Spin-off Details

Lotto24 AG (LO24) began trading on July 3, 2012, as a spin-off of Tipp24.

According to Tipp24’s CEO,

“we believe that a complete legal separation is the best option to provide Lotto24 AG with a starting position in the German market which is not burdened by legal disputes.”

Two board members from Tipp24, Petra von Strombeck and Magnus von Zitzewitz would join the new executive board of Lotto24 AG, with von Strombeck as CEO.

Priced at €2.50 per share, the spin-off jumped to the mid to high 3’s on the first day of trading before falling to a low of €2.78 only a month later.

Specific details of the spin-off included:

• Treated as a dividend in kind from Tipp24’s capital reserves
• Offered an additional 5,988,816 ordinary shares via a rights offering
• Total proceeds of approx. €13.87 million after-fees

Lotto24’s goal is to re-establish lottery brokerage services within Germany as soon as possible, essentially resuming Tipp24’s domestic business which was halted by the 2008 German State Treaty on Games of Chance (“GlüStV 2008”).

Q2 Financial Report

Lotto24 just released its first quarterly report as a public company, and it provided some detail about the company’s current state and future plans. Another quick history lesson on the German legal situation:

• Jan 1 2009: The GlüStV 2008 is passed, banning online gambling including lottery advertising and ticket brokerage over the internet

• Sept 2010: European Court of Justice (ECJ) declares that key elements of the GlüStV 2008 contravene EU law

• Dec 2011: Based on the ECJ’s opinion, the German States draft a new treaty

• Jan 2012: Schleswig-Holstein, one of the 16 German States, moves forward with its own law making online gaming legal and allowing LO24 to restart operations for SH residents

• March 2012: A revised treaty, the First State Treaty to Revise the State Treaty on Games of Chance (“GlüÄndStV”), is given to the ECJ for positive approval, but the ECJ does not approve or comment on it, casting doubt on whether it complies with EU law either

• July 1 2012: The GlüÄndStV treaty is ratified by the German States anyway

• July 2012: Schleswig-Holstein reverses its original course and now plans to join the other states in ratifying the GlüÄndStV this fall

So what does this all mean for online lottery brokerage in Germany? The short answer is that it’s still unclear.

The longer answer is that

“although the approval process [for nationwide rollout of online lottery brokerage] has been initiated, the permit criteria, Internet requirements, and advertising guidelines have not been finally decided yet.”

In addition, Lotto24 still believes that the new treaty’s validity as it relates to the ECJ ruling is still questionable:

“All in all, it is uncertain under such circumstances whether or not the GlüÄndStV can be legally applied.”

What the company does know is that the internet and TV advertising permits are handled by the German State of North-Rhine Westphalia, and will not be finalized until after their state elections – sometime in November 2012.

Although the GlüÄndStV might need to be revised even further to pass the ECJ (ultimately ending up in an even better situation for LO24 in all likelihood), the state of online gambling seems to be moving forward (albeit slowly and with a ton of uncertainty), and the company expects to be operating its lottery brokerage nationwide within the next twelve months.

On the financial side, LO24 has total equity of €32.6million, with the vast majority made up of cash (€14.7mil) and goodwill (€18.9mil). The goodwill is a result of the contribution in kind from Tipp24 for the “business opportunity for the resumption of online lottery brokerage in Germany.”

Unlike other start-ups, Lotto24 does not have to re-invest much back into operations or R&D – the software is developed already and can sit on the shelf without incurring holding costs, and the majority of expenses (like marketing) are discretionary and can be ramped up when the internet ban is lifted.

Operating expenses through the first six months of the year were €1.6 million. However, €960 thousand of that expense was due to one-time IPO costs.

After removing these non-recurring items and annualizing this figure for the entire year, LO24’s has a steady-state cash burn rate of €1.25 million per year.

With almost €15 million in cash, that’s a long runway…

Lotto24 Positives

Brand recognition:

With more than 2.5 million customers prior to the internet ban, German lottery players are familiar with the Lotto24 brand – it seems reasonable to assume that they will return to a familiar and trustworthy service. Lotto24 should benefit from a sharp initial jump in customers when the online lottery market resumes.

Negative working capital:

Lotto24 benefits from advanced customer payments and a slight lag in payouts, leading to “steadily increasing negative working capital” balance. With limited reinvestment requirements, FCF will be higher than net income[1. For reference, from 2003-2007, Tipp24 had cumulative FCF that was 2x of total earnings.]. This is very similar to insurance float, and allows LO24 to grow basically for free.

Stable investor base:

Gunther Holdings, a large shareholder in Tipp24, increased its stake even further (to 33%) via the rights offering, signaling confidence in the stock’s prospects. Gunther has been involved in the Germany gambling industry for decades, and will likely be a stabilizing shareholder through any delays in starting up operations.

Broadband penetration:

More internet users = a greater number of people who can gamble online. Over the past five years, Germany’s broadband penetration rate grew by 76.8% to 32 users per 100 inhabitants. This is faster than any Western European country save Ireland, and Germany now ranks 5th overall in broadband penetration out of the entire European Union. Basically, the pool of potential customers has almost doubled since 2007.

Growing lottery market:

See below.

Lottery Market

The gaming gambling, at least when looking at global numbers, is largely immune from economic downturns, growing at 4.9% per year from 1999-2011 without a single down year (2009 was flat):

As the second largest market (only slightly behind North America), Europe is expected to grow from $122.9 billion in 2010 to $171.5 billion by 2015, or 5.7% CAGR, slightly faster than the global rate:

The largest gambling product worldwide?

Lotteries, with 29.1% market share.

German Lottery

While it has been four years since the GlüStV 2008 was passed, a relaxation of the law seemed inevitable.

First, as shown by the above charts, people love to gamble and have done so via lotteries for hundreds of years – moving that business online seems logical.

Second, the ECJ was strongly critical of the original treaty and will likely continue to apply pressure to the German states until a compliant law is passed.

Finally and most importantly, money from the state lotteries goes towards the sports, environment, youth projects, and state budgets.

To put this in perspective, the German lottery had total receipts of €6.66 billion in 2011. Due in part to the treaty, this number is down more than €3 billion from the average levels from 2004-2007 – a pretty staggering drop – and no doubt forcing some unpopular budget cuts.

With a restart of online lottery brokerage, Lotto24 is planning for an immediate jump in lottery receipts to €8 billion, with the overall lottery market in Germany growing to €12 billion by 2020.

The company is also projecting a rapid increase in online ticket sales, growing to €6 billion by 2020, or 50% of total lottery sales.

While this growth rate seems optimistic, it is not crazy outlandish. Two thoughts:

1. Already, some countries (such as the UK) have more than 20% of gambling done via online/mobile channels – 50% in the next eight years seems within the realm of possibility:

2. While lotteries are still the most popular form of gambling, they lag other products in online sales, so there is even a larger runway for internet growth:

In summary, there is a ton of potential for LO24 once the company’s marketing machine can crank up again.

Historical Business Model

Lotto24’s plan is to sell tickets online for the State Lottery and take a small percentage commission. This is the same model that Tipp24 employed from 2003-2007, before the German gambling ban forced the management team to focus on secondary lotteries abroad.

Tipp24 was the dominant player in German lottery brokerage, reaching 60% market share of online ticket sales by 2007.

Check out this growth rate:

Roughly 25-30% customers were ‘active’ (completing at least one transaction per month), but Tipp24 earned almost €600 in billings per active customer[2. Active customers play a lot, and show almost no churn after the first year].

In the brokerage model, Tipp24 generated revenue from three sources:

• 10% distribution fee on traditional lottery ticket sales
• 20-30% markup fees for premium lottery products like scratch cards
• 15-20% margins on ‘white label’ business services (Tipp24’s technology powered the back-end on other lottery broker websites)

Therefore, blended gross margins – revenues / gross lottery receipts – were historically around 13%.

Here are the biggest operating expenses as a percentage of revenue:

Both marketing and other expenses were skewed higher in 2006-2007, as the company spent money on legal/consulting fees while also dealing with slowing customer growth due to the uncertainty surrounding the impending internet ban – Tipp24’s management was targeting marketing expenses at 30% of revenue.

As shown by the cost breakdown, the key part of the brokerage business model is marketing, as money spent to attract new customers is the largest expense by a wide margin. Customer acquisition costs averaged roughly €20 per new registered customer.

As the business matures however, these costs should fall as the rate of sign-ups slows and the company moves towards maintenance marketing.

This is a highly scalable business model, in that ‘other’ expenses (such as personnel, rent, etc.) will fall dramatically as a percentage of revenues as the number of customers grows.

Once the infrastructure is in place, the marginal cost of selling another lottery ticket is basically zero.

This should lead to future margin expansion, with a steady-state ceiling well above the 20% EBIT margins shown by Tipp24 historically, assuming the growth materializes and management executes successfully.

Lotto24 Forecasts / Valuation

So what is LO24 worth?

LO24 is essentially a start-up right now – with only a few thousand existing customers and negligible revenue – facing a still uncertain legal situation.

There are a ton of variables to consider:

• what year (and if) the ban is reversed
• legal restrictions in the new permitting process
• growth rate of the lottery market overall
• % of lottery market share taken by online tickets
• growth trajectory of LO24’s market share
• new customer acquisition cost curve
• and the list goes on…

However, with five years of Tipp24 financial history, there are some historical benchmarks to guide the exercise.

Here are key metrics for Tipp24 from 2007, the last year before its business was disrupted by the GlüStV 2008:

These metrics can be used as a baseline to forecast possible growth scenarios, in order to value Lotto24 based on its expected future cash flows through 2020, discounted back to the present.

First, some core assumptions which apply across each scenario:

• Activity rate starts out at 30% but falls as the market matures
• Billings per active customer gets an initial boost when the ban is lifted (i.e. the most die-hard lottery players sign up first) but stabilizes around €580 per active customer
• Gross margins start out at 8% and rise to 12% as premium lottery products and business services are phased in
• The company burns cash until the ban is lifted, but once legalized, operating margins rise steadily due to the scalability in the business model (i.e. falling marketing expenditures & other operating costs as a percentage of revenue)
• Capex and depreciation cancel each other out (reinvestment is negligible)
• Business model benefits from negative working capital, and FCF outpaces net income (consistent with Tipp24’s track record of cash flow generation)

Finding a precise value is not the goal[3. Whew!], but the exercise can demonstrate a range of scenarios.

Here is how Lotto24 might look in 2020:

Bull Case

This assumes that the online market is fully legalized by 2013, and grows – both overall and online – to meet management’s forecasts of €12 billion and €6 billion respectively. It also models sustainable EBIT margins of 30%[4. Analysts were predicting 5-year margins closer to 40% for Tipp24 back in 2005-2006, so 30% seems achievable].

Even with a peak market share well below the company’s past history, if this plays out, LO24 would be an absolute home-run investment.

Base Case

This projects a more realistic growth trajectory for lottery sales (5% CAGR), with online transactions making up 15% of the total (still a €1.5 billion market).

It also assumes that the internet ban isn’t lifted until 2014, even though LO24’s management is predicting full resumption of activities within 12 months.

Even so, this scenario still results in over 100% upside.

Bear Case

In the bear case, Lotto24 burns money for three years before finally winning the legal argument and starting up in 2015.

The total lottery market does get an ‘internet spike’ in 2015 (20% growth, back to pre-internet levels), but barely grows above the rate of inflation overall, with online sales reaching only 10% of the total.

Active customers fall to 20%, as LO24’s customers get bored and move to new forms of gambling , and economies of scale never kick in to boost EBIT margins north of 20%.

The market thinks the bear case is likely (i.e. Lotto24 is fairly valued).

Ultra-Bear Case

The stock goes to zero, a possibility for any start-up.

In this world view, the German government never allows internet brokering of lottery tickets and/or centralizes that function within the state lottery itself.

LO24 burns through its cash fighting legal battles and eventually goes bankrupt.

While this seems unlikely, there are still lots of uncertainties, and management will have to prove that they can navigate the legal and regulatory situation while executing on the company’s growth potential once the opportunity arises.

Growth Comparison

Here is a simple chart that shows the growth in registered customers under the various scenarios:

Conclusion

Putting it all together, LO24 is more of a special situations investment, where investors are weighing the probabilities of several scenarios and not necessarily coming up with a specific intrinsic value.

Using this range of outcomes, here is the expected value of making the investment:

This assumes a reasonable chance that Lotto24 is a success, while giving some weight to the extreme outliers on both the positive and negative side. With these probabilities, investing in the stock seems to be a very +EV decision.

Inverting the argument, here is what the market is currently forecasting:

In order for the stock to be fairly valued, the market is assigning zero probability for the bull case, and a 30% chance of the stock going bankrupt (even though a full bankruptcy is unlikely, given that LO24’s cash pile is almost 12x the current cash burn rate).

In fact, because the bullish outcome has such a high reward, the chances of the bull case playing out only needs to be 7.6% for an +EV outcome, even if the rest of the probability (92.4%) is assigned to a the stock going bankrupt.

In poker, maximizing positive expected value decisions is one of the keys to making money over the long term. Unlike poker – where hands can be analyzed – the exact probability weightings are unknown in Lotto24’s circumstances, but it appears that the odds are heavily in favor of some sort of positive outcome.

With a poker background, passing up +EV situations is against my nature – with the odds on Lotto24, I’ll stay in the hand and see how the river plays out…

Disclosure

Long LO24, TIM

P.S. – If anyone has updated lottery statistics from LaFluer’s 2012 World Lottery Almanac, please contact me.

Company History

Founded in 1999, Tipp24 SE (TIM) was an early pioneer of online lotteries in Germany and other European countries. The original business model had Tipp24 serving as an online broker to the German state lottery, essentially funneling lottery ticket sales through an online interface and keeping a 10% markup fee.

From 2002-2008, the number of subscribers grew from 0.4mil to 2.5mil (28% CAGR), as Tipp24’s market share rose to 60%.

The stock went public in 2005, and has turned in a remarkable run since, with revenues and EBIT rising nearly every single year (a small EBIT dip in 2008 as the sole exception):

Legal Environment

But in 2008, the German government ratified the State Treaty on Gaming (GIStv), which banned all online lottery brokering and advertising. This basically eliminated Tipp24’s core business, and management had to scramble to come up with a new strategy. The company ended up applying for a gambling license to begin operating secondary lotteries via a UK subsidiary.

In September 2010, the European Union proclaimed that the GIStv violated European law, and that Germany would need to submit a revised treaty.

Then in 2011, one of the German states, Schleswig-Holstein, broke off from the others and ratified its own state treaty to allow online lotteries starting in 2012 – meanwhile, the new GIStv is still making its way through the court system for the rest of the country.

While the lottery ban seems unlikely to stand forever, it has cost Tipp24 millions of euros in legal fees and lost business.

The legal situation remains complicated in Germany, but fortunately Tipp24’s management team finally decided to spin-off the old brokerage segment into a new company, Lotto24 AG (ticker: LO24), which began trading on July 3, 2012.

This action separates the legal fight in Germany from the UK operation, and it’s the UK business which will be the focus of the investment thesis. Despite all of the controversy and legal battles in the home country, the UK operation has thrived.

(To try to avoid confusion, the use of “Tipp24” and “company” references the new standalone UK business)

UK Business Overview

Tipp24’s UK subsidiary, MyLotto24 Ltd. (not to be confused with Lotto24, the new spin-off), operates a secondary or “virtual” lottery, allowing players to participate in lotteries such as the EuroMillions and German “6/49” lotteries.

Essentially, customers are “betting” on the traditional state lottery – keeping the same odds of winning the possible jackpot, but without having to physically go to the store and purchase a ticket. Tipp24 bears the risk if the jackpot is hit, but crucially, only pays if one of their customers is the winner.

The payout ratio is set at 50%, so Tipp24 keeps the difference between the price it charges for the lottery ticket and the expected payout, and then subtracts out a 15% UK gambling tax and any hedging costs to produce its overall profit.

Investment Thesis

#1) Attractive business model with high margins and free cash flow with little reinvestment requirements

Tipp24’s product offering is entirely online, and this asset-light business model is reflected in 2011 gross and net margins of 57.6% and 27.5% respectively.

Historically, the old brokerage model operated with negative invested capital.

In order to start-up the UK operation from scratch, management invested ~€30mil over the last four years, mostly in software upgrades. Total capital expenditures, including software and PP&E, were €36.5mil or roughly €9mil per year.

Even with this start-up investment, Tipp24 generated €54.3mil of EBIT (€38m after-tax) with only €31.7mil in invested capital. ROIC is more than 100% – this is a phenomenally profitable business:

Management is forecasting total capex (including software) of only €3-5mil in both 2012 and 2013. Since software assets are amortized over four years and make up the majority of Tipp24’s non-cash invested capital, amortization will likely exceed reinvestment needs and ROIC should improve.

Limited capital requirements also mean that the company has significant free cash flow available for share repurchases or dividends:

Even with the start-up costs, FCF has averaged €20.7mil over the last three years for a FCF yield of 7.3%, or 11.8% using estimated maintenance capex.

#2) Spin-off of German operations eliminates most of legal headaches, creating a catalyst (likely a large special dividend) within the next 12-18 months

Due to the legal situation, Tipp24 was forced to transfer control over its UK subsidiary, MyLotto24 Ltd. In effect, the company was trying to segregate the UK operations – running successfully since 2007 without political pressure – from the legal situation in Germany.

To accomplish the split, 60% of the preference shares in MyLotto24 Ltd. were sold to a Swiss foundation, as a way to show independence to German regulators. Importantly, Tipp24 retained a call option to repurchase the shares of Mylotto24 Ltd. from the Swiss foundation for £30k, and therefore can regain full control over the UK subsidiary at any time.

Once the corporate structure is simplified, the parent company would then have access to the subsidiary’s cash balance of €133.5mil, 47% of the stock’s current market cap.

A substantial amount of that cash would be excess, even considering the requirement to keep cash on hand to pay the deductible, so a large special dividend is likely in the next 12-18 months.

The company did pay a €0.50 per share dividend back in 2008/2009, equivalent to roughly 65% of EPS – that same payout percentage would result in a dividend per share of around €3.00 (an 8.5% dividend yield).

#3) New hedging mechanism improves cost structure, leading to potential margin improvements

Historically, Tipp24 hedged its jackpot exposure in two different ways:

– Via an insurance contract for the German “6/49” lottery, which kicked in for any jackpot payouts over €10mil

– Via “native hedging” on the EuroMillions and other lotteries, which meant buying a ticket with the same numbers and earning a profit through markup and distribution fees

In September 2011, the company announced a new hedging mechanism with the issuance of a three year €70.5mil catastrophe bond (CAT bond). This bond transfers the payment obligation to a third party while having Tipp24 retain the first €22.5mil in jackpot payments (i.e. its annual ‘deductible’).

Essentially, the new bond allows Tipp24 to eliminate native hedging whenever the EuroMillions jackpot is less than €50mil – before, the company had to hedge every ticket sold regardless of the jackpot size. These hedging costs were significant, running around 10-11% of UK revenues:

Through Q1 2012, hedging costs have fallen 49%, from €5.0mil to €2.6mil – annualizing this figure results in a FY cost of €10.24mil, for a savings of €6.3mil.

This new strategy could boost EBIT by €5-6mil in 2012, without any growth in the number of players or popularity of the EuroMillions product, which seems conservative.

To make the benefits clear, here is an estimate of the economics of the EuroMillions lottery ticket, under the new strategy (i.e. no natural hedging required):

While not representative of true margins (there are other direct expenses, and the company will have to hedge tickets anytime the jackpot is over €50mil), it does showcase the benefits of this new strategy.

Valuation

Due to the legal uncertainty, the Germany segment posted €26.5mil in operating losses over the past three years, which must be removed for the new standalone company.

In addition, statistical fluctuations should be excluded to get a better picture of the UK’s earnings power, assuming the “average or expected” result:

Management is forecasting revenues of at least €130mil and EBIT of €35mil for 2012.

However, this EBIT forecast builds in a €10mil buffer for statistical fluctuations, so the true EBIT forecast is €45mil. Even this number seems conservative considering:

a) the potential cost savings from the new hedging strategy

b) the spin-off of the costly Germany segment

c) any growth from re-focused operations and management attention

2011 earnings were skewed upwards by an insurance payment, counterbalanced by charges for the C-bond issuance, costs related to the spin-off, management changes, etc.

Let’s say that normalized earnings are €50mil per year – or €35mil after-tax.

With limited reinvestment needs, net operating profit after tax (NOPAT) matches up almost exactly with free cash flow.

Capitalizing the €35mil number at a 10% discount rate yields a no-growth value for the operating business of €43.83/share, or 24% upside from the current stock price. This valuation is giving no credit for all of the excess cash on the balance sheet, plus any additional growth opportunities.

Here are the upside scenarios at varying discount rates and estimates of excess cash:

Put another way, the base valuation of €53.85/share (52% upside) is consistent with 9.5x P/E, plus the ~€85mil in excess cash – a rather conservative multiple for such a profitable business model.

Risks

Regulated operating environment – Gambling and lotteries are heavily scrutinized activities, and Tipp24 runs the risk of legal or political changes which could negatively affect the business model.

Negative statistical fluctuations – Even with the new hedging strategy, the company is still on the hook to pay jackpots up to €22.5mil, and lottery results could run below expectation for an extended period of time. Unlike other business models, poor results can occur purely by chance.

Management turnover – The size of both the executive and supervisory boards have been changed several times – for example, Marcus Geiss was added in April 2011, but left prematurely in April 2012. The current CEO and co-founder, Dr. Hans Cornehl, has been involved with the company since 2002, although the other co-founder left in 2009. Current management holds less than 1% of shares.

Conclusion

Essentially, Tipp24’s business model is rather simple:

In exchange for €25mil in invested capital (basically cash that is set aside in the case of a jackpot payout), Tipp24 takes a cut of potential payoffs (50% ‘rake’ on each ticket, less the cost of hedging), for running a secondary lottery – which just so happens to be more convenient to play than the real thing.

This €25mil in cash sits in the bank and generates €30-35mil in after-tax proceeds each year. Not a bad return, and better than a savings account.

To some degree, this is still a ‘wager’ on Tipp24’s part (essentially betting that two large jackpots won’t be hit back-to-back for example), but the jackpot odds are so small that the risk/reward is skewed heavily to the positive side.

No wonder lotteries have been around for hundreds of years…

Disclosure

Long TIM, LO24

Company Overview

Mitani Group (8066:TYO) is a Japanese conglomerate that operates in segments from concrete to semiconductors and from bowling alleys to nursing homes. With roots going back to 1914, the company now manages almost 100 subsidiaries – an overview of the group structure is included on the website.

Many of these subsidiaries have operations that are hard to categorize, but the company is broadly organized into three main segments:

Information Systems – includes CATV, software development, and outsourced IT services

Energy / Life Support – includes housing equipment, gas stations, and wind power generation

Construction Materials – includes building materials, concrete products, and aluminum sales

Of the three, the Construction Materials segment is the most important, accounting for almost 70% of sales and total profits:

With a market cap of ¥26,134mm (~$330mm), Mitani is quite a bit larger than other Japanese net-nets like Maruka Machinery and Fuji Oozx.

Financial Overview

For the 2012 fiscal year, Mitani reported sales of ¥403,336mm, an 11% increase over the prior year and up 24% from recession lows. All three major business segments had positive growth, led by a 12% increase in the Energy & Life Support division.

Both operating and net income rose even faster, up 18% and 30% respectively, with EPS reaching a record of ¥232.

Over the past decade, revenues have grown 4.8%/year while SG&A costs climbed only 3.1%/year – these costs now consume 6% of revenue versus 8% ten years ago.

Unlike many other Japanese net-nets, Mitani does have some short and long-term debt on the balance sheet, totaling ¥9,919m, plus another ¥2,065m in retirement obligations.

However, this debt is offset by ¥45,136mm in cash and a very manageable debt-to-equity ratio of 16%.

Although Mitani has spent over ¥7,800mm on acquisitions over the past ten years, total goodwill and intangibles of ¥1,468mm is negligible when compared to ¥177,576mm in total assets.

FCF has averaged just over ¥5,000mm over the past ten years, for a FCF yield of almost 20%.

Investment Positives

Conglomerate structure helps dampen swings in economic cycle, which translates into smoother top and bottom line growth

Although Construction Materials makes up a significant portion of revenues and profits, the varied business lines among the operating subsidiaries insulate the company from economic swings.

Here are YoY revenue growth rates for each business over the past five years:

Every business struggled in FY2010, but historically, drawdowns in one segment (such as in FY09) can be compensated by growth in other areas.

Compare Mitani’s negative swings to several other Japanese net-nets:

This consistency has translated into 4.8% annual revenue growth over the past ten years, a solid result considering the economic environment in Japan.

Due to operating margin increases and share repurchases, EPS grew at 27% annually over that same time period.

Positive industry dynamics will translate into continued demand for construction materials over the next 2-3 years, boosted by domestic rebuilding after the Japanese earthquake

Many construction materials and supply companies saw a sharp jump in stock price after the March 2011 Japanese earthquake on anticipations of a massive rebuilding effort.

Mitani’s stock price hit ¥1,405 per share in early May, up 67% in fewer than 30 days post-quake – other construction stocks showed similar increases.

However, the price jump reversed itself quickly, and Mitani’s stock price returned to pre-quake levels only six months later.

While the initial thesis was straightforward – earthquake/tsunami damage leads to greater requirements for building products like cement and concrete – investors seemed to misjudge how long the process would take.

The fact remains that the rebuilding in many of the hardest hit areas has only just begun, as this USNews report shows: “Before and After: One Year After the Japan Earthquake.”

This is backed by cement shipments to those tsunami-affected prefectures (with cement demand being a good enough proxy for rebuilding efforts): 

Notice how the demand spike did not occur until the first two quarters of 2012, almost a year after the quake.

Analysts are expecting total cement demand to peak at 45b tons in FY2013 , with reconstruction demand providing a 3b ton boost:

While growth in the cement industry has been modest, it reverses a two-decade trend of declining demand:

(Looking at the chart, FY2010 was a rough year: cement demand was half of the 1990 peak. That same year, total Japanese construction investment hit a low not seen since the late 1960s – truly staggering)

Mitani’s Construction Materials segment showed a 10% sales increase in FY2012, growth which should accelerate over the next 1-2 years.

History of conservative guidance softens impact of poor outlook in latest annual report

Despite the seemingly positive macro trends (at least in the construction industry), the FY2012 financial report provided a very conservative outlook for the coming year: sales up only 0.4%, operating income down 9.8%, and net income down 9.4%.

In the 30 days after the May 9th release of the annual report, the stock fell 18%.

However, Mitani’s management has a history of conservative forecasts:

In each of the past three years, management has revised both the revenue and profit figures upwards – with the final result ending up even higher than the revised forecast.

While past history is no guarantee of future performance, the cautious outlook for FY2013 does not appear to be a major concern.

Availability of English-language financial statements

Not to be overlooked. While the raw financial numbers can be found in CapIQ or Bloomberg, Mitani publishes translated financial statements online.

This prevents translations mistakes (Google Translate struggles with Japanese. Trust me, I’ve spent hours trying to make sense of reports), and provides important information.

For example, Mitani clearly shows that ¥5,110mm of its long-term investments are Investment Securities.

While Mitani’s translated reports do not include financial notes or management commentary, even the provided info is lacking in many other Japanese microcaps.

Investment Negatives

Conglomerate structure – reduces chances of acquisition by competing firm, which is a key source of unlocking value in many microcaps.

Conglomerate discount – Markets often price conglomerates at discount to comparable pure-play companies (although discounting to zero seems a bit extreme).

Domestic-based – Mitani is highly dependent on the economic and political environment in Japan. Much has been written about the Japanese situation, with passionate arguments on either side. Readers can make their own judgments on the macro risks.

Currency risk – Many investors are betting on a weakening of the Japanese yen, which would reduce the holding period return when closing out a position and converting proceeds back to USD. Even with possible currency losses, the margin of safety with Japanese net-nets is huge – here are some interesting views on the yen and currency hedging (here and here).

Valuation

As with the other Japanese stocks I’ve invested in, Mitani is a traditional Graham net-net stock selling for less than NCAV:

The company’s enterprise value is negative -¥1,222m, meaning that the market thinks that Mitani’s collection of 100+ subsidiaries is worth less than zero.

However, the Information Systems and Construction Materials segments are actually good businesses, with double digit pre-tax return on assets[1. Pretax ROA calculated as segment operating profit ÷ total segment assets, without adjustment for inter-segment sales or corporate-level assets.].

Even the Energy & Life Support segment has shown steady improvement:

Over the past decade, Mitani’s ROE has averaged 8.4%. Since FY2008 (right through a global recession) average ROE actually improved to 8.7% – nothing spectacular, but very good compared to the majority of Japanese net-nets.

At 0.39x of book value, investors are getting a stock that has compounded BV/share by 9.3% annually for 10 years, in addition to offering a 2-3% dividend yield since 2009.

Mitani’s P/B multiple has averaged 0.52x over that time period, with a trough of 0.21x during the depths of the crisis.

Here are a range of IRR scenarios using BV growth and P/B multiples, starting with the 3/31/12 BV/share of ¥2,429 and forecasting through FY2015:

If the stock trades back up near its historical P/B range of 0.5x and continues growing BV/share at 9% per year, the resulting IRR would be 20% per year (or roughly 22.5% with dividends included).

On a P/E basis, Mitani’s multiple has averaged 7.4x over the past decade vs. a current TTM P/E of 4.1x, so a return to long-run averages would imply a price target of ¥1,719, or 81% upside.

Conclusion

Several recent articles have highlighted the potential in Japanese small-caps:

Managers see big profits in Japan’s smaller-caps

Ex-Goldman Trader Run-Symphony Seeks Money for Hedge Funds

This renewed investor interest could lead to more activism in this unloved space.

To conclude, it might be helpful to provide a quick illustration of the potential with many of these Japanese net-nets. Consider:

1. If these activists and hedge fund managers can shake up the situation in Japan (a big if)

2. And market valuations return to more rational levels (probably a bigger if)

…then a growing, consistently profitable business like Mitani should never sell for less than net cash.

So what might someone bid for the entire company in a private transaction?

Getting bought out at a “fair” price is wishful thinking given the Japanese environment right now, especially in the small-cap space, but even a return to NCAV within the next few years could offer double digit annual returns.

Disclosure

Long Mitani