Summary

San A is not currently a buy, but investors ought to follow share prices periodically for buying opportunities at 3,200 yen per share (vs. current 5,010 yen per share).
Strong regional moat provides San A with Japanese retail industry-leading business performance with ROE at 10.35% (10 Year Average: 9%).
Franchising opportunities likely to lead to continued earnings growth.

** NOTE: Post updated on 4/10/2017 with commentary on convenience store business which was not reflected accurately in the original post. Added commentary is clearly indicated in the post.

Tearsheet

Introduction

San A is primarily engaged in the retail business: providing groceries, clothing, restaurants, and home related products. Since its founding in 1949, the company has expanded its operation to include 66 retail locations (grocery stores, shopping strips, full-size malls), 191 convenience stores (under the “Lawson” brand), 15 franchised restaurants, and 1 hotel.

All of the company’s operations are located in Okinawa prefecture – the southernmost, secluded chain of islands in Japan. Here’s a map:

Source: Google Maps (illustration by me)

As a general strategy, San A management is focused on its existing retail locations – planting deep roots within the neighborhoods they operate in. The management team pursues slow growth and there has been no mention of expanding outside of Okinawa.

During the 02/2016 reporting period, San A posted 163.8 Billion yen in sales with an operating profit of 50.8 Billion yen (31% operating margin). Net income for the period was 8.7 Billion yen.

The largest revenue-driving segment for San A is the Grocery business (57.1% of 2016 revenues), followed by the Home-related business (28.9% of 2016 revenues). The two segments combined have accounted for 80+% of San A’s revenues for over 10 years.

Source: San A filings (chart generated by me)

** ADDED 4/10/2017:

In addition to the revenues above, San A has tenant income (mall space rental) and franchise income (convenience stores), which account for a significant part of San A’s operating income, but are not included in revenues.

** End of added section.

Operating Environment (Okinawa)

San A operates in Okinawa, the southernmost prefecture in Japan (full disclosure: I spent my childhood in Okinawa). Approximately 1.4 million people call Okinawa home. Major industries include: Tourism, Agriculture, Fishery, and Retail. Known for its beaches and subtropical climate, Okinawa is often called the Hawaii of Japan. In 2015, 7.9 million tourists visited Okinawa.

While Okinawa is technically a part of Japan, it has its own culture for several reasons. Here is a brief timeline of Okinawa’s historical possession:

Source: History – various sources

Somewhere between being annexed by Japan, experiencing the bloodiest battle in the Pacific during World War II, being secluded from mainland Japan, and hosting 60+% of US military forces in Japan, there is some disconnect between Okinawans and the mainland Japanese.

Okinawans tend to stick to Okinawan things. For example, Orion Breweries (headquartered in Okinawa) has a 1% market share in the Japanese beer market, but maintains a 50+% strong market share in Okinawa. Similarly, Okinawa Cellular (TYO: 9436) holds a 50+% Okinawa market share while NTT Docomo (TYO: 9437) is dominant in the rest of Japan (46% share). It is difficult to say whether there is a correlation between the “Okinawa brand” and Okinawans’ disconnect with mainland Japan.

Food For Thought

When western investors hear about the Japanese market, one of the first thoughts that come to mind would probably be the declining/aging population. Japan’s fertility rate is 1.45 (2.1 to sustain population). Okinawa happens to lead the fertility game in all of Japan at 1.96. This isn’t a coincidence either, Okinawa has been the leader for 42 years.

In fact, Okinawa is the only prefecture in Japan that is expected to have a population increase going into 2020, according to the National Institute of Population and Social Security Research (Japanese source). Combine this with the number of tourist visits and it’s no surprise that retail is big business in Okinawa.

It is no secret that Japan has a labor shortage. Frankly, Okinawa has plenty of available labor. Okinawa’s unemployment levels have been the highest in all of Japan for at least the past decade. It is difficult to say whether companies would be more inclined to open operations in Okinawa as the labor shortage worsens on the mainland. The alternative would be Okinawans moving to Japan, which has never really been the case.

Other related measures that Okinawa is #1 in:

Highest divorce rate.
Lowest standardized test scores.
Lowest income level.

While anecdotal, I have seen an increasing number of foreign workers (even in Okinawa) in my last few visits to Japan (most recent being January of 2017). Foreign workers seem to occupy jobs in retail (like convenience stores and restaurants). Most of them speak decent Japanese with the occasional miscommunication.

Mainland Japan’s Market Entrance

It is fairly common for Mainland Japanese companies to partner with local Okinawan businesses in order to gain market share in Okinawa. A prime example is the convenience store industry in Okinawa.

Prior to Family Mart’s (TYO: 8028) merger with Circle K Sunkus (TYO: 3337), the Japanese convenience store industry was dominated by 7-Eleven (TYO: 3382):

Source: Livedoor News (Japanese Source)

7-Eleven is still the largest convenience store chain in Japan. They have stores in all 47 of Japan’s prefectures, except Okinawa. Interestingly, 7-Eleven has plans to make a dramatic entrance into the Okinawan market by setting up 300 stores in 2018. As a reference, Okinawa’s current total store count is 509 stores.

The number one convenience chain in Okinawa is Family Mart with 318 stores, followed by Lawson with 191 stores. All 3 have Okinawan partners:

Source: Various sources

With distinct differences in culture and taste, partnerships are almost a necessity for mainland Japanese companies to gain traction in Okinawa.

Competitive Landscape

For the purpose of evaluating San A, it is safe to say that analyzing Japan’s retail environment as a whole is rather unhelpful. We will primarily keep the discussion in this section centered around retailers with a presence in Okinawa – and more specifically, retailers engaged in the Grocery and Home-related businesses as well as mall/shopping center operators.

Grocery

Here are the key competitors in Okinawa’s grocery business:

Source: Various sources

Most of these grocery stores are standalone grocery stores. However, Ryubo tends to have various tenants in a small shopping strip (fast food chains, coffee shops, etc). Many of the San A grocery stores are located within shopping centers and malls (the 22 stores listed above). Apart from Union and MaxValu’s 24 hour operation and Co-op’s neighborhood delivery, it is difficult to say who has any particular advantage other than being the familiar grocery store in the neighborhood.

MaxValu has been the exception to the rule when it comes to setting up local partnerships in Okinawa. MaxValu’s parent company, AEON (TYO: 8267), has established its grocery and shopping mall presence in Okinawa without local partnerships. Fun fact: AEON owns the largest mall in Okinawa (Aeonmall Rycom).

Home-Related

Here are the key competitors in Okinawa’s home-related business:

Source: Various sources

By home-related, we are mostly talking about home appliances and electronics. Among Okinawans, Best Denki has been the longest standing, most familiar home-related store.

Though EDON has had some trouble with the law in the past, it is still the 3rd largest home appliance retailer in Japan (after a merger of 5 smaller retailers). EDON has partnered with San A, and San A actually operates all of the EDON stores in Okinawa.

Yamada Denki is the largest home appliance and electronics chain in all of Japan (about double the size of EDON in terms of sales). They also have a controlling interest in Best Denki (52% ownership).

Malls/Shopping Centers

Source: Various sources

San A is the sole leader when it comes to Malls and Shopping Centers in Okinawa. According to Japan Council of Shopping Centers there are 38 shopping centers & malls in Okinawa (Japanese source), so the above 3 companies cover roughly 90% of the Okinawan market.

** ADDED 4/10/2017:

Convenience Store

In 2009, San A became Lawson’s Okinawa partner, which spelled the birth of Lawson Okinawa. San A owns 51% and Lawson owns 49% of Lawson Okinawa. In total, there are 191 Lawson stores in Okinawa, 2 are directly operated by San A and 189 are franchised.

The Revenue Distribution by Segment chart in the Introduction shows that the convenience store business accounts for less than 1% of San A revenues. However, this is not entirely true since only the two San A operated store revenues are included. The remaining 189 stores contribute to San A’s income statement through a line item called “Franchise Income”:

Source: My compilation of San A filings

Historically, Family Mart had been the dominant convenience store in Okinawa – mostly because they were the first to dive into a regional franchising strategy in Okinawa. However, Lawson Okinawa has steadily improved performance since partnering with San A.

While the improved performance at Lawson Okinawa is admirable, competitive pressure in Okinawa is expected to increase with 7-Eleven’s planned 300-store entrance. It is probably best to consider this a no-growth area for San A, just to remain conservative.

** End of added section.

General Comments

As a tourist destination and one of the very few Japanese prefectures with an increasing population, Okinawa will likely gain more corporate attention in the coming years. This is probably both good and bad for San A, as competition from peers would increase while the consumer base expands.

San A’s Business Strategy

Historical Strategy

San A’s birthplace is a remote island called Miyako-jima (yes, even more remote than the main island of Okinawa):

Source: Google Maps

Miyako-jima has about a 60 square mile area with approximately 55,000 people.

Small Money Problems

San A’s entrance into mainland Okinawa happened in 1970, back when Okinawa was still US territory. At this time, there were several powerhouses like Mitsukoshi (mainland Japanese) and Ryubo (Okinawan) primarily concentrated in Naha, the capital of Okinawa.

According to journalist Fumiaki Hikita, who interviewed San A founder Kisaku Orita, San A’s mainland Okinawa entrance was inspired by the Viet Cong’s war strategy during the Vietnam War. The Viet Cong leveraged their knowledge of local geography to execute a guerilla warfare strategy against a resource-rich US military. This proved effective for the Viet Cong, which did not have nearly as many resources available.

Similarly, San A did not have the resources that the powerhouses had, so they fought with local knowledge. Interestingly, this translated into a Wal-Mart-like, small town strategy: San A started opening neighborhood supermarkets outside of the Okinawan capital where powerhouses would never bother to look. San A has played the local knowledge game since and is focused on being extra sensitive to customer needs. San A’s V21 grocery chain catch phrase is pretty much in line with their guerilla, locally-focused tactic: “Our customer’s refrigerator”.

More Money, More Problems

As the company evolved, so did its problems. Much like the US, private label brands started popping up in Japan around the 1960s and increasingly gained traction in the 1980s. For the most part, private label brands were born as a result of giant retailers looking for ways to offer lower cost goods to consumers while maintaining margins. This meant displacing national brands while offering private label products to take its place.

At this point (1980s), San A was an established mid-tier retailer. That said, San A had nowhere near the purchasing power or resources that the corporate giants had. That meant no internally developed private label brands, which meant no lower priced goods to offer next to national brands. Instead of fighting a losing battle against the corporate giants, San A decided to join the Nichiryu Group (1989).

The Nichiryu Group is a result of many mid-tier retailers facing the same problems that San A faced: lack of purchasing power. Basically, many of the mid-tier retailers got together in order to take advantage of large volume orders, and they also developed private label products (“Kurashimoa” brand).

Today’s Strategy

Today, San A pursues a variant of a strategy called the “Dominant strategy”, which was made famous by 7-Eleven Japan. The basic idea of this strategy is to open multiple stores in a concentrated area to drive efficiency in construction, management, logistics, purchasing, and product localization.

San A’s version of the dominant strategy places their “V21” grocery stores close to one another. Often times, when San A decides to build a major mall, they also start building their V21 grocery chains in nearby neighborhoods. One truck often delivers products to multiple stores before returning to the distribution center. Furthermore, this allows San A to deploy inventory 5 times a day to all of their stores. This enables San A to maintain lower prices while avoiding stockouts.

Source: Nichiryu Website (Japanese Source)

The secluded nature of Okinawa benefits San A. While corporate giants in mainland Japan are still able to drive down product purchase prices based on volume, the story changes when the products need to be shipped to and distributed in Okinawa. In many cases, distribution networks of corporate giants are optimized for national distribution, which often creates inefficiencies by the time Okinawa gets into the picture. In this sense, San A has a geographical moat that comes from having a locally scaled store network with established distribution routes.

My (Assumed) San A Strategy

Aside from the grocery business, San A has been quietly working on its franchised restaurant operations. A little under 5% of 02/2016 revenues came from restaurant operations. However, this segment also provides the highest gross margin percentage among all of San A’s operation:

Source: Filings

Note: These are gross margin percentage “estimates” because San A reports cost of purchased goods (vs. cost of goods sold) in their annual filings.

Here is what gross margin by segment for 02/2016 looks like:

Source: Filings

** ADDED 4/10/2017:

Similar to the Revenue Distribution by Segment chart in the Introduction, the Gross Margin distribution chart above does not include tenant or franchise income.

** End of added section.

San A explicitly mentions that they are focused on improving current operations. As far as their grocery operations goes, they have grocery stores at every location. This makes sense because San A built their whole business around groceries (and clothing). However, the malls and shopping centers have plenty of room for franchised restaurants (which is where most of San A’s restaurants are located). Expansion of franchised restaurant operations would be a good way to leverage San A’s existing infrastructure (distribution centers, logistics lanes, malls/shopping centers, etc) without deploying too much capital. With only 15 restaurants currently operating, this is a healthy opportunity set.

Business Performance & Financials

Source: Filings

There is nothing explosive about San A’s financials, just plain, boring, and predictable. San A’s website briefly talks about their focus on slow growth. That’s exactly what San A has been experiencing. Frankly, San A has one of the healthiest balance sheets with the highest returns in its peer group (other shopping center and mall operators).

Source: Filings

ROE has floated around 9% over the past 10 years with very little variance (+/- 2%). ROIC has remained in line with ROE since San A has never had a significant amount of debt. For a Japanese company, this is very healthy. In fact, ex-cash ROE has improved from 13.5% 10 years ago to 17.3% today (San A is sitting on 46 Billion yen of cash now vs 10 B yen of cash 10 years ago).

Source: Filings

San A posted a one-time gain of 432 M yen in 2012 after modifying their retirement program, which explains most of the net income dip in 2013. Otherwise, San A has mostly seen a stable increase in net income over the past 10 years.

Valuation

Source: Filings

The Japanese market has performed fairly well over the past 5 years. On a historical basis, San A appears a bit expensive. That said, San A has consistently delivered top-line growth while maintaining gross margins.

Despite San A’s consistent performance, the stock has traded below book for several years following 2009. This is in line with the Nikkei 225, which saw a drop similar to the S&P 500 around 2008.

Peer Comparison:

Source: Financial Times (Date retrieved: 4/6/2017)

The peer comparison chart above is a comparison of regional shopping center retailers. As far as business performance goes, San A leads the group with a 10.35% ROE. It is important to note here that San A leads the pack with the lowest debt/equity ratio.

While it is clear that San A has a unique regional moat to its business model, it’s hard to ignore the recent P/E and P/B ratio expansion. For the purpose of being conservative, it is appropriate to use 10 year averages as reference points:

Here is a back-of-the-napkin approach to valuing San A:

P/E Approach:

8.7 B yen (2016 earnings) * 12 (10 Year Average P/E) = 104 B Yen

P/B Approach:

94 B yen (2016 Book Value) * 1.1 (10 Year Average P/B) = 103 B Yen

Current Market Capitalization for San A is 166 B Yen. The valuation above has been reached as recently as 2015 (lowest market capitalization in 2015 was 89 B Yen). Even in 2016, market cap has fluctuated by 75 B Yen, so it would not be the biggest surprise on the planet if San A’s market cap came back down to 100 B Yen.

Even at the current price, San A wouldn’t be the riskiest place to put your money, especially with 46 B Yen in cash on the balance sheet (Ref. total liabilities = 30 B Yen).

Conclusion

Given the historical volatility in San A’s share price, it is best to wait until the price is right to initiate a position (appx. 3,200 yen per share vs. current 5,010 yen per share). That said, San A has the combination of a strong regional moat and consistent, industry-leading business performance. San A belongs in your “Wait until the price is right” portfolio (if you don’t have one, make one).