June 2006

LONG ONLY JAPANESE EQUITIES

We have added to our positions in pharmaceutical shares, partly in response to short term weakness in prices but also in recognition of the prospect for steady future dividend growth and accretive share repurchases.

Takeda Pharmaceutical transformed its business in the mid 1990's with the launch of four important in house developed drugs. All have been global sellers, especially in the USA, with annual sales of between $1-2bn and $4bn for the largest, Prevacid, an anti- ulcer drug. Prevacid is distributed in the USA by a joint venture established with Abbott Laboratories whereas Actos, an anti-diabetic drug, has been co- promoted with Eli Lilly until this year when Takeda takes the responsibility in house. Largely as a result of the success of these drugs, Takeda, Japan's largest drug company is the only one in Japan to boast true global scale, with 67% of its ethical drug net sales earned outside Japan. Even so it ranks 11th largest by sales versus other companies illustrating what minnows Japanese drugs companies are on the global stage. Size matters as it determines the resources for the research and development ('R&D') budget, the source of future sales and profits. For instance Pfizer's budget is $7.5bn compared to $1.5bn for Takeda even though it represents the same percentage of overall sales. Nevertheless, we are encouraged by the effectiveness of Takeda's R&D spending as was manifest in the successful development of the current leading products. As investors we are crucially dependant on a repeat of such success in the future, of which there is no guarantee, but we are confident that the commitment to R&D will produce a good probability for future success. Only 12% of Takeda's current ethical pharmaceutical revenue comes from off- patent products today but that figure will rise from 2009 when the patent expiries on Prevacid. Much of today's R&D efforts are concentrated on securing replacement revenues, which includes buying compounds in development as well as nurturing in house developed products. One such product is Ramelton, a drug designed to counter insomnia, which is coming to market this year and has similar encouraging sales potential to some of the current successful drugs. Takeda plans to distribute it themselves in the USA with Actos, further optimising their in house distribution capability. Partly because of its high percentage of in house developed products, Takeda earns impressive operating margins, averaging 32% (adjusting for sales and profits of affiliates) over the last 5 years, equal with some of the biggest companies such as Pfizer, Merck and GSK. It is good to see that over the last 5 years the company has been steadily reducing its exposure to legacy peripheral businesses which today account for 13% of overall sales (including sales of affiliates). As these businesses only produce 4% of operating profits a further concentration of the business on ethical drugs would improve margins more and increase returns on capital. When we bought Takeda we did so when its enterprise value was under 2x sales. Today that has increased to just below 3x sales but well below the 3-4x of sales multiples that other similarly profitable companies are valued. Takeda has one of the best annualised dividend growth rates in the market at 20% over the last 11 years and this year for the first time ever the company is supplementing its dividends with share buybacks that equate in size to another annual dividend.

Astellas is the other ethical pharmaceutical company we own, though priced considerably cheaper at less than 2x enterprise value/sales. As the company is the product of a merger it will be a few years before we know the real earnings power of the combined company but we suspect it is higher than currently reported. Certainly, like Takeda, there is commitment to R&D spending with 17% of sales allocated last year and an even higher percentage this year due to the cost of an acquisition of the licence of new drug from FibroGen. Like Takeda the company has invested in externally developed products to supplement what is developed internally to replace sales moving off-patent. The company's top selling drugs Harnal (treatment of enlarged prostrate) and Prograf (immuno-suppressant for post-transplant patients) both come off-patent in the next 2 years. Concentrating on the company's specialism in Urology it has just launched a promising new drug this year called Vesicare, which alleviates incontinence. The company's sales are increasingly dependant on overseas markets, especially in Europe, with a third of sales overseas. This is a good measure of how competitive the company is globally and differentiates it, and Takeda, from other Japanese drug companies, like Taisho's pharmaceutical business mentioned below, who tend to concentrate on the domestic market alone. Annualised dividend growth of 12% over the last 11 years has been supplemented with an active share buyback programme. We have been able to buy shares recently on a prospective free cash flow yield above 6% and a dividend yield above 2%, which, in our view, significantly undervalues future prospects.

We noted with interest Johnson and Johnson's purchase of Pfizer's consumer health business for 4.3x its sales. Last year Boots sold a similar business to Reckitt Benckiser for 3.7x its sales. Clearly these businesses, which at their core sell branded over the counter ('OTC') medicines, are valuable and sought after for such heavyweights to pay so much. Profitability is high with operating profit margins at 18% and 17% respectively. Cash flow is good as well because many of the products were first introduced many years ago and have strong brand recognition, such as Listerine mouthwash and Sudafed cold medicines. This means that the bulk of expenses are promotional, in maintaining and enhancing the brand, rather than hefty spending on research and development. Taisho Pharmaceutical is Japan's closest equivalent. The majority its business specialises in sales of similar branded OTC products even if its dominant products are tonic drinks which are exclusive to the Japanese market. Unfortunately, the company has many problems: profits are overly reliant on tonic drinks where sales are falling, a significant minority of the business is the production and sale of off-patent ethical pharmaceuticals, a business where the company lacks scale and resource, versus the likes of larger pharmaceutical companies such as Takeda or Astellas, supermarkets, which have become a new and important distribution channel, are pressuring margins and the family controlled board seem pedestrian in responding to these challenges. Not surprisingly, profits have suffered, falling for the last two years. Nevertheless, the operating margin is still 17% and the valuation at 2.3x sales, 1.1x enterprise value/sales seems to ignore its strategic value as Japan's largest consumer health franchise. We own the shares and take much comfort from these transaction values as a validation that there is much more potential value in Taisho's business than widely recognised.


Michael Lindsell
July 2006

LTL 000-038-1