Mar 2006

LONG ONLY JAPANESE EQUITIES

This month we were in Japan visiting companies. One such company was Chintai.

This month we were in Japan visiting companies. One such company was Chintai. We purchased an initial holding of approximately 1% in February in response to a sharply weaker share price. We had visited the company in late 2004, liked what we saw and had established a buying price 20% above the level we dealt at. The company is the largest advertiser of rental property in Japan. It producers 30 regional monthly magazines sold at bookstores and convenience stores advertising properties to rent. The advertisements are place mostly (70%) by its affiliated company Able, Japan's second largest rental estate agency and increasingly by small independent agents. Chintai reckon they now carry advertisements for 2,000 out of the around 12,000 rental estate agents in Japan. They have no direct nationwide competition and certainly no one who can match their brand power. Now that the internet and mobile phones are increasingly used to advertise rental property the company offers a service to advertise in all three media as long as the broker inputs the relevant data automatically via a web page. Switching customers to this service saves the company significant costs. This part of Chintai's business is very profitable. Operating Margins are 35-40% and capital expenditure is low as most is on computer technology and software that are expensed. Unfortunately when visiting the company again last week we unearthed a number of issues that has moderated our enthusiasm for the company. Firstly, we discovered that business from independent brokers, the company's main source of growth, was not nearly as profitable as the business from Able. Next, the company was undertaking to move into real estate sales advertising, a far more competitive business in our judgement, fire insurance, tenant deposit financing and inexplicably an internet travel agency business. We had a sense that not only was the company was trying to do too much too quickly but that the company was potentially too dependant on favourable pricing from its affiliate. Finally there was a discernable change in the strategy of the company between the two meetings and a related concern about the integrity of the management. As a result we decided to sell out of the entire position, fortunately at a price 30% higher than we bought.

We visited Kirin Brewery, had an informative meeting, but formed a strong impression that any changes, that we think are necessary and inevitable, to raise the dividend payout ratio and better manage retained earnings would progress but take time. Our view has always been that Kirin is a great business that could be better managed. For instance Kirin's beer sales from its 11 breweries are one third of Anheuser Busch's that has 12 breweries to cover the whole of the USA. Also, its Australasian subsidiary Lion Nathan generates 80% of Kirin's beer operating profits from the equivalent of 30% of its sales. Unfortunately, part of the problem is the resilience of Kirin's business. Having such a robust business has shielded the management from the need to restructure and focus on returns quite in the same way as other Japanese companies. Nevertheless so the company is making progress even if it is slow, as reflected in dividend growth over the last 3 years of 10% per annum.

We visited Takefuji. The business, having been hit by scandal in 2003-2004, is in a period of flux while the government reviews legislation on unsecured lending. Near term this is likely to mean higher provisions but longer-term more clarity, which should favour the business. Meanwhile, even without growth the company continues to build book value which should reach Y1T sometime next fiscal year. This has been a longstanding aim and has resulted in an exceptionally conservative balance sheet structure with every loan financed 59% by equity. Given the flux in the industry and the poor financial heath of its core customers, employees of small non-manufacturing companies whose confidence, job security and income have yet to improve, it is perhaps encouraging and appropriate that the balance sheet should be such a rock solid state at this juncture. The management hinted that once the target is reached capital generated above this level may be returned to shareholders. Were the prospects for the industry to improve, they conceded that maintaining the Y1T of shareholders equity may seem too prudent. The company is one of the market's highest yielder's at 3.2%. With the prospect of a higher dividend payout next year it is perhaps not so surprising that the shares have been resilient in the face of bad news. We wait for annual bad debt provisions to diminish, which should happen next year, and prospects for growth to improve at which point we think the shares could be worth at least 70% more.

We added a new holding to the portfolio last month, that of Namco-Bandai, a newly created company following the merger of Namco and Bandai. Both produce video game software and have iconic franchises. Bandai's are centred on characters, mostly developed by the company, including Gandam, Tamagotchi and Power Rangers whereas Namco's best known game franchise is Tekken. Namco is also involved amusement arcade business. The combined company is aiming to exploit existing franchises and create new ones based on characters for the video game, toy and hobby, amusement arcade and TV and music markets. They will particularly target overseas markets partly out of opportunity, partly though necessity as Japan's declining birth rate has put much pressure on the domestic business. It will first require the integration of the two companies. Knowing Japan, we expect that process will be slow and tortuous. Business results have been weak of late, largely because of the platform changes by the major video console companies Microsoft, Sony and Nintendo. This is fortunate, as it is forcing a faster pace of integration than would otherwise be the case. Historically Bandai's business has been the better one and it is good to see that the proposed structure of the new company is modelled along Bandai lines. We believe the combined businesses ought to generate 10% operating margins and should remain highly cash generative. The company currently has unutilised cash equivalent to 30% of market capitalisation, providing us with adequate downside protection while the company works through its integration. We think the combined company should be able to generate an 8% free cash flow yield at the price we accessed the shares and generate higher dividends. The current dividend yield is 1.7%.


Michael Lindsell
Apr 2006