MISAKI Newsletter

Akira Kurokawa (Chairman and CEO, Santen Pharmaceutical Co., Ltd.) × Yasunori Nakagami (CEO, Misaki Capital Inc.)

Quest for “Excellence in Management”

2019 Early Summer Vol.13

A Dialogue on “Resilient Barrier”

2019.6 Vol.13

Forward for releasing the 13th issue of

Quest for “Excellence in Management”

Do you know what long-term investors are desperately trying to gauge? The answer is “high level of

sustainable profits” that underpins long-term investment as you may imagine. However, in a world

of ever-intensifying competition, is there such a thing as high level of sustainable profits? If so, how

can we achieve?

Misaki’s answer to this question can be summed in one word, and that is “Barrier.” There are many

types of businesses in the world but Misaki separates them all into two categories: “Opportunistic

Businesses” and “Business with Barrier .”

“Opportunistic Businesses" refer to businesses that generate profits by taking advantage of the

business opportunities that appear and disappear in the world. “Such businesses are wonderful,”

you might think but long-term investors do not even give them a second glance. This is because

the profit generated from the businesses will not stay as competitors emerge and try to steal their

profits unless they are protected by “Barrier”. Long-term investors are not interested in the one-off

profits generated by “Opportunistic Businesses”.

On the other hand, long-term investors will willingly consider investment in companies with “Barrier”

or companies that are building up such "Barrier”, even if the companies are not particularly profitable

at the present time. This is because “Barrier” will generate sustainable excess profits in the long-

term. At the heart of the investment process of long-term investors, which seems to be mysterious

from outside, there is the question. “Is this business protected by “Barrier”?”

I intensely focused on this point whether the companies have “Barrier” or not when I became the

investor who “chooses” strategies from the management consultant who “creates” strategies. The

world “strategies” is overflown in our day to day life, but “strategies that encourage investments” are

rare. The majorities are “strategies subject to the trading”. Warren Buffett called them “moats” rather

than barriers.

Today, we welcome the Chairman of Santen Pharmaceutical Co., Ltd., which we believe possesses

such a “Barrier.” This “Barrier” is protecting the company from the competition and generating

sustainable profits.

It would be my greatest pleasure if you could learn from Chairman Kurokawa how the “Barrier” which

investors love more than anything is created and how the “Barrier” could demonstrate its power once

it is implemented. I also expect this edition could contribute to your strategic planning.

Yasunori Nakagami, CEO

Misaki Capital Inc.

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“Resilient Barriers”

Akira Kurokawa (Chairman and CEO, Santen Pharmaceutical Co., Ltd.) × Yasunori Nakagami (CEO, Misaki Capital Inc.)

※This dialogue was held in January 2019.

How is the “Barrier” built? Understanding the fundamentals of the business

Nakagami: This newsletter has mainly addressed governance, finance and other management themes that are

common to most companies, and the business strategies itself was not discussed until now. This is due to our

belief that the readers of our newsletter would not recognize direct benefit from such discussions for their

management given that strategies tend to be highly company specific.

The word “strategy” is everywhere in our life, but it is rare that these strategies are based on the “Barrier,” which is

the main focus of long-term investors.

It goes without saying that long-term investors hope for the sustainable long-term profit growth from the

companies they invest in. However, in this highly competitive world, once the business is deemed profitable,

competitors rush in to wrest their share of the profits. Therefore, unless a company has “Barrier” that is high enough

to repel its competitors when they become aggressive to steal the business, investors will not admit the strategy

truly credible.

From this perspective, I admire Santen’s strategy. This is because Santen’s strategy seems to be appropriate to

be perceived as “Barrier” which is built upon uniqueness of the targeted organs, i.e. the “eyes,” and the very nature

of its customers, i.e. “ophthalmologists,”.

Firstly, I would like to ask Chairman Kurokawa to tell us about the core principal of the strategy, which came from

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Santen’s observation on the unique characteristics of “eyes”.

Kurokawa: Our business specializes in the areas relating to the eyes. Santen’s main products are the ethical drugs

prescribed by ophthalmologists. We don’t limit our services just providing drugs and treatment. Santen works

closely with the ophthalmologists to deal with all the concerns from the patients such as early diagnosis of the

problem and encouraging patients to continue the treatment albeit indirectly.

One of the basic characteristics of eye diseases is that many of the diseases tend to be chronic and difficult to cure

completely. The common eye disease, glaucoma is a typical example. Administering medication can slow the

progression of the disease but the parts of the vision that have been lost cannot be restored.

Accordingly, a patient contracted with an eye disease must use eye drops continuously. Otherwise, the patient is

exposed to the extremely high risk of ablepsia, losing the entire vision.

Nakagami: In other words, the very organs of the “eyes” encourage the continuous use of medication. So, in

today’s jargon, it has the characteristics of turning the business into a “recurring business.” I guess this also means

that the business environment could facilitate another type of “Barrier” such that consumers continuously buy the

product even against their will.

Because the patients are exposed to the high risk of ablepsia, the products may also be described as “mission

critical products.” In general, when the customers are facing bigger risk, they tend to be more willing to spend on

the medication even if they are premium products. This leads to higher profitability for the company. As a result, I

believe that Santen specialized in the eyes ultimately position itself to be in the lucrative business environment.

To tell you the truth, I have been undergoing the treatment for an eye ailment and have been using eye drops for

many years. I would rather use the medicine that I am familiar with especially when it comes to eyedrops. Having

said this, I tend to forget applying the eye drops as I don’t normally notice any symptoms and got told off by my

wife every night (Laughter).

Kurokawa: That’s right. When there is no noticeable symptom, you tend to forget your eyedrops. Therefore, we

are developing ways of connecting the patients with their doctors adopting to the changing environment, such as

sending out daily reminders using the smartphone.

How is the “Barrier” built? Understanding the market and competitive landscape

Nakagami: While the end-users of Santen drugs are the patients, the ophthalmologists prescribe Santen drugs to

the patients. In this sense, the direct customers of Santen could be ophthalmologists who write the daily

prescriptions.

What are the unique characteristics of the

ophthalmology market and the

ophthalmologists as customers compared

with the other medical departments?

Kurokawa: First of all, compared to

systemic drugs, such as the drugs for

internal medicine, ophthalmology market

is small and a niche segment. Therefore,

not many companies are willing to enter

this small market. There are examples of

systemic drug manufacturers entering this

market with specific products but there are

very few specialized manufacturers.

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Nakagami: So, compared to other companies that have entered this market as a side business, Santen, as a

specialized player, is in a position to concentrate its resources in this market and thus is in a position to build

“Barrier” more easily.

Kurokawa: Additionally, there is also the characteristic that ophthalmology has the highest proportion of running

own practice rather than working for the hospital comparing to other field of medical care and there are numerous

small to medium size specialized clinics around Japan. Currently, there are approximately 13,000 ophthalmologists

in Japan, of which around 60 to 70 percent are self-owned practice i.e private practice. This is a major difference

compared to internists, which mainly operate within the large hospitals.

Nakagami: So, internists has a hierarchy with large hospitals at the top of the pyramid whereas ophthalmologist

has numerous small to medium size specialized clinics and self-owned practice spread across the country.

In internists, patients need to go to larger hospitals to undergo more serious surgery while in ophthalmology,

patients seem to be able to receive consultation, treatment and surgery at the local clinics.

Kurokawa: Because of the high degree of specialization, the medical test performed at university hospitals is not

significantly different from the test performed by private practitioners / clinics. Even clinics carry out the major

tests, such as measuring the ocular pressure and the examining the ocular fundus.

Nakagami: In such a market structure, what do the ophthalmologists expect from the manufacturers?

Kurokawa: The biggest concern of the ophthalmologists at the clinics is the difficulty to obtain the latest

information on the medication and the treatment.

Internist at large hospital is working in an environment where the latest information on the medication and the

treatment are available. On the other hand, ophthalmologists, the majority of whom are private practitioners, are

finding it difficult to gather the latest information just by working on the site. Ophthalmologists are also spread

over a wide geographical area in Japan, which makes it difficult to share information among its peers.

Of course, there are local medical associations for ophthalmologists but, as the ophthalmologists are self-employed

doctors running their own practices, information-sharing will be difficult, as it may create additional competition

among them.

We want our doctors to concentrate more on treating their patients rather than worrying about these things. That

is why our services providing the information to the ophthalmologists becomes even more important than the same

services to the doctors of other fields.

Nakagami: In other words, the doctors are expecting manufacturers to correct the information gap not just

providing medication.

Kurokawa: That’s right. That is why our medical representatives (MRs) are not only providing the latest information

to the ophthalmologists but also offering consultations on the various concerns of the practitioners, when

requested.

For example, the MRs hold workshops at the clinics; distributing information magazines on hospital management,

handing out leaflets for patients and providing a wide range of advice including advice on the layout of the clinics.

Nakagami: I am surprised to hear that the MRs even provide information on hospital management. It must be a

heavy burden on the manufacturer, but it helps Santen to win trust from the ophthalmologists because Santen is

attentively offering help to them. By the way, what is Santen’s market share?

Kurokawa: Santen’s share of ophthalmological ethical drugs is 47 percent in Japan. This number itself is extremely

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high, however our mind share of the doctors is believed to be nearly 70 percent. We have over 50 product items in

the ophthalmological field and ophthalmologists cannot conduct practices without our products. I believe that the

recognition of our broad product lineup and our service of offering information required by ophthalmologists being

highly appreciated. This lead to high percentage of doctors replying, “We can’t live without Santen” ,”We want Santen”

and “Santen is No.1.”

Nakagami: Another unique feature of Santen’s MRs seems to be

their productivity. Santen has approximately 400 MRs and sales

per MR is ¥330 million, which is by far the highest levels

compared to other major Japanese pharmaceutical companies. In

order to achieve such results, I imagine that the effort to improve

the sales efficiency has been finely conducted.

Kurokawa: We put strong emphasis on the sales efficiency of

our MRs. For example, if sales figure fails to increase despite

proactive efforts, we will slightly reduce the number of visits by

MRs. On the other hand, if we receive numerous requests and strong feedbacks from a particular clinic, we will

increase our visits and offer management support through providing information on the medication and the

treatment.

Nakagami: I think we should also mention Santen’s large number of MRs despite the size of the market. An

ordinary business owner might think, “Is it wise to allocate 400 MRs when there are only 13,000 ophthalmologists

in Japan?”

However, because Santen has allocated such a large number of MRs in this small market, it has made it difficult for

other companies to enter the market, despite Santen’s enviable level of high profit margins.

I think this seems irony to say, “because Santen is spending outrageous amount of cost, it is generating the highest

level of productivity.”

I believe that this is a result of three things such as, dense and efficient sales network, the provision of information

and value in line with customer profiles and the broad product lineup. Santen is the classic example of a “big fish

in a small pond” or being protected by a resilient “Barrier.”

Kurokawa: Our MRs play a major part in spreading and promoting the use of our medicines. Furthermore, as we

are dedicated to ophthalmology, our customer base is limited. This enabled us to have enough strength not to rely

too much on the sales capacity of wholesale distributor.

Of course, due to regulatory restrictions wholesalers need to physically deliver the medicines, but the margin we

pay to them may not be as high as the competition.

Nakagami: I think what you have just said, “not necessarily rely on the sales capacity of wholesalers ” is symbolic

and the indication of the strength of Santen’s “Barriers”. So, wholesalers have no choice but to deal with Santen,

despite the meager margin.

Mr. Kurokawa, I think these words symbolize the business model, which I mentioned to you when we first met, i.e.

“Santen is a manufacturer but it seems to be competing on the strengths of its added value in distribution rather

than its added value in manufacturing.”

What “Barrier” achieves: The possibility of sustainable profits

Nakagami What kind of benefits does Santen enjoy by building such a high “Barrier”?

Kurokawa: There are many benefits. One example is lesser impact of reduced prices as a result of the National

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Health Insurance (NHI) price revision. Pharmaceutical companies cannot escape from the prices reduction as a

result of NHI price revisions. Furthermore, when the patent of your drug is expired, generic drugs will enter the

market and intensify the price competition.

However, ophthalmology patients have relatively high tendency to continue using the same eye drops, i.e. the

products that already have a high market share. Furthermore even if a generic manufacturer were to enter the

market, given that we have captured 70 percent of the mind share of the doctors, they would face even higher

obstacles to have their medications prescribed.

Therefore, as long as we keep raising the customer satisfaction from the ophthalmologists, we will be able to keep

the impact of falling prices down to a minimum.

Nakagami: So, in other words, Santen’s “Barrier” possesses the power of resistance toward NHI price revisions and

the competition from generic drug manufacturers which consistently suffer the other pharmaceutical manufacturers.

What are other benefits?

Kurokawa: Another benefit is that other pharmaceutical companies come to Santen and ask us to promote the eye

drops, which they have developed in-house. Since we already have a solid sales network in the domestic market,

in most cases, other companies ask us to promote their eye drops.

When we are called on by the other companies and once we accept their offer, we always achieve the numbers

which we have committed ourselves to. It is imperative that we create a win-win situation for both parties. In fact,

we have been successful with almost all the products that we have undertaken.

Nakagami: For the other pharmaceutical manufacturers, given that Santen has already built overwhelmingly strong

“Barrier” around itself in the domestic market, they probably think that it is better for them to cooperate with Santen.

I think it also means that because of its “Barrier”, Santen has also been successful in capturing new business

opportunities.

What is Santen’s standpoint toward research and development, which is generally thought to be the most important

part of a pharmaceutical manufacturer?

Kurokawa: We are focusing on “development” rather than on “research.”

If we start the development of the new drug from the synthesis of compounds, it would take years to launch the

new drug like other systemic drugs even in the ophthalmology field. Basic research including creation and screening

of new compounds requires five years. Subsequently, the clinical testing stage after the R&D takes another seven

to eight years, and finally another two years will be required until it is launched in the market.

Conducting R&D from the basic research stage requires a wide range of research. For Santen as we specialize in

the small “eyes” market, spending dozens of years on R&D does not make us generate a viable ROI.

That is why we are focusing on development rather than basic research. When we find a superior pharmaceutical

ingredient, we will proactively adopt it from other systemic drug manufacturers and subsequently concentrate our

resources in the development, which leads toward the market launch.

Kurokawa: Santen used to have a research lab but we made the difficult decision to terminate the basic research

activities. It may also have discouraged people involved in the research.

Therefore, in the process of termination, we spoke to the research people repeatedly and explained that a

pharmaceutical company is different from a university lab. We have iterated “We cannot keep conducting research

for the sake of research. We need to commercialize the research and generate profits”. We also explained that in a

small market such as the ophthalmology market, no matter how much effort we put into basic research, it may end

up in wasting our time and money.

Nakagami: We always assumed that R&D was an integral part of a pharmaceutical company but, I guess R&D is

not necessarily paid off in a niche and small field such as ophthalmological drugs.

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Building a resilient “Barrier” entails significant risks and costs. Accordingly, it is not possible to put up “Barrier” in

all directions. I can imagine that there was a sophisticated management decision that determined where to build

the “Barrier” and which added value to protect.

Nakagami: In this sense, Santen’s decision to withdraw from the lucrative rheumatism medication business, which

boasted an operating margin of 50 percent, does not seem totally unrelated to its basic strategy of providing

overwhelmingly large added value based on distribution in the niche market of ophthalmology.

I feel it is an effective way of allocating corporate resources for the company to build up a business portfolio based

on the existence and the strength of “Barrier” rather than randomly undertaking “selection and concentration” or

making management decisions based on current profit margins.

Virtuous Circle formed by the “Barrier” and a relationship of trust

Nakagami In this way, Santen has already built up powerful “Barrier”. What kind of initiatives are being taken by

Santen to extend the life of these “Barrier”?

Kurokawa: As the leading company in ophthalmology, we support the development of optical care by cooperating

with the academic societies. We believe that we can make contribution by corroborating with academia, in

response to the changing needs of ophthalmological treatment, as patients getting older.

Another initiative is our human resources development. Because we specialize in the field of ophthalmology, we

are able to educate specialized talent through OJT (On the Job Training). They understand the genuine concerns of

the ophthalmologists and provide support in finding solutions.

Nakagami: The world is full of companies claiming to be partners of their customers but I think Santen is the

authentic case. There are structural reasons in the ophthalmological market that requires the partnership and

Santen’s management seems to be focusing on meeting this requirement.

Kurokawa: Of course, the most important thing is customer satisfaction. By focusing on the ophthalmological field,

we have been improving customer satisfaction.

It is important not only to offer a wide lineup of eye medicine but also to listen to the ophthalmologists’ various

concerns as a true partner.

Nakagami: The fact that Santen has built up a relationship of trust with not only its customers but also with the

other pharmaceutical companies looks also special.

Kurokawa: In 1981, we introduced and marketed a product called Timoptol from the US company, Merck & Co Inc.

in Japan and it was a huge success. Since then, Santen has built a relationship of trust with Merck, which has led to

Santen’s acquisition of Merck’s ophthalmic assets (excluding the US) in 2014.

In business, a relationship of trust cannot be built, unless there is a mutual benefit. As the pharmaceutical business

is a long-term business, human relationships built on trust are extremely important and that is something you

cannot betray.

Nakagami: Many companies claim to have built relationships of trust but I believe that in Santen’s case, because

of its resilient “Barrier” which enabled Santen to earn long-term profits it was able to build long-lasting relationships

of trust. And the trust probably further strengthened such “Barriers”.

The Right Attitude required for the business owner and investor to ensure long-term profits

Nakagami: Finally, I would like to ask you about what kind of management structure is required to build such

“Barrier”.

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Chairman Kurokawa, you were appointed as the President in 2006 and the President & CEO in 2008. Since 2018

you have been at the helm of Santen’s leadership as the Chairman and CEO.

Building “Barrier” takes a lot of effort and time. I think this is only achievable under the management with long-

term commitment. Therefore, I imagine the tenure of the president becomes naturally longer.

Do you also think that unless there is a certain level of concentration of power it will be difficult to promote strategic

hypothesis due to disruption from the office politics?

Kurokawa: With regard to the management, I personally believe that the term of office of presidents should be

shorter.

The role of the CEO is to decisively execute drastic reforms when necessary.

There are decisions to adopt to the changing environment such as deciding on new business domains, adopting

new technological innovations and making structural reforms in marketing, but they may be delayed if the tenure

of the president is too long.

Therefore, I don’t think that it is simply better for the president to have a longer tenure. Long-term commitment

is essential, but they are not associated by just being a CEO for a long time.

Nakagami: Admittedly, reforms should not be prolonged but executed at once. That may be one of the approaches.

On the other hand, building “Barrier” requires expending costs continuously regardless of one-time performance

and taking huge risks. In such cases, how much weight do you think you should put on the business performance

of each term?

Kurokawa: Of course, our ultimate goal is to create a dominant market position which enables us to achieve

sustainable growth. To this end, we are deploying our strategies based on our hypotheses. If there are any

deficiencies in the hypotheses, they would be reflected in the current business performance. We should not leave

this out.

In such cases, I think that it is important that we look at the current business performance and flexibly maneuver

the strategies rather than try to patch up performance through easy measurements such as cost reduction.

Nakagami: In other words, you are using short-term business performance as a barometer for the management

and the progress on the long-term strategies.

I think this is similar to the perspective of investors like us, who carefully look at the quarterly results. We are not

too much focusing on the current business results, but checking whether the management hasn’t derailed from its

long-term scenarios.

Kurokawa: In Santen’s case, the “Long-term Vision” and “Long-term Strategies,” which were formulated in 1990

upon conducting thorough global research, remain to this day as our main hypothesis.

Since then, we have been formulating long-term visions in 10-year time and reflecting them in medium-term plans

covering 3- to 4-years. Furthermore, management has been setting long-term incentives for achieving these goals

and ensuring medium and long-term economic alignment.

During this time, our efforts to enhance our marketing, which has been our focus, and the productivity of R&D have

always been under the scrutiny of the Board of Directors.

Nakagami: There are multitudes of companies that uphold “long-term management” but there seems to be no

shortage of companies which use the word “long-term” to disguise their current low profitability.

On the other hand, there are companies that are actually laying out costs and taking risks in order to build “Barrier”

from a long-term perspective.

For a long-term investor the ability to identify the good investment will be tested when temporally business

performance drops. There may be the case that costs of the company is simply going up or it may be laying out

costs to build “Barrier”.

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We will distinguish between the two and willingly make major investments in companies that are spending costs

for the establishment of their “Barrier” and share future benefits with them. Through this process I hope to continue

supporting genuine long-term management.

Thank you, Mr. Kurokawa for your fascinating story today.

January 2019

At Nihonbashi

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* No part of the reference to the company featured in this newsletter is intended to suggest our past investment

performance or current investment policy.

Chairman and CEO,

Santen Pharmaceutical

Mr. Kurokawa graduated from Waseda University with BA in Political Science and

Economics.After graduating from the university, Mr. Kurokawa joined Santen

Pharmaceutical Co., Ltd. in 1977.

He accumulated his career serving for the mainstream businesses of

prescription pharmaceuticals and corporate development and became President

& CEO in 2008.

In 2010, he announced “Development into a specialized pharmaceutical

company with a global presence by 2020” as the long-term vision further

concentrating management resources in ophthalmology, accelerating global

expansion, and rapidly increasing sales and the proportion of overseas sales.

He was appointed Representative Director of the Board, Chairman and CEO in

2018. Akira Kurokawa

Interviewee Profile

Misaki’s Voice

Investment Officer

Takemune Iwasa

The team is making a concerted effort to redesign the research process in

order to continuously raise the competitive barriers around Misaki Capital.

We will raise the quality of our investment decisions and engagements

through better-quality internal processes, including when, where and what

type of resources will be spent and to what extent.

Sakurai Bldg. 3F, 5-11-1 Minami Aoyama, Minato-ku, Tokyo 107-0062, Japan

+813-6427-7431

info@misaki-capital.com

http://www.misaki-capital.com/

Published

by

Misaki Capital Inc.

*Cover photo: Kamui Misaki.

One of the three major capes of Shakotan Peninsula. The beautiful blue sea resembling the color of blue paint is called “Shakotan blue.”

How did Santen build its “Resilient Barrier?” Looking back on its history I believe it came from Santen’s

insightful ability to gauge the company’s true capabilities when the company was performing strongly.

The catalyst was when “Tarivid,” a prescription, synthetic and antibacterial eye drop was released in

1987 which became a big hit. Net sales nearly doubled from fiscal year 1987 to 1991 and ordinary

income increased 2.8 folds. Santen’s growth caught the attention in the industry. An ordinary company

would not think of further strengthen its “Barrier” when the performance was in good shape. Instead,

it would carry on managing the company in the same way as before assuming that the strong

performance would continue.

However, Santen was not the ordinary company. Amid the strong performance of “Tarivid,” Santen

evaluated its capabilities in a rationale manner. Mr. Morita, the President at that time, said, “We are not

sure if we can continue to come up with big hits like Tarivid. The rapid growth of Santen in these past

few years may not necessarily be commensurate with Santen’s true capabilities.” (Nikkei Business,

October 12, 1992 issue)

Subsequently in 1991, Santen formulated its long-term vision and built its “Resilient Barrier” by making

proactive investments in the improvement of its sales networks. If Santen had become complacent with

its success with “Tarivid,” it may not have been able to build today’s “Barrier”.

To gauge one’s true capabilities is easier said than done. Zeami, the sarugaku performer of the

Muromachi era wrote in the Fūshikaden ("Style and the Flower"), “He who thinks that flowers that are

currently in bloom are true flowers, may not see the true flowers.” One cannot be an expert if he or

she just looks at the flowers currently blooming. In our history, mankind has been fooled by what he

or she can see.

We as long-term investors are also being constantly tested on our ability to gauge the “true

capabilities” of the companies which we invest in. Only God knows the true value of the company, but

I am hoping to come closer to the “true capabilities” of the company without being fooled by “the

flowers that are currently in bloom.”

Editor’s Note

Yutaka Sugiura

Associate