I wanted to take a moment to share some important news with you.

After much thought, I’ve decided to wind down the paid service for this Substack as I shift my focus to a new role in the industry.

Writing here has been a highly rewarding experience. And along the way, I’ve appreciated the thoughtful engagement from many of you. Any success this newsletter had was because of you.

Going forward, I won’t publish on a regular schedule. I may still post occasionally if I come across something worth sharing. If you choose to stay subscribed, you’ll continue to receive these posts whenever they come. Think of this less as a newsletter and more as an occasional update from someone who still enjoys thinking and writing.

For paid subscribers, pro-rated refunds will be processed automatically back to your original payment method used at sign-up. No action is required on your end.

As I move into this next chapter, I hope we can stay connected. One of the best parts of writing here has been the relationships formed along the way, and I’d like to carry those forward.

Thank you again for your support. It’s been a privilege to write for you.

Until next time!

Carlit is a small Japanese conglomerate that happens to control a critical chokepoint: it is Japan’s monopoly producer of ammonium perchlorate (AP), a key material that’s needed to produce missiles and rockets.

Carlit trades has a market cap of 32bn yen and has 4.5bn in net cash and 8.6bn of long-term investment securities. It trades at an EV/EBIT of 4.5x (FY27ce) or P/E of 10x (which becomes 6.3x after adjusting for net cash and investment securities). In today’s world, what do you think is an appropriate multiple for a monopoly defense player?

What is ammonium perchlorate (AP) and why it matters

Earth’s upper atmosphere and space contains little to no oxygen, so missiles and rockets have to carry their own source of oxygen for combustion. This is where AP comes in.

AP is an oxidizer, which means when ignited, it decomposes rapidly and “donates” oxygen to produce high-temperature combustion. It’s mixed with fuel, binders, and other chemical agents as part of the solid propellant for missiles and rockets. AP comprises 50-70% of the weight of the solid propellant.

There is no other oxidizer that can match AP’s combination of high performance, cost, and track record. AP has been used globally as the dominant oxidizer for the last seven decades. You can read about “green” oxidizers or other experimental alternatives in the labs today but for now, AP is irreplaceable.

Demand

Modern wars are increasingly fought with missiles, with boots on the ground reserved as a last resort. It’s worth noting that the current missile stockpiles maintained by countries around the world are essentially “peacetime stockpiles.” These levels are insufficient for a sustained conflict (as the recent Iran/Israel exchanges have clearly shown).

The trend is clear: countries are now scrambling to build more missiles. And among them, Japan stands out for having underinvested in this area. Japan is now playing catch up. Japan’s defense spending plans for FY2019–2023 vs.FY2023–2027 illustrate the scale of this shift:

• The budget for “stand-off defense capabilities” will jump from 0.2 trillion yen to 5 trillion yen (a 25x increase!) This covers offensive missiles designed to strike enemy ground, sea, and air targets.

• The budget for “integrated air and missile defense capabilities” will rise from 1 tn to 3 tn, which are defensive systems to intercept incoming missiles.

• The budget for “cross-domain operation capabilities” will increase from 3 tn to 8 tn, which includes investments in the space domain.

Japan also plans to expand its space program, spanning both government and private-sector efforts. To support this, the government will revisit its space regulations, with new rules expected by 2026 in order to promote greater activity and increase private sector launches.

Carlit will be a direct beneficiary, since the company is Japan’s monopoly supplier of AP to both the defense and space programs (with defense expected to be the bigger contributor to growth). Currently, 100% of Carlit’s AP production is consumed domestically. Japan’s rising demand alone is absorbing all the capacity but in the future I think there could also be a market for exports.

Supply

Carlit is currently undergoing AP capacity expansion that will increase its total production by 2–3x. This expansion is demand-driven as outlined earlier.

Total investment is 2.5bn yen across three phases. Phase 1 is complete; Phase 2 will be complete in the first half of FY2026/3 (i.e. by September 2025); and Phase 3 is expected to be complete in the second half (i.e. by March 2026). Full operations are slated to begin from April 2026 onward.

The supply chain works as follows: Carlit produces AP and supplies it to NOF (4403), which blends the AP with other materials to manufacture solid propellant. NOF then delivers the solid propellant to IHI (I’ve covered IHI, see here for my deep-dive), which integrates it into a rocket motor, before supplying to final assemblers such as Mitsubishi Heavy Industries.

It’s also worth noting that NOF itself is undertaking a major capacity expansion for solid propellant, with completion timeline around September 2027. This means that while Carlit’s expansion will be finished by March 2026, there may be a lag before sales can fully ramp (depending on NOF’s current capacity, so the exact timing of the ramp remains somewhat uncertain).

The moat

The biggest question investors may have is why Carlit is the monopoly producer of AP (and whether this is sustainable).

Actually, Japan is not an exception. AP production in most countries around the world currently operate under a monopoly or duopoly structure.

• United States: Duopoly in theory (American Pacific and Northrop Grumman) but in reality American Pacific dominates.

• Japan: Monopoly (Carlit).

• Continental Europe: Duopoly (French state-owned Eurenco and ArianeGroup, which is a JV between Airbus and Safran).

• UK: Monopoly (Chemring).

• Russia: Monopoly (state-owned ANOSIT).

• India: Monopoly (state-owned APEP), although Solar Industries and Premier Explosives are trying to enter.

• China: The only exception, with multiple SOEs producing AP.

Historically, there were more producers. For example, the U.S. had four producers during the Cold War. But decades of industry consolidation driven by defense budget cutbacks reduced the number of suppliers. Now that governments are scrambling to increase missile production, AP has emerged as a critical chokepoint. Every country wants more AP suppliers, but the challenge is that introducing new suppliers is easier said than done.

Why?

Producing AP is not hard, but AP from different suppliers may not be chemically identical. When it comes to something as sophisticated as ballistic missiles, even microscopic differences in the chemistry of AP can affect its ballistic curve (i.e. accuracy and performance). This means each weapons program has its own qualification process for a new supplier, and this often takes a lot of time and cost.

Ballistic missile launches cost millions of dollars for short-to-medium range missiles and tens of millions for long-range. Spending these amount only to validate AP, which costs only a few percentage of the total missile cost, makes little sense. Another reason qualification process takes time is due to the necessity of shelf-life testing. This is because missiles are designed to be stockpiled for decades, so degradation of AP over time is a key concern.

AP is also extremely hazardous in nature, and licenses and production sites are tightly regulated. The risks here are not just theoretical. In 1988, American Pacific suffered two massive explosions (measuring 3.0 and 3.5 on the Richter scale), resulting in two deaths, 372 injuries, and $100 million in damages to buildings within a 10-mile radius.

There is also the need for strict export controls, as AP is just white powder making it easy to smuggle. Its only real use case is in making extremely dangerous weapons. Governments strictly regulate exports and vet suppliers to prevent AP from falling into the wrong hands (terrorist groups, rogue states, etc.)

The conclusion is that producers with licensed facilities that already have their AP qualified and integrated into existing weapons programs enjoy a big moat. In fact, the barriers are so high that even with governments actively trying to diversify suppliers, new entrants have hard time breaking in. The US market serves as a great case study.

• In the US, American Pacific (AMPAC) has been the monopoly AP producer, supplying the US government since the 1950s.

• Northrop Grumman tried to enter recently. It built its first AP line in 2019–2020, scaled up in 2022, and received a generic qualification in 2021. On paper this created two suppliers, but progress has been slow. If you are interested, this is a good article on WSJ: “Northrop’s Rocket Fuel Factory Is Slow To Take Off”

• As the author put it: “Years after building a factory to make more of the key chemical, Northrop’s output is still missing from the fuel powering many U.S. weapon systems.”

AMPAC itself has traded hands several times. The Huntsman family bought it in 2015, sold it to AE Industrial Partners (PE) in 2020, and in January 2024 it was acquired by publicly listed Newmarket Corp for $700mn.

Newmarket now reports AMPAC under its “Specialty Materials” segment. In FY2024 AMPAC delivered $141.2mn sales and $17.5mn in operating profit. The acquisition multiple was 40x forward operating profit.

Carlit

Vertically integrated producer of AP

Carlit also produces sodium chlorate and sodium perchlorate which are key inputs in the AP production process. These also have other industrial applications, in addition to their use in producing AP.

This vertical integration is another layer of moat for Carlit. For a second supplier to be cost competitive with Carlit, it would also need to internalize sodium chlorate production. But this may not be as easy as it sounds.

Case in point is Russia. According to one report, Russia has had no domestic production of sodium chlorate since the collapse of the USSR! As the article describes: “Ammonium perchlorate cannot be produced without sodium chlorate. Russia lost the ability to produce sodium chlorate domestically after the collapse of the USSR and remains dependent on imports, especially from China and Uzbekistan.”

Expanding upstream

Carlit is expanding beyond AP production into the design and production of solid propellant (in which AP is the key input) aiming to capture more value up the chain. The company has been supplying solid propellant to Japan’s space programs since 2017. But on the defense side (missiles), Carlit has so far only supplied AP. This is set to change, as Carlit is now investing 8bn yen to build solid propellant capabilities with plans for experimental mass production in 2027 and commercialization in 2028.

We know that Japan is advancing its indigenous missile capabilities. The timing of Carlit’s investment lines up with two key programs that are coming online soon and could feature Carlit’s solid propellant.

• Hyper Velocity Gliding Projectile (HVGP): launched by a solid booster, with initial deployment scheduled for FY2026 (by Mar 2027). This is the most likely and most significant demand driver for Carlit’s solid propellant.

• Upgraded Type-12 Surface-to-Ship Missile: first deployments pulled forward to FY2025 (by Mar 2026). These use solid boosters for launch but AP demand here is smaller relative to HVGP.

Looking further ahead, the Carlit’s TAM could also expand due to export opportunities. For example, China and Russia already exports AP to Iran. If allied nations face industrial bottlenecks or if conflict in Europe intensifies, Japan could very plausibly step in as a supplier of AP.

Estimating Carlit’s AP sales

Carlit’s management doesn’t disclose its exact AP sales but we can make a reasonable estimate as follows:

• In April, AMPAC disclosed that it’s spending $100mn on its Utah expansion to add ~50% capacity. Its 2024 sales were $141mn which means $100mn capex added ~$70m annual sales.

• Carlit is spending 2.5bn yen ($17m), which based on above should add ~1.75 bn of annual sales.

• If this represents a 2-3x capacity increase, existing AP sales must be between 0.875 bn to 1.75 bn. Take the midpoint to get 1.3 bn, which represents 3.5% of Carlit’s consolidated sales, or 5.8% of the sales of the Chemical Products segment.

• Carlit has provided guidance on its AP sales trajectory as shown below:

Carlit’s business portfolio

As shown earlier AP only accounts for a small portion of Carlit’s sales (although this is set to grow rapidly). Carlit is a diversified conglomerate with many businesses.

The company started as an explosives maker. Today, the chemical products segment includes not just AP but also industrial explosives, signal flares, and other products. These are mostly regulated, stable, and profitable businesses. Carlit also offers hazard assessment & testing which is a niche but attractive area. Because Carlit has long experience handling dangerous materials, it has built expertise in safety testing. This has become a profitable services business.

I’m not going to go through all of the businesses here but suffice to say that the company still operates many businesses that are shareholder value destructive. For example, there’s no reason why Carlit should be in the business of beverage bottling or producing silicon wafers. Management has not disclosed plans to divest these businesses but is instead focused on improving their profitability.

But governance has been improving. Carlit has been reducing cross-shareholdings, freeing up cash for shareholder returns. In May 2025, Carlit announced a major buyback program of 1.3mn shares (5.4% of outstanding). Dividend payout ratio has increased from 30% to 40% and management has explicitly stated it aims for PBR >1x.

Catalysts

• Carlit’s AP capacity expansion will be done in March 2026. Management is guiding for profit growth, with FY2027/3 operating income forecasted at 4.2 bn yen, up from 3.1 bn in FY2026/3 and 3.05 bn in FY2025/3.

• Japan announcing extra spending on defense and space programs. The Japanese government has been turning more right-wing and this could be further tailwind for defense spending.

• Large-cap defense names like MHI, IHI, and KHI have already re-rated sharply. Even a small spillover of capital into names like Carlit could make its valuation skyrocket.

• Publicly listed peers have done well. Newmarket (AMPAC’s parent), Chemring, and NOF’s shares have all surged recently. Is it Carlit’s turn?

• Potential take-private: Carlit’s small market cap stands in stark contrast to its strategic importance as Japan’s sole AP producer. In fact it’s hard to think of another publicly listed company this small that plays such a critical role in national defense. Hence, this raises the question: is Carlit too strategic to remain listed? One possible scenario is that the Japanese government pressures a larger defense company (NOF being the most logical candidate) to acquire Carlit and delist it.

Risks:

• Operational and natural disaster risk: an AP facility explosion would be catastrophic. The probability is very small but the outcome could be devastating. It’s worth keeping this in mind when sizing the position (this is more a reminder to myself since Carlit is now my largest position).

• Carlit’s growth is partly tied to Japan’s space ambitions. Any major setbacks to Japan’s current space program (e.g. if the next few launches of the new H3 rocket ends as failures) would weight on future space-related demand.

• Rotation away from defense names: Defense is a crowded trade. Any “permanent” ceasefire (Gaza/Israel, Ukraine/Russia) could lead to rotation out of defense names, until the next major conflict reignites investor interest.

• Alternative technology: There is no immediate threat, but the possibility of a superior material replacing AP in the future cannot be fully ruled out.

Disclosure: The author holds shares of Carlit at the time of publication and may choose to sell these shares at any time without notice. This article does not constitute investment advice. Please refer to the disclaimer at the beginning of this article, and always conduct your own due diligence before making any investment decisions.

The portfolio gained 27.5% during Q2 2025 and is up 72.4% since inception (January 17, 2024), measured in HKD.

Positions and Weights

Here’s how the portfolio looked as of the end of Q2. New positions initiated during the quarter are highlighted in green.

Read more

Introduction

Air Water is Japan’s #2 industrial gas company, with c. 30% share in air separation gases. The market leader, Nippon Sanso, holds closer to c. 40%.

Why should you pay attention? Because it’s an industrial gas company still flying under the radar of most global investors, and it might just be the last clear “bargain” still left in this amazing sector.

But of course, there are reasons for this: Air Water has long struggled with both a lack of focus and a lack of growth.

The lack of focus is almost legendary. Since 2000, Air Water has made 245 acquisitions, most of them unrelated to industrial gas. The company happens to be Japan’s largest producer of table salt (42% share) and also raw ham (30% share). Yes, you read that right. And the list goes on — the company is a bottler of canned and bottled juice beverages, producer of aerosol sprays, sells electricity from its own biomass power plants, processes vegetables, owns a supermarket chain, makes construction supplies…you get the point.

Even in its industrial gas business, the business returns in Japan have historically been unattractive. The market offered no growth and pricing has remained flat. This stands in contrast to most other developed markets, where industrial gas has been a standout business.

However, there are some signs of positive change:

• Air Water’s industrial gas business is improving.

  • In Japan, margins are expanding thanks to pricing increases and contract rationalization. The growth of Japan’s semiconductor industry has also been a tailwind, as new fabs require steady supplies of nitrogen and specialty gases.

  • Air Water has been growing outside Japan; it became the #3 player in India after it bought the Indian assets of Praxair and Linde in 2019, and the company also has operations in the US.

• There is a governance improvement story here, although I’d characterize it as still in the very early stages. The new mid-term plan announced in June marks a shift in focus from topline growth to profitability, with plans for business exits and divestments, as well as a 1 trillion yen market cap target.

The chart below compares the 10 year performance of Air Water and Nippon Sanso, its main Japanese rival. The performance gap between the two should continue to attract investor attention and add pressure to Air Water’s management. Will it finally be Air Water’s turn to re-rate?

There hasn’t been any activist involvement yet in the name, and I see this as a good set-up. Air Water has no controlling shareholder, trades below book, owns many noncore assets that can be divested, and importantly, industrial gas is a high-quality, globally proven business model with the potential to command a significantly higher multiple.

For global investors, this is a chance to buy a longstanding industrial gas company at a valuation that could, in hindsight, look absurdly cheap.

Industrial gas

(If you are already familiar with the industrial gas business model, feel free to skip this section)

I recently heard Linde’s CFO describe the industrial gas business as an “unregulated utility”.

• It’s like water and electricity in your home — one of the most important things in your life that you rely on everyday, but pay very little for compared to your other life expenses.

• Similarly, industrial gas is essential to countless businesses. For them, the cost of gas is relatively small, but it’s mission critical. They cannot run their operations without it.

• For customers, reliability comes first when choosing suppliers, before cost. They have a preference for established players and are unlikely to switch suppliers unless something goes very wrong. This results in an industry dynamic that highly favors the incumbents.

Going deeper, the three main supply models are:

1. On-Site/Pipeline: The industry gas company builds ASU (air separation unit) at or near the site of a large industrial customer (typically steel, petrochemicals, or semiconductors). It owns and operates the facility, and sells gas to the customer under a long-term supply agreement (10-20 years), typically with minimum purchase commitment and inflation-protected pricing.

2. Bulk/Merchant: Gas is produced at a central ASU, liquefied, and transported to customers using specialized trucks. At the customer site, it is stored in on-site cryogenic tanks, then vaporized and used as needed. The gas company typically owns both the trucks and the on-site storage tanks, providing a turnkey solution. Customers usually sign supply contracts, although the contracts are much shorter (5 years or less) than the onsite contracts.

3. Cylinder/Packaged: Gases are compressed into cylinders at filling plants and distributed to smaller end-users through a network of third-party regional gas distributors. This model serves smaller users that don’t require continuous gas supply.

The three supply models are often interconnected. A large ASU might primarily serve an on-site customer under a long-term contract, but also produce excess gas that can serve nearby customers under the bulk and packaged models. This allows the gas company to better manage the ASU utilization and bring down the per-unit cost. Think of it this way: onsite is the foundation while the bulk and packaged models help to further drive the return on capital.

This is also the reason why industrial gas companies can run the ASU better than a customer can do it by themselves if they were to own and operate in-house.

The key moats in this business are:

• Switching cost: most evident in the on-site model, where customers are locked into long-term contracts. Even in the bulk and packaged models, gas is mission-critical and customers are naturally reluctant to switch suppliers.

• Low-cost: Having multiple customers around a single ASU and building dense delivery routes results in lower cost to serve each customer (through better utilization of ASU and more efficient delivery).

• Distribution: Reaching small, fragmented users requires strong local networks, often built through partnerships with regional distributors.

Lastly, domain-specific expertise and product offerings matter a lot in certain sectors.

• In semiconductors, fabs require more than 100 types of special gases for various production processes, along with specialty chemicals and non-gas services like logistics and materials recycling. Industrial gas majors can provide all of these.

• In healthcare, gas companies don’t just supply medical oxygen; they also build medical gas piping systems and supply hospital with both goods (e.g. medical supplies) and services (e.g. supply chain management, logistics).

In these areas, winning often requires a full value chain approach rather than being able to sell just the gas.

Business drivers: Japan and India

Japan

In Japan, Air Water has recently begun to exercise its pricing power. The company raised prices in April 2024 and again in January 2025—by over 10% for air separation gases and 20–30% or more for specialty gases. Beyond pricing, there is also significant room to rationalize and improve contractual terms, which in many cases lag behind global standards. Both of these should serve as margin drivers going forward.

The semiconductor industry is emerging as a key growth driver.

• A major industry trend is that fabs are increasingly looking for partners capable of providing total facilities management. Air Water is well-positioned to meet this demand, offering a comprehensive suite of gases, chemicals and materials, as well as on-site services.

• Air Water supplies Japan’s two main memory makers, Kioxia (formerly Toshiba) and Micron (formerly Elpida Memory which got acquired by Micron), in addition to other key discrete, power, and analog players in the country.

• Air Water is investing in a large on-site gas facility for Kioxia’s new plant (phase 2 of Kitakami, Iwate), which will produce the 8^th generation NAND chips for AI applications starting in September 2025. Micron’s Hiroshima fab, also supplied by Air Water, is expected to undergo capacity expansion for advanced DRAM manufacturing by 2027.

• While the memory market deteriorated in 2H 2024, Kioxia management expects inventories to normalize by mid-2025, followed by demand recovery in 2H 2025 (Kioxia’s recent share price momentum seems to support this). Another catalyst is the end of Windows 10 support in October 2025, which could lead to further PC demand.

An underpenetrated area for Air Water is cutting-edge logic, but breaking into this isn’t easy.

• So far Air Water has lost out to Nippon Sanso for the gas supply contract to Rapidus in Hokkaido. In Kyushu, Air Liquide is supplying TSMC’s fab #1.

• It seems like Nippon Sanso and Air Water are now competing for Fab #2 which is under construction and set to commence operations in 2027.

• Air Water has build a “multipurpose facility” near TSMC, so it looks like it has won some kind of contract here (probably logistics or materials procurement).

• The key question is whether TSMC will be looking to diversify from Air Liquide in Japan. This may be a challenge as Air Liquide has already invested a significant amount of money in Kyushu.

Of course, any supply wins with Rapidus or TSMC would be huge news, although at this point I think the probability is low.

If you’re interested in Japan’s semiconductor industry, also check out Japan Materials (6055), which I think is the closest peer to Air Water’s semiconductor business. It’s a niche company that provides services to fabs, including procurement, engineering, and maintenance. Kioxia is also the main client (Yokkaichi fab), resembling Air Water. Note that Japan Material’s revenue is roughly half the size of Air Water’s “Electronics” segment (for semiconductor industry) and it trades at a market cap of JPY 150 bn which is one third of Air Water’s total market cap.

India

Air Water entered India by acquiring Linde and Praxair’s assets divested as part of the regulatory requirements needed for their 2018 merger.

• These are profitable on-site businesses supplying India’s largest steelmakers (Tata Steel and JSW). The prices paid appear reasonable — 2.7x sales for Praxair’s business (which includes on-site supply to Tata Steel’s Jamshedpur plant) and 3.5x for Linde’s business (includes on-site supply to JSW’s Bellary plant). The Japanese company didn’t overpay this time! The deal also included regional gas filling stations giving Air Water a foothold in the regional markets to serve smaller-scale users.

• According to Frost & Sullivan, India’s industrial gas market was valued at USD 1.2 bn in 2023. The market is projected to grow at 4.3% CAGR by volume and 7.5% CAGR by value from 2024 to 2028.

• Air Water India has #3 market share, behind #1 Linde India and #2 INOX Air Products (JV between INOX and Air Products & Chemicals).

• The risk here is that Air Water India has very high exposure to India’s steel industry. It’s a growing industry — India’s crude steel output is expected to reach 210 MT by 2030, up from 125 MT in 2023 and on a per capita basis India remains well below global averages (India 88kg/person vs. China 700kg, Japan 696kg, and US 270kg). But we also know this industry is highly cyclical.

• In September 2023, Air Water won a major on-site contract for state-owned SAIL’s Durgapur Plant, with operations set to begin in October 2025. This adds roughly 28% to Air Water India’s currently installed capacity. With this, Air Water now does business with three of the top four Indian steelmakers. It’s impressive that the SAIL win was organic, although one has to wonder what kind of terms were necessary in order to secure a deal with a client like SAIL…

• According to Air Water’s management, they are “receiving multiple inquiries from blast furnace makers”. So the business sounds solid, as long as India’s steel industry can keep pace.

• Management also commented it’s interested in doing an onsite business in Western India. This might possibly be in connection with Tata’s planned semiconductor fab in Western India, which Air Water is reportedly competing for. This would be a big win.

Note that the only listed industrial gas pureplay in India at the moment, Linde India, trades at a market cap of RS 595bn (EV/sales: 22x). Applying this to Air Water India’s sales of JPY 20.1 bn would imply a valuation of JPY 442 bn, which is close to 100% of Air Water’s market cap.

Of course, this comparison is premature as Air Water has not disclosed any plans to list its Indian business (and based on my conversation with IR, it does not appear to be under active consideration at the moment).

That said, I believe there’s a business case for listing in India. Doing so would allow Air Water to tap into the high valuations of the Indian market and raise capital to capture new customer segments, supporting its diversification away from its current heavy exposure to the steel sector. It’s also worth noting that a local Indian industrial gas player, Ellenbarrie, is set to go public soon (Fun fact: Air Water held a 51% stake in Ellenbarrie until 2021).

Management

A brief history: There were three key figures in Air Water’s history: Hiroshi Aoki (born 1928), Masahiro Toyoda (born 1932), and Kikuo Toyoda (born 1948). The two Toyodas are believed to be brothers, separated by 16 years. Kikuo Toyoda is the current Chairman and CEO.

Aoki was the long-time executive at Daido, the predecessor company of Air Water. He ran the company from the time of merger with Hokusan (1993) until 2015, and is the key architect behind Air Water’s historical M&A strategy (i.e. the empire builder). His protégé, Masahiro Toyoda, succeeded Aoki from 2015 to 2019 (Aoki passed away in 2018). In 2019, Toyoda passed on the torch to his younger brother Kikuo (Masahiro, 93 years old, still sits on the board but has no formal title/functions).

I’m not sure what the relationship is between Aoki and the Toyoda brothers — my guess is they are either extended family or the Toyoda brothers were part of the founding family at Daido or some other company that got absorbed into the group. In any case, Air Water should be considered a “family company” since Kikuo Toyoda likely sees himself as a family member rather than a hired CEO.

The key question is whether Kikuo Toyoda is better than his predecessors.

Is he a hardline reformer or a staunch governance advocate? No.

But is he the exact same as his predecessors? No.

My view is that he sits somewhere in the middle. I’ll lay out the facts here and let you decide.

1. Under Kikuo Toyoda, the most notable shift has been a renewed focus on the industrial gas business, with overseas growth being made into a key priority. FY2021 marked a turning point. Before this, investments were scattered across a range of non-core businesses, but since then, it has become apparent that industrial gas has become the focus for investments.

2. HR decisions aligned with the above:

   • The most significant was promoting Ryosuke Matsubayashi to President and COO in March 2023. Matsubayashi is a gas engineer by background who previously led R&D and served as CEO of Air Water America before taking charge of global operations in India and the U.S. He seems highly motivated to make the company more global - e.g. he introduced a policy requiring all new graduate hires in Japan to complete a three-month overseas training program in either India or the U.S.

   • Newly appointing Rochelle Kopp, a non-Japanese, as independent director. Kopp is a cross-cultural communications expert and also sits on the board of MS&AD Insurance, Japan’s second-largest non-life insurer. This seems like a step in the right direction.

3. New mid-term plan (“terrAWell30 2025-2027”) - link here

Sell-side analysts seem very positive about the new midterm plan. SMBC Nikko called it a “major reform,” while Bank of America described it as a “major shift.”

The mid-term plan touches on a range of topics, but in my view, the most important for investors to assess is the company’s stance on its business portfolio. Specifically, its willingness to divest non-core businesses.

During the Q&A session of the mid-term plan, Chairman Toyoda described the company as follows:

冷蔵庫の中にはたくさんものが入っていて、何が入って いるかは忘れているものもあるし、隠れているものもある。その状態が今のエア・ウォーターグループです。 未知のものがたくさんある一方で、中には捨てるものもあります。

Translation: “There are a lot of things in the refrigerator, some of which we forget what is in there, and some of which are hidden. That’s the current state of the Air Water Group. While there are many with potential or hidden value, there are also things that need to be thrown out.”

• In line with this, Air Water will conduct a “comprehensive review” of the business portfolio.

  • Detailed disclosures were limited, but the company did provide one clear quantitative benchmark: businesses with operating margins below 5% will be classified as “low-profitability” and subject to strategic review.

  • In total, the businesses under review will be roughly 50 bn yen in revenue, or about 5% of the company’s total.

  • FY2025 has been designated as a review period, although based on my conversation with IR, it sounds like the first actual business divestment is more likely to take place in 2–3 years, toward the end of the mid-term plan.

• The plan also includes capital market goals, including market cap of 1 trillion yen by 2030 and a stated aim to “continuously improve P/B ratio through earning a return on capital in excess of cost of capital” (however, worth noting that these goals are not currently tied to executive compensation).

• Profitability continues to be the focus: “Comprehensive reassessment of low-margin dealings by product and customer” and “Thorough price management to secure the resources necessary for business continuity.”

• IR mentioned that both Chairman Toyoda and President Matsubayashi have begun meeting with investors for the first time — a small but encouraging sign of improved engagement with investors.

My initial reaction was one of slight disappointment. While the overall direction looks positive, the company is still in the very early stages of transformation, and there’s clearly a lot left to do. The pace doesn’t feel fast enough and there doesn’t seem to be much urgency behind it.

That said, I do think there is a kind of a governance “put” here: If the business does well, then great. If it doesn’t, underperformance could prompt accelerated reform, as we’ve seen with other Japanese companies.

Another potential catalyst is the future involvement of activist investors.

Valuation and return profile

Based on my sum-of-the-parts (SOTP) analysis, I believe the stock is trading roughly 40% below fair value. This is a conservative estimate — for example, I applied a 30% discount to peer multiples when valuing the industrial gas segment.

Management is guiding for a 10% profit growth p.a., plus a 3.5% dividend yield, with additional upside from multiple expansion driven by governance improvements. At 9x forward P/E, the valuation looks undemanding. Altogether I think it’s reasonable to underwrite a 15–20% annual return from current levels.

For context, Nippon Sanso trades at 23x P/E, which suggests that multiple expansion is the single largest source of upside potential if Air Water can close even part of that gap.

In a downside case where profit growth remains sluggish (say 5% annually, in line with the past three years) and governance reforms fail to gain traction, investors could still see a return of 8% (5% growth + 3.5% dividend). While that won’t be exciting, it’s a pretty reasonable floor in my view.

Disclosure: The author holds shares of Air Water at the time of publication and may choose to sell these shares at any time without notice. This article does not constitute investment advice. Please refer to the disclaimer at the beginning of this article, and always conduct your own due diligence before making any investment decisions.

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The portfolio gained 6.6% in Q1 2025 and is up 35.2% since inception (January 17, 2024), measured in HKD.

(This was the calm before the storm, ahead of the tariff war. April update: Using April 25th as the end point, YTD performance stands at +11.4%, with return since inception of 41.3%. The portfolio has recovered ATH.)

Positions and weights

Here’s how the portfolio looked as of the end of Q1. New positions initiated during the quarter are highlighted in green.

Read more

In Part 2, we’ll dive into IHI’s defense and power generation businesses. These contribute to Japan’s national security and energy needs, aligning with the country’s most critical long-term interests. We’ll wrap up with a discussion on valuation and risks, including IHI’s exposure to the recently announced Trump tariffs.

Defense business

IHI’s defense segment breaks down as follows:

• 60-70% from military aircraft engines. IHI covers all fighter jet models used by Japan’s air force.

• 15-20% from rocket motors (propulsion system for missiles), and

• 10-15% from gas turbines for navy vessels and other defense equipment.

Japan’s air force operates Japanese variants of the U.S. F-15, F-16, and F-35. Mitsubishi Heavy Industries (MHI) manufactures these aircrafts under license from Boeing and Lockheed Martin. IHI produces the engines under license from GE and Pratt & Whitney (one exception is the F-35: IHI supplies components to P&W but does not assemble the engines in Japan ) and handles maintenance & repair for all engine models.

In addition to licensed production, IHI also develops proprietary engines. It manufactures the engines for the Kawasaki P-1 maritime patrol aircraft and the T-4 training jet using its own designs. IHI also produces the T700 engine for military helicopters under license from GE.

Today, Japan is on a path to increasing its defense budget to 2% of GDP by FY2027 (from ~1% historically). The chart below shows the projected increase in defense spending (blue bar, JPY trillions). To get to the 2% GDP target, Japan will increase its spending by a trillion yen every year until 2027. Cumulative spending will be JPY 43 tn between FY2023-2027 compared to JPY 27 tn between FY2019-2023.

The Pentagon has requested Japan to raise its defense spending to 3% of GDP. Although Japan has so far brushed this aside, I think this remains a potential catalyst, with some experts viewing 3% as a realistic target for Japan (now that NATO is also reportedly discussing 3% as its next goal).

The U.S. has been actively promoting so-called “friend-shoring” of the defense supply chain. Recognizing that its own industrial capacity has fallen much behind China’s, the US has been actively trying to leverage the industrial capacity of its allies.

The U.S. ambassador to Japan urged Tokyo on Tuesday to take a greater role in developing, producing and supplying weapons "to enhance our collective security" amid conflict in Ukraine, Gaza and elsewhere…The United States alone can no longer supply all democracies, Ambassador Rahm Emanuel said during a visit to a Mitsubishi Heavy Industries' F-35 fighter jet factory. He stressed the importance of stronger defense industry cooperation between the allies…The countries will now look at what Japan can co-license, co-produce and co-develop, Emanuel told reporters. "It's extremely exciting to bring Japan's industrial capability, its engineering smarts, onto the field on behalf of the alliance," he said.

- Mainichi Shimbun (link)

This “friend-shoring” push also aligns with Japan’s own incentives. Japan wants to participate in weapons manufacturing so that technological learning happens within its own border. The F-2 program (Japanese variant of the F-16 fighter) resulted in a 60% and 40% production split for Japan and US.

Raising the defense sector profit

Decades of Japan’s pacifist military policy led to many of the country’s defense contractors withdrawing from the business (it is said that in the past 20 years, over 100 defense contractors have withdrawn). As Japan looks to re-militarize, it finds itself with an inadequate domestic defense industry which has suffered from decades of underinvestment.

To rejuvenate the defense sector, Japan has committed to increasing the sector profitability. In the past, the standard profit margin on defense contracts was 8%, but contracts from FY2023 onwards will be under a new structure (below chart, right side). Effectively, the maximum operating margin will be increased to 15% from 8%, with an inflation cost adjustment component.

Missile spending explodes (no pun)

Japan’s spending on “Stand-off defense capabilities” will increase from JPY 200 bn to 5 tn (25-fold increase!) and “integrated air and missile defense capabilities” will increase from JPY 1 tn to 2 tn (Note: MoD’s published figure is 3 tn, which is larger than IHI’s 2 tn, but maybe IHI is referring to its own addressable market within the segment).

The former category has a more pre-emptive or retaliatory focus (e.g. long-range cruise missiles, anti-ship and land attack missiles) while the latter involves more defensive focus (intercepting oncoming missiles and aircrafts).

IHI’s rocket motors serve as propulsion system for missiles. Currently, IHI is supplying mainly the latter category of defensive missiles such as the SM-3 and PAC-3 (“Patriot missiles”). However, the 25-fold budget increase on the "offensive side” can become a significant opportunity if IHI can capture a portion of it in the future.

Easing export restrictions

Historically, Japan maintained very strict arms export controls. In 2014, the Abe administration replaced the existing framework to support the growth of the country’s defense exports. Since then, Japan has gradually relaxed these restrictions.

IHI has capitalized on this shift. It previously produced F-35 engine components solely for Japan, but as of April 2024, it began manufacturing engine modules for export to global F-35 operators across 18 countries. Japan has also eased export rules to allow the replenishment of U.S. Patriot missile stockpiles depleted by the war in Ukraine.

Further relaxation of export controls is expected, potentially unlocking growth opportunities in areas where Japan is seen as a technological leader, such as ships and maritime patrol aircraft. News: Italy is reported to be interested in purchasing the Kawasaki P-1 maritime patrol plane.

Finally, it’s worth noting Japan’s participation in the Global Combat Air Programme (GCAP), a joint project with UK and Italy to develop a sixth generation fighter jet by 2035 (with Saudi Arabia potentially joining). A Japanese consortium, including IHI, will hold a one-third stake in the program. What makes this significant is that Japan is stepping up as a full development partner, rather than just importing or producing US fighter jets under license.

(Side note: the most interesting thing is Japan chose European partners instead of the US — reportedly due to the US's inflexibility and unwillingness to treat Japan as an equal partner, and Japan’s desire to diversify its defense partnerships. Given what we’ve seen during Trump’s second term so far, this has proved to be a wise decision for both the Japanese and the Europeans…)

The key take-away here is that Japan is ambitious, and its main defense contractors including IHI will play a key role in supporting Japan’s climb up the defense value chain.

Resources, Energy, and Environment

This segment is expected to generate 26% of FY2025/3E sales and 12% of operating profit (before corp. eliminations).

Within this segment you’ll find several different businesses. Please note below isn’t IHI’s official disclosure — it’s my own way of categorizing them:

• Manufacturing, which produces power plant and industrial plant equipment. Key products here are boilers and gas turbines. IHI also produces large diesel engines for land and marine use.

• IHI Plant, which engage in EPC (engineering, procurement, and construction) across power generation, LNG receiving and storage, petrochemical, and industrial plants.

• Jurong Engineering (JEL), a consolidated subsidiary headquartered in Singapore, which engage in power plant EPC in developing Asia, mainly Southeast Asia, South Asia, and the Middle East regions.

• A nuclear business, which makes “picks and shovels” nuclear power plant components and structures including containment vessel, steel structure modules, piping systems, and waste facilities. IHI is also an investor in leading SMR company NuScale (IHI invested $20 mn in 2021 according to this article).

Therefore, IHI operates as an end-to-end player across both EPC and manufacturing. The EPC, which “owns” the customers, can distribute IHI’s power plant and industrial plant equipment while also providing customer insights to the manufacturing side. In turn, the EPC business benefits from having internal manufacturing capabilities, allowing greater flexibility to meet customization needs.

A significant portion of the segment’s sales comes from aftermarket. The exact figure is undisclosed, but I estimate it to be at least 50%. Key products in this segment, such as plant boilers and gas turbines, are among the most aftermarket-intensive areas, with easily over half of their sales generated from spare parts and long-term operating and maintenance contracts. Also, the nuclear business is 100% aftermarket (there has been no new nuclear power plant construction in Japan since Fukushima, so all of it comes from servicing and maintenance including decommissioning and restarts).

There are three key areas of growth within this segment:

Gas turbines

Gas turbines are the core component of natural gas power plants, and demand has recently surged to unprecedented levels.

• Since the war in Ukraine, Europe has re-embraced fossil fuel and has been rapidly constructing natural gas plants. In 2025, Europe’s natural gas power generation capacity is expected to 5x YoY, leading to record orders for gas turbines.

• The AI boom has been a significant driver. Data centers and new semiconductor facilities increasingly utilize their own gas turbines to generate power on-site. Mitsubishi Heavy and GE Vernova have each sold out their capacity through 2028.

• According to Jeffries, 10 months ago, prices for a standard Mitsubishi J or GEV HA turbine ranged from $60-65MM, but are now up more than 50% to $85-110MM on awarded contracts today.

Three major global players in gas turbine are GE Vernova, Siemens, and Mitsubishi Heavy which controls two-thirds of the global market.

IHI’s gas turbine business consists of its own turbines and licensed production from GE. IHI’s own turbines are focused on smaller output models, mostly used in cogeneration and small industrial use cases for only the Japanese market. The more important business for IHI is its longstanding partnership (50 years) with GE to manufacture and service GE gas turbines in Asia. Currently, this includes the GE LM-series which is among the best-selling aeroderivative gas turbine models in the world. As of March 2023, IHI had 242 total gas turbines in operation (162 are the LM models), with 159 in Japan and 83 in Asia, with Thailand and Australia being the largest markets outside Japan.

The benefit of gas turbines is that it has higher efficiency and lower emissions than coal-fired boilers, and it’s been taking share away from the latter. This has led to some concern by investors that coal-fired boilers, which represents a major part of IHI’s sales, is being cannibalized. However, the reality is that the world is desperately hungry for more energy consumption. Aftersales of installed boilers will continue to be a major revenue generator for IHI, as existing coal plants will be in service for decades. During this time, many coal boilers will also be retrofitted with co-firing biomass or ammonia to reduce emissions and extend their lifetime. This is another business opportunity for IHI, as we will discuss later.

Nuclear

Over the next five years, IHI’s nuclear business will likely enter a growth phase.

A decade after shutting down all of the country’s nuclear power plants following the Fukushima accident, Japan is gradually re-embracing nuclear again to meet its rising energy demand. Japan’s new nuclear energy plan calls for “maximizing the use of nuclear energy.” Of Japan’s 33 operable nuclear reactors, 12 have resumed operations after meeting post-Fukushima safety standards. Japan aims to increase the share of nuclear in its energy mix to 20% by 2040 (up from the current 8%), and is now considering the construction of the country’s first new nuclear plant since Fukushima.

While there are lots of discussions on evolving reactor technologies, IHI’s product portfolio focuses more on the the boring “picks and shovels” part of the nuclear power plant. This makes IHI less vulnerable to rapid technological changes.

For example, a major area for IHI is containment vessels, which is an extra thick, high-integrity structure that surrounds the main reactor pressure vessel (where the fission occurs). The containment vessel serves as a safety barrier, forming a second line of defense in the case of reactor failure. Even as nuclear technology advances, the fundamental need for a physical containment structure to prevent accidents remains the same. Can you imagine regulators saying “we no longer need safety barrier for our new generation of reactors”?

IHI’s investment in leading SMR player NuScale is providing IHI an opportunity to learn advanced SMR designs. Through this, IHI is repurposing its nuclear portfolio for future SMR deployments (both in Japan and overseas), including the development of new containment vessel designs for SMRs. Management has announced plans to deploy its first SMR project in the United States in 2029.

Ammonia

“The Group targets approximately 900.0 billion yen in 2050 as revenue from the entire Ammonia Value Chain business…In terms of profitability we currently anticipate a profit margin equal to the average of the IHI group”

- IHI

JPY 900 bn from the ammonia business alone is quite a significant figure, considering the total revenue of the resources and energy segment today is around JPY 420bn.

Ammonia 101

Ammonia (NH₃) is one of the most common industrial chemicals, used mainly in the production of fertilizers and other industrial applications.

Ammonia burns cleanly, and is being explored for its role in power generation. However, its properties makes the combustion process technically challenging to manage. IHI is spearheading the development of technology which allows conventional power generating equipment, such as gas turbines, to be able to effectively burn ammonia as fuel (IHI leveraged its knowhow from its jet engine combustion technology, taking 10 years to develop a proprietary method for ammonia combustion).

The idea is to start by mixing a certain percentage of ammonia with fossil fuel, so that we end up using less volume of fossil fuel to achieve the same energy output. This is called ammonia “co-firing”. First, it will be done at a ratio of 80% fossil fuel (coal or natural gas) and 20% ammonia. Over time, the ratio of ammonia will be increased as technology improves. Ultimately, the goal will be to burn 100% ammonia.

Thus, ammonia can be thought of as a “transitional” fuel source, although it also has a potential to serve as an “end-state” fuel source once we get to burning 100% ammonia. It’s similar to the concept of hybrid cars being a transitional solution to a full EV, if you like this analogy.

Is Japan crazy for going down the ammonia path?

Japan has announced plans to utilize ammonia for 1% of total power generation by 2030 (through co-firing), and 10% of the country’s total power generation by 2050.

Japan’s enthusiasm for ammonia is unique among G7 nations. Most other members have taken on an “all or nothing” approach, viewing transitional fuels like ammonia as largely a waste of time and advocating for the direct transition to renewables such as wind and solar.

What we are starting to see, however, is that climate goals have proven to be unrealistic. Europe has been quietly turning back to fossil fuel. It reminds me of what’s also happening in the auto market. Toyota’s hybrid sales are currently reaching record highs, years after the company was mocked for being slow to embrace a pure EV future. Perhaps Japan’s focus on transitional solutions, whether hybrid vehicles or ammonia, is more practical and grounded in reality than many have given it credit for.

After the Fukushima nuclear accident, Japan shut down all of the country’s nuclear power plants and built many new coal and gas fired plants (see below chart). Ammonia provides an effective way to “off-ramp” these fossil fuel plants in the coming decades, while still keeping them in operation for as long as possible. This is the key reason why Japan is highly focused on ammonia.

The usefulness of ammonia extends beyond Japan, however. Many developing markets are in a similar situation, having built a large number of coal power plants recently to meet the growing energy needs of their population. Renewables like solar and wind remains out of reach for them, and they need a practical solution to transition their coal plants while keeping them in operation for as long as possible.

IHI therefore sees developing Asian markets as a high potential market for its ammonia technology. Countries like India, Indonesia, Malaysia, and Thailand are giving ammonia a serious look. Another key point is that these countries, like India and Indonesia, are gearing up to produce green ammonia for export to Japan. If they are going to become major producers, it only makes sense that they seriously consider its use for their domestic market as well.

It helps tremendously that IHI has a large presence in developing Asia through its subsidiary Jurong Engineering, a scaled player in the Asian power EPC market. Jurong’s established relationships with power plant operators in the region helps it to influence customer roadmaps and promote the ammonia technology. With Jurong owning the customer relationships and IHI the ammonia technology, this is a good example illustrating the advantages of IHI’s end-to-end capabilities.

Main challenges: supply and cost

Ammonia is nothing new; it’s already widely used in the production of fertilizers and many industrial applications. Hence, there’s already existing infrastructure for shipping and storing ammonia. A huge advantage of ammonia is that it’s relatively easy to store and transport. Unlike hydrogen which needs to be cooled to -253 degrees to liquify (versus only -33 degrees for ammonia), ammonia does not require highly costly and specialized supply chain.

“Ammonia is easy to handle. We have the infrastructure to handle ammonia now. We just modify it, scale it up and make it safe. That is the quickest way to get to carbon neutral. It is the best way to do that compared to hydrogen and other sources”

– Akihiko Numazawa, IHI (source: Financial Review)

GE (biased they may be as they are IHI’s partner) has also stated:

Hydrogen has been hailed as the decarbonization “Swiss Army knife,” but ammonia could actually be closer to cracking the code and becoming the end-to-end solution the world really needs. Hydrogen remains an important focus for GE Vernova, but unlike ammonia, it can’t affordably or easily be shipped across oceans.

- GE Vernova

IHI estimates global ammonia demand will reach 700 mn metric tons by 2050 which includes all use cases. Japan will require 30 mn tons for power generation by then. Today, the global ammonia supply is roughly 200mn tons, and out of this, about 20 mn is available in the export market (the majority of ammonia is being consumed in the market it is produced). Even assuming Japan can secure all the freely traded ammonia in the world right now, it will still not be enough to satisfy Japan’s future demand.

The main challenge with ammonia is hence the supply. Japan will need to secure additional ammonia at an acceptable cost. What makes this particularly challenging is that the ammonia must also be clean (“green ammonia”).

You see, while ammonia burns cleanly, the production process to manufacture ammonia may not be clean (just like EV batteries). Ammonia production always requires hydrogen, but the environmental impact depends on how that hydrogen is produced. Obviously, clean ammonia costs way more than dirty ammonia.

• “Gray ammonia”: dirtiest form produced using fossil fuels, involving applying pressure and high temperature to natural gas (methane), which emits CO2 in the process.

• “Blue ammonia”: produced using fossil fuels, but with 80-90% of CO2 emissions captured by CCS (carbon capture and storage) technology to store it underground.

• “Green ammonia”: produced using renewable energy to split water atom (H2O) using electrolysis.

Currently, all ammonia in the market are gray, as blue/green ammonia are not yet mass produced. From 2027, Japan plans to start the import of blue ammonia, and starting in 2028-2029, green ammonia capacity will start to come out as well. Cost is the big issue, however. In the initial stages, to support the adoption, government subsidies will likely play a big role.

I believe the ability to procure blue or green ammonia at a low enough cost will be the key element that makes or breaks the ammonia roadmap. This is a key risk for the ammonia strategy that needs to be monitored.

Significance for IHI

We are still in the very early stages with lots of unknowns for the ammonia roadmap. However, if we get there, IHI will be in a position to lead the industry.

• IHI and Mitsubishi Heavy are the only two companies investing in ammonia power generation. The Japanese market will be a duopoly, with IHI and MHI likely leading the Asian markets as well.

• IHI has reached two critical milestones.

  • In 2022, IHI successfully demonstrated a 100% ammonia burning gas turbine, the first in the world. While it was achieved in a small-scale 2 MW gas turbine, this was an important technological proof of concept to show that ammonia can serve as a single fuel source.

  • In 2024, IHI successfully completed the world’s first large-scale ammonia “co-firing” (20% ammonia) demonstration. This is significant, because it was conducted at 1GW output (the scale of a major city’s power supply), demonstrating ammonia co-firing is viable at commercial scale.

• IHI has another key advantage: partnership with GE. IHI and GE are co-developing gas turbines capable of burning 100% ammonia, aiming for commercialization in 2030. They are looking to equip GE’s existing 6F.03, 7F and 9F models with IHI’s proprietary ammonia combustion technology. For IHI, this is major win for another reason. GE’s 6F.03, 7F, and 9F are heavy-duty models designed for large-scale utility use, which IHI currently lacks in its lineup. Until now, IHI’s gas turbines, including the GE-licensed LM series (LM2500, LM6000), have been aeroderivative models which are not suitable for large scale deployments. With this collaboration, IHI moves up the value chain and expands its lineup (see the chart below).

  • In 2023, a MoU was signed with Singapore’s Semborp, which operates two GE 9F gas turbines at its Singapore-based power plant which will be retrofitted with ammonia-firing capabilities by IHI. According to GE Vernova: “If this large-scale experiment proves successful, it could pave the way for worldwide adoption of a lower-cost, lower-carbon alternative fuel for gas turbines.”

• IHI is not just offering a “point solution”. It will be involved across the entire ammonia value chain, including power generation (gas turbine and boilers), ammonia shipping and receiving terminals, and ammonia production including providing equipment for green ammonia synthesis and investment participation in producers.

With these in mind, what I think could happen is that IHI will become thematically tied to ammonia at some point. If the world starts reconsidering the role of transitional energy solutions like ammonia and more countries gradually start to incorporate ammonia into their energy mix forecasts, especially in developing Asia, I think IHI has significant room to re-rate further as the regional (and possibly global) leader.

In fact, this has happened with Japan Engine Corp (6016), which is a marine engine maker that’s part of the Mitsubishi keiretsu (MHI owns 14.8%).

In May 2023, the company announced it has successfully tested ammonia co-powered engine for large ships, and in January 2024, it announced the planned delivery of the ship in late 2026. These sent the shares soaring (see above chart).

But perhaps what the market missed was that in the same press release, it was announced that IHI is also part of the consortium that’s building this ship! MHI is the largest shareholder of Japan Engine Corp, so it’s intriguing that IHI (a competitor) even has a seat in the consortium. I see this as a strong endorsement of IHI’s ammonia technology. It’s increasingly looking like IHI and MHI will be duopolizing every business related to ammonia power generation in Japan, from land to sea.

Valuation

As shown below, IHI is much cheaper than both its Japanese peers (MHI and Hitachi) and overseas peers (MTU and Safran).

The figures in the above chart doesn’t adjust for IHI’s investments and real estate holdings. Adjusting for these, I’ve calculated IHI’s EV/EBIT to be 9.2x and EV/sales to be 0.83x.

• Market cap: JPY 1.36 tn (share price: JPY 9000)

• Net debt and minority interest: JPY 311 bn and JPY 26 bn

• Equity method and other financial assets (includes policy shareholdings): JPY 113 bn.

• Real estate portfolio at fair value: JPY 341 bn. Apply a 30% capital gains tax on the difference between fair value and book value (JPY 34 bn), leaving JPY 249 bn net of tax.

• FY2025/3 sales and EBIT forecasts of JPY 1600 bn and JPY 145 bn

If we apply MTU and Safran’s EV/EBIT multiple on IHI’s aerospace segment EBIT, we get JPY 2.5 to 3 tn. Even if you argue IHI’s business is not as high quality and deserve a 30% discount to these peers, that’s still JPY 1.8 to 2.1 tn in just the value of the aerospace segment. Today, we can buy all of IHI for JPY 1.3 tn.

We haven’t even considered the resources & energy segment and rest of the company, which collectively generates JPY 1 tn in revenue and JPY 47 bn in EBIT, and has exposure to valuable growth areas like gas turbines, nuclear, and ammonia. How much are these worth? If we value these at 10-20x EBIT, the rest of the company are worth another JPY 0.5 to 1 tn.

Plus, IHI owns 35% of Japan Marine United (#2 largest shipbuilder in Japan). Under equity method, this is recorded on IHI’s balance sheet at only JPY 9 bn, valuing the entire company at 25bn. Note that in FY2024/3, JMU generated JPY 286 bn in revenue and 4 bn in profit.

I believe IHI’s shares can 2-3x before it reaches its fair value. I also think IHI can fairly easily overshoot this too, thanks to geopolitical optionality and the scarcity of high-quality defense names in Japan.

Risks

Tariff risk: IHI’s exposure to Trump’s latest round of tariffs is as follows:

North America sales (no separate disclosure for USA):

Note:

• Tariff exposure of the “Industrial Systems and General Purpose Machinery” segment could be much lower, since IHI owns a production facility in the US (IHI Turbo America) for producing vehicle turbochargers, its main product.

• All civilian aerospace parts are produced in Japan and will be fully subject to tariffs.

Operating profit:

Therefore, roughly 20% of IHI’s total sales (90% of civilian aerospace sales) and 50-60% of operating profit are at risk due to tariffs.

Flows-related risk: Ceasefire in Russia/Ukraine could lead to sector rotation out of defense names. Slowdown in air travel (passenger traffic decline) could also result in rotation out of aerospace.

GTF engine: GTF program is recovering from its costly recall incident, and things would have to go smoothly from here. Any further recalls or incidents could cause irrevocable reputational damage. At this point, we have to trust that P&W has things under control, and that the nature of the recall incident was indeed a “one-time manufacturing defect,” as opposed to, say, something fundamentally unsound with the core technology of the engine itself, which could undermine the entire GTF program.

Ammonia becomes a money sink: If ammonia turns out to be an unrealistic solution for power generation, then that will impair all of the work and development IHI has put into this area.

Dependency on GE partnership: IHI lacks proprietary technology in areas like gas turbines and has heavy reliance on its partner GE. I believe GE has been highly focused on capital efficiency (especially since Larry Culp took over as CEO in 2018), and will be keen to continue to rely on co-development partners like IHI for its non-core markets. The upcoming energy transition should increase GE’s reliance on regional partners more (e.g. GE isn’t looing to invest in ammonia, given limited market opportunity in North America).

IHI obviously comes with its share of risks, but the good news is that the thesis spans multiple angles — from governance reforms to civilian aerospace, defense, and power generation. In other words, there are multiple ways to win, and enough diversification to size this up as a large position without losing much sleep.

Thanks for reading!

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IHI has had a great run in the last 12 months (along with the other two Japanese heavy industry names, MHI and KHI). Although the stock is no longer trading at 3,000 yen like it did a year ago, I still think it’s compelling at 9-10k yen.

For some context, here’s my journey with IHI. A year ago, I built a 5-6% position at an average price in the low 3,000s. In 2024, the stock tripled. When it hit around 8,000s in Q4 I gave into the temptation to “risk manage” and trimmed half of my position. After some reflection, I began to think I took money off the table too soon. So in January, I bought back the position and some more (again, in the low 8000s). As of today (April 2) IHI is a 19% position for me.

This deep dive (>11k words) will be split into two parts:

• Part 1: IHI’s value-unlock strategy, looking at how IHI is adopting the “Hitachi playbook” (which resulted in Hitachi’s stock becoming a seven-bagger in five years). We will also dive deep into IHI’s civilian aerospace engine business.

• Part 2: IHI’s defense business and the company’s resources and energy segment, and valuation/risks.

Below is a summary:

Thesis summary

IHI is one of Japan’s oldest industrial conglomerates, tracing its origins back to the Ishikawajima Shipyard in 1853. Today, it operates a diversified business portfolio spanning aerospace and defense, resources and energy, social infrastructure, and industrial systems and machinery. IHI enjoys high market shares and significant barriers to entry across multiple business areas.

Shareholder value unlock

For most of its history, IHI was a sleepy Japanese conglomerate with total disregard for shareholder value. However, this is changing as I believe IHI’s management is serious about transforming. Hitachi is a compelling case study. It shows us how much these century-old conglomerates can evolve, and I think IHI is now following in Hitachi’s footsteps: prioritizing capital efficiency through selection and concentration of business portfolio, divesting non-business assets including real estate and policy shareholdings, improving WC and cash flows, and expanding its recurring revenue (lifecycle business) and profit margins.

The value unlock story is still quite recent. It’s only been a few quarters since it has really started, and it usually takes time for investors to gain confidence in these things (AND especially IHI which was terrible historically). This is why the opportunity still exists, in my view. Hitachi is now a consensus “shareholder friendly” name but it took years for this perception to crystallize.

IHI is “moated” and enjoys strong business growth

In the civilian jet engine business, IHI is the leading partner in Asia to GE Aerospace and Pratt & Whitney (RTX), the #1 and #2 global jet engine OEMs. In my view, IHI is the most important and highest quality aerospace name listed in Asia — something investors should increasingly recognize over time. The business is enjoying growth amid a tight aerospace market in both new deliveries and aftermarket. It’s worth noting that historically, air traffic has only declined five times in the last five decades. A key driver is MRO (an area that IHI has historically under-earned) and management expects its MRO sales to quadruple in the coming years.

IHI is also a major defense contractor, involved in the production and aftermarket for every model of fighter jet engine used by the Japanese air force. It’s involved in Japan’s 6th generation fighter jet development (a global partnership with UK and Italy) and also has exposure to missiles, one of the most significant areas of Japan’s defense spending increases.

In the resources and energy segment, IHI is an end-to-end player in Asia’s power generation value chain, operating across both EPC and manufacturing. It manufactures and services gas turbines (where it’s a partner to GE Vernova in Asia) and one of the two key players (along with MHI) in Japan’s emerging ammonia value chain. IHI also has a nuclear business where it produces containment vessels and other key components for nuclear power plants. Another little-known fact: IHI is an investor in NuScale, the leading player in SMR (small modular reactors). It also owns a 35% stake in Japan Marine United, Japan’s second-largest shipbuilder.

Valuation, catalysts, and flows

Valuation: At 9,000 yen per share (EV/EBIT at 9.2x), IHI trades at less than half the multiple of its domestic peers (MHI, KHI, Hitachi) and international peers (MTU, Safran).

Given the similarity of their businesses, I think IHI’s aerospace segment deserves a “MTU/Safran-like” multiple. If investors are willing to value IHI on this basis, then the value of IHI’s aerospace segment alone would exceed IHI’s entire market cap today. This means all the other businesses, which generates more than JPY 1 trillion in revenue combined, are unaccounted for.

Catalysts: it may appear that the “defense” theme has played out already, but I think we are still in the early stages in terms of the positive news-flows to come, including potential upward revision to Japan’s defense spending (3% of GDP) and further easing of arms export restrictions (e.g. Italy’s reported interest in purchasing Japan’s P-1 plane, which by the way uses IHI’s engine). Even after the notable run-up we’ve seen, I find myself asking “what if we are not bullish enough on defense” (yes, crazy I know).

Flows: the market sees IHI as a defense name (even though defense is only 10% of its revenue), which means stock performance is heavily tied to the flow of hot money playing the defense theme. However, within this I see two opportunities for IHI:

• Fund managers have crowded into Hitachi and MHI as consensus longs. Going forward, IHI could serve as a reservoir for owners of Hitachi and MHI as they look for a similar but cheaper alternative (note that IHI is currently 1/13th the market cap of Hitachi and 1/5th the market cap of MHI).

• European managers are revisiting their ESG policies to potentially remove investment restrictions on the defense sector. There are reports that Amundi, Europe’s largest asset manager, has been working on the launch of European defense ETF, along with Vaneck following suit. Fund flows into defense names may still be in the early stages.

Despite the recent run-up in stock price, I continue to see IHI as a compelling bargain, with a potential upside of 2-3x to reach its fair value, and also a good chance to overshoot its fair value given the geopolitical optionality. My price target (if that means anything) is 30k yen.

Once again, this is only the personal opinion of the author and NOT investment advice.

Value unlock

Following in Hitachi’s footsteps

By the time I heard about Hitachi’s incredible turnaround, I had completely missed it. Actually, I met Hitachi’s CFO back in 2013, shortly after starting my buyside career. Looking back, they had already started their transformation. I was too skeptical in thinking anything could change, and my status quo bias (i.e. lazy mind) was ultimately proven wrong.

So when I started noticing signs that IHI was following a similar path, I paid attention. Then, progressively over the course of the past year, the signs became more and more clear. My conviction grew that IHI could be the next Hitachi.

So let’s look at what Hitachi did.

Between 2006 and 2010, Hitachi lost USD 12.5 bn. In 2008 alone, it posted a record USD 8.1 bn loss, which was the largest single-year corporate loss in Japanese history at the time. Hiroaki Nakanishi, who became CEO in 2010, is credited with initiating the transformation efforts, which were carried forward by his successor, Toshiaki Higashihara, after he took over in 2016. Interestingly, Mr. Nakanishi was a “lifer” at Hitachi — an insider who had spent his entire career at the company (Mr. Higashihara too).

This contrasts with the typical American approach, where an outsider CEO with strong credentials is brought in to shake things up. Hitachi instead executed its transformation entirely from within (another example of a transformation from within is Nippon Steel, which I have covered in this article). The point is that in Japan, corporate transformations often start without much fanfare. As a result, it’s easy for investors to miss unless you’re paying very close attention.

However, a clear sign that Hitachi was serious about change was when it executed on its selection & concentration strategy, selling one business after another. This included: sale of HDD business, TV production, merging with rivals for thermal power generation and HVAC, sale of Hitachi Kokusai’s semiconductor equipment business and Hitachi Koki (power tools) to KKR, selling the medical imaging business to Fujifilm, sale of Hitachi Chemical, the car navigation business, and sale of Hitachi Maxell. Altogether, the number of consolidated subsidiaries decreased from 963 in 2012 to 696 in 2023.

Another transformation which was happening at the same time was moving from a hardware-based to a solution-based business model. Hitachi emphasized subscription services & long-term contracts (leading to more recurring revenue rather than one-off sales), as well as prioritizing working capital efficiency and profitability.

The result? See below stock chart. The path wasn’t linear. While turnaround efforts began in the early 2010’s, it took a while with several bumps along the way until the very dramatic re-rating in the early 2020’s.

What about IHI?

IHI’s transformation is also a “change from within” story. Mr. Ide, who became CEO in 2021, has been with the company since 1983.

Like Hitachi, IHI also appears to have been galvanized into action by a major crisis. In IHI’s case, it was FY2023 which was the second largest loss in the company’s history, caused by a massive recall in its civilian engine business related to issues with the new P&W1100G engine (a problem which wasn’t even directly IHI’s fault — we’ll come back to this story later).

After posting disastrous earnings, IHI started to talk about transforming its business portfolio, including divesting underperforming businesses, a topic which management has never been explicit about in the past. From that point, the messaging only grew louder, to the point where by Q2 FY2024 this topic had dominated IHI’s corporate presentation.

A clear theme has emerged: selection and concentration. The slide below shows how serious IHI is. What they are saying here, basically, is that they are placing every business outside of aerospace/defense and ammonia (key growth drivers) under strategic review — that’s 60% of their revenue that could be on the chopping block.

To take things a step further, IHI has begun to track its divestitures (in my view, a clear signal that it is committed). So far the company has announced the sale of its material handling system business and the general-purpose boiler business. On March 7th, the company announced the sale of IHI Construction Machinery (1% of total sales and 7% of social infrastructure segment sales). Management has been making clear progress here.

In addition, IHI has also announced plans to sell non-operating assets, including:

• Policy shareholdings: IHI has committed to selling all of its policy shareholdings (see below slide). Notice the language here. Most Japanese companies tend to use softer language (e.g. “reviewing” their investment portfolio), whereas IHI commits to selling all.

• Real estate holdings in Toyosu: IHI owns prime real estate in Toyosu, a redeveloped waterfront district in Tokyo that was once home to the company’s shipbuilding operations. Over time, Toyosu has transformed from an industrial area into a major commercial and retail hub, with high-rise offices and shopping centers. IHI currently leases land and office buildings occupying a total of 5 hectares (12.4 acres). The fair value of its investment real estate assets was disclosed to be JPY 341 bn, with a book value of JPY 134 bn (as of March 2024).

Finally, IHI is actively transforming its business model, shifting to a solution-based model emphasizing aftermarket sales. They use the term “LCB” (lifecycle business) to refer to aftermarket sales. The contribution of aftermarket as a proportion of the firm’s total revenue has been steadily growing, as shown below.

IHI has an ROIC target of 8%. The company is on track to achieving ROIC of 10.5% in FY2025/3 (they may have to come up with a new target soon). Management performance bonuses are directly tied to achieving ROIC target, alongside net profit and operating cash flow as KPIs.

Currently, 4 out of 12 directors of IHI are independent (still a long way from Hitachi which is 9 out of 12 independent directors, including an independent Chairman of the Board). IHI recently announced the appoint of Mr. Kenichiro Yoshida (no, not the Sony CEO, but same name) as independent director, who is ex-Ichigo Asset Management and currently an advisor for engagement investing at Aozora Bank. Adding an equity market professional as an independent director is yet another sign that IHI’s management is committed to shareholder value.

Business portfolio

For the remainder of the report, I will focus on two key segments: aero/defense and resources/energy. These segments serve as IHI’s primary growth drivers and together generates 84% of the company’s profit.

Aero engine, space & defense segment

This segment is expected to generate 72% of IHI’s FY2024E operating profit (before corp. eliminations). Between FY2024E to FY2030, segment sales is forecasted to grow from JPY 540 bn to 800 bn. The defense business is forecasted to grow from JPY 155 bn to 250 bn, which implies civilian jet engine and space will grow from JPY 385 bn to 550 bn.

Here, we will focus on the civilian jet engine business, then in Part 2, we will discuss the defense business (we’ll skip the space business as it’s not financially material).

Industry overview

Japan has three major aerospace companies: IHI, Mitsubishi Heavy Industries (MHI) and Kawasaki Heavy Industries (KHI). In the civilian market, all three are consortium partners to global engine OEMs, with IHI the largest of the three. In defense, MHI and KHI rank as Japan’s top two defense contractors, as they manufacture complete military aircrafts, whereas IHI is an engine pureplay. As a result, MHI and KHI generate higher total aerospace revenue than IHI, although IHI is the most dominant within engines with 70% market share of Japan’s total jet engine production across both civilian and military.

Globally, IHI’s closest peer is MTU (Germany), which can be seen as its larger counterpart. They are quite similar, but the key difference is that MTU operates a highly successful, industry-leading independent servicing/MRO business and for this reason MTU is considered a higher quality company.

Then there are the engine OEMS, which traditionally includes three players: GE, Pratt & Whitney, and Rolls Royce. Safran (France) occupies a unique position. Some would say Safran is an OEM given its 50/50 joint venture with GE in CFM, while others argue that it’s not technologically on par with the major OEMs, and that it straddles somewhere in the middle between a partner (e.g. IHI, MTU) and an OEM.

The chart below illustrates value chain.

Business model

Investors must understand two key features of the civilian engine business: 1) Consortium structure and 2) Aftermarket.

Companies like IHI and MTU are partners in an engine development consortium, rather than a traditional supplier. The consortium can take on two forms: JV or RRSP (risk and revenue sharing partner). We won’t get into the technical differences between the two, but both function similarly in that all partners share the economic upside and downside of a project over its lifespan based on pre-agreed upon percentage allocations.

The industry has adopted a consortium model rather than a simpler OEM-supplier relationship due to the unique characteristics of the business:

• Engine development is very costly and risks are high. The model helps to mutualize the financial burden and risk among participants.

• A high degree of collaboration is demanded, both from technological and regulatory perspective, going beyond what is typical in a standard OEM-supplier relationship.

• Jet engines are mission critical components with long lifespan. The structure ensures long-term alignment, incentivizing partners to prioritize long-term reliability and performance.

The below slide shows IHI’s engine portfolio and the economic split for each program. Usually, the engine OEM retains the majority stake (50-66%). Historically, IHI has received on average allocation in the mid-teens. OEMs takes the largest share because they handle the most technologically complex parts of the engine, along with leading the design, testing, regulatory approval, and marketing efforts.

Aftermarket is another key feature of the business model. In a given year, 60-70% of IHI’s revenue in this business comes from aftermarket.

At the program level (which spans 40-50 years), the first decade of commercial production is loss-making. Two reasons: 1) The development cost must be amortized, and 2) Engines are often sold at a loss to secure market share and lock in the long stream of aftersales revenue.

At the individual engine level (20-25 years lifespan), engines begin requiring more frequent maintenance (overhauls) after year five, driving significant aftermarket revenue. Over an engine’s full lifecycle, 80% of total revenue comes from aftermarket, with only 20% from the initial sale of the engine.

Moat

Does IHI have a moat in this business? Absolutely. This is actually easy to see. IHI has secured a role in the successor programs of every engine consortium it has participated in. Namely,

• V2500 —> PW1100G

• GE90 —> GEnx and GE9X, and

• CF34 —> GE Passport

Not only that, but IHI’s program share has increased from first generation to second generation. Its allocation increased from 14% in the V2500 to 15% in the PW1100G, and from 9% in the GE90 to 13% in the GEnx and 10% in the GE9X. This is clear evidence that OEMs are increasingly reliant on IHI, suggesting that IHI’s moat is widening.

“I would say the engines have become far more complex…these engines are way more complex and the technology has matured. Those partners have been key, and they have a lot of IP as you stated earlier. They have a lot of IP themselves now that the OEMs are not privy to or can't use.”

- Former Associate Director at Pratt & Whitney (Alphasense, May 25, 2023)

There are three elements to understanding the moat (and why it’s widening).

Design and certification-related: As the above quote highlights, consortium partners like IHI hold key IPs. OEMs don’t design engines from scratch. Each new generation of engines builds off on the technological foundation of its predecessor, creating a lock-in effect. OEMs must rely on partners’ IP. Not doing so would be extremely costly from a design and regulatory certification standpoint, making it almost impossible for OEMs to push out or exclude their consortium partners.

Jet engines are at the front and center of aerospace innovation: Engines are the most innovative part of an aircraft. It’s where most of the performance and efficiency gains of an airliner comes from (see below quote). The technology doesn’t sit still, and that’s important because it means it’s hard for IHI’s business to get commoditized. OEMs constantly rely on their consortium partners to step up their capabilities, so OEMs can realize their own design ambitions. For instance, IHI produces modules that achieve optimal integration, resulting in weight reduction and better efficiency.

“I would say, on average you can get about 0.75%-1% year-over-year of engine performance improvement. Over 20 years when you launch a brand new program, you would expect roughly 20% every 20 years out of a new engine program.”

- Former Chief Commercial Officer at Airbus (November 16, 2023, Alphasense)

IHI has grown its program share, contributing to the industry’s increasing need for specialization. In the early days of jet engines, OEMs made everything in house. Over time, partners like IHI took on more of the manufacturing, delivering specialized modules which allowed OEMs to concentrate on pushing the envelope on the most critical and high-value parts within the engine (e.g. the geared-fan system in the PW1100G). As engines grow more complex, the industry is moving further towards specialization, and consortium partners are enablers of this. This reflects both consortium partners’ growing technical capabilities as well as the OEM’s desire for greater specialization (to remain competitive in their field).

Typically OEMs concentrate on the “hot section” of the engine, which operates under extreme stress. This includes the high pressure turbine, high-pressure compressor, and key components in the combustion chamber. Consortium partners modularize other areas such as the low pressure turbine, low pressure compressor, low-pressure shaft, fan module, and combustion chamber structure. Whether IHI will eventually take on work in the “hot section” is uncertain. However, the broad trend is clear — consortium partners have been steadily increasing their share of engine programs.

IHI’s engine portfolio

A good portfolio strikes the right balance between profitability and growth. Ideally, it should have mature platforms with established install base generating strong aftersales profit, while reinvesting into newer platforms that will secure future market share. IHI has a well-balanced portfolio, as shown below. The first generation platforms (V2500, CF34, GE90) are cash cows, while the second generation (PW1100Gand GEnx and Passport) are steadily ramping up. Its newest engine GE9X for the Boeing 777X will soon see its first commercial delivery.

Within the portfolio, the PW1100G deserves a special mention. It’s the flagship model of Pratt & Whitney’s breakthrough GTF (Geared Turbofan) family of engines for narrow-body aircrafts, powering the popular Airbus A320neo family.

The PW1100G competes directly with CFM’s LEAP engines, but the GTF is seen as the more innovative option, with P&W currently holding a monopoly on GTF technology. By employing a gear system that allows the fan and turbine to spin at different speeds, GTF technology can deliver up to 20% fuel savings and 75% reduced noise level thanks to optimal control of fan-speed.

How did P&W establish its position? P&W embarked on an entirely new innovation trajectory while CFM has opted to pursue incremental improvement on a conventional design. This is because GE’s core technology is unmatched in the industry, allowing CFM to keep pursuing incremental improvements without taking on too much risk. Seeing that it can never catch up to GE in the core technology, P&W embarked on a high-risk, high-reward path by betting on the novel GTF technology.

P&W’s bet seems to have paid off, with GTF engine earning widespread industry praise. And thanks to its new architecture, the GTF offers greater headroom for future enhancements than CFM’s LEAP, as this expert discusses.

“When you project within 10 or 15 years the LEAP, I think GE and Safran will really, really struggle to improve the LEAP because they have already put all of their best technologies in the engine. They have done this very well, by the way, but there is not really that much they can go after. They can still improve it a little bit, but they will struggle to find probably 4%, 5% more percent”

- Former Chief Commercial Officer at Airbus (November 2023, Alphasense)

However, the big issue with P&W is that it faced a major recall in recent years with the PW1100G engine (we’ll come back to this issue later, but for now let me just say that I think P&W can overcome this challenge).

Aftermarket growth (MRO)

For FY2023, IHI’s sales was split into:

• Main unit (engine): 37%

• Aftermarket: 63%

  • Spare parts: 58%

  • Maintenance, Repair, Overhaul (MRO): 5%

Until now, in a very Japanese fashion, IHI has focused on making the hardware (engine and spare parts) while being underexposed to servicing. However, this is about to change. IHI now wants to become a major player in MRO. CEO Ide has unveiled an ambitious plan to increase IHI’s maintenance capacity from 70 planes to 400, growing its MRO revenue from JPY 20 bn to 80bn. If you do the math, you will see that this is roughly 40% of the total growth of the civilian aero engine business.

I am bullish IHI’s growth in MRO, for several reasons.

MRO capacity shortage

Air traffic has only declined five times in the last five decades. It's grown over the last 20 years, anywhere from 3.7 to 7.5% air traffic growth p.a. according to Jeffries. As shown below, aftermarket growth rebounded after Covid and hit a peak in 2022 and 2023. While growth rate in 2024 has moderated, it is still above historical average. Note the figures in the chart below includes both spare parts and services. For services alone, the growth rate was actually 40% in 2024!

Several factors have contributed to the ongoing tightness in MRO:

• During Covid, airliners deferred maintenance to cut costs, often swapping engines from idle aircraft to delay servicing. This created a massive backlog of deferred MRO work, which is still being cleared.

• Structurally, many workers including mechanics left during the pandemic, and the resulting labor shortage has yet to fully recover (and may never?)

• On the demand side, strong travel demand has kept flights consistently full.

• First-generation engines like the CFM34 and GE90 (which require more frequent servicing to keep them operating) are being kept in service for longer, given the high travel demand and the slow delivery of new planes to replace them.

GTF as the growth driver

Over the coming years, more and more GTF engines will be past the five year mark, requiring more frequent and intensive shop visits including costly overhauls.

There’s also a new dynamic at play with the GTF engines. Engine OEMs typically build out their MRO network by granting overhaul licenses to third party shops, certifying them to perform work on the specific engine model. The key to note is that P&W seems to be pursuing a more “closed” MRO network for GTF engines than in the past (in contrast with CFM’s LEAP pursuing a more open model). Due to the novel design and complexity of the GTF engine, P&W has likely decided it wants to closely safeguard its trade secrets within its trusted network, thus relying more on its consortium partners to build out its MRO network.

If we look at GTF’s MRO network in Asia, the licensees are IHI, MHI, and MTU Zhuhai (which are all consortium partners), and three airlines: Korean Air, Air China, and China Air (P&W likely gave out the overhaul licenses to the airlines as a “sweetener” for the engine deals, which is a common practice in the industry). No independent MRO provider in Asia has been granted a GTF overhaul license. Compared to first generation engines where a long tail of third party MRO providers were part of the network, GTF’s network is more restricted to just the consortium partners.

Business development

Another big change we will see is IHI proactively pursing business development in MRO, compared to its more passive approach in the past. Until now, a large part of IHI’s business has been subcontracted work given by OEM (for OEM maintenance programs) or by other MRO shops when they want IHI to repair the components or modules they produced.

A true full-fledged MRO business goes beyond just taking on subcontracted work. If we look at MTU which operates the industry’s largest independent MRO, it’s much more than just repairing their own products. They’ve become a comprehensive provider, not only taking on subcontracted work but also independently go after and signing on their own customers including airlines and aircraft leasing companies, selling them comprehensive servicing packages.

MRO sales accounts for 66% of MTU’s total aerospace sales (i.e. 2x its manufacturing business including engine and spare parts). MRO sales includes reselling of third party components (as part of total servicing package), so it’s not just services revenue alone (it’s said that ~70% of MRO bill is material). That said, it gives you an idea of the scale of a full-fledged independent MRO business. While IHI will not reach MTU’s scale in MRO anytime soon, IHI’s current MRO sales at only 5% of revenue has significant room to grow from such a small base.

IHI has a key advantage in the MRO business as a consortium player that manufactures parts. By leveraging its spare parts business, IHI can effectively subsidize MRO growth, offering parts at cost to undercut other third party MROs. If IHI is truly committed to growing its MRO business, I think non-consortium players would struggle to compete.

I expect IHI to ramp up its business development focus on LCCs (low cost carriers). First, LCC fleets mainly consist of narrow-body jets and are thus major operators of GTF engines. Second, IHI has the opportunity to sign comprehensive servicing agreements with LCCs, as many lack in-house maintenance facilities, often relying on the facilities of larger airlines or independent MROs.

Industry cycle

Currently, both GE and P&W are seeing around 10-11k new engine orders and commitments for their LEAP and GTF engines respectively. With GE’s current delivery rate of around 1.4-1.5k engines per year, and P&W just under 1k, this is equivalent to 6 to 10 years of new engine backlog (note: Boeing and Airbus are averaging 14 years!)

The backlog continues to grow across both new engines and servicing: GE booked 50% commercial order growth in Q4 2024 with a book-to-bill ratio of 1.67 (1.35 in services and 2.47 in new engines).

Amid tightness, the industry has been turning to pricing increases. Rolls Royce is the most notorious for spearheading this, after its new charismatic CEO Mr. Tufan said he doesn’t believe airlines and OEMs are paying enough for the level of technology engine providers are providing. Rolls calls their new pricing strategy “value-driven pricing”. While Rolls has been the most vocal, others have also followed, with IHI reporting a pricing increase for the GEnx engine during its recent quarterly results.

Another very interesting observation comes from an industry veteran. Every company in civilian aerospace also has a defense business. When it comes to capacity, he thinks these firms will all prioritize the more lucrative defense side, possibly exacerbating the under-capacity on the civilian side.

“There is another issue that is playing out is I think it's in Europe and Japan and in Asia and in U.S., both North America. Defense spending hasn't slowed down…You know how long it takes to get paid when you are working on a defense contract? You have any idea? Two weeks. Yeah, two weeks. Yeah and it's a cost-plus. If MTU is producing a part and they just have to say, "Hey, my price went up by 12%." They can validate. Department of Defense will accept that, and they will write them a check. On the commercial side, if MTU says, "My price went up by 12%," all the different customers will be all over them and say why, this and that, and boom, boom. If I have a choice, where would I put my capacity? I will put it towards defense.”

- Former Director at Pratt & Whitney (May 2023, Alphasense Transcript)

More on the PW1100G recall

Contaminated powdered metal was found in the alloys of certain engine parts manufactured between Q4 2015 and Q3 2021, prompting a recall of around 3,000 engines. This resulted in major operational delays to airlines, as each engine required 250–300 days of overhaul to fix.

The issue affected the high-pressure turbine area, which is solely P&W’s responsibility and does not involve any of the consortium partners. However, losses are mutualized within the consortium. Total losses amounted to USD 7 bn including compensation to customers. Given its 15% program share, IHI took on roughly USD 1 bn in losses. All of this was written off in a single year in FY2024/3, and management expects no further financial impact.

Most importantly, what does this mean for the future of GTF?

• P&W booked 950 GTF orders in 2024, compared to total engine shipment of 996. Book-to-bill should be around 1x (P&W doesn’t provide a breakdown but the vast majority of total shipment should be GTF)

• Compared to LEAP’s book-to-bill of 2.14x, it does seem like some customers have been lost to GE.

• Longer term I expect the GTF to make a comeback. First, based on expert calls, the industry still seems to recognize the technical advantage of the GTF and its long-term potential. Second, the current industry tightness makes it hard for customers to cancel additional orders. Third, the industry doesn’t want CFM to monopolize the narrow-body market, and thus should continue to support P&W.

What the recall revealed however was a flaw in the consortium model. Most high-risk developments occur in the engine’s “hot areas” which are handled by the OEMs. However, the risk is shared across consortium partners, leaving them vulnerable to the OEM’s faults despite having little control over these areas. While flawed, the consortium model isn’t expected to change however. Partners will just have to suck it up. Learning from this incident, IHI says that for its upcoming GE9X engine, they have “taken preventive measures based on our experience in this incident,” although specifics were not mentioned.

Thank you for reading. To be continued into Part 2…

Share

If you’re interested in a large-cap idea that has a mix of statistical cheapness, a clear catalyst, and an intriguing Japan corporate governance angle, then Toyota Industries Corp is worth a closer look.

A little-known fact: Toyota Industries Corp (6201), not Toyota Motor Corp (7203), was actually the “original” Toyota (from here, I will refer to the former as “TIC” and latter “TMC” to avoid confusion).

Founded in 1926 by Sakichi Toyoda to manufacture the Type G automatic loom, TIC expanded into automobiles in 1933. It built its first passenger car prototype (Model A1) in 1935 and spun off the automotive division as Toyota Motor Co. in 1937. It also spun off its steel division in 1940, now known as Aichi Steel.

In 1956, TIC entered the materials handling business, producing forklifts—a business that has since become its core. TIC is now the world’s largest forklift maker, with a 30% global market share (vs. KION at 14% and Jungheinrich at 9%). This business now accounts for 67% of TIC’s sales and 83% of its operating profit.

Where’s the opportunity?

At JPY 13,000 per share, the market cap of TIC is JPY 3.9 trillion (adjusted for treasury shares).

• TIC owns 1.19 bn shares of TMC (9% of S/O), currently valued at JPY 3.3 tn. This accounts for 85% of TIC’s market cap.

• TIC owns stakes in various Toyota group companies, collectively worth JPY 0.9tn, or 23% of TIC’s market cap. The largest are:

  • Denso: 157 mn shares (5.4% of S/O), JPY 306 bn market value

  • Toyota Tsusho: 118 mn shares (11.2% of S/O), JPY 304 bn market value

  • Toyota Fudosan: Unlisted, fair value of JPY 132 bn according to TIC’s March 2024 Yuho.

  • Ibiden: 6.2mn shares (4.5% of S/O), JPY 26 bn market value.

  • Aisin Corp: 7.7 mn shares (3% of S/O), JPY 14 bn market value

  • Other listed and unlisted stakes: Fair value of roughly JPY 90 bn as of March 2024 according to Yuho.

• TIC has JPY 1.3 tn of net debt (total debt minus cash).

• Major shareholders of TIC include: TMC (24% of S/O), Denso (6.8%), Toyota Fudosan (5.3%), Toyota Tsusho (5%), Aisin (2%). Thus, Toyota group firms own at least 43% of TIC shares.

  • Confused yet? I hope not! This is typical of Toyota group shareholding structure.

Adding these up, TIC has an EV of JPY 1 trillion and is forecasted to generate JPY 220 bn in OP for FY2025/3. That’s an EV/EBIT of just 4.5x for the world’s leading forklift manufacturer. Given its growth profile, I think a more reasonable valuation would be 10-15x EBIT, implying a potential 2-3x return potential.

The undervaluation is clear. But what’s the catalyst for unlocking this value? Toyota Group restructuring.

Toyota Group restructuring

The restructuring is still in the early stages, although I think the trend is quite clear.

Industry change

TMC Chairman Akio Toyoda has repeatedly stressed that the automotive industry is undergoing a “once-in-a-century shift” driven by technology changes (vehicle electrification and autonomous driving) and the rapid rise of competition (Chinese OEMs in particular).

• The Toyota Group structure was a competitive advantage in the past, but it’s starting to be regarded as a liability, even by Toyota management.

• Increasingly, TMC will have to design cars from a “first principles” approach. This includes breaking down the barrier and working with global suppliers, not just within the Toyota Group.

• Case in point: Toyota’s new EV for the Chinese market, the bZ3X, is its lowest-priced EV ever at only RMB 110,000 (USD 15,150). TMC chose Nidec’s low-cost electric motor and made extensive use of local Chinese suppliers to bring down cost. Even the ADAS was jointly developed with Momenta, a Chinese company.

• The more TMC faces competitive pressure from Chinese OEMs (both in China and globally), the faster the Toyota Group restructuring is likely to be.

• By the way, if you’re bullish Chinese automakers and believe in them taking over the world, then betting on Toyota Group restructuring might be an indirect way to play this.

Capital markets pressure

TMC is also facing mounting capital markets pressure.

• It was recently reported by Nikkei that TMC is considering adopting a 20% ROE target. TMC’s ROE in recent years ranged from 9-16%, while BYD’s ROE surpassed 20% in FY23 and FY24.

• This 20% figure hasn’t yet been officially confirmed by TMC, but corporate actions coming out in the last 1-2 years clearly indicate TMC’s shift to prioritize capital efficiency. This includes the partial sales of stakes in Denso and Aisin, and raising the share repurchase limits on a previously announced large-scale repurchase in 2024.

• Another surprise was the decline in Akio Toyoda’s approval rating, which fell from 96% at the 2022 AGM to 85% in 2023 and then to 72% in 2024. Proxy advisors ISS and Glass Lewis recommended shareholders vote against the re-election of Toyoda (as well as Vice Chairman Shigeru Hayakawa), expressing concerns ranging from certification testing violation to corporate governance.

• In February 2025, TMC announced plans to transition to a “Company with an Audit and Supervisory Committee” to strengthen board oversight and independent director roles. It’s clear this is an appeasement effort after facing mounting capital markets pressure in 2024.

Now let’s shift our focus back to TIC:

• TIC has sold down its stake in Aisin from 7.68% to 3% between March to September 2024.

• In October, it announced it will sell off all of its Denso shares and will also “review other held shares in the future”.

• In May 2024, it announced a major share repurchase (up to 180bn yen, equal to 4% of S/O). Very positive, as it clearly signals that management is willing to return, rather than hoarding, cash from share sales.

It’s interesting to see that TIC seems to be taking a more drastic approach to restructuring than TMC. It makes sense, as TIC is essentially a standalone forklifts maker and has little rationale to be tied down to the Toyota Group.

The diagram below, taken from TIC’s corporate presentation, shows “policy-held shares” going to almost zero. We should expect the sales of Toyota Tsusho, Toyota Fudosan, and other held shares in the future. As for TMC, this may be part of what management refers to as “other owned shares” which they have not yet committed to selling down but will be “scrutinized in the future”.

As the Toyota Group restructuring proceeds, the end game for TIC shareholders is that it’s left owning the world’s largest forklift maker at a bargain price, with excess cash that will either be returned to shareholders or reinvested into the warehouse automation area (where there is actually good business rationale for doing so).

Business outlook

Material handling equipment segment (Industrial Vehicle in the chart above):

TIC has benefited from the logistics and warehousing boom. Revenue is up 76% compared to pre-COVID levels, growing at a 12% CAGR over the past five years. The weak yen has helped, but growth remains strong.

Going forward, management sees warehouse digitization and automation as a key growth driver. Currently, solutions sales contribute 20% of the segment’s revenue, and there should be room for further expansion, possibly through M&A.

Automobile segment:

This segment mainly supplies TMC and engage in the production of vehicles (RAV 4), engine (Landcruiser, Hiace, RAV 4), air conditioning compressors, and vehicle electronic parts. Margins are abysmal (under 2% OPM last year, and even in good years 3-4%). It essentially acts as TMC’s off-balance sheet production asset, and it obviously has no bargaining power over TMC.

I’m not sure what happens to this segment over time. The most logical course would perhaps be to sell the assets to TMC, but I doubt TMC would want to buy it. Maybe TIC will be left carrying this bag for a while. Or maybe the assets could be sold to new entrants into the auto industry, like Foxconn.

Risks

While we wait for the Toyota Group restructuring to progress, a risk is TMC losing its competitiveness faster than expected, leading to its shares losing value.

Another possible outcome is that TMC launches a takeover bid for TIC, “stealing” it from minority shareholders. While this risk has been often discussed in the past, I think it looks less likely now. TMC’s focus on capital efficiency means it likely wants to be leaner, rather than consolidating legacy auto production assets and TIC’s forklift business which is unrelated to TMC’s core.

Plus, TSE’s new ruleset for the protection of minority shareholders (in the case of MBO, etc.) is expected to be released in Spring 2025, which should further mitigate the risk of take-unders.

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Japan Optimist

MAGA worries

By popular request, here some thoughts on “Trump risks” for the Japan outlook. My focus is deliberately not on assessing implied risks and implication from possible changes to the U.S. economy. Too much of that already in your inbox…. Instead, I focus on the almost certain boost to China’s export competitiveness in general, the inevitable intensificatio…

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a year ago · 12 likes · 9 comments · Jesper Koll

Jesper’s article led me down a rabbit hole of thoughts. I’ll highlight some interesting quotes from his piece, while also adding some of my own thoughts along the way too.

To distinguish between the two, all quotes by Jesper will be bolded, while my own thoughts will be in italic. This not only gives proper credit to Jesper’s original work, but also makes it clear which takes come from a seasoned expert and which come from a rambling parrot.

“Make no mistake: Japan has become a ‘trust fund babe’ or rentier economy (living off the assets accumulated by the previous generation…). Japan is no longer an export powerhouse.”

I never heard anyone describing Japan as a “trust fund babe” which I thought was true and hilarious…

Ok getting into the more serious stuff…

“The Yen has collapsed by 80% since the start of Abenomics in 2013 and is now weaker than it was in the late 1960s, ie. before Breton Woods (according to Bank of Japan calculations of that the real effective Yen). Japan’s exports should be booming…but are not. Or put in another way, the Yen is still not weak enough to boost Japan’s exports.”

In other words, Japanese exporters have lost competitiveness faster than they’ve benefitted from a much weaker yen. This raises an unsettling question: over the next decade, if the yen stays the same or strengthens, are we going to see an accelerated decline in Japan’s export competitiveness? Kind of a scary thought, isn’t it? The one-two punch of lower US interest rate + stronger yen could also reduce Japan’s “trust fund income” from abroad.

A stronger yen seems to be what most people in Japan want nowadays, with inflation and rising cost of living top of mind. But be careful what you wish for? It seems there is no easy answer…

“Made-in-China competition is real”

“It is hard to imagine - even for the Japan optimist - that the Japan moat in the specialized and precision machinery sectors can be defended forever: China spends more than 3-times on Research and Development than Japan, US$500 billion versus US$150 billion; and China is reported to have more than 6 million people working full-time in R&D, compared to an estimated 710,000 in Japan.”

“Make no mistake: true Made-in-Japan global champions - robot maker Fanuc, factory automation giant Keyence, electronic component powerhouse Murata, to name but a few Japan superstars - are feeling the heat from made-in-chinas relentless rise in overall competitive power. It’s no longer just price. The gaps in quality of manufacturing, quality of after-sales servicing, and qualitative innovation are narrowing fast. Japan knows full well that China is an awe inspiring competitor.”

I actually wish these quotes were not from Jesper, but from Japanese management instead. Because you see, I think a big challenge that investors face is that management teams are never forthcoming regarding the extent of Chinese competition. I’ve heard Japanese management (equally applies to US/European management) blame interest rates, inventory cycle, war in Ukraine, weather… anything except the Chinese companies directly eating their lunch. This has happened long enough that I’ve stopped asking them at all. The only option is to do your own research and manage exposure properly.

Rather than betting on Japan competing and winning against China, I’d rather bet on areas where Japan has no competition (why would you want to fight such a hard battle)? I’ve been deploying more capital over the past year into Japanese software (SaaS), defense, and beneficiaries of in-bound tourism.

“U.S. protectionism - or the threat of it - will turbo-charge the trend of Japan’s loss of global market share and competitiveness in non-US markets. Why? Because U.S. protectionism will further aggravate China’s excess capacity - China must keep producing to keep employment, but will lose U.S. customers. The net effect will almost certainly force de-facto dumping of Made-in-China consumer- and capital goods onto the world in general, the Global South in particular.”

One of the biggest tests facing Corporate Japan over the next decade, in my view, is how they will defend Southeast Asia which is their golden goose. Southeast Asia remains the most “moated” and attractive region for Japanese businesses, in a world where neither China nor the US are easy places to operate in (next time you are visiting Thailand or Indonesia, count how many commercial trucks are Isuzu or how many passenger cars on the road are Toyota. Then walk into a convenience store or try going into an upscale mall).

Southeast Asia will be a key battleground, a showdown between entrenched Japanese interests and aggressive Chinese challengers. If Japan loses Southeast Asia, I think it’ll be a permanent liver blow to Japan, one it will have a hard time recovering from. But that’s exactly why Japan will fight fiercely to defend its position…

“…human capital has been accelerating consistently for over three years now; and more generally, the pick-up in Japan’s corporate metabolism — record M&A, MBOs, IPOs, spin-offs and buyouts — is poised to deliver a more efficient and productive domestic industrial structure.”

Jesper seems most optimistic on what he calls the rise in “corporate metablism”. This has been my own focus as well, looking for companies with a long runway to improve their metabolism.

Some ideas to chew on:

• Shareholder register: Avoid large controlling shareholders. The opportunity cost is too high since activists or strategic buyers can’t easily get involved. Even with family ownership, it needs to be small enough for management to be vulnerable.

• Which companies have underlying businesses that are proven to be good, that could significantly re-rate if they just got their acts together?

• Conglomerates pursuing selection & concentration. A record number of PEs have entered Japan in recent years (and these guys need to do deals to earn their paycheck). Can this accelerate the trend of Japanese companies shedding their non-core assets?

• Investors love flocking to industry leaders. This can create massive valuation gaps that are hard to justify between the #1 in the industry and the rest. If the “underdogs” demonstrate a willingness to improve, there’s ton of upside. When the stock price of your rival goes up 5-10x, it becomes increasingly difficult for the laggards to just sit still and do nothing (capital markets pressure + exposed to being activist/takeover target)

I have been looking for opportunities at the intersection of these ideas. I hope to share them with you guys soon.

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So why Haier (and why now)?

With the introduction of the trade-in subsidies for home appliances in the second half of last year (which was further expanded in scope in January), China has downside support thanks to policy. On the international front, growth has been impressive, particularly in Europe where sales have grown organically at 20% CAGR with Haier rising quickly to become a major competitor to industry leader Bosch (BSH) in recent years. Haier has a capable management team with a solid track record in overseas M&A, including the successful turnaround of GE Appliances which was acquired in 2016, and continues to outperform in the North American market.

My investment thesis has five main points:

1) International growth: Over the past decade, Chinese and Korean appliance makers have steadily gained market share in nearly every major international market, while Western makers like Whirlpool and Electrolux have ceded ground — a trend which is expected to continue. A historically weak yuan (with potential for further devaluation in 2025) should provide additional tailwind.

2) China offers robust policy support: In China, Haier held a 28% overall market share in home appliances in 2023, with a particularly dominant 40-50% share in the refrigeration and laundry segments. In the second half of last year, the Chinese government introduced a trade-in subsidy program targeting eight categories of home appliances, making Haier a key policy beneficiary. In January 2025, this policy was expanded in scope, underscoring the government’s continued focus to support consumer spending.

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First, thank you for being a subscriber throughout 2024. Wishing you and your family good health and happiness in the new year. And here’s to hoping 2025 will be a strong year for Asian equities!

Let’s kick things off with a portfolio update. Q4 was an exceptionally active quarter for me. I bought six new positions (four in Japan and two in China), which is quite a lot by my standards, and I also exited from five names.

Year-end felt like the perfect time to reassess my portfolio, so I brought out the axe. I’ve re-evaluated my original theses and the risk-reward for each holding. This led to selling names that I felt lacked catalysts, growth drivers, or clear paths to improvement heading into 2025, and replacing them with those that do.

As always, I will cover portfolio performance, provide an updated list of holdings, and share my thoughts on the new buys and sells during the quarter.

Performance

The portfolio was down 2.8% during the fourth quarter and up 26.9% since inception (January 17, 2024), measured in HKD (essentially the same as in USD).

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Pacifica imports all its energy resources—oil, gas, coal—just to keep the lights on. It runs a consistent trade deficit of physical goods, importing more than it exports, year after year.

To offset this imbalance, Pacifica relies on its natural beauty and cultural heritage, luring millions of tourists annually who flock to its temples and vibrant cities. These visitors pump money into basic industries like food and lodging, temporarily buoying the economy.

But beneath the booming tourism industry lies a glaring weakness: much of the spending in the country’s digital ecosystem—from enterprise computing to consumer devices and apps—flows to foreign firms. As a result, all of the hard-earned surplus from tourism (and more) is funneled into buying digital services from abroad.

A twin deficit in goods and services trade, coupled with a weakening currency, have resulted in Pacifica’s citizens seeing their purchasing power eroded over time. And there is no end to the structural imbalance in sight.

Maybe you’re picturing a Southeast Asian country like Thailand or Indonesia. Or a Mediterranean destination like Greece.

But you might have guessed already — Pacifica is Japan.

In this article, I want to shed some light on the significance of Japan’s “digital dependency crisis” — a crisis stemming from Japan’s failure to achieve digital sovereignty and its overreliance on US tech giants.

Put simply, US big tech has grown so dominant that it’s singlehandedly blowing a hole in the trade balance of a nation as large as Japan. Let that sink for a moment.

Can you blame Tim Cook for looking so happy here?

In 2023, Japan recorded JPY 5.5 trillion in so-called digital trade deficit. The Ministry of International Trade and Industry (MITI) projects this to grow to JPY 8 trillion by 2030, at which point it could surpass Japan’s annual import of crude oil.

Japan’s total goods and services trade deficit in 2023 was JPY 6 trillion, with the digital deficit accounting for JPY 5.5 trillion.

With far-reaching consequences from the FX markets to potentially transformative shifts in Japan’s digital policy, I expect it will draw increasing attention in the years to come.

A closer look

Let’s build our case from the ground up. Japan’s FY2023 current account is shown below.

A reminder:

Current account = Goods and services balance + primary income + secondary income.

Where

• Goods and services balance is the net exports of goods and services.

• Primary income includes income from foreign investments, such as dividends from foreign subsidiaries, interest from foreign bonds, etc. (reported net of income paid to foreign entities)

• Secondary income captures one-way transfers from abroad, including remittances, foreign aid, etc. (also reported on a net basis). Secondary income is not a major component and for simplicity we will ignore it here.

In 2023, Japan recorded a goods and services deficit of roughly JPY 6 trillion (breaking down into JPY 3.5 trillion from goods deficit and JPY 2.5 trillion from services deficit).

Offsetting this trade deficit is a massive primary income surplus of JPY 35 trillion, which keeps Japan’s current account deeply positive. Some may argue that this substantial primary income surplus mitigates concerns about Japan’s trade deficits, but we’ll come back to this point later on.

But for now, let’s dive further into the goods and services components.

Goods trade deficit

Japan has been in a structural deficit for goods trade over the past two decades. This may come as a surprise to those who have held onto the old idea that Japan is an export powerhouse.

There are several reasons for the shift:

• Japanese firms have moved production overseas. This isn’t entirely negative since Japanese firms (and their profits) continue to grow, but it has contributed to a widening trade deficit.

• Japan’s loss of global competitiveness in certain industries, like chips and appliances, to rivals such as South Korea.

• Rising cost of imports driven by energy shocks, rising overseas inflation, and weak yen.

The third point deserves elaboration. Japan’s reliance on imported energy has long been a critical structural weakness. For example, following 2011 Fukushima nuclear disaster, Japan significantly reduced domestic nuclear energy production and increased its reliance on imported LNG, becoming a major contributor to trade deficit.

A similar pattern emerged post-Covid. Global oil and commodity prices surged. This was compounded by high rates of overseas inflation on general imports. On top, a historically weak yen made imports even more expensive.

Another contributor has been Japan’s reliance on cutting-edge pharmaceuticals (e.g. cancer drugs) from Western firms. This highlights gaps in R&D capabilities between Japanese and Western pharma, particularly in areas like biological drugs. Given Japan’s aging population, the demand for pharma imports will only grow.

Services trade deficit

The chart above breaks down Japan’s services trade balance.

Two components stand out:

• Tourism (Dark blue bar): shifted from net deficit to a surplus in 2016 and has continued to grow, as visitor arrivals far outnumber Japanese residents traveling overseas.

• Other services (Light blue bar): The majority of this category (over 90%) consists of the “digital deficit,” essentially payments made to US tech giants. The remainder includes various other services like payments to big four accounting firms.

Let’s dive deeper into this digital deficit component.

Since 2014, the Japanese government has been disclosing the digital deficit, which has grown 2.6-fold from 2014 to JPY 5.5 trillion in 2023. This is a net figure derived from JPY 9.2 trillion paid for digital services and JPY 3.7 trillion received from abroad.

The above chart breaks down the JPY 5.5 trillion deficit by its main components:

• IP royalties: includes payments for OS, app stores, and apps (e.g. Apple, Android)

• Telecommunications, computer, and information services: includes IT consulting and cloud services (e.g. AWS, Azure)

• Professional and management consulting services: includes digital advertising (e.g. Facebook, Instagram, Google)

Not surprisingly, all three components have grown.

The picture is quite clear: on the services side, Japan is taking its hard-earned surplus from tourism and spending it all on paying for digital services.

How will this play out? While I’m personally bullish on the Japanese tourism industry, it still has natural growth constraints. However, there is no ceiling on how much Japan can continue to spend on digital services. In fact, digital services spend could accelerate given:

• Japan is already playing catch-up in the digital realm, and is behind other major countries in many key digital metrics.

• AI is poised to make Japan’s digital dependency crisis even worse, in a world where firms like Nvidia and those that are able to scale AI services (e.g. hyperscalers) dominate AI economics.

Without an AI champion of its own, Japan has few options if it wants to avoid being left behind in the new digital paradigm.

The myth of Japan’s current account surplus

By now, some readers might be eager to counter: “Japan has a deeply positive current account surplus!”

True, Japan owns a lot of foreign assets which generates significant income from abroad. This is recorded as “primary income,” which more than offsets the goods and services trade deficit. However, the caveat here is that much of this income doesn’t make its way back to Japan.

Let’s consider two cases:

• A Japanese company owns an overseas subsidiary generating US$100 mn in profit, of which $20 mn is paid as dividend to the Japanese parent company, and the remaining $80 bn is reinvested in the subsidiary. The entire $100 mn is recorded as primary income, but only $20 mn represents the actual cash flow that’s repatriated.

• Japan (through government, financial institutions, and corporations) owns a significant amount of foreign fixed income securities (mainly US government bonds). The interest earned on these is recorded as primary income, even though much of it is reinvested under an automatic reinvestment program to purchase more bonds. This income isn’t repatriated to Japan.

The two cases presented above account for roughly 60% of Japan’s primary income.

As such, rather than take the headline current account figures, it makes sense to also look at it on a “cash flow” basis. This has already been done by Daisuke Karakama, Chief Market Economist at Mizuho bank, who has created the excellent chart below. I’ve added English headings to the chart for reader convenience.

The dotted line at the top of the chart shows Japan’s headline current account surplus, which looks impressive. But when you put that into cash flow terms, it becomes the line with the pink circles (the difference between the goods and services trade balance and the portion of primary income that’s repatriated back to Japan) which has been negative in recent years.

This also explains why, at the margin, movements in goods and services trade remain very important—even if they appear small relative to Japan’s total primary income.

Implications

FX

Based on our discussion so far, does it surprise you that the Japanese yen has been weak?

“According to an analysis by Mizuho Research & Technologies, if the digital deficit doubles from the 2023 level by the end of March 2026, it will add another 5 to 6 yen of depreciation in the Japanese currency's value against the dollar.”

- Nikkei Asian Review

Or let me put it another way — would you feel bullish about the currency of a country that relies on tourism as its primary growing surplus, while ultimately funneling all those earnings (and more) into paying for essential energy imports and ever-increasing digital spend on big tech?

Of course, there are other factors which influence FX, such as interest rates, which are beyond the scope of this current discussion. However, I believe long-term FX fundamentals are inseparable from the underlying demand and supply for a currency driven by real economic activity.

Digital policy

In the coming years, we may see a significant shift in Japan’s digital policies.

• Will Japan adopt the EU model of heavy regulations and fines to maximize value extraction?

• Will it adopt the Chinese playbook of developing its own homegrown tech champions?

• Both?

Either way, I think we are past the peak of Japan’s hand-off approach.

Donald Trump’s coming presidency adds an interesting layer to this dynamic. Trump is likely looking to renegotiate a host of economic contracts with partners and allies, including Japan. In turn, I believe Japan would be foolish to not leverage its current situation with the US big tech as its own bargaining chip.

There’s a clear parallel here. Trump has accused the Japanese automakers of hollowing out the US auto industry. But today, Japan could make a similar argument against US big tech, which has held Japan’s digital ecosystem captive and has blown a hole in the country’s trade balance.

One notable recent development is the Japanese government’s issuance of “administrative guidance” to LY Corp, urging it to reassess its capital ties with South Korea’s Naver which is one of its parent companies. LY Corp is Japan’s largest homegrown internet company — an entity formed through the merger of Line (owned by Naver), and Yahoo Japan (owned by Softbank). The current ownership structure, following the merger and subsequent restructuring, is shown below.

As you would expect, there was fierce backlash from South Korea. And given the warm ties between the two countries’ current administrations, Japan seems to have backed on its “administrative guidance” for now. However, I believe it shows the government’s hand.

(Side note: Once Japan-South Korea ties sour again, which is a matter of time given President Yoon’s downfall and the next likely candidate for South Korea’s presidency is Lee Jae-Myung who is decidedly pro-China, we will probably see this back on the table again)

Japan has also studied the EU’s heavy-handed approach closely. A recently proposed bill, if passed next year, could allow the regulator to impose fines up to 20% of annual domestic revenue on tech companies for abuse of power. If you assume a profit margin of 20%, then it means this bill can effectively claw-back all of the profits of tech firms.

In recent years we’ve seen how hard Japan has been trying to reclaim its position in the semiconductor industry. But do they only care about hardware and not its digital sovereignty? Will Japan continue to sit back and let US tech giants profit endlessly, or will it finally confront its position as a digital colony?

Finally, if there’s truth to any of this, it raises another interesting question: is now a good time to revisit the Japanese homegrown tech champions, such as LY Corp and maybe a few others?

So, when I found out about the “Atour of Japan,” it immediately became my research priority. I saw several parallels between Atour and Kyoritsu Maintenance, which operates the popular Japanese hotel chain Dormy Inn.

While neither company is a global giant, both are winning in their domestic markets. Their founder-led, customer-centric cultures and unique service offerings drive strong customer loyalty. Although neither is positioned as a luxury hotel, customers feel they receive five-star service, earning high guest satisfaction scores. Both hotel groups have outperformed their peers on key metrics including RevPAR growth and profitability.

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But every so often, a company breaks the mold, building a differentiated brand with a loyal fanbase in an otherwise commoditized business, creating a ton of shareholder value along the way.

• In retail, a good example is Japan’s Pan Pacific Holdings, which operates the famous Don Quijote stores. They’ve turned shopping into a treasure hunt, with endless surprises for customers around every corner. Don Quijote’s “organized chaos” retail concept has become enormously popular with both Japanese locals and tourists alike.

• In the US, Southwest Airlines redefined the airline industry, as a budget airline known for having a “personality” and being customer-oriented. Customers love Southwest for perks like free checked bags, flexible cancellation policy, and a fun crew that occasionally turns a pre-flight safety briefing into a rap.

Today I am writing about a company that’s doing something similar in Japan’s budget hotel industry (without the rap, unfortunately). The company is Kyoritsu Maintenance, which operates the popular Dormy Inn hotel chain.

Dormy Inn has been in a constant state of room undersupply, thanks to the brand’s immense popularity. For years, it was a “best-kept secret” among Japanese travelers. But as foreign tourists have caught on to its superior value, demand has surged.

This fiscal year, Dormy Inn’s net sales are projected to be 80% higher than pre-Covid levels. It’s performing so well that the company is on track to meet its 2028 sales target (for the Dormy Inn segment) by 2025, three years ahead of schedule. Dormy Inn has maintained an occupancy rate between 80-90% (except for during Covid), consistently 10-20 percentage points above the industry average.

For a while now, I’ve been on the lookout for an attractive play on Japan’s booming tourism industry. Finding one with a combination of growth and reasonable valuation has been difficult, but Kyoritsu stands out. After studying the business and actually spending three nights at one of their hotels in Japan, I’m convinced this one is a gem.

Company history — An unconventional start

Kyouritsu Maintenance didn’t start as a hotel business. Founder and current Chairman Haruhisa Ishizuka started the business in 1978 offering outsourced meal preparations (“Kyushoku”) for corporate canteens. In 1980, the company expanded into the dormitory business, managing college and corporate dormitories. Back then it was more common for Japanese companies to provide dormitories to new hires, and Kyoritsu managed dormitories as an outsourced partner.

Kyoritsu was very good at this and earned a strong reputation among clients. Corporate employees asked whether they can also stay at Kyoritsu-managed properties while on business trips. This demand led to the creation of the Dormy Inn hotel brand in 1993 (the name Dormy Inn comes from Dorm + Inn), with the goal of offering a hotel experience that felt as cozy as staying in one’s own dormitory.

Dormy Inn initially started as a “business hotel,” mainly serving Japanese businessmen on domestic trips. Major competitors in Japan’s business hotel category include APA Group, RouteInn, Toyoko Inn, Super Hotel, and Washington Hotel.

Typically, Japan’s business hotels are budget accommodations focused on efficiency. They offer a basic room and a bed for a quick overnight stay. After late nights out with clients, businessmen would simply return to their rooms to sleep. These hotels were not known for their comfort or service.

That is, until the arrival of Dormy Inn, which pioneered the concept of making business hotels an enjoyable stay. In a commodity business, Dormy Inn emerged as a differentiated player with a distinct brand and a loyal fanbase. Dormy Inn grew via word-of-mouth as more and more business travelers caught on.

If the first phase of Dormy Inn’s growth was driven by business travelers, the second phase saw its expansion into leisure and family travel. Businessmen who stayed for work started choosing Dormy Inn for family vacations too. Today, Dormy Inn is in its third phase of growth, driven by foreign tourists drawn to its superior value.

Dormy Inn is famous for its unconventional services (which we’ll explore throughout this report). Management credits much of this creativity and out-of-box thinking to the company’s unconventional origins of having not started in the hotel industry. For instance, guests are encouraged to roam the hotel property in pajamas provided (like in the picture below), much like students in a dormitory, creating a relaxed and at-home environment.

Dormy Inn

I picked up the below guidebook on Dormy Inn. What’s special is that it wasn’t written or sponsored by the company. It was written by a group of self-proclaimed fans who share what they love about Dormy Inn and offer tips on how best to enjoy a stay there. The authors disclose that they are independent from Dormy Inn and received no compensation from the company for writing it (find me a fan-made book like this on Hilton or Marriott)

It’s clear that people love Dormy Inn. But what makes it special?

There are three features which are considered hallmarks at every Dormy Inn location: Japanese-style communal bath, delicious breakfast, and free late-evening ramen service.

The communal bath is undoubtedly the flagship offering at any Dormy Inn location. As most readers know, bathing culture is huge in Japan (Furo or Onsen). Dormy Inn’s communal baths are of such high quality that it has become synonymous with the hotel brand.

• The bath uses real hot spring water, transported by trucks from natural sources. The Japanese are truly serious about their baths! There is even a third-party water analysis certificate showing the exact water source and its mineral composition.

• The baths are beautifully designed using high quality material. Some locations even feature robenburo (open-air baths on terraces or balconies). There is great attention to detail, such as showers equipped with pressure-adjustable shower heads and change rooms equipped with premium hair dryers.

• Guests also love the fact that Dormy Inn’s baths stay open throughout the night until 10am the next morning (competing hotel chains that offer baths typically close them at midnight).

• After a soak, guests can relax in the lounge area, which offers ice cream, probiotic drinks, and massage chairs—all for free.

Dormy Inn’s second most famous offering (after the communal bath) is its legendary Japanese-style breakfast.

• Prices vary by location but generally range from ¥2,000-2,500 for the all-you-can-eat breakfast.

• Each Dormy Inn location features a signature local dish from the region (this reminds me of Atour in China, which I wrote about in June).

• Perhaps what made Dormy Inn’s breakfast most famous is the all-you-can-eat kaisendon available at many locations. Guests can pile as much sashimi as they like onto a bed of rice (with some locations even offering fresh scallops, salmon roe, and real crab meat!)

• According to management, the profit margin on breakfast is “very slim.” Once you experience it, you might find that to be a generous statement.

• A picture is worth a thousand words, so here are some images of the breakfast.

  

  

Finally, another service that has made Dormy Inn famous is its signature late-evening ramen service (“Yonaki soba”)

• Between 9:30 to 11pm, guests can enjoy a complimentary bowl of freshly made ramen (reminds me of Atour’s evening congee and dim sum service in China).

• This is served in the same restaurant as the breakfast. In the evening the space transforms into a lounge where guests can gather for a light meal and have tea with their families and friends.

Brands under the “Dormy Inn segment”

There’s some room for confusion here because Dormy Inn is the name of the specific hotel brand, but also refers to the company’s operating segment (“Dormy Inn segment”.)

Within the Dormy Inn segment, there are actually four sub-brands. As of March 2023, the Dormy Inn segment operated 91 hotels, broken down as follows:

• Dormy Inn (53 locations)

• Dormy Inn Premium (18 locations)

• Dormy Inn Express (9 locations)

• Onyado Nono (11 locations)

Among these, Onyado Nono (御宿 野乃) deserves special mention, as it’s the fastest-growing sub-brand within the segment. Think of it as a slightly more upscale Dormy Inn, featuring “Japanese style” rooms (similar to those of traditional Japanese style inns or Ryokan), primarily catering to tourists.

Ryokan accomodations offer a traditional Japanese experience but are often located in rural or less accessible areas. Onyado Nono bridges this gap by providing the authentic ryokan experience in city-center locations at more affordable rates than full-service ryokans, which has made it particularly appealing to tourists. Onyado Nono is the most premium offering within the Dormy Inn segment, and it’s typically priced at something like 10-30% premium over standard Dormy Inn hotels. But depending on the location and dates, the premium can get to as high as 50-100%.

Business economics

It’s now time to dive into the numbers.

Revenue

Capacity

The company’s expansion plans for the Dormy Inn segment are shown below.

By March 2028, the Dormy Inn segment will operate 116 hotels (vs. 91 in March 2023). Room capacity is expected to reach 20,544 (vs. 16,435 in March 2023) representing an annual growth of 4.6%. This expansion includes:

• Dormy Inn (63 locations, up from 53)

• Dormy Inn Premium (19 locations, up from 18)

• Dormy Inn Express (15 locations, up from 9)

• Onyado Nono (19 locations, up from 11)

The projected growth rate of 4.6% appears conservative to me. In the last five years, room capacity expanded by 5% annually, even throughout Covid. Japan’s tourist arrivals should comfortably exceed this going forward. In the month of September 2024, visitor arrivals was up 31% YoY and 26% compared to the same month in 2019. At an expansion rate of 4-5% the company should have no problem maintaining high occupancy and pricing, especially considering the current state of undersupply.

In fact, the question is why aren’t they expanding capacity faster. The answer likely lies in their asset heavy model which demands significant capex. This approach, while ensuring control over properties and consistent quality, can limit the pace of expansion (more on this later).

RevPAR

RevPAR (Revenue per Available Room) is a key metric in the hotel industry, calculated by multiplying occupancy rate by ADR (Average Daily Rate). The trend is shown below, illustrating steady growth in RevPAR driven by consistent increases in ADR while maintaining a high occupancy rate.

Occupancy

For the past nine quarters occupancy has trended in the 85-89% range, indicative of undersupply. For context, the average occupancy rate in Japan’s business hotel industry is roughly 73%, and historically Dormy Inn has enjoyed occupancy rates 10-20 percentage points higher than the industry average.

In my view, this high demand is the result of the Dormy Inn brand being in a unique sweet spot as it appeals highly to both foreign tourists and Japanese travelers alike. Foreign visitors appreciate the authentic Japanese experience, and many are just beginning to discover that Dormy Inn offers a differentiated, better-value alternative to other hotels at similar price points.

Meanwhile, demand from Japanese guests remain strong, particularly in recent years due to Japan’s economic environment. The weak yen has led to fewer Japanese traveling internationally, with many opting for domestic trips instead. Also, with the inflation and decline in purchasing power, Dormy Inn is likely benefitting as Japanese guests seek more value-oriented options, trading down from full-service hotels.

ADR

Dormy Inn has consistently grown its ADR since bottoming in Covid. The current ADR at ¥16.1k (as of Q2 FY3/25) compares to pre-Covid peak of ¥11.4k, marking a 7.1% annual pricing growth. But occupancy is currently 87% (Q2 FY3/25), down from 95% pre-Covid. Despite lower occupancy today, ADR is 40% higher! This suggests pricing increase is not just cyclical, but rather reflects a permanent ability to pass on higher prices as Dormy Inn is able to capitalize on its brand value.

It’s worth noting that prices can fluctuate significantly during the week, with tourism peaking on Friday and Saturday nights. I have seen Dormy Inn Premium at popular locations selling out completely at ¥25-30k per night on these days. On weekdays, when there are fewer tourists and more local business travelers, prices can sometimes drop to ¥10k or below especially in more rural locations.

Simply put, foreigners are willing to pay much more than Japanese guests. If tourism continues to grow, the gradual crowding out of Japanese travelers seems inevitable. Already, in popular areas like Tokyo, Kyoto, and Osaka, room rates are high year-round, and these locations are seeing fewer Japanese guests. Business travelers, for instance, are often unable to stay at Dormy Inn in these locations due to their corporate budgets which are typically capped at ¥10k per night (¥8-9k for more junior employees) for domestic travel.

This dynamic also shows the pricing upside if tourism continues to grow and the crowding out of Japanese guests continues. It’s not hard at all to imagine ADR rising to ¥20k and beyond. We’ve already started to see some locations fully booked out at much higher rates.

Margins

In 1H, operating margin at the Dormy Inn segment reached an all-time high of 21%. I think there is still room to expand further, driven by:

1. Increase in direct bookings through the membership program; and

2. Pricing increases

In FY3/24, only 18% of hotel bookings were made directly through the company website. By 2028, the company aims to increase this to 40%, which would boost profitability by reducing commissions paid to travel agencies. 40% seems like a reasonable target, given successful hotel groups globally have achieved direct booking rates in the 50-60% range.

A key driver for achieving this is Dormy’s, the company’s membership program, which was introduced in December 2022. Yes, you read that right — Dormy Inn didn’t have a membership program until then (crazy, right?) Guests had long been asking when Dormy Inn will finally launch a loyalty program. They finally delivered.

If you’re wondering what took them so long, I think there are two reasons:

1. Management says they wanted a membership program that would not be just for Dormy Inn but integrates across the company’s other facilities, which took time to coordinate.

2. But honestly, I think the real reason is simply that Dormy Inn had such a loyal customer base and offered such high value that they didn’t need a loyalty program to keep guests coming back.

Management will also continue to raise prices (management likes to say “normalize prices” instead, which is just a nicer way of saying the same).

With so much freebies and perks provided to guests, management has plenty of flexibility to either charge more or reduce costs to drive profitability. In this case, they’ve indicated a preference for raising prices rather than cutting costs to avoid negatively impacting service quality and the brand value, which I think is the right call.

Putting it together

Here are my assumptions:

• Annual capacity growth of 4.6% (as per management guidance)

• RevPAR growth of 5% (assuming no change in occupancy rate and a 5% increase in ADR, compared to 7.1% they achieved in the last five years,) and

• Operating margin expansion of 1-2 percentage points per year.

This results in a topline growth rate of about 10% and a profit CAGR of 15-20%. Depending on the margin assumption, profit growth could vary significantly, but I think we should be reasonably looking at mid-teens profit CAGR for the next several years for the Dormy Inn segment.

To be continued in Part 2…

Disclosure: The author owns shares in Kyoritsu Maintenance

One of the takeaways for me was that we may be entering a new era of inbound M&As in Japan, with more Japanese companies becoming viable takeover targets for foreign acquirers, facilitated by a pro-M&A policy shift. Imagine if Couche-tard’s bid for Seven & I is just the tip of the iceberg.

This raises the question: Who’s the “next Seven & I”? In this post, I will spotlight a large blue-chip company:

• A ripe takeover target that foreign acquirers should be eyeing with interest.

• Not only are the assets valuable, but strategic acquirers also have a realistic shot at obtaining control.

• It’s always fun to speculate on a takeover but I certainly recognize that it may not happen. However, this is not a binary bet — value can be unlocked even if an actual takeover doesn’t materialize. There are more than one way to win.

I hope this highlights not only an interesting company, but also a framework that readers can use to identify good setups.

FWIW — my last takeover pick, Descente, was acquired three months after I published my writeup, for a 35% gain (below article).

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On August 31, 2023, METI released a new set of M&A guidelines in a 72-page document (“The Guidelines for Corporate Takeovers”), aiming to foster a “healthily functioning fair M&A market” (in METI’s own words).

Most are familiar with Japan’s Corporate Governance Code. I like to think of this as METI’s equivalent “M&A Code,” which establishes a code of conduct for management and boards in handling M&As, particularly unsolicited bids.

What are the key messages? How are experts (Japanese M&A lawyers) interpreting them? And what are the implications for the Japanese market?

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It’s clear that readers are interested, and perhaps I underestimated the importance of this as a component of the investment newsletter business. Starting with this post, I will provide the following portfolio disclosure:

1. Performance

2. Positions and weights

3. Activity

Updates will be provided quarterly.

Conviction and risk levels can be hard to fully convey through words alone, so I hope that these quantitative disclosures help readers better understand how I’m thinking about the individual names. Also, as I cover more companies over time, readers will likely want to know which ones I still own and which I’ve sold.

Please note, the main purpose of disclosures is as a “communication tool.” It’s not about proving that I can consistently outperform the market. There will be times when I outperform and times when I underperform, but I’m committed to maintaining transparency, regardless of whether my numbers look good or not.

Performance

I launched East Asia Stock Insights on January 17th, 2024, and will use this date as the portfolio’s inception. Before this, I held a personal portfolio that’s much more globally diversified, but since the launch I’ve reallocated my portfolio significantly towards East Asia in order to better align my personal investments with my research focus.

The portfolio was up about 18% (since inception) prior to the recent China stimulus rally. Given my overweight position in China going into the rally, this pushed up the returns to roughly 30%. China has done so well in such a short period of time, leaving me contemplating the next steps (a topic for another day). For those of you in the same boat, here’s a fun piece to reflect on the current state of the market.

Moatless Musings

There are weeks when decades happen.

On July 25, I started drafting an article on Substack. As a self annointed value investor, I wanted to write something along the lines of Warren Buffett’s famous “Buy American, I am” article in the New York Times in 2008. Selfishly speaking I wanted to call the bottom in Chinese equities - after a ~3 year downdraft (started with amortizing obviously cra…

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2 years ago · 8 likes · Moatless Capital

Some of my individual positions outside of China have also done well, including a significant stake in a Japanese industrial conglomerate, which has become my top holding.

The performance since inception is shown below.

Portfolio positions and weights

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The pitch was authored by Healthy Stock Picks (“HSP”), a healthcare sector specialist based in Hong Kong, whom I recently had the pleasure of meeting in person. It was a very thoughtful pitch that I enjoyed a lot, so I’m excited to share the idea, along with a brief Q&A with HSP, with my subscribers.

Following the Q&A, you’ll find the stock pitch and a link to download the full deck. Enjoy!

Q&A with “Healthy Stock Picks”

1. You launched “Healthy Stock Picks” this year. Can you tell us about your newsletter and what inspired you to start it?

The idea with Healthy Stock Picks is to become a Healthcare sector specialist and share deep dives and overviews of different sub-sectors of the global healthcare space. Over time I plan to add more and more sub-sectors to my skill set, for the moment I'm mostly focusing on Med-tech. I have previously been on a 8 year journey to evaluate myself as an investor, become more structured in company analysis and find an investment style that suits me. I did that by putting my ideas and reviews on a blog called GlobalStockPicking.com. Reviewing my 8 year journey, there were two things that stood out: I really enjoyed digging deep into healthcare related ideas. Going back and evaluating my performance, the healthcare ideas also had (on average) much better returns. Looking online for other healthcare investing blogs and not really finding much kind of sealed the deal.

2. Tell us a bit more about your investing journey.

My investing journey started when I was a kid, I sat at the kitchen table with the daily Swedish newspaper looking at how my mutual funds had moved day by day. But it was exactly 20 years ago that I bought my first stock position from my dorm-room as a student. The investing grabbed me so strongly during the Uni years that I shifted my Msc engineering degree towards quant finance. That unfortunately did not lead to a full time investing role but I did get other roles within banking. I divide this 20 year time-period into two parts: My first ten years as an amateur investor, many hard lessons were learned and 2008 colored me to be a more cautious investor. The second ten years has been a journey of becoming a more sophisticated investor. This was spurred on by a few things, taking a CFA was important as I hadn't even studied basic accounting. Later working as a fund allocator running a Fund of Funds strategy. I met many professional investing teams during this time period and drew a lot of inspiration from their way of working. This inspiration was also the reason I started the GlobalStockPicking blog.

3. How would you describe your investment style?

My basic thoughts have been to not constrain my investment universe. My investing style first of all is global (or as global as my broker allows me to be). Secondly, from the experience with all those professional investing teams I understood how high the competition is. I try to compete with as few as possible highly intelligent investors. This led me to looking at smaller companies but also hated sectors/markets etc. I try to invest in areas where I have good knowledge and a higher possibility to have an edge. I grew up in Sweden and since many years lived in Hong Kong so I gravitated to investments closer to these markets. Finally I have a value tilt to my investing style, but I challenge myself and also try to own other types of companies, for example loss making companies are common in the healthcare space. My ideal company is probably something with Growth at Reasonable Price (GARP). Putting all of these things together, my portfolio is mostly Nordic or Hong Kong stocks in the micro to small cap space, mostly profitable with decent growth and a not-too-demanding valuation.  

4. As a healthcare sector specialist, are there any common misunderstandings or misconceptions about healthcare stocks?

When I talk to other investors most of them actually avoid the healthcare space, especially Pharma. Given how large part of the global benchmark is within Healthcare I really think this is a shame. Sure some companies are very hard to understand within Biotech etc, and perhaps they are best to be avoided, but Healthcare is a nice defensive sector which in a portfolio context works really well with the rest of your non-Healthcare holdings. Especially among the smaller companies, they are actually not that hard to understand, AngelAlign is a good example of that. 

5. Speaking of AngelAlign—how did you come across this company?

I have followed the company since its IPO. The IPO serendipitously helped me a lot, as it pulled up the valuation of my other holding Modern Dental (link to write-up). Angelalign had a ridiculous valuation at IPO and I was not at all interested. I started to learn about the dental sector six years ago when I invested in Modern Dental. Since then I decided to understand the whole sector globally and what all players are up to. Somehow by having this global understanding of how all players operated, it just fell into place in my head this idea that MBK should buy Angelalign. This might of course never happen, but I think it makes a lot of sense. So from there I just had to dig deeper if it's investable as a stand-alone business without this potential "kicker". I think this is also a nice example of how one can connect the dots by really understanding a space globally and applying the ideas to smaller stocks which aren't well covered.

6. Are there any specific sub-sectors or trends within healthcare that you’re particularly excited about for the next few years?

Given how we changed habits in the last 50 years in terms of computer usage, staring down in a smartphone all day, these habitual changes create new healthcare problems, like for example spinal problems (which I myself experienced), I see this as an extremely interesting space for investments given the enormous tailwind. In the same way I focused on dental as there is this huge structural tailwind of aging in the rich world. It's an inevitable fact that when we get old, our teeth will shatter and fall out. I like to identify major tailwinds like that and then dig deeper for ideas that benefit from that tailwind. 

7. What’s the best way for readers to follow your work or get in touch with you?

Just subscribe to my Substack and follow me on Twitter (X). I'm in a transition period now where I still mostly write under my old handle @GlobalStockPick, but my new handle is @HealthStockPick

AngelAlign (6699 HK)

Elevator Pitch

AngelAlign, listed on the HK exchange, has emerged as the only other substantial stand-alone clear aligner brand worldwide. With a 3% global market share, AngelAlign is on par with the other big dental companies who all try to land grab within the clear aligner space. Many dentists want to at least have an option to Invisalign to both offer different price points but also to not be at the mercy of Align Technology’s pricing.

The pitch has two parts:

1. Buy-out speculation: Korean Private Equity powerhouse MBK is recently acquiring dental assets to create a new global dental giant, especially focused on the more “value oriented” customer. They have all major business lines under their umbrella by now, except clear aligners. AngelAlign stands out as the only viable option if they want a complete product portfolio.

2. Regular attractive growth company to own: After a spectacular IPO in 2021 with massive interest from investors (2000 times oversubscribed), the AngelAlign stock has equally spectacularly crashed and been left for dead in the Hong Kong bear market. That has not really changed the company fundamentals which is performing quite well. AngelAlign is still a unique asset, and now trading at an undemanding price given their strong position in the clear aligner space.

Align Technology pioneered the clear aligners through their Invisalign brand in the late 1990’s. As different patents fell off the large incumbent dental companies have been trying to win market share in this highly attractive dental category. When visiting a dentist one of the most expensive procedures offered by the dentist is clear aligners and as such this a large category of dental sales. A more detailed pitch follows. Press below to download the deck, hope you enjoy it!

Angelalign Healthystockpicks

1.57MB ∙ PDF file

Download

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• HKEX’s sales and profits have nearly recovered to the previous highs of 2021, following a challenging period from 2022-2023.

• Notably, Northbound Stock Connect reached an all-time high turnover in 1H2024—so much for “nobody is investing in China”!

• Hong Kong’s beleaguered IPO market could see bottoming, with renewed confidence bolstered by Midea’s strong recent listing.

• On top of this, with the rate-cutting cycle now underway following the Fed’s recent 50bps cut, there is further support for the IPO market and listed stocks in Hong Kong, particularly in the property and tech sectors.

• Longer-term momentum continues to build. In April, CSRC introduced five new measures to expand the scope of the Stock Connect and to support Hong Kong as a listing destination for Mainland firms. Let there be no doubt: Hong Kong remains a “super-connector” to the Mainland.

• Another emerging megatrend is the growing number of Mainland firms looking to expand internationally. Hong Kong continues to attract Mainland firms as they establish offshore headquarters, playing a key support role for those looking to venture abroad.

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Canon has long been the poster child of a large-cap value trap. Its two main businesses — cameras and printers — have faced long-term stagnation. Its stock is trading at the same price as in 2008.

However, things may be finally changing. Dare I say, it might be time for investors to put Canon (back) on the radar.

The key to this shift lies in Canon’s semiconductor business. Wait, semiconductor business? Yes, Canon has quietly maintained an important position in lithography. Only that it has been largely overshadowed by the dominance of the Dutch juggernaut ASML, causing many to overlook Canon’s presence in the field.

While Canon may not be operating at the cutting edge like ASML, it still plays an important role in the industry. Canon’s older deep ultraviolet (DUV) equipment has been experiencing strong demand; last year it sold 187 units (which is over 40% of total units ASML sold), and this year, it’s projected to reach 247 units (+32% YoY).

Older generation equipment are still being used to a great extent, and in fact, their use cases are expanding. For example, Canon’s older i-line technology is finding new applications in back-end chip manufacturing for 2.5/3D advanced packaging — a key process in producing AI chips. Another subtle point is that Canon’s product portfolio focused on older technologies (KrF and i-line) are largely excluded from export restrictions to China, which primarily seeks to block the export of the newer EUV and ArF platforms which Canon does not possess.

While the growth of older generation equipment has been accelerating, the real catalyst for Canon lies in its new nanoimprint lithography (NIL) technology. After two decades of development, Canon began commercializing NIL in 2023. If successful, it offers a viable alternative to conventional photolithography, potentially becoming a game-changer for both the chipmaking industry and also Canon as a firm. The next 3-5 years could be transformative for Canon, putting the stock “back in play”.

In this writeup, we will examine Canon’s history and positioning in lithography, how it stacks up to rivals (ASML, Nikon), Canon’s growth strategies—particularly with the nanoimprint lithography—and, finally, wrapping up with what all of this means for Canon’s stock.

Canon’s history in lithography

Lithography is a process for creating the complex patterns on silicon wafers that form the circuits in electronic devices. Over the past several decades, photolithography, which uses light to transfer these patterns onto wafers, has become the standard in chip manufacturing.

Photolithography was first introduced in chip manufacturing in the 1950s, with the United States leading both the invention and early innovation stages. Foundational work was carried out at Bell Labs and Fairchild Semiconductor. As the semiconductor industry grew in the 1960s and 1970s, Perkin-Elmer and the Geophysics Corporation of America (GCA) emerged as key players, innovating to meet the increasingly technical demands of the field.

The success of American companies did not go unnoticed by Japan. In the 1970’s Japan’s Ministry of International Trade and Industry (MITI) spearheaded a drive to catch up to the US. Japan was successful, and by the 1980s and 1990s, Japan entered a dominant era with Nikon and Canon controlling 75% of the global market for lithography equipment. This dominance extended beyond just lithography, as Japan led across the entire semiconductor value chain.

While the United States and Japan were vying for dominance, a new player was quietly emerging in Europe. ASML was founded in 1984 in the Netherlands as a JV between ASM International and Philips. ASML was a risk taker and through a series of bold technological bets that proved successful, it emerged victorious over the Japanese.

Two innovations stand out as particularly transformative for ASML:

• The first was the development of ArF immersion lithography, often referred to as the “wet” process, which introduced a layer of water between the lens and the silicon wafer during the lithography process. This reduced the light’s wavelength, allowing for the creation of finer features. With ArF immersion, ASML secured a decisive advantage over the Japanese, which struggled to keep pace.

• The second and most significant was the Extreme Ultraviolet (EUV). This took over 10 years, $25 billion, and the backing of key industry players like TSMC, Samsung, and Intel to bring to market. The technological barrier is so high that ASML has a complete monopoly on EUV equipment, with no other company able to produce it.

When looking back at the evolution of lithography since the 1950’s, what we observe is that industry leadership has shifted every 20-30 years, moving from early inventors like Bell Labs and Fairchild to Perkin-Elmer and GCA, then to Canon and Nikon, and ultimately to ASML (who’s next?) This is a dynamic industry. At one point, ASML itself was a newcomer in the industry. History suggests that there is always a fighting chance for new players, even when incumbents may appear insurmountable.

The lithography industry market share from 1995 to 2023 is shown below (chart credit: Takashi Yunogami).

From this chart, one might conclude that ASML has won. That’s correct. However, one might also assume that the Japanese players are no longer relevant in the industry. This would be the wrong conclusion, as we’ll explore next.

Competitive landscape

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