Description

Magical things can happen when you buy very good businesses at very cheap prices, particularly when the management team “gets it” and is working for you to create value. 10 days ago Ozeki was just a very good business at a very cheap price. Today Ozeki is a very good business at a very cheap price, but more importantly with a new management team that wants to see a higher share price.

When you read the Bloomberg description you will probably not be particularly impressed.

“Ozeki operates a chain of supermarkets which mainly handle seafood, meats, and vegetables. The Company establishes stores near train stations, and stores are concentrated in the Tokyo area.”

Fair enough if you think time to stop reading. However take a quick look at the EBIT margins and RONA below which suggest this grocery store operator is not your normal corner grocer. By the way capex is less than depreciation and the business is working capital negative, so fair to assume EBIT is a conservative proxy for pretax cashflow. Chart below is in billions of yen, so roughly speaking sales of USD650m and EBIT of USD50m.

(billions of yen)

	2001	2002	2003	2004	2005	2006	2007	2008	2009 F
Net Sales	37.5	40.8	45.7	48.6	52.0	55.8	62.6	65.0	65.5
% change		8.8%	12.0%	6.3%	6.9%	7.4%	12.2%	3.9%	0.7%
GP	9.2	9.8	11.0	11.7	12.3	13.4	15.2	16.1	16.3
GP %	24.5%	24.0%	24.1%	24.1%	23.6%	24.1%	24.3%	24.8%	24.9%
EBIT	3.0	3.5	4.0	3.9	4.1	4.1	4.6	5.0	5.1
% margin	8.0%	8.7%	8.6%	8.0%	7.8%	7.4%	7.3%	7.7%	7.8%
Inventory				0.5	0.6	0.7	0.7	0.7
Prepaids				0.1	0.1	0.2	0.2	0.2
Guarantee deposits				3.0	3.0	3.7	3.5	3.5
PPE				9.6	11.9	13.0	12.8	12.5
				13.2	15.6	17.5	17.1	16.8
AP				3.3	3.4	3.6	3.9	4.1
Accrued expenses				0.5	0.4	0.5	0.6	0.6
Deposits received				0.2	0.2	0.2	0.2	0.2
				4.0	4.0	4.2	4.7	5.0
Net Assets				9.2	11.6	13.2	12.4	11.8
EBIT/Avg Net Assets					39%	33%	36%	41%

Please note the 2009F above is based on the publicly disclosed company forecast. The company has been making public forecasts since the IPO in 2000. During this time period the company has exceeded the full year company forecast every year (e.g. 100% hit ratio). I realize this may suggest the company sandbags their annual forecast, but it also means they are savvy enough to know that you don’t get in anybody’s good books by consistently setting unrealistic expectations.

As to how these economics are achieved, I copy and paste the following from the company’s English language annual results release.

Basic policy and strategy

The Ozeki corporate philosophy since founding has been “Customers are No.1,” and our unique business model is based on maintaining store independence, procuring at the individual-store level, and ensuring a high ratio of full-time employees to part-time employees.

We believe the “Customers are No.1” principle drives a cycle of satisfaction and happiness: we satisfy our customers and make them happy through food, and this in turn translates into satisfaction and happiness for suppliers, employees, and shareholders.

We believe the most important focus in store management is having a rich product line-up, fresh food, quality goods, low prices, and top-notch service. We also aim to win the support of local communities by flexibly responding to changing customer needs.

To achieve our numerical business targets , we will continue to prioritize operations at the store level, the forefront of our business, and aim to ensure our existing stores are strongly community-based. We aim to ensure a rich product line-up, fresh food, quality goods, low prices, and top-notch service at new stores to quickly enhance their presence in their respective local communities. In short, we will focus on ensuring a strong workforce, attractive store layouts, and quality merchandise. In developing new stores, we intend to reduce preparation time and improve investment efficiency by not only securing low-rent properties, but also purchasing land wholly or partially to flexibly invest in the future as we do in our employees.

Admittedly the above description may require some color on our part to paint the full picture. Our qualitative comments are that Ozeki succeeds by taking a long-term approach to business. While other retailers have 70% part-time disinterested staff with high turnover, Ozeki has 70% full-time, well trained and passionate staff with low turnover. There are plenty of opportunities for advancement as the company has a strong history of promoting from within, such that individuals can move up the chain as new store openings create opportunities to move onwards and upwards.

The company strives to differentiate itself from the competition by delegating employees of each store to go out each day and find goods that delight the customer. If your store is in a wealthier area you should play that up by finding premium goods that really appeal to your local customers. If your customers are more value focused it is your responsibility to skew your offerings to appeal to that trait. Regardless, each store chief and his department managers are told to search for the freshest goods or something unique that will drive people to their respective store, and then price goods fairly and treat customers with a high level of customer service.

For those of you not used to investing in Japan, it is worth noting that delegating this type of control to store and department managers is an anomaly in a country well known for thinking inside rather than outside the box. I would argue it would take many many years to try and recreate this culture, and even so it would not be an easy task to accomplish. As an example, at a competitor you may have a part timer behind the fish counter who doesn’t know the product well and is essentially doing an administrative task when serving customers. At Ozeki you have an experienced full time operator behind the counter who can upsell customers on high quality product, tell you how to cook it, and over time learn what you like and don’t like.

Another anecdote is that at the time of the IPO an accounting firm was conducting due diligence. When it came to calculating the waste as a % of inventory the figure was off the charts low. The due diligence team kept pushing back saying it was impossible to run at such a low %. Further investigation proved it actually is possible, but only if you have the culture whereby your employees care about the figure and are actually empowered to take matters into their own hands to reduce waste (e.g. marking things down quickly, moving items in the store around to make sure seasonal perishables catch the eyes of customers, etc.).

By keeping a sharp eye on costs and having a sales mix with a higher than usual average of meat, vegetables, fish (the highest margin categories) Ozeki has a unique gameplan that generates excellent profitability. It is no surprise when you mull this over that Ozeki is amongst the top 3 listed Japanese grocers (actually usually #1) in terms of operating margin, sales per meter squared, sales per employee, inventory turnover, SG&A/Sales, RONA.

As for the sustainability of the model, we would argue it is rock solid. Ozeki has a very strong brand name in Tokyo for consistently satisfying local customers. As the local grocer, virtually all of the customers actually walk or ride their bike to the store multiple times a week to pick up fresh produce and fish. This makes sense intuitively when one considers that the Japanese diet is based largely on fish and fresh produce and the avg home is relatively small in size (very little storage space). As such, if you visit a store you don’t see a big parking lot for cars, but rather a little parking lot for all the mothers to park their bikes (all of which have baskets above the handlebars to get the groceries home). You don’t have to worry about a Wal-Mart type discounter opening up a few miles away and stealing your customers. The concept is local as are the customers.

The company also has it’s own “points” program that inspires loyalty among the customer base and allows the company to successfully emulate loyalty programs offered by larger competitors. There are ~700k members, whom account for 87.5% of total sales.

It is also worth noting that the organization was founded within the Setagaya ward of Tokyo, the largest by population in Tokyo and one of the wealthier areas. Anecdotally Setagaya is reputed to be a desirable area to live as during the Tokyo earthquake of 1923 it was the ward that suffered the least amount of damage. History what it is, local residents seem to believe it is one of the safer areas to live. I will leave VIC energy experts to examine the geological data to determine if this is an urban myth or a legend of substance. All of this aside, Ozeki is essentially dominant in the Setagaya region.

Now of course let us not forget the valuation. I will throw out for a good steady business 4x EBIT is sufficiently inexpensive to raise an eyebrow or two.

s/o				12.65
share price				2,690
Mkt cap				34.0	bn yen
Cash				13.3
EV				20.7
EV/EBIT				4.1

“Aha” I hear you mutter in the background, “It is only cheap on EV because 40% of market cap is held in cash.”

“Aha” I say back to you and refer you to my opening paragraph.

Go back a few years and Ozeki was run by the company founder. Upon his unexpected death a nephew who worked within the company took over. We have met him multiple times. Struck us as a good operator and very focused on store profitability, but no real fire in the belly to open up new store locations.

The largest shareholders in the company are the Founder’s daughter and her husband. The daughter previously worked as a Director in the company before taking time off to raise her children. Her husband actually was previously President of Ozeki before getting recruited by Goldman Sachs private equity division to run another retailer. The husband left Ozeki with the idea that he would learn more about other retail concepts during his departure, but ultimately he would likely return to Ozeki as an even stronger President.

Together the daughter and husband own about 25% of the company. Last week it was announced the daughter and husband are rejoining the firm as senior management (formally she is the new President, him a Director). The husband previously did a great job as Ozeki President, keeping store profitability high and successfully opening new stores (13 of the company’s 29 stores were opened during his tenure from 2002-2005). The daughter previously held a position as Director with responsibility for training staff and strengthening the company’s unique culture.

We spoke to the couple earlier this week. After witnessing store openings stagnate over the past few years the couple’s plan is to get the pace of new openings back on track. With only 29 stores currently and potential for roughly 50, management thinks they can open up 2-4 stores per year, implying 5-10 years of growth for new boxes. This pace of new store openings is in line with what the company was doing before the nephew temporarily took over. Given that the company has never had to close an unsuccessful store, we feel pretty comfortable with the team expanding at a similar rate to the past.

As for unit economics they very attractive, as suggested by the consolidated RONA of about 40%. Pretax payback for a new box is under 2 years if the company simply leases land (box unit RONA higher than consolidated RONA due to economies of scale on corporate expenses and distribution). Management understands ROC and prefers to lease stores, but will purchases when they think the location is A+, the math works, and the only way they can lock in the site is by making an outright acquisition. As a data point, the company only owns land at 7 out of their 29 stores, so the family is not predisposed towards building a real estate empire.

Now I know this smells like a value trap. The only reason I am writing this up because when we spoke to the daughter/husband earlier this week we chatted extensively about the cash. We were told explicitly that:

1) Cash is too high

2) Dividend payout ratio is too low

3) Shares are cheap

4) Management wants to enhance corporate value and see share price higher

5) Share repurchases will be seriously examined as a method to redeploy surplus cash

Now this is all fine and dandy, but to buy now you need conviction that they will walk the walk and not just talk the talk. I offer up the following desperately grabbing at straws anecdotes.

In Japan it is actually often very hard to meet with senior management. It can takes months to arrange a meeting, and you typically only get an audience with CEO by pulling favors. Upon the announcement of change in management, the couple said they would talk with us immediately, gave us several days of our choice, blocked off several hours to chat.

Even more impressive is that we have a friend visiting Tokyo in two weeks but his schedule was already full. He contacted the
company, and the managing couple suggested a Saturday morning meeting before his flight departs. I would argue these are data points the company is not trying to hide from shareholders in classic Japanese fashion.

Moreover the company has always been very accessible to shareholders, meeting regularly, publishing English language reports and presentations, and providing fabulous transparency including gross profit by product category by month and sales disclosed on an individual store basis.

Catalyst

Big picture I think this is a very good business at a very cheap price with a rock solid balance sheet and I am quietly whispering "Abracadabra" each day while I wait for some magic to happen.