June 2008

LONG ONLY JAPANESE EQUITIES

One of the cheapest companies we own (measured as the difference between the current price and our estimate of intrinsic value) is Medikit, a small family owned business (family ownership is currently 62%) that we have been invested in for three years. The company makes specialised disposable medical equipment such as needles for use in dialysis; angiographic catheters, which are designed to deliver drugs to specific parts of the body via the venous system; and indwelling needles for the administering of drugs and fluids in hospital. The legacy business of the dialysis needles generates cash flow and the indwelling needles, which have a patented mechanism that prevents the backflow of blood and thus reduces infection, provides the growth. For the last two years sales of indwelling needles have grown at a 25% clip, which has helped offset the decline in prices imposed on the sales of the other products due to Japanese government mandated health price cuts. Looking to the future, especially after FY 2009, the sales of indwelling needles should drive modest growth in sales for the whole company as the proportion of sales rises to near 20%. This is because sales of indwelling needles are mainly overseas, away from the influence of the price cutting regime. Thus the company continues to progress, if modestly, in line with expectations and earning a decent 16% return on capital. But like some other companies in our portfolio the balance sheet is awash with cash earning low returns and depressing return on equity, currently less than 7%. The company made a half hearted attempt to buyback shares last year and only pays a dividend that is approximately 30% of net profits, when capital investment needs are adequately accounted for by annual depreciation. Much more could be done to boost shareholder returns, something we encouraged in our meeting with management earlier in the month.

Our small holding in Morinaga & Co, the confectioner, remains a frustration to us.
Late last year, after we had bought a nascent holding, the company announced it was planning to spend Y50bn on new facilities. These included a new factory and the rationalisation of existing sites, including a closure of old facilities, reducing the number of plants from seven to three or four. The company maintained that it would result in a material boost to margins, cutting cost of sales by 5%. We were concerned about such an expensive capital expenditure plan and immediately curtailed the accumulation of the position for the strategy. After all, the annual sales of the company are only Y170bn and making sweets is not rocket science. When challenged about the proposed investment on our recent visit, the company refused to divulge any further information except to say that it was postponed in light of poor market conditions for profits. This had not stopped the company buying around Y7-8bn worth of land for the proposed new factory, financed by bank borrowings. With almost all raw materials increasing in price the company is trying to offset the immediate impact with rises in product prices, but this is difficult as some products have remained the same price for as long as 30 years making customers hostile to change. Initially, volume tends to decline in reaction to such price hikes, even if for the best brands it soon recovers. Clearly the volatility of input prices and weakness of sales makes delivering the 5% cut in the cost of sales much less certain. To build the position any further we need more clarity on how Y50bn of expenditure can credibly improve margins to the extent the company predicts, more confidence that the company will concentrate its resources on improving its portfolio of top selling brands and more evidence that the company has a credible strategy to improve return on capital. Morinaga is representative of a company in a stable and cosy domestic industry, with few foreign competitors, earning sub-standard investment returns for investors who seemingly do not care. Ironically the more the pressure on profits the more likely it is for the fragmented industry not only to consider consolidation (which should ultimately benefit those owners of the best brands) but also for investors, both overseas and Japanese, to demand better returns. The allure of owning a business under such pressure now is for a transformation in its valuation from 40% of sales to nearer 3 times sales, which is where other well managed confectionery businesses trade in overseas markets.

The beleaguered management of Aderans have announced an EGM at the beginning of August and have proposed new directors to replace those dismissed in the recent AGM (see the May 2008 monthly review). These include three outside directors, one as a representative from the activist fund that initiated all these changes, who will form a committee ‘for the purpose of reviewing and evaluating strategic alternatives for enhancing the corporate and shareholder value of the company’. The statement also indicated that Nikko Citigroup would be retained as advisors. In other words there will be a root and branch reform of the company, its strategy, its cost base and its bloated balance sheet for the benefit of existing shareholders. This is a first in Japan for a company of this size with this heritage and is an important test case for the activist approach. Thus far the market’s response to the announcement has been surprisingly muted, especially as we regard this type of activity as representing an important fillip for the ongoing process of improving shareholder returns and the allocation of capital. Maybe the market remains sceptical as it is inured by the failure of such strategies in the past, but we think this is likely to be seen as an important turning point in the drive by activist and private equity investors to initiate a rationalisation of sheltered domestic businesses for the benefit of consumers and investors alike. There is a long way to go but we believe that, as the new business strategy for Aderans becomes clearer, the market will respond positively to any enhancement of shareholder value. Ultimately we think this could approximate to a price double the current one.

Michael Lindsell
May 2008

11 July 2008 LTL 000-066-7