Brief Japan: Aruhi Placement – Bigger than the IPO but Good Track Record and Price Performance Should Help and more

In this briefing:

1. Aruhi Placement – Bigger than the IPO but Good Track Record and Price Performance Should Help
2. FANCL: Playing the Long Game
3. Pepper Food Services 4QFY2018 Results: Burnt, But a Lesson Learnt
4. Musashino Bank  (8336 JP): Braking Bad
5. Japan: Catching Valuation Differences – Worst Quarter Since 2017-Q2 – Time for Shareholders to Act

1. Aruhi Placement – Bigger than the IPO but Good Track Record and Price Performance Should Help

Carlyle, along with SBI, plans to sell the rest of its stake in Aruhi Corp (7198 JP) for around US$280m.

Aruhi listed in Dec 2017, when Carlyle sold 18m shares. This is the second and final tranche of shares owned by Carlyle.  The total sale accounts for 41% of the company’s outstanding shares making it a relatively large deal to digest. 

However, the shares have done well since listing and the stock scores well on our framework. Valuations appear reasonable, if the company is able to achieve its mid-term targets.

2. FANCL: Playing the Long Game

• The declining and ageing population in Japan has been a major cause for concern to many Japanese companies.
• Fancl Corp (4921 JP), is a relatively small player in the Japanese cosmetics and nutritional supplements space who is expected to benefit from the declining and ageing population.
• Compared to the peer average, EV/Sales discount narrowed down significantly over the course of the last year. But we believe the discount remains the same on a growth adjusted basis.
• Still too small for institutional investors to notice. But we expect them to start noticing the company over the coming years.
• One of the cheapest stocks on a long term forward multiple, as we expect FANCL to sustain its high growth over a long period of time.

We are not sure if Fancl Corp (4921 JP) can ever be in the same league as Shiseido or Kao, but we certainly believe the company doesn’t deserve to be about 10% of the size of Shiseido. Thus, we have a very long-term bullish view on FANCL and expect to see the company’s market cap to double over the next 5-7 years

3. Pepper Food Services 4QFY2018 Results: Burnt, But a Lesson Learnt

On Thursday the 14^th Feb 2019, Pepper Food Service (3053 JP) announced its results for FY2018 and the guidance for both 1HFY2019 and FY2019. The company managed to grow its revenue by an impressive 75.3% YoY outperforming its own estimate by 6.4%.

However, the gross profit only grew by 69.9% during the year as the gross margin slipped 137bps in FY2018 driven by higher energy prices and wages. Higher wages were due to active recruitment of foreign workers within the food service industry which created a supply shortage. To tackle increasing costs, towards the end of the year, Ikinari Steak restaurants increased the prices of its steak. We believe the margin recovery witnessed in 4Q2018 was a direct result of this price increase.

Gross Margin Showing Signs of Recovery

Pepper Food Services saw its EBIT margin decline by 20bps to 6.1% in FY2018, as revenue growth offset most of the gross margin drop through gains from operating leverage. However, its restaurants in New York City continued to underperform. The company expected those restaurants to turn a corner and start contributing to the overall EBIT from FY2018, however, those restaurants failed miserably and continued to drag the overall EBIT margin down. Hence, the company failed to meet its EBIT margin forecast with EBIT falling 4.6% short of company guidance.

4. Musashino Bank  (8336 JP): Braking Bad

Musashino Bank (8336 JP) was one of the last regional banks to announce 3Q FY3/2019 results, and they were a nasty surprise: a consolidated net loss for the nine months to 31 December 2018, caused by heavy reserving in Q3 (October-December 2018) against the bank’s exposure to the troubled Akebono Brake Industry Co (7238 JP) .  While the bank has slashed its full-year net profit guidance from ¥11.1 billion to ¥4.5 billion, this would still require an heroic level of profits in Q4 which the bank has never before achieved.  The share price has fallen over 31% in the last twelve months.  Valuations at current levels are still high (FY3/2019 PER is 17.6x) and we consider the share price to be vulnerable to further weakness.  Caveat emptor (May the buyer beware) !

5. Japan: Catching Valuation Differences – Worst Quarter Since 2017-Q2 – Time for Shareholders to Act

COMPREHENSIVE INCOME – Since 2011, a Statement of Comprehensive Income (CSI) has been a mandatory addition to the Income Statement for Japanese companies reporting under Japanese GAAP (J-GAAP). CSI has long been a part of US-GAAP and is also an integral part of the IFRS reporting standards. A critical difference is that under J-GAAP, items of Other Comprehensive Income (OCI) are added or subtracted from Net Assets and do not impact Shareholder’s Equity which is the denominator for Return on Equity (RoE). Under US-GAAP and IFRS the amounts are deducted from Shareholder’s Equity and, therefore, as an increasing number of Japanese companies are switching to IFRS, these items cannot be ignored and can often lead to significant changes in RoE calculations. 

VALUATION DIFFERENCES – In an earlier Insight Japan: What to Buy & Sell if the ¥ Rises to 90, we used the Foreign Currency Translation Adjustment item in Other Comprehensive Income to determine companies’ sensitivity to changes in exchange rates. In this Insight, we look at the Valuation Differences item which is more fully described as “Unrealised Gains/Losses on Available-for-Sale Securities”. With many Japanese companies running in effect long/short equity funds (see our recent Insight on Toppan Printing: Money for Nothing), the quarterly portfolio ‘marks’ are a useful performance update. The extent to which shareholders should condone these efforts at ‘cash management’ is a wider topic which has been covered by Travis Lundy. Some companies, such as Tokyo Broadcasting System (9401 JP), have already seen ‘attention’ from activist investors, while others, such as Toyota Industries (6201 JP) and Japan Petroleum Exploration (1662 JP), feature in the Smartkarma HoldCo Monitor and are familiar to this audience.  For the others, at the very least, we can start the exercise of ‘naming and shaming’ to encourage more scrutiny in the future.

Source: Japan Analytics

WORST QUARTER FOR VALUATION DIFFERENCES SINCE FY2017 Q2 – The aggregate of the Valuation Differences for all 3,574 listed non-financial companies for the most recent quarter was -¥85b, the worst result since 2017 Q2. As not all of the securities valued are domestic equity, the correlation with the Japanese equity market is not exact and movements in the US$/¥ exchange rate also play a role. Only a small percentage of companies have significant valuation differences. In the most recent quarter, only 29 companies saw a positive change of more than ¥1b. However, 637 saw a negative change or at least -¥1b.  In the DETAIL section below we shall look at the top twenty-five companies by negative and positive change relative to both shareholder’s equity and market capitalisation and make some brief comments on a number of companies, including Japan Petroleum Exploration (1662 JP), Tokyo Broadcasting System (9401 JP), Toyota Industries (6201 JP), Mitsubishi Materials (5711 JP) , Vital KSK (3151 JP), Bank Of Kyoto (8369 JP), Toppan Printing (7911 JP), and Inabata (8098 JP). 

SHAREHOLDER ACTION REQUIRED – A large number of Japanese companies continue to hold large investment portfolios and the various iterations of Japan’s Corporate Governance Code have tried to nudge companies towards reducing such holdings. The latest version which was released in June 2018 and was well-covered by Travis Lundy in his excellent Insight – Japan’s Corporate Governance Code Amendments – A Much Bigger Stick for Activists and Stewards. The relevant provision is as follows: –

As Travis then noted: – 

This is Big News. It means there is considerable friction, and explanatory embarrassment, in continuing to hold cross-holdings.

• Every year requires a reassessment of the financial benefits and the return on capital measured against the cost of capital. This will not be pretty. 
• Requiring a set of policies on voting shares probably means setting standards which would not be lesser than the standards they adhere to in their own business. And it would require the possibility they might vote against management.
• It would be much easier to just get rid of the Cross-Shareholdings. The boards of the major banks, which each hold hundreds of cross-shareholding positions, will need to reassess each of the positions on an economic basis and business basis every single year. Expect this to change quickly. This is the perfect excuse for banks and corporates to say “Shōganai”, and sell.

SO FAR, NOT MUCH – In the seven months the revised code has been in effect, this ‘bigger stick’ has yielded few results as companies continue to hold onto their portfolios and file ‘boilerplate’ statements in the Corporate Governance filings. The author and leading promoter of the Governance Code, Nicholas Benes, has just made an interesting proposal on his blog entitled How to Demolish Japan’s Wall of Yes-Man Allegiant Shareholders which we have reproduced in full at the end of the DETAIL section below.