|Shares Out. (in M):||221||P/E||13||0|
|Market Cap (in $M):||10,613||P/FCF||800||0|
|Net Debt (in $M):||1||EBIT||823||0|
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Apologies, this is not an original idea but rather a follow-up to razor99’s original posting on Taiwan Sakura (9911 TT) back in January 2018.
Sakura’s stock price is up 25% since razor99’s posting (thanks/congrats!!), but we would just like to highlight a few things that were not mentioned before that we feel still make this company exceptionally cheap with good growth potential even though the stock price has risen.
Updated English background on the company can be found in the latest IR presentation https://mops.twse.com.tw/nas/STR/991120190529E001.pdf and annual report https://doc.twse.com.tw/pdf/2018_9911_20190624FE4_20190719_081331.pdf
1) Taiwan Sakura owns a significant amount of income-generating investment property, much of which has not been revalued, that is unrelated to the core business in Taiwan that generates all the consolidated cash profits. The mainland China investment property alone is worth at least 15% of market cap now, which together with net cash equals at least 30% of market cap today.
The largest of these income-generating properties, and the one not properly reflected on the financial statements, is actually located in Southern China in Shunde district, Foshan city, of Guangdong province. The rental income from this property is captured in the “Huanan” business segment, which as you can see in the above annual report (pdf page 83) designates “real-estate leasing” as a core business.
The property that generates all the revenues for the Huanan segment (roughly ~TWD 60-70 million per year depending on exchange rates) is a water heater factory for the Sakura China joint-venture (51% owned by Noritz and 49% owned by Sakura).
This factory is situated in a rapidly gentrifying location pretty close to Hong Kong: 廣東省佛山市順德區容桂大道南2號. All the Taiwan Sakura annual reports prior to the year 2017 mistakenly listed the address of this property as廣東省順德市桂洲鎮桂中南路138 號, which today would not show up on google maps or any other online mapping service. The reason why the two addresses is that Taiwan Sakura acquired this property so many years ago that city/district addresses at the time of acquisition had since been redefined for city/provincial mapping purposes. But the updated address never made it into Taiwan Sakura’s annual report until just recently.
According to Taiwan Sakura, the land at this location totals roughly 84,000 square meters while the plant (a very low rise building) occupies 81,000 square meters. If you were to street-view this location on Baidu maps (just type in 佛山市樱顺卫厨用品公司) then you would clearly see that the factory is surrounded by fairly nice-looking residential properties.
This Huanan property has definitely not been revalued in the financial statements of Taiwan Sakura since inception, and we think there is significant latent value at this location should the company ever monetize it (i.e. the paid-in capital of the Huanan subsidiary represents less than 10x the annual rental income, and a neighboring factory property was asked to vacate by the government not long ago). For example, a rough online check we did over a year ago showed the finished apartments across the street were selling for as much as RMB 12,000 per square meter.
We also hired a professional appraiser (one of the big global property brokerages) to do a desktop estimate of the fair rental income that this factory property should generate per square meter on a monthly basis as a factory and they came back with no less than RMB 18-20 per square meter per month. At 81,000 square meters for the factory building alone this translates into almost TWD 80 million per year, higher than the segment revenues of Huanan currently suggest. The same appraiser also informed us the current construction cost for this factory in this location would easily total RMB 1,500 – 1,800 per square meter and the land cost could easily reach RMB 1,500 – 1,649 per square meter. We spoke with an institutional China property fund manager and their personal guess was this location would – even under extremely bearish assumptions – easily fetch no less than RMB 2,000 per square meter in capital value for the entire 165,000 square meters of land/building currently on the site, or RMB 330 million (TWD 1.5 billion, 15% of the market cap today). Note none of the above estimates assumes rezoning from factory usage into residential usage – if that were to happen the capital value would be significantly higher than TWD 1.5 billion. That TWD 1.5 billion translates into about a 4% cap rate based on the Huanan segment revenues reported today.
We have shared our findings with the company. While we don’t expect anything to be done on this front short-term (realistically the most we can hope for is maybe an increase in the rent charged to the JV but that isn't what the company guided). Yet if you believe in the gentrification potential of the Greater Bay Area development plan (i.e. to merge Hong Kong / Macau with the rest of Southern China https://www.bayarea.gov.hk/filemanager/en/share/pdf/Outline_Development_Plan.pdf) then Taiwan Sakura is currently sitting on a very nice long-term option. We personally are skeptical that Sakura's mainland China appliance business can amount to anything really valuable given the severe competition from local players but should the whole thing fall apart then at least Taiwan Sakura has 100% ownership of the most valuable piece of their activity in China right now.
2) Water Heater distribution in Taiwan is rigged in favor of Taiwan Sakura and anyone else with a large after-sales service network because a) it does not rely on local gas utilities to play the middle-man, b) consumers are directly incentivized to replace/upgrade to energy-saving higher-margin water heaters, and c) a large chunk of the population does not have piped gas service yet but they eventually will (and buy a water heater in the process).
Water heaters are not normally an appliance that consumers spend much time thinking about, so barring an emergency, how do they get prodded into a replacement sale? The President and General Manager of North America Water Heating at AO Smith, the leading water heater company in America, answered that best in a November 2018 conference call. If you listen to the conference call (http://investor.aosmith.com/events-and-presentations) or have a transcript, you’ll see he underscored the role that gas utility companies play in incentivizing replacement sales:
“As I mentioned on the replacement side, the utilities are out there today incentivizing the replacement of products. There are 17 states right now that are offering incentives, 217 different programs out there touching over 30 million people. And so the incentives range from $300 up to $1,000 in some markets if the consumer will pull out their existing electric water heater and replace it with a heat pump residential product. So we're really tuned in to the utility and utility activity to help us for our growth moving forward.”
We spoke with someone who used to occupy a senior position at Rinnai in Hong Kong (one of Taiwan Sakura’s foreign markets) and he confirmed that the role of local utilities in distribution is critical in some markets like Japan or Hong Kong. We hear that in Hong Kong, for example, if your water heater breaks then your friendly Town Gas (the local monopoly gas utility) repair man will present you with a menu of replacement models to choose from. This replacement menu model (see example here: https://www.dropbox.com/s/6la116khmnn5nao/201809%20brochure.pdf?dl=0) will only have models from three companies to choose from: Rinnai (made-in-Japan models), Rinnai (made-in-China models), Noritz (made-in-China models), Noritz (made-in-Japan models) and Taiwan Sakura (made-in-Taiwan models). The brand names are of these three companies are hidden in the brochure but if you ask the repairman he will tell you the model numbers give away the manufacturing origin of each model (TNSW = Noritz China, RJW = Rinnai Japan, RS = Rinnai China, TNJ = Noritz Japan, ST = Taiwan Sakura).
In Taiwan, however, Sakura’s relationship with gas utilities is very different. The island’s 23 million people are served by 25 regional gas monopolies. 19 of these 25 gas utilities are controlled by the government’s Veteran’s Affairs Commission, and six are publicly traded. We visited four of the publicly traded gas utilities (including two that are privately-controlled), and we learned some insights that should bode well for Sakura’s replacement sales long-term.
First, Taiwan’s gas utilities are a poor appliance marketing channel because they’re extremely fragmented: the largest company Great Taipei Gas only serves 389,000 customers. Hence, the none of these gas utilities alone could really move the needle for Sakura as a sales channel. Taiwan’s gas utilities are legally required to visit homes for mandatory “safety checks” every two years – a prime replacement sales opportunity for many appliances – but no single utility that can cover the entire map. As we know from our investments in Taiwanese elevator companies, after-sales service requires economies of scale. The lack of a dominant gas utility in Taiwan meant that Sakura had to build its own island-wide service network to provide proprietary (free-of-charge) “safety checks” and “meter readings” to promote replacement products. Today, that after-sales service network (and the customer data it holds) is one of the key advantages Sakura brags about.
Second, Taiwan’s gas utilities are not incentivized to help (or compete) with Sakura in gas appliance distribution because their core business of supplying gas is so consistently profitable. Why? Because the Taiwan government has legally granted each of the 25 gas utilities a “cost-plus” pricing model that guarantees them a fixed gross profit per unit volume of gas sold. In other words, Taiwan’s gas utilities face zero commodity price risk – all any inflation is 100% shouldered by Taiwanese consumers. Not surprisingly, potential energy savings are a key selling point for Sakura’s gas appliances.
Third, the other reason Taiwan’s gas utilities are not incentivized to help or compete with Sakura in gas appliance distribution is because they receive enormous sums of free “float” in the form of prepaid maintenance and installation fees. For example, when a residential property developer launches an apartment building with a hundred units, they owe their local gas utility company a hefty prepaid fee for each of those hundred units. The prepaid fees amount to many years’ worth of potential maintenance capex. Not surprisingly, Taiwanese utility companies have taken full advantage of this interest-free float to make side investments in securities and real estate. This float is the key reason why Taiwan’s publicly traded gas utilities each earn double digit unleveraged returns on equity.
Lastly, the number of gas utility customers in Taiwan are almost certainly going to continue to increase for years to come. Why? Because many households still don’t use piped gas to heat their homes and cook their food. Most of these families live in extremely old housing structures that rely on tanked gas or electricity for their heating and cooking – but neither alternative is as cheap or as safe as piped gas. As these families upgrade out of older housing structures and into modern homes, there’s an extremely high chance they finally get connected to a piped gas utility. Likewise, the continued growth of gas utility customers should be an important tailwind for Sakura’s appliance sales going forward.
All of the above reasons convinced us that the Taiwan gas appliance replacement market is currently rigged in Sakura’s favor. As Rinnai and AO Smith have done in Japan and the US, respectively, Sakura has replaced old water heaters with higher-priced, feature-rich models – a boon for profit margins, yet this still hasn’t led to a dramatically higher P/E multiple or dividend yield, which is still at a big discount to regional peers with arguably less growth potential.
 Sakura sold 350,400 (mostly replacement) water heaters in Taiwan in 2017.
 Tokyo Gas in Kanto Japan or Town Gas in Hong Kong would be examples of regionally dominant gas utilities that can and do distribute a lot of appliances.
 It’s strange system: gas utility customers in different territories pay very different gas prices, and the differences are not related to income levels. Some lower income suburbs of Taipei, for example, have higher gas prices than higher income parts of central Taipei.
 Staff at Taiwan’s gas utilities are just not that hard-working. In our October 2018 visit Shin Hai Gas, for example, by the time our meeting was over at 5pm, security guards had to re-open the gates to let us out (everyone else had gone home already).
 From 2009 to 2017, water heater unit sales at Sakura’s parent company have only increased 14%, but total revenue increased 40% thanks to premiumization from replacement demand. Rinnai trades at 18x P/E with a 1% dividend yield while Kyung Dong Navien, the Korean leader in water heaters, trades at 25x P/E and a 0.5% dividend yield.
Continued growth in the core Taiwan business which leads to higher dividends; monetization of the Huanan property in China.
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