Evaluating the margin of safety on Dainichi Co Ltd

Dainichi Co Ltd (5951.Japan)

Trading at ¥632 (5/6/2011)

Dainichi is a Japanese company located in north western Japan, and was unaffected by the recent earthquake.  The company manufactures oil heaters along with a few other minor business lines.  The company introduced a vaporized oil heater in the early 70s and have expanded their product line using their original technology.  They've since expanded to coffee roasters, and garbage processing machines.

Dainichi is undeniably cheap, it's trading below NCAV and below discounted net working capital.  Dainichi is very cheap on a balance sheet basis, but I'm not sure that the balance sheet tells the whole story.  The danger with investing in a net-net is that even while the company is cheap the operating business is doing something to destroy the margin of safety.

So let's take a look at a few factors, first the net-net worksheet:

We can see that NCAV is ¥828 or 31% above the current price, while NWC is 2% above the current price, even the cash per share is 65% of the current market price.  From a balance sheet perspective there is an undeniable margin of safety, the company is trading below liquidation value.

Having a fortress balance sheet is great but for a company to survive it needs to either be break even or turning a profit, to evaluate that we take a look at Dainichi's current income statement.

From an income statement perspective the margin is safe, the company is profitable earning ¥79 per share.  The company only lost money once in the last five years which is a pretty decent track record considering the economic shape of Japan.  So far the margin looks intact, great balance sheet, and great income statement.

I have always liked the expression "The income statement tells how the business is doing, the statement of cash flows tells if management is lying, and the balance sheet is a snapshot in time."  I feel the line about the cash flows tells the biggest story with Dainichi.  So the company posted a profit, of ¥79 per share, but cash flow from operations was a negative ¥347 per share, what's going on?

The first thing I did was plug in the numbers into my earnings accrual worksheet.  The higher the percentage of accrual earnings the lower the quality of earnings.  Stated another way high quality earnings have cash flow behind them, low quality earnings are mostly booked items with little to no cash flow following.  So what do we have for Dainichi?  Here's the worksheet:

An amazing 56.94% of the earnings are accrued earnings without any cash flow.  This is quite concerning, I'm not saying the company is a fraud, it's just that they have pretty aggressive revenue recognition policies.  How else do we know this, well accounts receivable ballooned ¥9938bn in the latest period.

So knowing that earnings quality isn't very strong let's look at the relevant cash flow items for the current period.

The cash flow statement lies bare the fact that the margin is not safe.  In the latest period the operating division burned through ¥6262bn.  In addition the company also spent ¥1013bn on investments and ¥421 on dividends and share buybacks.  It seems crazy to me that they're still paying a dividend and buying back stock, but as noted elsewhere, Japanese companies seem to work with different corporate interests.

So what does this all mean?  For me the big takeaway is that while the balance sheet looks great, and the income statement seems to strengthen the investment case of Dainichi the cash flows just aren't there to support the numbers.  In addition there is a real concern that the cash outflows at the company could lead to either financing the operational cash flow gap, or insolvency.  

I didn't expect this post to turn out into a walk through on how I evaluate margins of safety in net-nets, I expected to just write up another Japanese stock that looked decent.  But as I went through the story the statements told was so clear I couldn't help but write my post to show the destruction of safety.  To just throw out the net-net figures and say it's profitable without delving into the reality is dangerous.  Sometimes the market is very wrong about stocks, but other times the market is right.  In Dainichi's case I think the market is correct to discount their share price, if the company keeps performing at the same level they might not exist in a few years.

Disclosure: I own none of the issues mentioned in this post.



  1. Hi Nate,

    Thanks for the great analysis and keep up the good work.
    I am interested in Japanese companies also and have some concerns. I like to get your view on it:
    Since most japanese companies financials are in Japanese, how do you get to understand it? I don't understand Japanese.

    Also, most financials are "reviewed" but not audited as in the States. How trustworthy do you think the numbers are?


  2. James,

    I do a few things to get the financials, I usually use Google Translate on the filings from either the Tokyo stock exchange website, or the corporate website to see what the latest numbers are. Then I go to FT.com and examine what they have, if the numbers are the same I use FT.com for all my data. FT is the most reliable if the numbers have been out for a few months, so companies that report annually and semi-annually are great. For some Japanese companies that report more often there is a lag, so I will use the translated filings to fill in my own spreadsheets for each statement.

    Google Translate is great, it's extremely accurate on European languages, Japanese is hit and miss. I usually keep up the original language filing as well to compare. For example in a company I was recently looking at the line for Total Equity and Liabilities was translated as Total Net Debt. By reading the statement I could tell this wasn't accurate so I went digging, I copied the original language for the Total Net Debt translation and plugged it into google along with the word debt. What I retrieved was some filings where the Japanese and English were side by side, I matched up the Japanese word that was mistranslated and found the correct one. So an understanding of accounting and spot checking worked on that one.

    As per auditing it's a great question, but honestly I don't put much faith in auditors of any company, even American companies. I have to admit, I have a strange interest in reading about frauds and I have read about a TON of frauds, and a common theme runs through all of them, the auditor go too close and missed things. Obviously if an auditor issues an adverse opinion then that's a nice easy red flag, but what auditors do doesn't detect fraud and most are not trained to find fraud.

    So how to find if something is fishy, stateside or otherwise? I do a few checks:
    1) I run the numbers through my accrual spreadsheet, higher accruals means lower quality earnings. The lower quality earnings are suspect, there could be a great reason, or it's a warning.
    2) I check for cash to back up earnings, in most cases if earnings are very poor quality the cash flow is only a small percentage of what it should be. A good rule of thumb is that over time say five years average net income should be roughly equal to cfo. For companies that only give out an income statement and balance sheet I construct my own cash flow statement. I prefer the direct method, if you're interested I can send you my spreadsheet.
    3) I check the taxes paid, in most cases of fraud investors are duped, but tax collectors are not. If there is a large disparity this is a huge warning sign. Usually taxes paid will be hidden in the notes, or you'll need to calculate by tax withheld and the change in deferred tax amounts.
    4) I check for things that seem fishy, a large increase in accounts receivable, or increase in debt. Usually a company that has poor earnings and low cash flow will finance their operations either through share issuances, or short term debt.

    Hopefully this helps!

  3. Thank you very much for your explanation


  4. Really like this post! I learned a lot!

  5. That is strange. As far as I can see it Operational CF was negative
    only once in 2007 on heavy inventory build-up.
    Am I wrong?


  6. Anon,

    The CFO I referenced in this post was a quarterly read, on a yearly basis you're correct it was only negative once back in 2007.


  7. OK. That is interesting. I have another profitable japan net-net in my portfolio (ryoyo jp:8068) where
    that happened too.
    I didnt like it at all! But isnt it the case, that
    many finance there working capital on a seasonal
    basis and that has an effect on the cfo?

    Anyway. Congrats to this great blog. Very insightful and rare to find someone who dares venturing into japanese equities.