Kappa Create: Negatives Priced In But Stumbling Along (OTCMKTS:KPCCF)

Investment thesis

Kappa Create’s (OTCPK:KPCCF) strategy to drive sales growth as a low-price conveyor-belt sushi restaurant experience is bearing fruit, but is not enough to offset inflationary cost pressures leading to operating losses. With no visible efforts to address this issue, we see no reasons to invest. We rate the shares as neutral.

Quick primer

Established in 1973, Kappa Create operates a conveyor-belt sushi restaurant chain under the ‘Kappa Sushi’ brand in Japan, and a food processing business (making bento boxes and baked goods for convenience stores). The company is Japan’s sixth largest conveyor-belt sushi restaurant chain with 311 sites. Specializing in the cheaper end of the market with dishes starting from JPY110 (USD0.85), key peers include FOOD & LIFE COS (OTCPK:SGLOF) with the market-leading ‘Sushiro’ brand operating 651 sites, Kura Sushi (2695), and Genki Sushi (9828).

Kappa Create was embroiled in controversy in September 2022 when former CEO Koki Tanabe was arrested for illegally obtaining data that was a trade secret of rival chain Hama-Sushi. He has admitted to the charge, saying he was trying to help his struggling firm. The new CEO Tsuyoshi Yamakado was appointed in October 2022.

The domestic conveyor-belt restaurant industry suffered a significant reputational loss in February 2023, following viral social videos of a customer’s unhygienic activities with utensils and passing sushi dishes at a Sushiro restaurant operated by Food & Life Companies.

The company revised down its FY3/2023 guidance on February 8, 2023, lowering its operating profit forecast to a loss (for the third consecutive year).

Key financials with revised company guidance for FY3/2023

Our objectives

Kappa Create has had a torrid year, with initial post-pandemic recovery aspirations dashed with its CEO arrested, and the negative press associated with errant customers making unhelpful viral videos. The shares have significantly underperformed its peers Food & Life Companies and Genki Sushi, although it has outperformed Kura Sushi. We want to assess whether all the bad news is priced in and that this is a buying opportunity for the shares.

Recent trading fair but costs pressures evident

Monthly data to January 2023 had shown that both store sales growth (+5.4% YoY) driven by average customer unit pricing (+5.4% YoY) was heading in the right direction YoY, but the pace was lower than had been initially hoped. As a result, the downward revision to company guidance (the second one this FY) appears not to have been a negative surprise.

With market leader Food & Life Companies seeing negative store sales growth YoY since October 2022, Kappa Create has been performing relatively well. However, a key concern for the industry overall is inflationary cost pressure, with major hikes in utility bills, rents, and staffing costs. Aiming to be a price leader, Kappa Create needs to drive volume significantly in order to compete profitably. Measures are being introduced in the industry to make the restaurants more tamper-free in response to the viral videos such as providing disinfected tableware, which is, unfortunately, pushing up operating costs.

Remarkably, the negative viral video incident appears to have highlighted the sector in a positive light, driving footfall back to these restaurants as the public showed a sign of support for these established eateries. Although this may be a one-off event, it does point to domestic demand well on the post-pandemic recovery profile.

With sales volume significantly below pre-pandemic levels, we believe a combination of normalized domestic demand as well as inbound tourism will be required. The latter may still take some time, and hence we believe a recovery in revenues will still take 2 to 3 years, and profitability levels may be lower than previously witnessed at below 1%.

Outlook – not entirely convincing

We believe the company will face significant challenges over profitability. The company’s business has limited scale, operates in the cheaper end of the market spectrum, and is now facing unprecedented cost pressures – there is only so much leeway in your business model if your average 10-year operating margin is in negative territory.

On a positive note, the company is well-capitalized with a net debt-to-equity ratio of 20% in FY3/2022. However, it may find it more costly and difficult to raise debt financing in order to support or grow the business. The company has been losing market share for the last 5 years, and now with management clearly in disarray, the business is not in a positive place.

Valuation

The current EV/sales multiple of 1.0x highlights that the company is ex-growth. Unfortunately, we see no evidence of a ‘growth renaissance’ whereby new management, product innovation, or restructuring leads to positive change and hence drive multiple expansion.

Risks

Upside risk comes from a major lift in monthly data for store sales growth. Recent trends in footfall and customer unit price are on the rise, and an acceleration here could result in a recovery into FY3/2024.

The company could be an acquisition target, although this may be difficult considering the founding family still owns over 50% of the company and is unlikely to sell.

Downside risk stems from persistent losses for the medium term, as the company fails to get to grips with limited sales growth and inflating costs.

From an ESG perspective, the company will rank significantly lower than before with the CEO controversy, making it more likely for passive funds to cut positions adding to selling pressure.

Conclusion

Kappa Create has undergone a tough and dramatic 12 months, and we would like to think that most of the negatives have been priced in. However, with limited management capability, the company is set to stumble along and is unlikely to generate value creation for investors in the short to medium term. With no hurry to invest, we rate the shares as neutral.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.