Poking The Convenience Giants – Welcia Holdings (TYO: 3141)

Thinking Points

  • Major drug store operator Welcia (TYO: 3141)  is becoming Japan’s neighborhood pharmacy.
  • In doing so, the company directly competes with the convenience industry.
  • Welcia maintains a strong position against the giants in convenience, thanks to Aeon’s (TYO: 8267) backing.
  • With its 18x EV/EBIT price tag and many moving parts, Welcia does not present a compelling investment opportunity.
  • Investors ought to look at pharmacy and drug store related industries for opportunities.

This article is a continuation of my recent Japanese drug store and pharmacy coverage. The coverage started with an overview of the convenience, drug store, and pharmacy industries in Drug Stores Inconveniencing 7-Eleven. This was followed by an article about Cosmos Pharmaceuticals (TYO: 3349). Today’s article will be about Welcia Holdings (TYO: 3141), one of the leading drug store operators in Japan.

Introduction

Welcia’s roots can be traced back to a 1997 merger between two companies, then a subsequent partnership with Aeon Group (TYO: 8267) in 2000. Since then, the company has merged, acquired, and started over 10 companies, which were mostly small or mid size drug store operators. Today, Welcia is Japan’s second largest drug store operator by store count.

Even as Japan’s second largest drug store operator, Welcia only operates a little over 1,500 stores. In comparison, the second largest Japanese convenience chain operator, UNY Family Mart (TYO: 8028), operates nearly 18,000 stores. Despite its considerably smaller scale, Welcia is taking the fight to the big convenience chains.

“We will start offering products commonly available at convenience stores”

– Takamitsu Ikeno, Welcia Chairman

At first glance, it looks like Welcia doesn’t stand a chance against the convenience giants. OTC drug regulation is loosening up and convenience chains are fully scaled, loaded, and looking for new business. That said, Welcia’s business strategy combined with its Aeon Group affiliation (50.54% stake in Welcia) puts the company in a position of strength.

Business Strategy

There are several key interrelated points to Welcia’s business strategy, which can be summarized as:

  1. Neighborhood pharmacy focus
  2. Convenience race
  3. Food

In the article Drug Stores Inconveniencing 7-Eleven, I presented the top 5 drug store operators as well as the top 5 pharmacy operators. Welcia is the second largest drug store operator and the largest pharmacy operator among drug store operators. In fact, Welcia would take the #6 spot even as a pure pharmacy operator. Nearly 70% of its drug stores can fill prescriptions. The company plans to take that figure up to 85% by 2020.

The convergence of the convenience, drug store, and pharmacy industries in Japan isn’t a coincidence. In order to better support its aging population, the Japanese government wants to build a network of neighborhood pharmacies. A big part of this support system involves the “family pharmacist”; a local pharmacist familiar with the patient’s situation, one phone call away.

Of course, a neighborhood pharmacy network focused on the family pharmacist is practically useless if it isn’t available in the middle of the night for an emergency. Hence, Welcia is expanding its network of 24 hour stores, which comes at a cost. In this context, Welcia going head to head with convenience stores (most of which operate 24 hours), isn’t such a surprise. Pharmacists are expensive. If you’re going to keep one at the store overnight anyway, you might as well give consumers other reasons to visit the pharmacy – like food, ATM machines, and shipping services.

To be sure, competing with fully scaled convenience chains is not a walk in the park. If Welcia was alone in this endeavor with its 1,500 stores pursuing the path it is currently taking, the company has no chance. The convenience stores would flood into the OTC drug and prescription market before Welcia can build a competitive offering that supports Japan’s aging population. In this sense, Welcia is most interesting because of its close ties to Aeon, one of the largest retailers in Japan.

Summarily, Welcia is positioning itself as Japan’s neighborhood pharmacy. In doing so, the company directly competes with convenience chains, diving deeper into the food category along the way.

Where is Welcia headed?

Welcia is Aeon’s chosen child, leading the charge for industry consolidation. The company is already a melting pot of Aeon-related drug stores and pharmacies, along with several smaller players. The melting pot briefly gave Welcia the #1 spot in the drug store industry in 2016. Then Tsuruha (TYO: 3391) acquired Kyorindo, a smaller drug store operator, taking the #1 spot away from Welcia.

Interestingly, Aeon Group owns 12.9% of Tsuruha. They also own 25% of Medical Ikkou (TYO: 3353), a mid tier (~100 stores) pharmacy operator. And then there is Ministop (TYO: 9946), a mostly forgotten, barely profitable #4 convenience store operator with about 2,300 stores in Japan. Aeon holds a 47% stake in Ministop.

I’m not suggesting that all Aeon related companies will start merging, but it’s also hard to ignore. Not only do Medical Ikkou, Tsuruha, and Welcia all have ties to Aeon Group, they’ve all got each other’s people as board members. Perhaps this is Aeon’s emergence in the convenience industry. Consolidating its drug store affiliates presents a real chance at establishing dominance in the drug store & pharmacy industries while playing catch up in convenience.

Financials, business performance, and valuation

I will keep this section brief. Most of the charts are recycled from my last article about Cosmos Pharmaceuticals.

Welcia maintains industry leading gross margins with industry lagging operating margins:

With the number of mergers, acquisitions, and new businesses Welcia takes on, it’s hard to be surprised about the company’s high gross margin, low operating margin combo. If I had to guess, management has probably spent a significant amount of energy integrating operations in the past decade. With that said, operating margins have steadily improved over the past couple years and TTM operating margin is a hair above 4%. Perhaps the company is benefiting from its increased scale. Going forward, however, I don’t expect to see any significant improvement in operating margins as Welcia expands its 24 hour store network (currently less than 100 stores).

Business performance isn’t absolutely terrible, but leaves a lot to be desired.

Interestingly, Welcia trades at high multiples on a EV/EBIT and P/E basis compared to its peers.

Takeaways

Welcia’s story is exciting and fun to follow, especially with Aeon Group’s involvement. That said, I’m not entirely sure where Welcia stands on the quality spectrum. If I had to choose between following Cosmos and Welcia, I’d choose Cosmos. Welcia’s many moving parts and 18x EV/EBIT price tag is something I can’t get comfortable with. Cosmos’ every day low price, dominant, no M&A strategy is more understandable to me.

If there is one big takeaway here, it’s that Japanese drug stores and pharmacies are growing. With its aging population, Japan shows no signs of slowing down with drugs and prescriptions either. To be sure, the growth story is well known and reflected in the price of just about every drug store and pharmacy related company I’ve looked at. The lowest EV/EBIT I’ve seen thus far is 9x for Cocokara Fine (TYO: 3098). With that said, I’ve seen a few interesting companies with attractive price points in industries closely related to Japan’s drug stores and pharmacies.

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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!

2 thoughts on “Poking The Convenience Giants – Welcia Holdings (TYO: 3141)”

  1. Clay,

    What do you know about customer behavior in this space and how it relates to Welcia/Aeon’s strategy? How is their move into these competing spaces creating value rather than diluting it? Who has ever successfully fought a two front (or three front) war? Etc.

    Yes, there are precedents in the US with Wal-Mart, Costco, etc. entering the prescription drug space. So I am not saying it can’t be done. But I would love to better understand how you rate the strategy here. Do they have one? What is it? Why would it create value compared to what competitors are doing and what customers want?

    1. Hey Lion,

      Thanks for the comment and questions!

      Welcia/Aeon’s strategy bets on the Japanese government’s family/neighborhood pharmacy push to work (more specifically for prescription business). For prescriptions, most people get them filled at pharmacies attached to hospitals.

      The position of convenience stores vs. drug stores vs. pharmacies in Japan is broadly this:
      1. Convenience stores are a place you go to to grab a quick meal, cigarettes, coffee, pay bills, etc. Many people have a habit of walking into a nearby convenience store on a daily basis (on the way to work, school, etc).
      2. Drug stores are a place you go to for pain killers, cold medicine, cosmetics, etc. It’s not part of the Japanese daily routine.
      3. Pharmacies are a place you go to when the doctor writes you a prescription. Also not part of the daily routine.

      With this context, I think Welcia/Aeon’s move into the competing convenience space makes sense. The push for neighborhood/family pharmacist favors 24 hour stores and being one call away. If Welcia keeps its old product offering (cosmetics, OTC drugs, prescription mainly) and simply extends its store hours (which would mean having a pharmacist on duty overnight), it’s likely to reduce operating margins. Since Welcia will have the stores and operate 24 hours anyway, they might as well give customers other reasons to stop and buy something – like products typically offered at convenience stores. An expanded product offering ought to slowly change Welcia’s position from that place you go when you have the sniffles to a daily routine similar to convenience stores. As for value creation, that’s a tough one. I presume graveyard hours would come with a financial loss, but creates customer loyalty. We’d have to weigh that against the benefits of Welcia’s positioning as a daily destination and how that translates into income.

      Though I think Welcia has a sensible strategy, I personally prefer Cosmos Pharmaceutical’s every day low price strategy. Not so much because I think Cosmos’ strategy is more sensible than Welcia’s, but because it is sensible and has a solid track record. In comparison, Welcia’s approach is sensible, but doesn’t have a track record.

      Anyway, I’m sure I didn’t answer all of your questions, but those are my thoughts for now!

      Thanks 🙂
      Clay

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