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Morningstar | Fast Retailing Missed Profit Targets for Warm Weather; Increasing Markdowns to Squeeze 2Q Margins

Narrow-moat Fast Retailing’s first-quarter profits, down more than 8%, came in below our expectation and the company’s target as unseasonal weather depressed demand for warm clothes. Given increased markdowns in Japan and East Asia including greater China and Korea into the second quarter, we have maintained our forecasts, slightly below the profit guidance, and fair value estimate of JPY 47,000. Despite our belief that Uniqlo’s cost advantage and intangible assets will sustain the group growth, fueled by expansion in Asia, Fast Retailing’s shares remain overvalued, trading at a 11% premium to our fair value estimate. We prefer to own the name when it offers a sufficient margin of safety.

The 4.4% sales growth was bolstered by a nearly 13% increase in overseas Uniqlo’s sales and a nearly 8% growth in Gu. It appears Uniqlo’s same-store growth in mainland China has slowed to single digits mainly due to the warm weather but no impacts of trade war. Sales were healthy in the western markets with a sizable profit increase as improved product mix and operations lifted Uniqlo’s U.S. sales while Russia posted a robust growth.

Meanwhile, domestic Uniqlo saw same-store sales including the online channel plunged 4.3% as a result of a high comparison hurdle in addition to the unfavorable weather. Despite a solid 5.2% same-store growth posted by domestic Uniqlo in December, it appears to be boosted by increased markdowns.

A 230 basis-point contraction in business profit margin was mainly attributable to a 540 basis-point dip in domestic Uniqlo’s margin while the margin of overseas Uniqlo was maintained at 18%. Due to increased markdowns and yen depreciation, gross margin of domestic Uniqlo shrunk 320 basis points. Additionally, increased investment in logistic automation and IT systems for supply chain management further depress margins by more than 200 basis points. Management expects more rigorous cost control along with more favorable hedged foreign exchange rates to kick in will boost profits of domestic Uniqlo in the second half. However, we think it is challenging to make up the profit shortfall of the first half.

Inventory has increased by more than 30% year on year excluding the impact of changed timing of inventory recognition as management decided to build up a higher level of winter inventories, particularly for domestic Uniqlo, to prevent the stockout it experienced last winter. The increased discounting is likely to further eaten up its margins. Because profits generated in the first half often comprise more than 70% of the full-year profits, the guidance of a 14% growth in operating profits looks challenging.

The first-half result will allow us to further examine the efficacy of enhanced inventory management of which management has credited for the substantial margin expansion achieved by domestic Uniqlo in the first half of full-year 2018 while we believe it was inflated by favorable weather. It appears that the issue of demand fluctuation caused by weather is unlikely to resolved unless management improves its forecast accuracy and shortens product lead-time substantially. Nevertheless, a better grasp of inventory status enables management to respond to markdowns in a timely fashion.