Buy Aeon Stores (984)

i follow the investment principal that one should invest in stocks as if he owns the underlying business. i look for businesses that pay out increasing amount of dividends and generate increasing amount of cash from operating activities. i feel more comfortable of investing in businesses that i am familiar with than otherwise. That makes it easier for me to assess the competitiveness of the businesses in question. Usually, i hold stocks for at least one year.

Recently, i have been reconsidering Aeon Stores #984, although i covered it for some time when i worked for Quam. And i found that this retail chain has been doing better and better since then. Therefore, i would like to share my view regarding the company here.

If i am going to own a retail business, the first thing that concern me is the inventory risk. No matter how great the goods i sell and how hot they are in the market. The market taste must be changing faster than i can anticipate. If one day the demand for those goods hit the wall and the unsold goods are left sitting in the warehouse with little market value, i will be snookered.

Since i would have already paid my suppliers in cash by then, and to keep the business running, i would have to sell those out-of-fashion goods at deep discounts. Those losses would probably wipe out all the hard-earned profits i have previously made, for what i earn is nothing but a small fraction of the previous sales revenue after deducting the purchasing costs, rents and labor expenses. Therefore, my business must have a very low inventory risk.

Secondly, i fear that i need to put a large amount of cash in terms of inventories. Even though those inventories do not depreciate over time, they sit on the warehouse and shelves and prevent me from converting them to cash for other better use. These so-called working capital will be a form of idled cash forever, until i close down the business. Worse, if the business goes well and i need to open another shop, i need to double the amount of the idled cash.

i image my shops are located in second-tier shopping districts, instead of the hottest corners in Causeway Bay and Mongkok. i hope my goods and services are so good that people do not mind walking a few more blocks to visit us. If the business is only to offer convenience, it would end up being exploited by landlords because it is the landlords who own the value of convenience, the locations.

Ideally, i wish to have a return on equity exceeding 15% which means for every dollar i invest in the business i earn 15 cents per year. And i wish i do not have to inject new capital, as the internally generated cash will take care of the on-going business expansion.

The wish list could be longer if i do not stop here, but the key points have been stretched.

Let's look at Aeon Stores. During 2005, Aeon bought HK$4.1 billion worth of goods. At the end of the year, it was keeping HK$383 million, less than 10% of the goods purchased for the whole year. The average period for its goods sitting in the warehouse and shelves is 34 days.

At last New Year Eve, Aeon owed its suppliers HK$796 million, twice as much as the value of the inventories. On average, Aeon repays its suppliers 70 days after it makes the purchase. That means that Aeon is able to sell the goods and collect the sales proceeds way before it needs to repay its suppliers. Therefore, it doesn't need to idle any cash for working capital. Instead, it practically locks up suppliers' cash at its own disposal. As at the end of last year, Aeon locked up about HK$400 million of suppliers' cash. The bigger the business, the more cash it locks up.

For 2005, Aeon recorded a net profit of HK$125 million while it added HK$266 million cash into bank balances.

That Aeon can sell goods so quickly is a result of many good things in operations, from merchandising, sales and marketing, logistics and services.

Aeon generated about three quarters of sales in Hong Kong and the rest quarter in the PRC. In Hong Kong, its major "general merchandise" shops are located in Tseung Kwan O, Kornhill, Whampoa, etc, far from central shopping districts. Most of its major shops work as department stores except that they offer foods as well. Aeon has recently opened a new supermarket in Kwun Tong, focusing on food, which is another sensible move.

Aeon shops are those shops that you don't mind walking a few more blocks to visit. It paid HK$314 million in rents in the nine-month period ended December 2004, presenting about 8% of the HK$4 billion sales for the same period. 2005 figures are not yet available.

With the strong cash flow, Aeon borrowed little from banks. Also, it does not need to raise funds from shareholders. Since its IPO in 1994, Aeon has never raised any funds. In 2005, it had HK$644 million in shareholders' equity. Return on equity was 19%.

2005 total dividend will be 19.5 cents per share, compared with 12.5 HK cents per share for the 10 months ended December 2004 and 14 HK cents per share for the year ended February 2004. It changed the ending date of financial year from end-February to end-December.

Looking forward, i expect Aeon to strengthen its market presence in the local middle-end general merchandise market. Additional growth would come from mainland China when it enjoys the economies of scale as sales goes up.

Based on the market price of HK$9.4 per share and 260 million shares outstanding, Aeon is capitalized at $2.44 billion, or 20 times its 2005 net profit. Excluding the net cash of HK$1.03 billion, Aeon's enterprise value was HK$1.41 billion, or 13 times its 2005 net profit adjusted for investment income. i recommend a buy.


Disclosure of interest: i am not holding shares in Aeon, but i intend to buy the shares at least 24 hours after the publication of this article.

Apr 19, 2006
Copyright Quamnet