Description

Take note of the ticker as there are several listed businesses with the name “Fuji”. Fuji Corporation has a $270 MM market cap with less than a million dollars of daily trading liquidity so not actionable for all accounts. Shoutout to Teddy Okuyama who pointed this business out to me (he runs a business connecting international investors to Japanese corporates and you can find him on Twitter under his name. Other than pointing the business out, Teddy has not been involved in this write up; all the mistakes are strictly my own).

Why is this an attractive investment?

1. Competitive advantages: Fuji Corporation is a tire retailer focusing on the discount segment and as far as I am aware is both the price and cost leader in Japan. It achieves its cost leadership through focus (only tires and wheels), scale (among the Top 3 tire retailers, I estimate Fuji has a c5% volume share of replacement tires), high levels of automation of its distribution, store layout and site selection (secondary locations, small footprints, owned stores), and a relentless focus on volume throughput which is particularly important as the cost of each store is largely fixed irrespective how how much volume you put through them. This enables Fuji to charge between 10-30% less than the next best competitor (they are for example 15-20% below Costco Japan which has a reputation for being very cheap; the difference seems to be the smallest with certain Bridgestone tire models sold at Autobacs Seven where the difference can be as low as 10%) while still being able to generate low teens EBIT margins and attractive returns on capital (high teens unlevered ROE). Importantly, I think it will be difficult for a competitor to undercut Fuji. For most the lack of scale would likely mean many years of losses. For the two competitors that have sufficient scale (Autobacs Seven and Yellow Hat) there are other impediments that I think will largely keep them out of Fuji’s little niche.

2. Growth: Fuji Corp has a significant online offering (more than a third of sales) that seems to do well growing double digits and I believe that there is room to double the physical store count as there is significant white space in Japan (more on that below).

3. Resilient sales: replacing worn tires is legally mandated. In times of economic stress people tend to drive less and buy less tires, but a greater share of the tires they do buy ends up with discounters (that said sales growth did come to a halt in 2009 and was slightly down in 2020)

4. Capital allocation: Fuji Corp announced a stock buyback program that is aggressive for a Japanese company. At inception (14-Jun-23) they were planning to buyback c.5% of shares outstanding. The share price has since increased such that they will not hit that target, but I think it shows the management is at least thinking in the right direction. A significant portion of the balance sheet is net cash, but this is a recent development. They seem not to be the typical cash hoarding Japanese corporate.

5. Management: Fuji is led by its founder Fumiki Endo who has built this business from practically nothing to what it is today and retains a 38% stake. IR is not very responsive to requests in English, but they put out monthly operating reports and financials in English which for a Japanese company of its size is not bad and in my view shows that they care about shareholders.

6. Valuation: FY23 EV/ EBIT of 6.4x, PE of 10.5x, P/B 1.6x (note that these numbers are based on the preliminary results announcement dated Sep-5 which includes projected year-end figures which are different from LTM CapIQ figures for example). RoE FY 22 was 17%, but about a quarter of book equity is net cash and they own many of the stores and distribution facilities. Earnings growth over the last five to ten years has been low twenties, high teens based on high single digit sales growth together with some margin expansion. I would not expect further margin expansion, but I do expect a slight acceleration in sales growth going forward as their financial flexibility has increased dramatically. Over the next 5 years I would expect 10% sales growth based on 3-4% lfl growth, 2-3% from new stores, 4% from ecommerce growing at 10% while contributing about 40% to sales on average with EPS growth slightly above due to operating leverage. Together with 1% per year from dividends and share buybacks each you would end up with a low double-digit IRR. It is possible to do a bit better on the back of rerating, but this being Japan I would not bet on it.

 Risks and things that are not great

1. Management: Very conservative and unlikely to grow the business aggressively. They have been opening new stores, but very slowly. The founder is also relatively old (73), so a management succession in the next 10 years is not unlikely.

2. End market changes: A lot of changes appear to be coming to automotive end markets: EVs, self-driving cars, new market entrants etc. Tires are not at the centre of these changes, but some of these trends esp. self-driving cars could have a pretty material impact. I have no insight in how these trends will develop or on what timeline, though it seems to me that given how slow moving the Japanese government tends to be, widespread adoption of self-driving cars is more than 10 years away.

3. Retailer: At the end of the day Fuji is a retailer and like any retailer its relationship with its customers is precarious. Ecommerce is a particular risk in this regard because Fuji’s relative competitive position is weaker in ecommerce. However, tires are a bulky, heavy, low margin product that is subject to some specific storage and transportation requirements. In addition, the installation requires special tools such that customers if they buy the product online subsequently need to visit a physical store detracting significantly from the convenience of ecommerce and making it less competitive than in many other categories. That said Fuji generates something like a third of its sales from ecommerce growing more quickly than the rest of the business and is present on many ecommerce platforms including Amazon, so it clearly can be done. Delivery fees are considerable for tires ranging from 5-10% depending on the price of the tire.

4. Customer experience: In order to maximize volume throughput per branch, Fuji Corp does not schedule precise appointments with customers. Rather you get an approximate time and date and you have to wait your turn. The turnaround time of each car is pretty quick, but the waiting time can be considerable and can run into hours. A fair number of customer complaints exist online about this issue. However, I think almost all discounters with maybe the exceptions of Costco are forced make compromises on service quality and frequent customer complaints are almost typical of this business model (think Ryanair or IBKR) which is OK I think as long ‘value for money’ is great.

5. Demographics: a bit complicated story; see below

6. Climate change: Winter tires are higher margin and changing tires gets customers into the store. Milder winters which seem likely are therefore a headwind.

7. Overearning: last year’s margins were a record and LTM is higher still, so it is possible that they are overearning due to a Covid related transitory factor that I am not seeing. However, if you look at margins over the last 10 years, they have gradually trended upwards. I believe due to economies of scale and improvements in their distribution, but it is hard to be 100% certain that there is nothing else going on

8. Competition: The two principal competitors Autobacs Seven and Yellow Hat are well run businesses and strong competitors with significant scale

9. Side lines: They sell wine olive oil and pasta. Sales are tiny. Why are they doing that? God knows. My guess is that it’s a pet project of Fumiki Endo. The risk obviously is that the side line takes away management attention from the real business. Does not seem to be the case so far, but something to keep an eye on.

The Japanese Market for Tires

The four large Japanese tire manufacturers (Bridgestone, Sumitomo, Yokohama, Toyo) have a market share of somewhere around 80%. Tires are sold slightly differently in Japan than in the US or Europe as gas stations and car dealers play a much larger role with c. 25% of tires sold while tire and auto parts retailers as well as captive retail account for c. 60% with the remainder split between independent garages, ecommerce and general retail.

Gas stations are more important because most gas stations in Japan are attended and offer a lot of services, changing tires being one of them. However, increasing urbanisation and lack of succession has about halved the number gas stations over the past 20 years. Prices for tires at gas stations vary wildly, but prices that are about a third higher than auto part retailers are common. It has become a common consumer strategy to purchase tires online and have them installed at a gas station paying only the installation fee even though this is not exactly convenient.

Car dealerships are particularly important among older consumer cohorts because many offer pick-up and/or delivery of the vehicle in connection with the tire change. Prices vary by brand but tend to be significantly above the prices at gas stations.

Among auto part retailers there are two particularly noteworthy competitors:

Autobacs Seven is largely a franchised model (corporate owns about 25% of the stores) that operates about 585 stores in Japan and offers the whole range of auto parts and accessories as well as vehicle inspection services. Autobacs has spent significant amounts on advertisement and celebrity endorsements and has become “the” auto parts retailer brand in the minds of many consumers. The stores are typically located in high traffic areas, large and carry an assortment of many thousand SKUs. Tires in Japan account for about 26% of Autobacs Seven’s sales or JPY 46 Bn in FY2021 i.e. about the same size as Fuji Corp.

Yellow Hat is an auto parts retailer similar to Autobacs Seven and offers the full product range. Yellow Hat operates about 750 stores of which about half are under franchise agreements, but the agreements give a lot more operational autonomy to the individual franchisee and the arrangement can be thought of as a buyer association (which I understand is the origin of Yellow Hat’s business). Yellow hat operates a few different store models including a store focused on motorcycles as well as a discount focused tire retailer similar to Fuji Corp that was started in 2012 and currently has about 46 stores (initial roll-out was fast, peaked at 50 in 2020 and has since gone sideways). Yellow Hat tends to focus on secondary, lower traffic locations and often opens stores in spaces that have been vacated by other retail formats and the locations are similar to what Fuji targets. Tires accounted for about 29% of Yellow Hat sales or about Yen 43 Bn in FY2021.

Could Autobacs Seven or Yellow Hat undercut or match Fuji’s prices? Without a separate discount chain this appears tough to me. First, both Yellow Hat and Autobacs Seven have larger stores. Larger stores obviously mean more costs all else being equal. Second, Fuji Corp generates a lot more sales per store (about Yen 500 MM) than either Autobacs Seven (about Yen 300 MM) or Yellow Hat (about Yen 200 MM) and it does so with similar staffing levels meaning labor costs are much larger too. Third, while both Yellow Hat and Autobacs have much more revenues than Fuji Corp if you look at tires alone there are roughly equal meaning neither Yellow Hat nor Autobacs is likely to have a big advantage in purchasing. 

Despite all these issues, what would it look like if Yellow Hat/ Autobacs decided to match Fuji Corp’s prices anyway? In most countries tires are among the least profitable products for an auto parts retailer and I think Japan is no exception meaning it is likely that neither Yellow Hat nor Autobacs makes a lot of money on tires to begin with. The reason they price them the way they do is that it brings customers into the store who tend to be very conscious of the price of tires because it is a big-ticket item. If Yellow Hat (the same logic is true for Autobacs but let’s focus on Yellow Hat for a second) cuts its prices to match Fuji Corp they would probably have to cut by about 15%. Tires account for 29% of Yellow Hat Sales so that 15% cut means they would lose about Yen 6 Bn EBT out of a total EBT of Yen 16 Bn. First, that sounds pretty painful. Second, a big portion of Yellow Hat’s store fleet are franchisees, which may not be excited with the new pricing strategy and as far as I can tell they have the flexibility not to adopt the new pricing, which means you end up with pricing that is inconsistent and confusing to the customers and probably limits market share gains. Third, it is true that Yellow Hat would likely get some extra volume, but I think the incremental savings due to increased bargaining power are relatively small given how big Yellow Hat already is and I think after the price cut Yellow Hat is likely to lose money on each tire so trying to make it up through volume is a problematic strategy. Fourth, the price cut is not enough to put them out of business and they may even find a way to cut their price in return.

Could Autobacs Seven then start a discount chain and Yellow Hat grow theirs? That seems like a more viable strategy to compete with Fuji. But there are some problems with that approach. First, tire discounting is a bit of a niche, and I am not sure there is enough room for several sizable players. Second, there are local economies of scale as tires are bulky and heavy so distance to a distribution center is important, but each distribution center needs a certain number of stores to be efficient in spreading the fixed costs. Combine that with the limited demand and you end up with these regional clusters of stores which are probably difficult to challenge. Third, conflicts with franchisees are likely if Autobacs starts/ Yellow Hat expands a discount chain as franchisees will not like the competition. Fourth, one takeaway from other discounters I have looked at is that relentless focus is critically important to keep the costs down. I am not aware of many successful discounters that have a many different formats or business models. Maybe I am underestimating them, but I doubt that either Autobacs or Yellow Hat can pull it off as a side line to their normal business.

Demographics and Market Outlook

Even before considering the potential changes due to self-driving cars there are some worrying developments in the market for replacement tires due to unfavorable demographics, urbanization and lower household car ownership. However, while each of these factors is important and will have an impact I think that longer vehicle service lives, declining numbers of gas stations and car dealerships and an increase in the number of electric vehicles will roughly offset the headwinds:

The number of households are expected to decrease by about 40 bps per year until 2040. Cars per household have decreased from 2010 to 2020 from 1.08 per household to 1.04 per household which coincidentally works out to a decrease of about 40 bps per year on top of that. I would expect that the next twenty years look like the past 10 years meaning the total car pool decreases by about 80 bps each year (assuming no dramatic shift in technology such as self-driving which we will come to in second).

In addition, miles driven per car have consistently declined as people switch to public transportation because of urbanization. Over the last 10 years the average miles driven have decreased by about 84 bps per year. Again, I think the recent past is probably a good approximation of the future and would therefore assume that tire demand will shrink by about 1.6% (half from falling car numbers and half from less miles driven per car) per year for the next twenty years.

However, each car comes equipped from the OEM with a set of tires. Only the replacement tires are relevant for Fuji as it does not compete for the original OEM equipment. With increasing service age, the proportion of replacement tires of total tire demand is likely to increase. Over the last 10 years the average service life of cars increased from 12.7 years to 13.5 years. I assume that the typical tire lasts for about 5 years which means that the replacement tire demand has increased by about 1% per year all else being equal.

Moreover, the number of gas stations have decreased by about 2.7% per year (though recently slower) and the number car dealers have decreased by about 60 bps per year. It seems logical that as a result both have donated share to other channels and the Autobacs IR made that claim to us in a conversation. How much? Hard to say but 30 bps seems plausible to me.  

In summary I would assume that the demand relevant for Fuji will be slightly down to roughly flat over the next twenty years before considering any changes in technology.

Electric vehicles are one obvious technological change. Currently EVs are a small proportion of the Japanese car fleet (I have seen estimates put the proportion at less than 3% of new vehicles vs. 20% for the Chinese market), but it seems likely that EVs share of the total fleet will increase over time. The roll resistance of the tires is very important for electric vehicles to achieve rated battery performance. Tires with low roll resistance are more expensive (I understand 10-30% more expensive) and have higher margins for manufacturers and retailers as a result. In addition, due to the weight of the battery electric vehicles tend to be heavier than internal combustion equivalents which means EVs tend to wear out their tires quicker. How much quicker? Estimates vary, but I understand c.20-30% under comparable conditions. Moreover, electric vehicles have lower variable operating costs which should encourage driving.

What about self-driving vehicles? In theory self driving vehicles could be good news as I would think that their adoption would boost miles driven which should increase tire demand. However, if these self-driving vehicles are all owned by a handful of ride hailing services the net effect might well be negative for a business like Fuji. I don’t worry too much about this risk as it seems to me that mass adoption of ride hailing services employing self-driving vehicles is at least a decade away in Japan if not more and there will be plenty of time to act before Fuji becomes a melting ice cube if we do end up in that scenario which is not a forgone conclusion in my view.

White Space

While Autobacs Seven has not grown its store number in Japan significantly over the past ten years Yellow Hat has been much more aggressive growing store numbers from 500 in FY11 to 750 in FY21. And while Autobacs has no public targets to grow store count, Yellow Hat targets plans to open 20-30 stores over the medium term and sees the potential to have a store fleet of 1,000 stores in Japan based on their view that about 50 thousand households are required to support one store. Fuji Corp’s discount model needs a lot of volume to be successful and therefore needs more households to support one store. How much more? I am not sure, but I am assuming that the Tohoku region where Fuji Corp started is saturated by now at 389k households per store. However, note that Yellow Hat has a higher density of 36k households per store in the Tohoku region vs. their saturation estimate of 50k households. So maybe the Tohoku region is special in some way and the saturation point for Japan overall is somewhat higher. So, I would go with 500k households in general except in the Kanto and Kinki regions because they include large population centers with relatively low car ownership where I would assume 1,000k households per store to be on the safe side. The implication of this analysis is that I believe that Fuji can almost double its store footprint. Note though that in order to do so I think they would need a new distribution center for the southern regions, and I would therefore assume the store opening cadence to be very uneven. Lastly, I think the real constraint is not so much the white space but how aggressively management will pursue this growth opportunity (I am assuming between 1-2 new stores per year).

The below table shows a comparison between the store fleets for Autobacs Seven, Yellow Hat and Fuji Corp by the eight major regions of Japan.

Disclaimer

I am not Japanese, I don’t speak Japanese and I have never lived in Japan and neither has anyone who participated in putting this write-up to paper.
We own this (surprise!).
We have tried to take care in preparing this write-up, but you know, it could be all wrong.
We may sell or change our mind and we won’t tell you about it.

Catalyst

Share buybacks and earnings growth (i.e. no hard catalyst)