Nifco: A Japanese take on Korean autos

by SR on March 9, 2012

For those of you that can invest in small to mid-caps, Nifco (7988) should be on your radar screens if it isn’t already. Here’s a well-managed Japanese firm that is expanding its overseas customer base rapidly. Related stocks: ITW; Piolax; Hyundai Motor. I have admired Nifco for years so I’ll give a potted summary of the company below. I think it’s a long-term success story but its outperformance relative to Topix over the past 12 months has been sizeable (see chart at botttom of this post) and the valuations are a bit stiff. One could argue that represents a premium for Nifco’s growth potential.

  • Solid profits, low capex. Nifco’s competitive advantage is tied to its design skills rather than on the facilities it runs, so it can ramp new capacity quickly and cheaply. It should be able to maintain 10-15% margins over the long term due to barriers to entry in the auto parts space and its relationships with OEMs both inside and outside Japan.
  • Inroads into foreign customer base. Hyundai Motor is a rapidly expanding customer for Nifco, helped by Nifco’s top-notch Korean sales team that has been exporting its ideas to other Nifco branches. I expect Nissan also to grow in importance as a customer.
  • Decentralised management. President Masaru Onodera once commented to me that Nifco should no longer be regarded as a Japanese firm in the traditonal sense of the word because the overseas branches have a high degree autonomy, are locally managed and generate significant business. Example: Nifco is doing well with Ford in China, but that push has come from Nifco UK, which has an excellent relationship with Ford, rather than from Nifco Japan.
  • A strong base in China. Nifco is setting up new facilities in Japan to conduct intensive testing of raw materials. The company already has production facilities in China (see map below), but the next step is to move aggressively into the use of local raw materials to dramatically reduce overall costs. That would be risky without world-class evaluation procedures but these new laboratories will give Nifco the capabilities it needs.

Nifco's production facilities in China

The news

The Nikkei carried a piece in the 9 March 2012 morning edition on Nifco (7988), suggesting that the firm’s operating profit will hit Y13bn in the next financial year, namely FY3/13. That would be an increase of 18% YoY over management’s guidance of Y11bn for FY3/12, the financial year that ends this month. If we can avoid any more natural disasters in 2012 I reckon that this figure – which probably comes from senior management at Nifco – is too low and will be easily beaten.

What Nifco does

Nifco supplies plastic fasteners and similar components (roughly 90% of revenues) primarily to the auto industry. Its main competitor globally is Illinois Tool Works, a significant rival in the US and Europe but claimed by Nifco to be relatively weak in Asia. Japanese small-cap Piolax (5988) is another competitor closer to home. Toyota (7203) accounts for slightly more than 20% of sales in a “normal” year and Hyundai Motor for slightly less than 20%; these two are Nifco’s largest customers. Nifco also has the license to sell Simmons luxury beds in Japan and Asia, including China.

By region, Japan accounted for 53% of sales and 56% of profits during the first nine months of FY3/12, whereas Asia accounted for 31% of sales and 38% of operating profit. Asia is already a very significant contributor to earnings and growth.

Europe and North America only account for a few percent of profits each, but I expect the absolute amount to rise over time. Nifco has successfully begunĀ  business with Volkswagen in Europe and with Hyundai Motor in Mexico (as well as in Korea and China) and I suspect that with the way Nissan is pushing in North America that Nifco will be getting some business from them too before long. The VW business will take a while to grow, I feel, although they are already generating revenues and their new sales office in Wolfsburg can only help.

Long term operating margin for Nifco

Global production

One of the attractions of Nifco for its customers is a truly global production and sales network. The company has production sites in China and Mexico, naturally, so it can cover the two very important regions of the US and China. Moreover, its components are physically small and light so transportation costs are low. A company like VW or Hyundai may need your engineers to be there to talk to them in Germany or Korea, but the production order might well come from Shanghai or Tijuana.

The other reassuring thing about Nifco is that its capital expenditure requirements are low. The expertise of the company lies in design, not in having lots of expensive toys (a bad habit that arguably contributed to the downfall of the Japanese semiconductor industry). What this means in practical terms is that in order to start production Nifco needs a shed (well, OK, a factory building), some injection molding equipment and some dies (tools, molds, whatever you wish to call them). That’s pretty much it. If the “I” in ROI can be kept low, the hurdle for returns can also be lower, making it easier and quicker to come to a “go / no go” decision on a new project.

An edge in design, not facilities

In the face of this simplicity and the apparently low barriers to entry posed by the facilities, my clients have sometimes questioned the viability of Nifco’s business plan longer term. The components that Nifco makes seem so low-tech and low-tech has a connotation of low-added value. Investors point out that some Chinese die suppliers have come up the curve very rapidly over the past few years (true) and are now competitive with Japanese or German suppliers for some designs. I would tend to agree, but being able to create a die to order for a customer and being able to design a die from scratch to create a product for a specific application at a specific customer as part of a proposal-based marketing effort are two different things.

Nifco long-term quarterly sales and operating profit trend

I like the story Nifco tells of its sales approach to a certain Chinese auto OEM. Nifco bought one of the cars manufactured by this potential customer, literally tore it down, reassembled it using their own fasteners and other components and took it back to show to the OEM. It was a persuasive demonstration of how much weight the OEM could save by shifting to plastic fasteners. Snap fasteners of this kind can have tact time advantages as well – they can often be attached and fixed more quickly than metal equivalents. (And yes, Nifco did get to open an account with that Chinese OEM.)

Not as low-tech as it looks

In some ways Nifco reminds of Hirose Electric (6806), which makes apparently humble connectors and yet has been very profitable over the years. Like Nifco, Hirose relies on its tooling design skills to maintain margins – and it has kept them them for decades. I first visited Hirose in 1995, determined to show that it had no competitive edge. Management gently disagreed with my arguments then and time has proven them right and me wrong. Nifco is a slightly different case to Hirose in that the auto parts sector is characterised by longer product cycles and higher barriers to entry. On the other hand, although a more stable place to do business than the tech space, the testing and reliability requirements for auto parts are orders of magnitude more arduous and this incurs significant costs.

If volumes rise, these costs can be offset and operating leverage is allowed to exert its positive influence. The key revenue growth drivers for Nifco are:

(a) the expansion of the global light vehicle market
(b) gains in market share at new customers such as Hyundai Motor
(c) the rising sell-in per vehicle

On that last point, the yen value of product sold per car by Nifco in FY3/04 was about Y4,050 but by FY3/11 that had topped Y5,100. The logic is simple: lighter plastic parts lead to better fuel economy.

Outlook for FY3/12 and FY3/13

Management guidance for FY3/12 revenue is Y120bn, from which the company expects to generate Y11bn in operating profit. That is despite the negative effects (mostly on customers rather than on Nifco) of the earthquake and the Thai floods. Management has already revised up its guidance once for this year, but the impact of the floods has so far prevented it from a second hike. As for FY3/13, the Nikkei article is suggesting Y130bn in sales and Y13bn in OP. I would say that an 8% YoY rise in revenues on the low side and that 10-12% growth in output is more realistic given the rebound I expect in Japan auto output in FY3/13.

What does this suggest? I would say we could exceed the previous peak OP of Y14.6bn posted in FY3/08 and possibly get over Y16bn in profit for the year. Recall that the company managed to post a record high operating margin last year before the earthquake hit the industry, so it is not as if management has found it impossible to get back to peak profitability.

Operating margins by year and quarter for Nifco

This level of OP would translate to about 180 yen in EPS, which would put the stock on 12x. And there’s the rub. It’s a great little company, well-managed and with a bright future due to its exposure to all the right trends: fuel economy, China, non-Japanese customers. But you never seem to be able to get it cheaply.

As I point out in this post, Bridgestone is arguably trading on between 7x and 8x next year’s earnings and that is a global leader in its market with a decently liquid stock and, yes, it does have growth prospects as well. So unless you were a small-cap specialist, it becomes hard to justify. Having said that, I do expect Nifco to post a higher rate of revenue growth over the next five years than a company like Bridgestone. So, for the (increasingly rare) long-term investor in industrials Nifco would be a great choice. For those who will be judged on a quarterly basis the timing becomes more difficult.

Nifco share price performance relative to Topix index

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