Can You Guess This Asian Wide-Moat Company?

The Five Principles of Success: ‘Romance’, “Vision’, “Motivation’, ‘Curiosity’, ‘Obsession’

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. 

What is the investment Achilles heel of Warren Buffett and Charlie Munger?

It 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. 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. Buffett had also 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.

Make no mistake: NFM and IKEA are the rare exceptions. Furniture retailers face critical economic hurdles and problems in building a wide moat and scaling up the business. Furniture is a category of product that is difficult for a retailer to handle, because (1) inventory turnover rates are low for durable goods, thus few furniture retailers manufacture their own products because of low purchase frequency and distribution efficiency, (2) unlike consumer electronics, it is rare for a furniture manufacturer to have a well-known brand, and it is hard to alter product features notably over a short period, making it difficult to promote replacement demand, (3) furniture sales usually require direct customer contact and explanations in-store, as well as delivery, which adds to the SG&A cost burden. Those rare few innovators who can overcome these formidable business dynamics like IKEA will enjoy increasing returns to scale and the business gets easier as it gets bigger.

In this month of September/October, we investigate another IKEA-like innovator who is the undisputed dominant specialty chain in furniture and home furnishing in its domestic market with rarity value as the only listed Asian company with a unique integrated manufacturing-logistics-retail business model in the industry with an 90% self-developed private label product ratio to sell low- to mid-priced high-quality functional merchandise to the masses. Whereas most furniture retailers simply sell furniture, [Company’s name] has put effort into offering a complete lineup of “home fashion” products which contribute to 60% of its sales. “Home fashion” products are purchased frequently, and by devoting effort to the development of such products, [Company’s name] has achieved the kind of customer-drawing power that other specialty furniture retailers lack. [Company’s name] develops these products itself for over 80% of its offerings.

[Company’s name] has achieved an astounding 29 consecutive years of growth in sales and profit, converting macroeconomic adversities ranging from consumption tax hike to currency volatility into opportunities to grow further. Despite [Company’s name] market leadership, it is still operating in a fragmented domestic market with around 10% market share in the home and garden market and has a long runway ahead to extend its market leadership, particularly in the urban areas. [Company’s name] has expanded its market share in the low-end category, but it has also been releasing mid-priced products that offer additional value in terms of quality and function since 2012, and this has led to the expansion of its customer base. [Company’s name] currently has a network of domestic stores and 37 overseas stores and targets 1,000 stores by 2022, 3,000 stores by 2032. [Company’s name] was established in in 1967 by founder Mr N.

Furniture and home furnishing business has low inventory turnover and loading efficiency is poor. As a result, controlling procurement and distribution costs is critical to achieving low-cost operations and to coordinate store openings and expansion. [Company’s name] manages the whole process of product planning, materials procurement, production, distribution and sales in order to reduce its intermediary costs, which enables it to offer highly functional quality products at low prices. This source of [Company’s name] wide-moat competitive strength is very much under-appreciated until the value investor understands the business economics of the furniture and home furnishing business. [Company’s name] “returns” benefits gained from lower COGS (on raw material changes, design revisions, and improved production yields at overseas plants) to customers through lower pricing. This policy has generated a virtuous circle of sales expansion from increasing economies of scale, and high customer loyalty is captured.

Powered by its unique integrated manufacturing-logistics-retail business model that is perhaps rivalled by only the unlisted giant IKEA, [Company’s name] is able to enjoy a lasting wide-moat competitive advantage that grows stronger with time with the virtuous cycle of customer returns that generate one of the highest ROE at 23.3% and profit margin relative to all its industry peers. Notably, [Company’s name] present operating profit margin at 16.3% is the highest in the industry, which is a steady structural progress over the years from 6% in 2001 to 13% to 2009, and looks set to improve further with a higher sales mix of higher-margin mid-priced quality functional products that expand its customer base. [Company’s name] has a healthy balance sheet with a 13.3% net cash-to-equity ratio to generate an impressive ROE of 23.3% and it currently trades at EV/EBIT 16.3x. [Company’s name] suffered a short-term 23% correction in share price from its recent high in July due to overall market uncertainty and without any major negative firm-specific news. We believe that once its upcoming earnings are announced on Sep 27, 2016 delivering another record-high results, the share price will rebound strongly.

From Wal-Mart to IKEA, companies with a greater sense of Purpose and insurgency in making available to the masses once expensive products and services that used to be affordable by only the rich, the “10X price disruptors”, are powerful super-compounders delivering superior shareholders’ returns for a long period of time. Motivated by this grand purpose to bring true life affluence to customers following his learning trip to US in 1972, Mr. N resolved to cut the middlemen and dedicated his life mission to building a unique integrated manufacturing-logistics-retail business model to offer quality merchandise at low affordable prices. [Company’s name] grew from 2 stores into a nationwide chain with dominant market leadership. We are highly impressed by the unique business model that gets stronger and easier over time and [Company’s name] still has a long runway to grow its store network in the fragmented furniture and home furnishing market in both domestic and overseas markets. [Company’s name] has also developed a powerful human capital strategy which has been a powerful enabler in supporting store expansion to achieve growth in sales and profit for 30 consecutive years. We think this is very rare for an Asian company and [Company’s name] deserves a valuation premium for its staying power and genuine potential to be one of the rare Asian company to reach the $100bn market cap milestone.

Below are some excerpts with the CEO Mr. N on his entrepreneurial journey to scale up his business into a formidable world-class innovator:

Q: “Chairman, [Company’s name] has achieved phenomenal success since it was established in 1967 to command domestic market share leadership in furniture and home fashion & furnishings. Can you share with us how the wonderful story of [Company’s name] started, including your own journey, especially the tipping point and challenges along the way? What is your personal driving force?”

Mr N: “It all began 49 years ago. The year was 1967 when I opened a small furniture store. My tiny 1,000 square foot store served the local community. Then I married and opened another store of about maybe three times that size. We finally managed to earn a decent living with the stores’ sales. However, a year later, another company opened a store of five times that size which made us go almost bankrupt. These were busy days and uncertain times but I continued to look forward and search for ways to grow my new venture.

In 1972, I was then 27, one study tour organized by an industry association to the United States was all it took to change the course of my struggling furniture store. During a week in California, I witnessed how differently Americans shopped and lived. Obviously, that I was deeply shocked. I was truly astonished, moved and struck. In the US there was no stand-alone furniture. Everything was built on the building, like walk-in closets. Compared to our country’s crowded living spaces, California homes were spacious with separate areas for entertaining and dining where guests would be welcomed, and the further back there would be a family-room. American consumers went to convenient retail stores to buy color-coordinated furniture and accessories to enhance their beautiful homes. In contrast, we had only mismatched offerings to choose from. They even had one bathroom on each floor! Most shocking to me was how inexpensive the high-quality merchandise in the US was compared to similar products back home. American furniture was designed to make life easier for consumers, not simply to pad manufacturers’ bottom lines. I recalled that I was so astonished by the difference in furniture and interior decor products in terms of price, selection, and quality.

It was like a dream world, I was so excited I could barely get any sleep. I wanted to bring the affluence of the US to my country. It was at this moment that I decided to bring back to my country what I had learned in the US. At first, I was pursuing my own sales and profit. Then I realized I was wrong. Ever since I visited the US, I changed my life philosophy, setting up an aim to enrich everyday life of people. I made my mind to develop and provide affordable and full-featured products for people. Furniture had occupied an important position in the lifestyle of the people. I would use my company to help people live as prosperously and comfortably as Americans. That wish and determination have never switched since [Company’s name] was founded, and remains there during every moment of its development. Setting and realizing this goal is our greatest pleasure.

Tracing back to the time when we advanced nationwide, we heard customers that they were surprised to see the numerous choices and the low prices in [Company’s name]. We can’t help but imagine the house we like and the room we desire, after what we saw in [Company’s name]. Not to mention it is the first time that we realize our imagination may come true. Every time we hear this, we are reminded once again, that our unremitting efforts have come to a result. We promise to keep an ear out for our customers as always, to step onto the arena of the whole world, to realize our dream deep inside, and to achieve so, we will do our utmost. We continue to chant the strong and simple words ‘to enrich the people’s life’ and to spread a dream to the customers, build a fire of motivation in the employees, stakeholders and business partners.

My personal driving force has been this ‘romance’ and purpose to help people around the world achieve the richness of living in the true sense by providing products with the appropriate quality and functionality for the customers at affordable price. Pursuing higher goals over a long period of time is critical because otherwise improvement will be superficial.

Looking back and our scale of our company is like a dream. [Company’s name] has been able to create value and grow successfully with tenacity and staying power because there was ‘romance’ and a long-term vision. That’s right, I have repeatedly told employees that to work at [Company’s name], it is important to have this five principles of success: ‘Romance’, “Vision’, “Motivation’, ‘Curiosity’, ‘Obsession’. ‘Romance’ is a feeling in one to contribute for the people and for the sake of the world over one’s life. Without such a Purpose, life is nothing. Humans were originally born for the people, for the sake of the world. Life is aspiring to become a person useful to the world. This is an ideal to get right from young, and even when one is 50 years old, 60 years old.”

Who is Mr. N and this Asian wide-moat innovator?

Warm regards,

KB

The Moat Report Asia

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