Cargo-Cult Companies - Japan's 2Q Duponts

The MOF's 2Q survey of private sector balance sheets and p&ls reveals this: more than ever before, corporate Japan's ROE depends only on the ability to source supplies cheaply, and there is little sign it wishes to change this business model or expand its reach. It is a cargo-cult approach, in which all depends on the vale of what washes up on Japan's shores.

On the downside, this confirms that Abenomics' hoped-for rejuvenation of the Japanese economy is nowhere to be seen. On the upside, in the short term, a devaluation of the Rmb will probably aid Japanese profits, rather than erode them as I initially thought.

The 2Q private survey presents a picture of extremes:

• the highest operating margins since my data starts in 1980; 
• the lowest asset turns since my data starts in 1980; 
• the lowest financial leverage since my data starts in 1980. 

At the moment, the gains in operating margins trump all else, raising ROE to 10.4% (just below the post-200 average) and ROA to 3.9% (1SD above the post-2000 average). So it is probably no surprise that as the key ratios which determine return on equity scale off in both directions to to previously unseen extremes, there is no sign of any change whatsoever in corporate behaviour.

And what does it all add up to? Operating profits growth running at just 7% yoy on a 12m basis, and investment in plant and equipment up just 5.5%, only just enough to cover the depreciation allowances claimed.

In 2Q sales rose 1.1% yoy (1.4% 12ma) whilst operating profits jumped 20.5% yoy (7.4% 12ma), and as a result, margins rose to 4.81% (vs 4.52% in 1Q), and 4.3% on 12m. These are the fattest operating margins for Japan since my data begins in 1980.

The reason for the rise in margins is simply an improvement in corporate terms of trade, with the cost of goods sold ratio falling 0.9pps qoq to 76.4%, the lowest since at least 1980 (although on a 12m basis, the 77.3% ratio was matched in 2Q11). There is no further improvement in SG&A /Sales, with the ratio rising slightly to 18.8% (vs 18.2% in 1Q and 18.7% in 2Q14). And there was practically no further improvement in the sales/expenses per employee ratio, as sales per employee fell 3.1% yoy whilst expenses per employee fell 3.4% yoy. 

Both asset turns and financial leverage continue to decline to new lows. Total assets rose 5.2% yoy and 5.9% 12ma whilst sales rose 1.1% yoy and 1.4% on a 12ma, so annualized asset turns fell to 0.87, from 0.95 in 1Q and 0.91 in 2Q14. On a 12m basis, asset turns fall to 0.906x, the lowest since 1980s.

Whilst total assets rose 5.2% yoy in 2Q, shareholders’ net worth rose 6.5% yoy, so financial leverage fell to 2.63, or 2.66x on a 12m basis: again, the lowest since 1980 at least. The cash portion of that net worth continues to rise, up 8.6% yoy in 2Q, equivalent to 11.4% of total assets, or 11.3% on a 12 basis - the highest proportion since 1992 in the immediate aftermath of the zaiteku financing bubble years.  Those cash holdings strip 4.5 percentage points from return on equity, cutting it to 10.4% from the ex-cash ratio of 14.9%.