Why Is Accountability Needed NOW at Kumagai Gumi?
During President Sakurano’s tenure, the Company has faced:
· Operational issues
· Governance and oversight issues
· Capital allocation issues
· A failure of the strategic alliance with Sumitomo Forestry
Operational Issues
Kumagai’s operational difficulties are clear, but management has failed to effectively address the issues. While its competitors, on average, manage to achieve a 10% operating margin in their civil engineering businesses, Kumagai achieves just 2%.
Its weaknesses in negotiating design changes and tendency to take on loss-making projects are not a secret, but management appear to be incapable of improving the situation. This year, Kumagai once again failed to achieve its initial guidance, achieving an operating profit of just JPY11.5BLN. This is a far cry from the JPY50BLN that it had promised to achieve this year following the third-party allocation to Sumitomo Forestry in 2017. Kumagai’s return on equity (“ROE”) declined to under 5%, slumping to just 4.7% with little improvement forecasted for the year ahead, well below its cost of capital.
In its most recent results briefing, Kumagai considers that they may announce improved Mid-Term Plan in May 2024. We are baffled as to why management does not have any specific measures to address these issues immediately. Kumagai should have been working on solutions far earlier. Management appear to be unfocused on the core business.
Governance and Oversight Issues
Kumagai’s recent scandal of testing failures on the Hokkaido Shinkansen project raises further concerns about management’s risk control and oversight functions and ability to effectively manage construction projects.
The root of the scandal is the shortage of construction engineers and Kumagai’s ability to manage its manpower. These issues are not new, and management should have controls in place to manage this situation and ensure that no scandals arise.
At its most recent results briefing, President Sakurano admitted that synergies with Sumitomo Forestry have still not been realized. In fact, Kumagai has admitted that the working groups focused on collaboration have been downsized from eight to just six. After five years of failure and delayed targets, it is hard to see how any potential collaboration will generate any material benefits to the Company in the future under the current structure.
Yet, even with the failure to realize synergies, Kumagai appointed a Sumitomo Forestry representative, Tatsuru Sato, to its board of directors.
Capital Allocation Issues
Kumagai’s inefficient capital allocation policies are surprisingly wide-ranging. Kumagai not only failed to execute its investment plan in its entirety over the last five years, but almost every investment it has made has been a failure from either a returns perspective or from the perspective of expanding its future business. In terms of its shareholder return policy, as Japanese companies are taking a step forward, Kumagai is taking two steps backwards.
Fortunately for shareholders, Kumagai invested less than half of the JPY60BLN it had planned in 2017. Unfortunately for shareholders, the JPY28BLN invested has largely been inefficient spent.
In its response to Oasis’s shareholder proposals, Kumagai claims that its outside directors and third-party outside experts have helped verify its investments. If this is truly the case, then the Company needs new outside directors and new third-party advisors. To date, the Company has spent JPY9.5BLN on real estate investments, yet it has, bizarrely, not utilized leverage at all and instead used cash for all of its acquisitions. This demonstrates a complete lack of knowledge or understanding of cost of capital or real estate investing. We have yet to meet a real estate investor that has not used leverage to generate returns on investment. If nothing else, this demonstrates that the Company does not have the ability to invest effectively. The Company’s decision to invest in the Iidabashi area is also a concern as the redevelopment of the area has been substantially delayed and may be far more difficult to execute than the Company realized.
Kumagai’s track record of investment in renewable energy has also been poor. Kumagai originally allocated JPY9BLN to renewable energy; however, in the last five years, they have spent just JPY0.2BLN on a solar power plant in Shizuoka, JPY0.2BLN on a biomass power plant, and 1.0BLN for a minority stake in a solar power plant in Vietnam. These investments are a waste of management and financial resources and will provide little, if any, material benefit to stakeholders in the future.
One of the largest investments that Kumagai has made, JPY3BLN, was into a US real estate fund owned by Sumitomo Forestry, for which we imagine fees are charged. As Kumagai has no business in the US and there are no plans for Kumagai to have any practical involvement in the fund’s investments, we see little benefit to Kumagai’s core business or future for undertaking this investment.
Kumagai’s shareholder return policies also do not stand up to scrutiny. Ironically, Kumagai is using its poor performance to convince shareholders that they are focused on shareholder returns. In their response to our shareholder proposals, management stated that the payout ratio for the latest fiscal year will be 72%, which they say is an appropriate level. Yet, the payout ratio is only high because of the poor performance of the Company’s core business and investment failures. Despite trading at a significant discount to book value, the Company is decreasing its shareholder buyback from JPY4BLN a year in the last two years to just JPY2BLN this year.
Strategic Review of the Capital Alliance
In 2017, Kumagai conducted a third-party allotment to Sumitomo Forestry to create a capital alliance that diluted shareholders by 25.5%, despite Kumagai having sufficient capital resources. Since then, and as admitted by President Sakurano at the latest results briefing, no synergies have been generated, despite the original high hopes. We do not know the reasons as to why the capital alliance has failed so dramatically, nevertheless, it is clear that the current structure is not effective and has used up management resources that should be focused on fixing Kumagai’s core business.
In its mid-term plan, Kumagai was supposed to leverage the capital alliance to become a market leader in the construction of wooden buildings. However, its record is average at best, and it is well behind Takenaka and Maeda Corporation.
More concerning, Sumitomo Forestry has relied on other construction companies more than Kumagai, such as its JV with Maeda Corporation and Kajima, for its wooden building construction. It appears that the capital alliance provides no preference for Sumitomo Forestry to use Kumagai.
The same situation appears in its renewable energy development, another key area of synergy. Since the capital alliance Sumitomo Forestry has chosen RENOVA (2 projects) and Haseko (1 project) to develop projects but has still not conducted a joint renewable energy project with Kumagai.
Kumagai had also expected synergies to appear from overseas businesses in Taiwan, Myanmar and Vietnam. Outside of one joint project in Indonesia, there seems to be little business being conducted together overseas, beyond Kumagai giving some technical support to Sumitomo Forestry’s project in Thailand and Vietnam, which has no material benefit for Kumagai.
The capital alliance has also failed to generate any significant synergies from R&D. Kumagai seems to be conducting R&D on wooden materials alone and has only conducted two joint projects with Sumitomo Forestry out of its 48 R&D projects.
The lack of synergies is outstanding and more perplexing considering that Kumagai even appointed a representative director from Sumitomo Forestry to its board of directors. The capital alliance is clearly not working for Kumagai or its stakeholders in its current form and needs a dramatic overhaul.
Oasis demands that a strategic review of the capital alliance is undertaken. Either the capital alliance should be dissolved, with Kumagai buying back Sumitomo Forestry’s stake in the Company, or Kumagai should become a wholly owned subsidiary of Sumitomo Forestry, where it would truly benefit from all of Sumitomo Forestry’s resources. The current situation is clearly not working.
