SECOM Research Report September 2009

Introduction
Secom (TYO: 9735) together with its subsidiaries, operates in the security services industry in Japan and internationally. The company started in 1962 when Makoto Iida, a visionary and pioneer, along with Juichi Toda, established the Japan Patrol Security Corporation, the first security service in Japan. Makoto Iida is a visionary who pioneered the provision of security services in Japan. Secom expanded over the years and diversified its business. Today, the company operates in seven segments: Security Services, Fire Protection Services, Medical Services, Insurance Services, Geographic Information Services, Real Estate Services and Information and Communication Related and Other Services. The Secom brand is well-known and trusted throughout Japan and is synonymous with safety and security. With more than 60% market share, Secom is an industry leader and a dominant company in the Japanese security services industry. Although Secom is a low growth business, its market position coupled with superior margins has afforded it the luxury to produce substantial free cash flow over the years. This together with a conservative approach to business has lead Secom to sustain and maintain a strong balance sheet with net cash. Even though the Security Services business has been a strong performer, over the years due to Secoms foray into other, sometimes unrelated business, the margins and ROIC have rather suffered. Recently, due to losses in the Real Estate services and Insurance services segments and general economic woes, Secoms share price precipitously declined from a high of 6,330/share achieved in November 2007 to a low of 3,120 in March 2009. Today, at 4,530/share Secom has a yield of 1.88% and is trading at 12x last fiscal years Earnings before Income and Taxes (EBIT).

Segment Analysis and Valuation

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Security Services
Security Services growing at 4% is accountable for 62% of the revenue for Secom and is the original and central business segment. It involves the provision of on-line centralized security services for commercial (60%) and residential (40%) premises, static guard services, and armored car services for cash collection and deposit. Secom is vertically integrated and therefore the company also develops, manufactures, and sells various type of security equipment. Secom enjoys a dominant market position in the Security Services industry in Japan with the backdrop of a strong and durable moat. Secoms electronic security business model involves the following; (1) the manufacture facilities that develop and manufacture the security equipment; (2) new subscription orders that can come directly through the client or the sales departments at Secom; (3) installation of the equipment at the clients premises upon approval the client is charged an installation and security fee; and (4) maintenance of communication centers and depots with security guards who can be dispersed when required the client is charged a monthly fee. The essence of Secoms competitive advantage is its scale. Being a pioneer in the Security Services industry Secom had the first movers advantage. As Secom built market share, its products became perceived as the industry standard, which helped to drive additional market shareresulting in increasing returns to scale. Initial feedback is critical to a products success and it is very difficult to obtain this information if a company is the second or third vendor to enter the market. Also, history has shown that the market share leader emerges early and early market share is sustainable as is the case with Intel and AMD, for example. As the market share leader, the cost structure provides important economies of scale in manufacturing, distribution channels and guarding via depots. In manufacturing, Secom can be a low cost producer as manufacturing yields improve and average costs decrease dramatically as the cumulative volume increases. Secom can spread the costs of manufacturing, selling and administration expenses over a larger base and therefore generate above average margins. The communication center and the security depots become more profitable as new customers are added without the need for substantial additional expenses. This is not at the level, but also is not dissimilar to the operating leverage that firms like MasterCard and Google enjoy. This position awards Secom the luxury to expend resources on efficiencies and improvements thereby leading to an improvement in service a continuous positive feedback loop. Secom also has 3

telecommunication networks that it uses in order to transmit data to its communication center. This was a competitive advantage as the infrastructure required is substantial, but with the advent of the fiber optic cable the data can now be transmitted via the internet. However, barriers to entry are significant as any new entrant however will have to spend a huge amount of capital on, (a) manufacture equipment or pay a premium for outsourcing, (b) build communication centers, (c) build security guard depots, (d) put together sales teams to incite new subscribers, (e) train security guards, and (f) more importantly earn the trust of the public. Another competitive advantage that Secom enjoys is an embedded customer base. Secom, for example, charges an installation fee of 130,000, a security deposit of 20,000 and a monthly fee of 10,000 for a 3 bedroom house under the rental arrangement. If however, the customer chooses to buy instead of rent, the equipment has a one time expense of 600,000 and a 4,725 monthly fee. The customer under either scenario has high switching costs and is therefore likely to provide Secom with a recurring revenue stream. The company over the decades has built a very strong brand in Japan associated with security and safety through its innovation, high quality security services, TV commercials, and a foundation dedicated to researching security. In security services where perception is key, Secom overwhelms all others in the power of the brand. Also, in Japan where trust is a powerful marketing tool, a customer is unlikely to switch. Leveraging the Secom brand name, the company also provides static guarding and cash transport services. These are variable cost, lower margin business which complete Secoms portfolio in providing end to end security services. The Security Services industry lends itself to a substantial degree of rollover among employees, which needless to say lowers the operating margins as the employees have to be re-trained and so on (the company had also suffered in the beginning due to scandals involving theft by Secoms security guards). Secom, due to its commanding market position, brand name and stability consequently becomes the preferred place to work for most security guards and also attracts the best at every level of the firm another competitive advantage, another positive feedback loop much in the vein of a firm like Goldman Sachs which can attract top talent due to similar aforementioned factors. Furthermore, Secom has led the way in innovation which reinforces its position, and perception as the market leader. It launched COCOSECOM which uses signals from Global Positioning System (GPS) satellites and cellular telephone base stations to pinpoint the location of transmitter devices. COCO-SECOMs transmitter device when 4

pushed, connects to an operator at the COCO-SECOM operations center, if requested, emergency response personnel from the nearest Secom emergency depot are dispatched. Secom has also developed robots for patrolling large sites. In Japan, the media exacerbate any news of fear and worried families are opt to spend any spare cash they have on turning their houses into high-tech fortresses. In addition, the continued trend of increased outsourcing of security services poses a huge opportunity since a significant part of the total available market is not outsourced. Increased industrialization and increased wealth will continue to pose very good growth prospects. Another trend benefitting Secom is the aging population - a growing number of homes with lonely elderly residents validate the need for Secoms security services. Secom, through affiliates, also has substantial presence in Taiwan, Korea, United States, and the UK among others and lately has been expanding its operations in China. Secom completes with Alsok in Japan which has a 31% market share with the rest shared by a myriad of companies. Guard services naturally tends itself to fragmented market share as the barriers to entry in the lower margin, localized guard services are low. Here, firms compete principally on price and a price conscious customer might not value the quality of service or the brand. Alsok offers a similar portfolio and therefore can be directly compared to Secom. Other large global players such as G4S, Securitas, Prosegur, and Tyco (ADT) have differing portfolios and niches and do not lend themselves to direct comparison. Growt h SECOM ALSOK G4S Securitas Tyco (ADT)
Prosegur

EV/EBIT* 12.07x 11.62x 13.17x 10.56x 9.59x

Operatin g Margins 21% 3% 7% 5.8% 11.4% 10%

ROA** 23.5% (6.7% corporate) 3.44% 7.5% (13.54% tangible) 8.64% (14% tangible) 7.4% 14.2% (17.5% tangible)

4% 0-1% 11-15% 5-9% 5-6% 11-13%

*The multiples are for the last fiscal year for each company, with EV based on current market prices; for Secom the multiple is for the company as a whole and not just the security services business **ROA was measured as operating earnings/Average Assets, due to differing tax rates for better comparison

In deciphering the reasons for the differences, we observe the following: Sohgo Security Services Co. (ALSOK) - Japan's second-largest Security Services Company, has a 31% market share in the electronic security market compared to Secoms 60%. While Secoms market share gives it economies of scale, it hurts ALSOKs margins as it has to maintain a substantial infrastructural base with a much lower subscriber base (if youre not first, your last). The operating margins, consequently, have been deteriorating year after year. In addition, ALSOK has 52% market share in stationed guard services and 32% market share in secure transportation services both higher than Secom and both in lower margin businesses with little or no competitive advantages. Staff costs have been stifling the margins and are the chief culprit responsible for lackluster operating performance. The company has been offering innovate plans but looking at the revenues, ALSOK has not been, and is not, taking any market share away from Secom. G4S G4S is a very specialized security services provider. In addition to regular security services, a large part of its revenues come from risk consultancy, landmine clearing, training, high risk security services (read: unstable countries), and long term outsourcing contracts with various government sectors. G4S has also had extensive experience in building and managing custody facilities, a sector which Secom is just entering. G4S has a significant presence in the UK and Continental Europe, with sizeable penetration in the North American and emerging markets. It has a higher growth profile than Secom as growth is generally coming from emerging economies; Argentina, for example, had organic growth of over 30% in 2008. Unlike Secom, however it has very little operating leverage, as most of its business requires variable human capital and therefore its margins are low. Tax rates for G4S are also low, with a marginal tax rate of 27% compared to Secoms 40%. Securitas Securitas, a behemoth in the security services industry has trimmed its portfolio and now focuses exclusively on the guard and mobile security services businesses little operating leverage. Even with its large size and brand recognition, it has a market share of 18% in the US, with the largest 7 players adding up to a combined 56% market share. Comparatively, Secom alone has over 60% of Japans market and through affiliates a significant presence in Taiwan and 6

Korea. In addition, Securitas also has a large presence in Europe and is aggressively expanding in emerging markets. Its marginal tax rate is 25-28%. Tyco (ADT) Tyco through ADT worldwide designs, sells, services and monitors electronic security systems for residential, commercial, industrial and commercial sectors a very similar business profile to that of Secoms. Over the years, ADT has grown, primarily through the acquisition of other companies. They now have over 35% market share in the US, a leading market share in the UK, and have made strides recently into South America, Europe and the Asia-Pacific region. ADTs operating margins are lower than Secoms and the reasons seem to be: (a) lack of sufficient scale, (b) legacy issues with acquisitions, restructuring, poor working capital management and SG&A and other costs, (c) customer acquisition costs (and attrition) due to dealer programs, and (d) recent investments in sales efforts. The ROA above is skewed because of a large amount of intangible assets mainly due to acquisition of dealer accounts. Prosegur - Prosegur is a Spanish company that provides a broad range of security services including guarding, cash handling, security systems and home alarms. Prosegur has close to 50% of its sales in Spain and some 15% in other southern European countries. The remaining 3035% of sales are in Latin America the major source of growth. It is also worth mentioning that although the companies mentioned above have global ambitions, they rarely mention Japan anywhere in their annual reports.

Valuation
Income Statement for Security Services ( millions) 2005 2006 2007 2008 382,36 400,04 415,41 435,30 Security Services Revenue 0 4 0 6 Growth (%) 4.05% 4.62% 3.84% 4.79% 103,13 Operating Income (Reported) 90,414 86,660 96,162 7 Minus Share of Corp. Expenses 9,822 11,724 9,095 8,774 Operating Income 80,592 74,936 87,067 94,363 21.08 18.73 20.96 21.68 Operating Income Margin % % % % Plus D&A 44,042 44,942 49,168 47,191 Minus Amortization of Deferred 13,538 14,045 14,474 14,953 7 2009 436,91 8 0.37% 102,47 5 9,339 93,136 21.32 % 45,428 15,359

Charges Minus Capex adj EBIT adj EBIT Margin

30,255 29,351 33,306 33,192 29,722 80,84 76,48 88,45 93,40 93,48 1 2 5 9 3 21.14 19.12 21.29 21.46 21.40 % % % % %

On the positive side, owing to the market position, stability of the revenue, operating margins and low interest rates in Japan, comparatively, the Security Services business should be valued at 1415x adj EBIT. The multiple, however, will also be negatively affected by the higher tax rates for Secom and the general investor sentiment in and towards Japan. Again, specifically looking at the peers and the relative superior performance numbers for Secom, it may be determined that the multiple should be higher. This analysis, while intuitive, does not take into account the return on capital a private entity might accept if it were to agree to after tax owner earnings in perpetuity (with 3-4% growth). Furthermore, Mr. Market tends to give more credence to growth than value. Valuing this business therefore at 13x adj EBIT gives us an enterprise value of 1,215,279. On a per share basis at 218,037,197 shares the value of the security services segment would be 5,574/share.

Fire Protection Services (FPS)

Secom, through a 50.34% owned subsidiary Nohmi Bosai, engages in the development, marketing, installation, and maintenance of various fire protection systems. The growth of FPS, at 3.5% is responsible for 12% of the revenue for Secom and is the second largest segment in Secoms portfolio. This business marketed under the Secom brand complements the security services business as it provides a total solution for a corporation or a household. Secom becomes the onestop shop for a customer for security services and fire protection services for complete peace of mind akin IT and IBM in the 90s. Nohmi Bosai is one of the largest manufactures of these systems in Japan and enjoys economies of scale. The FPS enjoys some of the same advantages as the Security Services business mentioned above, such as innovation, brand name recognition, economies of scale in manufacturing, customer retention etc. as the security services business mentioned above. It does, however, face more competition than the Security Services division - the products themselves compete principally on price. Japan has wood and paper structures and the buildings are very close to each other and therefore the fire risk is heightened. Under the

surveillance of an online computer controlled system, when fires break out or tremors erupt, Secom uses the same security services channels to inform the fire department and send personnel from the emergency depot. Importantly, leveraging the security system infrastructure and distribution channels for fire protection systems provides further operating leverage where these services are being offered on the same infrastructural base and hence lowering costs. A standalone fire protection company would be hard-pressed to offer the same services at lower costs as the infrastructure required is substantial. The products differentiate themselves on marketing with the Secom brand name and innovation. Tyco Fire products are a major producer of similar products in the US. At present, that business (32% of segment revenue) is earning 7-9% margins, higher than what Nohmi Bosai is earning in Japan. The difference is attributable to price competition in Japan. It is noteworthy that the Tyco Fire business was also earning 5% margins circa 2006, but the management endeavored and subsequently succeeded in bringing costs down.

Valuation
Income Statement for Fire Protection Services ( millions)

Fire Protection Services Growth (%) Operating Income Operating Income Margin Plus D&A Minus Capex adj EBIT adj EBIT Margin

2008 82,575 3.60% 4,948 5.99% 1,171 1,556 4,563 5.53%

2009 85,175 3.15% 5,353 6.28% 1,250 1,524 5,079 5.96%

A proportionate share of corporate expenses was not deducted from this division as it is a consolidated subsidiary and therefore these expenses would be immaterial. Nohmi Bosai is valued in the market at 45,340 million. Looking at the market position, growth, improvement in operating margins, and low interest rate environment this segment can be valued at 10x adj EBIT or 50,900 million. Secom owns 50.34% of this segment giving us 22,824 million at market value and 25,623 million at our valuation. On a per share basis, this translates to 105/share at market and 118/share at our valuation.

Information and Communication and Other Services (ICS)

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This segment mainly through Secom Trust Systems (Secom TS) accounts for 4.6% of the revenues for Secom. Established in 2006 through the merger of Secom Information Systems and Secom Trust Net, this segment provides comprehensive information security systems and network system operations services. Secom TS offers a wide range of services including data centers, security audits, intruder detection services, digital certification, and consulting service. As is the case with FPS, it has the advantage of offering a one-stop shop for both virtual and physical security. This provides an added layer of security - not only are the servers protected from online attacks, but in Japan which is prone to earthquakes the data servers are also protected from natural calamities. This is the competitive advantage that this division holds over a pure play company like VeriSign Japan. Importantly, the customers have to agree to either: (a) a contract with an installation and monthly fees (b) buying the equipment outright, and front ending the expenses. This induces substantial switching costs for the customer and is the major competitive advantage in this business. This business also leverages the COCO-SECOM system to detect the whereabouts of employees and/or vehicles. Its competitor in Information Services is VeriSign Japan, which is a majority owned subsidiary of VeriSign and provides SSL certifications (business authentication) and IAS (user authentication). While revenues for the ICS segment decreased 8% in 2009, revenues for VeriSign Japan increased 10%. Also, Symantec Corporation the worldwide leader in provides security, storage and systems management solutions to help businesses and consumers secure and manage their information.

Valuation
Income Statement for ICS ( millions) 2008 ICS Revenue 35,543 Growth (%) 4.17% Operating Income (Reported) 4,718 Minus Prop. Share of Corp. Expenses 599 Operating Income 4,119 Operating Income Margin 11.59% Plus D&A 2,707 Minus Capex 5,622 adj EBIT 1,204 2009 31,649 -10.96% 4,918 566 4,352 13.75% 2,680 10,614 (3,582)

Please note that the 2008 capital expenditure figure is more indicative of this segments economics. Although the revenues have been 10

decreasing, the segment is now engaged is higher margin businesses. VeriSign is being valued in the market at 9.5x EBITDA (ttm); it is a bigger company with higher operating margins, lower Capex and positive year over year growth. Symantec Corporation, the market leader, being valued at 7x EBITDA (ttm) is much bigger and has a slightly dissimilar and diversified business profile. It also has higher operating margins, lower relative capital expenditure and a similar growth profile. Both boast of a strong balance sheet with a net cash position. Accordingly, due to its domicile, negative growth profile, high relative capital expenditure requirements, lower margins, higher tax rates, conservatively valuing ICS at 4.5x EBITDA gives us 31,644 million or 145/share.

Geographical Informational Services (GIS)

Secom through Pasco, a 69.84% owned subsidiary is using Geographic Information System (GIS) technologies to develop and sell a wide range of geospatial information services. This division, growing at around 5-8% provides 5.8% of the total revenue. Pasco has obtained exclusive rights in Japan and nonexclusive rights worldwide to sell image data generated by Terra SAR-X, a German commercial satellite that delivers a resolution higher than any other commercial satellite the source of this divisions fragile moat. This satellite is unique in that it can capture high-frequency, high- resolution images regardless of the weather or the time of day. This division offers surveying, measuring and consulting services. It is not clear, however, when these exclusive rights will expire. Additional global players include GeoEye Inc, Navtek (navigation), Digital Globe and Leica Geosystems among others. The moat is weak and importantly not durable because there are substitutes available and the threat of new competitors (entry of existing players) with better technology is a real possibility.

Valuation
Income Statement for GIS ( millions) 2005 GIS Revenue Growth (%) Operating Income (Reported) Operating Income Margin Plus D&A 1,236 34,91 5 2006 39,12 5 12.06 % 900 2007 2008 2009 Normaliz ed 40,207 0.00% 1,809 4.50% 1,690 36,43 39,37 40,20 8 6 7 8.06% 2.11% 6.87% 394 1,439 2,045

3.54% 2.30% 1.08% 3.65% 5.09% 1,631 1,666 1,631 1,666 1,675

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Minus Capex adj EBIT

1,882 985

1,450 1,116

1,882 143

1,450 299 1,655 3,421

1,200 2,300

Pasco is also a publically listed company (TYO:9232) and has a market cap of 12,400 million of which Secom owns 68% or 8,432 million. In 2009, the management made in-depth efforts to improve management of production processes, which reduced cost of sales. This ultimately led to margins increasing from an already historically high 3.65% to 5.09%. This business lends itself to cyclical fluctuations in operating margins. A temporary advantage in technology or a big contract would improve operating margins, while competition, over time will force these margins to come down. In 2007, for example the margins were low because of the price competition in the market. Given the efforts to reduce cost of sales, however, on a normalized basis the GIS division would have a profile similar to that shown under the Normalized scenario above. GeoEye Inc. (GEOY) trades at 9.5x EBITDA and Digital Globe (DGI) trades at 7.5x EBITDA. While the business mix and product profile at these companies is slightly different, both have much better operating margins and higher growth. As a result, for most of the reasons mentioned in the ICS valuation and taking into account the aforementioned competitors; conservatively valuing the GIS division at 5.5x EBITDA gives us an enterprise value of 19,245 million; with Secoms share at 13,806 million or 60/share. This division also carries added uncertainty as Pasco Corporation is in litigation with another corporation. Pending a decision, the company provided a reserve for litigation of 2,415 million.

Medical Services Division (MDS)

The medical services business is spearheaded by subsidiary Secom Medical Services Co., Ltd. It is growing at 10-15% and is accountable for 9% of Secoms revenues. MDS provides services such as home nursing, patient consulting and pharmaceutical dispensing, and medical equipment sales among others. Secom, starting in 1991 was the first private sector firm to provide home nursing in Japan. Benefiting from the growing population, MDS is leveraging Secoms cumulative experience to develop and manage residences for seniors. Even though Secom is capitalizing on favorable demographics, this division has very few inborn competitive advantages. Secom has attempted to replicate the depots in security service with nurse stations (with much higher labor expenses) in MDS. Importantly, this business model is not very capital intensive and can be replicated; Secom does however, have the first movers advantage. They have approximately 42 Secom visiting nurse stations, with around 260

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nurses. Secom also entered the senior residence business and it is difficult to comment on this business without further disclosures. It is not easy to earn above average returns in this business, but with a large fixed asset base Secom has tried to differentiate itself by designing senior residences with the SECOMFORT brand name and establishing affiliations with various hospitals. To illustrate, if you move one person to a facility the approximate monthly costs can be 278,000, while for 2 people the costs would be 473,000/month. In addition, this division also provides innovative medical records service.

Valuation
Income Statement 2003 19,63 Medical Services 7 63.20 Growth (%) % Operating Income 1,905 (Reported) Plus Goodwill 89 Impairment Minus Share of Corp. 569 Expenses Operating Income Operating Income Margin Plus D&A Minus Capex adj EBIT 1,425 7.26 % 953 5,115 (2,73 7) for Medical Services 2004 2005 2006 21,14 34,68 39,31 7 8 5 7.69 64.03 13.34 % % % (1,51 (1,32 1,641 9) 1) 93 592 (2,01 8) 9.54 % 1,164 1,625 (2,47 9) 1,274 876 2,039 5.88 % 1,531 8,647 (5,07 7) 149 1,008 (2,18 0) 5.54 % 1,629 8,474 (9,02 5) ( millions) 2007 2008 45,85 50,74 2 1 16.63 10.66 % % (2,91 (1,08 4) 3) 2,366 873 (1,42 1) 3.10 % 3,202 5,985 (4,20 4) 876 862 (1,06 9) 2.11 % 3,816 4,674 (1,92 7) 2009 52,22 0 2.91% 11 996 915 92 0.18% 2,026 2,153 (35)

After capital expenditures, Secom has persistently lost money in the MDS division. The consistent write downs in Goodwill shows that management has always overpaid when acquiring/developing and thereby overestimated when budgeting. Due to improved results in the senior facility operations, the division was able to break even in 2009. The results in 2005 were an anomaly, as they reflected results from newly consolidated VIEs. Also, operating margins have been improving steadily in the last few years, indicating a comprehensible improvement in the business. The conservative way of valuing the business would be to not assume that the growth or the improvement in operating margins will continue, as it is all still very uncertain.

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This leaves us with liquidation value analysis. This can only be a very rough estimate as the author does not have the means to identify or appraise the assets individually. The MDS division has listed assets of 122,960 million. While historically, these assets have been the nurse stations, recently they have also come to include real estate in senior residences. Due to the generally low returns on assets in Japan and the inability of these particular assets to produce profits for Secom, the assets can be valued at 30-50% of their face value or 36,888 to 61,480 million. On a per share basis, this gives a value of 168/share to 281/share (again, very roughly). No taxes were assumed as the assets are being sold below book value. Please note that the liabilities could not be deciphered specifically for the MDS division and therefore there is no mention of them. This value signifies the amount Secom will get in the market if it systematically liquidates this business (the probability of which is very low), while keeping any related liabilities on its Balance Sheet. It is entirely possible that the improved trend in margins continue, in that case well treat that event as an option.

Insurance Services
Secom General Insurance Co., Ltd is a 95.83% owned subsidiary that is responsible for 4% of Secoms revenues. Secom provides home insurance, vehicle insurance and a niche cancer treatment policy among other policies. Secoms small advantage in this division is that: (1) Secom leverages its security guard depot infrastructure to provide value added services for vehicle insurance, and (2) it also provides added discounts to households with security and fire systems, perhaps because it can understand the risks better. Insurance is a commodity type product (except super-cat) and profitability depends on the underwriting discipline and investing acumen of the management. This business really illuminates the managerial talent or lack thereof. In Secoms case, it is difficult to decipher this information as the underwriting ratios or investing performance for the insurance division is not available.

Valuation
Income Statement for Insurance Services ( millions) Normaliz 2005 2006 2007 2008 2009 ed 26,46 29,53 31,97 33,22 21,53 Insurance Services 25,930 5 7 8 9 0 Growth (%) 12.44 11.61 8.26 3.91 35.21 Operating Income (3,01 5,051 3,752 3,766 (8,22 -

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(Reported) Minus Share of Corp. Expenses Operating Income

1) 655 767 606 563

2) 382 -

(3,66 (8,60 4,284 3,146 3,203 2,074 6) 4) Operating Income 13.85 14.50 39.96 9.84% 9.64% 8.00% Margin % % % Plus D&A 1,175 1,143 1,206 1,225 1,220 1,110 Minus Capex 1,380 1,733 49 8 309 400 (3,87 (7,69 adj EBIT 3,694 4,303 4,420 2,784 1) 3) Over the last 10 years the cumulative earnings from the Insurance Services division have been essentially flat. It lost money in 2003 and 2009 due to write downs in investment securities. In 2005, however the division lost money owing to losses on typhoons and other natural disasters. Consequently, 2006-2008 were highly profitable due to the ensuing upturn in the insurance market (as only the strongest survive and the insurance companies usually increase premiums after industry losses). Looking at the Capital expenditure and Depreciation schedules, the company made most of its fixed investments in this division in the early 2000s. Also, the unrealized losses in the insurance portfolio until realized make it difficult for the management to take advantage of other, perhaps better opportunities. The normalized scenario shown above is not necessarily for valuation purposes, but to shed light on this division in the event of moderate returns on invested assets and a reasonable underwriting performance. While it is difficult to find a peer for the Insurance Services division, profitable Insurance companies on average trade for 1.0x to 1.5x book value, depending on the growth in book value. At one end of the spectrum, Kingsway Financial, a troubled vehicle insurer trades at 0.62x Book Value; at the other end however, a premier P&C insurer like Markel is trading at 1.32x Book Value. AllState, a diversified insurance company including vehicle, property and causality and life insurance divisions trades at 1.04x Book Value. Taking all of the above into consideration and valuing this business at 0.75x its Book Value of 47,753 gives us 34,320 or 157/share for Secoms 95.83% share of this division.

Real Estate Development and Sales (REDS)

Secom over the last few years has also developed condominiums for sale, which are equipped with advanced SECOM security systems. Due to the downturn in the real estate market, the amount of write-down on real estate inventories included in cost of sales for the year ending

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March 31, 2009 was 8,366 million. Secom has no competitive advantages in this business and probably penetrated the business to deploy excess cash.

Valuation
Secom participated in the upturn in the real estate market, which when ended, produced substantial losses. The REDS division is also holding 67,614 in real estate inventory and has listed assets of 76,095; this essentially means that most of what is saleable (or in the process) is held in inventory and the division has few long-term assets. As with the MDS division, the liabilities are not clear and valuing this division at a discount to inventory is the prudent approach. Assuming the division faces further losses on the inventory, this segment can be valued at 0.8x inventory or 47,330 million. On a per share basis, this gives us an enterprise value of 217/share. No taxes were assumed as the assets are being sold below book value.

Valuation
Sum of Parts Valuation:
In addition to the seven business segments, Secom also has stakes in four companies which are accounted for under the equity method. For the sum of parts valuation purposes these entities will be valued at market as follows: S1 Corporation (KSC:A012750), a Korean affiliate trades at a market capitalization of 1.73 trillion won or 1,312,700 million yen at an exchange ratio of 1:0.76 yen. Secom owns 27.2% of S1 Corp. and this stake is valued at 35,700 million. Taiwan Secom (TAI:9917), a Taiwanese affiliate has a market capitalization of 22,270 million Taiwanese Dollars (TWD) or 61,814 million at an exchange ratio of 1:2.77 yen. Secoms share in Taiwan Secom is valued at 17,370 as it owns 28.1% Tokyo Biso Kogyo Corp (TYO:9615) is valued at 10,540 million of which Secom owns 36.6% or 3,858 million. Toyo Tech Co. Ltds 27.8% stake was purchased for 5,146 million and is being valued at cost as an ascertainable market value could not be obtained. In total, Secoms stake in the four affiliate companies is valued above 62,073 million or 285/share. In essence, the sum of parts valuation is as follows:

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Sum of Parts Valuation Security Services Business Fire Protection Services Geographical Information Systems Information, Communication & Others Medical Services Division Insurance Division Real Estate Division Affiliates Total Enterprise Value

/Share 5,574 118 60 145 168 157 217 285 6,724

In addition, Secom has 159,393 million or 731/share in Cash and 157,826 million or 723/share in Total Debt (bank loans, long term debt, pension and lease liabilities). Also, Secom has 206,201 million in investment securities; it was not clear from the disclosures however, how much of these belong to the insurance business and how much are corporate investments. Taking the interest and divided income of 2,195 and valuing this as a perpetuity at 3% (rate used for pensions), Present Value comes to 73,167 million or 336/share. In conclusion, the Net Asset Value (NAV) of Secom is equal to the Enterprise Value plus Cash plus PV of Interest and Dividends minus Total Debt or 7,068/share. It must be stressed, however, that this value where some segments were valued on assets and not earnings. Secom is unlikely to reach this value until those segments produce operating incomes in proportion to their assets.

Consolidated Valuation:
A few adjustments need to be made to the consolidated statements as follows: 1. Converting Operating Leases into debt ( millions) Year Minimum Payments Present Value 1 2,419.00 2,386.31 2 2,288.00 2,226.57 3 2,242.00 2,152.32 4 2,197.00 2,080.62 5 2,193.00 2,048.76 Years 6-15 2,079.89 16,347.68 Debt Value of 27,242.26

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Leases The present value has been calculated using a discount rate of 1.25% (assumed pre-tax cost of debt) and the number of years were determined by taking into account the lease expense in year 5 and dividing it with the amount thereafter. The Balance Sheet consequence of this translation would be an increase in the asset and liability accounts of 27,242 million and no change to equity. While the operating lease expense will be subtracted, depreciation expense (straight line) from the asset and interest expense from the liability will be added to the Income Statement. 2. Proportionate Consolidation of Affiliates Balance Sheet ( millions) Current Assets Non Current Assets Total Assets Current Liabilities Non Current Liabilities Shareholders Equity (Investment in affiliates and goodwill) Total Liability and Shareholders Equity

March 2009 31,722 37,190 68,913 14,030 12,099 42,782 68,913

The net effect on the consolidated balance sheet would be the elimination of Investment in affiliated companies of 40,072 and Goodwill of 2,710 from Secoms asset base. In its place, the proportionate share of affiliate assets and liabilities as shown above will be added. With these aforementioned changes, the equity and net income accounts of Secom will not be affected. A combined ratio of 35.084% was used in the above calculations. In addition, Secom has certain Variable Interest Entitys (VIE). Secom is the primary beneficiary in a VIE holding 16,594 million in assets which it consolidates. Secom also has interest in another VIE holding 46,654 million in assets in which it is not a primary beneficiary and therefore this VIE has not been consolidated. The company is not responsible for absorbing majority of the losses in this VIE and its proportionate share is not disclosed. It therefore, becomes very difficult to consolidate this VIE (if we wanted to). Secom does disclose that its maximum exposure to losses relation to VIEs was 9,794 at March 2009. No changes were made to the balance sheet with respect to the VIEs.

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With these changes a condensed, restated Balance Sheet would look as follows (the June 2009 Balance Sheet was not used due to lack of disclosures): Consolidated Balance Sheet ( millions) March Assets Liabilities 2009 Cash and Cash Equivalents 159,393 Bank Loans Share of affiliate Current Share of affiliate Current 31,722 Assets Liabilities Other Current Assets 333,148 Other Current Liabilities Total Current Assets 524,263 Total Current Liabilities Investments w/o affiliates Lease Asset Share of other affiliate Assets PP & E Other Assets w/o affiliate Goodwill 250,846 27,242 37,190 259,282 97,690 Long Term Debt Lease Liability Share of other affiliate Liabilities Other Liabilities Total Liability Shareholders Equity Minority Interest in Subsidiaries Total Liability and Shareholders Equity

March 2009 78,180 14,030 205,257 297,467 36,404 27,242 12,099 233,510 606,722 528,721 61,069 1,196,5 12

Total Assets

1,196,5 12

Before the consolidated valuation, here are some of the risks confronting Secom: 1. The security services business is based on trust and perception. Any breach in the security system, leaks by Secom, or scandals involving staff would dilute Secoms brand. While Secom is wounded, a competitor at this time might be able to grab market share. In a worst case scenario, Secom could perhaps loose 510% of its security services revenue. Because operating leverage cuts both ways, the margins would be lower well assume 10%. 2. Secom insures for fire damage. The company also provides heavy discounts if the client subscribes to Secoms services. This means that the company would essentially have no out in the event of a major catastrophe, and consequently, would suffer heavy losses. For example, it would not be able to refuse damages on grounds of faulty equipment as the equipment is provided by Secom. 3. Secom could further lose money on the investment portfolio

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4. The Real Estate market might not rebound for another few years and Secom could further lose money on the real estate inventory 5. A risk to our evaluation of the company comes from the fact that the management may still decide to venture into another unrelated business, thereby sinking more shareholder money. These being the risks, the worst case scenario would typically be when (1), (2), (3), and (4) occur at the same time. It is assumed for the Worst Case scenario that (a) Secom loses 10% of its Security Services and Fire Services revenue; (b) it suffers underwritings losses in the insurance division; (c) it suffers losses in investment security and real estate portfolios (we wont reverse 2008 losses); and (d) other corporate expenses increase as a consequence of these events. Correspondingly, the Income Statement showing the true economics (owner earnings) of the business with 2009 as a base year is as follows: Consolidated Income Statement ( millions) Base Case Worst Case Revenue 688,771 637,197 Costs and Expenses 612,072 573,371 Reported Operating Profit 76,699 63,826 Plus Write-down of Securities and Real Estate 27,900 0 Plus Depreciation expense from converted Lease 1,945 1,945 Minus Expense for Operating Lease (2,504) (2,504) Operating Income 104,040 63,267 Plus Depreciation and Amortization 54,625 54,625 Minus Amortization of Deferred Charges (15,359) (15,359) Minus Capital Expenditures (44,855) (44,855) adj EBIT 98,451 57,678 Interest and Dividends 2,300 2,300 Share in Affiliate Income (no taxes) 8,733 6,113 Minority Interest in Subsidiaries (no taxes) (4,928) (4,928) Interest Expense (2,019) (2,019) Other recurring expenses (3,000) (6,000) Other Income (Expense) 1,086 (4,534) Earnings Power (Pre-tax) 100,623 48,610 Earlier, we valued the Security Services business at 13x adj EBIT. Incorporating other businesses, which induce uncertainty and volatility

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into the earnings, the multiple would have to be revised downward. Valuing the entire business at 12x Economic Pre-tax Income we get 1,207,476 million or 5,538/share. This value is much lower than the value in sum of parts analysis as some businesses were valued at liquidation value. These businesses contribute little or nothing to the bottom line and hence are worth more dead than alive. On the other hand, some of these same businesses, in cyclical upturns, will boost Secoms earnings - we cannot however, handicap the probability of if, when, or by how much. Due to persistently low interest rates, it must also be noted that this multiple is a little higher than what a comparable business would fetch in North America. Clearly, the future is uncertain. Normally, to account for these uncertainties and, importantly human error, known or unknown, a business should be purchased at 60-65% of its intrinsic value - in Secoms case, at or around 3,323 per share. This is while getting a 1.88% dividend yield and a 3-4% increase in intrinsic value every year. Absent any corporate action, Mr. Market is more likely to value Secom at consolidated valuation than the sum of parts valuation. At 12x worst case adj EBIT, the business can be valued at 692,136 million or 3,174 per share. This is substantially below the current market valuation, but it should be noted that the probability of this scenario occurring again (fiscal 2009 was very close to worst case) is low. It may also be argued that in the worst case scenario, the company would trade at a lower multiple. Experience suggests that this argument is valid, but as long as the company has a strong balance sheet, resultant valuation is very temporary. We will use Return on Invested Capital (ROIC) to capture the key drivers of value creation for Secom. The ROIC increased from 7.2% in 2005 to 10.18% in 2008, before falling to 7.2% in 2009. On a normalized basis, ROIC was 9.76% in 2009. If, just for comparison, we include the cash and investment securities the ROIC goes down to the 5-6% range. Secom, as a result, is hurting corporate returns by its investments in securities and by holding excess cash. In the three months ending June 2009, Secom had an operating profit of 23,637 compared to 23,514 in the three months ending June 2008. The performance is very comparable. Due to the very short time period and lack of disclosures, not much can be said at this point.

Management
In 2009, twelve Secom Directors (also executives) received 492 million in compensation base and bonuses or 41 million per 21

Director. In one of the worst years for Secom, included in the above total amount are the Directors' bonuses of 68 million. In comparison, these Directors earned a total of 592 million with 98 million in bonuses in 2008. This leads us to conclude the following, (a) managements compensation is reasonable, even low (when compared to similar sized North American corporations), and (b) a major fraction of the compensation is the fixed base salary and not performance based bonus. Unfortunately, the compensation committee is not harnessing the power of incentives in setting compensation. In similar vein, except the founder, co-founder and chairman who own 4,320,500 (2%), 3,152,216 (1.45%) and 37,300 shares respectively, no other director has substantial shareholdings in Secom. The management accordingly has very little in terms of incentives to increase shareholder value. It is not clear from the disclosures how other officers of the company get compensated. In view of the aforementioned, it is no surprise that managements marginal performance over the years has been dismal. On the positive side, the management, and before that the founders have done a great job in strengthening and expanding the Security Services business. It is a business today, where management would have to make major errors in judgment to harm the franchise (the reputation of the business will stay intact). Likewise, the decision to buy a stake and partner with Nohmi Bosai is prudent. Although numbers wise it hurts marginal performance, it helps strengthen Secoms moat by making it a one stop shop as discussed before. The ICS and GIS divisions also lend themselves to similar reasoning. Secom also boasts of a strong Balance Sheet negating the probability of permanent loss of capital. The management also steered the business to a position where it is not dependent on the capital markets and if the markets close for 10 years, Secom would come out unscathed. The ability of a business to invest its capital at enticing incremental returns is the key driver to creating long-term market value. The ROIC for example, was 7.2% for the entire business while the ROA (a tougher measure) of the Security Services business itself (after taxes) was 14.14% in 2009. Looking at this in a very crude manner (as D&A, Write-offs etc. are not included), the MDS division, for example, has 122,960 million in assets the amount of capital that Secom over the years invested in this division. While depriving the owners, this capital has added nothing to Secoms bottom line. Moreover, the market will assign a higher multiple, all other things being equal, to a firm with stable earnings than one with volatile earnings. The additions of the Medical Services, Insurance, and Real Estate businesses, although a small part of Secoms portfolio, introduce volatility (although this volatility is responsible for providing a buy-in window to Secom for an 22

enterprising value investor). Secom essentially is trying to be all things to all people - a difficult strategy, even in the best of times. This course of action, while unfavorable to shareholders, is not foreign in Japan. Having said that, management did repurchase shares in 2009 when they saw an opportunity and have regularly paid a dividend, thus returning wealth to shareholders. An investment in Secom should be made with the understanding that the management will continue deworsifying and thereby plowing capital into other businesses.

Conclusion
It is imperative to be in a business experiencing tailwinds. With an ageing population and rising crime rates or the perception thereof, security and related services become essential. Secom is wellpositioned to capitalize on this opportunity. With deflation rampant in Japan, where people regularly decide to buy tomorrow and where corporations regularly decide to invest tomorrow, comparatively, Secom has made great strides. The new government in Japan has a mandate to increase internal consumption, directly benefitting Secom. The business today has a strong, and importantly, durable moat which allows it to earn above average rate of returns. True, the management has shrunken shareholders share by diversifying into other business, but on the other hand Secom did not reach its current status by running on autopilot. The Secom brand is a trusted and well respected brand in Japan. Secom continues to push ahead with new technology, busily forming joint ventures to improve its services and stay ahead of the curve. Change, while inevitable, cuts both ways for an investor. The best business returns are usually achieved by companies that are doing something quite similar to today to what they were doing five or ten years ago. Secom has been, and will be for many years, provide premier security services in Japan. Very few people have, or will calculate IRRs on security there is no price for peace of mind. Disclosures: None

Bibliography Secom. Annual Reports, http://www.secom.co.jp/english/ir. 19982009

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Annual Report. Sohogo Security Co. Ltd, G4S, Securitas, Tyco, Prosguer, Nohmi Bosai, VeriSign, Symantec Corp. 2008-2009 Tanikawa, Miki. Secure Stock Pick In Uneasy Japan. The New York Times. January 2002 Tanikawa, Miki. Secom's steady profit draws notice: The next blue chip? The New York Times. May 2002 McFalan, F. Warren et all. Secom: Managing Information Security in a Risky World. Harvard Business School. April 2008 Shimazaki, Hiroshi. Vision in Japanese entrepreneurship: the evolution of a security enterprise. December 1992, Pg. 146 154 Ishikawa, Akira and Nej, Tai. Top global companies in Japan. January 2004 Purpura, P. Philip. The security handbook. November 2002 Lewis, Leo. Selling safety gets serious: security giant Secom soars on a mix of media hype and menace Upfront. BNET. January 2004 More families willing to pay companies for home security. The Japan Times. May 2007 Google Finance, http://www.google.com/finance Yahoo Finance, http://finance.yahoo.com/ Financial Times, http://markets.ft.com/tearsheets/

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