A few weeks ago, I wrote about my first international stock – Fuji Oozx – a net net stock trading in Japan.

Japan has the highest quality net-nets of anywhere in the world, and despite the historic challenges of investing in the country, I’ve taken the plunge and allocated a small but not insignificant portion of my portfolio into a few of the most promising net-net stocks.

Company Overview

Dainichi Co. LTD (5951:TYO) manufactures and sells oil heating and environmental equipment such as kerosene heaters, air purifiers, fuel stoves, humidifiers, and coffee makers. Just like Fuji Oozx, Dainichi has been in business for decades, going back to the company’s start in 1964.

These are the businesses I like investing in, boring businesses that are often ignored by investors looking to capture the newest technology trend.

Financial Results

As with many Japanese companies, Dainichi reported its 2011 annual results last month, reporting sales of ¥18,738 million, up 2.18% over the prior year.

The company saw a steep drop-off in sales during 2008 (when sales fell to ¥14,712 million), but business has rebounded nicely since then.

Operating income came in at ¥1,904 million, with operating margins returning to double digits, a significant improvement over the ~4% margins during the depths of the recession.

Net income was ¥1,041 million, the best result since 2007.

Importantly, the company has remained profitable for the past 10 years, a rarity in the world of net-net investing.

In all likelihood, Dainichi will continue to report decent profits for the foreseeable future.

Balance Sheet

However, my investment in the company is due to the balance sheet rather than earnings power.

At recent prices, the stock trades with a market cap of roughly ¥11,500 million, yet carries ¥11,038 million in cash and cash equivalents on the balance sheet.

Combining this cash balance with the ¥792 million in “Securities” translates into a negative enterprise value, meaning the market is assigning a negative value to an operating business that is cash flow positive and profitable.

In addition, the company also holds ¥3,745 million in “Investment Securities”, which includes equity shares, company bonds, and municipal & government bonds.

Although these types of securities are usually not included in the cash balance, they represent relatively liquid securities which can be easily converted to cash.

This means that a large portion of Dainichi’s NCAV is made up of highly liquid assets, as opposed to other net-nets where the majority of assets are tied up in things like inventory (which are usually company-specific and often end up obsolete).

Book value is ¥22,374m, for a P/B value of 0.51. Book value has grown since 2006, but only at 1.43% CAGR, typical for many of the small Japanese companies I have researched.

While growth is low, the company has reduced shares outstanding at a decent rate, with shares falling from 19.1m in 2006 to 17.7m in 2011, for a net reduction of roughly 7%.

Valuation

For a Japanese net-net, Dainichi’s operating metrics are pretty decent: average ROE is 4.29%, ROIC is 8.42%, and CROIC is 8.2%.

FCF yield is currently 5.4% using 2011 owner earnings – however, capex in 2011 was 2x the average from previous years, a number that had traditionally been very stable.

FCF using the formula “operating cash flow – capex” is much lumpier, but at current prices, translates into a FCF yield of more than 23%.

Here are several valuation scenarios after applying very conservative assumptions to the value of the operating business:

Both the EBIT and FCF figures (FCF is calculated using both owner earnings and traditional FCF) are using the company’s 5-year averages, which obviously take into account the global recession of 2008/2009 – Dainichi’s true earnings power is likely higher.

Conclusion

The recent Japanese earthquake did not affect Dainichi’s 2011 figures, but results could be impacted in the upcoming quarters.

There is also currency risk with the Japanese yen, a risk that I’m choosing not to hedge (read this post on currency and value investing for a good explanation of my position on currencies, along with my conclusion in the Fuji Oozx post).

While Dainichi is not ‘exciting,’ consistently profitable, cash flow producing companies should not be selling for less than net cash, and would never do so in the private market.

Despite Japan’s record of poor corporate governance and anemic investment returns, I think there is a substantial margin of safety in investing in these net-net situations. It will likely take a few years for the market to re-price these securities, but I don’t think they will stay ignored forever.

In the mean time, Dainichi pays a dividend, currently yielding 2.81%, cushioning the waiting game a little bit.

Disclosure

Long Dainichi (5951:TYO)

Check out another view on the company here.

Buying companies at a discount to their net asset value is a strategy that has outperformed the markets for decades.

2008/2009 provided an amazing opportunity for net-net investing in the U.S., but most of the bargains have now disappeared, and the current qualifying stocks are unattractive, ugly businesses.

After making the switch to Interactive Brokers, I now have access to the world’s stock markets, and have actively been trying to diversify my holdings internationally.

Investing abroad provides a host of challenges – accounting variations, currency risk exposure, language barriers, etc. – so sticking with a proven, mechanical strategy such as net-net investing is the easiest pathway into new markets.

And there is no other place in the world with more quality net-nets than Japan.

Fuji Oozx (7299:TYO)

Fuji Oozx is a Japanese maker of engine valve components used in the auto industry. It has been in business for almost 60 years.

I came across the stock using a new screener, Screener.co, that is the best global stock screener on the marketplace (note: affiliate link)

Fuji has several operating subsidiaries and is partially owned by Daido Steel, one of the world’s largest manufacturers of specialty steel ($2b market cap).

The company operates in four business segments:

“The Product segment manufactures and sells engine valves and others, as well as manufactures molds through one of its subsidiaries. The Merchandise (Machinery) segment sells mechanical equipment and jigs. The Technology segment is involved in the licensing of technology to its associated companies. The Distribution and Service and Others segment is involved in the transportation of its products, as well as the provision of employee welfare services. “

The Products segment makes up the majority of revenues and profits.

Financial Information

Results for the year ended March 31, 2011 were  reported a few weeks ago. Revenues jumped 18%, to ¥16,062 million, as Fuji was one of the few net-net stocks showing significant revenue improvement.

These results were driven largely by a 17.2% sales increase in the Products segment, although all four operating units reported gains for the year.

Historically, the business is capable of producing revenue in the ¥20,000-22,000 million range (as evidenced by 2006-2008 results), leaving additional room for top-line growth.

Operating income jumped to ¥1,803 million, an increase of 141% from ¥746 million in the previous year.

Profits were down significantly in 2009 and 2010 as Fuji faced reduced demand from auto manufacturers during the worldwide recession.

The strong increase in operating profit led to operating margins around ~11%, a sharp increase from the 6% average margins from 2008-2010, but consistent with the company’s margins in the boom years of 2005-2007.

Operating cash flow is strong at ¥2,314 million, and the company has generated positive free cash flow for at least the past six years.

For fiscal year 2011, free cash flow (using owner earnings) was positive ¥998 million, for a FCF yield of almost 15%.

Balance Sheet

While the positive operating results are a great sign, the investment thesis relies heavily on the balance sheet.

At current prices, Fuji Oozx is trading for less than net cash, meaning the operating business is available for free.

The most recent year shows a cash balance of ¥6,964 million, compared to a market cap of roughly ¥6,719 million, meaning the market is assigning a negative value to the operating businesses.

This translates into an enterprise value of negative ¥245 million yen…for a business that has produced an average operating income of ¥1,728 million for the past ten years.

Net Current Asset Value (NCAV) is ¥11,254 million, so the stock is currently trading at only 60% of its NCAV value.

It just so happens that Ben Graham’s original rules on investing in net-nets called for at least a 33% discount to NCAV, so Fuji Oozx qualifies under even the strictest definition of net-net investing.

Book value is ¥965.75 per share, translating to a ridiculously low P/B of 0.34x.

Over the past 6 years, book value has grown at 4.15% while shares outstanding has remained constant at 20.5m.

Valuation

For a Japanese company, Fuji Oozx actually has decent operating ratios. TTM ROE is 4.7%, held back by the excess cash balance, but CROIC was 13.8%.

A traditional multiple-based valuation metric (such as EV/EBIT or EV/FCF) doesn’t provide much insight since the stock currently has a negative enterprise value.

But looking at the past 6 years of financial results, Fuji Oozx’s EV/EBIT and EV/FCF multiple has averaged 2.8x and 3.8x respectively.

Here are several valuation scenarios, using both 2011 results and 2009 results (Fuji’s recession-low):

It doesn’t make sense to spend a great deal of time on valuation scenarios – at these prices, Fuji Oozx is ridiculously cheap.

Risks

Even so, there are certainly risks to investing in Fuji Oozx.

Earthquake

Obviously the Japanese earthquake has caused severe disruptions throughout the region, with an economic cost in the hundreds of billions of dollars.

It doesn’t appear that Fuji’s Oozx locations were damaged in the quake, but it has caused problems with some of the company’s major customers.

The full financial outcome of the quake probably won’t be known for several months, as it occurred too late in the quarter to impact the most recent results – there is a chance that Fuji’s results could be materially lower.

At this time, the company is not making any predictions, as results are still uncertain and difficult to predict.

Fuji USA Liquidation

The latest annual report also shows that the company decided to close down its USA subsidiary, which has been in operation since 1994.

I couldn’t get a good sense of why the decision was made, but the company already took a ¥130 million charge related to the liquidation.

Subsidiary Problems

Fuji also announced a ¥221 million charge related to bad loans in the company’s Shinhan Valve subsidiary. I was unable to determine whether this charge has already been taken or if it will apply to next period’s results.

While this revelation is a yellow flag around the company’s internal controls, Fuji has several subsidiary companies, the backing of a major steel corporation, and a long track record in Japan.

I view this revelation as an isolated incident which doesn’t materially affect the investment thesis – it hardly makes a dent in the company’s cash balance.

Currency

Finally, I invested directly in the stock on the Tokyo stock exchange, meaning I had to convert US dollars into Japanese yen. The exchange rate between the dollar and yen is roughly 1 USD = 82 yen.

The historical exchange rate is probably closer to 1 USD = 110 yen.

If the exchange rate moves closer to its historical average, it would cause a loss on the currency part of the transaction.

Conclusion

Even with an overvalued currency, Fuji Oozx and other Japanese stocks are substantially cheaper than their U.S. counterparts.

Fuji Oozx could likely see results suffer in the next period or two, as the auto manufactures and the rest of Japan suffer from power outages and lower output as a result of the earthquake.

Full productivity is unlikely to return until later this year.

But the company has been in business for 60 years and, despite the short-term setbacks, will likely remain in business going forward.

Some value should be assigned to a profitable operating business.

This is a great example of Mr. Market mispricing a public security – no rational seller would ever let go of a piece of a profitable operating business for free.

As for the currency, there are several options to hedging this risk, but I’ve decided to let mine ride for now.

All of my assets, as well as my retirement savings, job, car, household possessions, etc are all based in U.S. dollars and I’m not very bullish on the dollars prospect’s going forward.

Therefore, some currency diversification is prudent.

From a portfolio perspective, I’ve set aside 10-15% of my portfolio to invest in Japan, and will likely spread that money over 3-4 companies.

Investors have been losing money in Japan for 20+ years, but as a value investor, you just don’t get too many chances to pick up profitable businesses at these prices.

Disclosure

Long Fuji Oozx (7299:TYO)

International Baler Corp (IBAL.OB) is manufacturing company that has been in business since 1945 and currently qualifies as a net-net stock investment.

The company manufactures baling equipment, large complicated machinery that compresses a variety of materials (including scrap metal, boxes, cans, etc) into bales for easier shipping, storage, and recycling.

A leader in the field, especially for made-to-order and customized baling equipment, International Baler has over 40,000 units installed worldwide.

The stock suffered through a rough 2009 (along with many heavy equipment manufacturers) as customers put off cap-ex purchases – the company’s products cost between $4k and $500k.

A micro-cap stock with a market capitalization of only $3.5m, IBAL’s balance sheet remains rock solid, and the stock price has barely moved despite strong evidence that financials are strengthening in a big way.

Company Financials

After 6 years of steady growth in revenue from 2002-2008, IBAL saw a sharp sales decrease in 2009, with sales dropping 48.4%. The company suffered a small net loss, its first since 2003, as orders for every type of product were down across the board.

IBAL bounced back in 2010, with revenues up 16% and profits coming in at $254k.

Gross margins have remained steady over the past 5 years with a median just under 20%, while both operating and net margins hover around 5%.

For the year, these results translated into an EPS of $0.05 and owner earnings of $336k, for a CROIC and FCF Yield of 13.84% and 17.3% respectively.

2010 ROE was only 6.46%, as the company has consistently stockpiled cash to go along with an unused $1M credit line.

Overall, IBAL is a company that has gone about its business for over 50 years – although the recent recession affected the numbers in 2009, the company has proven it has the power to stay afloat during tough times.

Quarterly Analysis

Although it will probably take some time to match 2008 levels – a banner year – the latest quarterly reports show signs of improvement, not only in the actual numbers but in management’s language.

From the Q1 report last year:

“The decrease in revenue is the result of lower shipments in the first quarter of fiscal 2010, reflecting the deteriorated market conditions and lower commodity prices for recycled materials compared to the prior year first quarter”

And the latest quarter:

“This increase in revenue is the result of higher shipments in the first quarter of fiscal 2011 reflecting the improved market conditions and higher commodity prices for recycled materials compared to the first quarter 2010… The market for baling equipment has been moving toward larger, more productive and efficient equipment in recent years.”

This movement towards larger baler equipment is a good sign for the company, as there is much less competition on the high-end products (along with higher margins as well).

The recently released Q1 results show another sales increase, up 18% to $1.8m compared to the prior quarter last year.

Pre-tax income increased to $68k, compared to nearly zero last year, benefiting from higher product shipments and continuation of the company’s cost reduction efforts in 2009.

Even better, IBAL’s sales backlog more than doubled to $3.2m compared to $1.59m in 2010.

For comparison purposes, the backlog on Jan 31, 2008 was $2.8m – a year in which the company had sales and EBIT of more than $12m and $1.2m respectively!

While the company likely won’t approach those results, it has definitely gotten off to a good start in 2011.

Yet, despite the positive outlook, the stock has barely moved. In fact, it now trades at a discount to its working capital – compare the market cap $3.5m to net working capital of $3.68m.

Cash now sits at $3.08m, or $0.62 per share, unencumbered by any debt.

So IBAL is currently trading for less than working capital despite being solidly profitable, earning decent returns on capital, and announcing a record backlog!

Risks

Insider Ownership

Company insiders hold 58.8% of outstanding stock – I like to see management have a stake in the business but am cautious when the stock is so closely-held, as management can set compensation and make decisions at the expense of minority shareholders.

Digging into the latest proxy statement, the husband and wife team of LaRita & Leland Boren collectively own 51%, giving them tight control over the future of the company.

Outside of the Boren’s, little stock is owned by other company insiders or directors.

Recessionary Pressure

The company’s short-term results are heavily dependent on the economy. As commodity prices rise, it becomes more attractive and economical to purchase recycling equipment such as balers.

While the economy is showing signs of growth, a double-dip recession could reapply pressure to IBAL’s customers, potentially delaying purchases into the future.

Employee Lawsuit

On August 26, 2010, IBAL was served with a wrongful death lawsuit from a former employee for events that had occurred back in 2008. The lawsuit is asking for $2.5m, a huge potential liability for a company this small.

Lawsuits can be fickle and the company has liability insurance that should help cover any losses, but these sorts of cases can take a great deal of time and resources away from day-to-day responsibilities.

Positives

High-end Custom Baling Equipment

These special order products can cost up to $500k and offer much higher profit margins than traditional equipment.

These special orders remain a key growth segment for the company going forward – with such a wide array of configurations and over five decades of experience, the company is well positioned in the marketplace to capture the trend towards higher-end and custom equipment.

Undervalued Assets

The company owns its manufacturing facility in Jacksonville, FL, situated in a prime location next to a railroad and near a major highway. The facility is 62,000 square feet and sits on 8 acres.

With no mortgage, the company has depreciated the land, building, and all its contents down to $795k.

The land and buildings should be worth substantially more than the current carrying cost. Here are a few comparables:

Assigning a rough estimate at $30/sq ft to IBAL’s facility would yield a comparable value of almost $1m more than the current carrying cost (just for the building and land) – that’s almost $0.20 per share of additional value.

While it is unlikely that the company would sell the facility anytime soon (in fact, they had plans to expand the operation at one point), it is still a significant consideration for a company with a market cap of only $3.5m.

Insider Buying

John Martorana, a newly elected director, purchased almost 20k shares in the fall of 2010 at prices ranging from $0.45 – $0.52.

While the dollar value isn’t significant, insider buying is nearly-always a good sign for future prospects.

The CFO recently exercised his options and now holds 250k shares – it will be interesting to see what he chooses to do with this newly acquired stake in the business.

Valuation

There is no doubt that the stock is cheap on an asset basis – book value sits at $0.927, so the stock is trading at a P/B ratio of 0.75x.

Using Graham’s definition, the stock is a net-net, trading below its NCAV of $0.74.

Typically, these figures provide a measure of protection by limiting risk on the downside in the case of a liquidation.

Using TTM figures and the recent $0.70 stock price, IBAL trades for .75x EV/EBIT and only 1x EV/FCF, making it one of the cheapest stocks I’ve ever seen.

Consider this:

If the current sales and cash flow trend continue, the company will generate more owner earnings in a single year than the entire enterprise value of the company.

Conclusion

I’ve been purchasing shares for the past several months under $0.60 – basically picking up a piece of a growing, profitable business for less than the cash on the balance sheet.

At that price, the company actually has a negative enterprise value, meaning the market thinks that the baling business is worth more dead than alive – and yet it is very much alive.

Book value has compounded at 22% per year since the Boren’s took over in 2005, and the large jump in backlog should forecast good things in the coming months.

With a solid balance sheet, competitive products, and undervalued assets, the company is ripe for an acquisition or merger.

Tragically, LaRita Boren passed away in February 2011, meaning her ownership stake passes to an Estate controlled by her husband, Leland Boren.

Leland Boren, now 87, not only controls IBAL, but is also in charge of Avis Industrial Corporation, a conglomerate of industrial companies including one of IBAL’s competitors, American Baler Corporation.

With the recent passing of Mrs. Boren, and the advancing age of Mr. Boren, estate planning is surely a consideration – I think the company is now poised to unlock shareholder value via a number of different catalysts – whether it is a merger with Avis Industrial or an outright sale.

Long term, the increase in fuel prices and other commodities, along with greater awareness and acceptance towards recycling, will only increase the need for the International Baler’s products.

At current prices, IBAL represents one of the most undervalued stocks I’ve ever seen.

Disclosure

Long IBAL

Other Articles on IBAL

Bailing out of the bailed out market and into International Baler (Ragnar)