Japanese Stocks Look Cheap Compared with U.S. Land

In the past few weeks we've seen more and more articles predicting the continued downturn of the US economy and housing market. A particularly useful set of graphs was published in Business Week, the second of which illustrates the sharp jump in housing prices in the past few years.

It’s helpful to compare these prices to those for Tokyo residential real estate. From 1985 to 1991, Tokyo real estate prices went up almost 150%. By 2005, prices had retreated to 1985 levels, with the biggest losses posted in the three-year 1991-94 period.

It is often argued that a similar collapse is impossible in the US, especially in places like California. But it’s wise to remember that much the same thing was said about real estate in Tokyo in 1990, namely, that the city is the center of Japan’s economy, and land supply cannot be expanded. In short, real estate prices could never go down.

Prices of California homes went up 167% in the past 10 years, and in the past year have only dropped less than 10%:

While many people won't (or don't want to) believe the 20%-30% drop predicted by BusinessWeek is possible, if the Tokyo example is at all similar, there is certainly the possibility that those declines will be realized.

The Japanese stock market was one of the world’ worst-performing markets last year. The economy is not any better this year, but stock prices may have been already battered enough. Some bottom-fishing is now possible.

Analysts Debate Sharp Rise in 4Q GDP
Japan's GDP in the fourth quarter of 2007 rose at an annual rate of 3.7%, more than twice the level of consensus estimates. Greater outlays for factories and facilities and strong exports of cars and software helped spur the expansion. The solid performance boosted growth for the full year to 2.1%. Investors responded positively to the news, sending the Nikkei 225 up 558 points, or more than 4%.

But many analysts were skeptical. Glen Maguire, the chief Asia economist for Société Générale, said "Every now and then Japan produces an economic number that prints diametrically opposite to what common sense would suggest.” Some observers noted that consumer spending was buoyed only by high oil prices and cold weather. Government ministers were equally cautious, warning of downside risks for the economy. Other analysts expected the estimates to eventually be cut.

Still, some observers were heartened by the news. "Japan's economy may not be great, but it's never as bad as investors think,'' said Masayuki Kubota, who helps oversee $2.2 billion in assets at Daiwa SB Investments Ltd. in Tokyo. "Japan's GDP figure and the U.S. retail data are evidence for a more positive view on the market outlook today.''

One overarching -- and disconcerting -- phenomenon is the skepticism with which Japan's real GDP numbers are viewed. Some suggest that nominal GDP -- which grew more slowly in the quarter -- is less riddled by distortions and presents a more accurate picture of the economy. Takehiro Sato of Morgan Stanley notes that, while the economic cycle in the US can be traced by GDP, in Japan it's the industrial production numbers that count. All in all, although the strong 4Q GDP growth for Japan should not be ignored, it will take stronger evidence to convince analysts that the Japanese economy is doing as well as the recent news would indicate.

Opportunity in Japanese Car Navigation?
Thanks to more advanced and user-friendly graphical interfaces (among other developments), personal navigation devices (PND) -- portable and economic versions of car navigation systems -- are seeing high demand. PND sales doubled in 2007, and according to Amazon, it was one of the hottest product categories during the past holiday season. Garmin (GRMN), the leading U.S. maker, saw its sales increase nearly 70% in the first nine months of 2007 (see photo of Garmin nuvi2000 below). Canaccord Adams recently raised its rating on the company from "hold" to "buy". Another leading maker is TomTom of Netherlands, and Taiwan's Mio is also doing well and growing sales in the U.S.

Japanese makers are notably absent from this race in the U.S. While many companies, including Fujitsu, Pioneer, Sony, and Panasonic, offer PNDs in Japan, we don't see any of these names in the U.S. market. What happened? Japanese makers are usually good at marketing these clever small devices. And the car navigation market in Japan was at least several years ahead of that in the U.S.

A likely reason is the advance of originally equipped car navigation systems. Japan has a relatively mature car navigation market, dominated by expensive systems embedded in the car (at additional costs of $500 or more). When much cheaper PNDs (some around $100) started showing more advanced functions and usability, Japanese makers had difficulty competing in this market for fear of cannibalizing their own more expensive systems.

So are there no Japanese companies that will benefit from the expanding U.S. PND market? An interesting name to watch might be Zenrin (TSE: 9474), an old map company that started providing digital map databases to car navigation makers in the early 1990s and recently was in the process of shifting more of its energies into its mapping database business. It has about a 70% market share of the maps used by original equipment car navigation systems in Japan, and many PND makers also buy map data from the company. More recently, one of NTT Docomo's newest mobile handsets, "905i", was equipped with Zenrin's map software, opening potential content revenues for the company.

In the U.S. and European markets, upward integration (M&A) was evident in the last quarter of 2007. The leading US PND maker Garmin fought to acquire Tele Atlas (TLATF), bidding $3.4 billion for this a Dutch digital map company; but it gave up this expensive bid to rival TomTom, also a Dutch company. At the same time, Nokia offered $8.1 billion, or 50 times earnings, to buy Navteq (NVT), a Chicago-based digital mapping company. While these M&A deals sound very expensive, if consolidation proceeds in the navigation sector, mapping data companies may become rare and expensive assets. Map content is very time-consuming to build, so it's something all navigation system providers have to pay to license. In December, Microsoft bought U.K mapping company Multimap in a bid to compete with Google in online mapping tools.

At this point, it is speculative to think Zenrin will be an M&A target. For one thing, its large share in Japan would make it difficult for one of the device makers to own it. And currently selling at 40 times forward earnings, the stock is expensive. Still, if we were to see any major developments -- fierce PND competition from foreign makers like Garmin and Mio (which are already selling in Japan), development of Zenrin's next generation content "guidable city mobile (GCM), etc. -- this might be an interesting company to follow in this sector.

Zenrin stock chart

Is Higher Oil Fully Reflected in Japanese Utility Stock Prices?
In recent weeks the yen has rebounded nicely against the dollar, moving from a high of ¥124 this past summer to the recent low of ¥107. Some observers say the yen carry trade has almost unwound and the yen has peaked. Others predict that, with continuing mortgage woes in the US, the yen is slated to move under ¥100.



The strong yen is bad news for the many Japanese companies that rely heavily on exports (Sony, Toyota, Honda, and Nintendo, to name just a few). But Japan is also a net importer in certain sectors, most notably energy, food, and wood. In particular, Japan imports most of its oil from abroad, thus margins at electric utilities are strongly affected both by the crude oil price and currency exchange rate. Electric utility company stocks had rebounded late in 2007, before the sharp decline at the beginning of 2008 with the rest of the Japanese market.

Currently the average forward PER of Japan's utility companies is 23.4. Do their stock prices reflect both the effect of rising energy costs and a stronger yen? We think that recent surge in oil prices to around $100 has not been incorporated in many of the March 2008 earnings estimates that were announced a few months ago. Thus when third- quarter results are released in late January they should include some "surprises" -- which really shouldn't be surprises at all if you do some rough calculations to adjust the previously announced estimates.



For example, Chubu Electric's (9502) most recent forecasts for the March 2008 year is ¥145 million for ordinary income and ¥89 million for net income. These estimates assume a crude oil price of $68.10 per barrel for the fiscal first half and $70 for the second half (October 2007 to March 2008).

However, the actual average oil price for the second half is more likely to be around $85 or even $90. Chubu's disclosures tell us that every $1 rise in crude oil prices adds ¥7.6 million to its costs. So if the average oil price for the year is $85 instead of $70, the gross impact on costs would be ¥121.6 million. That amount would be somewhat offset by the benefits of a rising yen: if the average exchange rate is ¥115/$ instead of ¥120/$ that their current estimates incorporate, the gross positive impact on the margin would be ¥26 million. However, considering that ordinary income is pegged at only ¥145 million, the overall impact from higher oil prices would still be substantial.

Of course, utility companies use various hedging contracts for commodities and exchange rates (for which we could not find detailed disclosures). There are other factors as well -- such as the percentage of electricity generated from nuclear -- so the back-of-the-envelope calculation offered above is not the whole picture. But it's helpful to remember that Chubu's forward PER of 24 is based on estimates released two months ago – whose assumptions are now very different from current reality.

The Self-Inflicted Wounds of the Japanese Economy
The AFP has a good story about how three over-reactions to consumer worries by Japan's bureaucrats hurt the economy during the past year.

The first instance was the introduction of stricter construction standards for earthquake resistance following the falsification of data by a Japanese architect. It sounds fine on paper, but the new rules lengthened the permit approval process from three weeks to more than two months.

The second was new regulations that severely limited the interest rates charged by consumer finance companies. Again, the aim was laudable, in this case to protect poorer Japanese from high debt. But less-well-off consumers depended on the high-priced loans from the finance companies, and they now have to turn more often to the black market.

Finally, life insurers have been forced to go back over 30 years' worth of records to find policyholders who were entitled to benefits but didn't receive them. The action shifted the burden for notification from policyholder (where it resides in the US) to the company. Again, noble goal, but it cost the industry in excess of $2 billion and reduced the level of trust between consumer and the insurers.

New Stock Exchange for Japanese Start-Ups
Last week the London Stock Exchange and the Tokyo Stock Exchange announced that they would set up a new stock market for Japanese start-up companies. The market, which has yet to be named, will seek to eliminate numerous requirements for listing and will only be available to professional investors. The LSE already operates a similar market in London called AIM. The two exchanges hope to have the new market up and running by the end of 2008.

The move comes as Japanese financial authorities work to re-establish Tokyo as an international financial center. In recent years, the TSE has seen the number of foreign listings fall, and overall Japan has been losing its luster as a financial center compared with other East Asian markets, most notably Shanghai.

Whether the new market will be successful is open to to question. Some suggest that AIM itself poses significant competition. The London market has been extremely successful in capturing foreign listings. In 2006 the market held 462 IPOs compared with 138 launched on NASDAQ and 136 at JASDAQ, Mothers, and Hercules combined. Japanese start-ups may figure that AIM serves its needs nicely and decide to list on AIM instead. In July of last year, Secure Design, a provider of biometric verification systems, became the first Japanese company to list on AIM.

On the other hand, there's reason to doubt whether AIM will act as a drag on the new exchange. Unlike U.S. or many European companies that need to prepare all of their financial documents in English anyway, it will be a significant burden for small Japanese companies to prepare all their disclosures in English and do the IPO "tour" for an English-speaking audience. That's a major reason why Japanese ADR listings are so few and limited to mostly very large companies.

Notably, this latest venture follows JASDAQ's move in August to establish a small company exchange called NEO to compete with TSE Mothers and OSE Hercules. Thus far the response to that entity has been underwhelming. It's interesting timing that there are so many efforts to establish exchanges for smaller cap companies when existing exchanges are not succeeding.

Japanese Firms to Benefit from Strong Airbag Sales

One area of the auto industry that may grow faster than actual vehicles is airbags. Two recent developments brighten the outlook for this industry segment. First, Toyota announced in July that all of its models sold in Japan will be equipped with side and curtain airbags. Second, the US NHTSA will gradually mandate side/curtain airbags beginning September 2009. This will triple the cost of airbags for each car compared with current levels with just the requirement of front seat bags.

There are essentially three airbag providers for the Japanese auto industry: Takata (7312), Toyota Gosei (7282), and Nihon Plast (7291). Among them, Takata may benefit most since 47% of its sales come from outside Japan. Because vehicles of the U.S. Big Three are less likely to be equipped with side/curtain airbags compared with Japanese cars, the NHTSA mandate should have a relatively strong impact on Takata.