japan macro plus 1

8/13/2019 Japan Macro Plus 1

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Japan Equity Research23 August 2013

Jesper J Koll(81-3) 6736-8600

[email protected]

Table of ContentsMacro (Jesper Koll)Japan The Inflation Opportunity ..........................................3Inflation Forces at Work........................................................4The Great Squeeze................................................................4Buying Power of the People ....................................................5From More Jobs but Less Pay to More Jobs and More Pay .7Money Matters ..........................................................................8Rich Japan ................................................................................9Bottom Line Yes, Demand-Pull ..........................................12Consumption Tax Hike...........................................................12

Food, Beverage and Tobacco Sector (Ritsuko Tsunoda)Food, Beverage and Tobacco Sector ..................................13Manufacturers' control over pricing tested by transitionfrom deflation to inflation ......................................................13Analysis of factors in manufacturers' costs ........................14Trends in raw material prices ................................................15Rise in raw material costs due to weak yen .........................17Consumption tax hike............................................................19Endgame for deflation; trends in store prices and PBs......21Manufacturers control over pricing redefined.................25Price diversity, importance of category share .....................25Investment ideas ....................................................................28

Retail Sector (Dairo Murata)Retail Sector ..........................................................................30With inflation ticking up, retailers must deliver added valueaside from pricing ..................................................................30Retail price trends: Per-customer sales bottom out at listedretailers ...................................................................................31Current mood and pricing policies of major retailers .........34Reassessing the impact of consumption tax hikes.............35Competition: Demand growth to offset impact of higherprices, supply-side growth....................................................40Retail price outlook and implications ...................................41Investment ideas ....................................................................44

Appendix Food & HPC Sector ............................................46Appendix Retail Sector .......................................................54


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Jesper J Koll(81-3) 6736-8600

[email protected]

Japan The Inflation OpportunityJapan stands at a key inflection point: after decades of de-facto stagnation anddeflation, growth and inflation are now on the horizon. In our view, the Japanconsensus may well be too conservative on both points. In this paper we try tohighlight how exactly inflation may come to Japan, combining both a macrooverview with sector specific analysts from the producer-to-consumer chain in thefood & beverage sector.

We are doing so because we aim to get away from a mere macro analysis focus. Thisis because, in our view, a key lesson from Japans unprecedentedly drawn outexperience of deflation is that simple macro economic theoretical frameworks do notgo far to explain the extraordinary shifts in both absolute and relative prices acrossJapan that occurred over the past 20 years. To wit: at end-2012, nominal GDP wasstuck at levels last seen in 1991; residential property prices were at levels last seen in1985; but real GDP did grow by about 1% on average over the past 20 years.

In our view, the leaders of Abenomics deserve full credit for recognizing thecomplexity at work in Japans economy: their overriding goal is to end deflation, toget toward 2% real and 3% nominal GDP growth; and to get out of deflation, theyseek to activate all policy tools available money, fiscal, and regulatory. In otherwords, to hit these targets, they do not simply rely on some sort of preconceiveddogma like, for example, inflation is always a monetary phenomena; no, they are

pragmatists and realists, knowing that the combination of macro and micro is neededto achieve a fundamental break from the deeply entrenched deflationaryequilibrium.

Make no mistake: in our view, Japan offers potentially high rewards for investors

precisely because the consensus investor and analyst community remains convincedthat Prime Minister Abe will fail to achieve his 2% real, 3% nominal growth goals.

Figure 1: Nominal GDP, Real GDP and Land Prices trillion trillion

Source: Cabinet Office (National Accounts of Japan), J.P. Morgan.

Land (LHS)

Nominal GDP (RHS) Real GDP (RHS)

200

250

300

350

400

450

500

550

400

600

800

1,000

1,200

1,400

1,600

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Jesper J Koll(81-3) 6736-8600

[email protected]


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Jesper J Koll(81-3) 6736-8600

[email protected]

Inflation Forces at WorkIn our view, all major signposts in Japan point toward inflation. This is true from

both sides cost-push inflation and demand-pull:

! Cost-push:

1) Weak yen

2) Rising commodity prices

3) Labor market bottlenecks

4) Rules, regulations & taxes

! Demand-pull:

1) A new credit & leverage cycle

2) Rising employment & wages

3) Wealth effects

4) Rules, regulation and taxes

Importantly, these economic drivers of inflation are compounded by a policy regimethat has made a complete about turn from previous practices: Prime Minister Abeand his team do want inflation: they did force a fundamental change onto the Bank ofJapans policy goal, i.e. they now do have an inflation target they are accountable for.

The Great SqueezeThe cost-push from the weaker yen and rising global commodity prices is easilydocumented. The BoJ corporate price index data shows raw materials pricescurrently rising at almost 18% from a year ago, while intermediate goods prices arerising at 5% and final goods prices at about 3%.

Figure 2: Cost-Push Inflation%YoY

Source: Bank of Japan, J.P. Morgan.

Final goods

Intermediate goods

Raw materials

-10.0-5.00.05.0

10.015.0

20.025.030.035.0

Jan-10 Nov-10 Sep-11 Jul-12 May-13


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Jesper J Koll(81-3) 6736-8600

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In our view, the really interesting inflection point did occur much earlier, in 2003/04.That was when the relationship between intermediate goods prices and final goods

prices began to fundamentally change: until 2004, both intermediate and final goods prices more or less moved at the same trend. Since 2004, intermediate goods pricesstarted to rise, while final goods prices continued their moderate decline.

Figure 3: The Great Squeeze - Intermediate Goods Price and Final Goods Prices2010=100


The Great Squeeze forced fundamental changes in Japan retail industry and the producer-supplier relationship. White Label and Private Brand or Own Brand production got adopted by those retailers with a vision and the financial power toimplement it.

In our view, no matter how much final goods price power returns, the fundamental

break in the producer-retailer relationship that started about a decade ago is unlikelyto change. If at all, cost-push pressures are poised to widen the gap further betweenthose retailers who can implement more aggressive own-brand strategies and thosewho cannot.

Buying Power of the PeopleWhere does the buying power of the people come from? Here, the increasingtightness of the labor market is a key positive dynamics, in our view.

First of all, Japan has turned into a genuine job-creating machine: the number of people employed has surged at an annualized rate of just below 3% since the start of

this year. Make no mistake the basic thrust in the labor market has turnedsupportive for consumer demand growth, in our view.

80

90

100

110

120

130

140

Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10

Final goods

Intermediate goods


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Figure 4: Japan Non-farm Employment Up and AwayMillion people

Source: Ministry of Internal Affairs and Communications, J.P. Morgan.

The detailed dynamics of Japans employment upturn is further testimony to howmuch Japans economy has actually been changing: the manufacturing sector has

been cutting jobs manufacturing employment is down by 1.6 million people since2000; almost all the job creation has come from the merchandising sector, wholesaleand retail, up 903,000 since 2000, and the service sector (which is really services forindividuals, like barbers, nurses, etc.), up 1.24 million. In addition, Japans non-profitsector has been a big growth sector, with employment there up 355,000.

Figure 5: Japan Employment & Compensation by Major Sector

Share in Employment (%) Share in Compensat ion (%) Employment Growth('000 people)

Per Capita Wage( million)

2001 2011 2001 2011 2001 to 2011 2001 2011

Agriculture 1.5 1.7 0.8 0.9 145 2.64 2.28 Manufacturing 20.5 17.1 21.7 20.0 -1,550 5.24 5.23

Construction 9.2 7.4 9.4 8.3 -887 5.04 4.99 Utilities 0.8 0.9 1.4 1.3 34 8.09 6.60 Wholesale and retail trade 17.6 18.7 14.9 14.6 903 4.19 3.45

Finance and insurance 3.3 3.2 4.5 4.5 10 6.77 6.29 Real estate 1.3 1.4 1.3 1.5 87 5.17 4.89 Transport and communications 6.5 5.9 7.1 6.8 -206 5.42 5.06 Information & Communications 2,9 3.2 3.0 3.2 134 3.57 4.42

Service activities 29.1 30.4 23.6 22.7 1,238 4.03 3.29

Government services 7.8 7.1 12.4 12.1 355 7.89 7.54 Public administration 4.8 4.3 7.8 7.9 -213 8.11 8.18

Non-profit services 2.5 3.1 2.9 3.9 355 5.77 5.57Source: Cabinet Office (National Accounts of Japan), J.P. Morgan.

53.0

53.5

54.0

54.5

55.0

55.556.0

2000 2001 2002 2004 2005 2006 2008 2009 2010 2012LFS-employed, SA - Japan


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Jesper J Koll(81-3) 6736-8600

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From More Jobs but Less Pay to More

Jobs and More PayUnfortunately, the switch from a manufacturing to a service economy did actuallyforce a net loss of purchasing power for employees. This is because the high jobgrowth sectors started out relatively low paying: the average manufacturing sector

job paid 5.24 million per year per worker in 2000, and that was virtually unchanged by 2011. Meanwhile, the average merchandising job wholesale or retail paid4.19 million in 2000 but only 3.45 million by 2001, a drop of almost 18%. Thedynamics are similar for the services industry (and indeed the non-profit sector).

So while manufacturing now accounts for barely 17% of total employment (downfrom 20.5% in 2000), it still accounts for 20% of total compensation (from 21.7% in2000). Against this, wholesale and retail now employs 18.7% of all workers but

accounts for only 14.6% of total compensation.

Interestingly, the biggest gap between employment share and compensation share isactually Government services in general, public administration in particular, withthe latter accounting for 4.3% of all employment but 7.9% of all compensation.

Figure 6: Average Annual Compensation by Employee by Sector million / employee

Source: Cabinet Office (National Accounts of Japan), J.P. Morgan

From here, the key dynamics, in our view, is poised to be an upturn in wages andtotal compensation in the relatively lower- and middle-pay sectors of Japan, i.e.merchandising, construction and individual services. All these sectors are highlylabor intensive, with limited room for greater automation.

The demand-pull implications of this thesis are obviously positive. At the same time,the cost-push implications are also significant: if we are right, and wholesale andretail wages start to rise, cost-push pressures for retailers are poised to force moreconsolidation and sector streamlining, in our view. Moreover, the growing tightnessin the supply of labor is poised to raise the premium for better on-the-job training.Companies with true career development programs are poised to be able to widentheir skills and corporate culture gaps to those companies that cannot afford to offer them. Clear speak: Japans labor market tightness and skills shortage is poised to be a

positive driver for corporate consolidation, particularly in the merchandising sectors,in our view.

Manufacturing

Construction

Utilities

Wholesale & Retail

Finance

Services

Publicadministration

3.0

4.0

5.0

6.0

7.0

8.0

9.0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012


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Jesper J Koll(81-3) 6736-8600

[email protected]

Money MattersWhile labor market developments are always going to be a lagging indicator ofaggregate demand and inflation, Japans money and credit economy offers insights inmore immediate developments, if not forward-looking. Here, the news isunambiguously positive for our pro-growth, pro-inflation thesis.

Monetary aggregates speak for themselves. Note here the synchronized pickup in allthe data, from narrow BoJ base money via M2 money supply, all the way to M3

broad liquidity. The last time this synchronized expansion occurred was in 2005 to2007, when it was forced to an end by the BoJ engineering a sharp slowdown in basemoney creation. Given the new BoJ focus and mandate, it appears unlikely this will

be repeated in the foreseeable future, in our view.

Figure 7: Money Economy - Now Growing Across All Aggregates%YoY % YoY


Importantly, a key driver for the expansion in Japans broader monetary aggregates isthe beginning of a new leverage cycle from Japans household sector.

Specifically, demand for mortgages has been rising steadily over the past two years,after the Fukushima disaster set off a disaster-induced rebuilding cycle. However, themortgage demand cycle has steadily grown and has now expanded out to across allthe major urban areas of Japan.

In our view, this start of a new leverage cycle, led by households, is a key reason to be optimistic that, yes, this time is different the Bank of Japan is no longer just

pushing on a string.

M2 (LHS)

M3 (LHS)

BoJ total asset(RHS)

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

-1.0

0.0

1.0

2.0

3.0

4.0

Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12


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Jesper J Koll(81-3) 6736-8600

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Figure 8: Mortgage Growth - A New Credit Cycle Gets Going%YoY


Rich JapanFor the mortgage credit and leverage cycle to be sustained, the expected upturn inJapans labor and income markets are very much key. At the same time, there is agreat supporting factor coming into play, in our view: positive wealth effects ingeneral, and in particular the positive asset carry effects from a combination of highhomeownership and record-low debt burden.

Japans household sector balance sheet is in tremendous health, in our view. In the beginning we outlined that residential real estate prices are back to a level last seen in1985. This deflationary adjustment did force a strong negative undercurrent for

domestic demand over the past 20 years.

At the same time, however, Japanese households did work hard to restore theiroverall financial wealth and balance sheet: they repaid 50 trillion of debt over the

past 15 years, while growing their non-real estate assets at the same time. Whencombining net financial assets together with real estate holdings, Japanese household

balance sheets actually never really declined.

Figure 9: Balance Sheet of Households trillion trillion

Source: Cabinet Office (National Accounts of Japan), J.P. Morgan.

-4.0-3.0-2.0-1.00.01.02.03.04.0

Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14mortgage

Financial assets(LHS)

Currency anddeposits (LHS)

Land + Net Financial Assests (LHS)

Liabilities(RHS)

250

270

290

310

330

350

370

390

410

430

0

500

1,000

1,500

2,000

2,500

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012


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Jesper J Koll(81-3) 6736-8600

[email protected]

Importantly, home ownership has actually continued to increase: in 2012, 73.1% ofall Japanese households owned the home they live in. Remarkably, only 36.7% of all

Japanese carry a mortgage.Figure 10: Home Ownership Ratio by Age Group%of Group

Source: Statistics Bureau, Ministry of Internal Affairs and Communications, J.P. Morgan.

Figure 11: Percentage of Age Group that Carries a Mortgage%of Group


It is no surprise that mortgage debt falls with age. However, given Japans population pyramid, the implications are very significant.

Specifically, of the Japanese people who are twenty years old or older, we calculatethat, as of 2012, 43.8% actually own their home and carry zero debt. That is up from39.5% ten years ago.

73.1

4.5

20.8

44.2

58.5

73.578.6 82.5

86.8 88.382.2

87.7

0.010.020.0

30.040.050.060.070.080.090.0

100.0

total 2024

2529

3034

3539

4044

4549

5054

5559

6064

6569

70

own house( ) as of 2000 own house( ) as of 2012

36.7

1.9

10.6

33.3

43.151.8 48.1

40.8

31.7

17.214.1

7.6

0.0

10.0

20.0

30.0

40.0

50.0

60.0

total 2024

2529

3034

3539

4044

4549

5054

5559

6064

6569

70

who pays mortgage loan (%) as of 2000 who pays mortgage loan (%) as of 2012


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Jesper J Koll(81-3) 6736-8600

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Figure 12: Japanese with Zero Debt and Full Home Ownership%of Population over 20 Years Old


Figure 13: Debt and Home Ownership in 2000000 people, %

Total 2024

2529

3034

3539

4044

4549

5054

5559

6064

6569

70

Population over 20 100,737 8,421 9,790 8,777 8,115 7,800 8,916 10,442 8,734 7,736 7,106 14,900People without debt 76,764 8,210 8,694 6,548 5,137 4,329 4,859 6,537 6,105 6,258 6,125 13,961 % of total 76.2 8.2 8.6 6.5 5.1 4.3 4.8 6.5 6.1 6.2 6.1 13.9

People without debt + Home 39,781 354 999 1,018 1,347 2,028 3,076 4,647 4,961 5,168 4,875 11,309 % of total 39.5 0.4 1.0 1.0 1.3 2.0 3.1 4.6 4.9 5.1 4.8 11.2Source: Statistics Bureau, Ministry of Internal Affairs and Communications, J.P. Morgan.

Figure 14: Debt and Home Ownership in 2012000 people, %

Total 2024

2529

3034

3539

4044

4549

5054

5559

6064

6569

70

Population over 20 105,019 6,370 7,219 8,093 9,712 9,315 7,966 7,639 8,320 10,632 7,861 21,892People without debt 78,240 6,249 6,454 5,398 5,526 4,490 4,134 4,522 5,683 8,803 6,753 20,228 % of total 74.5 6.0 6.1 5.1 5.3 4.3 3.9 4.3 5.4 8.4 6.4 19.3People without debt + Home 45,949 166 736 882 1,496 2,021 2,430 3,185 4,584 7,559 5,353 17,535 % of total 43.8 0.2 0.7 0.8 1.4 1.9 2.3 3.0 4.4 7.2 5.1 16.7


The key takeaway here is simple: Japans household sector has a tremendouslystrong balance sheet; and while Japan is ageing rapidly, the age-cohort analysissuggests that the now retiring baby boom generation has remarkably high homeownership, without any debt to speak off.

For consumer demand, this suggests that positive wealth effects from rising realestate prices are first and foremost likely to pull up spending demand from seniors,rather than juniors. This should keep high a rising preference for services and high-

brand conscious, as well as domestically produced goods.

0.8 1.41.9 2.3

3.04.4

7.25.1

16.7

0.02.04.06.08.0

10.012.014.016.018.0

3034

3539

4044

4549

5054

5559

6064

6569

70

People without debt & Home as of 2000


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Jesper J Koll(81-3) 6736-8600

[email protected]

Bottom Line Yes, Demand-PullIn our view, the combination of a tightening labor market, growing credit demand, aswell as solid prospects for positive wealth effects from high real estate exposure bythe household sector, should indeed allow for an asymmetric inflation and growthoutlook bias for Japan going forward.

At the same time, cost-push factors are also real. The combination is poised toforce not a rising tide that lifts all boats, but more industry and sectorconsolidation.

Consumption Tax Hike

In our view, the upcoming consumption tax hike is poised to add momentum to theunderlying forces outlined above. Frontloading momentum is poised to be strong,with consumers eager to lock in pre-tax hike prices for large ticket items. At the sametime, we judge that consequent payback is poised to be much more limited thanduring previous tax hike periods. This is because the combination of a tighteninglabor market and rising bank credit and leverage is creating a backdrop that simplycannot be compared to the past two episodes of tax hikes.

When the consumption tax was introduced in April 1989, it was part of an overall policy tightening designed to cool the economy and bring down inflation. Windowguidance on tighter bank lending standards, as well as restrictions on lending for realestate development, had been put in place one year before the consumption tax wentfrom zero to 3%; and barely eight weeks after the tax hike came into effect, the Bankof Japan hiked interest rates the first in a series of hikes that launched a hardmonetary attack on the bubble economy.

When the tax was hiked from 3% to 5% in April 1997, the Asia financial crisis hit just three months later, forcing an unprecedented collapse in Japans exporteconomy. Asian contagion spread throughout global asset markets and, on October27, 1997, Wall Street crashed 7.2%. In our view, it takes a serious stretch of theimagination to even try and correlate the 1997 tax hike to possible futureimplications of consequent hikes: yes, 1997/98 was special, but not because ofJapans tax hike.


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Jesper J Koll(81-3) 6736-8600

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Food, Beverage and Tobacco Sector

Manufacturers' control over pricing testedby transition from deflation to inflationWe believe this is a good opportunity to review manufacturers' control over pricingat a time of keen interest in how prices will shape up alongside the consumption taxhike. Looking back, our assessment of manufacturers' control over pricing has beenconfined merely to their ability to transfer input costs into prices. This has certainly

been influenced by an environment characterized by protracted deflation and atendency toward low ambitions, but we think there are fledgling signs of a change inhow consumers react to prices.

Consumers appear to be less inclined to react positively and increase their unit purchases in response to campaigns that seek to make products appear good value byincreasing quantities. It looks to us as though food products are becoming less price-elastic. Looking back at the unprecedented increase in tobacco tax in October 2010and the corresponding sharp price hikes implemented by the cigarette industry, price-elasticity was not as high as manufacturers feared. In addition to examining thesetrends, we also highlight the fact that cash wages have started to turn up.

Retailers and manufacturers have pursued deflationary strategies because of this longdecline in incomes. However, we believe "affordability" strategies that set prices atlevels that make it easy for consumers to buy products have effectively ended up asstrategies to attract customers to stores, meaning rock-bottom pricing has become thenorm, while the system of tax-inclusive price labels has also encouraged uniform

pricing at the store level. So how will tax-exclusive labeling and the consumption taxhike affect rock-bottom pricing? Will ex-tax rock-bottom pricing emerge?

Or will manufacturers still have to absorb costs in order to achieve the rock-bottom pricing that has become so firmly established under tax-inclusive price stickers?Finally, did this kind of ossified pricing really tally with consumer needs, given thecontent of what was offered?

Assuming that greater freedom to set prices will lead to a change in corporatestrategies themselves, we examine conditions and strategies for firms to break ranksfrom standard strategies brought by uniform pricing, and to avoid commoditization.

In this report we set out points for discussion between industrial corporates and

investors, and we draw up our own investment ideas within the sector, via (1) asummary of the current situation by analyzing cost factors for manufacturers, (2) areview of store-level pricing, share, and PB trends in major products by category, (3)our own redefinition of "control over pricing," and (4) examination of new pricingstrategies to maximize margins by leveraging diversification in prices.

Ritsuko Tsunoda(81-3) 6736-8627

[email protected] JPMA TSUNODA

Figure 15: Cash Earnings Trend(excl. bonus payments)

Source: Ministry of Health, Labor and WelfareMonthly Labor Survey

320,000

325,000

330,000

335,000

340,000

2 0 0 8 / 0 1

2 0 0 8 / 0 7

2 0 0 9 / 0 1

2 0 0 9 / 0 7

2 0 1 0 / 0 1

2 0 1 0 / 0 7

2 0 1 1 / 0 1

2 0 1 1 / 0 7

2 0 1 2 / 0 1

2 0 1 2 / 0 7

2 0 1 3 / 0 1


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Jesper J Koll(81-3) 6736-8600

[email protected]

Analysis of factors in manufacturers' costsManufacturers' operating costs can be divided broadly into COGS and SG&Aexpenses, though factors driving up costs fall roughly into two categories, namelyraw material prices and rebates to retailers.

Variable factors for COGSWhen raw material prices increase because of market prices or a weaker yen,manufacturers need to transfer all or part of this into their own prices. However,when raw material prices fall, it is the commodity food companies supplying

processed food production manufacturers with bulk food materials that can reducetheir purchasing prices, whereas branded food product firms try and keep prices atelevated levels, either by launching campaigns that offer larger quantities or by usinghigher-quality raw materials to revamp products whose appeal rests on their value-

added.

However, manufacturers have to be able to create products that convince theircustomers (retailers and consumers) of the value-added appeal, and only a handful offirms are capable of passing this stringent test. Thus, ordinary products that do notqualify for this come under pressure for price cuts, and manufacturers' shipment

prices also see a certain increase in the burden of rebates. Monies paid to retailers forcooperating in campaigns that play on the perception of value-for-money in store

prices are booked on the manufacturers' statements of income as higher promotionalexpenses. On the other hand, the retail counterparties' approach to booking suchrevenue is inconsistent, and it is thus hard to pin down many elements from outsidein this rather opaque trading practice.

Changes in branded product companies' ASPs reflected notin sales but in promotional expensesUnder Japanese GAAP, actual changes in manufacturers' prices are poorly reflectedin higher or lower sales. Rebates agreed between retails and wholesalers are includedin sales, clouding the picture for prices that ought to be visible in manufacturers'sales. European and US companies with home markets in mature, inflationarynations can explain inflation in terms of changes in prices and in mix, giving clearmargin analysis and making it easy to pin down final profits attributable toshareholders. The high degree of transparency in earnings is assured by simple

business models and well-polished presentations. This can also be easily reflected inshare prices.

On the other hand, information meetings with many Japanese companies pass oversales and immediately look at changes in operating profitindeed, many firms arekeen to talk in terms of variance in absolute monetary values. Corporate sales targetsunder deflation have frequently been hard-to-achieve goals, rather than commitmentto realistic figures. This has meant that attention has tended to focus on the details ofcost-savings designed to absorb the fall in profits associated with a top-line shortfall.We feel it has thus been more efficient to talk about these factors in terms ofincreases/decreases in absolute values. However, sticking to Japan's unique,traditional style confuses global investors and might make global comparisons hardto draw.


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Jesper J Koll(81-3) 6736-8600

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Trends in raw material prices

Protracted rise in market prices; now some prices rising,some fallingThe JPMJ Basic Materials Index rose to 305.7 as of July 2013 (January 2000 = 100),while the JPMJ Materials Index climbed to 388.3 over the same period. The rawmaterials index is currently down 1.1% compared with last year, whereas thematerials index is up 9.7% because of the rise in petrochemical markets. Since thestart of this year they are up 3.6% and down 4.2%, respectively. On top of thechanges in market prices since the start of this year, we have applied a simpleaverage of +6.4% for gasoline and natural gas prices to reflect fluctuations since thestart of this year, and a provisional figure of +1% for indirect manufacturing costs.From these weighted averages we estimate that manufacturers' COGS will rise 1%.In order to absorb this cost increase the companies would have to pass along 0.6% of

this into prices to maintain margins, and 0.6% to keep gross profits unchanged aswell.

Figure 16: YTD Change in JPMJ Basic Materials Index, JPMJ Materials Index, and Fuel Costs

Change YTDJPMJ Basic Materials Index 3.6%JPMJ Materials Index -4.2%Fuel Costs 6.4%Source: J.P. Morgan

Figure 17: Manufacturers Cost Analysis

Input Cost for Food & Beverage + HPC % of Total COGS YoY chg.Food & Beverage +HPC 50% 3.6%

Packaging 30% -4.2%Overheads 10% 1.0%Energy/Distribution 10% 6.4%COGS Increase 1.0%Gross Margin 30%-70%

Before Price Hike After Price HikeCase 1 Case 2

Input 100 101 101GP 67 67 67GPM 40.0% 40.0% 39.9%Sales 167.0 168.0 168.0

% increase to retailer 1) Maintaining the same gross margin 0.6%2) Maintaining the same gross profit 0.6%

Source: J.P. Morgan

Assuming retailers' purchasing costs and manufacturers' sales are equivalent, andestimating total COGS by grossing up purchasing costs COGS ratios of 84%,retailers would need to pass along 0.4% to keep margins unchanged, and 0.4% tokeep gross profits at the same level. If they leave prices unchanged, gross profitmargins would erode by 0.3% under this calculation.

The degree to which companies will need to transfer costs into prices given thecurrent rise in markets is relatively modest, but our impression is that the increase inthe cost of imported raw materials caused by the weaker yen is more serious.


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Jesper J Koll(81-3) 6736-8600

[email protected]

Figure 18: Retail Cost Analysis

Input Costs % of Total COGS YoY chg.

Merchandise 84% 0.6%PB COGS 13% 0.6%Energy/Distribution 3% 6.4%COGS Increase 0.8%Gross Margin 26%

Before Price Hike After Price HikeCase 1 Case 2 Case 3

Input 199 200 200 200Of which, merchandise 167 168 168 168

GP 70 70 70 69GPM 26.0% 26.0% 25.9% 25.7%Sales 269 270 270 269

Retailers price hike scenario1) Maintaining the same gross margin 0.4%2) Maintaining the same gross profit 0.4%

3) No pass-through price hike 0.0%Source: J.P. Morgan

Figure 19: JPMJ Basic Materials Index (Jan. 2000 = 100)

Source: J.P. Morgan

Figure 20: JPMJ Materials Index (Jan. 2000 = 100)

Source: J.P. Morgan

0

50100150200250300350400

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[email protected]

Rise in raw material costs due to weak yen Next we summarize the results of our talks with the companies at the end of the fiscalyear about the earnings impact of the weaker yen on commodity food productearnings. It is no exaggeration to say that scarcely any branded food product or HPCcompanies either provided a full explanation of the impact of the weaker yen orfactored this into their earnings forecasts.

Figure 21: Full-Year Company Guidance and 1Q/2Q FY13A: Impact on Operating Profit from Higher Material Costs and Weaker Yen

millionFY2013 Co. E 1Q/2Q FY13 A

Commodity Food Company OP Impact of highermaterial costs

(lower) Impact of yen depreciation

Net impact ofhigher material

costs(lower)Higher material

costs (lower)Impact of yendepreciation

2264 Morinaga Milk 11,500 3,200 2,000 700 700 0

2269 Meiji HD 29,000 5,500 No estimates 700 700 02270 Megmilk Snow Brand 17,000 2,000 Not considered 150 150 02607 Fuji Oil 16,000 1,800 2,000 Not disclosed Not disclosed Not disclosed2602 Nissin Oilio Group 6,700 10,700 13,600 200 -2,950 3,1502613 J-Oil Mills 6,600 20,800 19,300 4,600 1,600 3,0002001 Nippon Flour Mills 11,000 0 No impact due to passalong to

shipment price0 0 0

2002 Nissin Seifun Group 23,700 1,100 600 0 -200 2002284 Ito Ham 7,000 4,000 No estimates 510 410 1002282 Nippon Meat packers 34,000 4,500 No estimates 1,800 900 9001332 Nippon Suisan 12,500 600 500 0 0 01331 Maruha Nichiro HD 18,000 1,500 1,500 0 -600 600

FY2013 Co. E 1Q/2Q FY13 ABranded Company OP Impact of higher

material costs(lower) Impact of Yen depreciation

Net impact ofhigher material

costs(lower)Higher material

costs (lower)Impact of Yen

depreciation4452 Kao 116,000 2,000 Not disclosed 3,500 0 35004911 Shiseido 39,000 1,000 Not disclosed 0 0 08113 Unicharm 70,000 3,500 800 200 -100 3002914 JT 616,000 Not disclosed Not disclosed 0 0 02501 Sapporo HD 15,300 400 Not considered 100 -100 2002502 Asahi GHD 118,000 3,500 1,000 -700 -1700 10002503 Kirin HD 150,000 -1,600 Not considered -600 -2600 20002897 Nissin Foods 25,500 1,200 1,200 -400 -400 02875 Toyo Suisan 31,000 870 400 -400 -400 02802 Ajinomoto 75,000 4,700 Not disclosed 2,300 1300 10002801 Kikkoman 22,500 1,400 1,100 500 0 5002267 Yakult 29,000 1,400 Not disclosed -200 -200 02220 Kameda Seika 4,000 400 400 310 310 02229 Calbee 18,000 1,500 185 185 02810 House Foods HD 12,500 800 800 20 20 02871 Nichirei 17,000 8,500 7,000 2,000 500 15002593 Ito En 23,000 2,100 2,100 NA NA NA2587 SBF 75,000 Not disclosed 0 0 -1,000 1,000Source: Data from companies and hearingsNote: Higher material costs from impact of yen depreciation for Nisshin Oilio and J-Oil Mills will be net impact of 500 million to take into account the higher meal prices.Morinaga Milk: Euro=120 and OP sensitivity to 1 move is 30 million.Note: Overall, Kao stands to benefit from 5 billion in lower raw material costs, even though such costs have actually risen for pretty much everything other than palm oil. The chemical segment isnot affected by price reductions, but the consumer segment must contend with a lingering 2 billion impact from higher raw material costs.

Ajinomoto expects its domestic food business to encounter an approximately 1.7 billion increase in raw material costs (1.2 billion for processed foods, 500 million for frozen foods). Note,however, some raw materialsmost notably rice and dried bonitoare not exposed to forex shifts.Calbee's forex rate is actually an average for raw-material purchasing; it is not the same as the target rate it uses for financial planning purposes.Ito En will disclose 1Q results onSeptember 2.


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[email protected]

In AprilJune corporate earnings, commodity foods were conspicuously affected byhigher costs brought by the weaker yen, but the impact on branded food product

firms also appears to have been surprisingly heavy. However, market prices arecurrently falling, while companies are also working to cut purchasing unit prices,such as by changing specifications of raw materials used in products, offsetting theincrease in costs associated with the weaker yen, and this is making it superficiallyhard to see the true picture. That said, the impact will surface each quarter, andcompanies will presumably have to respond. The risk of a downward revision at 1Hresults announcements will grow for companies unable to pass along higher costsinto prices from summer through autumn this year.

Figure 22: Price Revisions Due to Increase in Raw Material Costs and Weak Yen

Company AnnouncementDate

EffectiveDate

Price Revision

Yamazaki Baking 2013/05/23 2013/07/01 Hikes shipment prices for bread 3-6%, sweet buns 2-6%

Kewpie 2013/08/07 2013/10/18 Mayonnaise contents changed from 500g to 450gNippon Meat Packer 2013/05/13 2013/07/01 Prices hikes on 89 types of ham/sausage and 62 processed food products (both home-use and commercial).Prices revisions stem from changes in product planning and boost prices 5-11%; average price hike is 8%.

Ito Ham 2013/06/13 2013/07/22 Retail/wholesale prices hiked 5-15% (average: 8%) on 210 ham/sausage products and 70 processed precookedfood productsMaruha Nichiro HD 2013/08/01 2013/09/02 Price hikes by subsidiary Aixia (pet food processor/seller)Nisshin Seifun Group 2013/05/22 2013/07/01 Price hikes home-use wheat flour +2-7%, some home-use pasta sauces +9-11%Nippon Flour Mills 2013/06/03 2013/07/01 Price hikes home-use wheat flour +2-6%, home-use mix flour +2-5%Meiji HD 2013/07/23 2013/10/01 16 products of milk hiked 1-4% on a 5/kg increase in the dairy farm priceMorinaga Milk 2013/07/25 2013/10/01 Milk price hiked by 5/kg, increasing shipment price by 5Megmilk Snow Brand 2013/08/02 2013/10/01 Shipping price of 29 products (including milk) increased 1-4%

Takara Shuzo 2013/08/20 2013/10/01The shipment value of refined sake and cooking sake (about 170 products) rose 2-7% (average of 4%). Thisnumber excludes sales of autumn and winter seasonal products, year-end gift sets, and ShochikubaiShirakabegura "Mio"

Source: Data from companies and hearings


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Jesper J Koll(81-3) 6736-8600

[email protected]

Consumption tax hikeSpecial legislation has been introduced to ensure higher consumption tax istransferred into prices, and the Fair Trade Commission will forbid retailers fromrefusing to pass this along into prices, and ban both retailers and manufacturers fromsharing the pain. Nevertheless, rebates may be levied under a different name, leadingto cuts in ex-tax prices in real terms. This is because retailersin particular, volume-sales supermarkets, GMS, and discount storesare firmly wedded to rock-bottom

pricing in order to make products look good value-for-money in store-level prices.

Assuming manufacturers have to absorb the cost of cutting ex-tax prices far enoughto offset the 3% consumption tax hike, a simple calculation suggests this will giverise to reductions of 3% in revenue and 3ppt in gross profit/operating profit margins.In particular the food sector has many subsectors and companies with operating

profit margins under 3%, so simply speaking we can envisage a scenario under which profits are wiped out. If the second consumption tax hike in October 2015 goesahead, the cost burden will increase by 2ppt from 8% to 10%. We feel companieslanguishing on low margins now face a period in which they will have to justify theirexistence.

Manufacturers have developed and launched a constant stream of new productssupported by highly profitable items amid the long struggle with retailers for margin,

but this has left many weak products with no prospects for a long future on themarket, supported by strong products. True innovation is hard to achieve, and duringthis period consumers have become more selective, leading to commoditization.Manufacturers' marketing prowess is being put to the test in a commodity era, andcompanies are clearly polarizing into winners and losers. The days when a strategy ofuniformity seeking safety in numbers used to work are now over, in our view.

In light of other countries' consumption tax levels, we would not be particularlysurprised to see further tax rate increases in Japan in the future. Costs are on a long-term uptrend, so we assume no lasting reductions from now, even if there are marketcorrections or near-term price fluctuations. Manufacturers' profitability will worsenunless they can transfer costs into prices. This is an uncomfortable fact, but needs to

be taken on board for businesses to survive. We think perceived scale in categorymarket shares will be seen as increasingly important.

Figure 23: Consumption TaxRate by Country

Source: Country data

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[email protected]

Figure 24: GPM (Y-axis) and OPM (X-axis) Scatter Chart in FY2012 for Branded and Commodity Food Companies

Source: Bloomberg and J.P. Morgan. Note: Three beer companies with * show sales excluding alcohol tax and OP goodwill adjusted.

Figure 25: GPM (Y-axis) and OPM (X-axis) Scatter Chart in FY2012 for HPC Companies

Source: Bloomberg

Asahi GHD*

KirinHD*

Sapporo HD*

Ajinomoto

Nissin Foods HD

Toyo SuisanYamazaki BakingKikkoman

Kiwpie

House Foods Calbee

SapporoHD Asahi GHD

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[email protected]

Endgame for deflation; trends in store

prices and PBsAlthough we take a more detailed look in the retail sector chapter, existing-storeASPs in the traditional retail channel appear to be turning up. We have looked forevidence that deflation is winding down in light of PB products' category weightings,

product prices in main categories, and share levels, based on Nikkei POS data.

Figure 26: Ranking of Categories with High Private Brand (PB) Weightings%

Source: Nikkei POS as of July 2013

Figure 27: Ranking of Categories by Degree of Dominance of Top Three Companies%

Source: Nikkei POS as of July 2013

23.7

13.912.7 11.6

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[email protected]

Categories with high PB weightingsWe examined Fuji Keizai and other data, in addition to Nikkei POS, to analyze theweight of PB products by category. Although there is no great difference in broadtrends, there are variations in approaches to data and big differentials in datasets forsome products. In this report we have integrated product category data for theJapanese market with the Nikkei POS data we update and distribute monthly. (POSdata hereafter are as of July 2013.)

The Nikkei POS data samples 24 categories, of which PB weightings are over 10%in four, namely ham & bacon (23.7%), frozen foods (13.9%), bread (12.7%), andsausages (11.6%).

Within these, ham & bacon and sausage ASPs are broadly flat. The top threecompanies' combined share of the ham & bacon category is 43.0%, while the topfour companies have a combined market share of 54.0% (Nippon Meat Packers

15.9%, Itoham 14.2%, Prima Ham 12.9%, Marudai Foods 11.0%). In the sausagecategory, the top three companies have a combined share of 59.7% (Nippon MeatPackers 24.8%, Itoham 20.7%, Marudai Foods 14.2%).

ASPs are falling in the frozen foods and loaf bread segments, and again taking thedegree of market dominance in terms of the top three companies' share and thenumber of firms with aggregate share over 50%, these are 33.9% and five companiesin the frozen foods category (Ajinomoto 12.6%, Nichirei 12.4%, Nippon Suisan8.9%, TableMark 8.8%, Maruha Nichiro 7.8%; aggregate share of 50.5%), and70.5% and two companies in the loaf bread category (Yamazaki Baking 37.0%,Shikishima Baking 24.7%; aggregate share of 61.7%).

Looking more closely at trends in frozen foods, ASPs at Ajinomoto (industry leader

with 12.6% share) are rising, running counter to the industry average, and its PB prices are also above the industry average. Despite this, other NB manufacturers'ASPs are below the industry average, while five companies are needed to give amajority market share, so the degree of industry dominance is relatively low.

On the other hand, in the loaf bread market, industry leader Yamazaki Baking has a37.0% market share, and adding in second-ranked Shikishima Baking givesaggregate share of 61.7%, but even then the PB weighting is still high, and averageindustry product ASPs are falling.

Categories with high degree of dominanceThere are 15 categories in which the top three companies' share exceeds 70% (indescending order): tobacco, umami condiments, liquid clothing detergent, babydiapers, feminine care, powder clothing detergent, beer, alcohol-free beer, lowmalt/new genre, instant noodles (pillow bag), instant cup noodles, sweet buns,lactobacillus beverages, female colored cosmetics, and bread. Price trends for each ofthese are as follows.

Rising product ASPs: Five categories, namely liquid clothing detergent, baby diapers,alcohol-free beer, instant noodles (pillow bag) and lactobacillus drinks.

Flat product ASPs: Four categories, namely tobacco, beer, low malt/new genre, andfemale colored cosmetics.


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Falling product ASPs: Six categories, namely umami condiments, feminine care, powder clothing detergent, instant cup noodles, sweet buns, and bread.

Product categories with fairly low degree of dominance butstable ASPsThe only category with a fairly low degree of dominance but rising ASPs isshampoo, with the top three companies occupying an aggregate 52.2% of the market(Kao 22.0%, P&G 18.4%, Shiseido 11.8%) and even the top four companiesaccounting for 63.1% (the above three plus Unilever's 10.9%). Soft drink ASPs areflat, but the top three have only 58.5% of the market (based on Inryou Souken datafor FY2012). In the ham & bacon and sausage markets, PB weightings arecomparatively high, as stated, but product ASPs are stable. Female colored cosmeticsand soy sauce tend to be stable as well. One category in which the top three firms'aggregate share of 69.6% gives a relatively high degree of dominance but moderatelyfalling ASPs is curry.

Categories in which ASPs continue to fallAlthough there is some overlap with the above categories, ASPs are declining in ninecategories: curry, loaf bread, sweet buns, prepared bread, instant cup noodles,

powder clothing detergent, umami condiments, feminine care, and frozen foods.P&G's low-priced strategy has affected powder clothing detergent, having a markedimpact in JanuaryMarch 2013, but Kao's new product, Attack Funmatsu Tsumekae,launched thereafter appears to have checked the decline in ASPs. This consumer-friendly new product is sold in an innovative package that took six years to develop.

As the change in Kao's ASP precipitated by the launch of a new value-added productshows, we believe the market leader's pricing strategy has a major impact on productcategories that are dominated by a few players.

House Foods has top share for curry (46.5%), but it pursues a low-priced strategy.

In response to the average 9.7% increase in the government's selling price ofimported wheat in the April 2013 revision, Yamazaki Baking increased its own pricefor July 1 shipments of loaf bread by 36% and sweet buns by 26%, but this wassimply in response to the increase in its wheat costs, and the company plans torespond to the higher cost of other raw materials such as oils and sugar by changing

product specifications and cost-cutting. Despite strategically cutting its ASP, it wasunable to secure corresponding volumes, and 1H operating profit fell 24%.

The price downtrend in the instant cup noodle segment is being affected by risingdemand for value-added non-fried bagged noodles, and we think company marketingstrategies are probably focusing on the latter. Cup noodles and bagged noodles areeaten in differing circumstances, but innovations in bagged noodles engenderconsiderable surprise, while it looks as though cup noodles are fairly steady. If the

price band at which consumers regard NBs as value-for-money is coming down,there is the a that price hikes associated with the increase in the consumption tax willinflict a painful decline in volume.

Figure 28: Industry ASP forPowder Clothing DetergentMonthly Trend

Source: Nikkei POS

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Figure 29: Degree of Dominance for Top Three Companies in Each Category and ASP Trends% of PB

(%)Share by Top 3

(%)ASP Trends by Trend line

Liquid Clothing Detergent 3.4 92.6 UptrendBaby diaper 5.0 90.6 Uptrend

Alcohol-Free Beer 5.7 82.6 UptrendInstant Noodles (pillow bag) 5.6 78.7 UptrendLactobacillus Beverage 6.3 71.4 UptrendTobacco 0.0 99.4 Flat ABeer 1.2 86.0 Flat ALow Malt + New Genre 6.8 79.5 Flat AFemale Colored Cosmetics 0.5 71.1 Flat AUmami Condiment 1.1 98.2 Downtrend BFeminine care 0.0 88.2 Downtrend BPowder Clothing Detergent 9.3 87.9 Downtrend BInstant Noodles (cup) 7.0 77.7 Downtrend BSweet bun 2.4 73.1 Downtrend BBread 12.7 70.5 Downtrend BShampoo 2.1 52.2 UptrendFemale Basic Skin Care 1.1 69.8 Flat CSoy Sauce 7.6 64.6 Flat CSausage 11.6 59.7 Flat CSoft Drinks 2.6 58.5 Flat CCurry 4.1 69.6 DowntrendHam & Bacon 23.7 43.0 FlatPrepared bread 7.2 46.4 DowntrendFrozen Food 13.9 33.9 Downtrend

Source: Nikkei POS as of July 2013 andJ.P. MorganNote: A, B and C refer to Figure 30.

Figure 30: Degree of Dominance for Top Three Companies in Each Category and ASP Trends(Image Chart)

Source: Nikkei POS andJ.P. MorganNote: Category A: Beer, Low Malt + New Genre and Female Colored Cosmetics. Category B: Umami Condiment,Feminine care, Powder Clothing Detergent, Instant Noodles (cup), Sweet bunand Bread. Category C: Female Basic Skin Care, SoySauce, Sausageand Soft Drinks.

Price

Price

Share Share

BabyDiaper

LiquidClothing Detergent AlcFree Beer

Instant Noodle (pillow bag)

A

B

Lactobacillus Beverage

C

Prepared Bread,Frozen Foods

Shampoo

Curry

Ham & Bacon


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[email protected]

Manufacturers control over pricing

redefinedHitherto our assessment of manufacturers' control over pricing has been limited totheir ability to maintain margins in response to changing market conditionsin otherwords, their ability to transfer higher input costs into product prices. However, wethink an era has begun in it which it will be increasingly important to align product

presentation more closely with consumer needs, such as by changing container sizesand offering more user-friendly packaging, in light of falling price elasticity evidentin fledgling changes in consumer purchasing behavior and the growing preferencefor products packaged in sizes that leave no waste out of environmental concerns.

On the assumption that greater freedom to set prices will naturally lead to a change incorporate strategies, we examine conditions for firms to break ranks from standard

strategies that have brought uniform pricingin the form of rock-bottom prices and to avoid commoditization. We highlight new pricing strategies designed tomaximize margins by leveraging diversification in prices, and we change ourunderstanding of "control over pricing" from "the ability to transfer higher inputcosts through to pricing" with "the ability to control volume through flexible

pricing."

Price diversity, importance of categoryshareConsumers and the retail sector are impressed by innovation. The best business casefor manufacturers is when they create new value that has not existed before.

However, we believe this kind of innovation occurs at the time of generationalchanges in products and technology, taking place on a very long cycle. For example,it was 1999 when Microsofts market cap posted its sharpest growth, and it then took14 years before Apple's market cap peaked out in 2013. If Windows is appraised interms of growth in market share resulting from the broad applicability of itstechnology rather than any change through genuine innovation, then perhaps we haveto go back to the invention of the printing press to find the last technologicalinnovation before Apple. Although it takes time to implement genuine innovation,competition between companies furthers efforts toward creating technologicalreform, shortening product lifecycles. Products for which technological innovationleads directly to lower prices react as if they are commodity items, a far cry fromhow branded products react to prices.

Fortunately, in the consumer staples sector the pace of technological reform is slow,and both technological advances and new product development are leading to a betterASP mix. Innovation in this sector for food and drink consists of offering newflavors and fresh value (time-saving, diet). For toiletries it involves repositioning byrevamping daily products to suit the times, and developing human healthcare

products for an aging society.

In mature, inflationary nations in which consumer selectivity is already well-tempered, prices have to convincingly reflect value. We think the aim ofmanufacturers' product development will evolve into a drive to evoke both passionand empathy.

Figure 31: Market Cap Trends forMicrosoft and Apple

$ billion

Source: Bloomberg

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Long-lasting first-comer benefits for firms with high shareOn the other hand, in the food and HPC sector, technological innovation progressesslowly, so first-comer benefits last a long time. Product categories in whichtechnological innovation has not taken shape are a goldmine for companies with highmarket shares. Kao CEO Michitaka Sawada said (when talking about Kao's ironingstarch brand Keeping) that revamping even brands in low-growth markets to alignthem with the times changed their relative positioning.

We estimate that Kao has a share of more than 80% in this category. There is nogrowth in the market, so product development has low priority. However, ironingstarch is a daily essential, and demand for a product that satisfies the concept ofsmartening up the appearance of clothing is likely to persist, even in a hundred years'time. In this case, Kao is likely to stimulate the market through innovation, and thenreap the benefits as the company with top market share. We also envisage increasesin ASPs corresponding to value-added as product upgrades are added. We estimate

that a scenario of rising ASPs would substantially lift Kao's margins, with its highmarket share for daily essentials.

Opportunities to win market share through technologicalinnovation in mature marketsOn the other hand, one example of a turnaround in a similarly low-growth productthat does not lend itself to innovation is instant bagged noodles. In 2012 Toyo Suisanlaunched Maruchan Seimen non-fried instant bagged noodles. This created value-added inherent in the taste sensation of fresh noodles combined with reducedcalories, thereby breathing fresh life into the bagged noodle market. Toyo Suisan'sshare of the bagged noodle market was very low, and it thus played second fiddle tomarket leader Nissin Foods. However, the fact that its share was low to start withmeant it did not cannibalize the market for its own products, and the company thusachieved net growth.

Supply was unable to keep up with demand, leaving some shortages, so categoryASPs had been rising, but a fierce onslaught by Nissin Foods and increased

production capacity have given both companies capacity for about 300 millionservings. Although ASPs turned down to some extent from August, they haverecently shown a recovery trend. Current store prices stand at about 350 for a five-serving pack, but bargain sale prices could become established at 298, in our view.On the other hand, the impact on cup noodle demand of the perceived value-for-money in bagged noodles is a point of concern. Average industry cup noodle pricesare below 105 but remain above 100, though consumers are used to perceivedvalue-for-money, and we will need to keep a close eye on how they react to highercup noodle ASPs as bagged noodle promotions gear up.

Signs of a spread in format managementManufacturers scrap campaigns driven by larger quantities, showing efficacy isrecedingOne regular, established way of making products look good value for money withoutlowering prices has been through sales of products in larger sizes, but a growingnumber of food manufacturers are scrapping these. The appeal of buying products inlarger quantities has receded, compounding the issues of higher raw material costsresulting from rising market prices and the weaker yen. Although the number of

people per household is in decline, the number of households is growing. We believe

Figure 32: Industry ASP WeeklyTrend for Instant Noodles (PillowBag)

Source: Nikkei POS

180

185

190

195

200

205

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215

5 / 1 2

5 / 1 9

5 / 2 6 6 /

2 6 / 9

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4 8 / 1 1

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Industry Average


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that the focus will need to be more on portraying value-for-money through qualityrather than quantity when seeking to capture senior demand.

Kewpie hikes mayonnaise ASPs per gram by changing container sizeOne leading example of an overwhelming market share in Japan's food industry ismayonnaise, in which market leader Kewpie (66.0% market share) announced achange in the size of its mayonnaise containers for the first time in 50 years. Itannounced a switch from the 500g mayonnaise containers that had been on sale foraround 50 years (since March 1964) to 450g. The manufacturer recommends usingthe product within 30 days of opening to maintain the flavor, but it took an averageof around 34 days to use up each bottle in 2012, so the company decided to change toan appropriate container size.

The smaller container meant packaging materials account for a higher proportion ofcosts, thus leading to an increase in ASP per gram. The recommended retail price forthe 500g bottle is 382 excluding consumption tax, or 0.76 per gram. The retail

price for the 450g bottle is 350, which seems less expensive than the 500g unit, butASP per gram of 0.78 on the former is 2.6% higher than on the latter. The retail

price of a 350g container is 294, or 0.84 per gram, putting the ASP per gram10.5% higher than for the 500g bottle and 7.7% higher than for the 450g container.

Drinks companies trial price hikes at some vending machinesThe vending machine channel faces both upside potential and downside risk fromhigher consumption tax rates, and major beverage companies that use this as theirmain channel are experimenting with various pricing strategies in some machinesand in some regions, such as selling 130 canned coffee. Suntory Beverage & Food'sSenior Managing Director Shinichiro Hizuka said at the results briefing that it wastrialing price changes. We think this is mainly to pin down price elasticity. AlthoughJapan's food and beverage manufacturers are not used to raising prices, we think thatthey will be able to run more flexible pricing strategies and efficiently deploy

promotional expenses once they have accumulated trial data on price elasticity bycategory. The broad picture overlaps with that of JT three years ago, before itexperienced large-scale price revisions.

Categories in which domestic and overseas price gapssuggest scope for big price hikesComparing consumer staple prices between the mature developed nations ofEurope/the US and Japan reveals big gaps between domestic and overseas prices inthe following categories (Figures 34-36). There are differentials of 2-3x in areas suchcigarettes and laundry detergent.

Figure 34: Price of Cigarettes (20 sticks)

Source: Euromonitor as of Jan. 2013

Figure 35: Price of Concentrated LiquidDetergents

Source: Euromonitor as of Sep. 2012

Figure 36: Price of Bread

Source: Euromonitor as of June2012

0200400600800

1,0001,200

US UK Japan0

50

100

150

UK US Japan0

20

40

60

80

US Japan UK

Figure 33: Kewpie MayonnaiseCorrelation b/w Size and Price

per gram

Source: Company dataNote: Permission for use granted.


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[email protected]

Investment ideasLooking at near-term implications of the consumption tax hike for the food, beverageand tobacco sector, one possible scenario is the negative one of an increased burdenon consumers diminishing purchasing power, but over the medium term we think areduction in corporate tax can feed through to higher wages, improved employment,and rising capital expenditure, and this would be positive if the propensity toconsume were also to improve.

We believe the change in how labels display in-store prices implemented alongsidethe consumption tax hike will allow manufacturers to strategically diversify pricesaway from ranges that have become ossified under tax-inclusive sticker prices duringthe long period of deflation. Companies capable of leveraging such advantages haveto have high category market shares as a basic prerequisite, and we think differencesin perceived share will open up the gap between individual firms.

JT (2914, Overweight): Strongest control over pricing indomestic sectors, upgrading Mevius to premium statusOur top pick in Japan's food, drink, and tobacco sector from a global perspective isthe tobacco industryin other words, JTwhich has the greatest control over

pricing of all the sub-sectors. JT changed its long-selling Mild Seven line into theMevius brand in a successful global rebranding operation rarely seen evenworldwide. Its share of the Japanese market continues to rise thanks to the change inthe brand, and we believe we can look for JT to exercise its ability to set pricescommensurate with value, regardless of the consumption tax hike.

There are no particularly conspicuous incentives surrounding earnings in this period

after 1Q results, while the yen has firmed, and JT has underperformed TOPIX, butwe regard this as an attractive entry level. JT is the only company in Japan'sconsumer sector to use IFRS, while its FY2014 P/E of 11.4x, EV/EBITDA of 7.0x,FCF yield of 7.2%, and dividend yield of 4.0% are at discounts of 21%, 35%, and13%, respectively, to the global averages, whereas its dividend yield of 3.9% is 13%

below the global average based on the August 20 share price.

JT has a highly competitive portfolio that allows it to capture both trading down indeveloped nations and trading up in emerging economies. Thus, although itmaintains the highest double-digit EBITDA growth rate worldwide, we believe that astaged increase in its payout ratio will generate a dividend growth rate in excess of30% over the coming three years through FY2015. We believe that JT's dividendgrowth and improving dividend yield will help push up valuations, but this is not yet

factored into the share price.

Suntory Beverage & Food (2587, Overweight): Record ofcreating brand value and broadening format managementSuntory Beverage & Food started up its soft drinks business from scratch and hasestablished itself in the No. 2 spot in the industry by creating strong second-placed

brands. The nature of the soft drinks business means that utilitarian thirst-quenchingdrinks and indulgence drinks are sold differently, but the company has a record ofexpanding the scale of sales through the virtuous circle of using high brand shareswon through small-volume containers to effectively promote sales of drinks in larger


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packages. The company flexibly changes ASPs by selling the same drinks indifferent sizes, and has managed to develop mega-brands in this way.

It has a record of not merely transferring costs into prices but also of seeking tomaximize margins by setting different prices according to the container size. This ishow we interpret President Nobuhiro Torii's comment that "you sometimes have tosell cheaply to build up a brand." It was talks with SBF that gave us the opportunityto review our definition of control over pricing as the ability to control salesvolumes.

The company acquired Orangina in 2009 and is currently running a strategy of liftingASPs per milliliter by playing on a perceived sense of value through small-size

packaging in the European market, where there are concerns over momentum inconsumption. It has created a group-wide environment conducive to using itsexpertise and experience to set ASPs commensurate with brand value and to operatean active pricing strategy, even in challenging business conditions in mature markets.

Kao (4452, Overweight): Benefits from high category marketsharesConsumer staple companies' operating profit margins can be broadly explained bycategory market shares, in our view. Kao's market shares in its major productcategories range from around 30% to over 60%. Its domestic consumer segment'soperating profit margin is nearly 12%, while we put Kanebo Cosmetics' EBIT ratioafter adjusting for goodwill amortization expenses at about 15%, but we think marginimprovement of about 5ppt will not be too hard to achieve when prices are rising.

Figure 37: Category Share and EBITA/OP MarginEBITA/OP Margin, %

Category share, %Source: Company data and Nikkei POSNote: Category share by Nikkei POS as of July 2013.

Skin care / Coloredcosmetics

ShampooLiquid detergent Powdery

detergent

Feminine care Baby diaper

0.0

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10.0

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20.0

25.0

0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0


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Retail Sector

With inflation ticking up, retailers mustdeliver added value aside from pricing! Regarding retail prices, we believe deflation has ended and we are now entering

a period of moderate price inflation. Based on our bottom-up research, we believe it is premature to expect a paradigm shift to a sustained period of 2%inflation. However, we believe the 15-year cycle of deflation is over and pricesare finally poised to trend upward moderately.

! The longer-term outlook for retail prices and retailer sales, including after the

proposed consumption tax hike in 2014, varies considerably depending on targetcustomers, types of products sold, and business strategy. On the demand side,we currently forecast (1) relatively strong consumption by lower incomehouseholds thanks to government policy measures (aggressive publicinvestment, temporary benefits, and income subsidies), and (2) continued briskdemand among wealthier households thanks to the impact of unprecedentedmonetary easing on asset values (wealth effect). However, we do not expectconsumption by middle-income households, the largest market segment, torecover in earnest until after the income environment improves and theconsumption tax hike as taken effectfrom around mid-2014 at the earliest.

! Regarding the supply side, we expect the market to become an increasinglycrowded red ocean, as rising input costs, consumption tax hikes, and industry

reorganization (greater emphasis on profitability) drive stiffer competition tooffer the same quality at a lower price. Accordingly, we believe (1) smallerretailers will continue to lose market share, and (2) larger, more competitiveretailers with robust systems and scale will become even more dominant.Assuming an environment of moderate price inflation, we think the keys to stockselection are structure and capability to deliver satisfaction and added value toconsumers beyond just lower prices for the same level of quality.

! The sub-sectors (and stocks) we favor, assuming a sustained uptrend in retail prices, include the major convenience store chains (Seven & i Holdings,FamilyMart), which dominate in terms of store convenience and merchandising;major SPA retailers (Ryohin Keikaku, ABC-Mart, Point), which haveestablished clear competitive superiority through differentiation; and discount

chains such as Don Quijote, which boasts unique store management andmerchandising strategies. Conversely, we think the business environment will become increasingly challenging for smaller GMS and supermarket chains, aswell as smaller home centers, drugstores, and CVS chains that have failed toadequately differentiate themselves.

Dairo Murata(81-3) 6736-8620

[email protected] JPMA MURATA


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Unit prices already rising even in consumer electricssegment, a key driver of deflation

Nitori, a quintessential low-price manufacturer/retailer, is successfully increasing its per-customer sales by strengthening its lineup of slightly higher-end merchandise(Appendix Figure 114). Per-customer sales are even rebounding in the homeelectronics segment, which is widely viewed as one of the main drivers of pricedeflation in Japan.

At Ks Holdings, per-customer sales had been declining steadily since 2009, but theystarted rising again from February 2013 and the company says they are still trendingupward. In this particular segment, the drop in per-customer sales owed in large partto TV prices, but TV prices have stabilized over the last six months or so and arecurrently up at least 10% YoY (Figure 40).

Figure 40: Sustained Growth in Ks Holdings Same-store Sales per Customer from 2013YoY%

Source: Company data, J.P. MorganNote: 3-month MA for customer traffic

Trends in apparel segment vary based on companystrategyA notable exception to the environment described above is the apparel segment. Insome cases per-customer sales at clothing retailers are still declining due to factorsspecific to the individual company. A good example is domestic Uniqlo stores,where per-customer sales continue to decline because (1) relatively inexpensive

bottoms (leggings, etc.) are accounting for a growing share of overall sales, and (2)Uniqlo increased the number of weekend sale days (since Oct 2012). On the otherhand, customer traffic has improved considerably.

At Ryohin Keikaku, food sales are currently solid, and at Point, per-customer salesare declining because cut & sew items are accounting for a larger share of total sales.However, because these retailers are not intentionally pursuing low-price strategies,we look for their per-customer sales to start improving moderately from this autumn.

-30.0%

-25.0%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

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-50.0%

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1 3 / 0 2

1 3 / 0 4

1 3 / 0 6

Sales per customer (LHS) Customer traffic (RHS)


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[email protected]

Reasons for disparity between macro and micro conditionsTo summarize, the macro CPI trend basically conforms with the trend in listedretailers sales data, but in certain product segments there is some disparity. Weattribute this to (1) factors specific to the individual companies; (2) the impact of

players other than the major listed retailers (unlisted firms, smaller listed firms, etc.);and (3) differences in pricing definitions (e.g., with respect to home electronics, theMinistry of Internal Affairs and Communications uses a quality standard andtherefore determines that prices have declined in the event that technologyimprovements result in a lower price.

Current mood and pricing policies of majorretailers

Some retailers are turning bullish on the prospects forsustained inflationIn our discussions with listed retailers, we heard comments indicative of a bullishoutlook on prices along with comments suggesting the opposite. At this point it isstill a minority of major retailing firms that, based on a top-down approach, believeJapan has entered a long-term period of sustained inflation and are implementingappropriate countermeasures. It is our impression that opinions vary depending onlocation, type of merchandise, and managements attitude. The following are some ofthe comments we have heard from major retailers that sound bullish on the prospectsfor sustained inflation.

! Thanks to rising stock prices and the resulting improvements in asset values and

consumer confidence, sales of luxury brands, jewelry, watches, and other high- priced items are strong. We hiked prices for several luxury brands by over 10%due to the weaker yen, but sales volumes are still increasing. (Major departmentstore)

! Instead of the lowest priced option, consumers are increasingly opting for aslightly more expensive but better product within the same category (includingshampoo, toothpaste, food items, etc.) (Major discount retailer)

! Price is an element of added value. When competitors are selling the same products, we must be conscious of market pricing. However, we are not trying to be the low-price leader. We want to minimize the price factor by increasingadded value in other ways. (Major convenience store chain)

Among retailers that have benefited from deflation,managements mindset will have to changeOn the other hand, some retailers remain skeptical about the prospects for sustainedinflation. Most of Japans major listed retailers have benefited from deflation andhave grown their market shares over the past 15 years. For many firms, higher pricestend to reduce customer traffic, so they resist price hikes. In fact, the term pricehike is virtually taboo, and thus the prevailing view seems to one of skepticismabout the possibility of sustained inflation. We believe this management mindset willhave to change in order for a healthy rate of inflation to take hold in Japan. Thefollowing are some of the more skeptical comments we heard.


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[email protected]

! With respect to womens apparel, sales to middle-income and upper-middle-income consumers are not recovering noticeably. This is probably because

salaries are not rising. (Major department store)! We try to project a price image to consumers, and as a company we never

announce price hikes. Consumers are extremely selective and price-sensitive,which makes it difficult to raise the price of an identical item. We can, however,lift price points by introducing new products with better features or improvedquality. (Major clothing retailer)

! Some other firms are raising prices due to the weak yen, but it is our policy tonot raise prices. We will not pass the consumption tax increase along to ourcustomers. In our view, low price is one of the valuable services we offer ourcustomers. The weak yen and pending consumption tax hike make for achallenging environment, but we actually consider this an opportunity to work

together to improve our company in areas like raw materials and productdevelopment. (Major furniture and interior goods retailer)

! We researched ret

japan macro plus 1

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