Summary:

Yurtec is a construction company of electric power facilities. It is a beneficiary of:

1. Increased Power Consumption: The growth of existing and new semiconductor fabrication plants is leading to higher power demands, necessitating the development of additional power generation facilities.
2. Reshoring Manufacturing: In response to the post-Covid environment, Japanese firms are repatriating overseas manufacturing operations to Japan, which is driving demand for construction services.
3. Construction Boom: There is a surge in construction activities, particularly due to government-backed offshore wind power and solar projects.
4. Financial Health: With a robust balance sheet featuring ¥27 Bn in net cash, the company is well-equipped to finance its expansion initiatives, which include the digitization of work processes and M&As.

On 4/25/24, the company released its full FY3/24 results. The YT shares popped about 15% on the day, positively reacting to 1) record sales of ¥232.2 Bn, 2) a 15% operating profits increase guided for FY3/25, and 3) a dividends hike from in ¥28 (payout 30.5%) in FY3/23 to ¥42 (40.1%) in FY3/24. The further increase is guided for FY3/25 to ¥46 (payout 40.2%).

Its shares have appreciated 35% year to date but still trade at a low PE of 13.3x for FY3/25E and PB of 0.76x. Management has laid out growth plans that should aid the company in catching up with an industry leader, Kyudenko, which trades at 17.7x PE. Under this multiple expansion scenario, YT shares can go up by 30%.

Why is Yurtec (“YT” or the “company”) a catch-up trade?

The below table summarizes the fundamentals of 5 power engineering companies. Each mainly services distinctly different economic zones of Japan. This sector, as a whole, is garnering investor interest with an average YTD share price appreciation of 30%. All reported their FY3/24 results and FY3/25 guidance on 4/25 – 4/26. Yurtec, the smallest among 5, reported the smallest FY 3/24 y/y gains of 10.3% in operating profits. Nagoya-based Toenec (1946)’s operating profits grew 54.7% y/y and the industry leader, Kyudenko (1959)’s operating profits gained 18.5% y/y. Important points for consideration are:

• YT’s 3/24 operating margin, while improving from 4.2% in FY3/23, was the lowest at 4.3%. The average among 5 peers was 6.4%.
• YT guided the largest operating profit growth from FY3/24 to FY3/25 at 15.9%. This likely reflects the fact that some large and profitable projects might have pushed into FY3/25. Indeed, Toenec guided an 18% decline in OP after experiencing a 55% jump in FY3/24. However, the other factors are likely influencing YT’s robust guidance. YT’s margin improvement measures which will be detailed later in this report, are gradually yielding results.
• YT’s low margin is the major factor behind its below-average PE at 13.3x (the average is 15.04x). Kyudenko, with an operating margin of 8.1%, trades at 17.7x.

YT has several top-line growth initiatives in the pipeline, including the construction of semiconductor fabs, offshore wind projects, upgrades to aging power buildings and transmission lines, and expansion into the Kanto region. These large-scale, high-margin projects, along with YT’s ongoing efforts in process digitization, are expected to enhance margins. Consequently, this should elevate YT’s valuation, potentially aligning it more closely with that of Kyudenko.

The majority of this report is devoted to 1) why YT’s PE is low and 2) measures YT has set forth to lift its valuation.

Who is Yurtec?

The company is a comprehensive facility engineering company. Their comprehensive suite of services includes the construction, maintenance, and repair of power facilities, as well as electrical, air conditioning, water supply, drainage, and information and communication systems.

Origin:

In 1944, nine major electrical contractors from the six prefectures of Tohoku and Niigata Prefecture (northern part of Japan) merged to establish Tohoku Electrical Construction Co., Ltd. Later, in 1991, the company name was changed to the current Yurtec Corporation. The meaning of the name is ‘‘YOUR TECHNOLOGY”.

The stable parent company: Tohoku Electric Power Group:

Having Tohoku Electric Power as a 41.8% owner/parent provides the stability of the revenue stream. Tohoku Power is an electric utility, servicing 7.6 million individual and corporate customers in six prefectures in the Tohoku region plus Niigata \Prefecture. It is the fourth-largest electric utility in Japan in terms of revenues, behind TEPCO (Tokyo), KEPCO (Osaka), and Chubu Electric Power (Nagoya).

A recent development on Tohoku Power:

Tohoku Power got government approval to increase its “regulated electricity rate” for households by 32.94% on average starting on 4/22. This is the first time a Japanese utility has sought permission to raise its regulated rate since 2012-2015 when it has suffered losses from the post-earthquake closure of nuclear reactors. Russia’s invasion of Ukraine in 2/22 fueled the surge in fuel costs which prompted the company’s rate hike approval. The rate increase would affect 5.28 million households in northeastern Japan, which accounts for 77 % of the contracts held by the company. For an average household, the monthly bill will increase by ¥2,717($20) to ¥11,282.

The company, under the new pricing system, is planning to proceed with systematic renovation aimed at stable power supply and building transmission and distribution equipment that is resistant to disasters. This should translate into a stable order flow to YT.

YT’s customer profile:

They have two separate groups of customers.

1) General construction services(general contractors, government offices, corporations, etc.): 60% of sales

4 services are provided by this group:

• Indoor wiring work
• Air conditioning, plumbing, and fire protection systems-related work
• Information and communication infrastructure work
• Renewable energy (wind and solar power) construction and distribution. Power generated from offshore power firms will be sent to the Tokyo area.

2) Tohoku Electric Power Group construction: 40% of sales

For Tohoku Power’s various electrical facilities, YT handles the construction and maintenance of distribution lines and power generation buildings.

For the company as a whole, indoor wiring, air conditioning infrastructure, and power distribution line construction account for 70% of the company’s sales.

I. Investment thesis

1. The P/E gap should be closed

As discussed earlier, YT is trading at a discount compared to other electrical engineering companies. Kandenko (1942) has a PB of around 1.3x, Kinden (1944), affiliated with Kansai Electric Power, has around 1.0x, and Toenec (1946), affiliated with Chubu Electric Power, has around 0.9x, while YT is only around 0.86x.

Kyudenko (1959), affiliated with Kyushu Electric Power, is being traded at around 1.9x PB.

Why does Kyudenko trade at PE of 17.7 vs. Yurtech 13.3x?

There seem to be two factors contributing to this valuation differential: Operating margin difference and Investor Perception.

1) Operating margin difference between YT and the leader, Kyudenko

Kyudenko is also a comprehensive facility management company and belongs to the Kyushu Electric Power Co. Inc. group. Kyushu Power is located in Kyushu, southwest part of Japan.

For FY3/24, Yurtec recorded an operating margin of 4.3% vs. Kyudenko at 8.1%.

YT management acknowledges that the disparity in margins is partially attributable to the distinct characteristics of the service regions and the product offerings unique to each power construction company. Bearing this in mind, the management has established a pragmatic target of attaining the industry’s average operating margin of 5% as an initial milestone

I believe that TK can achieve higher than this average margin of 5% in several years. My optimism is based on 1) the reasons behind the margin difference and 2) YT’s measures to close this difference.

First, I list the below factors as reasons for this large margin gap:

1) Employee profile: Kyudenko has a younger worker profile (38.9 years old vs 41.9 YT) and lower average salaries (¥6,840K vs. ¥7,150K).

2) Size: Kyudenko is bigger with FY3/23 sales of ¥460Bn vs. YT’s ¥241Bn. Thus, it can spread back office expenses. It can also handle bigger projects with higher margins. FY3/23 Operating profit per employee is ¥1,700K with YT vs. Kyushu’s ¥3,050K.

3) DX (Digitization):

Kyudenko has achieved superior margins more swiftly through enhanced process efficiency driven by digitization. Recognizing the importance of digital transformation early on, Kyudenko established a DX Promotion Department in October 2020. In contrast, YT formed its DX Promotion Committee later, in April 2022. This proactive approach may have contributed to Kyudenko receiving the ‘DX-certified operator’ certification from the Ministry of Economy, Trade and Industry, an accolade not yet attained by YT. Additionally, being situated in Fukuoka, a major start-up hub in Kyushu, likely bolstered Kyudenko’s commitment to digitization.

YT’s DX Initiatives

YT has now set the below DX initiatives to catch up with Kyudenko and other peers.

The company earmarked a total investment pool of ¥30.0 Bn with a focus on digitization and M&As.

• Digitize internal documents completely by the end of FY2025
• Expand the use of tablets/smartphones. For example, previously, employees had to take printed drawings to worksites, take construction photos, and bring them back to the office to organize them. Now, the workers manage drawing data in the cloud via the use of tablets. Corrections and revisions can be shared instantly as data, and photos taken at worksites can be organized on the spot.
• The use of wearable cameras makes it possible for experienced technicians to provide remote guidance for technicians with little on-site experience, contributing significantly to productivity improvement.

Numerically, reduction of 248,000 hours or ¥1.11 Bn cost savings in FY3/26 through digitization of paperwork and decision-making flow:

With net cash of ¥27.7 Bn as of FY3/23, YT has ample financial prowess to fund these growth plans.

4) Service area: The Tohoku region suffers from a steeper population decline.

The Tohoku region, located in the northern part of Japan, is known for its harsh winter weather. Additionally, the lingering memory of the Fukushima disaster still impacts the area, deterring the younger workforce from settling there. Consequently, the region’s population decline is more pronounced than the national average. In response to these demographic challenges, the company has been progressively expanding its projects beyond its traditional Tohoku market.

4-a) Expansion to Kanto

In the Kanto region which houses Tokyo, there are robust construction needs for large logistics facilities, redevelopment projects in the metropolitan area, and data center facilities. Tokyo accounts for 28% of Kyudenko sales but only 8% for YT. Still, thanks to YT’s marketing efforts, YT’s earnings from the Kanto region have been expanded from ¥13Bn in FY3/12 to ¥19.2Bn (+47%) in FY3/24 and are forecast to further risen to ¥28 Bn in FY3/26.

4-b) Overseas expansion

Overseas sales currently account only for 4% of the total sales, but it is the fastest growing segment rising from ¥9.6Bn to ¥24 Bn (forecast) in FY3/26.

Vietnam: Vietnam is the core region in YT’s overseas expansion strategy. YT has over 25 years of experience in Vietnam and expects to see high economic growth in the upcoming years.

Bangladesh: The first Japanese industrial park opened in 2022, and the entry of Japanese companies is expected to accelerate. Therefore, YT stationed personnel locally and is working on gathering marketing data.

Africa and Southeast Asia: The company has a track record of construction in over 30 countries as part of development assistance and ODA (Official Development Assistance) projects for power transmission and distribution networks funded by the Japanese government.

The other Initiatives to improve margins:

• Targeting new/renewal project balance of 60%/40%. The profit margin for renovation/renewal work tends to be higher because it targets existing customers, making it less susceptible to competitive pricing compared to other construction work. Also, the margin is higher since the renovation often includes making buildings energy-efficient.
• Lump-sum contracting of indoor wiring and air conditioning ducts which carry higher operating margin
• Increase orders of large buildings with higher margins
• Expanding orders for information and communication construction that includes building annexes. The government is pursuing Beyond5G (6G) and the number and density of base stations and related work are expected to grow tremendously

2) Investors’ Perception

 

Markets attach a higher valuation to Kyudenko which is viewed as “AI-related”, as the area they serve will be the home to two fabs of TSMC (Taiwan Semiconductor Manufacturing Company), the world’s largest contract chipmaker. The first factory, located in Kumamoto on the Kyushu island, is expected to begin volume production in Q4/24, while the second factory is planned to start operations by the end of 2027. Total investment will likely rise to $20Bn which includes the Tokyo government’s support.

This decision aligns with Tokyo’s strategy to revive advanced semiconductor manufacturing and secure industrial supply chains amid growing tensions with China. The Japanese government has designated semiconductors as “specified critical materials” and set aside more than ¥1 Tn (around $7Bn) for semiconductor manufacturing plants. Reuters reported that the decision to build a second fab is a vote of confidence by TSMC in Japan where construction of the first fab has run smoothly.

Economic implications

The construction of semiconductor fabrication plants has had a multifaceted impact on the local economy and industry. Not only has it generated employment opportunities, but it has also increased the electricity demand. This surge in power consumption has, in turn, positively influenced the stock price of Kyudenko, which has seen an uptick as a result of the heightened energy requirements to support the operations of these high-tech facilities.

However, a less-known fact is that Japan’s semiconductor revival is not confined to the Kyushu area alone.

The northern regions of Japan present a significant advantage for technological capital investments due to the cold climate, which naturally aids in cooling data centers and semiconductor manufacturing facilities.

Japan-based Rapidus has chosen to build, with a partnership with IBM, a state-of-the-art semiconductor factory in Hokkaido.

Taiwan’s Powerchip Semiconductor Manufacturing (PSMC) plans to partner with SBI Holdings (8473) to move into the Sendai Northern Core Industrial Park (Oohira Village) in Miyagi Prefecture. They plan to invest over ¥800Bn ($5.35Bn) and produce 40,000 semiconductor wafers per month, ranging from 55 to 28 nanometers, by 2029.

Miyagi Prefecture already hosts a Tokyo Electron (8035) factory, and a new factory is under construction in Oshu City, Iwate Prefecture. With Kioxia in Iwate and Sony Semiconductor’s factory in Yamagata, the Tohoku region is already advancing as a cluster of semiconductor-related factories. Yurtec is likely to be a very important stock in this context. The company has noted that they have received orders for semiconductor factories from clients such as Kioxia and TDK, and most recently, it has secured orders from Tokyo Electron.

Microsoft impacts

On April 9, Microsoft announced a plan to invest $2.9 Bn (approximately ¥440 Bn) over the next two years to enhance hyperscale cloud computing and artificial intelligence (AI) infrastructure in Japan. This investment is the largest the company has made in Japan to date. According to the announcement, Microsoft plans to establish a lab in Japan that specializes in AI and robotics engineering and to deepen its collaboration with the Japanese government in the field of cybersecurity. While a specific location was not announced, the positive impacts can be substantial. Upon this announcement, many power-related stocks (power generators, distributors, and construction companies) shot up by 4-10%.

Conclusion:

Once the company continues to record an improvement in operating margin, multiple expansions close to Kyudenko can be possible. Applying Kyudenko PE of 17x to FY3/25 net income per share estimate, the stock can appreciate by around 30%.

2. Skillsets in alignment with the government’s alternative energy goal

2-a) The Japanese renewable energy industry has been growing steadily.

As of 2022, the market had total revenues of $36.4Bn, with a compound annual growth rate (CAGR) of 7.1% between 2017 and 2022. Under Japan’s new Strategic Energy Plan, the government aims to increase the share of renewable energy to 38% by 2030. Additionally, Japan has set a lofty goal to become entirely carbon neutral by 2050. Nationwide, the government plans to spend ¥6-7 Tn for carbon neutrality of which around ¥650 Bn will be needed within the Tohoku region, and ¥200 Bn for the area between Tohoku and Tokyo. YT has received orders for multiple projects such as the ‘Miyagi Marumori Main Line Construction’ and the ‘Dewa Main Line Construction,’ and the recent expected sales from this plan are projected to be around ¥10 Bn.

2-b) Wind offshore power projects: Tohoku got a bulk of attention and resources

Japan is also planning to add 10 GW of offshore wind power by 2030 and up to 45 GW by 2040. Ministry of Economy, Trade and Industry indicates that the Tohoku region is a suitable location, and many large-scale offshore wind-related construction projects are being planned.

The power transmission network needs to be upgraded to handle the increased electricity from these projects. Additionally, a ‘Regional Decarbonization Roadmap’ is in place, promoting energy efficiency and market growth. YT’s local presence and technical expertise are seen as key strengths in advancing toward carbon neutrality.

3. Steady Financial performance and the potential to get closer to Kyudenko

Financial results for the last 20 years

On 3/21, the Great East Japan Earthquake occurred. Tohoku Electric Power’s power plants suffered extensive damage and both Tohoku Power and YT faced a very challenging operating environment For FY3/13 and FY3/14.

From FY3/15 onwards, YT’s performance rapidly recovered and remained at a high level due to an increase in earthquake recovery and reconstruction work, as well as renewable energy construction projects such as mega solar power plants with high margins. The company achieved the all-time high profits in FY3/15.

Subsequently, there was a sales decline due to a decrease in earthquake recovery and reconstruction work and renewable energy construction projects. However, from FY3/22 onwards, YT has received a steady flow of large-scale project orders, leading to its historically high sales in FY3/24. Its profits have also recovered.

The last 5 years

(source: company)

Despite the multiple COVID-induced construction halts, the company has managed to record a sales CAGR of 3.6% during FY3/19 through FY3/24.

In 1/24, considering recent performance trends, they have revised their full-year performance forecasts as follows. However, actual numbers reported on 4/25/24 were stronger, since work Order received, sales, and contracts-in-progress are at an all-time high.

• Revenue: guidance upped from ¥235 Bn to ¥241 Bn, Actual : ¥243 Bn (+7% y/y)
• Operating profit: from ¥9.2 Bn to ¥9.6 Bn, Actual: ¥10.5 Bn (+10.3% y/y)
• Net profits: from ¥6.3 Bn to ¥7.0 Bn, Actual:¥7.5 Bn (+14.5% y/y)

Specifically,

Sales have increased due to an increase in air conditioning duct work, power distribution line construction, and power transmission work. The sales increase was able to absorb cost hikes, leading to a 10.3% rise in operating profits.

Comparison to Kyudenko FY3/24 results:

Kyudenko reported stronger results, deserving a higher multiple:

Sales: ¥ 469 Bn (+18.5% y/y)

Operating inome: ¥38 Bn (+18.5% y/y)

Net income: ¥38 Bn (+6.3% y/y)

FY 3/25 guidance: YT vs Kyudenko

However, Kyudenko forecast its sales growth is comparatively subdued for FY3/25 because a large-scale and high-margin wind power project has been postponed, due to delays in obtaining permits and approvals. Additionally, the commencement of construction for the Ukushima Solar Power Project has been delayed, and there has been an unexpected increase in costs, including labor expenses.

Kyudenko FY3/25 guidance:

Sales ¥500 bn (+6.6% y/y)

Operating income: ¥39.5 Bn (+3.9%)

On the other hand, while YT forecasts slower sales growth of 3.6%, its foresees operating income will grow by 15.9% thanks to productivity improvement initiatives discussed earlier (mainly, active sales efforts on large/upgrade projects and realization of “paperless office”). Also, YT faces an easier comp vs. FY3/24 operating profit increase of 10.3%. Kyudenko recorded an impressive 18.5% rise in operating profit in FY3/24.

YT FY3/25 guidance below:

Sales ¥252 Bn (+3.6% y/y)

Operating income: ¥12.2 Bn (+15.9%)

II. Weaknesses/Risks

1. Severe labor shortage

Japan’s industries are widely experiencing a labor shortage. Despite this, YT has successfully recruited new hires in line with its strategic plan: 125 in FY3/22, 149 in FY3/23, and 162 in FY3/24. The company anticipates a similar influx of recruits for FY3/25 and FY3/26.

Furthermore, YT has inaugurated a ‘Human Resource Development Center,’ designed to accommodate up to 300 individuals. This center is dedicated to supporting all employees in achieving success within their chosen fields.

2. Continuing increase of material costs

Rising material costs and weak yen appear to continue for a foreseeable future, pressuring the company’s bottom line. To this end, YT believes that they have many measures in place to improve productivity to combat the cost hikes.

[Disclaimer]

1. Current Investment. I currently have a small long position in the position mentioned in this writeup. Therefore, I will benefit if YT stock price increases. I may buy or sell the securities at any time without notice to anyone. No representation is being made with respect to whether such investment would be profitable.

2. The opinions expressed above should not be constructed as investment advice. This commentary is not tailored to specific investment objectives. Reliance on this information for the purpose of buying the securities to which this information relates may expose a person to significant risk. The information contained in this article is not intended to make any offer, inducement, invitation or commitment to purchase, subscribe to, provide or sell any securities, service or product or to provide any recommendations on which one should rely for financial securities, investment or other advice or to take any decision. Readers are encouraged to seek individual advice from their personal, financial, legal and other advisers before making any investment or financial decisions or purchasing any financial, securities or investment related service or product. Information provided, whether charts or any other statements regarding market, real estate or other financial information, is obtained from sources which we and our suppliers believe reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future performance.