Thinking Points

  • Original Engineering Consultants (TSE: 4642) is a healthy construction consulting company specialized in water works.
  • In the several years leading up to 2012, the company recorded operating losses. The founder and leading shareholder replaced the CEO with his son-in-law in 2012, and the company has managed to deliver positive operating performance since.
  • With the state of Japan’s water systems and the founding family reassuming management roles, the company’s future prospects are positive.
  • At today’s 973 yen per share price, OEC trades at 1.1x EV/EBIT. Adjusting for a recent large scale share repurchase, investment security holdings, and stock options, the company trades for 2.2x EV/EBIT.
  • Investors can expect a three year investment CAGR of between 5.4% and 15.6%.

Introduction

Original Engineering Consultants (OEC, TSE: 4642) is a construction consulting firm specializing in water supply and drainage related design and engineering. The company is single segment operation, but categorized revenues into two categories: Construction consulting and information processing.

Source: Company filings


OEC’s recent history has been eventful. After a period of losses, the founder voted the CEO out and placed a family member as CEO (2012). The company has remained profitable since. More recently, the founder effectively transferred shares to a family fund, and the company subsequently conducted a large scale share repurchase program.

The business & environment

Over the last few years, water works has been a hot topic in Japanese media, with 15% of water pipes across the nation outliving its 40-year useful life as of 2016. In late 2018, the Japanese Diet passed an amendment to the Water Supply Act, effectively enabling privatization of water works. This happened despite the global trend of re-municipalizing control in parts of France, US, and Germany, for example.

Whether water works is privatized or not, the Japanese water system needs more investment. To that extent, the macro favors OEC. The national budget for water facilities maintenance over the last ten years are below:

Source: Federation of Japan Water Industries (FJWI), Ministry of Health, Labour, and Welfare (MHLW)


OEC primarily offers construction consulting services including survey, planning, design, and construction management for water related works. Additionally, the company offers asset lifecycle management software development and maintenance through its information processing business.

As CEO Nobuhiko Suga puts it, the industry is facing a major shift from building water systems to maintaining an already built system. The company does not split out revenues by new build/maintenance work, but here is how the current revenue categories have performed historically:

Source: Company filings


Unlike the private sector, where events like the global financial crisis of 2008-2010 tend to affect business performance, water works is largely dependent on the national budget. Historically, 95+% of OEC revenues have been government related:

Source: Company filings


What’s interesting about OEC’s business performance is that the company has managed to grow revenues between 2012 and 2017 despite the historically lower national budget levels. More importantly, 2012 was a key turning point for OEC as the company’s founder, Osamu Suga, effectively kicked the CEO out and placed his son-in-law in the role.

Prior to 2012, the company’s performance was unstable, recording losses in 2008, 2009, 2011, and 2012. Since Nobuhiko Suga, the founder’s son-in-law, took the CEO position, the company has remained profitable. With that said, there isn’t a particularly obvious shift in strategy to OEC’s now profitable strategy.

In any case, the outlook for the company’s future performance appears healthy for two main reasons: An increasing national budget and an overextended lifecycle for the Japanese water system. Although government involvement can slow down the rebuilding & maintenance process, increased workloads for OEC is a highly likely eventuality.

Unlike many Japanese companies with a fiscal year end in March, OEC’s fiscal year ends in December. As of this writing, 2018 results are not in yet. For fiscal 2018, the company guided for 6,400 million yen ($58.2 million USD) in revenues and 900 million yen ($8.2 million USD) in operating income.

During the first three quarters of fiscal 2017, however, the company reported 4,810 million yen ($43.8 million USD) in revenues and 912 million yen ($8.3 million USD) in operating income. Often times with Japanese construction companies, the first six months of the year are the busiest as the Japanese government operates on an April to March budget calendar. The fourth quarter (ending December 31st) typically either comes in marginally profitable or with light operating losses for OEC. It’s highly likely that OEC will either meet or beat its guidance for 2018.

Shareholders

As of Q3 fiscal 2018 (ending September 30th, 2018), OEC had 7,796,800 shares issued and 1,026,965 shares in treasury, putting outstanding shares at 6,769,835. With that said, the company conducted a 1,000,000 share repurchase program (12.83% of issued shares) between December 6th, 2018 and January 24th, 2019. The repurchase price was 1,000 yen per share, a 1.52% premium to the company’s closing share price of 985 yen on December 5th, 2018 (one day prior to announcement).

Here are the major shareholders:

Source: Company filings, Nikkei, Market Screener, Kenkyo estimates


The Suga family owns Mizu Infra, the parent company of Tokyo Specs.  Between November 6th and December 4th of 2018, Tokyo Specs acquired 1,470,535 shares through a discounted tender offer (850 yen per share) from Osamu Suga. This was effectively a means of transferring shares from Osamu’s personal account to the Suga family’s fund. Combined with Tokyo Specs prior holdings, the Suga family fund owns 35.1% of outstanding shares.

There are currently 42,000 unexercised stock options given to management in 2015. The shares became exercisable as the company met financial targets (above 5,500 million yen in ordinary income for 2017).

Financials & Valuation

  • Original Engineering Consultants is a financially healthy construction consulting firm specializing in water works.
  • With the overextended lifecycle of the Japanese water system, OEC’s future business prospects are positive, although the government’s move for privatization may be a cause for delayed projects.
  • Even with the recent 1,000,000 share repurchase, OEC would have net cash equivalent to approximately 37% of its current market cap of 6,587 million yen ($59.9 million USD).
  • At today’s 973 yen per share price, the company trades at an unadjusted EV/EBIT multiple of 1.1 on a trailing twelve month basis. Adjusted for cash (net of buybacks), investment security holdings, and guided EBIT, this multiple would be 2.2.
  • Investors can expect an investment CAGR of between 5.4% and 15.6% over the next three years.

Original Engineering Consultants is a well-established, financially healthy construction consulting firm specializing in water works. In the few years leading up to 2012, the company’s business performance suffered despite relatively high levels of the Japanese government’s water facilities maintenance budget. The founder and leading shareholder, Osamu Suga, took action by effectively removing the then-CEO and putting his son-in-law as a replacement.

In the few years following the change in management, OEC’s business performance steadily improved despite historically lower levels of water facilities maintenance budget. More recently, however, the Japanese government has been increasing the budget, and OEC is well-positioned to take advantages.

There are risks too, with regulations allowing privatization of water works already in place. Overall, given the state of Japan’s overextended water system, the near to medium term outlook for OEC’s business prospects are positive as the system will need heavy reconstruction and maintenance regardless of whether it is government operated or privately operated.

OEC is light on assets, with 58% of total assets in the form of cash and equivalents (adjusted for buybacks & investment securities). Its net cash position has been increasing over the last five years as well:

Source: Company filings, GuruFocus, Kenkyo estimates (2018 adjusted figures)


At today’s 973 yen per share price, OEC trades at a 1.1x EV/EBIT multiple. Adjusted for share repurchases, investment security holdings, and guided EBIT, the company trades at 2.2x EV/EBIT. To be sure, the company’s operating income is at recent highs:

Source: Company financials, GuruFocus


Taking the five year average of operating income, current EV/EBIT would come out to 3.6x. Given OEC’s scale, a multiple of between 3 and 6 should be fair. Put another way, the investor’s downside is largely protected in the event that operating performance declines. With talks of industry privatization, this can happen, especially if projects are held during transition. Overall, however, the near to mid term outlook of OEC is positive.

Assuming operating income of 500 million yen ($4.6 million USD) per year over the next three years and a fair value EV/EBIT multiple of 3x, OEC’s share price should come out to 1,140 yen per share inclusive of dividends. This would be equivalent to a three year investment CAGR of 5.4%.

If 2017-level performance carried out over the next three years and a fair value EV/EBIT multiple of 3x, OEC’s share price should be worth 1,500 yen per share inclusive of dividends. This would be equivalent to a three year investment CAGR of 15.6%.

The bottom line

Original Engineering Consultants is a healthy construction consulting company specialized in water works. With the state of Japan’s water systems and the founding family reassuming management roles, the company’s future prospects are positive. At today’s 973 yen per share price, investors can expect a three year investment CAGR of between 5.4% and 15.6%.


Kenkyo Investing
Kenkyo Investing

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