Cost cuts in a crisis: will Toyota be the car in front?

Toyota’s forecast provides some light in a murky earnings season

An earnings season with no earnings forecasts is pretty dull, to say the least. So kudos to Akio Toyoda for his decision to provide earnings guidance - at a time when most Japanese industrials are neglecting to even hazard a guess at what the pandemic will do to their P&L. Toyota Motor expects a 22% fall in unit sales, 20% in revenue terms, and an 80% fall in OP for FY3/21 to Y500bn. That will probably prove conservative, as it often has before: coming out of the financial crisis, Toyota forecast a loss of Y850bn at the start of FY3/10, then went on to make a profit of Y148bn. Admittedly it was reeling from the shock of a Y460bn loss the previous year, on the back of a 22% revenue decline, so that forecast was given under some duress. 

This new forecast may also be wrong. But what is interesting is Mr Toyoda’s assertion (in the Nikkei JP | EN) that the ability to remain profitable is the outcome of “strengthening the corporate structure,” which is Japanese-manager code for cutting costs. As it turns out, apart from the GFC and the recovery from it, Toyota’s gross margin and SG&A/sales have been highly consistent; it is spending the same SG&A to sales today as it did in 3/08, before the crisis hit, while gross margin is slightly lower (mainly due to currency):

blue: gross margin, red: SG&A/sales

Source: S&P CapitalIQ

Cost cuts in a crisis predict better performance beyond it

But wait a minute - look at that SG&A/sales line after FY3/09: having spiked to 12% with the fall in sales, Toyota had it down below 10% even before the top line and gross margin recovered - in fact it took some Y700bn out of SG&A by FY3/12. Perhaps what Mr Toyoda is really telling us is that the company will be even better at cutting overhead this time than it was post-Lehman?

If so, does that mean Toyota is a particular standout in its ability to cut costs in a crisis? Or will other companies be just as successful at doing so? If so, that might also be an indicator of likely operating performance coming out of the crisis. McKinsey reckons so - in a recent, excellent piece here. This is the killer quote:

“...resilient companies—those that most successfully weathered the 2008 downturn ... achieved three times the improvement in operating expenses as a percentage of revenue than their “nonresilient” peers, and did so substantially earlier, “saving their powder” and preserving capacity to invest in growth, while keeping SG&A in line with sales as revenue fell. Additionally, most companies classified as resilient stand apart from peers on multiple financial and operational metrics through both downturns and recovery…”

The article covers a number of stages of downturn and recovery, and provides a roadmap for CFOs to deploy SG&A in a sensible way both on the way down, and back up again as the business recovers. We believe this is particularly important for Japan - where managements are not known for nimbleness; fast reactions now might well enable a competitive advantage later. 

the financial crisis SG&A “Crash diet”— and abenomics rebound

With that in mind, let’s investigate in relation to other listed companies: if a management has historically been adept at cutting SG&A, that might well mean we can count on the same in the coming couple of years. Time to run a screening. We looked at more liquid names in Japan to see who cut SG&A the most in FY3/12 vs FY3/08 - the “crash diet” phase - and while we are at it, we’ll check to see if any of them managed to keep the weight off, by maintaining or reducing SG&A/sales further. Our suspicion is 10 years of up-cycle plus labour and other cost inflation during the Abenomics era mean avoiding a rebound has been quite an achievement.

We’ll compare within broad industry groups, because of the difference in cost structures and also because like companies will generally have similar accounting treatments (i.e. comparable SG&A).

autos and parts - who was asleep at the wheel?

Source: S&P CapitalIQ, Vido Research

And the winner is… Mazda Motor. Carlos Ghosn might have been known as le cost-cutter at Nissan, but perhaps he was asleep at the wheel post Lehman? Nissan’s 33% SG&A cut pales in comparison with Mazda, which not only brought SG&A down by 56% from FY3/08 to FY3/12, but also reduced the ratio to sales further, even as the top line recovered after that. Toyota Industries wins the prize for the worst rebound since FY3/12; and the mothership Toyota Motor itself has been… nothing if not consistent.

Machinery - the McKinsey analysis plays out

Source: S&P CapitalIQ, Vido Research

Here, McKinsey’s analysis seems to play out: higher growth and higher margin names generally outdid their peers post GFC (Fanuc and SMC beating Yaskawa and CKD; Komatsu outdoing HCM). The story post FY3/12 is rather different, however, and Fanuc and Komatsu, along with Nabtesco and Kurita, look like having the most rebound fat to cut from here. Meanwhile the Heavy Industry names are looking a little heavy round the SG&A waistline, which may prove to be a burden in view of massive production cuts at their customer Boeing, and engine-making partner GE (WSJ here).

Elec components/elec machinery - habitual cost-controllers

Source: S&P CapitalIQ, Vido Research

A seriously hardcore bunch: six companies who cut SG&A/sales from 3/08 to 3/12, and then carried on to do more from 3/12 to 3/19, though the size of cut needed was not as great as for the autos. Arguably Keyence should be in the previous table (we relied on S&P CapitalIQ’s taxonomy), where it would have been a close second to SMC. Congratulations to the other five champions at cost control, among which Kyocera is a conspicuous laggard since the March 2020 lows…

Source: S&P CapitalIQ, Vido Research

Hopefully this analysis provides some clues as to which manufacturers will be best at managing the COVID-19 crisis, when it comes to cutting costs. Assessing them fully also requires an understanding of the end markets and, perhaps now more than ever, the quality of management. We are here to help - please get in touch. 

Roll up, roll up - subs are on sale

Parent-child listings are up for negotiation

As we discussed in our first post, when markets are in crisis, corporate Japan tends to err on the side of caution when it comes to deploying capital. However, the longer term trend of corporate governance reform remains in play - and one of the highlights of that for us is the government’s encouragement of reform in companies with a group structure. As longtime observers of Japan’s most diverse, complex and often challenged companies (a thankless task, but someone has to do it), we are very interested in how those groups address the thorny issue of listed subsidiaries.

Why think about this now? We believe managements are not stupid, and at this time of market dislocation it may be that a subsidiary previously deemed expensive to buy in, becomes substantially cheaper because of greater exposure to the ravages of coronavirus; in some cases it is possible the subs become distressed (some are already at distressed valuations). Alternatively, it may be the parent struggling - and the sub thriving, at least in terms of its valuation, making it a source of funds.

Better group governance is a government policy

The background to this thinking is nearly a year old - that’s how long we have waited, in vain, for METI to translate its Group Governance System Guidelines released in June 2019 (here - a mere 142 pages, 20 in summary form), but there is no sign; thankfully, Nagashima, Ohno and Tsunematsu have provided a very helpful English précis (here). The guidelines emphasise how Groups are expected to manage their businesses as a portfolio, and to consider who is the “right” owner of a given business: therefore there should sometimes be a need for disposals as well as additions to optimise the Group’s structure. 

In relation to listed subsidiaries, the guidelines identify the many conflicts of interest between majority and minority shareholders, as came to the fore in Z Holdings’ (then Yahoo! Japan) spat with Askul. Historically, a listed parent could dominate the subsidiary at will, and without penalty, apart from potential reputational damage; but this state of affairs is no longer to be tolerated. There will also be times when a subsidiary - ostensibly independently managed - takes actions (large M&A for instance) which substantially impact its balance sheet, and therefore that of the parent too, through consolidation; especially if the sub takes a rather different view on the use of leverage. 

Leading groups are already walking the walk

Managements who read and fully digest these guidelines will reach the conclusion that in many cases, their Group’s governance structure does not really allow for majority-owned (or deemed-controlled) subs to be both listed and independently managed, as the guidelines require. As it turns out, the managers who helped write them took them to heart: it’s no coincidence that Mitsubishi Chemical Holdings’ Chairman, Mr Kobayashi, who was heavily involved, soon after saw fit to buy-in drug-making subsidiary Mitsubishi Tanabe Pharma. Hitachi (also represented on the committee) is also committed to tidying up its listed subs, a process that has been ongoing for years, but accelerated recently. Also involved were representatives of Toshiba, Mitsubishi Heavy, and Shiseido; not coincidentally Toshiba has also been hard at work buying up its subs. We expect far more listed subsidiaries to be rolled up, or sold down, in the coming year or two, and the recent price action may accelerate the process where it has created a disparity in valuations.

We have screened for Japan-listed names with 40%+ ownership by another Japanese listed entity, and include the indebtedness of the parent and the size of the outstanding unowned stake in relation to market cap to give some idea of “affordability” at today’s prices - this list is just the subs who have underperformed their parents and therefore increased the likelihood of being bought in. Please contact us to learn more and to receive the rest of the list - names that have outperformed, and might be sold down by a parent needing cash, for instance.

View fullsize

Source: S&P Capital IQ, Vido Research

The Aeon Group is the prime example of a parent outperforming because it is hit less hard than its subs by coronavirus: its core is the supermarket business serving daily needs, while the tenant areas of Aeon Mall have mainly been shuttered, and Aeon Fantasy’s game centres have been forced to close. Some other groups have several subs currently “on sale” - Shin-Etsu Chemical and Itochu for instance. 

Cash crunches and weak end markets could prompt reforms

We also wonder whether the current crisis might bring about some long-anticipated changes: is it too far-fetched to think Toyota Motor might finally begin reforms of its convoluted group structure and governance? This network of holdings of course stretches far beyond just the listed subs in the table above. As the Nikkei writes here (JP lang only), the cash crunch from production and sales stoppages (not to mention damage from falling residuals of leasing fleets) is going to put greater pressure on auto OEM and parts maker balance sheets at a time when CASE (connected, autonomous, shared, electric)-related R&D and investment still need to be ramped up; but that’s a story for another post.  

Speak softly, but carry a large “brick”

Investors in Japan may, in many cases, be unfamiliar with the Group Governance System Guidelines (METI, please translate them). This is a shame, given both Japanese companies' propensity to own large numbers of unrelated businesses with no synergy, and also the sheer volume of listed subs where either the listing, or the capital relationship itself have outlived their usefulness. At least minority investors are now encouraged to engage with company management on this topic; our suggested approach is to speak softly, but carry a large “brick” - in the form of a hardcopy of the GGS guidelines.

---

About Vido Research Consultants

This blog is intended to inform, entertain and occasionally to amuse - but its main purpose is to give a taste of what Vido Research offers. Contact us here to see what we can do for you, on-the-ground in Japan. We provide honest and objective bespoke insights into Japan, a service we believe is even more valuable now the pandemic means travel bans, time differences, and conference calls through interpreters making life more difficult. See here for details of how we can help.

Hedge funds - really just "collateral damage?"

Market meltdown? Global pandemic? At times like these, “cash is king.”

Nidec’s outspoken CEO Mr Nagamori - hitherto a profligate spender when it comes to M&A - told us as much from the front page of the Nikkei (JP | EN). Companies will hoard cash in the face of a sharp revenue decline because, well, they have to - or some of them do.

It’s therefore little surprise to find those pesky corporate raiders, the barbarians at the gate - otherwise known as activist hedge funds - under attack in the press once more (see this Bloomberg Opinion piece). Now the problem is not their behaviour, but that the opportunity set has evaporated, because corporate leaders like Mr Nagamori are hoarding cash and no amount of backroom diplomacy, letters to management, or AGM proposals is going to get them to part with it. The “great cash grab” has ended.

Cash rich companies have outperformed

Certainly, you’d have been much better off on average over the past three months if your portfolio were stuffed with cash-hoarders rather than heavily indebted stocks in Japan: on a simple average share price performance basis, indebted stocks were down 23%, net-cash stocks only 9%. The cash might not be being handed out, but the market has given credit for it - and activists have probably outperformed.

View fullsize

But the flight to cash, and the obsessive hoarding of it, is a temporary state of being. It’s the painful period before we learn to “dance” with coronavirus (this is the best we’ve seen on that topic) rather than having to impose the “hammer” of economy-crushing lockdowns to control it. But when the economy opens up again, and we figure out how to walk, talk, eat and work together again without infecting each other, the opportunities will still be there. 

Activists need not give up - companies haven’t

Arguably, those opportunities will grow, not necessarily because of activism - but because it makes business sense to Japanese companies, and because the government is encouraging them to do so through its governance codes and guidelines. It was reported this week that NTT - which already has half its $85bn market cap in net debt - intends to sell assets (Nikkei, JP only) - not just a few, but up to twenty-eight billion dollars’ worth - in order to slim the balance sheet and fund greater shareholder returns. Longtime followers of the company may not be so surprised: NTT has, despite significant government ownership, been a generous payer of dividends and an early proponent of stock buybacks. It also realises that some parts of its business are mature, and so the quest for greater return on equity must, in part, be driven by changes to the balance sheet. Big ones.

Telcos have been a great beneficiary of the work-from-home trend - now is not the time to be cancelling your phone subscription, and many users are upgrading their internet connections. So perhaps it’s unfair to single out one of the few companies that will suffer least from the COVID-19 pandemic.

In that case, how about Ricoh? We are all working from home, while the office printer sits idle, failing to generate the cash flow from the sale of consumables (“non-hardware” in local industry parlance) that its manufacturer counts on as the core of profits. As China is starting to show, however, after lockdown comes a return to work and some degree of normality (while Hong Kong has shown that it can carry on more or less throughout, if the spread is well-managed). The problem is we don’t know exactly when that will be. So while Ricoh’s medium term plan didn’t bring any hard numbers in terms of future earnings - too early to say - it did promise to go ahead with a further ¥100bn shareholder return (press release) as soon as reasonably possible. For those struggling to work from home, it is also a premier provider of teleworking packages here in Japan, something with which SMEs continue to grapple. 

A 20% buyback from a blue chip? In your dreams…

The fact that Ricoh's share price, one of the worst-hit in the COVID-induced crash, could not bring itself to react positively to such a shareholder-friendly move perhaps proves that Nagamori-san is right - cash is king, and you should probably hold on to it for now. But this won’t be forever. Taking a step back, most activists in Japan over the last ten years would never in their wildest dreams have expected a campaign to bring about a buyback of twenty percent of outstanding stock by a Japanese blue chip (yes, Ricoh’s market cap is now less than ¥507bn), or to see a telecom company liquidating assets to the tune of one third of its market cap, to improve shareholder returns.

These are the times we live in - where “henkaku” (change, reform, revolution, transformation) is a daily occurrence, thanks to the coronavirus: but it is also a product of the long process of governance reform in Japan, one that won’t stop just because hedge fund “corporate raiders” (Bloomberg’s term) are unable to extract cash from Japan Inc’s balance sheets over the next few months. The companies will do it for them, given a little patience. And some dancing lessons.

---

About Vido Research Consultants

Enjoyed this post? Want to learn more? Contact us here to see what Vido Research can do for you, on-the-ground in Japan. We provide honest and objective bespoke insights into Japan, a service we believe is even more valuable now the pandemic means travel bans, time differences, and conference calls through interpreters making life more difficult. See here for details of how we can help.