November 2009

LONG ONLY JAPANESE EQUITIES

Last month I was in Japan knocking on the doors of some the companies we own interspersed with visits to new ones. Unlike London, where there are few visible signs of recession, in Japan it is more obvious. The country lacks the vitality, the hustle and bustle that I can remember from the past and instead the weekdays felt like Sundays - glorious if you happen to be travelling around with a hectic schedule but also symptomatic of a creeping malaise that is deflation. What is worse is the widespread expectation that this is going to continue, with some corporate executives having given up trying to do anything about it or unable to conceive how things might change for the better. Amidst the gloom I am more optimistic than I have been for many years with the important caveat that conditions may worsen - in fact need to worsen - in the short term to induce necessary change through restructuring and deregulation that should provide the platform for a sustainable recovery.

In a microcosm, what is happening at Aderans is indicative of what could happen in the wider economy. Aderans has all the makings of a good business, albeit a specialised business with a limit to the potential for its sales. As our regular readers will know, we like businesses that can engender repeat business revenues that last for many years and the business of selling wigs is just such one. Such repeat sales tend to be higher margin as little expense is incurred in generating the recurring revenues. However, Aderans has experienced a number of problems. First, the men’s business on which the company was founded was in long-term decline as the stigma of baldness on which its sales depended is less than it was, if it has not disappeared altogether. Next, in the desperation to maintain revenues the company’s salesmen ‘pushed’ sales aggressively, alienating customers. Then, in a search for new sources of revenue the company diversified, frittering away shareholders’ capital. This was symptomatic of a company that had little appreciation for shareholder value and a more recent record of allocating capital poorly. The result of all this was a boardroom shakeup earlier this year, engineered by non-Japanese shareholders. New talent has been brought in and the founder, who remains a 10% shareholder, was reappointed Chairman. The company is rolling out a complete revamp of its brands (amalgamating some, abandoning others), renovating its outlets, retraining its staff and introducing a new advertising strategy and campaign. The emphasis is now on improving customer satisfaction rather than ‘pushing’ sales at any cost as in that way repeat sales should be encouraged. Somewhat inevitably, the initial effect of this is an accelerating decline of sales as ‘sales push’ is abandoned and old advertising stopped. Sales in the second half of the fiscal year will likely fall 25% and significant operating losses will be incurred. We expect to see an improvement from 2010 although it will take longer for profits to fully recover given the investment cost associated with the new strategy. It is a good sign that the company is more open to discuss and articulate its problems and promises increased transparency in the future as transpired at my meeting. Also encouraging is the obvious alignment of interest between the management and shareholders, with all parties having an interest in the new changes working. We expect to see other companies following a similar path.

I also visited Namco Bandai, which I think is on the mend. The company specializes in developing children’s characters, which it then distributes and merchandises through a number of media platforms including toys (this is usually where the characters are first trialled), games, arcades and visual and music. Successful characters can generate revenues over many year across a number of media outlets and can earn the company high returns on capital. Obvious successes include Power Rangers and Tamagotchi that still generate material revenues today. For future success the company needs to develop new core characters. One such success is ‘BEN10’ a character developed outside Japan, which is a first for the company. Namco Bandai needs to raise its profile outside Japan so a success like this one is important to build on. The company’s core franchise is in Japan where they have been particularly successful with the 1-5 years old market, which is currently growing at 20% p.a. with a diverse range of characters led by the 29 year old ‘Mobile Suit Gundam series’. Conversely, in the 6-10 year old market, Namco Bandai has suffered lately at the hands of competitor Tomy. In games, traditionally the most profitable of their businesses, the company has a strong line-up for the second half of the year and has already achieved successful title releases. Arcades is lower margin and has been recently rationalised with the number of sites in Japan falling from 300 to 230. But the key to success is overseas, where there is scope for growth, and in games which earn high margins. Thus the company’s strategy is focused on building its franchise in these areas around successful new characters like ‘BEN10’ and a recent Japanese export ‘Masked (Kamen) Rider’.

I was also reassured by my visit to Ryoyo Electro where we have recently added to the position. The company has been bearing down on costs and lowering the break-even level of sales. Management remains cautious about demand and could cut back more if necessary. Despite the awful environment the company remains cash flow positive and is committed to maintaining its dividend. Cash reserves are plentiful (167% of market capitalisation). Some would be required to expand working capital in the event of a rise in sales but the rest could be used to acquire new customers, which the company expects to be able to do when industry consolidation begins.

Michael Lindsell
November 2009

11 December 2009 LTL 000-084-7