Unlocking latent value in Japanese companies

The overnight success of the Japanese markets has been more than a decade in the making. In late Feb 2024, financial markets were quick to celebrate the Nikkei crossing its previous all-time high of 38,915 (established more than 34 years ago in Dec 1989). While a lot of market participants appear super excited about the market’s prospects, it is worth noting that the market’s trajectory has been upward since Dec 2012 when PM Abe came to power and, with the BoJ Governor Kuroda, went to work unleashing the animal spirits.

Exhibits 1 & 2: The price-weighted Nikkei 225 recently hit an all-time high, finally overtaking the last high established in Dec 1989. Even the market cap-weighted TOPIX (lower chart) is within shouting distance of its 1989 high.

Despite the recent headlines about the Nikkei finally overtaking the last high of 1989, it is worth pointing out that the price-weighted Nikkei is quite quirky, especially for foreigners who measure returns in USD. In fact, the Tokyo Stock Exchange’s market capitalization (in USD terms) had already exceeded the 1989 high in 2000 (during the dot-com bubble), in 2008 (just before the Global Financial Crisis) and then again many times during the Abe-Kuroda period (Exh 3 below). The recent jubilation in Feb was again misplaced: in USD terms, the Japanese markets actually peaked in Sep 2021, and not in Feb 2023 (Exh 3).

Exh 3: Japan's Market Capitalization from Jan 1980 to Feb 2024

But I quibble over data. The fact is, starting in early 2013 the Japanese markets have done very well, with Abe and Kuroda prodding corporate Japan, the regulators, and the monolithic pension fund (the world’s largest). The markets, in fact, have more than trebled since then in JPY terms and more than doubled in USD terms (Exh 3 above shows how the markets were in a holding pattern between 1990 and 2013, only to decisively break out after that). You might say all the low-hanging fruit has been picked by now.

So far there have been many drivers of the markets, some recent and some dating back to 2013: ?

• Good fundamentals: Earnings growth momentum has been strong since 2020 (Exh 4), and analysts expect earnings growth in the next three years to grow in double-digits.
• Regulatory changes: increasing allocation of pension funds to equities, changes in NISA accounts that encourage more retail participation in the market, etc. (Exh 5).
• Deflation is finally in the rear-view mirror allowing the BOJ to perhaps normalize rates.
• Improving corporate governance.

And so on…. The list is much longer and has been discussed elsewhere in greater details by more competent people. ?

Exh 4: Ordinary profits of Japanese companies – Quarterly trend

Exh 5: Growth in NISA accounts is channeling savings to the equities markets

In this piece, I want to focus on one way the Japanese markets can continue to perform well going forward which is: better corporate governance leading to unlocking of latent value in these companies.

If the markets must perform from here on, one will need the following, in addition to all that has already been happening: higher returns, higher multiples.

• The pressure on improving P/B ratios increases pressure to increase ROEs, which in turn increases pressure to sell non-core, low-return assets.
• Apart from sales of meaningless cross-holdings, this may require carve-outs of entire divisions and sales of other monetizable assets such as land and buildings.
• Failing all of the above, companies may choose to sell themselves or take themselves private.

Quick caveat: Old “Japan hands” have a well-earned right to be cynical here. Most of these corporate governance changes have been promised but not delivered. Decades of disappointment from unincentivized managements can engender a healthy dose of cynicism (many older Japan watchers have remained skeptical even as the markets have grinded higher).

And now, the points above imply that corporate Japan will need to completely change its DNA itself. Left to themselves, these companies are not going to do it. They have had a carrots-and-stick approach from the government and regulators, their external environment has become challenging, and now they have more activist investors that have arrived with more powers. All in all, conditions are ripe for better corporate governance being foisted on these companies.

In isolation, the changing environment has already delivered some of these: buy-backs (too many to mention), privatizations (Toshiba, Hitachi Transport Systems) including management buyouts (Taisho Pharmaceuticals, Roland, Fuji Glass), take-private-and-exits (Roland, Kokusai Electric), activist investors driving change (Fanuc, Toshiba, Dai Nippon Printing), and non-core asset sales (Hitachi Group, Hino Motors, Denso, etc). (Note some of these deals have only been announced and are yet to close.)

Despite the weak yen and higher rates, Japanese companies in tough industries are even attempting outbound M&A to create value, such as Nippon Steel’s attempt to acquire US Steel (Nippon Steel itself acquired domestic competitor Sumitomo Metal over a decade ago). ?

All in all, it is a great time in Japan to be a stockbroker (all those block trades of marketable securities from companies keep coming), banker (advisory, M&A and possible cap raises) and a private equity investor (carve-outs and privatizations).

The latent value in plain sight

In Sep 2023, Hino Motors (7205.T), a subsidiary of Toyota, made a deal of a lifetime: it sold land near its Tokyo HQ for about JPY50bn (~US$334m) to property developer Mitsui Fudosan (8801.T).?Hino had been carrying this asset on its books at a value of JPY100mn (US$670,000). This is hardly an aberration. Seibu Holdings is now considering selling its 36-story Tokyo Garden Terrace Kioicho office and hotel complex for a reported JPY300bn (around US$2bn).

Corporate Japan has been full of stories like these. But only now the pressures of the business, the markets and the regulators are finally forcing companies to act and monetize assets.

In fact, when I relocated to Japan in 2008, while apartment-hunting I would often see large apartments in central Tokyo bought by large companies (such as NTT, Sony, etc.) during the go-go years and then lying mostly vacant. But companies are now finally beginning to dispose off such low-return assets.

This is hardly a comprehensive list of other potential transactions, but to explain how significant these are in Japan, here is one such story that is an illustrative example of the latent value hidden in Japanese companies.

The Tokyo Steel story (nod to Ozu)

When I started covering Japanese stocks back in the 1990s, I was mostly a “tourist” – flying in for company visits and writing what were probably very superficial notes on these companies, without a single colleague on the ground to help guide me. But then I would relocate there in mid-aughts and start covering them in earnest.

One of the smaller, mid-cap companies – Tokyo Steel (5423; Market cap: US$~1.7bn) – always intrigued me. It was in the competitive business of making steel using scrap and electricity. By the mid-aughts when I covered this company, the manufacturing base of Japan was withering, and most Asian countries could no longer compete with Chinese producers in the steel business. Yet, somehow Tokyo Steel stood out – compared even to other domestic giants like Nippon Steel and JFE.

One of Tokyo Steel’s strengths was having some near-death experiences in the past that forced them to become efficient. But a hidden strength was a large land holding they had in north-central Tokyo (the reason the company is called Tokyo Steel). At some point in the early days this land used to have their facilities, but by this time the land had been cleared and was rented out to other companies that were running an amusement park. Collecting a small amount of rent was a very inefficient use of the land and the Tokyo Steel management always maintained they intended to develop this land.

Tokyo Steel’s US$240,000 land could be worth as much as US$150mn. That land – about 33,070 m2 – is still on its books (Exh 6) and is being valued at just JPY 36 m (~US$ 240,000). Conservatively, that land is probably worth US$110m – US$150m (strictly back-of-the-envelope calculations! This is NOT investment advice!!). This would be about 15% of its current enterprise value.

Exh 6: Tokyo Steel’s land holdings

And this is if the company chooses to sell its land on an as-is basis. Should it redevelop this land into apartments, it could be worth a lot more, situated as it is in a bucolic part of Tokyo between the Sumida and Arakawa rivers (Exh 7).?

Exh 7: The location of Tokyo Steel’s land suggests it has high redevelopment potential

In fact, Tokyo Steel's land is smack in the middle of a redevelopment plan for the area, organized by the Bureau of Urban Development of the Tokyo Metropolitan Government. The idea was to generate 2,600 apartment units in the area owned by Tokyo Steel (and Okada Shoji). The plans were formulated in 1994 but have not come to fruition yet (hey, this is Japan!). So, make of that what you will, but should it ever get going, that land could be worth even more than our back-of-the-envelope calculations suggest.

Even without the above, Tokyo Steel appears to have a net-cash position of JPY 108bn – or about 43% of its market cap of JPY 252 bn (US$~1.7bn). Consensus forward P/E is 6.8X, or just 4X – when you strip out the cash. Indicative dividend yield is 3%.

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Appendix Exh 8: Indicative land prices in Japan's capital Tokyo in 2023, by district (in 1,000 Japanese yen per square meter)