Japanese defence companies have in my view almost limitless potential. In April 2014, Shinzo Abe lifted Japan’s arms embargo for the first time since the late 1960s. One implication is that domestic manufacturers of defence equipment can now export products freely, massively increasing their potential target market. Japan will continue the restriction of exports to states subject to UN embargoes, but otherwise – the world is their oyster.
Japanese manufacturing prowess is well known. Since the first US exports in the 1950s, Japanese auto companies have reached a global market share of close to 30%. Their cars are of consistently high quality control and offers good value for money. The question now is whether the same journey can be repeated in the Japanese defence industry.
Over the past decade, defence spending has ballooned globally, particularly in Russia and China, whose spending is up 4-5x in a decade. Japan’s defence spending, however, has stayed flat.
Due to constraints in section 9 of the Japanese constitution, defence spending cannot exceed 1% of GDP and should be for self-defence purposes only. This is minuscule in comparison to Australia (2%), China (2%), Russia (4%) and the United States (4%).
With the re-election in 2016, Shinzo Abe now has the votes to change the constitution to allow for higher military expenditures. But even though Abe has a 2/3 majority in both parliamentary bodies, real constitutional reform also requires a simple majority in a national referendum. Given Japanese support for pacifism, constitutional reform is not a done deal. It will probably take direct conflicts in the South China Sea or elsewhere to make citizens understand the urgency for self-defence.
China’s military aggressiveness has ramped up successively. For all Xi Jinping’s talk about China wanting to avoid the “Thucydides Trap”, the Chinese government is spending large amounts of money to upgrade its military, including building military aircraft carriers.
Japan has long served as a symbol of a common enemy, perhaps in order to unite the Chinese people and create social cohesion. China is expected to spend US$233 billion by 2020, many multiples higher than Japan’s current defence spending of US$44bn. Japan may sooner or later feel a need to match this number.
Conflicts in the South China Sea as well as Trump’s intent to withdraw forces from Philippines and perhaps even from Japan, make the situation unsustainable. The South and East China Sea conflicts started in 2012 with the Chinese government setting up a website claiming that Diaoyu/Senkaku Islands belonged to the People’s Republic. Since then, China has built military bases across the South China Sea, stating that it controls the waters all the way down to Indonesia and along the Vietnamese and Filipino coasts. Recent images show anti-missile systems being built on some of the islands. China appears to have no willingness to engage in any type of compromise. Japan has now started to engage in military training exercises in the South China Sea together with the United States, and has offered patrol ships and surveillance aircraft to Vietnam and Philippines. At the same time, People’s Liberation Army aircraft were spotted close to Okinawa last month, though China refuted that the event ever happened. A Japanese government agency claims that the Chinese government has launched a campaign to stir public opinion in Okinawa towards independence from Japan. Conflicts are stirring up.
As a reaction to the South and East China Sea conflicts, the budget for Japan’s Coast Guard will rise significantly in 2017 – up from JPY 188 billion to JPY 211 billion. This budget will be spent on amphibious armoured vehicles, F-35 stealth fighter jets, aerial tankers and large transport helicopters.
Meanwhile, Japanese defence exports are almost certain to blossom, though it could take longer than what many expect. The recent weak Yen may accelerate the process somewhat. According to Richard Spencer of UK’s Royal Marines who is now in Japan to advise the SDF, Japan’s military contractors make sophisticated submarines and amphibious aircraft. The export potential is probably the greatest in these two areas. The first assembly of a military jet in Japan – the F-35 – finished in 2016. Japan has also recently become a maintenance hub for Joint Strike Fighter in the northern Pacific region. Japan is bidding for the privilege of producing Soryu-class submarines for Australia as well as for India. Those submarines will be jointly produced by Mitsubishi Heavy Industries and Kawasaki Heavy Industries. But so far, no contract has been signed.
One company that has done better in its export markets is ShinMaywa (7224.JP). Its US-2 seaplane has been sold to India, and rumours have it that Indonesia will place an order as well. ShinMaywa itself has two principal operating segments: aircraft and special purpose trucks, together representing about 75% of operating profit. The company also produces industrial machinery and parking systems.
In the aircraft segment, ShinMaywa produces the US-1A and US-2 STOL Search and Rescue Amphibian planes for the Japanese Maritime Self-Defense Force. The planes are used for rescue missions as well as emergency medical transports on water, perfect for missions around the South and East China Seas, for example. The US-2 aircraft is currently the only amphibian aircraft capable of landing on rough seas with 3 metre high waves thanks to a device called “boundary layer control system”, that lets it take off and land over distances 1/4 as long as normal commercial aircraft. The plane has a range of 4,7000km and a pressurised upper hull enables high-altitude flights. One US-2 aircraft costs about US$110 million. Japan’s self-defence force already has 7 US-2’s.
The aircraft division also produces main wing spars for the Boeing 787 and aircraft boarding bridges. A major driver of the aircraft business is the Yen – a declining exchange rate is positive for ShinMaywa as most of its aircraft division revenues are denominated in US Dollar.
The special purpose truck division produces dump trucks, concrete mixers, refuse compactors, sewerage trucks, tail lifts and other truck-related products. The main driver of this segment is Japanese domestic construction activity.
Both segments have done well in recent years, particularly in 2013 when the Yen started depreciating. Revenues were down 3% in the interim period ending Sep 2016, though most of the weaker performance can be attributed to the strengthening of the Yen, which has now almost come back to its previously low level. Given that about half of ShinMaywa’s revenues are in US Dollar, it makes sense for the share price to rise in Yen terms when the currency depreciates.
Should we worried about the cyclicality of the truck business? Probably not in the near-term, given that the Japanese PMI is hitting an 11-month high at 52.3 and rising. Condo sales have weakened somewhat due to lower foreign demand. Construction activity is showing signs of stalling somewhat. But it is unclear whether we are looking at noise in the data or if those data points truly can be extrapolated.
On the aircraft side, the commercial aircraft market is stable. Boeing’s book-to-bill ratio is 0.79x. The number of airport projects under construction globally increased by 25% in 2016, a leading indicator for the company’s aircraft boarding bridge business.
The most potential in the business is undoubtedly for the company’s search and rescue aircraft, of which 15 were recently sold to India. Given geopolitics, Japanese defence and coast guard spending has only one way to go – and that is upwards. Aircraft capable of landing in the waters around the East and South China Seas should be critical for any serious military operations. Aviation consultancy Ascend estimates that there are 575 fixed-wing emergency medical service aircraft in operation globally, a number that has grown about 9% per year since 2008.
Although ShinMaywa has only scratched the surface of potential export deals, the numbers being discussed are already substantial. The ground-breaking Indian deal for ShinMaywa 15 US-2 planes is worth US$1.2 billion – a big number compared to ShinMaywa’s total sales of US$1.7 billion. The aircraft will be used in civilian missions. Japan’s government is now considering providing low-interest loans from a state-run bank to support exports of military aircraft. The real potential of defence exports have not even started to impact ShinMaywa’s financial statements.
Sell-side expectations are low. Marusan Securities and Okasan Securities predict EPS of JPY 94 and JPY 102 by FY2019, while revenue is not expected to exceed JPY 210m, implying an expected revenue CAGR of just 1% the next two years and EPS well below FY2016 levels.
The Indian US-2 deal led to a sharp rally in the stock. The enthusiasm for either the stock or the Japanese stock market as a whole may cool down at some point, particularly if the Indian deal doesn’t go through.
Multiples aren’t very high though. A market cap of JPY 109 billion and an EV of JPY 92 billion compares with net profit of JPY 10 billion and EBIT of JPY 15 billion gives the stock a trailing P/E of 11x and EV/EBIT of 6x. Profits will come down in FY2017 due to the temporarily strong Yen, but this in my view will be a chance to buy more than anything else. It is not difficult to see growth rates significantly in excess of what the stock is pricing in, particularly if Japanese defence spending and the company’s defence exports really take off. Can the stock one day be rewarded with a growth multiple? I can’t see why not. If the company continues to secure orders for its US-2 aircraft and continues to innovate with new products that meet the demands of the Japanese Self-Defense Forces, the long-term potential of the business should be strong. ShinMaywa is definitely worth putting on a watch list.