Description

Long Investment Idea: Seria Co (2782 JP)

Seria, which operates a chain of 100 yen stores in Japan, is a best-in-class thrift retailer, generates strong returns (17% ROCE and rising), and has material store expansion and margin enhancement opportunities. The stock has performed well this year and each of the past four years, but we think the recent 20%+ correction provides a good entry point into a cheap stock that should continue to consistently grow profits at a double digit rate. We believe the sell-off in the stock was caused by yen weakness, a one-off cost in the last quarter, and a weak October SSS number. As we will discuss below, we don’t believe any of these issues alter the attractive short- and long-term outlook for the company.

Market Opportunity / Sales Growth

The 100 yen store is the Japanese version of the dollar store format, which most US investors will be very familiar with. Currently the company has 1,086 stores, about 10% of which are franchised and the rest directly owned. Of the directly owned stores, about 70% are Seria stores and 30% are “Color the Days” stores.  A typical Seria store sells about 18,000 SKUs, with confectionary goods contributing to 5% of sales. The remaining 95% are sundry household items (kitchen utensils, bathroom items, cosmetics, stationary, etc.).

Seria’s 1,086 stores account for about 20% of the total 100 yen store count in Japan. Seria is #2 in the industry by store count behind unlisted competitor Daiso, which has 2,680 stores and about 50% of the total market. #3 Can Do (2698 JP) has 819 stores and #4 Watts (2735 JP) has 726 stores.

Seria believes that ultimately it could open 6,000 stores across Japan based on 1 store per 20,000 people in a 2 km radius as the targeted store density. A more conservative 2,200 store potential can be estimated by assuming that Seria eventually achieves a nationwide density similar to the current store density in Chubu, where the company is headquartered. Either estimate implies significant expansion potential remains. Management is conservative and at the current net store opening rate of about 40-60 stores p.a., they won’t get close to 2000-6000 stores anytime soon. But we think they can easily open 4-6% new stores p.a. with potentially some upside to that number if management gets a little more aggressive. Historically most of the stores have been in roadside suburban locations but recently the company is focusing more on locations in shopping malls and small outlets within large general retailers in larger cities. New stores cost approximately 20 million yen to open including inventory with a typical cash payback in 2-3 years. The focus for new store openings are directly-owned, “Color the Days” stores which are about twice as large as the traditional Seria format.

With prices largely fixed at 100 yen per item, same-store-sales are primarily driven by volume. SSS in the last three years has been decent at +2.2%, +0.3% and +5.0% respectively for FY09-FY11. However last year’s +5.0% SSS benefited from post-earthquake demand so growth is probably unlikely to reach that level in a normal year. Year-to-date SSS are -0.3% which we think is fairly good in light of the difficult earthquake comp. SSS were weak in October (-2.8% y/y) and this was one of the factors behind the recent stock correction. However, this was against a +6.9% comp in Oct-11 and SSS improved to +0.6% in November. Management’s SSS guidance for FY12e is only +0.2% and we think this is very achievable with easier comps coming up for the remainder of the fiscal year.

It is worth noting that based on available data, Seria appears to be taking share from and materially outperforming its 100 yen rivals. For reference, Seria’s sales are up +40% since FY08 vs. -0.5% for Can Do and +24% for Watts. Publicly available data for Daiso is limited but we have anecdotally heard that Seria is also significantly outperforming their larger rival.

Margins

Seria has improved its operating margins from a historical range of 2.3-5.0% in FY02-FY09 to 8.2% in FY11. Management is targeting 8.6% in FY12e and told us that they believe 10% is possible in the next few years. Most of the improvement has been driven by gross margins, which went from 37-40% historically to 41.7% last year. Management attributes much of this gain to the implementation of a POS inventory management system since Dec-08, which has allowed them to monitor demand patterns and store inventory levels in a systematic, centralized manner from headquarters. This has improved sales, procurement efficiency, and cut down on inventory build of low-turnover products.

Management is targeting a 44% gross margin compared to current margins of ~42% with further benefits from the POS system expected. SG&A has been declining gradually as a % of sales (33.5% in FY11) so we think margins could top 10% if a 44% gross margin is achieved.

One quick comment on the recent September quarter Q2 results. Operating profit slightly missed the company’s first half forecast. However, the reason was due to the expensing of a new POS system for 250 million yen, which is a one-time cost that wasn’t included in the initial guidance. This may have contributed to the recent stock price correction, but we don’t believe it raises any concern about the achievability of management’s full year guidance.

Risks

Oil prices and exchange rates are potential risks given the limited price flexibility of the store format and a high proportion of plastic contained in items sold. Since oil and commodity prices are typically dollar-based, a major depreciation of the yen against the dollar would be an incremental negative. Seria sources about 40% of products in Japan and the rest primarily from China so a depreciation of the yen against the renminbi is also a risk. Incidentally, we believe the recent 20%+ correction in the stock is partly due to the recent yen weakness (as well as general rotation into higher beta plays in Japan). We are not concerned about the move in the yen thus far for a few reasons. First, the current yen/dollar rate is still at a similar level as it has been for the past few years. Second, the price of oil in yen is still at the average level of the past four years. Finally, even if manufacturing costs face some inflation we expect most of the initial burden to be borne by the manufacturers and wholesalers. That being said, if the yen depreciates to 120 per USD or 16 per renminbi, we would have some concerns. If a sustained inflation were to take hold in Japan (we have our doubts about this in the near-term despite Shinzo Abe’s proclamation), we think management could adjust their package sizing and pricing policy somewhat to provide more flexibility.

Other risks include SSS weakness and increased competition. One additional risk we see is for returns to be diluted by cash piling up on the balance sheet. Seria reached a net cash position in FY11 (11% of market cap currently) and the company consistently generates significant free cash flow (FCF/EV is around 15%). Despite that, the company has had a payout ratio below 10%. We have urged the company to pay higher dividends and/or buyback stock. The founding family owns 36.8% of the company and it might be logical for them to pay themselves with higher dividends, but this being Japan we are not holding our breath. Any capital management initiatives would be an incremental positive surprise.

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