Japan’s new PM

A new leader of the LDP was elected today - Shigeru ISHIBA. He will become Japan’s Prime Minister. Ishiba, a many time candidate, saw off competition from Takaichi in the last round. This result was a surprise as he had been behind Takaichi after the first round of voting. It seems that even Ishiba was surprised! Whilst always popular with the LDP party members he has finally managed to win over enough of his Diet colleagues who have been reluctant to support him before. His lack of a strong personal franchise in parliament may constrain his ability to act. It seems that the LDP was not ready to move to the next generation leaders such as Koizumi and Takaichi who so far lack senior Cabinet experience. We would expect that they both receive senior roles. They’ll be back…

Ishiba is seen as being relatively dovish on China (a more equal relationship with US policy) but as defence minister has advocated forcefully and successfully for a bigger defence budget; and in favour of fiscal steps to reduce the deficit including higher interest rates. This is a classic Ministry of Finance supported position. He is thought less interested in reform and represents a bigger change in policy stance than Takaichi would have been. In his latest book he referenced PM Ishibashi, the great rival of Kishi (Shinzo ABEs grandfather), as his inspiration and he has been personally opposed to Abe for much of his career. At the least we should assume that political pressure around a reflationary policy framework including to keep interest rates very low will be reduced giving the BoJ more flexibility.

Key policy platform points

• Yen is too weak
• Nuclear power is bad and should be stopped. No new reactors
• Tax should be higher on financial income
• Fiscal policy should be ‘disciplined’
• Change constitution to allow for a military

The immediate market response has been for the Yen to strengthen towards 142 /$ and futures to sell off around 2%.

Astroscale

7&i

News that one of Japan’s leading retailers and owner of 7/11 had received an approach from its leading convenience store competitor Couche Tard (ACT) was a big boost to the market for corporate control in Japan. 7&i has long been two businesses - a world class global CVS chain and its struggling domestic supermarket, department store and other retail assets - which traded at a large conglomerate discount. Deeply entrenched management and a weak board have allowed this situation to persist over any years.

We have previously owned the stock as prospects for unlocking this value seemed brighter with the engagement of a US activist fund. Management did reform the board and had agreed in principle to separate the group into pieces however the glacial pace of change fuelled by fierce internal opposition to change and challenging trading encouraged us to exit. The value was present but the positive catalyst that we require was not. ACT took advantage of the weak share price and has proposed a takeover. Whilst details are few we would expect that they will sell off non CVS assets to help fund the deal, along with new equity and a hefty slug of debt. This proposal is not that different from what so many investors have been asking management to do for 15 years… at this stage the company risks lowing control of the pace of change.

Our sense is that the price is not high enough; that management can probably promise enough self help and there are enough anti trust obstacles that cast doubt on the deal to maintain 7&i’s independence. However, the management team is now ‘on notice’ and their flexibility is gone. Sympathy is not in order as they have had at least a decade - two! - to address their operational challenges, group structure and low valuation. That they have failed to do so despite frequent, strong requests for change means that they have only themselves to blame. We often say to firms that if they do not act voluntarily there is a good chance that other prospective owners will force their hand. I’m sure that 7&i management now wish that they had listened to shareholders more closely and moved faster in response.

Despite the higher share price in recent days selling 7&i was the right decision. The weak operational execution and lacklustre commitment to reform have led the shares to underperform the broad market over not just the last year but also over many years. The big risk in investing in such a value situation is the length of time it takes to play out. The opportunity cost of owning structurally underperforming shares is very high in a market where so many others are taking proactive steps to improve returns and look after shareholders.

20.08.2024/155

Japanese Market: The Last Two Days

Japan fell heavily for a second day. This is the worst day that the Japanese stock market has experienced in 8 years and the worst two day move since the Tsunami in March 2011. The broader benchmark has fallen close to -10%.

Worst day in 8 years for Japanese stocks:
^{Topix index, daily % change}

Source: LSEG

Value has marginally underperformed growth as a style. Our latest report: Base Camp reached…now the hard partargued that further upside short term in the market might be challenging as certain segments of the market had become significantly overbought. We argued that the Yen was trading at the wrong price against the dollar and sterling and that small caps would outperform.

Over 35 years covering Japan I am never surprised by the types of moves we have witnessed in the last two days. We have warned that a stronger Yen currency would initially cause indices to fall. What has been more difficult to gauge is the extent of the Yen carry trade. This week the Bank of Japan raised interest rates to 0.25%. This comes at a time when the both the Federal Reserve and the Bank of England look to be moving towards an easing cycle. The Yen has moved from over ¥160/$1 to the current level of ¥149/$1.

The yen is strengthening after hitting a 38-year low in July

Source: LSEG 

My co-manager David Mitchinson reminded me today about simply not knowing the extent of potential carry trade unwind. The BOJ has clearly come under a lot of pressure from the likes of LDP digital minister, Taro Kono regarding imported inflation and this newfound “hawkishness” is somewhat precarious. It comes at a time when the US economy looks vulnerable to weaker employment and consumption and a Chinese economy that has so far failed to bounce back. The two-day sector losers have included Brokers (-15%), Insurance (-14%), trading Companies (-11%), Auto’s (-11%) and Technology (-10%). These are all “overcrowded” trades that have seen foreigner’s pile into. The scale of hedge fund involvement and structured fund involvement is just not known.

Where to from here? A stronger Yen now seems likely. This will lead to a bifurcated market where perhaps the “winners” of the last year bounce short term but thereafter struggle. Many of these names are Yen sensitive and exposed to the global economic cycle. Our portfolio remains very domestically orientated. We will nibble at some existing names that have pulled back but are cognisant that the deleveraging may have further to go in certain names.

On a more positive note, we have managed to pick up some relative performance during this sell off. Our concerns around positioning, valuation and overexuberance are all short term concerns that do not detract from our longer term optimism on capital allocation change in Japan.

 02.08.2024/147.

STOP PRESS: Sun Corporation

Further news to the 22nd July post

Today, after the market closed, True Wind Capital extended their offer to acquire 20% of Sun Corp—a company we have owned in the Zennor Japan Fund since we launched in 2021. Our initial book cost for Sun Corp was ¥2700, and at a takeout price of ¥5500, we intend to tender our shares. Based on our analysis, we believe there is a potential upside of 35% based on the intrinsic value. However, given that the shares have already appreciated by more than 150% this year and liquidity is somewhat constrained, we have decided to pass the last leg of this to someone else.

02.08.2024/146.

Bank of Japan Announcement

The Bank of Japan has increased its interest rate from between 0 to 0.1% to “around” 0.25%. This is only the second hike in 17 years. It marks the last central bank in the G7 finally shifting to a normalisation of monetary policy from quantitative easing. Mr Ueda also announced plans to halve its bond purchases. Amazingly, 0.25% is the highest interest rate since 2008. If prices continue to rise the bank indicated that rates will go higher. At Zennor we feel that this announcement was somewhat more hawkish than most commentators had expected. What then is a neutral rate? Insiders tell us that the Ministry of Finance have assumed a 1.5% interest rate assumption one year out in their revenue/expenditure models. The 10-year long bond yield stands at 1.05%. The Bank of Japan added that prices and economic activity have been developing in line with their assumptions earlier in the year. They pointed to a good outlook for capital expenditure and strong profits growth. Wage hikes have boosted consumption and have begun to spread to smaller sized companies. Despite the hike in interest rates real rates remain firmly negative. The following quote from the BOJ website is instructive. We believe that Mr Ueda has come under intense pressure from the government and Ministry of Finance regarding the collapse in the yen.

“As for the future conduct of monetary policy, while it will depend on developments in economic activity and prices as well as financial conditions going forward, given that real interest rates are at significantly low levels, if the outlook for economic activity and prices presented in the July Outlook Report will be realized, the Bank will accordingly continue to raise the policy interest rate and adjust the degree of monetary accommodation”.

Sometimes, we at Zennor have sounded like a broken record. We have consistently said for two years that the yen is mispriced. We apologise, as we have been wrong. However, our central argument that inflation was somewhat more entrenched has been proved right. What we have also highlighted is the huge yen carry trade and the risk that this could have on global financial assets. We think that this exit from the yen carry trade has only just begun. This, as we have argued has huge ramifications for sector selection and stock selection. Both funds have a large skew towards domestic sectors and small and mid-cap shares. Our Yen sales weight is 75% for both funds. This compares to a 55% for the broader market.

02.08.2024/146.

New share buybacks announced by portfolio companies

The parent business Sanken Electric (6707) is relatively a mediocre business that manufactures Discrete Integrated Circuits used in electrical appliances like air conditioners. However Sanken own 51% of a good company in the USA called Allegro Microsystems in the Power Integrated Circuit space. The numbers are ludicrous. Sanken’s market cap is ¥205bn. The Allegro stake is worth ¥390bn. Net Debt is ¥90bn. Today, the company announced 38% of its holding will be sold raising ¥146bn. This will be used to pay down debt and buy back shares. The shares are up 19% so far in July. Link to the announcement: https://www.sanken-ele.co.jp/corp/en/news/ir.ht

We really like Canon Marketing Japan Inc (8060). It is a closet IT software company and also a Canon distributor. The software side has been seeing +15% growth at the operating level in the recent quarter. Canon Inc agreed today to sell 20m shares of its 75m share stake in Canon Marketing Japan at ¥4091 per share. Canon Marketing will repurchase up to 22m shares representing 16.78% of the company and then cancel those shares. Earnings per share should rise 15%.

These are further examples of the corporate governance revolution in action.

29.07.2024/145.

Sun Corporation

Sun Corp. is an IT company that has been held in the Fund since its inception. They develop a wide range of products, including pachinko parts, gaming software, and IoT solutions. In 2007, Sun Corp acquired the company Cellebrite, a decision motivated by Cellebrite's proprietary UFED technology. Cellebrite is now listed on Nasdaq and is a market leader in encryption software.

Sun Corp. has a market capitalization of ¥118bn, and a substantial net cash reserves of ¥28 billion. The company's investment in Cellebrite has a pre-tax valuation of ¥194bn, and ¥135bn on a post-tax basis. So, on a sum of the parts calculation, Sun Corp trades at a 30% discount to cash and securities.

True Wind Capital, a US-based PE firm, which owns 6% of Cellebrite, has stepped forward with two tender offers aimed at acquiring a 20% interest in Sun Corp. Their most recent offer of ¥4750 per share represents a 91.5% premium to Sun Corp's share price in the 12-month period (prior to the offer launch) of ¥2481 per share.

Sun Corp. is currently 2.6% of the Zennor Japan fund. Since May, the shares are up 47%, and year-to-date, they are up 120%.

29.07.2024/145.

News: The Yen

The Yen is having a bit more of a bounce. From ¥161.5 to the US$ we are now at ¥156. Whilst you never quite know why now we can highlight some FX intervention. This is both in market and also open mouth comments from senior politicians such as Taro Kono. Kono has a big mouth but has probably been given some licence to say that Bank of Japan should raise rates to stabilise the Yen. There is a growing view in Japan that a too weak Yen is just as harmful as a too strong Yen. We doubt any companies would be seriously impacted at ¥140 or even ¥130, which is what simple interest rate spread models would suggest. Goldman Sachs estimate that their fair value is sub ¥100/$.

We have been wrong on Yen direction for at least the past 18 months but with other global Central Banks now thinking about rate cut timing the Bank of Japan is still focused on normalising their negative real rates. Our view has been that as interest rate differentials tightened the attraction of JPY carry trades would diminish.

A stronger Yen may have some negative impact on exporter translated earnings but it should also boost our domestically exposed earnings streams. We suspect that this may also help smaller cap names performance against their export sensitive large caps. The fund remains 60-70% <$5bn market cap. 

New Position: Sanken Electric (6707)

Sanken is a second tier power semiconductor company. The firm has migrated their own power semiconductor business away from consumer devices towards automotive (EV) and industrial applications and is steadily improving operations. The company has also exited a struggling subsidiary Polar. Operationally Sanken is getting much better. Many years ago Sanken acquired a US competitor Allegro, restructured it and eventually relisted it. Allegro has performed exceptionally well since then and their 51% stake is now worth ~¥400bn, vastly more than their own market cap. The company has activist shareholders owning in excess of 40% of the company and has publicly commented that it is working with them to unlock this value. Adjusting their balance sheet for debt and their equity holdings (after tax) suggests that you can acquire Sanken for less than free. You are being paid to take on their operating business! We think that Sanken is attractively valued, moving in the right direction and has clear positive catalysts ahead as the Allegro situation is resolved. We have initiated with a 2% position for the fund.

Exited: Skymark Airlines (9204)

Skymark Airlines is a company we bought at IPO in December 2022 (see Post of 31 Dec 2022). The company had been rescued from bankruptcy and resuscitated. We read the operating environment well as seat occupancy has been improving sequentially since purchase. What we mis-read was the weakness of the Yen and substantially higher oil prices, which had caused the share price to fall from around ¥1400 to less than ¥800, which was -60% relative underperformance.

The earnings downward revisions were more negative than our estimates and given that our portfolio was already quite geared to a stronger yen we decided to sell the shares. Additionally, a central tenant of our process is to ask whether we would have bought the shares with a fresh piece of paper (old advice from James’ mentor Michael Thomas). In the case of Skymark the answer was “No”.

New Position: Appier (4180)

Appier is a leading provider of cloud marketing tools. They help merchants increase the conversion rate of customers on their own websites. We had tried to buy Appier a few years ago but the share price had quickly moved away from us. The long sell off in smaller growth companies has given us another opportunity. The companies own execution has been excellent with growth running ahead of expectations. We believe that the catalyst for a reappraisal is the realisation that margin leverage is just starting. The company will be moving from just over break even to a 15% margin over the next 2 years at the same time top line growth should continue to exceed 30% p.a.. Normally you would expect that a combination of very high growth, rising profitability and fantastic returns would command a premium multiple. On our estimates Appier will trade at a market PER in just 18 months’ time assuming it only reaches the low end of their margin target range.  We understand that the market’s caution is that so few companies actually deliver this kind of operational leverage. We have spent much time with the management team and believe that they will start to show this dramatic margin improvement from this year onwards as they have already completed much of the upfront fixed cost investment and are now moving into a monetisation period. 

Why has Appier been under selling pressure? One reason is the excitement around AI. The leadership team at Appier has very strong data science backgrounds in ML and AI. They remain convinced that their access to granular and highly proprietary data sets at customers is an edge that cannot be replicated using public data sets. They also insist that what they do is not possible to replicate with LLM (Large Language Models) style AI models – which they are very familiar with. The company has so far executed flawlessly. The opportunity to purchase such an outstanding business, at a key inflection point in their profitability, at a market multiple is rare.

Exited: Nippon Soda (4041)

Nippon Soda has been a mainstay holding in the Zennor Japan Fund since June 2022 and a holding that has made the fund close to 30%. We also bought it for the Income fund at launch. The company has doing a great job on communication to shareholders, it also has a good balance sheet, great dividend and a much-improved ESG disclosure. We began to worry that there are some near term negative catalysts caused by the inventory overhang in the agrochemical markets in Europe and South America. They have enjoyed an almost perfect business environment with their equity accounted Brazilian affiliate Ihara, and significant gains in market share in Europe. The long-term outlook is structurally very positive but the poor guidance they put out for this fiscal year after we sold has been justified. This is a stock that we will revisit, but for the time being we are happy to be sitting on the side lines.

New Position: Hachijuni Bank (8359)

When we launched the Zennor Japan Fund in February 2021, we were able to buy city banks on less than 0.4x price to book ratios. Hachijuni was bought in early March 2024 to take advantage of a bank still trading on less than 0.5x book. This large regional bank is based in Nagano Prefecture. Long term investment securities are 140% of market capitalisation. Two well known activists are now involved and in May they announced a 2% share buyback. With MUFG now trading above book value we again look forward to better corporate governance news and wider net interest margins as monetary policy is tightened. At the time of writing it is a little over a 2% position.

Exited: Rakuten Bank (5838)

Rakuten Bank was spun out of Japanese internet giant Rakuten. Their high growth, online only, low cost operation and attractive Net Interest Marging were all positive factors. The valuation when we bought was just 1x PBR when we felt that something closer to 2x was appropriate. This offered us a return of 100% in valuation and more with the impact of compounding growth. Rakuten Bank also offered the optionality of high exposure to higher Japanese interest rates given the floating nature of its loan book. In short this was a well run asset being offered at a meaningful discount to intrinsic value with some powerful catalysts ahead. We exited Rakuten Bank after the shares had appreciated strongly and were nearing our targeted valuation. A second factor was that a wider re-organisation of Rakuten’s financial assets was announced. In principle Rakuten Bank would merge with unlisted Rakuten Securities, credit card, payment and insurance subsidiaries. We like these assets a lot but at this stage there is no clarity on the terms of this deal – what is the consideration, how many shares will be issued – if any etc. This makes estimating the fair value of Rakuten Bank very difficult. The twin factors of reduced upside to our initial intrinsic value range AND uncertainty around exactly what the company would look like caused us to exit. We will certainly revisit Rakuten Bank once its final structure is clearer. 

New Position: Toda Corporation (1860)

A better outlook for building construction and civil engineering, plus booking significant gains on real estate holdings augurs well for the coming fiscal year. Visited by James in January, the company has many deep value characteristics. Net cash, long term investment securities and unrealised gains on real estate come to 54% of market capitalisation. If one adds in net receivables the figure comes to 84%. The jewel in the crown is the Toda building which is due to be completed in November. This should add ¥5bn in income with 100% occupancy on day one. We are also at the beginning of a long journey regarding shareholder returns.

Stop Press: Early signs are encouraging with a new share buy back announced in May 2024.

Insurance companies are forced to divest shares

On the 26th of December the 4 large non-life insurance companies were issued with a business improvement directive following violations of anti-trust and governance failures. The companies are due to submit these plans by the end of February 2024. Usually in Japan this kind of order is met with a small fine, a shaming public apology and tweaks to the business process. This time their regulator, the FSA, has reputedly also asked them to unwind at least 80% of their large strategic equity holdings as they believe that this has led to conflicts of interest in terms of how they managed their businesses. This logic clearly applies to many other sectors as well.

This forced equity disposal would improve governance, raise RoE and lead to higher shareholder returns. It is also a sign that it is not just the TSE in Japan that is keen to improve governance.Following on from this request Sompo Holdings (8630) has said that they will fully exit their strategic shareholdings. Our holding MS&AD (8725) has the largest portfolio compared to its market cap and hence should see the greatest impact compared to industry leader Tokio Marine (8766) and Sompo. MS&AD only trades at book, 11x earnings and has a good chance of delivering a high teens RoE after balance sheet ‘slimming’ which suggests continued material undervaluation despite the recent move up in the share price.

16.02.2024/107

Koike Sanso

The company is involved in cutting tools used in a variety of industries such as construction, steel, shipbuilding, and heavy industry. The company produce gas, plasma and laser cutting tools. Market Cap ex treasury is ¥16.1bn, so Zennor’s smallest stock. It resides in our Income Fund. It has cash of roughly ¥22bn or over 140% of market capitalisation. In addition, there are some unrealised gains on real estate. Founded in 1929, these could be considerable. Order backlog is at record highs. Over 25% of sales come from abroad. The USA and Asia account for most of the overseas sales. Koike Aronson, based in New York has an excellent website. The parent business makes an operating margin of only 5.5% with the consolidated add on having sales of ¥20bn and an 8% margin. The weaker yen should be making it easy on the consolidated subsidiaries to import core parts from Chiba and Hyogo manufacturing bases.

Recent results are impressive. Net profit for the first half was revised up by 60%. Assuming they revise the full year by the same amount as the half year beat the shares trade on 6X price to earnings ratio and stand at a 55% discount to book value. James hopes to visit them in Tokyo in January 2024. The free cash flow is about ¥3bn. So, on market cap alone the yield is 20%. Rarely do you find companies this cheap. The technology is genuinely very impressive. I suspect this is a perfect MBO example. There is no real reason for listing as the family and related parties appear to own close to 50% of the free float. The shares yield 3%.

Upside is Considerable. No reason it can’t double.

13.11.2023/175

Bank of Japan

Today the Bank of Japan took one further step to normalising Japanese interest rates. Whilst the market’s initial reaction was one of mild disappointment we view this as setting the ground for further change next year and a balance between those who wanted no action and those looking for bigger change.

What happened?

The BoJ indicate that their Yield Curve Control policy was not rigidly fixed at 1% but was now a ‘range’ around 1%. Effectively this abandons the YCC policy as a binding policy constraint.

The Bank of Japan increased their inflation outlook for 2023 (2.5->2.8%) and 2024 (1.9->2.8%) - substantially over 2%. This would mark three consecutive years of >2% inflation. However it has retained 2025s outlook at 1.7% which maintains a more dovish policy tilt. IE they are indicating that although 3 years of >2% inflation is likely to be achieved this is not yet firmly embedded. Their preferred core core CPI measure remains just under 2% reinforcing this message about core reflationary pressures being slightly below their target level.

The key change for us was not the YCC ‘tweak’ but the uplift in inflation outlook that emphasises that the BoJ reflationary policy is working AND that more work remains to be done. We suspect this sense that the BoJ will remain accommodative for longer was what nudged the Yen lower today. Tactically this makes sense but misses the strategic shift that EXIT is now coming.

This step has significantly weakened the logic around YCC and has moved the BoJ decisively towards an exit of YCC. Economists now expect further action but it is unclear whether NIRP or YCC will be ended first. The key determinant of further change will be the Spring Shunto wage round where the BoJ highlighted this explicitly as a key factor in their thinking about inflation durability.

Taken together this combination of changed inflationary  expectations and flexibility in the long end of the curve clearly sets the BoJ on a normalising path even if the tweak today fell short of what some had been pushing for.

At a stock level this has limited direct impact on earnings but a change in short rates would be very impactful for financials and for regional and deposit rich banks especially. It would also substantially help those companies with large cash positions.

Goldman Sachs has estimated the net income profitability impact of short term rates moving up to 0.5%. We have exposure to Rakuten Bank and t Japan Post – two of the most rate sensitive financials. The impact on profitability should be in excess of 50% and possibly much more. We also own a number of regional banks that are especially geared to higher rates (and capital structure reform) but not covered by GS.

01.11.2023/171

Panasonic

There is a perception that Japan has always been a country where financial institutions and their customers have been bound together by mutual cross-shareholdings and that shareholders are subservient to managers and should be quiet passengers on a company’s voyage. This passivity was the natural order of things in Japan. But it hasn’t always been this way…

Mr Matsushita, the legendary founder of what is now Panasonic (6752) and sometimes called “the God of Japanese management”, certainly saw things very differently. Writing half a century ago during the great Japanese economic boom he said:

“…corporations are not the property of presidents or executives, but of shareholders. At the same time, companies are also “public institutions” of society. Executives report their performance at the shareholders meeting every fiscal year, and when it is good, they receive praise and appreciation from shareholders. When performance is below expectations, executives should humbly accept the harsh complaints and criticism they receive. This is the way corporations were meant to be. Managers should never forget that shareholders are their masters. As for shareholders, for them it is important not to resort to short-term trading, but rather to maintain an undaunted stance and fulfil their role as the ”central actor” of the corporation. Shareholders’ behaviour is admirable when they do not merely hold stocks and quietly receive dividends, but rather, when they warmly encourage and rigorously guide management with authority, and provide insights as shareholders…..”

Zennor would like to heed Mr Matsushita’s sage advice and will continue to ‘warmly encourage and rigorously guide… and provide insight’ to our investments. This is true engagement and helps us understand that the Revolution in Corporate Governance is really a conservative revolution of bringing things back to how they should be.

17.10.2023/165

Arealink

We recently revisited Japan’s largest self storage room operator - Arealink - and formed a very positive long term outlook for the business. We decided to follow up with CEO Suzuki and Founder/Chairman Hayashi to understand how the model has evolved and especially how they are addressing the key challenge that the company has encountered over time - volatility driven by its development activity. The changes that they have introduced over the past few years will push the company away from large, expensive, buildings towards container type storage that is much cheaper and that offers far higher returns. This evolution will allow them to scale back the capital intensive development activity and focus on growing through internal cash flows. From our perspective this means that a volatile top line has masked a strongly growing underlying revenue stream and will turn into a much more stable growth trajectory and allow other investors to appreciate the attractiveness of their business model. Freeing up this lumpy investment capital will also enable them to accelerate their core storage unit openings.

The market opportunity in Japan is still underdeveloped. Utilization rates/population are far lower. Whilst a full move to US levels of usage is unlikely it does suggest an addressable market that can expand several times over the medium term.

Source: Arealink

Arealink intends to address this storage opportunity by rapidly growing its presence. It is already the market leader with 20% share but believes that it can exceed market growth.

Source: Arealink

The economics of these smaller units are also far better. The time to profitability is under 6 months, whereas large buildings may take up to 43 years to break even and often struggle with low occupancy. The management of these units is also handled remotely whereas buildings require staff to be on hand further increasing costs.  Arealink manages around 2000 locations with just 70 employees.

Source: Arealink

One benefit of their market share and their nationwide footprint is that they have extensive data which new CEO Suzuki is using to enhance yields and to help identify attractive locations for new units. This includes enhancing the customer experience with digital keycards, courier services and storage rack rental. Small competitors cannot offer these enhanced services. Arealink is the first storage company in Japan to allow customers to sign up online and to pay via credit card. This may seem straightforward but is just another example of how they are different from their domestic competitors. These numerous small edges compound into being a large moat. Their distinctive branding and almost unique nationwide coverage along with online digital marketing means that they are usually one of the top ranked sites when customers are looking for storage.

The company has also participated in several TV shows such as this one… The other conclusion having watched the video is that Japanese storage units are MUCH tidier!

Source: Arealink

We think that this backdrop of a strong model and significant growth runway is not appreciated. With over 80% of revenue coming from recurring stock businesses this should be a highly predictable and highly valued revenue stream but it is not seen as such today. Why? History!

The company previously had a large ‘flow’ business doing development, and brokering real estate. At times this was highly successful but in other periods it slumped and caused losses. Eventually the company realised that their core rental storage business was by far their most attractive one and that they should focus on this. This business has grown for 20 years and without the volatility driven by the flow segments. These are now expected to decline as a proportion of revenues and the company is strategically deemphasising them (no more large scale development, no more storage unit brokerage etc.). This should radically reduce the volatility of earnings but is something that is hard to see today given the volatility from COVID and due to the drop out of these volatile revenues between 2019 and 2021. We think that this uncovered company has simply been ignored by many investors due to its small size (35bn), and non-core business volatility.  We do not think that this anomalous situation will last long!

Source: Arealink

Catalysts?

• Current trading is strong so they are highly likely to revise up earnings and also dividends
• Openings and pipeline are progressing ahead of plan
• Further progress in expanding stable revenue % vs. flow business
• Further exit of some non-core assets that can accelerate growth in per share value
• Improved coverage – the company is working to attract investors and also analysts after they have made these business model refinements and improved growth stability

Zennor will share the Arealink story with some other likeminded investors…

Intrinsic Value?

Our investment case as a buyer today is that the company will compound earnings at a 10%+ CAGR without recourse for additional equity capital. Dividends will grow at the same rate or higher bolstering the running yield from the current 2.4%.

As the business model stability is reappraised we believe it can rerate to 15x EBITDA. The current 7x EBITDA stands in contrast to global peers such as Shurguard 21x, Storagevault Canada 25x, Public Storage 15x or Lok N Store 18x. Unlike those firms Arealink is not heavily indebted AND is growing very quickly.

Taking a five year view we expect the company to have an intrinsic value of approx. 150bn JPY against today’s 35bn. This implies a >25% compound total return. Even if it does not rerate Arealink should still deliver a mid teens compound return if we are roughly right.

This may seem like a high IRR but our assumptions imply that the company does not hit their own unit opening targets (they are ahead), the firm does not raise prices (when inflation is back) or misses its utilisation assumptions (very stable for many years) and that it also continues to trade at a -25% discount to relevant global peers (we shall have to see!). We also do not assume any M&A which is possible...

05.09.2023/153 

Nittetsu Mining

The Fund has a meaningful weighting in Nittetsu Mining. A Copper smelter and upstream producer in Chile, the company has huge amounts of cash, investments and latent real estate gains. We make a point of “engaging” with companies, rather than being an outright “activist”. This has served us well. Many of the company’s management know us over 35 and 25 years respectively. Whilst difficult at times we are always fair.

Nittestsu has been a slow burn shareholder awareness story for us. We have spoken to them about ESG and we are promised a full carbon reduction report this year. We are glad to report that the “G” has seen a major development at the end of last week. The company are moving to a minimum dividend on equity of 3% and a pay-out ratio of 40%. This is good news. The shares should yield 3.4% this year and given its old fashioned approach this should be the first of many actions.

29.08.2023/152

Lifedrink

It is often useful for fund managers to independently review companies to fact check the other manager and get an unbiased steer. I interviewed Lifedrink today which has been one of our most accretive stocks in the last two years. We seldom attribute a stock to one individual but in this case my partner David had the original idea. This note goes some way to explaining how as a more value orientated manager I have accepted this stock idea and embraced it. Over three years the process has evolved into a value with growth at a reasonable price philosophy and I have become more pragmatic on growth whilst David appears to have moved much closer to a GARP style from yesteryear.

CLSA have a 50% stake in the company and are selling down 25% thus raising $90m. It is all secondary issuance. The company will transfer to the Prime index. Demand for their beverages, water, tea and carbonated water continues to outstrip growth in the overall industry. This is a brandless water story (60%) although 40% is their own products, sold primarily to supermarkets. Brandless drink in Japan only accounts for 10% of the overall market and this is compared to 40% for the US market. The market is growing at +5%, whereas Lifedrink are growing at +10%. The reason for this is that they can sell their products much more cheaply than competitors. The number of products they have is limited and the content of the bottles is only 2 Litres or 500ml. Product efficiency is high as factories are evenly spread across the nation. They have a high weight of internalisation and transportation costs are low because of plant diversification.

Capacity has been expanded in recent years at the existing plant and a new plant at Gotemba will be finished in just over a year. In January 2023 they bough Nitto Beverage from Nitto Boseki. Currently production is 43m cases but with the new capacity at Gotemba and expansion of existing plants capacity will grow to 57m cases. Gotemba has 8m cases capacity. Nitto beverage still has room to squeeze more production as there is idle land available.

Although not on the balance sheet the company has just secured ¥8bn of bank loans funded at around 0.5% for 10 years. Current sales in 2-3 years should hit ¥45bn and the President is convinced that he can squeeze margins a bit higher. Last year the OPM was 10.3% and 11% seems possible in 2-3 years, although the headwind from raw materials and electricity price rises has been quite large. It detracted ¥1bn from OP last year.

Longer term the company target 76m cases from the current 43m cases. Free cash flow is negative as one would expect in a capex phase, but this will die down and I expect that free cash flow should range between ¥2bn and ¥3bn in the future. The Gotemba factory will raise margins as it is Kanto based and close to many of their clients. Major beverage companies have raised prices by +10% and LD by +5%. Labour costs are rising +6% and the President was convinced that inflation IS happening in Japan. Nitto Beverage is lower margin and I expect this to rise substantially in the future. Sales contribution is ¥3.5bn.

Looking at FV I have to agree with David that this is indeed a special situation. Fast/guaranteed growth trajectory. Simple business model and economies of scale. The President was very impressive. Shareholders equity will continue to grow with great cash flow.  Assuming ¥45bn of sales to 3/26 and a margin of 11% then Net Profit at 30% tax would be ¥3.7bn or ¥284/share. To 2030 a sales number of ¥65bn could be possible. Suntory Beverage trades on 1.1X sales. Assuming ¥65bn of sales to 3/30 then if we assumed 1.5X sales because of the high earnings growth story then eventually the market cap could double again. That is over 7 years.

The shares came back 8% today and may drift lower prior to the deal. Ideally one would want a second bite at below ¥3000 as then the PER multiple you are paying is close to 11X 3/26. Longer term these types of companies should trade on 20X. This again suggests 80-100% upside. Price to book remains rich but ROE is 28%. It is our most expensive PBR stock but it is guaranteed growth in an uncertain world.

I often challenge David to tell me what his weighting would be with a fresh piece of paper, and I would personally run 3% here.

05.06.2023/134

Excerpts from an Engagement Letter

This series pulls out excerpts from engagement letters that Zennor has sent to companies. Edits have been made for clarity, ease of reading, and anonymity.

On Cost of Capital

We believe that [the company] is a great business. However, we do feel that the capital structure needs addressing urgently. As you know the Tokyo Stock Exchange is actively pressing companies to explain their cost of capital and return on invested capital. Our calculations show that you indeed have a negative WACC/ROIC spread. Your cost of capital is 9.8%, yet your ROIC is only 3.6%. The TSE will eventually seek to delist companies who cannot raise their ROIC to match cost of capital. The balance sheet remains hugely over capitalized with cash and investments of ¥60bn. This is pulling down ROIC. Understandably, you will need some cash for expansion, but the business is spinning off decent cash flow. We see that you made an accounting entry called “Deferred Revenue” of ¥17bn which we would like explained.

Suggestions

The company now need to buy back shares at just above book value and move to a 100% payout ratio. Shrinking equity capital is important. A shrinkage of equity by say 30% over three years would raise the ROIC to above 10% and thus cover your cost of capital. Most of the net profits should be paid as dividend. Our initial suggestion, to be conservative would be to move to a pay-out ratio of 80% and then deliver at least a 100% total payout ratio. Look at what that has done for the shares of [comparable company].

05.06.2023/132.

Excerpts from an Engagement Letter - Key Issues

This series pulls out excerpts from engagement letters that Zennor has sent to companies. Edits have been made for clarity, ease of reading, and anonymity.

Orders

The contracts or orders that you win need some degree of modification. Firstly, there are long delays in partial booking of sales and receipt of cash versus payables which are settled much more quickly. Although your receivables will eventually end in cash it is meaning that the company is very negative cash generating at the moment. In 2022 and 2023 you have seen huge increases in accounts receivable. Although sales have clearly been recognized partially this has not translated into cash in. This can be partially fixed by a more rigorous contract with the customer which does not allow for such slippage. Especially, as you say when the product is of the highest quality.

Capital Structure

Our calculations suggest that your cost of capital is at least 8% yet the ROIC even on 2030 projections would only just exceed the cost of capital. The TSE will be ruthless about this. My suggestion would be to raise the total payout of dividends and share buybacks to 120%. This would mean that the company is yielding at least 7%-10% in total which would attract income investors. If over three years, the company bought 15% of the company back then this would go some way to improving the capital structure, but you would still have to improve cash flow and improve the operating margins radically.

Opportunity

We are glad that you have more exposure to North America. Given your technological expertise and customers getting better “yield” from your machines then a resetting of contract prices and payments is imperative. You have an enormous potential which may just miss the whole upcycle if this does not take place.

Risk

The TSE makes the point that capital is not “free”. It is imperative then to raise the price to book ratio well above 1X. The risk becomes ultimately a delisting.

05.06.2023/133

New Position: Seikitokyu Kogyo (1898)

We took a 3% position in Seikitokyu Kogyo. We were attracted to this construction company given a low price to book and over 50% of its market capitalisation tied up in cash, securities and net receivables. An activist investor has also been involved in calling for higher returns. During the market today the company announced full year results and forecasts. Full year forecasts suggest the company is on 10X Price to Earnings ratio. The combined push from shareholders and the moves by the TSE to unlock value and raise the price to book have caused the company to discover real shareholder awareness. They have announced a 100% future dividend pay-out ratio and a minimum 8% dividend on equity. Fantastic! That gives us a yield of 8%. Just what we need for our Japan Income story!

24.05.2023/130

Biggest Pay Rise for 30 years

The Japanese annual wage round has just finished and delivered the biggest wage hikes for 30 years. This provides some additional support for the BoJ to exit the YCC interest rate policy.

The Japanese trade union group (Rengo) has reported on this year’s shuntowage negotiation for large companies the results of which are better than most had expected. Most large Japanese companies and groups have in house company trade unions who conduct annual negotiations on wages. They should be seen as mostly collaborative rather than confrontational. During the bubble collapse they have emphasised employment stability rather than higher compensation. There are signs that this balance is changing.  The Japanese business year starts on April 1 and for the next year the salaries for employees will increase +3.8% (2022 +2.07%). Base wages increased +2.33%. A survey of economists had expected a gain of 2.95%. This is against a backdrop of real wages remaining mostly flat since the early 1990s vs. 25% growth in real wages  the US. Rengo has also been focused on aspects such as ‘work-life’ balance, and ‘voluntary’ overtime in recent years. This may be seen as Japanese workers finally regaining some pricing power as the labour force contracts. Certainly many Japanese workers are not very well paid especially in smaller companies where most workers are employed.

Outgoing BoJ Governor Kuroda had argued that sustained wage increases of more than 3% were required before he would consider normalising interest rate policy – he has finally achieved it.

17.03.2023/114

On Regional Banks' and City Banks' Performance

Walter Bagehot famously said of British investors that “John Bull can stand a great deal, but he cannot stand two percent”. It seems that what was true in 1852 is still true today. With ultra-low interest rates causing some investors to lose discipline and seek higher returns but only through taking on much more risk. The turmoil seen in the UK Gilt market in Autumn, at CS and in the US regional banks sector over recent days spilled over to Japan this week despite the strong action taken by the US to protect depositors. Zennor believes that there are very few similarities between the US and Japanese banking system in this regard and that the sell off is misplaced.

Before we discuss the Japanese Banks, let us have a brief reality check. Many banks had risen +50-100% relative to the market in the past 18 months. In December, we wrote about the Bank of Japan’s ability to surprise by widening the interest rate band for (YCC) yield curve control. We suggested that an end to ultra loose monetary policy was in sight. Kuroda did not sign off by abandoning YCC. He left it to Mr Ueda to take over the reins at the Bank of Japan. Sifting through Mr Ueda’s comments over the past ten years, it is not easy to pigeon hole him as either a Kuroda acolyte or a hawkish alternative in the traditional of the 1990’s school of BOJ management. What is clear is that he has been uncomfortable with the BOJ’s huge ownership of the bond market and the distorting effects of this on the bond market domestically.

Not unsurprisingly, Kuroda left YCC unchanged as his final gesture. Given the move in share prices since November and the problems at Silicon Valley Bank (SVB), it is not surprising that share prices have corrected. Short interest has risen dramatically this week. Since the end of October, the Banking Index is still up +21% with the leading gainers witnessing some large moves, despite last week’s turmoil.

Source: Bloomberg

The collapse of SVB and Signature seem very different to 2008. The renormalisation of central bank policies was an inevitability and a necessity. The two sectors that benefitted the most from excess liquidity and ultra-low interest rates in the Covid period were the technology sector and residential construction sector. The rise in interest rates is exposing weak business models and we expect more skeletons will emerge as interest rates normalize and the excesses are unwound. Investors have become used to a Fed that has their backs. After the moves over the weekend the perception is that the Fed will stop hiking - bonds have celebrated with dramatic moves up in prices. We are more cautious given the end of the disinflationary era. Until the Fed achieves a PCE (Personal Consumer Inflation) reading much closer to 2% interest rates will have to keep on rising despite a de facto tightening of liquidity as banks become more cautious on lending.

SVB seems to have used most of the deposits it raised from the technology sector to invest in longer term US treasuries and mortgage-backed securities. Unable to find good alternatives among a low interest rate environment to deploy the deposits SVB reached for yield and duration to increase their returns – exploiting the held to maturity (HTM) mark to market loophole. HTM allows banks to value bonds in the balance sheet at prices different from the market price so long as they agree to hold them to maturity and do not plan to sell them – this is designed to stop low bond prices creating pressure on bank balance sheets pro-cyclically. This was introduced in the US to ‘fix’ the problem of collapsing bond prices during 2008/9. To be very clear this was a known and deliberate ‘feature’ and not a ‘bug’ of the US banking system. However, it also meant that in a period of constantly falling rates some banks became overly complacent and have not properly hedged their portfolios. This only becomes a problem if the bank is forced to sell their mis-marked bond and realise the loss. SVB had 70% of deposits in marketable securities, of which 75% were held-to-maturity and just 7% of deposits were in cash and interest-bearing accounts. A further 10% was in venture loans to startups – dependent on further venture rounds to repay the capital (but coming with equity warrants that have been very lucrative over the past few years). Their balance sheet was illiquid and had an increasingly large mismatch between its balance sheet and market valuations. Several analysts had identified that their equity was threatened by this – and, once this became more widely known, a very fierce bank run on more than 25% of its deposit base in 24 hours commenced – dooming SVB who were both illiquid and insolvent.

That isn’t the case in Japan! A prolonged debt deflation cycle has induced extreme conservatism in balance sheet management, accounting, and regulation. Typically, Japanese city and regional banks have extremely low loan/deposit ratios, ranging from 50% for the city banks to 75% for the regionals. The crucial difference between the Japanese regionals and SVB/ Signature is not the loan deposit rate but what SVB did with its deposits. The Japanese banks have a large proportion of deposits held at the Bank of Japan. In the case of city banks that ratio is about 50% and in the case of regionals that ratio is around 35% (vs. 7% at SVB!). Japanese banks have enough liquid reserves to meet a bank run of SVB proportions. Foreign bond holdings are classified in Japan as available for sale securities and thus have already reflected losses on their balance sheet at the end of December 2022. Typically, these are about only 5% of shareholders equity. These losses are likely to be less at this point as treasuries have rallied hard. Given 10-year yields are at 30bp there are no issues for domestic bonds. Japanese banks have kept their bond portfolio maturity relatively short - this has hurt their earnings power given zero interest rates but prevented capital losses. Japanese bank business models are also lower beta (and lower return). In the US banks originate and then distribute loans to investors as securities introducing pricing volatility; whereas in Japan banks typically originate and then hold the loan to maturity.

Capital ratios are healthy at both the regionals and city banks. Even after stripping out (very large) unrealised gains on equity the capital ratios are strong. SMFG has a CET1 ratio of 15%, MUFG 11%, and regionals are typically around 12%.

The reason regionals have run up over the past year are twofold. Firstly, they are more interest rate sensitive than the city banks as they have higher exposure to rate sensitive banking activities and less to fee business, asset management and investment banking. A +0.1% increase in lending spreads would impact regional bank net profits by +15% on average versus +6% for the city banks. Zennor still believe that a pivot by Mr Ueda will be inevitable later this year as wage inflation is gradually taking hold and inflation prints continue to be higher than expected. We are seeing multiple companies in our research coverage raising product prices suggesting that higher inflation will persist.  It is possible that the concerns raised by SVB may delay – but not stop - the move towards higher rates in Japan.

The second factor that has driven the rally and will continue to do so are expectations for improved capital efficiency. The Tokyo Stock Exchange is asking companies to quantify their cost of capital and to address persistently low valuations (i.e., trading below a PBR 1X). Many regional banks have very low valuations, low returns and huge long-term securities holdings and we expect that management will be pressured to sell these and return the excess capital to shareholders. These stocks are not held on a mark-to-market basis but in Japan’s case this means at the lower of either the purchase cost or the market price – the reverse of the US model! We estimate that an overall mark to market in Japan would result in a profit – not losses. In the case of Bank of Kyoto and Shiga Bank the market value of the stock portfolios significantly exceeds the market cap and the potential impact on stocks trading at below 0.5x unadjusted PBR could be dramatic if capital strategy changes. These firms have low returns, high cost of capital and plenty of it to be redeployed in addressing ‘persistent undervaluation’.

We have been exposed to several domestically oriented banks due to our expectations for improved capital policy and have used the recent sell off to increase our exposure.

16.03.2023/111

New Holding: Fukushima Galilei

One recent investment operates in the niche segment of industrial chilling cabinets and refrigerators for supermarkets and convenience stores and we believe that its capital policy is finally thawing.

Fukushima Galilei is not a bad company having delivered consistent double digit margins and a long track record of generating positive cashflow. The company has built up a cash pile equal to nearly half the market cap, a significant investment portfolio and nearly 10% in Treasury stock - taken together along with real estate brings net financial assets to nearly 100% of market cap. FG is at least very cheap at less than 2x EV/EBITDA! What is intriguing is that the company’s new COO, and son of the founder, is interested in ways to improve investor communication, address shortcomings in their sustainability disclosure and increase corporate value. We have known the company for many years but this is the first time that they have actively sought input from investors. This change is the positive catalyst that we have been looking for. We have shared our thoughts with the company over several meetings and suggested to them improving the sustainability disclosure on a quantitative basis, increasing the dividend payout ratio from a low 15%, cancelling >9% in treasury stock and setting a challenging RoIC target to bring both operating excellence and balance sheet discipline after benchmarking some competitors pricing and cost structures. The management team have been very engaged and our sense is that the door for change is open – even if not all of our suggestions are likely to be adopted.

In the short run we are confident that their trading is improving as their customers seek to improve the energy efficiency of their operations by upgrading their refrigerators. The real change that we are looking for will come from a big uplift in returns if the company accepts some of our suggestions. A change in returns would lead to a material re-rating. Leading peer competitors trade at closer to 10x rather than 2x. Starting from such a low level of valuation means that small changes in shareholder friendliness are likely to produce much larger changes in valuation multiple. We may be wrong that the company is changing but a combination of extremely cheap valuation, very robust balance sheet protecting on the downside along with the positive catalysts that we expect from earnings and potentially also changes to disclosure and capital policy tilt the odds very much in our favour.

02.02.2023/110

Nohmi Bosai - Now that’s what I call Value!

The company is a subsidiary of Secom. As we have highlighted before the Corporate Governance code has urged parent companies to delist their subsidiaries. Many have acquiesced and the fund has seen takeout’s in Secom Joshinetsu at a 66% premium and also Daibiru being subsumed by Mitsui OSK. Nohmi Bosai has two main businesses. Fire alarms and fire extinguishers. Delays in orders and concentration of profitable projects in the previous fiscal year have hit profits this year. Margins in a normalised environment are 12-14%, with both divisions fairly similar. There is one word we love. Maintenance! This is 1/3 of profits! Recent orders appear to be progressing somewhat better. Only green shoots but nevertheless, encouraging.

Assuming a return to 2022 operating profits of ¥12bn and an 11-12% margin then EPS should reach ¥130-¥140. This puts the shares on a multiple of 13x for a strong free cash flow business with a decent maintenance business. Free cash flow yield is 6%. Now the balance sheet - this is the crux. Market Cap is ¥102bn. Cash is ¥52bn. Securities are ¥7bn. Other investment assets are ¥8bn. There is no debt. The real enterprise value is thus ¥35bn and the free cash yield to EV is 18%. Secom Joshinetsu was bought out at 30x earnings and a big premium to book value. The founder of the parent company sadly died a few weeks ago and there are signs that the parent is beginning to change and adopt some more shareholder friendly measures. The parent conducted its first buyback. Nohmi Bosai is a serial grower of shareholders equity. Cash keeps piling up.

We have taken a 3% stake in the parent company where valuations are super depressed for a brilliant cash flow business with a large maintenance angle. Secom, like many parent companies will be forced to delist this last subsidiary and even more encouraging is that they have form with Secom Joshinetsu.

02.02.2023/107

Transcosmos

We have owned outsourced business service provider Transcosmos for some time but have increased our exposure over the last few months. Our investment thesis rests around a strong operating model that is capital light and highly free cash flow generative but that is obscured by  opaque  disclosure. This attractive operating business  and a very lazy balance sheet combine to support a high intrinsic value. In contrast market fears of a short term business slump as one time Covid orders drop out have dragged the multiple to all time lows. We believe that these fears are very short term,  overstated, and also that following a management change that disclosure and investor communication will improve which should help investors understand the underlying business dynamic properly.

Transcosmos has better operating metrics than its peers but due to its very strong balance sheet has lower returns on equity and capital. Transcosmos has significant optionality in it’s balance sheet. A large net cash position, real estate and investment securities and 20% of shares held in Treasury all provide downside protection and the potential to catalyse value if they are deployed. Cancelling Treasury shares would grow earnings per share and dividends as well as improve returns on capital. This in itself should drive shares higher. More importantly it would also flag a change in attitude towards shareholders which we believe is the key to a re-rating of the company. Overall we know that Transcomos is a well-run business but a well-considered  capital strategy has been absent and as a result the company has assets far in excess of those required to run the business. We are engaging with the new management team on these points.

We have seen partial validation of this thesis as their competitor Relia is being acquired by their large shareholder Mitsui&Co and will be merged with a similar business at Telecom operator KDDI.  This firstly supports our view that this is an attractive industry to invest in for industrial buyers. Secondly, the agreed valuation price is at a 100% premium to where Transcosmos trades (for a lower margin and slower growing business). Interestingly the advisors suggested that a range another 50-100% higher than the bid was fair value I.E. 9-12x EBITDA. So bankers think that FV for this kind of business is 3-4x higher than Transcosmos is currently trading on. We think this re-validates our insight that Transcosmos is very, very cheap and that industrial buyers who know the sector well agree and are using their own funds to back this view. Transcosmos has not always been a cheap stock and only 5 years ago traded at 15-16x EBITDA so we know that the market can  award this company a much higher multiple. It’s sole remaining listed peer trades on 7x EBITDA highlighting the significant discount that Transcosmos (<3x) is trading on even if it does not return to peak valuations.

The company offers the enticing prospect of accelerating underlying operations after Covid, new management, potential for balance sheet change, scope for improved disclosure and valuations that are currently very low reflecting depressed levels of expectation. Our downside is limited due to strong operations and a robust balance sheet and the upside is considerable even if they only partially execute on the catalysts of disclosure improvement and capital strategy shift.

30.01.2023/105

Sold: Toshiba

Toshiba was our largest holding for much of the year significantly outperforming technology and industrial peers due to the ongoing value crystallisation process but as an investment thesis it ultimately failed. Having sold much of our position in October we  exited our last position in December to fund positions in stocks such as Skymark where we saw  stronger catalysts and better upside. We exited Toshiba far below our estimate of intrinsic value as it became clear that the strategic review process had been compromised by domestic political considerations. Whilst we had factored in a large discount it became clear to us that nothing close to a full value would be reached and capital was better allocated elsewhere. We still believe that Toshiba does not make sense as a single entity and should be broken up into more agile constituent parts creating tremendous value for owners. The management team disagrees and has orchestrated an ‘all Japan’ bid that will not realise full value for shareholders but will protect insiders. We exited our position realising around 4700/share,  above todays share price, and allowing  for the long closing period for any transaction at levels that did not have a high enough expected upside to justify holding longer. This capital was deployed into two new opportunities that have both returned in excess of 30% already.

Our investment thesis in Toshiba failed. We  saw tremendous value locked inside a bloated corporate structure, we saw shareholders push hard and get a strategic review and path towards a go private transaction. This process did not yield the result that we were hoping for (at time of writing) with the preferred bidding group being highly politically connected and supported by insiders – the other potential  bids have been sidelined. This isn’t the outcome that we wished for but our absolute downside was limited due to our low entry valuation and the stock did outperform both the broad Japanese benchmark and especially technology stocks over the last year. The final bid is not yet announced so we may well be wrong yet again!  As our positive catalyst diminished we stuck to our process and exited the stock.

We deliberately try and create situations where ‘heads we win and tails we do not lose much’. Toshiba shows us that even when a thesis doesn’t work out that this limited downside emphasis really does protect investor capital. We lost but far less than the market and were able to recycle capital to ideas that have done FAR better more than recouping any losses.

16.01.2023/104

New Holding: Skymark

Skymark is Japan’s leading low cost airline. Its domestic business has excellent operating performance, a lean cost structure and an efficient route network. We participated in the IPO as we believe that there is considerable upside to both passenger miles as Japan re-opens but also to their pricing which is at a large discount to Japan’s flag carriers JAL and ANA. At IPO our analysis suggested that Skymark was trading on a mid single digit PER which looked low given the reopening dynamic and peer group multiples. We also believe that due to tax shields and aircraft deposit releases that the company will generate substantially more free cash flow than most analysts expect.

Why is Skymark so cheap?

Well, there is always a reason! In this case it is that the previous management team took the strong domestic franchise and tried to expand into international long haul airline routes. This involved ordering several Airbus A380s directly – not leasing them – which blew up the company balance sheet and forced a restructuring supported by ANA and Japanese government investment funds. The current CEO is ex-ANA and is very focused on the core domestic business execution. Whilst he certainly won’t make that mistake again many domestic investors were burned by the old management team and it will take time to rebuild credibility and to be eligible for many domestic investors . This allowed us exploit what we saw as a profound mispricing. Even after the post IPO rally we still see around 100% upside to intrinsic value.

16.01.2023/103

Now That's What I Call Value: The Case for Katakura

After a good year for the stock last year we have to admit that our holding here is down 18% and has not performed well. The case for Katakura for patient investors is strong. A diversified business with tentacles in areas such as pharmaceuticals, auto parts and real estate leasing, it was “restructured” several years ago and the activist investor, Oasis, to their credit did a good job of persuading the company to buy back shares and also cut labour costs aggressively. Then Oasis left the shareholder register and announced that the Aso group was taking on their stake. An MBO was mooted at Y2150 (share price today Y2000) and we voted against this as we see huge NAV adjusted upside to the present NAV per share. The pharmaceutical business is undergoing inventory write downs as the company moves to an in house sales system. Operating profit loss was Y2bn in the first half for this division.

The jewel in the crown is an enormous unrealised gain on commercial property. This stock comes into our “undervalued assets” bucket. The portfolio includes Cocoon City, Saitama and the ex-head office near Tokyo station called “Tokyo Square”. The book value of the properties is Y50bn, but the market value is Y127bn. Cash is Y31bn and long term investment securities are Y16bn. Treasury stock equates to Y4bn. Debt is only Y14bn.

So, what are we left with? A market cap of Y66bn ex treasury. This compares to an adjusted book value of Y164bn. In other words just to get the stock back to book would require the share price to trade at Y4900 versus a price of Y2000 today. No wonder we and other value investors voted against management.

The question therefore is what is the catalyst?

1. Given the abundant value another activist could easily take a position
2. It is not clear what the intentions of the Aso Group are as they now own 10% of the company.
3. Another MBO attempt is quite possible. Management clearly don’t enjoy meetings with foreigners and investors putting them under pressure regarding unlocking value. We were on the receiving end of this in September of this year.
4. A number of analysts have recently been dusting off spreadsheets regarding the property uplift for such deep value stocks.
5. As low hanging fruit goes this is a clear anomaly.

We may have to be patient, but we have taken our weighting up to 1.8%. Lets hope 2023 is somewhat better for the share price.

2022/136

New Purchase: Bank of Iwate

Iwate is in the north-eastern part of Japan. Demographics are poor but there is a buoyant manufacturing base there in the automobile and semi-industries. Net interest income has declined from Y35bn to Y26.3bn caused by aggressive loosening by the Bank of Japan. The capital adequacy ratio is around 11%. The company target an OHR of 70% and Net Income of Y5bn under their medium-term business plan, which finishes in 3/23. Currently results look on target to exceed forecasts and the shares trade on 6.7X earnings. The shares yield just under 5%. The Loan to deposit ratio is 55% much lower than in Western banks. The bank has a huge deposit base of Y3.4 trillion and yet the market capitalisation is a tiny Y36bn. It thus trades at 1% of deposits versus 6% for Lloyd’s bank in the UK. Bank of Iwate trades on 0.18X book value. Investment Securities are Y15bn Versus the market Cap of Y36bn. At some stage next year, we can expect a pivot from The Bank of Japan. This should be good for domestic orientated banks and further consolidation within the sector is a given. Again, we like the fact that Silchester, the value investor agrees with our view!

Source: Bloomberg

The chart is a peach. Just what we like for our “under valued” assets bucket! The relative PBR is even more interesting. Going back to 2008 the lowest PBR relative to the market has been 0.10 and we are currently at 0.14. It has been as high as 0.3 back in 2016. With a better outlook for interest rate changes this stock could easily double from here.

Source: Bloomberg

2022/135

New Holding: Hirano Tecseed

So, we bid farewell to DTS (IT software). Valuations have become somewhat stretched. On 19X earnings with a risk of an initial FY23 forecast that is conservative we have decided to recycle the money. A great balance sheet and an activist have helped but we have a couple of new ideas. Let us deal with our first new idea.

Source: Bloomberg

This is a coating machine specialist. Its machines are used for thin film coating in the LCD industry, and organic OLED technology. Increasingly, its machines are being used for electronic vehicle battery coating purposes (copper and aluminium film). The chart above suggests that sales are not the issue. The main issue has been profitability of the battery coating machines. As a result of the China lockdown, installation has been problematic. Lead times in this industry are notoriously long and accounting practices have only booked sales upon completion. This is changing from this year. Supply side issues are still not completely solved either. There is a shortage of electronic components such as machine control parts and panels to attach to machines, and some customers are demanding volume discounts. Current orders may be delivered in 2025/6 but the order backlog is super positive if they can sort out the supply side problems and lockdown issues in China end. The below chart highlights the ballooning of the order book which is now twice sales.

Source: Hirano Tecseed

Assuming that they can sort out supply side issues next year and the covid lockdown in China (huge customer base) ends then we should see at least a return to margins of 13-15%. The company made 18% operating margins in 2007/08. This will be difficult to repeat because battery customers are car makers and there is pricing pressure. In 2006-08 the 18% margin came down to the LCD boom and prices were more rigid then.

Valuation and Intrinsic Value

Assuming that sales should annually be Y50bn then with a peak OPM of 13% Y6.5bn operating profit is possible three years out at the latest. Assume an effective tax rate of 30% and net should be Y4.5bn. With Y12bn of net cash and treasury of Y2.7bn and long-term investments of Y2bn enterprise value is only Y14bn. EV/Net Profit is thus only 3.1x!

The below chart also reminds us that relative PBR is also super depressed, having traded at 1.5X the market’s PBR in 2018 and now on 0.74X.

Source: Bloomberg

We would suggest that this is a company that will see some degree of pricing pressure, yet the end demand for EV battery coating machines will explode in the future. What discount should it trade at? Assuming it trades on 6.2X PER (before cash and securities) then we would give it parity to the 12X that the market trades on. This suggests 100% upside but then the cash and securities could take that upside to over 150%. It was only back in 2021 that we hit Y3500, and the price is now Y2000.

Source: Bloomberg

FV=Y4000 (short term) with 150% upside to an ex-cash multiple of 8X and 1.9X book value. In Buffet speak too we have a couple of excellent holders. Fidelity and the activist NAVF also seem to see the merits. Dividend yield at 3% is attractive too and current PBR is 0.8X.

2022/134

Jafco

We have had a large stake in Jafco the venture capital company. We referred to the buy case in a note not so long ago. It has always been over capitalised through excess cash and a huge stake in NRI (Nomura Research Institute).

Source: Bloomberg

The above chart shows how the company have sold down shares in NRI to fund buy-backs. Infact the company under the influence of Polar and Marathon have bought back close to 40% of the company in the last four years. At Zennor we have been engaged with the company regarding balance sheet efficiency and we are delighted to say that the company has today made the decision to sell their remaining 24 million shares and buy back 25% of their own company. Pressure has intensified from the activist Mr Murukami who owns 19% of the company. We will be selling into the tender. The fund has a 3.7% weighting.

2022/133

Piolax

Piolax is a company that we recently initiated a position in. It reflects how a shift in broader governance and pressure for improvement across the market can make itself felt in companies who are not directly under pressure but who might become an engagement target. We often encourage companies like Piolax to take control of their own destiny and enact needed changes before they are forced to do so.

Piolax has a direct competitor in the fastenings industry that has delivered stronger returns and margins over the past few years. A significant part of this can be found in client mix where Piolax has faced a steady decline in Nissan business volume and this has catalysed a shift in strategy towards increased value added and non Nissan customers. Luckily Nissan’s own pipeline is looking stronger and should help volumes recover - the company is pushing hard on their EV exposure which is a tailwind. We believe that this will become more evident over the next few years as these new designs are introduced. Piolax is a beneficiary of the trend towards EVs as a combination of light weighting and lower heat resistant requirements favour their fastenings products. These cyclical and structural drivers are coupled with a dramatic shift in their capital policy.

What changed?

Piolax has announced a shift to generate positive economic value added.  The first step is a 100% payout ratio but this will need to be supplemented with meaningful buybacks to raise EVA. This will still leave the company with a substantial net cash position. The stock is barely covered and trades at only half of the pre-Covid level. Whilst there was an initial reaction to the change in policy the follow through has been muted as some investors question their new found commitment to value creation.

Piolax Price Chart

Source: Bloomberg

Historically, there is a positive correlation between returns and valuation.

Past and Future Expected Nissan Model Changes

Source: Daiwa

What is the new policy?

• Positive EVA by 2024 – this will require additional buybacks
• 100% payout for next three years. Limit further growth in shareholder equity levels

Why?

Fear of activist shareholders? Large cash position and balance sheet with solid underlying performance make this a potentially attractive investment. Peers such as Calsonic and Yorozu have already faced activists/PE.

Is this attainable?

Piolax earns a 20% EBITDA margin and >double digit OPM. The business is generating an Operating return that is respectable. However, returns are depressed by the ultra strong balance sheet. It is this capital efficiency aspect that Piolax has to manage over the next few years. This change in capital management policy will not impair the forward looking investment or growth trajectory.

How does ST trading look

Higher Nissan exposure -> greater volatility and a slower topline. NIFCO has done a much better job of growing content value. However their product cycle is improving over next few years.

Past and Future Expected Nissan Model Changes

Source: Daiwa

D/G H1 earnings on raw mat pass through lag and lower volumes. Likely FY cut given scale of miss. This is well reflected both in street expectations and in the valuation. Nissan production is ramping up as parts availability improves which will bolster H2 production levels. Piolax is also improving its price mix and we expect that this will drive OPM towards the mid teens in time.

Operating Profit Margin (annual)

Simplified Comparison of Avg. Value of Parts Installed per Vehicle for Domestic Ops (1Q 13 = 1.0)

Source: Daiwa

LT Outlook

25% ICE exposure. 75% from still growing areas. Fuel systems is winning share but is obviously impacted in LR from EV shift. Fasteners, and open-close parts are beneficiaries of this shift. This will likely limit the multiple but also there will be NO new entrants to this segment, great FCF and probable survivorship rewards for more than a decade.

Balance sheet – strong

• Cash at  34bn = >50% market cap.
• Net Working Capital of 25bn. Working capital = 8months of sales vs. sector at 3months
• 7% treasury stock
• 10bn in X shareholdings
• Meaningful PP&E OF net 24bn
• Saga Tekkohsho 10bn? 20% stake but they own 15.9% of Piolax…

Cash Flow

Company is consistently FCF generative – FCF > 10%. This is despite a deterioration in Working capital cycle days which has increased from 115 days -> 150. AR and inventory turnover has slowed. Some of this is due to COVID and supply chain disruption. Some seems excessive…

Ownership

• Senior mgmt. own a total of 77,000 shares – not meaningful. There is a lack of alignment with shareholders. We are encouraging management to increase the stock weighting for themselves and the senior leadership team.
• Very few institutional fund managers own the shares. This represents an opportunity for Piolax to bring new investors on board. FMR and domestics are the main ones.
• Large Treasury position of 7.1%. This could be cancelled. Results in overstated valuation.
• Few classic X shareholder positions. Top shareholder is a related party.

Saga Tekosho Piolax owns 20% (equity affiliate) and they are a Nissan nut and bolt supplier with 4bn NI and 74bn in sales. They are also the largest shareholder. . Hang over from Carlos Ghosn jidai. This stake worth 10bn+? This represents both a governance issue but also a substantial opportunity for mutual capital unlock. Why not swap and cancel?

Source: Bloomberg

Sustainability

See separate note. Unrecognised due to poor disclosure methodology. This will be a point of engagement and an easy win! The company simply has to change how they present the data and strategy that they already have in place…

Catalyst

• Capital policy change -> >10% running dividend yield
• Nissan volume recovery -market AND model pipeline shift
• Value / vehicle rises as part of new strategy
• Shift to EV plays out increasing fastener demand
• Well founded ESG strategy appreciated with better disclosure
• Capital policy evolves further. Saga relationship unwind? T stock cancellation?
• Rising EVA -> higher multiple. Potential for this to double?

Risk

• Key risk is ongoing production challenges for Nissan that hinders Piolax’s recovery
• Raw material price hikes that cannot be passed on
• Very rapid EV transition that kills 25% of legacy business before growth segments can offset.
• Loss of market share in fasteners

Valuation

A return to 2019 earnings power implies 13bn EBITDA or 2.5x EVEBITDA (unadjusted). This would be supported by a double digit dividend yield AND a share buyback.

Absolute PBR valuations are close to distress levels suggesting limited downside.50% of market cap is net cash whilst the balance sheet offers numerous other sources of downside value support

Zennor believes that Piolax should trade towards book without even more radical capital strategy changes  - Implies c 100% upside or 5x EBITDA.

In truth this is merely a return to levels last seen in 2018. In a more optimistic scenario where EVA / ROIC thinking is fully embedded in the company we can see significant further upside as the balance sheet is rightsized. Direct peer NIFCO trades at 1.5x PBR, has inline margins, but better capital efficiency.

09.11.2022/132

Sangetsu Update

We recently published an entry on a new holding that we added to the fund in the summer, Sangetsu, the interior products company (see post on 19th August 2022). We assumed that they might get to a 10% operating margin in 2-3 years. Yesterday upgraded numbers surprised even us. Operating margins this year will exceed 10%. Sales were revised +7% higher and the P/E drops to 8x. That is without another price hike which has recently just been enacted. Assuming ¥14bn of free cash the free cash flow yield to EV is 14%-15%. This is a stock that can double from here and upside remains 60-100% on a number of measures.

The share price reacted positively to the news rising from ¥1580 to ¥1800, an increase of over +14% on the day.

Engagement in Action

We are often asked what it means to engage with our current or prospective holdings. Sometimes, more pointedly, what do the companies get from engaging with a small UK Japan fund? Here is one recent example.

We conducted a call with the CFO of a significant Tokyo based real estate owner and developer. Their current operations are solid, the balance sheet reasonable and valuation is reasonably close to fair value as currently structured. A nice company but an unexciting investment from our perspective. We did have a chance to discuss with the company what could they do differently?

We suggested that they really had 3 distinct businesses.

1. A real estate development business. Short cycle, capital intensive, volatile and with a high cost of capital (low multiple)
2. A real estate management business operating an extensive Tokyo wide portfolio for inhouse and external capital. This is a high RoIC, low volatility business with a low cost of capital (high multiple)
3. Substantial portfolio of physical real estate assets. A low volatility, low cost of capital business. The income streams from these physical assets are taxed, whereas income streams from REITS are pass through (untaxed at source). Given Japanese corporate taxes this implies a 40% drag to distributable income. Or ceteris paribus a lower value to owners (they get less cash from exactly the same asset) than if the same assets were held in a more tax efficient structure. This is not immaterial to the market cap.

Different investors will value each of these businesses quite differently. Those investors seeking stability and income will appreciate the long duration businesses 2 and 3 but will dislike the volatility from the development business 1. Those who are willing to accept higher volatility but also higher returns might invest in development but are unlikely to want the low return from the large physical RE portfolio. Currently each group of investors is somewhat unhappy… and the multiple is discounted by the volatility introduced by development profits. The most obvious solution is to separate these distinct revenue streams into distinct entities. One alternative would be to introduce far more external capital with the company becoming an organiser of RE development funds, and a manager of and minority co-investor in RE portfolios. This would dramatically reduce the capital intensity of their business, massively dilute the volatility and in our opinion offer potentially dramatic upside to the whole group. We offered as a business model example Brookfield and Macquarie.

This is also a rather radical departure from how the company is currently organised – there are some technical difficulties in unwinding so many years of history. Nonetheless this is not the feedback that senior leaders in Japan often receive from investors. This suggestion led to a very stimulating and informative discussion with the company that was much richer as a result. We certainly learned a lot about this management team and we hope that the team learned something about how capital markets perceive their company and each of its businesses. In truth the perceptions aren’t that far apart internally and externally.

Afterwards we were very happy to receive the following feedback from the company. We aren’t saying that our radical suggestion has already changed the company but rather that a very senior leader within the firm was open to the challenge of re-imagining what his firm could and should look like. This is opening the Pandora’s box…

The CFO, [redacted] really appreciated the valuable comments by David.

He honestly admitted after the meeting, these words from David are contained something important to their company and he would like to take this opinion into consideration to change themselves into a higher level as management team.

We will follow up with the CFO in Tokyo.

New Holding: Jafco

We are often asked how we work together, and the following is an example of how our investment process works and how two fund managers come to a final decision on when to purchase a stock. 

As many of our shareholders know, we have known the company for 25 years and have a close relationship with the President, Mr Fuki. We have met the company at least 20 times. It was a hugely accretive stock for us last year, but we exited in early January as we were worried about the global economy and a slowdown in small cap IPO’s. We have re-entered the stock, having not lost out since we sold it. The catalyst has arrived in the form of the activist, Mr Murukami who has taken a 15% stake. In addition to his entity Oasis, the hedge fund activist owns 10%, as does Marathon Asset management. Mr Fuki has been true to his word on governance. Having sold all his cross held shares in Nomura he has bought back close to 50% of the company over three years. Jafco’s shares still stand at a deep discount to our book value calculation. We think that there is at least 70% upside from here and with a market cap of Y160bn there is Y52bn in cash and a stake in Nomura Research (listed) worth Y97bn. Assuming the venture capital business is worth an average mark up of 5.3X over the cycle that adds another Y177bn to the value. Admittedly, we have not taxed the Nomura Research holding. If Mr Murukami persuades the management to buy back shares and sell the NRI stake we could see another 30% buyback or more likely a white knight rescue. Again, the corporate governance story that we have been highlighting continues to make traction. Incidentally, City Index (Murukami) have increased their stake in Toa to 10% today. This is one of our core construction holdings.

We have taken a 2.5% position TP=Y4900

Source: Bloomberg, 19 Aug 2022

New Holding: Sangetsu

We are often asked how we work together, and the following is an example of how our investment process works and how two fund managers come to a final decision on when to purchase a stock. It also shows how the Zennor process fuses value with GARP and how the evolution of our investment process continues. In the case of Sangetsu, we have fused both PER and free cash flow yield analysis and EV/Sales to derive our intrinsic value. It also demonstrates how under covered Japan is. 50% of the market have no coverage yet the Zennor team have visited at least 15,000 companies over 54 years in the small cap and mid cap space.

One of our most reliable brokers with a huge wealth of knowledge on small cap value alerted us to this stock. We booked a meeting with them yesterday. Infact JS and DM had met the company a few times in their careers, but it was seen as badly managed and low margin and despite its peer company Aica Kogyo running a double-digit operating margin business, Sangetsu had a similar but “fabless” business with operating margins as low as 3.2% in 2018.

Sangetsu is essentially a trading company specialising in wallcoverings, flooring materials, curtains and other decorating products. Whilst predominately domestic focussed the company has operations in the USA and Asia. They took a Y5bn impairment charge on goodwill last year in the USA. Demand for their products is highly linked to the construction cycle. Given the demographic issues and lower housing starts since the bursting of the bubble, overall demand for interior products has fallen 20% in Japan as a whole. However, since the Lehman crisis there has been a decent bounce in housing starts. Overall Sangetsu has seen its sales far surpass the overall housing market and office building market growth rates. The company has 12,000 products and relies on 270 suppliers. Sangetsu designs, outsources production and then delivers. Until now they have not charged clients for design or for delivery (which they are now doing). Under a new President who has come from Mitsubishi Corporation the company has managed to raise prices twice. In September 2021 it raised prices by between 13-18% and then by 18-24% in April 2022. It plans a further set of price rises in October 2022 by 7-12%. Clearly, the company has been selling its key products far too cheaply and designing and delivering for no cost. For the current fiscal year, the company is projecting a 6.2% margin. However, given that in the first quarter they made 9.8% margins and momentum has continued in sales the new pricing structure is clearly paying dividends.

The business model has also changed in that whilst the company used to focus on the residential market it has paid much more attention to the office (non-residential) refurbishing market. It is this area of refurbishment in the non-residential and residential that will be focussed on. Clearly, suppliers are raising their prices, but we feel that their end selling prices have been artificially low in a deflationary environment. The new President has seen the current inflation spike as a clear opportunity to change the business model. The company were expecting that there would be negative sales momentum after the price hike in April 2022, but this has not materialised. Momentum in sales remains strong and unaffected by the price rises. The company continues to reform and streamline its distribution system. Whilst we worry about losses in the overseas operations these are more US related and as mentioned the company has taken an impairment loss of Y5bn of goodwill and the plan is to move into the black operationally overseas in 2026 (from losses of Y1.7bn).

Whilst the outlook for housing and office build is dull, we believe that the company can grow top line at 5% per annum from a shift to a renewal/refurbishment model and increasing market share which currently sits at over 50%. Assuming a move in margins to 10% over three years we can assume that sales will be in the region of Y185bn or 2X current EV. Based on EV/Sales of 1X there is 100% upside. Based on the 3 year forward cash flow of Y20bn the free cash yield is 24%. Assuming we tax this at 35% the sustainable free cash flow is Y14.1bn and assuming a target cash yield of 10% gives upside of 63%.  A PER of 15x which is not unreasonable suggests 100% upside. Upside could be even higher if we adjust for excess working capital.

We are taking a 3% weighting and have decided that there is 100% upside. The range of our different methodologies ranges from 63% upside to 161%.

ESG considerations were also given. The company aims to reduce energy consumption by 4% and their recycling ratio is 83%. 37% of the workforce are female and 20% of those are in managerial positions. Governance is excellent. The dividend pay-out ratio is 59% and there is an intention to pay out 100% of profit to shareholders. Assuming Y12bn of net profit to 3/25 assumes a total pay-out ratio of 12.5%.

Both managers were in total agreement. The turnaround time from meeting to investment was 24 hours. The company has been seen at least six times in 32 years. TP=Y3264

Source: Bloomberg, 19 Aug 2022

From the Archives: Observations on Nittetsu Mining

One of the most useful tools we have is a long back catalogue of company notes over thirty-three years. For ten years this information was overlooked; quantitative easing caused growth stock valuations to climb ever higher and breadth in the market became very narrow. “Winners” were run longer and everything else that didn’t have a technology angle or was asset light was discarded. This brings us onto Nittetsu, the copper smelter and upstream miner, with assets in Chile. Looking back through my notes I found my first visit was in 1993 at Martin Currie. There was no coverage then and there is no coverage now!

I wrote in 1993; “While their earnings trend is largely dictated by natural resource prices the balance sheet offers attraction, most notably the unrealised value of their property holdings”. Back in 1993 (John Major was still Prime Minister) the company had ¥33bn of cash of its balance sheet and long-term Investment Securities of ¥8.6bn. Debt was ¥27bn. The company have substantial leasing assets and in 1993 the book cost was ¥5.7bn. Last week in a company interview this figure was confirmed. In 1993 the market value of land was estimated (Yuho statement) at ¥20bn, implying an unrealised gain of ¥15bn. Again, last week when we asked the question of “unrealised gains” the figure was a touch higher at ¥27bn.

So, in 30 odd years we have the same “belts and braces” in balance sheet strength that we have always looked for. Currently cash is ¥33bn, long term investments are ¥29bn, and debt is ¥23bn. With a market capitalisation of ¥49bn the current EV is negative-a very large figure (untaxed) of ¥12bn. Added to which it is spinning off at least ¥4bn in free cash flow.

The company serially underestimates forecasts. This year is no different. The firm guides for a copper price of 410 cents/lb and a $/¥ exchange rate of 120. Given where the copper price and the currency are there would be at least a 20% uplift to profits to 3/23. The sensitivities given were the same thirty years ago as they are today.

If we are right, then we could see ¥900 per share and a PER of 6X and a dividend yield of 4%. What was especially pleasing was the finding that the company will write extensively on ESG and carbon footprint. They will also be addressing issues such as cross shareholdings.

Historical knowledge has always been important in Japan as management does not change that quickly. As the great reversal beckons, we are glad to have access to such a large back catalogue of information and are looking forward to highlighting further gems from the archives. 

-James Salter, 05/06/2022

Results Round Up

Guidance for 3/23 is conservative but dull. Group Net Profit forecasts are for a small fall of 3.0%. Quite a lot of this is Toyota, reporting a sharp fall in profits due to rising costs and supply side issues centring on chip shortages. This new reality is quite a bit below consensus which is looking for +8% Net Profit Growth. We will also see a substantial fall in Shipping Industry growth compared to 3/22 as the one-off pricing environment and supply side constraints dissipate. Sectors that expect to see higher growth to 3/23 include typical reopening plays such as railways and Airlines. Industries looking at a fall in profits include Automobiles (Toyota), Trading Companies, and Oil and gas.

The good news is that our story on Corporate Governance Reform continues to gain traction. The following chart from CLSA shows YTD buybacks up 45%.  2022 looks likely to surpass previous years.

Source: CLSA

As we continue to flirt with stagflation across the developed world, we think that Japan stands out as a stock market where physical real assets are now being appreciated. 40% of TSE First Section has 20% or more of equity in net cash.

Source: CLSA

Source: CLSA

In addition, 50% of the market trades below break up value. All this value needs a catalyst. We now have that with over 97 activist events last year and close to 30 already this year, until end of April.

Source: CLSA

Finally, CLSA have produced this chart which we like. It shows the percentage of TSE First Section companies covered by analysts within the market.  An astounding 43% of TSE First is uncovered. Interesting to see that the S&P is almost “efficient”.

Source: CLSA

In our April Newsletter we emphasised that despite the poor macro climate globally there were nuggets of real value and exciting special situations in Japan. This is the case with the portfolio. To highlight a few of our core ideas; JGC (1963), the LNG construction company reported a great set of numbers. Order guidance for FY22 is above all analysts’ expectations and gross profit margins too. The order guidance takes it to within reach of its all-time high numbers. Despite a sharp move, the shares trade on 15X earnings with a pristine balance sheet.

Sankyo Pachinko (6417), a recent holding and one where we have high hopes for an MBO, announced operating profit growth for 3/23 of 36% YoY. The company has continued to deliver hit pachinko machine titles. The shares trade on a PER of 12X and have about 80% of their market cap in net cash.

Our reopening play, MatsukiyoCocokara (3088) (drug stores) saw 4^th quarter operating growth of 67% YoY. It is also guiding for 28% growth in operating profits. Group synergies are increasingly apparent as are efforts to raise the percentage of private brand goods. The shares trade on 14X earnings and are a good play on the tourists returning in the autumn.

Finally, our small water bottling company, Lifedrink (2585), delivered as promised, projecting 16% operating profit growth to 3/23.

The portfolio trades on a forward PER of 10.5X versus 12X for the TSE First Section. Our dividend yield is 2.4%, although that ignores a 3% special dividend from Toshiba. The portfolio trades on 0.8X book value versus 1.1X for the market. Our ROE is at 7% versus the market on 9%.  Average price to Sales ratio is 0.7X.

Bank of Kyoto (8369) and Katakura (3001)

We have recently added to our long-standing position in Bank of Kyoto and reintroduced Katakura to the Zennor Japan Fund.

We have long held the view that the regional banking sector needs radical reorganisation. Put simply, there are far too many regional banks, most of which do not make any meaningful profits in their core banking businesses. Many of these companies trade well below break-up value and also hold many long-term investment securities on their balance sheets, carrying large historic gains.

Bank of Kyoto exemplifies all that is wrong with the sector and why we believe that it is imperative that key shareholders continue to exert pressure on management to address both returns and shareholder rewards. The bank has significant equity holdings in a range of Kyoto based companies, ranging from Nintendo to Murata. Currently, those holdings are worth ¥1 trillion, which compares to the bank’s market capitalisation of ¥430bn. All of Bank of Kyoto’s profits come from the dividends they receive from those Kyoto based companies, meaning that core profits are negligible and return on equity is extremely low at between 2.5%-3%. The company made a step in the right direction towards the end of last year when they announced plans to pay out 50% of EPS as dividend. Whilst we commend that, given that 100% of the EPS comes from those dividends received, both ourselves, and most recently, very vocally, Silchester have asked for the bank to pay out 100% of those dividends received and 50% of core banking profits. That would amount to a dividend yield of 5%. Silchester have asked for a special dividend to be paid this year and have asked for this resolution to be included in the AGM agenda. If this is not adhered to, they will call an EGM as they own over 6% of the company.

The Zennor Japan currently has approximately 5% of the fund in Bank of Kyoto. At 0.3x break-up value and resembling an Investment Trust, there is little downside risk and with an activist now pressurizing management for change, there is considerable upside to our own Intrinsic value calculation. If the core banking business could ever see a recovery, that upside would be even greater.

Finally, Katakura. This is a position that was held by the fund all last year and was a large contributor to performance. It is a mini conglomerate, with diversified businesses from pharmaceutical to textiles. The jewel in the crown is the Real Estate business. Despite its current market capitalisation of ¥80bn, there is ¥34bn of hard cash on the balance sheet, ¥4bn in treasury stock and a further ¥15bn in Long term held investment securities. With ¥14bn of debt, Enterprise Value is approximately ¥41bn.

However, they have a real estate portfolio worth ¥127bn. In 2017, the activist fund, Oasis, began to pressurise the company to enact structural reform. Loss making businesses were exited and cost cuts made through a voluntary early retirement programme. They began to buy back shares and appointed a new outside CEO and three new independent directors. At the end of 2021 an attempted MBO took place at ¥2150. This was rejected by shareholders, but Oasis sold their stake (17%) and those shares have ultimately been taken by the Aso Group. Given the large discount to Intrinsic value we believe that the shares are now in play and offer excellent downside protection as earnings have already been released and that the Aso Group is likely to increase its stake.  Accordingly, the Zennor Japan Fund has recently reinvested in Katakura with a position of 1.5%.

Kumagai Gumi (1861)

We recently wrote about a new holding Kumagai Gumi 1861 highlighting its improving trading, appreciating the strong balance sheet and praising its new found commitment to increased shareholder returns. A follow up meeting with the company reminded us that this vision of a ‘new’ Kumagai Gumi is not seemingly shared by all of its senior management team…

The company spokesman we met with said that he still felt that the capital raise that they conducted some years before had been a good thing due to the stronger ties they now had with Sumitomo Forestry. When asked how this had materialised in additional business opportunities the answer was that in fact the links were still rather limited… So with their new found capital strategy would they do this again? ‘Yes!’ he beamed. As the shares had performed well in the market sell off we took this as a sign that we should step away and re-assess our investment thesis…

Our thoughts today are that several explanations present themselves:

1. Our speaker was not inline with the current company strategy and we simply received bad information from him. We HOPE that this is the case…
2. The company is internally divided between ‘new’ and ‘old’ ways of thinking about capital and the debate is still raging!
3. The company has not changed at all – and is just ‘pretending’ to have changed with some minor capital policy changes but nothing that impacts the balance sheet or cash flows materially

In any case we felt that there were sufficient questions about capital policy and management strategy that we could not be confident that our thesis was correct. In these cases we simply (and shamelessly) exit the investment and move on as part of our SELL discipline. We are very open minded to re-assessing the investment hypothesis but we do it from scratch not as ‘trapped holders’ where the investment case has failed.

We will revisit the senior management team and try and get to the bottom of this mystery!

Yen weakness, inflation and the market

John Authers recently wrote an interesting article on Japan. He makes three points the first on the Yen weakness; the second on inflation; and the third on the market. In all respects the backdrop is slightly different than it has been since 1990.

Regarding the Yen. We do not believe that it is materially over valued – if anything the opposite. A purchasing power parity (PPP) estimate would probably have a fair value around 90-95 vs. USD – over time the fair value of the Yen has been STRONGER. As such the current falls in the JPY are pushing it further from fair value not towards it. Generally the Yen has not moved radically far from FV and in practice has oscillated around it. The main perceived driver of weakness just now is a deterioration in the terms of trade caused by higher raw material prices but more importantly – Bank of Japan (BoJ) policy. The BoJ today chose to defend the top of its yield curve control (YCC) rate range with unlimited buying providing traders with comfort – for now – that interest rates will not be allowed to rally whilst in the US increasingly hawkish commentary from the Fed provides the opposite conviction. They risk having to now do this every day to protect the upper bound… Within Japan there is increasing unease at the weaker Yen – whilst BoJ governor Kuroda sees this as a tool that helps him reach a positive inflation rate. Mr Kuroda however is not in charge of Yen policy - that lies with MoF. Controlling the currency whilst also being committed to unlimited bond market intervention as part of YCC is inconsistent. There are increasingly vocal voices who worry that this may squeeze household incomes. It is true that Japan imports much of its energy but as an economy it is not very open – the impacts are quite weak BOTH on REAL INCOMES and on INFLATION rates.   A weaker Yen is good for Japanese market earnings - on balance; not necessarily as positive for the economy as a whole. Certainly the current level is very supportive of many exporter transactional and translational earnings power. The carry trade is a wonderful thing whilst it lasts – however when it ends the move tends to be brutal. Already hedging costs for Japanese exporters have increased sharply which may lead some to go unhedged – but is also a reflection of an unhealthy one-sidedness in market positioning. Effectively you are betting against a country where the trade account is usually in surplus AND where the capital is being exported when the currency is already near historical cheap levels. If anything causes this state of affairs to reverse then speculators can find themselves very offside. It is this reversal in capital flows at times of significant market stress that causes the Yen to strengthen – not the current account moves or interest rate differentials. Tactically, in the very short run seasonality favours a stronger Yen as dividends are reinvested.

Japan’s Current Account Breakdown (Source: MoF)

Pressure for rate normalisation post Kuroda is a further risk if the BoJ decides to adjust the YCC policy framework. Specifically regarding AUD there are good reasons to think that it has not moved enough given the change in commodity prices. No one is keener on betting on carry trades than Japanese retail investors! This can push JPY further. So whilst momentum may carry JPY weaker we are starting off at already low levels; traders are unbalanced in positioning and it is likely that the macro settings in Japan will change once Kuroda stands down next year with growing mutterings about the speed of the recent move. It doesn’t feel like a wonderful moment to be aggressively shorting Yen from a 1 year out perspective. In general we would only try and strategically have a Yen view if we believed that the currency was radically wrongly priced – we are stock pickers not macroeconomists. So at 122 we think JPY is cheap; at say 150 probably that it is absurdly, unsustainably, cheap… and we would have to reflect that into portfolios.

What the softer Yen can do is boost Japanese inflation. Inputs will rise and some will get passed on. In general industrial companies have more experience of adjusting prices than domestic facing industries. That said we are seeing changes in pricing becoming less contentious – were it not for slumping mobile phone prices Japanese inflation would be running much higher – though still far lower than in the US or UK. Excluding mobile phone prices sees an underlying inflation rate of +2.4% (mobile phones are taking off -1.45% in February YoY) – the impact of this will start to drop off in April. Japanese inflation (excluding tax hikes) have been above 2% for just 3 monthssince 2000 so for Japan there already is a significant level of inflation in most sectors. From April onwards we should really see that start to come through at the headline level. Domestic companies do continue to face excess competition making it hard to change prices – some have probably forgotten how! But some larger firms are raising prices e.g. beer, soft drinks, milk and these will be the first movers. Other industries like paper are raising prices, and utility bills will be increasing. The Japanese basket is different and less Ukraine exposed than ours – rice, fish and utility prices that are based off longer term contracts vs. spot pricing, meat and wheat. It seems likely though that higher global inflation will likely gradually drag up Japanese inflation rates. Inflationary expectations in Japan are very backward looking – they reflect what has happened far more than anticipating what will happen. A sustained period of positive pricing will be required to shake off the engrained disinflationary mindset. All of Mr Kuroda’s efforts since becoming BoJ governor have been directed to achieving exactly this aim of shifting the inflation expectations.

John’s chart suggests that Japan is a lagging market since 2010-> It has lagged MSCI World but has actually materially outperformed both Europe and Emerging markets. It has simply lagged behind the US – more than entirely due to US multiple expansion rather than underlying earnings growth. Japanese firms have made large strides in improving RoE and margin structures. They have made less progress in slimming bloated balance sheets. The mix within the Japanese market has also shifted – there are far more robust domestic service companies e.g. Internet; and export companies have localised their production to a large degree. Consequently, the impact of the Yen is less transactional and more translational than it used to be. This dilutes the leverage of GDP to weak Yen induced export surges. It is natural and healthy for the market to be less dominated by moves in currency than it used to be. It is not just Zennor who is finding good value in Japan. Private equity and corporates are also very active in M&A – to date we have had 7 portfolio companies experience material capital events (ToB, MBO, etc) reflecting this profound under valuation coupled with the ongoing corporate governance revolution – and numerous other examples of more shareholder friendly behaviour such as buybacks and management change.

We remain focused on finding materially mispriced individual securities that have positive catalysts combining them in a portfolio that has very idiosyncratic drivers. Whilst we do not ignore macro it is also only one part of the story. The fund is broadly overweighted in reflationary beneficiaries financials; industrials; and materials whilst being generally underweight domestic services and consumption. Most of these positions also benefit from a weaker Yen. Our banks (MUFG 8306, Shiga 8366, Kyoto 8369) make practically no money through domestic banking – just imagine what a positive yield curve could do to their earnings power and multiples? In domestic consumption what we own are discount stores that benefit from their ability to procure; and companies going through large structural reform (PPIH 7532) and supermarkets (Seven &I 3382) where the ability to pass on prices is easier. In both cases there are other aspects to their story that we like. We also have exposure to domestic travel and tourism and recruitment in anticipation of a post COVID reopening boom. In materials, technology and industrials we have numerous globally exposed businesses which will get a boost from a softer Yen but where their own industrial product cycle or self-help is what we are really excited by such as JGC’s (1963) exposure to LNG investment or Shinko’s (6967) leverage to datacentre capex cycles.

Daiho (1822): A cheap company with a catalyst

Daiho is a mid-tier construction company where, under outside pressure, a domestic company has stepped in to take control of the company in a white knight deal at a significant premium – we are being offered 4,730 and a dividend of 220 per share => 4,950 for shares that are successfully tendered.

The deal combines many elements that we look for in our Corporate Governance Revolution thesis: a strong balance sheet and stable operating entity at very low valuation; engagement with the company by shareholders; a catalyst (in this case a White Knight investor); and an unlocking of the abundant value trapped in the legacy corporate structure. Prior to the tender offer the market cap was just 65bn. The effective bid valuation is close to 100bn.

Daiho was a holding in the Zennor pre-launch model portfolio and in the fund from launch. At the market lows of 2020 Daiho traded significantly below net cash i.e. VERY cheaply.

Source: Bloomberg

Construction is a sector where value abounds but where extricating that value can be challenging. Investors typically assign a very low value to balance sheet assets unless/until there is a clear strategy for those assets to be returned by the company to shareholders. Typically the shareholder lists are very defensive which makes this difficult. The Japanese market is inefficient at pricing balance sheet rich operating companies.

The value opportunity at Daiho? Our analysis suggests an intrinsic value of 160bn looking at both asset base and operating business. Taking these two components together gave us a realistic exit valuation above 100bn. Daiho was clearly VERY cheap but without a catalyst this was not enough

In Daiho we found both a cheap company AND a catalyst.

The numbers

Operating Business = 60bn

• Revenues of 150bn and stable profits around 10bn EBITDA, and 6-7bn in Net Income. If we assume that the core business is worth just 10x PER (transactions have taken place at 20x recently) this implies a conservative warranted value for the earnings stream of 60bn
• This is likely conservative

Balance Sheet Assets = 100bn

• Like so many peers it has an asset rich balance sheet – and to disguise the large and growing cash position had been systematically expanding its working capital.
• This assumes full value extraction from the balance sheet – which is somewhat aggressive on a going concern basis.
• Bloated working capital - over several years the  cash conversion cycle grew from 40 days to more than 85. This had the impact of consuming >15bn in Free Cash Flow. Total net working capital is 50bn.

Source: Bloomberg

• High Net Cash position: The company has funded this through running down their bloated Cash position – from >100% of market cap to 1/3 of market cap… but simply by pushing their cash out to their customers. Net cash stands at 15bn.

Source: Bloomberg

• The business which also has: financial investments of JPY 8bn, long term investments of 11bn, real estate book value of 17bn

The Catalyst

Whilst Daiho had appeared on our value screenings for a long time the incentive to get involved was the involvement of a Japanese family with a proven engagement track record. Looking at the shareholder list we quickly appreciated that there were no controlling family or Keiretsu relationships that could easily block them. Given the extreme undervaluation at purchase we felt that this was an opportunity worth engaging with. The value that could be unlocked through a change of control was significant.

The company had little option once the balance sheet value was exposed but to find a new controlling investor, MBO, or radically change its business model and return the excess capital.

The Japanese investor gradually increased their exposure – including a standstill agreement to allow the company time to find a white knight (Aso). It is reported that they offered to either take over the company themselves, or alternatively that the company conduct an MBO. In the end they probably introduced Aso as a sponsor for the tender offer/take control process.

Whilst the structure of the deal still leaves potential value upside to our intrinsic value estimate we believe that this is a good outcome for shareholders - an opportunity to crystalise operating and balance sheet value at a large premium to the prevailing market price.

Navigating Market Volatility

Our sense is that the Fed will still raise rates next week. However, as a result of the Russia/ Ukraine crisis the pace of rate hikes is reduced. Members of the Fed committee seem inclined towards normalisation. ECB action on rate hikes will not happen anytime soon. Nor will the Bank of Japan change their current stance. This is a challenging time for central bankers as high inflationary pressure and a tight labour market are confronted with the commodity supply shock which will impact real disposable purchasing power. They must judge carefully whether this combination will spill into a persistent price-wage spiral which they should crush now, thus tipping the economy into recession, or whether they should remain easy, or if there is a middle way… This is in large part a consequence of their over easy policies of the last years – they created this impossible choice between Scylla and Charybdis. The commodity price jumps represent a dramatic shift of purchasing power in favour of commodity producers from commodity consumers - real consumer spending power will be hit. If the Fed continues with its hawkish tone to control inflation it is likely that we will see an inverted yield curve as they provoke a recession. The good news is that many consumers have high levels of savings after COVID and can draw down on this to smooth consumption.

Q1 looks difficult for the Japanese economy. This is as a result of the Omicron variant and continued supply side issues which are proving to be longer lasting than initially expected. There is very limited direct impact from the Ukrainian crisis visible as yet. The good news is we expect that the second quarter of 2022 will witness a sharp bounce back. With Omicron almost past its peak and the prospect of reopening happening soon, combined with supply side issues improving (thus enabling automobile production to kick in) there should be an enormous tailwind for the economy. Export growth should pick up substantially. We have been surprised by the Yen’s relative weakness in the last two weeks. With higher commodities, the trade deficit is likely to widen which may explain this (plus a different picture on rate rises versus the USA). This should support earnings for many exporters.

We are probably most bullish initially about Japanese consumption recovery, given the government’s “Go to” travel campaign which should simulate travel and dining as well as transportation related areas. We have exposure via Pan Pacific (7532), Seven & I (3382), and Orix (8591) amongst others. Capital expenditure should continue its gradual uptrend.

The events of the last week will have a profound long-term impact on governmental policy. One new aspect is going to be the emphasis on security and stability of supply of essential materials and products. This will happen even at the expense of progress on longer term goals such as carbon neutrality. A more localised, de-globalised (and less efficient?) supply chain will evolve. Between them Xi and Putin have killed globalisation. This will necessitate a relocation of production and increased capex in many industries structurally. It is also ceteris paribus productivity reducing.  JGC (1963), Mitsui (8031) and Orix (8591) should be beneficiaries of this trend in energy.

We have flattened the portfolio given the wide range of potential outcomes. This has meant scaling back or exiting some stocks that may be overly exposed to input price changes in the short run. Equally some companies have sold off aggressively and now provide substantial upside and we are allocating incremental capital cautiously to them. A ‘good’ outcome could easily see an abrupt reversal of recent trends – yet a continued escalation would merely reinforce them. We are trying to remain balanced between those outcomes, preserving capital and getting ready for more decisive positioning when the opportunity is right. Put in terms of our usual process the opportunities of meaningfully undervalued stocks are many; what we are looking for is the ‘catalyst’ to commit capital. To this end we have been more net sellers than buyers amongst the volatility preparing for what we believe will be a meaningful opportunity to deploy capital aggressively. Within that we have been slowly rotating capital from some lower beta ideas to now extremely oversold recovery candidates. We do not pretend to have any unique insight into how the Ukraine situation resolves itself and we are unwilling to make a bet on the outcome – but we are getting prepared to do so. For us that means it is as important to have an offence (semiconductors, autos, financials and industrials) as it is to play defensively (disrupted commodities, balance sheet strength, consumers). Topix is at 1.1x PBR – in March 2020 it bottomed at 0.9x, after the Fukushima Earthquake and during GFC the market bottomed around 0.85x. We are not far very away from those valuation levels of extreme system stress. Despite the headlines we want to be careful to be neither too positive (and early) nor too defensive (and late). The portfolio trades on 9.8X PER and 0.78X Book. We see more than 100% upside to intrinsic value.

Keeping Faith with Sun Corporation (6736)

We took a position for the fund at launch in February 2021. Sun is a frustrating illustration of a hugely undervalued intrinsic value holding lacking a current mechanism to extract that value. The business was set up in 1971 by Mr Maeda. It started manufacturing automatic ticket vending machines for Omron. Then, it branched out into the Pachinko field producing control systems for Pachinko halls. This then led to the company trying to develop video games for arcades and pachinko halls. In the early 2000’s Mr Maeda began operating electronic commerce sites and gaming sites for mobile. On his travels to Israel, he purchased close to 100% of a company called Cellebrite. Cellebrite software is used in extracting data from mobile phones and smartphones and is used predominantly by the police, and law enforcement agencies globally. It was after the Boston Marathon terrorist attack that Cellebrite’s software was used to track down the terrorists.

Cellebrite, is now listed on Nasdaq and has a market capitalisation of $1.4bn. Sun Corporation own 52%, having been paid $230m to part with about 25% of the company prior to listing (de-SPAC). Cellebrite’s top line is forecast at $300m this year and thus trades on about 4.5X sales. Its gross margin is 81% and adjusted EBITDA margin is 15%. This understates the profitability as currently R&D is 27% of sales and sales and marketing are also 29% of sales as the company is in an expansionary phase. Listing costs and option granting costs and costs of recent acquisitions have also hit the EBITDA level. Trading on 28X 12/23 EBITDA is quite rich but top line is growing at a 30% clip. ARR is forecast to grow at 34-42% YoY in 2022. The ARR grew 37% in the 4^th quarter of 2021. Subscriptions account for 74% of revenue now.

Now for the maths. Sun Corp has a market capitalisation of ¥43bn. We assume that they have about ¥26bn of net cash on the balance sheet. Cellebrite has a market capitalisation of ¥161bn, and Sun have 52% of the company or ¥84bn. Tax that at 40% which is harsh, and this leaves them with a ¥50bn holding in a fast-growing software company. Assuming that the parent is close to worthless,  (we would say ¥5bn which is 1X sales) the sum of the parts suggests a fair value of ¥81bn versus the current market capitalisation of ¥43bn. Close to 100% upside to intrinsic value.

How can this be extracted? We are suggesting to Cellebrite to take in Sun Corp. If they were to pay a 50% premium, they could buy Sun for ¥63bn. Less the cash of ¥26bn the real acquisition cost would be ¥37bn or $320m. This would require perhaps issuing 24% new shares. They would inherit 52% of their own stock. Cancel 40% and leave 12% in treasury for future acquisitions and EPS at Cellebrite would be boosted significantly. With Oasis, the activist on the board of Cellebrite and Sun Corp we sincerely hope that both boards will come to the same conclusion.

New position: Renesas (6723)

We recently initiated a position in Renesas 6723. The brutal -25% technology sell off dragged Renesas down to compelling valuations leaving it as a mispriced cash flow.

Renesas is a leading micro controller semiconductor company with strong historic ties to Toyota but with a rapidly growing presence in other manufacturers and other industrial end markets. Their micro controllers are used to manage data from sensors that enable cars to drive more safely, more comfortably and more efficiently. These are big trends in auto and are growing at a double digit growth rate – MUCH higher than underlying automotive volumes – as digital/semiconductor content increases in cars. We are also positive in the short term automotive production outlook as supply constraints ease.

Earnings

Earnings have been steadily growing. On Feb 9^th the company released very strong full year numbers and a bullish earnings outlook driven by increasing profitability and a strong order book. We expect that the positive earnings revisions will continue. We expect that the company will be able to generate in excess of 400bn in EBITDA and >200bn in FCF annually.

Valuation

The Renesas valuation had slumped to levels usually seen at the bottom of the market. Lower even than March 2020! Trading on just 9.6x PER this undervalues one of the key players in automotive electrification.

This situation is unusual as Renesas has substantially derated against its' global peer group over the last few months. It is now trading at a near 50% discount to the peer group. Quite often in history this has been a premium… This is not a case of a company that has traded at a persistent discount. 

What is the counter to the Bear case ?

Please read the post below ( What of the Bear Case?) for context.

Politics

We will have to rely on a Japanese source to suggest that politics is probably not quite as bad as it seems. Kishida’s priority is modelled on the 1960s ‘double income’ and ‘garden city’ strategy of Ohira. A ‘gentler capitalism’ after the post WW2 privations eased a little. Focus is to most importantly Survive COVID – which took down Suga on his perceived mishandling of it.

Then and only then:

1. Economic Growth – digital garden cities
2. Higher wages
3. Realistic foreign policy (almost all LDP leadership candidates have a ‘hard line ‘ on China/NK).

First signs of movement on re-opening should be visible from Easter onwards – student and work visas first.

Cycle/Market

Yes, we are mid cycle but not end cycle. The constant interruptions of COVID has created a de-synchronised cycle with some countries at different stages of re-opening or lock down. Many countries with re-opening and have pent up demand ahead of them. For Japan supply chain disruptions have been material to tech and autos. Japan is also still in a state of quasi-emergency with limited restaurant opening hours and shopping creating a generally cautious consumer atmosphere. As this eases there is plenty of scope for much higher production, travel and shopping. Reopening and restarting will have a notable impact on earnings and activity. We expect the US to slow but that it is unlikely to be crushed by the Fed – or at least not yet! Real rates are incredibly low and policy is still/will be very accommodative. China is also easing once again and in economic impact terms this could more than offset the US. 

In general Japan has a low resource intensity and has a long term strategic (autarchic) energy and materials procurement policy. There may be some transitory margin impacts but not likely something that specifically impacts Japan more than other manufacturing countries. 

Japanese CPI could possibly reach 2% this year which may allow Japan to exit NIRP (Negative Interested Rate Policy) and YCC (Yield Curve Control) which can have some perverse liquidity impacts and proclaim ‘first step to normalisation’.

Commitment

Prime index joiners have all just signed up to higher standards publicly. It would be shaming not to follow through. Generally this means better governance not worse.

ESG is not going away. Japan is only just starting to embrace it and it is the new consensus move for corporate Japan. The consensus is that in Japan E and S are basically solid and that it is governance that is the weak point. The low starting point implies that there are easy wins for Japan Inc. here. The RoE decomposition shows that margins have improved the easier part of balance sheet and asset slimming is the next lever that can be pulled. Hiking a dividend or conducting a buyback is surely easier than exiting a division or closing a factory?

Lifedrink (2585): a broken IPO, not a broken company

Note: all figures quoted are in Japanese Yen

Our View in Brief

Lifedrink is a new purchase after a not entirely successful IPO... Currently it trades at 1050 which we believe is meaningfully too low in the short run and insultingly so over the medium term. Lifedrink ultimately offers >3x upside through higher earnings and multiple re-rating. This is a classic case of an Mispriced Cash Flow stock that suffers from lack of coverage.

About Lifedrink

Lifedrink is a producer of private brand sparkling and still bottled water, and tea. Its core edge is its vertically integrated production process which drives a low cost structure. It competes against many large branded drinks companies such as Suntory, and Coca Cola Japan but does so without the marketing and brand company overhead. Consequently it can sell at a lower price (58-68JPY vs. 88-98 for the market) and still generate better margins.  This formula is powering sales growth – the main constraint is their lack of capacity which is now being addressed. The company keeps its costs low through focusing on a limited number of products in a limited number of packaging sizes. This radically simplifies production and distribution whilst supporting economies of scale.

Attractive qualities:

Exposed to structural growth

• Consumption of bottled water and tea is growing steadily
• Lifedrink's customers (large supermarkets, drug and convenience store chains) are steadily winning market share
• Private brand penetration is growing - Japan's private brand market share in water is just 9% vs 49% in the US

 Capacity

• Lifedrink is now investing behind this growth opportunity, and they only expand capacity when they have already secured demand from their customers, substantially reducing the risk of investing. This also provides better than average visibility into future sales trends. As Lifedrink is not exposed to the volatile trends around coffee, carbonated and other non-staple drinks their business risk is much reduced.

Potential for increased profitability through rising sales and rising margin

• As Lifedrink grows we see the potential for margin improvement via investment in logistics capability to reduce operating costs and increased automation.

Sustainability

• Management at Lifedrink is well aligned with investors with the senior leadership owning >1% of the company directly. We are encouraging deeper ownership of equity throughout the company. Governance structures are strong.
• They are working to minimise their environmental footprint through reducing packaging, and increased use of recycled materials. They are also improving their distribution system which should reduce the impact of distribution. We are engaging with them to share best practice and work on disclosure.

Potential Catalysts

• Sell side initiation reports raising awareness
• Post IPO management investor engagement
• Strong quarterly trading highlighting their growth trajectory
• Strategic buyer for the Sunrise PE position resolving the overhang

Katakura (3001)

The shares were bought in August 2021. The Company is a diversified company with interests ranging from Textiles to Pharmaceuticals to Machinery. The Jewel in the crown has always been the Real Estate division. Leveraging its property portfolio, it conducts businesses centred on shopping centres, day-care centres, and outdoor fitness clubs.

The company has been followed by the managers for over twenty years. The restructuring of the business began in 2016. An aggressive withdrawal from key areas of businesses that were loss making has been carried out and a voluntary retirement scheme was introduced. The company is one of Japan’s oldest, founded in 1873, only five years after the Meiji revolution. Since announcing the restructuring in 2016, operating profits have over doubled. The pharmaceutical business has recovered from large losses, as has the textiles business. What is most encouraging is that the company have made strident efforts to unlock the real estate assets. Five loss making business were shut down. And the company introduced formal targets for both ROE and ROIC.

The Zennor thesis on Katakura was as follows:

1. Company known by the team, yet no analyst coverage.
2. Clear signs of restructuring
3. An activist engaged in pushing management to achieve better returns
4. Clear evidence of buybacks.
5. Huge discount to Intrinsic Value. Estimated at Y5400 Pre-Tax
6. Shares bought at Y1450. Market Cap was Y50bn. Y4bn was in treasury stock and a further Y16bn in Long Term Equities. A further Y30bn in cash and very little debt. Book Value was Y80bn but unrealised gains on land were Y100bn.

Management has attempted to do an MBO. An initial offer has been made at Y2150 or close to a 20% premium. Zennor thinks that ultimately a higher price could and should be achieved. This was seen with a stock called Sakai Ovex. An MBO was announced but the final price ended up being 33% higher.

Zennor retain a 3% stake and set a target price of Y2800 still a huge discount to Intrinsic value. Thus, if we are ultimately successful the trade will have returned 100%.

Japanese market catalysts for the latter third of 2021

Since the fund launched on 8th February 2021 the broad Japanese market has done nothing - fortunately this is much better than the MSCI China index is off -20% since our fund launched!

The reasons are-

1. Chinese regulatory tightening and reduction in policy stimulus. This has impacted SOME Japanese stocks such as Fast Retailing and Softbank -two big Nikkei index components.
2. The Delta variant spreading within Asia again and rising Japanese infections. The Olympics, whilst a success for Japanese athletes has been a horror story for the PM, Mr Suga. Fear of COVID has only slowly been offset by rapidly increasing vaccinations – and strong performance by Team Japan.
3. Japan as a ‘value’ linked market has tended to struggle when US yield curve has flattened – as it has over the past 6 months. As we move out of ‘initial recovery’ into a more stable growth phase markets often struggle to reconcile good growth rates with slower rates of growth. We believe that we are nearing the end of this correction based on historical analogues.
4. Given the 3 factors above global investors remain sellers of Japan. We believe that this misses the powerful, slow-burning, revolution in corporate governance. Very strong balance sheets, robust cash flow and low valuations and increasing pressure to raise returns make for an interesting dynamic.

It is our belief that Japan may play catch up in the final 1/3 of the year as numerous catalysts play out.

1. First quarter numbers have been impressive. Obviously the YOY impact is very large as this time last year was the bottom of the cycle. Q1 sales are so far +23%, operating profit +182% and +370% in Net profit. Operating profit equates to roughly 60% of first half targets across all industries. The forecast revision index is moving in the right direction. As September half year numbers get closer, we expect to see formal (and additional) full year revisions up and shareholder rewards such as buybacks coming to the fore once again. We have been struck by the malaise with which great numbers have been taken. We have avoided any poor numbers in the portfolio and yet a few of our names have reacted poorly. This is what we refer to as a great time to be in the UK and not on holiday! We will be adding to these names and taking advantage of short-term noise.
2. Japan’s economy fully re-opens after Covid and the Olympics. Numerous domestic firms are moving sideways as the ongoing State of Emergency continues. With rapidly increasing vaccination rates there are some tentative signs of a more relaxed policy from the autumn. This should support both economic activity but also related stocks many of which have hardly performed over the last year.
3. Corporate M&A activity which has hardly slowed in COVID looks set to resume with a vengeance as those who have held back during the downdraft come back with more requests on capital policy and management strategy. For instance, Toshiba will unveil its own strategic review outcomes, and this should presage a period of significant group change. Preparations for the new Prime index will also catalyse activity.

First Quarter Results

We are pleased by the 1st Quarter results announced so far. A re-rating of Japanese equities from the autumn looks quite likely. Not only will the vaccine rollout have accelerated by then but foreigners, having recently sold Japanese equities should now focus on accelerating earnings and continued corporate reform. On a bottom-up basis, the market trades on 14X. This compares favourably against the S&P on 22X. As the Federal Reserve looks to reign in the growth in money stock, interest rates should gradually rise again on the US long bond. This should both weaken the Yen somewhat and cause an outperformance of Japanese Equities. Even a slight pickup in inflationary expectations in Japan will be good for selected financials, autos, construction and real estate, all areas that we are overweight. Exposure to Emerging Markets and high growth/valuation stocks could prove to be costly in this environment. It is our belief that a return to a more value biased market is likely in the final quarter.

We had a quiet month regarding new names. Our conviction in Seven and I’s free cash flow outlook and its ability to reorganise the group structure has increased. We raised our weighting to over 4%. We returned to Jafco. Our sale a few months back at close to Y8000 was well timed so we were delighted to have another bite of the cherry at Y6200. With over 50% upside in the venture capital company and the chance of further buybacks and/or M&A we reinitiated a position. Two deep value names that sell far below book value are TBS (Broadcasting) and Bank of Kyoto. We have added to these on the pullback. Bank of Kyoto now trades on less than 1/3 of the value of its stock portfolio.

Fujitec

Fujitec manufactures elevators and escalators. It would directly be comparable to both Otis and Kone. What appeals to us about the model is that it is a classic “Canon” type model where recurring maintenance revenues are roughly half of sales and more of profits. The company is very free cash flow generative, operates in an oligopoly along with just five other players and has proved to be remarkably defensive in major economic downturns. Whilst the company has much lower returns than its peers it is at last making some meaningful changes in corporate governance. It has cancelled the poison pill and set a dividend payout ratio of at least 50%. It now aims to achieve an ROE of >10% and an operating margin of at least 10%. Its weakness is in North America and Europe. It has excelled in East Asia (China). Whilst it lacks scale in the USA and Europe it is strong in the domestic market and Asia.

One of the reasons we were attracted to Fujitec is its extremely healthy balance sheet. 25% of the market Cap is in net cash and its equity ratio is a very robust 54%. However, the Return on equity is very poor in comparison to its international peer group. Part of that comes from the overcapitalized balance sheet but also part of this comes from lacking the scale and leverage to higher sales that both Kone and Otis have. Indeed, net sales per employee are poor in comparison and if you look at Kone you can see a clear link between Net sales and operating profit margin.

Source: Zennor Asset Management

Kone is a brilliantly run company, but you pay up for that growth. Its forward PER is 32X. Fujitec trades at about 18X, less than 15X ex-cash, with very inferior profitability. Price to assets multiples reveal the similar gaps.  We would expect to see Fujitec focus on increasing scale in East Asia and raise the productivity of its workforce. Whilst much of the good news is in Kone’s share price Fujitec is priced for little improvement in operating margins and balance sheet reorientation. Several activists have appeared on the shareholder register, and we expect those institutions to continue to push management for better disclosure and better management of its cash and payout ratio. Above all it needs to develop local scale up as this should enable higher operational leverage. It could also conduct M&A (Toshiba Building systems?), particularly within East Asia to increase critical mass. There are risks from an increased Asia focus. Operating in China is often fraught with problems in terms of pricing and receivables. Too much reliance on the stagnant Japanese market is also an issue. Its high OPM in Southeast Asia is to be applauded, particularly in Singapore – and shows that the company can compete successfully whilst generating appropriate margins against global competition. It was a first mover there and this expertise in the Far East is a long term positive. Cash conversion Cycle is 82 days versus Kone’s 62 days offering scope for improved working capital efficiency.

Fujitec already has strong products and a substantial installed base – all it really must do is imitate what market leaders are doing to materially increase margin and returns. This in turn is likely to drive a meaningful re-rating of the business. It is a myth that Japanese companies cannot have world class margins and efficiency – Keyence has a >50% OPM, Daikin also has a strong ROIC profile and both trade on much higher multiples of assets and earnings power to name just two. It is a choice – usually because management teams will not make difficult decisions.

So Fujitec offers

• Strong balance sheet and resilient earnings model limiting business risk
• Inferior margins in most markets to industry peers – but comparable product quality
• Unfocused management historically
• Low multiple of sales, assets and earnings that could increase
• Limited sell side coverage
• An open shareholder base
• Pressure for change from multiple engaged investors

We do not know that they will succeed but the upside formula

higher earnings * higher multiple => a much higher stock price

seems like the likely outcome IF they can execute better than they have so far. If the management team cannot improve then the shareholder register offers the prospect of corporate activity as another exit route.

Seven & I, Toyo Seikan, Secom Joshinetsu

The market for corporate control continued with the ongoing activity around Toshiba; an engagement by ValueAct with Seven & I; Toyo Seikan was the subject of a new campaign by Oasis; and the ToB for our (small) holding Secom Joshinetsu. A long-time subsidiary of Secom - Joshinetsu traded very cheaply based on cash flow and balance sheet and was an ideal candidate for Parent-Child consolidation. Secom bid a 66% premium.

Toyo Seikan adjusting for non-core financial assets trades at 1x EV/EBITDA. Clearly it is not an expensive business, but the management is deeply entrenched and committed to their lacklustre strategy. The abundant value may be difficult to access. Seven & I already saw a shareholder revolt over the planned family succession. ValueAct has invested just as they complete on their transformative acquisition in the US. This will leave 80% of cash earnings coming from high quality businesses and material exposure to the growing US and emerging markets. On ValueAct numbers 7&I trades on 11x PER. Looking at the non-CVS business shows a company struggling with the transition to modern retailing but one also loaded with prime assets. Their Specialty business contains several category leaders by sales but not by margin. For the right operator these struggling divisions represent an opportunity to acquire space, and underperforming brands. We believe that their value is a lot higher than the value (zero) that the market places on them. Our thesis for 7&I was that both the CVS AND the non-CVS business were mispriced but that a catalyst was lacking. With Valueact we now have an operationally focused investor who will exert ongoing pressure on management to execute.

The results season also threw up one new opportunity that we had been working on. BeNext Yumeshin is a recent merger and their release of Q3 numbers with heavy goodwill amortisation under JGAAP was a catalyst for a >30% decline in the share price. We are focused on the cash earnings power and see a company trading on a 20% FCF yield in a few years. A shift to IFRS should reveal to the market the low multiple of real earnings power that it trades on.

CVC's unsuccessful bid for Toshiba

The market for corporate control in Japan continues to be active. The most significant event was the tentative bid for Toshiba Corp launched by CVC. Toshiba as a business has been reorganising itself since rescue in 2017. Minority shareholders have been increasingly involved as management has failed to execute and returns continue to underperform relevant peer groups. The last year has seen an increasingly acrimonious relationship between the CEO Kurumatani and large shareholders who rejected his vision for the company’s future direction. These large shareholders successfully forced a resolution to investigate voting disparities at last year’s AGM and are holding management to account. The bid by CVC, closely associated with CEO Kurumatani and Board Director Fujimori, should be seen as an attempt to resolve this strategic clash between senior leadership and shareholders.

The potential bid was rebuffed by the company and CEO Kurumatani ‘resigned’. However, when we look at the $20bn that was proposed by CVC we believe that this substantially undervalues Toshiba’s operating business. Subtracting non-core assets such as the stake in Kioxia, listed investments and net cash we saw an industrial EV of just $6bn for a business with revenue of close to $20bn - 0.3x sales is not an appropriate Price to Sales multiple. Taking a global peer multiple would see Toshiba trade at >2x Price to Sales or $50bn in industrial value. We do not believe that Toshiba as currently organised will be able to generate peer levels of return but find it hard to argue for less than 1x Price to Sales. The frustration with Toshiba management is their inability to focus on Return on Invested Capital in a disciplined way as local and global peers have managed to do but instead to chase scale without rigour. This presents a very large opportunity for outside players and/or a revitalised management team to create dramatic value.

With most shares held by foreign institutions, many of whom are strongly engaged, Toshiba is under tremendous pressure. Our analysis suggests that industrial Toshiba should be worth between 3x-10x what is implied in the current share price.

Toshiba has exposure to politically sensitive businesses in defence and energy which will prevent some potential bidders from participating in any deal. However, that CVC felt enabled to bid; that Bain is already deeply involved with Kioxia and other sensitive businesses; and there are many rumours of local partner involvement suggests that this should not be an insurmountable problem. The real issue is that the Toshiba management team has systematically ignored and alienated its owners/rescuers – who are now explicitly demanding oversight and involvement at a board level. The owners have shown that they have the votes to pass resolutions in the face of management opposition and that they are willing to use them.

Who controls Toshiba? The shareholders or the management team? The answer from Effissimo, 3D, Farallon, King Street and many others is that shareholders do.

Trend: Tougher Rules for Prime Index Members

The Bank of Japan (BoJ) announced a change in its ETF (Exchange Traded Fund) buying strategy. Whereas until now the BoJ has focused buying on the Nikkei 225 ETFs it will now focus on the broad TOPIX benchmark. The Nikkei is a price weighted benchmark with the top 5 stocks accounting for nearly 30%. In many cases these stocks also have limited free float due to insider positions increasing the impact of passive ETF buying. Whilst we admire and like each of these businesses, we find that their current share prices are not compelling. In contrast the top 5 positions in TOPIX account for just 12% and the benchmark has 2,185 members. We believe that this shift in ETF buying has longer term consequences for the supply/demand balance between a narrow group of high-priced quality growth stocks and the broad market. At the very least BoJ activity will no longer reinforce an existing trend towards growth and momentum but will be broadly spread over the whole market.

The ending of the Japanese fiscal year has also seen the release of the latest TSE proposals for Prime Index members – as such it will become the minimum standard all large companies in Japan will have to adhere to. These proposals are focused on TCFD compliance; external directors comprising at least one third of board members; management diversity (female, foreign, mid-career hiring); and English language disclosure. The introduction of TCFD illustrates the growing commitment to global best practice on Environmental disclosures in line with PM Suga’s commitment to reduce carbon emissions.

The only area that is disappointing is on lack of further measures to unwind strategic shareholdings – this remains an area of intense market focus and in our view will be revisited if additional progress is not made. Overall, these proposals show the clear, ongoing, trend for tougher rules that underpins our thesis for a revolution in corporate governance.

Inflation ahead?

February 2021 was a quite extraordinary month, one that we only see sporadically. Not only did bond yields in the US spike from 1.0% to 1.4% on the 10 year but the prospect of a genuine inflation pick up has now become apparent. As pent-up savings find their way into the broader economy later in the summer, combined with the massive outstanding fiscal stimuli still to come, the economies of the developed economies are likely to see a sustained period of above average growth. Whilst we welcome some inflationary pickup central banks will have to be prepared to allow an above average inflation rate, but at the same time suppress rates for fear of an explosion in debt servicing costs. Bonds look exposed at this juncture. Recent data in the USA on purchasing prices and PPI suggest a sharp pick up in upstream industries.

Third Quarter earnings were excellent in totality. Whilst sales for ex-Financials were -2.1%YoY, net profits were +61% YoY. Within manufacturing sales were -1.5% YoY and net profits were +61% YoY. By sector high profit growth rates were seen in cyclical sectors such as Marine Transport, Rubber, and Iron and Steel. Poor Net profit growth was seen in electric utilities and land transportation. The ratio of companies raising guidance and beating pre-release consensus were extremely high. Significant cost cutting, particularly within COGS (fixed costs, and reduction in inventories) was evident and demand growth was much improved within the automobile sector, digital orientated companies and stay at home demand.