Thinking Points

  • No. 1 (TSE: 3562) is mainly engaged in the sales and maintenance of office automation (OA) and information security equipment like multifunction printers, business phones, and network security equipment.
  • The company is recently listed and has delivered respectable revenue growth of 6.9% CAGR over the last three years.
  • With that said, the growth was not driven by business areas that management considers as growth drivers. Instead, it came from OA equipment sales, which is a highly competitive and declining market.
  • What’s more, the company has some red flags like founder selling most of his stake post-IPO and an independent news source reporting that No. 1 is under criminal investigation.
  • Investors are best advised to steer clear of No. 1, although we have provided simple valuation on the company as a reference.

Introduction

No. 1 (TSE: 3562) is mainly engaged in the sales and maintenance of office automation (OA) and information security equipment like multifunction printers, business phones, and network security equipment. As of late, the company is focused on growing recurring revenues (i.e., maintenance) with mixed results. No. 1 reports revenues through two business segments (Office Consulting and System Support) and five total subcategories:

Source: Company filings


Although much of No. 1’s sales are in OA equipment, a declining market, the company’s been able to grow revenues at a 6.9% CAGR over the last three years. Consolidated financial data prior to fiscal 2015 isn’t available as No. 1 has only been on the market since March 2017.

The business and environment

In its IPO interview from 2017 (Japanese), CEO Takayuki Tatsumi emphasized that it caters to small businesses (generally under 10 employees), focuses in a “market in” rather than a “product out” sales approach (more on that later), and self developed product and support services for future growth.

What’s interesting about the first comment is that the company filings, at first glance, seems to tell a different story. In the interview, Takayuki presented the following slide explaining that No. 1 caters to the small and mid size businesses that account for 99.8% of all businesses in Japan:


Source: Stockvoice

No. 1’s filings show that Credit Saison (TSE: 8253) accounted for 34.7% of company revenues in 2018. Moreover, companies like NTT Finance (subsidiary of NTT [TSE: 9432]) and Orix (TSE: 8591) have shown up on No. 1’s filings as major customers in the past.  These aren’t small companies by any means.

What becomes clear in the details of the annual filings is that 51.8% of 2018 revenues came from lease sales. No. 1 sells OA equipment to the leasing company and the leasing company maintains leasing contracts with the end customers. According to the 2018 filings, 66.9% of lease sales came from one company.

Interestingly, the filings don’t disclose the name of the leasing company. But if we take 2018 revenues (7,717 million yen), multiply it by the percentage of leasing revenues for 2018 (51.8%), then multiply it by 66.9%, we get 2,674 million yen ($24.7 million USD). This is the same amount as 2018 revenues from Credit Saison.

On to the second point, Takayuki explains No. 1 started selling network security equipment and offering system maintenance services because customers asked for IT help, even though No. 1 only provided services for multifunction printers and business phones. In other words, No. 1 isn’t trying to sell a product (i.e., “Product out”), rather, the company prefers to bring in a product that is already in demand (i.e., “Market in”).

This leads to the third point, self developed product and support services as a growth driver. Basically, No. 1 buys multifunction printers and business phones from name brands like Sharp (TSE: 6753), Canon (TSE: 7751), and Kyocera (TSE: 6971), then sells/leases them to customers. And then sometimes this leads to maintenance and support services.

Source: Company website

When it comes to network equipment, however, No. 1 partners with companies to develop some of its product lineup. Just like multifunction printers and business phones, No. 1 offers maintenance and after service.

Both in the interview and in the company filings, No. 1 mentions self developed products and support services as a growth driver. However, revenues for both have either declined or gone roughly nowhere over the last few years:

Source: Company filings

Much of growth has been driven by continued OA equipment sales, management support, and office e-commerce sales.

Management support includes design and printing of various company material (handbook, logo, uniform, marketing material, etc), web design, and consultation services in a variety of areas like accounting, legal, marketing, and human resources. Office e-commerce consists of fulfilling orders that come through Askul (TSE: 2678), a growing office furniture and equipment e-commerce company.

So far, the company has been able to maintain operating margins above similarly sized peers like Hyper (TSE: 3054) and Ktk (TSE: 3035):

Source: GuruFocus


What’s concerning, however, is the lackluster growth in the company’s supposed growth drivers.

Management guidance

For fiscal 2019, No. 1 guided 7,908 million yen ($73 million USD, +2.5% YoY) in revenues and 328 million yen ($3 million USD, +18.5% YoY) in operating income. Two quarters in, the company delivered 3,979 million yen ($36.7 million USD, +3.7% HoH) in revenues and 101 million yen ($930K USD, – 21.1% HoH) in operating income. The company attributes the lower operating performance to an increase in sales commissions (some of the sales come through franchises) and investment in redeveloping its sales process.

Shareholders

As of Q2 2019 (ending September 30th, 2018), No. 1 had 3,127,520 shares issued and no shares in treasury.

Here are the major shareholders:

Source: Company filings, Nikkei, author calculations (adjusted for stock split)


What’s interesting about the major shareholder list is that the founder isn’t on it. In fact, the founder sold most of his stake right after IPO. The largest shareholder is actually Hikari Tsushin (TSE: 9435) which owns IE Group and Infoservice.

A March 2018 report by Outsiders Report (Japanese), an independent blog by Shuhei Handa (probably a pseudonym), mentions that No. 1 had a criminal complaint filed against it for copying a customer list from an acquisition target. A follow up report published in August 2018 (Japanese) mentions that the police searched No. 1 on suspicion that the company violated the Unfair Competition Prevention Act. Strangely, no other sources have reports about this.

Now, the same Shuhei Handa has a bit of a trackrecord after uncovering fraudulent accounting for Eneres (TSE: 6079) during his time at Tokyo Outlaws, an independent publisher of news generally revolving around corporate fraud. On the Japanese internet, the Eneres incident is sometimes referred to as “Little Enron”. As far as red flags go, the founder selling off the bulk of his stake right after IPO alone raises some eyebrows.

As with many recently listed companies, No. 1 has a considerable number of unexercised stock options. Since these are only laid out in detail on the annual filings, the information is a little dated, but here are the list of stock options as of fiscal 2018 year end (February 28th, 2018):

Source: 2018 filings, split adjusted


In total, there were 518,000 unexercised shares, or 16.6% of outstanding shares (as of fiscal 2018 end).

Financials & Valuation

  • Aside from growing revenues, there isn’t much to be excited about No. 1’s operating business, especially since much of the growth comes from OA sales.
  • Additionally, the company has delivered lackluster performance in self developed products and support services, two areas which the company notes as growth drivers.
  • Still, the company delivers healthy operating performance. Moreover, at today’s 622 yen per share price, No. 1 trades at an EV/EBIT multiple of 2.1x.
  • There are several concerns like the founder selling nearly all of his stake post IPO and an independent publisher reporting on a criminal investigation of the company.
  • While we recommend avoiding No. 1 for these concerns, if we ignore these concerns for the sake of valuation, investors may see an optimistic three year investment CAGR of between 0.5% and 4.8%.

Much of No. 1’s recent growth came from OA sales. Meanwhile, the company’s focus is on growing self developed product and support service sales, which hasn’t performed well. Seeing that OA sales consists of products with declining demand (like multifunction printers and business phones), there isn’t much to be excited about with No. 1.

With that said, at today’s share price of 622 yen, No. 1 trades at an EV/EBIT multiple of 2.1x. To be sure, concerns like the founder selling most of his stake post IPO and an independent publisher reporting on a criminal investigation of No. 1 raise red flags. Investors are best advised to avoid No. 1 for now.

For the sake of valuation, however, we will disregard the concerns and estimate how much No. 1 is worth. First, the company’s annual sales is below 10,000 million yen ($92.3 million USD) and its current market cap is 1,917 million yen ($17.7 million USD). Although No. 1 has been growing revenues at a respectable 6.9% CAGR over the last three years, the company is mostly involved in a highly competitive and shrinking OA equipment sales and leasing business. With this in mind, the company should probably trade no higher than 3x EV/EBIT.

If No. 1 maintains its revenue growth rate of 6.9% per annum and operating margins of 3.2%, company shares will trade for around 800 yen at an EV/EBIT of 3x. Taking exercisable stock options into account, shares ought to trade around 716 yen per share. This comes out to a three year investment CAGR of 4.8%. In a no growth scenario, investors can expect a three year investment CAGR of 0.5%.

In short, No. 1’s core operating business (i.e., OA equipment) is in a highly competitive and declining market, the company has red flags (i.e., founder selling out, suspicious reports), and there is a significant number of unexercised options. Frankly, there isn’t much left for investors to get excited about. Hence, investors ought to look elsewhere for investment opportunities.

The bottom line

No. 1 is a recently listed company mainly engaged in the sales and maintenance of office automation (OA) and information security equipment. Although the company has grown revenues at 6.9% CAGR over the last three years, much of it was generated outside of areas that management considers key growth drivers. At today’s 2.1x EV/EBIT multiple, the company appears cheap. However, between suspicious reports and significant unexercised stock options, there isn’t much left for investors to get excited about. Hence, investors are advised to look elsewhere for investment opportunities.


Kenkyo Investing
Kenkyo Investing

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