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Shimano (7309 JP) updated

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March 20, 2017 – Comments (0)

Summary

Shimano is the largest sports bicycle component system manufacturer in the world. It is a wide moat company with durable high return on capital built on durable competitive advantage. In this report, I analyze Shimano’s moat in terms of favorable industry structure, dominant market share, superior brand power, best-in-class technology, consistent innovation, low-cost production and quality management, and conduct valuation of the stock. I conclude that while current share price is a bit pricey compared to my estimate of current intrinsic value based on current normalized FCF, given the company’s high quality and strong growth potential, investors should have satisfactory long-term return even buying at current price, and should use any meaningful share price decline as chance to load up holdings.

Company introduction

Founded in 1921 and headquartered in Osaka, Japan, Shimano is the largest sports bicycle component system manufacturer in the world, with market share of over 50%. As of 2016, bicycle parts business accounts for 80% of total revenue and 90% of operating profit. Shimano’s core product is the so called ‘system component’, referring to a package of core bicycle components including derailleurs, brakes, cranks, etc. The rest of business is mainly fishing tackle, which Shimano has leveraged its technology and knowhow in gear system to develop into a major global brand.

Industry analysis

A favorable industry structure

The sports bicycle component industry is an oligopolistic market where Shimano has dominant market share and few competitors. Existing players are protected by high entry barriers and benefit from low level of price competition. Below we examine the industry structure though a brief Porter’s Five Forces analysis.   

 

1. Threat of new entrants

For the past 20 years or so, the sports bicycle component market has seen no major new entrant, despite of the attractive return on capital as shown by Shimano. Threat of new entrants remains low due to high barriers to entry. Major entry barriers include technology and knowhow, capability of product development and innovation, and in particular brand power and customer loyalty. As will be elaborated later, brand power of components, in particular the core components such as derailleurs, is important for sports bicycle users. And when quality and brand matter more than price for consumers, it becomes difficult for new entrants to gain market share from established players.

2. Bargaining power of buyers

While the sports bicycle component industry is an oligopolistic market, the finished bicycle manufacturing industry is much more fragmented. There are only three major component systems makers, but dozens of finished bicycle makers in the world where the largest company has around 10% market share vs Shimano’s over 50%. In addition, in the world of sports bicycle, value is mainly created by parts makers while the finished bicycle makers are essentially just assemblers with little value added. The core components that Shimano and its competitors make are the primary determinants of performance for sports bikes. Thus, the component makers have strong power against the finished set assemblers.

 

3. Bargaining power of suppliers

The primary raw materials of core bicycle components are aluminum and carbon fiber. There are numerous suppliers of these commodities, hence power of suppliers is not particularly strong. Bicycle component companies don’t have strong bargain power against their suppliers, either, but given their strong position vs their customers, they are usually able to pass on increase in input cost to output.

 

4. Threat of substitutes

We believe threat of substitutes to sports bicycle is low due to the unique attractiveness of cycling. Bicycles can be divided into two categories, low-end bikes for transportation use and mid-to-high end bikes for sports and leisure use. The former can be easily substituted by other transportation means such as motorcycles and cars, but it is not Shimano’s target market. Shimano’s main market is mid-to-high end derailleur-equipped bikes, mostly sports bikes. Although there are many other leisure and sports activities, cycling provides unique experience in terms of a combination of speed, outdoor scenery, exercise, fun and practical use as transportation means.

 

5. Competitive conditions

There are only three major players in the road bike component system market: Shimano, Campagnolo, and SRAM, and two major players in the MTB (mountain bike) component system market: Shimano and SRAM. Plus, Shimano has a virtual monopoly in supply of gear shifters for electric bicycles. As such, competition in the industry is not intense.

 

Stable demand with growth potential

The global market size of sports bicycles is roughly 50 million units annually. In the major markets Europe, US and Japan, bicycle sales in value has been growing over the past ten years or so, driven by ASP increase. I think this was mainly because of product upgrade, which led to price inflation, and volume growth in the mid-to-high end segment (mainly sports bikes), which led to mix improvement. Although the market of low-end bikes for transportation use has shrunk, demand for sports bikes remains stable, as demand for sports and leisure is unchanged.

 

Chart 1: Bicycle sales in value in the developed markets (Indexed, 2002=100)

 

Source: COLIBI/COLIPED, Japan Bicycle Promotion Institute

 

Going forward, I expect stable volume sales and steadily rising ASP in the developed markets. In emerging markets such as China and Southeast Asia, I see structural growth potential in both volume and price, as these markets catch up with the developed ones. Overall, as the urbanization rate rises and middle class expands in the world, global demand for cycling and sports bicycles have potential to grow further. As an industry icon with overwhelming brand power, Shimano is likely to benefit from cycling demand growth at anywhere in the world.

 

Company analysis

Dominant market share and superior brand power

Shimao has over 70% market share in global road bike component market and around 50% share in global MTB component market. That is to say, more than 50% of sports bicycles sold in the world use derailleurs and other key components made by Shimano.  And if we expand the population from sports bicycles to all derailleur-equipped or multi-gear bicycles, Shimano’s market share should be even higher.

Such dominant market share is a result and proof of its superior brand power, which I believe is one of the most important pillars of the company’s wide moat. In many industries, brand of components may matter for the finished product manufacturers, but much less, if at all, for the end users. The sports bicycle industry is unique in that the brand of components matters a lot to end users. Buyers of sports bicycles care about whether the bike is Giant or Trek, but care equally or, in many cases, even more about whether the components are Shimano or SRAM or some unknown brands. As an industry icon, Shimano’s brand power and market share is unmatched by any of its competitors nor any bicycle maker.

Shimano’s superior brand power is of course based on the high quality of its products, but smart marketing strategies have also played an important part in its brand building. The company’s marketing can be described as both ‘top-down’ and ‘bottom-up’. Shimano was not No.1 from Day 1. When it entered the sports bike component market, Campagnolo was the industry icon. As a late comer, in order to be recognized by customers, Shimano invaded from the top – professional races.  It started sponsoring racing teams in Europe from 1973, and has been working closely with professional cyclists since then. It had its major break in the 1996 Atlantic Olympic Games, where all winners from No.1 to No. 12 in the 220km road race used Shimano products, and was finally crowned as top of industry in 1999, when Shimano user Lance Armstrong won Tour de France, the supreme honor a professional cyclist can have. Since then, Shimano has continued dominating winning teams in Tour de France and other important international races. Most recently, in Tour de France 2016, 17 out of the 22 teams attending the race used Shimano products.

Such success in professional races had massive spillover effect on general users. It is powerful publicity that can’t be copied by anyone else. On the other hand, Shimano has made consistent effort in direct marketing to general end users, too. It holds or sponsors races and cycling events, opens Shimano corners in bicycle retail stores to provide after sale services, trying to talk to users directly. By doing so, the company publicizes its brand while collecting valuable information from end users in a direct way. Such bottom-up approach is one of the reasons behind Shimano’s success, and is not often seen at its competitors.

Durable competitive advantage

The ambition of Shimano is unsubtly revealed by the name of its flagship product DuraAce – the durable ace in the industry. We believe the durable competitive advantage of Shimano comes from a combination of best-in-class technology, consistent innovation, and low-cost production. In a word, it is the ability to make better products with lower cost.

Bicycle is no rocket science, but technology and knowhow is still an important differentiating factor, especially for Shimano’s core product derailleur gear system, which has higher requirement for good technology than other components. One of Shimano’s core technologies is cold forging. Shimano was among the first Japanese companies to master this technology and apply it to mass production in the 1960s, even earlier than Toyota. Nowadays, cold forging is widely used in manufacturing, so Shimano’s competitive advantage in this single technology has weakened than before, but it has maintained its leading position in terms of the capability to press complicated shapes, durability of the molds, perfection of details, and low production cost.

All technology becomes obsolete and no moat is forever safe. So in order to maintain competitive advantage, one has to keep working. Over the past few decades, Shimano has made consistent effort in product development and innovation, which has not only led to its sustained growth, but also the evolution of the whole bicycle industry. Some of its major past innovation includes the SIS (Shimano Index System), STI (Shimano Total Integration) and electric component system Di2. For details, please refer to the Appendix section.

The company spends 3%~4% of its total revenue in R&D, and generates over 100 patents every year, more than twice of the No.2 player SRAM. It has effectively built a barricade with its various patents, making it difficult for rivals and new joiners to expand market share by imitation. In addition, compared to its rivals, Shimano’s product development and innovation is characterized by its mass user perspective. Under the ‘stress free’ concept, it has focused on improving riding experience and minimizing stress of ordinary users, not simply raising specs. This was exactly the driving force behind the invention of SIS, which made gear shifting easier for mass users, and STI, which allowed the rider to shift gears without removing hands from the handlebar.

Besides product competitiveness, Shimano has also made consistent effort in improving its cost competitiveness. Its cold forging technology is superior not only in making high performance products, but also in lowering production cost. As a result, compared to its competitors, Shimano can offer better quality at same price, especially for lower end products. This is an important reason why Shimano has gained much more mass users than rivals.

In recent years, the company has increased in-house production of molds and other inputs, enhanced factory productivity by automation, and further streamlined production process. This has led to structural improvement in its profit margin and capital return. I expect such improvement to continue in future, as the company sees potential for further reduction of costs and lifting of productivity.  

Consistently high return on capital, along with high growth

Shimano’s operating return on invested capital averaged over 30% in the past 10 years. This is because of the small size of annual capital investment required relative to the size of its business, the high value-added it creates, and the efficient way it produces in, and has been sustained by its wide moat in terms of superior brand power, best-in-class technology, consistent innovation, low-cost production, etc.

Table 1: Shimano’s ROA, ROE, ROIC (operating profit based)

 

The strong profitability of Shimano has come hand in hand with high earnings growth. On a normalized and adjusted (mainly for currency impact) basis, long-term average growth of top-line has been around 7% in the past 10 years or so. And with an operating leverage of about 35%, long-term average growth of operating profit has been around 10%.

Going forward, I believe Shimano’s return on capital will remain high, if not becoming even higher. Thanks to the stable demand for cycling, the high entry barrier of the industry and strong competitive advantage of Shimano, I do not expect any structural deterioration of the company’s probability from competition or substitute in foreseeable future. Rather, I see structural upside potential as the company continues its effort to improve factory productivity, which could help offset any potential downward pressure to capital return.

As for growth, while the 50% market share may have limited upside, there should still be ample room for future growth from secular growth of emerging markets, expansion of certain product segments such as E-Bike components and disc brakes, and the company’s product development and innovation. Thus, I think it is not imprudent to expect continued growth of earnings in future.

Good management with abundant net cash

Management quality is high, as shown by the company’s consistent strong earnings performance. Current CEO Yozo Shimano is the third generation of the founder family, and has been leading this company since 2001. He started showing his management capability in the early 1980s, when he was tasked to rebuild the Shimano brand after a crisis caused by the company’s failed new product DuraAce AX. He successfully brought the company back on track, and revived Shimano’s glory with a hit product called 105 in 1982, followed by the groundbreaking innovation of SIS in 1983.

Since he became top of the firm, the company has achieved 7% CAGR of top line, 13% CAGR of operating profit and 15% CAGR of net profit. At the same time, profitability has massively improved, too, with operating margin, ROIC, ROA, ROE all having doubled. Market cap expanded from around Y200mn 15 years ago to about Y1.6bn now.

The management has shown good discipline in expansion. It only enters new businesses when it has comparative advantage, such as EPAC drive unit, and has generally avoided entering businesses that make low value-added and low return, such as frames, so as not to dilute its comparative advantage and profitability.

Besides being business savvy, the management is also owner minded, as they are owner themselves. The CEO and his family is the largest shareholder of this company, owning about 15% of outstanding shares. The position and mind of owner is behind the management’s consistent focus on enhancing competitiveness and profitability, and its prudent use of cash. As of end 2016, the company had net cash of Y191bn, which is 49% of its net assets and 12% of its market cap. While this is a drag on capital returns, it is good to hear the management saying that they would like to always be ready for when unexpected investment opportunity shows up. In addition, potential of share buyback should serve as a downside support of share price. The company did large scale share buyback frequently in the past, but much less in recent years, as valuation of its stock kept rising. I like the management’s stance of not to buy shares when price is not cheap, and think management has both capability and willingness to do share buyback when they deem appropriate.   

Valuation

My estimate of normalized free cash flow is Y48bn, based on normalized net income of Y50bn, depreciation of Y16bn and maintenance capex of around Y18bn. Using WACC of 4%, I estimate the intrinsic equity value is around Y1.4tr, or Y15,000 per share. The implied intrinsic PER is 27x FY2016 EPS, which is close to the mid-point of the historical range of 20x-40x. My intrinsic value estimate is lower than current share price by over 10%, but this premium doesn’t look too big to pay for a great company. Moreover, this intrinsic value is just the company’s current value based on current normalized earning power, and is likely to keep growing going forward, given the company’s durable high return on capital built on durable competitive advantage. Thus, investors should have satisfactory long-term return even buying at current price, and should use any meaningful share price decline as chance to load up holdings.

Chart 2: Shimano’s historical P/E

 

Key risks

In long term, we see two major risks unique to this company.

Cannibalization of EPACs with sports bikes

In Europe and Japan, EPACs (Electric Power Assisted Cycles) have grown rapidly in recent years. In the past five years, CAGR of EPAC volume sales was 18% in EU and 7% in Japan. This is a risk for Shimano because if users of sports bicycles shift to EPACs, the demand for Shimano’s components will likely decrease. Most EPACs use derailleurs, too, but require less in number and/or in quality. However, we believe such risk is limited, due to below reasons.

EPACs have small market size: EPACs have been in the market for more than ten years, but still account for only around 6% of overall bicycle volume sales in Europe and Japan, and only have meaningful size in these two markets. Thus, even if high growth continues, the impact on sales of sports bikes should be limited.

EPACs have different customer base from sports bikes: Main users of EPACs are housewives and senior citizens, who are not major customers for sports bikes in the first place.  

EPACs create new demand:  EPACs may cannibalize existing demand to some extent, but they create new demand at the same time. Not everyone has the stamina and energy required for cycling, but EPACs significantly lower the hurdle of this sports with its electric power assistance, thus attracting people who wouldn’t ride bicycle otherwise.

Growth of EPACs offers opportunity: EPACs use almost all components Shimano makes and Shimano has a near monopoly position in EPAC components. Thus, the positive impact from growth of EPACs will likely outweigh negative impact from cannibalization. 

Shimano can adapt: Every company faces challenges and problems from time to time, and what differentiates winners from losers is usually whether one can adapt to change in environment. I believe Shimano has such capability. It has already taken the growth of EPACs as opportunity and tapped into the market of electric drive unit. Leveraging their strength as a bicycle parts maker, they are successfully growing sales and gaining share in this market.   

Currency movement

More than 50% of Shimano’s sales is based in foreign currency, mainly USD, and around 40% of its costs is in Asian currencies, mainly MYR, SGD and CNY. Thus, impact of currency fluctuation on earnings is inevitable. Based on my estimate, the impact on OP from 1% move of FX is ~Y500mn for USDJPY, ~Y400mn for USDMYR, ~Y400mn for USDSGD, ~Y200mn for USDCNY. As such, short-term impact can be significant, but long-term impact should be limited even in the worst case scenario where all currencies move against the company for many years. Actually, Shimano was in such situation in 2007-2012, when FX movement continued having negative impact on its price competitiveness and operating profit, yet the company still managed to almost double its OP in those six years, and only saw OP decline in 2009 (-46%) and 2011 (-3%).

I think this is due to 1) Shimano’s strong brand power, customer stickiness and product competitiveness that beats negative FX impact on price, 2) its ability to pass on cost increase to customers or absorb it by cost cutting, 3) its ability to adapt to massive change in FX conditions by adjusting weight of overseas production vs domestic production. Going forward, I believe these factors will continue to protect Shimano against adverse long-term impact from currency movement.

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