December 2009

LONG ONLY JAPANESE EQUITIES

One company we own that represents particularly good value today is Astellas, Japan’s second largest pharmaceutical company with particular specializations in urology, oncology, immunology and infectious diseases, neuroscience and dermatology. With revenues just under Y1T the company generates c.20% profit margins and in addition has Y500m of cash for investment, yet today its market capitalization is Y1.5T, well below the Y3T or so that we think it is worth. In FY 2006 the company pioneered a plan to raise return on equity (ROE’) from 10% to 18% by 2011 and to improve shareholders’ returns. I say ‘pioneered’ because although many other Japanese companies claim to want to improve ROE most see it as a function of improving profit margins only rather than the interplay of margins, leverage and asset turnover that stood out in Astellas’s more detailed and credible plan from the start. Three years into that plan ROE is expected to be 16%, dividends have been raised 79%, and the company’s shares in issue have fallen by 19% as a result of share buybacks, costing Y425bn, and the retiring of treasury shares. In addition the company has invested in new drug development by investing an annual average of Y160bn in research and development (all of which is expensed) as well as making acquisitions and initiating joint ventures which has involved the payment of an additional Y80bn from 2006 to 2009. Indeed in the last quarter of 2009 alone the company teamed up with Ambit Pharmaceutical to develop a compound for treatment of Leukemia, with Seattle Genetics (through their American subsidiary Agensys) in the development of proprietary antibodies for treatment of cancer, with Ironwood Pharmaceuticals to develop and commercialise a compound for the treatment of irritable bowel syndrome and with Medivation to co-develop and co-commercialise a treatment for prostate cancer. Typically these deals require up-front cash payments followed by profit sharing once commercialised and approved. Profit margins will tend to be lower than for in-house developed product. Of course, we would prefer for Astellas to develop its full drug line-up in house but the timing and commercialisation of such products is unpredictable. Supplementing the drug line-up as they are trying to do whist at the same time raising the return on uninvested shareholders’ funds seems the next best option and one that should deliver handsome cash flow returns in comparison to most other quoted businesses. The concern that the combination of patent expiries and the inability of in-house developed products to smoothly replace such sales has caused the shares to trade under 1x enterprise value (market capitalization minus net cash)/sales, a level of valuation synonymous to a low margin manufacturing company. While expectations on the ability of the company to innovate and allocate capital are so low it seems a good time to own it as positive surprises from the extensive investments the company has made recently (over Y1T amalgamating research and development, acquisitions and share repurchases) are more likely to have a material influence on the share price.

We are pleased that two more of the companies we own announced decisions to buyback shares. First, Morningstar Japan (35% owned by Morningstar US) has Y6.5bn of uninvested cash versus a market capitalization of Y7.5bn and sales of Y2.5bn. Y4bn of the cash is retained in the parent company. Morningstar’s core business of rating and analysing mutual funds and advising and managing assets is highly cash generative and now that the acquisition of the Kabushki Shimbum, a specialist financial newspaper, has been rationalised and transferred on line the company clearly thinks that using cash to invest in its own shares is the most rational use of cash flow. We agree. Ito En, the soft drinks company with the highest market share in green tea beverages, one of Japan’s top selling beverage categories, announced results in line with expectations that showed a significant uplift in cash generations on account of higher profits and diminished investment costs. The business is part financed by preference shares that trade on a hefty 5.5% dividend yield as opposed to pure equity that trades on a yield of 2.7%. Preference dividends are mandated to be 25% higher than ordinary dividends. The management announced a small buyback of the preference shares, quite rational we think given the wide disparity in yields. We own the preference shares believing them to be as, if not more, valuable than the ordinary shares.

Kirin Holdings’ proposed merger with Suntory seems to be on track. Rumours of a merger ratio of 1:0.7 (Kirin: Suntory) would be better than we and others had hoped. It is pleasing to see that San Miguel Corp has sold all of its overseas brewery operations to San Miguel Brewery, thus completing the transfer of all the San Miguel brewery assets into a pure brewing and drinks subsidiary 49% owned by Kirin. In due course we hope Kirin might own the majority in much the same way as they now own all of Lion Nathan.

Michael Lindsell
December 2009

12 January 2010 LTL 000-085-5