Thinking Points

  • Kitano Construction (TSE: 1866) is a healthy mid-tier general contractor based out of Nagano prefecture, a remote area of Japan.
  • The company grew by supporting Tokyo’s post-war reconstruction efforts. Today, it maintains an office in Tokyo while remaining the largest general contractor in Nagano.
  • Over the last several years, the company posted “super margins” alongside industry peers, delivering healthy business performance. But recent shareholder dilutive action is a concern.
  • At 3,115 yen per share, Kitano Construction trades at an adjusted 0.4x EV/EBIT with a market cap of 19,350 million yen ($173 million USD).
  • Assuming operating margins fall back to historical norms (1~3%) and Kitano management does not take further action resulting in minority shareholder dilution, investors can expect an investment CAGR of between 3.9% and 12.3%, inclusive of dividends, over a 3 year period.

Introduction

Kitano Construction (TSE: 1866) is a mid-tier general contractor based out of Nagano prefecture, a remote area of Japan where it is the largest construction contractor. In addition to construction, the company operates hotels, a country club, and an advertising agency.

Source: Company filings


Some investors may have noticed Kitano Construction’s high dividend yield (3.2% at 3,115 yen [Apr. 15, 2019]) and record-level 1,009 million yen ($9 million USD) share repurchases in 2018. A closer look, however, raises red flags, as the bulk of repurchased shares are effectively donated to a newly setup foundation controlled by the Kitano family.

The business & environment

Kitano Construction’s roots can be traced back to a silk reeling company back in 1887, founded by current Kitano Construction CEO Takahiro Kitano’s grandfather in Nagano. After silk prices declined dramatically, the company switched to construction material manufacturing.

Tsuguto Kitano, the second generation CEO of Kitano Construction is responsible for building the company into what it is today. Shortly after World War II, Tsuguto started the construction arm of the company, rebuilding a war-torn Tokyo.

An enterprising individual, Tsuguto proceeded to open Japan’s first apartment hotel in 1964, separate from Kitano Construction. In 1973, the company purchased the Murray Hotel on Park Avenue (New York) from the Rockefellers. After 55 million dollars in renovations, the hotel reopened as The Kitano.

As a Kamikaze pilot during World War II, Tsuguto had lost many friends in various parts of the world. A 2016 Nikkei article (Japanese) published shortly after his death described that, from this experience, Tsuguto had strong feelings toward international contribution, leading to various construction projects all over the world.

Current CEO Takahiro Kitano took over the company in 2007 in what can only be described as a messy transition. After the shareholder meeting in June of 2007, a board meeting was held where an emergency resolution to have Tsuguto’s eldest daughter’s husband Takehiko Yamaguchi as CEO was put into motion, surprising stakeholders.

As it turns out, Takehiko effectively removed Tsuguto from the CEO post, noting that Tsuguto wasn’t fit for the position having suffered a stroke and hearing loss. Tsuguto proceeded to increase his stake in the company, putting his son Takahiro in the CEO post a month later and maintaining a director position himself.

In 2008, after the dust settled, Takahiro removed Tsuguto from the director position, leading to the Kitano Group splitting into two: Kitano Construction led by Takahiro and the Kitano Arms (apartment hotels), The Kitano Hotel New York, Kitano Museum and Kitano Culture Center led by Tsuguto and Kako Koike (Tsuguto’s second daughter). Tsuguto passed away in 2015.

As far as Kitano Construction is concerned, its construction and development works have accounted for 90+% of revenues for over a decade. The company owns hotels, a country club, and an advertising agency as well, which collectively turn a trivial amount of profit, but the rest of this report will be focused on the construction business.

What’s particularly interesting about Kitano Construction is its high level of private sector construction projects compared to government-related projects:

Source: Company filings


Much like the rest of the construction industry, Kitano Construction has a history of normalized 1 to 3% operating margins, which then expanded to 5+% “super margins” over the last several years.

Source: Company filings, compiled by Kenkyo Investing


Here are the industry average figures presented by the Japan Federation of Construction Contractors:


Source: Japan Federation of Construction Contractors (Japanese), translation by Kenkyo Investing


Here is Kitano Construction’s historical order book:

Source: Company filings, compiled by Kenkyo Investing


At first glance, business appears to be slowing down. With most Japanese companies on a April-March budgeting cycle, however, projects are often signed off in the last three months of the cycle (Q4 for Kitano Construction). In other words, it’s too early to tell whether work is actually slowing down for Kitano Construction.

For fiscal 2019, the company originally guided for 80,000 million yen ($714 million USD, -4.5% YoY) in revenues and 3,100 million yen ($27.7 million USD, -36.6% YoY) in operating income. This was adjusted to 77,500 million yen ($692 million USD, -7.5% YoY) in revenues and 4,300 million yen ($38.4 million USD, -12% YoY) in operating income in February 2019.

Shareholders

As of Q3 2019 (ending December 31st, 2018), Kitano Construction had 6,836,853 shares issued and 1,343,654 shares in treasury, putting outstanding shares at 5,493,199 shares. In the major shareholder list below, however, outstanding shares is calculated at 6,293,199 shares, which will be explained in further detail shortly.

Here are the major shareholders:

Source: Company filings, Nikkei, and adjustments by Kenkyo Investing


During fiscal 2018, Kitano Construction spent 1,009 million yen ($9 million USD) repurchasing shares. In fiscal 2019, the company went further, spending 1,990 million yen ($17.8 million USD).

Source: Company filings, compiled by Kenkyo Investing


On March 14th, 2019, the newly founded Kitano Foundation became the largest shareholder after purchasing 800,000 shares from Kitano Construction at 10 yen per share (Japanese). As a reference, the average repurchase cost per share (split-adjusted) from the above chart is 3,980 yen. To be sure, this transaction was proposed by the board and approved at the 2018 general shareholder meeting. Still, it effectively gives the Kitano family increased ownership and influence while diluting minority shareholders’ stakes, raising corporate governance concerns.

Interestingly, Hachijuni Bank (TSE: 8359), the #5 shareholder on the list above, financed the transaction for Kitano Foundation.

Financials & Valuation

  • Kitano Construction is a healthy mid-tier general construction contractor based out of the remote area of Nagano prefecture.
  • The company grew by supporting Tokyo’s post-war reconstruction efforts. Today, it maintains an office in Tokyo while remaining the largest general contractor in Nagano.
  • Over the last several years, the company posted “super margins” alongside industry peers, delivering healthy business performance. With that said, recent shareholder dilutive actions is a cause for concern.
  • At 3,115 yen per share, Kitano Construction trades at an adjusted 0.4x EV/EBIT with a market cap of 19,350 million yen ($173 million USD).
  • Assuming operating margins fall back to historical norms (1~3%) and Kitano management does not take further action resulting in minority shareholder dilution, investors can expect an investment CAGR of between 3.9% and 12.3%, inclusive of dividends, over a 3 year period.

Kitano Construction has a long history and a strong presence in the Nagano area. Originally starting out as a silk reeling company in 1887, the company grew into what it is today by supporting Tokyo’s post-war reconstruction efforts.

The company’s performance is much in-line with industry peers of similar size. Normalized operating margins tend to range between 1% and 3%. Over the last several years, however, operating margins have been strong at 5+%, a trend seen in the construction industry.

Much like other established construction companies, Kitano Construction owns land. With a mix of subsidiaries and small-scale hotel operations, however, it’s difficult to estimate whether the book value of this land reflects market prices.

At 3,115 yen per share, Kitano Construction trades at 1.6x EV/EBIT with a market cap of 19,350 million yen ($173 million USD). Adjusted for investment securities, the company trades at 0.4 EV/EBIT. Assuming operating margins fall back to historical norms (1~3%) and Kitano management does not take further action resulting in minority shareholder dilution, investors can expect an investment CAGR of between 3.9% and 12.3%, inclusive of dividends, over a 3 year period.

The bottom line

Kitano Construction is an operationally healthy mid-tier general contractor. The company grew into what it is today by supporting Tokyo’s post-war reconstruction efforts, eventually making it the largest general contractor in Nagano. Over the last few years, the company, along with industry peers, has enjoyed a period of “super margins”. But Kitano management, after two years of record-level share repurchases, effectively donated the bulk of treasury shares to Kitano Foundation, a foundation controlled by the Kitano family. Assuming operating margins fall back to historical norms (1~3%) and Kitano management does not take further action resulting in minority shareholder dilution, investors can expect an investment CAGR of between 3.9% and 12.3%, inclusive of dividends, over a 3 year period.


Kenkyo Investing
Kenkyo Investing

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