How ValueAct can help elevate Sanwa from a good company to a great one

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Google Earth view of Sanwa Holdings Corporation, Shinjuku Mitsui Building, 52F 2 Chome-1-1 Nishishinjuku, Shinjuku City, Tokyo 163-0478, Japan

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Company: Sanwa Holdings Corp. (5929.T)

Business: Sanwa Holdings is a Japan-based company principally engaged in the manufacture and sale of construction materials for buildings and commercial facilities, as well as the provision of maintenance and renovation services. The company operates in three geographic segments: Japan, North America and Europe. The offer includes shutters, doors for buildings and apartments, partitions, stainless steel products, reception products, windows and outdoor products.

Market value: 874.8 billion Japanese yen (3,820.00 yen per share).)

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Sanwa Holdings shares in 2024

Activist: ValueAct Capital

Percentage ownership: 5.94%

Average cost: n/a

Comment from activists: ValueAct has been a leading corporate governance investor for over 20 years. The company's directors typically sit on the boards of half of ValueAct's core portfolio holdings and have held 56 board appointments at listed companies over 23 years. ValueAct was a pioneer of US-led international activism, particularly in Japan. A significant portion of their portfolio is invested internationally. Rob Hale, co-CEO of ValueAct and co-portfolio manager of ValueAct's Japan fund, is a board member of Japanese companies. This is an unprecedented and industry-leading action for US activist funds. ValueAct previously had 27 international activist investments and delivered an average return of 48.15% versus an average of 7.60% for the MSCI EAFE Index over the same period. In addition, two of the company's best international investments were two Japanese companies where Hale is on the board: Olympus (177.82% vs. 19.68% at MSCI EAFE) and JSR Corp (135.77% vs. 44.35% at MSCI EAFE). MSCI EAFE).

What happens

On September 25, ValueAct Capital announced that it owned 5.94% of Sanwa Holdings.

Behind the scenes

Sanwa is a manufacturer of shutters, garage doors and other related products for residential and commercial applications worldwide. The company holds a compelling position in its industry as the No. 1 player in Japan (50% to 60% market share) and is among the top 2 players in the US (30%) and Europe. In the last fiscal year, Sanwa generated 43% of its sales in Japan, 37% in North America, 18% in Europe and 2% in the rest of Asia. This is a high quality and growing company that does not face many of the problems that typically arise with attacks on activists in Japan.

ValueAct Capital has disclosed in a major holdings report that it has built a 5.94% stake in the company for the purpose of investing, advising management or making important proposals. This makes them one of Sanwa's top five shareholders based on the company's most recent disclosure of major shareholders in June 2024. This is a typical activist position for ValueAct as it is a good company with a strong management team in which it has a provides opportunity for the company to work with management to maximize shareholder value. There are three ways to create value here: (i) US margin expansion; (ii) margin expansion in Japan; and (iii) capital allocation and balance sheet efficiency.

The U.S. business accounts for nearly 37% of the Company's revenue and 50% of its earnings before interest and taxes (“EBIT”). This business was built through many good acquisitions that were not integrated efficiently. As a result, Sanwa operates over 15 factories in the US (versus two to four for competitors), and dual corporate functions and regional management teams continue. Accordingly, U.S. EBIT margins are in the mid-teens, compared to over 30% for competitors Clopay (owned by Griffon Corp) and CHI Overhead Doors (which KKR sold to Nucor in 2022). There is a huge opportunity to centralize, consolidate and professionalize its US operations, which could result in margins that are at least in the low to mid-20s in the next few years.

There is also a margin opportunity in Japan. Currently, Sanwa's Japanese business has an EBIT margin of around 11%, which is likely to improve by a few hundred basis points over the next few years. Margins are much lower in Japan for a variety of reasons: One key reason is that the company is vertically integrated in Japan and does installation in addition to manufacturing, which is more labor-intensive and expensive given recent wage inflation. However, in Japan, demand remains strong due to urban renewal, and the first inflationary environment in a long time is likely to make passing on price increases more palatable. Since Sanwa is the largest player in Japan by market share, it could likely exert additional pricing power in the future.

Finally, ValueAct will likely focus on capital allocation and optimizing Sanwa's balance sheet, which has been a key part of the company's theses in other investments in Japan. The company currently holds approximately 10% of its market cap in cash. This is clearly excessive compared to competitors, and in Japan it is quite typical for companies to accumulate cash and securities unnecessarily and for no reason and well in excess of their working capital needs. In anticipation of creating value for shareholders, ValueAct will likely demand higher returns to shareholders in the form of buybacks to take advantage of Sanwa's relatively low valuation.

Further expansion of both companies' margins and share repurchases should result in a continued reassessment of the company's value from the current 8.5 times enterprise value/earnings before interest, taxes, depreciation and amortization (“EV/EBITDA”) The low teens are trafficked by their peers.

ValueAct has a reputation as a cooperative and friendly activist, and there is no reason why this should be different, especially since Sanwa has a long history of doing many of the right things. For several years and especially after Corona, the company has continuously increased sales, profits, return on equity, return on capital, earnings per share and dividends, with a target payout ratio of 40% of consolidated profits. Since the start of 2020, the company has delivered a share price return of +180% and a total return to shareholders of +225%, significantly outperforming the S&P 500 and Nikkei 225 during this period. ValueAct and Sanwa likely agree on what needs to be done and are both confident that management can achieve it. With ValueAct in the picture, there should be more urgency to achieve it much quicker. Historically, the company has held board positions in approximately half of its portfolio holdings. But ValueAct doesn't take board seats just like that, but when the company and management agree on the value creation potential from the company's presence in the boardroom. Additionally, the company is only required to take a seat on the board if it believes management is not pursuing or realizing value creation opportunities or if it does not believe it could be effective as an active shareholder. Neither seems to be the case here. ValueAct will likely continue to be an active shareholder while Sanwa continues to do what it has been doing, just on a faster schedule.

There is also a potential strategic opportunity here. The US and Japanese businesses are operated independently. If the US business were sold at 13 times EBITDA at which KKR sold the CHI Overhead Doors business, it would be equivalent to almost the entire enterprise value of both the US and Japanese companies and would essentially put the strong Japanese business for nothing receive. This is not something ValueAct has advocated for in the past. The company isn't advocating that here either, but if an unsolicited offer were to come in, ValueAct, as a fiduciary and economic animal, would ensure that management weighs it against the long-term value of a standalone company and takes the best path forward for shareholders.

In summary, it is a good company. There's the share price, the key financial metrics – things are moving in the right direction. But sometimes good companies enjoy the status quo, especially in Japan, and feel no incentive to take the steps to become great companies. As a committed investor, ValueAct has a history of bridging the gap between “good” and “great” by helping management execute its plan.

One final note: This company is no stranger to activists. Dalton Investments had already exceeded the 5% registration threshold with Sanwa on June 30, 2023. The company reported that it had submitted three shareholder proposals but quickly withdrew those proposals as the company proactively disclosed measures to improve capital allocation and corporate governance. Less than a year later, Dalton began selling that position. Now ValueAct will pick up where Dalton left off, but we're sure ValueAct is coming in with a much longer-term mindset.

Ken Squire is 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, an investment fund that invests in a portfolio of 13D activist investments.