Daiwa Industries: Phenomenal Economics, Almost Entirely For Free (OTCMKTS:DAWIF)

Daiwa Industries (OTCPK:DAWIF) is one of the best publicly listed businesses on the market in Japan, covered in the past here as a Top Idea and again in May 2023 where we commented on some new product launches and generally strong profit growth performance. We will recap some of the primer for the business here, but the Top Idea article is very thorough and should be used as the more definitive the primer for the business based on our understandings.

It also has close to a zero EV driven down by cash balances, meaning the operating assets come virtually for free as the stock value is almost fully accounted for by the cash. It was less before it appreciated (referring to TSE issue which is more liquid). They have a history of dramatically underestimating their own performance. With mix effects against them yet achieving growth, and with concerns around substantially higher rates assuaged by a very weak BoJ pivot, there really isn’t much risk here of the restaurant industry, which can be cyclical at time in Japan, going under. The valuation case is still astronomical, although management has not yet released a plan consistent with the TSE memo to low P/B companies to release a clear management and capital plan. We believe that any announcement of capital allocation plans will grow the stock on that day by at least 15%, consistent with what we’ve seen in the rest of our low-EV coverage. Thereafter, probable profit growth will do the rest to realise value. Superb stock.

March Earnings Comments

The results came in ahead of expectations, but expectations were that there would be a deceleration into Q4 in sales and profits. Recall, detailed in our initial coverage, that the company primarily sells refrigeration equipment for konbini and for the restaurant industry, mainly small customers. They manufacture the refrigeration equipment, but they also sell other products manufactured externally such as water purifiers and convection ovens for convenience stores a.k.a konbini in Japan. There is an important component of inspection revenues in the mix, which is a much higher margin activity than selling new units, and is the important recurring component on the installed base. We don’t have segment margins, but we understand that the inspection segment is substantially higher margin than the equipment sales segment.

When new unit sales start ebbing, inspection revenues start flowing which creates a rather resilient EBIT profile, hence the great economic profile akin to razor and blades businesses like elevators, which we use as a comp in the valuation.

Ultimately, sales were quite in line with expectations but profits, particularly it seems on cost control rather than mix effects, came in substantially ahead of expectations. The reason we are quite confident that it’s not mix effects that played a role is that the inspection revenue also decelerated into Q4.

In fact, where non-inspection revenue decelerated by about 1 billion JPY compared to annualisations from Q3 cumulatives, inspection revenue decelerated around 0.5 billion JPY. So actually inspection is a 33% of the deceleration, compared to being around 22% of the sales mix. So mix effects were actually negative in the quarter, even though profit surprised.

The company is forecasting for the next FY pretty substantial deceleration in results again, particularly on the profit side.

We recognise concerns. If rates come up, that will be a little scary for end markets, where there is a lot of exposure to the restaurant business, and where small to medium sized enterprises in Japan are often zombies and incapable of staying solvent.

On the other hand, where we see higher rates as the only risk factor for the end-markets, Daiwa isn’t recognising the profit effect it will have due to its massive cash balance, currently yielding barely above 0%. Even a moderate change upwards to 0.5% yield on the cash balances, would grow ordinary profit by 3-4% just from interest income. This is clearly not reflected in forecasts, which leads us to believe that Daiwa is being overly conservative again in its estimates.

We see higher rates as the only major risk, and think that the unit growth that we’ve seen this year would contribute to mix effects from more inspection in the mix next year if we were to see that deceleration of sales in new equipment.

Bottom Line

We don’t understand the conservatism on results forecasts, and think that they are likely to be underestimating themselves again. We believe directional progress is likely, and this will simply continue to bolster the value case. The value case is based on a NOPAT multiple set of comps from other razor and blades businesses with different economics. Due to the fact that Daiwa is a family owned business and it’s important that one day the non-operating assets become used productively for minority shareholders to benefit, we have used a fudge factor by halving the multiple from the comps. There is no exact way to do this – a more rigorous way may be a 20-30% multiple discount to reflect lack of possible minority shareholder control, but we wanted to be harsher than that. The upside is still very substantial and in a lot of ways, Daiwa has better economics, with lower incremental working capital and fixed capital intensity. Its margin, as we explained a bit earlier, can be assumed to be driven very meaningfully by inspection, but we really have no idea of the exact figure – could be that it’s the only profit making revenue line, although it’s unlikely given that they also had profit growth in the past on other products for that they sell like convection ovens and water purifiers, which were launched during COVID-19 and we cover in the previous coverage.

We mentioned that higher rates are the only major risk to Daiwa’s end markets, but the BoJ pivot was extremely light, and explicit language points to continued accommodation by the BoJ. So major rate hikes that could rattle the economy are off the table, although a slight boost to returns on the cash balances should come.

In the end, we don’t see the risk factors materialising. We see mix effects improving going forward thanks to the resilient and likely growing high-margin recurring inspection component, even if unit sales decelerate, and we continue to recognise the phenomenal value case where cash balances account for almost all of the market cap, meaning the operating business, even after some appreciation in the stock, basically comes for free. As long as Daiwa’s customers don’t go bankrupt, the inspection revenue should make an improvement in 2024. Rates would be the only major concern here. There has been a slowdown in consumer spending in Japan, which the company is weathering without issue, but higher rates on top of that would be more concerning for Daiwa’s end markets, even though the non-operating asset upside still remains, and would be catalysed by any management plan release as seen in other parts of the low P/B Japanese markets. Higher yields on cash balances would meaningfully offset any income pressure though just because of how large the cash balances are.

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