Thinking Points

  • Defactostandard (TSE: 3545) is a late stage startup that operates “Brandear”, a thrift store specializing in fashion brands with a purely online presence.
  • The company took the traditionally experience-intensive second hand brand goods evaluation process and created a system/database, enabling inexperienced workers to quickly evaluate goods.
  • While recent business performance is impressive, with a five year revenue CAGR at 12.5% and operating income at 20%, the cost structure is mostly variable and highly sensitive to gross margin movement and logistics costs.
  • That said, the company is quickly growing its own sales channel (online auction) and reducing its dependence on Yahoo! Auctions, which accounted for 74.1% of revenues in 2011 and 47.1% in 2017.
  • Assuming Defactostandard continues on its current track, investors can expect a three year investment CAGR of between negative 8% and 17.7%. The risk/reward profile changes greatly if the company leaps outside of fashion brands or self-procured goods.

This post was originally published on November 21st, 2018 as a part of the Kenkyo Magic Formula offering

Introduction

Defactostandard (TSE: 3545) is a late stage startup operating the website “Brandear”, where people can sell their second-hand branded fashion goods. The company evaluates and purchases the goods, then lists them on major online sites (like Yahoo! Auction, Rakuten, eBay, etc) for sale. More recently, the focus is on expanding the lineup of brands handled and developing its own online marketplace.

Source: Brandear

The company was founded in 2004, then in 2006 became a subsidiary of Beenos (TSE: 3328), which invests in online retail/services and related businesses in Japan and internationally. In August 2016, Defactostandard went public, listing its shares on the Mothers section of the Tokyo Stock Exchange. More recently in September 2018, the company transferred to Section 1.

The business

Defactostandard’s Brandear is essentially a thrift shop with a purely online storefront. The company offers home pickup of second hand branded fashion goods, which it brings to its warehouse for evaluation and eventual purchase. Since its founding, the company didn’t have its own sales channel, and sold through sites like Yahoo! Auctions, eBay, Rakuten Marketplace, and others.

Corporate culture and the edge

What’s particularly interesting about Brandear is its ability to scale the thrift shop model. Normally, buying and selling second hand goods requires extensive domain-specific knowledge to operate profitably. The “database” is often inside an individual’s head, and generally requires several years to build. Meanwhile, Brandear deals with over 7,000 different brands, yet 90+% of the evaluation is performed by part-time workers with little experience. This is because the company, over the years, built a database of transactions which includes historical pricing and tips on how to identify counterfeit items.

In a 2017 interview with Goodfind (Japanese), a career information site for university students, CEO Takato Ojima explained how Brandear came to operate the way it does today. While the systemization of product evaluation and home pickup are key points of differentiation, Takato insists that this is a result of nurturing a culture that challenges the status quo.

One event that helps build this culture is the company’s quarterly inventory count. All employees – full time, part time, managers, directors, everybody – are involved. And the inventory count is lead by a newly hired fresh college graduate. Now, including part-timers, the headcount is north of 900 people, and there are over 400,000 items in inventory. This is no easy task, especially for a fresh graduate with no experience running a warehouse. Doing this, according to Takato, helps employees grow, quickly adjusting to pressure and learning from failure, all while flattening the organization.

Market

Defactostandard presents the following chart in its earnings presentation:

Source: Company presentation

Interestingly, the company’s five year revenues CAGR is 12.6%. Apparently this is roughly in line with the “Brand-name items & Furnishings” reuse market.

Defactostandard does face formidable competition from traditional thrift stores. Some examples are:

  • Treasure Factory (TSE: 3093) – primarily in Tokyo capital region. Some stores exclusively dealing in clothes. Also offers home pickup services. Five year revenue CAGR of 12.5%.
  • SOU (TSE: 9270) – runs “Nanboya” purchasing branded items. Mainly sells to organizations. Also offers home pickup services. Five year revenue CAGR of 20.5%.
  • Komehyo (TSE: 2780) – operates stores in major metropolitan areas. Deals in branded goods, cameras, musical instruments, etc. Also offers home pickup services. Five year revenue CAGR of 2.5%

Inventory risk

Here’s how Brandear works:

  1. Register online
  2. Choose number and size of boxes needed
  3. Place second hand goods in box(es)
  4. Ship box to Brandear/Defactostandard
  5. Brandear/Defactostandard performs evaluation and proposes purchase price (or rejects)
  6. Users make one of three decisions: Return (to user), accept offer, or dispose.

Now, if users accept the offer, Brandear processes payment the following day. The boxes from #2 are covered by Brandear, shipping costs from #4 is covered by Brandear, and if the user elects to have the product returned, the shipping cost here is also covered by Brandear. The same goes with inventory disposition.

More recently, the company has shifted focus toward purchasing higher priced items, or what the company calls “high second brand”:

Source: Company presentation

The brand categorization is set arbitrarily by Defactostandard. In any case, the shift in focus wasn’t preannounced. The company mentioned the shift only after recording a significant increase in inventory:

Source: Company filings, chart created by author

Inventory to revenues went from 9.6% to 13.3% between 2017 and 2018. This figure floated around 11% between 2014 and 2016. Q12019 will be interesting to see as it’ll show how the high second brand strategy started off.

Cost structure

Though Brandear has the fixed cost advantage over traditional thrift stores in that it does not maintain physical stores, shipping is a critical cost component. And the Japanese door-to-door shipping industry is in a crunch, with major operators raising fees.

Source: Company filings, table created by author

Aside from miscellaneous wages and other expenses, operating costs appear to be proportionate to revenues. A misstep in purchasing or further increase in shipping costs can quickly eat into Defactostandard’s slim operating margins.

Direction

Historically, Defactostandard has been heavily dependent on Yahoo! Auction. According to the fiscal 2017 filing, Yahoo accounted for 74.1% of revenues in fiscal 2011 and 47.1% of revenues in fiscal 2017. In order to reduce its dependence on a single sales channel, the company started using other e-commerce auction platforms (like Rakuten, eBay) and built its own platform “Brandear Auction” as well. In 2017 Brandear Auction accounted for 20.9% of revenues. In fiscal 2018, this figure rose to 31.8%.

Another thing Defactostandard has been working on is controlling miscellaneous wages by moving the exhibition process (taking picture, measurements, checking quality, and folding) to home-based workers. The impact of this is visible between 2017 and 2018, where miscellaneous wages dropped from 9.4% of revenues to 7.7%.

As mentioned earlier, Defactostandard also started focusing on dealing in high second brand items with the intention to capture higher margins per unit.

Guidance

Having been listed for only a couple years, Defactostandard doesn’t have much of a record yet. The company reached its guidance targets in 2017 and missed in 2018:

Source: Company presentations

The company is looking to increase sales promotions in 2019, particularly for products in the higher-end of the second brand category.

Shareholders

As of fiscal 2018 year end (ending September 30th, 2018), Defactostandard had 9,140,000 shares issued and 15,016 shares in treasury, leaving outstanding shares at 9,052,270.

Here are the major shareholders as of March 31, 2018:

Source: Nikkei & company filings

According to a form submitted to the Financial Services Agency on November 14, 2018, CEO Takato Ojima held 660,000 shares as well as 160,000 unexercised options.

Itochu Corporation (TSE: 8001) sold 250,000 shares in an off-market transaction on August 15, 2018 at 702 yen per share. The disclosure statement submitted to TDNet (Japanese) explains that the transaction took place in order to satisfy the TSE Section 1 shareholder count requirement (2,200).

There are currently 699,300 shares in stock options exercisable at 668 yen per share.

Financials & Valuation

  • Over the last five years, Defactostandard revenues grew at 12.6% CAGR while operating income grew at 20% CAGR.
  • Although the company has streamlined the thrift store business model, much of the tasks are still labor intensive, making it difficult to realize any major scale benefits.
  • Key risks for Defactostandard are: increased competition (especially if it drives up second hand goods purchasing price) and increased logistics cost.
  • That said, the company seems to be doing all the right things – like building its own auction platform (and reducing dependency on others), targeting another product class, and promoting its platform.
  • Investors considering Defactostandard may want to look at the company beyond branded fashion goods and focus on the platform itself.

Defactostandard is on the Magic Formula shortlist because of a mistake. Some financial data providers miscategorize the “Other” operating expense line item under “Other income/expense” items. This wildly distorts the company’s operating performance, putting operating margins north of 20% when reality is around 4%. Even then, the correct and current EV/EBIT ratio is 8.2, which seems a little low for a fast-growing company.

The competition is stiff, with many of the larger thrift store operators also offering home pickup services. While Defactostandard’s cost seems to scale in line with revenues, it still does not require the same level of overhead that the traditional thrift store model requires.

If Defactostandard can manage to continue its sales growth at 12% per annum while keeping its current cost structure (misc wages/other expenses relatively constant, rest variable), operating margins should come in the mid 4% range in the next 3 years, even with an increase in logistics costs (~7.5% of revenues vs. current 7%). Fortunately, even with no revenue growth, the company can keep operating performance at slightly lower levels compared to today.

Now, in the event Defactostandard’s gross margins fall below 45% (currently at 49%), the company will start losing money. With that in mind, the higher margin high second brand focus seems sensible, although it would’ve been much more encouraging had the management team mentioned the shift in strategy prior to execution.

Assuming Defactostandard continues with its current business (i.e., not expanding into other domains like used smartphones and laptops), continued growth on par with the recent past ought to yield investors a three year investment CAGR of 17.7% (after adjusting for stock options). Zero growth would be more like a three year investment CAGR of negative 8%, possibly more depending on how investor sentiment shifts. Key factors to keep in mind are gross margins, logistics costs, and whether or not Defactostandard leaps beyond second hand branded goods. Emphasis added on the last factor as the company operates an emerging online auction platform.

The bottom line

Only investors with a high tolerance for downside and volatility should consider investing in Defactostandard. Assuming the company continues its current way of business, investors can expect a three year investment CAGR of anywhere between negative 8% and 17.7%. Interested investors ought to follow the company’s English IR page, paying close attention to gross margins, logistics costs, and whether the company leaps beyond second hand branded goods.

Author: Kenkyo Investing

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