Thinking Points

  • CVS Bay Area (TSE: 2687) historically operated convenience stores, but is now transitioning its core business to hotel operations as competition intensifies.
  • The transition is going slower than expected with its Tokyo capsule hotels, but there are interesting developments in the pipeline with the company’s heavy hotel and land investment in Ichikawa City (Chiba prefecture), right by Tokyo Bay.
  • Though an optimistic scenario presents attractive opportunities, the Ichikawa City project not materializing can put the company in a bind.
  • Investors familiar with Tokyo Bay area real estate may want to take a closer look, but it’s probably best for other investors to pass up on CVS Bay Area at today’s 753 yen per share price.

Introduction

CVS Bay Area (TSE: 2687) operates through five segments: Convenience store, condo front desk services, hotel operations, cleaning services, and other. Until recently, the convenience store segment was a core part of company operations. Amidst an increasingly competitive convenience industry, CVS Bay Area started shifting its focus to hotel operations in 2009. In March 2018, the company sold most of its convenience stores.

Although CVS Bay Area shows up on the Small Cap Japan Magic Formula shortlist, this is by mistake. Perhaps a Japan-specific peculiarity, but some financial data sources include one-time gains/losses for Japanese companies in EBIT calculations, thereby affecting the Magic Formula’s earnings yield and return on capital calculations. In CVS Bay Area’s case, the proceeds from the sale of the company’s convenience business was included in trailing-twelve-month EBIT, considerably inflating both earnings yield and return on capital.

While the miscalculation is mildly disappointing, the company is transitioning its core business from convenience store operations to hotel operations, making the company more interesting.

 

The business & environment

CVS Bay Area got its start in 1981, operating 7-Eleven franchises in the Tokyo Bay area (Chiba & Tokyo). In search for a franchisor that allows more leeway, the company converted its stores to the Sankus franchise. By 2002, the company had 100 convenience stores (including sub franchises). Then in 2012, when the Sankus franchise agreement expired, the company converted to the Lawson franchise.

Until March 2018, CVS Bay Area directly operated 99 Lawson (TSE: 2651) franchise convenience stores while managing 5 stores as an area franchisor. 91 of the 99 directly operated stores were sold to a wholly owned subsidiary of Lawson, and the 5 sub franchisees signed a new and separate franchise contract with Lawson directly.

Over the last decade or so, CVS Bay Area’s filings made note of the increasingly competitive convenience environment. The big 3 chains – 7-Eleven, Family Mart, and Lawson – increasing its presence in the Tokyo and surrounding areas, making it difficult for CVS Bay Area to find new and affordable locations with good business prospects.

After looking at the last ten years of business performance (or the lack of it), the recent sale of the convenience business to Lawson only looks like a struggling business finding a way out. That said, there are several factors that lead me to believe that the management team at CVS Bay Area is resourceful and battle-tested.

 

Counterintuitive, but sensible

Earlier, I mentioned CVS Bay Area switched away from 7-Eleven in search for a franchisor with more leeway. What CVS management did was ahead of its time. A 2006 Bridge Salon report (Japanese) highlights this.

CVS Bay Area took convenience one step further from early on by tailoring each store’s offering to its surroundings. One such example is the former Sankus store at Shinagawa Pier, opened in 1998, where only two people actually resided. While typically not a location convenience chains would scope out, CVS Bay Area did, targeting the 5,000 or so workers in the area during the work day and all the truck drivers coming in and out.

At some of the other stores with heavy truck traffic, the company offered sashimi (raw fish sliced thin, a Japanese delicacy) during peak hours, pulling in truck drivers. CVS Bay Area also introduced dry cleaning/laundry services and 1,000 yen ($8.8 USD) haircut services in 2000 – ahead of the big chains.

Another thing the 2006 report highlighted was the company’s push for expanding its condo laundry agency business. In some ways, the company was already growing out of the traditional convenience store model. Now board chairman Yutaka Izumisawa envisioned an aging Japanese society increasingly needing products and services delivered, leading him to venture into condo front desk services, cleaning and laundry services, and more.

According to the fiscal 2018 filings, CVS Bay Area’s average daily revenue per store (a common metric in convenience industry) was 543,000 yen ($4,760 USD) for directly operated stores and 586,000 yen ($5,137 USD) for franchisees. This is slightly higher than Lawson’s average daily revenue per store of 536,000 yen ($4,699 USD), but still considerably lower than 7-Eleven Japan’s 653,000 yen ($5,724 USD).

 

Moving forward

During Q1 2019, CVS Bay Area sold off most of its convenience business as well as some of its land. The company recorded one time gains of 3,540 million yen ($31 million USD) for the sale of its convenience business and 2,665 million yen ($23.4 million USD) for the sale of its land.

Since 2009, CVS Bay Area started hotel operations, slowly shifting away from the convenience store business. In 2015, this operation took a drastic shift, introducing three high-end economical “smart hotels”.

While generally unknown in the west, there are many “capsule hotels” in Japan. This is literally a bed space smaller than your closet, and it looks like this:

Source: Oyster.com

 

As you might imagine, staying in one of these is often considerably more affordable than booking an apartment-type hotel room. Generally, however, these capsule hotels have been considered cheap and dirty.

CVS Bay Area opened 3 capsule hotels in 2015 and then another 3 in 2016, except with a “high end” modern Japanese theme:

Source: Tokyo Ginza Bay Hotel

 

Today, the company operates 9 hotels, 6 of which are capsule hotels (or “smart” hotels as the company calls it) in Tokyo, and three more traditional apartment-type/business hotels in Chiba prefecture. One of the smart hotels is exclusively for women.

So far, it’s still difficult to gauge hotel business performance as key metrics like occupancy rates are not yet published.

 

What the new CVS Bay Area looks like

CVS Bay Area is shifting its core operations from convenience stores to hotels, but it also offers condo front desk, cleaning, and other services. Here’s how each segment performed historically:

 

As a part of selling most of the convenience business, the plan was to move 160 of CVS Bay Area’s 230 or so employees to Lawson (Japanese). The portion of the convenience business that was sold generated the following revenues and gross profits during fiscal 2018 (in millions of JPY):

Source: Fiscal 2018 company filings

 

In the first half of fiscal 2019, corporate adjustment actually went up compared to the same time period in fiscal 2018:

Fiscal 2018 H1:

 

Fiscal 2019 H1:

 

Assuming all segment performance remains relatively strong, it appears CVS Bay Area may break even for the full year. Management is projecting 72 million yen ($630K USD) in operating income. As a reference, interest expense ought to come in around 40 million yen ($350K USD).

 

Shareholders

As of Q2 2019 short form filings (quarter ending August 31, 2018), CVS Bay Area had 5,064,000 shares issued and 127,730 shares in treasury, leaving outstanding shares at 4,936,270.

Here are the top 10 shareholders:

Source: Nikkei and company filings

 

Board chairman Yutaka Izumisawa founded Yuneisia in 1973 and has been CEO since. Presumably, this is a family fund.

More importantly, Yutaka reported an off-market transaction recently (Japanese), selling off 120,000 shares at 749 yen per share on October 17, 2018. The shareholder chart above does not reflect this. The transaction reduces Yutaka’s stake down to 14.7% of outstanding shares. Collectively, the Izumisawa family owned 51.7% of outstanding shares before the transaction and 49.3% after. However, there is a possibility of other family members not on the major shareholder list giving the family a controlling stake. There was no explanation provided for the sale.

Setsuko Izumisawa is Yutaka’s wife. Current CEO Tomihiko Kamiyama (owns 28,100 shares) is Setsuko’s younger brother. Mario Izumisawa is Yutaka’s eldest son.

 

Financials & Valuation

  • Though CVS Bay Area appears high up on the Magic Formula stock list, this is due to a peculiarity/mistake.
  • With that said, the company is still interesting, being in the middle of a core business transition from convenience store operations to hotel operations.
  • CVS Bay Area has done a good job at keeping its convenience stores profitable, but the industry consolidation and increasingly competitive environment has resulted in reduced profitability and management’s decision to sell most of the segment.
  • The convenience business sale is a done deal, but hotel operations (more specifically, capsule hotels) has taken longer than expected to reach profitability. The company overall is currently right around break-even operationally.
  • An optimistic scenario in the company’s Ichikawa City investment presents attractive returns, but the downside scenario puts the company in a bind. Investing in CVS Bay Area is a bet on management’s eye for Tokyo Bay real estate.

First things first, special situations and event-driven investors should be the only ones considering CVS Bay Area as an investment. Using management guidance and 2019 Q2 financials, adjusted EV/EBIT is at 18x with an equity-asset ratio of 0.4. But this metric doesn’t matter for a company going through a core business transition with no “normalized” earnings.

 

Recent Asset Purchase

Here is the breakdown of fixed assets from the fiscal 2018 filings:

Source: Fiscal 2018 filings (translated by author)

 

Breakdowns aren’t included in quarterly filings. Since the above information was filed, two things have happened: Building and opening of one new capsule hotel and partial sale of land (where CVS Bay Hotel – Main & New buildings sit).

Here is the breakdown of fixed assets from fiscal 2017:

Source: Fiscal 2017 filings (translated by author)

 

During fiscal 2018, the company wrote off a considerable portion of its capsule hotel assets as some of them were generating operating losses:

Toward the end of 2016, the company announced its planned purchase of the land that its apartment-type hotel sits on (Japanese). Then, the company put 20% of the 1,917 million yen ($16.8 million USD) purchase price down in April 2017. In December 2017, the company paid off the remaining balance with a loan (Japanese). CVS Bay Area paid 1,917 million yen ($16.8 million USD) for 11,172 sqm of land, or about 171,600 yen ($1,507 USD) per square meter.

Then in March 2018, the company announced the sale of a portion of the land it just bought, resulting in the 2,665 million yen ($23.4 million USD) in one time gains mentioned earlier. As you can see from the asset breakdowns, CVS Bay Area not only recorded gains on the sale, but also retained some of the land and reduced rent payment considerably (~60%) as a result. No details were released as to how much of the land was sold, and the asset breakdown above does not cover all land assets that CVS Bay Area owns. Q2/H1 filings show 4,844 million yen ($42.5 million USD) of cash flow from the sale of investment real estate.

As a result of the sale, CVS Bay Area’s land value on the balance sheet went from 1,532 million yen ($13.4 million USD) to 1,098 million yen ($9.6 million USD) and investment real estate from 4,380 million yen ($38.4 million USD) to 2,562 million yen ($22.5 million USD) between fiscal year end 2018 and Q1 2019.

What’s interesting about this land is that it’s part of a rezoning project (Japanese) spanning approximately 113,000 sqm, which is one portion of an even bigger development project. The project is located right beside Ichikawa-Shiohama train station, which is two stations/five minutes away from Tokyo Disney Resort. To the east of the project lies an industrial area, which includes Amazon’s fulfillment center. There are four businesses and the City of Ichikawa involved. One blogger posted pictures of the area from April 2018 (Japanese). The 11,172 sqm of land that CVS Bay Area bought was created as a result of rezoning.

Source: Ichikawa City, CVS Bay Area Hotel indication added by author.

What’s more, CVS Bay Area announced its plans to build a third building last week (Japanese), adding 107 rooms to its current 179 room hotel. The company estimates this will cost 1,600 million yen ($14 million USD) and the building will be ready for business in the summer of 2020.

Considering the land value of the two apartment-type hotel buildings and headquarter building combined add up to ~616 million yen ($5.4 million USD) and land value on balance sheet shows 1,098 million yen ($9.6 million USD), it’s probably safe to assume CVS Bay Area owns at least some part of the land it’s building on.

So the second thing: one new capsule hotel opening. In the fiscal 2018 filings, the projected investment was 75 million yen ($658K USD). While not trivial, it’s clear the Ichikawa City rezoning project is management’s focus.

 

Valuation

With its capsule hotels taking some time to get on track, CVS Bay Area’s investments haven’t quite played out as management intended so far. That said, CVS Bay Area management is deeply familiar with Tokyo Bay Area real estate through its decades of convenience store operations, and is now investing heavily into the Ichikawa City development project.

At this point, it’s difficult to tell what sort of operating margins to expect in the coming years. Given the slower-than-expected capsule hotel profitability combined with current operating performance of about break-even, I see two possible scenarios playing out in the next 3 to 5 years.

One is where the Ichikawa City project is successfully completed and CVS Bay Area doubles its asset value in the area with the additional benefit of an operationally healthy hotel.

The second scenario is where the Ichikawa City project is either considerably delayed, doesn’t quite materialize, or Japan’s record level tourism cools down. Given current circumstances, the company will probably come in somewhere between breakeven and a small loss.

In thinking about the second scenario, the company would’ve already invested a considerable portion of its cash (at least 1,600 million yen of the current 5,163 million yen in cash). With current debt at 3,451 million yen ($30.3 million USD), the scenario would put CVS Bay Area in a real bind.

With that in mind, the Ichikawa City project gone well ought to get the company back into shape. At the current stock price of 753 yen per share, price-to-book is at 0.69x. CVS Bay Area’s Ichikawa City land values will probably double, adding roughly 1,000 million yen ($8.8 million USD) in book value (which will not appear on the balance sheet as land is recorded at purchase cost). Then the company will have a 286 room hotel on top. Though a very rough sketch, 1x book would put the share price at 1,290 yen per share in this scenario. Over a 3 to 5 year time horizon, this would be an investment CAGR of between 11.4% and 19.7%.

 

The bottom line

Investing in CVS Bay Area is a bet on management’s eye for Tokyo Bay real estate. Given the possible downside scenario, I would avoid investing in the company. With that said, more optimistic and familiar investors may find the current valuation attractive. A rough sketch valuation on the optimistic scenario playing out could yield investors an investment CAGR of between 11.4% and 19.7% over the 3 to 5 year timeframe.


Kenkyo Investing
Kenkyo Investing

Kenkyo Investing applies a value investing approach to Japanese equities, providing insights that are often unavailable to non-Japanese speakers.