September 2009

LONG ONLY JAPANESE EQUITIES

We tendered all our shares in Ozeki this month, having failed to extract a better price from the management in their buyout of the minority holdings. Investing in a company dominated by one shareholder always brings risks, especially in the event of a takeover or sale. We have to make a judgement when we invest that these risks are smal relative to the potential uplift in the value we see in the investment. This proved to be the case with Ozeki. Even though we sold at a less then optimal price we made a very decent return of approximately 40% in a year. We know other holders of Ozeki, whose combined holdings amounted to approximately 20% of the company, all of whom were equally disenchanted with the MBO price. In other jurisdictions such a body of investors would most likely have extracted some price concessions from the acquirer. As it was the ‘squeeze-out’ provisions - that is, the mechanism for majority shareholders to forcibly buy out the minorities and delist the shares - are weighed against minority shareholders in Japan. For instance, in the UK such provisions only come into force when the majority shareholder owns 90% or more, yet in Japan it is enforceable at the level of ownership at which a supermajority (67%) can be achieved at an EGM. As a result an acquirer can brazenly ignore the protestations of minority shareholders even if they collectively own more than a quarter of the company. This is what happened in Ozeki’s case. We know that these ‘squeeze-out’ provisions are under review currently at the Japanese FSA and the TSE and the fuss kicked up in this case will, we hope, help to add to the argument for change.

Kirin’s corporate repositioning continues. This time the company plans to merge with Suntory, a private company with interests in beverages, beer and other alcoholic drinks mainly in Japan. Combining market share of the two companies will transform Kirin’s positioning in key areas. In beer it will rise from 37% to 50%, in wine from 16% to 39%, in low alcohol products from 38% to 68% and most importantly in beverages from 11% to 31%. It is in beverages where Kirin is weakest and it has most to gain from Suntory. Conceptually, the deal is exactly what we have been hoping Japanese management would do to counter weak profitability and stagnant end markets. If it goes ahead the soft drinks market in Japan will become a step more concentrated. Four companies will account for 80% of the market. Still more consolidation is needed in the very fragmented remaining 20%, but pricing should improve for the larger companies – necessary in an industry that earns profits that we think are less than a third of similar companies in overseas markets. On the negative side Suntory has some debt which will increase if it succeeds in buying Orangina from Blackstone for what seems a full price. Also, we think the combination might run into anti-trust issues with the resulting market shares in low alcohol products. Of course, all this talk is academic at the moment as we need details on the merger ratio and its approval by anti-trust regulators before we can be sure that it will be accretive to Kirin shareholders. The combined business will have considerable scale on a global basis. It will rank 2nd amongst all beverage and drinks companies in terms of sales but 5th in terms of operating profitability. The challenge for management will be to optimise economies of scale by improving returns on sales and capital.

Late in the month Nomura announced plans to raise more capital, this time Y430bn on top of the Y310bn raised earlier in the year. Taking account of these issues and the potential dilution from the issuance of a convertible security, this year shareholders have suffered a huge dilution effect of 89%. We have always stated that the part of Nomura we like most is the domestic retail and asset management business. We currently value that at Y1.9T. As we were able to buy our Nomura shares earlier this year at a market capitalisation of approximately Y1.2T there was a significant margin of safety between the two. Obviously Nomura has other businesses, which are worth something, notably the domestic corporate finance business, but we have reservations about the current aim to expand the global wholesale business through the acquisition of Lehman’s Europe and Asian operations and by investing Y250BN of the recent capital raised. Wholesale securities operations, domestic and overseas, are a necessary adjunct for an investment bank such as Nomura although only in so much as they support the product development and facilitation of the retail and corporate finance business. But Nomura’s management seem intent on building the wholesale business into a significant profit centre even though the return on capital from this business is historically less than the ones we are interested in. Wholesale broking is a highly competitive and unpredictable business, especially for participants operating out of home markets. Also it can be dominated by personalities who have a habit of moving on after relatively short periods, certainly in relation to the time horizons we consider for an investment. Nomura’s current push into this area is led by Shibata, who made a success of Nomura’s business in London by employing Guy Hands and his private equity team but his time with Nomura will be finite. Who succeeds him? He is cognisant of all the concerns we may have but insists Nomura is changing, becoming more meritocratic with talented individuals from a range of jurisdictions running a global business. The cynic in me has heard all this before. Nomura’s expansions and retrenchments from businesses over the years are many, which is why book value before these issues was below the level it was in 1992, 17 years ago. The point is that if we can access the key parts of Nomura with enough of a margin of safety to guard against the risks of something going wrong elsewhere we think it is a risk worth taking as the domestic franchises of Nomura are unique and could be worth much more in more positive market circumstances. Unfortunately, at the price of the most recent offering that margin was not there as the market capitalisation of the company was Y2.1T, above our valuation of the parts of the business we like. We did not participate in the issue but would be keen to add to our holding in the future if the market capitalisation falls again.

Michael Lindsell
September 2009

14 October 2009 TLT 000-082-8