CLEANING UP IN JAPAN
Home-care specialist Kao blazes the M&A trail for Japan’s old-economy companies with its acquisition of cosmetics giant Kanebo.
By Miki Tanikawa

Ask an international asset manager what his top holdings in Japan are, and he will rattle off the usual suspects: Toyota, the world’s most profitable carmaker; Mitsubishi Financial Group, Japan’s largest bank; Canon, a global leader in business machines, cameras, and optical products; – and Kao Corporation. Kao who? Unless you’re Japanese or someone who delights in doing laundry or cleaning floors, you probably have not heard of Kao, Japan’s biggest maker of toiletries, detergents, and other homecare products.

The credit goes to Kao’s managers, including the finance team led by CFO and representative director Toshio Hoshino. “They’ve always had strong management and a solid balance sheet,” says Stephen Hill, portfolio manager at MFC Global Investment Management based in London. “Being in the consumer durables business, they have to compete against the likes of P&G and Unilever. Management always has to be on its best, or else [Kao would] get wiped away.” For example, the company adopted economic value added (EVA) as a company-wide objective in 1999, when many other companies were allocating budgets on negotiation skills and other internal dynamics, instead of value added as measured by set criteria.

These days, Kao is once again at the vanguard, this time of Japan’s nascent mergers and acquisition wave. The company led off last year’s spate of M&A deals in Japan’s old-economy industries, a trend that many analysts see as the beginning of a new era of corporate restructuring.

After Kao’s 427-bn-yen (US$3.5 bn) acquisition of Kanebo, the country’s number-two cosmetics maker, Oji Paper, Japan’s largest paper company, attempted a hostile takeover of Hokuetsu Paper Mills, but failed. Aoki Holdings, a major men’s suit retailer, tried to acquire rival Futata, only to be pipped by bigger suit seller Konaka, which had a small stake in Futata. Other big deals followed, including Kirin Beverage’s acquisition of wine producer Mercian and foodmaker Nisshin’s acquisition of Myojo Foods.

Biting the Bullet

These transactions are a new development in Japan, where the emphasis typically has been on mergers rather than acquisitions, and the transactions have mostly been in finance and technology. Nobody knows whether M&A, with the focus on the “A”, will work in Japan’s old-line industries, which are under pressure to bite the restructuring bullet as competition from multinationals and more agile domestic start-ups intensifies in the mature home market, even as high-growth battlegrounds like China are getting overcrowded. They are counting on M&As to create larger economies of scale, achieve greater efficiency and regain pricing power.

The stakes are high for Kao. For the first time in 24 years, its group pre-tax profit of 121 bn yen for the fiscal year to March 2006 showed flat growth compared with the previous year. Sales grew only 3.7% to 971 bn yen. Interim results for the period April to October 2006 did show a sales uptick of 25% year-on-year, but operating profit actually fell 7%.

In response, Kao has lopped 4 bn yen from its original net-profit target for the fiscal year ending March 2007, citing among other reasons costlier raw materials as a result of the weak yen, the deteriorating pricing power of its mainstay products, and higher-than-anticipated marketing expenses for new products.

“Competition in the company’s core consumer products segment, which accounts for around 60% of total sales, has been intensifying globally,” notes K Yamaguchi of Nomura Securities. “Competition with major foreign manufacturers such as P&G, Unilever, and L’Oreal appears to be heating up. We think Kao has no choice but to keep marketing expenditure in the consumer products segment higher than we originally anticipated.”

Kao cannot expect relief through price increases, at least in the near term. According to Nomura, consumer prices of 15 categories of toiletries products such as shampoos and toothpastes declined from an index of 100 in March 2003 to 93 in March 2006.

CFO Hoshino and other Kao executives have long read the writing on the wall. In late 2003, Kao entered into an agreement with the management of then Kanebo Limited to establish a cosmetics joint venture. Struggling under a mountain of debt, Kanebo agreed to spin off its cosmetics division and inject it into the new entity, which will also receive Kao’s much smaller cosmetics assets.

Then as now, Kao was counting on high margin cosmetics to provide the growth that its core consumer products business could no longer deliver. The idea was to invest the steady if unspectacular earnings from the household segment to strengthen the higher value but tiny cosmetics line, not only in Japan but more importantly in China, where rival Shiseido has found success.

But there were fierce objections from Kanebo’s powerful labor union, which was worried about job cuts and appalled at the prospect of selling out to a long-time rival (both Kao and Kanebo were founded in 1887). The deal did not go through, although Kao remained interested in Kanebo. It got a second chance when Kanebo sought assistance from the Industrial Revitalization Corporation of Japan (IRCJ), essentially a government-funded turnaround fund devised as a way to resuscitate ailing Japanese companies saddled with massive loans.

IRCJ split up Kanebo into two parts, the cosmetics division and the rest of the business, including toiletries and synthetic fiber. The former became Kanebo Cosmetics, which the IRCJ then proceeded to bid out and eventually sold to Kao.

Now the Hard Part

Kao is not at an amateur at mergers and acquisitions. It had previously done mid-sized M&As overseas, among them the acquisition of American skin care brand Jergens in 1988 and British counterpart Molton Brown in 2005. But CFO Hoshino says courses of action to reap synergies and cost savings that work in the West cannot be transplanted to Japan. “It’s critical that we get to know each other first,” he insists. “Western investors often say we ought to take this operation, and merge it with another one or cut out the excesses here and there. That’s a bit too rash. We ought to fix inefficiencies over time.”

Kao has formed a “Synergy Committee” headed by company president Motoki Ozaki that is tasked with cutting a total of 10 bn yen to 15 bn yen from the Kao-Kanebo combine by fiscal year ending March 2011. Initially, the savings are projected to come from joint materials procurement, sharing of production facilities, coordinated media buying, and joint deliveries. Understandably, given Kao’s experience with Kanebo’s labor union, there is no talk of trimming the workforce. Kao has said that Kanebo Cosmetics will continue to operate as a separate organization, and that Kao will consider improving the compensation packages of its 10,501 employees. “They feel that Kanebo’s knowledge is better than theirs, and they are utilizing it,” says MFC Global’s Hill.

Analysts say it is difficult to judge the prospects of a successful merger because Kao has not been forthcoming with details. “I understand the sensitivities involved,” says Yukiko Oshima, analyst for Credit Suisse Securities in Tokyo. “But it could be more specific as to what it intends to achieve and how it is progressing so far. We have not seen as much disclosure along those lines as we had expected.” Hill is more patient. “Yes, there are other synergies that could be taken out and they are not taking them out immediately, but I would give them the benefit of the doubt to some extent,” he says. “If they can get more out of the work staff without ruffling too many feathers, then they would do that.”

Hoshino makes no apologies for Kao’s deliberate pace. “When things don’t work out as planned, you might be driven into a situation where suddenly you are impelled to do something rash and drastic,” he argues. “We don’t want that.” On the lack of clarity, it is possible that the company really has no progress to report because it is still building consensus on the way forward. Hoshino says Kao’s agenda will not be set at the top and then drummed into Kanebo. “We need to share common goals and targets and work towards them,” he stresses.

Financial Firsts

To be fair, Kao has shown that it is open to non-Japanese M&A ways if it judges that the circumstances call for it. In financing the deal, Kao opted to tap the debt market, something that most Japanese companies tend to avoid. “Because of deflation, there was always the sense (in Japan) that the burden of debt becomes heavier as time goes by,” says Hoshino, who had previously kept Kao’s balance sheet practically debt-free. The company had faced bankruptcy in 1954, a near-death experience that made it especially wary of taking on large borrowings.

But after computing the cost of raising capital (via placing new issues, for example) versus the cost of borrowings, Kao concluded that debt was more cost-effective for shareholders, given Japan’s near zero interest rate and the vanquishing of deflation. Kao raised 400 bn yen from a bond issue, syndicated bank loans, and borrowings from life insurance companies. (The company’s internal resources provided the rest of the purchase price.) The money went to the IRCJ and three funds for the purchase of 100% of Kanebo Cosmetics shares, and to Kanebo’s lenders, which were owed more than 146 bn yen.

Kao’s balance sheet is now burdened by 408 bn yen in total interest bearing liabilities, from just 22.7 bn yen the previous year. But Credit Suisse expects Hoshino to pare debt as much as he can, noting that Kanebo is forecast to increase Kao’s free cash flow by 20 bn yen a year. Kao is also due to benefit from tax breaks worth some 100 bn yen as a result of its purchase of Kanebo, and save 10 bn yen to 15 bn yen in the next four years from the anticipated cost synergies. Credit Suisse forecasts total interest bearing liabilities to fall 9% to 371 bn yen next fiscal year, and be halved to 181 bn yen by fiscal 2010.

Hoshino is confident that Kao can continue to keep its finances in tip-top shape despite the new leverage because of the lessons from the 1954 debacle. “We were reborn with the help of the banks, and the managers were resolute about not repeating the same mistake,” he recalls. “The determination was made to be first-class in finance and accounting.” Kao introduced an advanced method of calculating unit costs, began reporting profit and loss per product, and was the first in Japan to adopt paperless accounting. It all culminated with the adoption of EVA. “Part of your bonus now changes in accordance with the level of improvement you make in EVA,” says Hoshino.

Cost-cutting has also become part of the company DNA. In 1986, Kao launched a program dubbed TCR, for total cost reduction, at a time when most big Japanese companies were focused on growing the top line and winning more market share. “There were no sacred cows,” says Hoshino, recounting how the company cut down on the use of colors for packages from four to three. Kao also embarked on the then unheard of practice of selling non-core businesses, including a major floppy disk manufacturer.

What Next?

The latest change comes in April this year, when subsidiaries Kao Cosmetics Sales and Kao Hanbai, which handles consumer products, merge to form Kao Customer Marketing. The decision is emblematic of Kao’s next challenge, which is to refocus on topline growth. Kao is hitting the sales ceiling in Japan, where a declining birth rate and an ageing population limit demand for home care products and even cosmetics. The company projects only 1% to 2% year-on-year expansion at home, even after acquiring Kanebo’s 20,000 dedicated cosmetics stores, which draw women willing to pay a premium for personalized skin-care and make-up counseling.

Growth will have to come from abroad, particularly in China, where Kao aims to boost sales to 20 bn yen a year by 2010, from a mere 2 bn yen currently. Kanebo is key to this strategy. Credit Suisse estimates that Kao’s main Chinese brand, AQUA, is sold in only 200 department store outlets, less than half the distribution reach of rival Shiseido. “We believe that one factor responsible for this difference in business performance is the gap between the two firms in brand appeal and product lineup,” analyst Oshima writes in a report. Kao’s plan is to plug the gap by fielding Kanebo brands, R&D, and marketing know-how. According to Credit Suisse estimates, Kao may spend an extra 10 bn yen a year on marketing to surpass Shiseido’s Chinese sales, which are already in the 20 bn yen range.

That brings Kao back to the all-important task of integrating Kanebo into the Kao fold. Can Kao really afford to mark time in China and other overseas markets while it woos and waltzes with Kanebo in the stately, consensus-building style of Japanese M&A? Everyone will be watching. “We all know that Kao is a well-managed company,” says Credit Suisse’s Oshima. “The question is where they go from here and what new things they are doing to deliver.” It’s a question that will increasingly be asked of Japan’s other old economy companies – and indeed a question they will be asking themselves.