YMATF - Nippon Air Conditioning Services: Business Activity Is Cooling Off With Rising Cost Pressure

2023-04-23 03:24:35 ET

Summary

• Nippon Air Conditioning Services is experiencing headwinds from market demand and inflationary cost pressure.
• The company has limited tools at its disposal to drive demand, and price hike opportunities appear unavailable.
• With limited upside to earnings, we believe the shares are a sell.

Investment summary

Operating in a competitive and low-margin business maintenance business, Nippon Air Conditioning Services (NPNAF) is under pressure from slowing market demand and inflationary cost pressures. With no visible upside to earnings and valuations not discounted enough, we believe the shares are a sell.

Quick primer

Established in 1964, Nippon Air Conditioning Services (the Company) is an independent Japanese building maintenance company based in Nagoya City. It specializes in HVAC (heating, ventilation, and air conditioning systems), in technically more demanding infrastructures such as hospitals and food and beverage manufacturing plants. It competes with peers such as Taikisha ( TKIAF ) and Sanki Engineering (1961) in a relatively crowded marketplace, as well as conventional building maintenance peers such as Azbil ( YMATF ) and HVAC manufacturers such as Daikin ( DKILF ).

The key earnings drivers are new customer acquisitions, focusing on gaining market share in the manufacturing sector. It has a relatively stable business, with approximately 40% of sales ( page 17 ) from rolling annual contracts. The company expanded into China in 1999, but its overseas sales make up less than 5% of the total.

Key historical financials

Our objectives

The Company is a well-capitalized business with a strong net cash balance sheet with ex-growth but stable revenues but relatively low operating margins of around 6%. Management is keen to enhance corporate value ( page 27 ), aiming to keep valuations above book value (still quite a common occurrence to trade below book in Japan's small and micro caps), and have a 50% dividend payout policy. With our impression that management is proactive in rewarding shareholders, we want to assess whether the shares are a long-term investment.

Limited growth prospects

In what is a commoditized business activity, there is unfortunately limited scope for improving profitability in building maintenance. It would appear that revenue stability is dependent on attractive low pricing, making attempts to raise prices a difficult business decision. This difficulty is highlighted in Q1-3 FY3/2023 results , where the company reported sales growth of 3.1% YoY with operating profits falling 8.9% YoY. Cost inflation has arrived in Japan impacting raw material prices as well as staff costs, but there have been no visible attempts to pass these costs on to the customer.

Despite this challenging backdrop, management is aiming to grow sales and profits by seeking alternative opportunities. There has been recent demand coming from solar power generation plant-related work, but there has been a shift toward smaller plant construction for in-house use at customer sites, as opposed to more lucrative projects for plants constructed for resale. The company is aiming to drum up such 'latent demand', but there is limited appetite compared to before with an economic slowdown and more difficult access to cheap funding. The company's options are limited to digging up demand for building maintenance projects related to energy conservation and cost efficiencies, which are becoming more competitive to win.

The short to medium-term outlook for the business appears tough to demonstrate growth, and margin enhancement also looks challenging.

Longer-term view - market consolidation

With overseas growth prospects limited to date, the company's prospects for growth appear limited in the mature domestic industry. This inevitably leads to whether there is any prospect for market consolidation and whether the company would be able to take part either as a target or an acquirer. In 2015, the company increased its majority stakes in group companies (Nihon Kucho) which acted as its regional market operator. To date, the market has already undergone some consolidation, but this could go up another gear as it becomes more difficult to generate any organic growth. With net cash of around JPY7 billion/USD52 million, the company has some scope for acquisitive growth, and there could be some attractive targets in the private sector in a fragmented industry.

As a potential target, the company would be difficult to justify as a purchase considering the limitations over margin enhancement, and topline growth. Although it would be price-dependent, we believe any acquirer would refrain from buying at a major premium.

If there is a major economic downturn, companies with the strongest balance sheets should survive. Unfortunately, whilst its performance will also suffer temporarily, the company may get an opportunity to swoop in on many peers in need of cash to survive, and domestic market share gains may be available at attractive returns.

Valuation

With a notable earnings decline in Q1-3 FY3/2023 dampening prospects for FY3/2024, we estimate the shares are trading on PER FY3/2024 15.0x and a PBR of 1.4x. Although not demanding multiples, we think the shares look quite pricey for a business in a downward cyclical reset.

Although the historic dividend yield was high in FY3/2022, this included a one-time distribution related to the sale of cross-shareholding investments. For FY3/2023, there is a forecast cut in dividends YoY from JPY41.50 to JPY28.00, resulting in a dividend yield of 3.8%.

Risks

Upside risk comes from a sudden upturn in demand for construction-related work in alternative energy development such as solar farms.

There have been temporary secular drivers for growth in the recent past, such as mandatory installation of air conditioners in schools given rising summertime temperatures - there could be more similar initiatives given global warming.

Downside risk comes from the continued decline in operating margins, due to high competition and inflationary cost pressures.

The company may cut full-year dividends, as a declining EPS profile will mean continued increases in the payout ratio.

Conclusion

Under relatively calm market conditions, we see business maintenance as a low-risk and stable business that can provide stable free cash flow and potentially steady returns. However, the company is now under pressure from the topline as well as cost inflation, and with limited tactics to oppose these measures, we believe the earnings outlook is negative. With no valuation attraction and M&A not a likely scenario in the short term, we believe the shares are not worth holding and rate them as a sell.

For further details see: