Unlocking Shareholder Value in Japanese Balance Sheets

How Nishikawa Rubber Achieved 1x Price-to-Book
 

By: Naoki Ito

The Tokyo Stock Exchange (TSE) directed all companies to develop plans for improving their valuations, sparking a wave of reforms as companies took action to try to achieve the goal of being valued at greater than 1x price-to-book (P/B) ratio. But almost two years after the directive, over 1,600 companies, representing approximately 40% of listed stocks on the TSE, are still trading below 1x book.

We believe achieving this objective is much easier than most of these companies’ management teams understand. Shrinking bloated balance sheets and using the proceeds to fund increased dividends and buybacks can solve the problem for the vast majority of the delinquents. Most companies don’t need complicated plans. They can take simple, direct action and significantly improve their valuations almost overnight.

Sometimes an example is worth a thousand statistics. Today, we wanted to profile a company that went from 0.5x book to 1.0x book in three days, increasing share price by 112%.

Nishikawa Rubber (TSE:5161) is an auto parts manufacturer listed on the Standard Market that generated 118 billion yen (~$816M) in revenue last year, according to data from Capital IQ. On February 10, they announced two commitments to shareholders: to pay dividends at 8% of book value annually from next fiscal year (approximately 7x of current dividend per share) and to reduce their ratio of book value to total assets from 63% to 55% by FY2031. At the time of the announcement, the company was trading at 0.5x book value, making the promised dividend of 8% book equivalent to a 16% expected dividend yield—an audacious and concrete commitment that immediately captured investor attention.

How is the company funding this level of dividends for several years going forward? Easy. Nishikawa Rubber will reduce its significant cash holdings and sell approximately 10 billion yen worth of cross-shareholdings. Before the announcement, it had a market capitalization of approximately 42 billion yen, while its balance sheet showed 45 billion yen in cash and 31 billion yen in long-term investments. Combined, these assets amounted to 76 billion yen, a whopping 180% of Nishikawa Rubber’s pre-announcement market capitalization. This idle capital alone would be more than sufficient to fulfill its bold shareholder return commitment, estimated to total 47 billion yen by FY2031.

Importantly, this capital reduction will not compromise business operations or growth investments. By FY2031, Nishikawa Rubber expects to generate a cumulative 96 billion yen in cash flow from operating activities, with 64 billion yen allocated for capital expenditures to drive growth. This leaves surplus funds, offering flexibility for other strategic initiatives.

Further demonstrating strategic foresight, Nishikawa Rubber has indicated that it is considering the use of interest-bearing debt for potential M&A opportunities—a highly rational approach given Japan's low interest rate environment.

The 1,600 Japanese companies still trading at below 1x book have a lot to learn from this bold and logical action. In March 2023, when the TSE announced the “Action to Implement Management that is Conscious of Cost of Capital and Stock Price,” Nishikawa Rubber was one of the worst performers, trading at around 0.3x P/B. Despite unveiling a reform plan the previous year, they failed to inspire investors due to a lack of clear vision and concrete targets, among many other reasons.

Acknowledging this shortcoming, Nishikawa Rubber revised its plan this time with detailed, actionable steps to improve balance sheet efficiency and shareholder returns, directly addressing its undervaluation. They openly admitted the limitations of their previous approach, particularly in managing reserved cash and cross-shareholdings. Unlike companies that rely on vague income metrics like revenue growth or margin expansion, Nishikawa Rubber offered a more transparent outlook on asset efficiency and returns.

Many companies still struggle to set specific targets for capital efficiency, especially in capital-reduction policies. However, the original intention of TSE's guideline was to encourage a strategic review of the balance sheet, focusing on capital efficiency rather than just sales and profit. Addressing capital inefficiency can enhance both ROE and P/B ratio without requiring substantial earnings growth.

Nishikawa’s success was not due to a magical transformation but rather a simple strategic shift with a clear communication of an achievable commitment to its balance sheet. This is an approach other companies can easily adopt to enhance value and investor expectations.

For those questioning what inefficient capital management looks like, a comparison of balance sheet distributions between Japanese and US-listed companies provides a clear illustration. At the median, Japanese companies hold 33% of their market capitalization in cash and 16% in long-term investments, primarily cross-shareholdings. By comparison, US companies’ cash and long-term investment holdings are almost negligible. This stark contrast is particularly pronounced among smaller companies, as seen below.

Figure 1: Balance Sheet Comparison, Japan vs. US (Median Cash Equivalents and Long-Term Investments as % of Market Cap)

Source: Verdad Analysis, S&P Capital IQ. Small Caps: market cap < $1B. Large Caps: market cap ≥ $1B. For each bar, medians of cash/market cap and long-term investments/market cap are calculated separately and then combined.

This highlights a widespread issue in Japan, where many companies continue to exhibit similar capital inefficiencies as Nishikawa Rubber did until recently. Hoarding cash without productive use is an extremely inefficient way to manage assets. Japanese executives need to recognize that having net assets valued below book value is a point of shame, reflecting poor capital utilization. As the TSE suggests, even companies with a P/B ratio above 1 are not necessarily safe; they must analyze why foreign peers trade at higher P/B ratios and understand the factors contributing to these differences.

In addition to reducing unproductive capital, Nishikawa Rubber’s willingness to strategically use more debt reflects a progressive approach to leveraging growth. Despite having lower borrowing costs than in the US, Japanese companies are notably conservative in using debt. Over the past decade, our analysis shows that the median debt-to-capital ratio in Japan has been just 20%, half of the 40% seen in the US. While the median US company maintains an inverse interest coverage ratio (interest expense to operating income) of about 13%, demonstrating aggressive leverage to generate earnings, the median Japanese company bears minimal interest expenses at only 2%, highlighting ample room to use leverage to enhance ROE and maximize growth. Although debt aversion is often seen as prudent in Japan, excessive caution can hinder business returns.
 
Figure 2: Median Inverse Interest Coverage Ratio (Left Panel) and Median Debt-to-Capital Ratio (Right Panel) for Public Companies in Japan vs. US (2015-2024)

Source: Verdad Analysis, S&P Capital IQ

Improving capital efficiency necessitates reassessing the balance between equity and debt. Although the use of Weighted Average Cost of Capital (WACC) has become more common to measure capital cost among Japanese companies, few actively aim to reduce WACC by optimizing their capital structure. For instance, if paying interest on debt is cheaper than the returns shareholders expect from dividends or stock price appreciation, then adjusting the balance sheet by increasing debt and buying back shares would be a rational strategy for many companies to achieve targets such as higher ROE.   

Furthermore, Nishikawa Rubber's pursuit of M&A is strategically significant, particularly given the traditionally conservative stance of Japanese companies compared to their American counterparts. Our analysis reveals that the median Japanese company allocates only 1.2% of its 10-year cumulative operating cash flow to acquisitions, whereas the median US company allocates 7.4%.

This cautious approach starkly contrasts with the clear benefits observed in Japan: companies that allocated over 10% of their operating cash flow to acquisitions experienced median EBITDA growth at twice the rate of those that did not engage in M&A over the past decade, as illustrated below.

Figure 3: 10Y Median EBITDA Growth by Acquisition Spending-to-Cash Flow from Operating Activities Ratio in Japan

Source: Verdad Analysis, Capital IQ

Japan's relatively low median P/B ratios indicate that many companies could be undervalued, presenting opportunities for strategic acquisitions at attractive prices. Acquiring established businesses at a discount is often faster and more cost-effective than building growth from scratch.

A common rationale given for not pursuing large-scale shareholder returns is the need to retain capital for growth-oriented projects. However, in this context, it is puzzling why more Japanese companies are not aggressively pursuing M&A—not only by utilizing surplus cash but also by leveraging low-cost debt—to gain more assets at a discount, accelerate growth and maximize shareholder value.

Nishikawa Rubber’s strategy is commendable not only as a response to TSE’s guidelines but also as a proactive approach to effective capital allocation. Management must continuously evaluate all capital allocation options—cash reserves, maintenance investments, growth initiatives, M&A, debt repayment, share buybacks, and dividends—by rigorously analyzing potential returns, such as EPS impact, and dynamically adjusting strategies to maximize value.

For a public company, value must ultimately translate into shareholder value. While stakeholder interests are important, if management fails to return value to shareholders, it raises questions about their qualifications to operate as a public entity. A disciplined and adaptable approach to capital allocation is essential for strategic management and long-term value creation.