Sugimoto Shoji is a trading company focused on measurement devices and equipment and tools, as well as consumables for them. They have a decentralized model, with individual sales offices focused on different geographical areas being responsible for their own profit and loss, and making their own decisions on business development. This is quite rare amongst Japanese companies, which tend to be managed top-down in the way similar to a government ministry, and with just as much bureaucracy. About 90% of their sales are in Japan.
What do Japanese trading companies do?
At this point, you may be asking "what is a Japanese trading company?" A trading company in Japan is basically a jack of all trades, something like Goldman Sachs without a Bloomberg terminal, getting involved in areas ranging from food retail to oil field development (notably Mitsui). They get involved in anything that seems to be profitable, particularly involving import, export, and trade finance, and they are essentially well-connected middlemen with access to relatively cheap financing from banks, who they tend to be very good friends with. Connections are the name of the game, and trading companies have lots of them. The largest trading companies are the well-known names of Mitsubishi, Sumitomo, Itochu, Mitsui and Marubeni.
The advantage to investing in this kind of company is that many of them will not go bust under almost any circumstance, due to their connections with unbreakable banks. And, conversely, the disadvantage is that you might not know what they are up to, because they tend to have a dense wave of overlapping interest with other companies.
Does difficult to analyse mean easy to ignore?
Most people will walk away from a balance sheet that they do not understand. However, it is also true that everything (excluding derivatives) is worth buying at a certain price. If I gave you control of a trading company for free, would you take it? Many trading companies are net-nets, as is Sugimoto.
From a valuation standpoint, a trading company will have related company debt and equity on its balance sheet, so how to handle investment assets is an issue. My approach for assets is to only take current assets and investments into consideration, mark at market the investments with market values given in the notes to the accounts, and halve the rest. Also, for trading companies I assume that their inventories are worth 25 cents on the dollar. For liabilities, I assume that there will be some off-balance sheet liability somewhere, such as an underfunded pension, and go through the notes to the accounts to find it.
Looking at Sugimoto's balance sheet
I have used the company's last annual report, taking deposits valued at market value given in the notes to the account (about 45 B yen lower than the value on the balance sheet). Within investments, there is 1.5 B yen of debt held to maturity, but this is being marked to 50% in our valuation anyway.
I used the latest Q for the balance sheet numbers, but looked at the last annual report for accounting details.
Notes receivable: As of the last annual report, the largest three counterparties owed Sugimoto 81 M yen, 57 M yen, and 41 M yen, so the 4.2 B yen of total notes receivable is spread out over a large number of counterparties. All the disclosed notes receivable counterparties are machinery companies. About 3 B yen of the 4.2 B yen is due within six months.
Accounts receivable: As of the last annual report, the largest three counterparties owed Sugimoto 315 M yen, 124 M yen, and 83 M yen (total was 5.4 B yen).
Inventories are measuring device and various tools, which we take 25% of in our valuation.
In the last annual report, they had a 5 B yen pension deficit not on their balance sheet. Much of this was due to the movement in asset prices (down) over the last few years.
The company made an operating loss in 2010, but turned it into a net profit due to non-operating income, however, considering that they are massively exposed to the capital expenditure cycle, the small operating loss was quite good relatively speaking.
The shares are lower now than in 2009.
The top three owners are all called Sugimoto. Expect no unnecessary transparency here.
Trading company valuations
For comparison purposes, here are some stats on the major trading companies in Japan:
Interestingly, Sugimoto is larger in market cap and net income than the well-known general trading companies. Some people may say that it should be at a discount to Mitsui et al due to less access to financing. I say to that - are you kidding me? What do they need the financing for? They have 19 B yen in current assets, of which 5.9 B is in cash. I can accept that there is a tail risk of a really bad depression, much worse than '09, in which nearly all their customers go bust. But what is the likelihood of that? Remember, in that scenario it needs to be so bad that the company will get through all of its 5.9 B yen of cash (vs. 4.7 B yen in total liabilities) and not collect any of its 10 B yen in receivables from a myriad of small companies that depend on it for their business.
So, anyway, we can look at this in one of two ways: we can apply various discounts to items on the balance sheet, assign a value to their free cash flow, and then see how much of a discount that appears to be from their market; or, we can assume that the market is efficient and reverse-engineer the valuation to see what kind of damage to the balance sheet it is expecting.
This approach gives us a market In excess of the bankruptcy value of about 2.2 B yen, for a company with a free cash flow of about 0.5 B yen. This gives us a free cash flow yield, assuming bankruptcy (which is a fantasy, actually, in Japan-more about that elsewhere) of 25%, and a downside to bankruptcy value of about 27%. You can apply your own estimate of a realistic free cash flow yield in a 1% interest rate environment to generate your own results (hint: you should value 0.5 B yen of cash flow at higher than 2.5 B yen).
Let us assume that a realistic free cash flow yield for this company is 10%. This would imply a value of 56 B yen for the free cash flow, which you can add to the 6 B yen of bankruptcy value, to get a value of 62 B yen. Using 15% gets you to 37 B + 6 B = 43 B yen. Play around with it.
There will be people saying that China is going to implode, causing the demand for this company's products to disintegrate, and that may be true. However, it is worth noting that in 2009 the company did eke out a net profit.
Clearly, not everyone is scrambling to get into the shares of this company. It is controlled by insiders, and you can assume that the company will never be taken over. Does this mean that a bankruptcy-based evaluation approach is not suitable? Perhaps, but that is a slightly philosophical question. For me, I would rather look at companies with a higher growth in net assets per share and with more diversified business model, even if they are slightly more expensive. Actually, I should also mention that the volatility in their pension asset liabilities implies that the quality of the assets in their pension fund could be a cause for concern. Having said that, the bankruptcy valuation is fairly conservative, and buying half 1 B yen of cash flow for 2.5 B yen is not a terrible deal.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.