Daniel Loeb Comments on IHI Corporation
IHI is a mid‐cap Japanese conglomerate exposed to three big themes: commercial aerospace, automotive fuel efficiency, and Abenomics‐led real estate reflation in Tokyo.
Over the past few years, Third Point has successfully invested in numerous companies in the commercial aerospace sector. While air travel has grown historically at ~2x GDP, increasing fuel costs – which account for roughly 40% of cash operating costs for airlines – are driving the decision to upgrade to new, more fuel‐efficient planes. A substantial increase in air travel by new fliers in emerging markets is also expected to drive demand for new aircraft in coming decades. Today, emerging market‐focused airlines account for more than 2/3 of global aircraft orders while representing only 1/4 of the global fleet.
As the leading Japanese jet engine manufacturer, IHI partners with engine OEMs like GE, Pratt & Whitney, and Rolls Royce to design engine platforms to power best‐selling airplanes like the A320, A320neo, B787, B777, and B777X. IHI's focus on quality, safety, and on‐time delivery has resulted in it consistently increasing its share of key engine programs in new airliners. We believe we are investing in IHI at an attractive price because the market assigns an undeserved conglomerate discount to it.
In one of its two key segments – aerospace and defense – IHI's margins will expand as its commercial installed engine base grows, driven by spare parts sales which will provide the company with a long‐tailed, high‐quality, dollar‐denominated annuity stream. We expect IHI's spare parts business to grow volumes by over 10% annually for the next few years while achieving average annual price increases of 5% in dollar terms on a predominantly yen‐denominated cost base. With spare parts incremental margins of well over 50%, IHI's jet engines business' earnings are set to grow dramatically despite significant R&D investments in new platforms.
The second key business in IHI's portfolio that offers both growth and high returns is vehicular turbochargers. In this business, IHI is a global #3 (after Borgwarner and Honeywell). IHI's superior engineering capabilities and willingness to develop bespoke solutions for auto OEMs has led it to outgrow the industry and gain market share. As the internal combustion engine faces increasingly stringent government mandates for reduced fuel consumption and CO2 emissions, we expect widespread turbocharger adoption, enabling IHI to grow topline in the high teens while closing some of the margin gap to its main competitors. We also expect growth emanating from Chinese demand thanks to IHI's strong relationships with European OEMs like Volkswagen, Fiat, and Daimler.
While these two segments account for two‐thirds of IHI's earnings, the company is involved in many other engineering businesses – from the manufacturing of boilers and turbines to LNG terminals and tanks – which impact its market perception disproportionately.Throughout the years, the results from these many small businesses have ranged fromacceptable to horrible, thus explaining the conglomerate discount applied by the market. IHI is also regarded warily by investors because management shocked investors in 2007 with an announcement of large cost overruns in its energy division. Nearly half of thecompany’s market cap was wiped out. This prompted management change and anincreased focus on project risk management and capital allocation, includingdeconsolidating its shipbuilding operation. We think the changes have been positive andthe company should no longer be punished for 2007’s mistakes.
Finally, IHI has another significant asset – valuable non‐core real estate. The companyowns a large land bank in Toyosu, a central district of Tokyo located in the vicinity of the 2020 Tokyo Olympic village. The company also owns large office buildings and retailfacilities built on the land and is in the process of further development work. IHI listed thebook value of its real estate to be ¥252 billion as of March 2013. Third Point commissionedtwo independent appraisals of the land bank and buildings and concluded the value to becloser to ¥350 billion, or over 50% of IHI’s current market capitalization.
Should management decide to spin off the property into a separate company that couldachieve substantial financial leverage for redevelopment purposes (hotels, condos, andoffice buildings in Toyosu and a modern logistic park in Koto ward), the company wouldrealize enormous value for shareholders. As property values rise and rental incomeincreases, IHI will be able to reduce its participation in the listed real estate company andreinvest in its jet engines and turbochargers segments.
We see the intrinsic value of IHI at more than ¥1000 per share, well above where the stocktrades today. IHI’s path to value could be substantially streamlined if management were tochoose to increase its focus on its high return segments and continue its move away from the suboptimal conglomerate structure of the past.
From Daniel Loeb (Trades, Portfolio)'s Third Point 2014 First Quarter Letter to Investors.