Japan's Monetary Policy Appears On Course
On the heels of a 4.8% boost in fourth-quarter GNP, on February 21 the BOJ raised its benchmark interest rate to 0.5%. The move was a little surprising to economists, the majority of whom thought the Bank would keep rates steady. At its January meeting, the BOJ had done just that -- and was promptly accused by some of bowing to political pressure.

Viewed over a longer time-frame, however, monetary policy appears on course. From March 2001 to March 2006, the BOJ maintained its so-called monetary easing policy. Instituted to combat deflation, the policy also helped to maintain stability in the financial system and get the big banks back on a sound financial footing. Although some now criticize the BOJ for allowing the yen to weaken, thus prolonging and deepening the yen "carry trade," a precipitous rise in rates would do more harm. The strength of consumer spending remains questionable, with the increase in the latest quarter merely offset weakness in the previous period. After 15 years of declining asset values and widening cracks in the Japanese lifetime employment system, who can blame the Japanese consumer for being wary of pronouncements of economic recovery?

The BOJ policy seems attuned to this sentiment, and the broader requirements of Japan's economic health. At least so far as the recent hike is concerned, executives at Japan's big companies seem to agree: according to a Nikkei survey, 60% of them thought it was an "appropriate time" for such a hike.

Fallen Angel or Rising Phoenix? The Jury's Still Out on Raccoon

For a U.S.-based analyst, even thinking about recommending a company like Raccoon (Mothers; 3031), a Japanese online B2B wholesale broker that went public in April 2006, is a little scary. Raccoon's stock price, after hitting 3,860,000 yen a few days after its IPO and listing on the TSE's Mothers section -- known for its "new economy" companies with sky-high PEs -- continued to decline to a low of 285,000 yen, almost a 93% drop. Along the way, the company, which had been profitable for two fiscal years prior to the IPO, incurred a midyear loss in October, and revised its forecasts downward to net losses for the years ending April 2007 and 2008. Is this deja-vu all over again, a replay of the bust in US Internet stocks, circa 1999?

Source: Yahoo Finance Japan

Or is it really not that bad? Perhaps at the current price of 400,000 yen the company deserves another look. While it incurred a net loss of 77 million yen for the 6 months ended October 2006, compared with 35 million yen in net income for the year-earlier period, gross revenues increased 60.5%, and gross profit was up 28.2%. The net loss included a revaluation for the write-off of deferred taxes of 57 million yen. Operating cash flow was positive at 29 million yen.

More important, the revised forecasts to negative territory for 2007 and 2008 are largely due to the company's shift in its medium-term strategy. Judging that there is a significant opportunity in bridging the B2B business for Japan's small- and medium-size firms -- a sector known for its complicated, fragmented, and inefficient supply chain -- Raccoon decided to (1) change its fee structure from payments upfront to a recurring fee model, and (2) invest heavily in advertising to attract a retail-store customer base. The changes in fee structure had an immediate, negative effect on the bottom line, since some existing customers departed and there was a drop in initial, one-time revenues when new merchants signed up. However, the company's belief that the new fees will bring in continuing monthly income seems to make sense (see the chart below by Investment Bridge, Raccoon's IR firm).









Green bar - revenue model with former fee structure
Orange bar - revenue model under new fee structure

Is the increased advertising bringing in new customers and merchants? The jury's still out, but customer/merchant acquisition data shows an increase in the customer base of around 4% per month since October, and as of the end of January it is up 37.3% since the end of last fiscal year in April 2006. The company doesn't release monthly revenues, but in the past they have been strongly correlated to the number of customers.

We're not ready to call Raccoon a buy until we find out the relationship between new advertising/customer acquisition costs and their impact on revenues. The PE based on last year's results is approximately 20, while the forward PE based on the company's April 2009 results would be approximately 15. We know that Japan's new exchanges, especially Mothers, are supposedly scary places, full of new, risky companies with lofty PEs. But at least compared to some of the U.S. bubble-economy companies that in 1999 had PEs of 500 based on EPS five years or so down the road, Raccoon does not look so frightening.

Note, however, that even with a positive turnaround, the stock price may take a while to react. The pool of available is limited - at a per-share price of 400,000 yen (about US$3,300), quotes are too high for most individual investors, while at a market cap of about US$30 million, the company would be too small for many institutions.

Citigroup to Apply for First Section Listing

Nikkei reports that Citigroup will apply within the year for a First Section listing on the TSE. The Bank wants to expand its operations in Japan and has decided a TSE listing is a necessity. The move could make it easier for Citigroup to buy Japanese companies through stock swaps.

The move comes as plans proceed to introduce so-called Japan Depository Receipts, similar to ADRs, through which yen-denominated foreign shares would be traded, as well as a possible tie-up between the New York and Tokyo exchanges. The TSE has continued to lose listings of foreign stocks and hopes to regain its international presence. 日経, Reuters

Steel Partners Seek Two-Thirds of Sapporo

Following its attempt last November to take over Myojo Foods, Steel Partners now seeks to raise its stake in Sapporo Holdings, the well-known brewery and foods company, to 66.6% from its current 17.5%. Sapporo management has warned it will try to stave off the bid. Last year, it introduced anti-takeover measures that will allow it to dilute its stock to rebuff a hostile bid seeking more than 20 percent of voting rights.

Besides Myojo, Steel Partners has also targeted fast-food chain Mos Food Services Inc. and Brother Industries Ltd., the maker of copiers and inkjet printers. 日経, Bloomberg

UPDATE 2/16/07
As Sapporo stock's price surged more than 12% to Y891, talk swirled about Sapporo possibly tying up with other large beverage makers, most notably Asahi and Kirin. A tie-up with either firm would give the combined company more than 50% of the beer market.

This Reuters article has a lot of information about the recent developments and the companies involved, including one historical factoid I did not know: Asahi and Sapporo were a single firm in the early 20th century.

Japanese Stocks and the Impact of Low Interest Rates

Equity analysts that work for the big banks have it relatively easy when it comes to economic forecasts. They can always use the projections of their in-house economist and, assuming his forecasts isn't off in left field, know that they won't be too harshly criticized when those assumptions turn out wrong.The rest of us aren't so fortunate. We can of course use consensus estimates, but that's a cop-out if forecasts are all over the map. Thus it's always disconcerting to read doomsday scenarios that are given credence by people who are a lot smarter in these matters than we are.

Some see looming disaster because of the giant credit bubble that Japan's low interest-rates are creating. There's been a great deal of talk of the "carry trade," ie, borrowers taken loads of cheap yen and investing them in higher-yielding currencies. One economist cited believes that the yen is as much as 29% undervalued. Eventually, the bubble will burst, exchange rates will realign, and the yen will appreciate to 100 yen -- even 70 yen -- to the dollar. In this scenario, even the offsetting advantages of cheaper imports would be insufficient to stem a sharp, broad decline in world and Japanese business conditions. While the authors don't explictly say so, it's hard to imagine that Japanese stocks would do well in such an environment.

It's a substantially different economic world over at Business Week. Although the piece on "low, low rates" naturally focuses on the US rather than Japan, there's no prognosis of the burst of a giant credit bubble. While cautioning about the impact low interest rates worldwide are having on credit quality, overall the article is positive. Companies are investing, profits are booming, and housing is making the all-desirable soft landing.

In the scenario seen by authors Michael Mandel and David Henry, the sources of excess liquidity are India and China (the BOJ isn't mentioned). These countries are very good at raising capital but very bad at allocating it. Thus the funds thereflow overseas. Coupled with the overall globalization of financial markets and the increasing sophistication of financial instruments (notably in the form of collateralized debt obligations), the real cost of capital continues to decline. The authors expect the low-interest rate environment to continue.

Getting back to Japan, according to a recent article in the FT, market observers continue to be bullish on the Japanese economy. And they expect 2007 to be a much better year for stocks than 2006. (Although that may not be so great for other world markets, since the Japanese bourse tends to have its own drummer.)

As I said, we like to focus on Japanese companies, not her role in the world economy. It's a sandbox I'm not comfortable playing in.

Still, a couple of gut-feel thoughts:

(1) If you look at a five year yen/dollar chart, the trading range is about 132 (beginning of '03) to 103 (end of '04). A rate of 121 or 122 just doesn't feel like a number that's so out of whack that it would have the dire consequences the pessimists believe.

(2) Despite all the talk about Japan's recovery, there shouldn't be any sense of irrational exuberance. Consumer spending has been up a bit lately, but overall it remains lackluster. Real estate prices have firmed, but except perhaps for a few pockets of Tokyo, they're hardly raging. Since January 2006, the Nikkei has stayed in the 16,000/17,000 trading range. Putting aside Japan's longer-term debt problems, which are considerable, the environment doesn't call for a huge rise in interest rates by the BOJ.

(3) Japan's exporters operate under their own economic law. They have made money at rates of 120 and 100 yen to the dollar, and if they had to do it at 90 yen, they would. I'm worried about people no longer buying Sony because of a declining reputation for creativity and quality, not because in a strong yen environment they wouldn't figure out how to make their stuff cheaper in the globalized workshop.

The upshot is that I don't see a wild surge in the yen and, even if it occurred, the Japanese economy and markets would react a lot better than some people expect they would.

Generic Drug Makers to Benefit from Health Care Reform

Japan's brand drug makers are facing difficult challenges. The country's baby boomers – the cohort born between 1947 and 1949 – are starting to retire in numbers this year. With an aging population and limited financial resources, Japan's government is seeking to reduce ballooning spending by its national health care insurance system. Some consolidation in the industry is inevitable, as already evidenced by the recently announced merger between Tanabe (4508), and Mitsubishi Pharma.

One sector within the drug industry that should benefit from the new regulations aimed at cost-cutting is generic drugs. Since April 2003, co-payments for individuals in Japan's health care insurance system have been lifted from 20% to 30%, making consumers more sensitive to their healthcare costs. In the U.S. and many European countries, the generic drug market is well established, but Japan is behind as much as 20 years. On a unit basis, generics represent only 10% of Japan's drug market, against 40% to 50% in the US and Europe.

Source: Bando-Yakuhin
Note: Red bars are for units; blue bars are for local currencies


In addition to issuing various "guidance," the government has published regulations to promote wider use of generic drugs. These include price revisions in 2002 to provide additional incentive payouts to insurers for generic drugs, and last year's change in the prescription format to allow pharmacies to change to generics when pre-approved by a doctor.

Japan's generic drug industry is highly fragmented; there are about 200 manufacturers, mostly small, privately owned companies. The expanded market opportunities bring more competition, not only among generic firms but from entry by the big, name-brand pharmaceutical companies. Consolidation in this segment is inevitable. While there are a limited number of publicly traded generic drug companies, the leading names may offer investment potential because (a) by acquiring smaller competitors, the leading companies will post higher growth; and (2) they also are acquisition candidates for Japan's brand drug makers as well as large overseas companies.

Already, there are signs of foreign interest in this segment; specifically, several Indian generic drug makers announced they will enter the Japanese market to exploit their price competitiveness. Also, this year stock-swap acquisitions by overseas companies will be allowed, making purchase and investment easier for U.S., European, and Asian companies, many of which are better capitalized than their Japanese counterparts.

There are only a handful of publicly traded companies in Japan that focus on generic drugs. Their stocks trade at PEs of 20 to 25, about the market average. In addition, a few of the brand pharmaceutical makers get a good portion of their business from generics. Elmed Eisai, a subsidiary of Eisai (4523; ADR:ESALY), boasts the top reputation among medical professionals. Sawai (4555) seems the most reputable among independents; it's also the market leader and is increasing production volume by purchasing a plant owned by Schering Japan.

Nichi-Iko (4541) is aggressive in M&A and tie-ups; it has formed an alliance for itemization and standard-making with Towa (4553), another leading generic company, and Sawai. The company has had to revise its earnings expectations upward several times in the past few years. Towa is known for aggressive direct sales to pharmacies, which may be attractive to overseas companies entering the Japanese market.

Implications of Fujiya's Problems for Japanese Business
Fujiya is caught in a scandal concerning the use of ingredients past their sell-by dates. Now apparently other poor practices, including "lax quality control systems and poor information handling," have been uncovered.

As I've mentioned before, I was often told while working in Japan that the country's vaunted reputation for quality did not extend to industries that center on domestic consumption. I haven't studied if the stories coming out of Japan on poor quality control in the food industry are more numerous than those in the US; but they do seem to occur (mislabeled beef, tainted milk) with regularity. I wonder at what point these stories -- along with bad publicity about Japanese products that are in fact used overseas, such as Toyota vehicles and Sony notebook batteries --begin to seriously damage Japan's reputation for quality goods.

Another revealing line in the article was "The environment was one in which employees observed experienced workers and emulated their skills." We usually think of this as a positive in the Japanese training system, the story of master craftsmen, their skills honed by years of on-the-job experience, patiently explain to young employees their insights and tools of the trade."

The downside of an emphasis on the way things are done instead of the way things should be done -- as would be taught in formal training classes -- is that bad habits can be handed down from generation to generation. Although graduates of formal training classes will do their postgraduate study in the school of "the way we do things around here," it's also likely that some of the admonishments of doing things by the book will rub off on them.

Late-Night Hours Helps McDonald's Both in the US and Japan
Yesterday McDonald's reported net profits of 1.6 billion yen for 2006 in Japan after posting almost no income the year before.

What I found interesting was that the jump was due to many of the same factors mentioned in the Business Week cover story on the company a couple of weeks ago. Most prominently, McDonald's has extended its opening hours in many restaurants deep into the night or even 24/7. This is likely more of a competitive move in Japan, where the late-night convenience store, of which Japan has no shortage, is an important rival. Both articles also discuss McDonald's efforts to offer a more diverse menu (desserts were mentioned in both pieces) to customers.

Machine Tools Orders Rose in January
There was a good number from the machine tools industry today. Orders in Janauary were up 5.7% year to year to about 120 billion yen, the second straight monthly increase. But the trend of domestic orders, down 7.5%, and foreign bookings, up 20.7%, diverged sharply. 日経

Tourist Industry Looks to Boomers to Boost Revenue
As we've noted before, the baby boom generation is defined far differently in Japan than it is in the US. In America, it's those born between 1946 and 1964, a wide span that includes people about to retire as well as those having their first children. In Japan, the baby boom cohort spans a narrow three years, some 6.8 million Japanese born between 1947 to 1949. Although the shorter time-span makes the effect of Japan's baby boomers less powerful and pervasive, the more concentrated birth bulge makes their impact more certain. Moreover, retirement in Japan is more likely to become at a fixed age, ie, 60, making predictions even firmer.

In this latest piece of news, the Japan Travel Bureau now anticipates that overseas Japanese travelers will reach 17.9 million in 2007, up 1.4% from the year before. JTB says that overseas travel by younger people is stagnant, but increased trips from the retiring boomer generation to China and Europe will more than compensate for the slack. Together with strong business demand to Asia, particularly China, JTB predicts about a 2% increase in yen volume for overseas travel by Japanese.

Head of BOJ Says Consumer Spending "A Little Restrained"
BOJ Governor Toshihiko Fukui, in response to a Komeito lawmaker's question in the Budget Committee of Japan's House of Representatives, said that the slow pace of wage hikes has limited the increase in consumer outlays. With respect to the recent decision of the BOJ's policy board not to hike interest rates, Mr. Fukui said that the choice was made based on various indicators of the economy's strengths and weaknesses, with the focus on measures of consumer spending. He said he thought consumer spending would continue to receive the spotlight at the next policy board meeting on February 20.

Mr. Fukui also noted that the strength of recovery in small and medium-size business has been varied depending on the size of the company and other factors. 日経