Aug 2004

LONG ONLY JAPANESE EQUITIES

One domestic industry undergoing structural change in Japan is retail and distribution. It is where retailing in Britain was in the 1970’s.

Looking at it in another way, Japan and the USA have the same number of retail stores even though Japan has only 4% of the USA’s landmass and 163m fewer people. The top 5 retailers in Japan only account for 10% of the market yet in the UK the top 5 dominate the market. Until 4 years ago there were strict regulations that prevented the opening of large-scale retail formats. As a result, development in the retail sector was stifled which is why any visitor to Japan, a modern country by most standards, is amazed at the plethora of seemingly inefficient tiny retail formats. Still today, as was Britain in the 1960’s and 1970’s, large department stores dominate the centre of cities and are considered the most prestigious locations to shop. However following changes to laws 4 years ago allowing the easier expansion of malls, supermarkets and hypermarkets, change is afoot. The biggest losers from change are the distributors. Depending on the retail niche, there are many layers of them who perform, in some cases no function other than claiming part of the distribution margin as a reward for a long-standing relationship with another in the chain. As retail formats expand in size and the number of retailers declines, a trend now firmly established, distributors are forced to amalgamate to survive. Many small ones fail. Small retail formats are also under pressure, not having the economies of scale to survive unless the products they sell or the services they provide stands out above all others. Mom and Pop stores are most vulnerable but least driven by the profit motive given that the proprietors live over the shop. As a result they tend to close only when the proprietors retire.

The winners will be the large efficient retail formats but unlike the USA and the UK these formats will be fighting for market share at a time when retail sales volumes and prices are falling. Also competition from overseas has already entered the market in the form of Wal-Mart and Tesco who arguably have more experience of executing change, even if they have less knowledge of the local market, than the domestic Japanese companies. We view the obvious opportunities for rationalisation of the retail sector with interest, but while prices are falling and demand stagnant the increase in retail floor space planned as companies jockey for position, is likely to lead to more losses on capital committed than decent returns. We think that only when retail floor space begins to shrink might returns improve. As a result the investment in the Fund in the retail sector is small and restricted to two specialist companies: Seven-Eleven Japan and Impact 21.

Seven-Eleven operates the largest chain of convenience stores in Japan. The 10,303 stores (Mar 2004) well exceed the nearest competitor, Lawson that operates 7,800. All of Seven-Eleven stores are franchised which allows the company to expand quickly and to access some of the best sites without tying up too much capital. Seven-Eleven as the franchisor provides merchandising, systems and branding and in some cases the land and building. The franchisee manages the store and contributes to the running expenses in return for a predetermined shared percentage of the gross profits generated by the store. The success of the convenience store industry has been aided by Japan’s population density, which ensures high customer throughput and large store densities. Today 52% of sales are Seven-Eleven’s original products dominated by fresh food, delicatessen and sandwiches prepared by Seven-Eleven locally run kitchen and distribution centres serving clusters of stores. Inevitably these products attract high margins. Other products include magazines, groceries, drinks including liquor and services such a banking, parcel collection and bill payment. Over the years Seven-Eleven has been extraordinarily successful in not only expanding its network around Japan but also maximising sales and returns from the existing network. Over the last 10 years sales have annualised at 9%, free cash flows at 10% and dividends at 11%, not bad in deflationary, rolling recession. Although there is scope for more growth the pace will inevitably slow down. Today the size and scope of the business itself together with its brand recognition presents opportunities for the future. Seven-Eleven’s distribution power is immense and has the potential to be exploited for other purposes, which is why Yamato Transport use the Seven-Eleven store network for their parcel delivery service. Also, Seven-Eleven’s majority shareholder, Ito Yokado, recently established the IY Bank's in joint venture with Seven-Eleven. Using the store networks as sites for ATM’s has allowed that business to reach profitability in its third year of operation. Seven-Eleven is trading at a free cash flow yield to enterprise value (market capitalisation-cash) of 4% so is not cheap today but it did become so last year and should that happen again we would consider an even larger position in the company.

Impact 21 manages Polo Ralph Lauren’s stores and product in Japan in joint venture with Onward Kashiyama. Together, both own more than half Impact’s equity. Although the brand is favoured by the Japanese its presence could grow significantly more from here. We sense the company has the resources and ambition to expand but until the general retailing environment is more favourable will manage the existing business as efficiently as possible. With no obvious growth the company shares have traded too cheaply in our view, for some time. We have no expectation of this changing in the short term but reassure ourselves with holding an asset with a free cash flow ratio of 7%, with 55% of the market capitalisation represented by cash.

14 Sep 2004 LTL 000-024-7