7-Eleven: A Backdoor Strategy Worth Considering (Part 2)

In the previous 7-Eleven backdoor strategy article, we covered Nakano Refrigerators (TSE:6411), which supplies refrigeration equipment to 7-Eleven and its parent Seven & i Holdings (TSE:3382). Today’s focal point is Warabeya Nichiyo (TSE:2918), another 7-Eleven supplier.

Warabeya Nichiyo is intimately involved with Seven & i Holdings, supplying fresh foods to 16,000 of the 19,000-plus 7-Eleven store network in Japan. These fresh foods are produced in its 27-factory domestic production network. To further tighten the relationship with 7-Eleven, the company is also engaged in the logistics business. Some of the 7-Eleven trucks seen in Japan are operated by Warabeya.

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Source: Japanese used truck website

7-Eleven Japan owns 12.46% of Warabeya Nichiyo. At this point, nobody should be surprised to learn that over 70% of Warabeya revenues are 7-Eleven related. In effect, analyzing Seven & i’s convenience business gives a pretty wholesome picture of where Warabeya is headed.

Where is Warabeya headed?

As mentioned in the Nakano Refrigerator article, 7-Eleven recently announced plans to roll out a new, refrigeration-heavy store layout across Japan at a 2,000 store per year pace going into 2021.

Though not all refrigeration space will be filled with Warabeya-produced lunches, food is at the front and center of Seven & i’s strategy. Seven & i CEO Ryuichi Isaka is not shy about it either, openly talking about rolling out 7-Eleven Japan’s food focus on a global scale. The U.S. operation is no exception.

In concurrence with 7-Eleven’s 1,100-store Sunoco acquisition announcement in April, Warabeya announced its investment in Prime Deli Corp., a Texas-based 7-Eleven fresh food supplier. This is significant for several reasons, but mostly because the move shows Seven & i’s drive to position American 7-Elevens differently – and for good reason.

U.S. growth won’t come easily

Walking into a Japanese 7-Eleven to buy lunch is about culturally equivalent to going to a Jimmy John’s for a quick, moderately healthy, reasonably priced sandwich in the U.S. Frankly, the American 7-Elevens do not have anywhere near the quality of food that their Japanese counterparts do (for example, 7-Eleven U.S. pizza tastes like cardboard with tomato sauce).

It would be easy to say that 7-Eleven will execute its food-heavy dominant strategy and beat the competition into submission like it did in Japan. The U.S. and Japan are two considerably different cultures. In this context, Warabeya’s U.S. investment is a double-edged sword, largely dependent on 7-Eleven’s executional strength in the U.S. and America’s cultural acceptance of buying convenience store food. If the strategy gains traction, 7-Eleven has a whole country left to implement the strategy (7-Eleven currently holds about 5% market share in U.S. convenience, according to Seven & i IR). If the strategy doesn’t gain traction, it’s hard to say where Warabeya will go, especially with its high 7-Eleven dependency.

At this point, Warabeya’s U.S. investments are still a drop in the bucket. It is probably safe to say that Warabeya will be cautious about investing a significant sum of money in the U.S. until successes are seen at the micro level. For this reason, interested investors ought to pay close attention to Warabeya’s U.S. capital spending over the next year or two. A large increase would likely indicate that Warabeya has seen some success at the micro level and is ready to scale out operations.

Competitive pressures back home

Physical retailers are literally taking each other’s lunches in Japan.

Much like the U.S., Japanese physical retail faces ever-increasing competitive pressures from internet retailers. In the convenience industry, food has become the standard strategy, with 7-Eleven exerting exceptional executional strength. The problem is, food is working its way into the strategies of other industries, like drug stores and supermarkets.

All that said, 7-Eleven prides itself on being the lowest-cost operator in the convenience industry. Replicating 7-Eleven’s 19,000-plus store network and Warabeya’s 27 food factories would be difficult for any company. These competitive pressures are nothing new either, and 7-Eleven has steadily gained market share over the years. It may be difficult for this trend to continue at its historical pace, but 7-Eleven losing share in Japan is unlikely, given its scale and low-cost advantage.

According to Seven & i’s earnings presentation, Japan’s ready-made meal market was at 8.2 trillion yen ($72.829 billion) in 2008. This grew to 9.6 trillion yen in 2015. Over the same period, 7-Eleven’s share of the ready-made meal market grew from 9.2% to 13.3%.

Price, performance and valuation

Warabeya’s future isn’t as clear as Nakano Refrigerators’. If 7-Eleven’s food strategy gains traction in the U.S., Warabeya will stay busy for years. If the food strategy doesn’t take, Warabeya will find itself in a defensive position, protecting market share in a population-decreasing, increasingly competitive Japanese market.

Another point of concern for Warabeya is its business performance. Over the past 10 years, Warabeya’s top-line grew at 3.9% CAGR. During this time, the company maintained gross margins between 14% and 16%. Any meaningful growth in gross profits was offset by an increase in SG&A costs, which grew at a 4.9% CAGR over the same period. The end result is operating income lower than 10 years ago.

It’s not all bad for Warabeya, though, as the company produces a healthy amount of free cash flow. Current price to free cash flow ratio is at 7x, though this figure wildly fluctuated between 4.8 ~ 85 over the past 10 years. The good news is that Warabeya produced free cash flow even as it scaled out to support 7-Eleven Japan’s expansion. The expanded refrigeration space in 7-Eleven Japan’s new store layout should contribute to increased factory utilization at Warabeya as well.

Warabeya’s stock price has roughly doubled over the past 10 years. Perhaps, the scaled out production network and stable 7-Eleven business is baked into the price. At today’s ~3,000 yen per share price, EV/EBIT is at 12.5x. This seems high for a Japanese small-cap. That said, Warabeya may provide investors with an attractive opportunity to avoid Seven & i’s Japanese big retail exposure and take on more of the convenience growth story.

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

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