Description

Thesis
This is a relatively simply story, the cash and securities on the book are worth more than market cap and the operating business is free. Obayashi Corp is a Japanese construction and civil engineering company with a very long history that has allowed them to build up a book of real estate and Japanese securities. The securities, net cash and real estate are worth more than the current cap implying that the market is placing a negative value on the construction business which has averaged ¥20 billion in free cash flow per year. Weakness in the government’s public building pipeline and the market’s perception of that as a key driver, coupled with a recent bid rigging scandal, have creamed the stock price. I have met with the company and they are confident in the future of the construction business and also believe there is excellent potential in real estate. Management believes margins will recover close to the historical average and that group margins can go higher than that. The construction and civil engineering segment is valued using conservative assumptions considering the history. I assume sustained 2.5% free cash flow margins with little growth on a well entrenched business in Japan with significant technology and earthquake expertise expanding into Asia and California, not a stretch. On that basis and with the rest of the balance sheet at market you have over ¥1,000 per share.

Management says moral suffered greatly earlier this year with the bid rigging scandal and subsequent dismissal of the CEO and demotion of the Chairman, but the new President and CEO, Toru Shiraishi, has brought a renewed vigor and air of excitement. There is a decent amount of insider ownership with Takeo Obayashi, the former Chairman and family scion, owning 3.7% and the employee purchase plan owning 4.0%. Also, Shiraishi has indicated he plans to purchase shares

Business
The construction industry in Japan is concentrated among the four public super generals and one private competitor. These companies go back to WWII and before, and have benefited hugely over the years from the post war reconstruction and resulting government relationships. Obayashi traces its history all the way back to 1892.

Public construction and civil engineering contracts were abundant and highly profitable for much of this history. The structure of the industry allowed the five major players to essentially collude on price setting.. Obayashi used this decades of excess profitability to accumulate a massive securities book and real estate portfolio.
 
Recently public spending has moderated. The government is pulling back on infrastructure development in the face of population decline and tight finances. These fat public contracts have become fewer and further between. At the same time the collusive nature of the bidding and awarding of deals has come under the microscope. Historically this was the stereotypical construction market with massive public spending greased by large amounts of back office deals and envelopes of cash. Now, the public and the government want that to change. Obayashi has been the leader in publically committing itself to above board deals. That came back to bite earlier this year when a bid rigging scandal broke involving several current and former Obayashi employees. The parties involved were relatively low level. Obayashi acted decisively to head off public criticism by sacking the President and removing the namesake Chairman of the company, Takeo Obayashi, from his leadership post. He remained on as a company director.

I don’t believe the bid rigging scandal will have any material impact. It was truly a provincial issue and the company reacted resolutely in dealing with any fallout with high level forced departures. There were some suspensions from bidding on new deals by the Minister, but these caught essentially the entire construction industry, not just Obayashi. Several projects were simply put on hold until suspensions expired because there was no one left that was qualified to execute them. All that to say, one of the primary reasons the stock has gotten cheap is short term and will not have a material impact.

From a profitability perspective the rationalization of public contracts is impacting industry margins. This should impact Obayashi relatively less that their competitors as the construction and civil engineering business is less than 20% public building. 80% of the revenue comes from private construction. Orders received has been growing faster than revenue over the last five years helped by expansion into Asia and the United States. Obayashi’s earthquake zone construction expertise is in demand in these seismically active markets. Construction margins will be lower this year and into next, but management believes that the normal gross margin in construction will return to the 7% range in the next few years, which would generate cash flow above my valuation assumptions.

Management
The new appointed President and CEO, Toru Shiraishi, is bringing a new life to Obayashi. He has been at the company for several decades and worked his way up the ranks. The scandal and subsequent management shakeup earlier this year have given him a bit of a fresh slate. Being a lifer in a Japanese company it is doubtful that he will shake things up much, but he has brought a renewed optimism to the employees. There is substantial ownership among employee, most of whom will work at Obayashi their entire career. Takeo Obayashi is the great grandson of the company founder. He was forced to fall on his sword after the bid rigging scandal and step down as Chairman. He remains on the board and, assuming he is rational about his net worth, should be a positive influence on creating shareholder value. Importantly, Shiraishi has indicated that he intends to purchase more shares, a bit of a rarity in an old guard Japanese company such as this. The employee ownership, family board member ownership and CEO ownership will hopefully provide an alignment of interests with minority shareholders.

Securities Book
Obayashi owns over ¥500 billion yen in equities with a cost basis of ¥140 billion yen. There are 93 positions in all but 10 of those make up the bulk of the holdings led by Canon at ¥100 bill, Mitsubishi Estates at about ¥60 billion and Toyota at ¥50 billion. The Japanese market has been weak over the past few months, another reasons Obayashi has gotten cheaper, and these positions are worth more than the current carrying value. Obayashi claims that these are held for strategic business purposes, i.e. having cross holdings helps get construction business from these guys. However, when pushed they also admit that this is not the best use of capital. They say that management is quite aware of this as it is pointed out often. I suspect that a bigger reason why these are held is the tax consequences. At a cost basis of ¥140 with the Japanese corporate tax rate it would cost a healthy chuck of cash to exit. If there is not a better use for it the cash is better off being held in high quality securities such as these, especially since they are undervalued. An ideal development would be to sell off most of the securities and do a massive buyback here at half of intrinsic value. That would be seismic event for a company like this in Japan, and is highly unlikely to happen. That being said the company has indicated they plan on funding ¥200 bill in real estate acquisitions over the next few years from cash on cash and cash from operations. This seems to imply that they will harvest some of these securities to fund the reinvestment, showing that the company will monetize investments and pay taxes when they see an attractive outlet for the funds. In the absence of a buyback this is the best way to behave. To be safe I am dinging the value for the estimated present value of the tax hit of exiting the entire securities book. 

		Sym	Shares	Value
Canon		7751 JP	16,527,607	101.0
Mitsubishi Estates		8802	18,922,796	64.0
Toyota		7203	8,074,144	54.0
T&D Holdings		8795	3,530,000	26.0
Sumitomo Realty & Dev		8830	6,027,589	25.0
Central Japn Railway		9022	9,293	11.0
Takeda Pharma		4502	1,313,697	11.0
East Japan Railway		9020	10,016	9.0
Kobe Steel		5406	16,390,530	7.0
NTN Corp		6472	5,619,147	6.0
				314.0

Valuation
The constructional and civil engineering business throws off pretty good cash flow. There is little working capital due to the subcontractor structure of payables management. After tax free cash flow has averaged over ¥20 billion per year over the last five years, but has been much higher before with only one money losing year in the last 10. I am being conservative and flat-lining that ¥20 billion per year, run it out 10 years, terminal multiple of 14x’s FCF and using a Japanese discount rate of 7% (risk premium over 10 year gov’t bond) to get a value of ¥380 billion. The real estate, which is primary residential development around Tokyo, I am carrying at asset value, although I suspect the market value of these residential developments will end up being higher, which is ¥452 billion. The marketable securities are held at the balance sheet value as of last report, which is ¥502, and I am dinging them for the PV of the estimated capital gains tax liability if all this were sold. Since I am valuing this on a segment basis I have also added in the corporate overhead expense, which runs at ¥27 bill per year, and capitalizing that with a 10 multiple. Add in the debt, cash and the full underfunded value of the pension plan to get
                                    Value
Construction               380,000
Real Estate                 451,811
Cash & Equiv             107,131
Equities                       502,730
Cap Gains Liab           -81,164
Debt                           -284,388
Pension Underfund      -70,346
Corp Ex                     -270,000
Total Value                  735,324

Obayashi has 718.3 million shares outstanding after adjusting for the 1.6 million in treasury shares for a total per share value of ¥1,023.7.

Within that value note that the securities book is cheap here as many of their big Japanese companies, Toyota for example, are currently trading underneath intrinsic value. The real estate is quite probably worth more than the carrying value as well. Not to mention that I am dinging them for the full value of the underfunded pension plan and a full CorpEx value. Obayashi’s ultimate value will likely end up higher than my current value. It is not necessary to subtract a working capital charge as the construction business is self funding and often generates cash. The structure of long term payables to subcontractors versus upfront and milestone payments on receivables generates a positive float for Obayashi. 

At the last price of ¥579 yen you have 77% upside to intrinsic value. There is very little chance of losing money in this company under any scenario as the take out value of the assets are just too high. On a risk adjusted basis that upside is even more attractive.

Catalyst

The most important factor of any value investment, time, is critical here. Fiscal year 2009 should see construction margins begin to recover. By then the market will have put the bid rigging issues into the background as well. The cash and securities book will probably be trimmed for new investment which may help the market appreciate the real estate book and potential.