20% EBIT CAGR With A Walmart Twist – TYO: 3349 Cosmos Pharmaceuticals

Thinking Points

  • Cosmos Pharmaceuticals (TYO: 3349) operates drug stores with a Walmart and 7-Eleven-like strategy, delivering industry leading growth (20% 10 year EBIT CAGR) over the past decade.
  • The company’s larger than normal stores target small areas and resembles a neighborhood supermarket.
  • At 18x EV/EBIT, Cosmos is a high quality business trading at an even higher price.

Heads up!

First, I’d like to start with a warning: This article is about Cosmos Pharmaceuticals (TYO: 3349), a Japanese drug store operator which trades at 18x EV/EBIT. If you’re looking for an immediately actionable investment opportunity, Cosmos is probably not what you are looking for. That said, I find the company interesting, so I decided to read and write about it 🙂

Overview

My previous article, Drug Stores Inconveniencing 7-Eleven, broadly covered the drug store, pharmacy, and convenience store industries in Japan. Cosmos is a top 5 player in the drug store industry. There are two main things I found interesting about Cosmos:

  1. Food focus.
  2.  Walmart-like strategy

For starters, over half of Cosmos revenues comes from food, which is in direct competition with the convenience store industry. If you’ve been reading Kenkyo for a while, you’ve probably noticed that I tend to favor strategies that built Walmart and 7-Eleven; namely Walmart’s every day low price and 7-Eleven’s food-focus/dominant strategies. Anyway, I’ll be digging a little bit into Cosmos’ business strategy, financials, and price today.

Business Strategy

Cosmos is an oddball. The company targets small market areas, with each store targeting roughly 10,000 people. This doesn’t mean that Cosmos won’t go into larger markets, just that Cosmos is focused on micro-dominance. Additionally, Cosmos is committed to an every day low price strategy, which extends beyond over-the-counter (OTC) drugs.

What’s most interesting about the company is its disproportionate food sales. Over half of Cosmos sales comes from food. This is bizarre, considering Cosmos identifies itself as a drug store chain. In comparison, drug store competitors Matsumoto Kiyoshi (TYO: 3088) generates about 10% and Welcia (TYO: 3141) about 20% of total sales from food.

Cosmos’ disproportionate food sales isn’t a coincidence either. To state the obvious, a drug store is a place you go to when you need drugs. Most people don’t need drugs every day. Hence, consumers typically do not make daily visits to the drug store. Cosmos, however, established itself as a daily destination for its customers through food; a position similar to convenience stores and supermarkets in Japan.

With its larger than normal drug stores, Cosmos resembles a neighborhood supermarket. The main difference, other than selling OTC drugs, is that Cosmos does not handle high maintenance perishables like raw meat, fish, and vegetables.

The company has no point card program, limited time sales campaigns, or daily discount deals. This is in accordance to its hyper focus on cost. The company’s strategy page mentions offering same products at lower prices and same prices for higher quality products; a true every day low price strategy. The hyper focus on cost can be observed through the financials too.

Business performance, financials, and valuation

Let’s start with operating expenses:

** Welcia financials only go back 9 years.

Cosmos operating expenses as a percentage of revenues, in line with the company’s low cost strategy, is exceptionally low compared to its peers. However, that doesn’t paint the whole picture.

Cosmos has mostly been in the middle of the pack in terms of ROA. Taking a balanced approach, Sun and Cosmos seem to be in the same camp as far as cost control goes.

 

Gross margins for Cosmos are predictably low. I say “predictably” because of the company’s disproportionately large food sales and every day low price strategy.

Though the company does not report sales or margins by segment, it shows purchase cost and sales totals for each product category. Here is a summary table including estimated margins which I calculated:

 

Though it is likely that Cosmos revenues and earnings are stickier than its competitors due to the every day low price strategy, the company’s business performance has largely lagged compared to peers. Meanwhile, Sun delivers industry leading performance.

** 9 Year CAGR for Welcia

Unlike Welcia, which grew considerably through M&A, Cosmos has grown organically. As a side note, Cosmos is heavily concentrated in Western Japan and non existent in Eastern Japan. The company does not have any stores in Tokyo or the surrounding area, for example.

Capex as a percentage of revenues gives us a pretty good look into Cosmos’ growth. About 13 years ago, Cosmos ventured out of its home turf – Kyushu (far western region of Japan) – and aggressively expanded eastward.

Cosmos’ balance sheet isn’t spectacular. Equity to asset ratio is considerably lower than industry peers. That said, the balance sheet is slowly improving while Cosmos is aggressively growing. Given the company’s eminently lower cost of operations and aggressive growth, its relatively weak balance sheet is understandable.

Given Cosmos’ equity to asset ratio, it’s not particularly surprising that the company leads the pack with ROE.

Greenblatt ROIC paints a different picture. Compared to its peers, Cosmos lags significantly. That said, a 20% Greenblatt ROIC is still healthy. I would guess that low margin high volume food sales combined with the every day low price strategy probably influences this.

At today’s 18x EV/EBIT price tag, Cosmos is the most expensive among the top 5 drug store chains in Japan.

On a P/E basis, Cosmos traded on the high end of its peers in recent history, but now trades at similar levels as the industry’s top 5.

Again, an expensive looking chart for Cosmos.

Takeaways

In terms of price, I place the heaviest emphasis on EV/EBIT as it gives a wholesome picture with relatively little “wiggle room”. That is, it’s easier for companies to mess with P/E than it is EV/EBIT.

As a general pricing heuristic, I consider 8 – 10x EV/EBIT to be a fair price for well known, established, “blue chip” companies in Japan. Low-teen EV/EBIT may be understandable for a financially healthy firm with considerable growth expectations. In comparison, the top 5 drug chains trade at an average of 16.4x EV/EBIT today.

Perhaps the market is saying “Japan equals old people. Invest in drug stores”. While I have no doubt Japan will consume more drugs in the foreseeable future than it has in the past, it’s far more likely for new market entrants to serve an expanding drug consumer base rather than drug stores explosively growing. The recent relaxation of OTC drug regulation in Japan supports this.

With gradually relaxing OTC drug regulation and the drug store industry focusing on food, the dividing line between drug stores and convenience stores is less clear. This leads me to believe that the competitive environment for both drug store and convenience store industries are becoming increasingly difficult.

From a qualitative perspective, I think it’s fair to say that Cosmos’ revenues and margins are probably more sticky than its peers, mainly because of the every day low price strategy and unique positioning as a daily stop for consumers. I may have a different opinion as I spend more time reading and writing about the industry in the coming month or two.

In any case, it’s hard to see Cosmos’ growth prospects being worth 18x EV/EBIT. The relatively weak balance sheet should probably be a substitute for growth premium. In my book, Cosmos is a high quality company with an even higher price tag. I suggest putting Cosmos on a watchlist. As the company’s story develops, there may be hiccups that create investment opportunities.

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Author: Clayton Young

Hi! I’m Clayton. My value investing journey began in 2012 during my college days. It was not until recently (2016!) that I decided to leverage my Japanese language skills to research Japanese equities. I hope to provide valuable insight on Japanese companies to the English-speaking world through this blog!

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