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Clayton Young
Clayton Young
Articles (6)  | Author's Website |

7-Eleven: A Backdoor Strategy Worth Considering

Nakano Refrigerators may offer investors a more compelling opportunity

July 13, 2017 | About:

With its 1,100-store Sunoco (NYSE:SUN) acquisition announced in April, 7-Eleven parent company Seven & i Holdings Co. Ltd. (TSE:3382) 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), 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:

q7oNc_joLY4aQTHkpji8rTJfJbPtdGqtOKiI2p5I

Source: Seven & i Holdings Earning presentation (July 5), English text added by author.

The new store layout changed to this:

QOjxlyeE-CJUduo3BTIqSMK4laaudlu-xesW_JPb

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: I do not own any shares in the companies mentioned in this article.

About the author:

Clayton Young
I grew up in Japan and completed an MBA in the U.S., but learned more from reading Howard Marks. I apply an American value investing approach to Japanese companies that are often inscrutable to outsiders who lack fluency in the unique cultural context.

Visit Clayton Young's Website


Rating: 5.0/5 (2 votes)

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Comments

The Science of Hitting
The Science of Hitting - 1 month ago    Report SPAM

Good article Clayton. So the market cap is essentially equivalent to the net cash on the books? Does management have any plans for capital returns to shareholders? Thanks!

cyoung1989
Cyoung1989 premium member - 1 month ago

Thanks Alex. Net cash is roughly half of current market cap. The management team actually just repurchased 1,000,000 shares (about 16% of shares outstanding) from its top shareholder (Nakano family) in May.

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