Japan is big into cute characters. The most famous are probably Mario from Nintendo’s (TSE:7974, Financial) "Super Mario Brothers" or Pikachu from "Pokemon." Although Sanrio (TSE:8136, Financial) doesn’t own intellectual property (IP) rights to Mario or Pikachu, it owns Hello Kitty.
Hello Kitty, which Sanrio strongly states is not a cat, is loved by celebrities like Lady Gaga, Â Avril Lavigne and Katy Perry, among others. It doesn’t end there – Sanrio also owns rights to My Melody, Badtz Maru and Keroppi.
Many of these characters are not particularly known outside of Japan. Hello Kitty became an international sensation of sorts, especially in the U.S. Here is a 2014 Nippon article discussing the strategy behind Hello Kitty’s growth in the U.S. with Sanrio’s Ray Hatoyama. My condensed version is this:
The Hello Kitty IP grew in two ways in the U.S.: expanded distribution networks and licensing deals. Sanrio first started opening stores in the U.S. (1970s). Then it gradually started developing products in the U.S. (i.e., localization, 2000s). After that, it started adding new distribution channels outside of its own (recent years) – general merchandising stores, department stores and drugstores. Finally, Sanrio started signing licensing deals with specialty retailers like Hot Topic, Sephora and Forever 21 to produce collaborative products.
Sanrio has since experienced a steep decline, particularly in its North American business. In fiscal 2014, North America accounted for 48% of Sanrio’s 21 billion yen ($192.798 million) of total operating income. In fiscal 2017, this declined to 17% of Sanrio’s 7.2 billion yen of operating income. The company’s Europe division experienced a similar but less severe decline as well (see figures below). In the meantime, Sanrio’s Japan segment reported a loss. Company revenues dropped 19% while operating income fell by 66% over the past three years.
The company is still profitable as a whole, but the bleeding doesn’t seem to stop. About the only thing positive for Sanrio is the growth in Asia, which marks an impressive 13.8% CAGR operating income growth over the last four years. Unfortunately, the Asian growth hardly offsets the steep decline in the U.S. and Europe, and Sanrio’s Asia operating income actually decreased by 4.6% year over year.
Source: Sanrio IR (English added by author)
Retail shift and Disney dominance
If we take a moment to digest the Nippon article, the struggles in Sanrio’s U.S. business make sense. By design, Sanrio is heavily dependent on specialty retailers, which are predominantly physical retailers. It’s a well-known story that physical retail in the U.S. has been beaten down by Amazon (AMZN, Financial) and the internet. Just about all of physical retail is fighting for survival, and it doesn’t end there. Disney’s (DIS, Financial) IP from 2013 megahit movie "Frozen" has been taking shelf space away from Hello Kitty at big retailers like Walmart (WMT, Financial), according to Nikkei (Japanese).
It’s not like Sanrio is oblivious to the retail shift. In fact, the last section of the Nippon article points at Sanrio’s attempt to take new approaches to licensing, specifically mentioning the success of Hello Kitty stamps on the Japanese/Korean social networking service, Line. In many ways, though, Sanrio is structurally inflexible outside of Japan. Since most of Sanrio’s foreign operations consist of IP licensing, product design and development is generally left to the licensees. This limits Sanrio’s control over its own IP development and marketing.
Meanwhile, there are competitors like Disney that primarily build IP through movies and theme parks. Then we have the likes of Nintendo and Bandai Namco (TSE:7832, Financial) building IP through video games. The retail shift combined with Sanrio’s relative inability to direct its IP development in the Western world resulted in the perfect storm we’ve witnessed over the past few years.
Sanrio’s fight for survival
Hatoyama has since departed Sanrio, but the renewed licensing strategy is still en route. According to a Nikkei article from late 2016, Sanrio has increasingly focused on licensing to food-related businesses. The company is gradually shifting away from things (“mono” in Japanese) and moving into experiences (“koto”). Though analysts aren’t expecting the food-focused licensing to fill the product-focused hole in its entirety, food will likely provide a bottom. Sanrio founder-CEO Shintaro Tsuji commented on the painful reality that it’s getting increasingly difficult to sell products. In contrast, food is consumable, and fans are likely to repeatedly buy Sanrio-branded consumable goods instead of purchasing another Hello Kitty plush doll.
Though Sanrio does not break out figures for food-specific licensing deals, the filings indicate that the Asia strategy has seen success in “character cafes” and business promotion licensing (i.e., using Sanrio characters in promotions). Sanrio is trying to roll out this strategy in Europe and North America. For example, supermarket food service counter operator AFC Franchise Corp. celebrated its 30-year anniversary by putting Hello Kitty everywhere in and around its sushi booths.
It’s not all bad, and Hello Kitty isn’t dead. In fact, Sanrio even has newcomers gaining popularity. Gudetama, an egg with severe depression, recently entered the American pop culture scene through specialty retailers like Hot Topic and merchandiser Bioworld.
Financials
With all the context in mind, let’s take a look at the financials.
There is no end in sight for the continuing revenue decline. More importantly, operating income is declining rapidly. Sanrio management is guiding for an improved fiscal 2018, with revenues increasing 4.8% and operating income increasing 56.4% year over year.
Unlike most Japanese companies, Sanrio pays a large dividend – currently yielding 4%. With its 80-yen-per-share dividend, Sanrio had a 105% payout ratio. That’s right, it paid more money than it made in fiscal 2017. Clearly, this isn’t sustainable, but with a still-profitable business and a decent pile of cash (42 billion yen), it will take awhile before the high payouts become a problem for Sanrio. The company plans to keep its 80-yen-per-share dividend for fiscal 2018.
Sanrio’s stock has halved in the past four years. Today’s EV/EBIT stands at 19x. For reference, here’s a chart showing 10-year EV/EBIT multiple for Sanrio.
Excluding 2009, Sanrio’s EV/EBIT has mostly stayed around the mid- to high teens. It seems that Sanrio stock’s decline was appropriate, considering the deflated EBIT in recent years.
Closing thoughts
While I’d like to take Sanrio’s management guidance at face value, it’s hard not to be skeptical about a quick business performance recovery in all regions. Several of the key risks that I see here are:
CEO is 89 years old – who’s next? (Probably one of the founding family members.)
Limited control over IP development due to licensing deals vs. internal product development and distribution.
No proven model yet in the post-physical retail shift.
The challenge for Sanrio is in navigating through the retail shift in an increasingly competitive IP licensing arena. So far, the focus is shifting from things to experiences, but there’s no tangible sign that the strategy shift is working. Meanwhile, majors like Disney and Nintendo have clear-cut ways to develop and market IPs through movies, theme parks and video games while Hello Kitty and the Sanrio entourage are mostly just good at being cute.
Despite the declining business performance in recent years, I doubt this spells the death of Sanrio. Perhaps there is a slim chance that Sanrio goes down as an international one-hit wonder – only bringing Hello Kitty to the world and nothing else. There’s a lot more to Hello Kitty than Hello Kitty itself. The Hello Kitty brand opened up a tremendous number of doors and made Sanrio’s name familiar to every specialty retailer on the planet. This paves the way for other Sanrio characters. I wouldn’t be surprised if it experienced growth levels similar to 2009 to 2014. That said, given the uncertainty in Sanrio’s licensing and IP development strategy, it’s hard to find confidence in future business performance. I cannot make myself invest in Sanrio.
Disclosure: I do not own shares in any of the companies mentioned in this article.
