Price Monetizer

Volume 2, Issue 17
GaveKal Equity Strategy June 2, 2008
Author: Steven Vannelli
How Do You Say ‘Platform Company’ in Japanese?

GaveKal Asia
For the past two decades, investors in Japan have had to endure limited or negative
Suite 801, 8th Floor growth, deflation, deteriorating demographics, and a business environment that sup-
Chinachem Hollywood Cen- ports inefficient “walking dead” companies. Unsurprisingly, it has thus been a tough
tre, place to make money. Thus, we are not surprised to see that our past few months’
1-13 Hollywood Road, bullishness on Japan has been met by howls of skepticism and derision from clients.
Central, Hong Kong In an ad-hoc comment published last week (see Japan’s Return to Normalcy), Louis
tried to make the macro-case for Japan. In the following ad hoc comment, we will try
852-2869 8363 (tel) to show concrete examples of how the macro-trends we have highlighted in our re-
852-2869 8131 (fax) search are impacting Japanese companies today, and how Japanese companies some-
louis@gavekal.com times still fall short of Western investors’ expectation.
www.gavekal.com 1– Piggy-Backing on China’s Growth
Amongst the many complaints investors have about Japan is that the country’s
growth typically relies on exports—with the unspoken criticism being that Japan is
only piggy-backing on other people’s growth. In other words, Japan is little more
than a leverage play on global growth, at a time when global growth is slowing.
GaveKal Europe To be fair, there is a lot of validity to this criticism as Japan’s exports have grown
Norrlandsgatan 15 from representing 10% of GDP a decade ago to 17% today. However, over the
course of the past decade, Japan’s export picture has changed dramatically. Just five
11143 Stockholm
years ago, Japan was in essence a levered play on US consumption. But today, a
46 8 723-8080 (tel) growing amount of the country’s exports are moving to other Asian nations. Japan’s
46 8 723-0712 (fax) exporters have thrived in the Asian boom of the past five years (see chart below) and
Jean-louis@gavekal.com it can now be said that the sales of Japanese exporters are far more diversified (and
thus better), then they have ever been.
In Japan’s latest export expansion, the American consumer has simply not been a
leading force. Instead, it is China whose thirst for Japanese goods has allowed ex-
ports to grow as a percentage of GDP. Chinese imports from Japan have increased
more than four-fold in the last decade to the point where China is now very close in
GaveKal USA absolute terms to the United States as the largest importer of Japanese goods. At the
1600 Glenarm Place current pace, we should expect that China will overtake the US and become Japan’s
Suite 2611 biggest client in the next few years.
Denver, CO 80202 Japan
Japanese Exports by Major Country
303-534 8100 (tel) 20,000 20,000
303-534 8108 (fax) 18,000 18,000
steve@gavekal.com 16,000
16600.52
16,000
14,000 14,000
13093.89
12,000 12,000
GaveKal Middle-East
10,000 10,000
8,000 8,000
Makateb Business Center
6,000 6,000
Office No. 601/604
Al Salmien Tower 4,000 4,000
Electra Street 2,000

2677.42
1989.18 2,000
Abu Dhabi - UAE 1024.85
0 0
971 (0)50 6170287 (tel) '98 '99 '00 '01 '02
(MSUM 1Y) Exports United States of America, JPY - Japan
'03 '04 '05
(MSUM 1Y) Exports France, JPY - Japan
'06 '07
971 (0) 2 672 4344 (fax) (MSUM 1Y) Exports China, JPY - Japan
(MSUM 1Y) Exports Germany, JPY - Japan
(MSUM 1Y) Exports United Kingdom, JPY - Japan
Gavekal Research - www.GaveKal.com
June 2, 2008 Page 1/15

GaveKal Equity Strategy Japan’s export growth has benefited from a variety of sustainable factors, namely:
1– Proximity to a booming China & Asia: Japan is obviously very close to the
industrialized areas of eastern China. This helps keep shipping costs low.
2– Stable Exchange Rates: Stable exchange rates between two countries are
typically conducive to growing trade flows. And interestingly, over the past dec-
ade, the RMB-JPY exchange rate has been amazingly stable. When one considers
the upheavals that China (1997 Asian Crisis, SARS, boom linked to bank recapi-
talization…) and Japan (banking crisis, TMT bust…) had to endure over that
decade, one might wonder whether Japanese and Chinese monetary authorities
Japan’s prospects for are in fact not targeting their FX rates against the US$ but against one another?
continued export Japan
growth are very 0.085
RMB/JPY Exchange Rate
0.085
favourable.
0.08 0.08
0.08
0.075 0.075
0.07
0.07 0.07
0.07
0.065 0.07
0.065
0.06 0.06
0.055 0.055
0.05 0.05
From a close proximity '98
RMB/JPY
'99 '00 '01
Trendline: Average with 1st standard deviation

'02 '03 '04 '05 '06 '07
to, and improving rela- Gavekal Research - www.GaveKal.com
tions with, China... 3– A Massively Undervalued Yen: Japanese products, relative to similar prod-
ucts coming from major export-competing countries such as Germany, are today
very inexpensive thanks to a very cheap Yen (or an expensive Euro).
...to relatively inexpen- 50
Japan
JPY/EUR: PPP Value
400
sive products...
40
350
30
300
20
...Japan has advan- 10

14.36
250
tages when it comes to 0

the Asian export 200
market... -10 163.77
-14.36 150
-20
-26.75
100
-30
-40 50
'78 '79 '80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Over/Under Value - % (Left) Trendline: Average (hidden) with 1st standard deviation
Spot Rates JPY/EUR, Close Daily - Japan (Right)
GaveKal Research - www.GaveKal.com
4– Strong Labor Productivity Gains: Finally, and most importantly, Japan’s

recent export growth is buoyed by the country’s strong labor productivity. Simply
put, Japanese productivity per hour is rising, which is translating into lower unit
labor costs. In the last 10 years, Japan has experienced a substantial decline in its
unit labor costs on both an absolute as well as a relative basis compared to Ja-
pan’s main export competitors, the United States and Germany. The United
States and Germany have both had declining unit labor costs as well, but, as the
charts on the following page emphasizes, Japan’s decline in unit labor costs has
simply been more drastic.
June 2, 2008 Page 2/15

Japan
GaveKal Equity Strategy 140
Labor Productivity
15
136.11
130
10
120
5
Rising labor productiv- 110
ity, and a resulting de- 100

-1.60
0
cline in unit labor costs, -5
is another strength. 90
-10
80 79.27
70 -15
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08
(INDEX) Labour Cost Manufacturing industry, 2000=100, SA - Japan (Left)
(INDEX) Mfg Output Per Hour Index Civilian Labor Force Basis NSA - Japan (Left)
Unit Labor costs, Manufacturing (NSA, annual percent change) - Japan (Right)
Gavekal Research - www.GaveKal.com
Japan
Unit Labor Costs Relative to Major Competitors
105 105
100 100
97.92
95 95
90.87
90 90
85 85
80 80
75 75
73.11
70 70
'98 '99 '00 '01 '02 '03 '04 '05 '06
(INDEX) Mfg Unit Labor Cost Index, Natl Currency Basis Civilian Labor Force Basis NSA - Germany
(INDEX) Mfg Unit Labor Cost Index, Natl Currency Basis Civilian Labor Force Basis NSA - Japan
(INDEX) Mfg Unit Labor Cost Index, Natl Currency Basis Civilian Labor Force Basis NSA - United States
So what exactly has Japan been exporting to China? The answer, linked to
China’s infrastructure spending boom (see The Bullish Growth in China’s Road Infra-
structure Spending) has been machinery. In recent years, Japan’s industrial sector has
had a positive macro wind at its back. But is this enough to make Japanese indus-
trials an attractive investment proposition?
What, exactly, does Ja- Japan
Exports to China
pan export to China? 4,000 14,000
13093.89
3,500 3450.97
12,000
3,000
10,000
2,500 2475.89
2,000 2052.20
8,000
1805.16
1660.49
1,500
6,000
1087.41
1,000 929.8 9
792.8 5
779.9 7
4,000
478.5 1
500 437.3 7
390.8 8
283.6 0
0 2,000
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Exports China, JPY - Japan (Right) Exports China, mineral fuels, JPY - Japan (Left)
Exports China, chemicals, JPY - Japan (Left) Exports China, motor vehicles, JPY - Japan (Left)
Exports China, electrical machinery, JPY - Japan (Left) Exports China, nonferrous metals, JPY - Japan (Left)
Exports China, general machinery, JPY - Japan (Left) Exports China, raw materials, JPY - Japan (Left)
Exports China, integrated circuits, JPY - Japan (Left) Exports China, semiconductors etc, JPY - Japan (Left)
Exports China, iron and steel products, JPY - Japan (Left) Exports China, transport equipment, JPY - Japan (Left)
Exports China, manufactured goods, JPY - Japan (Left) Exports China, other, JPY - Japan (Left)
June 2, 2008 Page 3/15

GaveKal Equity Strategy 2– Japan’s Machinery Boom
Whenever we look at the fundamentals of a company, we attempt to figure out
whether it is a “price-monetizer” or a “volume-monetizer”. In other words,
does the company sell a product with a demand elasticity greater or less than 1?
And we can do the same for an industry. Knowing that revenues equals price
multiplied by quantity, we can create some simple models to help us understand
the underlying dynamics of almost any sector. After all, for nearly any product
China’s massive plans category out there—even services—there is a relevant price index that we can use
to deflate a revenue stream. And in this instance, we can take the export price
for infrastructure im- index for Japanese machinery and use it to deflate exports of machinery. Over
provement necessitates the last decade, export prices for Japanese machinery have fallen by about -7%
the import of large while revenues have roughly doubled. This means that volumes have increased
quantities of industrial some +70%.
equipment. Japan
Export Prices, Volumes, and Sales: Machinery & Equipment
180 180,000
170
163957.14
160,000
160
157.62
150
140,000
140
130 120,000
120
100,000
110
100
80,000
92.82
90
80 60,000
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
(INDEX) Export Prices Yen basis General machinery & equipment, 2005=100 - Japan (Left)
(INDEX) Exports Volume Machinery & equipment, 2000=100 - Japan (Left)
Japanese Machinery & Equipment Exports: 12 Month Mocving Sum (US$) (Right)
Across industries, the variable we find most often responsible for an increase in
volumes is an improvement in quality; deliver a better product to the consumer
for the same (or lower) price, and sit back while your volumes explode! This is
Japan has gained be- the epitome of the deflationary boom. But how do companies achieve increases
cause the country’s in quality? They invest in research and development!
machinery and equip- On the next page, we show the aggregate, sector-level, amount of money (US$)
ment industry is a spent on R&D by the companies that make up the Japan MSCI index. But when
volume monetizer. we drill down into the data, we find that the Japanese industrial sector itself is not
a terribly large investor in R&D. However, drilling down further, we quickly see
that the machinery-related sub-industries are heavy R&D contributors. In fact,
the four machinery-related sub-industries represent about 75% of the total
R&D spending by the industrial sector while these four sub-industries rep-
resent only about a third of the market capitalization of the sector. Thus we
can conclude that the R&D intensity of these industries is much higher than the
others (interestingly, we find that the R&D intensity [simply R&D as a percent of
sales] of these companies is about the same as that of the auto and auto parts in-
dustry, or of the appliance industry. Should we thus conclude that a 2-3% level of
R&D intensity is fairly normal for export-oriented durable goods producers?).
Most people tend to think that R&D investment is wasted on pocket protector-
clad scientists arguing over absolute rest or singularity and for most investors,
R&D is capital “R” and little “d” (a belief promulgated by accounting rules which
treats R&D as an expense rather than an investment—see The Need For New Ac-
counting Rules). But the reality is rather different.
June 2, 2008 Page 4/15

Japan R&D by Sector R&D Expense Net Sales Market Cap R&D Intensity
GaveKal Equity Strategy (US$) Sector Average
Consumer Discretionary
Sum 40,580.8 1,319,631.4 700,433.7 2.5
Consumer Staples
Sum 2,137.8 330,808.5 203,252.7 1.2
Energy
Sum 399.7 261,851.8 58,432.0 0.1
Financials
Sum 0.0 453,866.4 569,129.5 0.0
Health Care
Sum 8,576.2 130,266.4 167,430.9 11.0
Industrials
Sum 8,800.8 1,124,320.9 596,645.1 1.3
Information Technology
Sum 26,242.3 588,637.1 466,471.1 4.4
Relative to other sec- Materials
tors of Japanese Sum 7,281.7 459,037.8 269,073.2 1.9
Telecom Services
business, the Industri- Sum 3,263.5 218,087.0 174,090.5 1.1
als do not seem to in- Utilities
Sum 1,118.5 200,121.0 154,651.8 0.6
vest too heavily in R&D. Total 98,401.1 5,086,628.4 3,359,610.5 2.6
R&D Spending by Industrial Sub-Sector R&D Expense Sales Market Cap R&D Intensity
(US$) Sub-Sector Ave
Air Freight & Logistics
Sum #N/A 12,284.3 6,690.1 N/A
Airlines
Sum #N/A 37,256.8 15,668.5 N/A
Building Products
Sum 965.9 57,896.4 38,591.3 1.7
Commercial Printing
Sum 504.2 32,929.8 19,233.2 1.5
Construction & Engineering
Sum 367.9 101,677.4 24,944.8 0.3
Construction & Farm Machinery & Heavy Trucks
Sum 1,207.3 63,787.1 47,035.6 1.7
Diversified Commercial & Professional Services
Sum 50.8 7,662.5 12,386.3 0.7
Electrical Components & Equipment
Sum 1,796.2 77,459.7 28,642.9 2.2
Heavy Electrical Equipment
Sum 1,053.4 40,579.2 18,545.9 2.6
Human Resource & Employment Services
Sum 0.0 4,128.0 325.6 0.0
Industrial Conglomerates
The exception is the Sum #N/A 7,538.0 5,490.7 N/A
machinery sector. Industrial Machinery

Sum 2,263.3 130,870.6 101,114.7 2.0
Marine
Sum 11.4 58,730.9 32,303.3 0.0
Marine Ports & Services
Sum #N/A 3,886.6 4,418.9 N/A
Office Services & Supplies
Sum 11.8 2,260.2 1,013.5 0.5
Railroads
Sum 350.3 101,000.4 96,544.7 0.4
Trading Companies & Distributors
Sum 218.4 360,791.7 136,247.7 0.4
Trucking
Sum #N/A 23,581.2 7,447.6 N/A
Total 8,800.8 1,124,320.9 596,645.1 1.3
June 2, 2008 Page 5/15

GaveKal Equity Strategy 3– The Importance of R&D
Contrary to popular belief, most R&D expense concerns development. In the US,
we can see from (rather dated) statistics produced by the National Science Foun-
dation that development costs are far and away the largest component of R&D.
In short, we are watch- United States
Re sea rch & De velopment Spending Bre akdown
ing Japanese industrial 90 90
machinery companies 80
7 7.1 3
80
transform themselves 70 70
into platform compa- 60 60
nies. 50 50
40 40
30 30
20 1 8.6 6
20
10 10
4 .21
0 0
'98 '99 '00 '01 '02 '03
Appplied Research as a % of Total Development as a % of Total
Basic Research as a % of Total
Ga v e Ka l R es e a rc h - www.G a ve Ka l.c o m
Following on that example, in the global auto industry, 85% of R&D is dedicated
to the development of tooling for the new year’s model—and given the similari-
ties previously noted in R&D intensity, we would guess that this figure is proba-
bly similar for the machinery industry.
And the goal of R&D should of course always be to boost productivity—where
productivity is simply the change in the difference between input and output
(which is why volume growth sends such an important signal). Typically, we look
for productivity in two basic ways:
♦ A reduced level of capital intensity, indicative of a company moving to an
Sumitomo Electric is an asset-light strategy.
♦ An improved level of profitability, indicative of successfully moving up the
example of a Japanese
value chain.
firm that is moving to a
And of course, either of these trends can be seen as a sign that a company may be
platform-company transforming itself into a platform company.
model.
4– Becoming Platform Companies?
Sumitomo Electric, the largest Japanese electrical equipment manufacturer, pro-
vides an example of just such a transformation. Over the last decade, capital ex-
penditures as a percentage of sales have been in a shallow downtrend (interrupted
in the last recession by briefly falling sales).
Capital Expenditures as a % of Sales
Sumitomo Electric Industries Ltd. (5802)
10 10
9 9
8 8
7 7
6 6
5 5
4.743
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Capital Exp (Total) % Total Sales
Gave Kal Research - www.GaveKal.com
June 2, 2008 Page 6/15

GaveKal Equity Strategy And we find the same trend in Mitsubishi Electric Corp, Japan’s largest heavy
electrical equipment company:
C ap ital Expend itures as a % o f Sales
M itsubishi Electr ic C orp. (650 3)
8 8
7 7
6 6
Mitsubishi Electric is 5 5
also seeing a decline in

the capex-to-sales 4 4
ratio, while R&D spend-

3 .5 7 1
3 3
ing is on the rise. ' 98 '99 '00 '01 '02 '03 ' 04 ' 05 '06 '07
Ca pital Exp (T otal) % T otal Sales
Of course, it is one thing to employ less physical capital—anyone can do that—

but is quite another to more efficiently use a stock of fixed capital. This is why
R&D spending is so important: because it leads to a deepening of the human
and organizational capital stock, that then provides the foundation upon
which to leverage one’s physical capital stock.
Identifying companies generating improved capital productivity is actually not so
challenging. A first sign is a rising trend in sales over net property plant and
equipment. Looking again at Mitsubishi Electric Corp and also at Fanuc Inc., Ja-
pan’s largest industrial machinery company, we find a marked improvement in
that ratio:
Net Property, Plant and Equipment Turnover
Mitsubishi Electric Corp. (6503)
6.727
6.5 6.5
6 6
5.5 5.5
5 5
4.5 4.5
4 4
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Property, Plant & Equip - Net
N et P ro pe rty , P l ant a nd E q uip m en t Tu rno v er

Fa nuc Ltd. (69 54)
P,P,&E turnover is on the 2.2 2. 2 0 9

2.2
rise for a number of

Japanese firms—a 2 2
sign of improving 1.8 1.8
capital productivity.
1.6 1.6
1.4 1.4
1.2 1.2
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
P r op erty , P lant & E qui p - Net
Ga v e K a l R es e a rc h - www.G a ve K a l.c o m
June 2, 2008 Page 7/15

GaveKal Equity Strategy The impact of improved capital productivity can be seen in working capital
trends as well. An improved flow of goods out of the fixed capital base allows
companies to leverage their inventories.
Inventory Turnover
7.5 7.5
7 7
6.844
6.5 6.5
6 6
5.5 5.5
5 5
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Inventory Turnover
Inventory Turnover
5.5 5.5
5.396
Better working capital 5 5
trends are seen in

variables such as im-
proved inventory turn- 4.5 4.5
over.
4 4
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Inventory Turnover
In any traded-good industry—especially one where unit labor costs are low and
the currency is undervalued—we look for a company to be grabbing market
share. This is a two-fer for businesses selling products with positive demand elas-
ticity because it means their slice of the pie is growing and the whole pie is grow-
ing too.
Fo reign Sales as a % Total Sales
Sumitomo Electric Industries Ltd. (580 2)
3 5 .4 3 4
35 35
30 30
25 25
20 20
15 15
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
F oreign Sales % T otal Sales
June 2, 2008 Page 8/15

Foreign Sales as a % Total Sales
GaveKal Equity Strategy 50

Fanuc Ltd. (6954)
50
49.461
48 48
46 46
44 44
42 42
40 40
38 38
36 36
34 34
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Foreign Sales % Total Sales
Just as we have done on the macro level, we can also deconstruct a company’s
For machinery makers, revenues and see the extent to which the company is generating volume gains. In
the next chart, we take the Japanese producer price index for machinery and
foreign sales as a per- equipment and use it to deflate revenues. What we see, is Sumitomo doubled
cent of the total have revenues despite a –15% drop in prices. This was achieved through a 140% in-
grown dramatically crease in volumes.
over the last decade. Japanese Machinery & Equipment
Producer Prices, Volume Index & Revenues
Sumitomo Electric Industrie s Ltd.
260 22,000
240 240.0 3
20291.20
20,000
220
18,000
200
180 16,000
160
14,000
140
12,000
120
10,000
100
85.41
80 8,000
'93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08
(INDEX) JPN PPI MACH & EQUIP, Index, Publication Base Year (2000), 2000Y - JAPAN (Left)
Sumitomo Electric Industries Ltd. - Sales - Net (US $) (Right)
(INDEX) Sumitomo Electric Industries Ltd. - Volume Index (Left)
Gav ekal R esearch - www .Gav eKal.com
All of the above should culminate in a structurally rising trend in return on in-
vested capital.
R et urn on I nv e s te d C ap it al
Sumit omo Elec tric Indus tries Ltd. (580 2)
6.1 69
6 6
5 5
4 4
3 3
2 2
1 1
0 0
-1 -1
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Return on Invest ed Capital
© Fa c tS e t Re se a r ch S y ste m s
June 2, 2008 Page 9/15

Return on Invested Capital
GaveKal Equity Strategy Mitsubishi Electric Corp. (6503)
10 10
9.653
8 8
6 6
4 4
2 2
0 0
-2 -2
-4 -4
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Return on Invested Capital
©FactSet Research System s
5– Stumbling At An Important Hurdle

When we try to identify companies adopting the “platform-company” business
model (as explained in Our Brave New World), we like to see signs that companies
Focusing more on the are throwing off excess capital. While Japanese companies are shrinking the size
of their balance sheets (mostly by reducing leverage), they are not doing so ac-
balance sheet of these tively enough. Most of the time, we find that companies are not necessarily pay-
Japanese machinery ing down debt but instead avoiding new debt:
makers, we like to see
companies reducing Long Term Debt as a % Total Capital
their levels of debt.

30 30
25 25
20 20
15 14.718
15
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Long Term Debt % Total Capital
Long Term Debt as a % Total Capital

60 60
55 55
50 50
45 45
40 40
35 35
30 30
25 24.585
25
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Long Term Debt % Total Capital
June 2, 2008 Page 10/15

GaveKal Equity Strategy Of course, this begs the question of what Japanese companies are doing with the
excess capital that they are generating? Are they hoarding it? It doesn’t seem so:
Cash as a % Total Assets
M itsubishi Electr ic Corp. (650 3)
16 16
15 15
14 14
13 13
12 12
11 11
What are companies 10

9 .86 5
10
doing with the excess

capital that they are ' 98 '99
Ca sh as a % T otal As sets
'00 '01 ' 02 '03 '04 '05 '06 '07
Gav eKal R es earc h - www.GaveKal.c om
generating? Cash as a % Total Assets

12 12
11 11
10 10
9 9
They don’t seem to be 8 8
hoarding the cash... 7 7
6.335
6 6
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Cash as a % Total Assets
Are they giving it back to shareholders (like American companies), via huge stock
buybacks and massively increased dividends? A little bit of the latter but not
enough of the former:
Div idends & Share Buybacks
30,000 30,000
20,000 20,000
...but nor are they pay-

ing huge dividends or
10,000 10,000
repurchasing large
amounts of shares.
0 -1.0 00 0
-10,000 -10,000
-15 4 77 .00 0
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
C ommon & Pfd Stk - Change ( CF) Dividends Paid - T otal (CF )
GaveKal Researc h - www.GaveKal.c om
June 2, 2008 Page 11/15

Dividends & Share Buybacks
GaveKal Equity Strategy Mitsubishi Electric Corp. (6503)
0 30.000 0
-5,000 -5,000
-10,000 -10,000
-15,000 -15,000
-20,000 -20,000
-25,000 -25,000
-25758.000
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Common & Pfd Stk - Change (CF) Dividends Paid - Total (CF)
Then where is the money going? This is the part that makes us cringe. All too
often, instead of returning excess capital to shareholders, Japanese companies
instead invest in other companies. Needless to say, this usually proves to be a
misallocation of capital if only because, all too often, it has less to do with seeking
out the highest rate of return for shareholders’ money than with establishing de-
fenses against takeovers. In the charts below, we take acquisitions/investment
Unfortunately, excess from the financing section of the cash flow statement and compare it to invest-
cash is often invested ments in unconsolidated subsidiaries from the balance sheet:
in other companies — Cash Flow Spent on I nvestments & Level of Investments i n Subsi diaries
1,600
and not for the right 400
1554.556
reasons. 1,500
350
1,400
300
1,300
250 1,200
200 1,100
159.3 07
1,000
150
Associate income and 100

900
minority interests re- 800
duces the quality of '98 '99 '00

Acquisitions & Investments - (CF)
'01 '02 '03 '04
Invest ments - in Unconsolidated Subsidiaries
'05 '06 '07
both earnings and the Gav e Ka l R es ea rc h - www.G aveKal.c om
balance sheet. These investments in other companies make financial statements much less trans-
parent than we would like to see. Equity in earnings, which results when one
company treats an investment in an unconsolidated subsidiary under the equity
method, is the proportional share of the subsidiaries’ income. For example, if
company A owns 10% of company B, and company B reports $100 of income,
company A books $10 as equity in earnings. However because we do not see the
full accounts of company B, we do not know how secure that income will be in
the future.
Conversely, when a company has sold a stake in itself (think private equity), that
investment is recorded on the balance sheet as a minority interest. Minority inter-
est holders are first in line to claim income, followed by preferred and common
shareholders. However when a company has a large minority interest as a share
June 2, 2008 Page 12/15

GaveKal Equity Strategy of its capital base, the balance sheet is of lower quality—because you have no in-
formation on the accounts of the shareholders.
Equity In Earnings of Unconsolidated Sunsidiaries
19765.000
20,000
25
20 15,000
15
13.265
10,000
10
5,000
5
When companies go
0
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
about buying small Equity in Earnings of Unconsol Subs - Pretax (Right)

Equity in Earnings of Unconsolidated Subs as a % Operating Inomce After Depreciation (Left)
pieces of other compa- M in o rit y In te re st

S u m it o m o E le c tr ic In d us t r ie s L td . ( 5 8 0 2 )
nies, we sense an ulte- 1 6 0 ,0 0 0

1 6 06 75 . 00 0 1 3 .5
rior motive. 1 5 0 ,0 0 0
13
1 2 .5
1 4 0 ,0 0 0
1 2 .1 45
12
1 3 0 ,0 0 0
1 1 .5
1 2 0 ,0 0 0
11
1 1 0 ,0 0 0
1 0 .5
1 0 0 ,0 0 0
10
9 0 ,0 0 0
'9 8 '99 ' 00 '0 1 '0 2 '0 3 '0 4 '0 5 '0 6 '07
M i n o ri ty In te re st a s a % T o ta l C a p i ta l ( R i g h t) M i n o ri ty In te r e st - Ac cu mu l a te d (L e ft)
© Fa c tS e t R e se a r ch S y ste m s
While we like to see a healthy level of other long-term assets, we prefer it when
Perhaps we are picky, those assets are largely goodwill from an acquisition. Some bemoan large chunks
but we would much of goodwill on company balance sheets, but at least it is a value that reflects com-
rather see an increase plete control. That value may turn out to be spectacularly wrong (i.e.: AOL?) but
it is, after all, transparent. Conversely, when companies run around buying small
in other long-term as- pieces of other companies, we sense that the motivation may be different than
sets due to an acquisi- the maximization of returns. And we have to admit that the rising trend in these
tion. “other long term assets”—a reflection of bolstering takeover defenses—is very
disheartening. If only a company like Sumitomo Electric, generating huge volume
gains, and minting money, wasn’t so economically xenophobic!
Other Long Term Assets as a % Total Assets
26 26
24 24
22 22
21.740
20 20
18 18
16 16
14 14
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Assets - Total
June 2, 2008 Page 13/15

GaveKal Equity Strategy 6– Conclusion
So, as investors, we have two opposing forces to weigh. On the one hand, Japa-
nese industrial companies are experiencing tremendous growth on the back of
smart investments and an explosion in demand from China. Even more encour-
agingly, Japanese machinery companies are starting to demonstrate many of the
attributes of platform companies. This force is so powerful that, despite the eco-
nomic slowdown unfolding around the world, Japanese industrial companies are
demonstrating tremendous earnings momentum. In fact, they are the only sector
with rising earnings estimates in Japan. On the other hand, balance sheets and
income statements are murky and companies are throwing too much of their
money down the nezumi hole.
Our colleague Chris Russell, who just spent a week in Japan meeting with compa-
nies and investors, had this to say in response to Louis’ recently published Japan’s
Return to Normalcy: “It is interesting to hear 1) how many long/short managers
have folded, especially those who started relatively recently, and 2) that Japan is
no longer an independent asset class… Regarding macro or long-only institu-
Is the paranoid tional investors, Merrill Lynch estimates, from their Global Fund Manager Sur-
behavior of Japanese vey, that global investors are now as underweight Japan as at anytime since 2003
but when asked what their one-year view would be, there are now 10% more
management largely managers who would be overweight Japan, mirroring a change in their view of
discounted? Europe from over to under. This is a good time to make the case for relative per-
formance arising from a structural more than a cyclical change in Japanese eq-
uity.”
Which basically brings us back to the question at hand, namely if the big hurdle
to an equity market rally is the paranoid behavior of Japanese management, then
to what extent is that value-destructive attitude reflected in current valuations?
Today, we find a number of companies selling near book value and at historically
low multiples of whatever one cares to compare: earnings, cash flow, or sales.
Thus, we cannot help but feel that, after two decades of valuation compression,
Japanese machinery companies (at the very least) are worth a look. By and large,
they have wisely pursued and executed on a platform company strategy, which
has allowed them to become more resilient to external shocks. And we believe
that this new strategy, and resilience, is not yet reflected in share prices.
So how do you say ‘Platform Company’ in Japanese? We put that question to a
Japanese-speaking friend and her response was, “It doesn’t translate”. In the
years to come, and especially for the sake of our overweighting of Japan, let’s
hope that it does. Japan is now so close.
Japan
Index of IBES Earings Estimates 12 Months Forward
130 130
120 120
117.45
110 110
103.94
103.43
102.21
100 99.1 7 100
96.7 6
93.5 7
90 86.9 1
90
85.7 1
80 80
70 70
60 60
50 50
44.9 6
40 40
May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr
(INDEX) MSCI Japan / Consumer Discretionary -SEC - IBES Aggregates - Mean EPS Est - 12 Months
(INDEX) MSCI Japan / Consumer Staples -SEC - IBES Aggregates - Mean EPS Est - 12 Months
(INDEX) MSCI Japan / Energy -SEC - IBES Aggregates - Mean EPS Est - 12 Months
(INDEX) MSCI Japan / Financials -SEC - IBES Aggregates - Mean EPS Est - 12 Months
(INDEX) MSCI Japan / Health Care -SEC - IBES Aggregates - Mean EPS Est - 12 Months
(INDEX) MSCI Japan / Industrials -SEC - IBES Aggregates - Mean EPS Est - 12 Months
(INDEX) MSCI Japan / Informat ion Technology -SEC - IBES Aggregates - Mean EPS Est - 12 Months
(INDEX) MSCI Japan / Materials -SEC - IBES Aggregates - Mean EPS Est - 12 Months
(INDEX) MSCI Japan / Telecommunications Services -SEC - IBES Aggregates - Mean EPS Est - 12 Months
(INDEX) MSCI Japan / Utilities -SEC - IBES Aggregates - Mean EPS Est - 12 Months
June 2, 2008 Page 14/15

Price to Book Value Ratio
GaveKal Equity Strategy Sumitomo Electric Industries Ltd. (5802)
Japan - Industrials - Electrical Components & Equipment
4.5 4.5
4 4
3.5 3.5
3 3
2.5 2.5
2 2
1.5 1.5
1.061
1 1
0.5 0.5
'88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Price to Sales Ratio

1.4 1.4
These various valuation

measures provide fur- 1.2 1.2
ther fuel for our 1 1
optimistic fire.
0.8 0.8
0.6 0.6
0.4 .398 0.4
0.2 0.2
'88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07
Price to Cash Flow Ratio

22 22
20 20
18 18
16 16
14 14
12 12
10 10
8 8
6 6
4.790
4 4
'88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07
GaveKal Research - www.gavekal.com
Dividend Yield
1.8 1.8
1.6 1.6
1.538
1.4 1.4
1.2 1.2
1 1
0.8 0.8
0.6 0.6
0.4 0.4
'88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07
June 2, 2008 Page 15/15

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Volume 2, Issue 17

GaveKal Equity Strategy June 2, 2008

Author: Steven Vannelli

How Do You Say ‘Platform Company’ in Japanese?

303-534 8108 (fax) 18,000 18,000

Electra Street 2,000

June 2, 2008 Page 1/15

Trendline: Average with 1st standard deviation

to, and improving rela- Gavekal Research - www.GaveKal.com

...Japan has advan- 10

tages when it comes to 0

market... -10 163.77

4– Strong Labor Productivity Gains: Finally, and most importantly, Japan’s

June 2, 2008 Page 2/15

Rising labor productiv- 110

ity, and a resulting de- 100

cline in unit labor costs, -5

June 2, 2008 Page 3/15

June 2, 2008 Page 4/15

machinery sector. Industrial Machinery

June 2, 2008 Page 5/15

into platform compa- 60 60

June 2, 2008 Page 6/15

also seeing a decline in

ratio, while R&D spend-

Of course, it is one thing to employ less physical capital—anyone can do that—

N et P ro pe rty , P l ant a nd E q uip m en t Tu rno v er

P,P,&E turnover is on the 2.2 2. 2 0 9

rise for a number of

sign of improving 1.8 1.8

June 2, 2008 Page 7/15

Better working capital 5 5

trends are seen in

June 2, 2008 Page 8/15

GaveKal Equity Strategy 50

June 2, 2008 Page 9/15

5– Stumbling At An Important Hurdle

their levels of debt.

Long Term Debt as a % Total Capital

June 2, 2008 Page 10/15

What are companies 10

doing with the excess

Gav eKal R es earc h - www.GaveKal.c om

generating? Cash as a % Total Assets

They don’t seem to be 8 8

hoarding the cash... 7 7

...but nor are they pay-

June 2, 2008 Page 11/15

Associate income and 100

minority interests re- 800

duces the quality of '98 '99 '00

both earnings and the Gav e Ka l R es ea rc h - www.G aveKal.c om

June 2, 2008 Page 12/15

about buying small Equity in Earnings of Unconsol Subs - Pretax (Right)

pieces of other compa- M in o rit y In te re st

nies, we sense an ulte- 1 6 0 ,0 0 0

June 2, 2008 Page 13/15

June 2, 2008 Page 14/15

Price to Sales Ratio

These various valuation

ther fuel for our 1 1

0.4 .398 0.4