FUWAF - Furukawa Battery: Not A Special Situations Investment

Summary

• Furukawa Battery is 57.2% owned by parent Furukawa Electric, which divested an asset to private equity in November 2022.
• With growing attention of erasing parent-listed subsidiary structures in corporate Japan, Furukawa Battery appears like a potential candidate.
• Unfortunately, with Furukawa Electric indirectly engaged with activists with affiliate company UACJ, a special situation event with Furukawa Battery look unlikely. We rate the shares as neutral.

Investment thesis

Furukawa Battery ( OTC:FRKWF ) is 57.2% owned by the parent Furukawa Electric ( OTCPK:FUWAF ). Although there is growing urgency in corporate Japan to erase listed subsidiary structures, we assume the parent is not prioritizing the transformation of Furukawa Battery into a private 100%-owned subsidiary. An immediate asset sale is also unlikely. With no special situation in the works, we rate Furukawa Battery's shares as neutral.

Quick primer

Established in 1914 and spun out of parent Furukawa Electric in 1950 (the current top shareholder with 57.2%), Furukawa Battery is a manufacturer of storage batteries and power supply units, focusing on the automotive industry which made up 70% of FY3/2022 sales. Its main products are lead-acid batteries for cars and motorcycles. Peers include GS Yuasa ( OTCPK:GYUAF ), Toyo Systems, Panasonic ( OTCPK:PCRFY ), CATL, BYD ( OTCPK:BYDDF ), and LG Energy Solutions (373220 KS), as well as specialists in bipolar battery technology such as Effpower, Advanced Battery Concepts, Gridential, and ArcActive.

Key financials and our earnings estimates

Our objectives

With commodity prices still at historically high levels, Furukawa Battery is experiencing high input costs (primarily lead - see S&P lead index below) which are dampening margins - we want to assess whether these can be passed onto the customer. The company is also a potential divestment target by leading shareholder Furukawa Electric, who in November 2022 sold off its 57.0% stake in Totoku Electric (formerly 5807 JP) to the Carlyle Group for US$199 million at a 157% premium to the pre-bid market price - we want to see how likely this would be.

Limited ability to pass on costs

The company reported weak Q1-2 FY3/2023 results, explaining that lead prices had risen from JPY305,000 per tonne to JPY342,000 per tonne YoY (+12.1% YoY) ( page 4 ). With increased energy costs and continued semiconductor shortages limiting auto-related production, underlying sales growth was limited at 5.5% YoY. However, reported numbers fared better with the weakening yen at 11.3% growth YoY ( page 5 ). Although the company managed to pass on most of the rise in lead prices, energy and other raw material cost rises were absorbed by the company resulting in operating margins dropping from 5.1% to negative 1.2% compared to Q1-2 FY3/2022.

Operating a seasonally strong business into the second half of the year, the company has maintained full-year forecasts of JPY70.0 billion/USD540 million (+11.5% YoY) and operating profit of JPY2.4 billion/USD18.5 million (-25.3% YoY) ( front page ). However, with a weak start to the year, the company is likely to miss despite some positive outlooks from overseas as demand is recovering for four-wheeler production volumes in Thailand and Indonesia. With the shares down 25% over the last 12 months, we believe this is already priced in.

With cost inflation still in play, we believe Furukawa Battery will find it difficult to return to operating margins in excess of 6.0%, with the performance of 7.3% in FY3/2021 being an outlier. With limited prospects for margin expansion, we believe earnings visibility does not look overly attractive.

The listed subsidiary problem

We have previously mentioned the rising trend in corporate Japan regarding the structural conflicts of interest and information asymmetries that are harmful to minority shareholders in listed subsidiary structures. Many listed subsidiaries have undertaken going-private transactions (potentially our piece on Cybernet Systems ), and Furukawa Battery could be a candidate. Moreover, with the parent Furukawa Electric appearing to be active in managing its business portfolio (with Totoku Electric), a divestment could be an option. Either option is positive for the equity holder, with the high premiums involved in both instances.

Totoku Electric was a relatively well-run business with 15% operating margins, generating free cash flow and an ROE of 13.8%; one can see that private equity would see potential as an investment. Unfortunately, with low single-digit operating margins and ROE, Furukawa Battery is not in the same position and is unlikely to be seen as a major PE investment opportunity.

When looking at the parent company Furukawa Electric, the levered balance sheet, low returns and limited financial flexibility leads us to conclude that making Furukawa Battery into a 100%-held subsidiary is not a high priority, and a sale does not look to be an immediate event. Furukawa Electric's priorities may lie with UACJ (5741 JP), an aluminum supplier for which it holds a 25% shareholding which is currently getting activist attention from Effissimo Capital , who are large shareholders of Toshiba ( OTCPK:TOSBF ).

Valuation

The shares are trading on PER FY3/2024 14.7x, PBR 1.0x, and a free cash flow yield of 2.0%. We believe these multiples are not demanding, but considering low profitability and a limited growth outlook, we believe valuations are fair.

Risks

Upside risk comes from portfolio management at parent Furukawa Electric, who decide to make the company private by making it a 100% subsidiary.

An outright acquisition of the business by a third party would also be positive for the share price.

Downside risk comes from a cash-burn profile as rising input costs cannot be offset by price hikes, resulting in value destruction.

Parent Furukawa Electric confirming its passive strategic stake in the business will mean no full parent-subsidiary takeover for the time being.

Conclusion

On paper, Furukawa Battery looks to be a potential candidate for a parent-subsidiary takeover given increasing scrutiny in Japan for going-private transactions. Unfortunately, we believe the parent Furukawa Electric is not in an immediate position to conduct such activity given 1) its relatively weak balance sheet, and 2) its current priority is working with affiliate UACJ which is under scrutiny from activists. With no special situation event in the works, we see no reason to invest and rate the shares as neutral.

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