Thinking Points

  • Daihatsu Diesel’s (TSE: 6023) business case is still the same: parts and maintenance, new production facility, and shipbuilding industry recovery.
  • The company’s recent real business performance deteriorated, but was supported by favorable exchange rates.
  • At today’s  890 yen per share, there isn’t much room for excitement.

I first wrote about marine engine manufacturer Daihatsu Diesel (TSE: 6023) a year and a half ago. Much of the commentary revolved around three things:

  1. Focus on parts and maintenance business
  2. New production facility (2018 target open)
  3. Global downturn in shipbuilding industry

Daihatsu’s business performance has not improved or deteriorated in the last year and a half, at least on the surface (I’ll discuss this more later). The parts and maintenance business slowed down, shipbuilding is still down, but the new production facility is right on schedule.

In the original writeup, I outlined a moderately negative outlook and put Daihatsu Diesel at 800 yen per share. The case was simple. After managing to lose a quarter of its book value (1,075 yen per share) through the downturn, Daihatsu Diesel gets valued at book (800 yen per share) in the in the next optimistic market. This post is an update to the original post.

 

Parts and maintenance

Daihatsu Diesel’s parts and maintenance business is my biggest focal point by far. A little over 10 years ago, the company produced land and marine engines, but did not make any effort to build out a service parts and maintenance business. Over the last 10 years, this has changed.

The difficult part in analyzing the parts and maintenance business is that Daihatsu does not disclose its gross profit mix. The segment is broken out between marine and land engines. We can only see parts and maintenance revenues through the biannual investor presentation slides.

Among industry professional, the high margin nature of maintenance, repair, and overhaul (MRO) is common knowledge. In my original writeup, I estimated Daihatsu Diesel’s gross profit margins for Engine, Parts, Service, and Other:

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More recently, parts and maintenance revenues declined. At the end of the first half of fiscal 2016, parts and maintenance revenues reached 12,442 million yen ($115.7 million USD). Since then, revenues declined to 11,510 million yen ($107 million USD) in 1H 2017 and 11,165 million yen ($103.8 million USD) in 1H 2018. Management only vaguely addressed this decline as a downturn in the market.

Shipbuilding industry downturn

Over the past couple of decades, China and Korea lead the world in shipbuilding. Together with Japan, the three countries often account for over 90% of ships built (by tonnage). In recent years, the shipbuilding industry has gone through the worst downturn in history, with 2016 being particularly bad. Though the industry is showing some signs of recovery, the three big Korean shipbuilders are expecting a gloomy 2018.

It’s difficult to say whether this is good or bad for Daihatsu Diesel. The Korean shipbuilders are probably more inclined to take orders at low margins just to keep the facilities running. At the same time, a weakening yen (vs. same time last year) has helped Daihatsu Diesel considerably.

New production facility

Daihatsu Diesel currently operates out of two inland facilities in Shiga Prefecture (Kansai region). The new facility will be on the waterfront in Himeji City, Hyogo Prefecture (also Kansai region).

One thing management has repeatedly mentioned over the last few years is the low profitability of engines. Additionally, the market is shifting toward a higher concentration of large ships. In order to meet market demands, Daihatsu Diesel needs to disassemble, transport, and reassemble engines for larger ships. The waterfront Himeji facility is expected to reduce assembly rework.

Putting it together

One thing is clear: The industry is still in a downturn. The recent decline in high margin parts and maintenance revenues has had a smaller effect on Daihatsu Diesel’s operating performance than I imagined. That said, the 1H 2018 presentation highlighted the weakening yen’s positive impact:

Source: Daihatsu Diesel 1H 2018 earnings presentation

Management noted that the change in inventory valuation allowance was largely a function of exchange rates. Looking at the chart above, that means 1,048 million yen ($9.75 million USD) of 1,454 million yen ($13.52 million USD) in 1H 2018 operating income was only a function of exchange rates. In real terms, Daihatsu Diesel’s business performance deteriorated. This is no surprise, however, as shipbuilding is still in a downturn. I wouldn’t be particularly surprised if Daihatsu Diesel recorded losses, which may happen, especially if the yen strengthens.

Interestingly, the market seems more optimistic about Daihatsu Diesel, which now trades at 890 yen per share. When I first wrote about the company, shares traded at 590 yen. Perhaps news about struggling Korean shipbuilders combined with the weakening yen helped.

This was a small surprise to me, as I put Daihatsu Diesel conservatively worth 800 yen per share over 3 years… about 1.5 years ago. I figured the company would operate at a loss for a year or two before riding the recovery wave.

Looking forward

The business case for Daihatsu Diesel is still the same: High margin parts and maintenance business.

The company got its first contract for its new satellite engine monitoring system back in July 2017. The system is Daihatsu Diesel’s first adventure into the Internet of Things (IoT). This is a shift in approach to the company’s historically reactive stance to parts and maintenance. The system is intended to identify problems before things start breaking down.

Management continued its usual commentary about less than ideal margins on engines. There ought to be some real improvement (i.e., not just favorable exchange rate) as the Himeji facility comes online later this year.

With no specific guidance from management on parts and maintenance revenues and cost savings on engine production through the new Himeji facility, it’s hard to say how this all ties into business performance. That said, it’s safe to say Daihatsu Diesel is moving in the right direction.

If the company manages to remain profitable through the downturn, it may be in a good position to ride an even more positive investor sentiment. Even then, I think book value is about as optimistic as the market gets, seeing the historically consistent below book market valuations.

However, Daihatsu Diesel has strengthened its balance sheet over the past 10 years. Equity to asset ratio improved from 0.2 to today’s 0.48. At 890 yen per share (0.76x book, 4.8 EV/EBIT), I’m not particularly interested in Daihatsu Diesel as an investment, but I like the higher quality revenues(vs. 10 years ago) and company direction.

The bottom line

The business case is still the same with Daihatsu Diesel. The focal points are: Parts and maintenance, Himeji facility, and industry recovery. Business performance deteriorated recently,  but has been supported by favorable exchange rates. As the industry recovers, investors ought to see the improved quality of revenues (i.e., parts and maintenance). However, given the seemingly optimistic market valuation at today’s 890 yen per share, I’m not particularly interested in the company as an investment.


Kenkyo Investing
Kenkyo Investing

Kenkyo Investing applies a value investing approach to Japanese equities, providing insights that are often unavailable to non-Japanese speakers.