Nov 2005

LONG ONLY JAPANESE EQUITIES

When in Japan last month we visited six of our long-standing holdings and two brand new positions, Obic Business Consultants (‘OBC’) and Medikit.

OBC produces business application packaged software for small and medium sized companies. Its range of products caters for the smallest enterprise as well as the more sophisticated packages that can be customised and require more support. The cheapest product sold through retailer’s costs £400 the main products include stand-alone accounting, payroll, sales control, tax packages etc. sell for £750-£1,250 and the most sophisticated ERP type products for multiple users in one company sell for £6,000-£15,000. OBC has the top market share in Japan of approximately 30% for sales of business software to small and medium sized companies. The company has pricing power as this year it raised prices, especially of the cheaper products. It has 210,000 customers to whom they have sold 400,000 products. New package sales are growing at 30,000 per annum. Around half the customers take out annual maintenance contracts which give them basic software and tax reform updates and telephone enquiry services. 90% of these are automatically renewed. The most attractive aspect of the business is once a company becomes a customer it rarely cancels and almost always upgrades to either replacement software or a more sophisticated product. In fact cancellations are more often than not due to bankruptcy than for any other reason. As a result OBC knows with some certainly that when they introduce a new suite of products as they plan in 2006-2007 based upon Microsoft’s new .NET product, they have a guaranteed customer base even before they seek out new customers. In advance of these new launches business is relatively weak as customers delay purchases and as the company has to spend more than normal on development costs. As a result profits are likely to be down this year. Nevertheless the company has a healthy cushion as its average operating margins are 40% and cash and investments were 45% of market capitalisation. We were able to buy a 2.5% position for the Fund at a free cash flow yield of 8%, subtracting the cash from the market capitalisation. This valuation is especially compelling as we expect these cash flows to grow materially from FY 2007 as new products are introduced. Our only concern is how the company manages its retained earnings. Much of the cash is invested in long-term income yielding assets such as REITS and some mutual funds. In our view the company would do better either repurchasing shares or preferably buying smaller competitors in order to add customers. However in our meeting with management they made it plain that the policy is to grow organically for the while, which we think may open them up to competition in a fragmented market sooner than need be the case. We will have to monitor this carefully.

Medikit is a recently listed manufacturer of intravenous needles and catheters for dialysis as well as other blood related medical equipment. It is a relatively small company with annual sales of Y10bn (£50m), with a competitive edge in processing resins give these products the functionality they require. Healthcare and medical services especially those that Medikit is producing are growing as the population ages, on the other hand the reduction of government reimbursements for medical expenditure is forcing prices down. The net effect of this makes for stable low growth business for the company. Competition is evident particularly from Terumo, but market shares in dialysis are high affording the company some cushion. The company is expanding overseas not only to sell its products but also to access cheap manufacturing, which should help to offset selling price pressure in Japan. Operating margins are 30%, but are likely to fall over time. It seem reasonable that they should have little downside below Terumo’s at 20%. The company is valued at 1x enterprise value (‘EV’) (market capitalisation-net debt)/sales, a 6% free cash flow yield and a 1.8% dividend yield. This we judge as good value for as business with such high margins. Interestingly in the USA, Johnson and Johnson have just bid 5x EV/sales for Guidant, a much larger business selling similar types of products with comparable profitability. If nothing else this value confirms that at 1x EV/sales there is some cushion to the downside, i.e. a comfortable margin of safety.

Michael Lindsell
Dec 2005