Shinsho Corporation: Is the stock a bargain?

I was reading SG TTI’s post on Shinsho Corporation and Kobe Steel (read here), and I think it is a good read. For one, it spurs me to find out more about Shinsho Corporation. Or shall I say nudge me a bit out of my slumber :p

I like companies embroiled in scandals, especially scandals that do not affect the business fundamentals of the company but causes a temporary share drop. It reminds me of my experience with Sun Hung Kai Properties.

I typically don’t treat these stocks as long-term plays (unless in the rare case, it turns out to be a really good growth company with long-term profitability). It is basically about going in with the guns flaming and leaving when the hype of the news dies down. I am more concerned about the nature of the scandal (eg. will it have a long-term impact on its business), and whether the company has a strong balance sheet, and profitability to ride out the crisis.

More often than not, it is the stock which chooses me rather than me being the one picking the stock. These are situational plays and it can occur to any company at any time.

In the case of Shinsho Corporation, it is a cyclical stock and I typically don’t like to have a buy and hold strategy for cyclical stocks. And true to its nature, Shinso’s financials is… for a lack of better word, lumpy.

Shinsho Corp Balance Sheet

Generally, Shinsho asset to liabilities ratio looks ok. However, I wouldn’t think too much about asset values. Its values tend to tank in a worst-case scenario.

The latest Current Ratio of 1.19 seems slightly low but not alarming. (Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses). The Current Ratio has been trending upwards which is good.

Financial leverage is on the high side. But the figure has been trending downwards which is also good.

Debt/Equity ratio is also on the high side, but not alarming. From a pure risk perspective, lower ratios (0.4 or lower) are considered better debt ratios. However, again the figure has been trending downwards which is also good.

In gist, not exactly in the best shape but not in an alarming dismal state. Most importantly, I reckon it should be able to survive periods of low profitability.

Shinsho Exposure to Kobe

SG TTI mentioned in his post that for the year ending March 2017, as Kobe Steel is a client of Shinsho as well, Kobe bought ¥259,479mil of materials for equipment from Shinso. Now let’s extrapolate this back furthermore. Remember: Cyclical = Lumpy results; Quick buy and sell- no point extrapolating too far back…

Looking at the results from 2014 to 2017, we can see that the Sale to Kobe Steel accounted for approx. 37% of Shinsho’s revenue (average out). Note: I can’t find the sales amount figure in Kobe Steel 2013 Annual Report. It only reported the Sales of Kobe product not the purchase amount from Shinsho.

The tricky bit is forecasting how much Kobe’s revenue will drop (and how much it would impact Shinsho’s sale to Kobe). Kobe has retracted its annual financial forecast, saying it doesn’t know how much the scandal will end up costing.

Kobe Steel is forecasting profit of 35 billion yen (US$313 million) in the year through March 2018, after two annual losses, mostly recently because of falling margins in its steel business and a one-off loss related to its China construction machinery unit.

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While the immediate impact from the cheating scandal exposes 500 companies to potential safety issues, Kobe Steel’s total client base is far larger.

In Japan alone, more than 2,100 companies deal with the company, according to credit research firm Teikoku Databank. The majority of these firms, 56 percent, are the small to medium enterprises which make up the backbone of Japan’s economy.

(read here)

Looking at Kobe Steel’s financial (see below)… hmm how shall I put it… Under normal circumstances, I would not take a second look at this company. There isn’t any trend, and if there is – it is downwards.

Kobe Steel has lost money in five of the last 10 years. Then again, it might be the best time to invest in this cyclical stock.

A key point highlighted by SG TTI is that the industry is doing so well right now that Kobe Steel’s customers cannot switch to their peers even if they wanted to, as all their peers are running at full capacity right now.

In a best case scenario, the cleanup won’t cost Kobe more than a few hundred million dollars, leaving the company humbled but intact, according to analyst Takeshi Irisawa at Tachibana Securities Co. in Tokyo. In a worst case scenario, fines from the U.S. Department of Justice and claims from overseas customers could get a lot more expensive. (read here)

As of now, articles highlighting that Kobe Steel is losing certifications over its metal products and facing lawsuits have been popping up… so the exact impact will not be immediate. Come to think of it – it may not turn out to a hit and run kind of stock. The share price might continue further south in the immediate period.

Well, let’s just assume the worst. For instance, there is totally no sales to Kobe steel by Shinsho. Hence, 37% of Shinsho’s revenue / EPS will go up in smoke for the second half of 2017. This is even a worse case scenario than stated by SG TTI. The final year EPS will only be approx. 525.5 yen (Eg. 2H 2017 will be 63% of 1H 2017 EPS which is 322.41yen).

Thoughts on the Price to Earnings Ratio and Price to Book Ratio for Shinsho Corporation

Share-price of Shinsho on 12 Jan 2018 is 3,505 yen. So that gives us a Price to Earnings value of 6.7. That figure is not at the low end of Shinsho’s historical PE. For example, the PE was 5.20 in 2015 and 4.82 in 2011.

And if we assume EPS will not be that much affected, the current PE of 7.02 is higher than the 5-year average PE of 6.75.

On the other hand, Price to Book is also an important metric when looking at a cyclical stock. The current Price/Book Ratio is 0.64. Again historically that is not low. In fact, it is higher than the 5-year average figure of 0.55.

I like to have a bigger margin of safety should I choose to invest. Perhaps the bigger hit (and impact to its financial) to Kobe Steel is yet to be announced, and consequently a bigger drop in share price in the future.

Still, it is a tempting stock to purchase. That is primarily due to the second part of SG TTI’s thesis. The booming steel industry in Japan.

The slight above average Price to Book ratio seen in the context of the booming steel industry does indeed make the stock look like a bargain.

• Boom for Japan’s largest steel mill on China clean air push (read here)
• China’s Push for Cleaner Skies Is Good News for Global Steelmakers (read here)

Typically for cyclical stocks, one should look for a high PE and low Price to Book value – which is the period prior to the boom when earnings are low. Often it means that a company is passing through the worst of the doldrums, and soon its business will improve.

Peter Lynch who made many investments in cyclical companies, mentioned that cyclical investors need to think differently. He said that with most stocks, a low PE ratio is a good thing, but not with cyclicals. Buy high, sell low. (read here)

Another article mention that investing base on P/E for cyclical stocks is tricky (read here): Investing based on a low price-to-book value is a much smarter strategy. When a company is priced below book value, investors are saying that its future is so bad that the firm isn’t even worth the money that management has spent on assets to conduct business. Buying at a price below NCAV allows you to achieve significantly higher returns than your peers when the industry eventually turns, while taking far less risk. The approach is to buy cyclical NCAV stocks when the industry is deeply depressed and then to sell those stocks shortly after they reach their average earning potential.

When the Boom is already here

However, given the fact that the Japan Steel Industry is already having a boom (since mid-2017). We are already past that stage when companies have terrible earnings – and investors are already aware of the boom and bidding up the share prices. So looking at the PE ratio is tricky.

• Global steel riding high as profits soar at Japan mill (read here)

Looking at the chart below, we can see that the share prices of Nippon Steel & Sumitomo Metal, JFE Holdings, Kobe Steel and Shinsho Corp have all been steadily marching up since mid-2017. (UACJ Corporation share price seem range bound).

The plunge in the share prices of Kobe Steel ad Shinsho Corp in early Oct 2017, only seems to temporarily slow down their upward march. Shinsho Corp share price prior to the plunge seems to be enjoying a huge rally.

Looking at the below Price to Book ratios of the various companies, we can see that the Price to Book value in 2015 is, in general, the lowest among the other years’ values.

That is with the exception of Kobe Steel. The current Price to Book value of Kobe Steel is lower than its value in 2015.

Just as the global steel industry basks in a return to profit after the worst slump in years in 2015, the outlook has soured for Kobe Steel, Japan’s third-largest producer, after the company admitted that it faked data on metal products for years. (read here)

Shinsho’s Price to Book ratio is a bit more tricky. It isn’t exactly low or cheap (in relation to 2015 value).

However, given the context of the steel boom (and rare sweet spots that Japanese steelmakers are in), it could present an opportunity.

Anyway just my 2 cents.