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Rakuten and the 'Dog Shogun'
One of the most misunderstood figures in Japanese history is the ‘Dog Shogun’, Tokugawa Tsunayoshi, who was appointed the de facto ruler of Japan in the late 17th century. Himself born in the year of the dog, he enacted a law that compelled citizens not to harm their canine companions for fear of death. The result was a foul-smelling ancient Tokyo that ran amok with stray and diseased dogs. Eventually, 50,000 dogs were shipped to kennels in the suburbs of the city to be housed and fed at the expense of the taxpayer.
That this notorious law became his legacy is perhaps no surprise, but what this overlooks is that it was just one of several edicts passed by the Dog Shogun that evidenced a compassion that was lacking in previous eras. Laws defending the rights of the weakest members of society, such as banning the abandoning of children and limiting samurais' right to kill indiscriminately, helped spawn a period of unprecedented cultural growth and prosperity during his reign. No animals are involved in the investment case for the new Global Alpha holding Rakuten, yet we think a similar misunderstanding hounds the market's view of the company. In the search for unappreciated growth, it is exactly this misunderstanding that creates a compelling buying opportunity at its current price.
The Japanese Amazon
Rakuten has been described in the past as the Japanese Amazon, but considering its breadth of services across ecommerce, travel, credit cards, banking and brokerage services, it is arguably even more ubiquitous in Japan than its American counterpart in its domestic market. Like Amazon, Rakuten was founded during the original internet boom of the late 90s by Hiroshi Mikitani, a former investment banker who saw the immense potential of the internet. Its original business was Rakuten Ichiba, an online market for third-party sellers, that was essentially a curated form of eBay. Its ability to raise capital and move quickly created a lead over competitors in ecommerce but also provided the opportunity to expand quickly into adjacent areas such as travel and credit cards.
Due to their initial success, they had by the late 2000s learned the wrong lesson, that expansion will always work. What followed was a series of international acquisitions such as Play.com and Buy.com and a series of joint ventures in China. This period of international expansion was largely a failure, as the company increasingly entered fiercely competitive markets, doing battle with established local brands in countries where it had little or no brand value of its own. It has now largely retrenched to its core market in Japan and to its key services, where it continues to grow due to its strong locally-based competitive advantages. Today, ecommerce and travel make up roughly half of its revenues, while its financial services segment another 30 per cent.
The key to its edge is twofold: a trustworthy reputation and a reinforcing ecosystem. Japanese consumers can be cautious. The adoption of online services was slowed by a wariness to make transactions online for fear of theft or fraud. Rakuten quickly built a trusted brand and access to a wide pool of merchants. That trusted brand remains today. Secondly, the company has used its initial expansion outwards to create an ecosystem to reward its customers. They have a point system that can be used across their range of services. A bag bought online, or a credit card transaction earns points to use towards the cost of a holiday and vice versa. This creates an incentive to consume more Rakuten services and allows the company to cut customer acquisition costs through cross-selling. Considering that it tends to be a leading player in each area, this network is hard to replicate.
Taking on the telecoms giants
So far, this is all well appreciated by the market. Where our view differs is in the value added by its newest venture, establishing a mobile network. Some scepticism here is warranted. Japanese telecoms are dominated by a big three oligopoly of Docomo, KDDI and Softbank Mobile. With their high-quality network services, customer inertia is strong as shown by their very low customer switching rates from year to year. Add to this the significant capital that Rakuten has had to invest to build out their own proprietary network that has pushed them from operating margins near 20 per cent to unprofitable, the market consensus – scarred by the company’s expansion in the 2010s - is that this amounts to a bonfire of shareholder capital.
For several reasons, we, however, do not agree. The first boils down to the differentiated design of their open network which essentially means it is cheaper to maintain than competitor networks. The second is how immature their penetration into the market is. They have less than 8 million mobile users in a market of roughly 200 million. Most importantly, Rakuten can use mobile to push other services and increase the value of its overall ecosystem. Now the network has been built, each new customer has a growing marginal contribution to profits. This is not to mention the incredibly valuable customer data and distribution advantage that the mobile network provides them. This becomes increasingly important due to the vast opportunity presented by AI applications it could build in the years ahead.
Unpopular decisions today breed the success of tomorrow
All in all, while it is still unprofitable today, we believe Rakuten’s bold and unpopular telecom investment can drive a period of profitable growth for the company. Evidencing that this part of the business can breakeven is important but what is even more important is what it can become over the next five to ten years. Taking this view enables us to see a company at an inflection point and not one compromised by poor decision-making. The investment case is further underpinned by its strong reputation and reinforcing ecosystem despite the market’s fathomable scepticism.
Just as one well-intentioned law had calamitous consequences for the Dog Shogun’s legacy, missing the broadly positive consequences of his actions, Rakuten’s telecoms investment poses similar risks for the company’s reputation. The market’s concerns are clear in its current valuation. This has created an attractive entry point just at the time that the company can prove its competitive edge. We believe the company has the potential to deliver its own form of prosperity to its shareholders, as long ago, the misjudged Dog Shogun enabled for the people of Japan.
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This communication was produced and approved in November 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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