AEON – A Property Company With Retail Business?

34462036 - 09_04_2015 - JAPAN-ECONOMY-AEON

What business is AEON in?

If you were to ask this question to anyone, most people would tell you AEON is in the retail business. Well, technically, they are right. Today, AEON is the leading retailer in Malaysia with total revenue of RM 4 billion. Over almost four decades, AEON has established itself as the leading chain of Super Market, General Merchandise Stores and malls. No other retailer which operate on the same integrated retail model comes close in terms of market share. Their most similar competitor is Isetan – another retail giant from Japan. But then, Isetan are only present in the urban hotspots of KLCC, Gardens and One Utama. In contrast, AEON caters to the suburban population all over Malaysia.

Despite the unique business model, AEON is not entirely free from competition. In each retail sub-segment, AEON is facing fierce competition from its counterparts. In the super market segment, AEON is challenged by the rise of premium grocers such as Jaya Grocer, Village Grocer and Cold Storage as well as the traditional big format discount retailers like Giant, Tesco and Econsave. In the GMS segment, AEON has a strong challenger in PARKSON and Metrojaya. In the specialty store business like AEON Wellness Pharmacy, they have Watsons Pharmacy, Guardian Pharmacy and Caring Pharmacy to think about. Furthermore, there is the threat of e-commerce eating into every brick-and-mortar retailers’ market pie. As we have seen in the developed markets such as the US or Singapore, this threat is very real and retailers are very much affected.

In a retail business, the primary teller of the health of business environment is none other than revenue and gross margin. When competition is fierce, the typical company will show flattish or minute growth in revenue with decreasing gross profit margin as the company resorts to price cuts in order to protect market share. The retail business is a pretty commoditized business that allows little differentiation. Hence, the most logical strategy for any new comers to create market presence is to enter a market and cut prices more aggressively than the encumbrances. As a result, the reaction from the encumbrances is almost always a more aggressive stance in pricing which lead to price wars.

fh2015

From the financial numbers posted by AEON in the last few years, AEON certainly did not perform well. In the last 3 years, AEON had grown its retail sales from RM 2.8 billion in 2013 to RM 3.2 billion in 2016 with CAGR of about 5.2%. The revenue growth is there. However, its segmental profit which is obtained from annual report’s footnote has declined from RM 170 million in 2013 to a paltry RM 3.3 million in 2016. Since AEON did not reveal its Cost of Goods Sold in their financial report, I am unable to compute a gross profit margin for their retail business. The segmental profit should more or less reflect the profit trend of the retail business.

AEON’s management have attributed this sub-par financial performance to challenging macroeconomic factors (Decline in Oil Price, Ringgit Weakening, Weak Consument Spending etc). Well, these factors could indeed affect consumer spending. However, out there in the retail industry, it is notable that there are certain retail players who are doing well eg. Padini. As it has shown in the past, the retail business is a very difficult business to turn around. For one, Warren Buffett has time and time again expressed the challenges in the retail business. Besides, even renowned hedge fund managers like Edward Lampert and Bill Ackman who understood numbers have failed to turn around the fallen SEARS and JC Penney respectively. For any investors in AEON, the biggest red flag in maintaining their investment in the company is when the retail business goes into the red because the task of turning around a retail brand is tough.

Understanding AEON’s business model

Many investors like to analyze AEON like a retail company. Before we start ascertaining any value to AEON group, we first need to understand what kind of business model they are running on.

aeonflywheel

The first step of AEON’s expansion strategy involves identifying a suitable location at a suburban area, buying up the land and building a shopping mall on top of it. Here, the key element is for AEON to own the land and building which sits the shopping mall. Without owning the land and building, the whole philosophy of this business model cannot work. This is because maintaining ownership of the property asset albeit more capital intensive will ensure profitability as well as creating wholesale transfer pricing.

Next, AEON would have its retail operations as the anchor tenant of the shopping mall they have built. People used to say, “If you build it, they will come”. In this case, AEON had built a shopping mall. The role of the retail operation which consists of super market, general merchandise store and specialty stores is acting as a crowd puller which drives foot traffic into the shopping mall. When the location is right, there will be no problem for the retail operation to show a profit. Hence, there is a co-beneficial relationship here between AEON’s property investment and the retail operation, killing two birds in one stone.

Third, as the AEON retail operation establishes, any additional mall spaces in the form of shoplots would be rented out to external retailers. With the correct tenant mix, more foot traffic would be attracted to the shopping mall driving the growth of the business and viability of this business model. AEON is quite successful in attracting retailers to rent at their malls. From the 2015 annual report, it could be seen that their shopping malls have  a tenancy ratio of 90%. Hence, each element in AEON’s business model reinforces once another to ensure profititable growth.

Eventhough there are three important elements in AEON’s business model, the key engine to profitability is in the property management business. For illustration purpose, I will be using AEON’s FY 2015 annual report. If you look deeper into AEON’s numbers, you would notice that retail operation accounts for 85% of the group’s revenue. The other 15% is taken by its property management operation. Interestingly, in terms of profitability, property management accounts for 80% of the group’s net profit while the retail operation accounts for the rest.

Thus, this is a case of when the obvious is obviously not. AEON may have a strong retail business but the main profit engine behind the company is its property management business. Instead of analyzing AEON as a pure play retail company, I would prefer to look at it from two perspectives; a) Property Management Business and b) Retail Business. A sum of part valuation (SOP) would be more appropriate as both business segments have to be valued differently from each other. In Part 2 of this series, I will be talking more about Aeon’s valuation and how they could unlock value in the company.

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