Sony Seen Reject From Japan Shame Index in Losing Stock Cull

Jul 29, 2014 2:39 am ET

(Closes today’s share and index prices in seventh paragraph.)

July 29 (Bloomberg) -- Sony Corp. is poised to be rejected from Japan’s government-backed stock index started in January.

The JPX-Nikkei Index 400 picks companies with the best operating income, return on equity and market value to shame executives of those it excludes into boosting profit and shareholder returns. Japan’s biggest consumer-electronics maker will be kicked out when the gauge reassesses its constituents next month, according to UBS AG, Goldman Sachs Group Inc. and at least four other brokerages, as losses create negative return on equity that dwindling operating income and market value no longer counter.

Goldman Sachs says Sony, creator of the PlayStation, is surpassed by 959 businesses jostling for the 400 spots. Rejection matters as investors including the $1.2 trillion government pension fund buy and sell shares to emulate the gauge’s movements. Sony has fallen from grace as it struggles to stem losses in its television business.

“If you’re dropped, the impact on your share price could be quite big,” said Tomomi Yamashita, who helps oversee the equivalent of $6.3 billion at Shinkin Asset Management Co. in Tokyo and says he can now list almost all 400 companies on the measure. “It’s also going to hurt your image.”

Founded in 1946 in Tokyo’s Nihonbashi district, Sony grew from a telecommunications-equipment maker with 190,000 yen in capital to a Fortune Global 500 company credited with helping popularize consumer electronics in the U.S. with Japan’s first transistor radio. Hit products followed, from the Walkman in 1979 to the world’s first CD player in 1982.

More Losses

Now Sony is falling behind Samsung Electronics Co. and Apple Inc., posting losses in five of the past six years and predicting another one to come. Market value was $18.4 billion yesterday, data compiled by Bloomberg show, compared with a peak of $125.8 billion in 2000 and $21.2 billion on June 28, 2013, the base date for the first selection of the index’s companies.

The JPX-Nikkei 400 climbed 0.4 percent to 11,756.95 at the close of trading in Tokyo today, paring its decline this year to less than 0.1 percent. Sony fell 0.8 percent to 1,784 yen, its biggest drop since July 11, extending the stock’s decline for 2014 to 2.3 percent.

JPX-Nikkei 400 constituents are chosen based on three-year average return on equity, which measures how efficiently capital is used, and cumulative operating profit, each accounting for 40 percent of the selection criteria, while market value makes up the remaining 20 percent. About 10 firms can also be replaced based on corporate-governance standards, such as providing English-language results and appointing at least two independent outside directors.

Bigger Problems

Sony had a higher three-year operating income when the gauge’s companies were first chosen, helping it get into the measure despite negative ROE, while peers like Panasonic Corp. and Olympus Corp. were left out. Sony’s cumulative profit earned from regular business operations sank to 189.3 billion yen once this year’s results were included, compared with 362.6 billion yen at the end of the previous period. Its three-year average return on equity was minus 7.9 percent, according to data compiled by Bloomberg.

“It’s amazing Sony was there in the first place,” said Seiichiro Iwamoto, who helps oversee the equivalent of $39 billion at Mizuho Asset Management Co. “To be blunt, ROE is the least of its worries. Sony needs to restructure its business and income streams or it’s in big trouble. I hope this pushes it to want to get back on the index.”

Sony spokeswoman Yo Kikuchi declined to comment by phone on July 23 as changes in index members haven’t been decided yet. The updated list is announced on Aug. 7. Natsuho Torii, a spokeswoman for Japan Exchange Group Inc., declined to comment.

TV Unit

The cost to insure Sony’s debt against non-payment rose 42 basis points this year to as high as 182 basis points last week, exceeding that of Tokyo Electric Power Co., the utility embroiled in the worst nuclear crisis since Chernobyl, for the first time since November 2012, CMA data show. The Markit iTraxx Japan credit-default swap index declined 3.5 to 64 since Dec. 31, while the measure for U.S. companies fell 2.9.

In an attempt to stop the losses, Sony has exited its PC business and split its TV division into a separate entity. Chief Executive Officer Kazuo Hirai said in May the TV unit could make its first profit in more than a decade even if it misses sales forecasts by as much as 16 percent.

The JPX-Nikkei 400, the brainchild of the bourse and planners loyal to Prime Minister Shinzo Abe, seeks to push Japanese companies to change business strategies that have kept returns at half the global average. As the nation exits deflation, Abe wants companies to focus more on making profit and investing it for growth or distributing it to shareholders.

GPIF, BOJ

Japan’s Government Pension Investment Fund, which is being urged to buy more stocks and use the JPX-Nikkei 400, said earlier this month it had about $1.5 billion yen of its more than $205 billion in local stocks tracking the measure by the end of March. The Bank of Japan is considering buying exchange- trade funds based on the JPX-Nikkei 400, people familiar with the central bank’s discussions told Bloomberg News this month.

Equity returns at Japanese companies are improving. Return on equity for members of the broader Topix index, which tracks 1,809 stocks, rose to 8.6 percent for the 12 months ended June, according to data compiled by Bloomberg. That compares with a 10-year average of 6.2 percent through 2013, the second-lowest among 24 major developed markets and half the figure for the MSCI World Index. ROE on the JPX-Nikkei 400 was 9.1 percent as of June 30.

Record Buybacks

Companies are buying back their own shares at the fastest rate ever, with about $28 billion of announced purchases by Topix companies so far this year. Some have tied this largesse to getting onto the JPX-Nikkei 400, with Amada Co., a maker of metalworking machines, saying it decided to distribute all its profit to shareholders so that it could be picked for the gauge.

Amada was one of 74 Nikkei 225 companies that failed to make the cut when the index first chose its constituents. Other rejects included Panasonic, which returned to profit last year after two years of losses of at least 750 billion yen, Olympus, an endoscope maker whose accounting fraud led to a revamp of its board, and Tokyo Electric Power Co., the utility at the center of the biggest nuclear accident since Chernobyl.

Should Sony fall out, it’s likely be to accompanied by at least 37 other companies, if history is any guide. Backtesting by Japan Exchange over seven years showed a minimum of 38 and an average of 53 companies were replaced. That compares with three companies projected to be changed on the Nikkei 225 this year, according to a Daiwa Securities Group Inc. report on June 23.

Fund Inflow

While there are signs the JPX-Nikkei 400 is gaining traction, the cash tied to it is still dwarfed by Japan’s more established Nikkei 225 stock index.

Aside from GPIF’s investments, about 130 billion yen was following the JPX-Nikkei 400 through 23 investment trusts and ETFs as of June 30, according to Mizuho Securities Co. That compares with 5.8 trillion yen tracking the Nikkei 225, according to Daiwa Securities.

“There still isn’t that much money following the JPX- Nikkei 400, so this year’s member change is more a topic for discussion,” than likely to bring about drastic moves in share prices, said Hayato Nagayoshi, chief quantitative analyst at Mizuho Securities. “As the index still has a short history, and more funds will start to use it, there’s a chance demand will come from funds planning to track it anew.”

Goldman Sachs, UBS, Mizuho Securities, SMBC Nikko Securities Inc., Daiwa and Nomura Holdings Inc. say Sony will lose its spot on the gauge when the bourse announces new members on Aug. 7. The changes come into effect from Aug. 29.

Pocari Sweat

The favorite to be added is Tokyo-based Otsuka Holdings Co., Japan’s third-biggest drugmaker by market value and the producer of “Pocari Sweat” sports drinks. With a 16 percent increase in cumulative three-year operating profit and three- year average return on equity of 9.4 percent, up from 8.5 percent last year, at least four brokerages rate it top choice for inclusion. Otsuka wasn’t chosen originally as it hadn’t cleared the requirement to be listed for at least three years.

Otsuka’s shares rose 1.3 percent today to their highest close since July 2013.

Seiko Epson Corp. and Aiful Corp. are also likely to come in from the cold, according to seven brokerages. Daiwa, Japan’s second-largest securities company, which had negative ROE for two straight years ended March 2012, is poised to claim a place, the analysts said.

“Company managers will be able to feel superior to their rivals if they’re chosen for the JPX-Nikkei 400, and it will also lead to more demand for their shares,” said Tatsushi Maeno, head of Japanese equities at PineBridge Investment Japan Co. in Tokyo, which oversees about $2.9 billion. “If you’re excluded, you have to think of capital measures to raise ROE or improve management efficiency. That’s the aim of Abenomics.”

--With assistance from Grace Huang in Tokyo and Sridhar Natarajan in New York.