Elite Client Idea #64

Watanabe Sato Co., Ltd. ‘Watanabe’ (TSE Ticker: 1807; Price: ¥2514/share)

(Latest financials are for the quarter ending June 30th 2023; Year-end: March 31st)

Watanabe is a relatively small Japan-based contractor primarily engaged in pavement and civil engineering works. It generated two-thirds of FY23 revenues from government agencies.

It also sells asphalt mixtures and related products (13% of FY23 revenues).

Though recent public and private orders are relatively strong, Watanabe is exposed to increasing competition for projects, rising raw material costs (primarily straight asphalt), increased energy costs, and manpower shortages (including regulations to limit overtime).

It reported TTM revenues of ¥34.7bn (FY22: ¥37.5bn), ebit of ¥782mn (FY22: ¥2.5bn), and net profits of ¥580mn (FY22: ¥1.7bn).

~40-45% of revenues are recognized using the input method, which is subject to estimates of costs to complete contracts. Moreover, project timing can distort annual results. Further, most revenues are recognized in Q4 in line with project completion and execution of government budgets whereas administrative expenses are allocated evenly – therefore Q1-Q3 losses aren’t abnormal.

Overall cash conversion is excellent and FY21-23 free cash flows were ~¥1.4bn excluding a bolt-on acquisition for ¥490mn in FY23 (to expand business in the Hokkaido region).

Reviewing the track record, Watanabe generated average revenues of ~¥37bn, and average ebit and net profits of ~¥1.7bn and ~¥1.1bn respectively.

The balance sheet is loaded with net cash of ¥8.5bn, and the net current asset value (NCAV) is ¥5.1bn. Adding the market value of stocks (¥1.2bn) and real estate leased out (¥4bn) to NCAV results in minimum realizable asset value of ¥10.3bn. Unadjusted tangible equity is ¥18.7bn.

Net retirement benefit liabilities of ¥2.5bn comprised gross liabilities of ¥4.9bn offset by pension assets of ¥2.4bn - discounted at a conservative 0.811%.

The equity trades for ~¥7.7bn, which is a 26% discount from minimum realizable asset value, ~7x earnings, 5.4x free cash flows, and 41% of tangible equity. Net of cash, the market assigns zero value to the operating business.

Three-year average dividends were ¥326mn yielding ~4.2% at market. Management could pay out a lot more from the cash hoard but the yield is acceptable.

Offsetting this are issues of treasury shares to third parties, directors and employees. Cash settlements for directors/employees via disposals of stock at seemingly low prices seems indiscriminate. Nevertheless, management buys in stock first - instead of simply issuing new shares.

Prospects are reasonably favorable with increased demand for infrastructure repairs of aging bridges, etc.

Overall, the shares are selling well below its value to a private owner and meets our investment tests.