Japan Foods FY16 results

Japan Foods Holdings (JFH) released FY16 results three weeks ago. FY16 revenue was flat from FY15, while the EBIT fell by 10% yoy. You can refer to my previous post for my analysis on this Company. This post serves as follow up on the Company’s development.

Financials FY16

Impairment Charge

There was an impairment charge of $810k due to store closures. Without this impairment charge, the EBIT would have grown by 7.4% yoy, and the EBIT margin would’ve increased from 7.4% in FY15 to 8.0% in FY16. Therefore, the underlying fundamental of the business has slightly improved. For a slow grower that JFH has become, long-term EBIT margin plays one of the key roles in determining the valuation. A 1% increase in long-term EBIT margin could increase the value by nearly 10% for JFH.

We shouldn’t, however, treat this impairment charge as really one off. This impairment charge on PPE also occured in FY11, costing 1.55m. Store closure is part and parcel of the restaurants business. Under-performing stores will be closed so that the capital and resources can be better invested elsewhere. So, while this impairment charge may not occur every year, it will occur every few years for JFH. It is not just accounting cost. It’s a real cost as it means that some capital invested in the past was lost permanently. Those renovation, furniture and fittings that were sitting on the Balance Sheet and worth several hundred thousands of dollars will be worth nearly zero when the stores are closed. Some companies use impairment as kitchen sink to throw all losses into one year so that they can start the following year afresh and with higher earnings growth.

So, how so we treat impairment charge like this in valuation? There is no standard answer or practice on this, but here is how I do it in this case.

First, I look at the latest result without this impairment charge to assess the underlying performance. For FY16, the fundamental has improved as the costs were better controlled, and, consequently, the margin improved by 0.6% points. So, that is positive.

Second, the impairment charge should be included in the overall cost “over the years”. If I spread the impairment charge of 810k over the last 5 years (since the last impairment charge took place in FY11), then it averaged $162k per year. That’s close to 0.25% of revenue. Previously, I assume my long-term EBIT margin was 9.3%, which was lower than the average of 9.85% over the period of 5 years from FY11 to FY15. I adjusted it down to 9.0% now to be more conservative. This is negative to the valuation.

Comparison with the Peers

The long-term EBIT margin of 9% is still better than the average in the industry. The average EBIT margin over the past 5 years for several listed F&B retail companies in Singapore is 6-8% while JFH achieved closer to 10%.

In terms of ROE, JFH’s latest ROE dropped to 12.2% (after impairment). The average over past 5 years was around 20%, better than most peers’, where the average was around 17%.

Note that out of JFH’s 30.8m book value, 16.8m (or 55%) was in cash, which was held due to conservatism of the management. There is no debt. Without this excess cash, FY16’s ROE would increase to 27%, indicating a good return on capital. Even though the operating environment remains tough, the Company continues to generate return above the cost of capital and create value for the shareholders.

Valuation

While I adjusted the long-term EBIT margin down from 9.3% to 9.0%, the increased net cash holdings and the improved underlying business offset that. My valuation on JFH remains at 75m (based on DCF). At current market cap of 65.4m, it’s undervalued by 12.8%.

I bought the shares even though the margin of safety was only around 10% because of a few things:

– The dividend yield is 5.0-5.5%, which is quite good.

– 10% undervaluation

– The Company is opening 6 new stores in 2016, which will support top line.

– The ROE remains good in this tough business environment. The 6 new stores are likely to be value accretive.

– The business condition should improve 2-4 years from now, after which JFH’s operating margin could rise to its long-term average level. As a result, the earning could rise by more than 20%.

– The management is competent in running the Company (though I wish they return half the excess cash to shareholders or buy back more shares).

Over the next 3 years, if the business does improve, the potential return could be a total of 40-50%, giving an annual return of 12-14%.

If the business does not improve, I hope my estimate on the undervaluation could be corrected, which will yield a total return of ~25% including dividends. That’s annual return of 7-8%, still a decent level.

If the business gets slightly worse, there could be 0 to -10% loss after dividends. The worst case scenario can be anything, but given its historical performance and competency, the probability is low.

Given the range of outcomes, I think my investment in JFH should give a decent annual return of ~10% in 3-5 years.

Valuation Multiples

Based on the valuation multiple, it does not appear cheap. The current unadjusted P/E is 17.3x. Without the impairment charge, the adjusted P/E is 14.8x. But the cash holding alone is worth nearly 9.7 cents or nearly 25% of the market cap. Therefore, we need to look at EV/EBIT, which is more relevant to JFH. The adjusted EV/EBIT is 10.2x, which does not look cheap either.

The reason above valuation multiples are high is because they are based on last year’s earning, which was downbeat in this down cycle. I estimate that the normalized earning will have EBIT margin of 9% (lower than the averaged 10+% achieved in the 8 years). If last year’s revenue is to continue, then normalized EBIT is  9% x 62.8m = 5.65m, yielding EV/EBIT (normalized) of 7.8x.  This looks more appealing , though not very low either.

I’m not looking for just very low valuation multiple to buy. I have evaluated JFH’s business and assessed that the quality of the business does not deserve low valuation multiple. The market tends to pay a lot of attention to P/E multiple. Given the unadjusted P/E of 17.3x, the market is likely to think that it’s high. So, don’t expect the share price to have rally any time soon.

If the market has another sell off and JFH’s share price was beaten down further, I will reassess the fundamental business. If the fundamental remains good, I may add on the position as the margin of safety widens.

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