2023-11-21 08:18:30 ET
Summary
- Noritz's profits were down due to softer demand in the Japanese market and issues with its equity affiliate Kangaroo.
- The overseas business performed well, but the equity accounted loss from Kangaroo widened and the downsides of operating leverage in the domestic business led to steep profit declines.
- Noritz is unwinding cross-shareholdings, freeing up cash for investments, and has a stock with sufficient market support to allow for buybacks without running into problems with the TYO.
- Patience is required, but the intense pressure on Japanese companies by their own governing bodies should promote some more reinvestment and deployment of cash.
Noritz (NRTZF) didn't have a great quarter. Profits were down substantially on softer underlying demand, reflecting issues in the general economy of its domestic market of Japan - price increases were simply met with less demand. Moreover, the investment they have in Kangaroo , the water purifier business focused on Vietnam, encountered some troubles, and that equity accounted loss widened meaningfully detracting from net profits. However, the overseas business was really impressive.
There are things to note though. They are finally unwinding some of the cross-shareholdings, and are therefore freeing up cash to be able to invest in several initiatives that can improve profitability. Moreover, the excellent valuation case still stands. Furthermore, they have sufficient liquidity to support buybacks without hitting TYO liquidity requirement minimums. However, we still don't have confirmation that they are going to pursue aggressive shareholder payouts. Patience will be required, but as investors we remain satisfied with the current organic initiatives that the company has planned.
Earnings Review
Noritz has revised down its year forecasts substantially, primarily due to sluggish demand. Price increases were substantial and would have been able to offset some of the inflationary pressures coming from parts and material prices, but sales pressures in the domestic business have been a problem, in line with the general trends we've seen in aggregate consumer spending in Japan, which has been reflecting consumer reticence in the face of inflation, and in spite of wage increases.
The overseas business is performing well, and there's been an expansion of the commercial contracts for managing the water heating systems of facilities. These provided margin uplift as hoped, as well as growth that beat the benchmarks of established companies that focus on residential markets. Really not too bad of a performance, especially in China where issues could have been expected.
The bottom line impacts of the equity accounted affiliate, Kangaroo, are also pretty severe. While it was a pretty meaningful profit detractor in previous quarters, it has just gotten worse on the quoted "instability" of the Vietnamese economy. Exports have been recovering which supported headline figures, but consumption is still weak and there continue to be concerns around the real estate sector .
They were previously guiding for slight profit growth, with hopes pinned on price increases which had been delayed last quarter, but the forecasts now reflect a much softer consumer reality which caused the stock to fall around 10% on earnings day.
Bottom Line
They are at least keeping up the dividend, which addresses the balance sheet situation a bit in the face of lower net income and less retaining of earnings, but there is no doubt that this quarter is a bit of a disaster in terms of performance. Operating leverage remains evident, and the company is just not far enough away from breakeven.
However, they are addressing that in various ways. Firstly, they have their V-plan going which is supposed to generate secular cost savings. They are also expanding the logistics and manufacturing in China and in the US. Furthermore, they are pushing in a focused way into non-residential markets to provide full-service contracts. This may not be very capitally intensive, but it is somewhat of a sink and will at the very least scale the overseas businesses which seem a lot more resilient.
They also have CAPEX projects for manufacturing lined up for Kangaroo, which should improve profitability and help scale that business better so it will hopefully no longer be such a profit detractor.
The valuation case remains the same as before.
We halved the multiple just to encapsulate the differences in multiples in Japan, and the fact that there are outstanding management concerns.
The reality is that corporate governance initiatives by the Tokyo Stock Exchange continue to put pressure on companies to reform their capital payout policies by addressing their low PBRs. They are even going to adopt a name and shame system in order to call out companies that haven't yet released plans addressing low PBRs and bloated cash balances.
Cross-shareholding was a first target for quickly resolving the issue of corporate investors not contributing to a company's liquidity nor putting pressure on management, which at least institutional investors will do. Noritz had started liquidating those in 2022.
Their dividend policy is more generous than many other Japanese companies, with a lower limit DOE of 2%, and a target payout ratio of 50%. 30% is what you can generally expect of Japanese companies, and many with especially bloated cash balances have less than that in payout ratios.
Another thing to note with Noritz is that millions of USD equivalent trades daily. There are several minimum liquidity requirements for listed TYO companies. In our conversations with less liquid Japanese companies, we often heard that buybacks were desirable, but too much of them would excessively absorb the float and impinge on the requirements to be listed. Noritz has no such limitations, and a 10% of shares outstanding in the treasury is a sign that the company has been inclined to do this in the past.
The ideal path forward is M&A and capitally intensive expansion in the overseas business, accompanied by buybacks. Expansion is being done, but whether it draws down on the bloated, ignored cash balances is the question, and those balances must be invested profitably in order to get supernormal returns with Noritz.
For further details see:
Noritz: Substantially Undervalued, Liquidity Could Support Buybacks