Japan Strategy

June 2019

Major global markets finished mixed in the second quarter. The reporting period began steadily enough, but fears regarding new tariffs and trade wars caused market volatility mid-quarter before markets rallied in June. Trade talks between the U.S. and China faltered once again and rattled markets in May, despite some forward progress in April. However, following meetings at the G-20 Summit in late June, markets cheered the progression made by U.S. President Donald Trump and Chinese President Xi Jinping, both of whom agreed to reopen trade negotiations and cease additional tariff increases in the hopes of eventually reaching a trade deal. Similarly, after announcing a planned 5% tariff on goods imported from Mexico in May with the goal of deterring illegal immigration from Mexico into the U.S., Mexico’s efforts to mitigate this issue were enough to prompt Trump to suspend his plans to implement new tariffs on the country. Irrespective of the noise, indexes in the U.S. touched record highs during the period. 
Meanwhile, crude oil prices also experienced instability in the second quarter as markets weighed the implications of data and global happenings on supply and demand. In April, the U.S. announced it was ending sanction waivers on Iranian-produced crude oil, sending prices higher. However, continued uncertainty regarding trade tensions sparked demand concerns in May. Ultimately, growing tensions between the U.S. and Iran and subsequent supply uncertainties spurred a boost to crude oil prices late in the second quarter.  
In the U.K., Prime Minister Theresa May announced her resignation, effective June 7, as she was unable to build consensus on a Brexit deal to lead her country out of the European Union (EU). As of the end of the second quarter, May’s replacement had yet to be named. As things stand, the country will leave the EU on October 31 with or without a deal (unless a withdrawal agreement is settled upon prior to that date), leaving room for many possible outcomes and causing continued unease for investors.  
We believe that although a company’s share price may be performing poorly, it is not always indicative that a business is performing poorly. We seek to identify companies with hidden value that feature high-quality business fundamentals and management teams that act in the best interests of shareholders. Often these opportunities unearth themselves during ambiguous times like these when we can take advantage of short-term hindrances to unlock underlying value in underappreciated companies. 

Top Performers: 
Sugi Holdings’ 2018 earnings results exceeded market expectations as well as our own. We appreciated the company’s efforts to reduce selling, general and administrative costs in the fourth quarter. In addition, fourth-quarter operating profit margins expanded to 6.3% and finished 40 basis points higher year-over-year, driven by gross profit margin expansion. The company also executed its first share repurchase program worth JPY 9 billion. Later, Sugi’s first-quarter earnings report showed a good start to the year, in our view, with quality margin progression, healthy topline growth, gross profit margin expansion, and better selling, general and administrative cost control. Sugi also announced the potential acquisition of Cocokara Fine, another drug store operator. We met with management during the reporting period and learned of plans to better control costs this year, including reducing overtime hours thanks to increased automation. Overall, we viewed the meeting positively and find the company’s guidance for 2019 to be conservative. We believe Sugi is working to add value for its shareholders, adding to our confidence in the investment. 

Toyota Motor released its full-year earnings report that we viewed as healthy when compared with other global vehicle manufacturers. The company’s full-year total revenue increased 2.8% from a year ago, which far outpaced our estimates. In addition, operating profit advanced 2.9% and the operating margin also expanded. The underlying auto segment realized revenue growth of 2.6%, which was better than our estimates. Regionally, sales in Japan were up 3%, despite a 1% decline in volumes as Toyota’s mix of models helped offset weak volumes. Europe was a standout performer, from our perspective, with sales advancing 4% and volumes rising 3%, driven by market share gains as Toyota is a leading provider of hybrid vehicles in the region. Notably, margins in Europe jumped 130 basis points from last year and operating profit grew 57%. Sales in North America (excluding imports from Japan) grew 2%, while volumes fell 2%. The North American market remains a key area of focus for Toyota as the company is working to double the operating profit margin to 8% (including imports from Japan) from 4% levels today. Lastly, free cash flow reached JPY 1,135 billion, which Toyota used to buy back shares (JPY 550 billion) and pay dividends (JPY 640 billion). Management also announced a new share repurchase plan worth JPY 300 billion (or 1.7% of the shares outstanding). We like that the company’s leadership team continues to prioritize rewarding shareholders. 

Toyota Industries issued fiscal full-year results that the market viewed positively. Net sales advanced 10.5% from the previous year, which management attributed primarily to favorable results in the materials handling equipment segment. While operating profit declined 8.7%, management indicated that the loss was due to some one-time factors associated with changes in the company’s retirement benefit plan in the previous fiscal year. Excluding these one-time events, we believe that profit would have increased. In addition, the company increased the shareholder dividend by roughly 3% to JPY 155 per share. Management’s fiscal-year 2020 guidance includes increases in net sales, operating profit and profit before tax of 3.8%, 7.7% and 2.9%, respectively. We believe Toyota Industries can continue to reward shareholders over the long term.

Bottom Performers:
NSK issued fiscal full-year results with revenue that was better than we had estimated, while earnings, operating profit and the earnings margin all missed our expectations. The shortfall came from weak margins in the auto segment, particularly in the fourth quarter. Operating profit reached only JPY 13 billion in the fourth quarter, which reflected a 52% decline from the prior year, and was well below the market’s forecast of JPY 17.6 billion. For the full fiscal year, revenue from the steering business dropped 12%, as we had expected, while automotive bearings decreased 0.6%, driven by global auto production that fell 2.2% during the period. Concurrently, the auto segment margin was impacted by higher steel costs and labor cost inflation. Management is guiding for an overall operating profit decline of 20% for fiscal-year 2020 owing to further auto segment challenges, particularly from ongoing weakness in the steering business, expectations for sluggish global auto production, pricing pressure and cost inflation. Meanwhile, earnings in the industrial machinery segment were precisely in line with our estimates, driven by the high-margin precision machinery business that reached a record revenue level in 2019. In light of current auto segment performance and management’s outlook, we reduced some of our near-term valuation metrics. Nevertheless, we believe NSK’s share price is trading at a discount to our estimate of the company’s intrinsic value. 

Sundrug’s sales data from March showed a 0.2% decline year-over-year in same-store sales in the drugstore business. However, all-store sales increased 1.5%. Later, the company’s fiscal fourth-quarter earnings results were largely in line with expectations, but operating profit finished lower for the year on weakness in the discount store business. In addition, Sundrug store openings amounted to only a little more than half of the intended amount for the period. However, in our view, an aging Japanese population, a transition away from buying cosmetics at higher-end stores, and a shift from buying food and daily necessities at traditional supermarkets and general merchandise stores are driving growth for the drug store industry as a whole. Moreover, Sundrug’s size as one of the largest drug store operators in Japan positions it well to benefit from the consolidation of the drug store industry as larger players continue to take share from smaller operators who lack the scale and capital to compete. 

Yamaha Motor delivered disappointing first-quarter earnings results, including a 13% decline in operating profit year-over-year and higher selling, general and administrative costs for the quarter. Earlier in the year, management expressed concern for the motorcycle business in 2019 due to an uncertain demand environment and a lull in new models. Despite expectations for weak unit volume growth and higher marketing spending, Yamaha believes the model cycle refresh in 2020 will reverse these trends. As a whole, we appreciate the company’s strong market share in the Asian motorcycle oligopoly. We think that while Yamaha may face some short-term obstacles, its long-term outlook is promising.

There were no new purchases or final sales during the quarter.


Past performance is no guarantee of future results.



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