May 2008

LONG ONLY JAPANESE EQUITIES

Takefuji continues to disappoint us both in terms of the share price performance and the cost of the restructuring necessary to adjust by mid 2010 to the new regulations imposed on the consumer lending industry two years ago (lower maximum lending rates and restrictions on loans as a proportion of an individual's income). Recently the company announced poor profit forecasts for the current fiscal year, a further cut in the dividend to follow on from the one last year, and the issue of a convertible bond. Although galling, the first two announcements were understandable given the pressures on the industry brought about by a contraction of the balance sheet as inappropriate borrowers under the new regulatory regime were cut off. What was more frustrating was that a company with so much excess capital needs to raise new funding with the issue of convertible bonds thereby diluting, albeit at higher prices, the ownership of existing shareholders. It seemed the combination of size (Y70bn), duration and the low coupon (1.5%) was too tempting for the company in an environment where funding is clearly more difficult than before, even in Japan, a country relatively unscathed by the credit crisis. Perhaps management was correct in grabbing the opportunity lest the situation deteriorate further, which it might. Time will tell. The one compensation is that management has bought itself considerably more flexibility now than it had before.

Amid the excuses for the disappointing performance it is worth reiterating the investment case for the company. Takefuji is one of four, increasingly dominant, companies lending unsecured funds to consumers. It is a specialised business and one in which the banks have hitherto lacked any expertise. Takefuji's 'Yen shops' are well known all over Japan and the company is regularly listed as one of the most recognised brands in the country. Over the years, increased regulation and access to capital have raised barriers to entry which are now, following recent law changes, higher than ever before. Lending funds at the newly mandated average rate of 17% should still be a highly cash generative business on the assumption that: of that 17%, debt finance costs 3.5% (assumed interest rate 5%), provisions average 4%, operating costs 5%, and tax 2% leaving 2.5% for shareholders of which half is returned as dividends. This assumes that provisions fall from 5.5% of income in the past to 4% as asset quality improves. There is negligible capital investment. We estimate the loan portfolio to contract further to nearer Y900bn from Y1.2T today, down from just under Y1.8T at its peak. Optimal funding of the loan portfolio should be 30% equity, 70% debt, which should release significant excess capital in the future. Tax losses are another hidden asset. Our valuation of the cash flow and excess capital point to a fully diluted price more than 80% above that currently prevailing and think we have been conservative about the future and past level of provisioning implying there may be write backs and future tax benefits also. Although this is a target price reduced from the one we had some years ago, reflecting both a reduction of the return on assets of the business brought about by the change in regulations and a much larger contraction of the loan book than we originally envisaged, the upside remains substantial.

On a more positive note, the shareholders of Aderans voted to dismiss the entire executive board of directors of the company. Such an event would be rare enough in Western markets but in Japan it is unprecedented. It happened because the current management has failed to prevent or mitigate a loss of market share in the company's traditional wig business in Japan. The company has allowed the next largest competitor, Artnature, with sales less than half those of Aderans's, to grow at its expense. Also the management has made some questionable investment decisions including the expansion into the hair replacement market into the USA. Although this is complementary to the existing business it lacks the repeatable revenue that makes the wig business so alluring (once a customer has a wig fitted, it and its replacements tend to be worn for life) and returns on capital are lower. Finally, last year the management irked investors by adopting a 'poison pill', structured to protect the interests of management in the event of takeover over the wider interests of shareholders. We met the management last week, who had not a clue as to what is to happen next and somewhat bizarrely imagined that a new board would be chosen by the departing one some time in September! More likely an EGM will be arranged much sooner and new directors proposed with explicit approval of the protesting shareholders. We hope these directors are incentivised to manage the company to further shareholder value in the interests of all shareholders and to quickly reposition the business to deal with its current problems. Certainly, this is what we will be voting for.

This is a rare victory for investors labelled as "shareholder activists", who deliberately buy large stakes in companies with the purpose of shaking up management in order to release full strategic value. The same investors did a good job with Sotoh, a sleepily managed textile company, in 2003. The share price quadrupled from its lows three years earlier when the management responded to hostile tender offers with payment of large one-off dividends to distribute idle cash. Since then, more generally Japanese managements have raised barriers with the introduction of poison pills and some have even resorted to the old-style tactic of boosting cross-shareholdings. However, as a recently published white paper on corporate governance in Japan by the Asian Corporate Governance Association stresses, it is domestic investors more than any other who are likely to gain from better supervision and accountability of Japanese corporate boards. So, despite claiming in public that activists are no better than green-mailers, behind closed doors our impression is that Japanese institutional investors are delighted that these activists are doing their dirty work for them. As a result we would expect a greater proportion of successes in cases where such investors take on Japanese management, even if some failures will persist. What is now important is that, as in the case of Aderans, such drastic activity works. That is, the new board succeeds in delivering value for shareholders at a far higher level than was the case with the previous management in the past.

Michael Lindsell
May 2008

16 June 2008 LTL 000-065-0