June 2010

LONG ONLY JAPANESE EQUITIES

Meiko Network, the extracurricular education specialist, reported better than expected half-year results to the end of February. It seems the management have been placing more emphasis on training its franchisees, that operate 1,612 of the 1,813 schools run under the company’s brand. This meant that more students enrolled for winter courses than anticipated and the average fee per student was higher than in previous years. The company plans to enhance franchisee education further to improve efficiency even more. There are other incentives that could contribute to growth over the next three years. First, the Gakken referral system has just started and should yield more value in the future. Gakken runs classes for elementary school children, Meiko’s classes are mainly for junior high school (middle) pupils, the next step up. Meiko provides a financial incentive to Gakken franchisees to refer its pupils to Mieko. As Gakken has 200,000 students versus Meiko’s 120,000 this could yield an important new stream of business if it worked. On top of that, Meiko plans to expand into the elementary school market itself. Next, Meiko, which is known for its teaching of average and underachieving children has a plan to appeal to overachievers as well. More details of exactly what strategies the company plans to further these ambitions will follow later this year. But, in the meantime, what may be more important will be the planned changes in the national curriculum starting in 2011 for elementary schools and 2012 for middle schools. Curriculum changes invariably increase demand for extracurricular teaching. Also surveys suggest that payments of the government’s child rearing subsidies will to a significant extent be spent on education. All these initiatives should help counter the effect of the recession that has hit demand - even if quality providers such as Meiko have been less affected. A further and most welcome positive development was the purchase by the company of 17% of its own shares from Benesse, which inherited the holding from its takeover of Tokyo Individualised Education. This purchase at current low prices is very accretive to remaining shareholders and at a stroke has the effect of increasing the prospective free cash flow yield to August 2010 from 8.9% to 10.6% and reducing the P/E from 11.8x to 9.8x.

We added a new holding, Milbon, to the strategy. Milbon is a small company with a market capitalisation of Y27bn or £400m. It specialises in supplying professional hair care products to the 200,000 salons and beauty parlours in Japan. It has the highest market share in this very fragmented niche market at 17%, ahead of L’Oreal (12%) and Proctor and Gamble (7%), having built it up steadily from c.5% in the late 1980’s. In urban areas the market share is higher, at 33% in Kansai and 20% in Tokyo. The company attributes this success both to targeted sales (the company’s 200 salesmen target 7,300 high growth salons which they visit to promote Milbon's products directly) and Milbon’s field agents, who develop successful products in collaboration with salons and designers. Milbon introduces 8-10 new products every year, double that of its competitors. The combination of winning products and targeted sales have boosted Milbon's reputation and brand strength in the industry. Although other companies allow salons to sell products on to consumers, Milbon does not, preferring to give the exclusivity of the product to the salon. As market share builds so the hurdle is raised for competitors to keep up. Only L’Oreal is considered a real threat. All products are sold through 150 wholesale agencies with the loyalty of salons to their products cemented by the quality, the branding and the efforts of the Milbon sales force and field agents. Demand for the company’s products has been negatively affected by the recession (the frequency of salon visits fall) but with the rising market share the company’s sales are projected to rise 2% versus a fall of 3% for the market. We would expect that trend to continue as the market polarises to fewer dominant competitors in coming years, like markets for many other consumer products in Japan. Profitability is good with operating margins averaging 20%. The company has just upgraded its production facilities to cope with a 50% expansion in sales. With little need for investment and high margins, cash flow is abundant financing dividend growth of 16% per annum over the last 10 years. With a free cash flow yield approaching 10% we believe that the shares could double in price from current levels.

Michael Lindsell

July 2010

2 July 2010 LTL 000-091-6