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Nov 2007 LONG ONLY JAPANESE EQUITIES Having written previously about the growing pressure on Japanese companies to improve shareholder returns, we are encouraged by the number of companies in our portfolios which are pioneering the trend - a trend that is in its early stages but one which will, we think, last for many years. Companies may put their excess cash resources and retained earnings to work in a number of different ways aside from investment to support organic growth. We expect to harness extra portfolio returns from three sources: higher dividends, share repurchases and investing into new businesses, and we will look at each in turn.Higher Dividends An important change in Japan in the last three years is that many companies in the market are now linking dividends to corporate performance, as opposed to making stable payouts as they did in the past. However, at a time of huge increases in corporate profitability, only a few companies have actually increased payout ratios - the exceptions include almost all of those we own, which have collectively raised payouts from 25% in FY 2002 to an estimate of 44% in FY 2007. On the other hand the payout ratio for the market remains stuck at below 30%. Of course, higher dividends are welcome so long as they are well covered by profits, as is the case with our companies, and additionally the dividends are shielded from short-term declines in profitability by the excess cash reserves held on balance sheets. Having abandoned stable dividends most of our companies articulate a dividend policy in reference to a targeted payout ratio together with a desire never to cut the dividend. Thus, when profits fall temporarily and the payout ratio exceeds its target, excess cash reserves from prior years' successes are used to maintain the dividend payment. In targeting a payout ratio a company is implicitly acknowledging the need to provide a higher ongoing income return to investors, which is a direct result of the increasing demands from shareholders, many of whose age profiles now place increased priority on return from income as opposed to capital gain. The scale of the payout ratio is a delicate balance between the demand for income from investors, the opportunity for new investment in new businesses, which itself is an assessment of whether the return on capital will likely exceed or equal that of the existing businesses or the relative attractiveness of executing share repurchases. To our mind, it seems inflexible to commit to specific levels of payout when the relative attractiveness of the alternative uses of retained earnings can change, i.e. good capital allocation needs to be dynamic and responsive to changing opportunities. After all, for those investors with less requirement for current income, paying a higher dividend means that the shareholder is left with the onus of re-investing it. At the same time, it is far less tax efficient for shareholders to reinvest dividends than for management to reinvest earnings, which is why in a utopian world non-income seeking shareholders should logically prefer companies to repurchase shares at reasonable or undervalued prices or invest to grow their business rather than raise payouts at all. However, the world is not utopian; managements make what may seem illogical decisions, shares often trade at expensive prices, some businesses generate more capital than they can readily re-absorb and expected rates of return fail to live up to expectations. This is why in the real world we like to strike a balance, but not necessarily a fixed balance, between these three sources of return in the companies we own. Share Repurchases Today, we would prefer our companies to buy back more shares. For FY 2007 to date the 'share repurchase payout ratio' for the portfolio is 14%, but it has been much higher in previous years. Given the idle cash on the balance sheet of our companies and dividend payout ratios of just 44% we believe our companies could do much more. Recent activity is more encouraging. We drew attention to the spate of buybacks announced by our companies as share prices began to weaken in August and now, to accompany the recent falls in prices since September, further buybacks have been announced by Fuji Film, Kao, Astellas, Rohm and Takefuji. Investing into new businesses Investing into new businesses is usually the riskiest of the three sources of increased return and is also the least common as, historically, merger and acquisition activity in Japan has been stifled by the web of interconnecting business relationships. However, as these relationships are increasingly seen as anachronistic in the modern world and the pressure on all companies, listed and unlisted, to enhance shareholder returns intensifies, such activity is increasing. We see encouraging evidence of this in the pick-up in acquisition activity for companies in our portfolio and we highlight two recent examples below. Last year Nissin Food, Japan's largest instant noodle maker, bought Myojo Food to gain a further 10% share of the instant noodle market, bringing its share to 55% for an enterprise value ('EV') of just Y19bn. Then last month the company entered an agreement to buy a 49% stake in Katokichi, a frozen food supplier, which amongst other products sells frozen noodles where it has a dominant 51% share of the market. When this is added to Nissin's existing 12% share it is clear that with such a commanding position there is a good chance that pricing power may improve and thus the combined business should generate better returns than individually prior to the acquisition. However the structure of the deal, as revealed to shareholders to date, looks complicated. The acquisition was brokered by Japan Tobacco, which has ambitions to expand into the food business. They already had a business relationship with Katokichi and owned 5% of its equity. JT bid for the whole company, valuing it at ¥117bn (an EV of ¥153bn) with an agreement to sell on 49% to Nissin, for what we presume will be a price of ¥57bn (reducing Nissin's excess cash by 35%). On balance we think this is a good deal. It is undoubtedly good that the company is putting idle cash to use in a business it knows well and the resulting consolidation of market shares looks promising. However, it will be a challenge for Nissin to match the returns on capital in its existing business and, as we mentioned above, the structure of the arrangement is complex, so although it is likely to enhance return on equity immediately it may not be by as much as one might hope for from an investment of this scale. Kirin Brewery has made two acquisitions in quick succession. First it bought 50.1% of Kyowa Hakko, a pharmaceutical, food and chemical company, by means of a tender offer for 28% of Kyowa Hakko's shares and an acceptance of new shares in Kyowa Hakko issued in consideration for the transfer of Kirin's pharmaceutical business. Depending on the way you look at it, either Kirin has paid approximately ¥315bn for control of a business that generates sales of ¥395bn and operating margins of 10%, or sold its pharmaceutical business to Kyowa Hakko for nearly 5 times sales. Either way it's a good deal for Kirin and a lousy one for Kyowa Hakko shareholders. This smacks of a defensive merger engineered by the Kyowa Hakko management to preserve their independence. The president of Kyowa Hakko will run the combined business with a promise of no alteration in the current ownership structure for ten years. Overall we think the deal makes sense for Kirin shareholders. Combining the pharmaceuticals businesses generates better scale and, perhaps more importantly, Kyowa Hakko has developed a range of promising proprietary antibody compounds and technology that we believe are the real attraction of the company to Kirin, which we expect the combined company to exploit with better effect. One caveat is that Kyowa Hakko has other businesses (chemicals and food) that have no synergies with Kirin's and currently make poor returns. We expect these will be rationalised or sold, but this may take some time. Next, Kirin paid ¥94bn for Australian National Foods ('ANF'), Australia's largest dairy and fruit juice company, with sales of A$1.8bn. The company has debt of ¥200bn and earns operating margins just under 10%. The EV/sales is 1.7x, relatively high for a company operating in a market where Kirin will achieve few synergies. We understand that Kirin plans to swap the debt into yen, cutting interest costs and boosting cash flow. I fail to fully understand the rationale of the deal. However, it is intriguing that ANF was bought from San Miguel, Kirin's 20% Philippine associate. Thus this deal may be the first step in a bigger reorganisation of San Miguel assets, from which Kirin will derive more advantage in the future. Kirin will finance both these acquisitions from cash and new debt, although I would have preferred the company sell some of its bloated financial assets to fund the purchases. Maybe it will. Kirin has been true to its ambition to grow through acquisition and on balance these deals should raise return on equity from the paltry 5% it currently earns, but I for one will be looking for more reassurance on the rationale behind the Australian acquisition in future discussions with management. Michael Lindsell Nov 2007 10 Dec 2007 LTL 000-056-4 |
This document is produced solely for information purposes only. It is not intended for use by private individuals. Opinions expressed whether in general or both on the performance of individual securities or funds and in a wider economic context represents the view of the fund manager at the time of preparation and may be subject to change without notice. It should not be interpreted as giving investment advice or an investment recommendation. This document is produced solely for information purposes only and may not be copied or distributed without expressed permission. Past performance is not a guide or guarantee to future performance. Investments are subject to risks and their value and income from them may go up as well as down. Investors may not get back the amount they originally invested. Issued by Lindsell Train Limited Authorised and regulated by the Financial Services Authority |
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| Dec | I Wished A Client... | Japan Eq | |
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| Sept | Do Dividends Really Matter? | Japan Eq | |
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| May | Reflections on Markets in 2009 | ||
| May | You Will Come | Japan Eq | |
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| Jan | I Forgot More Than You'll Ever Know | Japan Eq | |
| Feb | Cash Hoarders & Debt Dependants | ||
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| Feb | What's up in 2007 | Japan Eq | |
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| May | Various thoughts on Japan | Japan Eq | |
| Jun | Idea Updates | Japan Eq | |
| Jul | The Bids | Japan Eq | |
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| Nov | On the Failure... | Japan Eq | |
| Nov | Is Japan a 'Buy'? | Japan Eq | |
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