Thinking Points

  • Dairei (TSE: 2883) is a fabless seafood processing company that specializes in boneless fish products.
  • The company is a pioneer in the niche boneless fish market, with patented processing methods for boneless fish and frozen food products.
  • At May 11, 2018 closing price of 1,996 yen per share Dairei is fairly valued with a 7 to 11 EV/EBIT multiple and 2.76% dividend yield. The company would be an interesting investment opportunity if share prices dropped below 1,600 yen per share.

Dairei (TSE: 2883) is a fabless seafood processing company specializing in boneless fish. The company produces both private label and Dairei-branded products, which are manufactured by partnered processors, and sold in Japan. In addition to boneless fish, the company is working to develop its meat business into a second core segment.

Source: filings

 

Boneless fish

The first important thing to note is that Dairei is the pioneer in boneless fish processing (referred to as “deboning”). Oddly, there is an English language source for this information. The process isn’t as simple as removing bones from fish, as the deboning process affects the texture and integrity of fish meat. Even today, this process is primarily done by skilled workers as fish come in different sizes. Deboning machines do exist, but precision costs money, and the current machines often remove a considerable amount of fish meat along with the bones when compared to skilled workers. In this context, the machine vs. skilled worker processing decision is largely influenced by labor cost, raw material cost, post-deboning weight recovery, and machine cost.

Source: Dairei

The second important thing to note is that Dairei has a patent in boneless fish processing methods (2007). Its more recent patents are in frozen food processing methods (2009, 2010, 2014). In total, the company has 5 patents. The value of these patents are difficult to determine as it is difficult to identify cases of patent infringement.

The third important thing to note is that boneless fish was originally developed targeting elderly consumers, who often experience difficulty removing fish bones while eating. As the elderly population continues to increase in Japan, the market for boneless fish is expected to grow. Today, the market for boneless fish in Japan is estimated at 45 to 50 billion yen ($410 to $460 million USD) per year (Japanese source). Dairei, along with, Maruha Nichiro (TSE: 1333), Oka Foods (private), Kyokuyo (TSE: 1301), and Nissui (TSE: 1332) account for approximately 70% of the market. Needless to say, competition is intensifying, and Dairei is facing some difficulty expanding share.

Meat

Dairei is expanding its meat business. As with the boneless fish lineup, much of the meat lineup is frozen. Here are a few examples of recipes using “Rakuraku Takumi” branded meat products:

Source: Company website

Interestingly, the controlling shareholder of Dairei is Koji Furuta (through personal and family fund, about 52% stake). The Furuta group controls Furuta Foods (private), the market share leader in American style corn dogs in Japan. Additionally, the group controls Sekitei Foods (private). I wasn’t able to find/access the root source, but according to the internet (2011) (Japanese), Furuta has about an 80% share in American style corn dogs in Japan. Furuta Foods and Sekitei Foods are the partnered food processor for this product, along with several others in the meat category.

Other

In its annual filings, Dairei explains that its Other products mainly consists of products suggested by partnered food processors. This includes a variety of products from frozen value-added products to frozen seafood/vegetables (which have little added value in terms of processing). The low-value-added products are essentially a commodity and profitability is heavily affected by market price (and currency exchange). Thus, Dairei intends to strategically decrease its exposure to low-value-added products.

Dairei Operations

Dairei got its start in 1972, originally focusing on fish fillet and eventually developing its boneless fish business. After making unsuccessful attempts at expanding its product line in the 1990s, the company faced insolvency in 2001. This is when the Furuta group started getting involved. In 2003, Osamu Saito (the current CEO) was appointed by Furuta to lead restructuring efforts.

With the help of all stakeholders as well as new capital injection from the Furuta group and the current Tablemark (private), Dairei survived. Osamu focused the company’s efforts on boneless fish and shifted to a fabless business model. This proved successful and Dairei IPOd in 2014, listing its shares on the second section of the Tokyo Stock Exchange. In 2016, it successfully completed a section transfer, listing its shares on the first section.

The company’s efforts over the past several years mainly revolved around reinventing its corporate image from “the boneless fish Dairei” to “Rakuraku Dairei” (rakuraku = effortless). This shift is particularly visible in its recent product lineup, which is focused on frozen-to-cook products. About 60% of these products are produced outside of Japan, with Chinese partners accounting for about half of the foreign production.

Recent Issues

Most recently, Dairei was hit with a warning by the Fair Trade Commission (FTC) that some of Dairei’s business practices were in violation of the Subcontract Act. More specifically, for partnered food processing companies developing Dairei-branded products, Dairei was charging quality control supervision, technical development supervision, and claim support fees. Additionally, the transaction fees associated with the payment of these services were charged to the partnered companies. The FTC determined that these practices were in violation of the Subcontract Act, as the fees should be included as a part of the purchasing contract terms.

Dairei processed refund payments totalling approximately 470 million yen ($4.3 million USD), or about 37% of its 2017 operating income, to its partners on March 30, 2018, upon issuing its disclosure statement related to the matter (Japanese source). As of March 1, 2018, the company no longer charges these fees.

In the short form financials, management notes the intensifying competition in the boneless fish business. It also mentions that the company has been competing by reducing its sale price. Though this is traditionally frowned upon in the investment world, I believe near term price reduction may be a viable solution for Dairei, given the boneless fish market’s small size and Dairei competitors’ large scale. The effects of the price decrease can already be seen in the operating margin decline from 6.3% in fiscal 2014 down to 4.2% in fiscal 2016. Margins recovered a bit in fiscal 2017 to 4.7%, then dropped to 3.1% in fiscal 2018 (due to FTC issue). Adjusted for the 470 million yen refund, operating margin would be around 4.8%.

Boneless fish processing requires considerable domain expertise and is still a labor intensive process. Additionally, Dairei has an efficient model already established. That is, after the deboning process, the processor is left with: out-of-spec material and fish bones (with some meat left). In food processing, making use of this “waste” is a big part of improving cost efficiency. According to a 2013 interview with Seisho Foods, a Dairei partner producing boneless fish, just about 100% of the fish is being used. Bones are made into feed and the remaining meat is used as processed fish meat.

To be sure, it wouldn’t be difficult for Dairei’s larger competitors to figure out how to use the “waste”. It is highly likely that the competitors already have a similar approach with other variations of processed fish products. The difficult part to replicate would be Dairei’s expertise in boneless processing. Moreover, the smallest among Dairei’s publicly traded competitors is Kyokuyo, which booked fiscal 2018 revenues of 255 billion yen ($2.34 billion USD), or about 9 times Dairei’s total revenues and 5 times the domestic boneless fish market size. Dairei is considerably more “right-sized” than its large competitors for boneless fish processing. Hence, driving out big competition through near term price reductions may prove effective in the long run.

The bigger threat is likely the continued increase in Chinese labor costs. The 2013 Seisho Foods interview briefly touched on this subject, mentioning that labor rates increased about 3 fold over the last 10 years. I heard the same statement being made during my visit to three Chinese seafood processing facilities in November 2017.

Valuation

Still, price reductions means margin compression unless cost efficiency is improved. Dairei has made efforts to consolidate its delivery network in Japan, reducing its previously 10 inventory stocked facilities down to 6 (~2015). Each location stocks about 100 million yen ($915k USD) in inventory, so the consolidation effectively reduced inventory by 400 million yen ($3.67 million USD).

With this context, historical operating margins has floated around 4-7%, with the clear exception of fiscal 2018 (FTC Subcontract Act issue). Just as the FTC suggested, I think it is fair to assume that Dairei’s “management fees” will be negotiated as a part of the purchasing contract and continue without significant impact on business performance.

Dairei maintains a healthy, debt free balance sheet and has remained consistently free cash flow since going public in 2014. The equity to asset ratio is 0.64, and depending on how we define what a normalized operating income would look like, the EV/EBIT ratio today is between 7 and 11. For a small company like Dairei, this is a bit on the expensive side (in Japan) even taking the low end of the range.

Management is guiding 27,400 million yen ($251 million USD) in revenues and 1,100 million yen ($10 million USD) in operating income. This puts operating margins at 4% and EV/EBIT multiple at 8.4. Management plans on maintaining its 55 yen per share dividend payout, which would give Dairei stock a solid dividend yield of 2.76% at May 11, 2018 closing price of 1,996 yen per share. I think Dairei is currently fairly valued, but would be interesting if share prices dropped below 1,600 yen per share (3.4% dividend yield, 6x EV/EBIT).

Bottom line

Dairei is a healthy company delivering solid operating performance. Recent competitive pressures are dragging down the profitability of boneless fish products, Dairei’s key product line. Given the company’s “right-sized” competitive position in the niche boneless fish industry, and Dairei competitors’ much larger scale, near-term price competition ought to drive out some of the competitors. At today’s price of 1,996 yen per share, Dairei stock is fairly valued with a EV/EBIT multiple between 7 and 11, and a dividend yield of 2.76%. If prices go below 1,600 yen per share, Dairei would provide an attractive value proposition for investors.


Kenkyo Investing
Kenkyo Investing

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