Japan Strategy

September 2019

THE MARKET ENVIRONMENT
Major global markets finished mixed in the third quarter. August served as the most volatile month, bookended by relatively flat performance in July and September. Most recently, trade negotiations between the U.S. and China are providing a positive impact on global markets as the two countries agreed to restart trade negotiations in early October. Ahead of the planned trade talks, the U.S. delayed a planned tariff hike on Chinese goods from October 1 to October 15 in “a gesture of good will.” On the other hand, China exempted soybeans, cancer drugs and pesticides, among others, from tariffs on the U.S.

Despite the tempered situation between the U.S. and China, U.S. President Donald Trump made headlines for another matter late in September as a whistleblower brought to light the leader’s July telephone conversation with Ukrainian President Volodymyr Zelensky. In the call, Trump asked Zelensky to “look into” 2020 U.S. Democratic presidential hopeful Joe Biden and his son, news of which spooked investors. In response, Speaker of the U.S. House of Representatives Nancy Pelosi announced a formal impeachment inquiry on Trump to further delve into the matter. 

Elsewhere, the political crisis in the U.K. carried on as the U.K. Supreme Court ruled Prime Minister Boris Johnson’s suspension of Parliament earlier in the third quarter as unlawful. Once back in session, the body passed a law requiring Johnson to request an extension from the European Union (EU) on the U.K.’s current exit date of October 31, should the country fail to agree on a Brexit deal with the EU prior to the bloc’s summit on October 17-18. These ongoing situations stoked continued uncertainty surrounding global markets. 

Meanwhile, the European Central Bank opted to lower interest rates and ramp up quantitative easing at its September meeting, which prompted the euro to fall to a two-year low. The Federal Reserve also trimmed U.S. interest rates twice in the third quarter, while the Swiss National Bank and the Bank of Japan maintained negative interest rates in September. 

In our estimation, the lingering memory of the Great Recession is causing investors to be much more fearful than they should be at present. We see no signs of excesses in the economy that typically precede a recession. We believe the noise present today will dissipate and trade will ultimately flow more freely in the next several years. In the meantime, we weather the short-term distractions and volatility in pursuit of long-term results.

THE PORTFOLIO
Top Performers: 
Fiscal first-half results from Sugi Holdings aligned with our estimates and surpassed management’s forecasts and market expectations. Sales increased 8.1% from the prior year, driven by like-for-like growth of 2.8% (Sugi Pharmacy +3.5%) and the opening of 49 net new stores. Consistent with Sugi’s long-term trend, dispensing operations, which were up 16% in the second quarter and 14% in the first quarter, drove like-for-like sales advances. Operating profit rose 15% as gross profit margins improved by 80 basis points mainly due to product mix and operating profit margins also continued to expand. Sugi also has effectively controlled costs, from our perspective, and has done a good job of cutting advertising and selling expenses. Lastly, the company is slightly ahead of schedule to meet its goal to open 90 net new stores in the current fiscal year. We will be traveling to Japan in the coming months and plan to meet with Sugi’s management team. In the meantime, we like the fundamental progress this company continues to make. 

Sundrug’s fiscal first-quarter results included increases in sales and operating profit of 4.7% and 7.6%, respectively, from the same period last year. Both exceeded market expectations and management’s targets. The gross margin improved, driven by contributions from drugstores (owing to sales of natural plant product cosmetics and accelerated double-digit duty-free sales) and discount stores (seasonal goods and increased fresh food sales). In addition, expenses were lower than projected, despite personnel cost growth that was somewhat elevated. The company opened 12 new stores in the first quarter (six drugstores and six discount stores). Management previously issued guidance to open 70 new stores in the current fiscal year, and though it appears store openings are behind schedule, management commented that first-quarter openings were broadly in line with its plans. In addition, Sundrug recently appointed Hiroshi Sadakata as its new CEO. Formerly the head of Direx, Sadakata turned operations around quickly following Sundrug’s acquisition of the chain. We continue to believe Sundrug is undervalued relative to our perception of its intrinsic value. 

Olympus issued fiscal first-quarter results that were in line with market forecasts and management’s guidance. Sales rose 1% year-over-year, while operating profit (excluding one-time items incurred last year) rose 18%. In the medical segment, sales of both endoscopes and therapeutic equipment rose 5% (local currency). This growth is especially notable given that the Visera Elite II infra-red imaging endoscope is not yet approved in the U.S. and the current generation of endoscopes is nearing the end of the device lifecycle. Even so, first-quarter medical margins were roughly unchanged compared with last year and undershot our expectations. The shortfall was partly due to upfront investments management is making in the therapeutic segment, which we believe will be a core area of growth going forward. Conversely, the imaging segment continued to face challenges as revenues declined 25% from weakness across all types of cameras. Subsequent to the earnings release, Olympus announced it would buy back 5% of its shares from Sony, which will further reduce cross holdings. We view this action as another positive step in what may likely be a long restructuring process at the company.

Bottom Performers:
Fiscal first-quarter results from Hakuhodo DY Holdings included year-over-year revenue growth of 5.2% and billings growth of 6% (both excluding one-time contributions from Mercari). However, the operating profit margin contracted by 390 basis points and total operating profit (before goodwill amortization) declined 26.5% from the prior year. It is important to note that the first quarter is seasonally the weakest for Hakuhodo and the company’s significant investment spending (such as increased hiring and activities to strengthen the digital platform) had an outsized impact on the operating margin and profits for the period. By service segment, internet billings rose 11%, which fell short of our estimates, while TV billings grew 0.6%, which was ahead of our estimates. In addition, billings in both the creative and marketing/promotion service segments declined and missed our forecasts. Despite the inconsistent first-quarter performance, management left full-year revenue and operating profit margin guidance unchanged. 

Komatsu’s fiscal first-quarter earnings results fell short of market expectations as consolidated net sales declined 5.6% and operating profit fell 22.2%. In Indonesia, sales were 28% lower on a reported basis with lower demand from China caused by import restrictions and reduced coal prices. China was also a drag on reported results with a 28% decrease in sales due to macro weaknesses caused by the trade war and a soft property market. However, reported sales in the U.S., Europe and Oceania were up 2%, 9% and 12%, respectively, and management noted it would look to cut operating costs in the second half of the year. We recently met with CFO Takeshi Horikoshi and discussed strategies for improving performance going forward. Horikoshi stated that because the macro environment has worsened, particularly in Indonesia, the company is rethinking plans to increase fixed costs by JPY 12 billion this year for technology improvements and to drive higher revenue growth, among other initiatives. While the short-term outlook is weak, we believe Komatsu is trading at a steep discount to our perception of its intrinsic value. 

NSK’s fiscal first-quarter results were weaker than we had expected. Total revenue fell 14.5% year-over-year, which was a more significant decline than we had estimated. Operating income dropped nearly 59% from the prior-year period and the operating profit margin contracted by more than half. The automotive segment drove much of the shortfall as this segment faced worse-than-expected volume/mix challenges that led to a 15.3% decrease in revenue. In addition, the automotive operating profit margin of 3.3% was the lowest in the last five years. However, we note that the current downturn in vehicle production had an outsized impact on NSK due to operating leverage in the bearings, electric power steering and automatic transmission businesses. In the industrial segment, revenue decreased 12.2% from last year, mainly due to a decline in precision machinery and parts revenue of 25%. Still, precision equipment revenues have grown significantly during the last two years, which makes current-year comparisons look especially weak. Even though NSK’s first-quarter results were dissatisfying, we are optimistic that performance will strengthen going forward.

During the quarter we eliminated Recruit Holdings and Yamaha Motors from the portfolio.

 

Past performance is no guarantee of future results.

 

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