Dec 2005

LONG ONLY JAPANESE EQUITIES

The year ended with some encouraging news from four of the companies we own.

First, as we hoped, Kao Corporation succeeded in acquiring Kanebo Cosmetics. This is a major initiative: the cost is ¥400bn (£2.0bn), 25% of pre-acquisition market capitalisation; the cost will absorb all company cash balances and will result in net debt equalling 65% of shareholders funds in 2006; Kanebo is a prestigious, major Japanese cosmetics brand, such businesses rarely come up for sale in any market; Kanebo's sales are 40% of Shiseido's, the largest company in the market and when amalgamated with the existing Kao cosmetic's sales would be 55%; Kanebo's brands are well known and have a high reputation; finally there is a valid suspicion that the turmoil affecting Kanebo's overall business in the last 5 years will have had a negative impact on its prospects that with proven, stable management at Kao may well enhance prospects for the combined company in the future. The acquisition will have little immediate impact on reported operating profits as amortisation charges neatly match the additional Kanebo Cosmetics operating profit contribution. However, Kao will benefit from a lower tax charge, as it utilises Kanebo's tax losses, and Kanebo's extra cash flow, improving overall cash flow returns. On the same pre-acquisition price, Kao's 2006 free cash flow yield rises from 5.1% to 6.4%. There may be synergy benefits, in addition, but the extent to which these are offset by integration costs and interest charges is, as yet, difficult to discern. What is promising for Kao is that cosmetics or 'beauty' will make up 25% of sales. Beauty is a better business that household products. It is reliant on ladies' vanity, a characteristic that should not be lacking in a wealthy, rapidly aging Japanese population. The raw material inputs are a tiny cost of production. The other more material costs are product design, marketing, brand positioning and distribution, all activities that Kao has proven expertise. We think Kao should not only be able to raise margins in its combined cosmetics business but should also be able to grow as it develops a better offering to consumers. We think it should take under 6 years of cash flow returns to pay off the acquisition cost. We raise our target price 31%, which equates to a market capitalisation of roughly 2 times sales, a level at which many other global quoted consumer products businesses are valued by markets today.

Aderans, another company dependant on vanity, in its case both men's and women's desire to preserve or substitute a full head of hair, has turned around its business after a difficult 2 years. Management confidence in the stability of the business model over the last 5 years has been reinforced by periodic share repurchases, another of which took place in December. Over the last 5 years the company has either repurchased or paid as dividend 77% of free cash flow, more than double the percentage from the previous 5 years period, a testament to the greater importance the company sees in shareholder returns.

Next, Canon increased its 2005 dividend by 54%, a material hike for this company as it puts the shares on the highest dividend yield for 15 years. In reality, this is but a small gesture to shareholders after a number of years of substandard payouts in bumper years for the company's business. Such has been the mismatch between success (increased profits) and reward (dividends) that much of the spoils sit idly on the company's balance sheet, in cash, earning a minimal rate of interest. This increased dividend payment will make no dent in that sum; it just ensures the cash pile (now 15% of market capitalisation) grows more slowly than before. Our enthusiasm for Canon as a business relates to the repeatable business model (low margin hardware sales that are followed by high margin consumable sales) inherent in the printer and the copier business and the dominant position that Canon has in this business worldwide. We believe that there are many more years of high free cash flow returns to be generated from its accumulated investment in this area. The problem for Canon is what to do with the spoils. Such a strong financial position gives it a massive advantage in committing funds to research and development and new businesses but the company has to be sure that any new ventures have the capability to earn comparable returns on capital to the existing business otherwise, arguably, the cash is better used funding share repurchases at current prices. The new business venture that Canon is pioneering with Toshiba is the mass production of SED flat panel monitors. These are equivalent to LCD screens, but are easier to make, larger, have better definition and may prove cheaper. There is no doubt that the flat panel market is a massive one which should Canon claim a significant market share, could provide another material leg of sales growth for a company its size. What is more doubtful to us is whether the capital returns are likely to hold up in what is likely to become a fiercely competitive consumer hardware market. This is why understanding Canon's principles of capital allocation from here are important for judging the next phase of the company's development.

Finally Ito-En, the beverage company, which has a 30% market share in green tea beverages, the largest and fastest growing segment of the Japanese beverage market, raised it's dividend by 7%, slightly less than the 11% average increase over the last 10 years, but nonetheless creditable. The continued progress of the company's business inspired a further rise in the shares (23% in December) taking it marginally ahead of its intrinsic value.

Michael Lindsell
Jan 2006