Summary

Minebea Mitsumi is currently not a buy at 1,620 yen per share (5/9/2017 closing), but would be a compelling investment as 715 yen per share.
Key driver for Minebea Mitsumi is its Machine Component segment, particularly its industry-leading miniature ball bearing business.
Minebea Mitsumi’s investor sentiment is likely driven by explosive revenue growth in smart phone LED backlight business (50% CAGR between 2013-2016).
Key near-term drivers are: consistent performance in Machine Components, technological tail-end profits from smart phone LED backlights, and healthy Nintendo Switch sales.
Minebea Mitsumi was recently formed through the merger of Minebea and Mitsumi Electric.

Tearsheet

** Some of the above metrics may not be the same on major financial websites such as Financial Times, Nikkei, WSJ, etc. This is because Minebea Mitsumi was newly formed on 1/27/2017 through the merger of Minebea and Mitsumi Electric. Some sites likely reflect Minebea’s metrics and have not incorporated Mitsumi’s metrics.

Introduction

This report will be slightly different from the previous reports. The main reason being that Minebea Mitsumi is actually a company that was recently formed (January 27, 2017) through the merger of two companies: Minebea and Mitsumi. In large part, the focus of this report will revolve around Minebea Mitsumi’s strategy + execution (at least conceptually) and less on the operating environment.

Minebea

Founded in 1951, Minebea was the first miniature bearing focused bearing company established in Japan. From the very beginning, Minebea has served the aircraft industry. It is currently the 4th largest Japanese bearing manufacturer, behind NSK (TYO: 6471), NTN (TYO: 6472), and Jtekt (TYO: 6473). While the 3 largest Japanese bearing manufacturers have large exposure to the automotive industry, Minebea’s automotive exposure for 2016 bearing sales was at 18% (aircraft industry was #1 with 33% of sales).

In addition to miniature bearings, Minebea has expanded into the manufacturing of various types of motors, sensors, and lighting components. There are two points about Minebea that are very “Un-Japanese”:

Only 13% of 2016 sales came from Japan (China at 30% and US at 26%)
A whopping 59% of 2016 production was done in Thailand. Thailand and China production combined accounted for 75% of 2016 production.

Minebea’s reporting segments are split into Machine Components (27% of 2016 revenue) and Electronic Devices (73% of 2016 revenue). Each segment is split into sub-segments:

Machine Components (27%)

Pivot Assembly
Rod End Fastener
Ball Bearing

Electronic Devices (73%)

Sensing Devices
Electro Devices
Motors
Other

Source: Minebea Filings

Mitsumi

Mitsumi was founded in 1954. In 1955, the company released the poly variable condenser, which was pivotal to Mitsumi’s success early on. Mitsumi is probably best known for its work on Nintendo devices. As is the story with many of Japan’s electronics manufacturers, Mitsumi has also experienced a steep decline. Much of the decline was due to a combination of the slowdown in video game hardware as well as losing some of Nintendo’s work to competitors. Over the past 10 years, Mitsumi has cumulatively generated a net loss, with sales decreasing by 30%. Shareholder’s equity for Mitsumi today is roughly equivalent to what it was 10 years ago.

About a third of Mitsumi’s 2016 revenues came from Japan, and more than half came from Asia (ex-Japan). About two-thirds of Mitsumi’s PPE assets are in Japan and one-third is in Asia (ex-Japan). Nintendo remains a big customer, accounting for 14% of Mitsumi’s 2016 revenues.

As for reporting segments, Mitsumi has 5 of them (percentage of 2016 revenues):

Semiconductor Device
Optical Device
Machine Parts
High Frequency Components
Power Components

Source: Mitsumi Filings

The Merger

While the two management teams insisted that the merger between Minebea and Mitsumi was a “merger of equals”, it is widely viewed that Minebea came in to save Mitsumi from a slow and painful death.

Directionally speaking, the newly formed Minebea Mitsumi is aiming to leverage Minebea’s strength in industrial high-precision parts and Mitsumi’s strengths in wireless communication to develop products geared for smart city infrastructure. The company has been pretty open about trying to make a shift from parts supplier to product manufacturer.

M&A, Industry Volatility, and Management Thinking

This section will primarily focus on conceptual commentary and less on “hard data”, or numbers.

Minebea – the frontrunner in Japanese M&A

In Japan, Minebea has historically been considered an M&A driven company. In many ways, Minebea’s business approach reminds me of the way Cisco Systems (CSCO) operates. For those that are not familiar with Cisco’s business strategy, M&A sits at the core. However, the amount of attention Cisco gets for its M&A is probably less in comparison to similar-sized competitors. This is largely because Cisco acquires smaller companies (unlike Dell’s $60B+ acquisition of EMC). Now, Cisco isn’t only known for buying companies. The company is known for integrating acquired companies quickly and effectively.

Minebea is like a much smaller, less effective, Japanese version of Cisco. The international expansion of Minebea was somewhat forced upon the company from the start. Since there were already large, established bearing manufacturers in Japan, Minebea not only focused on specialization (miniature bearings), but also looked to the US market in the 1960s. The international expansion for survival originally started through sales agreements with an American miniature bearing manufacturer. In the 1970s, Minebea started production in the US and purchased companies both domestically and internationally. Since then, M&A has been a large part of Minebea’s strategy. Overall, Minebea’s strategy could be characterized as “decisive”. The company does not hesitate to withdraw from segments that are not profitable, as seen in its withdrawal from speaker and keyboard production in the past.

Technology

As observed in the revenue distribution chart in the introduction, ball bearings still command a significant portion of Minebea revenues (16% share). The largest segment is “Electro Devices”, which mostly consists of backlights for LED displays on high-end consumer electronics (think: Apple products). According to a Nikkei article from last year (Japanese), Minebea holds a 80% global market share for LED backlights on smartphones. On the surface, this is great news: Minebea has a technological moat. For the long-term investor, however, technological moats still need to translate into sticky revenues and profits. This lead me to ask the following question:

What good is having an 80% global share in a technology that would be obsolete in 5 years?

To be clear, I am not an engineer. I am also not suggesting that Minebea’s LED backlight technology would be obsolete in 5 years. That said, there is a real risk of Minebea’s LED backlights being displaced by OLED.

There is a lot we can learn from TVs. The newest and best TVs today are OLED TVs. The newest and best TVs of yesterday were LED/LCD TVs.

Again, I am not an engineer, but here is what I’ve gathered from doing my own, non-engineer research:

We had brown tube TVs, then we moved to LCD TVs, then we moved to LED TVs, and now we have OLED TVs. There is no doubt that brown tubes are pretty much gone, so I’ll leave that out.

What are the differences between LCD/LED/OLED? Here is an explanation for the laymen, by the laymen:

LCD and LED are effectively the same – LEDs are basically LCD pixels with backlights (which is what Minebea provides). OLED pixels are self-illuminating, removing the need for a backlight. Compared to LED, OLED TVs offer wider viewing angles, lighter/thinner displays, and is more energy-efficient. The only leg up that LED has over OLED is price, and even that advantage is expected to disappear soon. Just to be clear, Minebea’s strength for LED backlights is in the smart phone market.

Some investors may read this commentary and think about assessing how well Minebea can develop new business to replace old ones. While this may be a functional approach to investment analysis, as a generally conservative long-term investor, I feel that too much of the boring, predictable element is missing. Which leads into my next topic: Industry volatility.

Industry Volatility

Among the investment community, it’s common knowledge that consumer facing technology changes rapidly. 10 years ago, we were using flip phones. Today, the average Japanese person has fiber-speed mobile internet. In contrast, there are industries where technology change does not happen as quickly – like automotive, aerospace, etc. Minebea is heavily involved in these industries through bearings. As a general principle, new technology adoption in any industry where part failure results in human life loss (think: aircraft) is slower than consumer gadget new technology adoption (think: mobile phones).

As a long-term investor, the runway for growth in consumer tech-focused development is unpredictable at best, and limited at worst. Let me explain with an example that may be more familiar to western investors.

I believe Minebea (and a large part of Mitsum) shares a story with today’s GameStop (GME) as far as the consumer facing tech exposure goes. The bread and butter for GameStop has historically been in used physical game sales. As internet infrastructure developed and gaming systems gained better connections to the world wide web, video game enthusiasts started purchasing digital copies of video games over the internet. While it’s unlikely that physical games will completely disappear from this planet (e.g. we still see DVDs at Wal-Mart), GameStop’s most lucrative segment has experienced a decline over the past few years because of this general shift.

In order to make up for declining core-business profits, GameStop started acquiring an enormous number of AT&T stores (Spring Mobile) all over the US. The gross profits for these stores were north of 70% (as of late 2016). These are the stores where AT&T customers go to in order to sign up for DirecTV, AT&T U-verse, buy a new phone, etc. Margins are high right now, but the value proposition of a physical store that sells commoditized goods is dropping as the world becomes increasingly connected to the internet. Which leads to my next question: Will GameStop be fighting for survival again in 10 years?

Minebea Mitsumi faces the same problem. The company gained an 80% global share in smart phone LED backlights. While this is admirable, will Minebea Mitsumi’s Electronic Device’s segment be fighting for survival every 5 – 10 years? As a reference, Electro Devices (the subsegment with LED backlights) accounted for approximately 31% of Minebea Mitsumi’s 2016 combined revenues.

Management Thinking

Amazon CEO Jeff Bezos made an insightful quote in regards to business strategy:

“I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time.”

Source: Above The Crowd

We can reasonably predict that people will always value more pixels over less, higher resolution over lower resolution, higher energy efficiency, faster everything, etc. Is that enough stability to build a business strategy for Minebea Mitsumi?

In an industry that requires constant tweaking, where R&D doesn’t necessarily translate into long-term ROI, it’s difficult to analyze a business like Minebea Mitsumi with any degree of certainty beyond “I think the company will probably still sell LED backlights in 3 years” or “I think the company will be able to replace LED backlight revenues in 3 years”.

One Nikkei article (Japanese) leads me to believe that Minebea Mitsumi’s management team recognizes this. In the article, an unidentified Minebea leader mentions that the backlight business is highly volatile and that the company was able to take on the risk because of the (stable) profitable ball bearing business. At the very least, the management team seems to recognize that they need to constantly be thinking about what’s next.

Speaking of what’s next, the whole Minebea Mitsumi merger is intended to strengthen both companies’ ability to take on the IoT movement. While there aren’t many tangible results yet, the company is experimenting with LED lights. So far, a lot of attention has been given to the company’s high efficiency LED street light testing in Cambodia as well as the SALIOT smart lights. On the bright side, Minebea Mitsumi has the technological know-how to develop scalable products (like their Guinness World Record Smallest ball bearings or LED backlights). On the dark side, every other company is trying to ride the IoT wave.

Business Performance & Financials

As you might have already guessed, I’m not a fan of Minebea Mitsumi’s consumer facing tech exposure. That said, the company has proven its executional ability to bring valuable technology to the playing field through products like industry-leading miniature ball bearings and LED backlights. While this is all fun and good, it means very little to the investor if Minebea Mitsumi’s technological advancements does not translate into solid business performance.

Before I dig into the financials, here is my general approach: Minebea management will be driving the Minebea Mitsumi business as a whole. I will be focusing more on Minebea’s historical performance than Mitsumi’s. Despite the “merger of equals” commentary, Minebea has a history of integrating acquired companies. It’s also important to keep in mind that this was a friendly merger – the CEOs of Minebea and Mitsumi have been buddies for over 20 years.

Source: Minebea Filings

After 2013, Minebea’s revenue grew explosively (21% CAGR). The good news here is that every one of Minebea’s business segments grew. While not bad news, one point of concern is that half of the growth came from the Electro device segment (= LED backlights). The Electro devices segment grew at a 50% CAGR during the same time period.

One quick look at historical returns shows that Minebea management is unafraid of volatility:

Source: Minebea Filings

Over the past several years, the explosive growth has translated into solid equity growth:

Source: Minebea Filings

As an experiment, I combined Minebea’s historical financials with Mitsumi’s historical financials.

Source: Minebea & Mitsumi Historical Filings

Source: Minebea & Mitsumi Historical Financials

Source: Historical Minebea & Mitsumi Filings

While Minebea Mitsumi currently has a respectable 8% ROE, the fluctuations are wild. Let’s go back to the LED backlight story again. After growing revenue at 50% CAGR for 3 years, Minebea’s ROE reached a 10-year high at 17.1% in 2015. Furthermore, ROIC was at 10.5%, which leads me to believe that the high ROE was more a function of debt than high margin revenue. This is further confirmed when observing segment profits: In 2015, the electronic devices segment accounted for 69% of revenues and 22% of gross profits.

Looking at Minebea’s 2016 filings, here are some key information regarding the two segments:

Short term (~2 years) considerations:

The LED backlight business probably has at least another couple of years left before much of the technology shifts to OLED (or maybe even something newer).

Mitsumi is likely to return to profitability given its involvement with Nintendo hardware. Nintendo released its newest console (the Nintendo Switch), earlier this year. Release month unit sales for the Nintendo Switch has been the highest in Nintendo history.

Valuation

The asymmetrical revenue and profit distribution between the two Minebea segments is good and bad. The good news is that even if LED backlights become irrelevant tomorrow, the company will not be facing a life or death situation. The bad news, and I am leaping into speculative territory here, is that Minebea Mitsumi’s investor sentiment is probably pegged to LED backlights. It’s not exactly common knowledge that Minebea Mitsumi holds a 80% global share in smartphone LED backlights, but key information retrieved from surface level reading about the company are: Leader in miniature ball bearings and explosive growth in LED backlights. Thus, it is highly likely that investor sentiment is at least partially driven by the LED backlight business.

Thanks to the wild fluctuations in business performance, historical valuation metrics are also all over the place:

Source: Minebea & Mitsumi Filings, Author calculation for combined P/B

According to Nikkei, Minebea Mitsumi is currently trading at 2.59x book (as of 5/9/2017). My own calculations put Minebea Mitsumi’s current P/B at 2.04x. Keep in mind that the P/B ratios above are “mid-points”. I took the highest and lowest P/B values for each year, added them together, and then divided the sum by two. In reality, Minebea has seen P/B values ranging from 0.7x to almost 4x, all within the past 4 years. You may have already guessed it: The low P/B values came in around 2013/2014, before the LED backlight growth story went mainstream.

In contrast, Mitsumi has traded below book for quite a while. The last time Mitsumi traded above book was in 2011. The story of Japanese electronics companies losing business to Korean, Chinese, and Taiwanese firms is probably internationally known. Mitsumi is one of those Japanese electronics companies.

Given Minebea Mitsumi’s recent merger and exposure to a highly volatile consumer facing technology industry, I believe that even the simplest of DCF models would not reflect the value of Minebea Mitsumi to any degree of accuracy. While it would be interesting to see what sort of improvements Minebea could bring to Mitsumi’s resources, it is too early (and expensive) to put money into it at 2x book.

For the combined Minebea Mitsumi business, I believe the investment will be a fair play at book value (794 yen per share) and a moderately compelling one at 0.9x book (715 yen per share). The key value driver for Minebea Mitsumi is the miniature ball bearing business. Much of the uncertainty revolves around Minebea’s historically inconsistent business performance combined with Mitsumi’s historically consistent poor business performance. As an investor, there are two ways to mitigate risk here – get a PhD in electronics to get a better grasp of where the company is going, or pay a lower price.

If the machine component segment ever got spun off, I believe the segment warrants a 1.3 – 1.5x book valuation. Assuming gross profits remain at 2016 levels (40,854 M Yen), SG&A is at 16% (roughly historical average), tax rate is 35% (10-year avg.), we would be looking at 13-15% 1 year return at 1.3 – 1.5x book.

In Closing

Given the healthy Nintendo Switch sales and LED’s price advantage over OLED technology (expected to change in ~2 years), there might be short-term opportunities for investors interested in betting on near-term positive market sentiment. That said, Minebea has a history of performance volatility and Mitsumi has a history of consistent poor performance. I believe Minebea Mitsumi would be a compelling investment at 0.9x book (715 yen per share).