Description

Amidst all the current complex arbitrage opportunities, or business models in a high state of flux, this should be quite a simple old-fashioned idea: a good understandable business, cheap and safe, with plenty of insider ownership demonstrating alignment of incentives. 

Business quality

The Bloomberg description actually tells you quite a lot:

“Ozeki Co., Ltd. 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.”

Most VIC members would probably immediately guess several things about this business:

1.    Operating earnings are probably quite predictable for the proverbial reason: “People still eat even during a major economic recession”.
2.    High proportion of fresh food sales suggests high frequency of purchase, implying a habitual and predominantly loyal customer base. 
3.    Location near train stations suggests real estate location is an important part of their business that cannot be easily replicated. 
4.    If stores are concentrated geographically this might bring some additional benefits (e.g. economies of scale) and risks (if location becomes unfavourable.)
5.    Being a supermarket, working capital should be negative (cash received at point of sale, suppliers of inventories paid after a delay), meaning that the business has the benefit of float.  At current interest rates, even free float is probably not valued by the market, but one day when interest rates normalize higher this could be worth something.  Meanwhile low funding costs for potential capex of new stores is always a nice to have.

All these initial observations are applicable to Ozeki, which would suggest that it is at least of average business quality.  Below I describe some of the reasons why this is a business of slightly higher than average quality.  Nothing sensational, but the typical owner of this kind of business should earn acceptable to good returns on capital (Post-tax returns on net assets have averaged 19.8% 1998-09, or 24% during the past two years.  These calculated returns assign no benefit to the advantage of operating with negative working capital, which would obviously bring returns on total invested capital much higher).

For various reasons - all well described by dylex849 in his August 2008 write-up - Ozeki is considered by locals to be a superior supermarket operation (high autonomy granted to local store managers; high full-time/part-time employee rations; concentration in stable, wealthy, metropolitan Tokyo neighbourhoods; an owner management mentality from the shop floor to the CEO).  Loyalty is high (card carrying members account for between 76% and 94% of total sales depending on the store).  Ozeki consistently ranks in the top 3 of supermarkets in Japan by relevant metrics: sales per square metre and employee, inventory turnover, and returns on capital. In addition, Ozeki’s choice of locations next to major train stations (their store location maps look like public transport maps) has been key in attaining high profitability.  McDonalds executives in the US have been known to concede that they are really in the real estate business.  Ozeki is maybe a kind of Japanese equivalent, where home cooking from highly perishable ingredients still dominates daily eating habits, meaning that the combination of super-convenient location with a motivated workforce’s high attention to detail and quality of produce allows above average profitability.  Ozeki’s relatively high operating margins (fluctuating between 6.4% and 8.1% every year since 1998) and their consistency are the envy of supermarkets not just in Japan but worldwide (see comps).

Two additional factors make this case compelling: the startling valuation and the alignment of incentives with management through their significant equity ownership.

The valuation

The stock trades at an EV/EBIT of 2.57x (FY Feb 09) or 2.50x (FY Feb 10).  Need I go on?

A significant portion of EV is held in cash, earning almost nothing.  The management has adopted a very conservative mentality to capital structure, and typically invests this cash in bank deposits and low yielding bonds.  This gives the company several strategic options such as buybacks.  Meantime it helps to make the stock safe as well as cheap.

Operating earnings have increased every year since the 1999 IPO.  EBIT growth rates for most of the past 12 years have been 5.5%-10.5%, though have slowed in the past two years to 2.7%-3.9% as no new stores have been opened. Even in 2008-09 during one of the worst economies Japan has seen for, well, a year or two, the company still managed to increase profits by 3.6% in the period ending February 2009.

Dividend yield is 1.93%.

Tangible Book Value per share is ¥2,154 (Price / Tangible Book ratio is 1.10x).  Tangible book value is cash plus owned stores and land.

An interesting triangulation reference point to today’s valuation is that the founder specified as a condition of the IPO stock sale that he receive a minimum split-adjusted price of ¥2,125 per share.  (“If underwriters cannot manage the sale for at least ¥4,250 (N.B. Pre 2:1 stock split) per share, Ozeki will cancel the offering,” October 4, 1999.)
From the IPO until today, the business has more than doubled its earnings and increased its cash balance per split-adjusted share from ¥254 to the current ¥1,149 cash per share. It therefore appears very likely that the stock would not be available at the current price if the founder were still alive and had delayed the IPO until now: he simply would not sell his ownership at the current valuation.  I suppose that is a polite way of saying that the founder must be turning in his grave to see how cheaply the business he built during 50 years is now valued in the market; or that the public market investor now has an opportunity to purchase a minority stake in a business at a valuation point that might not be available under normal circumstances.


Comps

1999-2009 Operating Margins and Valuations for Supermarkets and Food Retailers in Various Geographies.      Data 22Apr2009, source: Bloomberg

US & UK	Whole Foods	Gristedes	Walmart	Kroger	Safeway	Tesco	Sainsbury
	WFMI	DJI	WMT	KR	SWY	TSCO.L	SBRY.L
Max	6.05%	3.74%	6.00%	5.17%	8.29%	5.99%	5.22%
Min	2.97%	0.59%	4.79%	3.23%	3.16%	5.47%	-1.13%
TTM	2.97%	private	5.62%	3.23%	4.20%	5.47%	2.92%
EV/EBIT	14.86x	private	10.19x	8.77x	7.46x	13.22	12.32x
Japan	Ozeki	Arcs	San-A	Daikokutenbussan	York Benumaru	MaxValu Nishinihon	Halows
	7617.JP	9948.JP	2659.JP	2791.JP	3382.JP	8287.JP	2742.JP
Max	8.14%	3.38%	6.87%	5.69%	7.13%	3.99%	3.64%
Min	7.35%	2.50%	5.44%	4.29%	5.38%	1.72%	2.99%
TTM	7.76%	3.38%	6.40%	4.29%	5.53%	3.96%	3.30%
EV/EBIT	2.57x	6.91x	3.64x	5.27x	7.32x	3.60x	6.42x
Tokyo	Ozeki	Inageya	Maruetsu	Tokyu Store Chain	Life	Yaoko	Belc
	7617.JP	8182.JP	8178.JP	8197.JP	8194.JP	8279.JP	9974.JP
Max	8.14%	2.17%	2.38%	2.29%	2.53%	4.02%	6.28%
Min	7.35%	0.57%	-0.51%	1.13%	0.69%	3.79%	3.63%
TTM	7.76%	1.54%	2.38%	1.92%	2.53%	4.02%	4.17%
EV/EBIT	2.57x	7.61%	9.65x	17.5x when  acquired*	10.77x	6.26x	6.06x

* June 25, 2008 Tokyu Corp (9005.JP) acquired Tokyu Store Chain, not dissimilar to Ozeki, as the Tokyo provider of passenger rail transportation sought to expanded its retail interests.

Company history: family context and current alignment of incentives

Summary: Extended family now owns 45% of the stock, with the current President (CEO) daughter of the late founder owning 24% of the stock.  She lives and breathes the business, having worked hard at it since the age of 20.  Finally at age 52, she has the opportunity to be the female leader of a family founded business, still quite rare in Japan, with interests closely aligned with minority shareholders: to protect the business value by a conservative capital structure and growth strategy, pay out some cash flow in dividends, and over the long term ensure that the stock market once again reflects the true value of the business, as she ultimately must consider succession and a change of ownership.

The late Tatsuo Sato began selling food products, mainly dry goods, in Tokyo in 1957, operating as the limited liability company Ozeki Sogo Shokuhin.  Over the years he allowed tenants to offer fresh food products in his retail spaces, learning in the process that the secret to higher margins in his business was either large volume (prohibited by the cramped conditions of the typical metropolitan Tokyo store) or high frequency of purchase (dictated by the short shelf life of fresh produce).  He therefore took over the fresh produce business from tenants in 1965.  To this day, fresh and perishable produce represents two thirds of total sales, and enjoy the highest gross margins (e.g. meat and fish, 25% of total sales, have a 29% gross margin, compared to liquor with 17% gross margins and just 7% of sales).  The company does not lose sight of the principle that high frequency of purchases allows higher inventory turnover, encourages habitual shopping behaviour, and results in less price comparison by consumers.  Growing the store network slowly and steadily only as ideally located properties became available, at age 71 the founder sold part of his stake at an IPO in October 1999, at a split adjusted price of ¥3000 per share.   The company has expanded over the past 50 years to its current 29 stores, and has not had to close a single store in its entire history, a testament to its slow but successful growth strategy.  In the wealthy Setagaya neighbourhood it operates ten stores, the second largest network of supermarkets in that locality after privately owned Summit.

Following the founder’s partial exit at IPO, he stepped down as President in May 2000.  There followed four separate family members taking turns at running the company.  The bad news is that a quick scan of the stock price history since IPO shows that these various managers have had different impacts on the stock price.  The best performing stock price period was under the Presidency of Tamon Ishiharazaka, the husband of the current President.  The good news is that the underlying business has consistently prospered, irrespective of which family member was in charge, although Tamon Ishiharazaka oversaw a period of faster store growth, with correspondingly higher sales and earnings growth.  The key is that the business has continued to prosper in the decade since IPO, almost irrespective of President, and perhaps the clearest lesson to shareholders has been once again that valuation matters: after an initial IPO pop of more than 400%, the stock has essentially treaded water and now sits at 20% below its 1999 IPO price, despite a doubling of profits and a multiplying of cash and net fixed assets in the interim period.

A male Sato was unavailable for succession in 2002 so the company picked the founder’s son-in-law, Tamon Ishiharazaka, as President in April 2002.  Despite doing what appears to have been a credible job at Ozeki from 1994 onwards, in June 2005 the founder and major shareholder replaced this non-Sato President with his then 32 year old nephew, Mikio Sato.  Understandably, the son-in-law and his wife, Sumie Ishiharazaka, were displeased by this decision, and chose to leave the company at that point, but retained their equity interest. Sumie Ishiharazaka, the founder’s daughter, had joined the company aged 20 in 1978, and left in 2005 aged 48.  With 1 million shares (valued at $32 million using today’s exchange rate) she was a wealthy woman, but held a stake in a company where neither she nor her husband had any further executive control.  The following 3 years were challenging for Sumie Ishiharazaka for at least three reasons.  First, Ozeki’s stock price stagnated under the new management as the company’s new store growth slowed to a trickle: just 2 new stores in three years.  (Nevertheless the company was still consistently profitable, and accumulated cash reserves rather than investing in store growth).  Secondly, her husband’s alternative career proved unsatisfactory as he failed to turnaround the already troubled Cowboy Co. Ltd, a discount food store in Hokkaido, and its stock price dropped 80% during the 10 months he was President.  Finally she was faced with the death of her father and boss for entire career in April 2007, when Tatsuo Sato was 79 years old.

On inheriting an additional 2 million shares from her father’s estate in December 2007, Sumie Ishiharazaka returned to Ozeki in May 2008, and after the August 2008 departure of the encumbent President, founder’s nephew Mikio Sato, she finally became President of the company in August 2008 at age 50.  Confronting a local economy that was even more difficult than usual, the new President had a lot to do.  So far so good.  She has implemented a stock buy-back of 5% of the shares for cash in February 2009, and has delivered her first partial Fiscal Year results with impressive consistency (unchanged 7.8% operating margins, sales and operating profits up 2.7% and 3.6% respectively).

Now aged 52, Chairman of the Board and President Sumie Ishiharazaka has the operating experience, the long standing employee and supplier relationships, the cash and fixed assets, and the responsibility of demonstrating her ability to continue and develop the business.  Owning 24% of the company, this is the kind of person that I want to partner with as a minority shareholder.  


Risks, and possible factors weighing on the stock price

1.  Japan.  Economy and demographics both look pretty horrible, with no obvious improvement in sight.  Demographics could have numerous negative impacts on the stock, for example fewer customers over time or fewer investors buying risky assets like stocks.  In a world of capital flight, this is no insificant observation.  An optimist would argue that aging customers are even more loyal to local grocery stores; or that a 40% pre-tax earnings yield would be highly attractive to many local wealthy residents of neighbourhoods served by Ozeki stores, who can understand the business, monitor it through store visits every couple of days, like the conservative capital structure, and are comfortable earning a higher nominal dividend yield than Japanese Government Bonds offer out to 15 years, with a good track record of dividend increases.  (Incidentally although I understand that Japan has been a graveyard for many value investors, so that the phrase “value trap” seems synonymous with the mention of almost any Japanese stock, I do find it inconsistent to apply higher discount rates for investing in Japanese businesses operating in a stable democracy with minimal systemic corruption than when compared to higher growth economies with far spottier political/macro track records.)  Nevertheless, a 40% pre-tax cash adjusted earnings yield should comfortably clear most hurdles.

2.  Cash gets lost through foolish financial investments.  The company does not engage in derivative transactions, and has traditionally been conservative in its investment policy.  However recent global events teach us to never think never.

3.  “Accounting irregularities” announced in October 2008 turn out to be the tip of a nasty iceberg.  Shortly after re-joining the company and becoming President, Sumie Ishiharazaka’s management team discovered and disclosed a ¥63.8 million ($650 thousand) accounting irregularity, revising its results for the past five years.  The irregularities involved the “the recording of incorrect rebates and money exchange”, were not motivated by financial compensation or for criminal purpose, and appear to have been once off and minor.  Auditors Ernst & Young LLP issued an unqualified opinion February 28, 2009.

4.  Cash accumulates perpetually under-leveraging the company.

5.  Competition erodes margins.  The metropolitan location, and commuter target market should face less competition than some other supermarket business models.  However, nothing that they do operationally is rocket science, and great real estate locations will come available over the long term for would-be competitors.



What’s changed since August 2008 write-up by dylex849?

1.  Business has continued to deliver during a severe recession – operating results up 3.6% yoy.  The business does not appear vulnerable to any of the threats that would normally accompany this kind of valuation (product obsolescence, litigation, regulatory environment, patents etc.)

2.  Valuation has improved from 4.1x EV/EBIT to 2.5.  Could cheapen further.

3.  Company’s new management has followed through on its promise to return cash to shareholders, by starting to buy back stock.  5% of outstanding shares were repurchased in February 2008 at ¥2,567 per share.

Catalyst

Buybacks anticipated of 5% of outstanding per year.

A motivated and aligned management that owns a significant portion of the company, who will work over the long term to return cash via dividends, and ultimately will aim for a change of control at a time and valuation which suits the owner managers.