Trading slightly above net cash: KSK Co Ltd

KSK Co Ltd (9687.Japan)

Price: ¥450 (3/7/2012)

Following up on my last post regarding the performance of Japanese net-net's over the past year it's only appropriate the next company I talk about is a Japanese net-net.  I found out about this company when a reader emailed me asking my opinion of it.  I did some research and put my thoughts together in a post.

KSK is a Japanese company IT services company grouped as following, hardware and semiconductor design, network design and maintenance, and network construction.  The company is listed on the Jasdaq which is part of the Osaka Exchange.  The Osaka Exchange is known for being a derivatives exchange and a secondary stock exchange.

The company also has a few subsidiaries, one subsidiary is a tech support company.  The second is a company formed to manage and maintain networks for the health insurance industry.  There might be a third subsidiary that provides tech support for a specific local government, I couldn't understand if this was part of the first subsidiary or not but it was broken out separately.

The main line of business for KSK is software for semiconductors.  The software they design can be found controlling chips in everything from Android phones to cars.  They create some software on a contract basis for clients and other software as stand alone products they sell themselves.

Quick Thesis & Highlights

The investment thesis on KSK is pretty simple, this is a company with a negative enterprise value that's trading for less than 2/3 discounted net asset value.  The company is profitable, has no debt, and has a solid stream of free cash flow.  Management seems to be aware of the valuation disparity and has been buying back shares somewhat aggressively over the past few years with 16.5% of outstanding shares being repurchased.

Here are some key bullets on the stock if the above paragraph is a bit too much to read:

• ¥3.4b market cap ($42m)
• ¥5.2b in cash and securities, only ¥40m in short term debt
• Net cash of ¥439/sh and discounted NCAV of ¥709
• Profitable for the past nine years
• 3.3% dividend yield
• Management has been buying back shares in 100,000 chunks when possible.  About 16.5% of the total outstanding shares have been repurchased.

Companies like this only come along in Japan.  I have two pictures below, my net-net worksheet, and my earnings accruals worksheet.  When investing in Japan I want two things, a strong asset based margin of safety and solid earnings/cash flow to support my margin of safety.  The accruals worksheet is one way to check the quality of earnings.

There is really nothing all that surprising with the balance sheet, a large amount of cash and receivables with a small bit of inventory.  I would be concerned if an IT services company was carrying inventory but that's not the case.  Liabilities are mostly composed of payables and other working capital items.

The accruals worksheet shows that balance sheet accruals dropped over the past year whereas income based accruals were running in the 6% range.  Neither of these numbers raise any eyebrows.  The explanation for the drop in balance sheet accruals is due to a drop in inventory.

Checking accruals seems like such a simple task but you'd be amazed at how many companies I've rejected based on poor quality earnings.  For a Japanese net-net to get my investment I want high quality assets along with high quality earnings.  I'll put up with low quality earnings, or a turnaround in the US, but in Japan I can demand both and find companies that meet my criteria.

Why cheap?

This is a question I always want to ask of any potential investment, why are the shares cheap?  I think investors often get complacent on this point, but even on a very cheap stock like KSK I think the exercise has value.

KSK is trading at such a large discount to liquidation value, and a reasonable valuation for what I believe are a few reasons:

• The company is in a tough market, IT services is a commodity business and the semiconductor segment is struggling with overcapacity.
• KSK has seen revenue slip and continues to talk about the tough economic conditions it faces.  Clearly this isn't a company on the cusp of record breaking earnings.  Some economic commentators have stated they feel Japan is in a depression.
• The company trades on the Osaka Exchange which is a lot less visible and is more illiquid.  Many foreigners don't have the ability to purchase stocks on the Osaka Exchange.
• While management seems to be somewhat friendly in the sense that they pay a dividend and are buying back shares a liquidation or a buyout doesn't seem likely.

Even with all the potential negative company specific factors and larger Japan macro factors at play I think KSK's discount to liquidation value more than compensates for the downside.  This is a company that if liquidated today would give shareholders an immediate 80% return.

Without anything glaring that could possibly justify the valuation I decided to add KSK Ltd to my collection of Japanese net-net stocks.  With the language differences and my lack of in-depth of understanding of their business I will probably sell KSK when the stock hits NCAV. 

Talk to Nate about KSK Co Ltd

Disclosure: Long 9687 KSK Co Ltd