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Morningstar | Profit Rebound in Gu and Continued Strength in Uniqlo Asia Fueled Profit Growth

Narrow-moat Fast Retailing’s third-quarter results were below our expectation with sales and business profits up 7.3% and 9.8%, respectively. The nearly double-digit profit growth was attributable to growth in the moaty Uniqlo in Asia and a leap in Gu’s profits. We anticipate the 27% same-store growth posted by domestic Uniqlo in June as well as reduced markdowns in the end of season to boost the fourth-quarter profits considerably. However, the hurdle to meet the company’s full-year profit target looks high given that the fourth quarter was in red over the past three years. We therefore revised down our operating profit forecasts by 2% for the current fiscal year but raised our fair value estimate to JPY 48,000 from JPY 47,000 to reflect the impact of the time value of money. While we are convinced that Uniqlo’s brand equity and cost advantage will sustain its long-term growth in Asia, the stock remains overvalued with a nearly 30% downside.

Gross margins improved 33 basis points thanks to an 800-basis-point jump in Gu’s gross margins. On the other hand, the new initiative to mark down products in the middle of the season, rather than discount heavily in the end, depressed gross margins of Uniqlo. Nevertheless, we expect the efforts to reduce excess inventory early, enabled by improved inventory visibility as part of its supply chain management endeavors, will result in improved gross margins in the summer? season. On the other hand, whether Gu will be able to maintain or expand gross margins will largely depend on its ability to create hit products.

The moaty overseas Uniqlo business saw sales and profits rise 15%, led by China and Southeast Asia, during the quarter. Despite low temperatures, same-store sales grew nearly double digits while online sales soared 30% in China. The strong performance echoes our argument that its brand equity supported by quality products, the result of cost advantages, as well as marketing investment will fuel growth in China.

As Uniqlo did not lower prices to reflect a 3% cut in value-added taxes in China, we reckon the tax cut contributed at least a quarter of 20% profit growth achieved in China. Due to unseasonal weather and political turmoil, profits fell in Western Europe and the U.S. While losses lessened in the U.S., it is likely to stay in red in the current fiscal year. Management also cut its store targets, mostly in Asia, with a net increase of 151, down from the initial target of 171. Yet, it continues to aim at adding 100 new doors in Greater China and Southeast Asia, respectively, over the midterm.

Same store sales of domestic Uniqlo fell marginally by 0.1% during the quarter in part due to a delay of its anniversary sale to June from May. As a result, same-store-sales rose 27% including a 70% growth in the online store in June. Additionally, the collaboration with the American street artist Kaws also contributed to the robust sales during the month. Yet, the strength of same-store growth is most likely one-off because the strong demand for the graphic tees was driven by the last collaboration between Uniqlo and the artist.