EUR 850.00 For Business Accounts Only

Morningstar | Donki Meeting Guidance as Expected; 20 More Joint-Brand Stores with Uny on the Way

Narrow-moat Donki's fourth-quarter profits were in line with our expectations and a touch above the company's target. Management has again guided to a conservative outlook of 6% growth in sales and a 2.8% growth in operating profits, but we expect the company gradually raises its full-year target through the year. We forecast an 8% growth in sales and 11% growth in operating profits for 2019. A strong rebound in profit growth in the fourth quarter was driven by margin improvement in addition to robust same-store sales growth. Management has raised dividend by JPY 5 per share to JPY 32 for 2018. Donki's price leadership combined with a broad array of product offerings will continue to drive its top-line and profit growth and sustain its market share gains through store expansion and increased customer traffic. We have finetuned our assumptions, which does not affect our fair value estimate of JPY 5,600. After a 16% correction from the recent peak, we view the shares as undervalued with a 14% upside.

A more than 40-basis-point expansion in gross margins, along with a healthy 3% same-store sales growth (total like-for-like sales growth excluding acquisition estimated at plus 7.5%), lifted fourth-quarter operating profits which grew 80%. The inventory build-up of imported watches and fashion accessories remains an issue that the company continues working on. Inventory turnover has improved somewhat after the headquarter centralizes sourcing of imported fashion goods to control the inventory level while it replaced offerings of imported fashion goods with other products at 83 stores. It is likely to take another couple of quarters to unload the inventory of luxury brands.

Management guides to 1% same-store sales growth for 2019, the same as our assumption. It kicked off the new fiscal year with a less impressive same-store growth of 0.4% in July as a result of unfavorable weather and one fewer holiday which usually depresses customer traffic by about 1.3%.

We are concerned a slowdown in foreign tourist traffic will depress its same-store sales growth. Sales to foreign tourists grew 56% in 2018 and comprise 8.7% of Don Quijote's store sales and contributed 2.2 percentage points out of the 4.1% same-store growth achieved in 2018. Given that Chinese and the other Asians comprise 43% and half of sales to tourists, respectively, it looks challenging to achieve the same pace of growth without a significant rise in Asian tourists.

Management also presented its new digital strategies which will be introduced in a new store opened in the greater Tokyo area this year. It plans to leverage new technologies including facial recognition and an app offering product information in a video form and in-store bonus games to enhance customers' shopping experiences. We think the in-store point-reward games may lure customers to the stores but it needs to create other fun features to make its app more attractive.

On the initiatives of revamping the general merchandise store industry, Donki has reached agreement with FamilyMart Uny Holdings to convert another 20 stores to the joint-brand format during 2019 after the performance of the six joint-brand stores is confirmed. The six joint-brand stores opened in March 2018 have achieved a 90% growth in sales and 60% growth in gross profits by the end of July. However, there seems some conflict between Donki and Uny's management who appears to resist to the changes that Donki is proposing. As we have highlighted in our FamilyMart note, the contrasting organizational cultures and business practices is one of our key concern over the joint-brand efforts. Given the support offered by the management of FamilyMart Uny Holdings and its largest shareholder Itochu who seems to prefer to unload the GMS business, we expect the store conversion will continue although it may be a time-consuming process.