About 3 ½ months have passed since I sent my first letter and shareowner proposals in late-February to the Board of Directors of Internet Initiative Japan (IIJI) (JP: 3774), a leading ISP and related services (cloud computing, systems integration, etc.) in Japan. As a longtime shareholder (since 2006), my concerns included the company’s level of capital spending, its corresponding levels of depreciation, and its deteriorating returns on assets/equity/etc., the latter being partially suppressed by a large, low-yielding cash position. And my proposals involved items that a Board of Directors typically has more direct influence over (as opposed to my aforementioned concerns) such as stock splits, share repurchases, dividends, and shareholder say in significant non-core business investments. continue reading…
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Internet Initiative Japan (IIJI) (3774) is a Japanese internet service provider offering a full suite of connectivity and outsourcing services. It is a pioneer among Japanese internet-related companies, having originally listed its shares on the Nasdaq in 1999, before eventually listing in Tokyo (Mothers) in 2005 and later transitioning to Topix 1st Section.
At the end of February, I submitted a letter to the company’s chairman (Mr. Suzuki) and its other directors. While applauding them for their prior decision to repurchase shares, the timing of which coincided with the bottoming of IIJ’s stock, and also for maintaining the dividend, I voiced some concerns and submitted proposals that are either to be actioned or designated for resolution at the Annual Shareholders’ Meeting this June. IIJ’s Investor Relations Officer has been helpful and cordial, and has already forwarded my letter and proposals. Below, I will briefly outline my position.
Unfortunately, despite having listed in the U.S., making it to Topix-1, and having a reasonable level of awareness within commerce and government in Japan, IIJ remains a largely unknown company in the investment community. Since I’ve been a shareholder for a while now I am not pleased about this, but it in fact represents an opportunity.
A cursory review of IIJ’s financials will show that the company met some hard times in 2008 (fiscal year-end March ‘09), as did most companies, but it remained profitable. However, given the weak economy in Japan and lingering deflation, 2009 (FYE 3/2010) is not looking as if it will be significantly better than 2008; that is, as revenues are forecast to be lower, although earnings are expected to rise about 20%, but still be only about a third of what they were between fiscal years 2006-2008. Meantime, IIJ is moving right along with capex, granted some of it is regarded as critical given the upgrade cycle of networking equipment. I have asked IIJ to review its capex/depreciation, while considering the models of Google and Amazon for cloud computing, an area, along with mobile connectivity, that represents great opportunity for the company.
One of my chief concerns relates to the level of capex and correspondingly, the heavy depreciation. Furthermore, the growth in assets, while it had led to top-line growth, it hasn’t brought an increase this year, and has not generated growth on the bottom-line for the past two years. To make matters worse, IIJ is sitting on a sizable pile of cash, nearly ¥8.5 billion ($94M) as of the most recent quarter’s end, compared to total assets of around ¥47 billion, and a market capitalization of around ¥40 billion (keep in mind that its shares are up about 25% in the past month). The company doesn’t have long-term debt, but it does utilize capital leases, which represent a “long-term” liability of ¥3.9 billion. IIJ has no working capital concerns whatsoever, and has access to very cheap bank lending facilities at a cost of capital under 2%.
My specific proposals involve:
I. A stock-split of the ordinary shares of at least 10:1, but preferably 100:1. Correspondingly, in light of the 400:1 ADR-to-Ordinary ratio and IIJ’s subsequent five-dollar per share ADSs, again I suggest a 100:1 ordinary split and a 1:4 ADR split. While stock splits don’t impact the fundamentals, they would most certainly help improve IIJ’s trading liquidity and improve its potential investor base.
II. Switch to a quarterly dividend payout schedule instead of biannually. I suggest this given it is common practice in the U.S. and the appreciation most shareholders will have for a more frequent payout.
II. Announce another stock buyback. I have already summarized IIJ’s cash position above. I regard IIJ as undervalued both based on a valuation of its assets and a return to at least the levels of profitability it achieved in the recent past. Use of cash for share repurchases is ideal considering IIJ’s recent low ROA (and ROE) and its foray into a non-core business (see below).
III. Allow shareholders to vote on any investment or acquisition in excess of ¥1 billion that does not involve IIJ’s core business related to internet connectivity and services. This proposal is prompted by its new ATM business. It has a majority stake in a business that places ATM’s in pachinko parlors (similar to how ATMs are placed in casinos). While this business may someday become profitable (I have asked for revenues/earnings guidance), it has accumulated losses to-date of over ¥1 billion, and it will need even more capital before all the thousands of ATMs are deployed.
One-year stock chart of IIJI:
Disclosure: The author owns shares of IIJ. Note this article does not constitute investment advice.
Reuters (article in Japanese) reports that Goldman Sachs issued a report earlier this week that argues M&A will be the major theme for Japanese equities in 2010. Having a ‘macro’ investment theme for the start of each new year is a ritual for brokerages in Japan, although it seems no one ever has the resolve to action or follow through; and the M&A theme itself is not a new one. So Goldman repeats known information that Japan (equities) was overly victimized in the financial crisis and remains largely defenseless to external shocks. With ROE so low, domestic demand remaining sluggish, and overseas competition ever-intensifying, the best bet for Japanese companies is to merge and restructure. M&A/restructuring should boost top-line growth, says Goldman, which also should help margins, and therefore drive stock prices higher.
However, the longstanding problem with inward M&A is that reorganization is easier said than done (as heads, and tails in the form of non-core subsidiaries, tend not to roll in Japan), the volume of M&A has often disappointed, and the size of deals has been on the small side. Nevertheless, all of that means there is still great opportunity in Japan. The best opportunities appear to continue to be in smaller-sized deals, where there are plenty of gems, and in listed subsidiaries. Goldman is said to favor retail, machinery, services, land transport, non-bank financials, warehousing, and real estate — the underlying idea is that these industries are the most fragmented.
Bottoms-up then, as 2009 is winding down and 2010 is poised to be the year of M&A (at least thematically or in a macro sense).
The latest and largest equity dilution — approx. $5.6B; 30% s/o — by Nomura (JP: 8604) (NMR: 5.63 +0.90%) has sent its shares down 16% to ¥573 in Tokyo ($6.35 at ¥90.3/$1) following an earlier rout in NY. I think the stock has further to fall, given that it was saved by its daily loss-limit (‘limit-down’) in Tokyo with volume of only 8.9 million shares. Volume thus far in September has ranged from a low of 17M shares traded to start the month, to a high of 65M last Friday.
At this point, the $5.6B it plans to raise over the next month would have been more than enough to have just acquired Lehman USA last year! Now the company and its shareholders face the challenge and risk of having to use the capital to expand existing U.S. operations and somehow grow some new business. Doing these things (profitably) has never been easy for Nomura, though it’s always been a dream of sorts.
Meantime, the stock is massively diluted, and unattractive at current levels due to the uncertainty of how effectively it will deploy the capital — it’s about 40% above its March low. While I agree with Goldman’s take that the capital raising is offensive, rather than defensive, in nature, I think it’s a little much. The Japanese business press does too, apparently, dubbing Nomura and the broader market’s sell-off the “Nomura shock.”
- No position in any companies mentioned.
Interesting developments in the Nikkei ahead of the parliamentary election at the end of this month, which at this point looks as if it will finally bring an end to LDP rule. A foreign exchange rate of $1/¥94 would have been practically inconceivable prior to the “Lehman shock” (as the Japanese refer to the genesis of the financial crisis), let alone a stock market rally. And now, ahead of what appears to be a DPJ (opposition party) that will let the yen appreciate and focus more on domestic demand (rightfully so), the stock indices are showing no fear of the yen.
A sustained rally in conjunction with even more yen appreciation bodes especially well for the domestic-oriented stocks, of which there are plenty — many that still have saliva-inducing valuations. However, exporters remain the headline grabbers, and it is not clear just how much yen strength can or will be tolerated (one suggestion is ¥87 is the trip wire, a level reached early this year, and a level not seen previously since the mid-90s). That being said, again what makes this all very interesting is that although the strong yen makes Japanese exports less competitive (great instead for instance, for South Korea (EWY: 50.09 +0.87%), it does allow them to invest more in production overseas, a win-win for the Japanese and local FDI recipient economies.
What worries me though is the pace of reform(s) versus expectations, assuming a DPJ victory. Meantime, there is no debating the fragility of the domestic/global economy and the recovery thus far in equities. Domestic and overseas investors are very fickle and just as quickly as money has been flowing in, it can reverse course equally as quickly. The seemingly conservative, opportunistic play would be to go long the yen (FXY: 117.28 -0.21%). The DPJ’s financial advisors (and by extension, one of them possibly being tapped as finance minister) have already gone public saying they don’t intend to intervene in forex, except in extraordinary cases. Another play would be to look at the smaller-cap funds like (DFJ: 39.71 +0.56%) and (JSC: 38.651 +1.11%), but unfortunately, these are not very liquid and are quite fragmented. Time-permitting I will look at posting some specific stock picks.
At the time of publishing, the author does not own any long/short positions in the funds mentioned.
The Nikkei, like many other benchmark indices, is hardly the volatile, motion sickness inducing headline producer that it was of months past. But no matter how hard I’ve tried, I just haven’t been able to turn myself into a green shoots market cheerleader. Nevertheless, I may be willing to concede that downside risk (in terms of a trading level) has lessened, although common sense would now suggest that significant further near-term upside is likely limited, too.
Now, on to the Nikkei 225’s valuation readings as of the end of May compared to a year ago’s levels.
- P/E ttm 05/08: 16.7 vs. 05/09: negative
- F/P/E 05/08: 17.1 vs. 05/09: 40.5
- PBV (book) 05/08: 1.68 vs 05/09: 1.24
- Dividend yield ttm 05/08: 1.4% vs. 05/09: 1.9%
- Dividend yield expected 05/08: 1.5% vs. 05/09: 1.6%
In case you’re wondering, the readings for Topix-1 suggest more “value” as the forward PE is at 35x, book value is 1.15x and the expected dividend yield is 1.8%. The benchmark 10-year JGB last had a yield of 1.49%.
If you are bullish, you would argue that Japanese stocks are still undervalued and you could even claim the bullishness of the old dividend yield indicator (vs. the JGB). On the other hand, the deep value of the N225 trading for less than book and with a dividend yield a full 100 basis points over the ten-year are history since the rally from the March bottom. The yen is interesting at 95 per US$1 because it’s near its reported break-even value for exporters, even though it’s 10% stronger than a year ago. While cost-cutting has clearly been helpful, the big boosts from forex profits are gone for now. Finally, Steel Partners continues to win ground against Aderans (JP: 8170), but the stock price is moving in the wrong direction. Who knows, maybe Warren will prove everyone wrong. I hope so. Meanwhile, it really is a comical game that most AIMs play in Japan.
Pricey, and Japanese stocks, are typically not heard together in the same sentence. However, since last September’s market rout, earnings have deteriorated to the point that the Nikkei 225 is trading at over 175x forward earnings; 10.1x on a trailing basis. No doubt the ratio will swell some more, potentially going negative for a quarter, before it begins to ease. For some time now, I have believed that Japanese stocks are being priced fairly by the market. Still, it remains true that money managers the world over see deep value in Japan.
In order to prevent this article from getting long winded I will summarize my position as follows: (1) Recent trading has been ostensibly positive given the strong rally in percentage terms off the bottom, but the action has been quite thin; which leads me to point (2) in that the 9,000 level has proven pretty elusive due it being right about the middle point of last year’s finish and this year’s high (remember the N225 flirted with 6,000 a month ago); and (3) buying up headline exporters and bank stocks is the easy and obvious way to play, 
but lack of participation and depth in this rally will surely create a situation of more range bound trading between 7,000 and 9,000. Therefore, with all eyes on the U.S., and with the country’s financial magicians seemingly running out of rabbits, I would exercise caution at current levels. Aside from media cheerleading, last check the economic negatives far outweighed the positives.
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About a year ago today, I published a weekly Nikkei outlook discussing whether the Nikkei was headed to 13,000 or back to 12,000. Suffice to say that much has happened since then. At the start of the new fiscal year today, the range in question is broader, 7,000 – 9,000, but obviously it is not any better (unless one has profited on the short side or had a timely exit). At any rate, investors might be excited since March was a particularly good month for equities.
The Nikkei 225 gave back 500+ points in the last two sessions of March, but the usual claims of year-end window-dressing were audible, since the N225 still managed to gain more than 11% for the month — the ascent was upwards of 18% through last Friday. The 11.4% return tied 1999 for the best March performance since at least 1991. That’s history. So what can we expect for April?
The last two Aprils have produced gains of 9.4% (2008) and 2.2% (2007) for the Nikkei 225. Both of those followed losses of approximately 1% in March. The last positive March in 2006 (7%) was followed by a 2.5% decline in April. Of bigger concern is the fact that the ensuing April to December periods for each of the past three years have been rather brutal: -31% (2008), -11.5% (2007), and +1% (2006). For those looking for a trade or a glimmer of hope, note that the N225 has closed higher two-thirds of the time in April over the past 18 years. However, the first day of trading is no indicator for the remainder of the month since up/down days are split 50:50. Lastly, know that the average monthly gain for April in the past 18 years is 1.3% and the median gain is 2.2%. By the way, the 11% March performance in 1999 was followed by a gain of more than 2% in April.
My assessment of Japanese equities in light of the domestic and global economy is still primarily negative. I continue to be of the opinion that the current trading level of the N225 reflects fair value. A simple way to play may be to consider the low-7,000 level as an area of support and a buying point, and the approach to 9,000 as an area of resistance and thus a selling point. Remember that the N225 closed the year in 2008 at 8,859. The 52-week low was back in late October at 6,994, but most recently on March 10, the Nikkei flirted with the 6,000 level again when it closed at 7,054. Keep in mind that the N225 is now down only 10% for the calendar year thanks to the March rally.
While it goes without saying that stocks are a “leading indicator” and will recover before the broader economy, the best thing to do is to be realistic. No need whatsoever to rush into equities. There are too many lingering uncertainties and the potential for even more doom and gloom. With all eyes seemingly on the U.S. (after all we got everyone into this mess), don’t put much faith in the longer-term efficacy of tweaking mark-to-market valuation or public-private investment schemes that rely on the “goodwill” of banks. Too many ifs would have to be realized before a meaningful amount of confidence could be restored and sustained.
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Former Japanese Finance Minister Nakagawa should never have been at the press conference that did in his career, and now has the Japanese press gone mad discussing “reputation risk.” It is disturbing that he was even allowed near the table. Equally troubling is how BoJ Governor Shirakawa didn’t preempt some questions, especially the one’s directed at him. Instead of fielding questions, he bobbled, and quite frankly, made himself look ridiculous by association. I would go as far to say that if the Japanese are so concerned about “reputation risk” that the journalists should have done the right thing and helped Nakagawa exit stage right, immediately, after becoming aware of his condition. They could have exposed him on the side or in back, instead of in front of the world.
As for Japanese stocks: I still believe that as a whole, Japanese stocks are being priced fairly by the market. Readers may have noticed how we are now rather quietly approaching last year’s low levels, which are effectively near the post-bubble trough and quarter-century ago levels. Japan may have been first into recession, but it is almost certain not to be first out — in fact, aside from the late-05 to early-07 period, Japan had basically never really exited. The current administration’s proposed economic stimulus for Japan is insignificant and deficient; and a recovery still depends more on a rebound in consumption in the US and EU, something not likely to happen soon enough or meaningful enough. Therefore, I don’t think there is any urgency for intervention to soften the yen. It would be premature. In addition, I see no rush to buy for instance, iShares MSCI Japan Index ETF (EWJ: 9.68 +0.73%). The worst case scenario is the status quo of depressed equities and relative yen strength, a double whammy.
The author’s intent is not to be misleading, but rather to be as frank as possible, regarding the longstanding debate of whether or not Japanese stocks are truly undervalued. In short, the answer is no. I no longer believe Japanese stocks are undervalued, not to the extent that I once did, and not to the lengths that some pundits and money managers try to make a case for. In fact, I would argue that Japanese stocks may best be described as being closer to fair value instead of being deeply undervalued. I mean Japanese stocks, for the foreseeable future, may be destined to be “undervalued” by traditional metrics, but fairly valued by the market and in relation to the economy. continue reading…
