Headquartered in Japan, Kyocera (KYO) manufacturers a broad range of ceramic-based products as well as other technology-oriented devices and equipment. The company manufacturers the majority of its products in Japan and other parts of Asia and is operated in seven operating segments plus a corporate segment.
In terms of income before tax, the largest of Kyocera's segments is Semiconductors, which consists of ceramic products used as packages and substrates for integrated circuits. A semiconductor package is essentially a casing which permanently protects the circuit. The second largest segment is Electronic Devices, which includes such devices as specialty LCDs, touch panels and a variety of electronic componentry, some using ceramics. Information Equipment is the third largest segment and comprises the company's printer and copier business. While profitable, the segment's market share is quite small compared to the leaders in the space.
Fine Ceramics and Applied Ceramics are both similarly sized and consist of products such as semiconductor manufacturing equipment, sapphire crystal wafers used for substrates and, other products such as fishing equipment, valves, medical implants and various types of industrial machinery. In addition, the company is a major manufacturer of solar panels and systems, the results of which are included in Applied Ceramics.
Kyocera produces CDMA mobile handsets under the Telecommunications segment, primarily for use in Japan and the United States. The company is currently transitioning from phones based on the CDMA technology to LTE. The Other segment comprises a number of smaller products such as insulation as well as the company's real estate business. The Corporate segment primary consists of the earnings on Kyocera's considerable holdings of cash and, short- and long-term investments.
Kyocera's revenue has been relatively flat since fiscal 2006 ending March 31, but operating and net income have grown at annual compounded rates of 4.6% and 7.6%, respectively. Income was down substantially in 2009 due to the recession with the profit recovery in 2010 driven by cost savings and in 2011 by a recovery in business conditions in virtually every segment. Profit has decreased in the TTM period due to significant weakness in solar panels as well as in the Electronic Device segment.
Analyst estimates for 2012 and 2013 call for about JPY 80,000 million of net income which is similar to the average profit from 2006 to the TTM period. Kyocera's profit has been quite volatile since 2006; therefore, average profit is likely a good representation of long-term profit potential.
Based on a little over JPY 80,000 of net income, returns on capital at the company are quite a bit below the cost of capital, even after adjusting for the very significant amount of non-operating assets on the company's balance sheet. Those assets are primarily cash, short-term investments and public equities which generated over JPY 14,000 million of income in the TTM period. Japanese companies are rather more difficult to estimate returns on capital for given differing accounting rules but considering the magnitude of the difference between returns on and cost of capital, it is highly likely that the company is destroying value.
Valuation is quite reliant on how the company's extensive non-operating assets are handled. The projected fiscal year ending March 2012 PE is about 16x before considering these assets. Based on the operating earnings and market capitalization less non-operating assets, the PE falls to about 7.2x. This seems quite cheap but there are two problems.
First, there is little reason to believe the company will ever distribute any of the excess non-operating assets to shareholders. This does not make them worthless, but the value to shareholders is probably somewhat less than market value. More importantly, the company's returns on capital are below the cost of capital which implies the company is currently destroying value on a yearly basis. With the company's returns on capital at about half the cost, the justified PE ratio would be about half of that compared to a company earning at least the cost of capital. In Japan that PE is about 15x for a no growth firm, or 16-17x for a company growing at about the pace of the economy. These factors shed some light on the company's relatively cheap looking valuation.
What makes Kyocera interesting from an investment perspective is the restructuring opportunity. While I do not expect changes to come in the near future, it is likely that an increasingly strong yen and growing frustration over the economy will at some point create a ripe environment for a fundamental shift in corporate Japan. In my view, a tremendous amount of value is tied up in certain Japanese companies such as Kyocera which could be released by the divestiture of non-operating assets and subsidiaries earning low returns. Even incremental change could unlock value in Kyocera's shares if the company can improve returns to a more normal rate.