• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Can You Guess This Asian Wide-Moat Company?

Building Asia ex-Japan’s largest maker of the “nervous system” in smart cars with Responsibility

How would you respond when you lose your finger in a workplace accident? We will be depressed, the inevitable and natural response which paralyzes and robs us of the ability to respond to our troubles and setbacks.

For Leonardo Del Vecchio who severed part of his finger in a mold-making factory while working as an apprentice to put himself through design school, he went on to build Luxottica (LUX), the world’s largest eyewear company with a market cap of $32.7 billion and became Italy’s second richest man. Luxottica is one of the world’s most respected companies that is responsible for revolutionizing and dominating the entire eyewear industry, creating a fashion concept out of a functional item and putting luxury glasses on the world.

For Mr. C who lost two of his fingers while manually operating a stamping machine, he went on to build Asia ex-Japan’s largest maker of [Flagship product’s name] in automobiles and motorcycles, a mission-critical auto part that is dubbed the “nervous system” of cars whose electronic content is rising due to the Green, Connected, Autonomous automotive trends. The painful accident made Mr. C “swear that I will change such a dangerous production method one day and I resolve to focus on the full automation of the production line.” Because of this resolve and determination, [Company’s name] is willing to commit to heavy investments in automated production lines. “As a result, our products are of a far higher quality and lower cost, by at least 20%, than other companies.” Mr. C also set his mind to build a sustainable, scalable, wide-moat business model with an “organizational-wide competitive ability and an organizational-wide management information system”.

This month of July, we highlight this Asian wide-moat innovator behind “the soul and connecting nervous system of the vehicle in transmitting signals to coordinate the various auto parts.” Without this “nervous system”, the auto parts cannot start and work. While it is considered a Tier-2 auto parts supplier, [Company’s name] directly participates in the design process of Tier-1 suppliers for most of its [Flagship product’s name] to be “designed-in” and as a result, enjoys sole supplier rights during the first 2-3 years following a new model launch. In addition, [Company’s name] has changed its sales model in China from a distributor model to direct selling, forging Tier-1 relationship with the major Chinese automakers, including accounting for over 50% of [Flagship product’s name] used in emerging electric vehicle maker BYD (1211 HK). Its top ten customers account for around 44-50% of sales. [Company’s name] has pursued the strategy of a diversified customer base to lower operating risk so that “no one “no one customer can seal the life and death of [Company’s name]”, and the rest of sales are contributed by hundreds of customers.

Our earlier highlight for the month of May about Asia’s #1 maker of a patented automotive electronics part that is part of the fast-growing multi-billion Advanced Driver Assistance System (ADAS) market and the race towards the autonomous car is up >25% in <2 months.

Read the story of Mr. C below and be inspired about the values of Responsibility – the ability to respond in times of hardship and adversity..

Q: “Chairman C, [Company’s name] has an illustrious business history since its establishment more than 38 years ago in 1977. Can you share with us how it all started, the philosophy and thought process underlying the evolution of the business model, the lessons learnt, and the ups and downs in your personal journey building [Company’s name]?”

Mr. C: “My personal journey in building [Company’s name]? I was poor when I was young and I always wanted to venture into business to give a better life to my family. After my middle school, I wanted to go straight to work but my father insisted that I must continue to study in the night school. So I work in the daytime in the metal stamping division of lighting company.

At that time, metal stamping is still operated manually by hand, with the operator using one hand to hold the metal, another hand to step on the machine’s pedal, stamping the metal piece by piece. However, an incorrect rhythm or a slight neglect will result in a workplace accident. An accident happened to me and I lost two of my fingers as a result. As a result, I swear that I will change such a dangerous production method one day and I resolve to focus on the full automation of the production line. Because of this resolve and determination, [Company’s name] is willing to commit to heavy investments in automated production lines. As a result, our products are of a far higher quality and lower cost, by at least 20%, than other companies.”

Q: “Thank you for sharing such a moving and inspiring personal story behind the impressive production automation commitment at [Company’s name]. Our curiosity is piqued, can you share with us what is so difficult about making these [Flagship product’s name] beyond having more capital and money?”

Mr. C: “Computer and smartphones can malfunction, but can cars afford to malfunction? When consumer electronics products break down, they will cause inconvenience, but they will not cause our lives. When a car is moving and it suddenly malfunctions, what would be the consequences? In terms of safety standards, automakers have far higher requirements for components and parts than those for consumer electronics products. Safety is of paramount importance. When there is an incident of a car engine on fire, a big reason is because of the breakdown of the [Flagship product’s name]. [Flagship product’s name] are first used during the World War II in fighter planes. The [Flagship product’s name] is small and not eye-catching, but it is the soul and connecting nervous system of the vehicle in transmitting signals to coordinate the various auto parts. Without them, the auto parts cannot start and work. Now, [Flagship product’s name] need to be even smaller and precise than ever before and the supplier has to produce customized parts according to the customer’s diverse requirements. Each car requires around 600 to 3,000 to 6,000 [Flagship product’s name], depending on the ‘smartness’ or electronic content of the model. So the demand is rather sizable in terms of volume and value.

“Yet in the early days, no one is interested in this business. The reason is simple. Besides the high barriers to entry and extremely high standards set by the customer, the supplier would have to produce small-lots and multi-items, and this does not make any economic sense from a cost perspective. The time period of investment is long and the payback even longer and uncertain. [Company’s name] has grasped the technical complexity of the functioning of the various auto parts and foresee the change in the shifting profits in the value chain towards high value-add electronic parts.

Hence [Company’s name] focuses on mission-critical [Flagship product’s name] in the safety area. The technical expertise required is much higher and the design and development of the molds requires deep know-how, but the margins are also much higher. There are other auto parts companies who also tried to break into this business but they started in producing the products that will not affect the safety and engine of the car, thinking that it will be a starting point to win more business. However, these companies underestimated the barriers to entry and they have all exited.

Thus, not anyone can enter this business. Because of the extremely high standards for safety and reliability, car makers are very strict in selecting their suppliers. Once the supplier is connected to the automakers’ supply chain, that’s ten-year worth of business at least. With mutual trust as the foundation, this relationship is not easily changed. However, this also means it is very difficult to break into the supply chain of an automaker.”

Q: “We understand the high barriers to entry and stringent quality standards required by the car makers. Still, we are curious – are there any specific production technique or know-how or secret to success that [Company’s name] has mastered over the 38 years that gives it a sustainable wide-moat competitive advantage to generate a relatively high ROE of 20.5% and to keep growing?”

Mr. C: “…. <SNIPPED>”

Q: “Do you have any words of advice for entrepreneurs? What is the best advice you have received that has guided your thinking?”

Mr. C: “I always remember what my parents have taught me since young, ‘Be kind to others’. My mother would also remind me, ‘If you manage to make money, you must treat your workers better.’ Our principles of management include: ‘Co-sharing of fruits reaped through teamwork’, ‘Human-friendly management’, ‘Whole-hearted trust and support’..

In the ruthless cut-throat automotive industry, the fact that [Company’s name]’s EBITDA margin at 33% is twice that of world-class Bosch India (BOS IN), arguably the best auto parts company listed in Asia, and [Company’s name]’s ROE of 20.5% is also higher than Bosch’s 14.5% speaks volume about [Company’s name]’s wide-moat advantage in securing long-term pricing power and earnings sustainability with the major OEM carmakers by winning their trust to strike long-term partnership. Bosch India trades at an expensive valuation premium of EV/EBITDA 42.9x compared to 12.2x for [Company’s name]. [Company’s name], with its technical superiority in developing low-cost innovative solutions and in generating higher profitability and growth, deserves to command comparable a higher valuation. Short-term downside is protected by a decent cash dividend yield of 4% and supported by a healthy net-cash balance sheet generated from internal free cashflow as opposed to external equity or debt funding.

Led by the highly inspiring Mr. C, [Company’s name] has toiled for more than 10 years since it entered China before bearing some of the fruits. [Company name]’s sales has climbed nearly 31% since FY11 while EBITDA growth is stronger at 78% with the impressive improvement in gross margin from 34.2% to 42.1% due to greater sales weight of higher value-add products that include [Flagship product’s name] for electric vehicles (EVs). Now the growth momentum has hit the tipping point for [Company’s name] to accelerate its profitability significantly in its visible long runway to supply the mission-critical auto part that is dubbed the “nervous system” of cars whose electronic content is rising due to the Green, Connected, Autonomous automotive trends. Net profit and EBITDA could potentially double in the next 5 years by FY2020, pointing towards a doubling in market value.

Who is Mr. C and this wide-moat Bamboo Innovator?

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Warren Buffett: “When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her. In California the girls slap you when you bring Russell Stover, and kiss you when you bring See’s. You cannot destroy the brand of See’s candy. Only See’s can do that. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. We link the product with happiness… there’s something in the mind about a brand. I mean, you have something in your mind about Coca-Cola – but you don’t have anything in your mind about RC Cola because they’ve never been, you know.”

Charlie Munger: “We didn’t know the power of a good brand until we bought See’s Candies. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning this changed Berkshire. It was really important… How would you try to create a brand that competes with Disney? Coke is a brand associated with people being happy around the world. That is what you want to have in a business. That is the moat. You want that moat to widen.” 

Last week, we discussed the Achilles heel of Buffett and Munger in retail stocks in the article “Buying Furniture with Warren Buffett and Mrs. B at Asia’s Wide-Moat Furniture Innovators” and how value investors can overcome this tough investment hurdle to identify compounders before their wide moats become obvious by the investment community. This week, we examine their greatest investment strength – picking consumer brands – and the case of an unusual wide-moat consumer-brand innovator in Asia.

Imagine if Warren Buffett-Charlie Munger’s See’s Candies, Coca-Cola, Gillette/Pampers (P&G), Heinz and a host of iconic consumer-branded products that they had successfully invested in are stripped of their trademarked name, logo and nice emblazoned packaging design. Would consumers – and Buffett and Munger! – consider them as “brands” and still buy them?

How would Buffett-Munger evaluate Ryohin Keikaku (7453 JP, MV $5.2bn), owner of MUJI? MUJI stands for Mujirushi Ryohin (無印良品), which translates to “No Brand Quality Goods” and “All Value No Frills”. None of MUJI’s 7,500 “minimalist” products, including household products (36.9% of sales, including linen & interior goods, furniture, household appliances, houseware, stationary, cosmetics), apparel (53.5% of sales, including underwear, socks, bags and shoes), and food products (8.2% of sales) have a logo or are wrapped in fancy, distinctive packaging. Plain but not generic, MUJI’s products have a simple aesthetic that appeals to certain customers. In fact, it is the lack of a name brand that many find enticing. With more than 700 stores worldwide (284 directly-managed and 117 licensed stores in Japan), including 301 stores overseas (130 in China), the Japanese retailer has a cult-like following. MUJI seems like a Japanese nazonazo (riddle): one of the most beloved Japanese brands that isn’t a brand.

Ryohin Keikaku (TSE: 7453) – Stock Price Performance 1995-2015 Vs Nikkei 225 Index

So what is it about MUJI that accounts for its rising success? Often hidden in the seemingly simple designs are functions that make MUJI’s products stand out. Its toilet brush, for example, has a small cover to protect water from splashing while cleaning. Their summer sheets are made of special linen that absorbs moisture better than cotton. But you might argue that many other companies can copy MUJI’s minimalist product concept. After all, wouldn’t MUJI lose its competitive edge in terms of pricing to the fast-fashion outlets such as apparel giant Uniqlo/Fast Retailing (9983 JP), low-priced furniture giant Nitori (9843 JP), and the myriad 100-yen stores that were features of every new mini-mall? And MUJI’s rising success is all the more amazing when we revisit one of Munger’s fascinating insights about brand-based moats. Munger imparted his wisdom that “informational advantage” enables brands to leverage into advantages of scale:

Munger: “The informational advantage of brands is hard to beat. And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is 40 cents and the other is 30 cents, am I going to take something I don’t know and put it in my mouth—which is a pretty personal place, after all, for a lousy dime? So, in effect, Wrigley simply by being so well known, has advantages of scale—which you might call an informational advantage. Everyone is influenced by what others do and approve. Another advantage of scale comes from psychology. The psychologists use the term, ‘social proof’. We are all influenced—subconsciously and to some extent consciously—by what we see others do and approve. Therefore, if everybody’s buying something, we think it is better. We don’t like to be the one guy who is out of step. Again, some of this is at a subconscious level and some if it isn’t. Sometimes we consciously and rationally think, ‘I don’t know much about this. They know more than I do. Therefore, why shouldn’t I follow them?’ The social proof phenomenon which comes right out of psychology gives the huge advantages to scale—for example, with very wide distributions, which of course is hard to get. One advantage of Coca-Cola is that it is available almost everywhere in the world. Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup—which is slowly won by a big enterprise—gets to be a huge advantage….And, if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you. All told, your advantages can add up to one tough moat.”

Thus, the “no-name” MUJI products apparently do not emit the “informational advantage” that Munger described – carrying or using a MUJI product is not observable by others and the “social proof” effect seemingly breaks down.

While the MUJI products have no brand logo to elicit the psychology-based “social proof”, MUJI is actually perceived as a great brand with thoughtful, innovative products. The design and stories around how these new innovative products came to be developed show the seriousness of MUJI to develop a new unique product – continuously. These designs have also come to MUJI winning more than 100 top-tier design and innovation prizes.

Amongst the design “stories” is a pair of “right-angled 90-degree socks” (Chokkaku Kutsuhsita) – the way your foot extends form your leg, rather than a conventional sock at a 120-degree angle. The angle between the heel and sole on the socks is 90 degrees, after research showed that the shape reduced shrinkage and damage. One of the global associates of MUJI sent information that a sock knitted by a grandmother in Czech for her grandchildren has a right angle. MUJI thought it was very MUJI and invited the grandmother to come to Japan. Her knitting was video-recorded and MUJI asked a manufacturer whether it can mass-produce the socks. An immediate response from the manufacturer was, “Please do not joke. We cannot produce such a pair of socks.” The reason dates back to as long as during the Industrial Revolution in England when machines mass-produce socks at 120-degrees, an angle which allows the well-balanced mass-production of socks. MUJI persisted and they found a way to make machines to mass-produce the right-angled sock which was introduced in 2006 and improved in 2011 in partnership with a research center in Nara Prefecture. MUJI also used a more breathable and elastic material in the redesign. MUJI created a hit product selling over 7 million pairs annually.

The wide-moat strength of the MUJI brand is the mission, values and unique philosophy the company founders have identified and carefully cultivated:

• Affordable, simple,  sleek, durable minimalist products designed well for a specific task and made of natural materials
• An antithesis to the consumption society and designs created simply for profit-making
• We leave room for the individuality of the customers to use products as users wish by eliminating commercialism and waste
• No name, anonymous, not inducing consumers to purchase due to the names of brands and designers
• We try to take the viewpoint of the purchasers, consumers

Its growing cult-like customers come to identify and associate with the MUJI values, much in the same way Buffett-Munger described the power of association in See’s and Coca-Cola, brands associated with people being happy around the world. MUJI customer is more about the lifestyle of the MUJI brand promise and values. Its core, core customer is really core. They don’t think about which furniture or stationary or household product store they should visit. MUJI is more about regular shopping, lifestyle shopping.

MUJI has also improved its excellent customer service with a revamped store environment offering detailed lifestyle suggestions and the experience of discovery, in which product advisors and specialty sale staff (styling advisors, interior advisors, tasting advisors) help tailor choices for customers, offering suggestions for living, and customers can also see, touch and feel to discover their own original style at the Fragrance Studio, Stamp and Gifts Corner, Wood Environment Play Area. MUJI’s online sales has also been growing steadily and now accounts for around 6.5% of sales.

MUJI was launched in 1980 by the late Seiji Tsutsumi (photo, left), the chairman of the Saison retail group, as an inexpensive house brand and line of merchandise for his Seiyu chain of supermarkets under the slogan “Cheap for a reason” (Wake Atte Yasui). Tsutsumi was the son of Yasujirō Tsutsumi, founder of the Seibu Railway. Following the death of his father in 1964, he led the spin-off of its logistics business to form the Saison Group, which eventually included the Seibu department stores, Seiyu supermarkets, Wave (a music shop), Parco (shopping complex), and the Muji and Loft variety store chains. MUJI no-name products soon garnered a following thanks to its iconoclastic simplicity designed by Ikko Tanaka (photo, right), a leading graphic designer, Kazuko Koike, who was MUJI’s creative director, and three other founding members. Tsutsumi-san and Tanaka-san observed that companies sell their products using highly manipulative marketing techniques and engage in meaningless branding. Tanaka had deep thoughts on how a man should be and live, and found it necessary to concretize his thoughts into products, expressing his antithesis to consumptive society. Thus, MUJI was born with a goal to produce products really valuable to consumers, instead of inducing them to purchase those with valueless brand names.

To concretize these values and concepts into products is not easy, which is why many imitators of MUJI did not go far. MUJI operationalize three processes: (1)…

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The systematic use of external designers and the crowdsourcing projects is an exemplification of the “open innovation” business model that characterized the “Bamboo Innovator”, as explained in earlier articles in how we systematically identify overlooked, underappreciated and misunderstood innovators.

MUJI’s information system also ensures the escalation of management reform. The sophisticated IT system can track with precise accuracy the movement of even a single pen throughout the country. MUJI also introduced an innovative business process support system for better decision-making in relation to customer information, automatic ordering to enable more accurate long-term demand forecasts and product planning. The logistics system was designed to coordinate every aspect of distribution from merchandise procurement to retail outlet supply (to ensure stable support of products), reduction of physical distribution costs, aggregation and transmission of product distribution information, and improvement of stores’ efficiency.

The evolution of MUJI also bears instructive lessons for value investors in looking beyond numbers to assess the erosion or widening of the economic moat. MUJI was very successful in the 1990s and they grew complacent. MUJI started to…

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The rise and fall and rise again of MUJI remind us of what the late American writer Carl Sandburg once said:

“When an institution goes down or a society perishes, one condition may always be found. It forgot where it came from. They lost sight of what had brought them along”

We observe the Sandburg effect in different companies. For instance, whenever McDonald’s was embroiled in controversies that were the result of its neglect of the core values, such as the usage of low-quality or unhealthy ingredients, it flounders. When the Golden Arches went back to rediscover the core values, it rises back up, like it did when it created a healthier and higher-quality image since 2003, although McDonald’s had neglected its core values to stumble again. Without the workable intangible culture and core values, the tangible assets, such as its vast retail property assets, would amount to a dark-cloud-like ominous liability, particularly when leverage is involved.

At MUJI, the innovative designer spirit of the founders that include Tsutsumi-san and Tanaka-san has lived on and endured. Through MUJI, value investors get to experience the role of design and designers in brand-based moats. A designer always approaches his or her work from the viewpoint of the consumer. Designers characteristically begin with the necessities in the life of the typical consumer. Design has the power to show consumers the future in a very tangible way. We believe that companies can use this power to communicate corporate vision, as well as to create new businesses and services that let consumers dream about future lifestyles while creating demand by society. Today, companies need to create new products and services over a shorter lifecycle and we live in a time where companies have to move beyond the question of process efficiency and “branding” through marketing, creating something to sell that is something more to do with commercialism rather than the essential nature of the product itself. The creativity of design can help companies make enormous leaps forward in developing new ideas.

Today, there aren’t many business leaders in the world today who have embraced design as a way to create business. MUJI has embraced and exemplified this idea from its earliest days. The MUJI approach takes design beyond an approach to management, incorporating it into every business and product as an inseparable part of the whole. MUJI was essentially founded by designers, not businessmen with retailing backgrounds. Tsutsumi-san brought Ikko Tanaka and a number of other designers and creators to create MUJI in a single generation.

Ikko Tanaka was the first MUJI art director, and he was famous for saying that they created MUJI as a way to find the best consumers in Japan. Normally, a business says that they want to offer the best products to the consumer. MUJI’s approach was the opposite, which is very refreshing. Retail companies will normally sell anything that the consumer will buy. But, MUJI refuses to sell anything that won’t lead to better living on the part of the consumer. MUJI is looking for the best consumers to offer them a more fulfilled, conscientious lifestyle.

Ikko Tanaka and the other designers-creators believed that design would be able to elevate the lifestyles of Japan’s regular citizens, rather than be something just for Japan’s noble or feudal class. They refused to accept the form and ornamentation of Japan’s traditional authoritarianism.

MUJI communicated the message that living well and enjoying a quality lifestyle didn’t mean buying the expensive brands and luxury items that were so popular. MUJI chose to pioneer a completely new path during a time when the markets were controlled by short-term popular trends. MUJI concept remains valid even as they expand globally. There’s a Japanese culture, spirit, and way of thinking that are inseparably connected with the MUJI philosophy. MUJI’s values meant that they didn’t have to focus on going out and selling products. The instant you focus on selling, you start to resort to flattery. The moment you focus on complex financing engineering schemes to generate short-term profits, you start to neglect the core business of serving customers and value investors can find this salient information in the footnotes on segmental performance that inevitably report the profit erosion in the core business. MUJI is a resilient Bamboo Innovator with a scalable open innovation business model that is embraced by employees, designers and consumers who share the same values and recognize not only the outward design, but also the underlying philosophies.

Above all, MUJI believe that corporate longevity depends on two principles: Flexibility and Conscience. Flexibility to respond to the fast environmental changes. Responding to these changes by asking two questions: “What brings happiness?” and “What will a fulfilled lifestyle look like for people in the future?” The second is the degree to which Japan values the principles of gratitude and service. MUJI does not believe in enriching ourselves at the expense of others. MUJI calls this value their “conscience.”

Flexibility and Conscience. This is the ultimate success factor behind Buffett-Munger when investing in consumer brands, viewing companies beyond the screens, checklist and numbers to assess both supply-side economics (network effect of distribution and IT system to scale up) and demand-side economics (psychology advantage in association with consumer happiness to sustain the competitive advantage period runway) in brand-based moats.

Have you shopped at MUJI to fully appreciate Buffett-Munger’s wisdom of brand-based moat to identify the next consumer-brand compounder? Brand it like Buffett-Munger at MUJI and other Asian innovators with Flexibility and Conscience!

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

PS: The Weekly will be back on 30 June with the Monthly Riddle to the monthly Moat Report Asia for the month of July.

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

In the month of June, we investigate the #1 ice cream and pasta maker in its domestic market in an Asian country. It is also the main supplier of buns to McDonald’s in its home market. Its high-speed bun production business has expanded to serve other quick-serve restaurants, including Wendy’s and KFC. The firm has nurtured a corporate culture and deep know-how in branding to establish an impressive track record in acquiring and turning small heritage brands into market leaders in different food and beverage categories. Its share price is down 37+% in the past year. This is despite resilient results announced in May. The company was incorporated in 1957 by a group of entrepreneurial families and is now led by an outstanding down-to-earth third-generation business leader.

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Buying Furniture with Warren Buffett and Mrs. B at Asia’s Wide-Moat Furniture Innovators

MUNGER: I think Warren and I can match anybody’s failures in retail.

BUFFETT: Yeah, we have a really bad record, starting in 1966. We bought what we thought was a second-rate department store in Baltimore at a third-rate price, but we found out very quickly that we bought a fourth-rate department store at a third-rate price. And we failed at it, and we failed… 

MUNGER: Quickly.

BUFFETT: Yeah, quickly. That’s true. We failed other times in retailing. Retailing is a tough, tough business, partly because your competitors are always attempting and very frequently successfully attempting to copy anything you do that’s working. And so the world keeps moving. It’s hard to establish a permanent moat that your competitor can’t cross. And you’ve seen the giants of retail…a lot of giants have been toppled.

MUNGER: Most of the giants of yesteryear are done. 

BUFFETT: Nobody is going to be able to compete with the Nebraska Furniture Mart. I mean, this store does more home furnishing business than any store in the country. And what are we in, I don’t know, the 50th market in the country? This store does $450 million annually… But there’s no store that remotely can offer the variety. There’s no store that can undersell us.

“Sell cheap and tell the truth.” – Rose Blumkin (Mrs. B) of Nebraska Furniture Mart (NFM)

“I’d rather wrestle grizzlies than compete with Mrs. B and her progeny.” – Buffett

Buffett in the 2004 AGM: “I cost us about $10 billion. I set out to buy 100 million sharers [in Wal-Mart], pre-split, at $23. We bought a little [5 million shares] and it moved up a bit and I stopped buying. Perhaps I thought it might come back a bit – who knows? That thumb-sucking, the reluctance to pay a little more, cost us a lot.”

What is the investment Achilles heel of Warren Buffett and Charlie Munger? How did they overcome this weakness? Are there positive inspiring entrepreneurial stories of wide-moat innovators in Asia in this area of vulnerability and how can value investors use a framework to identify them? We will travel together to Asia to examine the success factors of an Asian wide-moat innovator who still holds the record for the longest continuous sales and profit growth – 28 straight years – of any listed company in its country and its market cap had compounded over 9-folds since 2002 to $8.5bn.

First, back to Buffett’s Achilles heel, which appears to be in the “tough, tough” retail industry, from the above CNBC interview in 2014, given that it is “hard to establish a permanent moat that your competitors can’t cross”. Also, their biggest error of omission, as Buffett admitted during Berkshire Hathaway 2004 AGM, had been his “thumb-sucking” reluctance in investing more in Wal-Mart in the 1990s because of one-eighth of a point uptick in the stock price. Buffett’s self-awareness and candor saw him making right his earlier decision in Wal-Mart by building a large position in 2005, according to SEC filings, and now owns 60.385m of its shares, at probably an average price of $51-60 as compared to the current price of $72 per share.

Thus, one of the best investment deals that Warren Buffett considered he has made was ironically in a retailer, a furniture store called Nebraska Furniture Mart (NFM). NFM was founded in 1937 by the late Rose Blumkin, fondly known as “Mrs. B”, a Russian immigrant to America, with $500 she had saved for 16 years selling used clothes. NFM was set up in Omaha with no locational or product advantage and goes up against rich, long-entrenched competition – and grew to become one of the top furniture retailers in the country and into the radar screen of Buffett. After several attempts to buy the business and rebuffed each time Buffett acquired 90% of NFM for $55m on his birthday on Aug 30, 1983 with a purchase proposal just over a page without the involvement of investment bankers or lawyers. Buffett didn’t audit her company, nor did he check her receivables, inventory, and real estate titles. Mrs. B agreed to make a deal with Buffett at the age of 89 because, she figured, if she sold the company before she died, then her children wouldn’t fight over it. After tucking in the cheque, Mrs. B reportedly said: “Mr. Buffett, we’re going to put our competitors through a meat grinder.” Mrs. B work ethics was phenomenal: “I come home to eat and sleep, and that’s about it. I can’t wait until it gets daylight so I can get back to the business.” She was on the floor until retiring at 103, and died the following year in 1998, with the business well taken care of by her capable children. Today, more than 30 years later, the Omaha-based store generated more than $450m in annual sales, with Buffett proclaiming confidently that the store will become “very big” and “will do over $1 billion”.

Buffett had tried to assemble a furniture empire since with the purchase of Utah-based RC Wiley in May 1995, Star Furniture in Jun 1997, Jordan’s Furniture in Oct 1999, and rental furniture provider CORT Business Services Corporation in Jan 2000. But none came close to matching NFM’s success. In Jun 2004, Berkshire also invested 9% In home furnishing retailer Pier 1 Imports (NYSE: PIR), an investment that did not work out. In Aug 2007, according to Bloomberg news, Buffett even mentioned about the Swedish-controlled flat-packed furniture retail innovator IKEA as a possible investment target, though the trust foundation setup at IKEA made the acquisition impossible.

Every year, when undergraduate students from 40 universities compete for a trip to Omaha to spend a day with Buffett, the Oracle would bring students to Mrs. B’s store to show what can result from hard work and sheer will. Buffett has previously told reporters that he would have rather done business with Blumkin over any highly pedigreed MBA in the country. Buffett explained the success factors behind NFM: “I have been asked by a number of people just what secrets the Blumkins bring to their business. These are not very esoteric. All members of the family: (1) apply themselves with an enthusiasm and energy that would make Ben Franklin and Horatio Alger look like dropouts; (2) define with extraordinary realism their area of special competence and act decisively on all matters within it; (3) ignore even the most enticing propositions falling outside of that area of competence; and (4) unfailingly behave in a high grade manner with everyone they deal with. (Mrs. B boils it down to sell cheap and tell the truth.)” In his 2013 letter to BRK shareholders, Buffett wrote: “Aspiring business managers should look hard at the plain, but rare, attributes that produced Mrs. B’s incredible success. If they absorb Mrs. B’s lessons, they need none from me.”

Make no mistake: NFM and IKEA are the rare exceptions. Furniture retailers face at least two critical economic hurdles and problems in building a wide moat and scaling up its business model. After all, can anyone still remember the once-mighty Heilig-Myers (HM)? HM used to the largest furniture retailer in the United States in the 1990s with over 1,000 stores nationwide – and it filed for Chapter 11 bankruptcy on Aug 17, 2000 and was also embroiled in an accounting fraud scandal.

It was distribution and delivery problems that helped bring down HM when it over-expanded nation-wide in 1993 as it buckled under the costs of operating large distribution centers and sprawling home delivery systems. Thus, the first critical problem to understanding the wisdom of Buffett beyond the usual quant screens, checklist and financial numbers when he commented why it is “hard to establish a permanent moat” in retail: Every furniture retailer hoping to go national must eventually overcome the same economic hurdle: the diminishing returns that kick in when a single distribution center can no longer serve all of a chain’s stores.

The second critical problem: HM, like other furniture retailers, relied on financing customers’ furniture purchases with installment loans, usually of two-year duration. Much like a financial services firm, HM provided its own debt servicing and realized revenue from the interest and fees collected from servicing the installment loans. That revenue accounted for up to one-third of profit in some years. HM lost focus in its core business improvement and dabbled in complex financing engineering transactions to boost short-term profits.

Specifically, HM transferred most of its installment sales to a trust account that issued certificates backed by the collection of the installment loans—asset-backed securities (ABS), and some were held by HM in a special-purpose entity (SPE) which were reported on its balance sheet at fair-market value despite the fact that these securities were never traded in a public market. When consumers with better credit quality began using credit cards for purchases rather than Heilig-Meyers installment loan plans, the loan plans were increasingly issued to consumers with low credit quality who defaulted and HM was awashed in toxic waste. The accounting fraud scandal was that Heilig-Meyers kept two sets of accounting books: the company was basing its loss and delinquency statistics on historical patterns rather than current data based on actual payments and collections which showed that HM was not as profitable as they wanted investors to believe. Heilig-Meyers used a “recency” accounting method rather than the standard “contractual” method, and that actual loss and delinquency rates on the contracts were in fact twice as high as stated by the company. In short, the ABS was based on the overly optimistic figures, which improperly inflated the true collateral behind them.

Thus, making and selling affordable furniture for the end customers is critical to avoid the temptations of financial engineering.

Let’s examine the success factors and business model of Nitori Holdings (TSE: 9843, MV $8.5bn) who still holds the record for the longest continuous sales and profit growth – 28 straight years – of any TSE-listed company.

Nitori is the largest furniture retailer in Japan with a 15% market share with around 300 Nitori stores, 17 Deco Home and 19 overseas stores. Rivals include Shimachu (6% market share), IKEA Japan which entered Japan in 2006 (3%), Otsuka Kagu (2%), GMS (21%) and home centers (5%), department stores (4%) and small specialist mom-and-pop stores (44%). Nitori was established in 1972 by Akio Nitori in Sapporo, Hokkaido in the northern island of Japan. Hokkaido is home to a number of innovative retailers, many of which started out in the early 1990s, when the bubble economy collapsed. Nitori first listed in the Sapporo Stock Exchange in 1989, followed by the listing on TSE in 2002.

Nitori grew by…

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Nitori is also renowned for its tight quality control in which less than 1% of items sold are found to be defective, winning customer’s trust. To achieve this, Nitori hired former Honda engineering specialists, many of whom are in their 60s, and gave them an engineer’s paradise. Theses engineers break chairs to see why they splinter, wash pillow covers with acid to see if their colors bleed, left lightbulbs on for hours to see how hot they get.

Like the legendary Sam Walton who has a penchant for the right analysis of data, Nitori tracks a long list of data: customer traffic; the age of every store and employee; the number of quality complaints; profit and sales area per employee. To each the company assigns a target, most of which Nitori can recite from memory.

Nitori’s motto is: “Our greatest pleasure if offering and achieving ‘true life affluence’ for our Japanese customers.” Yet, like Mrs. B, many people do not know the pains and challenges that Nitori-san had to endure and overcome in order to realize this motto. Interestingly, both Mrs. B and Akio Nitori had the same life experience when they are trying to implement their low-price strategy.

For Mrs. B, Buffett wrote that when furniture manufacturers stopped selling directly to her after bigger customers in Omaha complained about her low retail prices, she travelled to Kansas City, Chicago and New York, bought from department stores and still undersold her rivals. Her competitors used fair means and foul, and after pressurising manufacturers to stop supplying her, hauled her into court charging her with violating Fair Trade laws. But “she not only won all the cases….at the end of one case she sold the judge $1,400 worth of carpet.”

In the late 1960s, when Akio Nitori was just starting its business, local furniture wholesalers wielded enormous power, because it was relatively difficult to buy products in Hokkaido, primarily due to geographical and transport-related factors. If a company tried to accelerate its store launches by selling products at low prices, wholesalers would refuse to do business with it, as such firms were seen as troublemakers disrupting the status quo of the industry. For this reason, Nitori started buying products from wholesalers based in Niigata and Gunma prefectures. “But the transactions with them ended quickly, as information was passed on from the Hokkaido-based wholesalers,” Nitori said.

A major life-changing event was when Akio Nitori joined the Pegasus Club in 1972, the year when Nitori was officially established. The Pegasus Club was formed in 1962 to study the US and European chain-store management system and led by distribution consultant Shunichi Atsumi. Young small-business retail executives at that time, such as Daiei’s Isao Nakauchi, Aeon’s Takuya Okada, and 7-Eleven/Ito-Yokaido’s Masatoshi Ito, were among the initial participants. A core principle of the Pegasus Club is “thorough rejection of the current situation and always looking ahead to a better format in 10-30 years.” Akio Nitori’s approach of setting long-term goals and determining the right steps to achieve these goals is heavily influenced by the Pegasus Club.

The Pegasus Club organized a trip to US and Akio Nitori, 27 and the owner of two furniture stores, joined in the trip to learn more about how overseas retailers operate. Nitori spent a week in California, shopping and observing the way Americans lived. He was inspired by the insights gleaned from the US trip and was determined to achieve a “logistics revolution” to grow and scale a national chain store:

“When I visited chain stores in the United States more than 30 years ago, I was overwhelmingly impressed and marveled at the wide disparities with Japan in terms of consumer values such as low prices, merchandise selection and product quality. Creating a home that is enjoyable, relaxing, harmonious and suited to the residents’ lifestyle is a well-established activity in Europe and America, and the reason is the means exist for easily purchasing, at a reasonable price, home products that can be readily coordinated. Nitori has declared its dreams of ‘realization of a society where Japanese can enjoy true life affluence’ and by taking the excitement, stimulation and resolve of that time as its starting point, Nitori is striving to achieve a “logistics revolution” centered on the creation of a national chain store.”

Thus, to the bullying powerful local furniture wholesalers, Nitori found a solution outside the country. The company started…

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Besides Nitori, another wide-moat furniture innovator that we have written earlier in Mar 2014 in the article Willingness to be Misunderstood and the Swedish Corporate Model to Scale an Asian Wide-Moat Compounder: The Story of “Korea’s IKEA” Hanssem is Korea’s Hanssem (009240 KS, MV $5.6bn), whose market cap had since jumped by 270%.

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In the 1983 annual report, Buffett explains how, at 23, Rose talked her way past a border guard to leave Russia for America. Mrs B had no formal education and knew no English. She learnt the language from her elder daughter who taught her, every evening, the words she learnt in school during the day. Mrs. B had worked in the store at age 6, talking her way into a job as a store clerk when she was 13 and becoming manager with six men working under her three years later. When her initial resources, the $500 savings that took her 16 years to accumulate to establish NFM, ran out, she sold every appliance and piece of furniture in her home to pay off a debt.

So how can value investors identify wide-moat business models and the entrepreneurial owner-operators, like the tough Mrs. B, who run them? Buffett revealed his mental model in the quote below and in a Charlie Rose:

“One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business—one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.”

Charlie Rose: How was she able to kill them [the competition]?

Warren Buffett: She cared and she was smart. She knew her limitations of her knowledge and she was confident in the circle of her competence. She didn’t get outside of it and she took care of her customers. She sold cheap and it took her a long time but she built the largest home furnishing store in the country in a town like Omaha, a town of 700,000 people. She was a remarkable woman, and Charlie, she could not read or write and I think every business school should study her.

Charlie Rose: What would they learn?

Buffett: They would learn the essence of business. They would learn that taking care of customers is what it is all about. Taking care of them. I mean by that, giving them good deals, which nobody would touch. She did and working like crazy she was there day after day. She had a passion for it. The truth is, if you took the Fortune 500 CEO’s and I gave you the first draft pick on 10 of them, and I put them in competition with her; she would win.

Buffett compared her to the late Walmart founder Sam Walton:

“One thing that Sam Walton and Mrs. B had in common is they had passion for the business. It isn’t about the money, at all. It was about winning. Passion counts enormously; you have to really be doing it because you love the results, rather than the money. When we buy businesses, we are looking for people that will not lose an ounce of passion for the business even after their business is sold. After all, doing business with someone who is driven by beating the competition by creating a superior company rather than simply finding ways to build a war chest is what it’s all about.”

In essence, Buffett’s mental model beyond the numbers to identify wide-moat innovators is to sense that an entrepreneur takes care of his or her customers in a deep way and keep delivering exceptional value to them. Even if it means pains and sacrifices. Even if there are bullies. Even if it takes a long time, working crazy day-in-day-out. Even if they grow rich. All possible only because they are committed to an idea larger than themselves.

When Nitori returned from California in his life-changing trip in 1972 and inspired to carry out his “logistics revolution” to offer and achieve “true life affluence” for the Japanese customers, he did some quick calculations. It took America 120 years to develop its retail industry, and he guessed it would take him 60 years to catch up. He began crafting a six-decade plan then that he continues to refine today. With his single-minded focus on keeping prices down for customers without disappointing them on quality.

Who are your Mrs. B and Akio Nitori in Asia?

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

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In the month of June, we investigate the #1 ice cream and pasta maker in its domestic market in an Asian country. It is also the main supplier of buns to McDonald’s in its home market. Its high-speed bun production business has expanded to serve other quick-serve restaurants, including Wendy’s and KFC. The firm has nurtured a corporate culture and deep know-how in branding to establish an impressive track record in acquiring and turning small heritage brands into market leaders in different food and beverage categories. Its share price is down 37+% in the past year. This is despite resilient results announced in May. The company was incorporated in 1957 by a group of entrepreneurial families and is now led by an outstanding down-to-earth third-generation business leader.

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Eating Out with Warren Buffett at Asia’s Wide-Moat Restaurant Innovators

“If you have an enemy, wish upon them a restaurant.”

– An old Chinese curse

“…the more important point even, is that 3G – they’re not buying things to sell. And the other private equity firms.. buy companies with the idea of either IPO-ing them or selling them to competitors, or selling them to another private equity firm. That is not 3G’s strategy. They bought Burger King which is now Restaurant Brands International. They bought that to keep.”

– Buffett in a CNBC interview. In a Berkshire Hathaway (BRK/A) news release dated December 12, 2014, Berkshire revealed that it currently owns 4.18% of the common shares of Restaurant Brands International (QSR), the new parent for Burger King and Tim Hortons fast-food chains. Berkshire also holds $3bn of preferred shares in Restaurant Brands that earns 9% annual interest.

Warren Buffett has defied this old Chinese curse of restaurant business only rarely in his illustrious investments career.

While restaurant chains have been a favorite target for value investors and private equity firms, because their cash-flow makes financing deals easy and brands can benefit from cost-cutting, the business dynamics of a restaurant business is characterized by challenges that makes them “a business that becomes harder as it grows bigger” and over 6 to 8 new restaurants out of 10 fail in the initial years. The deep-seated challenges surface in the form of (1) high fixed costs in operations; (2) the struggle to maintain consistent quality, uniqueness and experience in food and service at the individual outlets as it scales up in expansion – and one bad experience can eradicate three or four great customer experiences; (3) availability of suitable locations; (4) being held hostage by the key personnel that include the chef and restaurant manager and high employee turnover; and (5) low barriers-to-entry with little or no economic moat.

The deep thoughts behind Buffett’s restaurant investments hold important lessons for value investors to uncover inspiring innovators in the restaurant business in Asia. With Buffett’s wisdom, we will better understand the story of how an electrical engineer-turned-billionaire restaurant-prenuer has been able to build a wide-moat in his restaurant chain known for its “dancing staff”, tech innovations and whose market value compounded to $1.47bn in market value after growing from only one outlet prior to 1984 to over 550 restaurants throughout Asia.

However, such positive investment success stories in the restaurant business are uncommon. After all, Yum! Brands (YUM) had to write off $361m in goodwill in Feb 2015 related to the ever shrinking value of the company’s 2012 purchase of Little Sheep Mongolian Hot Pot for $860m from private equity firm 3i, following an earlier impairment charge of $258m in 3Q13. In Mar 2015, CVC Capital had to freeze the assets of the flamboyant Chinese restaurant owner Zhang Lan who sold sold a majority stake in her company South Beauty to the European private equity group last year for $300m, due to accounting tunnelling fraud. In India, there are private equity investment failures in Nirula’s, once the sole symbol of fast food in Delhi, south-Indian food chain Sagar Ratna Restaurant, Bangalore-based food chain Vasudev Adiga, etc.

But first, let’s understand Buffett’s previous restaurant investment 14 years ago before his recent deal in Restaurant Brands International (QSR), the new parent for Burger King and Tim Horton’s fast-food chains.

In 2001, Buffett bought 1.9m shares in OSI Restaurant Partners, owner of Outback Steakhouse, for $48m at around $25 per share. By 4Q06, Buffett completely sold his stake when OSI announced in Nov 2006 that it will be acquired by Bain Capital Partners for $3.18bn with the assumption of $185m in debt, or $40 per share, a 27% premium over its last traded price before the deal. In its final fiscal year (2006) as a public company, its operating profit was $152.3m. In 2008, revenue and profits declined and Bain was forced to take a goodwill impairment charge of $726m, an indication that it had seriously overpaid for Outback and the rest of OSI’s restaurant concepts. Prior to the acquisition, OSI’s debt was less than $200m, and its annual interest expense was just under $15m. After the takeover, debt was $2.6bn with $136m in interest, topping out in 2008 at $197m. OSI was relisted as Bloomin’ Brands Inc (BLMN) in Aug 2012 and it had managed to reduce its debt to $1.8bn and an annual interest bill of $83m. Its present market value at $2.7bn is still below the $3bn valuation nearly nine years when it was taken private. Interestingly, Buffalo’s Wild Wings (BWLD) is up more than 13-fold since its 2004 listing to a market cap of $2.9bn.

OSI is part of the two big waves of PE acquisitions in the restaurant industry in 2005-2006 and 2010-2011. Since 2005, over $21bn in transactions has been recorded. Despite their average EV/EBITDA at acquisition at the decently attractive level of around 7.4x, many have failed and entered into Chapter 11, including Charlie Brown’s, Uno Chicago Grill, Sbarro’s, Bugaboo Creek, etc. OSI former staff and early leaders who inspired Outback commented how with the new private equity owners, the people-first attitude has left and been replaced by a devotion to profits.

What could have attracted Buffett to OSI beyond the financial numbers? Or put in another way, why is Outback able to build a wide-moat in its business model when the general restaurant business has little or no economic moat?

Outback Steakhouse began as one restaurant in 1988. The founders were two corporate guys and two art majors, Chris Sullivan, Trudy Cooper, Bob Basham and Tim Gannon (photo on left), who established the company because they felt they were not treated fairly by their former employee, Pillsbury, after helping the company grow the Bennigan’s chain. The founders resolve that if they were ever to own a business, they would never make anyone feel the way they were made to feel – underappreciated and under-rewarded.

This was the underlying motivation behind the unique Outback ownership structure, which requires each restaurant manager invest $25,000 in his or her restaurant in exchange for a 10% ownership stake. Outback’s original reason was to create a company that did not take advantage of its employees but that shared the benefits of success with those who make it happen. The Outback’s founders understood people. They knew that (1) People want to be part of something that they can believe in and be proud of, (2) People want to be respected, treated fairly, recognized, and have the opportunity to advance, (3) People want to have control over their destiny.

Outback’s owners believed in decentralized management. “We’ve been in their shoes. We’ve worked for companies and said, “If you guys would just leave us alone and let us do our jobs, we would be so much more efficient.” Each restaurant is a separate entity owned by Outback, a regional partner, and the restaurant’s general manager. Ownership means actual equity ownership – sharing in the annual profits and building equity under a buyout formula of 5x the last 2 years’ average annual cashflow. Other store personnel share in a bonus system on a quarterly and annual basis. People can see career paths and actual ownership at Outback, where the founders take great pride in the fact that they have created more millionaires than any other restaurant company. Every restaurant manager, JV or regional partner, and in some cases, chefs, too, are required to invest $25,000 to $50,000 cash for a 6 to 10% ownership interest in the restaurant depending on the concept. Store managers then are paid a base salary, and they receive stock options and 10% of the restaurant’s profits. They have a 5-year employment agreement and at the end of 5 years, they can resign or sell back their ownership interest based on a formula of 5 times the average cashflow for the last two years. Most managers who work at Outback for 10 years become millionaires. They also care about their restaurant, act like owners (because they are), and are able to engage their employees. Interestingly, Outback has no HR department. In addition, each restaurant has a profit-sharing program for waiters, waitresses, hosts and hostesses that is paid out quarterly.

In addition, the company took steps to maintain positive working conditions for its employees, so that they would provide cheerful service to the restaurant’s patrons. “If you worry about your employees and their environment and their ability to do the job, and you make sure they’re happy, you don’t have to worry about the guest,” Gannon said. Accordingly, wait staff were responsible for only three tables apiece, and the company devoted 40% of the space at each location to the kitchen so food preparers would not be crowded. “We understand from having been managers, waiters, cooks, what they feel like,” Gannon said, “We know what the heat of the kitchen is like — personally.” Outback’s attractive arrangements for restaurant general managers and staff resulted in management turnover of 5% compared to 30 to 40% industrywide.

So who is the wide-moat restaurant innovator in Asia that we mentioned is famous for its “dancing staff” and tech innovations?

MK Restaurant Group PCL (SET: M) – Stock Price Performance 2013-2015

At family business MK Restaurants Group PCL (SET: M, MV $1.47bn), best known for its popular chain of value-for-money sukiyaki restaurants in Thailand where customers cook their food in hotpots at their tables, managing director Rit Thirakomen explained that the “MK dance” began within the company, as staff were asked to dance after arriving at their restaurants early in the morning, before they began serving customers. The original objective was to create an opportunity for restaurant managers to talk to their staff each day as a means of solving or pre-empting problems. It also helped to “energise” sleepy staff members. The MK dancing also helped staff to overcome shyness and work as a united group. Some diners have found it such fun that they have even formed a club to occasionally join in dancing with the MK staff. MK branches now have dancing shows for customers at noon and in the evening.

An electrical engineer, Khun Rit, 63, cofounded the book publisher Se-Education (SET: SEED, MV $69m) in 1974 and worked there until 1986, when he joined in 1984 his wife Yupin’s family restaurant business founded by his late mother-in-law. Khun Rit spearheaded MK’s expansion into sukiyaki and eventually other Japanese food with the Yayoi chain. Despite a slowing economy, Khun Rit opened 55 new restaurants in 2014, taking its total to 557, in line with its target of having 1,000 restaurants by 2018. In March 2015, MK made a splash with London Street, Thailand’s first community food mall in Bangkok on Phatthanakan Road based on the concept of a London-chic design, which houses all 5 of MK’s restaurant brands (photo on right). MK generates $448m in sales and $62m in net profits and  $110m in EBITDA, trading at EV/EBITDA of 13x with a debt-free balance sheet and net cash of $389m.

MK Restaurants has been investing in IT every year for almost a decade. Before the advent of iPad, MK had invested in personal digital assistant (PDA)-based ordering system in 2004, with the aim to improve service time in food ordering. Many people questioned the investment. Not only was the system able to save operating costs and time spent in serving customers, thereby freeing up tables more rapidly, but also a lot of customer satisfaction was created. The investment outlay would be returned in only two years and MK was able to satisfy even more customers. The restaurant chain also invested in GPS installed in all of its trucks to improve its logistics management and save on fuel costs. Khun Rit also planned to enhance the good relationship between MK Restaurants and its customers by issuing RFID-based member cards. In this way, existing customers will immediately be recognised in any branch and details revealed such as their favourite dishes. “With the smarter member cards, we will be able to treat our regular customers with the same standard of service as soon as they come in, even at different branches.”

An engineer by education, Khun Rit said he preferred systematic methods rather than solving problems case by case.  “From a small restaurant growing into over 500 branches, our target has always been to create customer satisfaction. Every customer must feel happy when they visit our restaurants. We don’t overlook even the smallest details. At MK, we design everything – from the smallest to the biggest matters,” Khun Rit explained. In paying attention to the smallest details, MK believes that most problems represent “the tip of the iceberg” and there is a need to discover the real causes. Some examples of MK’s attention to details incorporated into “MK designs” from design of services and extended into recruitment, training, motivation, the organisation’s culture, customer feedback, quality auditing and strategy alignment:

• MK’s customer-focus strategy includes providing comment cards on every table. To encourage clients to fill in the comment cards, the company created a colour-code scheme. If a customer rates MK’s service very highly, they mark the card in blue. Orange is used for a very poor rating, and red for areas that need improvement. The strategy has been used since 1996. In the first three years, Khun Rit saw red and orange colours being marked more often than blue. These responses helped the company identify and rectify its weaknesses.
• Instead of expecting each of its suppliers to deliver goods to the company’s restaurants all over the country, requiring more than 20,000 trips each day, MK has the goods delivered to one of its two factories. Here, the goods are processed or materials and ingredients combined and then the company’s own fleet delivers supplies to the restaurants at least once or twice daily, requiring about 300 trips per day.
• …

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Employees work hard for companies where they believe they have a future and where they can have an impact. In the case at OSI, when they see that current top managers started out where they are now, as line employees, a powerful, self-reinforcing system is created. But the attitude and resulting behavior of top management is key. Humbleness is mission-critical. Top managers who have a sense of entitlement or superiority generally do not fit at high-growth companies, where humility is more important than status. Top management receives few perks at these companies. Except for compensation, the companies try to eliminate elitist executive perks.

Like Buffett, the authentic value investors go beyond quant screens, checklists and financial numbers to understand the underlying business model dynamics that in turn is influenced by the motivation and character of the entrepreneurs and owner-managers.

Just as OSI founders were influenced deeply by their experience of unfair treatment at their former employers and wanted to make things right by building an owner-manager environment, MK’s Khun Rit was shaped profoundly by his childhood experience which led him to found his first company called SE Education (SET: SEED). Khun Rit reminisced: “When I was a child, Thailand was still poor. The people were less educated, with no opportunities for them to receive a good education. I was hoping to see everybody allowed to receive a good education. I successfully entered the engineering faculty of the prestigious Chulalongkorn University. Because my long-cherished desire to receive a good education was achieved, I studied even harder at the university. I also helped my friends from time to time by translating their materials into English for them. Many of them were poor at English, so I helped them. This experience led me to establish a company for publishing and selling books. That is the company now called Se-Education. Our company has 300 branches across the country. I launched this company with a few classmates who graduated from the university along with me. This was an achievement of my childhood dream. As the company expanded, my life became gradually wealthy. This made me feel happy about the fact that we are providing less-educated people opportunities to cultivate themselves.”

Besides MK as the role model of a wide-moat innovator in the casual-dining space in Asia, there are two wide-moat innovators in the quick-serve segment: Café de Coral (341 HK, $2.2bn) and…

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Café de Coral (341 HK) – Stock Price Performance 1986-2015

In an earlier article in Jul 2014, we had highlighted briefly Café de Coral, the largest fast-food chain in HK with over 580 outlets across its brands all over the world. Café de Coral was started in 1968 by Victor Lo Tang-seong and Lo Kai-muk, the second-generation leaders of the inspiring founder behind Vitasoy (345 HK, MV $1.8bn) – Dr. KS Lo. The spirit of Dr. KS Lo to want to produce a cheap, nutritious, high-protein soya milk after observing severe malnutrition in children caused by diseases in mainland China and HK had inspired the next generation of leaders in Sunny Lo Hoi-kwong (photo) who scaled Café de Coral to greater heights and had passed on the baton to his son-in-law Michael Chan. We wrote:

“Both Shin and KS were inspired by the idea larger than oneself: to bring about kindness and betterment to children and people in ruined lands through food technology and quality products and services. This larger idea has galvanized the trust and support among the community of customers, business partners and suppliers throughout the years. Whenever this core value is diluted, without the accompanying culture of trust and decentralization to empower the people in the pursuit of growth, globalization, size and diversification, chinks in the mighty armour start to appear and can deteriorate quickly into major problems that would bring down the organization.”

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Finally, to the next generation of leaders, MK’s Khun Rit offered the following viewpoint:

“Study hard and find what you want to do in life, something you feel passionate about. These cannot be found unless you look for them seriously. If you can find a career that you really aspired to, this should be better than anything else. We are like artists who try to create good works but returning to them again and again and improving them little by little. A beautiful work can be created with a repetition of very careful, not hasty, finishing touches. Entrepreneurs need to have passion in what they are doing and a strong belief that other people will have the same passion for the products and services they deliver.”

As we eat out with Warren Buffett at these Asian wide-moat restaurant innovators amidst the multiple restaurant failures with seemingly attractive low EV/EBITDA valuations multiples from the screens and checklist, value investors come out with one important insight to think differently about the way that we “eat” and to stay resilient against the old Chinese curse.

What unites the original OSI, MK, Café de Coral and… is a sense of mission towards their customers and the people around them which inspires the extra level of intensity and dedication for them, forged by enduring dimensions as character, values, beliefs, capabilities, and personality. In a business organization, these enduring characteristics are a firm’s culture – the so-called soft factors that will actually sustain it over many years and through many situations while the hard factors like financial performance all too quickly come and go. These enduring characteristics resonate like the resolute gong of the temple bell because the sound reverberates in our hearts, stirring the everlasting values that matter: Forbearance, Honor, Duty, Hardwork, Fairness, and Humility, the timeless values that epitomize the Warren Buffett and Charlie Munger way of value investing and the core values of the Bamboo Innovator that bend but never break.

Thus, before you start to bite into that restaurant stock based on its seemingly attractive numbers, make sure you are able to go back to the basics to digest this: Do you assess the numbers and valuations to be backed by a wide-moat business model and an enduring corporate culture that promotes owner-operators? Is there an idea larger than oneself underlying the business model? If your answer is a resounding Yes!, then you are able to eat well – and sleep soundly.

Warm regards,

KB

The Moat Report Asia

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In the month of June, we investigate the #1 ice cream and pasta maker in its domestic market in an Asian country. It is also the main supplier of buns to McDonald’s in its home market. Its high-speed bun production business has expanded to serve other quick-serve restaurants, including Wendy’s and KFC. The firm has nurtured a corporate culture and deep know-how in branding to establish an impressive track record in acquiring and turning small heritage brands into market leaders in different food and beverage categories. Its share price is down 37+% in the past year. This is despite resilient results announced in May. The company was incorporated in 1957 by a group of entrepreneurial families and is now led by an outstanding down-to-earth third-generation business leader.