August 2009

LONG ONLY JAPANESE EQUITIES

As expected the Liberal Democratic Party (‘LDP’) was trounced at the election and the Democratic Party of Japan (‘DPJ’) gained power with a massive majority in the lower house of parliament. However, the majority is just under the two thirds necessary to overrule legislation rejected by the upper house - where although the DPJ is the biggest party it does not have an overall majority. That may change next year when one third of the seats are up for re-election but such an outcome is dependent on the DPJ keeping up their popularity. Right now, the DPJ are keen to woo like-minded MPs in smaller fringe parties to ensure they have the muscle to pass key legislation through both houses. We will need to see who takes up the key ministerial appointments before we can predict whether there will be much immediate policy change. Instinctively, we think the market will be underwhelmed, partly because the government is unfamiliar with power and will prove too cautious, partly because its room for manoeuvre is limited as tax revenues fall and mainly because, at least initially, senior more conservative MPs, many who defected from the LDP and thus have similar political affiliations, will claim the top posts. Many observers view this transfer of power a seminal event for Japan. In retrospect it may look like that but the real motivation for change is the continued squeeze of the economy that will force politicians to take tough decisions that they would prefer to put off.

The Osaka Securities Exchange (‘OSE’) reported another quarter of good earnings in what should be a difficult environment for the business with market trading volumes falling. The OSE’s resilience is born from a dominant (if not quasi-monopolistic) market position in trading futures and options helped by adept management. First, fees earned on trading options have risen in the current environment as financial institutions are forced to trade exchange traded contracts rather than over the counter ones; second, two years ago the OSE introduced the Nikkei ‘mini’ for individual investors, a futures contract with an underlying value one tenth of the regular contract that appealed to individual investors and has helped offset the fall in regular futures trading fees on account of falling market volumes; third, last year the company bought the JASDAQ exchange which it merged with its own small company exchange, Hercules, in the attempt to create the new small company exchange of choice for Japanese investors. Not only are revenues higher than projected but also swingeing cost cutting has ensured that the exchange is already profitable, with it now expected to contribute materially to earnings for the full year. As a result earnings in the first quarter saw the company make 78% of its half-year target, suggesting that this year’s profitability should be considerably better than expected. The second half of the year may yet prove difficult but expecting the shares to fall further in order to increase our position in the company, as we did late last year, might prove unrealistic.

Namco Banda ireported disappointing earnings and revised down its expectations for the year. This has been an unsatisfactory investment even in the context of a sharply declining market and the hostile economic environment. What is particularly galling is that the company has failed to launch successful hit video game titles for the Nintendo Wii and DS platforms, having instead concentrated its development on the underperforming Sony platforms. It is galling because Namco Bandai’s child friendly content was always more likely to appeal to Nintendo users rather than Playstation’s. Indeed its content is so compatible that Nintendo themselves have a small stake in the company. Following the success of the Nintendo products the emphasis has now changed but it will take some time for results to materialise. Other businesses have been hit by the present slump in consumption, especially in toys which still accounts for 40% of sales. Apparently, demand for merchandising spinoffs has been especially weak. The key to the company is its ability to earn revenues from its portfolio of characters, the most resonant of which are Gundam, Power Rangers and Tamagotchi. There is a sense that the promotion of these key properties and other lesser known ones has lacked the imagination necessary to drive revenues and build audiences, a situation that needs to be addressed. Financial strength (cash represents 45% of today’s depressed valuation) is an obvious comfort but is not enough of a panacea to shield the company for the declining fortunes of its operating business. We plan on taking up these issues with management in the autumn.

It looks as though we might lose another investment to takeover, this time in the form of a management buyout by the latest generation of the founding family of Ozeki, the fresh food retailer which services customers in prosperous suburbs of Tokyo. It is a holding we began to accumulate just a year ago. Currently the family that dominate the management own approximately 40% of the company. Our gripe is with the price, which we think fails to account adequately for the idle cash and securities that have amassed over a number of years. Strong free cash flow generation has boosted cash and short term securities per share from Y162 in 2000 to Y1,242 in 2009. Earlier this year, following two meetings with the management, we wrote to the company expressing our concern that its return on equity was suffering (despite stable to rising return on capital) because the return on the rising idle cash was so low compared to the return on the operating business. We acknowledge that reserving some cash is prudent to fund unanticipated investment or working capital needs but today’s hoard - at 33% of market capitalisation - is excessive. The offer price is Y3,750. The three year moving average of earnings per share is Y243. As the company is growing this figure is conservative as it understates potential, yet at the offer price the value of the company (having deducted the value of excess cash) is just 10x earnings, too cheap for a business that is stable and predictable, that generates high margins and prodigious cash flow. We are agitating for a better deal.

Michael Lindsell
August 2009

7 September 2009 TLT 000-081-0