Jun 2007

LONG ONLY JAPANESE EQUITIES

It looks likely that we will benefit from the takeover of a second company in our portfolio this year. Sansei Food, the maker of sugar free confectionery sold under the Teicalo and Xylicrystal brands, is subject to a tender offer from Cadbury Schweppes of the UK.

Cadbury are offering a price 67% above the one that prevailed immediately prior to the offer, which equates to 2x enterprise value ('ev'- market capitalisation plus net debt) to sales. Even at this price this is a tiny acquisition for Cadbury at £56m but it complements the limited exposure to the Japanese market it has built to date through Halls cough sweets and Trident chewing gum. In its short operating history Sansei had generated average operating margins of 16% and is likely to be acquired on an estimated free cash flow yield just above 5%.

In our UK strategy we own large holdings of Cadbury, which itself has been the subject of potential corporate activity. Nelson Peltz, a US activist investor, acquired a 3% stake in the company that prompted an auction of the company's US soft drinks business and a general restructuring. We think the residual confectionery business is worth at least 3x ev/sales, so from this perspective Sansei's assets are cheap. On the other hand, in comparison, Sansei has few brands that have yet to stand the test of time and little scale and distribution clout in Japan, both of which would take many years to build. As a result we view this as a fair price from our perspective as the likely seller.

We have 'lost' two companies from our portfolio since mid 2005, Seven-Eleven Japan, which we sold and then Impact 21 which was acquired. Now Sansei is likely to make a third. Having a majority of our holdings taken off us by business buyers we think is a nice validation of our strategy. We like to think of ourselves investing like businessmen. Although practically we will never own a majority of a company we view our minority holding, however small, in the same way as if we were an owner of the whole business. We expect to generate returns from the cumulative free cash flows of the business and most importantly their subsequent reinvestment by the management even if the measurement of that value on a daily basis is the market value of the shares that may, for periods of time, have little relation to such flows other than through the payment of a dividend. Of course, a crucial difference - and one we have to make a judgement on - is that a majority owner would have control of capital allocation whereas we have none and instead delegate that function to the company's management. Thus, such a rational re-investment of retained earnings is a vital management function.

So long as the business retains the cash generative characteristics to which we were attracted in the first place, we expect to retain the investment. Only if the market places an outrageous value on those cash flows do we consider selling and redeploying the capital elsewhere. Of course, as investors rather than businessmen we have no ability to combine businesses to improve economies of scale but this option allows business purchasers such as Cadbury and Polo Ralph Lauren to pay fair prices for Sansei and Impact 21 respectively with the expectation of adding extra value in the future.

Historically, few businesses in our portfolio have disappeared through acquisition because of the lack of corporate activity in Japan, itself dampened by the protective cross-shareholdings that were a much larger part of the market than today. Now that acquisition activity is on the rise it does not surprise us that it has become more of a feature of our strategy. We view it as a good development overall as we think it will ultimately lead to a better allocation of capital in the Japanese equity market over the long term.

Michael Lindsell
Jun 2007

18 May 2007 LTL 000-050-4