Sep 2005

LONG ONLY JAPANESE EQUITIES

We have been building up positions in two companies this year, Mabuchi Motor and Rohm, which are thoroughly out of favour with investors. Mabuchi is currently 3% above its low price; one that was last traded in 1995 and is 70% below its peak in late 1999. Similarly Rohm is 2% above its low, last traded in 1997 and is 77% below its peak in late 1999. Although neither possess the extent of the 'deep value' characteristics we have written about before (a company valued for less than its short term financial assets minus all liabilities - see the October 2004 monthly) both represent intriguing investments from this perspective as we outline below.

Mabuchi and Rohm sell electronic components. Mabuchi produces micro motors, used in a plethora of applications including toys, electric toothbrushes, CD players, car wing mirrors, air conditioners and power tools. Rohm makes customised semiconductors mainly for consumer electronic and telecom applications, especially mobile phones. Normally investing in such component businesses would be the antithesis of what we do as without branding such companies' products may suffer from severe competition, are generally bought by a few highly sophisticated customers that are more likely to negotiate hard on price resulting in ongoing price pressure. What mitigates this to some extent is that Mabuchi and Rohm dominate their respective markets. Mabuchi, in particular, has a 60% market share. Rohm's market share is more difficult to measure. However, it is qualitatively the best company at what it does which is to work closely with its customers to develop key components that allow its customers to differentiate their products. Rather like a pharmaceutical company that produces a drug with brand new efficacy, with a result that its market share may be near 100% for that application for the first few years of its life, Rohm develops customised products that have similar 100% market shares until Chinese or Taiwanese competitors develop cheaper competing devices. The dominant market share in the case of Mabuchi and the 'pharmaceutical' type characteristics of Rohm's business allow both companies to earn high operating margins, 18% and 23% respectively on average over the last 15 years. However today both companies are suffering from the switch from analogue products, especially in audio/visual applications such as CD players, to digital ones such as MP3 players that has caused sales in this significant part of their businesses to fall.

For a business like Mabuchi producing one product, such a hit to sales (audio/visual sales were 30% of the total with CD players dominating) has caused a collapse in margins to 10%. Not only does the company have too much production capacity also it needs to search out new applications for its products in a very competitive market. All Mabuchi's production is in China, the company having pioneered a move there more than 20 years ago. Indeed this year the company is closing surplus high cost capacity in Malaysia and investing in new ultra cheap facilities in Vietnam. It is not immediately obvious how Mabuchi will solve its current predicament, and while this is the case there is risk of a further deterioration of the business and weakness in the share price. Aside from its high market share and relatively simple and well executed business model Mabuchi is extraordinarily well endowed with is cash, the fruits of many past years of success. Today cash represents 60% of market capitalisation and 66% of book value. Subtracting the cash the operating business values the business alone on a 6% free cash flow yield based on today's depressed earnings or on a 15% historic cash flow yield based on average cash flows over the last 15 years. If the share price falls to book value as we think it might, these already alluring yields increase materially. We have an open mind as to whether the business will ever be able to generate the 25-23% margins it earned in the last decade, and recognise the costs of downsizing its operations if no further significant applications can be found for its products but if the business stabilises or grows, even at a much reduced level of sales it would be worth a lot more than it is today in our estimation. More likely this harrowing time for Mabuchi is even more harrowing for its competitors resulting in a probable further rise in its market share. At a time when we find it hard to unearth more conventional value opportunities we take great comfort from the margin of safety that the cash provides from what is a nascent holding in this business. We might conceivably double it subject to price and on some greater sense of how the management is to tackle their predicament.

Rohm's close relationship with its customers is vitally important as it allows them to work with their clients to develop unique components. This close association has many benefits but its downside is most acute when Rohm's customers do badly as the malaise spreads to Rohm itself. Today Rohm's top ten customers are all Japanese companies except Samsung which is the only one whose business has been thriving lately. Sony and Sanyo, in particular, are likely to go though wrenching rationalisations in the near future following on from the recent experience of Matsushita (JVC and Panasonic). To overcome the current lack of growth and opportunity Rohm is investing heavily in new state of the art processes to give it the edge to develop world beating product for its customers. Like with pharmaceutical companies there is no guarantee of success but there is a history of innovation on which to base some comfort. There is no doubt that Rohm's business model is capital intensive and may be becoming more so as the extent of vertical integration increases giving it more propriety over its end products. Over the last 15 years 65% of free cash flow has been reinvested back into the business as compared to approximately 80% last year and this year. Unlike many other capital intensive business models, its ongoing investment has generated growth and sustainable margins and has allowed for an accumulation of substantial reserves of cash that today amount to 38% of market capitalisation and 57% of book value. In the same way as Mabuchi, by subtracting cash from the market capitalisation, the market values Rohm at a 7% free cash flow yield today. Perhaps even more so than Mabuchi we see further downside risk in the business and its market value while investors await new products, while the investment burden is so high and especially as the cash reserves offer less value protection. Nevertheless the future prospects for Rohm seem to us somewhat more tangible than Mabuchi's not least because its customers themselves can only thrive by innovating new product and Rohm remains a key part of that process. As with Mabuchi we have just begun a position which we expect to augment over the next few months, hopefully at lower prices.

Michael Lindsell
Oct 2005