Get Paid to Wait With Daihatsu Diesel

Troubled shipping industry

Not long ago, the shipbuilding industry fell apart. This particularly affected the Korean shipbuilders. What started with the collapse of Hanjin Shipping (HKSE:117930, Financial) cascaded down to major Korean shipbuilders like Daewoo Shipbuilding (XKRX:042660, Financial), Hyundai Heavy Industries (XKRX:009540) and Samsung Heavy Industries (XKRX:010140). These companies were all in financial distress as industry-wide new build orders for 2016 came in below financial crisis levels.

Source: Daihatsu Diesel 2017/3 Earnings Presentation

According to data from The Shipbuilders’ Association of Japan, the industry does not look like it is sailing toward recovery yet, with only 4.95 million tons of orders received worldwide in first-quarter 2017. Annualized, this is 19.8 million tons, which is slightly better than 2016’s 18.8 million tons. In comparison, the industry saw 33.6 million tons of orders in 2009.

Now, it is not like companies can order ships and have them delivered tomorrow. Shipbuilding often comes with long lead times. This means a decline in 2016 new orders can affect shipbuilders and affiliated companies into 2017 and 2018. In other words, there is a real chance companies involved in the shipbuilding industry have not felt the full extent of the pain just yet.

Daihatsu Diesel and its shifting business model

With this context, I would like to introduce Japan’s Daihatsu Diesel Manufacturing Co. Ltd. (TSE:6023, Financial). Daihatsu Diesel builds combustion engines for ships. On the surface, there is not a whole lot to be excited about with this company. For starters, revenue and gross profit have gone nowhere over the past 10 years:

However, Daihatsu management’s focus has shifted. Ten years ago, the company was building engines for ships. Today, the company still builds engines for ships, but also captures more after-sale service revenues. Investors familiar with the car and truck dealership model would be familiar. These companies do not make a whole lot of money on selling cars and trucks. The bread and butter is service and maintenance. It is not uncommon to see service parts and maintenance making up a third of revenues and two-thirds of gross profit. AutoNation (AN, Financial) and Rush Enterprises (RUSHA, Financial) (RUSHB, Financial) are educational companies to look at in this regard.

To be sure, Daihatsu Diesel is not a dealership, but it shares similar characteristics. Part of the reason for service parts and maintenance generating high margin revenues is because downtime of assets can be incredibly expensive. Trucks only make money when they are hauling a load. The same deal applies to ships.

According to Daihatsu Diesel’s 2017 third-quarter earnings presentation, after-sale service delivered revenues of 24 billion yen ($214.5 million), compared to 15 billion yen 10 years ago (9% CAGR). It is no secret shipbuilding is a cyclical industry as margins tend to be dependent on production levels. With few new orders coming in, asset utilization and operating margins decline:

What a normalized environment might look like

It might be strange to figure out what a “normalized” environment looks like for a largely choppy, cyclical industry. Given the downturn and Daihatsu’s shifting business model, however, having a rough idea of an OK year in the shipbuilding industry will clarify the effects of Daihatsu management’s efforts over the past 10 years.

Daihatsu Diesel does not break out gross profits for after-sale services. A mid-term business plan presented by management back in 2015, however, gives us a workable figure, though no specific percentages are shown:

Source: Charts by Daihatsu Diesel, English added by author

The figure in the middle of the charts show 50.6 billion yen in sales and 11.2 billion yen of gross profits. An eyeball estimate of the charts above shows approximately 40% of sales and 70% of gross profit from parts and service.

• 40% of 50.6 billion yen = 20.2 billion yen.
• 70% of 11.2 billion yen = 7.8 billion yen
• 7.8/20.2 = approximately 39% margin

With a similar approach, we can calculate a rough 10% margin on engines sales, though this figure is bound to fluctuate wildly due to the amount of operating leverage employed in engine production.

Using the revenue and gross profit distribution chart above, as well as the 39% parts and service margin as a baseline, we can play with numbers.

To be clear, management noted a decline in margins for engine sales. This is not particularly surprising given the industry-wide slump. They also noted a decline in after-sale service revenues (down from 26 billion yen in FY2016).

Time for some napkin math.

If non after-sale service revenues recover to 2008 levels (approximately 45.7 billion yen) and after-sale service revenues are maintained at current levels, revenues would come in at 69.7 billion yen. An approximation of gross profit would come in at 15.8 billion yen. Selling, general and administrative expenses (SG&A) remained roughly flat around 11 billion yen over the past 10 years. This gives us 4.8 billion yen in operating income. A three times EV/EBIT valuation would put Daihatsu Diesel’s enterprise value at 14.4 billion yen, which is 25% above today’s 11.5 billion yen. Historical EV/EBIT averaged around three to four times over the past 10 years, though fluctuating wildly.

As a reference, here’s how the U.S. dollar to Japanese yen exchange rate has moved over the past 10 years:

Source: Xe.com

Don’t lose any sleep

The last round of dividends paid out 15 yen per share. Today’s share price is 706 yen. That is still a little over 2% in dividend yield. It is not like Daihatsu Diesel is short on cash either. The balance sheet is holding strong with a debt-equity ratio of 0.38 and a 24 billion yen cash position. Even during the financial crisis, Daihatsu Diesel was profitably sailing along, and continues to do so today. In fact, the company has tripled shareholder’s equity over the past 10 years. Investors can also take comfort in the fact 35% of the company is owned by Daihatsu Kogyo, a wholly-owned subsidiary of Toyota Motors (TM, Financial).

It is difficult to lose here. Not only has Daihatsu Diesel consistently turned profits, it successfully shifted its business model to incorporate more of the after-sale service, which delivers high-margin revenue. This shift has largely gone unnoticed thanks to the troubled macro in shipbuilding. The good news is patient Daihatsu Diesel investors get paid to wait for the shipping industry to recover.

Disclosure: I do not own shares in companies mentioned in this article (yet).