Jun 2004

LONG ONLY JAPANESE EQUITIES

One of the best performing shares in the Fund last month was Ito-En.

It ended the month up 11% ostensibly in reaction to the well-anticipated results for the year ending April 2004. At the same time the company announced forecasts for the forthcoming business year anticipating a further 6% growth. This, we judge, was why the stock rallied. The announcement of the forecasts reminded investors just how dependable earnings from a quality beverage franchise can be. Over the last 10 years Ito-En has increased its sales every year (180% over the period), and its operating profits in every year but one (150% over the period), at a time when deflation was at its worst in Japan. Ito-En’s core brand is Green Tea. Green tea has been the staple recreational drink of the Japanese for generations; analogous to the allure the British have for Indian tea. Ito-En used to sell the dried leaves but over many years branched out into bottling the finished product in cans and, more recently, plastic (‘pet’) bottles served chilled in the summer and hot in the winter. The convenience and the quality, initially a crucial differentiating advantage (keeping canned or bottled tea from going off was an important technological breakthrough), made the brand (Oi-Ocha) the biggest selling tea in Japan. They command 33% of what is now a major non-carbonated soft drinks market.

Ito-En is a family company, led by a modern but autocratic father with plenty of family successors in the wings. They have been astute managers of shareholders capital investing sensibly in production and distribution, brand maintenance and with enough diversity of product in order to have enough variety up of soft drinks to sell to fill their vending machines. Unlike other countries vending machines serving both hot and cold products make up a vital 40% of the market. Vending machines offer a choice of drinks, which is one of the reasons why it is necessary for Ito-En to have a diverse range of beverages of drinks rather than just green tea. The strength of the brand should not be underestimated. Recently Kao Corp, another major holding, launched a competing green tea product that had a high concentration of catechin, a chemical that apparently helps to prevent certain cancers. At a higher price the launch has been successful for Kao but also has helped boost green tea sales for Ito-En as well, by association.

The beverage industry is notoriously competitive. Kirin beverage, a majority owned subsidiary of Kirin Brewery, one of our largest holdings struggles to maintain 5% margins yet this is one the better performers. Their problems stem from their diverse and ever changing portfolios of brands with little longevity and no real loyalty from customers. At least with Ito-En everyone knows what they stand for.

Ito-En is not cheaply priced as the shares have done well of late but for the predictability of the business a 4.5% free cash flow yield with annual growth of at least 2% is adequate value compared to most businesses we analyse in Japan. Dividends have risen 175% over the last 10 years and 43% over the last 5. In the last two years the company bought back shares in addition to paying dividends. In those years dividends and share buybacks accounted for 44% of net earnings as opposed to 27% in the prior 5 years. Slowly the company is raising payments to shareholders. Now that all debt has been paid off this might increase even further in the future, we think. It would be good to see return on assets raised to at least 10% from the pedestrian 8% average over the last 7 years. That should be possible if ROE increases above 15%, a low figure for comparable businesses in other markets and one the internal targets of the company see exceeding by April 2006.

We were able to buy shares in Ito-En at a then prospective free cash flow yield of 5.8% in late 2002. At the time we though it was good, but not outstanding value for business. This may sound penny pinching now that the shares are up 45% from that level but when we compare values of similar business in other markets it puts this reticence into perspective. AG Barr, a UK based carbonated beverage franchise we own in other mandates we manage with similar business characteristics and growth prospects, although only one tenth of Ito-En’s sales earns significantly higher operating margins (12% versus 7%) and has a higher ROA of 11% versus 8%. In terms of valuation Barr’s free cash flow yield is 11%, dividend yield 3.8% and P/E 12x all far more attractive than Ito-En’s both today and when we bought it. The only fundamental working in Ito-En’s favour is the discount rate currently 2.8% in Japan versus 4.9% in the UK is one assumes that the yield on the longest dated bond is the best proxy. Even so, that hardly compensates for the gulf in valuation and speaks volumes for the difficulty in finding good value in Japan today.



Michael Lindsell

14 Jul 2004 LTL 000-024-7