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Nov 2006
LONG ONLY JAPANESE EQUITIES
All recent new positions have been in small
companies, notably Sansei Food and Medikit. Over
the last two months we have added to that roster
with the initiation of a position in Earth Chemical.
Earth Chemical's business began as a drug maker in
1892 and only ventured into insecticides, the
mainstay of its current business, in 1929. From there
is has grown to dominate Japan's household
insecticide market with a 50% market share, with well
recognised brands such as 'Earth No-Mat', a mosquito
repellent. There are two main competitors, Dainihon
Jochugiku, a private company with 25% market share
and Fumakilla, with a 10% market share. Interestingly
Earth owns 4% of Fumakilla. Most householders
require insect repellent in Japan as hot and sticky
summers provide a perfect environment for insects
and bugs making demand for such products
predictable. However, we cannot expect much
growth from the company as the number of
households in Japan will likely peak and begin falling in
the next 10 years but we can anticipate
consolidation (the small stake in Fumakilla hints at
this) and a steady increase in profitability as the
company establishes overseas production facilities.
Not only will this cut the cost of manufacture,
through lower labour costs, but should allow the
company to access much cheaper raw materials, the
supply of which is controlled by regulation in Japan.
Aside from selling household insecticides the company
distributes oral hygiene products, notably
GlaxoSmithKline's denture cleaner and fixing agents.
These provide stable revenues but only low margins.
A further 15% of the company's sales are accounted
for by an environmental sanitation business
specialising in providing services to the food and
pharmaceutical industry, which is growing steadily
and generating 10% margins. Overall the company
generates 6% margins that we think could expand to
10% in the future. The company has ample
resources to fund the capacity expansion overseas,
is looking to consolidate the 5 production facilities in
Japan and to increase its dividend. Indeed it has
already announced a 20% rise for this financial year.
We were able to accumulate an initial position in the
shares at an enterprise value equating to 35% of
sales, a dividend yield of 2.5% and an earnings yield
(post-tax operating profit/enterprise value) of 8%,
from a business generating a steady 15% return on
capital.
Two companies we own have acquired new
businesses in the last month, which in both cases
should enhance return on capital as low yielding cash
is put to better use. Nissin Food is acting as a white
knight to a competitor, Myojo Food, by tendering for
a 33.4% stake and trumping the rival tender offer of
a US based private equity fund. Although this stake
does not give absolute control to Nissin it does give a
degree of management influence as board sponsored
amendments can be voted down by shareholders
owning a third of the company. Myojo has
approximately 10% market share in the instant noodle
market in Japan which when combined with Nissin's
will amount to a market share of 55%, further
consolidating Nissin's dominant position. The cost of
this is just Y12bn for influence over an extra 10%
market share. To put it in perspective Nissin's
enterprise value was ¥250bn (¥55.5bn for each 10%
of market share) before the announcement and not
surprisingly has since logically risen to ¥310bn.
Mercian is Japan's largest producer and distributor of
wine in Japan. Although wine commands a tiny share
of alcoholic beverage sales in Japan, it is growing fast
and as beer, Kirin's core product, is losing share
steadily it makes sense for Kirin to initiate a further
diversification of its business into this area. Like with
Nissin the cost is affordable. A majority stake of
50.1% values the business at the equivalent of 50%
of sales, just above book value at Y49bn. Kirin looks
as though it has paid a free cash flow yield of
approximately 4%, which seems low, even though it
is a better return than idle cash. On the other hand
it does not allow for the material potential synergies
possible from integrating Mercian into the wider Kirin
franchise, which we think could prove significant.
Michael Lindsell
Dec 2006
13 Dec 2006 LTL 000-041-8
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