitive advantage based on product differentiation successfully create better moat, and cause discerning buyers to pay more for a better solution.

The resulting brand name virtually locks up the customer base or niche market for the product or service for the foreseeable future. If the customers have no other source to turn to for a product, technology, or service that has a high demand, then that guarantees a large amount of sales until someone manages to penetrate their market.

Strategic assets- Intellectual Property, contracts, etc. 

Patents, trademarks, copyrights, domain names, and long term contracts would be examples of strategic assets that provide sustainable competitive advantages.

Companies with excellent research and development might have valuable strategic assets (i.e. International Business Machines (IBM).

Take the National Cash Register—John Patterson was struggling to make money in retail due to employee theft. When the cash register was invented, Patterson started making money. Being the shrewd man that he is, he went into the cash register business instead—he bought all the patents, hired the best salesman, and had a monopoly. In fact, one of his employees, a former Piano salesman, T.J Watson, started IBM after he left the National Cash Register.

Proprietary Information

In the form of knowledge (Glaxo Smith drug research), process (Tesla battery manufacturing) customer data and preferences (Amazon), and many other types.

 Location 

In the form of prime physical locations for the given customer segments (Starbucks) or the sheer number of locations (7 Eleven). If you are a property developer, winning a prime location or building a mall with a lot of traffic is an advantage. Exhibition centers, stores, malls, and various segments all benefit from good location.

Barriers to Entry

Cost advantages of an existing company over a new company is the most common barrier to entry. High investment costs (i.e. AT&T (T)) and government regulations are common impediments to companies trying to enter new markets. High barriers to entry sometimes create monopolies or near monopolies (i.e. utility companies).

Locked-up Supply 

When there are few to no other alternatives in the supply of product or service (DeBeers Diamonds).

Innovation- First Mover Advantage and Disadvantage

The first mover advantage may generate network effects afterwards such as smart phone operating systems like android and IOS where developers continue to support it with new software, making hardware suppliers reluctantly compliant to popular operating system. The network effect is so pervasive that it becomes winner takes all. Now there are only two operating systems for smart phones. This is the same for Facebook, Ebay, etc.

In other situations, you would want to wait for the startup to make the mistakes and copy their business model later as an incumbent.

Innovation based on constant uniqueness and novel use of technology (Google) and design (Dyson). Google wasn’t the first company to create the search engine, and Apple was not the first company attempting to create a smart phone.

Sometimes it pays off to be the first, other times, it is best to copy later after opponents have had a few iterations. This reminds me of the non-transitive dice Warren Buffett plays with his friends and guests. He asks his guests to choose a set of dice first. There are 3 sets with different colors. Each cancels out each other like rock paper scissors. Once your opponent picks first, rolling the other colors in succession will guarantee a victory.  

R & D /Talent

To illustrate, patents filed by pharmaceutical companies provide exclusive right to the company to manufacture the product for a specific period of time. However, this requires research and development, which requires talented people and facilities. Talented people can be hired away from other companies. Research and Development expense may be futile, since drugs still have to pass through 3 stages of clinical trials and various approvals. Should all of these go through, drug companies have the ability to mark up a ridiculous amount on their product. Not all Research and Development costs will materialize into an actual, profitable product, and uncertainty creates risk for owners.

Distribution Network:

Companies with strong distribution network allows them to penetrate deeper in the market and successfully cater to larger customer base, adding more sales and profit. In India and China, some companies deliberately target their new product to tier 2 and tier 3 cities, which is easier to penetrate. In China, Pepsi got into Disneyland instead of Coke due to their connections and shareholding with Chinese soft drink distributor TingYi.

Switching cost:

Switching cost refers to how difficult it is for a customer to switch to its competitor, despite lower prices or other perks. To illustrate, Apple has created an ecosystem which locks you in. If you are an Apple I-phone user, switching to an android may be difficult as you have to reload or copy all the apps, contacts, and other data from I-phone to android, and some of the files may not be compatible with the new operating system.

Government regulated

Electric utilities and steel factories all require government permits and are limited in number. Some countries have a limited number of quarries for producing cement. The limitation in government licenses restricts supply and creates pricing power.

Strong Balance Sheet / Cash

Companies with low debt and/or lots of cash have the flexibility to make opportunity investments and never have a problem with access to working capital, liquidity, or solvency (i.e Nike (NKE). The balance sheet is the foundation of the company. Banks and insurance companies usually expand abroad by buying up struggling financial firms with existing clients and assets.

7.      Is this business reasonably priced?

Thinking in terms of share price is wrong since there are stock splits, etc. Thinking in terms of market cap and enterprise value (marketcap + debt – cash) is the right way to go. But sometimes I like to add the debt and only subtract a portion of the cash. You never know if management will actually employ all of the cash via buybacks, dividends, or reinvest it back into the business.

Measuring the market cap or enterprise value to operating earnings or owners earnings which can be sustainable for the next five years is a better approach.

Looking at owner’s earnings or free cash flow recently to the market cap or price you pay is myopic or short-sighted, since cash-flow may not be abundant now due to a wise investment deployed on resources which will generate more cash in the future. Capital expenditures wisely invested in may distort cash-flow temporarily and make you feel that the multiple is too high, when in the long run, it will reward owners.

“If a business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital employed over 20 to 30 years, even if you pay an expensive looking price, you’ll end up with a fine result” – Charlie Munger

In the example above, if you hold the same company with the same earnings but purchase one at 20x earnings at an ROIC of 25% with all earnings reinvested, versus paying a cheaper company at 10 times earnings with only 50% of earnings reinvested at a rate of 10%, you will see that in 5 years, the first company gave you a 48% IRR, while the second company only gave you a 25% IRR.

In the long run, consistent return on invested capital (which takes debt into account) may play a bigger factor than a small premium paid on price. Should you choose between 2 similar companies in the same industry, one with a higher and consistent ROIC, but priced slightly more expensive and one with a lower price, but inconsistent and lower ROIC, you should, in general, pick the better business. When I mean priced slightly higher, I mean multiples of 8x to 15x. If you pay something like 35x to 100x earnings, you will surely get a bad result.

Looking at the table above, the company on the left was purchased at 20x, while the company on the right was purchased at 5x. Because of the price difference, despite superior management with great capital allocation skills, the price negates this performance.

Another point is the inflection point. While I believe that no one can truly time the market, there is a time when a company accrues enough significant advantages to warrant an inflection point. Li Lu of Himalaya capital bought the Chinese liquor company MaoTai when it was starting to accrue advantages from a mishap of a competitor, WuLiangYe when they had pricing and marketing errors. MaoTai also started to entrench themselves by selling to key political figures and influential figures, thus raising the status of the brand and commanding pricing power. Li Lu bought at an opportunistic time and all he had to do was hold on.

8.      A concentrated Portfolio- Everything is life is weighed in terms of opportunity costs.

If you only had 3 girls to choose from –Betty is stunning and a beauty pageant winner, but she has a terrible personality. Jenny is homely, has a good personality, but is 20 years older than you. Finally, Carol understands you, is willing to help you with your family and occasionally your business, is average looking, but has many positive traits. She is a few years younger than you. She fits like a glove.

I don’t think it takes a genius for you to choose the right girl. Over diversifying would be choosing them all and making them your mistresses. A cigar-butt would be choosing the beauty pageant winner for a short term fling. There are only so many spouses who will fit your specific requirements, and if you can’t find her, you sit on your ass and wait. Otherwise you don’t marry. This is true for investing as it is for life. It is as simple as that. As Thomas Jefferson said something along the lines of, “better to be single than in bad company.”

Having looked at these five points, inevitably there are few choices in the market which offers such a great opportunity. But why should there be? Bettors who win don’t bet frequently, and when the odds are in your favor, you bet heavily. Therefore, you always end up with a concentrated portfolio of less than 8 stocks.

If you truly know your company inside out, you won’t sell at the wrong time and will buy more. Once you research a new company and find that it can replace your weakest holding in your portfolio, you will naturally swap it out. Ideally, the companies should not be in the same field so the risks won’t be correlated.

Also, always choose the safer, more probable bet for the bulk of the portfolio. As long as you mitigate the losers— compounding will ensure you will become rich. Don’t add too much of situations where it is— high risk high return. 

Koito (TSE: 7276)

November 5, 2019   Koito Manufacturing (TSE:7276)

Brief Summary:

Market Cap ¥962-986B (USD9B)

Net sales ¥832B (USD7.6B)

Total Debt ¥29.6B (USD271M)

Cash ¥277.7B (USD2.5B)

Enterprise Value 986 + 29.6 – 277.7 = ¥737.9B (USD6.75B)

EBIT = ¥96.7B (USD885M)

FCF = ¥37B (USD338M)

Earnings power = ¥65-70B (USD640M)

Tangible Book Value = ¥507B (USD4.6B) 

Working Capital = Current Assets – Current Liabilities = 503 – 186 = ¥317B (USD2.9B)

Working Capital – Cash = ¥39.3B (USD 400M)

Net Property Plant & Equipment = Fixed Assets = ¥169B (USD 1.5B)

Capital Employed =

Debt + pensions + Fixed Assets + Working Capital -cash - goodwill - intangibles

= 235B yen (USD2.15B)

  

Capital Returned (Owner’s earnings) = ¥70B (USD640M)

ROIC = 12%

(ROIC for previous 4 years = 11-14%

Quick Summary:

Koito (TSE: 72726) is a Japanese automobile lighting OEM selling, as of November 2019, for 9x earnings, and only 7-8x earnings net of cash with a debt to equity of 7% and a quick ratio of 2.1x. Operating margins are 10%.

The company is a leader in automobile lighting and once captured 20-25% of the global auto-lighting market and was a target of T.Boone Pickens for a hostile acquisition back in the 1990’s which led Koito to change to a more protective ownership structure. Koito consists of 32 companies located in 12 countries worldwide, employs approximately 25,000 employees, and achieves annual sales of approximately USD 7 billion.

Koito has close ties with Toyota; Toyota owns 20% of Koito’s issued shares and makes up 21% of their orders and sales. Despite progress in North America and Asia, Koito’s global market share dropped from 18% to 13% when they got into a dispute with their Chinese partner Huayu, in which they had a JV in a company called Shanghai Koito. Huayu previously offered sales distribution, and the loss of a trading partner temporarily hit Koito’s sales in China.

Newer car models are switching from halogen bulbs to using Xenon Bulbs (gas filled) and now LEDs (light-emitting-diodes), which are more energy efficient. While LED’s average sale price may eventually drop, each set currently commands a 20-60% premium to halogen bulbs. When xenon bulbs were first released, its cost was 2-3 times more to produce than halogen bulbs.

While the automobile landscape is being changed by electric vehicles and autonomous driving, technological change will not render automobile lighting obsolete in the next decade. I also do not foresee a displacement of the current players by incumbents. Regulatory environment and significant funding for facilities create barriers to entry. Favorable new developments in Brazil, Asia, USA, and China makes Koito’s share price undervalued. 

Automobile Lighting Market Background:

A single car has about 30,000 parts, if you include parts down to the smallest screws. Many car models are released each year, and in terms of lighting for automobiles only, each model has a front lamp, rear lamp, signal lamp, fog lamp, interior lighting etc. Each lighting OEM bids for different sections for one vehicle model. For example, for the latest Toyota Camry, Koito may win the head lamp and signal lamps, while Japanese competitor Stanley Electric (TSE:6923) may win the rear lamp and interiors for a particular model. OEMs engage in a bidding process where quotations are submitted.

In the automobile supply chain, Koito is a Tier 1 supplier— they only supply parts directly to manufacturers and are tightly coupled with a few car brands and are at an arms-length relationship with others. Tier 2 suppliers do not supply directly to brands and may produce parts for non-automotive customers, while Tier 3 produces raw materials like metals or plastics.

Once automobile companies decide on successful bidder, there is a finalization on drawings and specifications. Koito and Stanley Electric was in trouble recently in an anti-trust litigation in Michigan for fixing prices and rigging bids in North America through their connections with Japanese automobile brands— Honda, Toyota, Nissan, Mitsubishi, Isuzu, etc.

Japanese car brands prefer maintaining a relationship rather than obtaining the lowest price on a tender— Japanese lamp OEMs have a small amount of shares of their Japanese customers and vice versa, and bids are “favored” towards particular OEMs, rewarding them with consistent demand. Corporate raider T. Boone Pickens was rattled about Toyota previously squeezing margins out of Koito as their favored supplier. While Koito is still Toyota’s preferred lighting supplier, Koito has a more diversified customer base now, including– Audi, GM, Geely, SAIC, thus Koito is not at the mercy of losing a particular customer. This is reflected in operating earnings of 10-15% today, when was only 5% a decade ago.

The automobile lighting market will grow from 30B in 2019 to 35-40B in the next five years. Of this 30B, 66% is predominantly passenger cars; 33% are vans, trucks, and larger vehicles. It makes sense to focus on the Asia Pacific region, as the compounded annual growth is 5-6%, while the U.S is 2-3.5% and China is also slowing down due to the trade war.

Competitors
To contrast this, in 2014, total operating profit was half of 2019, at 49B yen. Japan made up 60% EBIT at 30.3B yen, North America and Mexico had 3% of EBIT at 1.5B yen, China was 19% at 9.5B yen, and Asia was at 13% at 6.4B yen.


Situation in China:
China has the largest vehicle production in the world with a capacity for 35 million units, but only had a sales volume of 25-27 million units or less due to the termination of a tax exemption for small vehicles and the US-China trade-war.

There are 5 dominant OEMs in the automobile lighting business:
      1.    Koito-Manufacturing;

2.    Japanese competitor Stanley Electric which has close ties with Mazda;

3.    French company Valeo, which acquired Japanese company Ichikoh, and dominates the European market;

4.    German company Hella, which initially cooperated with Koito to enter the American market and now in Mexico;

5.  German company Osram which licenses their technology to both Koito and Stanley Electric. 

Auto-lamp OEMs should be conservative in building facilities abroad and growth of fixed assets. In a recession, should there be less demand, unit volume produced may not come close to capacity— a low utilization rate results in losses and negative operating margins. It also helps to have ample working capital and even excess cash. Koito passes all of these tests.

French company Valeo has the largest market share in Europe and has acquired struggling Japanese company Ichikoh. The synergy has proven to be less than desirable, as utilization rates and penetration into Asian markets are poor. Each year, Valeo’s revenues from Europe alone amount to USD 10.6 billion, while their total sales is the largest among peers at USD20B. In terms market share, Valeo is the largest auto-lighting company with USD9.3B market cap. Valeo is over-leveraged with debt to equity significantly higher than peers at 139%. Valeo delays payment to suppliers— their days-payable is 109 days, when the industry norm is 40-50 days.

Koito was wise not to build factories over aggressively in Europe to gain market share. Czech Republic and U.K are Koito’s only centers. Europe has been dominated by Valeo, with Hella licking the remaining scraps in Germany. Each additional unit sold in Germany may require additional marketing, passing of bureaucratic regulatory requirements, and might not create additional shareholder value.

German company Hella previously collaborated with Koito to enter the American market and still work together for new factories in Mexico. As of November 14, 2019, Hella’s enterprise value USD 5.89B, and operating earnings of approximately USD 500 million, bringing its multiple close to 12x, similar to Valeo’s. However, Hella is more conservatively financed with a debt to equity of 50% and cash of USD1.6B. Return on capital is 7%.

Osram has negative earnings due to weak growth in China and problems in their supply chain. They are not a pure player in automobile lighting; segments include— digital products, photonics, opto-semiconductors.  Osram licenses a lot of their proprietary technology such as white LEDs, and adaptive beam lighting. Toyota Corolla uses Koito Signal Lamps which employ XLS LED Signal Emitters from Osram.

Japanese listed Stanley Electric’s large customer is Mazda making up 12% of their sales and has a 33% ownership in a listed company called Thai Stanley Electric which has a domestic (Thai) monopoly on motorcycle lamps. Stanley Electric boosts higher gross margins than Koito, but SG&A margins are double of Koito at 10%, and ROIC has been in fluctuating single digits near 5-7%. Stanley Electric is conservatively financed with a debt to equity of 5%. Its market cap is priced at 4.6B, with an equity base of 3.42B and generates operating earnings of USD456M.

Geographical Business Performance:

To understand Koito, we have to look at its efficiency and how it performs relative to its peers.  In order to calculate utilization rates and market cap, you need to distinguish units in terms of

1.      Vehicles with Koito’s lamps installed

2.      Actual lamp sets produced per year

Total automobiles produced in 2019 globally were around 95 million; assume 100 million to keep calculations simple. 13 million vehicles produced had Koito lamps, which gives Koito approximately a 13% global market share based on unit volume. Previously, it was as high as 18-21%.

In terms of market share, 50-65% of Japanese automobile and motorcycle brands use Koito’s lamp. Koito has actually improved their market share in USA & Mexico, currently owning 24% of the market in contrast to 10-13% in 2014; with Asia (Thailand, Indonesia, Malaysia, and India) having a 13% market share. In 2019, Koito’s Chinese market share halved from 25% to 11.3%. What made this erode? Koito lost production due to an argument over Shanghai Koito which will be mentioned later.

Next we analyze utilization rates—Koito had 38-40 million sets of lamps produced in 2018-2019 when total capacity was 50-52 million, giving a net utilization rate of 72-75% and a net operating margin of 12%. Operating margins and utilization rate is directly proportional, and Koito’s Japanese factories have the highest EBIT margin due to utilization near 90%.

In terms of growth potential, China and Asia seems to be the greatest opportunity.  Gaining market share in Europe may be costly since it is dominated by Valeo and Hella; while Brazil may contribute to growth in the future, the incremental capital expenditure required to increase capacity may be higher than other countries. Production in Europe for Koito consists of the Czech Republic. 2-3 million lamp sets were produced when the total capacity was 4-5 million, bringing us to a utilization of 67% and an operating margin of 9%. Koito’s restraint in increasing European capacity is shrewd as there are other countries with higher growth.

In terms of fixed assets, in 2019, capital expenditures for machinery was— 22B yen in North America, 4.3B yen in Europe (UK & Czech), 12.3B yen in China, 8.1B yen in Asia, and 9.9B yen in Japan, and 2.1B in Brazil. Most machinery is concentrated in China, America, and Asia, which is justified, while Japan will be shrinking its production facilities due to smaller demand.

Total operating profit in 2019 was 101B yen, and Japan contributed to 56% of all operating profits at 57B yen, whereas America contributed 17% at 16.8B yen, China 13% at 12.8B yen, Asia 12% at 11.8B yen, and Europe 3.4B yen, with Brazil bleeding—its operating profits are a negative 1.5B yen.

In five years, operating profits in Asia doubled, China shrunk 3.3B yen, Japan almost doubled, while America spectacularly grew 11 times in operating profit. Koito has made in-roads in the American market by pulling in GM and Fiat Chrysler automobiles and by having facilities to back it up.

Koito has the largest capacity for lamp sets in North America and Mexico, with a combined output of 18 million lamps sets, and 12 million actually produced in 2019, which gives a utilization rate of 67%, leading to poorer operating margins of 9%. The American market, which includes Mexico, had 14.7 million vehicles produced for 2019 of which Koito had 3.5 million vehicles, which means that Koito has approximately 24% market share of North America and Mexico combined. Plans to increase production capacity by 50% at its plant in San Luis Potosi, Mexico was implemented in 2018.

Koito has saturated Japan in terms of market share for auto-lamps, but the entire market is shrinking. Domestic bases are concentrated in Shizuoka, with an additional plant in Kyushu. Japan produces 9.6 million cars annually and the amount is shrinking due to an inadequate labor force and a withering population. Koito is most dominant in Japan by owning 46% of the market— producing lamps for 4.47 million vehicles.

Utilization rate is the highest in Japan—ranging from 90-95% and producing 11.2 million lamp sets in 2019. This monopoly in Japan is one of Koito’s strengths, Stanley Electric only had 166B yen of sales in Japan compared to the 412B yen of sales Koito had. No matter how bad other geographic regions slump, Koito has Japan to rely on.

In October 2017, Koito invested BRL 221 million (USD 52.6M) for a factory to produce headlights and taillights in Sorocaba, Brazil. Brazil was a market Koito recently targeted, and the utilization rate was not up to par at 7-10%, causing operating earnings to be negative. The maximum capacity for lamp sets in Brazil is 3-5 million sets. Despite negative operating profits, production has increased 1529.2%. Hopefully in the next 2 years, Brazil will show its first profit.

Asia for Koito comprises of Malaysia, India, Taiwan, Indonesia, and Thailand. In 2018, Koito capital expenditures were for increasing production capacity by 50% at a manufacturing plant in Indonesia, which previously produced 1.3 million units annually. In December 2019, Koito’s 2 year project for establishing a new factory in Malaysia cost 5B yen. Koito estimates the factory will be able to produce head lamps and signal lamps for 250,000 cars per year.

Compared to America’s 12 million sets produced in 2019, Koito’s Asia segment produced 4.8-5 million units. Total capacity for Asia is 6.5-7 million units bringing utilization rate to 75%, and operating margins at 11%. Koito has been increasing capital expenditures in Thailand with its 3 already established factories. Asia is a segment which has untapped potential, especially since India is not a separate segment measured in itself and has untapped potential. 

Koito in 2019 has 11% market share in China–supplying lamps to more than 3 million vehicles. In terms of lamp per unit sets, Koito’s China operation has the capacity for 9 million sets of lamps. Approximately 7.5 million lamp sets were produced in 2019, giving a utilization rate of 70-80% and operating margins of 11-13%. These lamps are supported by 3 factories in GuangZhou, a joint venture with DaiYi (TSEC:1521) Taiwan in FuZhou with 3 plants, and a newly established factory in Hubei with also additional capital infusion for Daiyi.

One of the main problems in China was a joint venture dispute with Shanghai Koito. Koito and Huayu joint ventured to create Shanghai Koito, which helped them gain customers through Huayu’s connections with SAIC-GM, SAIC-Volkswagen, FAW Group, Dongfeng Group, bringing in a vast amount of sales and a production capacity of 3 million lamp sets. These customers were cultivated by Huayu for decades in China— Koito provided technology and capital injection for the factory, and Huayu provided investment, distribution, and sales into China.

Huayu argued that Koito was not providing the most advanced technology developed in Japan. Thus, Huayu started developing technology on their own and started shipping overseas. Koito wanted to keep the joint venture, but deemed Huayu’s international sales a conflict of interest due to overlap and cross-selling of lamp products. Huayu Automobile eventually bought back the 50% of the remaining shares for USD243million in which Koito hesitantly agreed.

This separation from Huayu resulted in a 40.6% decrease in China sales to 93.7B yen from 2018-2019. Koito knew separation was inevitable and had been preparing since 2014 to double production capacity after the split by building a new factory in Hubei with shared capital from Koito’s Taiwan distributor and partner of 30 years, Daiyi. Daiyi’s capital injection into Hubei, will allow them to directly share profits.

Toyota Motor's Chinese factory is the largest customer of Hubei Koito. Koito also relies on the Daiyi’s manufacturing expertise and Daiyi’s distribution network for orders  to help Hubei Koito— their aim is to grab previously lost Shanghai Koito Huayu customers, such as SAIC and Shanghai GM.

A joint investment with Daiyi was made previously for the factory in FuZhou. In January 2018, Koito’s plan was to increase production capacity by 70% in Fujian Province, which previously produced 1 million units annually. The main customers for Koito FuZhou Daiyi are Geely Automobile, Southeast Auto, and Mazda, which is exported to Japan. When Koito’s FuZhou division joined Geely’s supply chain, the initial product development costs were high. Utilization rates and raw materials were left stagnant. The profit contribution of the plant initial years were poor – production only covered USD 2.8million of sales. In the first half of the second year, growth returned and the production capacity increased by 30% for Fuzhou. In the second half of the second year, the company continued to grow orders and expanded production in response to Geely demand of USD 7.2 million of sales for 2 new automobile models. Under the continuous growth of the mainland auto market, DaiYi is optimistic that the Fuzhou plant will surpass the entire Taiwan production in 3 to 5 years with a 3^rd plant now in FuZhou. Fuzhou plant revenue was USD427million, about half of Koito’s Taiwan subsidiary, Daiyi.

Taiwan Daiyi is also speeding up exports from China to North America, shipping out 50% of the orders in anticipation of any impending tariffs from a trade-war, with two new orders for car models expected from Fiat Chrysler Automobiles (FCA). The North American market is expected to grow 10% as long as a recession does not hit. Feng Shi Zhong, the general manager of DaiYi, says that 25-30% of all exports are for Fiat Chrysler Automobiles.   

Shareholders and Toyota’s influence-

Toyota Motor Corporation owns 20% of Koito’s issued shares, while Japan’s master trust combined with Japan’s trustee services own 9.2%. Effectively, Toyota, trusts, and management own all voting shares to elect board of directors. 22% of all sales for Koito are from Toyota as a single customer. All other automobile customers take up less than 10% of sales. As with Japanese corporate culture, buybacks are not in their arsenal for creating shareholder value. However, another listed company was acquired by Koito called KI holdings and shareholders received a reasonable premium for Koito’s tender offer. Gross margins are slightly lower for Koito than its peers due to lower prices offered to Toyota. Toyota’s global dominance for automobiles and Koito’s monopoly in Japan ensures a minimum number of sales each year. New factories are built opportunistically and not solely for the benefit of Toyota.

Product Differentiation, Pricing Power, and Competitive Advantages

The questions to ask as a shareholder for Koito are – how will Koito look 10 years from now? What is causing Koito to succeed and have a sustainable competitive advantage? What will erode this advantage? How much product differentiation technology-wise is there, assuming all bids were fair?

Koito should still be the market leader in the next 5 years. Management might change and it is too hard to predict what will happen in the next decade, although I think there is a high probability that the industry will still exist. Pricing power and competitive advantage for Koito comes from connections with Japanese manufacturers, patents enforced, and technology licenses granted from other firms. Operating margins will improve from 7-10% to 15-18% when factories bring their utilization rate from 65-70% over 80%.

In terms of product differentiation, competitors can all build halogen, xenon, and LED lamps. Despite LEDs selling for a premium now, pricing will eventually taper off. Koito is investing in R&D and has patents of their own, but how much of these advances will benefit customers and how much will benefit owners/shareholders?

Koito has various patents and developed the first headlamp that was mercury free and has developed a lamp with an adaptive driving beam. Recently, Koito acquired 11,927,189 shares for 37% of an Isreali company called Bright Way Vision for USD 24M. Bright Way Vision has high-accuracy peripheral recognition sensors— fast gated-camera equipped with a unique Gated-CMOS sensor and a laser pulsed illuminator. These sensors are synchronized in specific domain which can handle rain or fog and conditions which impairs vision by generating a clear long-range image of the road ahead which are essential for the future of autonomous driving vehicles.

Risks-

Should demand contract in Koito’s main markets, financial results will be adversely affected. In particular, 56% of operating profits is contributed by Japan alone. While Koito is geographically diversified, production needs to increase in other countries also. Since 56% of operating profits derive from Japan, earthquakes, tsunamis, typhoons, are all a very realistic possibility. In particular, Koito’s production bases are concentrated in the Shizuoka prefecture, which is within the vicinity of Chubu Electric Power Inc., Hamaoka’s nuclear power station.

Changes in legal regulation and safety standards for vehicles will may affect Koito as certain molds or electronic components may need to be changed to cater to a particular market. A subsidiary, Koito Industries, faced an incident over aircraft seat quality in 2009 and was reestablished in 2011 as KI holdings.

Koito still has 3-4% of their business selling aircraft parts, railroad-car parts, various electric equipment, measuring instruments, and other products. This is a distraction to their main business and only a focused business can generate excess profits.

 As most of Koito’s lighting has an acrylic plastic cover, the prices of plastics, which is a key raw material in Koito’s business has been rising due to the market prices of crude oil. This rising trend could cause a rise in procurement costs for Koito.

Another complaint I have is that management could be more transparent with utilization rates and bad news. Shanghai Koito’s termination and the loss of customers with HuaYu’s connections required me to dig for news articles.

Valuation-

Koito’s owner’s earnings is 85B-90B yen or USD770M-800M. From 2014-2015, equity doubled. Capital employed, which included working capital and fixed assets, is prudently employed by Koito. While working capital has increased threefold from 108B yen to 330B, fixed assets only increased 28%, from 114B yen to 158B yen. Koito has been cautious in Europe and understands the shrinking demand in domestic production (Japan).

With a conservative growth rate of 3-4%, a discount rate of 15%, Koito would have to be at a market cap of USD5-6B to bring a greater margin of safety. It is currently selling at USD9B. Koito should be selling near 1400-1600Byen or USD13-14B. If Koito were to drop anywhere near USD 4-5B, it would be a solid buy.

Koito intends to double China’s production, and bring up capacity in Asia. Global utilization rates are only 70-75%, if Koito manages to bring this up to 85% and if EBIT margins go up to 15-18%, it is possible for Koito to reach over USD12billion in market capitalization.

While Koito’s market capitalization may seem expensive at USD8.97B, it has USD2.5B in cash and relatively little debt at USD272M, which leaves us with an enterprise value of UD6.6B generating an operating earning almost double of Stanley electric at USD890M. The multiple for enterprise value to operating earnings is similar for both at 8x, but due to Koito’s entrenched competitive advantage in Japan and connections with Toyota with a double digit ROIC of 12-13% which has been sustained over more than a decade, Koito provides better value at a similar multiple.  Koito’s cash conversion cycle is the shortest in the auto-lamp industry at 35 days. In terms of inventory turnover, Stanley Electric is 32 days and Koito is 35 days. Japanese companies have inventory turnover which is efficient than its European peers. Japanese auto-lamp manufacturers Koito and Stanley Electric have the lowest debt to equity of its peers at 7% and 5% respectively.

Catalyst

Despite not having the practice of repurchasing shares, management at Koito is disciplined and won’t over expand capital employed and won’t over-leverage, thus ensuring double digits for return on capital. Koito also has slight pricing power with connections to Japanese manufacturers, patents, and economies of scale which is sustainable for the next decade. Plans to increase production capacity in Mexico, Indonesia, China’s Fujian province and new factories in Brazil and Malaysia will eventually pay off when utilization rate is adequate.

Management paid 14.7B yen in dividends for 2019 when operating cash flow was 93.6B yen, which is 15% of total operating cash-flows.

Migration to LED automotive lamps from halogen and xenon lighting will also bring higher margins. Koito plans to double the ratio of LED headlamps to total headlamp shipments for overseas markets to 50% in five years. Koito will develop LED headlamps with a simplified pricing structure, and increase its LED headlamp production capacity in emerging markets particularly electric vehicles in China.

Sources:

Koito Annual Report

Thai Stanley Annual Report

Stanley Electric Annual Report

Marklines.com

Chinese news articles from the Huayu breakup

Chinese news articles regarding Taiwan Daiyi cooperation