April 2009

LONG ONLY JAPANESE EQUITIES

Over the last few months we have initiated a new position in Yakult, whose primary product and franchise is the fermented milk drink of the same name, which aids digestion and enhances health generally. It is a rare Japanese global consumer brand, with important market positions in emerging markets especially Mexico, Brazil, Thailand, Korea, the Philippines and Indonesia and recently China. However, its main market remains Japan, which still accounts for 35% of Yakult sales volumes. The company employs a unique distribution system, the ‘Yakult Lady System’, where sales ladies sell products door to door (or more accurately office to office) in cities. The model was first developed in Japan and then adopted overseas. Sales are best in those markets that employ this intensive vertically integrated sales distribution system as opposed to relying on conventional third party retail channels, but the investment in time is material before profits are generated. The system is particularly suited to emerging countries with high population densities where labour is plentiful and wages cheap. Once Japan had these characteristics, but no longer, and thus the profitability of the domestic dairy and beverage business is disappointingly low, currently 4% (excluding central corporate expenses) on sales, and since most central expenses are domestic it is likely that this business now operates at a loss. This compares to the 30% margins earned in the Americas (dominated by Mexico). The loss in profitability domestically has been ongoing for a number of years due to falling sales and rising costs. Profits have contracted by two thirds since 2001. We suspect this is partly due to the sub-scale Yakult brand beverages, which are also sold through more conventional retail channels that must in the current environment be unprofitable, but is a reflection of some legacy inefficiencies in the ‘Yakult Lady System’ itself. Today it operates through 128 sales and marketing companies of which only 20 are owned by Yakult. The rest are independent which not only leaches value to others but is massively unproductive. The company is trying to reclaim ownership and halve the number of companies but under current plans this will take time, maybe four years. We look for more assertive action to improve profitability from these two areas, something we expect with greater urgency now that the domestic business may be operating at a loss, but we do not depend on it. What we do rely on is the huge potential from growth overseas. Mexico is an example of what is possible (it alone accounts for 80% of overseas profits) and now China has the best prospects in its cities with high population densities. Sales are growing at a 30-40% clip. Yakult is established in Guangzhou, Shanghai and Beijing and has just started in Hangzhou and Suzhou. By 2011 the company plans to operate in 17 major cities. Over the next ten years overseas sales could triple and profits rise even more, led by gains in China and the Americas. To complicate the investment further, 12% of current sales and 30% of current profits come from sales of anti-cancer drugs. As with our holding of the OTC drug specialist Taisho Pharmaceutical, we do not ascribe any long-term value to these revenues in our analysis as the company has not the scale to compete in the prescription drugs business in the future. Valuing the company is anyway difficult due to limited disclosure but the core dairy business, with its emphasis on health, vertically integrated distribution and growth in emerging markets, should be worth at least 2x sales equalling a warranted value at least 40% higher than the cost of the position we have started in the shares.

Kirin Holdings is in the process of concluding two important acquisitions this year having attempted a third, thereby continuing with its stated policy of increasing investment outside Japan. The failed attempt was the bid for Coca-Cola Amatil, kyboshed by Coke itself, a 30% shareholder citing an inadequate price. The other acquisitions consolidate assets acquired earlier into better or more rational investments. First, the company exchanged its 20% shareholding in San Miguel Corp in the Philippines for a 43% holding in San Miguel Breweries and a cash payment of Y38bn to San Miguel Corp. Then at the same price the company tendered for another 5% from the market. Now Kirin owns 49% and San Miguel Corp 51%. San Miguel Corp’s focus has moved from beverages and food to mining, infrastructure and property and in order to fund investment in these areas has sold some of its beverage interests. The first to go was National Foods, the Australasian fruit drinks business, bought by Kirin in late 2007. At the time we wondered whether this sale could be part of a series of further deals with Kirin (see November 2007 monthly). It seems this was the case. Next San Miguel Corp spun off its domestic beer operations into San Miguel Brewery which was listed in mid 2007. San Miguel Brewery has 95% of the Philippine beer market and thus a virtual monopoly, one that generated operating margins of 20-30% and prodigious cash flow. We hope that San Miguel's overseas beer interests will also be transferred into the brewery company in due course. The brand is well known in Asia with important market positions in southern China amongst other countries. Second, Kirin has made a recommended offer for the 53% of Lion Nathan it does not own. Lion Nathan, with Fosters, has a duopoly in the Australasian beer market, a market position that has created much value for its shareholders including Kirin over the last 10 years. For Kirin to own all of it rather than just 46% makes rational sense. However, the price for control was high, at 3.75x enterprise value (‘ev’) to sales - just below InBev’s price for Anheuser Busch at 4x ev/sales and materially higher than the effective price paid for San Miguel Brewery at 3.2x ev/sales for a minority stake. Full ownership of Lion Nathan makes even more sense in light of the extent of Kirin’s other Australasian beverage investments in Dairy Farm and National Foods. Combining the distribution will save costs and improve coverage, helping to enhance overall value. All credit to the Kirin management for having commuted what appeared to be minority investments into ones of real strategic value with the caveat that the jewel in the crown would be full ownership of San Miguel Brewery and access to San Miguel’s overseas beer revenues. Buying rare assets such as these is never simple and unlikely to be cheap but given the steep price paid for Lion Nathan in particular, the management needs to reassure investors by demonstrating that synergies are material. What would be even better, and we have said this before, would be for Kirin to reduce its investments in securities, other than ones directly related to its core business. As a start, the termination of the company’s distribution agreement with Pernod Ricard will result in the sale of a 3.74% stake, netting the company approximately Y50bn, but more needs to be done to reduce the company’s debt burden which has risen following these acquisitions to a not insubstantial 85% of shareholders equity. Selling the remaining investment securities at current balance sheet values would reduce the net-debt to equity ratio to nearer 50%, making the level of gearing much more comfortable.

Michael Lindsell
Apr 2009

19 May 2009 LTL 000-077-9