April 18, 2011

Equity Research Investment Strategy & Macro Japan Equity Strategy

Fumiyuki Takahashi BCJL, Tokyo 81 3 4530 2943 fumiyuki.takahashi@barcap.com Arisa Mori BCJL, Tokyo 81 3 4530 2918 arisa.mori@barcap.com

Japan Equity Strategy

Market Commentary/Strategy

Move early to capture expectations of earnings recovery from FY12

Move early to capture expectations of earnings recovery from FY12 FY11 earnings outlook remains uncertain, but we expect market to price in FY12 recovery from around summer We estimate that the stock market has now priced in the upheaval and near-term earnings impact of the Tohoku Pacific Coast Earthquake, and will steadily rise as the prospects of longer-term recovery become clear. The outlook for FY11 (FY3/12) earnings remains uncertain, but we expect the market to price in the likelihood of recovery in FY12 (FY3/13) from around the summer. The disruption of Japanese supply chains for industrial products in areas such as automobiles, electronic components, and high-functional materials is now having worldwide repercussions. However, we do not believe Japanese products will easily lose their reputation for performance and quality. The earthquake should have a relatively major short-term impact on earnings, but we remain confident that exports will continue to drive a recovery.

Identify profit recovery candidates by screening for FCF and ROIC Given the uncertainty over the profit outlook, we screen for free cash flow (FCF) and return on invested capital (ROIC). We see the greatest prospect of profit recovery among companies that both generate adequate FCF and have high ROIC. Many companies with high ROIC also tend to have healthy balance sheets. Many of the stocks identified through this screening are in export sectors such as transportation equipment, chemicals, and electric appliances.

Barclays Capital 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. This research report has been prepared in whole or in part by research analysts based outside the US who are not registered/qualified as research analysts with FINRA.

PLEASE SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLOSURES ON PAGE 5.

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FY11 earnings outlook remains uncertain, but we expect market to price in FY12 recovery from around summer
We estimate that the stock market has now priced in the upheaval and near-term earnings impact of the Tohoku Pacific Coast Earthquake, and will steadily rise as the prospects of longer-term recovery become clear. The outlook for FY11 (FY3/12) earnings remains uncertain, but we expect the market to price in the likelihood of recovery in FY12 (FY3/13) from around the summer. We forecast major disruption to production and the economy in the near term, caused both by direct damage to facilities and the power shortages resulting from the nuclear accident. The stock market has become largely static, both because it is not yet clear how long it will take to restore severed industrial supply chains and because investors do not yet have enough information to quantify the impact on the economy and earnings. Several pieces of good news have appeared: many of the factories damaged in the earthquake have resumed operations, and TEPCO has raised its forecasts of power supply capacity to a degree (although the threat remains of shortages during peak summer demand). This appears to have reduced the downside risk to share prices, and suggests that a large double-dip is unlikely in the near term, as long as the nuclear situation does not deteriorate sharply. We expect the BoJ to purchase stocks (via ETFs) as part of its quantitative easing policy during market dips. The disruption of Japanese supply chains for industrial products in areas such as automobiles, electronic components, and highfunctional materials is now having worldwide repercussions. However, we do not believe Japanese products will easily lose their reputation for performance and quality. We forecast that Japanese corporate earnings will again recover, led by the exporters, once supply chains have been restored. The earthquake will have a relatively major short-term impact on earnings, but we remain confident that exports will continue to drive a recovery as demand grows from China and other emerging nations, and the US economic recovery remains intact. We also expect the yen to weaken over the longer term, based on the variance in growth rates between the Japanese and other developed economies, and the interest rate gap. Such external macro factors should support earnings growth at Japanese exporters once production capacity has recovered. We lowered our forecast of FY11 profit at the start of April to reflect the impact of the disaster, reducing TSE1 (excluding financials) RP growth from +12.2% before the earthquake to -12.0% after. We expect share prices to be weighed down until summer by the downside risk to earnings and the uncertain outlook. By the same token, we forecast that the uncertainty over earnings will recede during the summer as supply chains are restored and the impact of power shortages on earnings can be more accurately gauged. As this happens, we anticipate that the stock market will start to price in a FY12 profit recovery. It may therefore be an effective strategy to move early before the market begins to price this in.

Identify profit recovery candidates by screening for FCF and ROIC

Too little information is available to forecast earnings accurately. One result of this has been a wider divergence in analysts' 12month forecasts since the disaster. Given this uncertainty over the profit outlook, we screen for free cash flow (FCF) and return on invested capital (ROIC). Many companies, led by the exporters, had improved FCF greatly before the earthquake, and the recovery in profit was starting to catch up with the improvement in FCF. Capital efficiency (in terms of ROIC) was also improving markedly. We see the greatest prospect of profit recovery among companies that both generate adequate FCF and have high ROIC. Many companies with high ROIC also tend to have healthy balance sheets. Given that FY10 (FY3/11) reporting season has not yet begun fully, we screen for companies with high ROIC on an analyst OP forecast basis and high 4-quarter historical FCF. Many of the stocks identified through this screening are in export sectors such as transportation equipments, chemicals, and electric appliances sectors.

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Figure 1: Earnings forecast dispersion among analysts and share prices (TOPIX500 stocks)
200 1600

175

1400

150 1200 125 1000 100 800 75 600 (Month-end values) 25 12/2003 04/2004 08/2004 12/2004 04/2005 08/2005 12/2005 04/2006 08/2006 12/2006 04/2007 08/2007 12/2007 04/2008 08/2008 12/2008 04/2009 08/2009 12/2009 04/2010 08/2010 12/2010 15/04/2011 400

50

Analysts' earnings forecast dispersion index (LHS, End-Dec., 2003=100) TOPIX500 (RHS)

Note 1) Analysts earnings forecast dispersion is based on 12-month forward EPS data for companies covered by five or more analysts. 2) Earnings forecasts are based on I/B/E/S data. Source: Factset, Barclays Capital

Figure 2: Free cash flow and ROIC trends (TOPIX500 excluding financials)

12 10 8 6 4 2 0
(Month-end values)

-2 12/2003 04/2004 08/2004 12/2004 04/2005 08/2005 12/2005 04/2006 08/2006 12/2006 04/2007 08/2007 12/2007 04/2008 08/2008 12/2008 04/2009 08/2009 12/2009 04/2010 08/2010 12/2010 03/2011

FCF/TA

ROIC

Note: ROIC is defined as OP/(Net assets + interest-bearing debt) Source: Factset, Barclays Capital

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Figure 3: Stocks with the prospect of profit recovery in FY12: Stocks with high FCF and ROIC
Company Name ITO EN,LTD. KURARAY CO.,LTD. ZEON CORPORATION Kao Corporation Nissan Chemical Industries,Ltd. TOAGOSEI CO.,LTD. Hitachi Chemical Company,Ltd. UNI-CHARM CORPORATION NITTO DENKO CORPORATION HISAMITSU PHARMACEUTICAL CO.,INC. Shionogi & Co.,Ltd. Mochida Pharmaceutical Co.,Ltd. SANTEN PHARMACEUTICAL CO.,LTD. Asahi Glass Company,Limited NHK SPRING CO.,LTD. Nabtesco Corporation SEGA SAMMY HOLDINGS INC. SANKYO CO.,LTD. DISCO CORPORATION SMC CORPORATION OSG CORPORATION Dainippon Screen Mfg.Co.,Ltd. CANON INC. IBIDEN CO.,LTD. Yamatake Corporation BROTHER INDUSTRIES,LTD. SYSMEX CORPORATION Mitsubishi Electric Corporation HORIBA,Ltd. DAIHATSU MOTOR CO.,LTD. SHIMANO INC. ISUZU MOTORS LIMITED NISSIN KOGYO CO.,LTD. Fuji Heavy Industries Ltd. AISIN SEIKI CO.,LTD. KEIHIN CORPORATION TOKAI RIKA CO.,LTD. TOYODA GOSEI CO.,LTD. EXEDY Corporation TOKYO SEIMITSU CO.,LTD. HOYA CORPORATION TERUMO CORPORATION ORACLE CORPORATION JAPAN Yahoo Japan Corporation ITOCHU Techno-Solutions Corporation SOFTBANK CORP. Trend Micro Incorporated CAPCOM CO.,LTD. Sanrio Company,Ltd. K'S HOLDINGS CORPORATION SHIMAMURA Co.,Ltd. LAWSON,INC. POINT INC. SUNDRUG CO.,LTD. DeNA Co.,Ltd. USS Co.,Ltd. Code 2593 3405 4205 4452 4021 4045 4217 8113 6988 4530 4507 4534 4536 5201 5991 6268 6460 6417 6146 6273 6136 7735 7751 4062 6845 6448 6869 6503 6856 7262 7309 7202 7230 7270 7259 7251 6995 7282 7278 7729 7741 4543 4716 4689 4739 9984 4704 9697 8136 8282 8227 2651 2685 9989 2432 4732 Sector Foods Chemicals Chemicals Chemicals Chemicals Chemicals Chemicals Chemicals Chemicals Pharmaceutical Pharmaceutical Pharmaceutical Pharmaceutical Glass & Ceramics Products Metal Products Machinery Machinery Machinery Machinery Machinery Machinery Electric Appliances Electric Appliances Electric Appliances Electric Appliances Electric Appliances Electric Appliances Electric Appliances Electric Appliances Transportation Equipment Transportation Equipment Transportation Equipment Transportation Equipment Transportation Equipment Transportation Equipment Transportation Equipment Transportation Equipment Transportation Equipment Transportation Equipment Precision Instruments Precision Instruments Precision Instruments Information & Communication Information & Communication Information & Communication Information & Communication Information & Communication Information & Communication Wholesale Trade Retail Trade Retail Trade Retail Trade Retail Trade Retail Trade Services Services FCF/Total assets(%) 8.6 16.9 15.0 10.4 9.4 8.8 8.7 8.6 7.7 14.5 8.7 8.6 7.6 9.1 8.3 13.2 10.3 9.1 6.8 6.7 6.5 15.2 10.3 9.3 9.3 9.1 8.3 7.5 6.9 10.9 10.4 10.0 9.9 9.6 9.0 9.0 8.2 7.7 7.0 13.7 9.3 8.0 24.0 19.5 11.1 10.8 9.9 8.5 10.8 16.8 13.6 9.0 8.2 8.2 27.3 13.6 ROIC(%) 14.9 12.9 17.4 14.9 15.0 16.0* 13.9 11.9 18.4 19.4* 12.2 13.2 18.8 17.2* 15.7 17.7 20.2 13.1 14.6 15.1 12.5 18.1 14.5* 11.8 11.5 16.0 20.6 16.0 12.4* 15.0 19.1* 12.8 12.4 11.9 11.0 15.3 12.7 11.1 17.8 11.3 16.8 19.1 47.7 43.8 14.0 20.0 22.1* 21.0 23.8 19.9 18.9* 27.3* 43.2* 22.9 75.9 20.6 Share-price (4/15, JPY) 1,420 1,039 698 2,045 815 426 1,529 3,080 4,280 3,300 1,382 933 3,080 1,009 746 2,012 1,425 4,015 5,290 13,710 1,051 723 3,670 2,527 1,925 1,190 2,851 859 2,410 1,146 4,300 317 1,304 566 2,643 1,513 1,322 1,630 2,337 1,425 1,722 4,335 3,395 28,040 2,755 3,360 2,144 1,502 2,651 2,305 7,230 4,005 3,630 2,272 2,852 6,190

Note: 1) Analysis universe is TOPIX500 stocks excluding financials. 2) ROIC is based on OP estimates for FY2010 (forecast OP/(net assets + interest-bearing debt). ROIC values shown with * are based on actual OP. 3) Earnings forecasts are based on I/B/E/S analyst consensus data. Source: Factset, Barclays Capital

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ANALYST(S) CERTIFICATION(S):

We, Fumiyuki Takahashi and Arisa Mori, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report.

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