• Will

Incubating Innovative New Entrants Into "Boring", Conservative Industries in Japan

While our ongoing focus today continues to be our small business acquisition thesis in Japan, this work does not prevent us from occasionally thinking about and more casually exploring some of our other aims and visions of the future. To that end, this post will briefly discuss a compelling, differentiated approach to building "startups"...though not the flashy tech startups that immediately pop to mind. Rather, "startups" marrying the risk and strategies of private equity with the potential upside and business building efforts of venture capital within "boring", staid industries in Japan ripe for a more nimble, less conservative, dynamic new entrant adhering to more "rational", long-term oriented capital allocation and growth strategies.

With that said, let's jump into it...

Two of our favorite investment firms are Lux Capital and Atomic.vc. Both are innovative, forward-thinking and focused on the long-term. Both also have rather proactive investment models whereby they actively pool the resources - financial, human & know-how - to build a business in order to actualize a particular investment thesis. Put another way, they both, to varying degrees, identify unique, overlooked investment opportunities where there tends to be few, if any, existing teams and / or attractive assets that allow them to express these theses. As a result, they are willing and able to spec-build companies from the ground-up, so as to surface the "latent alpha" in said opportunities.

One of Lux's best known investments adhering to this model was Kurion, a contrarian bet in the unlikely business of cleaning up nuclear waste for profit. For Atomic, their whole investment model is predicated upon incubating businesses and effectively "spinning" them out. One of their break-out companies is Hims & Hers.

Being rather big fans of Japan, and more specifically the "hidden" business and investment opportunities in the country, we have often thought about building the Lux or Atomic of Japan at some point. While establishing Japan nuanced replicas of these firms may very well be a successful strategy, we can't ignore our affection for the truly "boring", "niche" and "unloved" opportunities outside of the more competition heavy arenas of today (e.x. typical tech startups, traditional private equity. We share a bit about our love for such investments in a prior post). More to the point, the main question here then is how exactly would our "Future Lux of Japan" look and what precisely would we focus on?

Well, to help answer these questions, let's walk through what could very well be an ideal investment for this "Future Lux of Japan".

So, to begin, what is a large, necessary, relatively "boring" and "unsexy" industry that won't attract much in the way of innovative risk capital or visionary entrepreneurs...particularly not so in Japan?

How about the...funeral industry!

Bingo. Let's look at some industry facts below (note: all info & data sourced from Shared Research):

The ~$14Bn Japanese funeral industry is set experience continued tailwinds for at least another 25 to 30 years.

In terms of the number of companies, the industry is quite fragmented & predominately populated by businesses operating with less than $500k in total capital. In percentage terms, the largest of players represent just 6.7% of active companies, while "SMBs" represent ~83%. One could very easily argue that many of these smaller companies are effectively "one-man shops", unlikely to survive as stand-alone businesses without the current owner-CEO in place.

Unfortunately, we have not been able to come upon any hard data around industry revenue breakdown by company size. However, there are four publicly listed funeral service players in Japan:

Heian Ceremony Services (Ticker: 2344)

Note the company's relatively stable & high Funeral segment operating profit margin of 30%. Also worth highlighting is the low to no-growth top-line.

Sun-Life Holding (Ticker: 7040)

Again, note the stable and relatively high operating profit margin of ~24%, though, yet again, a less-than-exciting top-line growth profile.

San Holdings (Ticker: 9628)

A lower, but still attractive operating profit margin coupled with - you guessed it - low revenue growth.

Tear Corp. (Ticker: 2485)

A similar financial overview for Tear is a bit too detailed for our purposes here, but, in short, Tear's relevant operating profit margin falls around 17% paired with a similarly very modest top-line growth.

Adding up the above four publicly listed companies' latest FY revenues, we end up with ~$529M at today's exchange rate of ~106 JPY / USD. So, we can roughly say that 4 of the presumably top players in the industry represent just shy of 4% of industry-wide revenues ($529M divided by $14Bn). Since we are doing a bit of napkin math here, let's just assume we are excluding a handful of other large private companies in the space and bump this "top of the class" group up to 15% of industry-wide revenue. Even then, it is still a very fragmented industry landscape.

An additional point worth noting, the above four companies currently trade at the following "cash on the balance sheet : market value" ratios in what is a profitable, steady industry with minimal obsolescence risk. Just as noteworthy, none are valued over $125M in the market today.

- Heian: 98% (no debt)

- Sun-Life: 226% (no debt)

- San: 39% (very minimal debt)

- Tear: 28% (modest debt at half the size of its cash position)

Put simply, "rational" capital allocation strategies are not being pursued.

In that vein, and connecting the above industry fragmentation data with this company specific information, an astute investor-businessperson may be thinking of how ripe the industry is for an M&A driven consolidation. Looking a bit further under the hood, however, reveals certain industry strategies / realities (i.e. very much a localized monopoly / geographic saturation play + overwhelming prevalence of many "one-man-shop" SMBs) that create a situation whereby any truly viable, attractive M&A targets are rare, and thus often priced at a premium, making an organic growth strategy more prudent and compelling in most cases.

Now, while this is largely what the listed incumbents are pursuing - organic growth - they are doing so in a very risk-conscious, conservative manner. Put another way, there does not appear to be any significant "barrier to entry" or "moat" that the industry's many SMBs have in place that would prevent a more rapid expansion strategy by incumbents...quite the opposite in fact. On top of this, these local "mom and pop" SMBs, who effectively "own" much of the industry revenue today, are themselves increasingly retiring and closing up shop.

So, we are left with an industry that quite frankly requires consolidation, though the only real viable, and in some cases prudent, way to achieve this consolidation is via organic growth by the large players, absorbing the increasingly "abandoned" profits of "retiring, successor-less SMBs". Problem is, the big guys arguably don't have the DNA to ramp up a more aggressive growth strategy (see anemic growth profiles above)...so, we are left with a growing "white space" in the industry effectively up for the taking...

Enter the "Future Lux of Japan".

First, a word of caution for any foreign group entering Japan with plans of grandeur...it is a unique culture with a very particular set of expectations, customs and nuances that must be acknowledged and baked into any business model or strategy. Ignoring this reality is setting oneself up for failure.

With that being said, there would appear to be a very clear opportunity for patient risk capital with the "right" local connections, team & know-how in Japan to build, from the-ground-up, a powerful, new competitor in the Japanese funeral services industry. Not only that, but particularly once publicly listed, this entity would most assuredly take a far more rational approach to capital allocation to fund its growth strategy and deliver ongoing value to shareholders (vs. the listed incumbents' actions today).

While I won't get into all of the specifics around how one could / should build such a "new" funeral business in Japan - largely because we haven't done the work on this yet today - it is relatively easy to imagine that a more digital-first marketing approach, a heavy reinvestment strategy early on while private, a more competitive and performance driven employee incentive model, a more aggressive recruiting practice, a more (very cheaply financed) debt fueled, focused growth strategy where it matters most (i.e. saturating core geographies with owned funeral halls), and so on...it isn't hard to imagine that a relatively straight forward, "industry differentiated" playbook implemented by a high quality, experienced local team and backed by patient, sophisticated "risk" capital could create tremendous value for all stakeholders over time. Dare we say a "unicorn" over the course of a decade or two...

So, to tie this all up, we are not suggesting that the above would be a simple cake-walk. There is a lot of execution risk, a good bit of investment capital that would be required, a ton of work in properly setting up the team, strategy and broader execution model, etc., all while being very cognizant of doing things in ways that adhere to the realities of Japanese culture and customs. However, unlike a venture capitalist backing a starry-eyed founder looking to infuse artificial intelligence into the plant watering process (the TAM is huge though...) or a private equity firm endlessly bidding for a highly competed asset, only to implement "necessary" cost cutting measures to drive returns...we will play where others aren't, in ways they won't, over time frames they can't to surface "latent alpha", quite literally, laying in plain sight. The opportunity set in Japan for these types of "boring", compounding and dynamic business building investments - across numerous industries and business models - is arguably the largest, most attractive and least tapped globally today.

In time, we'll get there...for now, we continue to lay the foundation.

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