Fund Performance Review
For the month of July, the Hennessy Japan Fund (HJPIX) returned 1.14%, outperforming the Russell Nomura Total Market™ Index which fell 1.44%. The Tokyo Stock Price Index (TOPIX) returned -1.07% for the same period.
Among the best performers were our investments in Keyence Corporation, the supplier of factory automation related sensors, Daikin Industries, the leading global manufacturer of commercial-use air conditioners, and Sony Corporation, a diversified consumer and professional electronics, gaming, entertainment and financial services conglomerate.
As for the laggards, SoftBank Group Corp., the telecom and Internet conglomerate, Fast Retailing, the operator of “UNIQLO” brand casual wear stores, and Terumo Corporation, Japan’s largest medical device manufacturer, detracted from the Fund’s performance.
Click here for full, standardized Fund performance.
We initiated a position in Hitachi earlier this year which we had briefly introduced in the June 2021 commentary. The company is a large-cap name with $60 billion in market value and is one of Japan’s oldest electric equipment and heavy industrial machinery manufacturers. Its scope of business ranges from manufacturing of industrial machinery, home appliances, electronics, medical equipment, the development of enterprise information technology (IT) systems, to the construction of social infrastructure such as rail systems, power plants, and building management systems.
Epitomizing Japan’s “lost decades,” Hitachi was a poorly run enterprise in the years leading up to 2008 whose downfall culminated amid the global financial crisis, incurring the largest loss ever recorded by a Japanese manufacturer at the time. Post the crisis, management got their act together, and through numerous restructurings, significantly improved its base-line profitability. This turnaround phase is largely complete with the quality of the company moving from “unattractive” to “average.” Now, we see the company poised to advance from “average” to “excellent.” We have been observing management making a transition from a manufacturing-driven hardware sales model to a scalable solution-based model built around their proprietary industrial IoT (Internet of Things) platform called Lumada. Following our research, we have a feeling they have figured out a playbook to grow profitably consistently going forward.
The stock is trading significantly below average price to earnings (P/E) with return on equity (ROE) in the mid-teens and a reasonably healthy balance sheet. As the business portfolio shift progresses, we expect its ROE to improve further accompanied by above average earnings growth, increases in free cash flow and strengthening of its balance sheet.
Restructuring Post-2008 Financial Crisis
The reasons for the ignominious 2008 losses can be traced back to a confluence of:
1. Overly-stretched product portfolio
2. Rapid catch-up by Korean and Chinese rivals during the 1990-2000s, intensifying competition
3. Management’s lack of urgency owing to its slow-moving bureaucratic corporate culture
The end of fiscal year (FY) 2008 was the beginning of a long journey for Hitachi to regain its footing. In the spring of 2009, then newly appointed chief Yoshihiko Kawamura, who had been president of a subsidiary, was called back to the parent company at age 69. This announcement raised eyebrows because he was seen as being too old to face the challenge of saving the giant, complex company. But there was a clear reason for Kawamura’s appointment. The aim was to install a monolithic chain of command for speedy execution, and Kawamura was the perfect “old” candidate in the Japanese seniority based decision-making culture, allowing him to smoothly push through his reform agenda without interference from the old guards. Kawamura even requested then-chairman, who still held sway inside the company, to be removed as a condition to take up the task.
When Kawamura swooped in, numerous changes were implemented including the divestiture of non-core assets such as coal-fired power plant, mobile phone handset, semiconductor, and plasma flat panel businesses. For the divisions that remained within the group, they were made responsible for their own profit and loss so as not to depend on others for group-wide financial performance. As a result of this, the company swung back into a record profit in just under 2 years.
In 2010, Kawamura passed the CEO baton to his deputy Hiroaki Nakanishi. During the ten years that followed, the company continued to revamp its image. Under Nakanishi’s leadership (2010-2016), among many organizational initiatives was the implementation of a globally centralized human resources system, which allowed for optimal allocation/transfer of workforce, removing the “glass ceiling” for non-Japanese employees to rise-up through the ranks through meritocracy. On the corporate governance front, Hitachi became a pioneer by appointing 10 out of 13 board members as independent directors, of which 6 are of foreign nationality today.
After Nakanishi finished his term, the next President and CEO Toshiaki Higashihara (2016-2021) presided over the launch of Lumada in 2016. He was instrumental in positioning it as a much-needed growth driver for the company. Furthermore, management has belatedly begun focusing on capital efficiency as a key performance metric, and is currently working towards improving return on invested capital (ROIC) to match global standards. In June this year, Kojima, the chief architect of Lumada’s business model, was promoted to President, marking a new chapter in Hitachi’s growth stage.
Lumada ushers in a new business model in which Hitachi aims to work with enterprise clients in search of software/hardware/service solutions by leveraging its industrial IoT data collection and analytics capabilities.
The gist of this business starts with Hitachi and the client collaborating to identify high-level management/operational bottlenecks, which the client wishes to tackle to drive the performance of the business. Once the issue is clarified, Hitachi then harnesses the client’s assets as well as its own IoT devices to collect a vast amount of real-time operational data directly from the client’s premises (i.e. factory floor, in-store, office buildings, etc). The types of data are wide-ranging from factory utilization, factory workers or shop clerks productivity, store traffic, merchandise data, raw materials data, production quality/error rates, manufacturing processes data, etc. The repository of the data is analyzed through artificial intelligence analytics to glean key business insights, and then packaged into turn-key solutions encompassing hardware/software sales, operational outsourcing, after-sale monitoring and maintenance services. Hitachi is uniquely able to deliver this because of its ability to bring together the following in-house capabilities:
• Information technology: The company has a long history in providing IT system integration services to corporate clients
• Operational technology: It has a deep knowhow in managing mission-critical infrastructure such as rail systems, building management systems, power plants, and power grids
• Products: It has a wealth of knowledge in product engineering and manufacturing thanks to its roots as an industrial equipment manufacturer
Having feet in all three domains under the same roof is what gives Hitachi a competitive advantage. For years, the company had been in a unique position to gather vast troves of industrial/manufacturing data in these areas without exactly knowing what to do with it. That is until the Lumada concept was conceived.
Examples of Lumada Use Cases
Clients turn to Hitachi to solve problems. The eventual goal is to drive business performance, increase efficiency, redesign business processes, improve decision-making, mitigate risks and enhance security, etc. Here are some of the actual use cases that went live in the last several years:
• Analyze operating conditions of manufacturing equipment at electrical equipment manufacturers to detect s product’s defective sign (spoilage expenses reduced by 75%)
• Prevent performance decline of power generation, deterioration or abnormality of photovoltaic panels
• Analyze vast amounts of sensor data from magnetic resonance imaging (MRIs) in hospitals with analytics to detect signs of failures and finding the causes of failures
• Optimize the frequency of public transportation service according to the fluctuation of demand by analyzing the data from sensors installed in railway stations and railway vehicles
• Analyze employee work activities at call centers and reflect in improvement measures (order rate improved by 27%)
• Cost visualization at manufacturing plants (loss cost visualization, real-time alerts). To view more: https: // you tu.be/ 4grNYmzBYC4
• Visualizing/digitalizing manual work of experts at a manufacturing factory. To know more: https: //you tu.be/ NRH7Tc8eTUg and https: // you tu.be/MKgRJHJ-slU
• Support the calculation of power consumption and carbon emissions for local municipalities and electric power companies
• Support efficient inspections using detection sensors, drones, underground radar to reduce accidents and maintenance costs for communications infrastructure and roads/bridges
Since its launch, Hitachi has invested heavily to accumulate these use cases, which management claims amounts to around 1,000 now. The cases are standardized for a wider rollout to apply to other verticals/companies facing similar problems. One illustrative example can be found in the FY2017 investor day presentation (see https: // you tu.be/ 0khgk6rxRGA from 17:37 onward). In this case, a beverage company was looking for ways to maintain the highest-grade drinking water throughout its plants for use in its soft drink products. As odor and taste problems in drinking water can ruin the product quality and undermine brand image, this was a critical issue that received top management priority. Enter Lumada. Hitachi set out collecting data from the client’s water-related assets via IoT devices and put together a solution to implement the highest quality standards around water treatment workflows as well as to minimize the operating costs associated with it. Once the project was complete, Hitachi identified similar requirements in other verticals such as public water utility departments, food companies and the paper industry.
Today, Hitachi’s businesses across all segments (IT, Energy, Industry, Mobility, Smart Life) are routed through the “Lumada” lens with a solution angle. This is a marked departure from the conventional hardware manufacturing/sale business model where each segment was run independently without much collaboration. The reason why we believe the odds of Lumada’s success are high is because it is about re-engineering of their existing business practices, not about venturing out to uncharted business territories or creating an entirely new business out of thin air.
The company’s efforts are already starting to show up in numbers. Since 2016, the Lumada business (housed under the IT segment), has been growing strongly. Even in FY2020, the business recorded a revenue increase of 7% year-over-year (YoY) amid a tough environment under the COVID-19 pandemic. In the current year (FY2021), management is forecasting a revenue of JPY 1,580 bn ($14 m), accounting for 17% of consolidated revenues. Management also revealed that OPM has recently exceeded 10%, much higher than firm-wide OPM of 5.7% (adjusted for one-off items) despite the heavy upfront investments. Margins are poised to rise further progressively as more use cases start to roll out. By FY2025, management expects the firm-wide OP to surpass JPY 10,000 bn ($91 m), up from JPY 4,951 bn ($45 m) in FY2020, adjusted for one-off items, half of which will come from Lumada.
One of the key ingredients to help Hitachi achieve this lofty goal is GlobalLogic, an U.S. company it acquired this year to round out Lumada’s product suite. GlobalLogic is a “chip-to-cloud” software engineering company to help businesses’ digital transformation (or DX for short) with a revenue of $921 mil (+19% YoY) and adjusted EBITDA margin of 23% in FY2020.
The two companies are complementary in the following ways:
• Hitachi’s IT segment revenue (including Lumada) is predominantly generated domestically, while all of GlobalLogic’s businesses take place overseas with no footprint in Japan.
• The software development approach used by Hitachi is the waterfall methodology, which is a traditional linear and sequential approach with easier costing but limited client engagement and less flexibility for system requirement changes. In contrast, GlobalLogic embraces the agile methodology, where customer satisfaction is higher due to their active involvement in the development process but is more complicated to manage
• Hitachi mainly works within the cloud domainas underlying IT infrastructure to build software applications, whereas GlobalLogic is strong not only in the cloud but also in edge servers (i.e. edge computing*) and Iot devices. Edge computing is the concept of placing computing resources that enable the collection and processing of data as close as possible to the sources of data generation.
The point about edge computing is particularly important in the 5G/6G era. Some of the key challenges of running software using data from IoT devices are bad latency and data processing speed. In mission critical applications like autonomous driving, remote surgery, or real-time infrastructure management, network latency must be minimal and servers need to be capable of processing continuous flows of large data sets quickly. While the 5G/6G networks can solve the former issue, edge computing, which is essentially distributed servers (on the “edge” of the computing network), can address the latter by substituting a large centralized cloud data center to perform real-time processing. In other words, the value proposition of edge computing can be greatly augmented by 5G/6G networks.
Another noteworthy trend is the growing demand from enterprises to be more resilient in an ever-changing operating environment, especially after last year’s COVID outbreak. In a world that is increasingly uncertain and volatile, the only defense is to build a system that can react quickly by monitoring changing data points and make decisions accordingly on a real-time basis. As such, there are many potential use cases for manufacturers, etc. The need for seamless connectivity between management and the factory floor means that the IT solution provider has to be well-versed in the cloud domain (where most data and applications reside to meet management’s IT requirements) as well as edge computing and IoT devices (where most of real time data and applications are sitting close to the sources of data generation) and be able to manage the entire spectrum reliably. GlobalLogic’s “chip to cloud” capabilities can be a perfect fit for this.
Other Acquisitions and Divestitures
GlobalLogic is hardly the only one Hitachi purchased in recent years. In fact, it has undergone rapid asset reshuffling totaling $30bn in buying, equivalent to one-third of its balance sheet. Nevertheless, the total assets remain nearly the same as 13 years ago as the company funded these purchases with sales of non-core assets.
All of the acquisitions were made with a view to maximizing the potential value by pairing with the Lumada business. Let’s look at Hitachi ABB Power Grid (acquired from Swiss-based ABB in 2020) as an example. The company is the world’s largest solution provider for electrical grids with a presence in 90 countries. It supplies products/systems/services across the value chain of power generation, transmission, and distribution, where the users are utility, industry, transportation, and infrastructure customers.
The electrical grid is the backbone of our society, and as such it is mission critical. With the rise of renewable energy and distributed power sources, the world increasingly needs software solutions in addition to hardware solutions. For renewable energy, the inherent issue is that the wind does not always blow and the sun does not always shine. Thus, the ability to effectively control fluctuating power output is of critical importance. Likewise, the proliferation of electric vehicles (EVs), solar panels, wind farms and other renewable energy sources promises the advent of the “virtual power plant (VPP),” in which distributed energy sources are aggregated into one big power generating unit with the EVs deployed as a grid-scale energy storage system. On the demand side, the increasing number of electricity-guzzling data centers is a phenomenon that calls for efficient management all the while meeting fail proof requirements of the grid infrastructure. All of these fall under the business domain of Hitachi ABB Power Grid, and for optimal results, Lumada’s data gathering and analytics will be essential.
Despite a lack of a long-term, sound track record prior to 2008, 13 years since the start of its turnaround combined with the stock’s current low valuation makes Hitachi a compelling investment case. At the time of our investment, Hitachi’s P/E multiple was only 10.5 times forward earnings, far below the TOPIX index average at the time of 15.7 times. In a very simple, back-of-the-envelope discounted cash flow model which assumes net profit equals free cash flow, a P/E of 10.5 times implies a 10% discount rate and 0.5% terminal growth rate, which we believe also confirms that the current share price is cheap.
As we wrote before, we are generally averse to investing in value stocks (as defined by low P/E or low price to book) due to the inherent subpar nature of the business. However, we believe Hitachi is potentially a growth stock disguised as a value stock. It is likely that the stock remains considerably undervalued due to the market’s “anchoring bias” from the times when the company was a lethargic, low margin, troubled hardware manufacturer.
If our investment view is correct, we expect both earnings growth and multiple expansion to drive up the share price. Why do we believe there will be re-rating? Firstly, as the proportion of the software-driven business increases, it should bring about earnings growth that will be accompanied by margin improvement. Secondly, it also implies less earnings volatility, as some of the Lumada use cases have a recurring revenue component. Thirdly, Hitachi will likely consume less capital going forward than when it was a pure manufacturing concern, which means more free cash flow generation with the potential for higher dividends and share buybacks in the future.
All of these trends should contribute to a lower equity risk-premium, resulting in a re-rating. On the other hand, if we are proven wrong, Hitachi will just remain a cheap manufacturing stock. However, thanks to the restructurings of the past years, the company already achieves mid-teen ROEs on a reasonably healthy balance sheet with an equity ratio of 30% and debt-to-equity ratio of 0.54 times.
There are six old tech giants in Japan who prospered mightily during the heydays of the ‘80s: Sony, Hitachi, Fujitsu, NEC, Panasonic, and Toshiba. They all had lost their luster over time with the 2008 financial crisis proving to be the coup de grace. Since then, it has been interesting to watch the polarization of their post-crisis fates.
For example, Sony, which was added to our portfolio in 2019 and has provided meaningful returns for us, went on its own transformative path in the entertainment business (gaming, music, and movies). Today, Sony has revived as one of the premier large cap global companies. Fujitsu and NEC also successfully re-established themselves in recent years as major computer system integrators and network system providers respectively riding Japan’s “digital transformation” wave. In contrast, Panasonic is still struggling to redefine itself, while Toshiba has been caught up in yet another corporate governance disarray this year. In our view, Hitachi has now figured out a playbook to grow sustainably in its own right as discussed above.
Both Sony and Hitachi investment cases may appear a bit antithetical to our track-record of focused investing approach. But if there is a potential for the business to transform into a quality grower, we are always happy to invest. Who knows, these tech “dinosaurs” may continue to prove fertile ground for attractive long-term growth stories in Japan? To that end, we will keep tabs on the corporate dramas as they unfold.
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