The Capital Cycle Podcast - Japanese Crown Jewels

Episode Date: September 6, 2024

How are corporate governance reforms in Japan working in reality? The discussion focuses on one particular company – Olympus. Presented by Edward ChancellorWith Toma Kobayashi, Portfolio Manager JapanFor more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Welcome to the Capital Cycle podcast from Marathon Asset Management. My name is Edward Chancellor. I'm a financial historian, journalist, and former investment strategist. In these podcasts, I will talk to the authors of Marathon's Global Investment Review about their current investment thoughts. Hello, welcome to the Capital Cycle podcast from Marathon Asset Management. My name is Edward Chancellor. I have with me Toma Kobayashi, who is a Japan portfolio manager at Marathon. And we're going to talk about the change in corporate governance and the way Japanese companies are managed about shareholder value in Japan.

And we're going to have this discussion around one company, Olympus, that is really, and tell me if you agree with me, this really seems to me emblematic of the changes that have come about in corporate Japan over a relatively short period. And let's start, Toma, by discussing this tremendous corporate scandal that occurred in Japan at which Olympus was the centre. So Michael would thought, British professional, was brought on board. and perhaps signify the change in the way the Japanese companies were run. But in fact, actually, he discovered dubious payments and accounting fraud, and he whistleblowed on this.

And instead of being rewarded for it, he was sucked. And it blew into a very significant scandal in which the stock prices collapsed. And there was in talks of being delisted as well. And in a way, many investors took that as a warning not to invest in Japan. But it wasn't really just a question of poor corporate governance or accountability to shareholders, as you write in your piece. Olympus was an example of business that was overly diversified at the time. You say that conglomerates are common in Japan with many companies operating. in multiple industries.

You say that the result of that is that the good businesses tend to get overlooked. That means the business is potentially undervalued. Right. Yeah. So Olympus had one amazing business in medical equipment, but it came with less competitive, non-coer businesses that was dragging down the overall profitability in the capital efficiency. So investors may get interested in the medical equipment business,

but they don't want all the other side business. so they tend to value the businesses that are still going to discount to some of the parts. And that results in less than satisfactory results for investors generally. And over the last 10 years or so, there has been a move of many Japanese companies to get rid of their underperforming subsidiaries and to focus on their higher return businesses. And again, Olympus is a. an example of this, yeah? Right. Yeah. So there has been a greater focus on return of investment capital and profitability at Corporate Japan. And so there has been a general movement

to try to focus on the core competencies. And on InPass has been one of the best examples in this, in the sense that they got rid of essentially everything aside from the core medical equipment business becoming a pure play in what is a globally competitive business now. Let's talk about the core medical business because that's another example, as far as I see, of a business in what we call a benign capital cycle. When we're talking about a benign capital cycle, we're talking, we're often talking about an industry that has what Warren Buffett would call a moat and therefore doesn't attract competitors. And explain to our listeners the nature of the moat around Olympus's medical business? The core product within the Olympus's medical equipment business is a gastrointestinal

endoscope for which the company has about 70% global market share. And the company has maintained its significant market share over its history despite its premium pricing due to high switching cost and its extensive distribution and servicing network and its exceptional brand and track records in delivering the exceptional products to its customers. And also, as you say, high switching costs when if you train the doctors and nurses to use the Olympus endoscope, they're reluctant to retool and learn on a different endoscope system. So, yes, once doctors get trained to use certain brands, they don't want to change the feel, they don't want to change the way the interface works and et cetera.

The other part of what makes the switching cost very high is that the hospitals seem to have multiple end-scope systems, core imaging systems and scopes. And these are only compatible within the same brand. So you can't use competitors' scope with, say, Olympus's imaging system. So if you want to switch from, say, Olympus endoscopes, it's extremely tricky because you have to give up all of the investing capital in the main imaging system as well as the scopes to do so. And there's no natural time to do it because the replacement cycle, for the imaging system and the scopes are different. So it gets extremely unpractical to switch.

You've got the customers locked in. And you mentioned in your piece how there's a new product release that makes that, is that make it particularly attractive for? Right. Yeah. So Olympus's main imaging system goes through a product cycle, historically about 68 years. This cycle has been a bit more elongated than the past.

But most recently, the company released a new gastrointestinal end scope, model called Evist X-1 in the U.S. market in October 2023 and to the Chinese market in November 2023. And this follows an area lunch in Europe, in Japan, in some Asian countries. And the new model is priced higher than the previous generation. And also it triggers a replacement demand given the improved functionalities and better imaging and better results. And one thing we haven't mentioned, which you probably ought to, is in your piece, you discuss high they get high servicing revenue. So it's not just the sale of the products, but again, they're locked in with profitable serving, a bit like the elevator operators. You sell the elevator

and then you send the Otis sends the service men around to fix it. Exactly. So yeah, so for hospitals, you don't want broken equipment disrupting your your services. So if you require maintenance, you need the repair person to come immediately, really effectively to help fix it. So Olympus has invested in significant servicing network and can also lend you temporarily replacement equipment if necessary to ensure that you can, the hospitals and can continue to operate. And so as a result, service revenue is very, very significant and accounts for 35% of Olympus's endoscopic solution division. So then the result is that you get a large recurring and captive profitable revenue stream. So Marathon has,

owned Olympus in the past, the market recognized Olympus's success, bid up the shares. Marathon then sold its shareholders, but then re-entered the Olympus stock after some recent problems with the US Food and Drug Administration. And we just discuss the nature of the problems that Olympus had with the FDA and why you think those are not permanently damaged. to its business. Right. So Olympus received three warning letters from FDA in early 2023. It's obviously a serious issue to get to warning letters. But it related to its manufacturing and reporting practices specifically about validation, which is a process where you collect and submit scientific evidence of delivering high product quality in a consistent matter. And also they received

warnings about complaint handling. So that is when the customers or FDA compliant about their products, how they respond to it and at what speed was not satisfactory to the regulator. So at least it was not directly related to the product quality or safety in itself. And perhaps it was validated also given that the AV-6-1 new gastrointestinal endoscope model was approved soon after these warning letters. But regardless, they received warning letters about their compliance procedures. And then there were problems who say about an anti-corruption campaign against the healthcare industry in China and the no-to earthquake. Just to start with an anti-corruption campaign. So there's been general movement in China against antitrust within healthcare, which just significantly disrupted

the bidding and the business, just the business overall. So Olympus has not been immune to that, given its significant market share, so the entire industry has been impacted as a result. At least China is only about 10% of Olympus's sales, so the impact is less meaningful compared to its largest market, which is North America. But it has been a negative impact from the disruption scene as a result of it.

There was also a large earthquake in January 2020, for in Japan, not is the region where the earthquake happened. LIMS's own facilities were not significantly impacted, but it's one of the city suppliers were significantly impacted through this earthquake. And that meant that there was an impact to its manufacturing and the short-term impact drove the sentiment down as a result. And the share price came down. And it came down at the point of which you thought it was then an attractive purchase candidate.

There is something interesting towards the end of your piece, which is how Olympus has been using the proceeds of its divestments to buy back its shares. Again, this is, as you know, something that American companies do to an excess possibly. And when foreigners looked at Japan, corporate governance and shareholder value, they often wanted Japanese companies to engage in share back. and Japanese managements were often reluctant to do so. But here, I was staggered by the size of these buybacks you're talking about.

Will you taught me through a bit about the buybacks? Yeah, so as Olympus reported, these negative developments, the company also announced large buybacks, especially using the proceeds from the sale of its non-cooperation. So the company announced 100 billion yen buyback in May 2023, and followed it up and again with 80 billion buyback in November 2023. So together in that year, they bought back about 7% of its outstanding shares. And then followed it up again with a 100 billion yen buyback in May 2024.

So that was quite opportunistic in capitalizing the short-term transitory issues or improving QA, QA quality assurance and regulatory fair framework, also some of the negative developments in China as well as earthquake impact. but also, as you mentioned, using its excess capital and a capacity in the balance sheet in a more effective way to enhance its order value. And you argue that the Olympus valuation at, you're saying, around 23 times depressed earnings looked attractive relative to the underlying profitability of the business. We must call this a quality business.

Here you have a quality business roughly what you estimate, the return on on capital or return on reinvested capital of the business? I believe this is a business that can do sort of 20% return to capital, 20% operating profit margins. I agree to your point that this is exceptional, high quality business that is undergoing short-term issues that the company is investing to rectify today. And as a sort of broader picture, before we started to record, you talked to me about how sometimes clients say to,

you, how far does this corporate restructuring have to run in Japan? If they were American, they'd say, what innings are you in? I was saying to you, I remember really the first global investment reviews put out by Marathon in the late 80s. They were observing exactly this type of development of conglomerates in the US, divesting their businesses, using the money for share buybacks. And even though the stocks looked, had had a good run and looked sort of relatively expensive historically, they still were poised to deliver great returns going forward. So tell me how, where you think Japan is. I think it only just started in terms of getting this improvements in efficiency and governments to come through. So there,

there are a lot of Japanese companies still sitting on excess capital in the form of net cash. And I think half of half of non-financial companies are having net cash balance sheets despite interest rates being where they are. They're also significant cross-share holdings. So I think last year they had a record high sale of cross-share holdings, which is the cross-ownership of domestic equity amongst themselves. And I think they sold 3.6 trillion yen last year in cross-share holdings, and they still set significant amount of equity on their balance sheets and their other non-operating assets on the corporate Japan's balance sheets as well. And in terms of conglomerates and the business structured as well, Olympus is a rare case where they're focused to the extent that they did.

There are still a lot of businesses operating in multiple industries in less than an optimal way. So I think Toma, we'll come back. I hope to discuss this. And when you come up with new examples and other examples, because I think the undergoing restructuring of corporate Japan is one of the great investment stories of the current decade and probably one of the most bullish. as far as I can see. So thanks for your thoughts on Olympus and we'll discuss other things soon, I hope. I hope you will listen to the next edition of the capital cycle. This communication

is provided for information purposes only. Please refer to Marathon's website and the global investment reviews for further information, including important disclosures.