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Evaluation of Takefuji

I evaluated a Japanese high-risk consumer lending company called Takefuji and am planning to take a position in it. I tried posting the report online but it's too big and formatting isn't the greatest but here it is (if anyone wants the PDF doc e-mail me):


Takefuji (JP: 8564; TAKAF.PK) Investment Evaluation

Written: June 27, 2007
Last Updated: July 17, 2007

Sivaram Velauthapillai
(sivaram.velauthapillai[AT]gmail.com)


I’m just a newbie investor with a contrarian tilt so feel free to e-mail or post comments to correct any mistakes or to improve things. Do not blindly base any decisions on anything I say; I don’t know what the hell I’m doing ;) . Also, since I write over a period of time, some facts and numbers may change from when I first looked them up (this is definitely the case with any market-price info e.g. P/E ratio).

Summary

Takefuji is a Japanese financial company that provides lending to high-risk consumers. It provides high interest unsecured loans to consumers who obviously are unable to get lower interest loans from conventional banks and other sources.

Takefuji looks attractive from a contrarian point of view. The stock has dropped 50%+ in the last few years due to changes in government opinion and court rulings. Essentially, the industry lost its ability to charge extremely high interest rates between 22% and 27% (in the so-called gray zone), and the courts ruled that the industry needs to refund consumers who were charged these high rates. Nearly all the companies in the industry wrote off large losses in fiscal year 2007 (ending in March 2007 for Takefuji). Takefuji lost around 30% of its book value due to the write-off.

I came across this company from John’s blog at controlledgreed.com (thanks John)…

Industry Comparison

The consumer lending market in Japan is dominated by four companies (Takefuji is the 4th largest lender by assets). Here is a market share chart of the consumer finance industry from an Aiful presentation:

(source: Aiful Investor presentation)


One can think of this sub-sector as an oligopoly but there are bigger financial companies (such as credit card companies, diversified banks, foreign financial institutions, etc) that can enter the market. Although conventional banks have more financial firepower, the consumer lenders have a big advantage with their consumer database, history of working with individuals & small businesses, and the ability to absorb bad publicity. Let’s face it, high-interest rates gets everyone riled up (happens in Canada and USA from time to time) and some conventional banks may not want that public relations issue.


[TABLE DOES NOT SHOW UP PROPERLY]

(Source: Bloomberg.com, finance.yahoo.com, bigcharts.com, company reports)



The chart above lists some competitors. I picked a few competitors and some random companies in the sector to look at them for reference (I need to find a better US company for comparison). I am also listing some figures from 2006 since that is the last profitable period (do note that profits will decline from the 06 peak due to legislative changes).

I was evaluating whether to go with Takefuji or Promise, and like Takefuji better. Promise is more diversified and has more potential, while Takefuji is safer. Takefuji’s dividend payout ratio is around 60% while Promise’s is around 37% (for 08 estimates; Promise’s dividend in 08 is half of what it was in 06 for some reason). With all the uncertainty in this industry, and with my lack of understanding of the Japanese market, I think it’s safer for me to go with Takefuji.

Takefuji has a forward 2008 P/E of 12 (management earnings estimate), while providing a 5% dividend yield. The price-to-bookvalue is 1.3, which isn’t very cheap but isn’t too expensive either. The P/E ratio has been around 14 during the last few years, with it hitting a low somewhere around 8 in 2003. So there is room for P/E expansion back to the historical past assuming profitability hasn’t been permanently damaged due to the regulatory changes.

I don’t know this industry well but ROE is very bad at around 5% in 2006 during the last profitable year (Promise has a similar ROE). We are basically looking at a low-growth company so that’s one thing that concerns me. Profit margin, however, is pretty decent with 13.4% in 2006. But I should note that Japanese companies are not run efficiently from a financial point of view. Many companies avoid debt and don’t buyback stock or pay out dividends as much and hold too much cash compared to American companies (all of these typically depresses ROE).

Valuation

INCOMPLETE (using net income instead of FCF)

I’m having a hard time figuring out the free cash flow. I’m not sure what the depreciation & amortization or change in working capital are in the following formula:

Unlevered Free Cash Flow (def 2) = EBIT after taxes [Operating Income – Taxes] + Depreciation & Amortization – Capital expenditures – Changes in Working Capital

I’m using this DCF calculator: http://creativeacademics.com/finance/dcf.html


Free Cash Flow: 53,600 (Yen) [estimated FY08 net income; need to use FCF]
Discount rate: 15%
Cash Flow Growth Rate: 5% [5% might be a bit high but book value grew at around 5% from 2002 to 2006. Even with the loss of the high interest loans, 5% is achievable.]

Present Value = Yen562.8B = US$4.6B

Using FY08 net income as a rough estimate for free cash flow yields a value of US$4.6B. The stock is trading around this value right now. Not too cheap according to this calculation but if you think that the company will trade above book value (historically it has, and most mid-cap/large-cap companies do) then it doesn’t look too bad.

Bull Case

Long History

Takefuji has been in business for many decades so this is not some fad that is going to disappear any time soon. The owner is not part of the company so the company may have lost something over time but things still look good for the long term.

Strength

Takefuji is one of the largest consumer lenders so it is likely to do better than the competition if things deteriorate further. Some companies are exiting or will go bankrupt in the gray zone credit area (eg. Citi decided to close 70+ branches), while Takefuji may do well and gain market share. Declining industries are not necessarily bad if you are the strong one that is gaining market share.

Positive Economics

The economic situation in Japan is finally improving. Although investors have been burned many times over the decades trying to pinpoint the turning of the Japanese economy, I think it has finally turned a tough corner. Here is a chart of unemployment from the Takefuji website:

(source: Takefuji Investor Relations website)

GDP growth is also pretty good so far this year, but it remains to be seen how Japan does if the US economy slows as I expect.

2003 redux?

The stock is presently trading below its December 2003 trough of around 4800Yen. You can basically buy the company as if it were 2003. Now, what has changed in the last 4 years? Well, the company is bigger, founder has passed away, more international owners, and the Japanese economy is in far better shape than back then. For instance, unemployment rate, default rate, and consumer spending are in far better shape now than back then.

The government legislation is a big negative change but profitability should return. Perhaps revenue won’t hit the levels in the past couple of years any time soon, but as investors we are paying for free cash flow (or earnings). I can see cash flow staying strong. This isn’t some industrial giant with high capex so trimming labour and discretionary spending to account for the new environment can return things to desirable levels. So I think the situation is not significantly worse than 2003 yet the market is pricing it lower.

High Dividend

If dividend is kept at the current amount, you are looking at a yield of around 5%. This should provide a floor to the stock, and help during any weakness (possibly if the world economy slows). However, it can be costly (for small investors like me with very little money) to re-invest the dividends (I basically won’t be reinvesting and hence will lose the compounding benefit  ).

Value Investors

Value investing firm Brandes Investment from USA has a big stake so this is a positive. They seem to be very focused on producing results and taking management to task. Unfortunately, Japanese companies seem to be caught up in nationalist thinking and often introduce poison pills that are harmful to shareholders.

John from ControlledGreed.com took a position, albeit money-losing one so far. I don’t know anything about him but he seems to be a contrarian-type investor. (There is a good lesson to be learned from John’s investment for contrarians and value investors. If I understand it correctly, one of the reasons John took a stake was because the company was trading below book value (around 0.7), with lots of cash on the book. But all that meant nothing when it had to take a massive loss due to interest re-payment back to their customers in 2007. So the book value really meant nothing and the company now has a book value of around 1.3).

Potential Yen Appreciation

Although making a call on a currency can be harmful to one’s health ;) , I think there is a reasonably high probability that the Yen is likely to appreciate over the long-run. Better economic growth, potential unwinding of the Yen carry-trade, and improved government policies are some reasons the Yen may strengthen against the US$ (and if commodities slow down as I expect, against CDN$ as well). Since most of the money is flowing into emerging markets and commodity-oriented currencies (eg. Canada, Australia, Brazil), a bullish Yen call is contrarian.

The Economist’s Big Mac Index and some investment banking studies quoted by the Economist imply that the Yen is the only major currency undervalued against the US$. Makes sense... I mean, who the hell wants to long the Yen when all the hot action is in emerging markets and currencies/countries levered to commodities.

Bear Case

Declining Revenue

Takefuji has seen declining sales and income for the last few years, even before the current onset of problems. For example, revenue declined from Y428B to Y351B in FY2006. Even before Takefuji started exiting the gray loan market, revenue has been weak. (However, management expects income to go up in FY08 compared to FY06).

Further Write-downs

There is a possibility that further write-downs may occur due to the lawsuits. It looks like most of the future problems are being accounted for, but one can never be sure.

Permanent Damage to the Industry?

One of the big risks is that the industry may have changed due to the court verdict eliminating the gray zone lending. The highly profitable sub-prime segment may have been weakened. This is where Takefuji had a big competitive advantage over conventional banks. Takefuji will now have to make money off more creditworthy customers and will put them into competition with a normal bank.

Margins may decline due to the lower max interest rate (it obviously will depend on cost cutting vs loss of the super-high-yield customers). More than 50% of outstanding loans were in the higher interest rate areas so it’s not clear how badly profitability will be impacted in the long-run.

Takefuji may permanently trade at a lower market cap in the future if consumer loans are not what they used to be. Namely, if Takefuji has to compete against the established conventional banks for a big chunk of its business, it may never recover its past valuation.
No Catalyst

There may be no catalyst to propel the stock upwards. The stock can stagnate for years and the opportunity cost of that can be high. This is not a sexy industry where a new product or technique will shine the light on this firm.

Worst Case Scenario

The company may start losing more sales due to the loss of the lucrative and competitively advantageous high-interest loans. Takefuji is one the strongest in the Japanese high-interest credit area so it should not do as badly as some of the competition. I think Takefuji can actually take away some market share even during bad times. So, the worst case may simply be another 30% to 40% decline in the stock price.

Another possibility is that the stock may not recover. The Japanese equity market is already trading at a high valuation (forward P/E on Nikkei is around 37) so it is possible for the stock to stagnate for many years at these levels. Opportunity cost of holding a flat stock for years can be high.

Investment Thesis

Takefuji looks attractive from a contrarian point of view. Takefuji has a long history, is a mid-cap, and is financially stable. The company is a potential turnaround story, which the market has not priced properly.

Business should stabilize and see positive growth in a few years. The macro environment is improving, with improving economic growth and declining unemployment rate. Furthermore, the Yen is likely to appreciate in the long term.

I think it’s worth buying the stock below 5000Yen (approx. US$40.65). I’m planning to open up a Yen-denominated account and try taking a small position. Since I think Japan has the potential to rebound for the long-term, it’s worth opening up a Yen account. If the stock goes back to its recent historical average of around 7000Yen (from 5000), one is looking at a 30% return (excluding dividends and potential Yen appreciation). Organic growth and shareholder activism (seriously needed in Japan) should boost the returns quite a bit above that.

I think it will take around 2 years before the company leaves behind the legislative problems (why invest now then? well, because it’s hard to call the exact bottom; Yen may appreciate; and the market sentiment may change for the positive). Lots of uncertainty but it’s a solid and profitable business.

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