Can ValueAct's amicable approach help boost margins at this Japanese medical device company?

Company: Nihon Kohden

Company: Nihon Kohden (6849.T-JP)

Nihon Kohden is a Japanese company that specializes in the research, development, production, and sale of medical electronic equipment, as well as providing maintenance and repair services. They offer a diverse range of devices to assist with medical diagnoses, including electroencephalographs, evoked potential testing equipment, electrocardiographs, cardiac catheterization equipment, diagnostic information systems, and related consumables. Additionally, the company is involved in sales promotion for its products, as well as 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

ValueAct has been a leading corporate governance investor for over 20 years, with principals typically holding board seats in half of the firm's core portfolio positions. The firm has had 56 public company board seats over 23 years and has been a pioneer of U.S.-led international activism, primarily in Japan. Co-CEOs Rob Hale and Mason Morfit are also co-portfolio managers of the firm's Japan fund, and a significant portion of the portfolio is invested internationally. Hale has been on the boards of Japanese companies, which is an unprecedented and industry-leading action for U.S. activist funds. Over the same periods, ValueAct has had an average return of 36.19% versus an average of 4.04% for the MSCI EAFE index, with two of their best international investments being 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 leader in U.S.-led activism in Japan, with a substantial portion of its portfolio invested abroad. Among its top international investments are two Japanese companies where ValueAct co-CEO Rob Hale serves on the board: Olympus and JSR. Nihon Kohden is a prominent Japanese medical devices manufacturer and distributor with a strong domestic market position and an excellent international reputation for timely delivery, service, and product quality.

ValueAct has invested in Nihon Kohden, a global medical device company, following its investment in Olympus in 2017 and receipt of a board seat in 2019. While both companies have excellent products and an ambition to be global, Nihon Kohden gets approximately 40% of its revenue from outside of Japan, compared to Olympus's 80%. However, Nihon Kohden could follow a path to globalization similar to Olympus's.

Nihon Kohden has three primary levers for value generation: expanding operating margins, optimizing the mix of equipment, consumables, and services revenue, and allocating capital disciplinedly. Although Nihon Kohden has 51% gross profit margins, its operating margins are only at 10%, which is lower than its competitors in both Japan and abroad, who are in the mid to high teens. Nihon Kohden has a 60% market share in Japan, where some of its revenue comes from distributing third-party products, and a 10% market share in the U.S., where the company has proprietary products. The growth and margin potential is greater in the U.S. market, and Nihon Kohden can use its reputational strength to capitalize on this opportunity. The company can quickly get to 15% operating margins within a few years and see incremental improvement in following years.

Nihon Kohden has historically been focused on hardware sales, with revenue split evenly between hardware, consumables, and services. However, there is an opportunity to increase revenue from consumables and services due to their recurring nature and higher margins. By pursuing these two strategies, Nihon Kohden can achieve 20% profit growth over the next three years.

The company currently has net cash equivalent to about 15% of its market cap. Similar to many Japanese companies, Nihon Kohden could generate value through an accretive capital deployment strategy that involves returning capital to shareholders or disciplined M&A. Historically, share buybacks have not been popular in Japan, but there has been an increase in them recently. The Tokyo Stock Exchange has been promoting them as part of a process to encourage companies to trade over one times book value.

ValueAct is known for being a cooperative and friendly activist, and there is no reason to believe this dynamic will change. Before earning this reputation, ValueAct likely spent time getting to know management, including CEO Hirokazu Ogino, over the past year. Additionally, ValueAct would not have invested in the company if it did not respect Ogino and the rest of the management team. We anticipate that ValueAct and management share similar views, particularly regarding margin improvement and capital allocation.

ValueAct does not take board seats through fear or force, but organically via dialogue and harmony. As a result, the firm supports management as an active shareholder and only takes a board seat when both parties feel the investor can add value. This approach has been successful in both Olympus and JSR, with returns of 109.48% and 116.86%, respectively, compared to the MSCI EAFE index. ValueAct remains on the board at both companies, and a similar outcome here could result in almost a doubling of the stock in two to three years.

Ken Squire is both 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.