Japan 1Q Duponts: What's Changing, What's Not

The easiest bull argument to make for Japan in the Abenomics era has been that if the economy can generate some nominal topline growth, whether achieved by currency depreciation or by a successfully aggressive monetary policy, or simply by overturning deeply ingrained deflationary expectations, then the resulting rise in asset turns would power a spectacular rise in return on capital.

The MOF's quarterly survey of private sector balance sheets and p&ls shows  accelerating topline gains and also sharp upturns in ROE and ROA, but for not for the reasons expected. Topline gains there have been – sales rose 5.6% yoy in 1Q - but corporate Japan's response has been to prioritize continued deleveraging over re-investment, and to focus profits-generating efforts on wage control.

Investment in plant and equipment rose 7.4% yoy, a sharper rise than expected, and the strongest since 2Q12. However, in absolute terms, the Y12.231tr spent on plant and equipment was rather less than the Y14.485tr fall in net debt during the same period, and only slightly more than the Y10.569tr in depreciation expenses. Whilst the rise in investment spending is of course to be welcomed, it is probably not the turning point in corporate behaviour which Abenomics is looking for.

Gains are certainly being made in ROE & ROA: operating profits rose 18.8% yoy whilst net worth rose only 4.3%,  which pushed ROE for the quarter reached 3%, the highest it has been since 1Q08.  Similarly, with total assets rising only 1.8% yoy, it was the strongest quarter for ROA since 1Q07, and the best on a 12m basis since mid-2008.

At the core of this was an improvement in operating margins: sales rose 5.6% yoy whilst operating profits rose 28.8%, which pushed OPM to 4.5%, the highest since the bubble years, with the 12m rise similarly spectacular.

How did it  happen? On a 12m basis, OPM rose 68bps yoy to 3.98%. This happened despite cost of goods sold actually rising by 7bps during the same time: the whole of this was counteracted by a 75bp fall in SG&A.  And drilling down further, the whole of that was accounted for by a 79bp fall in personnel expenses/sales to 12.6%. 

Essentially it boils down to this: on a 12m basis, sales per employee rose 7.2% yoy 12ma, whilst total expenses per employee rose only 5.5%. This took the multiple of sales/expenses per employee to 7.94x in 1Q14, and to 7.71x on a 12m basis.  As the chart shows, this multiple is still below its pre-crisis peak, and we should expect corporate Japan to continue to strive to raise this ratio, even if this means that wage growth is suppressed beneath inflation rates. 

The rise in sales also lifted asset turns (sales/assets) mildly, but at only 0.952x this remains extremely low by any standards, including Japan's own recent history – the average since 2000 is 1.03x.   Balance sheet management remains remarkably conservative, with financial leverage falling to a new low of 2.7x, with net debt falling 2.6% yoy, and net debt/equity falling to a new low of 55.2%. There is no sign of any change in this aspect of corporate behaviour.