Value Investors Club / KUBOTA CORP (KUBTY)

Description

Founded in Osaka, Japan, in 1890, Kubota is a tractor, engine and agricultural equipment

manufacturer. Kubota also produces a range of products such as pipes and pumps for water

management infrastructure which represent 9% of group contribution (and 15% of revenue). The

investment case largely rests on the dominant tractor and agricultural equipment business. Kubota’s

niche is in compact, relatively low powered (<120hp), tractors. These are particularly applicable to

‘Wet Crop Agriculture’ in Asian markets, such as rice paddy fields. In the West they are deployed to

some extent in livestock farming, but more so as lawn and garden tractors, compact utility tractors,

residential and commercial mowers, utility vehicles, and golf and turf equipment to commercial and

retail customers. We estimate that 25% of Kubota’s revenue comes from ‘Turf & Utility’, (e.g.

lawnmowers and buggies), 15% from construction (e.g. small diggers), 45% from agriculture, and 15%

from water infrastructure. These are market areas that industry giant, John Deere, is not completely

absent from, but where Kubota demonstrates focus and leadership.

Market leadership

Defined by its product category focus, Kubota is the market leader in the regions and segments in

which it operates. It is the top supplier of agricultural machinery in Japan with c. 50% share vs the #2

Yanmar with roughly 25-30% followed by Iseki with a 20% share. In North America, Kubota is the

market leader in the <40hp tractor segment with 38% share closely followed by Deere with 30-35%

share, CNH with c.10% and AGCO with 5%. In Europe, it has the top market share of the <60hp

category with c. 30%. In the growth market of Thailand, where Kubota has a significant manufacturing

presence, Kubota has 70-80% market share.

Kubota’s scale advantage in terms of margins is significant, as shown below.

Source: CapIQ

Product quality

In addition to its scale advantage, Kubota has been successful at building a global reputation for

quality. Kubota has built its engineering excellence in producing petrol and diesel engines over nearly

100 years, starting in 1922 with an oil-based engine for agriculture and industrial applications. It

pioneered technologies that led to greater fuel efficiency and reliability. 40% of engine production

satisfies internal requirements. 60% is supplied to external OEMs.

We view Kubota’s engineering excellence as central to the overall quality proposition to its customers.

We spoke to several market participants including customers, equipment dealers, and ex-employees.

Kubota’s products are valued for their durability, reliability and efficiency. Kubota is generally not the

cheapest product on offer, but it has low lifetime ownership costs, with one dealer telling us that they

don’t sell that many Kubota parts because the equipment is so reliable. Kubota leverages its

superiority in engineering to offer competitive warranties that provide the customer peace of mind

and act as a strong signal about underlying reliability. Our interviewees were consistent in their

enthusiasm for the quality of Kubota engines.

It became evident from our interviews that this reputation for product quality was building strong

customer loyalty with one dealer telling us that 60-70% of his Kubota customers were loyal to the

brand, with some customers having stuck with Kubota for over 30 years. This was supported by a

discussion with a farmer, who told us that for small equipment, he would only consider Kubota. We

would not go as far as to say the enthusiasm for the product was at the same level as Deere’s

customers (farmers love big tractors) but the sentiment we heard was not dissimilar.

Like Deere, Kubota’s sales efforts are largely through a network of dealers in all geographies in which

it operates –an asset which has taken decades to develop. In the US alone, there are over 1,100

Kubota dealers.

Growth drivers

We estimate that Kubota has been adding about 20bps of market share annually in US compact

tractors over the last 6 years, and that they are making some progress from a low base in the >100hp

segment. In Europe, double digit revenue growth in recent years has outstripped the underlying

construction and ‘Turf & Utility’ market. Given the reputation of the brand, we believe it is likely to

continue to grow its share in both markets where there is a long-term tailwind of continued

urbanisation of the population..

In Japan, where the population is declining, we model that Kubota will gradually shrink in real terms.

Management, by contrast, expects to be able to deliver low single digit growth as further

mechanisation is required to replace a continued reduction in agricultural employment.

Kubota has a significant presence in Thailand, China, India (combined 13% of FY 2018 revenues) and

other developing Asian countries. It should continue to benefit from market tailwinds there, for many

years. As these countries move up the development curve, they follow a process of increased

agricultural mechanisation. Machinery, as well as other improving technologies, substitute for labour

as labour costs rise. Thailand has 2.1x agricultural workers per hectare of farmed land vs Japan.

Thailand’s mechanisation intensity – amount of agricultural machinery per unit of food produced – is

only 30% of Japan’s. The mechanisation gap in Myanmar and Indonesia is even more significant as is

shown graphically below.

Source: USDA

Capital allocation

In some market commentaries, contrasts are made between the Japanese vs US schools of capital

allocation. US companies are caricatured as ‘shareholder-friendly’, heavily focused on shareholder

returns, enthusiastically returning cash to shareholders and sometimes criticised for short-termism.

Japanese companies are stereotyped for their commitment to long-term strategies, running prudent

balance sheets, and demonstrating excellence in design and manufacturing efficiency. It is often

remarked that they hoard cash, are reticent to return this to shareholders and in some case have over-

invested with insufficient focus on return on capital employed.

Kubota is an example of a Japanese corporate that combines some of the attractive features of both

countries. It returns cash to shareholders in the form of regular dividends, special dividends, and share

repurchases: 52% of free cash flow has been returned to shareholders in the last 10 years. Kubota

maintains a healthy balance sheet and raises moderate levels of debt only to match the finance it

provides to customers for which there is a corresponding asset in ‘finance receivables’. Kubota

continues to invest in R&D and has a successful track record of entering a new product category each

decade. It is currently investing heavily in its M7 series of mid-powered tractors and has just

announced as larger M8 Series. Kubota makes few acquisitions and largely seeks growth through

organic investment.

Return on capital employed at Kubota is strong and attractive. We calculate Kubota generates a

consistent unlevered pre-tax return on tangible capital employed, excluding its finance book, of 20%.

We are happy for the business to continue to deploy capital which compounds, if there are investment

opportunities at this level of return.

Our discussions with ex-employees suggest the managerial culture emphasises cost control and

efficiencies in areas such as inventory management. Also, Kubota management does not manage

from an ivory tower in Osaka; their product R&D teams spend considerable time in the field with

customers understanding their needs. This was a consistent theme from our interviews with US based

Kubota dealers; it was not something we heard when doing similar interviews with Deere dealers.

Admittedly, there are some quirks to Kubota’s corporate finance approach that are less commonly

observed in Western markets. For example, Kubota has a modest level of shareholdings in over 10

other Japanese corporatesthat are seeminglyunrelated to its core marketplace. Its annual report

explains that this is to “maintain and enhance business relationships”. Nevertheless, in all, we are

comfortable as shareholders that management are good custodians of our capital.

Recent performance

Operating margin declined from 13.6% in 2015 to 10.2% in 2018. The key driver of this has been the

increase in the price of steel, a significant input cost, which rose c. 60% from early 2016 to mid-2018.

For reasons we explain above, Kubota has a strong enough position in its markets that it is starting to

push through price increases to offset this. At the same time, steel prices have softened c. 15%. Group

operating margins were up 0.2% in H1 2019 and we expect Kubota’s margins to further normalise.

Kubota has set out a 3-year plan in 2017 targeting to raise operating margins back to historical norms

of 14%.

One disappointment and drag on performance has been China. Between 2001 and 2016, Kubota had

established market leadership in China in “Head Feed” combine harvesters with 60-65% market share.

Their Chinese customer is not the farm owner but contractors who rent out their services, including

equipment, to the farms on an hourly basis. Kubota was able to charge a 300% premium for its

equipment because reliability and, importantly, durability was so much higher than local Chinese

competitors. However, a combination of excess competition between the contractors and sharp falls

in rice prices has resulted in the margins of the contractors being so squeezed they are struggling to

generate sufficient cashflow to buy Kubota kit¹ and Kubota has been ceding share to their cheaper

competitors. Kubota is in the process of responding to this by developing a lower cost product for the

market. However, we have taken a conservative view in modelling this market. The impact is not that

significant as China represents less than 5% of revenue.

Valuation

It is difficult to be certain what has weighed on the share price recently in the context of robust Q1

and Q2 2019 results. The market sometimes gives disproportionate weight to US AEM data. Whilst US

market tractor sales volumes are up 3.7% YTD vs prior year, July data was weaker and down on July

2018.

The share price is currently Y1,500, down from a Jan-18 peak of Y2,300. EV/Fwd EBIT is 11.9x vs an

average for the last 5 years of 13.4x. The calculation of EV here includes all of the debt which has been

raised to support their asset backed finance book. In theory there is excess cash above any equity

requirement for the finance book which is distributable to shareholders. Calculating EV on this basis

means that EV/Fwd EBIT is lower than 10x.

¹ Kubota is not attempting to solve this problem by offering customer finance. These contractors are single

person companies with only their equipment as an asset – not a great counter party for asset finance!

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Our thesis is not predicated on a specific catalyst. However, improving margins from lower steel costs and price increases to recover recently increased input costs may be helpful.

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			2019	2020
Price:	1,528.00	EPS	0	0
Shares Out. (in M):	1,228	P/E	0	0
Market Cap (in $M):	17,500	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	23,800	TEV/EBIT	11.9	0