Tuesday, 5 March 2013

Japan's Deflationary Coils: What The Duponts Say

The compilation of quarterly balance sheets and p&ls by Japan's Ministry of Finance is one of the great statistical wonders of the world. It allows a fairly complete Dupont and cashflow analysis of the private sector, and by doing so allows us a deeper understanding of the pressures on corporate Japan, and the policy options being contemplated in response.

For 2012, the picture is surprisingly stable, but in a bad way: managements can and do attempt to extricate their companies from a vicious spiral, and we can track and admire their efforts. But with no topline growth - sales fell 2.9% in 2012 - the odds stacked against them are formidable, and their struggles end up tightening Japan's deflationary coils.  In the end, the decision to cut spending on plant and equipment (down 8.7% yoy in 4Q) is inevitable,  inexorable and politically intolerable. Hence the desperate hopes resting on Abe-nomics.

Dupont Analysis
Let's look closely at how corporate Japan managed in 2012, and start with the assumption that managers in Japan have as one of their main goals the preservation or raising of RoE and RoA. First, we can tell that 2012 was a year in which they almost achieved a stabilization in both: operating profits/shareholders equity (RoE for these purposes) averaged 8.8% in 2012, up slightly from the 8.6% achieved in 2011. Return on assets (RoA) also rose to 3.1% from 3.01% in 2011. In both cases, this is essentially a stabilization at historically low levels.

How was it achieved?  We can use Dupont analysis to tease it out, since changes in RoE can be made only through changes in asset turns (sales/total assets), financial leverage (total assets/shareholders equity), operating margins (operating profits/sales) or through changes in the tax burden.

Asset turns: Can't Shrink the Balance Sheet Fast Enough
The problem presents itself immediately, with sales falling 2.9% yoy in 2012, any attempt to preserve or raise RoE must start with an attempt to shrink the balance sheet in order to raise asset turns. And the attempt was made: by 4Q total assets had indeed been cut by precisely 2.9%, but on average the fall was only 1.8% - balance sheet cutting couldn't keep pace with the contraction of the top line.

This was the sharpest shedding of assets since 2002, but was nonetheless not enough: asset turns fell to 0.961 in 2012 from 0.972 in 2011, and on a 12 basis, 4Q was the fourth lowest asset turns in Japan's recent financial history, rivalled only by the depths reached in 2009.

But what can you do about the balance sheet?
On the liabilities side, it is bloated with cash on hand, which rose to 10.8% of total assets (from 10.7% in 2011), and was steady at 1.3 months of sales sales.
On the asset side, the intent to shrink the balance sheet led to a 3.7% yoy fall in inventories, and a 7% yoy fall in accounts receivable. In other words, it is stripping corporate credit out of an economy which for decades now has been without a functioning banking system.

Let's put that  into context, the fall in A/R and inventories amounted to Y16.74trillion in 2012, whilst the total increase in bank lending to the corporate sector rose only Y13.45 trillion in the same period, and total bank lending rose only Y5.47 trillion. In other words, the corporate imperative of shrinking balance sheets in order to raise asset turns is sufficiently large to deflate the entire economy.  And so, topline sales continue to shrink . . . 
Leverage: Shrinking Balance Sheet = More Cash = Deleveraging
Cutting leverage is the natural and automatic partner of trimming the balance sheet in the short term (unless shareholders' equity can be reduced by buying back and cancelling issued equity). And so financial leverage fell further, at a very slightly accelerated pace: total assets averaged down 1.8%, but equity fell only 0.5%, so leverage fell to 2.82 in 2012 from 2.86 in 2011.

You get the same conclusions looking at net debt/equity: net debt fell 5.1% yoy, and net DER fell to 62.3% by year-end, from 65.8% at end-2011. 

Margins: The Only Factor Doing the Lifting 
With asset turns and leverage both falling, any attempt to rescue RoE comes to rest solely on an ability to raise margins. And, actually rather remarkably, that's what Japanese management achieved: OPM were stable and average 3.22% for  year, up from 3.09% in 2011 and actually slightly higher than the 3.1% averaged since 2000. 

What's more, this is an achievement won the hard way: the cost of goods sold actually rose 0.1pp to 77.6% during the year, but SG&A ratio came down 20bps yoy to 19.1%, even though personnel expenses actually rose as a % of SG&A. In other words, it was the hardcore central admin costs that did the heavy lifting, falling by 30bps as % of sales. Plainly this is not the sort of thing that happens by accident, or which is achieved by lazy or complacent managements.

Conclusions: More Twists in the Coils

  • As sales fell 2.9% yoy in 2012, Japanese management wrestled hard to maintain ROE and ROA. In some aspects, they met with admirable and surprising success. But it is a battle they must inevitably lose: it was not possible to shrink balance sheets sufficiently quickly to protect asset turns, even though attempts accelerated sharply in 4Q.
  • Morever, whilst the attempt is being made, the net cash generation cut financial leverage ratios, which in turn eroded RoE.
  • It is extremely difficult to boost operating margins sufficiently to offset the negative impact on ROE of falling asset turns and leverage. And despite exemplary control on SG&A, Japan's managements have not pulled this off.
  • But in the meantime, balance-sheet control has stripped out more than three times net credit from their customers, in the form of inventories and accounts receivable, than the banking system managed to extend to the economy.  It these circumstances, it is well-nigh inevitable that domestic sales fell. 
  • This is the very definition of chasing one's own tail, and it is therefore not surprising that although corporate cashflow jumped by 18% yoy in 2012, investment in plant and equipment rose only 0.8%, and fell 8.7% yoy in 4Q.
  • This vicious circle of balance-sheet shrinkage, deleveraging and yet still-falling ROE also explains the urgent appeal of Abe-nomics: topline growth is needed at virtually any cost.   

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