Fund Performance Review
For the month of April, the Hennessy Japan Fund (HJPIX) returned -1.75%, underperforming the Russell Nomura Total Market™ Index which returned -0.95%. The Tokyo Stock Price Index (TOPIX) returned -1.43% for the same period.
Among the best performers were our investments in SoftBank Group Corp., the telecom and internet conglomerate, Mercari, Inc., an operator of “Mercari,” a flea market application having accumulated one hundred million downloads, and Keyence Corporation, the supplier of factory automation related sensors.
Click here for full, standardized Fund performance.
As for the laggards, Recruit Holdings Co., Ltd., Japan’s unique print and online media giant specializing in classified ads as well as providing human resources (HR) services, Sony Corporation, a diversified consumer and professional electronics, gaming, entertainment, and financial services conglomerate, and Nidec Corporation, the world’s leading comprehensive motor manufacturer, detracted from the Fund’s performance.
This month, the share prices of Sony and Nidec, two of the Fund’s biggest holdings, fell at the end of the month. Both companies remain strong businesses and long-term growth prospects remain compelling in our view.
Sony’s share price tanked following the results announcement on a weaker-than-expected fiscal year (FY) 2021 earnings guidance, which calls for a 4% decline in operating profit (OP) for the full year to March 2022. Generally speaking, we are of the view that management guidance should not be relied upon too much. For instance, last year in May, at the FY2019 (ended in Mar 2020) results briefing, Sony management withheld from providing a full-year guidance citing the uncertainties from COVID-19. Then, three months later in August, the company belatedly communicated to the analysts its full-year outlook of OP of JPY 620 billion ($5.85 billion) and profit before tax (PBT) of JPY 685 billion ($6.46 billion), down 27% Year-over-Year (YoY) and 14% YoY, respectively. However, when they released full-year results last month, the actual figures came in at OP JPY 972 bn ($8.94 billion) (+15% YoY), PBT JPY 1,192 bn ($10.96 billion) (+49% YoY), both of which were all-time highs.1
Turning to their FY2021 company guidance, some of the assumptions contributing to the lower profit forecasts include:
• Gaming (PlayStation franchise) revenue growth to decelerate owing to the stay-home consumption trend petering out.
• Cost increases related to the development of in-house video game titles.
• A pullback expected from last year’s monster-hit anime movie “Demon Slayer.”
• Absence of last year’s one-off gain from a partial sale of equity stake in subsidiaries.
• Increased spending in the movies segment with the resumption of movie production post-COVID.
• Delayed profit recovery in the complementary metal-oxide-semiconductor (CMOS) imaging sensor business, which was abruptly hit by the U.S. sanction against the Chinese smartphone maker Huawei last year.
However, there are also positive factors that may not be fully reflected in the guidance. Those include:
• Contrary to management’s assumption, PlayStation’s user engagement is maintaining strong growth.
• The launch of the PlayStation5 console is off to a solid start, and closely tracking the sales trend of the PS4 seven years ago.
• PlayStation Plus subscriber numbers reached 41.5 million as of the end of FY2020 and are still growing.
• Music streaming continues to be growing at a healthy rate.
• The reopening of movie theaters and film production are expected to reaccelerate the top-line growth at Sony Pictures. Sequels to its hit titles like “Peter Rabbit” and “Hotel Transylvania” will be released this year.
In terms of earnings visibility, Sony is in the not-so-easy-to-forecast businesses compared to businesses based on long-term contracts with fixed prices and volumes. Attempting to predict the exact earnings numbers 12 months out for its gaming, music, movies, electronics hardware, semiconductor, and financial services would be a fool’s errand. However, we do believe that the possible range of Sony’s mid- to long-term profits is skewed upward given its attractive business characteristics. To illustrate our point, here are some of the initiatives that are currently underway:
• In addition to the newly launched PS5 console, Sony has been exploring virtual reality (VR) gaming, cloud gaming, and beyond. For example, one differentiating feature of the PlayStation platform from mobile gaming is its immersive experience due to more sophisticated graphics and controller features. New VR functions can take gaming experiences to a whole new level.
• Management continues to strike a number of content deals. Over the last 6 months alone, the company made the following acquisition announcements which will add to its rich content library2:
- Som Livre (a Brazilian independent music label)
- AWAL (an artist support services business)
- American singer-songwriter Paul Simon’s music catalogue
- Crunchroll (a U.S. animation streaming platform)
- EVO (a e-sports tournament organizer)
- Additional investment in Epic Games (a U.S. video game publisher), etc.
• CMOS imaging sensors are expected to open up new applications such as autonomous driving, security camera devices, factory automation, etc. As a dominant market share leader, the company is also working on ways to build recurring revenue streams by combining chip devices with cutting-edge artificial intelligence (AI) software in industrial sensing applications.
• Sony’s expertise in electronics hardware/audiovisual equipment is a major lure for content creators. One example is the Virtual Production Lab, Sony’s innovative movie set equipped with virtual reality technology, which allows for film making in virtual settings, and potentially a great solution in the post COVID era.
We believe the company’s earnings should also be far more resistant to downside risks than in the past. Here is what we wrote in our 2020 February letter:
“ In the annual report, management articulates that the most important area of focus in their current 3-year business plan is to further strengthen its recurring business model to achieve stable revenue and profit base. This strategic decision stems from Sony’s historically volatile business results, in which it had often recorded a sharp decline in earnings the year after setting an all-time record.
There are numerous examples of Sony’s successful business transformation where revenue models are now recurring in nature, the biggest of which is PlayStation Network, the gaming download and network services for the PlayStation business, which accounts for more than 60% of the 2.3 trillion yen ($21.17 billion) segment revenue. Others include subscription-based PlayStation Plus service, royalty revenue from its music catalogue through streaming services, and character intellectual property (IP) revenue derived from its movie library. In the electronics hardware segment, Sony built a similar business model catering to repeat customers. For example, camera users who buy a high-performance mirrorless interchangeable lens camera and specialized lenses can continue to use their lens collection for a new camera body from Sony, ensuring longer-lasting user engagement. Even in the CMOS image sensors semiconductor business, the company is exploring ways to build a recurring revenue stream by combining chip devices with edge AI software in sensing applications for industrial customers. Learning about all of these, we became more optimistic that Sony’s much-improved return on equity (ROE) and its ability to generate free cash flows can be sustained into the future.”
Shares of Nidec also fell sharply after its FY2020 full-year results release. The reasons appear to stem from the following three concerns, all of which we consider as non-material.
1. The global chip shortages are feared to weigh on the current year’s automotive motors business.
2. Its electric vehicle (EV) traction motors revenue still remains small relative to its FY2025 projection.
3. Leadership change announcements fueling speculation that the charismatic founder Shigenobu Nagamori’s retirement date may be drawing near.
On the first point, the recent global semiconductor shortages are causing disruptions to car makers’ production schedules. Chips for use in cutting-edge technologies such as data centers, AI and 5G are gobbling up the worldwide capacity, pushing automotive semiconductors to the back burner. To make matters worse, the recent plant fire accident at Renesas (a leading supplier of power integrated circuits) and the suspension of chip factories in Texas due to the catastrophic power outage amid a cold wave are adding to the problem. Nidec management acknowledged that this would be a headwind for their automotive motor business this year, and the exact timeline for normalization is still unknown (with some forecasts saying up to “a couple of years”). However, we remain optimistic as the bottleneck is being addressed in earnest by various industry players. We are also confident Nidec has a strong balance sheet to manage through this turbulence. For long-term optimists, it presents a window of opportunity to accumulate shares.
On the second point, management may have cooled down investor enthusiasm when they revealed that actual cumulative sales of EVs powered by Nidec’s traction motors only amounts to 130,000 cars to date. However, we should not forget the fact that the EV industry is still in its infancy and an inflection point in demand is only expected to come around 2024-25, by which time the total cost of EV ownership could reach parity with conventional gasoline cars. On a brighter note, management commented that the current order book has already ramped up to 3 million EVs by FY2025, up from 2.5 million communicated previously. Nidec’s strategy is to boost enough capacity before the inflection point is hit. We will discuss later in this letter why we believe in the company’s success in this endeavor.
On the third point, the appointment of Mr. Seki to the top job is an important step towards the eventual succession of leadership. Thus, our impressions are positive ones. We regard the new heir apparent as an able manager as he was handpicked by the founder Nagamori after many years of searching (and trial and error). Founder Nagamori stressed that the handover process will take place over up to 10 years, if not longer. As such, the company effectively shifts to a dual-leadership mode for now. Mr. Nagamori remains a passionate, sharp-minded leader at age 76. In our view, it is too early to say his days are numbered.
Why we believe Nidec has a good chance of succeeding in the EV business
Nidec represents an investment case where our belief in Japan’s manufacturing excellence as a durable competitive advantage and our society’s commitment to environmental causes are perfectly aligned. The global initiatives to achieve zero emissions could be a massive structural tailwind for the company in years to come. But how can we be sure that Nidec will be at the forefront of the EV industry to capitalize on this megatrend? Here are some of our thoughts:
Nidec has a history of successfully expanding its motors portfolio beyond hard disk drive motors. Up until the mid-2000s, the company relied heavily on just one product category: hard disk drive (HDD) spindle motors. However, the scope of its business has grown much wider over the last decade now encompassing automotive, home appliances, industrial motors, etc. with the profit contribution from these new segments increasing steadily. This is made possible by leveraging existing know-how of small precision motors (i.e., HDD motors) and the addition of new product categories through acquisitions.
Some products in Nidec’s automotive motors segment already boost top global market share paving the way for potentially smoothing penetration of its EV components business. The company’s automotive motors have already made great success for applications like electric power steering (EPS) motors and electric brake system motors, in which Nidec is a global leader with a 30% and 50% market share, respectively (as of 2017). For instance, its subsidiary Nidec Elesys, acquired from the Japanese carmaker Honda in 2014, developed the world’s smallest and lightest EPS power pack which integrates the EPS motor and electronic control unit (ECU) in a single unit. Another product, sensor fusion, combines a sensing camera and millimeter wave radar unit, previously installed into one. Nidec has developed autonomous driving technology by connecting this sensor fusion to the EPS power pack. It is clear that Nidec already has a good track record and experience in the automotive space.
Key factors in motors manufacturing are compact size/lightweight, high performance and Nidec has an edge in all. According to Mr. Nagamori, the key differentiating features of their EV traction motors are: “performance,” “lightweight / small size,” and “competitive price.” Thanks to its position as the world’s largest comprehensive motor specialist, Nidec has all the necessary manufacturing know-how within its group (machining, press die-casting, injection molding, etc.) enabling it to internalize the entire production process. This may allow for quick responses to customer requirements as well as lowering costs compared to its rivals who are less self-sufficient. Plus, with current annual production volumes of 3 billion motors for a wide range of applications, there can be significant economies of scale in raw material sourcing. Being able to capitalize on the engineering separately inside the car, expertise from various types of motors to improve the quality and performance of its EV traction motors is another advantage.
The shift to EVs potentially will turn the entire car industry on its head giving rise to a supplier-centric eco-system. From an engineering point of view, electric cars are way simpler in structure with 40% fewer parts involved for assembly according to one study. We often hear that as long as the motors, batteries, and chassis (car frame) are purchased from outside, anyone can start a car business. As a result, car making as we know it today will see its entry barriers almost diminish going forward. Nidec believes there will be an onslaught of newcomers trying to sell own-brand EVs. This is already happening in China (Think NIO, Li Auto and Xpeng, which went public recently). Likewise, in the U.S., the world’s biggest tech company Apple has expressed interest to elbow into the market. And the list of new entrants goes on.
Why would these companies want to enter the car business that is on the cusp of being commoditized? Because non-traditional players have plans to compete on different dimensions. That is to say, EVs are viewed as “connected device” from which they can monetize through non-traditional ways such as over-the-air software updates (think Tesla) or in-car entertainment, etc. As such, “drivability” of a vehicle (properties like acceleration, horsepower, torque, etc. of the engine) to appeal to “car lovers” will no longer be areas of focus in product development. Instead, the hardware aspect of EVs will be simply evaluated on basic functions to serve transportation needs and cost competitiveness. These are exactly how Nidec intends to stand out from the competition. Furthermore, in order to provide “faster, cheaper” solutions to the newcomers looking to jump in the EV business quickly, Nidec is increasingly offering modular products (“EV platform”) where an EV can be instantly assembled by putting an upper part onto the base platform. This saves newly arrived EV makers significant time from design to the market.
Another interesting trend is shaping up in the traditional automobile industry. Until recently, incumbent car makers were developing and manufacturing traction motors internally for their own EV models. However, as the auto industry faces more stringent emission standards having to cover related costs on the gasoline engine side, car companies are warming up to the idea that it is more economical and efficient to procure the motors from a third party for the EV business. Such outsourcing needs by traditional carmakers should also drive Nidec’s revenue growth. Mr. Nagamori likens this to the emergence of Intel as the dominant supplier of CPUs in the personal computer era during the 1980s.
EV and self-driving technology are compatible
Autonomous driving could be the wave of the future. It is worth noting that EVs are considered more compatible with self-driving than conventional cars from a technological and engineering standpoint. That is to say, EVs are easier for computers to drive because the vehicle’s motion can be more directly controlled through regulating the motor than via the internal combustion engine mechanism. In a nutshell, EV technology and self-driving technology go hand-in-hand in our view.
EVs also appear to be more durable than conventional cars. If on-demand mobility services become ubiquitous in urban cities, this will be a key advantage as the utilization rate of autonomous cars deployed in such services will be much higher than human-driven vehicles. As previously explained, EVs have fewer moving pieces to run the vehicle versus conventional gasoline engine cars which typically contain many more “tiny pieces that have to be kept lubricated and they break every once in a while.”3
In a world where autonomously controlled cars are the norm, we believe more consumers will look at cars as just a means of transportation, not as a hobby, abandoning their private cars for Uber-like ride-hailing services. Years from now, the majority of vehicles on the road could be operated as a fleet by a handful of ride-hailing service companies. Selling cars could possibly no longer be a Business-to-Consumer business but become Business-to-Business. If such a scenario were to unfold, vehicle models would be consolidated into fewer variations for maximum scale economies, allowing key components to be consolidated in the process as well. This implies that the EV industry value chain will be concentrated in the hands of just a few dominant suppliers. Nidec could be one of them when that day comes.
As you can see, the thesis on Nidec rests on the EV revolution. And for now, we are bullish on the prospects. However, it would be too risky if the EV penetration is delayed by a decade or ceases to exist altogether. The good thing is that motors are one of the most fundamental machinery components used in almost every manufacturing sector, and about half of the world’s electricity is consumed through them. Therefore, Nidec’s playing field is not limited to EVs. As a matter of fact, management cites “automotive electrification,” “expansion of robot applications,” “home appliances driven by brushless direct-current (DC) motors,” “manpower-saving in agriculture & logistics” and “next-gen technologies stemming from 5G communications” as the biggest innovative waves Nidec can ride on. Even without the EV opportunity, these structural trends would bode well for Nidec’s businesses in the long run.
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