Philippine Markets Newsletter

This Japanese company is set to gain from hotter temperatures, but as-reported metrics make it look like it’s just a cost-of-capital business

June 23, 2021

The combination of the At-Home Revolution and the rising number of commercial and residential building construction activities is heating up demand for this Japanese company’s products.

However, as-reported metrics are downplaying how efficient the company really is, showing returns much lower than they really are. Uniform Accounting, on the other hand, proves this company has been both asset- and energy-efficient.

Also below, Uniform Accounting Embedded Expectations Analysis and the Uniform Accounting Performance and Valuation Tearsheet for the company.

Philippine Markets Daily:
Wednesday Uniform Earnings Tearsheets – Asia-listed Focus
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Summer is in full blast with April 2021 being recorded as one of the hottest months in the history of the earth. For most people staying indoors, an air conditioning (AC) unit is one of the ways to beat the heat.

These ACs become even more important in places with higher foot traffic. Commercial buildings such as malls and offices use these cooling systems to make their environment more attractive to visitors.

We’ve talked about the increasing demand for ACs as the planet heats up, and with the At-Home Revolution changing the way people work and play, we can expect increased activity for the installation of different cooling devices.

Asia and North America are already investing in building smart cities and industrial corridors, driving AC demands higher. It is due to this that the AC industry is forecasted to reach $310 billion in the next five years.

One company that’s benefitting from these recent developments is Daikin Industries, Ltd.

Founded in 1924 by Akira Yamada, Daikin is a Japanese multinational air conditioning manufacturing company based in Osaka, which has expanded its operations all over the world. It has established itself as a leading global company for over 90 years in the field of heating, ventilation, and air conditioning (HVAC).

Daikin’s success can be largely attributed to its ability to innovate and adapt to changing market conditions.

Unlike other Japanese manufacturers that target higher end markets, Daikin included the lower-cost market typically dominated by Korean and Chinese manufacturers. To manage its costs in order to compete in the high-volume, low-cost market, the company opted to use the same base for its units.

Daikin also focused on developing its products to service a global market with a localized mindset. Being able to meet each market’s needs meant the company had to have boots on the ground where it conducts business. To do this, it built 10 product development centers in key locations in Europe, Asia, and the U.S.

With the company’s adaptability and reputation, investors could assume Daikin is performing well in terms of returns. However, as-reported metrics show that the company’s performance has been weak, showing an ROA of just 6% in 2020.

On the other hand, under the Uniform Accounting lens, a different picture is brought to light. Specifically, the company’s Uniform returns are actually significantly higher than its as-reported metrics. In 2020, while as-reported ROA was only at 6%, Uniform ROA was actually more than double that at 13%.

The distortion between Uniform and as-reported ROAs comes from as-reported metrics failing to consider the amount of goodwill on Daikin’s balance sheet. In recent years, goodwill sits at about 17% to 24% of its total assets, stemming from the company’s acquisitions.

Goodwill is an intangible asset that is purely accounting-based and unrepresentative of the company’s actual operating performance. When as-reported accounting includes this in a company’s balance sheet, it creates an artificially inflated asset base.

As a result, as-reported ROAs are not capturing the strength of Daikin’s earning power. Adjusting for goodwill, we can see that the company isn’t actually performing poorly. In fact, it has been the complete opposite, with returns that are nearly 2x greater.

Daikin’s profitability is much more robust than you think

As-reported metrics are distorting the market’s perception of the firm’s profitability. If you were to just look at as-reported ROA, you would think that the company is a weaker business than real economic metrics reveal.

Daikin’s Uniform ROA has been higher than its as-reported ROA in recent years. For example, when Uniform ROA was at 13% in 2020, as-reported ROA was only 6%.

The company’s Uniform ROA for the past sixteen years has ranged from 3% to 14%, while as-reported ROA has ranged only from 2% to 7% in the same timeframe.

Specifically, Uniform ROA climbed from 7% in 2005 to 10% in 2008, before declining to 3% in 2010. It then gradually went up to peak 13%-14% levels from 2017 onwards.

Daikin’s Uniform earnings margins are weaker than you think but its robust Uniform asset turns make up for it

Volatility in Uniform ROA has been driven by trends in both Uniform earnings margin and Uniform asset turns, with peaks and troughs lining up historically with that of Uniform ROA.

Uniform margins remained at 5%-7% levels from 2005 to 2008, before declining to 3% in 2010. Then, Uniform margins gradually recovered to 9% peak levels from 2017 to 2020.

Meanwhile, Uniform turns trended at 1.1x-1.3x levels from 2005 to 2015, before improving to 1.6x in 2019 and slightly declining to 1.5x in 2020.

SUMMARY and Daikin Industries, Ltd. Tearsheet

As the Uniform Accounting tearsheet for Daikin Industries, Ltd. (6367:JPN) highlights, the Uniform P/E trades at 26.0x, which is above the global corporate average of 23.7x and its own historical average of 19.6x.

High P/Es require high EPS growth to sustain them. In the case of Daikin, the company has recently shown a 1% Uniform EPS growth.

Sell-side analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, sell-side analysts’ near-term earnings forecasts tend to have relevant information.

We take sell-side forecasts for Japan’s Modified International Standards (JMIS) earnings and convert them to Uniform earnings forecasts. When we do this, Daikin’s sell-side analyst-driven forecast is an immaterial EPS growth in 2021 and a 17% EPS growth in 2022.

Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Daikin’s JPY 20,805 stock price. These are often referred to as market embedded expectations.

Daikin is currently being valued as if Uniform earnings were to grow 7% annually over the next three years. What sell-side analysts expect for Daikin’s earnings growth is below what the current stock market valuation requires in 2021 but above that requirement in 2022.

Furthermore, the company’s earning power is 2x above the long-run corporate average. Also, cash flows and cash on hand are almost 3x its total obligations—including debt maturities, capex maintenance, and dividends. All in all, this signals a low credit and dividend risk.

To conclude, Daikin’s Uniform earnings growth is above its peer averages, and the company is also trading in line with its average peer valuations.

About the Philippine Markets Daily
“Wednesday Uniform Earnings Tearsheets – Asia-listed Focus”

Some of the world’s greatest investors learned from the Father of Value Investing or have learned to follow his investment philosophy very closely. That pioneer of value investing is Professor Benjamin Graham. His followers:

Warren Buffett and Charles Munger of Berkshire Hathaway; Shelby C. Davis of Davis Funds; Marty Whitman of Third Avenue Value Fund; Jean-Marie Eveillard of First Eagle; Mitch Julis of Canyon Capital; just to name a few.

Each of these great investors studied security analysis and valuation, applying this methodology to manage their multi-billion dollar portfolios. They did this without relying on as-reported numbers.

Uniform Adjusted Financial Reporting Standards (UAFRS or Uniform Accounting) is an answer to the many inconsistencies present in GAAP and IFRS, as well as in PFRS.

Under UAFRS, each company’s financial statements are rebuilt under a consistent set of rules, resulting in an apples-to-apples comparison. Resulting UAFRS-based earnings, assets, debts, cash flows from operations, investing, and financing, and other key elements become the basis for more reliable financial statement analysis.

Every Wednesday, we focus on one company listed in Asia that’s relevant to the Philippines and that’s particularly interesting from a UAFRS vs as-reported standpoint. We highlight one adjustment that illustrates why the as-reported numbers are unreliable.’

This way, we gain a better understanding of the factors driving a particular stock’s returns, and whether or not the firm’s true profitability is reflected in its current valuations.

Hope you’ve found this week’s Uniform Earning Tearsheet on an Asian company interesting and insightful.

Stay tuned for next week’s Asia company highlight!


Angelica Lim
Research Director
Philippine Markets Daily
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