Hirotako (HIRO MK)
7/20/2010

Summary
How would you like to buy a country-wide monopolist for 1x book and 3x EBIT? Hirotako (HIRO MK) has what amounts to a government-sanctioned monopoly in airbags and seatbelts in Malaysia. The company aggressively defends its monopoly against the rare and hapless competitor. There are significant growth opportunities within the monopoly, through higher penetration of airbags into Malaysian cars. But best of all - in stark contrast to some monopolists we know stateside – Hirotako’s management has been quite shareholder friendly, returning significant amounts to investors through a combination of stock buybacks and share dividends which clouds the financials somewhat but reduces taxes for shareholders.

Company description
In 2009, Malaysians bought 536,905 new cars, almost all of them manufactured domestically. This number has grown ~5%/year over the past decade, but surged 20% in the first half of 2010 . Hirotako makes or imports 70% of all seatbelts and 97%+ of all airbags for these cars. That’s because Hirotako is the only company with a license from the government to manufacture airbags and seatbelts in Malaysia.

About 60% of new cars sold in Malaysia have airbags. Hirotako manufactures 70% of those airbags in Malaysia. The remainder, 30%, is manufactured outside Malaysia and imported. Of the 30%, 90% is imported through Hirotako. Why do most importers cut Hirotako in? If they didn’t, they would have to pay a Malaysian tariff on the airbags to the tune of 30-40%, rendering their product uncompetitive. Hirotako doesn’t pay this tariff because it also manufactures airbags in Malaysia, and it is the only company in a position to do so, because of its manufacturing license. The logic may be circular but it is very much legally and economically real. Hirotako shares its tax savings with importers and thus keeps practically the whole market.

Hirotako originally got the license because it was the first Malaysian-controlled company to apply for it. “Controlled” is the keyword. The seatbelt and airbag manufacturer is structured as a joint venture between Hirotako, a Malaysian public company and Autoliv, a giant Swedish maker of automotive safety products. Autoliv contributed the manufacturing know-how and owns 49% of the JV. Hirotako, the Malaysian public company, contributed the local genes required to win the license and owns 51%. The JV is called Autoliv-Hirotako.

This monopoly has been good for Hirotako’s financials: In 2000-2009, they’ve had no annual losses, net income grew 8% a year and free cash flow grew 7% a year – faster than the growth in automobile volume, because they have also benefitted from broader adoption of seatbelts and airbags in Malaysian cars. Hirotako earned average operating margins of 17% and net margins of 9%. Return on capital averaged 34%.

Is the monopoly durable?
Such mouth-watering economics have attracted the attention of several competitors, but to-date, none have succeeded in capturing any significant share from Hirotako. Although Malaysian regulators would probably applaud new competition, particularly from a second Malaysian company, the costs of establishing a seatbelt and/or airbag factory are high:
1) You need to spend a large amount on the factory
2) Then you need to prove the products are safe to the satisfaction of a parade of inspectors (think crash tests)
3) Then you need win the trust of your customers – car manufacturers. Switching costs for car manufacturers are large, particularly for airbags which are tightly integrated into the automobile. Potential savings from switching are small, since airbags and especially seatbelts are very small components of the overall cost of making a car.

After all that, there are economies of scale to consider: You can’t cover the fixed costs of your factory with just a few orders. You need a large scale to be profitable, and the whole market is only ½ million vehicles a year.

Despite these barriers, the occasional competitor does try to enter the market: GSK, a Taiwanese company, bid against Hirotako for seatbelt and airbag contracts with Produa and Proton, the two dominant local automakers. GSK’s bid was initially 5% lower than Hirotako’s standing price. After several rounds of bidding, Hirotako undercut GSK by 3-5% and kept the contracts.

Valuation and share dividend
Hirotako is priced like a struggling commodity manufacturer (maybe a steelmaker) rather than a growing monopoly: It trades at about 1x book, with about 40% of that book value in net cash. Enterprise value is 3.3x EBIT and 2.5x free cash flow for 2009.

Hirotako pays a 3.5% cash dividend. However, this seriously understates the real/economic dividend yield: Since 2007, Hirotako has been buying back its shares in the market and issuing stock dividends to shareholders. The net effect is similar to a cash dividend. The purpose of this maneuver was to distribute value to shareholders without a) paying taxes on cash dividends or b) reducing the number of shares outstanding, which could hurt liquidity. If you add the effect of stock dividends, the overall dividend yield climbs to 9.26%.

Disclosure: SC Fundamental and affiliates are long Hirotako shares.

Hirotako is not covered by sell-side analysts, except for one technical analysis I saw about a month ago (which BTW claimed the stock was following the elusive but apparently desirable "cup and handle" formation and recommended a long term buy). I guess the variant view would be that a) How much money can you really make on seatbelts? b) It won't be long before competitors eat Hirotako's lunch and c) Where's Malaysia?

I hope I've dispelled a and b in the writeup.