Japan Foods Holdings

Love Japanese Food?  Ramen, sushi, sashimi, udon, yakitori, tempura, teriyaki, okonomiyaki, unagi? This post gives us a treat to Japan Foods.

Japan Foods Holding (JFH) operates more than 40 Japanese restaurants in Singapore. It has 10 franchise brands from Japan, 3 self-developed brands (Japanese food) and 1 franchise brand from Malaysian (non-Japanese food).  It sub-franchises the brands to 7 restaurants in Malaysia and Vietnam, earning the franchise and royalty fees. It also has interests in 15 restaurants in Hong Kong and China through associated companies.

The pictures below tell you the brands that the Group is operating, the number of outlets of each brand and their contributions to the revenue.

Brands - 2016 Apr

Revenue breakdown - 2016 9M

Outlets List - 2015 Dec    Overseas Outlets - 2015 Dec

 

Business

In short, Japan Foods is running restaurant chains with 14 different brands, out of which 13 are in Japanese food. Nearly 99% of the revenue comes from operating 44 restaurants in Singapore. This is a relatively simple business to understand: sell Japanese food and make sure the costs (mainly food costs, labor costs, rental, utilities and other miscellaneous costs) are lower so that they can generate profit.

JFH was started in 1997 with Ajisen Ramen brand and has expanded to a total of 44 outlets now in Singapore. Ajisen Ramen is its flagship brand and contributes 42% of the revenue with 15 outlets. Its second biggest contributor, Menya Musashi with 7 outlets , contributes 19% of the revenue and was only started in April 2012. Its third biggest contributor, Osaka Ohsho with 6 outlets, contributes 13% of the revenue and was started in November 2012.

 

Growth Strategy

The growth of its flagship brand, Ajisen Ramen, has slowed down since 2013. The number of Ajisen outlets has dropped from 20 in 2013 to 15 now, while experiencing negative same store sales growth (SSSG). The Group has brought in other brands to support the overall growth and will convert one brand to another if the existing one does not work well at its current location. This diversified portfolio of Japanese food brands give the management flexibility to rotate the brands at existing location without having to wait until the expiry of the lease.  The conversion comes with renovation cost and loss of business during the renovation period, so it’s not cheap. But it’s prudent to do if that existing outlet is earning very low return or making losses, and the conversion could have turned around the business. This is something that one-brand Company can’t do.

There is no perfect formula to bring in the right food brands. Besides the 14 brands listed above, the management have tried several other brands that eventually got closed down. This is the list of 11 brands (yes, 11) that have closed since 2011: Hokkyokusei, Toku Toku, Kura Ramen, Ajino Chanpon, Aoba, Sapporo Curry Yoshimi, Aji Tei, Let’s Sweets, Tokyo Deli Cafe, Manpuku, Osaka Town.  Even with the closing down of 11 brands, the Group’s return on investment from FY12 to FY15 is still decent, meaning that the mistakes are not too costly. In a good book “Built to Last” by Jim Collins and Jerry Porras, one of the principles of successful companies is to “try a lot of stuff and keep what works”. JFH practises this principle.

In late 2015, the Group tried something new for the first time. It brought in its first non-Japanese food franchise from Malaysia, New ManLee Bak Kut Teh. This version of Bak Kut Teh serves its soup with Japanese rice or udon in Singapore. The supply chain for main raw materials (pork, Japanese rice, udon) is similar to its existing businesses, and the preparation requirement fits well with existing central kitchen capability. The Group has opened 2 outlets of New ManLee Bak Kut Teh so far. I walked passed this new outlet at AMK hub for the past 3 days and observed that the queue was long during dinner time. I will try it when there is no queue next time.

While this is a departure from its present focus of Japanese food concept, we have to bear in mind that there is a very high concentration of Japanese restaurants in Singapore. You will probably find at least 3 Japanese restaurants in each shopping mall. Facing such high direct competition, some brands will surely fall. It’s ok to take risk to try something different and keep it if it works. All the things the Group has tried are still in its main business, F&B, so it has not really lost focus.

The Group plans to open 3 new stores in January 2016, 1 in February and 2 in March, bringing the total to 50 in December 2016. These new stores will support the top line. If these new stores achieve return on invested capital like the rest of the restaurants (or at slightly lower), then the Group is growing and creating more values for the shareholders with the expansion and will increase the value for the company.

Economic Moat

Warren Buffett popularizes the term of economic moat. An important question is “Does JFH possess an economic moat?” In other words, does it have a competitive advantage?

Ajisen Ramen has 89 stores in Japan and nearly 700 stores in overseas. Osaka Ohsho has over 300 outlets worldwide. I don’t have the information about Menya Musashi. Other brands have varying successes in their home country, Japan.

The flagship brand, Ajisen Ramen, has a known presence in Japan, China, Hong Kong and Singapore. It doesn’t produce a food quality that will rank among the best or even near the best. It does not really possess an economic moat that gives it a premium pricing/branding that protects it from the competitors or scale/network of chains that are hard to beat. Basically, consumers will not think of Ajisen Ramen when they want to eat Japanese food.

However, Ajisen Ramen produces decent food quality and services and sells them at a price point that is at the lower end for casual dining. This combination of decent products and services, attractive price point and years of known presence in the local markets secure certain market share in the Japanese restaurants business in the shopping malls. The key is the efficient operation of the business. Its past success in China, Hong Kong and Singapore has proven that it can achieve a good return on invested capital over the years.

If we are looking at a bigger picture, JFH is relying less on Ajisen Ramen than ever. The Group has a portfolio of brands that have proven success in Japan before they were brought into Singapore. This strategy of bringing only successful brands from Japan to Singapore is an advantage compared to starting something new and unproven from scratch. Also, having a diversified portfolio of brands enhances the Group’s ability to optimize the overall performance by converting one brand to another at the existing locations before the expiry of the lease if the former is not performing. Operating several brands at the same shopping malls also give the Group more bargaining power in negotiating the rent (but, this does not seem to be the case for JFH, given its high rent as a % of revenue. See the discussion below).

Even with the strategy of bringing only successful brands from Japan into Singapore, some brands still failed and got replaced. Food quality is just half the picture. The other half is the company’s ability to identify the changing tastes of consumers, introduce/bring in the right brand to meet their expectation and operate efficiently. As such, we will have to spend more effort in understanding the operation of the Group and its management.

Operational Costs

Margins  FY10  FY11  FY12  FY13  FY14  FY15
Gross Margins % 77.9% 77.5% 78.3% 80.1% 81.6% 83.4%
SGA % -64.2% -67.1% -69.3% -65.9% -67.7% -75.9%
EBIT Margins % 13.3% 6.4% 8.1% 12.6% 13.7% 7.3%
PBT Margins 12.8% 6.2% 8.0% 12.9% 14.0% 8.2%
Net Profit Margins % 10.4% 4.9% 6.6% 10.5% 11.6% 7.6%

Looking at the margins from FY10 to FY15 (financial year ends in March), EBIT margins are in the range 6.4% to 13.7%. In FY15 and 9M16, EBIT margins of ~7.5% are at the lower end of the range, indicating the tougher time that the Group is experiencing at the moment.

Let’s dig deeper into the notes in the Annual reports and focus on the costs breakdown.

Costs Breakdown %  FY10  FY11  FY12  FY13  FY14  FY15
COGS 22.1% 22.5% 21.7% 19.9% 18.4% 16.6%
Rental 24.4% 25.0% 27.3% 24.3% 25.4% 28.8%
Employee Compensation 21.9% 24.2% 25.1% 24.1% 24.7% 28.0%
Depreciation 6.5% 7.1% 7.1% 6.6% 6.7% 7.8%
Utilities 2.6% 3.6% 4.0% 4.1% 4.0% 4.2%
Repair and Maintenance 0.7% 0.9% 0.9% 1.2% 0.9% 1.4%
Royalty fees 1.4% 1.3% 1.3% 1.5% 1.6% 1.5%
Capex 8.5% 14.3% 5.2% 6.5% 9.2% 11.9%

% of COGS has steadily declined from 22.1% in FY10 to 16.6% in FY15 (it was even higher at 31% way back in FY08). The Management has done a good job in managing its food costs. The Group established a central kitchen in 2012 and expanded its capacity in 2015. It produces its own noodles and cooks many of the ingredients before distributing them to the restaurants.  This more efficient operation reduces its food costs as a % of the revenue. I’m impressed and at the same time have some doubt how they managed to reduce the COGS from 31% to 16.6% in 10 years. Many F&B operators have gross margins in the range 65-70%. See the table below. Perhaps, different companies classify certain costs differently. So, we’ll have to compare the operating margins for a clearer picture. We’ll discuss this later.

Gross Margin % FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15
Japan Foods 69 73.9 77.9 77.5 78.3 80.1 81.6 83.4
Sakae 69.7 69.4 69.2 70.4 71.7 72.2 70.8 69.7
ABR 39.2 42 42.2 46.4 47.4 46.3 46.1
Soup Restaurant 44.4 100 75 75.2 77.6 77 76.7 76.7
Tung Lok 69.9 69.2 69.9 71.6 71.6 72.1 71.5 71.7
Jumbo 62 63.1
BreadTalk 54.4 54.4 54.6 54.7 54 53 52.7 52.9
Select Group 65.5 68.5 71 68.6 67.2 68.4 67 66.4
Average 62.15 67.80 65.66 65.74 66.69 67.17 66.08 66.25

Note: These numbers are taken directly from Morningstar. Different companies have different financial year end and I did not adjust the period or the numbers. So, there might be little inaccuracy in the period or the numbers.

Even though % of COGS has fallen, other costs, mainly rental and labor costs, have increased substantially. Singapore economy is facing escalating rental costs like many other cities.  Government’s restriction on foreign worker hiring increases the labor costs across the sectors. Service lines, such as restaurants, are impacted more than others.

The Group’s rental cost in FY15 was 28.8% of the revenue, which is quite high compared to the peers. Typical rental cost for retail food operators is in the range 15-20%. JFH’s rental cost has included central kitchen and their offices, but with 44 outlets, the costs from central kitchen and office rent shouldn’t be substantial relative to the restaurants rent.  The sharp increase in FY15 rent was due to rental revisions for restaurants located at existing malls, additional rental costs for new openings and increased central kitchen capacity.

Labor costs have increased from 21.9% of revenue in FY10 to 28% in FY15. The management introduced employee performance shares from FY14 onwards to retain key staff and motivate them. When this performance shares were introduced in 2014, the share price was near its historical high of above 0.6/share, but it has steadily fallen to $0.4 now, making the value of the performance shares worth much less. The cost of performance shares is quite low, at about 0.5% of revenue or 2% of the total labor cost or 0.3% of the outstanding shares. The good thing that the management did is to expense this performance shares in P&L.

Now we know that the substantial rise in rental and labor costs is the main reasons for the falling operating margin. Other operating costs have also risen accordingly. Let’s compare JFH’s operating margins with other F&B operators in Singapore. Again, these numbers are from the Morningstar, without any adjustments. JFH’s EBIT margins are slightly different from those in the table above because I’ve adjusted the numbers to exclude certain non-operating gains, but, overall, the difference is very small.

EBIT Margins % FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15
Japan Foods 13.15 10.14 12.83 6.23 7.97 12.88 13.98 8.18
Sakae -3.94 3.76 3.63 7.57 -4.58 6.76 4.14 3
ABR 9.41 9.73 9.87 2.45 9.58 9.12 8.92
Soup Restaurant 13.81 9.44 11.17 6.39 11.51 2.04 2.48 1.51
Tung Lok -3.07 1.57 4.97 -2.48 -5.3 -12.87 -1.19 -0.33
Jumbo 13.87 12.33
BreadTalk 5.65 6.33 5.51 4.68 4.33 4.17 3.87 4.07
Neo Group 16.89 8.47 13.09 11.19
Select Group 0.15 -2.6 3.66 4 1.13 4.82 5.72
Average 10.87 5.83 7.97 7.90 6.46 7.09 7.93 6.25

In 7 out of 8 years, JFH has higher EBIT margins than the average. If we take the average EBIT margins of the past 5 years, JFH’s EBIT margins rank 3rd in the list of 9 F&B operators. If we take JFH’s lowest EBIT margins of 6.23% in FY11, it’s still higher than the average for 5 other companies. In conclusion, we know that JFH has a higher operating margin than its peers.

If analyzing a company with chains of outlets is not easy for you, let’s do it at a one-store level.

Per Outlet

Let’s divide the financial numbers by the number of outlets so that we can analyze the Group as if it’s just a one-store company. We can’t adjust the numbers to exclude expenses that are not related to store’s expense, such as salary at HQ office, depreciation at HQ office and central kitchen, rent for HQ office and central kitchen, general company expenses, etc, because we don’t have the data. For the same reason, we can’t calculate the average number of outlets throughout the year either. For quick calculation and simplicity for you, let’s just take the headline numbers and divide by the number of outlets at end of financial year (you can really adjust for certain numbers, but for simplicity, let’s just skip it).

Per Outlets ($’000)  FY12  FY13  FY14  FY15  Avg 4yrs
Store Counts 42 40 44 46 43
Revenue per outlet 1,336 1,533 1,426 1,363 1,414
EBIT per outlet 108 194 195 100 149
Net profit per outlet 89 160 166 103 129
Owners earnings per outlet 123 208 126 47 126
Labor costs per outlet 335 370 352 381 359
Rental per outlet 365 372 362 392 373
COGS per outlet 290 306 263 226 271
PPE Net per outlet 233 226 229 251 235
PPE Gross per outlet 521 584 624 711 610
Capex per outlet 69 100 131 162 115
Depreciation per outlet 94 102 95 106 99
Rental deposits per outlet 58  51 75  83 67

The average number of stores from FY12 to FY15 is 43. In those 4 years, each outlet earns revenue of $1.41m and net profit of $129k per year. Major costs: Food costs 271k, labor costs 359k, rental 373k.

PPE Gross tells us that the total investment (before any depreciation) in each store (kitchen equipment, furniture & fittings, renovation, motor vehicle, computer and office equipment) is 610k.

Rental deposits per store are 67k. As the rental is 373k per year, monthly rental is 31k. So, the rental deposits are around 2 months of rent.

As a business owner, to start one store, you will need to invest 610k in the store assets (renovation, kitchen equipment, etc) and rental deposits of 67k. You will also pay one month rental in advance, which is 31k. The total is 708k. You will also need some cash buffer for working capital, such as salary and inventory (food material). But let’s assume you can have one month of credit to pay them. That is, you pay the workers’ salary and suppliers at the end of the month. On the other hand, you have the advantage of collecting cash immediately from your customers in daily transactions.

For a total investment of 708k, you get net profit of 129k per year. That translates to a return on invested capital of 18.3%. In 5.5 years, you get back all your capital.

Now, these numbers are very raw and provide a rough calculation, but, overall, it gives you a rough idea how each store is doing, the net margin, cost breakdown, and return on investment. The best year in FY13 has return on invested capital of 24% and the worst year in FY15 has return on invested capital of 12.4%. That’s nearly 2x the difference.

If we are to adjust the numbers for one-store P&L, the net effect will be positive because the costs to take out will be higher than the income to take out. Net profits could be adjusted by taking out 1) 1.1m from the income side for “other income” and “share of profit of associated companies”, 2) more than 1.5m from expense side for key management and HQ office salary, 3) tens of thousands from expense side for HQ office & central kitchen rent and depreciation. HQ assets could also be taken out from the total invested capital, hence, with lower invested capital, the return rate would increase. Therefore, without the HQ overhead, we should expect higher net profit margin and return on investment. This could bring the payback period to 4 years or below.

As a business owner, each year you will need to spend on capital expenditure (capex) for kitchen equipment, furniture and renovation. For one store, not growing, the capex should generally be close to the depreciation amount or at slightly higher. Therefore, the net profit is quite close to cash flow that you can get out of the business.

Owner Earnings

Owner Earnings = Net Income + Depreciation & Amortization + Non-Cash charges – Capex – Change in Working Capital

If we take the raw numbers from FY12 to FY15, the average owner earnings is 126k per year, which is very close to net profit of 129k. However, note that the capex in the calculation of owner earnings should be maintenance capex. Our capex number above include both maintenance and expansion capex. The number of outlets expanded from 42 in FY12 to 46 in FY15; therefore, part of the capex in those periods was certainly for growth. The capex in any year could be as low as 69k to as high as 162k. When the capex is high, you expect the Group to open more outlets.

This owner earnings calculation is good for checking if the net profit is representative of the actual cash flow that the business owner can take out of the company. For some capital-intensive business, the companies can get 10% net profit but have to spend half of the profit to reinvest in the business just to stay competitive and maintain their unit volume for the following years.

Return on Equity

Returns on Investments  FY10  FY11  FY12  FY13  FY14  FY15
ROA 19.3% 9.8% 13.1% 18.9% 19.0% 12.4%
ROE 34.0% 14.2% 18.2% 25.6% 24.9% 15.5%
ROA excl. excess cash 24.8% 12.9% 21.3% 37.1% 37.4% 21.3%
ROE excl. excess cash 55.8% 21.8% 38.6% 77.2% 70.4% 32.3%

The returns on investment have declined from the high in FY10 to the low in FY15. However, even during the tough time in FY15, the ROE of 15.5% is still quite respectable, even more so after considering the excess cash that the Group is holding. If we exclude the excess cash from the book value, the ROE increases to 32.5%, reflecting a very profitable business for JFH.

Now, let’s compare it to the peers. Again, these numbers are from Morningstar without any adjustments.

ROE FY10 FY11 FY12 FY13 FY14 FY15
Japan Foods 45.55 16.08 19.6 28.18 26.85 15.8
Sakae 12.21 22.73 -20.73 11.99 4.04 2.36
ABR 17.11 17.19 91.48 9.09 8.32 8.14
Soup Restaurant 22.64 23.97 2.82 6.97 5.59
Tung Lok 52.14 -20.87 -55.01 -128.5 5.13 4.21
Jumbo 24.46 20.38
BreadTalk 17.44 15.82 14.95 15.41 12.41 6.56
Neo Group 52.37 21.81 33.76 31.08
Select Group 25.03 10.04 32.55 35.7
Average 27.85 24.84 32.81 15.90 16.87 12.34

JFH has higher ROE in all years except year FY11, in which they had 1.5m impairment on PPE, and year FY12, in which ABR had sky high ROE due to discontinued business. Taking the average ROE over the past 5 years, JFH’s ROE will rank 4th in the list of 9 operators. (notice the high ROE for Select Group, which was one of the reason why I bought it, and, luckily, I did it one month before the announcement of privatization plan). Therefore, both in terms of operating margins and return on equity, JFH is among the better performers. If the rental and labor crunch issues last way longer or get even worse, other operators will have to fight for survivability while JFH is still remote from the risk of closing down.

Management

High Management Ownership

The CEO and founder, Takahashi Kenichi, owns 65.98% of the outstanding shares. Its COO, Chan Chau Mui, owns 4.66%. That immediately tells you that the free float is low. As a matter of fact, it’s quite illiquid.

Performance-based compensation

The founder-CEO has a large interest in the company and wants to do it well. Prior to setting up JFH in 1997, he was a professional engineer in R&D. His total remuneration in FY15 was 564k, out of which 46% was salary (at around $260k) and the balance 54% was bonus and other benefits. His salary in FY14 was also around $260k but the total remuneration was higher at 716k due to performance bonus.

The total remuneration of the COO was 100-150k in FY15. For other key 4 management personnel, salary contributed around 45% of their total remuneration; bonus and other benefits contributed 15-20% while performance shares contributed the remaining 35-40%. Total remuneration of top 5 management personnel for FY15 was 1.02m. This remuneration agreement with more than half of the total based on performance is aligned with shareholders.

Conservative Financial Management

The management is quite conservative. Its internal policy is to always reserve cash for at least 6 months of operating expenses. The total expense in FY15 for salary, rental, repair and maintenance, royalty fee, utilities, consumables and other was 43m, and they held nearly 16m of cash (excluding rental deposit and financial assets totaling another 2.5m). This is cash generated from past years retained profits, not from debt. I actually wish they will use the excess cash to buy back their shares or pay dividends as this excess cash is earning very low return. Their business operation is earning a decent return on investment, but this excess cash holding bring down the overall return.

Conservative Expansion

In AGM2014, the management said they would not aim higher revenue at the expense of bottom-line results. Therefore, they are not adopting aggressive growth strategy in Singapore due to high operating costs, mainly in labor and rent. To grow, they will bring in new, proven concept from Japan to try in Singapore. If it works, they will expand it further. Menya Musashi and Osaka Ohsho are two examples. These 2 brands were brought in from Japan only in 2012 and have now expanded to 7 and 6 outlets respectively in Singapore.  The Group’s associated company runs Menya Musashi brands in overseas with 10 outlets in HK and 5 in China.

Given its experience and maturity to operating in Singapore, the Group could have chosen to expand to Malaysia and self-operate the restaurants there to grow the business. But it took lower risk and sub-franchised the Ajisen Ramen brand there in exchange for franchise and royalty fees. In FY15, it earned 242k royalty income and 213k franchise income for a total of 455k (vs 602k in FY14).

Cost Management

As mentioned earlier, they invested in central kitchen in 2012 to manage food costs and have since expanded the capacity in 2015. Since FY12, food costs have fallen from 21.7% of revenue to 16.6% in FY15 (and 15.9% for 9M16). The management is less able at managing other operating expenses, mainly labor and rental cost, but a significant part of this is beyond the management’s control.  The entire Singapore economy is facing the same issues.

To mitigate the increasing labor cost, the management have invested in automation. In 2013, they introduced iPad self-ordering system for some restaurants and have since expanded it to all restaurants. This frees up the staff to focus on providing faster food service and allow them to maintain a leaner crew. The impact has yet to been seen on the P&L though (or perhaps, without this ipad self-ordering system, the labor cost could have increased by another few percentage points?). The positive thing is that the management is willing to try using technology to improve their overall productivity.

Shares buy-back

As I mentioned earlier, I wish to see shares buy-back and, naturally, I felt excited when the management announced shares repurchase program in July 2015. The authorized buyback is 17.4m shares or 10% of the outstanding shares. It started its first buy back only in February 2016 and has done several times since then for an accumulated total of 500k shares (0.29% of the outstanding shares) with average price 0.38-0.40. Since this announcement in July 2015 until now, the share price has fallen by 20%. So, perhaps, the management think that share price below 0.40 is undervalued.

I am not sure if the management will buy back lots of shares. I think part of the reason to buy back shares is to offset the employee performance shares that been awarded. So, it’s likely that they will just buy back enough shares to offset the newly issued shares.

Overall, JFH has a management who are also major shareholders, with compensation package that is performance-based, conservative in its financial management and business expansion, willing to try different things and keep what works. They have also generated return on investment way above the cost over the years. In short, they are conservative, competent and run like a business owner. This gives me confidence that they are running the company in the interests of shareholders. What I wish the management could do is to retain less cash or use the excess cash to buy back shares or just return to shareholders in dividends. In FY15, the interest income was only 63k vs cash of 15.9m, implying interest rate of just ~0.4%.

Prospect & Risk

Singapore economy continues to face high rental and labor costs. But, there is brighter side. Retail rent fell by about 5% in 2015 and continues to fall in Q1 2016. More and more retail spaces are opening up in suburban area. When existing leasing agreements expire, tenants should have more bargaining power to negotiate for better rental rates.

Labor crunch continues to be an issue. Government does not seem to want to loosen the restriction on foreign workers hiring any time soon. However, since 2013, the Government have introduced several grants to help the local businesses, and JFH has benefited from them. In FY14, JFH received government grant worth $391k. In FY15, it received $416k and additional incentives for tax reduction. That’s why the effective tax rate for FY15 was around 8% only.  The Group will continue to receive grant for this year and next year at reduced rates.

When evaluating JFH’s business, we should theoretically exclude the government grant to calculate the actual operating margin. However, this government grant is available to all the SMEs and does help the bottom-line substantially. Better companies will also make good use of the grants to improve their overall productivity. Once the manpower shortage issue subsides, labor costs will be more manageable and the grant will be removed. The loss of government grant will be more than offset by the recovering operating margin if the company operates efficiently. JFH is an efficient operators compared to its peers, and, with so much cash reserve, I don’t worry that much about the labor crunch issue for JFH.

The negative SSSG for Ajisen Ramen, which has been going on for the past several years, is more worrying. If this persists, the Singapore market might have gotten “bored” with this brand, and this could be hard to turnaround. I see this as one of the biggest risks for JFH. F&B is a very competitive business and always has new entrants. In Singapore, as long as there is something new, many people are willing to queue long for it. The novelty of new restaurants will easily attract a large crowd of people to patronize the outlets. The good thing about JFH’s growth strategy is that it’s constantly trying to bring in new food concept to try and replace the unsuccessful ones. But with Ajisen Ramen contributing 42% of the revenue, JFH needs Ajisen Ramen to perform well to maintain or grow its profits.

 

Valuation

Now that we have analyzed the business of JFH. It has a strong balance sheet, good EBIT margins and ROE, and performs better than its peers. The management are conservative and operate like a business owner. We will value the Company.

I used Discounted Cash Flow (DCF) with some conservative assumptions:

  • With 6 new stores expected to open in 2016, the revenue could grow by 5-10% yoy in FY17. In current tough economy, I assume it could grow by only 3-4% in future years.
  • Operating margins could remain in 7-8% range for this year. The operating margins in the past 6 years averaged around 10%, so I assume the margins could rise to 9.3% over time, but still below the average 10% to be conservative.
  • FY16F expects to see higher depreciation, perhaps for the new investment in central kitchen in 2015 and new stores opening. However, with slowing revenue growth, I assume depreciation and capex will moderate.
  • 5 years of forecast period.
  • I used WACC of 9.5% and terminal growth rate of 3%. I think my WACC of 9.5% is quite high for JFH’s business. But again, I just want to be more conservative and see where it leads me to.

I arrived at ~75m valuation with these conservative assumptions. I hope my assumptions do turn out to be really conservative. If yes, then I will be well rewarded when the Group outperforms my expectation. If JFH performs worse than my expectation as the market deteriorates further, then I would have overestimated the value of the Company.

Compared to current market value of 68m, the JFH is undervalued by 10% using my conservative valuation estimate of 75m (or $0.43/share). This implies FY16 EV/EBIT of 12x and P/E of 17.2x. The net cash represents $0.093/share or nearly 24% of the market value. That’s quite high a percentage, hence P/E is not a good measure of valuation. EV/EBIT will be more appropriate in this case.

If I use less conservative assumptions (but not really aggressive though), the value estimate could rise to 85-90M (or $0.49-0.61/share), implying that the Company is undervalued by 20-25%.

Note that in the Enterprise Value (EV) estimation, nearly 75% comes from the terminal value. The present value of FCFF in the explicit 5-year forecast period contributed only 25% of the EV.  A 1% point change in WACC could increase/decrease the EV by 8-10m (or 14-18%). With such sensitivity, it’s foolish to think that our valuation is accurate or exact. In my past valuation exercises, a 1% point change in WACC could even change the estimate by more than 30%. Therefore, it’s important to be realistic in the DCF assumptions and use the final estimate as a guidance only, not treating it as an exact value of the Company being valued.

Catalyst

The share price has fallen by 40% from the high of 0.65 in July 2014 to 0.39 now. If I did this exercise at the start of 2016, I would have achieved the same valuation of 0.43 as now. Coincidentally, the share price was 0.43 at the start of the year, which would have been considered fairly valued at that time. However, if I had bought it then, I would have been sitting on 10% loss now. That’s why it’s important to buy with some margin of safety.

When the share price of a company keeps falling, even to way below our valuation, shall we buy immediately? or shall we wait for any catalyst to turnaround the company?

Example of catalysts in this case: profit margins recovered in FY16-FY17, or Ajisen Ramen brand reported positive SSSG, or revenue grew strongly with new stores opening, or government relaxed the foreign worker hire, or Singapore economy pick up, more stimulus, etc. For now, I don’t see any strong catalyst yet, and operating costs remain high. The 6 new stores opening in 2016 should be a good one to support the top line, and if the margins don’t compress further, we should see growing profit.

The answer to the question above really depends on how much you understand the business of the company and how confident you are with your valuation of the company. For the case above, I don’t have confidence in the year to year profit forecast as it always fluctuates. But given its operating history, business model, performance against the peers, and shareholder-oriented management, I have confidence that it can continue to compete profitably in F&B sector, the management will continue to run like a business owner, and its return on invested capital (though falling recently) will remain higher than the cost of capital. This should continue to create value for the shareholders.

As I have confidence with my valuation, I’ve decided to buy the company at current price of 0.39/share.

Other things to note:

  • JFH’s director, Eugene Wong, bought the shares twice in Nov 2015 for an average price of 0.47-0.48/share. The total value is not meaningful though (~$33.5k).
  • JFH bought back 500k shares (0.29% of the outstanding shares) in February – March 2016 for an average price of 0.38-0.4/share. This might form a support level for the share price.

 

Quick Estimation of Value

If JFH stops growing and opens no more new outlets from now on, we can reasonably expect the FCFF to be at least 3.6m per year. Dividing FCFF by (WACC – Terminal growth rate), we get 3.6/(9.5% – 3%) = 55.5m for EV. Adding the net cash of 16m, we get equity value of 71.5m. Share of profits from associated companies amounted to around 500k per year now. If we assign a low P/E of 7x on that profits, it’s worth 3.5m. Adding this to the total equity value of 71.5m, we get grand total of 75m.

This behind-the-envelope calculation is good to use when the company has become a slow grower with stable margin.

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4 thoughts on “Japan Foods Holdings

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