January 2009

LONG ONLY JAPANESE EQUITIES

The horror of what the current downturn will do to Japanese companies’ profitability is at last beginning to be appreciated by investors as results for the quarter ending December 2008 are reported. Indeed, such is the severity that the corporate sector as a whole might at some point over the next two years be in net loss. This primarily reflects the suddenness and severity of the downturn, the reliance on overseas demand for any growth and the low margin on sales earned by the average Japanese company. The low margin is a function of both a poor capital output ratio (return on capital) and a high fixed cost burden, in itself partly due to the inflexibility of the Japanese labour market. Corporate cash flows are plunging, with the best evidence of this being the sharp pick up in bank loans to fund continuing business and immediate working capital needs.

In essence corporate output has fallen by a quarter overnight, exemplified by the 25% collapse in domestic automobile sales for the last three months and the near 25% collapse in industrial production over the last two months. Companies are straining against an unprecedented situation that in our view will endure for some time. Corporations will respond to this in different ways. For some it will require painful decisions such as the sale or closure of businesses, staff redundancies and even the restructuring and consolidation of whole industries. Little of this has happened yet but when it does share prices have the potential to respond positively. Others will sit pat hoping the problem will go away. For these companies and their shareholders worse is probably to come.

The companies we own are generally less badly affected than the average business but even we have been surprised by the effect of the downturn on some of them. Canon, for example has just reported 2008 operating profits down by 34%, within the scope of expectation but in 2009 the company expects a further 68% contraction. If that proves the bottom profits will have declined almost 80% peak to trough, far worse than the last two downturns that both recorded a decline of “just” 32%. We had thought it would be worse than in the past but not as bad as it has proved to be. If profits match expectations this year the company will have to pay the dividend out of reserves, something that it could afford (20% of market capitalisation is represented by cash reserves) and may well do but sensibly has not committed to as yet. Admittedly Canon has been hit by a perfect storm – a collapse in business spending, a collapse in overseas sales and a super strong Yen exchange rate, which in the short term has done the most damage. However even for a ‘good’ company like Canon there are issues with its business that need to be answered. Aside from printer and copier businesses (c.60% sales), both of which attract high margin repeatable revenues and generate a return on capital (‘ROC’) of approximately 20%, the company has a substantial camera business and a semi-conductor manufacturing business which are not as reliable. Cameras (c.25% sales) include ‘SLR’ higher cost models, the profitable niche, and mass market digital cameras, which is highly competitive. Although Canon has the highest worldwide market share we expect a big fight for this from the fragmented array of Japanese, Korean and Chinese competitors,. Canon will survive, and probably with an enhanced market share, but also most likely with significant damage to margins and returns on capital. Over the last 10 years the tremendous growth in the market for digital cameras has flattered ROC that was on average 19%. Profits last year were especially poor, just as growth peaked, and we expect ROC to stabilise over the long term at nearer 10%. Even worse, the semi-conductor business (c.15% sales) has suffered from negative cash flows over the last 10 years. Not only are margins low but capital intensity is high and pricing power minimal. The outsize 4th quarter loss is typical of what happens to this type of business in a downturn as a small number of customers cancel orders and demand price concessions. We hope the management reviews the long-term prospects for the business in the same way as it did with its nascent display business two years ago, when it abandoned commercialising on the realisation that the returns did not stack up.

We expect similarly disappointing results and forecasts from other manufacturers we own such as Rohm and Mabuchi Motor but hope that their more substantial cash reserves (71% and 114% of current market capitalisation respectively) will put a brake on the downwards progression of their share prices.

Kao Corp’s profits have stagnated over the last two years as any rise in volumes has been offset by rising input prices. This year, with consumption even weaker than before and with input prices still remaining high, profits are expected to fall 10% rather than remain stable as Kao had previously predicted. The company talks of some respite from falling input prices next year which may help offset further volume declines but for a business which sells everyday goods – household and personal care products and cosmetics - to be as negatively effected as it has been illustrates quite how awful the environment is currently.

Even if earnings are declining in the short term, value is building and for most of our companies more so that we can ever remember. We continue to respond to price weakness where we can, especially when that weakness is extreme.

Michael Lindsell
Jan 2009

12 February 2009 LTL 000-074-1