Rakuten: Rewiring Japan's Digital Economy - [Business Breakdowns, EP.182]

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0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Welcome back to Business Breakdowns. This is Matt Russell, and today we are heading to Japan to cover the internet conglomerate Rakuten. To break down Rakuten, I'm joined by Matt Brett, the lead manager of the Japan Trust at Bailey Gifford. And Rakuten is the unique Japanese conglomerate that wasn't started over 100 years ago. Instead, it was part of the late 90s global internet boom. And Matt explains what was different about that internet boom in Japan and how Rakuten was really shaped from it.

1:25We also get into the various business lines from traditional e -commerce to the credit card business and others, but notably how the loyalty point system here has become the glue connecting everything together. I think we cover a lot of conglomerates. Sometimes it's not obvious how they all fit together. I think in this particular case, it is obvious how they've made this all work. And then perhaps the most interesting part of the conversation was covering Rakuten's major investment into the mobile phone market. And I think Matt gives a very intellectually honest look at why this is such a huge debate for Rakuten, for investors, and for anybody that's looking at the name.

2:03I really enjoyed this conversation. And I think it's another excellent case study on applying different business models in different markets, this one in particular in Japan. Please enjoy. All right, Matt, excited to break down Rakuten. It's always interesting to me to go into Japan, where I think there's so much to learn from the businesses there, how they operate. And there's usually this extremely long corporate history, particularly for the conglomerates. But Rakuten's slightly different here. So I'm excited to get into that and how this business was built. But I thought to start off, it'd be good just to give a basic overview in the best way that you could describe Rakuten, the conglomerate, what they are and what they do.

2:49I guess Rakuten is one of these ubiquitous internet companies in Japan. It does loads of different services now. So it spans e -commerce, finance, whether that's credit cards or banking, travel, and most recently getting into doing mobile telephony as well. So basically, if you live in Japan, Rakuten is a really ubiquitous brand. Would you say there's similarities to Amazon in the US, maybe with not quite the level of different services and segments, but similar just in terms of e -commerce and different offerings that they have? Yeah, I think you would draw that parallel with Amazon, definitely.

3:30I guess within Japan, in some ways, the Rakuten name is even more ubiquitous in the sense they have offline mobile phone shops and people are using it for multiple different activities as well. It's similar, but it's almost broader, if you like, than Amazon. But that's very much within Japan. And of course, the big difference is something like Amazon has been much more successful globally than Rakuten has. And so, for example, if you say e -commerce here in the UK, the first thing people are going to say is Amazon as well. That's another difference. Yes, it's interesting. We've discussed a few of these businesses where they've dominated in their local areas and maybe haven't had quite as much success when trying to expand abroad.

4:14Coupang immediately comes to mind. I want to get back to the origin story and the history here. Again, I mentioned right off the top, Japan, you think about these 100 plus, 150 plus year old businesses. This one was started more recently. Can you tell us a little bit more about the founder here and how the business was started? Yeah, so Rakuten is from the original TMT boom, e -commerce companies in Japan. So it was founded back in the late 90s. And then IPO'd, got the money in at that time. And there was a few businesses around this time, Quite a small handful, including what's now known as LY Corporation, but originally known as Yahoo Japan, was another one that got funding around this time.

4:59And it was founded by Hiroshi Mikitani, who was a former investment banker with Industrial Bank of Japan, and then went on to set up Rakuten. He and his fellow founders basically saw the opportunity to do a kind of internet business in Japan in a similar way to what they were seeing overseas. And I guess what's important to understand in this original founding period of Rakuten was basically that dot -com excitement in Japan, it didn't get as big as it got in America. And so there was less money available. Fewer companies got funded. But Rakuten was one of those ones that got the money in at the start.

5:41And then when the dot -com boom turned to bust, what you find was these original e -commerce companies in Japan were then in a really strong position because they'd secured the capital and were then ready to enter into different areas. When you say that there wasn't quite as much excitement as you had in the US, Was that mostly from a funding perspective where the capital markets weren't as willing to fund these businesses? Were there fewer entrepreneurs? Anything else that drove maybe the difference in terms of the graveyard of businesses that we have from the US .com era versus it seems like there were far fewer of those in Japan?

6:19Yeah, I think it was probably all of the above. The inherent Japanese conservatism, I think, meant that people were a bit less willing to give money to guys straight out of university with pretty sketchy business plan, but a big dream. And so when you look at the entrepreneurs who were succeeding in Japan, you had someone like Masayoshi Son of SoftBank, who's an iconoclastic entrepreneur and basically did it himself. And then you had people like Mr. Mikitani, who basically was establishment enough to be able to persuade people to finance him. And then, of course, maybe if the TMT boom had gone on for longer, you would have seen more businesses being able to secure funding.

7:06But there was only a handful. And then there were a couple of scandals with some of the smaller ones. And that didn't help the whole thing. And I think that's something very much that has changed in Japan over the years that nowadays, I think a young entrepreneur in Japan would be received more favorably than when we go back to the late 90s. With the original opportunity that McAtani saw, was it mostly around something similar to an Amazon where it's third party goods that are being sold? Was there a marketplace element to it? What was the original idea, original business plan that first launched Rakuten?

7:44So the original plan was this marketplace style website called Rakuten Achiba, which I think is probably best described as a curated version of eBay. So it's professional sellers with their own storefronts. Achiba is much more modifiable than eBay would have been. but importantly it also had curation i .e they didn't just let anyone sign up and sell they were quite selective and over the years they've continued to be quite selective as to which merchants they're prepared to work with and that's kept the quality up and meant that Rakuten has continued to thrive as a platform whereas I think what we've seen more in the UK and the US is much more success from the first party type of sellers like Amazon.

8:35And I think that's a difference in Japan. And then from Ichiba, they very quickly basically tried to do a land grab of other interesting business areas that they could see. So in the early 2000s, they acquired a brokerage business, they acquired a travel business, they then went on to acquire a credit card business by the mid -2000s. And all of these businesses are still part of the group today and have been quite successful. But they basically took advantage, I think, of that lack of funding and just basically having a bit of a bigger vision than other people that they could see that, look, it's not just e -commerce that can work in Japan.

9:18Brokerage, travel, credit cards can also all work. And those are all businesses models that we've seen evolve in the West. But I think Rakuten is probably unique and basically trying to get quite broad quite quickly. Was there a driving thesis to the build out of the conglomerate with Amazon, I think, starting with books and then expanding outward, but there was always this customer obsession and that led to the logistics network. I think of AWS as a bit of an outlier, but as they were layering on these services, they certainly make sense in terms of there being an opportunity, but how did they fit into the thesis?

9:55And was there a particular set of messaging that was going out to both shareholders and customers as they were doing it? Yeah, I think the big thing that glued the whole thing together in the early days, and again continues through to now, was the point system. And people could earn points from different services, but importantly, they could spend those points in other services. You could be earning points from booking through Rakuten Travel and using a brokerage account with them, But then you could use those points to get a discount when you were spending money on buying something through the Ichiba e -commerce website.

10:31So that part of it, I think, was the real glue that held it together. And some attempts to build these things end up very, very confused in the sense that people end up with services that don't talk to each other, etc. But within Japan, they've always used a single user ID. It's very easy for people, once they've signed up with Rakuten, to access multiple services in the different areas. And so over time, they've basically managed to develop this almost self -reinforcing ecosystem, incorporating a lot of different areas, and to share the trust they've built up in existing services when they've entered into new areas.

11:12It makes a lot of sense and ties back to your point on them becoming ubiquitous with the identification of online and that customer loyalty. I think it's something that comes up a lot with grocery delivery and why some of these businesses would introduce what seems like a low margin business in the US. But it can drive that same type of loyalty where you're looking at these as a one stop shop for much more than what they were traditionally run out as. As they were expanding the conglomerate, did they take any steps which maybe led to the wrong direction? You mentioned a lot of these businesses that they started still are parts of the business today.

11:48But were there any mishaps or major pivots or corrections that they had to go through in that time? Those initial rapid expansion into new areas, that worked really well. And those businesses are basically all with the company today. And I think probably then by the late 2000s, arguably they'd learned the wrong lesson, which was this will always work as a strategy. And I think it was a strategy that worked really well in almost like a blue ocean type of environment where there wasn't a great deal of competition. And they were there first and able to therefore occupy the space before other competitors turned up.

12:31And of course, although there's overseas competition in Japan and Amazon certainly is present in Japan, it's also the case that some of those language barriers, the different styles of websites, much more visually complicated websites that are popular in Japan, did, I think, also provide barriers to entry in that important initial build out phase. And then in some of these cases, by the time other companies got going, Rakuten were already strong and difficult to challenge. But as I say, of course, sometimes a good idea can be taken too far. And there was a period then from the late 2000s, 2010 -ish, when they did a variety of overseas acquisitions.

13:15They tried to do joint ventures in China. They bought buy .com, play .com. And frankly, those things generally haven't worked out as well for Rakuten. And I think the big difference here was instead of playing on their own turf, where they have that strong brand and they have that reinforcing point system, and importantly, they didn't have the tough competition that you find overseas. They came up in many of these cases against strong incumbents, and they were often buying the third, fourth, fifth place business and thinking they would be able to get it to number one. Now, that sounds good in theory, but in practice, when you're coming up against classic white Amazon in America, that's going to be a tough gig, proved to be for Rakuten.

14:08And I think in terms of learning from that, they then went through a period of significant retrenchment. They've still got some overseas parts, but the core of the business is very much domestic now. And I think if there's a lesson from that, I've shared with a few Japanese younger internet companies over the year. It's my five word business book for Japanese internet entrepreneurs. And it's just, please don't go to America. Simple. I mean, it's straightforward. They don't have to read between any lines there. It's very interesting. I think the third guest who's brought up the idea of websites and the visual aesthetics of websites that work in the U .S.

14:55really don't work in certain cultures and particular countries. And it's always just so interesting to know the cultural differences once you feel like you have a grasp on them. And there's always something there. And I think that's a very interesting point. on the success that they've had in Japan. There's some interesting research that I was reading through that your team did just talking about digitization in Japan. And it feels like it's been a bit slower or it hasn't moved quite as quickly as you've seen, particularly in the US and likely other areas of the world. Can you talk through that just in terms of what has led that market to maybe adopt digitization differently than elsewhere?

15:34Yeah, so I think there's a few different elements to that. I guess, first of all, in America, you've got Silicon Valley, you've got this great drive towards entrepreneurialism, and you've applied a great deal of capital to the internet space and to digitalization. And in Japan, you haven't had that level of capital applied in the earlier stages of the internet. And often also as well, things work pretty well as they were working before. Shops in Japan are incredibly well organized and convenient. Use of cash in Japan has been very safe because there's very limited crime and people don't worry about having a big pile of cash.

16:15But nonetheless, there are real efficiency benefits to digitalization. And what we've seen is basically that it's not that Japan is fundamentally completely different. It's just taken a bit longer. E -commerce penetration has steadily risen over the years. Things like, for example, more recently moving to various forms of electronic money, that's definitely accelerated in recent years, partly helped along by COVID. And I think those trends, almost from an investment point of view, those trends are super interesting to us. Because of course, if you can see that in a different country, you're getting to higher levels, but you know, Japan is broadly similar, but taking longer, it can give you a really high conviction as to where you're going to get before you've actually got there.

17:11I don't know if you have any of these numbers off the top of your head. Do you know where e -commerce as a percentage of retail sales, what that looks like in Japan and the US? I think it's in the low 20 % range and it's steadily moved up one to 2 % per year for a decade plus. But in Japan, do you have a sense of where that is? Slightly below that would be my sense. But I guess where I think you've got this interesting point is it's still growing everywhere. We don't really know where the limits are in the UK. The penetration is higher than the US, and maybe the UK is a better model for Japan because it's a more concentrated country in terms of where the population centers are.

17:54So I guess with all of these things, yeah, you're going along a similar direction. It's very fair. And me using US as the benchmark probably isn't right, given the geographical dynamics and certain rural areas versus what you see in Europe, particularly in Japan, where I think the density would suggest that that number could be much higher. Yes, very interesting to just get some of the nuances and differences. And I am sure that the competitive advantage or their protection of their market share that they have in the country is not just the website. Are they a leader in terms of cost advantage?

18:32Or is there anything else that they do differently versus new competitors, which I'm sure are both popping up and continuing to compete against them over the years? Is there something that stands out for them relative to the peer group? I think the main thing that stands out is the trust that they've built up over the years. So another feature of that slightly slower adoption of credit cards in Japan was also in the earlier days, people were quite reluctant to use a credit card on the internet. They were pretty cautious about that. And therefore, once Rakuten had established trust and had this big pool of merchants selling through them, that almost became a self -fulfilling edge in the sense that, yes, people could set up their own e -commerce website, but if it wasn't as trusted as selling through Rakuten, it didn't really help them as much.

19:25So I think a combination of that long established now history, plus on top of that, the points program, which allows this idea that if you're using more than one service, points are additive, and in some case, even multiplicative, depending how many services you're using. Those two together, I think, are really what's generated the edge over time. Interestingly, because most of their e -commerce is by third -party retailers, they don't really have the same edge they've built up in distribution that something like Amazon would have done. And indeed, Amazon has tried to build that up in Japan. But of course, in Japan, the logistics, the delivery services are incredibly efficient anyway.

20:13So that's almost like a minimum standard that's really, really high in Japan to start with. And the general focus on customer service is incredibly high everywhere. So I think that's an area where it's probably not been as much a source of edge as it may have been in other markets where things started from a lower level. Yeah, it's quite interesting to think about operating in Japan where the customer service and the focus on that often comes at the expense of the margins of that particular business. But if they're a supplier or a vendor of yours that is acting on your behalf, that could be used very much to your advantage, which seems like the case here.

20:54And that's quite interesting. When you step back and look at the business as a conglomerate, how do you approach the buckets of the business, whether it's the marketplace, the credit card, the wireless network? Do you have rough percentages for those? How big of a percentage of the pie do they represent? How do you isolate the parts? Yeah, so when we think about that, and one thing we've not talked about yet, because we've talked about the early days when they expanded rapidly domestically, and then they went through a phase of doing a few overseas things, which generally haven't worked out so well.

21:27And then in 2014, they entered the mobile phone business, initially as a mobile virtual network operator or MVNO. So basically piggybacking off someone else's network with their own brand. But then in 2019, they had this big idea, which was, hey, we could do mobile ourselves. And we could actually roll out a new mobile phone network in Japan. And of course, people said, well, you can't. It's too hard. There's already three networks. It's never going to work. And they thought about it. And actually, they decided to do it using an open RAN type of technology, which is essentially They built their own base stations and linked them together in their own way.

22:08This has proven to be quite expensive and it's still yet to turn profitable. But when we think about that whole, how does it hang together? That's an important element now to consider in what Rakuten has become, that it's got these established e -commerce businesses. It's got these established financial businesses, but it's also got this basically new mobile phone network. And that new mobile phone network is fully built now. It has upload, download speeds that are good. The dropped calls are equivalent to other networks. What it doesn't have yet is many customers. So currently it's got, I think, 7 .7 million customers out of a total addressable market of about 200 million.

22:55The listeners will be thinking to themselves, nah, there can't be 200 million customers. There's only roughly 120 million people in Japan, but people have more than one device for work and home and things like that. So there's roughly 200 million devices to go for. And so they've got a pretty small market share. The interesting thing when I think about this is, look, where could that market share get to? Thinking about that mobile business, A lot of people are very focused right now on, hey, when do they get to break even? But we all know that theoretically, the value of any business is the net present value of the future cash flows discounted into perpetuity.

23:38Now, of course, break even is an important point in starting to get those cash flows in. But ultimately, this business, the question is, for me, not whether they can get to the roughly eight or 10 million customers that's breakeven. I think that's a given. The question is, what can they get to over the next five, 10 years? And therefore, what kind of profits can start to flow in from that business? And I think one of the curious things about a mobile business is it's substantially fixed cost. You have to build out your network. You can't have half a mobile network. you've got to build the whole thing out.

24:16But once you've got it, you can add customers and it doesn't cost you very much and the revenue drops quite quickly to the bottom line. So that's certainly an important thing about thinking about the valuation. And then finally, to come back to trying to answer your question, which is how do we think about these chunks? Essentially, the way we've tended to think about valuing a conglomerate like Rakuten over the years is basically to take a mixture of different approaches and to try and see, well, how do these approaches look compared to each other? So over the years, we've done some of the parts where we break it down by business line and try and work out what each part is worth and then add them together.

25:02And then also we've used fairly simplistic metrics of just saying, well, look, what is the total sales of this company and how does the market cap compare with that? Does that feel too high or too low relative to the long -term opportunity? And then we've also, in the mobile business, looked at the total profitability of the current mobile industry in Japan and thought, well, look, if Rakuten could get to a percentage of that profit pool, what kind of value could that be worth? And so those are the types of things that we're looking at. And over the years, my experience of valuation has been that, generally speaking, if something's attractive, you can see that from a few different angles.

25:48And it's quite easy to get too precise about these things because the big picture question is really to try and roughly understand the chunks of value and to try and roughly understand whether each of those businesses has good prospects ahead of it or poor prospects ahead of it. It's a very helpful and detailed answer. And I want to get back to the mobile network, but to put a bow on the segment analysis, when you do that work, maybe more from a sum of the parts perspective, or I don't know if they break out the earning streams, but do certain things stand out where more than 50 % of the business is really coming from the marketplace or the mobile network or something along those lines.

26:31Do you have any feel for that, understanding that at the end of the day, they all are very much intertwined? Yeah. So I mean, in terms of the rough numbers here, roughly half of the sales currently come from those internet related businesses. So that's grouping together e -commerce and travel. And then roughly another 30 % are coming from the finance businesses. So there we're talking about the bank, the credit cards, the brokerage businesses. And then roughly the final 20 % is coming from mobile. But the mobile one is a particularly immature business at the moment. And obviously, you'd be very disappointed if it's stuck there.

27:12So I guess in terms of the biggest swing factor going forward, it really is now mainly about that mobile business and whether that can succeed. Yes. And hearing the build out of the network, again, being very far away, it's a very large investment, a unique investment, the way that they decided to build out their own network. Does it work abroad? If someone travels from Japan to the US, does the network still work? They can roam off networks overseas if they're a Rakuten customer, yes. And I believe actually it's quite good value for people doing that at the moment. But essentially, yeah, the point with the network is, as you say, it's an audacious move.

27:56It's an all or nothing type of move. But I guess what Mr. Mikitani sees in the Japanese mobile market is essentially the customers not being that well served in terms of the value being offered. It's quite similar pricing from the three major operators in Japan. I think compared with some countries, the pricing is fairly high. Now, yes, the quality of that network in Japan is exceptionally good, but it does create the potential space to have a price competitive disruptor coming in. And Rakuten have come in pricing at roughly half of what the main networks are offering. Now, some of the main networks have their sub -brands, which are a little bit cheaper.