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We benefited from the buyout of two subsidiaries last November when Toshiba Plant and NuFlare, were taken private by their parent, Toshiba Corp, at premia of 27% and 45%. As of the end of September AJOT had 17% of its NAV invested in listed subsidiaries.

Approximately half of this quarter’s performance was driven by Toshiba Plant Systems & Services and NuFlare Technology, which added +2.5% and +2.3% respectively to returns. Both Toshiba Plant and NuFlare received bids from their parent company, Toshiba Corp, at premiums of +28% and +46% to their prevailing share prices. We exited the positions in both companies following the offer, crystallising strong IRRs of +110% for NuFlare and +35% for Toshiba Plant (in local currency).

Toshiba Corp’s offer is a vindication of the “parent-child” theme within AJOT’s portfolio. We wrote about this extensively in our Q3 2019 letter, arguing that listed subsidiaries should be either bought in or sold off by the parent company given that the potential for the abuse of minority shareholders’ rights depresses share prices. With the Abe administration having been critical of these sorts of arrangements, and Toshiba Corp’s recently refreshed Board, it felt like simply a matter of time before the company would acquire or sell off its stakes in NuFlare and Toshiba Plant. After AJOT’s exit from NuFlare and Toshiba Plant, there remain three companies, exposed to the parent-subsidiary theme in the portfolio, accounting for 10% of NAV.

The actions of Toshiba Corp add to the weight of evidence that AJOT’s overarching thesis is valid. With pressure coming from the government, and increasingly shareholder-conscious institutional investors, Japan Inc. is shifting – slowly, but surely – towards a more efficient, fairer system of governance. The Toshiba Corp offer is but one example of this; we see further evidence in the form of rising share buybacks; higher payout ratios; increasing returns on equity; reductions in cross-shareholdings; and increasingly independent boards. We believe that our portfolio of high-quality, cash-generative, undemandingly-valued companies stands to benefit from this trend.

November was a particularly strong month for AJOT’s performance. This was primarily driven by Toshiba Corp’s offer to acquire 100% of two of its listed subsidiaries that we held in our portfolio. Both NuFlare Technology and Toshiba Plant received bids from their parent, Toshiba Corp, at significant premia to prevailing share prices. The two Toshiba subsidiaries have been successful investments for AJOT, generating an IRR of 110% in the case of NuFlare, and 35% for Toshiba Plant.

The month also saw the continued share price recovery of many holdings that had experienced weakness over the summer. Adding to these positions at depressed valuations further enhanced our performance.

Reported earnings for the quarter ending September 2019 were muted, with operating profits for the TOPIX falling -3.6% and companies revising full-year profits down by -4.3%. This seems to have already been priced in, with the market taking the news in its stride and appreciating by +7.7% in JPY over October and November (+1.3% in GBP).

The parent-child subsidiary theme is one we have discussed extensively since the launch of this fund. Many large conglomerate-like companies such as Toshiba Corp are coming under pressure from their shareholders to simplify and consolidate their often complex subsidiary portfolios. By owning 50% of listed subsidiaries, they have effective control of these companies without having to pay up for full ownership, and this can often be detrimental to the interests of minority shareholders. The corporate governance and stewardship codes are forcing companies to focus on shareholder returns, and there can be significant value trapped in these subsidiaries.

Over the month Mitsubishi Chemical launched a 50% premium tender offer for the 44% of Mitsubishi Tanabe it didn’t already own. Along with the two Toshiba buy-ins, there were no less than ten announced subsidiary acquisitions in November, and we believe this trend will continue. The two Toshiba subsidiaries we owned made up approximately 12% of the portfolio and we have a further 11% of the fund invested in five other subsidiary situations. Whilst the timing of these events is uncertain, the Toshiba case highlights the potential upside from these investments.

Post month-end there was some extremely positive news from our two Toshiba subsidiary investments – Toshiba Plant and Nuflare Technology. After Toshiba Corp confirmed it was considering making its 51% subsidiaries wholly-owned, the share prices of these two companies jumped 17% and 18% respectively. The consolidation of parent-child subsidiary arrangements has been a key theme of the portfolio and it is extremely encouraging to see this play out. Further details will emerge in coming days and we will update shareholders in next month’s newsletter.

As we discussed in previous quarterly letters, Toshiba Corp has been subject to a public activist campaign by King Street. As a result, Toshiba Corp’s board was revitalised at the June AGM with seven new independent directors joining the Board. These new directors have a wealth of international experience including investment management, and generally have a more sympathetic view towards shareholders. We have written to the new board to highlight the corporate governance flaws at two Toshiba Corp subsidiaries, NuFlare and Toshiba Plant, both AJOT holdings.

NuFlare manufactures highly specialised semiconductor machinery. Their focus on a niche part of the semiconductor manufacturing process has afforded them a near 100% market share. However, while they have an excellent technical position and a profitable business model, their corporate governance leaves much to be desired. Despite its £800m market cap, NuFlare is listed on the JASDAQ, an exchange intended for young, unestablished companies; all directors are male between the age of 54-60, having started their careers at either Toshiba Corp or Toshiba Machine; and the company has no capital allocation policy with 57% of balance sheet assets being made up of cash. This slack corporate governance drives a market discount with NuFlare trading on a derisory 2.6x EV/EBIT with 60% of its market cap covered by cash.

Toshiba Plant, as the name suggests, designs and constructs power plants along with industrial buildings such as factories. The appealing aspect of this business is the long-term contracts, predominantly coming from decommissioning and maintaining Toshiba Corp’s array of nuclear power plants. Since it became a fully integrated EPC (Engineering, Procurement, and Construction) company in 2004, it has only failed to achieve growth in one year (2017) and has grown profits at an annual compound rate of 12%. While Toshiba Plant has a strong business, it is let down by poor corporate governance. Six of the nine inside directors come from Toshiba Corp; the two independent directors have no relevant industry experience; and 38% of balance sheet assets are held in cash with the majority lent to its parent at an interest rate far below Toshiba Plant’s cost of capital. Again, the market demands a discount because of this poor governance and Toshiba Plant trades on an EV/EBIT of 4.8x with net cash covering 47% of its market cap.

With the improved oversight at Toshiba Corp and severe undervaluation at these two subsidiaries, we think the market is failing to see the huge potential from either improved corporate governance or a corporate event such as the trade sale of NuFlare or buy-in of Toshiba Plant. It is untenable for the new Board of Toshiba Corp to continue presiding over such appalling corporate governance and we believe they will act. In October, Toshiba Corp stated their intention to sell non-core businesses that do not have synergies in infrastructure and energy, highlighting the importance of Toshiba Plant and insignificance of NuFlare. Following this, Toshiba Plant and NuFlare rallied +8% and +5% respectively against a -0.5% decline in the MSCI Japan Small Cap Index[1].

In addition to our dialogue with the parent company, we have written to the Boards of NuFlare and Toshiba Plant suggesting corporate governance improvements and will press the issues further during our November trip. We expect to see positive developments at both companies and commensurately higher share prices over the coming year.

The issue of parent-child listings and poor protection for minority shareholders is one that is receiving more attention from shareholders and the Government. It has been suggested that listed companies with controlling

parent shareholders should be required to have a majority independent board to increase minority shareholder protection. The clear intention is to ultimately reduce the prevalence of parent-child listings, which are rarely seen in developed markets outside of Japan. Whether child subsidiaries improve governance, or the parent company restructures the business, the result should prove a boon to the share price. We have investments in six listed subsidiaries, accounting for 23% of AJOT’s NAV.

[1] 01/10/2019 – 10/10/2019

In March, King Street wrote a public letter to Toshiba requesting a new slate of majority independent directors.

Quite unceremoniously and without public resistance, Toshiba obliged. Toshiba successfully proposed a board of 12 directors to its June AGM, who have a wealth of experience including portfolio management, business turnarounds and M&A. 10 of the directors are independent with four hailing from outside Japan: an unheard-of composition for a Japanese board. As an aside, King Street also publicly suggested that Toshiba simplify their subsidiary structure, and, having invested in two of Toshiba’s subsidiaries (Toshiba Plant and NuFlare), we are well placed to benefit.

Hibiki Path Advisors’ proposals for a higher dividend and stock-based compensation were not approved by Sanyo Shokai’s shareholders, gaining just 10% and 12% support. While on the surface this seems disappointing, the outcome was inconsequential. Sanyo Shokai had already acquiesced by installing a stock-based compensation plan and at the start of May announced a 4.0% buyback.

Toshiba Plant Systems & Services. This
last holding is one we initiated in April and have since built up. Toshiba Plant
(52%-owned by parent Toshiba) designs, builds, and maintains power plants
in Japan and across South-East Asia. The company has grown operating
profit at a compound annual growth rate of 12% since 2005 and is asset-rich
with 55% of its market cap covered by cash. If one strips away this cash,
the quality of the underlying business is revealed by its 28% ROE.
EV/Trailing EBIT is just 5.6x, and the free cash-flow yield on an EV basis is
9%. Rather than return its excess cash to shareholders, however, Toshiba
Plant has instead historically lent it to its cash-strapped parent in return for a
miserly 1% interest rate. A recent court battle brought by an activist
shareholder was successful in securing the return of this cash to Toshiba
Plant and we expect a solution to be found to Toshiba’s need for the cash
that also advantages Toshiba Plant minority shareholders (a buyback or
special dividend).