JDEX Update

Back to Contents of Issue: November 2001

Japan's economy will probably get worse before it gets better. Perhaps the same can be said about the JDEX.

by Augie Tam

The Nikkei 225 average has reached 17-year lows, dipping under the crucial 10,000 mark in the wake of the terrorist attacks in New York and Washington. And rather than supporting the market, high-tech issues have actually weighed it down. The JDEX index, which we introduced at the beginning of this year to measure Japan's New Economy, reflected the malaise in the tech sector as it unsurprisingly lagged the Nikkei.

The task ahead for self-styled reformist Prime Minister Junichiro Koizumi is to roll up his sleeves, as he was literally pictured doing in his campaign poster, and get to work on the reforms he has promised. Despite being an LDP man, he was ushered into office by an idolizing public hungry for change. Few in the public understand exactly what change he has in mind or what pain they are expected to suffer before things are supposed to get better, but the belief was that some chance for reform was better than none at all. However, now that he has been in office for more than half a year, people are starting to wonder if his bark is bigger than his bite. Investors in particular have hoped that Koizumi would get banks to speed up the disposal of their bad loans within two to three years as he had proposed. But with the Tokyo stock market at record lows, the Ministry of Finance's Financial Services Agency envisions a scenario in which bad loans will be halved within seven years. It looks like this problem will be a test of political will.

The worldwide slump in demand for IT-related hardware has led to a succession of earnings warnings by high-tech manufacturers and concomitant share price drops to yearly lows. Export-heavy chip makers continue to suffer from DRAM and flash memory chip price cuts amid global inventory adjustments. In light of the deteriorating business environment, semiconductor firms are cutting back production capacity and are increasing outsourcing.

NEC is turning its chip plants into EMS (electronics manufacturing service) facilities as a desperate measure. It has also outsourced the unprofitable business of LCD production to a Taiwanese manufacturer, and is switching its focus away from hardware sales and toward network infrastructure and solutions. The company remains a global leader in WDM (wavelength-division multiplexing) equipment for optical networks and base stations for 3G wireless communication networks. Although telecom companies have reined in capital spending for optical networks, especially in North America and Europe, NEC and rival Fujitsu look forward to at least a domestic boost in spending on 3G cellular networks.

Fujitsu has also embarked on a major restructuring plan to shift focus from price-sensitive chip manufacturing to the steadier software solutions business. The company expects to book an extraordinary loss of JPY300 billion in restructuring costs in the current fiscal year. The restructuring entails withdrawal of chip production overseas and consolidation of plants in Japan, as well as a reduction of over 16,000 employees worldwide and transfer of other workers to areas such as systems engineering. Domestic demand for services such as systems integration remains strong, especially from larger corporations, but Fujitsu has been less successful in becoming a blue-chip solutions provider overseas.

The chip makers are emphasizing software and services to offset the decline in hardware, but growth in the solutions business is often a function of the number of qualified personnel available. Aside from outsourcing to software engineers in India or China, these companies may find growth in their solutions businesses hampered by the shortage of IT specialists. On the other hand, as semiconductor demand is cyclical, some analysts believe that the semiconductor firms' conservative approach toward capital expenditures compared with that in the telecom sector and their bold restructuring plans put them in a good position to bounce back when demand recovers.

Sony shares have been hit hard by the slowdown in both producer and consumer IT goods, as it announced a 90 percent year-on-year drop in group operating profit for the April-June quarter. Its traditionally strong electronics division suffered an operating loss of JPY800 million, versus an operating profit of JPY53 billion a year earlier, aggravated by recalls of defective mobile phone handsets. Sony's game division is approaching profitability, but not enough to offset the declines in operating profit from information and communications equipment, semiconductors, components, TVs, and video goods.

With a drop in sales of fine ceramic and electronics components, Kyocera expects group operating profit this fiscal year to fall 52 percent to JPY100 billion, the first decline in three years. Furthermore, Kyocera is one of the firms hurt by Japan's decision to impose so-called safeguard measures on certain Chinese farm products. China's retaliatory 100 percent import tariffs on Japanese automobiles, air conditioners, and mobile phones have crippled Kyocera's PHS handset sales and are forcing the com-pany to move more production to China. However, many handset makers are moving production to China anyway, where cellular phone market growth has been accelerating rather than slowing.

Telecom stocks worldwide have gotten battered because of over-investment in communications capacity that has yet to be met by demand. But in Japan the story is, of course, 3G.

Rolling out 3G cellular services, however, is proving to be more of a headache than anticipated. NTT DoCoMo delayed this year's launch of the world's first 3G services from May to October because of technical glitches. And the company postponed its listing on the New York and London stock exchanges, originally planned for September.

Whereas keitai users walking and talking on their little phones has been a common phenomenon, one is now more likely to bump into users walking and reading email. In fact, revenue from DoCoMo's i-mode data is coming to represent a greater proportion of the company's average revenue per user (ARPU), although not yet enough to cover the decline in revenue from voice. In fiscal 2000, i-mode ARPU stood at JPY880 (versus JPY120 the previous year) and voice ARPU at JPY7,770 (versus JPY8,620 the previous year). Overall ARPU thus fell one percent over the year, and the key to growth for all three of Japan's wireless carriers so far has been signing up and retaining new subscribers rather than squeezing more revenue out of each user.

It should be noted that data only began to contribute to mobile phone revenues since fiscal 1999, with the launch of i-mode, so it is too early to judge the impact of data on overall ARPU. Data packet usage is expected to boom with the penetration of Java and high-speed 3G handsets. But trial tests from DoCoMo's new Java-enabled handsets suggest that packet usage may be leveling off.

Japan Telecom's wireless unit, J-Phone, is catching up to KDDI's wireless unit in terms of subscribers. According to the Telecommunications Carrier Association, of the 43.5 million Internet-enabled mobile phone subscribers at the end of August, J-Phone's J-Sky service had an 18.96 percent market share, slightly behind KDDI's EZweb at 19.3 percent and still far from NTT DoCoMo's i-mode at 61.74 percent.

Although UK-based Vodafone, which owns 45 percent of Japan Telecom and 46 percent of J-Phone, is clearly interested in the wireless aspect of its shareholding (and was in majority takeover talks as we went to press), Japan Telecom still appears to be committed to its fixed line business. Recently, it entered into an alliance with DSL provider eAccess and hopes to expand its ADSL (asymmetrical digital subscriber line) service to cover 60 percent of Japan by the end of January 2002. And by April 2002, it plans to launch a business to distribute broadband content such as music and video to PCs.

This year appears to be the first time that global mobile phone handset sales will be less than in the previous year. Because of the increasing sophistication of mobile phones and the race for global market share, handset makers have been teaming up in strategic alliances. Japan's No. 2 handset maker NEC is tying up with top domestic maker Matsushita Electric Industrial to develop video and software for next-generation handsets. Other tie-ups between handset makers include Sony and Sweden's Ericsson, and Toshiba and Germany's Siemens.

At the beginning of the year, it seemed that the market for consumer digital goods in Japan was still going strong despite slowing in the United States. PC sales and Internet advertising revenue had both bucked trends overseas and continued to rise in Japan. But the bad news finally caught up with Japan. According to the Japan Electronics and Information Technology Industries Association (JEITA), PC sales in the April-June quarter declined 6 percent in value from the previous year (but remained flat in number of units as average unit price fell). PC shipments to households were responsible for the overall decline, as corporate shipments actually grew in light of strong IT investment. And in July, PC sales at large electronics stores fell 12.5 percent, according to Nikkei Market Access.

Part of the decline could be attributed to this year's especially hot summer, with mid-year bonuses going to purchases of air conditioners rather than PCs. But now that over half of Japanese households have PCs, the PC market is reaching a level of maturity similar to that in the US. In fact, American PC maker Gateway recently decided to exit Japan completely. To counter the decline in average PC prices and profit margins, makers are trying to push high-end PCs with features like broadband modems, DVD players, and TV tuners, although even low-end PCs these days satisfy the needs of most users.

The Uniqlo of Japanese PC makers, Sotec is particularly vulnerable to the slowdown in home PC sales precisely because its inexpensive models target households rather than corporations. The company, which posted a JPY1.48 billion net profit in fiscal 2000, expects a net loss of JPY1.85 billion in the current fiscal year.

The slowdown in home PC sales also concerns packaged software developers like Justsystem. Sales of its database software ConceptBase are robust, but sales of home-use software such as Ichitaro and JustHome have dropped. Although expecting sales to fall 2 percent in fiscal 2001 from the previous year, the company forecasts a group net profit of JPY500 million, its first time in the black since going public, due to gains from the sale of its ISP unit, WebOnline Networks, to Sony Communications Network and from the sale of securities.

PC makers, component manufacturers, and Internet companies all hope that broadband will revitalize consumer IT demand. Despite NTT's efforts to thwart it, there has been an explosion in recent months of new ADSL services offered by every major ISP. Softbank and its subsidiary Yahoo Japan are one of the latest to jump on the broadbandwagon with their ADSL service, Yahoo! BB. Launched in September at a cutthroat JPY2,280 per month, Yahoo! BB has forced other DSL providers to lower their rates.

For Softbank, broadband represents its new rallying cry, now that its portfolio of 800-plus Internet businesses is a meager shadow of its former self in terms of market valuation. As part of its broadband strategy, Softbank also recently took over cash-strapped DSL provider Tokyo Metallic.

For Yahoo Japan, ADSL services represent an alternative revenue source. Despite posting a record net profit of JPY2.97 billion in the year through March 2001, its mainstay online advertising revenue has begun to slide for the first time in three years, dropping 5 percent in the April-June quarter from the previous year to JPY3.7 billion. Yahoo Japan aims to reduce its reliance on advertising revenue and to generate more than half of its income from ADSL and other non-advertising services.

Investors, however, have not been impressed. DSL subscription fees alone can scarcely cover the heavy investment in infrastructure, and -- broadband or not -- there has been little online content that PC users are willing to pay for.

Two of the three JDEX issues that are up so far this year are Internet stocks, which -- while out of favor -- are apparently being evaluated on their individual merits.

Shares of online advertising firm Cyber Agent have advanced over 40 percent since the beginning of the year, although still sitting well under its heady IPO price of April 2000. Despite the overall decline in Internet advertising revenue in Japan, Cyber Agent managed in its third fiscal April-June quarter to record a parent pre-tax profit of JPY39.9 million (for the first time since its establishment). The positive results were attributed to growth in advertising revenue from email magazines and other online media such as cellphone and broadband ads. In July, parent revenue grew to JPY431 million, up 158.5 percent from a year earlier.

Shares of online mall operator Rakuten have hovered slightly above its start-of-year price thanks to improvement in the performance of group companies. Infoseek Japan, which was acquired last year, posted its first monthly operating profit of around JPY5 million in July by cutting costs, and Rakuten TV has been contributing around JPY12 million in monthly operating profit from satellite TV ads. But the number of tenants in Rakuten's principal online mall business also fell for the first time in the April-June quarter. In the fiscal year through December 2001, Rakuten expects group operating profit to double to JPY2.1 billion. However, it expects a group net loss of JPY1.15 billion, as it will write off as an extraordinary loss the goodwill (difference between purchase price and net assets purchased) on acquisitions including online auctioneer Bizseek and online game operator Jgame.

The only other JDEX issue that has gained since the inception of the index this year is leading parcel delivery company Yamato Transport. While we consider Yamato representative of Japan's New Economy because of the way it has transformed its industry (not without the help of IT), as a non-tech stock the black cat has escaped the brunt of the tech malaise.

In fiscal 2001, Yamato posted a group net loss of JPY4.2 billion, versus a profit of JPY20.4 billion a year earlier, because of extraordinary losses from pension shortfalls and securities sales. With a relatively recession-proof business, Yamato has seen an increase in its home parcel deliveries and has kept costs down by relying more and more on part-time workers. In the year through March 2002, the company forecasts a group net profit of JPY27.5 billion.

The JDEX reflects the bad year that tech stocks have had in 2001. The second half market rally that some prognosticators forecast hasn't happened yet, and few now dare call the bottom. Prime Minister Koizumi has told his citizens that things will get worse before they get better. Perhaps the same can be said about the performance of the JDEX. Nevertheless, change is happening in Japan, and we hope that, rather than as a recommended portfolio, the JDEX serves as an indicator of that change. @

Augie Tam is the founder of GaijinInvestor.com. He can be reached at augietam@gaijininvestor.com.

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