EUR 850.00 For Business Accounts Only

Morningstar | 7&I's C-store Profit Growth Set to Gradually Recover. See Updated Analyst Note from 14 Oct 2018

Narrow-moat Seven & i’s second quarter profits came in slightly above the company’s guidance but were largely in line with our expectation. Despite continued pressure from the one-percentage-point cut in domestic C-store, or SEJ, franchise charge, it managed to grow operating profits by a 2.6% thanks to a solid rebound in profits of the noncore superstore and specialty store business. We anticipate profit growth to accelerate from the third quarter after the impact of the cut in franchise charges cycles. Its strengths in private-label and ready-to-eat products will allow it to maintain the lead among C-stores. We have marginally lowered SEJ’s gross margin assumption by five basis points forecasts but lifted our fair value estimate to JPY 5,250, from JPY 5,150, to reflect the increased time value of money, implying an 8% upside. We prefer to wait for a greater margin of safety to own the shares.

The hot weather boosted SEJ’s same-store growth to 1.5% in the second quarter. Gross margins of SEJ improved marginally by an estimated 0.1 percentage point thanks to increased contribution of high-margin fast foods and beverage. It has been working on enhancing supply-chain productivity and extending shelf life of the ready-to-eat foods to entice franchisees to stock more inventories and reduce inventory disposal. The altered strategies of the new store layout that requires only partial store renovation will accelerate introduction of the new layout to the existing stores, up to 1850 stores in 2019 compared with 700 in 2018. The partial renovation does not require business to be closed compared with three-week closure for full renovation. The new layout will allow stores to carry more frozen foods and ready-to-eat items desired by consumers shopping at C-stores and thus boost daily sales. It plans to remodel 4,660 existing stores between 2019 and 2021.

On the other hand, U.S. C-stores, or SEI, saw growth in operating profits decelerate substantially to 1.8% in the second quarter compared with 33% for the first quarter in part due to high hurdles and thus a flat same-store sales growth compared with a nearly 2% posted in the first quarter. The fading boom of hand spinners depressed same store sales. An additional $1.2 million tax payment owing to past underpayment in some state combined with a decrease in gasoline margins and introduction of the loyalty reward program (7 Rewards) further depress profit growth.

While SEI’s gross margins of merchandise continued to slide, the decline has lessened to estimated 10 basis points compared with 30 basis points in the first quarter. Despite the fact that contracted gasoline margins caused by surging gasoline prices might linger, we expect profit growth will rebound as the same-store-sales growth has returned to a nearly 3% in July and August and gross margins will gradually pick up along with a change in the merchandise assortment of Sunoco stores to 7&i’s. Nevertheless, the project of strengthening the ready-to-eat product lineup, a key to differentiate its products from rivals’, remain a time-consuming task and might take a couple of years to yield results.

A solid recovery in the Itoyokado superstore business was a key driven behind the second-quarter profit growth thanks to improved same-store growth in addition to cost cut and improved margins of the apparel business. However, we believe it was helped by recent store renovations and higher-quality of inventory after the house cleaning in 2016-2017 and could be short-lived. Given the challenging operating environment as online retailers continue to gain shares and potential tax hikes scheduled for 2019 autumn, the business could go sour again after the renovation benefits fade and bad inventory builds up. Therefore, the market does not seem to value the management’s efforts to revive the superstore business and instead prefer the management to channel the group’s resources to the more competitive C-store business.

The market is not satisfied with the speed of restructuring of underperforming super-store and department store businesses. I believe that 7&i would consider selling the department store arm if it could find a buyer offering decent prices.