2024-01-08 22:47:22 ET
Summary
- Kubota, a legendary company in Japan, is facing headwinds due to dealer inventory adjustments and weaker sales but has an attractive valuation.
- The company is strong in small farming and industrial equipment and has a competitive moat with a global dealer network and strong brand.
- Kubota has shown profitability even during difficult times and is focusing on improving profit margins and returns on capital.
“Our products should not only be technically excellent, but also useful for the good of society.” -Gonshiro Kubota
Although not as well-known among Western investors, Kubota ( OTCPK:KUBTF )( OTCPK:KUBTY ) is a legendary company in Japan, being part of the TOPIX 100 and the Nikkei 225 indices. The company was founded in 1890 and has thus survived for over a century. While it has some cyclicality in its revenues and earnings and is exposed indirectly to commodity prices, at the right price we think it can be an interesting company to consider. Currently, the company is facing headwinds due to dealer inventory adjustments, and weaker sales of tractors and construction machinery, but the valuation is quite attractive. In the US, native shares trade under the symbol KUBTF, and the ADRs under KUBTY. The ratio of the ADRs to the underlying native shares is 1:5.
Kubota is particularly strong in small farming and industrial equipment. The company is the small tractor market leader in North America, Southeast Asia, and Japan. It is also a leading player in mini-excavators and other compact construction machinery. It has a strong competitive moat derived from a global dealer network and a very strong brand. Despite these solid fundamentals, the company has essentially experienced a 'lost decade', significantly underperforming the iShares MSCI Japan ETF ( EWJ ), the S&P 500 index ( SPY ), and competitor Deere & Company ( DE ). Still, the company has grown its revenue and earnings, which means that the valuation has been compressing for some time.
Measured in Japanese Yen ( FXY ), the company's performance appears better, having roughly doubled its share price. However, the Japanese Yen has significantly depreciated against the dollar during this period.
Company Overview
As a quick reminder, Kubota manufactures and sells small and midsize agricultural and construction equipment as well as water treatment equipment. Key products include small tractors, mini-excavators, compact track loaders, engines, and rice farming equipment. It also has a smaller business segment that provides pipe system products like ductile iron pipes and valves, water and waste treatment plants, and pumps, as well as related operation and maintenance services. The company employs around fifty thousand people, around half based in Japan.
Financials
Despite the cyclicality in its end markets, the company has done a good job of remaining profitable over the cycles. Gross profit margins, operating margins, and net margins are currently close to their ten-year averages.
Return on equity ((ROE)) is far from spectacular, but it is currently around 10%. Return on invested capital is considerably lower, as the company makes use of significant debt to provide financing to some of its customers.
In fact, this is addressed in the annual report, where the company states that it will focus more on improving its return on capital. This includes getting returns from some recent investments the company has made, which now have to start delivering results.
In the past, we have placed importance on growth, and this has meant that financial KPIs were focused on revenue and operating profit—i.e., monetary amounts—and the common belief in the Company is that increasing revenue would bring greater profit. However, since the peak operating margin of the period between FY2013 and FY2015 (when it reached 13–14%), it has dropped as we have made upfront investments in new regions and business fields. Taking into consideration in-house discussions and dialogue with those connected to capital markets, in 2021 we switched to a focus on operating margin and other ratios. In the past few years, we have made some sizable capital expenditures and M&As, and it is important that we get a return on the capital we have invested from now on. In the final three years of Mid-Term Business Plan 2025, it is important to raise business returns to create cash flows and recover our investments
The company has a very ambitious 2021-2025 CapEx plan, and capital expenditures have been increasing significantly since 2018 as can be seen below. As these investments start delivering results, we expect some benefits to the company's ROE and ROIC.
Growth
Revenue has grown over the past ten years from about $15 billion to almost $22 billion, with the quarterly average year-over-year growth rate at close to 6%. While this growth is commendable, the problem lies in the company's failure to leverage this revenue growth into significant earnings per share growth.
Looking at the normalized diluted EPS, we see that earnings per share have not really made that much progress in the past ten years. There is also more cyclicality than what is observed in the revenue chart. Still, we are encouraged by the company's admission in the annual report that they were too focused on growing revenues and that they will now put more attention to profit margins and returns on capital.
ESG
One area where it easily beats most of its competitors is in its ESG performance. For instance, its 2022 CDP Climate Score is A-, significantly outperforming its main competitors.
Company | CDP Climate Score 2022 |
Kubota | A- |
Deere & Company | C |
Caterpillar | F |
Volvo Group | F |
It is also part of several ESG indices, such as the FTSE4Good, and the FTSE Blossom Japan Index.
Outlook
Kubota's end markets have faced significant headwinds, for example, Japanese and Thai rice have been low for several years. This makes it more difficult for farmers to invest in new tractors and equipment, or even consider expanding operations.
Commodities, however, are cyclical, and the best cure for low commodity prices is itself low commodity prices. This encourages increased consumption and disincentivizes further production expansion, eventually resulting in a price increase.
We cannot predict how these commodities will trade in the next few years, but we are encouraged by the fact that Kubota has managed to remain profitable even during periods of low commodity prices. We are further encouraged by comments from management that they are now going to update their financial and capital strategy to put more focus on profit margins and ROIC.
Another variable affecting Kubota is the Japanese Yen exchange rate. It has positive and negative effects on the company and the shares. A weak Yen makes the company more competitive compared to other global competitors, especially considering that about half of the approximately fifty thousand employees Kubota has are located in Japan.
It also means that dividends declared in Japanese Yen result in smaller dividends for international investors, and if shares increase in price in the Japanese stock exchange, the increase can be reduced when converting to other currencies.
In the third quarter earnings presentation, the company provided a forecast for FY23. Things look relatively optimistic, with revenue forecasted to end the fiscal year more than 10% above 2022, and profits more than 30% higher.
Dividend
At current prices, shares offer a dividend yield of ~2.2%, which is above the ten-year average. The dividend is semiannual, with the company declaring two dividends of 24 yen per share in 2023, which translated to roughly two payments of $0.82 per ADR (before fees and withholding taxes).
When measured in Japanese Yen, the dividend has actually increased at a very healthy rate. Going from 28 yen per share in 2014, to 48 yen in 2023, or roughly a 6% CAGR, while still maintaining a very healthy payout ratio.
Balance Sheet
Japanese companies have a reputation for being extremely conservative with their balance sheets, usually carrying large amounts of cash and short-term investments and relatively little interest-paying debt. While Kubota does have significant liquidity in terms of cash and short-term investments, it also has a very significant and growing debt load. This is because the company has been providing financing to some of its customers. Financial debt to EBITDA is still at a reasonable level, but investors should definitely pay attention to how this evolves in the future.
The company has some commentary addressing this issue in its annual report, explaining that the company maintains a net cash position if one excludes retail financing.
We have provided customers in the Farm & Industrial Machinery business with retail financing in the form of installment sale and so we currently hold a great deal of interest-bearing debt (¥1,544.8 billion at the end of the last fiscal year). However, excluding this retail financing interest-bearing debt, at the end of the last fiscal year the Kubota Group maintained a net cash position.
Peers
There is currently a wide valuation gap between Kubota and other foreign competitors like the AB Volvo ( OTCPK:VLVLY ), and their US-based competitors. In terms of price/sales ratios, the difference is more than 2x, but some of it can be justified by higher profit margins.
There was a time when Kubota was ahead of the pack, but more recently the US-based competitors are delivering profit margins more than 2x higher. We believe Deere and Caterpillar have been more aggressive in cutting expenses and improving their cost structures, and they have also benefited by having a focus on bigger customers.
Valuation
Kubota looks very attractive on a number of valuation metrics. For example, it is trading at a significant discount to its ten-year price/book multiple, and not much higher compared to the low it reached during the worst of the Covid crisis.
It is also trading below its ten-year EV/EBITDA multiple average, as well as its industry's average of ~12x.
The price/earnings ratio is also near the bottom of its historical range, at least when looking at the last ten years. It is currently more than 3 turns lower than the ~15x ten-year average, which offers an 8%+ earnings yield.
Risks
The most important risk we see with Kubota is that it has significantly increased financing to its customers. While this has helped sales growth, it does add credit risk to the company. It has also ramped up CapEx significantly, and it remains to be seen if Kubota is able to get decent returns from these investments.
There is also the risk that comes from investing in a foreign company, including currency changes. For example, the dividend is declared in Japanese Yen, and if the currency continues to weaken, it will result in lower dividends when converted to the foreign investor's currency. These risks are mitigated by the company's strong competitive position, including a strong brand and delivery network.
Conclusion
Kubota is trading at a very attractive valuation as measured on a number of metrics, including price/earnings, price/sales, and price/book. While its customers are exposed to the cyclicality of the commodities they produce, Kubota has shown it can remain profitable even during difficult times. One important risk to consider is the financing the company has been providing to its customers, this is something to monitor closely.
We are encouraged by the company expressing its intention to refocus its attention towards profit margins and ROIC. Kubota has also made significant Ca?Ex investments that should start delivering results soon. For these reasons, we believe the company is undervalued, and are therefore maintaining our 'Buy' rating.
For further details see:
Kubota: This Legendary Japanese Company Has Rarely Been This Cheap