Apr 2004

LONG ONLY JAPANESE EQUITIES

Late April marks the beginning of the annual results season in Japan and although most is discounted the tradition of providing business forecasts for the coming year can produce some surprises.

Canon reported better than expected Q1 profits and forecasts for the full year. We revised up our share price target even though this years results may be tempered by the increased investment cost for their flat screen business. Kirin Brewery announced their 1st quarter results for FY2004. The company is one of our largest holdings at 7% of net assets. The results were encouraging as operating profits advanced by 46% on a 4% rise in sales. There was no revision to the forecast for the year but so far business is ahead. Most of the improvement can be traced to a recovery in sales of soft drinks, from the 60% owned Kirin Beverage, continued growth from their overseas businesses and strong sales for alcoholic fruit drinks. There is a hope that the beer business may be stabilising after many years of decline caused by deflation and loss of market share to Asahi Breweries and may even contribute materially to recovery over the crucial summer months as comparisons for sales this year should prove easy versus last year’s unseasonably cold summer.

Whatever the short term prospects, the last 7 years have been a harrowing time for brewers in Japan. Faced with a steady erosion in volumes brought about by restrained consumption the beer companies resorted to a price war amongst themselves that shattered their profits. In response Kirin conceived a new product, low malt beer, flavoured predominantly from rice and artificial flavourings instead of hops and malt that was materially cheaper because the government in taxing beer taxed the malt content. For a while this reinvigorated sales through lower prices but never did anything to stabilise profits. All price benefit was passed to the consumer. Last year the government raised the tax on low malt beer causing sales to dive and beer volumes overall to decline by 6.4%. We tell this tale because investors in the West have come to expect beer companies to grow modestly though thick and thin. In a deflationary environment selling beer can be a difficult business as well. Even so Kirin though all these problems has generated free cash flow in all but one year of the last twelve. Growth has indeed been hard to come by but compounding wealth while the value of money increases cannot be such a bad thing. This cash flow has been invested in a number of ways. It has funded a nascent pharmaceutical businesses based on yeast technology, which Kirin should know plenty about. It has spurned a flower growing operation and a number of food and nutrient businesses. In addition two higher profile investments were made overseas, one in 46% of Lion Nathan, Australian and New Zealand’s 2nd largest brewer, and a 15% stake in San Miguel the Philippines’ dominant local brewer. In aggregate these diversifications have paid off in that they generate a significantly greater proportion of earnings than before even if they represent a rag tag bag of investments with little synergy or overlap. Kirin is an example of a great company, a fantastically durable business run by indifferent management. The reassuring characteristic of great businesses is that even though it has been poorly managed it still generates free cash flows that other companies would die for. What needs to happen to turn Kirin into an investment as fantastic as the business? A combination of a stabilisation of beer market share, new products to grow the top line, better management of retained earnings and less diversification away from their core competence of making and selling beer. So far the newest product, the alcoholic fruit drinks have been a big hit and the biggest non-Japanese investment, Lion Nathan, is doing well churning out cash in the way that beer businesses can do. Recently the management announced their intention to increase the dividend by 8% this year the first change in 10 years. Maybe things are changing even if it is at a glacial pace. If so there could be a lot more out performance to look forward to.

Another large holding is Kao Corporation at 5% of NAV. Kao’s is easiest described as ‘Japan’s Proctor and Gamble’. It sells detergents, cleaning products, personal care products such as shampoos, feminine and baby care products, functional foods, and cosmetics mainly in Japan but also in Asia. Kao’s results beat expectations and forecasts for next year show modest but positive ambitions, which we view as realistic. What was more interesting was Kao’s projection of a 19% increase in this year’s dividend. In addition Kao has been serial repurchaser of its shares. Not only did the company announce the cancellation of some already held in Treasury but in addition an ambition to buy back 20m more this year, adding to the 85m repurchased since the fiscal year to March 2000, 14% of that years equity. Over the past 5 years Kao has generated an average of ¥64bn in free cash flow (compared to an average market capitalisation of ¥1,646bn). 24% was paid in dividends, 72% funded share repurchases and 4% retained. Return on equity averaged 13%. Kao is doing exactly what we hope the Japanese companies we hold in our portfolio will in time do: distribute the bulk of their prodigious free cash flow to shareholders (see discussion in Feb 04 report). Our only gripe with Kao is the balance between share repurchase and dividends. With most companies we would prefer the bulk distributed as dividends because we suspect that the motivations for repurchase are not what we would like them to be. We think many companies buy back shares to prevent the free float falling in to what they consider to be unstable hands or to simply support the short-term value of their shares. We want companies to buyback their shares because it represents a better use of retained capital than expanding their business and it generates an accretive increase in real returns for remaining shareholders over a measurable period of time. In Kao’s case share repurchases since their fiscal year to March 2000, have taken place on an average historic free cash flow yield of 4%, which provides some risk premium over bonds today but not enough in our view to wholly account for future risks. Despite this we are happy holders of the shares and recognise that not only have the management invested the capital at their disposal successfully in the past but they also have superior knowledge about their business that may allow them to tolerate a lower starting yield or be more confident on growth than us. The disappointing absolute performance of the shares validates our preference for a higher dividend distribution we think. The average price of the shares in the year to March 2000 was ¥2,950. Today they are some 12% lower at ¥2,600. Over that period dividends have advanced 60%, and together with this years hike the yield on the shares has by implication risen from 0.7% to 1.5% whilst 10-year bond yields are unchanged approximately at 1.7%. Maybe now the shares will receive some support from today’s level of distribution. Certainly the 11% rise in the share price since March suggests this.

12 May 2004 LTL 000-024-7