Aug 2006

LONG ONLY JAPANESE EQUITIES

Nintendo's share price continues to rise following more evidence of booming sales of the handheld Nintendo DS in Japan. In the latest week DS games dominated all the top ten slots in the software charts, the first time since the 1980's, a time when it had a real monopoly.

Sales of the DS in Europe and in North America are progressing satisfactorily if not spectacularly, as far as we can tell. This month will see the beginning of the pre-launch hype for the 'Wii', Nintendo's new game console, including the announcement of its launch date and pricing. The optionality of the success of the 'Wii' to Nintendo's business is enticing, especially having witnessed the success of the Nintendo DS in appealing to a wider audience of gamers. This has created a new market for the Nintendo DS which the company should be able to monopolise for some time as there is likely to be a significant lead time before the competitors, without the advantage of an integrated hardware and software business model, are able to generate rival product. We hope it will be the same for the 'Wii'.

Recently there was mini renaissance in the share price performance of Fuji Photo, following many months of relative disappointment. We cut back on the holding in Fuji Photo in early 2005 following the company's investment in businesses with a greater capital intensity than before. Like Kodak, over the past 5 years the company's core business, selling analogue film, has been decimated by the introduction of the digital camera. Fuji has done a better job of diversifying into new businesses but will probably never be able to replace the revenues with such a predictable income stream. Under a new holding company established next month the company with have two core divisions. One is Fuji Xerox predominantly a copier business, with high but not dominant market shares globally. Competition is intense but the predictability of the business is much enhanced by the repeatable revenues from consumables which make up approximately half of the profits of the division. The other division, FUJIFILM Corp., is made up of a cornucopia of businesses including the legacy colour film business, digital cameras (a poor business), medical imaging (the repeatable revenues are under threat from digitalisation), developing machines (in transition as analogue changes to digital, but could be good in the future with a useful repeatable revenue stream) and flat panel display materials. It is the fast growing, capital intensive flat panel display material business that has absorbed the bulk of new investment in recent years. The company shares a high margin duopoly with Konica Minolta in supplying essential components for these new displays. Indeed, approximately half of this division's profits should be accounted for by this business alone by the end of next fiscal year. The company is currently undertaking a wrenching restructuring, incurring many one costs which obscures the true profitability of the business. Recent results indicated that there are some signs that the business is past its trough, which is probably why the share price has begun to perform. Although we like some of Fuji's businesses we do not like them all, and are uncertain about the long term sustainability of the margins of the flat panel display business, its biggest area of expansion. Also the company, with some justification given the need to restructure and invest, pays a menial dividend. At share prices much higher than current levels we would want to have more conviction about the cash generative capacity of the newly restructured company to continue to have the size of commitment we have at the moment.

We visited Obic Business Consultants in late July and remain confident about the prospects for the business. Obic sells packaged business solutions software to small companies and has established the largest market share of approximately 30%, double the nearest competitor. This market share has grown marginally over the last 2 years, a testament to the new sign-ups that increase at approximately 6% per annum. One of the advantages of the business is that customers never cancel or switch providers as the perceived hassle of changing supplier is almost always greater than the benefit of accessing better software. As a result material increases in market share are unlikely unless the company buys customers, something that it has been reluctant to do up to now. We detect the management may consider making acquisitions now that excess cash has built up on the balance sheet. Approximately 70% of the market is accounted for by 4 companies with the rest much smaller concerns, which suggest small scale acquisitions should be possible. Apart from strategic concerns, the company is anticipated to benefit from both an increase in small business regulations and the introduction of the new Microsoft windows operating system 'Vista' which should boost new customers and upgrades of existing packages respectively. The shares have performed well since we bought them and are no longer so undervalued, but remain nonetheless finely positioned to benefit from continued growth in the years ahead.


Michael Lindsell
Sep 2006

LTL 000-039-9