With its 1,100-store Sunoco (SUN, Financial) acquisition announced in April, 7-Eleven parent company Seven & i Holdings Co. Ltd. (TSE:3382, Financial) is gaining more attention from Western investors. The story is simple: 7-Eleven dominates the convenience store industry in Japan and now looks outside of the country for further growth.
When looking at Seven & i’s convenience business specifically, the growth story makes a lot of sense: Highest average daily store revenue in Japan, largest store network, lowest-cost operator and the list of competitive advantages continues. What many investors overlook, however, is Seven & i’s lagging department store and general merchandising store (GMS) businesses. These two segments combined accounted for 48% of 2017 revenues but less than 7% of operating income. In comparison, the convenience business accounted for 43% of revenues and 86% of operating income. As a result, Seven & i delivers a meager 4% return on investment (ROI), making the convenience growth story considerably less compelling.
The back door: Nakano Refrigerators
All that said, there is more than one way to invest in Seven & i’s convenience growth. Nakano Refrigerators Co. Ltd. (TSE:6411, Financial), which supplies refrigeration equipment to Seven & i (Over 40% of Nakano revenues), is one such example.
One look at Nakano’s recent business performance paints a grim outlook:
- Revenue decline since 2014 (from 43.4 billion yen ($38 million) to 29.6 billion yen).
- Operating income decline since 2014 (from 7.4 billion yen to 2.9 billion yen).
- Return on equity decline since 2014 (from 19% to 8%).
Needless to say, the one-two combo of revenue decline and margin decline has significantly deteriorated Nakano’s profitability. It is not particularly surprising the company's management guided a mere 25.8 billion yen in revenues and 1.24 billion yen in operating income for 2017.
Conflicting information from Seven & i Holdings
Not long after Nakano Refrigerator reported 2016 earnings, Seven & i held its earnings presentation in April. In this earnings presentation, Seven & i made a major announcement: The standard store layout, which has not been modified to any significant extent in years, is changing.
The old layout looks like this:
Source: Seven & i Holdings Earning presentation (July 5), English text added by author.
The new store layout changed to this:
Source: Seven & i Holdings Earning presentation (July 5), English text added by author.
Most notably, refrigeration space almost doubled. Seven & i plans to roll out this store layout in 1,900 total stores by the end of 2017 (800 current stores and 1,100 new stores). The rollout plan is expected to continue at a 2,000-store per year pace through 2021.
More importantly, the food focused strategy is not exclusive to 7-Eleven. In fact, the whole Japanese convenience industry is focused on food. Malls, shopping centers and drug stores are all looking at food to internet-proof their businesses.
Forecast revisions
Sure enough, Nakano management revised its 2017 outlook in May:
Metric | February 2017 | May 2017 |
Revenue | 25.8 billion yen | 26.58 billion yen |
Operating income | 1.24 billion yen | 1.66 billion yen |
Source: Nakano Refrigerator IR News
In the news release, Nakano management explained demand from domestic convenience and supermarket business was above expectations.
Interestingly, a 3% increase in revenues results in a 34% increase in operating income in the above management forecast. This speaks to the amount of operating leverage employed by Nakano. With 1.66 billion yen in revenue, the company would be at the lowest level of operating income since 2009, when it reported 1.45 billion yen in operating income.
Price, performance and valuation
Normally, enterprise value to earnings before interest and taxes (EV/EBIT) would be a useful price-to-performance metric to look at. However, Nakano has had a negative enterprise value for over 10 years. Today, Nakano holds negligible debt and a 28.1 billion yen cash and equivalent position, marking the enterprise value of the company at -8.6 billion yen. The company’s market capitalization is at 29.2 billion yen as of closing on July 8.
Mohnish Pabrai (Trades, Portfolio)’s “heads I win, tails I don’t lose much” philosophy is probably the appropriate investor mindset to hold when considering Nakano Refrigerators. A large cash position, negative enterprise value, still profitable business and projected stable or increased demand from Seven & i Holdings ensures the safety of investor’s capital. The big upside to Nakano comes in the form of operating leverage. If Nakano reaches 2014-level revenues (43.4 billion yen), then return on equity (ROE) can reach over 19%. Combine this with today’s price-book (P/B) ratio of 0.63 and the investor will effectively be purchasing a 30% ROE company at book value (19% / 0.63 = 30%), with limited downside. As a reference, Nakano traded at a P/B ratio of 1.27 in 2014, when business performance was stellar.
Disclosure:Ă‚Â I do not own any shares in the companies mentioned in this article.
