3 March 2017 Asia Pacific/Japan Equity Research Product Marketing Japan Highlights Product Managers STRATEGY Daisuke Takato 813 4550 9671 [email protected] 3Q earnings growth led by cyclicals; upgraded Go Tanaka 81 3 4550 7266 SMC to OUTPERFORM; Morinagas to merge? [email protected] Figure 1: Cyclicals have seen robust earnings and are leading the rally as it benefits from the weaker yen (normalized as of 2016/9/30) 1.25 USD/JPY (RHS) 120 FTSE Japan Cyclical 1.20 FTSE Japan Defensive 115 1.15 110 1.10 105 1.05 100 1.00 0.95 95 0.90 90 9/30/2016 10/31/2016 11/30/2016 12/31/2016 1/31/2017 Source: Bloomberg ■ Cyclicals lead the way: Third-quarter NP beat consensus by 16%, with autos, chemicals, iron & steel, and banks leading the gains. Cost reductions were a key theme, as Honda (7267) and Hitachi (6501) reaped benefits from reducing COGS, curtailing SG&A expenses, and pushing through restructuring. Steelmaker JFE (5411) was aided by price increases and booked inventory valuation gains as a result, and trading companies such as Mitsubishi Corp. (8058) also benefited from rising commodity prices. In the bank sector, Mitsubishi UFJ (8306) saw its bottom line grow 17% YoY in 3Q, owing to cost-cutting, credit cost improvement, and net gains on equity holdings. ■ SMC upgrade, MHI downgrade: Analyst Shinji Kuroda upgraded SMC (6273) to OUTPERFORM and raised his target price as he expects record OP of ¥150bn in FY3/18, while valuations remain below past peaks. Separately, he downgraded Mitsubishi Heavy (7011) to UNDERPERFORM citing risks of write-downs and lawsuits. ■ If the Morinagas merged: The possibility of a merger between confectionery-maker Morinaga Co. (2201) and dairy-maker Morinaga Milk (2264), as reported by the Nikkei, would be a positive move that could create synergies in joint marketing, production optimization, overseas expansion, and raw material procurement, analyst Masashi Mori writes. DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. 3 March 2017 SMC upgrade, MHI downgrade Analyst Shinji Kuroda upgraded SMC (6273) to OUTPERFORM and raised his target price from ¥33,000 to ¥37,000. He expects FY3/18 OP to jump 13% to a record ¥150bn, while valuations remain below past peaks (current FY1 P/E ex-cash is 13.9x, vs. 16–18x previously), as well as compared to peers like Yaskawa (6506) and THK (6481). While concerns remain amid accusations regarding the company's cash and inventory accounting, Kuroda expects the company to clear up any remaining concerns when it announces full year results in May. Kuroda downgraded Mitsubishi Heavy (7011) to UNDERPERFORM and reduced his target price from ¥620 to ¥400. The company is mired in risks including: (1) lawsuits surrounding its nuclear power plant in southern California (maximum loss: ¥750bn, consensus estimate: ¥100bn loss); (2) ongoing litigation with Hitachi (6501) over the construction of 12 coal-fired power plants in South Africa (maximum loss: ¥1tn); and (3) cancellation of 204 out of 427 MRJ aircraft orders (total investment/R&D: ¥400bn). Kuroda forecasts a conservative ¥100bn in extraordinary losses for FY3/18 and ¥200bn for FY3/19, and cautions that the risk is to the downside. (See Page 6 of his report for details) Elsewhere in the heavy equipment sector, Kuroda upgraded IHI (7013) to NEUTRAL as a more attractive play, after news that several downside risks have played out – the company announced on 23 January that it will write down several US assets and on 17 February, Toshiba (6502) said that it will buy part of IHI's stake in US nuclear power subsidiary Westinghouse. Separately, we removed Toshiba from the Japan Focus List after the electronics conglomerate failed to announce Oct–Dec earnings on 14 February, citing internal control issues, and asked the regulators for a one-month delay. The company did release unaudited 3Q results on the same day, but it only highlighted the uncertainties surrounding its core businesses and financial position, specifically: (1) the company already has negative equity of ¥500bn as of end-December 2016, and negative equity of ¥150bn is expected at end-March; (2) the company is considering selling a majority of its NAND memory business, a significantly larger stake than the previously reported 20% sale. Figure 2: Relative P/E in factory automation sector Figure 3: Operating profit and P/E ex-cash Source: Thomson Reuters Datastream, Credit Suisse Estimates Source: Company data, Credit Suisse estimates Japan Highlights2 3 March 2017 The future of the Morinagas The Nikkei reported on 24 February that confectionary-maker Morinaga Co. (2201) and dairy-maker Morinaga Milk (2264) are in talks to merge (the companies have denied that any such integration has been decided). Analyst Masashi Mori writes that this would be a positive move as it could create synergies in joint marketing, production optimization, overseas expansion, and raw material procurement. In a pro forma estimate of the combined entity (Figure 4), Mori notes that while the company looks relatively expensive at a FY3/18E P/E of 19x, synergies could boost operating margins to levels at rival firms (Figure 5), and valuations could shift to more attractive levels of around 12–16x. Figure 4: Pro forma income statement and valuations of the combined Morinagas Source: Company data, Credit Suisse estimates Figure 5: Operating margins of rival companies' businesses that are similar to Morinaga Milk's B2C business (1–3Q FY3/17 basis) Source: Company data, Credit Suisse Japan Highlights3 3 March 2017 Apartment and housing loans Investors have been concerned that the Financial Services Agency (FSA) will instruct banks to suppress apartment loans, which have risen in tandem with the boom in apartment construction post-2015 inheritance tax hike. Our real estate analyst Masahiro Mochizuki, in a series of reports on the housing sector, explains why this clampdown has not yet occurred, while cautioning that it could be a risk in 2017, and that an industry shakeout is on the horizon. Bank analyst Takashi Miura agrees with this view; after conducting interviews with dozens of regional banks about their interactions with the FSA, he concludes that overheated apartment lending is only a problem in large regional cities, and for most regions including Tokyo, apartment loan supply is underlined by actual demand. Mochizuki recommends the largest developers, including his top OUTPERFORM picks Daito Trust (1878), Sekisui House (1928), and Daiwa House (1925), which are better equipped to provide higher quality apartments and can benefit from economies of scale. On the banking side, regional banks with the largest exposure to housing loans, including our top pick Bank of Kyoto (8369, OUTPERFORM) and Resona (8308, NEUTRAL) stand to gain. Figure 7: Lending to residential leasing businesses Figure 6: Number of people subject to inheritance run by individuals(YoY, CY) and order receipts at taxes almost doubled after law change Daito Trust (YoY) Source: National Tax Agency, Credit Suisse Source: BoJ, Company data, Credit Suisse Japan Highlights4 Japan Highlights Source: Company data,CreditSuisse estimates analysis10:Chemicalon HOLT Figure Hitachi(4217)–Forecastandmarket-impliedCFROIbased Source: Company data,CreditSuisse 8:LIXIL EV/EBITDA Figure 2 CFROI (%) 1 1 1 1 - - 0 0 1 2 3 4 5 6 7 8 2 1 0 2 4 6 4 6 8 0 . 0 0 0 0 0 0 0 2 - ( J x a ) n 4/30/2000 2 0 4/30/2001 0 3 5 - J 4/30/2002 a n 4/30/2003 2 0 0 4/30/2004 4 - J a 4/30/2005 n 2 0 4/30/2006 0 5 - 4/30/2007 J a n 4/30/2008 bonding materials,andLi-ion batterymaterials. elevated levels owing to the acquisition of new lead-acid battery operations, growth for die to have already priced in record profits for FY3/18. (4217) He believes earnings will remain at steel products for turbochargers. Masami rallied, and Sawato reflecting higher costs also associated with downgraded the new Hercunite heat-resistant downgraded cast We saw several other analysts also recommend profit-taking this month. Shinya Yamada NEUTRAL andrecommends takingprofitafterthesharepricereached histargetprice. profit growth is stagnating. businesses like Separately, Permasteelisa. 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