Description

My Pitch:

This is a recommendation to buy shares in Sotsu (ticker: 3711 JP).  Sotsu, founded in 1965 and listed in 2003, co-owns the intellectual property and related royalties of Mobile Suit Gundam (http://en.wikipedia.org/wiki/Mobile_Suit_Gundam), one of the oldest and most successful animation franchises in Japanese history.  Sotsu shares trade at just 1.1x net cash and less than 1x 2012 EV/EBIT (to be exact, EV = 1.2x trailing 6 months EBIT) despite the fact that:

1) most of its EBIT comes from high-margin/recurring Gundam-related product royalties,

2) it has the potential to quickly grow these royalties at the stroke of a pen with little risk via new licensing deals (i.e. in new products like video games or new regions like Asia ex-Japan),

3) returns on capital have been decent (since 2003 EBIT/total assets ranged from 11%-16% since 2003 while EBIT/ex-cash assets ranged from 29-50%), and

4) management allocated more than 51% of cumulative net profits between 2008-2011 (when the stock often traded below cash) to dividends and well-timed stock repurchases/cancellations (yes, this is a Japanese company that actually cancels repurchased shares).  

After re-rating from 2010-2011 on the back of aggressive share buybacks, Sotsu’s shares are looking cheap again partly because of recent regulatory changes regarding cash payments for virtual items in Japanese social networking (“SNS”) games.  In effect, the Japanese authorities unexpectedly adopted the attitude that certain pay-to-play SNS features are akin to gambling, which is illegal in Japan.  This draconian stance shocked the market and caused a sharp sell-off in SNS-related stocks (i.e. Gree, DeNa) since May (www.yomiuri.co.jp/dy/national/T120505002978.htm) and Sotsu shares – listed as a collateral damage stock by Yahoo Finance Japan given its exposure to video/SNS games royalties – have gone quiet since. 

I think any guilt-by-association sentiment Sotsu received from the SNS debacle makes little sense because SNS games contribute only a small fraction of the company’s total royalties, the growth of which has been blistering recently.  Sotsu’s 1^st half EBIT alone was up 83% YoY and hit 76% of the company’s full-year forecast.  The Nikkei newspaper confirmed this growth spurt is not over when it leaked Sotsu’s 9-month results a few weeks early on June 22 (http://tinyurl.com/77hetlv), claiming Sotsu saw 50% YoY EBIT growth.  Sotsu won’t officially announce 9-month results until July 9, and they released a statement that neither confirmed/denied the leak (www.sotsu-co.jp/ir/pdf/20120622.pdf).  But if the Nikkei (Japan’s dominant business paper and an unofficial mouthpiece) published this leak there’s probably some truth to it.

In a nutshell, Sotsu is not your average cheap Japanese stock with a low quality business, zero growth, and shameful capital allocation.  Sotsu is one of the rare opportunities in Japan to buy decent quality with realistic growth potential at a dirt cheap EV multiple and a market cap above USD 150m.  According to Bloomberg http://db.tt/bQP6FsPY, as of 2012 July 2 there were only 14 Japanese listed companies (out of a total 3,721 in the entire country) with 10%+ EBIT margins and 7%+ 5-yr average ROEs trading below 0.3x EV/market cap.  Sotsu is one of them.    

Consolidated results:

2012 first half:    revenue = JPY8.7b, EBIT = JPY1.7b

2011 first half:    revenue = JPY7.1b, EBIT = JPY0.9b

2012 (co. estimate): revenue = JPY17.2b, EBIT = JPY2.2b

2011:     revenue = JPY15.1b, EBIT = JPY1.7b, equity = JPY12.5b

2010:     revenue = JPY13.8b, EBIT = JPY1.6b, equity = JPY12.2b

2009:     revenue = JPY16.1b, EBIT = JPY1.6b, equity = JPY11.5b

2008:     revenue = JPY15.9b, EBIT = JPY1.8b, equity = JPY11.3b

2007:     revenue = JPY12.9b, EBIT = JPY1.5b, equity = JPY11.0b

2006:     revenue = JPY12.9b, EBIT = JPY1.6b, equity = JPY10.1b

2005:     revenue = JPY12.0b, EBIT = JPY1.6b, equity = JPY9.4b

Rights segment (i.e. royalties) results

2012 first half:    revenue = JPY1.8b, EBIT = JPY1b

2011 first half:    revenue = JPY1.2b, EBIT = JPY0.6b

2012 (co. estimate): revenue = JPY2.8b, EBIT = not given

2011:     revenue = JPY2.7b, EBIT = JPY1.4b

2010:     revenue = JPY2.5b, EBIT = JPY1.2b

2009:     revenue = JPY2.5b, EBIT = JPY1.3b

2008:     revenue = JPY2.8b, EBIT = JPY1.4b

2007:     revenue = JPY2.7b, EBIT = JPY1.4b

2006:     revenue = JPY2.7b, EBIT = JPY1.3b

2005:     revenue = JPY2.4b, EBIT = JPY1.1b

Frequently Asked Questions:

What is Mobile Suit Gundam?

If you’re a guy and live/grew up in Asia, then you probably know of Gundam.  For those that aren’t familiar, the easiest way for me to describe Gundam is that it’s the “Star-Trek” or “Transformers” of Japan, but bigger:   

“The original Mobile Suit Gundam was an animated science-fiction series which debuted on Japanese television in 1979. In this groundbreaking series, the traditional giant robots of Japanese anime were for the first time portrayed as realistic war machines instead of invincible superheroes. The people who used these machines to fight in a futuristic space war were complex characters whose motivations and beliefs didn't break down into simple good and evil, and the story encompassed human drama and social commentary as well as thrilling robot battles… Mobile Suit Gundam's popularity led to a series of sequels and followups - first a three-part movie compilation, then a succession of new television serials, original videos, and theatrical films. After more than two decades, this Gundam saga has expanded to include nine television series, four video series, ten movies, and countless novels, comics, and original video game adventures. This saga encompasses six different worlds, each with its own unique history and society, and showcases the work of the most celebrated talents of the anime industry.” -- www.gundamofficial.com/features/introduction.html

Millions of fans in Japan/Asia are still crazy about Gundam today:

-          a simple Google search for “top 10 anime of all time” will yield many pages praising Gundam as one of the best all time (http://www.myanimespace.org/top100.php, http://maskathor.hubpages.com/hub/Mecha-Animes, http://midnightgrifter.livejournal.com/33937.html). 

-          Gundam-related products are consistently the number one seller for Japanese toys/games giant Namco Bandai, generating JPY43b, JPY35b, and JPY38b of revenue in 2009-2011 (Namco Bandai 2011 annual report p. 7 www.bandainamco.co.jp/en/ir/annual/pdf_bnh/en_2011_3.pdf). 

-          When Sotsu helped erect a temporary life-size (i.e. 18 meters tall) Gundam statue in Tokyo 3 years ago to commemorate the series’ 30^th anniversary, over 4 million fans made the pilgrimage to see it in just 52 days. http://gundamfront-tokyo.com/en/welcome/

-          Over 400 million units of an anniversary edition Gundam plastic model were sold since 2010 (see Namco Bandai 2011 annual report p. 6 www.bandainamco.co.jp/en/ir/annual/pdf_bnh/en_2011_3.pdf).

-          A new Gundam theme park was just opened in Tokyo this April, again with the life-size statue www.japantimes.co.jp/text/nb20120420a2.html

How does Sotsu make money from Gundam?

One word: royalties.  Sotsu’s “rights business” collects product royalties on Sotsu’s portfolio of anime characters (there are 108 in total, but Gundam is the superstar). From 2007-2011 (August FY) these royalties generated just 18-21% of the consolidated revenue from but 80-90% of the consolidated EBIT.  The other 2 segments include a “media business” (this segment creates original animation content for TV stations but hasn’t created a true hit since Gundam) and a “sports business” (acts as the sole product licensing agent for the Tokyo Giants baseball team, a gig that taught Sotsu’s Founder/Chairman about mascots/logos/royalties and value of owning intellectual property before they created Gundam).  Neither of these 2 other segments are very profitable, but they’re managed on a tight budget (positive EBIT every year), and over the very long-term play a role in sustaining the high-margin rights business (i.e. there has to be more Gundam anime content created at every several years to fuel the fan base’s desire for merchandise).  

The rights business, however, is the key to understanding Sotsu’s investment potential.  The original Gundam animation was created by Sotsu and another company called Sunrise (now a subsidiary of Namco Bandai, a leading Japanese toys/games company) in 1979.  Sotsu/Sunrise still co-own the Gundam rights today (if you look closely at the copyrights for Gundam-related websites/products you’ll see “Sotsu-Sunrise” printed somewhere), an arrangement where they effectively split all Gundam-related product royalties 50/50.  Sotsu’s role is not passive – it selects/monitors all potential Gundam product licensees and ensures the proposed products are true to the spirit of the storyline and hardcore fan base.

In fact, Sotsu is the “primary” Gundam rights owner, so it stands first in line to receive the cash royalty revenues from product licensees, and later pays 50% of these royalties to Sunrise.  This 50% payment to Sunrise is essentially the only cost booked in Sotsu’s rights segment P&L (just 3 people work in this segment) and is the reason why Sotsu’s rights segment EBIT margins have been hovering at 50% since the company IPO’d back in 2003.

The actual royalties paid to Sotsu depend on the specific deal it strikes with product licensees (generally, these are 1 year deals with annual renewals if things go well but other terms are customized).  According to management, the royalty earned is calculated as a percentage of licensee product sales and is normally in the range of 1-10% (yes, this is vague, but management won’t reveal the exact percentages/clients for competitive reasons).  We can, however, work backwards to estimate a back-of-the-envelope royalty rate.  It’s public information that Namco Bandai’s toys division is the largest source of merchandise royalties for Sotsu, accounting for JPY1.9 billion of royalty revenue (68% of the total).  If we simply divide this JPY1.9 billion of Namco Bandai royalty revenue by the JPY38 billion of Gundam toy sales disclosed in Namco Bandai’s 2011 annual report, then we arrive at a crude 5% (i.e. 1.9/38 = .05) royalty rate. 

What types of licensees/products are generating all this royalty revenue for Sotsu? Here’s a few of the many examples you’ll find walking around in Japan/Asia today:

1)      Licensee: Uniqlo/Fast Retailing

Product: Gundam-themed T-shirts

Location: Hong Kong / Malaysia

Picture: http://db.tt/35JQhzYL

2)      Licensee: Sagamiya Foods

Product: Gundam-themed packaged tofu

Location: Japan

Video: http://www.youtube.com/watch?v=tf--bda2zPM

3)      Licensee: Namco Bandai

Product: Gundam PS3 game (the first “free” PS3 game with pay-as-you-go virtual items)

Location: Japan

Link: http://pgdp.channel.or.jp/gundam/ps3/

Pay-as-you-go explanation: http://kotaku.com/5921947/namco-bandais-latest-gundam-game-is-free-not-completely

The consistency of the rights segment revenue/EBIT breakdown above belies the fact that Sotsu doesn’t have great visibility on future royalties.  While licensees usually sign 1-year contracts with Sotsu, they aren’t obligated to provide a sales forecast and a lot of the licensed products are shorter life-cycle SKU’s that won’t be repeated again.  Hence, Sotsu’s annual rights segment revenue forecast has only been correct 2 out of the last 4 years (but the EBIT forecast was right 3 of those 4 years). 

But Sotsu management won’t ever feel that insecure about future royalties because Namco Bandai (i.e. biggest product licensee = 68% of total royalties) is its #3 shareholder with a +17% stake.  This relationship is admittedly strange (more on this below) but the way it’s set up now there’s likely to be more cooperation going forward since Gundam-themed toys have also been Namco Bandai’s top revenue producer for many years (Gundam toys = 10% of Namco Bandai’s consolidated sales and 25% of its toy segment’s sales). 

The big untapped opportunity for Sotsu is to expand its royalty revenues beyond traditional toys towards growth products like video games (which they’ve already been doing in a small way) and growth markets via oversees licensees (currently 20% of all Gundam royalties come from Asia ex-Japan, including HK/Taiwan/Korea/China).  Management stresses that it takes time to find the right licensees to growth with, but once they do, things could get interesting.

How is Namco Bandai involved?

Namco Bandai is the leading toys/games company in Japan, and they’re involved with Sotsu in 3 ways:

1)      As co-owner of Gundam rights: Sunrise Co., now a 100% subsidiary of Namco Bandai, co-created Gundam with Sotsu back in 1979 and retains co-ownership of the Gundam rights. 

2)      As a major customer: as mentioned earlier, Namco Bandai sells a lot of Gundam-themed toys every year, which means they have to pay Sotsu a lot of royalties (68% of their total).

3)      As a major shareholder: Namco Bandai owns over 17% of Sotsu today. 

Given the symbiotic between Namco Bandai/Sotsu, why doesn’t Sotsu just sell itself to Namco Bandai?  Namco Bandai would probably love to own 100% of the IP behind its best-selling product -- and they certainly have the resources to buy out Sotsu’s minorities.  But the hints I’ve been getting from Sotsu management suggests that Mr. Nasu Yuji, Sotsu’s Founder/Chairman and major shareholder (60% stake), doesn’t want to sell out yet despite the fact he’s already over 70 years old and doesn’t have any kids in line to take over the company.  Sotsu management maintains that Sotsu/Namco Bandai operate completely separate strategies and character portfolios, with the (big) exception of Gundam.  

In light of this, Namco Bandai’s current +17% stake in Sotsu is probably just a toe-hold investment in case Nasu Yuji changes his mind down the road.

Does Sotsu care about shareholders?

Yes.  First, dividends have increased a lot over time: since the 2003 IPO the ordinary dividend grew from JPY10/share to JPY30/share, with some special “anniversary” dividends thrown in along the way.  Yes, given the company’s strong cash flows the current dividend yield (<2%) appears stingy, but company’s payout philosophy is well-intentioned: they never want it to decrease YoY.  So to ensure they can honor this promise, proposed dividends need to be at a low enough level for them to feel comfortable that they’ll be able to pay it even in a crisis year.

Next, there have been multiple waves of share repurchases at great prices.  When Sotsu’s shares traded at a ridiculous negative enterprise value from 2Q2010 to 1Q2012, management initiated a few rounds of aggressive stock repurchases/cancellations, reducing shares outstanding declined from 8,600 to 7,800 (note: in Japan stock repurchases are uncommon, and cancelled repurchases are even less so). 

Interestingly, management  amplified the effectiveness of the repurchases by releasing unusually detailed press releases stating A) exactly how many shares they would repurchase, B) exactly how much money they would be willing spend, and 3) the exact number of days on which they would be repurchasing.  The latest example of this happened on 10 January 2012 http://www.sotsu-co.jp/ir/pdf/20120110_2.pdf.  At the time, Sotsu was trading at JPY1,240 per share (way below cash) when management suddenly announced a buyback of 100,000 shares (over 1% of the total at the time) for JPY150 million – implying they would spend up to JPY1,500 per share, or 21% more than the current stock price – and complete the repurchases by 22 February 2012.  Needless to say, the stock spiked to JPY1,500 per share immediately and the stock hasn’t traded below net cash since (though it hardly trades at a premium now).

Why did they tip their hat like that?  It was explained to me that Chairman Nasu Yuji was “disgusted” that his company’s market cap was not only trading below book value, but below net cash.  They made a determination that the stock price “floor” should be a 1x price/book multiple, and that they would continue to be opportunistic in stepping into the market for repurchases if the stock price went into silly cheap territory again. 

We’ll see if Sotsu’s management actually protect that floor valuation over time, but they’ve been walking the walk so far: the sums spent on dividends/repurchases works out to over 51% of cumulative net income from 2008-2011, a very high payout by Japanese standards (according to Bloomberg fewer than 12% of Japanese listed companies have dividend payout ratios higher than 50%).  While we would like to see them pay out even more given their huge/growing cash pile, it’s nice to know they have the stock price in mind.

Haven’t we seen this movie before?

Once upon a time (in late 2009 / early 2010) there was another Japanese company called Sanrio (ticker: 8136 JP) that owned the rights to another famous cartoon character, Hello Kitty.  Like Sotsu today, Sanrio back then was 1) reliant on licensing royalties for profits, and 2) underutilizing its international appeal to grow those royalties. 

So Sanrio management decided to rectify the situation and raise the number of oversees licensees to 1,800 in 2011 from 760 in 2007 (i.e. they signed big licensing deals with Wal-Mart in North America and Li & Fung in Greater China).  The result? Net income more than tripled from 2009 to 2012 and the stock price jumped from JPY700 in early 2010 to over JPY2,800 today (at one point the price even hit JPY4,000).

The amazing thing about Sanrio’s fairy tale re-rating is that it happened on the back of EPS growth alone in spite of the fact that management didn’t really respect shareholders (2010 Chairman interview: “Profit is not about money… Our staff are most important, next are all our partner manufacturers, then the customers who buy our products, then shareholders: that is the order” http://www.ft.com/intl/cms/s/0/370f5306-230c-11df-a25f-00144feab49a.html#axzz1zZxLMDBb) or treat them extra special (the dividend payout ratio stayed flat over this period).

Sotsu, on the other hand, has all the ingredients that Sanrio had in 2009-2010 and more:

-          it owns the rights to a character with at least as much pan-Asian appeal as Hello Kitty,

-          it’s only starting to expand overseas product licensing,

-          unlike Sanrio it has a far cleaner balance sheet with no loss-making segments, and

-          it actually cares about shareholders as evidenced by dividends / buybacks. 

So can Sotsu pull off a similar re-rating?  Only time will tell, but Sotsu’s current 1x EV/EBIT is not much to pay for that possibility.

Major risks

Cash wastage:

Management says they have no intention of tying up cash in treasury shares – all treasury shares they have will eventually be cancelled.  M&A of another similarly lucrative anime character is something they’re open to but management has insisted they will not overpay for this; no deals are live at this point.

Cooperation issues with Namco Bandai

There’s always something that could happen given how much the two rely on Gundam / each other to make money.

Rights expiration:

Strictly speaking, the ownership rights to an anime character under Japanese law last for 75 years from the date of content creation, but Sotsu’s management doesn’t believe its Gundam rights will ever “expire” – it just means they’ll have to renew or extend their ownership at a later date.  While it’s true the original Gundam character is 33 years into its 75 year shelf-life, the more recent Gundam universe characters are only a fraction of the way into their life-span.  Sotsu’s management stressed to us there’s never been a Japanese anime character – ever – that has ever come “off-patent” due to rights ownership expiration. 

Perhaps for the sake of thoroughness we should hire an expensive Japanese lawyer to double check this, but that could require us to convince Sotsu to dig out a bunch of confidential contracts, which they probably don’t want to do.  Since A) the original Gundam character (let alone the newer Gundam characters) hasn’t crossed the half-way mark to 75 years and B) Sotsu’s near-zero enterprise value is cheap enough to make any DCF run-off through year 75 look attractive already, I’m just going to give the management the benefit of the doubt for now.

Catalyst