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Bulls point the way forward for Japanese equities

26 Apr 2011

The long term outlook for Japanese equities remains positive, despite the after-effects of the Tohoku earthquake. Better dividend yields, a rise in M&A activity and an awakening of the convertibles market all indicate bright prospects.

Before March’s earthquake, a consensus view had been building among Tokyo-based analysts that the prospects for Japan’s equity market were better than they had been for many years. In the early part of 2011, scarcely a week went by without local equity strategists revising their forecast for the performance of the Topix upwards.

In the first week of January, for example, Deutsche Securities raised its 12-month Topix forecast from 1,000 to 1,050 (compared to its level at the end of December of 898.8). "Profit growth is higher at Japanese companies than at companies in other developed nations when sales are rising, and given that Japanese shares still appear undervalued, we anticipate a rebound, driven by P/E," Deutsche commented.

UBS Securities was another investment bank that revised its forecast for the Topix in early 2011. In February it advised clients that with earnings rising, costs flat and margins showing room for a "sharp" improvement, it was lifting its FY2011 Topix target from 1,100 to 1,200.

Nomura had also been bullish on the prospects for Japanese equities from the start of this calendar year, advising in January that it expected the market to outperform global equities "on both a local and common currency basis". Nomura pencilled in a 22% rise this year for the Topix and a 17% advance for the Nikkei-225, underpinned by a rotational shift away from bonds and into equities, adding that this would lead to "the first substantial rise for Japanese equities since 2005".

Brave words, and ones that inevitably needed to be re-evaluated following the Tohoku earthquake. Looking to the longer term, however, a positive outlook for Japanese equities appears to be supported by plenty of influences that need not have been derailed by March’s natural disaster.

One of these is that Japan is providing increasingly attractive opportunities for income funds, with dividend yields looking appealing by global standards. Bank of America Merrill Lynch expanded on this theme in a research document in January which said: "Backed by a recovery in corporate earnings and improved global economic outlook, we expect a rise in the number of companies announcing dividend hikes in the earnings announcement season over April-May, and for shareholder payout policies to become a major market theme." The BofA Merrill report added: "Dividend yields in Japan are no longer too low by international standards."

Another variable that is having an increasing effect on Japanese share prices is rising M&A activity. When Nippon Steel and Sumitomo Metal announced their merger plans, in early February, it was not just their share prices that rose. The iron and steel sub-index also bounced, and bankers say that the steel merger has sent out an important message to companies in other sectors as well as to equity investors in Japan. "Smaller firms in many industries that have historically clung to their independence may not be able to continue to do so," says one.

Rumours of mergers in Japan have also sent analysts scurrying to identify potential beneficiaries. In March, when the Japanese media reported that the Tokyo Stock Exchange (TSE) and the Osaka Securities Exchange (OSE) were in merger talks, both parties were quick to deny the rumour. But that did not stop Nomura putting out a research bulletin listing a handful of quoted companies that may benefit.

While dividend policies and some speculative fizz may combine to improve the longer term appeal of Japanese equities to overseas investors, the overwhelming influence on the performance of Japanese share prices will continue to be the yen-dollar exchange rate. In the case of a car maker like Nissan, for example, it has been estimated that a move of one yen to the dollar has an effect of about ¥10bn ($124m) on the company’s operating income.

Yen hitting new highs

Indeed, dispassionate though it may sound, in the immediate aftermath of March’s earthquake, some of the downward lurch in the Japanese equity market may have had more to do with the knee-jerk strengthening of the yen than with other factors. At the end of 2009, Japanese portfolio investment abroad amounted to about $2.9tr, according to a research note published a week after the earthquake by Commerzbank. Of this total, $1tr was in the US alone. It would not take much repatriation of these assets to push the yen towards previously unimaginable highs against the US dollar.

Analysts agree that fears about a widespread repatriation of these assets were generally overdone, and that the plunge in the Japanese equity market immediately after the Tohoku earthquake was more sentiment-driven than underpinned by fundamentals.

Nor, cautioned some analysts, should investors assume that Japanese equities would perform in the aftermath of 2010’s earthquake just as they had following the Kobe disaster of 1995. According to Morgan Stanley, in 1995 Japanese equities were demonstrably more expensive than they are in 2011. In 1995, Japan traded on a P/E ratio of 37.7 times earnings, and on a price to book (PB) value of two, according to Morgan Stanley. In 2011, Japanese equities trade at a P/E multiple of 15.4 and on a PB of 1.2.

March’s earthquake inevitably led to the postponement of a number of planned equity offerings. But a longer term recovery in the Japanese equity market of the magnitude that strategists were forecasting before March would certainly support further growth in the primary market.

Bankers in Tokyo say they are encouraged by issuance trends in FY2010. "Since the start of 2009, there have been about 20 ECM transactions valued at $1bn or more, and bear in mind that we saw this issuance in an economy with low growth," says Minoru Shinohara, senior managing director of investment banking at Nomura Securities in Tokyo. Shinohara has more than 20 years of experience in equity capital markets in Europe and Asia as well as Japan, having served until the start of FY2010 as chief executive of Nomura Asia in Hong Kong.

It is not so much the recent trends in the size of issues in the primary market that Tokyo-based bankers say is important, as the structure and diversity of the dealflow. "Although big deals continued to account for about 70%-80% of new issuance volume in 2010, the driving force last year was the fact that a wider range of issuers came to the market," says Takeo Kusunose, managing director and co-head of investment banking at Merrill Lynch Japan Securities in Tokyo. "The theme for 2009 was issuance dominated by financial institutions and megabanks, whereas in 2010 we saw issuance from a wider variety of industries."

Large issues from financial institutions did not dry up altogether in calendar or fiscal 2010. Dai Ichi Life’s ¥995bn ($11bn) IPO in March 2010, on which BofA Merrill, Mizuho and Nomura were joint global co-ordinators, was the biggest new listing in 10 years and the largest IPO anywhere in the world since Visa’s offering in March 2008. Extensively marketed on an 11-day roadshow taking in 19 cities, the IPO generated demand of ¥2.5tr or $27.8bn from 400 orders, 60 of which were for more than $500m.

High quality support

According to a deal summary published by Nomura, the Dai-Ichi IPO had very strong support from high quality investors in the US, Europe and Asia, with the international tranche almost four times oversubscribed. With the domestic offering also heavily oversubscribed, by more than three times, and with retail investors alone providing $12bn of non-price sensitive demand, the size of the domestic tranche was increased.

Elsewhere in the financial services sector, Mizuho completed a ¥780bn ($8.9bn) capital increase in July. This followed a fall of 20% in the bank’s share price in the month after the announcement of the capital raising programme at the end of June. Barclays Capital, Citi and Morgan Stanley fully underwrote the offer, with Mizuho, BofAML, JP Morgan, Goldman Sachs, Deutsche and UBS bookrunning the international tranche, and Mizuho and Nomura leading the Japanese public offer.

Another important equity capital market deal in the Japanese financial services sector in 2010 was the global add-on offering for the country’s fourth largest bank, Resona Holdings, originally announced in November. Underwritten by Bank of America Merrill Lynch Japan Securities, Daiwa Securities, Goldman Sachs and Nomura, the proceeds of this ¥572bn offering, completed in January, were for the partial repayment of public funds of up to ¥900bn, with the balance coming from retained earnings. Resona received close to ¥2tr from the government in 2003, and has been profitable since 2005.

"The Resona deal was a challenging transaction but one that was very successful in meeting the bank’s objective of transforming its capital structure," says Kusunose at BofAML. "People questioned how we could complete a transaction that represented 107% of the company’s market capitalisation, but we emphasised that this was in fact a capital exchange of preferred stock owned by the government into common stock.

"It was a successful price discovery exercise, and we managed to capture some very good interest from long-only investors, knowing that we would not be able to depend on much hedge fund support."

Kusunose adds that following an intensive roadshow, in which management met more than 250 investors in Japan, the US, Europe and Asia, a high quality order book from institutions around the world was built up. That, says Kusunose, was warranted by the robustness of Resona’s credit profile. "Resona is a solid regional bank with no overseas exposure and no Basel III concerns," he says. "About 50% of its loan portfolio is accounted for by high quality mortgage assets and its main markets are in the Kanto and Kansai regions where demand for mortgages is expanding."

At Nomura, Shinohara agrees that the Resona transaction was an important landmark not just for the issuer itself but also for the broader Japanese financial services sector. "The Resona transaction was a very clear signal that the industry’s difficulties in the early 2000s, when the government was forced to inject funding into the system, have come to an end," he says.

Controversial Tepco

Outside the financial services sector, with the benefit of hindsight, one of the more controversial ECM transactions of FY2010 was the ¥468bn ($5.7bn) follow-on offering from Tokyo Electric Power (Tepco).

Today, it is obvious enough why Tepco should be a focus of controversy, given that some ¥270bn of the proceeds from last year’s offering were earmarked for nuclear power generation plants and thermal power production facilities.

In the lead-up to last year’s equity offer, however, there was also some investor opposition to the Tepco offer. Against the backdrop of a slide in the company’s share price to an eight year low by September 2010, a number of analysts and institutions questioned the timing and necessity of the offer.

In the case of Tepco, there may now also be question marks over its planned expansion in the wake of March’s catastrophe at Fukushima, with Moody’s warning immediately after the quake that the impact on Tepco would be "material and prolonged". But it would be churlish to question on a retrospective basis the soundness of the company’s strategic vision for 2020 announced last September. That vision was based on an investment programme of ¥2.5tr "toward a low-carbon society" and a maximum of ¥1tr in growth businesses such as overseas projects.

As part of its 2020 Vision, Tepco added that "during the 10 years up to FY2020, we will aim to create an operating cashflow of more than ¥12tr to ensure such active investments... We will reinforce our earning strength and aim to achieve an ROA [return on assets] of 4.5% or higher in FY2020 (4% or higher in FY2015). Furthermore, we plan to accumulate capital to strengthen our risk response capacity in preparation for future business expansion so that our D/E [debt to equity] ratio will come close to the broad target of around 1.5 by FY2020."

The issuance of new shares in October, Tepco explained, was "designed to raise funds that will be devoted to capital investment toward low-carbon, high-efficiency power generation facilities, and also to provide investment and financing for growth businesses."

Although the Tepco share price was weak in the run-up to October’s issue, the offering itself was a success, with Nomura reporting that it generated "demand from international long-only investors and from domestic investors, of which retail investors were allocated 80%. The final book was around four times covered, with the Japanese retail portion three times covered and the international institutional portion, for which Nomura was solely responsible, 10 times covered."

The shares were offered to investors at ¥1,843, which represented a 3% discount (versus a 3%-5% indicated range), and a dilution rate of 15.8%. The share price performed steadily over the next few months, reaching ¥2,150 on March 11, before nose-diving to well below ¥1,000 in the aftermath of the Tohoku earthquake.

Tepco has, of course, evolved into a special situation since its October offering. Elsewhere in the energy sector, however, another landmark ECM transaction of FY2010 was the ¥542.2bn ($6.2bn) global follow-on offering from Japan’s leading upstream oil and gas company, Inpex, which as of March 2010 owned 74 projects in 26 countries. Goldman Sachs and Nomura were the joint global co-ordinators on the Inpex offering. The issue was priced at ¥417,000 a share, which again represented a 3% discount with a 35.5% dilution, a level at which the domestic tranche was covered twice, with the international offering 10 times covered.

Compelling case for Inpex

Inpex had very clear and compelling reasons for the offering in July 2010, the proceeds of which were to develop Inpex’s Ichthys LNG project in Australia.

"Some people asked why Inpex was raising equity at the time," says Salim Salam, managing director and head of Japan international equity syndicate at Nomura International in London. "In hindsight the company was quite right to take the opportunity to decrease its leverage and raise funding for its massive investments in Australia."

Bankers say that equity issues such as Inpex’s have been symptomatic of much more progressive, long-term thinking in boardrooms throughout Japan. "The last time we saw a rush of capital increases was in the early 1980s, when a number of companies raised risk capital to support capex spending in Japan," says one banker. "What has encouraged them to aggressively move forward to acquire equity capital is a recognition that the domestic economy is not growing and that they need to focus on longer term growth opportunities."

Another key equity offering of 2010, again identified by Shinohara as epitomising the more forward-looking attitudes of Japanese companies, was the $1.2bn capital increase announced in May by fabric company Toray Industries. In April 2009, Toray announced what it described at the time as a "new action programme" entitled "Project IT-II (Innovation Toray II)". Much of that programme was aimed at implementing cost reductions following the downturn of 2008, but Project IT-II was also designed to harness growth opportunities, especially in China and Korea. As Toray announced at the time of last year’s equity offering, "one of the main purposes of this funding by issuance of new shares is to procure the funds for these strategic investments."

While the devastating earthquake of March 2011 inevitably played havoc with the performance of Japanese equities, Shinohara says that up until then, the common theme among the companies that launched successful equity offerings was the strength of their performance following their issues. "Although some people questioned why companies were raising new equity in 2009 and 2010, in most cases within six to 12 months of the issues these companies’ business profiles had improved dramatically from a profit perspective, and their share price performance has also been strong," he says.

Shinohara and others concede, however, that while there has been no shortage of follow-on offerings in the equity capital market, activity in Japan’s IPO sphere has remained disappointing. One notable exception, however, was the ¥198.4bn ($2.4bn) global IPO for the pharmaceuticals company, Otsuka Holdings, in December. Nomura, Morgan Stanley and UBS were joint global co-ordinators for this landmark transaction, which was the largest Japanese corporate IPO in the last decade outside privatisation issues. It was also the largest ever global IPO in the healthcare sector.

According to a Morgan Stanley deal summary: "Despite the increasing uncertainty in the market, the transaction engaged high interest from both [the] global and domestic investor community, and the book was well subscribed at five times overall." Some 40% of the transaction went to domestic investors (split 50/50 between retail and institutional accounts), with investors from Hong Kong (21.7%), North America (17.6%), Singapore (17.4%) and the UK (11.4%) leading demand for the international tranche.

In the equity-linked market, meanwhile, Nomura and Morgan Stanley also teamed up in September 2010 as bookrunners of a ¥70bn ($820m) Euroyen convertible bond for the leading Japanese consumer products company, Unicharm. The book for this transaction was three times covered after four hours of bookbuilding, with European investors accounting for 65% of demand and Asian accounts for the remaining 35%.

Convertible encouragement

A more recent convertible transaction arranged by Nomura was the ¥20bn five year issue for the parcel company, Yamato Holdings, in February 2011, the proceeds of which were used for a share buyback. "The convertibles market had been closed since September, but we think the innovative and successful Yamato transaction may encourage other companies to come to the market," says Salam at Nomura in London.

Before the March earthquake, a consensus appeared to be building that FY2011 would be a vibrant year for Japanese equities at a primary as well as a secondary level. Indeed, in early 2011 Goldman Sachs sounded a warning to investors in the Japanese equity market that supply in the coming months could be a dampener on secondary market performance, although this is not perhaps as much of a threat in FY2011 as it was in 2010.

"As many veteran investors know, one negative factor that can that impede a market rally is large-scale equity supply indigestion as stronger markets tend to beget greater issuance," advised a Goldman research piece. "While it is difficult to accurate forecast supply we have made top-down assumptions for equity issuance and buybacks to arrive at an estimate of net equity supply in 2011. Relative to 2010, we expect net supply to be 27% lower at ¥3tr in 2011 (gross supply of ¥4.5tr less share buybacks of ¥1.5tr). This is largely because the cash-rich state of many listed firms and the extremely low cost of debt should — at least theoretically — reduce the temptation to issue expensive equity relative to the past."

Another source of new supply in the Japanese equity market may be rights issues, which have historically been conspicuous by their absence in Japan. This is chiefly because of the bureaucratic requirements such as the one that prospectuses for new issues are mailed to all shareholders. It can take up to three months to process applications, theoretically exposing rights issues to considerable execution risk. The government is now looking at ways of hauling the rights issue procedure into the 21st century by allowing prospectuses to be sent by e-mail rather than snail-mail.

Rising supply at a primary level means that support from foreign investors will remain critical for Japan’s equity capital market. That support, say bankers, may fall if the current backlash against hedge funds gathers intensity. "There is a debate about the influence that hedge funds are having on the market," says Kusunose at Merrill Lynch. "It looks as though shorting of single stocks by hedge funds is going to diminish which will make a big difference to the primary market landscape because they have historically provided very strong demand for multi-billion new issues."

Foreign support for Japanese equities is also important for the secondary market. According to an update from Barclays Capital at the start of this year: "Japan’s stock market remains heavily dependent on overseas investors, who have accounted for about 65% of commissioned trading value in recent months, far above individuals (slightly over 20%) and corporations (such as banks) at a little over 10%."

Much of the overseas buying of Japanese equities in the early part of calendar 2011, say local bankers, was driven by a rotational trade, with many international investors having switched into Japan towards the end of 2010 at the expense of other Asian markets perceived to have been overbought. It seems probable that much of this flow may have been reversed in the immediate aftermath of March’s earthquake, which many analysts believed may have created a very appealing buying opportunity for long term investors.
26 Apr 2011