May 2009

LONG ONLY JAPANESE EQUITIES

Aderans shareholders voted down the management for the second year running. This year the management teamed up with Unison Capital who they had brought in to restructure the business. The problem was that Unison wanted 35% of the company for their efforts at a bargain basement price, a deal that Steel Partners, the company’s largest shareholder, was not prepared to support. And other shareholders were not disillusioned enough to sell at current prices, even though the management themselves were prepared to sell treasury shares to help the deal along. Now that the deal is off and the discredited former president has resigned, the board is once again dominated with Steel Partner appointees. A year has already been wasted as the company flirted with Unison’s proposal, initially with the approval of Steel Partners. The new management needs to reinvigorate staff, who must by now be demoralised, confused and threatened by the musical chairs at the top. They need to take urgent action to shore up current revenues. The priorities must be to stem the loss of market share in the women’s wig business that has most future potential, given the ageing population; to cut costs, especially excess staff; and to shed excess assets. None of these are easy tasks in the current economic environment. Aderans is fast becoming a test case for what a foreign shareholder backed board can do to improve business returns in Japan. From our perspective progress is slow; we hope change will quicken from here.

Now that most results are in for FY 2008 market participants will in due course divine prospects for 2009 and beyond. So far it doesn’t look pretty. TOPIX index net earnings are forecast to be negative this year and dividends are expected to decline for the second year in a row. Not surprising given the economic backdrop but perhaps inconsistent with the recent buoyancy of the market. Market dividends are already falling but will decline at a faster rate next year as the cash squeeze on corporations intensifies. Prospects for our portfolio are better even if disagreeable compared to the experience of the last five years. At the moment our businesses (non-financials only) expect profits to decline 19% on top of a 21% decline last year. This takes profitability back to FY 2005 levels. Major contributors to these falls in both years were Canon and the pharmaceutical companies Astellas and Takeda, where patent expiries have either hit profits directly (Astellas in 2009) or the need to replace revenues with acquisitions has caused research and development budgets to soar (Takeda in 2008). More stable are portfolio dividends that fell 3% last year and are expected to fall 6% this year. Six companies are predicted to cut dividends this year: Aderans, Mabuchi Motor, Nintendo, Osaka Securities Exchange, Ryoyo and Takefuji, and four companies to hike dividends: Astellas, Earth Chemical, Keyence and Ozeki. Most dividends will remain unchanged. Of the companies that plan cuts, Aderans and Takefuji’s are responding to poor profitability, OSE and Nintendo to strict payout policies (i.e. where dividends are a direct function of changing profitability) and Mabuchi and Ryoyo might have been expected to maintain their dividends despite poor profitability as both companies have vast cash reserves that could be used to hold dividends in tough times such as now.

Nintendo, our largest holding, has been a notable poor performer this year having registered a total return in 2009 of minus 21% against a rise in the market of 6%. Investors fear for profits, especially now, as the company has signaled a 12% fall this year. They surmise that having reached such heights in recent years profits can only but shrink. We agree that profits may have reached a short-term peak but we disagree that profits will fall that much, which is the inherent fear of other investors. Instead we think the company will spend the next few years harvesting the installed base of hardware of 100m Nintendo DS’s and 50m Wii’s. Other software companies will be striving to deliver must-have software to this captive audience, the largest in the industry. Some will succeed which will guarantee large unit sales and big royalties for Nintendo. Of course, Nintendo will continue to develop its own titles which, if history is a guide, should sell the most. Successful software will also drive further hardware sales perpetuating the virtuous cycle that rewards the winners in this industry. Earning an average operating profit of Y400-500bn per annum for the next few years is not bad in the current environment. As enterprise value is today just Y2,000bn, it seems investors are offered a particularly generous return on an investment at today’s price and one that few other companies can match. We are keen to keep our maximum commitment to the company while its price languishes so unjustifiably.

Michael Lindsell
May 2009

10 June 2009 LTL 000-078-7