Financial Summary

Recent Updates

Highlights

On January 10, 2012, Don Quijote announced sales figures for December: click here to go directly to monthly sales charts.

(For original Japanese-only release in PDF format please click here.)

On December 9, 2011,the company announced sales figures for November.

On November 11, 2011, the company announced sales figures for October.

On November 4, 2011,the company announced Q1 FY06/12 results: click here to go directly to the Q1 FY06/12 results section.

In addition, the company also raised its 1H FY06/12 forecast.

(For original Japanese-only release in PDF format please click here. )

For corporate releases and developments more than three months old please refer to the News & Topics section.

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Trends & Outlook

Monthly Trends

December 2011

December comparable store sales were up 2.3% YoY. December is the busiest month of the year and gross profits for all product categories at comparable stores rose YoY. The company noted monthly sales hit all-time highs across group companies, led by the parent operation. By product category, sales for staples such as, household goods, and groceries continued to be solid while demand for higher priced goods increased due to bonus-season related demand.

November 2011

November comparable store sales were down 1.1% YoY. Electric appliances sales were sharply down YoY dragging overall numbers down, the decline in electric appliance sales was due to the base effects from strong last-minute demand 12-months earlier for televisions and peripheral devices. Barring the performance of electric appliances sales of watches, jewelry, imported brand, fashion items and other high value goods remained strong. Consequently, gross profit margin rose and comparable store gross profit likewise was up YoY.

October 2011

October comparable store sales increased 0.1% YoY. Electric appliances sales declined YoY due to due to a combination of the cessation of the eco-point program and waning demand since July. Demand for household goods and watches and fashion items continued to be strong.

September 2011

September comparable store sales were up 6.3% YoY. Demand for household goods and groceries grew steadily and were hardly affected by the unusual weather conditions during the month. Meanwhile sales of high-priced goods also increased, such as watches and imported brand goods. Electronic appliances sales declined YoY due to the rebound effects from the cessation of analogue signal TV broadcasting. However, the composition of private brand goods in the sales mix increased resulting in gross profit margin increasing YoY.

August 2011

August comparable store sales were down 0.8% YoY. The company noted lower demand for seasonal goods given poor weather and the lower number of Sundays in the month YoY were the main factors behind the slight decline. YoY comparable store sales adjusted for business days actually rose 0.7%. By product category, household goods and groceries continued to experience brisk sales, while sales for brand items, watches and other high-value goods staged a recovery.

July 2011

July comparable store sales increased 6.7% YoY, with both new and regular customer levels rising, according to the company. Total sales were up for all product groups YoY. Electronic appliances recovered strongly, boosted by the demand for digital TVs and tuners owing to a recent nationwide switch to solely digital TV broadcasting and strong electric fan sales as consumers rushed to conserve electricity, turning off air conditioners. Household goods also witnessed brisk sales driven by demand for goods such as sunscreens and “cool pajamas” to beat the summer heat.

June 2011

Comparable store sales for June rose 8.8% YoY - the highest monthly growth rate since June 2000 when the total number of company stores first exceeded 20. Electric appliances, household goods, food and watches & fashion, all experienced good sales helped by the company’s summer season promotional themes of "Power Saving", "eco-friendly", and "cool sensations".

May 2011

May comparable store sales were up 3.0% YoY. The company commented that despite negatives, such as poor weather over Golden Week, one less operating day in the month, and typhoons, sales were more stable than expected.

April 2011

April comparable store sales were up 3.3% YoY. The company noted that in addition to the continued strong demand for essential household goods and food products following the Tohoku earthquake in March, outdoor leisure products also sold well due to long-weekend holidays.

March 2011

March comparable store sales were up 4.2% YoY. The seven-day period from March 12 saw high demand for daily necessities following the Tohoku earthquake of March 11. However, from March 19 onwards, there were shortages of some products due to the earthquake and rolling electricity blackouts. This impacted consumer sentiment and sales of higher-priced items were negatively affected, as well as seasonal demand from new high school and college graduates.

February 2011

February comparable store sales were up 2.6%. Seasonal items including Valentine Day’s gifts and some medicines sold well. Sales of small home appliances, kitchen items, snacks, and instant coffees were also strong during the month. Sales of imported watches continued on a positive trend.

Q1 FY06/12 Results (Announced on November 4, 2011; please refer to the table above)

The company also raised its 1H FY06/12 forecast in addition to announcing its Q1 earnings.

Sales at 134.9 billion yen were up were up 8.1% YoY, or by 10.2 billion yen, breaking this down by group company: Don Quijote sales rose approximately 6.2 billion yen and Nagasakiya sales were up about 4.2 billion yen. Comparable store sales at the core Don Quijote store format rose 2.1% YoY (customer count increased 0.9% while average spend per customer declined 0.2%).

The company noted the hurdle was already high for YoY comparable store sales base comparisons and in addition the period was characterized by extremely hot weather and typhoons. Nonetheless, Don Quijote store sales were up 7.2% for the period and Nagasakiya stores (which account for 90.0% of Mega Don Quijote format shops) notched up a solid 14.1% YoY increase。

Gross profit margin came in pretty much flat YoY at 25.8% (vs. 25.7% last year). The company said it was satisfied with its gross profit margins given sales had been affected at the beginning of FY06/12 by the March 2011 earthquake in the Tohoku region. It believed consumers limited expenditures on luxury items and instead focused on daily necessities, food, and miscellaneous daily goods, thus, gross profit margin at the start of the quarter was comparatively low because of the product line-up to cater to this situation. However, from the middle of Q1 onwards, the company shifted its product line-up as store-level monitoring of customers flagged changes in their needs, which resulted in higher gross profit margin through strong sales of higher margin products. Product buzzwords and categories that sold well in Q1 were ‘energy saving’; ‘environmentally friendly’; and ‘feeling cool.’ Sales of import brands, such as Louis Vuitton and Gucci, and watches were also strong. Q1’s overall gross margin can thus be viewed as the blended result of a low initial margin followed by higher margins in the latter part of the quarter.

SG&A costs increased 7.3% YoY, reflecting an increase in staff numbers, but an increase in sales meant the company succeeded in keeping its SG&A-to-sales ratio in check at 20.1% (vs. 20.2% last year), which helped contribute to the rise in operating profit margin to 5.8% (against 5.5% last year). Operating profit rose 13.1% YoY to 7.8 billion yen. The company posted an extraordinary gain of 2.2 billion yen, of which 1.8 billion yen came from settlements of reorganization claims. Net income consequently grew 116.3% YoY to 6.7 billion yen – a record quarterly high.

Improved profitability at Nagasakiya was another key development over the quarter (in addition to the other factors outlined above). As of September 2011, Nagasakiya managed a total of 40 stores, of which 5 were general merchandise stores (GMS) and 35 were MEGA Don Quijote stores. Performance of the 35 MEGA Don Quijote stores improved significantly.

The July-September 2011 performance for the 35 MEGA Don Quijote stores was as follows:

(Figures in parentheses denote performance figures for July-September 2010.)

Sales growth: +16.2% YoY

Gross profit margin: 22.0% (21.3%)

SG&A to sales ratio: 18.7% (20.4%)

Operating profit margin: 3.3% (0.9%)

SR Inc. believes the improvement in profitability at Nagasakiya, which up to recently had consumed parent company management resources in its effort to restructure Nagasakiya, to be extremely significant. The format can now be expected to contribute to the profitability of the Group. The company’s decision to increase the number of its Don Quijote stores during FY06/12 reflects this point.

As of end-Q1 FY06/12 the total store count was 229 stores for the consolidated group (vs. 228 stores as of end-FY06/11). The company opened two new stores (one Don Quijote, and one Essence format) and closed one store. In addition, one Nagasakiya store was converted to the MEGA Don Quijote format in Q1.

The 1H FY06/12 revision was as follows:

• Sales: 272.0 billion yen (vs. previous forecast of 270.0 billion yen)
• Operating profit: 15.2 billion yen (vs. previous forecast of 14.7 billion yen)
• Recurring profit: 14.9 billion yen (vs. previous forecast of 14.6 billion yen)
• Net income: 10.0 billion yen (vs. previous forecast of 7.8 billion yen)

The company remarked it would review its full-year FY06/12 forecast when it releases 1H results on February 6, 2012.

The company commented that performance in November 2011 was also trending above forecast and as of October 2011 imported brands and other high-priced items were selling well.

FY06/11 Results

The company announced FY06/11 results on August 18, 2011 (see the table above).

Sales were up 4.1% YoY at 507.7 billion yen. Comparable store sales at the mainstay Don Quijote store format rose 3.4% YoY (customer count was up 3.1% and average spend per customer was up 0.3%) while total sales of operating Nagasakiya stores were up 9.8% YoY. The company managed the product mix successfully, with seasonal daily products, “lifestyle products” (e.g. cosmetics, interior and leisure related goods), and private brand items, all helping to expand the customer base and driving strong customer traffic. Operating profit rose 20.3% YoY to 25.3 billion yen thanks to SG&A cost controls, particularly of personnel costs.

The company recorded extraordinary losses of 5.4 billion yen, including 1.9 billion yen due to the March 2011 earthquake and 682 million yen in asset retirement obligations losses. The total extraordinary losses were only slightly up from the 5.2 billion yen in FY06/10, aided by lower investment securities valuation losses. Extraordinary gains were 1.4 billion yen, up from 892 million yen in FY06/10. Net income grew 23.7% YoY to 12.7 billion yen. Sales, operating and recurring profit, and net income all hit record highs.

Gross profit margin came in at 25.4%, a small 0.1% improvement YoY from FY06/10, but margins pre- and post-March 2011 earthquake differed. Up until the earthquake, the company had been revising its merchandise mix towards more mid-priced merchandise due to improving consumer sentiment at that time. Post-disaster, it shifted its strategy towards increasing customer traffic and sales per customer, thereby increasing its market share. This change in strategy was visible in the trends of the quarterly gross profit margins. Specifically, Q1 and Q2 margins were up YoY, while in Q3 and Q4 they declined. At the same time, Q3 and Q4 showed strong growth in sales, while operating profits were also up significantly due to effective SG&A cost controls.

Nagasakiya achieved its first operating profit since being acquired by Don Quijote. By company the results were as follows:

• Don Quijote: Sales of 346.6 billion yen (up 6.1% YoY) with an operating profit of 19.7 billion yen (up 14.4% YoY).
• Doit: Sales of 19.4 billion yen (down 1.7% YoY) with an operating profit of 768 million yen (down 49.1% YoY).
• Nagasakiya: Sales of 124.4 billion yen (up 2.9% YoY) with an operating profit of 748 million yen (vs. an operating loss of 1.9 billion yen in FY06/10).
• Don Quijote USA: Sales of 15.2 billion yen (down 11.8% YoY) with an operating profit of 754 million yen (up 5.0% YoY).

There was a net increase of 8 stores, taking the total store count to 228 stores as of end-FY06/11 for the consolidated group. The company opened 15 new stores (seven Don Quijote; three MEGA Don Quijote; four Doit, and one WR) and closed seven stores (one Don Quijote; one Picasso; two Nagasakiya; one MEGA Don Quijote, and one WR). In addition, nine Nagasakiya stores were converted to MEGA Don Quijote stores during FY06/11.

For details on previous quarterly and annual results please refer to the Historical Financial Statements section.

Full Year (FY06/12) Outlook

The company's operating and recurring profit forecast was a focal point due to a statement by Chairman Yasuda at the company's interim results meeting on February 4, 2011, where he said the goal was to achieve recurring profit of 30.0 billion yen in FY06/12. However, in the company’s official FY06/12 forecast the company chose a lower recurring profit target. Commenting that while 30.0 billion yen remained a valid goal, the company said its FY06/12 forecast was a more realistic and achievable target. SR Inc. believes the company is focused on hitting the 30.0 billion yen mark although that will not be easy without generating positive surprises at the top line; stronger than forecast comparable store sales will be the key to hitting Yasuda’s goal.

At the parent company, Don Quijote (not to be confused with the core store format), the forecast was as follows:

• Sales: 358.0 billion (increase of 3.3% YoY)

• Operating profit: 20.2 billion yen (increase of 2.6% YoY)

• Recurring profit: 20.0 billion yen (increase of 2.4% YoY)

• Net income: 10.4 billion yen (increase of 14.8% YoY)

Parent comparable store sales were forecast to be flat YoY (+1.0% YoY in 1H and -1.0% YoY in 2H). The company said it was conscious of FY06/11 comparable store sales, up 3.4% YoY and at multi-year highs. Indeed, 2H FY06/11 saw a very strong performance, above management’s expectations, and SR Inc. believes the company did not feel confident enough to forecast further YoY gains in 2H FY06/12 against that backdrop. SR Inc. feels given recent performance and solid execution across formats (with the exception of the now almost defunct Nagasakiya format), the company’s comparable store sales target is attainable. The total sales forecast also appears well balanced, given new store openings, an uncertain economic outlook, and the strong yen (which lowers purchasing costs but has a negative indirect impact on consumption.

The group hopes to open at least 15 new stores. As of September 2011, the breakdown for the confirmed 15 new stores was as follows: 13 Don Quijote format, 1 Doit format, and 1 New MEGA Don Quijote format. Regarding the increase in planned store openings vs. FY06/11, the company commented it had focused resources on establishing the MEGA Don Quijote format stores over the past several years, but conditions were now right for it to refocus efforts on the Don Quijote format. This renewed focus means that more resources can now be allocated to expanding in new geographic areas and the FY06/12 store opening mix is slanted towards opening of regional stores. In addition, a store format called Essence (see below) was also included in the company's new store plans.

The main reason why the group's profit margin was forecast to improve more than that of the parent company was due to expectations of further gains at the Nagasakiya subsidiary (where FY06/12 operating profit was forecast to increase by approximately 1.3 billion yen YoY).

Essence

Essence is a new store format the company started in FY06/12. With a sales floor area of 300 – 1,000 sq m and 10,000 to 20,000 items, the small stores will have a more specialized selection of items than Don Quijote-format stores. (For more details on Essence please refer to the Essence section later in this report.)

Longer Term Outlook

The mid-term strategy is to seek further growth in the domestic market. The management sees the Japanese market as a zero-sum game and believes it can achieve substantial and stable growth at the expense of weaker competitors. Its competitive advantage boils down to better execution, more flexibility, and above all a stronger commitment to growth and growing profits than rivals – a relatively unique combination of traits in corporate Japan. As an owner-managed company Don Quijote is hungry to prove itself the market-leader. To summarize Chairman Yasuda comments at the FY06/11 results meeting, “we are, and we want to be seen as, a first-class growth company, not just a quirky retailer”.

One of the mid-term strategic goals is to establish the MEGA Don Quijote and New MEGA Don Quijote formats. As of end-FY06/11 the MEGA Don Quijote format remained a work in progress (see the MEGA Don Quijote section for further discussion). The company wants to grow outside its traditional urban markets, and perfecting the development of the family-oriented discount store formats is thus a priority. Once MEGA and New MEGA Don Quijote formats are successful, the company intends to seek attractive store real estate occupied by other retailers, which would lower store expansion costs and contribute to faster growth and profitability. In terms of new store openings, 20-25 stores appears to be the goal. As new openings are more likely to be Don Quijote stores, as opposed to smaller formats, increases in sales area will likely remain substantial. The company also started refocusing on its core Don Quijote format as a growth driver as of FY06/12.

Based on discussions with the company, SR Inc. believes future top line growth is likely to be in the 5-10.0% range over the next 5 years, which should come in waves as new store acquisitions are made and successfully integrated into existing operations. Earnings growth should exceed this number if the company is successful with its “turnaround formats”, such as MEGA Don Quijote. As for smaller formats, such as the Essence stores, the jury is out – previous attempts by the company produced mixed results. However, Essence’s proposed product mix is closer to Don Quijote’s traditional offerings and if the company somehow manages to differentiate Essence from its rivals, it could be a promising attempt.

Given the discounting centered business model and deflationary pressures, profit margins are unlikely to improve substantially; SR Inc. believes 4-6.0% operating margins are a likely scenario.

In summary, assuming profitable acquisitions, earnings could expand around 7-10.0% per annum on average, while returns on invested capital are likely to improve (please see the Income Statement section for further discussion on this topic).

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Business

Business Description

Main Product Categories

Reflecting its widening customer base, Don Quijote’s product mix has been changing in recent years (please refer to the table below) and evolving away from its original focus on variety goods and clothing.

Several trends illustrate the evolution of the business in the past 10 years. Watches and Fashion Goods, Daily Goods, and Sports & Leisure goods were traditionally the main categories, but as stores became larger and opened outside of urban centers, the Foods category has come to play an important role (Sports and Leisure goods are now a minor part of the overall mix). Sales were equally divided between Electric Appliances, Household Goods, and Watches & Fashion Merchandise each representing 23-25.0% of total sales around 2000. Of these, Watches & Fashion Merchandise carried the highest margin and was therefore the largest profit contributor. Foods was only 17.0% of sales in FY06/00; mostly dry groceries and no fresh produce. This proportion changed gradually as the company opened more regional stores, and then substantially following the Nagasakiya acquisition. By FY06/11, 21.2% of sales came from the Apparel and Luxury Brands segment. Meanwhile in FY06/11 Household Goods accounted for 21.4%, Electric Appliance grew slightly YoY 11.1% and Foods contribution was 28.3%.

One of the biggest issues for the company is the development of the fresh produce category, one of the most difficult areas to get right. Quality fresh produce at competitive prices increases the frequency of customer visits and can be a key driver for many customers’ choice of where to shop. Food is lower margin than most other categories, and in fresh produce the inventory loss rates are quite high, often making fresh food a loss leader for supermarkets and GMS chains. That Don Quijote stores are open late into the night further complicates inventory management for this category, hence why the company was never enthusiastic about the food business. Now, in order to grow it has little choice but to move into the category. Unfortunately, the Nagasakiya acquisition did not bring along the desired expertise so some innovative solutions are in order.

SR Inc. believes one such solution could be to acquire a supermarket firm strong in fresh produce. Another solution, one that the company has been trying to develop, is to partner with outside vendors who possess the fresh food sales know-how and to incentivize them to sell food profitably.

The acquisition of Nagasakiya increased the percentage of tenant revenues in the overall revenue mix. Total tenant revenues were 15.8 billion yen in FY06/11.

Business Model

Don Quijote is a mass market discount retailer. Given Japan’s deflationary environment it has been hard or impossible for retailers to raise prices: to grow sales, retailers have had to grow volume by selling more per store or by opening new stores. Don Quijote has been very successful in the latter. After opening its first store in Fuchu (Tokyo) in 1989, the company expanded its store network in the Tokyo Metropolitan area (Tokyo prefecture and adjacent prefectures of Kanagawa, Chiba, and Saitama). From December 2001 Don Quijote started expanding outside the Tokyo Metropolitan area and opening large scale stores. It also continued building its Tokyo store network to achieve a dominant position as a discount retailer. As a result, total sales grew rapidly while per-store and per-square-meter metrics fell (see table below). Selling more per store is a function of store size or better efficiency (higher inventory turnover). Retailers tend to focus on customer traffic as a key performance metric, due to the eventual stabilization of per customer spend once a retail concept has been developed. Urban Don Quijote stores are high traffic, particularly busy between 6pm and 11pm. In suburban areas the company compensates for lower customer traffic with lower capital outlays and lease payments for new stores and focuses on faster moving inventory items such as food and sundries.

Invested capital per square meter of sales floor area dropped substantially following the Nagasakiya acquisition. Improving operating performance of the Nagasakiya stores, through conversion into MEGA or New MEGA Don Quijote formats could boost not only sales and earnings, but also increase ROI.

Past rapid growth created challenges for the company’s business model as urban locations became harder to find and suburban store openings required a different product mix. Larger suburban stores led to lower capital efficiency, forced more focus on the less profitable Food segment and pushed the company towards a more conventional discount retail model, away from its amusement merchandising niche.

Expanding store-count through acquiring companies or individual stores can be a successful strategy thanks to low initial capital outlays (often just assumption of the target’s debt, at a fraction of the cost of building a similar new store base). Don Quijote’s acquisitions of Doit and Nagasakiya were examples of this. However, while Doit was a good fit and easy restructuring story, Nagasakiya has been a significant challenge.

Discount retailers tend to have low gross profit margins (20-25.0%) and low SG&A costs. The key to earnings growth is fast inventory turnover, maintaining stable gross profit margins, and controlling SG&A. The traditional trade-off for retailers is between higher inventory turnover with lower margin goods or lower turnover with higher margin goods. All retailers need to keep fixed cost as lean as possible. Don Quijote found an innovative solution to address both inventory turnover and margins, and fixed costs. It uses a unique mix of standard discounted merchandise that is typically competitive and thus lower margin with highly profitable “spot” (opportunistically acquired “no-reorder” inventory) and novelty items. Don Quijote then crams an unusually large amount of inventory using its “compression display” technique into its store space, both increasing the probability customers will not leave empty-handed and lowering the fixed cost per inventory unit. This is further augmented with long opening hours and a focus on fast moving spot items. However, it remains to be seen if this strategy can be successfully transferred to regional stores and into the GMS MEGA Don Quijote format. Company data shows inventory turnover fell as Don Quijote moved into regional markets in the early 00’s.

To compensate for declining inventory turnover, Don Quijote has focused on improving gross margins – a risky trade-off for a discount retailer. FY06/08’s jump in gross margin partially reflects the impact from high margin apparel at Nagasakiya and DIY goods at Doit. There was however, also a visible jump in the SG&A to sales ratio to 22.9% in FY06/09 from 18.6% in FY06/06 (pre-acquisitions) due to the acquisition of inefficient Doit and Nagasakiya stores. Since FY06/09 the ratio has declined - to 20.4% in FY06/11 - reflecting successful restructuring and integration of the acquired retailers.

Like other retailers, Don Quijote’s sales and earnings are seasonal – stores are busy at calendar year end and late summer, however, seasonality is not overly pronounced as Don Quijote operates across several categories and distinct markets.

Merchandising and Inventory Management

Don Quijote Compression Display (Source: Company Data Processed by SR Inc.)

Don Quijote employs a combination of merchandising techniques that differentiates it from most other retailers:

1. Compression display - Merchandise is intentionally crammed to the ceiling to lower visibility and create a maze-like environment. Please see the Store Formats section for more details.
2. Mix of “staple” and “spot” items - Staple items are normal items easily available at other retailers, which are regularly replenished (and account for approximately 70.0% of products) and sold at competitive prices. Examples of staple items are basic food and household sundries. “Spot” items are bought on a one-off basis. They often include closeout and excess inventories acquired from wholesalers and manufacturers. Because of this, spot items can be priced unusually aggressively due to the low inventory cost, and attract consumer attention (essentially, “loss leaders” without the loss). Additionally, spot items simply can be unusual items unlikely to be sold by other retailers. Therefore spot items possess an element of ‘discovery’, both in products and prices.
3. Large number of SKUs and an eclectically wide variety of categories. Large urban Don Quijote stores carry around 40,000 items each, from basic food and apparel to Rolex watches, TV sets, and novelty items. The unusually wide offering creates a “treasure hunt” atmosphere and allows for creative and flexible merchandising solutions. Merchandise sourcing has become mostly centralized as the company has grown larger.

These merchandising methods and the heterogeneous nature of items carried at different stores create substantial inventory management challenges. Indeed, it could be argued that Don Quijote is a unique inventory management specialist. Currently, inventory is managed both vertically via geographical areas and horizontally across product groups. Product groups have ultimate responsibility for managing inventory levels. Staple items are generally reordered automatically and managed at the SKU level. The system prevents stale inventory from appearing. At the same time, the company is keen not to over-control and over-regiment the process to allow for unique items and unique methods to survive and flourish.

Store Formats/Number of Stores

Don Quijote is a conventional brick-and-mortar retailer selling its merchandise in standalone stores. Its main formats are Don Quijote, MEGA and New MEGA Don Quijote – large discount store formats created in response to its Nagasakiya acquisition. As of end-FY06/11, the company had a shrinking number of Nagasakiya stores and several Doit stores.

Most of the Don Quijote stores are operated by parent Don Quijote. Most MEGA and New MEGA Don Quijote stores are conversions from Nagasakiya, but there also some converted from other formats and newly opened stores.

The parent company owned 169 stores as of end-June 2011 (including Picasso and PAW formats). Of the total store-count, the regional stores (targeting housewives as their main customers) accounted for 60% of the total. The consolidated company had 228 stores as of end-FY06/11 vs. 220 in FY06/10.

Don Quijote (often referred to as ‘Donki’) is the flagship format; stores are between 1,000-1,500 sq m, normally with several floors. Merchandise is presented in “compression display” style – narrow passages and tall merchandise shelves packed with up to 40,000-60,000 SKUs (items) decorated with loud handwritten signs. The layout can be confusing for new customers and changes often. However, this sense of confusion is a calculated corporate strategy to draw repeat customers to merchandise that the store wants to emphasize. All available goods are on display, with no space provided for inventory storage.

The traditional format has been modified though for regional locations where core customers are housewives rather than time-killing 20-year-olds. This is arguably causing a drift towards a more mainstream retailing format. Moreover, the increasing ubiquity of Don Quijote stores has also caused some of the novelty value of the format to wear off. Don Quijote needs to stay original to continue successfully differentiating itself from competitors.

MEGA Don Quijote (Source: Company Data Processed by SR Inc.)

MEGA Don Quijote is a new large store format aiming to bridge the gap between the quirky urban Don Quijote format and the conventional GMS/large supermarket format. The company has searched for some years for a model to target a broader market and more suburban clientelle. The MEGA store concept emerged, when Don Quijote bought Nagasakiya (a failed GMS retailer with many stores in good locations): the first MEGA store was opened in April 2008. It is an attempt to retain the concept of ‘amusement’ while operating larger stores refurbished from existing Nagasakiya locations.

The MEGA Don Quijote store format is a family oriented discount store. If the traditional Don Quijote store format is 1/2 discounted goods and 1/2 ‘entertainment’ then MEGA Don Quijote could be viewed as 4/5 deep discounted goods and 1/5 entertainment. As of end-FY06/11, there were 43 MEGA stores. According to the company, assuming no additional investments the cash flow payback period (including inventory investment) is about 3 years, delivering a store-level ROI of 30% (calculations are based on leased stores i.e. no land investment; about 80% of MEGA Don Quijotes are currently leased). MEGA Don Quijote store sizes vary substantially, from 3,000 sq m to 9,000 sq m, as the format has replaced existing stores of other retailers that have vacated the premises or have been acquired by Don Quijote.

In terms of product mix, MEGA Don Quijote stores are heavy on food (52.7% vs. 24.7% at Don Quijote). Watches and apparel are only 19.7% at MEGA but 25.5% at Don Quijote (the comparison is based on sales for FY06/10 at MEGA stores and Don Quijote stores; Source: Company data).

Essence is a new store format the company started in FY06/12. With a sales floor area of 300 – 1,000 sq m and 10,000 to 20,000 items, the small stores have a more specialized selection of items than Don Quijote-format stores. The company envisions the format as urban discount stores that contain aspects of drug stores, supermarkets, and convenience stores. Don Quijote commented in September 2011 it was only planning on two stores at Kawaguchi Station and Ogikubo but would open more stores if the pair demonstrated stable profitability. SR Inc. believes based on the scale and merchandising mix, Essence could offer more flexibility for opening new stores than the Don Quijote format. Indeed, if this store format is a success, it could become an important component in the company's growth strategy.

PAW (pronounced “pow”) is a large shopping mall type format comprising Don Quijote and arcade game parlors as a core tenant, and other tenants including beauty salons, DVD rental services etc. PAW was the first attempt by the company to manage larger stores. The model is effectively the same as the traditional Don Quijote format, but with added drawing power and revenues of tenants. Initially, PAW stores were an impressive success, growing to the total of 28 stores as of end-FY06/08. PAW tenant structure has been impacted as game arcades, the main tenants in most PAW stores, suffered from regulatory restrictions on hours of operations, access for minors, and payouts on redemption games. It seems likely to SR Inc. that many PAW stores will be refitted with additional Don Quijote sales floors added instead of game centers or transformed into MEGA Don Quijote format. There were 23 PAW stores as of end-FY06/11.

Picasso is a small format targeting small catchment markets in the Metropolitan area; it is currently deemphasized. The company had high hopes for a new convenience store format combining discounted goods with ready-to-eat meals but found it difficult to generate enough customer traffic to achieve high profitability. The Picasso model store is 300-500 sq. m and requires 1/3 of the investment needed for Don Quijote stores and carries roughly 1/4 of Don Quijote store inventory.

Doit stores are DIY home centers. There were 16 Doit stores as of end-FY06/11, down from 24 at the moment of acquisition. The average size of Doit stores was about 2,800 square meters, 2-3x larger than normal Don Quijote stores. SR Inc. estimates that some or all remaining Doit stores will be transformed into Don Quijote and MEGA formats over time but as of FY06/10, the company didn't offer a specific timeline.

Nagasakiya. There were 6 Nagasakiya stores as of end-FY06/11.

Strengths and Weaknesses

The original Don Quijote model’s strength was its ability to quickly turn substantial inventory in relatively small stores allowing it to generate high returns and cash flows in a competitive domestic retail environment. Stores deliberately carry substantial inventory to keep customers interested. Inventory management is key and stale inventory needs to be liquidated quickly. Flexible layout and discounting; and a delegating these decisions to the store level are key components of Don Quijote’s strategy. For customers, Don Quijote provides an unmatched variety of competitively priced products in a fun and exciting environment. Average spend per customer is higher than for comparable category specialists or general merchandisers.

Strengths:

• Ambitious and driven management. Don Quijote is one of very few large Japanese owner-run companies. In Japan, where pursuit of shareholder value is not always the highest priority, owner-run companies tend to be managed for growth.
• Strong brand as a fun and low price shopping destination. The company has both cost and differentiation advantages versus its competitors. It has developed unique retail knowhow, which would be extremely hard to replicate, and shown that it is capable of taking its retail technology into new markets.
• Access to capital. As a listed company, Don Quijote has access to a variety of capital raising options. While obviously a feature shared by all listed retailers, this is an important distinction for the company as Japan’s only large listed discount retailer as of FY06/11. In the current consumption and demographic environment, general discounters are in a relatively advantageous position when it comes to absorbing underperforming general merchandisers and department stores. This is due to a large number of categories of goods they sell and flexibility in terms of adjusting categories they choose to emphasize, depending on location.

Weaknesses:

• Dependence of the original Don Quijote format on high traffic urban markets. The company has adapted its business to suburban locations with its MEGA Don Quijote format but it remains to be seen if it can keep its unique identity going forward.
• An issue in the long run is whether the Don Quijote model can be exported to pursue growth overseas. It is conceivable that with some experimenting, the company could bring its model to densely populated markets of Asia. So far the only overseas locations are 4 stores in Hawaii (currently operated as Don Quijote USA) - the result of an opportunistic acquisition in January 2006. It has been a modest success, turning from a money losing operation initially to the OPM of 4.2% in FY06/10. An overseas expansion blueprint would be required to enable the firm to expand into overseas markets in earnest.
• Legacy reputation problems. While the company has managed not to attract any controversy in the past few years, the reputation as a “trouble maker” will probably persist for some time. The irreverence of Chairman Yasuda, an iconoclastic business model, and loud self-promotion of the stores are unusual for the conservative Japanese society and the company is likely to attract unusual levels of public scrutiny.

Group Companies, M&A, Investments

As of FY0/11 the Don Quijote group comprised 16 companies focused on retailing - in the future it would be logical for Nagasakiya and Doit to be brought into the parent.

Nagasakiya is both the largest subsidiary and acquisition by Don Quijote. It had 56 large GMS stores at the time of acquisition. Nagasakiya stores, many of them in attractive locations near stations and large suburban population centers, are being converted into MEGA Don Quijote stores.

Struggling Kanto-based home center Doit was acquired in 2007, a few months before Nagasakiya. Although the company was unprofitable it had good store locations. Shortly after purchasing the firm, Don Quijote transformed Doit stores into the Don Quijote format or a blended format (Don Quijote with lots of DIY tools). Stores immediately turned profitable and became meaningful contributors to Group earnings. Excess labor was shifted to Don Quijote stores where there were chronic shortages of people. As of FY06/11, Don Quijote was focused on turning around Nagasakiya and developing the MEGA Don Quijote concept, therefore the official position is no new large acquisitions should be expected. The company is aware that in absence of impressive results on those two fronts, the market is likely to view further M&A negatively. Acquisitions have also put a strain on company finances and therefore FY06/10-FY06/11 period was a “digestion” period in terms of M&A. (For further details on past acquisitions please refer to the History section.)

As of March 31, 2011 the company held 7.2 million shares of Shibusawa Warehouse (TSE 9304) or 9.5% of the shares outstanding.

As of February 28, 2011 the company held 3.3 million shares, or 5.9% of Maruei Department Store (TSE 8245), a Nagoya based department store operator.

Overseas Operations

Don Quijote owns and operates 4 stores in Hawaii (currently Don Quijote USA) that it acquired from Daiei. Overseas operations are marginal for the company and unlikely to expand in the near future.

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Market & Value Chain

Market Overview

Japan’s retail market is mature, cyclical, and in secular decline. One reason for this is Japan’s demographic shift: the population started to decline in 2007 and is expected to continue to shrink while gradually aging. Larger chains thus have to compete predominantly on price to attract a diminishing consumer base. But large chains have struggled to differentiate themselves from smaller rivals due to Japan‘s fragmented supply chain, regional differences, and the factional nature of Japanese business that complicates growth through M&A and post-acquisition integration. Some of the most successful Japanese retailers focus on low prices (Don Quijote, Fast Retailing, Shimamura), but for all successful ones a relentless focus on execution has been the key.

“Japan has too many stores” has been a popular refrain among industry observers. Indeed, the country has as many retail establishments as the US, despite a much smaller population. However, this comparison overlooks substantially different consumption patterns between Japanese and US consumers. Japan’s dense population and the habit of shopping locally and on foot has allowed small shops to survive, whereas in the US stores have necessarily grown larger to horizontally integrate different consumption needs. Nonetheless, while urban Japanese neighborhoods normally have a shopping street with multiple small specialty vendors, these vendors have been under attack from larger retailers since the 1960’s. The domination of large chains has become more obvious in recent years given they there are better equipped to cope with deflation.

In SR Inc.’s view, Japanese retailing’s real problem is easy access to capital. A large number of underperforming retailers, such as Daiei, were kept afloat by banks under political pressure through the 1990s and into the 2000s. As the retail trade is a large employer plagued with an oversupply of labor, failures of retailers have negative social implications in terms of unemployment rates. There was therefore substantial political resistance to letting retailers fail. This stance combined with an era of ultra low interest rates and poor corporate control meant retailers that should have gone bankrupt could borrow very cheaply (approximately 1.0%), generate even lower returns, and further destroy value. Dozens of zombie retailers thus stayed afloat, resulting in excess competition for emerging retailers and exacerbating deflationary trends.

As banks crawled out of the post-2002 banking crisis though their attitudes have changed. While still reluctant to allow bankruptcies, banks have forced underperforming firms to restructure and to improve their financial position. Troubled companies still pay low interest rates, but new loans come with pressure to deal with problems. Corporate failures and resulting job losses have also became more publicly acceptable and a wave of consolidation in retailing has begun.

The changes currently underway in Japanese retailing mirror what is occurring globally. For example, in the US several trends are present:

• Price polarization has meant luxury brands with strong brand identity and low price retailers have thrived at the expense of the middle-ground. High end department stores strong in merchandising consolidated and survived. Discounters such as Wal-Mart Stores Inc. (US WMT), Target Corp. (US TGT), Costco Wholesale Corp. (US COST) and others thrived as mid-range retailers went extinct.
• Concentration of market share among a handful of large retailers resulting in homogenization of products offered.
• The rise of online ‘long-tail’ retailing.

Recent trends in Japan are surprisingly similar to the US: department stores have consolidated, low price chains dominate the retail environment and mid-range GMS chains and specialty retailers struggle. While low price specialty retailers such as Uniqlo, Yamada Denki and Nitori have thrived, in general merchandising a new model has been slow to appear. Major foreign players, such as Wal-Mart, Carrefour SA (France CA) and Tesco Plc. (TSCO), have all stumbled in Japan. Local heavyweight Aeon Co. (TSE 8267) has been trying to evolve into a low price general merchandiser. Nonetheless, Don Quijote’s MEGA Don Quijote model could theoretically fill a large gap in Japanese discount retailing. The company is already among the top 20 Japanese retailers by sales, according to its FY06/11 presentation materials.

Customers

Don Quijote has two overlapping but nevertheless distinct groups of customers:

• Younger consumers in their 20s and 30s who often shop late at night and see shopping at Don Quijote as a sort of entertainment. These are the company’s traditional and core customer group.
• Traditional day-time grocery buyers, mostly housewives, who shop primarily on price, freshness of produce and to some degree on convenience.

The importance of younger customers has been declining as the company has expanded regionally and into suburban locations but loyalty of both groups of customers is low (switching costs are minimal) although this also depends on availability of alternative options in local markets.

Suppliers

Don Quijote buys from up to several thousand wholesalers. Generally such suppliers have very little power vis-à-vis large retailers like Don Quijote.

Barriers to Entry

While generally barriers to entry in the retail space are low, barriers to creating a successful competitive retailer like Don Quijote are extremely high given the required operational knowhow of the market. In general, Don Quijote has access to capital and enjoys economies of scale in its purchasing that can only be enjoyed by the top two dozen or so Japanese retailers. Operating a large scale national chain is complex and Japan is also a challenging market itself.

Competitors

The company has multiple competitors. The most important competitors in urban areas are convenience stores at night and low price specialty retailers in the day-time. In suburban regions, low price supermarkets, and other discounters are the main threat.

Japanese chain retailing is fragmented, highly competitive and characterized by many local operations often driven not by profit maximization but by sustaining employment and other non-economic reasons, such as pride.

Don Quijote has a very competitive business model and has been successful in expanding from its original metropolitan night market to become a nationwide chain (ranked 15th in sales in 2009 by Nikkei MJ survey). One category though where the company is not particularly competitive is electronics, a field where size and price are the only differentiators and specialists like Yamada Denki Co. (TSE 9831) and Yodobashi Camera Co. (unlisted) set the standards.

In terms of discount retailers, Saitama-based retailer Rogers (unlisted) is one possible competitor, although it only had 11 stores as of end-August 2011 (according to the company’s website). Other examples include Daikuma (unlisted subsidiary of Yamada Denki Co. (TSE 9831)), Japan (unlisted subsidiary of Sugi Holdings Co. (TSE 7649)). The company also mentions Costco Wholesale Japan (unlisted subsidiary of Costco Wholesale Corp. (US COST)), which has 9 outlets across Japan.

Substitutes

There are multiple substitutes for what Don Quijote does. In terms of entertainment value, shopping at Don Quijote can be substituted by visiting a game arcade or bowling alley. The PAW format was an attempt to bring such substitute activities under own roof with Don Quijote, creating synergies instead of rivalry. In the past 10-15 years the majority of businesses catering to consumers extended their opening hours late into night where permitted by law. While creating some direct competition and substitution for Don Quijote, the net effect was to create a more vibrant night market. Recently however, there was a regulatory backlash aimed to restrict night-time entertainment, especially for minors. For instance, local governments across the country have been enacting legislation banning persons under 16 years of age from entering game arcades and similar establishments after 6pm.

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Strategy

Don Quijote’s strategy is growth through delivering what it calls CV+D+A (Convenience + Discount + Amusement) to its broad customer base. The focus is on opening or acquiring more stores (Convenience), low costs (Discount), while maintaining its unique identity of fun merchandising (Amusement). Generally speaking, this is a partially differentiated strategy of cost leadership.

It is reasonable to expect Don Quijote to eventually fold any retail operations it acquires into the parent to lower cost and streamline operations and retail formats. The company is likely to remain focused on its core competence for the foreseeable future and remain a single entity rather than a group of entities.

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Historical Financial Statements

Earnings Results Discussion for the Year Preceding Current Fiscal Year (For Reference Purposes)

Q3 FY06/11 Results

The company announced Q3 FY06/11 results on May 9, 2011.

Cumulative sales for the first three quarters of FY06/11 were up 2.7% YoY driven by product promotions for daily necessities, seasonal and private brand goods. At the core Don Quijote format, same store sales grew 3.0% YoY for the period (a 2.8% increase in customer numbers while average customer- spend was up 0.2 %).

Meanwhile operating profit hit a record 20.2 billion yen for the period as cost controls focused on personnel expenses drove operating profit up 22.0% YoY.

Figures for Q3 FY06/11 are shown in the table above. Gross profit margin was 24.7% below the 25.3% achieved in Q3 FY6/10. The company noted issues procuring merchandise, as well as some procurement price rises post-quake combined with strong sales while selling prices remained steady as the main reasons behind the fall in gross margin.

SR Inc. does not consider the lower gross margin to be of particular concern: an increase in customer numbers led to higher sales (see the Monthly Trends section for comparable store sales for March and April) and the company also emphasized cost controls were in place (the SG&A/sales ratio in Q3 FY6/11 was 20.0%, lower than Q3 FY6/10’s 20.7%).

Until the Tohoku earthquake, the company had been working on revising its product portfolio, shifting to watches, fashionable clothing, and sporting items. It had also been enhancing its sales of mid-priced merchandise. However, as of May 2011 the company expected consumer trends to mirror those following the Lehman Brothers bankruptcy and global recession of late 2008: increased demand for essential household goods and an emphasis on value for money.

The company noted March’s Tohoku Earthquake had the following impact on operations:

• On the day of the earthquake (March 11), 65 stores, or about 25%, of its total of 223 stores suspended operations. These stores have gradually resumed operations since then. By March 12 just 14 stores had suspended operations; this was reduced to eight stores by March 14, five as of March 23, two as of April 11; and one as of May 27.
• Comparable store sales up until the earthquake were +2.6% YoY. On March 11 it fell 25.4% but recovered mainly due to sales of food and everyday goods with comparable store sales up 4.2% YoY for March.
• The company believes the impact of the earthquake and power supply constraints will be generally small going forward from April 2011. The company has stated it was considering measures regarding operations during peak power consumption periods in the afternoon but it intends to maintain ordinary business hours. The company also plans to renovate its Nagasakiya stores and others with the aim of saving power and energy through the introduction of LED lighting at a cost of about 2 billion yen (it had already invested about 600 million yen as of April 2011).

New MEGA Don Quijote store format

In April 2011, the company launched two new stores under the MEGA Don Quijote store format: MEGA Don Quijote Kobe main branch and MEGA Don Quijote Uji. The two stores have floor space of around 3,300 square meters - about halfway between that of a normal Don Quijote store and the standard MEGA Don Quijote stores. The intention behind these stores is to improve store operations by downsizing areas of clothing aimed at 40 to 50 year old women and fresh food sections, which have been weak points for the company. A smooth start for these two stores has raised the possibility the company may open similar ones in the future.

Q2 (1H) FY06/11 Results

The company announced Q2 (1H) FY06/11 results on February 4, 2011. At the same time, the company released a revision to its FY 06/11 forecasts.

Solid 1H FY 06/11 results nearly matched the revised 1H FY06/11 estimates released by the company on February 1, 2011. Consolidated sales were up 1.9% YoY to 255.5 billion yen. Operating profit was up 27.9% YoY to 14.2 billion yen. Don Quijote format store sales were up 5.2% YoY to 177.9 billion yen, and operating profit rose 26.4% YoY to 11.4 billion yen. Parent company comparable store sales grew 2.7% YoY (customer count grew 2.2%YoY, average purchase amount grew +0.2%). Gross profit margin increased 0.4% YoY to 25.2%. An improved product mix including (more middle-priced items), leisure, and fashion goods all contributed to the increase. The SG&A to sales ratio declined by 0.7% YoY to 18.8% (SG&A was 33.4 billion yen in 1H FY06/11 vs. 33.0 billion yen in 1H FY 06/10). Operating profit margin increased 1.1% YoY to 6.4%.

After pledging financial support to Fidec (TSE 8423) in October 2010, the company paid 1.7 billion yen for the company’s shares on January 27, 2011, and will make Fidec a consolidated subsidiary. The new subsidiary would be reported on the income statement after April 1, 2011 and on the balance sheet at the end of March 2011. With about 11 billion yen of assets, and about 15.2 billion yen of liabilities (loans and interest bearing debt), the financial impact of consolidating Fidec is minimal.

Incidentally, the new membership format store "WR" started on October 1, 2010 but was subsequently closed on January 4, 2011 due to low membership levels. The company recognized an extraordinary loss of approximately 400 million yen in Q2 related to the closure.

Selected comments made by the company during the results meeting:

• Redemption of bonds will be funded by bank loans and debt issuance during March 2011. The company will not equity finance.
• The company is targeting recurring profit of 30 billion yen and a recurring profit margin of 6% for FY06/11. It anticipates an improvement in the parent's gross profit margin and increased revenue contribution from MEGA Don Quijote.

1H FY 06/11 results nearly matched the revised 1H FY06/11 estimates which the company released on February 1, 2011.

The revised FY06/11 forecast was as follows:

• Sales: 500.0 billion yen (previous forecast: 510.0 billion yen)
• Operating profit: 24.5 billion yen (previous forecast: 23.0 billion yen)
• Recurring profit: 23.5 billion yen (previous forecast: 22.0 billion yen)
• Net Income: 12.5 billion yen ( previous forecast: 11.6 billion yen)

The company indicated that the change in the full year forecasts was due to the 1H FY06/11 results.

Q1 Results

The company announced Q1 FY06/11 results and revised 1H FY06/11 estimates on November 4, 2010. As a percentage of revised 1H estimates, Q1 results were as follows:

Sales: 48.3% (vs. 1H forecast of 258.0 billion yen)

Operating profit: 55.0% (vs. 1H forecast of 12.5 billion yen)

Recurring profit: 54.4% (vs. 1H forecast of 11.8 billion yen)

Net income: 50.6% (vs. 1H forecast of 6.1 billion yen)

Consolidated sales grew 0.9% YoY, largely due to strong comparable store sales from Don Quijote format stores (average purchase amount was -0.2% YoY, but customer count increased 2.0% YoY, so comparable store sales ended up being +1.8% YoY). The company commented that sales growth in Don Quijote format stores was due to a change in the product mix, introducing items priced between its low and high offerings, and an extended warm summer. Higher margin products (like watches, accessories, and sporting goods) reversed recent trends and were strong sellers. SG&A costs, especially labor, were kept under control, and when combined with the sales growth lead to a record-high quarterly operating profit. Net income dropped 13.5% YoY, a result of some extraordinary losses related to asset retirement obligations (682 million yen).

While sales were below the plan (128 billion yen), operating profit exceeded the plan (6.1 billion yen).

Revised 1H FY06/11 estimates:

Sales: 258.0 billion yen (unchanged)

Operating profit: 12.5 billion yen (vs. previous forecast of 12.0 billion yen)

Recurring profit: 11.8 billion yen (vs. previous forecast of 11.2 billion yen)

Net income: 6.1 billion yen (vs. previous forecast of 5.7 billion yen)

The company indicated that it made the 1H revision as a result of a strong Q1. The full year forecast was unchanged, and the company said that it will make revisions if necessary after Q2 performance becomes clearer.

Selected comments made by the company during the results meeting:

• Subsidiaries are struggling to grow. MEGA Donki is still a work in progress, but profitability is improving (albeit slowly).
• Redemption of bonds will be funded by debt. The company will not equity finance.

Don Quijote: As mentioned earlier, comparable store sales were strong. The main factors explaining strong performance were revisions of the product mix and efforts to expand the depth of mid-priced item offerings. The extremely hot summer also helped a lot.

Regarding the product mix, foodstuffs and daily necessities sold well in Q1 FY06/10, whereas in Q1 FY06/11 higher margin items that make the company’s stores unique, watches and fashion merchandise being one example, helped driving performance. According to the company, this was the result of ideas put in place in Q4 FY06/10, such as changing store layout to feature such products more prominently. The company also began expanding its offering of mid-priced items because it felt that consumer behavior had been shifting away from “defensive spending” (i.e. spend as little as possible, always buy the cheapest) since the end of 2009. In early 2010, the company started increasing the weight of higher price point items in the mix. Lastly, the lingering summer heat lengthened the sales period for summer goods and eliminated the need to clear stock by reducing prices, etc. Strong sporting and leisure sales figures highlight this fact.

Comparable store sales in October 2010 were also strong with a 5.4% increase YoY. SR Inc. estimates that regardless of the effect of the weather, the updated product mix and increase of mid-priced products are probably proving effective.

MEGA Don Quijote: Comparable store sales (excluding stores being refurbished) were up by 5.8% YoY. When asked by SR Inc., company’s self-assessment of its MEGA performance was, “30-40 out of 100, we hope to be at about 50 in a year's time”.

Nagasakiya subsidiary as a whole showed an operating profit of 150 million yen in Q1 FY06/11 compared to a loss of 170 million in Q1 FY06/1). The company indicated that while Nakasakiya’s operating profit was positive for only 3 months out of 12 on average when acquired, it earned an operating profit in 5 months out of FY06/10.

WR: A new type of store launched on September 23, 2010. (Note - This format was discontinued after only several months.)

Update on the store network: At the parent level, there were 161 stores at the end of Q1 FY06/11 (net decrease of one during the quarter). Subsidiary Nagasakiya had 42 stores. On a consolidated basis, 4 new stores were opened (2 Don Quijote format, 1 Doit, and 1 WR), and three were closed for a net increase of 1 store during the quarter (total: 221). The company converted 3 Nagasakiya stores into MEGA Don Quijote and Don Quijote formats, and refurbished 4 MEGA Don Quijote stores during Q1 FY06/11.

Full Year FY06/10 Results

The company announced FY06/10 full year results on August 18, 2010. Results were as follows:

Sales: 487.6 billion yen (1.4% YoY)

Operating profit: 21.1 billion yen (22.7% YoY)

Recurring profit: 21.1 billion yen (32.0% YoY)

Net income: 10.2 billion yen (19.7% YoY)

Consolidated sales were up 1.4% YoY to 487.6 billion yen. Comparable store sales at the Don Quijote format were down 1.5% YoY, but the net 2 new stores contributed to consolidated basis. Food sales increased 13.6% YoY and sundries rose by 15.9% YoY. However, small home appliances sales were down 1.8% YoY and clothing was down 50.3% YoY (refer to Sales Breakdown by Product Group). Although the parent company’s gross profit margin was unchanged from the previous year, the consolidated gross profit margin was down 1.2% points. In addition to a change in the product mix and lower prices responding to demand, bad weather and the increased proportion of MEGA Don Quijote format stores impacted the consolidated gross profit margin. Of the 1.2%, 0.7% was due to tenant business costs moving to COGS.

The company worked towards more efficient group management and reduced expenses such as labor, rent and advertising. As a result, the operating profit margin improved from 3.6% in the previous year to 4.3% in FY06/10, and the operating profit significantly increased YoY to 21.1 billion yen (+22.7%).

The balance of extraordinary items was a negative 4.3 billion yen. The main items were a valuation loss on investments in securities (2.7 billion yen), loss on sale of investments in securities (0.5 billion yen) and losses from store closures (0.4 billion yen). Net income also showed a significant increase of 19.7% YoY to 10.2 billion yen.

Capex for FY06/10 was 22.8 billion yen; the company spent money on converting some stores to the MEGA Don Quijote format, new store openings, and acquiring land for future openings.

Stores: 162 stores at the end of FY06/10 at the parent level. The number of stores increased by 12 compared to the end of FY06/09. The largest subsidiary Nagasakiya had 42 stores. The consolidated store count was 220 stores (2 stores YoY). There were 9 new store openings (8 Don Quijote format and 1 Doit format) and 7 store closures. 10 Nagasakiya format stores were converted into MEGA Don Quijote and Don Quijote format stores and 11 MEGA Don Quijote format stores were refurbished.

Nagasakiya conversion

Following the acquisition of Nagasakiya in 2007, Don Quijote has been converting the Nagasakiya store formats to Don Quijote stores. Smaller Nagasakiya stores are converted into the Don Quijote format, while larger stores are converted into the MEGA Don Quijote format (an experimental new format). Of the 55 stores at the time of the acquisition, by the end of FY06/10 25 stores were converted to either Don Quijote or MEGA Don Quijote format, 14 stores were closed, and 17 were Nagasakiya stores. The company expected to convert 7 stores by the end of FY06/11. This meant that there would be 7 Nagasakiya stores left, which the company expected to operate as Nagasakiya for the foreseeable future.

Results by entity

Don Quijote (parent company): Sales were 326.7 billion yen (+6.1% YoY). Overall price deflation continued and comparable store sales decreased 1.5% YoY (vs. company estimate of -1.0%). The average price decline of 5.1% was partially offset by a 3.8% growth in the number of customer. Gross profit margin improved by 0.2%, and operating profit margin improved from 4.7% in FY06/09 to 5.3% in FY06/10. Operating profit was 17.2 billion yen, 81.7% of consolidated operating profit. Up until a few years ago, high-priced fashion items, brand products, and electronic appliances had been driving Don Quijote’s growth . When the economy slowed and sales of these products fell, the company was quick to shift its merchandizing mix to include more money-saving products such as food and household goods, which supported performance. In SR Inc.’s view, such agile merchandise management and marketing operations were key success factors for the remarkable profit increase in FY06/10, when the economy was still weak.

Nagasakiya: Sales were 120.9 billion yen (-1.6% YoY), impacted by a decrease in the number of stores (a net decrease of 6) and fewer days of operation caused by renovation work. The company commented that business conditions were on a path to profitability, and sales for the retail business were up 5.6% YoY. Clothing sales were weak (especially for housewives in their 40s and 50s; sales almost halved), but the company commented that core food sales were fairly good. Operating loss for FY06/10 was 1.9 billion yen vs. a loss of 69 million yen in FY06/09, but considering that the previous year’s operating profit included approximately 2.5-2.6 billion yen from tenant business (moved from Nagasakiya to another subsidiary), operating profit actually improved by 500-600 million yen. SR Inc. thinks that although the pace of improvement is a little slow, the improvement in profitability is encouraging. The “grand experiment” at MEGA Don Quijote is beginning to show results. Chairman Yasuda emphasized the recovery of MEGA Don Quijote at the result meeting held in August 2010, mentioning that MEGA Don Quijote stores are no longer generating losses. Fresh foods make up a large portion of sales at MEGA Don Quijote, and the format had difficulties attracting housewives, carrying heavy shopping bags, to sundry products, the focus of the Don Quijote format. One improvement was separating the food and Don Quijote sections on the first floor and second floor to make shopping easier for families (the husband can shop in the Don Quijote format while his wife shops in the food section).

Doit: Sales were 19.7 billion yen (-17.3% YoY). Sales of professional products such as lumber, hardware and coating materials (possibly a positive sign because these products are normally purchased after careful comparison between stores) were strong, but sales of gardening and landscaping products were weak. Although the segment’s contribution to total sales is smaller than other segments, profitability improved significantly: operating profit rose to 1,508 million yen in FY06/10 (an increase of 967 million yen vs. 541 million yen in FY06/09), and operating profit margin improved to 7.6%, higher than the margin of the parent Don Quijote (5.3%).

Income Statement

Historical Earnings Trends

Don Quijote enjoyed rapid growth since its establishment, and particularly after its listing, due to new store openings. Around 2000 this rapid growth raised controversy when local residents started protesting Don Quijote openings in their neighborhoods in the name of public order. Ideologically charged political groups and then media joined in. The company was late to respond and to recognize the reputational damage it was incurring. The conflict ended in about 6 months. This coincided with a shift away from central urban areas where store real estate was increasingly expensive and hard to find, to suburban regions. Larger emphasis on regional stores meant that the company needed to learn how to sell food. These factors resulted in a visible decline in ROIC.

The company has learned its lessons from past events. Specifically, it has been building and managing new stores in full compliance with the Large Store Location Law implemented in June 2000 and paying attention to the needs of local residents. Additional internal measures were taken to improve store opening practices. Although resulting in higher costs, all these steps ensured that despite the increase in the number of stores from 27 in June 2000 to over 160 in FY06/10, there was not a single conflict with local communities over store openings.

From 2007 a trend towards more and stricter legislation emerged in a number of areas relevant to the retailing business. Among the notable changes were restrictions on interest charged by consumer lenders, changes in the Architectural Standards Law, enactment of the Three Community Building Laws (Machizukurisanpo; consisting of the Large Scale Retail Store Law, the Revised Urban Planning Law and Revitalization of City Centers Law), stricter rules under the Entertainment Business Control Law, and local legislation to prevent “public nuisance”. To minimize the impact of these changes, Don Quijote embarked on improving upon its traditional business model. The yen weakening in 2005 negatively impacted imports and high commodity prices dampened domestic demand for jewelry and watches, which further complicated the situation. It is SR Inc.’s view that the company performance over recent years should be viewed through the prism of these challenges. Don Quijote itself believes it demonstrated the flexibility of its business model by successfully switching towards food and household goods. Food’s performance has been particularly strong, increasing 14.4% YoY at the parent basis in FY06/10.

The Doit and Nagasakiya acquisitions have masked Don Quijote’s sustained high profitability and returns on invested capital. Once these underperforming parts are turned around, ROE of close to 15% and close to 20% ROIC should be achievable.

Results vs. Historical Earnings Forecasts

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Balance Sheet

Don Quijote’s balance sheet is typical for a retailer. Inventory was 23.9%, or 81.6 billion yen, of end-FY06/11’s total assets of 341.3 billion (please see the Merchandising & Inventory Management section for further discussion). Further, 33.3 billion yen were store-related leasehold deposits. Of the total 206.8 billion yen of fixed assets in FY06/11, land accounted for 87.2 billion yen, buildings 58.1 billion yen and deposits 33.3 billion yen; the bulk of which were store property related. The company acquired a property in Meguro, housing a new corporate HQ and a Don Quijote store for about 7.0 billion yen in FY06/10. Don Quijote also had 4.4 billion yen in long term securities.

The liabilities side shows Don Quijote’s flexible use of various financing options. As of end-FY06/11, there was 39.6 billion yen of interest bearing debt in current liabilities (12.9 billion yen in bonds and 11.8 billion yen in current portion of long-term bank loans). Long-term interest bearing liabilities also included 35.6 billion yen in long-term bank loans, 58.0 billion in straight bonds and 3.5 billion in convertible bonds. The company has used a wide variety of financing options since its IPO on JASDAQ in 1996. Post IPO, the company raised equity though a public offering twice, in 1998 and 1999. Since then Don Quijote has been an active issuer of convertible bonds (CBs). The outstanding values as of October 2010 are shown below:

Don Quijote has been buying back stock; it purchased 3 million shares in FY06/09 (1748.58 yen per share), and 1.8 million shares (split adjusted) in 2004-2005 (1818.32 yen split adjusted).

In terms of financing needs, SR Inc. believes the company is keen to replenish its coffers, particularly following early redemption of its 2013 maturity convertible bonds. SR Inc. estimates the company is therefore likely to be looking to raise 20-30 billion yen in the near future. Importantly for equity holders, the company has been relying on straight debt and bonds in recent years, emphasizing that debt was a more attractive option than equity financing.

Per Share Data

Shareholder Returns

Don Quijote has been historically focused on growth and delivering shareholder returns through share price appreciation. Dividends have grown steadily since listing but the dividend payout ratio has historically been unspectacular: 16.7% in FY06/11.

Don Quijote has conducted two share buybacks since listing, when the management perceived the share price to be too low. Active use of convertible bonds and, in earlier years, of equity financing meant the number of shares had been increasing; there were 20.4% more shares outstanding (adjusted for splits) at the end of FY06/10 compared to FY06/00. EPS increased 211.8% over the same period, a CAGR of 12.0%.

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Cash Flow Statement

Examining Don Quijote’s simple cash flows reveals no obvious pattern to the use or creation of cash – the figures can aptly be characterized as lumpy. Upon closer examination of the components of the total changes in cash, the operating cash flows appear quite resilient, increasing at a compound rate of approximately 20% per period for the past 10 years. Financing cash flows have been an increasingly important source to meet the cash needs of Investments as the company has become a more aggressive acquirer.

It is important to note that the nature of Don Quijote’s operations have been changing over the period in question, and therefore it is difficult to derive strong conclusions relating to operating cash flows from the data provided. The increased awareness of ‘social’ risks (fire safety, prevention of crime and public nuisance) and resulting measures affected Don Quijote’s early remarkable cash flow generation. So did the move into profitable but less efficient locations. Acquisitions in 2006 and 2007 brought a dramatic increase in the gross area of sales space, and the company has been working on improving cash flow generation of newly acquired stores. Initial substantial acquisition and refurbishment (new format conversion) outlays would mask cash flow improvements but logically one would expect them to start appearing from FY06/11.

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Other Information

History

Don Quijote was established in 1980 by the current chairman and its largest shareholder Takao Yasuda. Cleaning and restocking his single shop at night, Yasuda discovered that there was a demand for late night shopping that he could profitably meet while the competition was literally asleep. Even today, Don Quijote stores generate more than 50.0% of sales from 8pm onwards. Yasuda opened his first Don Quijote (Donki) outlet in 1989 using two signature principles – late night opening hours and cramming in as many items as space would allow (“compression display”).

Other early features preserved to this day are handwritten ad-hoc point of purchase (POP) displays, a rich choice of variety goods ranging from parallel import Rolex watches to fancy dress costumes, and “spot” merchandise. 30.0-40.0% of items sold in Don Quijote stores are sourced from excess inventories in the retail market chain and inventory liquidations by wholesalers and other retailers. Buying these “spot” items allows the company to offer low prices but maintain high margins.

Another discovery made by Yasuda was young urbanites required shopping entertainment to kill time. Chaotic and fun, Don Quijote stores provided such entertainment. Its customers were ‘fun hunters’ rather than the bargain hunters of conventional discount retailing. They would buy novelty products that other retailers were not carrying, allowing the company to earn higher margins and completing its business model – Convenience+Discounts+Amusement (CV+D+A).

Initially, Don Quijote management gave chiefs of individual product sections at each store unprecedented freedom to make purchasing and merchandising decisions. They competed against their peers in other stores and other sections of their own store, stimulated by incentives and a transparent information flow system. This approach was partially changed in the recent years to a more centralized purchasing system but store staff still have a large degree of autonomy.

In 1996 Don Quijote listed on the Jasdaq market and in 2000 moved to the 1st Section of Tokyo Stock Exchange.

Don Quijote experienced some controversy in its early years as a listed company. When the company started opening bigger stores outside of night entertainment quarters, local residents vocally objected to the openings. Management eventually learned to deal with this issue by communicating with residents early on, compromising on details, and otherwise working to alleviate concerns. Don Quijote was also the victim of criminal incidents, which received substantial and sometimes unfavorable media attention. Problems subsided since late-2005 as the management learned from earlier PR mistakes. However, the non-conventional nature of the Don Quijote model will likely continue to draw public scrutiny, something that has sometimes affected its share price although had not dented its earnings.

The company rapidly expanded and had 27 stores in FY06/00 compared to seven at the end of FY06/97, becoming one of the top 30 Japanese retailers by recurring profit in FY06/04.

As part of the company’s search for a format that could be a competitor to convenience stores, FY06/01 saw the birth of the Picasso format, an experimental model for smaller markets. However, Picasso store openings were stopped at 15 stores in FY06/06 and they did not become a material earnings contributor. A large store format called PARO (“Purchase Amusement Rambling Oasis”) also emerged (later renamed PAW).

At end-FY06/02 The company talked about a ‘Second Stage of Growth’, mentioning Don Quijote, Picasso, and PAW as three fully established formats.The company also started growing outside its core Tokyo market and opened stores nationwide in Osaka, Nagoya, Fukuoka and Sapporo.

In FY06/03 the company started selling drugs using pharmacists connected to consumers in the store by a videophone in an innovative attempt to bypass Japan’s strict pharmaceutical retailing legislation. While this service was well received by customers it met objections from the Ministry of Health, Labor, and Welfare and after a prolonged debate the sales of drugs via videophone was allowed with some conditions. Ultimately though, the service was terminated following April 2009’s revised Pharmaceutical Affairs Law .

In FY06/04 the company announced a new mid-term plan, called “7532” (in reference to Don Quijote’s exchange ticker code): 7.0% recurring profit margin, 500 yen in EPS, 300.0 billion yen in sales within 3 years, and double-digit top line and 20.0% earnings growth.

The company faced negative media coverage in FY06/05 when an arson attack on two of its stores in December 2004 killed three employees and injured another eight people. The company’s compression display policy was blamed as a factor behind the rapid spread of the fire, and also hampered victims’ escape. In response, the company implemented fire safety measures in excess of legal requirements and placed permanent guards on duty at its stores.

In August 2005, Don Quijote announced its intention to acquire a stake in Origin Toshu (delisted; formerly TSE 7579), a ready-made meal/boxed-lunch (bento) retailer. Don Quijote was eager to develop a convenience-store format but lacked expertise in ready-made meals; acquiring Origin would have given it access to this essential know-how. By February 2006, Don Quijote had accumulated a 47.8% stake in Origin in the open market. Origin saw the move as hostile. Ultimately, Aeon Co. (TSE 8267) emerged as a white knight with Don Quijote selling its shares at a considerable profit. The company’s convenience store ambitions though were later put on hold.

Also in 2005 the company stirred a minor controversy, which might serve as an illustration of its corporate culture: after the successful March 2005 opening of a store in Osaka with an integrated Ferris wheel, the company erected a half-pipe roller coaster on the roof of its Roppongi store, causing an outcry among some local residents who complained about noise pollution. The company closed the attraction.

In November 2006 the company became the sponsor of the corporate restructuring of Doit, a DIY home center retailer with 24 stores in Saitama, Tokyo, and Kanagawa prefectures. Don Quijote took on the existing Doit debt for 14.9 billion yen. This translated into roughly 620 million yen investment per Doit store. Don Quijote gained access to a number of strong locations and acquired 9.0 billion yen (book value) worth of land. With the average floor space of 4,169 square meters (vs. average of 1,175 square meters for Don Quijote at the time), some of Doit stores were ideal for large-scale Don Quijote stores. Don Quijote proceeded to restructure operations. The theme of FY06/07 was “Do It Myself!” a word play on Do-It-Yourself Doit.

Doit (Source: Company Data Processed by SR Inc.)

In FY06/08 the pace of M&A accelerated with the acquisition of Nagasakiya in October 2007, a large supermarket operator with 55 stores in 18 prefectures. Don Quijote bought the initial 86.0% stake from Kyoden (TSE 6881) and related parties. It eventually paid a total of 13.3 billion yen for 100.0% of the company and assumed 3.0 billion yen in net debt. The acquisition gave Don Quijote 369,108 square meters of sales floor space overnight. The total investment translated into roughly 44,000 yen per square meter of sales space. By comparison, a new Don Quijote or PAW store usually costs around 200,000 yen per square meter. The acquisition pushed the company into one of the 25 largest Japanese retailers by sales.

In FY06/09 the attention was on the Nagasakiya turnaround. MEGA Don Quijote emerged as a new future template for growth. It acquired Big One, a discounter with 7 stores in prefectures of Aichi and Gifu, buying 100% of shares for 2.3 billion yen.

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News and Topics

On September, 2011

On September 22, 2011,the company announced it has signed a syndicated commitment line for up to 10.0 billion yen.

(For original Japanese-only release in PDF format please click here.)

The commitment line runs from September 22, 2011, to September 21, 2012. Resona Bank was the arranger for the commitment line with Mizuho Bank and Sumitomo Mitsui Banking Corp. acting as co-arrangers. The company commented that the purpose of the commitment line was to enhance the company’s financial stability.

On August 2011

On August 18, 2011, the company announced FY06/11 results: click here to go directly to the FY06/11 results section.

(For original Japanese-only release in PDF format please click here.)

June 2011.

On June 16, 2011, the company upwardly revised its forecast end-of-year FY06/11 dividend payout to 18 yen per share from 15 yen taking the full-year dividend payout for FY06/11 to 28 yen per share from 25 yen per share.

(For original Japanese-only release in PDF format please click here.)

May 2011.

On May 31, 2011, the company Chairman & CEO Yasuda Takao reported that he had sold some of his shares in the company, which resulted in changes to the company’s major shareholder list. 3.8 million shares will be transferred as of June 6, 2011, reducing Yasuda’s stake to 14.1% from 19.1%.

(For original Japanese-only release in PDF format please click here.)

March 2011.

On March 22, 2011, the company announced five of its stores in the region affected by the earthquake in the Tohoku area were temporarily closed.

On March 14, 2011, the company made an announcement regarding the March 11 Tohoku earthquake, saying some store buildings were damaged, with further damage occurring to fixtures and falling merchandise. As of 8 a.m. on March 13, 2011, nine stores were temporarily closed.

Note: The company has also shortened operating hours of some stores.

Future Outlook

The company didn’t know the extent of the damage the earthquake caused to its operations. It said it would release details as necessary if it becomes clear that FY06/11 earnings could be impacted.

February 2011

On February 1, 2011, the company announced a revision to its 1H FY06/11 forecasts as follows:

Sales: 255.4 billion yen (vs. previous forecast of 258.0 billion yen)

Operating profit: 14.1 billion yen (vs. previous forecast of 12.5 billion yen)

Recurring profit: 14.0 billion yen (vs. previous forecast of 11.8 billion yen)

Net income: 7.5 billion yen (vs. previous forecast of 6.1 billion yen)

The company explained that it revised sales downward due to markdowns on sundries. Meanwhile, the upward revision to operating profit was due to the combination of improved product mix (more private brands and higher margin goods) and controlled SG&A costs. The full year forecast was unchanged, but the company said that it would make revisions as necessary when the company releases Q2 results.

December 2010

On December 30, 2010, Don Quijote Co., Ltd. announced that internal auditors discovered that the former Chief Compliance Officer improperly used consulting expenditures.

On December 15, 2010, the company announced participation in a 3rd party offering of shares from Fidec Corporation (TSE 8423) and that Fidec would become its consolidated subsidiary. The release indicated that Fidec would issue 222,223 new shares at 9,000 yen per share, raising about 2 billion yen. Don Quijote Co., Ltd planned to acquire about 85 percent of the 3rd party offering, which would bring its total stake to about 48.6% of Fidec’s shares. The expected total cost was about 1.7 billion yen, and the announced completion date was January 27, 2011.

November 2010

On November 4, 2010, the company released Q1 FY06/11 results and revised 1H FY06/11 earnings estimates upward.

October 2010

On October 15, 2010, the company announced that it concluded a new contract of business and capital alliance with Fidec Corporation (TSE 8423), a provider of financial services (accounts receivable factoring, back office processing, etc.). The two companies had previously formed a business and capital alliance on April 27, 2009. Under the new contract, Don Quijote will provide financial support for Fidec, and increase the scope of business that it conducts with the company.

September 2010

On September 22, 2010, the company announced the launch of a new wholesale membership club, where registered members can buy merchandise at “member”, or wholesale, prices - about 30-40% below normal retail prices. The new format was based on an ‘Every Day Low Prices’ theme, and the first store was opened in Osaka prefecture with a large sales floor offering about 120,000 items, including apparel, interior goods, jewelry, and watches. The target was for annual revenue of 10.0 billion yen within three years. However, after an unsuccessful start, the format was discontinued in 2011.

On September 17, 2010, the company announced that it will redeem all of the zero coupon convertible bonds due 2011 (listed on London Stock Exchange). The closing price of its shares was above 120% of the conversion price for 30 consecutive trading days.

Summary of the redemption:

Summary of the bond:

June 2010

On June 11, 2010 the company announced that its Board of Directors made a decision on the same day to sell treasury stock.

Details were as follows:

• Maximum of 2,422,500 shares will be sold overseas, excluding US and Canada (purchased and underwritten by Deutsche Bank AG, London branch).
• The book building was set from June 11 to June 14, 2010.
• The offering price for the shares was fixed at 2,367 yen per share, a 4.01% discount to the June 11, 2010 closing price of 2,466 yen. The company would therefore receive 5,675.2 million yen after fees.
• The funds were to be used for the repayment of debt (approximately 9 billion yen) in June 2010.

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Top Management

Chairman Takao Yasuda founded Don Quijote, and in doing so created one of Japan’s more unusual and successful retailers. As such, he can be viewed as the main driver behind the company’s success. Yasuda is known for his no-nonsense, open conversational style and his passion for his company and the retail business.

Yasuda’s willingness to challenge conventional wisdom and Don Quijote’s non-orthodox business model has in the past created image problems for the company. Beginning around 2005 though the company has become much more aware about its public image and public perception regarding the company appears to have improved. For example, its store openings no longer draw local opposition compared to its early days. Nevertheless, the company and its management are different from many more traditional Japanese companies and that will continue to affect its image and possibly create polarized views.

Yasuda oversees group-level operations, sets high-level strategy and participates in regular store development meetings that decide on individual store opening plans. The acquisition of Nagasakiya in October 2007 prompted Yasuda to return to a more active role in day-to-day management.

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Employees and Organization

As of end FY06/11 Don Quijote group had 10,016 employees of which 4,164 were full-time. The parent company reported 5,683 employees in FY06/11 of which 2,455 were full time employees. The average age of parent full time employees was 31.6 years old, with an average salary 4.9 million yen.

The store network is managed through a matrix structure of 19 regional areas and 7 product groups. Their activities are coordinated through regular sales conferences attended by senior management.

In order to promote internal cooperation and develop managerial talent internally, Don Quijote initiated Neo Leader Conferences where regional managers mix with mid-level buyers and discuss issues facing the company. For lower level management, regular meetings with the company leadership are organized as channels of direct communication.

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Major Shareholder

Chairman Yasuda and his family control approximately 14.11% of the company shares. Foreign investors represent a large percentage of shareholders, 51.5% as of end-FY06/11.

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Investor Relations

IR department reports directly to the CFO.

The company organizes quarterly results meetings.

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By the Way

Latest Q&A

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