Thinking Points

  • Sophia Holdings (TSE: 6942) is a holding company engaged in system integration, software development, and pharmacy operations, among other things.
  • The company has a history of poor business performance, a few governance concerns, and no balance sheet strength.
  • Though controlling ownership has changed in December 2017, investors ought to steer clear of Sophia Holdings as there is little information available about the company itself or the new parent/grandparent company.

Sophia Holdings (TSE: 6942) is a holding company with various lines of businesses including system integration, software development, and (most recently) pharmacy operations. Now, an IT company adding pharmacies to its portfolio of businesses is odd, to say the least. But in December 2017,  controlling interest in Sophia switched hands. A company called Isopra (private), a wholly owned IT company subsidiary of E-BOND Holdings (also private), made a tender offer and gained 64.95% of issued Sophia shares.

The reason we’re covering Sophia Holdings is because the company’s been moving up the ranks on the Small Cap Japan Magic Formula list over the last month. Since announcing its two-pharmacy acquisition on August 10, 2018, share price has been tumbling.

Source: Google

At this point, it’s probably fair to say that if you’re not fond of complicated relationships, you may want to skip this company.

 

Business performance and recent events

Now, in case you’re wondering, Sophia’s market cap is 1,979 million yen ($17.7 million USD). Hence, a two store acquisition for 205.2 million yen ($1.8 million USD) is a big deal. With that said, there are several key notes to address without getting into specifics about the M&A deal.

First, the company has a history of wild unpredictability. Over the last 11 periods, revenues and operating income has been all over the board:

To be fair, the company isn’t shy about this. In fact, management offers no guidance specifically noting that business fluctuates unpredictably in the short term.

Sophia Holdings’ main business is in two areas: internet related business and data communication services.

The internet related business includes system development, data center maintenance and operations, and real-estate intermediary ASP software, among other things.

The data communication services mainly involves services for Mobile Virtual Network Operators (MVNO), Fixed Virtual Network Operators, and Internet Service Providers (ISP). Just as a quick overview in case you’re not familiar with MVNOs and FVNOs: These companies basically rent cell phone/landline networks from mobile network operators and fixed network operators. MVNOs are usually low-cost phone carriers like Cricket Wireless or Virgin Mobile in the US.

53.3% of fiscal 2018 revenues were driven by business from Rakuten Communications. Rakuten Communications is a wholly owned subsidiary of Rakuten (TSE: 4755), not to be confused with Rakuten Mobile (also a Rakuten subsidiary), one of Japan’s largest MVNOs. Rakuten Communications helps companies with telecommunication and internet related services – like building cloud services, call center operations, and communication infrastructure. In essence, Sophia Holdings is a sub-sub contractor.

In addition to Rakuten Communications, DMM is another key customer. Here’s a little trivia: DMM started as a video rental business, but exploded when it started making licensing deals in porn. In fiscal 2017, DMM-related companies (two of them) accounted for 28.8% of revenues. No disclosure for fiscal 2018 as companies normally only disclose when individual customer accounts for more than 10% of total annual sales.

Second, Sophia has a recent history of corporate governance issues. This was highlighted by an internal investigation into sales on a discontinued product’s remaining inventory. The report on this issue (released December 22, 2017) is 21 pages long and I won’t go into it. But the highlights are this:

  • After 2011/2012 when the Japanese courts decided two competitor products (TV recording tool) infringed on broadcasters’ copyrights, Sophia Digital (Sophia Holdings subsidiary) discontinued production of their own product and repurchased inventory from a customer .
  • The repurchase decision was made by then board member of Sophia Holdings (Mr. O), who was involved with the customer prior to joining Sophia Holdings, and was also effectively the CEO of Sophia Holdings because he had the backing of the majority shareholder.
  • To avoid writing off inventory, Mr. O made sales agreements (that were more like consignment deals) with another company.
  • The financial impact of this issue for Sophia Holdings is trivial, but it highlighted a couple issues, like the “effective CEO” wielding enough influence to direct improper accounting and the auditor being involved in the sales process.

This all came about soon after Isopra/E-BOND announced its tender offer.

Third, grandparent company E-BOND Holdings is private, and there isn’t a whole lot of information floating around. With that said, (very) basic financials were released (Japanese) on Sophia’s website. The company, through its 47 subsidiaries (including Sophia Holdings), is involved in pharmacy operations (264 stores), clinical studies, IT services, and distribution. The pharmacy business is at the core of E-BOND Holdings.

Interestingly, E-BOND Holdings reported 108 million yen ($9.7 million USD in revenues), negative 43 million yen ($-385K USD) in operating income, but 320 million yen ($2.86 million USD) in non-operating income. 76% of the non-operating income came from consulting fees. In addition to that, the company showed receivables of 643 million yen ($5.8 million USD) and payables of 651 million yen ($5.8 million USD). Net Assets of 2,325 million yen ($20.8 million USD) and debt/equity ratio of 1.98.

Little context is provided with the financials. And I mean little – I can’t tell if it’s consolidated or unconsolidated, audited or unaudited. The business description for E-BOND Holdings in the filing reads something along the lines of “Proposal and execution of group strategy. Business strategy and activity support of group companies.” Still rather confusing what exactly the company does to generate revenues. The financials are odd, to say the least. My bet is that it’s unconsolidated and unaudited (with the disclaimer that I’m not 100% certain).

Finally, since Isopra/E-BOND took controlling interest in Sophia, the company removed 3 of the 7 previous board members (including the former CEO), then added 8 new names (including the new CEO). The CEO change is almost customary at this point, having changed 7 times since 2007. Though a quick look at Isopra’s website shows that its business serves similar purposes as Sophia Holdings’ system integration and software development business goes, it’s still difficult to determine whether a change in controlling ownership is good as there is a general lack of information on both Isopra and its parent E-BOND. With that said, it’s difficult to imagine management getting worse.

 

Financials & Valuation

Sophia Holdings’ financials are terrible. Retained earnings have been in the red since fiscal 2009. Equity-to-asset is currently at 0.18. If you remove goodwill from the calculation, this figure comes down to 0.02.

About the only recognizable patterns in the company are that the CEO changes every year or two and the company bleeds money.

There is a chance that this is a legitimate turnaround attempt. Given the current lack of information and visibility, however, it is probably best for investors to stay away from the company. Hence, I won’t bother with valuation.

 

The bottom line

Sophia Holdings has a history of poor business performance and no noteworthy assets other than some cash. Controlling ownership of the company changed in December 2017, but it’s difficult to get any information or visibility into the new parent or grandparent company. Though this could be the beginning of a legitimate turnaround, investors ought to steer clear of Sophia Holdings given the current lack of information and poor past performance.

 


Kenkyo Investing
Kenkyo Investing

Kenkyo Investing applies a value investing approach to Japanese equities, providing insights that are often unavailable to non-Japanese speakers.