How ValueAct may bring an amicable approach to help boost margins at this Japanese medical device company

Investing

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Company: Nihon Kohden  

Company: Nihon Kohden (6849.T-JP)

Business: Nihon Kohden is a Japan-based company engaged in the research, development, manufacture and sale of medical electronic equipment, as well as the provision of maintenance and repair services. The company offers a wide array of devices to aid with medical diagnoses, including electroencephalographs, evoked potential testing equipment, electrocardiographs, cardiac catheterization equipment, diagnostic information systems and related consumables. The company is also engaged in the sales promotion for its products, as well as the general affair-related and manpower dispatching businesses.

Stock Market Value: $2.6B ($31.02 per share)

Activist: ValueAct Capital

Percentage Ownership: 5.01%

Average Cost: n/a

Activist Commentary: ValueAct has been a premier corporate governance investor for over 20 years. ValueAct principals are generally on the boards of half of the firm’s core portfolio positions and have had 56 public company board seats over 23 years. ValueAct has been a pioneer of U.S.-led international activism, primarily in Japan. ValueAct’s co-CEOs, Rob Hale and Mason Morfit, are also co-portfolio managers of the firm’s Japan fund. A significant amount of the portfolio is invested internationally. Hale is on the boards of Japanese companies, which is somewhat of an unprecedented and industry-leading action for U.S. activist funds. ValueAct has had 26 prior international activist investments and has had an average return of 36.19% versus an average of 4.04% for the MSCI EAFE index over the same periods. Moreover, two of their best international investments have been two Japanese companies where Hale is on the board – Olympus (109.48% versus 7.68% for the MSCI EAFE) and JSR (116.86% versus 38.57% for the MSCI EAFE).

What’s happening

On Dec. 25, ValueAct reported holding 5.01% of Nihon Kohden.

Behind the scenes

ValueAct has been a pioneer of U.S.-led activism in Japan. A significant amount of the firm’s portfolio is invested internationally. Two of its best international investments have been a pair of Japanese companies where ValueAct co-CEO Rob Hale is on the board: Olympus and JSR. Nihon Kohden is a Japanese medical devices manufacturer and distributor with a dominant market presence at home and an excellent reputation internationally for on-time delivery, service and product quality.

This is the third Japanese medical device company ValueAct has invested in. Notably, the firm invested in Olympus in 2017, received a board seat in 2019 and remains on the board today. Both Olympus and Nihon Kohden are global medical device companies. However, Olympus derives 80% of its revenue from outside of Japan, whereas Nihon Kohden gets approximately 40% of its revenue from outside of Japan. However, both companies have excellent products and an ambition to be global, and Nihon Kohden could follow a path to globalization that’s like the one Olympus has taken.

There are three primary levers for value generation at Nihon Kohden: operating margin expansion, optimizing the mix of equipment versus consumables and services revenue, and disciplined capital allocation. First, despite having 51% gross profit margins, Nihon Kohden’s operating margins are only at 10%, whereas competitors in both Japan and abroad are in the mid to high teens. With approximately 60% market share in Japan, where some of its revenue comes from distributing third-party products, and 10% market share in the U.S., where the company has proprietary products, the growth and margin potential is greater in the U.S. Nihon Kohden can use its reputational strength to capitalize on the U.S. market. The company has an opportunity to quickly get to 15% operating margins within a few years and can see incremental improvement in following years.  

Second, Nihon Kohden has historically been focused on hardware sales and its revenue is split approximately evenly between hardware and consumables and services. However, there is an opportunity for value creation if the company pursues a strategy to increase its revenue from consumables and services due to the recurring nature and higher margins of that type of revenue. From these two strategies alone, Nihon Kohden can drive 20% profit growth over the next three years.

Third, the company is currently sitting on net cash equivalent to about 15% of its market cap. Like many Japanese companies, Nihon Kohden could create value from an accretive capital deployment strategy that evaluates returning capital to shareholders or disciplined M&A. Historically, buying back shares hasn’t been a popular tactic in Japan, but share repurchases have been increasing over recent years. The Tokyo Stock Exchange has been encouraging them as part of a process to get companies to trade over one times book value.  

ValueAct has an earned reputation as a collaborative and amicable activist, and there is no reason why this situation should be any different. Before building up such a position, ValueAct likely has been getting to know management over the past year and spent considerable time with CEO Hirokazu Ogino. Moreover, ValueAct would not have made this investment if the firm did not have a high degree of respect for Ogino and the rest of the management team. We expect that ValueAct and management are aligned on their views, particularly with respect to margin improvement and capital allocation.

ValueAct does not take board seats through fear or force, but organically via dialogue and harmony. Accordingly, we would expect the firm to continue to support management as an active shareholder and only take a board seat at a time that both ValueAct and management feel the investor could add value. At Olympus, that took two years. At JSR, it took over a year. Both companies have been incredibly successful engagements for them, returning 109.48% at Olympus versus 7.68% for the MSCI EAFE, and 116.86% at JSR versus 38.57% for the MSCI EAFE. ValueAct is still on the board at both companies. A similar outcome here can result in almost a doubling of the stock in two to three years.

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments. 

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