Japanese Corporate Governance – Slowly Changing?

Maybe it is because I’m a closet fan of Koizumi and Takenaka, but I haven’t thrown in the towel on Japanese corporate governance yet. After the spectacular failure of Steel Partners to stop the Bulldog Sauce poison pill, most foreign investors seem to have given up hope completely. (Have you seen the Bulldog Sauce share price recently?) It’s simple to jump to the conclusion that corporate Japan hasn’t changed at all – but although you can only call them baby steps at best, I think that things are slowly changing.

Sure, an arrogant gaijin was a failure when he tried to pick a fight in true Western style, but we are slowly starting to see the emergence of a proactive Japanese corporate governance, too. Sparx has been the best example over the past twelve months or so, playing a key role in broking ground breaking mergers between Kenwood/JVC and Hoya/Pentax. While they don’t win every battle they fight, they seem to be slowly working towards finding a Japanese way of maximizing shareholder returns. But this is all old news. What most recently caught my attention was not from a pension fund, but from a real company. Are you on top of the fuss that the CEO of ジャスコ (Jusco, Japan’s largest super market) has started to kick up?

Motoya Okada – CEO of Aeon

The CEO of Aeon (イオン, Jusco’s holding company) is Motoya Okada (岡田元也). Okada is a young 56 years old, and has been running the show at Aeon since 1997 when he took over from his Charismatic father, Tatsuya (岡田卓也). (You might also recall that his brother is Katsuya Okada (岡田克也), a politician in the DPJ). Young Okada has a lot of pressure weighing on his shoulders. It’s not easier to better your father when he created Japan’s largest retail chain out of a dinky Mie-Prefecture vegie shop. While Okada is well known for being aggressive with his suppliers, this month we saw a new face, that of Motoya Okada – the shareholder ombudsman. Could this be the first sign of Japanese management making a stand on behalf of shareholders, instead of their usual friends (you know, culture, tradition, Tonkatsu sauce, employees, suppliers, etc etc)?

On October 5, 2007, two drug stores announced their intent to merge. CFS and Ain Pharmaciez. Never heard of either? Interestingly they are both within the top 10 drug store chains in Japan and if the merger is successful their combined sales will be about 250 billion JPY and rocket them into #2 in the industry (マツモトキヨシ, Matsukiyo being #1). Unless you live in Hokkaido, or have a fetish for strangely spelt pharmacies, you probably haven’t even seen an Ain store before. You might more luck recognizing CFS by its more common brand name, Hac (ハック). Yes, no better place to buy drugs from than a local Hack. But wait, there’s more! Hac has an in-house shopping card called “comes”, and a magazine to go with it (pic below). Hmmm… Maybe these two companies chose each other for their mutual sense of English naming skills??

The deal seemed signed and sealed for about 90 minutes, until Aeon’s Okada came out to publicly slam the deal in a press conference of his own. Aeon, it turns out, owns 15% of CFS. As the single largest shareholder of CFS, Okada sits on the board and isn’t shy about venting his opinions. (Did I mention that this man has an American MBA?) Okada’s argument is simple. CFS, he points out, has enough problems right now that it can’t afford the distraction of a merger. He’s worried that management are trying to merge with the more profitable Ainz as a method of hiding their poor job at running the business. He’s probably right. Even though CFS has almost double the sales of Ainz, their average profit over the last three years was less than half of what Ain achieved in the same period. CFS is symbolic of the saturation of the drug industry. Sales have been shrinking for five years in a row and the only way they can stay competitive is to bite into their margin with never ending discounts. So much so that CFS lost a whopping 3 bln JPY last year. Things aren’t getting any better. As the government is trying to lower the cost of drugs to the aging populace, legislation is set to change in the next two years to allow supermarkets and convenience stores to sell OTC drugs. Why would you buy your cough medicine from a Hack, when you can buy it from your local Lawson Station or Jusco? To be clear, CFS are losing money even before this legislation change. How will they ever get on after it?

On the other hand, Ainz is a reasonably profitable and well run business. Because they have a higher number of specially trained pharmacists they can sell higher margin drugs (real ones, not just OTC drugs) and don’t have to rely on discounting shampoo as a loss-leader in order to attract customers. A merger with Ainz is clearly the easy way out. Why deal with the problem of a loss making business when you can hide it behind a profitable one and delay the pain for a few years. Better yet there is almost zero geographical overlap between the two companies so there is no layoff staff. After all, who would want synergies from a Japanese-style merger? That’s why Okada’s stand is so symbolic. Can you remember any other time when a Japanese manager of a real company (because we all know that hedge funds aren’t real companies!) has protested against a defensive merger with zero synergies? I can’t. Japan needs more managers like Okada.

So where to from now? The good news is that the drama has only just begun. Okada has promised to come up with his own plan for reviving the company before the end of the month. It shouldn’t be too hard. You can see the hack’s official plan for the new company on their web page. You’d be forgiven for questioning your eyes after reading some of their targets. How on earth can a company that made less than 3 bln JPY in Operating profit last year (pro-forma for the merger) expect to increase profits to 10 bln JPY by 2010?

The HAC “Comes” Magazine
The perfect compliment to your “Comes point card”

What are they smoking? And which one of their drug stores can I buy it at? If they can achieve this they are probably the cheapest drug store in the world (5x earnings!) but lets stop sipping the Lipovitan D (リボピタンD) for a few moments and think carefully about this. Increasing profits by almost 4 times is no easy job. Especially in an industry that is about to be raped and pillaged by Japan’s retail Goliaths from the convenience store and supermarket industries. I’ll be very interested to see what plan Okada himself comes up with. Let’s not forget the catch-22 he finds himself in as there is almost no doubt that his supermarket, Jusco, will be leading the battle – in true Wal-mart style – against the drugstore industry by selling cheap OTC drugs once the new legislation is passed.

While I’m elated to see Okada standing up and making a point and wish him the best of luck with his restructuring, I have one more question that remains unanswered. What in jigokudani is Ainz doing? I can understand why the deal might seem attractive to the inexperienced management team from CFS (Okada is quick to point out that Yoneda (the CEO at CFS) is nothing more than a new rice that came from Itochu with no retail experience at all!) but what’s in it for Ainz? Ainz’s has been one of the few winners in this industry. Sales have been growing for seven years in a row and they make decent margins despite being located in the two most economically challenged regions in Japan, Hokkaido and Tohoku. Ainz’s average pre-tax profit per employee over the last 5 years was 1.2 mln JPY versus a miserly 0.4 mln JPY at CFS which explains why Ains has a higher market cap than CFS (200 bln vs. 135 bln). But hold on a second, taking a closer look at the material CFS is getting the prized seat of CEO at the new company! Who is taking over who here? The merger ratio (4.17 : 1) favors CFS by 15%. What on earth are Ainz shareholders doing paying a premium to buy a loss making company with negative growth? If I was Marubeni (who owns 13% of Ainz and is their second largest shareholder), I’d be lining up to sign Okada’s petition, too.

As much as I love what Okada appears to be doing, my biggest worry is that the real rationale might be somewhere else. CFS seems to be getting a pretty good deal (at least in terms of the merger ratio) and increasing scale will help their purchasing power. As it turns out, the only company who might really suffer from the merger (besides Ain!) is Aeon. Aeon runs a co-purchasing group called Welcia where a dozen or so sub-scale drugstores pool their purchasing together in order to assert more pressure on their suppliers (the pharmaceutical industry). In CFS felt after the merger they were large enough to go it alone, Aeon’s Welcia group would lose a significant portion of its bargaining power. Is Okada really only doing this because Aeon benefits from each of its “partners” remaining sub-scale? After all, Aeon’s own drug store subsidiary depends on the co-purchasing group to meet its own needs for cheap drugs (where can I sign up, I hear you say?)

Okada needs CFS to ensure his buying group doesn’t lose its bargaining power and his ego was probably pretty bruised after clearly being ignored in the board meeting that signed off on the merger. Perhaps even worse, he feels that he has to do something to prove himself after his own share price (Aeon) has fallen by 50% in the last two years. I’m sure he must hate the comparisons with his successful Father and must be feeling the warmth of the coals being lit beneath him by his own shareholders. If Japan were a real country, he’d probably focus on lifting his own share price. But let’s not get too carried away. Let’s just be grateful that at least someone is focusing on the concept of shareholder value. That has got to be a move in the right direction.