Jun 2005

LONG ONLY JAPANESE EQUITIES

While in Japan last month I visited the management of Takefuji and Nintendo, our largest long portfolio holdings. Both visits were encouraging.

Now that it is more than six months after Takefuji's former chairman's wiretapping prosecution and sentence the company has began advertising once again, to good effect, as its overall loan balance is beginning to increase. However the company continued to emphasise that with loan delinquencies still running at a higher level than usual they will not yet relax the more stringent loan assessments they imposed three years ago. On the other hand for the first time in my experience the management acknowledged that the balance sheet was overcapitalised and talked openly of an optimal equity ratio near 30% from the 50% it is today. The issue was now to address it, as the obvious and most effective way would be through share buybacks, which would require the former chairman to sell shares proportionately to keep his holding under 25% (necessary following his sentencing). Unfortunately he was deemed unlikely to agree to any such sales. Returning capital directly to shareholders through higher dividends would be another route. We only had to wait another week, for the AGM, to learn the management had decided to do just that by increasing the 2005 dividend 130%. The shares now yield 3.1% on a share price up 8% in one day on the news. This action might only stabilise the equity ratio at the current level. In time, especially in light of the recent discussions, we would expect the management to actively seek other ways to reduce the equity ratio and thereby improve shareholder returns, in which case we believe there is a good chance that the undervaluation we see in this company may be recognised by other investors.

In visiting the management of Nintendo we were encouraged by the latest sales of Nintendo DS hardware in Japan (the new handheld platform released late last year) as it has been largely inspired by two new popular games that are succeeding in appealing to casual gamers who might have not ordinarily bought games in the past. Nintendogs, a game allowing you to nurture, train and compete with a virtual dog (akin to appeal generated by Bandai's Tamagochi franchise) has particular appeal to women who represent over 40% of the buyers as compared to just 20% for other games. More recently Nintendo released a 'brain training' game that has appeal to adults where 80% of the buyers are aged over 19. Both games allow the user to play for shorter periods of time and do not require the completion of many complicated stages, a feature of existing games and one which Nintendo identified as a disincentive for casual gamers. Proof of the pudding will be the appeal of these titles in the larger US market where they will be released later this year. Also, we saw a new Gameboy Micro, a product to be launched worldwide in the autumn, the size of a small mobile phone. Nintendo envisage users playing games on this platform for short intervals of time, most likely while they travel or commute. We would expect new titles to be released in conjunction with its launch, again appealing to the casual gamer. Autumn also sees the launch of Nintendo's online strategy for the DS platform in Japan. Importantly gamers can select who they wish to play with and will be given free access to the internet through 1,000 internet wireless 'hotspots' established by Nintendo. It is good to see that the company is not short on ideas and reassuringly for investors these initiatives are unlikely to cost large incremental sums of money to bring to market allowing the company to continue to earn exceptional returns on its invested capital (as distinct from its cash reserves). This is in contrast to Sony and Microsoft both of whose hardware strategy is orientated around technical innovation to improve graphic quality. Not only does this require hefty investment but also it makes the games much more expensive to develop, as the $40m cost of Microsoft's latest software release 'Halo 2' revealed. As a result both companies have yet to demonstrate they can generate adequate investment returns from the business. In the 7 years to March 2005 Sony's games business generated just $455m of free cash flow, in the 3 years to December 2004 Microsoft incurred operating losses (in its home and entertainment division where Xbox is the major part) of $3,541m and in the 7 years to March 2005 Nintendo generated $4,483bn of free cash flow. At the moment these figures cut little ice with other investors who are more concerned about Nintendo's loss of market share to these deep pocketed competitors, failing, we think, to recognise the value of Nintendo's niche. We continue to believe that the market value of Nintendo today remains paltry compared to these cash flow returns which might be further enhanced if they prove successful in expanding the franchise with the initiatives described above.

Michael Lindsell
Jul 2005