On July 27th, Alpine Electronics (6816) received an offer from Alps Electric (6770), which owns 40.43% of Alpine’s shares, to buy out the remainder for 0.68 shares of Alps for each share of Alpine.
Oasis Management Company of Hong Kong, the largest minority shareholder in Alpine with a stake of 9.24%, has stated in a press release today that minority investors are not getting a ‘fair deal’ and have launched a website protectalpine.com to make their case for a higher offer from Alps. Alpine is now trading at a small premium to the offer in the hope that Oasis will prevail, as they did recently with Panahome.
There are clear issues of corporate governance concerning the process which led to this offer and the 18-month period before the offer is effective, but we shall leave this to others better qualified than Japan Analytics to comment.
Rather, we shall look at Alpine’s financial statements through the lens of the App’s residual income valuation model.
Alpine’s revenues have been volatile and the current forecast for March 2018 has revenue at the same level as a decade ago.
Gross margins peaked at 28% in 1991 and have declined by 10 percentage point since then.
Operating income has fluctuated widely. Operating margins have averaged 3.3% over the last 28 years. The current forecast is 2.6%.
Margin trend analysis shows a laudable attempt to cut SG&A in the face of rising COGS.
Alpine’s core operating income after tax (which we consider to be the most sustainable measure of income for valuation purposes) has totaled only ¥99b over the last 28 years, averaging only a 1.9% margin on sales.
The fluctuations in other operating income after tax reflect other comprehensive income currency translation adjustments.
In recent years, non-operating income (mostly sales of investments in securities and unconsolidated companies) has made an increasingly large contribution to comprehensive income, and, in the last two years, were able to offset net operating losses. Whether the sales would have occurred without the losses and pressure from Oasis is a moot point.
In 1995, financial liabilities were 32% of total assets, but are now zero. In addition, the company has only invested ¥22b in fixed assets out of the ¥87b it has generated in operating cash flow since 1990. Cash piled up on the balance sheet and Alpine started down the familiar path for Japanese companies of diversifying from its core business by financial means. Net financial assets now represent 47% of total assets.
Cumulative free cash flow has totaled ¥54b since 1990. Alpine has also raised a net ¥18b from shareholders, increasing the amount of shares outstanding shares by 68%. With a cumulative net financing cash outflow of ¥27b, the net change in cash was ¥42b.
The Japan Analytics valuation model starts with requiring a 6% return on the previous years’ net operating assets.
This is then subtracted from core operating income after tax and minorities to derive ‘residual’ income.
Alpine’s cumulative residual income since 1990 totals ¥26b, but has exceeded ¥4b in one year twice this decade.
The model assumes for each year that there will be no future residual income growth, but that the current level of residual income is sustainable.
The components of the model are net operating assets, net financial assets both of which are valued at current book cost, to which is added the current amount of residual income capitalized at 6%.
Our model shows that the market has consistently undervalued Alpine over most of the last 15 years. As the growth and sustainability of residual income became unclear, the market correctly anchored on book value after allowing for the tax that would have to paid on the disposal of financial assets.
Market perceptions were not helped by the company’s underestimation of its operating income (as represented by the valuations based on forecasts – the red dots).
If the current level of residual income is maintained, the company is being correctly valued at Alps’ current offer.
A valuation based on this decade’s peak residual income of 2015, would give 33% upside.
If, as Oasis indicate, operating income is expected to grow by 35% in each of the next two years and then is sustained at that new high level, the upside is just 27%.
As the offer is at a premium to the anchor book value and equal to a no-growth scenario for residual income, demanding a higher price requires speculation as to the growth in the business. The volatility of past earnings suggests that there is a risk that the growth that would lead to a higher valuation based on improving residual income will not occur.
We would vote for the bird in the hand which is 0.68 shares in Alps Electric.
As Alpine shareholders are being paid in Alps shares and the two trade in tandem, Alps own valuation and business prospects should also be considered.
Alps market cap is above our current no-growth valuation, but also reflects the future removal of minorities from the total and therefore should be considered fair.
The last three years have been the best in terms of residual income for three decades and suggests a degree of caution.
Alpine investors are, however, investing by proxy until January 2019 in a business with a 14.6% residual core return, which compares favorably to Alpine’s 2.6%.