Description

Nakano Refrigerators (“6411 JP”) trades at a 24% discount to its net cash balance sheet and recently bought back 19% of its shares outstanding.  The company is consistently profitable and trades cheaply at 11.1x our estimate of 2017 EPS without adjusting for the net cash balance sheet.  Beyond its cheapness, 6411 JP is a compelling investment today because the company is likely to experience a multi-year earnings tailwind due to a significant increase in demand for its products from its largest customer, 7-Eleven.  Additionally, the first non-Nakano CEO was announced last year, which is a big change for a family run Japanese company (Tomekichi Nakano founded the company in 1917).  The announcement of the CEO followed another large buyback of 15.9% of 6411 JP’s shares outstanding at the end of 2015.  At 10x our estimate of 2018 EPS, 6411 JP is worth 28.7% upside from its current close without adjusting for its net cash balance sheet.

This opportunity exists because of 6411 JP’s small-capitalization of $145 million (therefore, this is likely a PA trade for many on VIC) and the historical view of this being a sleepy, family run company (our hope is this changes with the new CEO).

Business Overview:

6411 JP’s core business is manufacturing and installing refrigerated display cases for supermarkets and convenient stores in Japan.  6411 JP also sells refrigeration systems to food distribution centers.  These markets are maturing and consist mainly of replacement orders as supermarkets and convenient stores upgrade equipment and refresh their floorplans, etc.  6411 JP has been happy to serve only these niche markets, managing costs when customers aren’t investing in new equipment, and innovating when customers are, leaving the business pretty much the same over the last 20 years.  As can be seen in the choppiness of sales from the table above, 6411 JP experiences fluctuations in sales due to the cyclical nature of customer capital expenditure programs.  We believe 6411 JP will soon begin to experience a significant increase in sales due to the recent announcement of 7-Eleven’s store upgrade cycle in Japan.

7-Eleven Opportunity:

In April of this year, after recognizing that frozen foods had been its fastest growing category, 7-Eleven announced a massive, multi-year renovation initiative in its Japanese convenient stores.  This is the largest renovation initiative in 40 years and, importantly for 6411 JP, the plan includes tripling its freezer/chiller footprint in its stores.

Historically, 7-Eleven has accounted for 41% to 56% of 6411 JP’s annual sales, and sales from 7-Eleven have generally grown over time as 7-Eleven has consistently built new stores in Japan.  Given 7-Eleven’s significant contribution to 6411 JP’s results and the long-term relationship between the two, we believe 7-Eleven’s new renovation initiative will be a multi-year earnings tailwind for 6411 JP as has historically been the case.  For example, in 2011 and 2012, 7-Eleven installed new chillers in close to 12,000 of their Japanese convenient stores, and 6411 JP experienced significant increases in revenues from 7-Eleven in both years (see table below).

Under its current plans, 7-Eleven will introduce its new store layout in 800 existing stores and 1,100 new stores in its current fiscal year (ending Feb 2018), and will renovate 10,000 existing stores cumulatively plus new stores by Feb 2022.  If this new initiative represents similar sales per store opportunity for 6411 JP (~0.8mm yen per store), this could mean 11bn yen potential incremental revenue for 6411 JP between its FYE 12/2018 and 12/2021, or an annual revenue potential equaling 10% of 6411 JP’s current annual revenue.  With a high fixed cost base, this should lead to a significant increase in earnings for 6411 JP.

Article on 7-Eleven’s new initiative: http://www.nikkei.com/article/DGXMZO16323690S7A510C1H11A00/

New layout plan is shown on pg. 9 of 7-Eleven’s recent investor deck: https://www.7andi.com/dbps_data/_template_/_user_/_SITE_/localhost/_res/en/ir/library/ks/pdf/2017_0406kse_02.pdf

Conservative Guidance:

Given its small market-capitalization and lack of analyst coverage, we don’t believe many are paying attention to the 7-Eleven announcement and putting the pieces together to extrapolate the earnings potential to 6411 JP.  Beyond higher earnings in the future, we also believe that 6411 JP is going to beat its FYE 12/2017 guidance significantly.  Every single year for the last five years, the company has raised earnings guidance twice throughout the year, only to end the year beating the most recent guidance.  While earnings guidance has already been raised once this year, we expect another raise most likely in August, given the company already earned 50% of revised FY2017 EBIT forecast in 1Q2017 (compared to 30% on average historically).

Future Capital Return:

6411 JP has bought back 34.8% of its shares outstanding since November 2015.  While most of this has been repurchased directly from the Nakano family (they’ve gone from 39% ownership to 14%), we believe the repurchases from the Nakano family, combined with the promotion of a non-Nakano to the CEO role, will lead to a more growth focused organization over time and potentially increased returns of capital to shareholders.

Summary:

With a cheap valuation, a significant margin of safety given the net cash balance sheet, a multi-year earnings tailwind, and the potential for further returns of capital, Nakano is a very compelling investment.

Catalyst

- guidance raise

- increased returns of capital