FREE KIC - NO. 7 APRIL 06

Japan has me confused.  Part II

  Last October for my first opinion piece I wrote about my confusion in relation to the long term prospects for Japan. At one stage I mentioned that there were differences between Japanese and non-Japanese company websites. What I meant by this was based on my experience of how difficult it is to find Japanese companies that webcast (in English) their results or analyst presentations.
In recent weeks I stumbled across a Japanese website called �gCompany Hotline�h (www.c-hotline.net) that provides this service. I have therefore been able to listen to strategy presentations from Asahi Chemical, Asahi Glass, Kurraray, Circle K Sunkus and Mizuho Bank. This is an interesting cross section of fairly traditional Japanese companies. If Japan is changing rapidly I would anticipate that this would be reflected in the plans of these companies.
I am reasonably familiar with Asahi Chemical and Asahi Glass. At one stage I held both of them in my AIB Investment Managers portfolio. I visited the Asahi Chemical head office back in the late 80s and I had a tour of an Asahi Glass float glass factory around the same time.
Having listened to these webcasts I want to explain why I remain confused as to why so many people are convinced that Japan really has changed.

I am going to concentrate on Asahi Chemical because to me it is representative of what I heard on all the webcasts. I will start by giving some background information on the company. Back in the �e80s I would have described Asahi Chemical as having the following characteristics:

• It was a typical Japanese conglomerate with divisions that ranged from chemicals and textiles to construction and electronics.
• It was one of the leading house builders in Japan with an interesting electronics division
• Management would tell investors like me that they were striving to achieve a certain Return on Equity target and that they would do whatever was necessary to achieve these targets. They would show me a business plan that had steadily improving margins in all divisions.

I bought Asahi Chemical back then believing what I was told. I believed that if textiles remained a terrible business well then they would sell up or shut down. The reality was not what I was led to believe. With the benefit of hindsight I would now say that during the 90s Asahi Chemical had the following characteristics:

• If one division was unprofitable for a period it didn�ft matter because the other divisions could subsidise them until times got better. They would not do anything as radical as pull out of a business like textiles.
• There was no pressure on management to only be in areas where they were clear market leaders generating consistently good margins and good returns on invested capital.
• Management would never be fired if the share price performed poorly or if certain returns were not achieved or if dividends were not increased.
• Management were more concerned about their Japanese employees than they were about shareholders. In fact it might be argued that they even kept open their Irish chemical factory longer than they should have because I believe that it sustained losses for a number of years before it was eventually shut down. (I am sure the people of Mayo will think that I am uncaring in my belief that Asahi Chemical should have closed a lot sooner but it is my belief that in the long run it is in their best interest that they work for successful companies rather than struggling companies)
• They had too much capacity, overheads were too high and competition from Asia had just got a lot tougher.

This was a difficult learning experience for me but in the end it gave me a greater understanding of Japanese culture and its influence on Japanese business practice.

As I mentioned in my last opinion piece I moved jobs in 1997 and from then on spent far less time on the Japanese stock market and I lost touch with developments at Asahi Chemical. It was therefore an interesting thing for me to catch up with what had happened and to listen to where they intended to go.

The following table illustrates what has happened to divisional margins in recent years

I find this table fascinating because it highlights that in '03 and '04 Asahi Chemical still had the same characteristics as in the 90s:

• Still a conglomerate
• Still losing money in some divisions with low margins in other divisions
• Still appears to be more concerned with employees than shareholders

In �f05 and �f06 it looks as if no division will lose money and even textiles have an almost respectable margin. Does this mean that Asahi Chemical has changed? Does it suggest that management have somehow really turned every division into a market leader? I ask these questions because it appears to me that a similar thing has happened at most Japanese companies. Sales and margins have improved and share prices have risen. The stock market has got excited and many foreign investors believe that the market is going to continue to go up.
The problem that I have with this thesis is that it happens to have coincided with a strong US and Asian economy. I wonder whether Asahi Chemicals improved margins have nothing to do with management and everything to do with strong demand across all their divisions? Even Asahi Chemical can do well when China is booming and operating close to full capacity.

I want to now turn to the strategic plan announced on March 7^th (�gGrowth Action 2010�h). I am not 100% sure what it was that I thought I would hear. I suppose I had hoped that there would be a commitment to withdraw from any business that didn�ft cover its cost of capital over the cycle. I suppose I had hoped that there would be an acknowledgement that chemicals and textiles were unlikely to be anything other than a low margin area and that therefore some tough decisions would need to be made. Instead my instinct tells me that I got the same sort of business plan that I would have got back in the 80s. The plan is based on steady increases in sales and profits in every division with an ROE target of 10%+. Management committed themselves to a dividend payout ratio of at least 20% (wow!).
In the end I really struggled to find anything that would make me believe that Asahi Chemical is being run in a way that is different to the past.

Here is a summary of Asahi Chemical now and how management see it at the end of the plan:

I listened to all the questions at the end of the presentation from analysts at stockbrokers like Japans number one, Nomura Securities, in the hope that they would now be asking tough probing questions rather than the wishy washy questions they have tended to ask in the past. I was disappointed to hear similar questions to the ones that I would have heard 15 years ago. Questions that were more concerned with details rather than the broader picture.
I would have liked management to answer this question: Is there any evidence that it makes sense to combine a company that builds houses with a company that makes electronics?
I really struggle to believe that being a conglomerate generally adds value. There are always exceptions but as far as I can see Asahi Chemical is no General Electric.

Is there a chance that Asahi Chemical is not representative of Japan Inc? Is there a chance that other companies will be as radical as some people believe? Having listened to a number of these strategic plans I didn�ft get the sense that anything different is happening in any of these companies. Given that these companies are at the leading edge of investor relations in Japan leads me to the conclusion that Japan Inc goes on as before. (In the original piece I talked about the threat of hostile takeover as a catalyst for change but in these webcasts I see no evidence that the fear of hostile takeover is making management change their ways).

In conclusion I want to say that I continue to struggle to find good long- term investments in the Japanese market.

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