February 2010

LONG ONLY JAPANESE EQUITIES

In a backward step Kirin and Suntory decided to abandon their proposed merger. Merging the two companies would have given the combined business 50% of Japan’s beer market and 31% of the soft drinks market. Profits would have benefitted from both increased scale and reduced costs. We had looked at this deal as a nascent sign of the consolidation that is needed in almost all Japan’s industrial sectors. Kirin’s price fell 11% during the month, a wholly rational reaction in our view. Kirin’s soft drinks business desperately needs more scale to compete profitably. Currently it barely makes money. We think that Kirin led the merger agenda and will now look for alternatives. Over the past five years Kirin has transformed its business, adding significant operations outside Japan. In addition to continuing this quest for more scale the company needs to raise profitability from what it has already acquired, which we think is the priority over the next two years. We expect some progress with this aim over the current year. Assuming the company makes no acquisitions, sales will stagnate but nevertheless profits are expected to edge forward. Also, cash generation will improve as capital expenditure is held back, working capital reduced and portfolio investments are sold. All together this should contribute to a reduction in debt and balance sheet leverage, paving the way for better shareholder returns in the future. Dividends are due to rise 9% this year having remained flat over the last two while acquisitions dominated events. It is worth reflecting that, since the company abandoned the stable dividend policy and linked dividends to corporate performance in 2004, dividends have grown at an impressive 12% annual rate.

We updated some earlier work on Nintendo, comparing its profitability with that of its major competitors Microsoft and Sony. Over the seven years from 2002 to 2009 Nintendo’s and Sony’s games divisions generated roughly equivalent cumulative sales, $64bn and $66bn respectively. Although Nintendo’s Wii and DS dominate unit sales today, Playstation 2 was the leading seller in the previous console cycle which is why Sony’s cumulative sales have eclipsed Nintendo’s. Microsoft, a later entrant into the industry without a handheld offering, generated cumulative sales of $40bn within its entertainment and devices division. But in term of operating profits Nintendo dominates, having generated $16bn over that same period implying a 26% margin on sales. In contrast, both Microsoft and Sony have lost money - $7bn and $1bn respectively. The gulf in profitability is a ready reminder of the importance of first party (i.e. in house produced and sold) software. This is central to Nintendo’s business model but lacking in Microsoft’s and Sony’s who prefer instead to license in software from third parties. Even eliminating the capital intensity and the lower margins of hardware sales changes profit dynamics little. Electronic Arts (‘EA’) - which pursues a similar business model to Nintendo and is the largest independent third party software publishing company - generated cumulative sales of $24bn over an equivalent period but profits of just $2bn at less than a third of Nintendo’s margin. So why does Nintendo earn so much more? Its skill is marrying the functionality of the hardware and software and thus creating a unique experience for its customers and then branding its franchises with cartoon characters such as Mario, Pokemon and Zelda which encourages repeat sales and strong customer loyalty. Much of EA’s software relies on sports or film titles which require large royalty payments to the original developers or owners of the content, crimping EA’s margin. The low/negative returns generated by Nintendo’s competitors call into question the wisdom of persevering in the business. But Microsoft and Sony have deep pockets and wider ambitions not necessarily solely associated with video games. Both companies would like to be the supplier of the entertainment hub in the future living room – having an expertise and franchise in video games could be one way to achieve that ambition. Deep pockets not withstanding, these companies will want to milk the current console cycle for all it is worth to try and generate at least some return on their investment.

Deflation has intensified in Japan over the last year with consumer prices now falling at an annualised rate of 2.5%. This provides a hostile backdrop for corporate revenues which to some extent has been offset by ongoing cuts in labour expenses through redundancies and, more significantly, declining wages. Wages have indeed fallen in 2009 but perhaps what is more interesting is the extent to which wages have fallen over longer periods. Total average wages per worker (in enterprises employing more than 5 persons) peaked in 2007 and since have declined 15% to 2009. 15% is not an immaterial figure as it takes the current wages back to the levels earned in the late 1980’s, more than 20 years ago. Record low interest rates and fiscal spending have had the effect of disguising the economic recession over a multi-year period, ameliorating any sudden adjustment but prolonging its effect over many years. One has to hope that similar policies do not have the same effect in Western markets, now battling with similar recessionary forces that Japan faced two decades ago.

Michael Lindsell
February 2010

9 March 2010 LTL 000-088-2