Could a strong Yen seriously change the face of the worldwide consumer goods market?

International trade is a key driver in the demand for foreign currency as consumers and firms around the world need foreign currency to trade with one another.  The globalisation of the marketplace in the last fifty years has intensified this demand and it was reported that by the early part of the 21st century over $1.5 trillion in national currencies was traded daily to support the expanded levels of worldwide trade.  However in order to trade in this competitive environment firms must accept exposure to the risks associated with changes in currency.  These risks can be great as foreign currency changes daily and directly impacts on the price and demand for goods and services.

Japan, for example, is a high exporter of consumer goods, in particular electronics and automobiles (cars), to countries like the US.  In order for US consumers to purchase Japanese goods they generally have to purchase Japanese Yen with their US Dollars to make payment.  As a result Japan’s trading position places them at risk to adverse changes in the short or long term movements of exchange rates.  We call this Economic Exposure.

As the graph highlights the Yen has strengthened considerably, by 13.89%, in the last two years.  In terms of a trading position this means that it costs US consumers more US$ to purchase Japanese goods.  But why has this happened?  This trend in Japanese currency strengthening has been apparent for a number of years and is due to the simple fact that more Japanese Yen is demanded than what is supplied.  The primary reason behind this is that western consumers have continuously purchased cheap goods from Japan for over 20 years, demanding Japanese Yen as they do so.  Furthermore the recent economic recession, the effects of which have been more profound in US and European economies, have meant investors have seen the Yen as a safer investment during times of uncertainty, causing it to appreciate in value.  The question is whether this is a sustainable trend for the Japanese economy?

The simple answer would be a resounding NO based on recent announcements about the country's performance.  Firstly Japan announced on the 25th January that 2011 saw the country’s first annual trade deficit in 30 years, with a deficit of 2.9 trillion Yen ($32bn, £20bn).  This came as exports fell 2.7% and imports rose by 12%.  The situation seems to have worsened further in recent weeks as it emerged exports in January were down 9.3% compared to 2011.  Furthermore car manufacturers Honda and Toyota and electrical manufacturers Sony and Panasonic have all announced either slowing or declining 2011 profits since the new year.  These companies are key contributors to the Japanese economy.

What will all this mean for Japanese manufacturers who export to places like the US? The problem for Japanese manufacturers is that their primary market lies overseas, in particular in the US and Europe.  During the past few years of economic recession consumers have tightened their belts and spent less on imported goods from places like Japan.  The currency strength has compounded this problem as not only do consumers have less to spend but it now costs them more to purchase their goods.  This could mean that Japanese companies begin to locate their production facilities overseas to help mitigate the Economic Exposure they are experiencing at the moment.  Toyota, for example, have recently announced that they are looking to expand exports from their US plant by 20% in 2012 to mitigate the problem caused by the strong Yen.  Generally though I feel we are more likely to see Japanese manufacturers relocate within Asia to countries like China and Thailand or even stay in Japan.  This is because Asia still holds a significant advantage over their western counterparts in terms of labour and production costs.  The Yen and other Asian currencies would have to strengthen a colossal amount for manufacturers to begin to filter production back to the US and Europe.

Could the strong Yen benefit UK manufacturers?  There have been a limited number of examples where UK manufacturing has strengthened due to companies avoiding the strong Yen.  Japan based car manufacturer Nissan has a production plant at Washington, Sunderland which in 2011 experienced a 14% rise in production taking its output to 480,000 vehicles and created over 1,500 new jobs.  This is a positive sign for the UK manufacturing industry and UK employment which is grateful for any positive news it can get.  However, is this a genuine sign that Japan based manufacturers may look to the UK as a valid alternative?  In reality Sunderland volume of output is just a drop in the ocean in comparison to Japan’s firms; in 2011 Honda produced 2.9m cars and market leader Toyota produced over 7m!  I think a more logical explanation for the Sunderland figures is that this is an example of a growing worldwide company, Nissan, diversifying its operations to respond quickly to the market all across the world. 

I think that overall the only outcome of the strengthening of the Japanese Yen will be a small change in the pricing of consumer goods exported from Japan.  Consumers who have got used to cheap electronics may see a marginal increase in prices.  A shift in the location of the production facilities, on the back of the Yen strength, quite simply is not on the cards.  Lets face it; it seems ridiculous to describe the current exchange rate of $1/¥79 as strong anyway, so any radical change in the worldwide consumer goods market seems unlikely to say the least.

Morrisons unusual recent finance activities

When companies are looking to raise finance from external sources they are presented with two options; equity finance and debt finance.  Equity finance usually involves issuing new ordinary shares.  Investors purchase the new shares in the market and the company uses the finance raised from the sale for their own purposes.  Debt finance is commonly achieved by seeking loans or debt securities from financial institutions in return for regular repayments.

WM Morrison Supermarkets (Morrisons), the UK’s fourth largest supermarket, has recently engaged in some intriguing financing activities.  On the 8^th December Morrisons issued a £400m sterling bond jointly provided by Barclays, RBS and HSBC.  The bond will attract an interest rate of 4.625% payable semi-annually as well as a bullet repayment (a cool financey word for lump sum) that will be made on maturity in 2023. Why have Morrisons decided to do this?

Officially Morrisons stated that “The proceeds from the issue of the Bond will be used for the Group's general corporate purposes”.  Well… the company could not be any vaguer about the purpose of the finance, meaning we are left to read very carefully between the lines.  Looking at Morrisons most recent annual reports it becomes apparent that the company is looking to enhance its store portfolio in the near future.  The company may therefore have sought the finance to support any potential bids for relating companies that could help achieve this.  Since the issue of the bond Morrisons have been linked with bids for frozen foods company Iceland and internet retailer specialist Ocado.  Regarding Iceland firstly, Morrisons have eventually backed out due to concerns about the risk of acquiring such a large chain in the current climate.  As a result the bidding war has been narrowed down to private equity firms BC Partners and Bain Capital.  Readers will recognise some of Bain’s companies in particular as they include well-known Dominos, Burger King, Toys ‘R’ Us and Staples.  The takeover bid for internet retailer specialist Ocado is still at the speculative stage but it is a move that would certainly help support Morrisons desire to move into the online retail market.  Although as of yet no significant investment has materialised it seems clear that Morrisons will certainly use the capital to support some kind of acquisition in the weeks and months ahead.

Why though did Morrisons choose to issue a bond as opposed to borrowing from a bank?  Generally bank loans are seen as restrictive as they are usually accompanied by debt covenants.  For example banks can stop companies from issuing any more debt or acquiring any new companies until the loan is repaid.  This would have seriously constrained Morrisons.  Bonds give the issuer greater freedom as they are issued for a long period of time and the bond market is more forgiving in their terms.  This means Morrisons can confidently take their time in choosing their next investment.  Iceland did not work out, Ocado is still in the pipeline or it could even be another company altogether.  By using debt finance, and in particular a bond issue, it is up to them when and if they act? 

However, unusually since the debt issuance Morrisons has spent over £9m purchasing their own shares to cancel through the Bank of America Merrill Lynch.  On the 31^st January they purchased 1.2m shares at 285.2913p and then on the 1^st February purchased 1.99m shares at 287.9934p; the shares were subsequently cancelled from trading.  To everyday people this would seem bizarre; you wouldn’t buy a new car to intentionally write it off the next day, so why have Morrisons done this?

Morrisons may have done this due to a personal feeling that the market was undervaluing the company’s shares.  Prior to the intervention the shares were at their lowest value in around six months and from the start of January had dropped by an alarming 40.3p (12.35%).  The subsequent increase in share price, shown by the graph, would suggest that their actions have been vindicated.  But would Morrisons really fork out over £9m just to restore some shareholder value?

I feel that the actions are more a sign of Morrisons increasing lack of creativity.  A lacklustre Christmas and a subsequent loss of market share verified by Kantar on the 31^st January shows the company is experiencing a rocky period.  I have explored above the possibility that the raising of £400m could be to support an upcoming takeover, but perhaps the recent purchase and cancellation of their own shares shows the company really doesn’t know what to spend the money on.  The leading lights of the company may think that it’s a good idea to use some of the funds to prop up the share price to help restore some shareholder confidence.  But for me this is merely papering over the cracks.

The cancellation of their own shares is the polar opposite of equity finance; where shares are created to raise finance, a method employed to fund their £3bn landmark takeover of Safeway in 2004.  At the time Morrisons issued over one billion shares at 249p to raise the large majority of the capital required for the takeover.  So it would appear that in recent times Morrisons preference has changed to debt finance as they have issued a bond and cancelled their own shares all in the last three months.  However I feel the extensive equity financing of the Safeway takeover was more due to the magnitude of the deal and the resulting finance required.  After all the key advantage of equity finance is that the funds do not have to be repaid so when such a vast amount is needed it makes sense to do this.  Generally I would argue Morrisons are in a stronger position now to finance any upcoming deals by issuing further debt rather than issuing shares.  However it is difficult to say what the next move will be. Could it be Ocado?  Cancel more shares? Or something else altogether?   Watch this space…

Rolls-Royce: Profits up, Share price down?

An efficient capital market is expected to display the following forms of efficiency; operational, allocational and, most importantly for this discussion, pricing efficiency.  Pricing efficiency means that share prices fully and fairly reflect all information whether past or future.  This idea was further developed by Fama (1970) who pioneered the concept of the Efficient Market Hypothesis (EMH).  EMH is a concept concerned with establishing share prices in a capital market and states that share prices reflect all relevant available information.  As a result it is expected that in an efficient capital market undervaluation and or overvaluation does not occur as current and past information is immediately reflected in the share price.  However this ideology is flawed as it relies on perfect market conditions.  This ‘perfect’ market quite simply cannot and will never exist.

The recent story of Rolls-Royce does little to support the theory of an efficient capital market.  On Thursday morning Rolls-Royce announced record profits of £1.16bn, an increase of 21% on the previous year.  This has been driven by increased demand for their civil aircraft engines; the order book upon announcement had reached £62bn as orders rose 5% from the previous year.  These are impressive figures for the company and it would be expected in an efficient market that the information would be reflected positively almost instantly in the share price.  This presumption seems logical and is what I would expect to happen.  However by mid-morning the shares had fallen over 3.5% in value; at 10.23am the share price was down by 32p to 753p.  This has left many scratching their heads.  How can an extremely positive announcement of record profits result in a fall in the share price?

So, why has this happened?  The graph shows that since the start of February Rolls-Royce shares have gone up by 49.5p, a notable short term increase in share value of 6.73%.  I believe it could be that these increases were the result of anticipatory trading activity from investors with insider knowledge.  Insiders and close followers of the company will have been well aware of the positive performance that had been achieved during 2011.  As a result they will have been trading up the price of the shares prior to Thursday’s announcement.  However when the news officially hit the market they will have been inclined to sell as the information was public knowledge and according to the EMH should have been immediately reflected in the share price.  I feel these investors selling their shares will have been a major factor in the share price falling immediately following the news announcement.

Is the Rolls-Royce case a supporter for the Random Walk theory? Random Walk (Kendall, 1953) theory suggests that the relationship between share prices across time periods is completely random.  This is because news, which affects share prices, is by definition rando making it impossible to predict future changes in share price.  Rolls-Royce share price has reacted in the opposite way to which theory and logic would suggest so maybe its share price is just following a random walk.  It is my opinion that generally, in periods of no relevant news, companies share prices do reflect a random walk or at least one which follows the general pattern of the entire market.  However I would expect when there is relevant news the market would react rationally in line with EMH theory.  To put this into context Diageo announced, also on Thursday morning, that its profits were up 15% to £1.86bn.  As a result shares rose steadily on the day by 13.81p, the kind of reaction expected on the back of a positive news announcement.  The puzzling thing about Rolls-Royce is that the opposite of what basic logic suggests should happen has happened.

Has the bombardment of positive news stories relating to Rolls-Royce played a part in this reaction?  Over the last year it seems there has been a constant stream of positive news stories relating to Rolls-Royce.  In the new year they announced that Rolls-Royce car sales were at a record high in the company’s 107 year history.  Also there have been many announcements in recent weeks detailing the company’s upcoming expansion plans in Asia.  Share prices over the last year have risen dramatically by 115p (17.49%) which could suggest that a lot of good news is already reflected in the Rolls-Royce share price.  It would be fair to expect that this uninterrupted increase cannot continue and at some point the share price will reach its optimum level.  I feel that perhaps Thursday’s announcement was one good news story too far and some investor’s immediate reaction was to get out while the going really was at its very best.  The remaining shareholders will be asking themselves; is now the time to sell up?

Tesco: Shareholder Wealth Maximisation

Shareholder wealth is maximised when the share price and dividends of a company are maximised over time.  Basic theory suggests that shareholders are the owners of the company and therefore deserve a share of any surplus wealth generated.  This seems logical, as shareholders are the highest risk bearers when it comes to corporate ownership.  They commit their own wealth and then generally the use of the funds is left to the discretion of the directors of the company.  Companies should seek to return capital to the shareholders as this should attract further investors and in turn provide additional capital to expand the business.

Tesco is an example where, in recent weeks, there has been a substantial destruction in shareholder wealth.  On 12^th January 2012 Tesco shares fell by 61.6p, dropping in value by nearly 16%, and knocking almost £5bn off the market value of the company.  This came after Tesco announced poor Christmas trading figures with like for like sales falling by 2.3% aswell as forecasts that 2012 will see a definite slowdown in Tesco’s profitability.  Clearly, this severely dented investor confidence and led to the extensive devaluation of Tesco shares. Over the Christmas period Tesco reduced prices, in a pricing strategy which commentators have coined the ‘big price flop’, in order to match competitors who had engaged in similar activities.  However Tesco failed to offer any coupons to reward regular spending, unlike its competitors, meaning customers were not properly rewarded for their loyalty.  This mistake is likely to have cost Tesco many customers at the checkouts.  In my opinion as Tesco is the market leading supermarket they should represent the cornerstone of quality, value and choice.  However they have decided to get embroiled in a pricing war with competitors like Sainsbury’s, who have introduced their well marketed brand match policy.  Sainsbury’s was the market leader for much of the 20^th century but is now the third largest UK supermarket chain and has seen its shares fall steeply in value in the last ten years (-34.81%).  It could be seen as acceptable for them to go in a new direction and attempt a daring pricing strategy in order to get customers back through the tills, albeit at low margin.  However, Tesco should not have sacrificed their reputation for quality in order to compete on low prices.  As a result profits, and ultimately shareholder wealth has paid the price.

It recently emerged that a senior Tesco executive sold over £200,000 worth of shares.  Bob Robbins, Chief Operating Officer of the UK business, sold 50,000 shares at 404.5p 8 days prior to the profit announcement.  This compounded the problem for Tesco as the news will surely have damaged shareholder confidence and added to the already negative effect of the profit announcement.  In a statement Tesco stated that “Bob Robbins sold less than 5% of his substantial shareholding in Tesco for necessary family expenditure” and that it was “approved in the usual way”.  Robbins is paid a base salary by Tesco of £832,000 which, according to the companies’ annual report, makes up a maximum of 40% of his total remuneration.  Robbins can earn over £3m in any one year.  The question has to be poised; who is Robbins and the company trying to kid?  Stringent Tesco shareholders should have seen this as a warning sign that it was time to get out and if they didn’t they most definitely did when it emerged eight days later that the companies’ profits were struggling.  The move by Robbins saved him just over £30,000 in share value but what were the repercussions of his actions for the remaining shareholders wealth.

However Tesco shareholders cannot have too much to grumble about surely?  Despite the recent dip in share price, Tesco shares have risen by 74.91% since the turn of the millennium.  This is in stark contrast to the FTSE 100 which has declined by 13.3% over the same period.  Tesco also paid out over £1bn in dividends in 2011.  Shareholder wealth has certainly been maximised as the company has witnessed unprecedented growth, largely down to its ongoing strategy to increase market share.  Tesco controls over 30% of the UK supermarket industry and in 2007 one in every seven pounds spent in the UK was at Tesco.  However, I would argue that perhaps too much emphasis is placed on the desire to maintain this high level of market share within the Tesco board.  The festive pricing strategy was seen by many as a decision made simply to match up to competitors and maintain the status quo, with Tesco by far and away the market leader.  Shareholders have good reason to be dissatisfied as the poorly thought out pricing strategy has caused to some extent the new year profitability warning and resulting share price drop.

Tesco’s growth previously has been achieved through the mass construction of superstores all across the UK to provide customers with a one stop place for all of their consumer needs.  However, I feel that there is beginning to be a shift in the UK market from superstores to convenience.  Customers no longer want to visit out of town superstores, they still want quality, choice and value but in a more convenient location.  This provides a challenging outlook for Tesco. In his BBC blog Robert Peston summated that “Companies have an organic quality. They have a lifecycle. No business continues on a path of unbroken growth forever”.  Have Tesco reached the peak of their growth?  They certainly have to rethink their strategy to help the company and ultimately maintain their good track record as a shareholder wealth maximiser.    Philip Clarke, Tesco CEO, recognised the challenge they faced, stating that “what is at stake is whether the core of this huge global business, the UK stores, can regain their vitality or must become reconciled to long-term stagnation or even shrinkage.” They cannot afford to have too many more days like the 12^th January or the slope may start to become even slippier.

It is worth noting that the supermarket industry has struggled across the board so far in 2012.  UK traded competitors Sainsbury’s (-2.58%) and Morrisons (-9.5%) share price has also declined since the new year.  Why is this the case?  During the recession supermarkets have generally been regarded as a ‘safe haven’ having remained strong or at least maintained their value to shareholders.  This has reflected consumer trends to eat out less and purchase higher quality ingredients to produce home cooked meals.  It may be that the recent decline was just a blip due to a tight Christmas and the growth of more savvy customers.  But, more likely, the signs for the general economy are that alarming that customers are watching there pennies at the supermarket checkouts now just as much as the high street.  If so this could be a worrying time for supermarket shareholders.