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Clayton Young
Clayton Young
Articles (11)  | Author's Website |

Have You Heard of This Mini Walmart-7-Eleven Hybrid?

Value investors love San-A's moat

Basics of Walmart and 7-Eleven Japan strategies

If you have read my previous posts, you can probably tell that I enjoy reading about business strategies. Supply chain strategies get me particularly excited. This is partly because my education and work experience has revolved around supply chain and operations. Needless to say, I have spent some time reading about various companies famous for their supply chains; companies like Wal-Mart Stores Inc. (NYSE:WMT), Toyota Motor (NYSE:TM), Amazon (NASDAQ:AMZN) and, to a lesser extent, 7-Eleven's parent company Seven & i Holdings (TSE:3382).

It is common knowledge Walmart was built on small-town America: open stores in small towns, maintain low margins, turn inventory and occasionally squeeze suppliers. In contrast, 7-Eleven Japan built its current business on what it calls “the dominant strategy.” When 7-Eleven enters a market, the company opens a high concentration of stores in a small area. This allows for efficient logistics. The company can leverage the efficiency to offer prices lower than competitors while maintaining margins. This often results in high 7-Eleven dominance in a small area.

Japan’s most profitable supermarket operator in the middle of nowhere

San-A Co. Ltd. (TSE:2659) is Japan’s most profitable, Walmart and 7-Eleven hybrid retailer that nobody has ever heard of. Admittedly, it has less than 1% of Japanese retail market share - and that will never change. Why? Because the company exclusively operates in Okinawa, a secluded chain of islands about 1,200 miles away from Tokyo.

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A few facts about Okinawa:

  1. It has the highest fertility rate in Japan, 42 years and running (1.96 childbirths per woman versus national average of 1.45).

  2. It is a major tourist destination (the Hawaii of Japan).

  3. Only prefecture with expected population increase going into 2020 (according to Japan’s National Institute of Population and Social Security Research)

Japan’s population currently sits at 127 million and has started declining. Okinawa’s 1.4 million population is expected to decrease eventually, but to a lesser extent compared to mainland Japan.

The secluded nature of Okinawa gives the chain of islands its own distinct culture. This has not been the easiest thing for mainland Japanese businesses to figure out. Japan’s convenience industry offers a perfect case study for this.

There are three major players in Japanese convenience: 7-Eleven, Family Mart (TSE:8028), and Lawson Inc. (TSE:2651). To start, 7-Eleven has exactly zero locations in Okinawa. Family Mart gained a leg up on Lawson when it decided to operate its Okinawan stores through a partnership with Ryubo (private), a strong local grocer. After struggling to gain market share, Lawson eventually partnered with San-A in 2007 to operate Okinawan stores. This local partnership approach has become the standard in Okinawan convenience. 7-Eleven recently announced its Okinawa entrance. It will also be partnering with a local grocer, Kanehide (private). As you might imagine, convenience stores in Okinawa today often have different promotions and products compared to their peers in mainland Japan to capture the hearts of its consumers.

How is San-A a hybrid of Walmart and 7-Eleven?

San-A was founded on a remote island (even for Okinawa) called Miyako (approximately 55,000 residents), about 200 miles southwest of mainland Okinawa. When deciding to enter the market in the 1970s, the company quickly figured out retail competition in the capital region (Naha city) was high; with powerhouses like Ryubo (Okinawan grocer) and mainland Japanese giant Mitsukoshi holding a significant presence.

Without the financial strength to muscle through competition in the capital region, San-A adopted what the founder referred to as the “Viet Cong” strategy; a guerilla tactic. Strangely, this resulted in something similar to Walmart’s small-town strategy. San-A leveraged its deep local knowledge (customer tastes, needs, etc.) and opened neighborhood supermarkets outside of the capital region. The slogan: “Our customer’s refrigerator.”

The neighborhood supermarkets proved successful. As San-A’s business developed, so did its financial strength. This afforded the company the opportunity to build malls in Okinawa. Today, about two-thirds of the malls in Okinawa are owned and operated by San-A. As business shifted, so did its strategy. The company's strategy now resembles 7-Eleven’s dominant strategy, except with a big retail twist.

San-A’s dominant strategy can be boiled down to this: build a mall, then build supermarkets nearby. Similar to 7-Eleven, this gives San-A a leg up on operations. Oftentimes, one truck will make deliveries to multiple stores before returning to the distribution center. Furthermore, the geographical concentration allows San-A to make five deliveries a day. This structure provides more than just a delivery cost benefit. San-A can stay lean on front-line inventory and react quickly to variations. Additionally, and probably more importantly, San-A can keep fresh products on the shelves.

Amazon-proofing

The big question in all of first-world, brick-and-mortar retail is what about Amazon? Not to discount Amazon’s threat, but it is probably safe to say the Amazon threat level for a brick-and-mortar grocer in New York is higher than that of a brick-and-mortar grocer in Oahu, Hawaii. Geography plays a big part in this: Amazon optimizes operations for macro efficiencies while local names optimize for micro efficiencies. Frankly, San-A dominates at the micro level. That said, the company is not likely ignoring the Amazon threat altogether.

To be clear, malls in Japan are struggling to remain relevant, too. In fact, 7-Eleven’s convenience growth story is rendered mediocre because of its struggling mall operations. As the big national mall operators reactively look to food strategies in order to survive, San-A has already established franchise agreements with restaurants, drug stores, appliance stores and others.

Essentially, San-A signs franchise agreements then opens stores in its own malls. It is better integrated compared to the big operators like Seven & i Holdings, Aeon Malls (TSE:8905) and others. This integration, at least in theory, allows San-A to capture larger margins. Perhaps more importantly, this gives the company a greater degree of control over floorspace and tenant mix. Of course, none of this eliminates the threat of Amazon. If risk were quantifiable, however, San-A’s risk profile would look healthier than national operators in larger, mainland Japan markets.

Financials, valuation and comments

There is a lot to like about San-A financials. Sure, the industry-leading business performance is nice, but the company delivers this with very little debt:

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Here are some of the business performance metrics I have been raving about:

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San-A has delivered remarkably consistent revenue growth while maintaining gross margins:

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This is not to say San-A is immune to the threats of Amazon or the macro population decline of Japan. However, the company is clearly less sensitive to these threats compared to many of its mainland Japan peers.

EV/EBIT today is around 7.5 times, which is actually on the high end for San-A. This figure floated around three times back in 2012 and averaged at around six times over the past 10 years. The recent increase in EV/EBIT levels is primarily a function of market cap increase.

I have to admit, I think part of the seemingly low valuation (despite impressive business performance) is partly because most Japanese people have never heard of San-A. I am only familiar with the company because they are headquartered in Ginowan City, Okinawa, which is my hometown.

Personally, I do not invest in retail. That said, at three times EV/EBIT (as seen in 2012), San-A would be mouthwatering. With a current dividend yield of less than 1% and the strong but limited regional moat, I do not know if San-A is a particularly compelling investment at today’s prices. However, you can bet I will produce an update if things start looking more interesting from an investment perspective.

Disclosure: I don't own any shares in companies mentioned in this article.

About the author:

Clayton Young
I grew up in Japan and completed an MBA in the U.S., but learned more from reading Howard Marks. I apply an American value investing approach to Japanese companies that are often inscrutable to outsiders who lack fluency in the unique cultural context.

Visit Clayton Young's Website


Rating: 5.0/5 (9 votes)

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Comments

bigzoo
Bigzoo - 1 month ago    Report SPAM

just wondering ... what would be your investment thesis for this company? ... if I get it right growth is not smtg one should expect from this company (no geog expansion, population decrease), dividend is quite low. I understand it is a popular tourist place, so what happnes when the economy is down (travelling is one of the firsts that people cut down)? I understand that it is a great company as is but why would you invest in it? thanks and thumbs up.

cyoung1989
Cyoung1989 premium member - 1 month ago

Hi Bigzoo,

Thanks for the comment and question!

Just to clarify, I would not invest in San-A at the current price. While the macro will probably eventually see a population decline, San-A is still one of the top 5 companies on Okinawa that control distribution. In the article, I mentioned Lawson stores being operated by San-A. They also operate Matsumoto Kiyoshi drug stores (Japan's largest chain) since 2006, Edion appliance/electronics stores (top 3 chain), MUJI stores (2013), and a bunch of food chains. In other words, they leverage their distribution network into other verticals. Started with grocery, built malls, and now operates drug stores, restaurants, convenience stores, specialty retail, etc. While growth would be harder to come across with scaled verticals (grocery, mall, convenience), there is still a long runway in other verticals (food, drug store, specialty retail).

As for the dividend, it's partly a function of price. If I remember correctly, they were yielding something like 1.5% back in 2012.

Again, I would not invest in San-A at current prices. I hope this helped! :)

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