MORIMATSU INTL, a potential player in the Hong Kong Stock Connect in September

After the previous series on the reversal of the Hong Kong stock market's dilemma, there are still many good companies in the Hong Kong stock market that are undervalued and their value has not been discovered, such as Morimatsu International (2155.HK).

In a complex geopolitical background, multinational companies with growth potential are rare, and Morimatsu International happens to be a company with a special background, mature overseas business development, unfairly undervalued by the market, and still has a considerable room for recovery.

One drawback is that the shareholder returns are not strong enough. If the company successfully enters the Hong Kong Stock Connect this year, and the company increases its shareholder return accordingly, the certainty of valuation re-rating will be further strengthened.

I. The Special Background of Morimatsu International

Morimatsu International is a manufacturer of pressure vessel equipment, which is the core equipment that achieves theoretically achievable infection and mass transfer effects in large-volume equipment. For example, bioreactors used in the biopharmaceutical field, oxidation reactors used in the chemical industry, and hydrogenation reactors used in the oil and gas industry.

The company's founder is from Japan, and Morimatsu International is a Japanese-funded company developing in China. Due to its factories being established in China and the largest revenue region being China, the company chose to list on the Hong Kong stock market.

In terms of operational model and corporate culture, Morimatsu International is similar to the Japanese manufacturing leader Kinsho. Both help customers design with strong innovative capabilities, which is conducive to long-term cooperation and deepening moats with customers.

For example, when customers encounter low efficiency in the production process or have new requirements, it requires equipment suppliers to collaborate with customers in research and development. This tests the design capabilities of equipment manufacturers, while most traditional manufacturers can only produce equipment and are weak in equipment innovation.

Morimatsu International's strength lies in its strong innovative capabilities, which stabilizes its customer base, consisting of leading companies in various industries with business operations overseas. As of 2023, half of the revenue comes from domestic and overseas sources.

To ensure the company's innovative capabilities, Morimatsu International has implemented an internal entrepreneurship mechanism. If employees can find new areas, they can form teams within the company to try development. When the business scale reaches a certain level, the company encourages the team to register a company. Morimatsu International holds 75% of the shares, and core employees hold 25%, which also prevents talent from being poached by other companies In simple terms, MORIMATSU INTL is a shovel stock in the manufacturing industry. When downstream customers have an expansion demand, they need to use MORIMATSU INTL's equipment. Taking the example of Kien Shih, innovation capability is the best moat and also the most direct way to maintain long-term cooperative relationships with customers.

Due to the low threshold of traditional pressure equipment and not all pressure equipment requiring a high level of technical expertise, the industry's concentration is very dispersed. MORIMATSU INTL only holds a market share of 1.5%, ranking fourth. Industries that have high requirements for pressure equipment are mainly pharmaceuticals, chemicals, oil and gas, and new energy industries.

This year, companies in these four industries with equipment renewal needs are mainly overseas companies, so this year the main focus for MORIMATSU INTL is overseas income. Business going global this year is also one of the hot topics in the capital market. MORIMATSU INTL is one of the most authentic global stocks, and the market has not fully reacted yet.

Second, the emergence of market misjudgments

Since the peak in February last year, MORIMATSU INTL has fallen by 50%, currently valued at 6.5 times PE. In the past two years, the company's valuation was at 18 times PE at its peak, with an average PE of around 14 times in 2022. Referring to historical valuations, there is at least a 1x recovery space.

Looking back at the reasons for the sharp decline, one is the impact of the interest rate hike cycle, with reduced investment spending in the largest revenue-generating biopharmaceutical industry, a decline in industry prosperity, and market concerns about the slowdown in equipment revenue growth. Other industries such as oil and gas, and chemicals have cyclical equipment, and the market did not anticipate revenue growth in other industries last year.

In addition, as WuXi AppTec is a major customer of MORIMATSU INTL, some funds speculate on MORIMATSU INTL as a pharmaceutical equipment stock. The correlation between MORIMATSU INTL and WuXi AppTec's stock prices is very strong, to the extent that when WuXi AppTec's overseas business was affected by sanctions earlier this year, MORIMATSU INTL also hit a historical low.

However, the stock price correlation has been lifted since MORIMATSU INTL disclosed its 2023 annual report at the end of April.

Secondly, cornerstone investors have been continuously reducing their holdings of MORIMATSU INTL over the past 3 years, and the divestment is almost complete. At the current turnaround of the company's performance, the exit of cornerstone investors can be seen as an opportunity for investors to dig a gold mine.

The cornerstone investors are Huayou Cobalt, WuXi AppTec, Huatai Fund, Crystal Optoelectronics, and two individual investors, who collectively hold 11.2% of the total share capital after the IPO (assuming the increase in share capital granted by the company's equity incentive), totaling 116 million shares Due to the poor liquidity of MORIMATSU INTL, the daily trading volume has been around several million Hong Kong dollars for a long time, leading to cornerstone investors taking 2-3 years to clear their positions. At the time of listing, the major shareholder of MORIMATSU INTL, "Morimatsu Corporation," held 75%, with cornerstone investors holding 11.2%, leaving around 13.8% of shares in circulation.

According to Futu data, five cornerstone investors including Hua You Hong Kong, WuXi AppTec, Crystal Pharmatech, Hwa AN HK, and Ms. Zhang Ning have all cleared their positions. Only Huatai Fund remains holding 4.145 million shares, representing about 0.35%, having sold over 14 million shares from the subscribed 18.85 million shares. Even if Huatai Fund continues to clear its position, the remaining few million shares will not have a significant impact on the stock price.

It is worth noting that most of the shares reduced by cornerstone investors have been taken over by foreign funds, with the majority currently held by foreign institutions, including the presence of the Norwegian central bank.

After the completion of the reduction in holdings by cornerstone investors, the decline in WuXi AppTec's stock should not have such a significant impact on MORIMATSU INTL. The market reaction has clearly been overly pessimistic.

1. MORIMATSU INTL's customer base is sufficiently diversified, with no reliance on a single major customer, all coming from leading companies in various industries. According to the 2023 annual report, only one customer's revenue accounts for 10% of the company's total revenue, with the largest customer's revenue at 798 million yuan. The overall revenue is sufficiently diversified, so even if WuXi AppTec's investment declines, the impact on MORIMATSU INTL is limited.

1. The performance and stock price have diverged significantly.

In terms of revenue, MORIMATSU INTL achieved a revenue of 7.36 billion yuan in 2023, a 13.5% increase from 2022. Net profit attributable to shareholders was 845 million yuan, a 26% year-on-year increase, achieving double-digit growth in revenue and profit. Over the past 3 years, MORIMATSU INTL has also maintained high growth.

The main growth contribution comes from overseas regions, with total revenue from overseas regions increasing from 2.9 billion yuan in 2022 to 3.5 billion yuan, while domestic revenue increased from 3.6 billion yuan to 3.9 billion yuan Among them, the revenue from biopharmaceuticals was 2.228 billion yuan, a year-on-year increase of 3.4%. This is a good performance in the current environment of rising financing costs in the biopharmaceutical industry. The chemical industry, which ranks second in terms of revenue, saw an 8.9% year-on-year increase, while the power battery raw materials industry, which ranks third in revenue share, saw a 15% year-on-year growth. These two industries have enabled Morimatsu International to achieve high growth in the market's low expectations.

Although the electronic chemicals, daily chemicals, and other industries have declined slightly, their revenue bases are not large and have not had much impact.

Optimistically, if the US dollar successfully lowers interest rates this year, next year's pharmaceutical investment will gradually rebound, which will benefit overseas pharmaceutical giants in expanding their equipment investment. Looking at it from an interest rate perspective, it can be confirmed that the worst period for the pharmaceutical industry in 2023 has already passed, and the interest rate cut is only a matter of time.

Looking at the XBI Biotech ETF in the US stock market, the capital market has already reacted in advance. The impact of the delayed interest rate hike on the US pharmaceutical sector is gradually diminishing, as the market is ahead of the curve because the interest rate cut will happen sooner or later. Similarly, the interest rate cut will also benefit the oil, gas, and chemical industries in increasing their investments.

Morimatsu International's clients cover 85% of the global top 20 pharmaceutical companies and two major CDMOs, while other domestic pharmaceutical equipment manufacturers still mainly serve traditional domestic pharmaceutical companies. On one hand, this is due to technological advantages, and on the other hand, foreign manufacturers are less likely to choose to cooperate with Chinese manufacturers, especially in an industry that requires long-term collaboration.

In the petrochemical industry, Morimatsu International has long-term partnerships with companies such as BASF, Covestro, Wanhua Chemical, and Shell. It also collaborates with giants in the daily chemical industry such as Procter & Gamble.

According to financial reports, the new contract amount in 2023 was 7.784 billion yuan, a decrease of 16.8% from 2022. Among the new orders, 71.2% are from overseas, with overseas orders accounting for 63% of the total, and the proportion of overseas revenue is expected to continue to increase from last year's 50%.

In the overseas CXO field, pharmaceutical companies such as Lonza have seen good order growth and capital expenditure plans this year, but due to the Biologics Act, these orders are not conducive to flowing to Chinese enterprises.

Morimatsu International's unique point lies in its Japanese enterprise background, which significantly reduces geopolitical risks. Therefore, even though it is listed on the Hong Kong stock market, it can attract many foreign institutional investors to buy in Next is the technological advantage. In the domestic pharmaceutical equipment industry, price advantage is a common advantage for each domestic manufacturer. Taking MORIMATSU INTL as an example, the price of stainless steel bioreactors of the same specifications is about 30% lower than foreign manufacturers. The key point here is not that the technology is much stronger than foreign manufacturers, but after establishing factories in China, the operating costs in the later stages are much lower compared to international counterparts, allowing MORIMATSU INTL to compete with international peers.

In simple terms, compared to domestic counterparts, MORIMATSU INTL has a technological advantage, as well as Japanese background, enabling it to engage in overseas business. Compared to international peers, MORIMATSU INTL has the cost advantage of China. The gross profit margin of overseas orders is higher, while the gross profit margin of domestic orders is lower.

For example, in Q1 this year, the market previously compared MORIMATSU INTL to A-share companies Dongfulong and Chutian Technology, both of which mainly focus on pharmaceutical equipment for domestic pharmaceutical factories. However, the performance of Dongfulong and Chutian Technology in the domestic market in Q1 2024 was very poor, marking their worst quarterly performance since 2020, in stark contrast to MORIMATSU INTL, which had a full order book for overseas orders.

Although the businesses are not exactly the same, Dongfulong, with a market value of 10.6 billion and an expected net profit of 750 million in 2024, has a PE ratio of around 14 times. In comparison, MORIMATSU INTL, expected to earn 1.02 billion this year, has a PE ratio of only 6.7 times, with a market value just over 7 billion. Its U.S. counterpart Danaher has a long-term PE ratio of around 30 times.

III. Why is it undervalued?

In addition to the pressure on stock prices from cornerstone investors reducing their holdings, another long-standing issue that has been criticized is the concentration of equity ownership, which has prevented inclusion in the Stock Connect program. In November 2021, the Hong Kong Securities and Futures Commission issued a notice regarding the high concentration of equity ownership in the company, stating that "MORIMATSU Co., Ltd." holds 72.29% of the shares, while 17 shareholders hold 21.14%, totaling approximately 93.43%, with only 6.57% held by other shareholders.

In fact, in recent years, MORIMATSU INTL has faced a lot of criticism. First, the pressure on stock prices from cornerstone investors reducing their holdings. When the stock price fell, the company continued to issue equity incentives. Due to the concentration of equity ownership, it has been unable to enter the Stock Connect program, making it difficult to address liquidity issues. These factors have indeed left a negative impression on most investors, despite good performance. The stock price is dismal, the company does not communicate with the outside world, has not been able to support the stock price through buybacks, and most of the cash flow has been used to expand production capacity and for mergers and acquisitions However, all of the above factors have improved, making it worth reevaluating Morimatsu International:

1. Before the company's IPO, 26.47 million shares were issued through an employee stock ownership plan. At the time of listing in 2021, the total share capital of the company was 1 billion shares, which has now increased to 1.214 billion shares, with about 5 million shares left for issuance, which will not have a significant impact on the stock price in the future.

The company's management has not significantly reduced its holdings in the past few years, and the company has shown stable growth. Having been established for decades, it is reasonable to reward employees through share issuance. Even tech giants in the US stock market use a similar method to incentivize employees.

1. At the IPO in 2021, the major shareholder "Morimatsu Corporation" held 75% of the shares. After issuing an additional 21 million shares in the past 3 years, the major shareholder's ownership has decreased to 65%, optimizing the shareholding ratio, which meets the conditions for inclusion in the Stock Connect program.

1. The company has started to focus on shareholder returns.

By the end of 2023, the company distributed its first cash dividend of HKD 122 million, with a dividend ratio of 14.4%, paying HKD 0.1 per share. The company has also initiated a share repurchase plan, repurchasing 1.16 million shares in the past 3 months, accounting for approximately 0.1% of the total share capital.

With a high proportion of shares held by the management without reduction, the method for rewarding the management in the future will be through dividends.

Based on the company's operating capabilities, it has the ability to increase the dividend ratio and share repurchase plan in the future.

The company has cash on hand of HKD 2.168 billion, interest-bearing bank loans of HKD 0.365 billion. The management has stated that the loans will be repaid within the year. After deducting liabilities, the book cash is HKD 1.8 billion, sufficient for this year's capital expenditures. The net profit added this year can be used as disposable cash, and the company has the ability to further increase the dividend ratio. According to Wind's median forecast, Morimatsu's net profit this year is expected to be HKD 1.02 billion.

IV. Conclusion

Morimatsu International is a good student in terms of business development. Despite negative factors in recent years and being listed on the Hong Kong stock market, it presents an opportunity of undervalued and undiscovered potential. If it is included in the Hang Seng Index this year and then added to the Stock Connect program, coupled with the company's expansion of dividends and share repurchases, the two combined efforts are expected to create a Davis Double Play Now is probably the most undervalued price since its listing, buying the best development stage of MORIMATSU INTL