Jul 2007

LONG ONLY JAPANESE EQUITIES

We have been digesting 1st quarter fiscal year 2007 results. On the positive side Nintendo reported exceptional figures and revised estimates for the full year.

Now the company expects sales of ¥1.4tn (up from an average of ¥500bn per annum in the 10 years before last year) and operating profits of ¥370bn. We had thought that sales of ¥1.5tn and operating margins of 30% (¥450bn) should be possible and now, only in the first full year of the Wii’s launch, these figures are already attainable. It is possible that the success of the company’s new strategy of appealing to a wider audience of non-traditional gamers may create virtuous network effects amongst users, that boost sales even further than we had earlier anticipated. The share price has advanced following the positive revisions and, at above ¥50,000, is up more than five times compared to its low in 2003. Despite this, the prospective dividend yield remains highly competitive at 1.7%, almost 40% higher than that of the market.

Astellas reported good figures, even better than expectations. We expect the company to announce significant share buybacks later on this year in order to improve shareholder returns to match the forecasts of improving return on capital announced late last year.

Aderans reported disappointing quarterly results and forecasts for the first half of the year. Their traditional wig business, especially those targeted at males, has been buffeted by slack demand and robust competition, which shows little sign of abating. The company is responding with promotions and new products. Although hair loss remains a growing problem (no pun intended) amongst middle aged Japanese men, the stigma of baldness is less than it used to be and hair replacement treatments are now a viable alternative. We think the female wig business has better long-term demand characteristics as the population of elderly ladies wanting to disguise a thinning pate grows and the use of wigs as fashion accessories for more youthful females expands. The company has been investing in hair loss treatments abroad, especially in the USA where they target a 15% share, the largest position, in a fragmented market. While the company struggles with domestic demand and digests the additions to its overseas business it relies upon its repeat business from existing customers which is not only high margin but also a reliable source of income.

The price of Credit Saison continues to fall as the uncertainty about future demand for unsecured loans continues and as consumer spending in general remains in the doldrums. While it does so we continue to become more enthusiastic about its long-term value, especially in respect of the company’s expanding credit card processing business. The company is actively seeking new partners at the same time as building up its business with recently established joint ventures.

We have begun to establish a new position in Morinaga & Co. Japan’s fifth largest confectionery company. In an international context this is a small company. Cadbury, the world’s largest confectionery company, with a 10% global market share, has confectionery sales of the equivalent of ¥1.1tn. To compare, Morinaga sales are ¥170bn. To put it in a Japanese context, the total confectionery market in Japan is just over ¥1tn, with the top five companies accounting for approximately 65% of sales. Like other sectors of the Japanese domestic food industry the market is extremely fragmented, which means that companies are unable to take advantage of scale economies and have to surrender pricing to distributors, suppliers and packagers more than they would other wise have to do. We think the industry is ripe for consolidation, especially as the background environment for sales growth is poor, with the population set to decline. There are signs that this is now beginning. In 2007 alone there have been three transactions. Tohato was bought by Yamazaki Baking (the leader in the industry) which also took a controlling majority stake in Fujiya, a struggling competitor, and only last month Cadbury bought Sansei Food. The combination of stagnating sales, without economies of scale, and the lack of innovative management sheltering behind such predictable cash flows means that average operating margins are below 5%, whereas experience tells us that similar businesses in other parts of the world without these impediments achieve margins above 10%. Even if sales are stagnant a ¥1T market is a significant one, especially as it features a number of long lasting brands as are generally found in any confectionery market. Morinaga’s business is no exception and is characterised by a series of important brands, the best of which include ‘Hi-Chew’ candy and ‘Chocoball’, ‘Koeda’ and ‘Dars’ chocolates. In addition, the company has other important brands in ice cream - ‘Choco Monaka’ - and health drinks - ‘Weider in Jelly’. The short-term prospects for the company are stagnant at best - after all, consumption is slack, input costs are up and pricing power is weak. Paradoxically these fundamentals may be helpful as they should help to concentrate the minds of management on the need for strategic change in the industry. The shares are valued on a free cash flow yield of 5%, with net cash accounting for 15% of market capitalisation, and a dividend yield of 2.3%. Apart from the dividend yield, value is fair rather than compelling. On the other hand the shares are valued at 0.3x enterprise value to sales (‘ev/sales’), which even for a confectionery business in Japan is exceptionally low (Sansei Food sold for 2x sales, Tohato 1x sales and even control of the scandal tainted Fujiya - the company used expired ingredients in their cake products - was acquired for the equivalent of 0.7x sales). We think a business of the quality and size of Cadbury’s is worth nearer 3x sales. Clearly Morinaga is nothing like Cadbury today but on the other hand it is also worth a lot more than it is valued at currently and even at a modest 0.5x ev/sales would be worth a price at least 40% above today’s.

Michael Lindsell
Jul 2007

15 Aug 2007 LTL 000-051-4