Seven & i Holdings
During the third quarter, we continued to add to our investment in Japan's Seven & i Holdings (TSE:3382) (the parent company for the 7-Eleven franchise) at attractive valuations. The company has a $40 billion market cap and derives more than 100% of its cash flow from the operation of a 90%-franchised convenience store network in Japan, the U.S. and Southeast Asia.
In Japan, the company has 18,000 stores and a market-leading 41% share in a rapidly consolidating convenience store industry with latent pricing power. An aging population, a tight labor market and increased labor force participation by women are playing to 7-Eleven's strengths of offering high quality prepared meals, coffee and personal care products at affordable prices on the best corners in Japan. Seven-Eleven generates one-third higher sales per store than its competitors thanks to its commitment to innovation,state-of-the-art inventory management and logistics networking that allows store replenishment up to three times a day and superior private label products manufactured at dedicated facilities.
In the U.S., where the company operates close to 9,000 stores, a recovering economy and cheap gas prices have left more discretionary dollars in consumers' pockets to spend on snacks and Slurpees, contributing to strong sales momentum. In emerging economies, where the company master franchises local markets, store count is growing rapidly due to urbanization and the powerful 7-Eleven brand.
A key contributor to the success of the company is its CEO, Toshifumi Suzuki, who introduced the convenience store concept to Japan in the 1970s and was instrumental in acquiring 7-Eleven’s U.S. parent company after it ran into financial difficulties. Suzuki instills a culture of singular focus on the customer, a passion for selling only the highest quality products and urgency to continually improve the company’s best-in-class delivery systems and information technology. All this has propelled the company to achieve unparalleled productivity and organic growth.
Despite being the most valuable Japanese retailer by market capitalization, the company remains grossly underlevered and undervalued, trading at only 7.2x forward EBITDA versus global peers such as Couche-Tard and Walgreens (NASDAQ:WBA), which trade at 10x to 12x EBITDA. This valuation gap stems from Seven & i’s long standing divergence between its best-in-class convenience store businesses and its other retail operations, in particular its Ito Yokado superstores, which have an equally notable record of underperformance. Shareholders have suffered from the subsidization of Ito Yokado for so long that Seven & i is emerging as one of the most crucial tests for the success of corporate governance reform in Japan. And while Ito, the author of the corporate governance reform review, was appointed to Seven & i's board last year, shareholders are still faced with a highly inefficient capital structure, a sub-10% ROE, a low dividend and no buybacks.
However, there are signs that management’s focus is shifting in the right direction and that Japan’s renewed emphasis on corporate governance is bringing shareholders’ interests to the forefront. We are encouraged by CEO Suzuki’s announcement earlier this month that 20% of underperforming Ito Yokado stores will be closed and 30% of its corporate office staff will be streamlined. We believe the CEO should go even further: Ito Yokado should leave the group and restructure as a stand-alone company. If Seven & i evolves into a global convenience store pure-play, shareholders would benefit from a meaningful rerating.
As Seven & i’s growth capex spend in Japan comes to an end due to industry consolidation, free cash flow generation will accelerate meaningfully and a significant capital return story will emerge allowing for substantial dividend increases and buybacks in the years ahead. The review of shareholder returns should start immediately, however, as the company’s balance sheet is vastly overcapitalized, and its dividend is only half of what most shareholders desire.
An additional lever of value creation would be a partial listing of 7-Eleven U.S. which management has told us it has considered. By tapping an underlevered balance sheet, 7-Eleven U.S. could accelerate the consolidation of the fragmented North American convenience store industry and trade at a premium multiple.
From Daniel Loeb (Trades, Portfolio)'s Third Point shareholder letter for third quarter 2015.
