Valuing Return on Capital – Smith & Wesson (NASDAQ:SWHC)

Lately I have been reading through Berkshire Hathaway’s annual reports. While sometimes repetitive, there are gems within Warren Buffett’s prose. I consider myself both a value and a growth investor. In a perfect world, every investment would cheap compared to both the current shareholder returns and the future growth prospects of the business. Buffett has some great perspective to offer on how to measure the quality of management in terms of both quality and growth.

“Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor….. Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return” – Warren Buffett

Return on Capital is one of Buffett’s favorite tools to measure management with. A well-managed company should have Return on Capital that is both strong and growing. If a company can yield returns on capital far above cost of capital for many years, it probably has a good business model and a good management team in place. Put another way, if you loan a kid $1 to start a lemonade stand, you would hope that they give you back at least $1. If the kid comes back and hands you a ten, consider firing your current financial adviser.

If the kid returns less than $1 to you, then they have destroyed a part of your equity. Basically we want ROC > WACC for many years. The higher the better. It is incredibly simple, yet many of the fad stocks of the day fail to meet this basic requirement (looking at you NYSE:TWTR and NASDAQ:ANGI).

The conundrum I have encountered is how to value ROC. How much is it worth? This is where some Buffett comments really helped out. Berkshire purchases companies when it can buy the cash flow stream for less than half of the return on capital. Price to Cash Flow and Enterprise Value to EBIT are both decent proxies for this. It is important for the investor to ensure that Operating Cash Flow represents the bulk of the Cash Flow or EBIT being applied.

Let’s look at Smith & Wesson (NASDAQ:SWHC). Paul Howanitz, a classmate, pitched this stock in September. I liked it so much I bought it for my portfolio, and intend to buy more soon. Paul can be thanked for finding this diamond-in-the-rough at: Paul_Howanitz@kenan-flagler.unc.eduSWHC Price

SWHC is up 17% since Paul pitched it, and I fully expect it to go higher. In 2009 a new CEO – James Debney stepped in to turn the company around. Mr. Debney was so confident that he could improve the situation that he bought shares of the company in the open market on several occasions. According to Return on Capital metrics, he was certainly not overconfident. Price to Cash Flow and Enterprise Value/EBIT indicate that the company is still undervalued despite the stock tripling within 2 years.

Note the significant ROC growth
Note the significant ROC growth since 2009

From April to October, Price to Cash Flow went up 23%. EV/EBIT has gone up 17%. Return on Capital has gone up a mind-boggling 43% thanks to strong top and bottom line growth and share repurchases. Debney has had only one year where both P/CF and EV/EBIT were not less than half of Return on Capital and has averaged significantly higher ROC than his predecessor. The trend can not continue forever, but it certainly indicates two things:

  1. The company is being very well-managed according to the returns on incremental cash flow
  2. At present, the stock is cheap relative to those same cash flows

Again, Paul Howanitz can be reached at: Paul_Howanitz@kenan-flagler.unc.edu. Thank Paul for this amazing find. He has a nice slide deck with many more salient points about the company and industry which he might let you see. Also, buy SWHC while it is cheap.

 

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Care Service Company – A Japanese Demographics Play (TYO:2425)

company_mi

This impish sign belies the fascinating success story of a micro-cap company, founded in 1970 as a minuscule futon-cleaning service, which has grown to a market cap of approximately $16M in US dollars. I would imagine that Toshio Fukuhara (Founder and CEO) ran a very tight ship then, and he certainly runs a tight ship now.

Current 5 Yr Avg
P/E LTM 9.5 10.6
P/Bk 1.4 1.5
P/CF 9.1 6.4
P/Sales 0.2 0.2
EV/EBITDA 3.2 3.7
EV/Sales 0.2 0.2
main-img
No idea what it says but they sure look happy don’t they?

Care Service Co., Ltd. is a Japan-based company principally engaged in the provision of nursing care services in the vicinity of Tokyo. The Company operates in three business segments:

  • The Nursing Care segment is engaged in the provision of daycare services, home visiting and bath services, home visiting and care services, home care support services, nursing care equipment rental services, as well as the sale of certain nursing care equipment mainly in Tokyo Metropolitan area. Nursing Care represents 74% of revenue, but only 53% of operating income.
  • The Angel Care segment is engaged in the provision of washing services, as well as cosmetic, dressing and coffin (CDC) services for the deceased. Angel Care represents 21% of revenues, but 40% of operating income. This segment offers the most promising margin and growth opportunities for the company, and will be a focus in the next few years.
  • The Houses with Services for the Elderly segment is engaged in the provision of houses with home-care services for the elderly.
Company care center locations
Company care center locations

I was floored when I saw the financial performance at Care Service Company. Return on Invested Capital has averaged around 10%. For the past year, a turbulent one for the company, ROIC was over 12%.  Since the installation of a new CFO in 2008, Free Cash Flow Yield has stayed between 5-40% per share, factoring in a stock split in June of last year. Furthermore the demographic trends in Japan are promising from the standpoint of Care Service Company.

Note the bulge around and under 65
Note the bulge around and under 65

Japan has the world’s highest percentage of population over 65 years of age, and the trend is set to grow further. The modern Japanese family has gone nuclear, with a very similar corollary to the American version. Working-age children of the elderly would rather pay someone to care for their parents than sacrifice work-time. This bodes well for industry prospects over the next 10 years or so. Annual elder care costs will more than double by 2026, to 19.8 trillion yen ($212 billion), from March 2013, the Japanese health ministry estimates.

Recent changes to health insurance law in Japan have changed the industry dynamic. Currently over 70% of Care Service Company’s Nursing Care business comes from Japanese health insurers. The health law changes will force them to trim payments for daycare and home visiting services by 1-3%. Management has determined that the best way forward is to go high-end, to target wealthier patrons who are willing to pay outside of the health insurance system.

Interestingly, here in the U.S. managed care providers have essentially made the same cost-cutting choice, forcing companies like LHCG and NHC to adjust accordingly. Comps were hard to come by. There really aren’t any big Japanese players in the space, but here are some international comparisons.

Management has drastically improved operating cash flows
Management has drastically improved operating cash flows

Now for the DCF.

Base Case
Base Case

I estimate historical WACC to have been approximately 5%. The Discounted Cash Flow analysis uses 6%, enough to factor in some rate rising on Japanese bonds. At current prices, the base case would yield a 33% upside.

Discount and Terminal Rates

Risks

Ownership

Insiders control 73% of the company, leaving only 27% for the float. The founder alone controls 52.28%. He has no record of stock sales. Some investors might be wary of hitching their cash to someone else’s wagon. The float has continuously shrunk from 38% in 2006 down to the current 27%.

Japan’s Economy

The public debt level in Japan remains unsuitably high, additionally investing in a foreign company naturally entails some foreign exchange risk. Though investing in a single well-chosen company is arguably far safer than macro bets on currency movements. A prolonged economic downturn in Japan could completely change the current family dynamic, and increase cross-generational living situations.

The Founder is 70

Losing Toshio Fukuhara could damage the company prospects. No clear family succession in place, though the Senior Manager (CEO) has been in place for over a decade and is only 43 years old.

Cost of Labor Continues to Rise

A big factor on the company’s bottom line lately has been cost of labor. New regulations foisted new training and education programs on the firm. Rising wages have raised salary costs as well. Robots have been touted by news agencies as a possible solution. I personally doubt this would be practical. The real solution is immigration reform, but it could be a long, long time before a country as insular as Japan starts raining visas on immigrants.

Competition Increasing

Management has a strategy in place and will continue to execute. By shifting towards the Angel Care segment, the firm can grow both the top and bottom line. Additionally, the firm has a strong foothold in the Tokyo area and is continuing to emphasize it’s  regional focus.

Conclusion

At only a $16M market cap, Care Service Company stock is almost impossible for institutional investors to acquire at the meaningful sizes of shares they would need. This leaves small investors who can access the Japanese markets with a distinct advantage.

The new CFO, Mitsuru Iwahara, has had a hugely positive impact on finances, the founder still has his hand firmly on the company till, and has not sold any shares. Additionally, the demographic trends in Japan promise top-line growth within the industry. Mr. Fukuhara has been through booms and busts aplenty, and will find ways to stay profitable. Any firm which can shift from cleaning futons, to nursing the elderly, to funeral services is at no risk of failing to evolve at the pace of business. For those willing to take the risks, Care Service Company offers a compelling value proposition.