Japan's Noble Management

Every quarter Japan's MOF conducts a massive survey of private sector balance sheets and p&ls, collecting data from just over a million firms, large and small. This is closest anyone can get to seeing how Japan's economy really works in near real-time. It's doubly interesting right now because this is the quarter in Japan came face to face with the multiple disasters which followed the March 11 earthquake.

What's grabbed the headlines was a 7.8% YoY decline in capital spending during the quarter, which for some reason took Japan's economists by surprise. But forget that for a moment, because the survey tells us some other things about Japan, some of which are surprising in the best possible ways.

The first thing I do with these figures is look at what happened to corporate Japan's Dupont ratios. You know straight off these are going to be pretty nasty, given that the knock-out blow to the supply-side of Japan's economy pushed sales down 11.6% YoY during the quarter. Still, here's what happened:

1. Margins (operating profit/sales) fell from 3.31% in 1Q to 2.85% in 2Q. That compares with an average of 3.1% since 2000, and a reading of 3.27% in 1Q10. It's not even half a standard deviation below the long-term average.
   The details are surprising – uplifting even. There was no deterioration at all in the Cost of Goods/Sales ratio, which remained static at 77.3% - seemingly no profiteering at a time of colossal disruption and supply-pressure. The entire 46bp margin deterioration was owing to a rise in SG&A expenses (19.9%). And of that, there was a 117bp rise in total total personnel expenses/sales, offset by a 72bp fall in SG&A ex-labour costs.
   If we cut the jargon for a moment, this tells us that in the face of cruel disaster, Japanese management kept hold of its workers, and cut its own expenses in order to offset the cost of that benign policy. I think the word for that is 'noble'. More, management did it whilst maintaining margins with half a standard deviation of the long term average. The word for that is 'efficient'.

2. Annualized asset turns (sales/total assets) fell to 0.92 in 2Q, compared with 1.01 in 1Q and an average since 2000 of 1.05. This was, in fact, nearly three standard deviations below the long-term average. This is where the full impact of the disruption was taken – unavoidably.
   
   
3. Leverage (total assets/equity). Given that capital destruction fell on this economy in the most dramatic possible way, this is perhaps a little surprising. Total assets fell by Y50.8 trillion, and net worth fell by Y23.8 trillion – more total assets were destroyed than equity. So given a starting financial leverage ratio of 2.71X the net result was that Japan's financial leverage continued to fall, very marginally. If you want a more direct measurement, net debt fell by Y2.5 trillion QoQ, and net debt/equity picked up very slightly, to 63.8% from 1Q's 62.2%. The scale of this up-tick is barely distinguishable from the normal seasonal patterns.

In short, the interruption in supply-chains killed asset turns, but the impact on margins and leverage habits was far less pronounced than one would have expected.

All of which would tend to imply that the impact on corporate cashflows from this disaster were relatively modest. And that seems to be right. Japan's corporate cashflow is always significantly lumpy, but using a proxy of investment outlays + change in net debt suggests corporate cashflows came in around Y10.2 trillion in 2Q. This which was down from Y15.4 trillion in 1Q, but up from the Y3.3 trillion of 2Q10.

When we look at the secondary indicators of cashflow, the news is the same: there was no self-destructive rush to cut credit to the rest of the economy in order to bolster corporate cash coffers. Yes, accounts receivable fell by Y18.2 trillion during the quarter, but then sales fell by Y28.6 trillion – so accounts receivable as a percentage of sales was static (at 0.671). Meanwhile, inventories actually rose by Y2 trillion. If one looks at the combination of inventories and accounts receivable as a percentage of sales, as being an indicator of corporate Japan's extension of credit to the economy, it actually rose modestly during the quarter.

I don't want to over-react, and many words have already been written about the marvel of Japan's social cohesion in the face of disaster. What this quarterly survey illustrates is the role Japan's corporate managers in demonstrating and reinforcing that social cohesion under difficult circumstances. I believe that social cohesion is a form of capital (if you doubt it, consider how much capital was destroyed during London's riots). If so, although corporate Japan's investment in plant and equipment may have fallen 7.8% YoY during 2Q, in the long run, there was plenty of investment made during the quarter.