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Morningstar | 7&I's 3Q Profits Fell Short for Tepid C-store Growth and Warm Weather; Growth Set to Pick up in 4Q

Narrow-moat Seven & I’s third-quarter profits fell short of our expectation and the company’s internal target given weakness in the superstore and department store business and a tepid growth in the moaty C-store business. We have slightly reduced our profit projection for the C-store business given that the implied 15% profit growth target for the fourth quarter looks somewhat challenging although the management is committed to meeting its full-year guidance. We have maintained our fair value estimate of JPY 5,250, implying a 7% upside, and prefer to wait for a greater margin of safety to own the shares.

While we had anticipated SEJ (Seven-Eleven Japan) profit growth to accelerate from the third quarter after the impact of the cut in franchise charges cycled, it failed to pick up as the franchise charges were depressed by an increased number of new stores opened by the existing franchisees who pay lower charges for the second stores. Same-store sales grew 1.7% during the quarter, largely lifted by the surge in cigarette demand prior to October tax hikes. Despite increased contribution of low-margin cigarettes and DVDs, gross margins managed to tick up during the quarter thanks to increased contribution of the high-margin fried food (hot foods served at the counter) sales. It plans to accelerate store renovations, adding another 1000 stores with the more inviting store layout during the fourth quarter to drive customer traffic. It will bring the total number of stores with new formats to 3,300 by the end of fiscal 2018. Stores with the new layout appear to have seen sales rise by 1.5%-3%.

Likewise, U.S. C-stores (SEI) saw a mere 6% growth in operating profits although the same-store growth picked up to 2.2% during the quarter. A deteriorated mix caused by Sunoco acquisition and margin contraction of gasoline sales, along with increased costs associated with 7-Reward loyalty program and selling and administrative expenses related to the directly operated stores depressed profit growth. Per-store sales have continued to improve along with sales of Sunoco stores catching up to the level of 7-Eleven’s. While the nine-month profit growth fell short of its guidance, the company is confident that profits will catch up in the fourth quarter as expenses are expected to decrease.

The momentum of ItoYokado’s recovery slowed during the quarter while the department store business continues to struggle to improve profitability. The result resonates our concerns that growth driven by recent store renovations and higher-quality of inventory after the house cleaning in 2016-2017 and could be short-lived. The operating environment is likely to remain challenging as online retailers continue to gain shares and consumers may tighten their purse strings if the consumption tax hikes takes place in October 2019. While the management clarified the risk of inventory build-up as the inventory level of apparel stays flat year on year, the market has been demanding management to take more drastic measures to downsize or exit the underperforming businesses rather than putting more efforts to revive them. We believe this is one of key concerns deterring inventors from owning the stock.

Management has taken baby steps toward improvement of its digital strategies and expects to launch the mobile payment service in Japan during the first half of fiscal 2019. The schedule has been delayed from spring 2019 as the company is working on improving the interface and contents of its mobile app. Despite more than 10 million downloads, the actual usage is merely 6.6% at 7-Eleven. Given a surge in cashless payment offerings as companies fight for the scarce growth opportunities and control over consumer purchasing data, the customer acquisition costs are rising. We think SEJ is better positioned than the other C-store operators given its more than 10% higher customer traffic than the peers. Consumers are most likely to keep a limited number of mobile payment apps in their smartphones and the ones offered by the retailers they most frequently shop or provided by vendors with the most attractive cashback/loyalty programs are most likely to win.