KR - Seven & i Holdings: Positive Business Transformation But Fairly Valued For Now

Summary

• Seven & i Holdings is demonstrating signs of positive overseas expansion with the Speedway acquisition.
• The business has transformed positively, with lowered exposure to the ex-growth domestic business. However, continued business investment is required to drive growth.
• The shares appear fairly valued given a decelerating growth profile, on a prospective consensus PER multiple of 17.9x.

Investment thesis

Seven & i Holdings ( SVNDF ) has improved its business model via successful expansion in the US with the Speedway acquisition. This is a positive development considering the previously high ex-growth domestic earnings profile. Despite this improvement, continued business investment and inflationary costs will mean limited earnings upside for the medium term. We rate the shares as neutral.

Quick primer

Seven & i Holdings is a retail operation focused on the convenience store format. It is the largest operator of convenience stores in Japan with over 21,000 stores, and also in the US with 13,000 stores. In August 2021, the company acquired US convenience store and gas station chain Speedway for US$21 billion (initially rejecting a deal back in March 2021); this asset has been delivering returns faster than expected, through a combination of cost control as well as effective merchandising driving store sales growth.

Key financials with consensus forecasts

Our objectives

The company has undergone major changes since our last piece in February 2021 . We want to update our view on the shares, given the current robust trading profile, the US business becoming the largest earnings driver in Q1-3 FY2/2023, and consensus expectations of a slowdown in the medium term.

Over the last three years, we note that Seven & i Holdings' shares have performed in the middle of the road versus its global peers, with convenience store peer Couche-Tard ( ANCTF ) and grocer Kroger ( KR ) outperforming, whilst domestic retail peer Aeon ( AONNY ) and European grocer Tesco ( TSCDF ) underperforming.

M&A is a key earnings driver for the retail sector. It is notable that Couche-Tard held takeover talks by Carrefour ( CRRFY ) in 2021, and has grown its global footprint via multiple M&A; it was recently outbid by Seven & i Holdings for the Speedway sale. Kroger announced a major M&A deal with Albertsons ( ACI ) in October 2022. Aeon is centered around strategic growth in South East Asia, but Tesco is on the back foot and recently announced restructuring plans and staff cuts on the back of the cost of living crisis in the UK.

Strong performance in Q1-3 FY2/2023

Following a healthy profile for monthly existing store sales growth YoY at both domestic and US convenience stores, Q1-3 FY2/2023 results were positive. The company raised its FY guidance. This was not a major surprise considering the high run-rate versus company plans in H1 FY1/2023 ( page 32 ), although the improvement in profitability YoY was a clear positive. FY1/2023 sales guidance was raised by 0.8% from the original, with operating profit increased by 4.8%.

The overseas convenience store operation is now expected to make up 57% of FY2/2023 operating profit, versus the domestic convenience store operation making up 46%. This development is noteworthy as overseas made up only 27% of operating profit in FY2/2022. Management has been executing well in the US, implementing effective cost control as well as successfully exporting formulas that have worked domestically such as differentiated food and merchandise, and expanding the 'NOW7' online delivery service which tends to attract a high average shopping basket. We believe there is further margin expansion potential for the overseas operation, given the company's market-leading expertise honed in Japan.

Facing high hurdles YoY for existing store sales growth, increasing challenges over inflationary costs (particularly energy), and concerns over consumer sentiment over an economic slowdown, we see that consensus forecasts have inked in a major slowdown in growth in FY2/2024 and FY2/2025, with limited expectations over margin improvement. Free cash flow generation is also expected to decline, as the company prepares to invest to meet targets of its medium-term plan ending FY2/2026.

Medium-term outlook - ok but not stellar

The convenience store business model depends on increasing footfall and average spending for growth, together with new store openings. The company is targeting 15,000 stores in North America by FY2/2026 and driving fresh food sales in the region, expanding its global footprint (primarily in Asia), and increasing spending per customer in Japan. Although driving revenues can be achieved relatively easily with new US store openings, the sales mix is significantly different from Japan, which could result in overall margin dilution (Japanese convenience stores do not sell gasoline). Investment in the US business will mean continued capex, and we note consensus expecting spending to remain at elevated levels for the next 2 years.

The Speedway deal has resulted in the company going from a net cash position to a net debt to equity of 94% in FY2/2022 (an estimated 79% in FY2/2023). Whilst gearing is manageable, this may place further major M&A activity on hold, placing the business more reliant on organic growth which takes more time to execute.

The increased scale of operations should provide opportunities for cost reductions, allowing for underlying profitability to increase despite cost inflation pressures. This needs to be balanced with investment in business growth, and as this remains the long-term focus (as the Japanese market is ex-growth), we do not expect to see major margin improvements in the medium term.

Valuation

On consensus forecasts, the shares are trading on PER FY2/2024 17.9x, with a free cash flow yield of 6.6%, and a dividend yield of 1.9%. These valuation metrics do not look expensive, yet do not indicate a major undervaluation for a retail business on ROE below 10%.

Risks

Upside risk comes from a major boost in profitability in the US convenience store segment, which could drive overall operating margins towards 5% plus in the short to medium term.

Management is telegraphing that shareholder returns will improve, although this will be dependent on EPS growth and the share price performance (with regard to buybacks).

Downside risk comes from dilutive financing risk as the company aims to scale more significantly via M&A activity overseas. Debt financing could also place pressure on the balance sheet, resulting in discount valuations.

Although operating in consumer staples, a macro slowdown could result in a sudden drop in consumption into the second half of 2023 as interest rate increases continue worldwide.

Conclusion

Seven & i Holdings has made a significant step in becoming a major global retailer with the Speedway deal, and early signs suggest that it is capable of improving the asset. The key takeaway is that the company is not an ex-growth domestic operation, but maintaining organic growth momentum will require continued business investment at elevated levels compared to the past. We were wrong with our sell rating back in February 2021, not expecting to see the Speedway deal and its subsequent success. However, we feel current valuations are fair and have a neutral rating.

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