June 2009

LONG ONLY JAPANESE EQUITIES

Nintendo has proved a disappointing investment for over a year, having done spectacularly well prior to 2008. Aside from the decline in the market over that period, we think Nintendo’s decline stems from general investors’ belief that demand for the existing products, Nintendo DS and Wii, have peaked and will now fall until the new generation of products is launched. This provokes uncertainty, as there is no guarantee that Nintendo will have the lead versus the competitors in the new cycle as they do in the current one. Our view, however, is that there is much to reap from the existing cycle. Nintendo has plenty of ideas, imagination and guile to develop new versions of software that appeal to customers who might never have previously contemplated playing a video game. And more importantly for this year’s success, well known third party game software developers are launching products that have taken some years to develop, fully utilizing the intuitive and innovative control functions of the Nintendo machines. Third party developers want to produce their best products and franchises for the machines with the biggest installed base. This has been Playstation 2 - with 140m units sold - but in the current generation it is the Nintendo DS (over 100m units) and Wii (over 50m units). Most developers made the mistake of expecting Playstation 3 to be a runaway success like its forebear. When Playstation 3 proved to be a flop (less than 20m units sold to date) it took time for the companies to reorientate development to the more successful Wii and only now are the fruits of their labours hitting the market. In this industry, quality software sales drive hardware sales. Up until now it has been Nintendo’s first party software doing all the work. But this year third party titles should help make the running, especially as Playstation 2 is coming to the end of its life with minimal new software support. Rather than a gradual decline in Nintendo’s sales we see an extended plateau supported by the ever expanding installed bases. After all why, with Playstation 2 appeal concentrated only on the core gamer demographic of boys and young males, should not the Wii, that appeals to a far wider demographic, sell many more units over its lifecycle? Just getting to 150m units, the likely lifetime sales for Playstation 2, is only three times what Wii has sold to date. This extended plateau earns shareholders a free cash flow yield of 8% and a dividend yield of 4.8%. Not bad when the averages for the market are 4% and 2.0% respectively.

More news from Aderans. The management has cancelled the company’s treasury shares and the anti-takeover measures that the previous management had introduced before the board changes sponsored by Steel Partners . Two small steps to rationality but progress nonetheless. We look forward to further measures more directly concerned with addressing issues in the operating business that is inevitably struggling in the current environment.

We visited the management of Ozeki, a small fresh food retailer which operates mainly in Setagaya, a well-to-do suburb of Tokyo, and one of the few companies that is growing in the current hostile environment. Growth is driven by positive existing store sales, a function of clever and competitive merchandising and new store openings amounting to 2-3 per annum on a base of 30. Opening new stores is costly, a reason why we are put off investing in other retail formats, but for Ozeki capital expenditure costs fall well within cash flow because operating margins are so high (8% versus 5% or less for typical supermarkets). Cashflow has been so prodigious that it has funded an 18% annualized increase in dividends over the last 10 years and a build-up in cash reserves over that time from Y2bn to Y14.5bn. Current market capitalization is Y50bn. Return on capital is above 30% and has risen as the company has improved its efficiency and the cost of new store openings has fallen. However, return on equity is much lower, at 13% and falling, as the dead weight of accumulated cash dampens returns. Last year the company spent Y1.4bn on share repurchases at a price that equated to a 9% free cash flow yield. We hope for more such purchases or a rise in the dividend payout ratio so that shareholders can more directly benefit from the efficency gains from the operating business.

We are in the process of selling the remainder of our holding in Takefuji. This investment has been a tortuous experience for us and one we hope never to repeat. The final straw was the lack of any signs of replacement funding for the business this year. This is forcing the company to accelerate the repayment of its loans. In doing so it is cutting the business to the bone and ceding market share to bank funded competitors who have a more stable source of funding. Winning such business back will be hard in an environment where bank funding costs remain at a significant discount to the wholesale markets. Also, shrinking assets faster than anticipated in the current environment heightens the risk of provisioning which additionally chips away at the net worth of the company - that anyway has been diminished by the bigger provisions that the company has had to bear for repayments of excessive interest claims (see February 2009 monthly). It was the company’s prodigious excess capital that gave us comfort with the investment in recent years. Now much of that is gone.

There are lessons to be learnt here. First, we took comfort from the assumption that, however unattractive it is for businesses to charge customers high interest rates, the government would tolerate unsecured lending undertaken by Takefuji and its competitors as it offered a vital and necessary service to consumers who otherwise would resort to even more unscrupulous providers of finance. Then we were too dismissive of the zeal of government to bring the regulation of these non-bank financial businesses under the aegis of the Ministry of Finance, at whatever cost. And finally, reassured by the transaction prices of other businesses in the industry, we failed to recognize that the essential requirement for the future, with the onset of the credit crunch and the evaporation of non-Japanese funding from the market, was a bank funded model. Almost all businesses are subject to some form of regulation but some are more burdened than others and thus more vulnerable when regulations change. This is something we take into account when considering the durability of business models we examine. We misjudged that the political sensitivity of Takefuji’s made it one of these more vulnerable candidates and as such the combination of stricter regulation and bureaucratic and judicial fiat has wounded the business model badly compounded by the dearth of funding and Takefuji’s adherence to a wholesale funded business model making a difficult situation worse. We will be much more thoughtful and perhaps circumspect in the future about the impact that changing regulation might have on our candidate investments. Additionally, we need to be more attuned to the influence of bureaucratic edicts which in Japan can have more of an influence on long-term prospects than in other countries.

Michael Lindsell
June 2009

8 Jul 2009 TLT 000-079-0