Analysis of Wakachiku Construction Co Ltd (1888:TYO)

Here is an update of my analysis of last summer regarding Wakachiku Construction, a very small Japanese company active since 1890, in construction and real estate.

Valuation & dividend

Wakachiku is trading at an extremely cheap price in several respects. Its price is:

• 5.63 times current recurring earnings
• 7.09 times average recurring earnings
• 0.65 times book value and tangible assets
• 0.18 times sales
• 178.52 times current free cash flow
• 18.51 times the average free cash flow

As we can see, the company's valuation is particularly cheap compared to all criteria, except for the FCF. We note in particular that it is the last published free cash flow that poses a problem, since the average of the last five years remains quite correct, despite this latest increase. If we compare the enterprise value in relation to the FCF, we find ourselves in similar proportions, but a little more interesting, with a current EV/FCF ratio of 96.88 and an average EV/FCF of 10.04. It is quite normal for the free cash flow to undergo quite marked variations from one year to the next and that is why it is important to take the average into account. What is disturbing here is the extent of this variation, since last year the price was trading at only 5 times the current FCF. We will see a little later what explains these significant jumps.

That being said, the title nevertheless remains extremely accessible overall from a price point of view, which is confirmed by the EBIT which amounts to the trifle of 46% of the enterprise value (idem for the EBITDA).

Wakachiku's dividend is attractive, with a yield of 4%, always good to take in these times. It is also particularly well covered in relation to profits, with a current distribution ratio of 22,32% and an average ratio of 28,10%. On the other hand, the situation is obviously less good in relation to free cash flow, with a current distribution ratio of 707,92% and an average ratio of 73,99%. As we have already seen above, the average is more significant than the current data, given the normal variation of the FCF. The dividend is therefore not directly threatened, on the other hand it is very likely that it will no longer be able to progress as quickly as in the past (22,42% per year on average over the last five years).

Balance sheet & result

Just like the dividend, profits, asset values and cash reserves are growing over the long term, which proves the solidity of the business model of this Tom Thumb of construction. Wakachiku manages to create value for its shareholders, even if this has difficulty translating into stock market performance. The price has in fact "only" doubled in ten years. This is certainly not bad for ordinary mortals, but quite far from what one might expect from this type of stock. It must be said that the company is off the radar of most analysts and institutions (even Fidelity is not there). It should also be noted that the stock has underperformed over the past twelve months, with a loss of 17%, even more than other Japanese stocks. FCF's recent difficulties are part of the explanation, but we will see a little further down that it is not the only one.

Despite recently declining available cash, Wakachiku has still managed to increase its current ratio to 1.5, for a quick ratio of 1.37. This is certainly not huge, but no problem in any case for paying the bills. What is more problematic, however, are the margins. The gross margin is in fact only 10%, the net margin 3.21% and the free cash flow margin... 0.10%. That explains a lot! The company has difficulty transforming its sales into available cash, which means that despite a constantly growing turnover, the slightest variation in cash flow or equipment expenditure is immediately and significantly noticeable. The same phenomenon can be seen in Wakachiku's profitability, which is nevertheless correct. While the ROA is 3.92% (up) and the ROE is 11.52%, the cash flow return on assets (CFROA) only amounts to 0.41%.

The Tokyo-based manufacturer has a good handle on borrowing, with a long-term debt-to-asset ratio of only 1,38% (a notable decrease). The total debt represents only 0.2 times equity. Despite these more than correct figures, Wakachiku would still need a little over five years to repay all of its debt, given its low FCF. This is certainly not dramatic, but not ideal either. It should also be noted that despite a decrease in long-term debt over the last five years, net debt has paradoxically increased due to an increase in current liabilities. This represents a negative impact of 7,92% per year on average on shareholder returns, which is not insignificant. Fortunately, however, the number of shares outstanding has been stable for several years, which avoids any dilution of the company's owners' equity.

Conclusion

There is undeniably some good in this very small company, but also some bad. The FCF is struggling, with a very low margin and significant variations from one year to the next. The other black spot, which explains, with the weakness of FCF, why the stock is struggling to take off, is as we saw above the increase in net debt in recent years, despite a decrease in long-term debt. This has an unfavorable impact on the average shareholder yield (Shareholder Yield), which is negative (-5.15%) despite a dividend of nearly 4% and a stable number of shares outstanding.

That being said, we should not paint the devil on the wall either. Capital expenditure needs represent on average only 26.4% of profits. This means that the company can convert a large part of its cash flow into available cash. So, as long as the Cash Flow is assured, the FCF is also assured, and in some years like 2016 and 2018 this is particularly evident. In addition, the significant variations in cash flows have not prevented the company from continuing to grow its dividend, the value of its assets, its profit and even its cash reserves in recent years. It must be said that Wakachiku is not born yesterday, its origins dating back to the 19th century and its business can be considered rather defensive in nature, especially for the real estate part. This translates into a beta of 0.77, despite a fairly marked volatility, at 25.47%.

The negative return to shareholders due to the increase in net debt must also be put into perspective by the fact that the company's total debt remains at very prudent levels. The Z-Score (Altman), with 2.15, places Wakachiku in the gray zone, i.e. not absolutely safe, but also not at imminent risk of going bankrupt. The F-Score (Piotroski) is also very high, with eight out of nine possible points. It tells us that the company is financially solid and that its fundamentals are improving. This score is a fairly reliable indicator of the future performance of a stock.

At the current price, I believe the stock should nearly double to reflect its intrinsic value. The dividend should theoretically follow the same progression, although it may be slowed in the short term due to the FCF. Since I like to put things in historical perspective, in the late 90s, Wakachiku was trading at over 27 times its current price. If the pendulum had clearly swung too far in one direction at the time, it would seem that today it has swung too far in the other direction.

Is this Japanese SME therefore a buying opportunity, given its very attractive valuation? Since my acquisition last year, the price has fallen by 17% and the Japanese market has returned to a negative trend. For the moment, I therefore consider Wakachiku as a stock to watch because the momentum is clearly not going in the right direction. It is also possible that I will have to part with it, to remain faithful to my procedure stop loss. Yet another paradox linked to this very cheap company but whose share price is definitely not taking off, quite the contrary...