Feb 2006

LONG ONLY JAPANESE EQUITIES

Most Japanese companies end their fiscal years in March. However retailers choose the low inventory month of February to close their books and one or two others choose the calendar year end as most companies do in the USA.

Canon's fiscal year ends in December and has just reported its 2005 results in early February. The 4th quarter proved a little disappointing but behind the results was the steadying influence of rising colour printer penetration, in substitution for both black and white printers and slow speed black and white photocopiers, and most importantly, the high margin, related sales of consumables. We think this repeatable business model has much mileage in it. Any concerns with Canon are focussed on the rising capital intensity of new businesses. The company has already begun investing with Toshiba in a different type of flat screen technology (see the December 2005 monthly review). Not only does the business have a high investment burden but it is serving a highly competitive marketplace. Maybe as a sign of times to come, the company's capital expenditure bill last year was ¥400bn, up materially from ¥250hn and lower in prior years. Although operating cash flows are rising, free cash flows are stagnating. We are yet to be convinced that the returns on new investment are likely to be as good as returns on current investment. One good outcome from the results was the confirmation of the 56% rise in the 2005 dividend, and the guidance that the company will target a 30% payout ratio in future. This would imply a further 40% rise in the dividend in 2006 as well. Such a change will not prevent the company's net cash mountain from rising above the ¥1T it reached in FY 2005. As it earns nothing on the cash at today's interest rates, its size is holding back return on equity, something we would like to see addressed as soon as possible.

Another December year-end company is Kirin Brewery whose results turned out better than expected. We sense that after almost 20 years of losing beer market share to Asahi, Kirin's star is on the rise again driven by popular launches of cheaper priced low malt and beer substitute brands (all the rage in Japan as beer taxes are levied on malt content) that now make up 21% of the market in Japan. Our oft aired gripe is that Kirin remains an unfocussed business with investments in food, pharmaceuticals and a plethora of soft drink brands, which we hope one day will change (see the April 2004 monthly review). Fortunately the company has been far more responsive to changing tastes in Japan than others and, in addition, its investments in Lion Nathan and San Miguel have proved successful. We prefer to value the business on a sum of the part basis and in doing so divine a warranted intrinsic value some 7% higher from the current level. A good sign was that dividends were up by 7% following on from the 14% rise in FY 2004. We expect more progress in 2006.

Mabuchi Motor, the manufacturer of micro-motors, posted dismal results and even more dismal forecasts. We are well aware of the company's short term plight (see the September and November 2005 monthly reviews) and are enthusiastic holders of the shares on the basis that business will improve in the future, though we have no idea of precisely when. In the meantime the store of cash on the balance sheet provides a cushion of value and some downside protection. In some senses we rather hope that business conditions might remain difficult so that we have a chance to build a higher weighting at even more favourable values. We took much encouragement from a visit to the company's major competitor in Hong Kong, Johnson Electric. Like Mabuchi, Johnson's business is based in China where it has been squeezed by the dramatic rise in the price of raw materials especially steel and copper, which rose 22% and 27% respectively, in 2005. In this business raw materials account for 52% of sales and 71% of cost of goods sold whereas labour is only 6%, so it is not surprising that both companies should be suffering. Incidentally, most Chinese manufacturing businesses have similar low labour and high raw materials inputs illustrating the scale of the profits squeeze for the domestic manufacturing industry today. Johnson is faring better than Mabuchi overall because it has little exposure to the contracting audio visual market (CD motors in particular). Johnson also confirmed our belief in the potential for micro-motors in many other applications giving us encouragement that once this shakeout is over there should be good prospects for the dominant two companies in this market to reinvigorate their businesses.

Nintendo has been a good performer for the strategy since the beginning of the year, rising 21%. The company's policy to use the handheld Nintendo DS to broaden the market appeal of Nintendo products to adults and girls as well as young boys has worked in Japan. As a result the DS and the 'brain teasing' games have become a something of phenomenon. The company cannot produce enough machines to satisfy demand. What is more crucial and less certain is whether this strategy takes off in the same way in the USA and Europe where Nintendo would typically sell 3 times as many units as in Japan in each continent. Also there is a heightened level of expectation about the launch of the new revolution console later this year. With so many initiatives ongoing it is perhaps not so surprising that the shares have been firmer of late, not least because the potential for more success introduces an 'optionality' in the investment that could have a dramatic effect on cash flows and business value were they to pay off. While we wait we earn a 2% yield, not bad for a Japanese company, especially one with so much potential.

Nissin Food, the company with the largest market share in the instant noodle market in Japan, was castigated in the October monthly review for hoarding cash and paying paltry dividends. Last month the company announced a plan to buy back 0.7% of its equity. We would prefer a higher dividend at the current price of the shares. Nonetheless, this is the first buyback the company has ever announced and shows that attitudes are changing, even though its size is paltry relative to the cash pile, which equates to 37% of market capitalisation. Maybe the buyback it was in response to stake building buy the same US private equity house that forced substantial dividends out of two smaller cash rich Japanese companies?

Finally our holding in the Osaka Securities Exchange continues to perform well. The price is up 42% this year following on from the 158% rise last. With stock and futures trading so buoyant it is, perhaps, not so surprising but the company's willingness to raise dividends in line with the improvement in profitability, definitely helps. The dividend for FY 2005 will rise 56% following on from the 125% rise last year. The price today is significantly above our original estimate of intrinsic value, as a result we have sold between a quarter and a third of the original holding.

Michael Lindsell
Mar 2006