Following the 2008 financial crisis and one of the worst recessions in Japan since the Showa Depression of the 1920s, listed Japanese companies by September 2010 had built up free cash on hand of more than JPY64 trillion (USD5.3 billion), and all companies covered in the Bank of Japan’s Tankan business survey (including unlisted companies) had cash and cash equivalents of more than JPY202 trillion (USD2.4 trillion).
This cash was generated by slashing payrolls, capital expenditures and delaying any potential M&A deals. Data by M&A boutique Recof show that M&A deals involving Japanese companies also fell off a cliff in 2008~2010 even though the stronger yen propelled outbound acquisitions to double last year. This is because the bulk of Japan’s M&A activity is between Japanese companies.
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Of 1,034 listed non-financial firms with market capitalizations of at least JPY20 billion yen at the end of September 2010, 498 boast net cash positions and 38% of these companies have more than JPY100 billion (USD1.2 billion) net cash. Further, around half of the country’s publicly traded non-financial firms are debt-free.
Source: JapanInvestor.com
Now that global economies are recovering and financial markets have stabilized, investors are increasingly asking Japanese management what they intend to do with all this free cash. Japanese corporations have been singled out by foreign investor groups such as the Asian Corporate Governance Association for hoarding too much cash. If they continue to hoard this cash, it only makes them more susceptible to activist shareholders or potentially hostile takeovers.
Corporations around the world now find themselves with a significant cash hoard following the 2008 financial crisis, but the high cash positions in Japan are chronic. A 2006 survey by Brandes Investment Partners showed that Japanese companies on average had a cash/market cap ratio of 30%, versus 15% for Europe and 10% for the US. In terms of cash/book value, the ratio for Japanese companies was more like 60% versus around 45% for European, and 40% for US companies. The consumer discretionary and industrial sectors have the highest chronically high cash balances. In the US, the cash hoards are concentrated in technology, among the likes of Microsoft (MSFT), Apple (AAPL), Cisco (CSCO) and Google (GOOG).
While Japanese corporations need to put excess cash to work, investors will need to keep a close eye on how this cash is used as regards improvement in shareholder returns. Normally, companies would use this cash to, a) buy back their shares to reduce the excess supply of script, b) use the funds for strategic M&A, c) pay more cash out to shareholders in the form of dividends, and/or d) expand capital expenditures to grow their business and hire more employees.
Stock Buybacks
Japanese companies have already been actively buying back their own shares due to the excessive supply of script from structural net selling by domestic financial institutions. At the end of September 2010, a record number of companies (181) had become the top shareholders in their own firms, according to a Nikkei survey, or double the number of such firms four years ago. In FY2010 alone, Japanese corporations are estimated to have bought back about JPY1 trillion in FY2010, up some 40% from the previous year.
Dividend Distributions
Dividend distributions and stock buybacks in FY2010 increased about 10% YoY to around JPY6 trillion, the first rise in three years. The majority of this was higher dividend payouts, which climbed some 12% YoY to JPY5.34 trillion as around 615 listed companies raised their dividends. While the YoY increase in dividends looks modest compared to an approximate 80% YoY increase in net income to around JPY16 trillion, cash directly returned to shareholders as dividends represents an aggregate payout ratio of roughly 50%. The average dividend yield for Nikkei 225 companies is 1.63% on forward earnings and the average forward earnings yield is 5.81%, ostensibly making Japanese stocks much more attractive than JGBs.
Muted Revival of Capital Expenditures
Domestically, there is still too much production capacity in Japan, creating a lingering supply-demand gap. The Cabinet Office estimates that the supply-demand gap in Japan’s economy widened again in the October~December quarter to an annual JPY20 trillion, meaning there is still plenty of deflationary pressure in Japan. GDP-based capital expenditures--which account for 16% of GDP, rose 2.9%, 1.5% and minus 0.1% Q-on-Q in the calendar Q2, Q3 and Q4 quarters, but Q4 capex was still growing at an annualized 3.7%. Given Japanese companies’ persistent sense of excessive capital stock, the BOJ believes the pace of improvement in capital investment is likely to remain moderate.
Avoid the M&A Hype: Look for the Beef, Which Is Shareholder Returns
Twenty years ago at the height of Japan’s bubble, Japanese companies became notorious for “tsunami” M&A bids, i.e., bidding up potential acquisitions way beyond believed reasonable by any other potential suitor. They snatched up vanity assets such like the Rockefeller Center and the Pebble Beach golf course—only to beat a humiliating retreat. Whether Japanese firms are now wiser buyers remains to be seen, the content of this in/out cross-border M&A by Japanese companies is markedly different now than in the bubble years, as much more thought appears to be being put into the M&A deals being struck now as they are in general much more strategic.
A major M&A driver is that Japanese companies are notoriously late in emerging markets, and therefore need to buy their way in. Acquisitions speed market entry and bring local talent, something Japanese firms have been historically poor at attracting. The target of most Japanese M&A deals overseas is now Asian firms. Thomson Reuters data show that Japanese M&A deals targeting Asian companies in 2010 rose 83% to 274 cases. Although the value of these deals rose only 3%, they still accounted for 52% of all Japanese cross-border M&A.
Further, more Asian companies are targeting Japanese companies, with out>in M&A by Asian companies growing 24% in 2010 in terms of cases, and 87% in value. Asian companies of course are after Japan’s technology and brand recognition, as well as the relatively attractive yields of Japanese property. That said, investors need to take predictions by investment bankers and M&A firms about the next M&A boom with a grain of salt, and look at each deal in terms of "what's in it for me, the shareholder?".
Big mergers between large Japanese companies, like the Panasonic (NYSE:PC) consolidation of Panasonic Electric Works and Sangyo Electric in electronics and the recently announced merger between Nippon Steel (NITSY.PK) and Sumitomo Metal, do serve to reduce the excess capacity from too many firms producing essentially the same products and stimulate interest in the stock market.
In the worst case, however, the merger creates a holding company with the two companies operating more or less independently, which generates no economies of scale. Mergers are also often announced and then not consummated until a year or more after the announcement. The mergers that usually work the best are where the acquired company and its corporate culture are completely integrated into the acquirer as soon as possible. In Japan however, many big mergers are often termed “mergers of equals”, which of course is not the case in reality.
How Japanese Companies Use Their Cash Is Important for Investors
Deep value investors like to look for cash-rich companies with solid business models, ostensibly because someone is likely to come along and take them over. But if the possibility of unlocking this cash and/or unrealized asset values is limited, these cash hoards merely reduce shareholder returns and are a net negative for the stock price.
If companies do decide to use this cash, investors need to determine whether the use of this cash will improve their shareholder returns. If the excess cash is used to raise dividends, it’s a no-brainer positive, while questions will remain regarding the sustainability of this dividend through earnings growth. Stock that is repurchased and retired is also a positive, as it increases the book value as well as earnings available to shareholders.
On the other hand, buying back stock and holding it as treasury stock in the worst case merely represents potential future dilution if it is re-issued when supply-demand conditions improve. If it is used for an M&A transaction, investors need to have a view on whether the merger improves the acquirer’s potential for future growth/value-added and ostensibly improved shareholder returns. Generating shareholder returns from the transaction requires a realization of cost savings and economies of scale, while leveraging the growth potential also requires innovation.
Our first reaction to an announced merger in Japan is to buy the acquiree and sell the acquirer, because Japanese companies have a poor track record for deal making--from overpaying for trophy properties in the bubble years, to a string of disastrous acquisitions at the height of the IT bubble, to shareholder value destroying megabank mergers. Shareholders in the M&A target company inevitably make out better short-term than shareholders in the acquiring company do, given that the buyout price is usually at a premium to the current value of the acquired company’s stock.
Disclosure: Author is long GOOG.
