Thinking Points

  • ERI Holdings (TSE: 6083) is the largest building inspection and home evaluation company in Japan, with a 19% market share and 33 field offices across the nation.
  • Business performance is heavily influenced by the construction industry’s health, with ERI recording operating losses during the global financial crisis.
  • With a projected decline of new home builds in Japan and business restrictions placed on ERI Holdings because of its position as an inspector, the company may face challenges in growing revenues in its current core business.
  • At 890 yen per share, ERI Holdings trades at 5.7x EV/EBIT with a market capitalization of 6,831 million yen ($62 million USD).
  • Overall, investors can expect an investment CAGR of between -9.9% and 12.6%, inclusive of dividends, over the next three years.

Introduction

ERI Holdings (TSE: 6083) is primarily engaged in the evaluation, rating, and inspection business in the construction industry. The company operates through four segments: Building Inspections, Residential Property Evaluations, Solutions, and Other.

Source: Company filings

The company is the market leader in confirmation inspections and residential property evaluations, and the only one to have sales offices nationwide. Its competitors primarily operate locally or regionally.

The business & environment

ERI Holdings was formed in 2015 as a holding company, but its main subsidiary Nihon ERI was founded in 1999. While many of the key companies in the construction industry have a long history often extending beyond 50 years, ERI Holdings is fairly new. This is because the inspection and evaluation industry didn’t exist until 1999, when Japan passed a revision to the Building Standards Law. The revised law allowed non-government entities to perform building inspections.

From then on, building inspections were rapidly transitioned to the private sector:

Source: Company filings

As of May 2018, ERI is the largest of 134 firms designated to perform building inspections. Most of its competitors have a local or regional focus and none have a nationwide office network matching ERI’s scale or coverage area (33 offices).

In addition to the Building Standards Law revision, the Housing Quality Assurance Law was passed in 2000, mandating home builders to take responsibility for structural defects for ten years. As a part of enacting the law, the government set up a program for housing evaluation performed on new builds by designated third parties.

While the law does not mandate housing evaluations, it is pushing for a 50% adoption rate by 2020. Adoption rates so far are below target:

Source: Company filings

ERI is also the largest of 122 firms performing new home evaluations. Similarly, most competitors have a local or regional focus, with ERI as the only operator with a nationwide office network. The company holds a 19% market share in home and condo engineering inspections as of May 2018. The top 5 firms in the industry represent 51% of the market, and the top 10 firms represent 72% of the market.

For fiscal 2018, building inspections and home evaluations accounted for 78% of revenues and have historically remained the company’s core business segments:

Source: Company filings


The increase in 2018 revenues was largely a function of the company acquiring a home evaluation company, which contributed to 1,200 million yen ($10.9 million USD) in revenues. In other words, ERI’s existing business grew organically by approximately 540 million yen ($4.9 million USD), or 4.8% YoY.

New home builds in Japan are expected to decline with a shrinking population pool, and ERI is expecting increasing competition, particularly for contracts with large home builders. Nomura Research Institute projects new home builds will decline to 600,000 units in 2030 compared to 950,000 units in 2017 (Japanese).

On the same note, ERI is also expecting opportunities to acquire smaller local inspection and evaluation firms, noting that it’ll primarily be a means to acquire talent rather than expanding market share. As a side note, ERI may be in a difficult position to start new businesses in related fields because of its positioning as an inspector. For example, Japanese law places limitations on ERI’s ability to operate as an engineering firm, construction company, real estate company, and elevator company.

Daiwa House (TSE: 1925) is the #4 shareholder (tied) in ERI and regularly contributes to more than 10% of annual revenues. Other major shareholders include Sekisui Chemical (TSE: 4204), Mitsui Homes, and Misawa Hom (TSE: 1722), all tied as the #4 shareholder.

Business performance is heavily influenced by the construction industry’s health. The company reported operating losses through the global financial crisis:

Source: Company filings

For fiscal 2019, ERI originally guided for 14,916 million yen ($136 million USD, +13.9% YoY) in revenues and 757 million yen ($6.9 million USD, +9.7% YoY) in operating income. As of Q3 2019, the company reported 11,200 million yen ($102 million USD, +20.3% YoY) in revenues and 725 million yen ($6.6 million USD, +87.9% YoY) in operating income with no revisions to the original guidance.

In its medium term guidance (fiscal 2017~2020), the company is targeting 16,000 million yen ($146 million USD) in revenues, 1,200 million yen ($10.9 million USD) in operating income, 7.5+% operating margins, 20+% ROE, and a dividend payout ratio of above 30%.

Shareholders

As of Q3 2019 (ending February 28th, 2019), ERI Holdings had 7,832,400 shares issued and 253,285 shares in treasury, putting outstanding shares at 7,579,115.

Here are the major shareholders:

Source: Company filings & Nikkei

Takahide Suzuki is the founder of Nihon ERI and former CEO and board chairman of the company.

There are no stock options outstanding.

Similar to business restrictions placed on ERI Holdings because of its position as an inspector, there are restrictions to share ownership by engineering firms, construction companies, real estate companies, and elevator companies. Shareholder representation should not exceed one-third of total representation.

Financials & Valuation

  • ERI Holdings is the largest building inspection and home evaluation company in Japan, with a 19% market share and 33 field offices across the nation.
  • Business performance is heavily influenced by the construction industry’s health, with ERI recording operating losses during the global financial crisis.
  • With a projected decline of new home builds in Japan and business restrictions placed on ERI Holdings because of its position as an inspector, the company may face challenges in growing revenues in its current core business.
  • At 890 yen per share, ERI Holdings trades at 5.7x EV/EBIT with a market capitalization of 6,831 million yen ($62 million USD).
  • Overall, investors can expect an investment CAGR of between -9.9% and 12.6%, inclusive of dividends, over the next three years.

ERI was formed shortly after Japan opened up building inspections to approved firms in the private sector in 1999. The following year, Japan passed the Housing Quality Assurance Law, tightening regulations and encouraging home evaluations in the process. From there on, building inspections and home evaluations became core businesses for ERI.

Over the last two decades, the company established itself as the market leader in building inspections and home evaluations, with a 19% market share. Although regulations will make it difficult to start competing businesses, competition is increasing as new home builds are decreasing. Moreover, ERI’s position as an inspector makes it difficult to expand into other related businesses as there are regulator restrictions in place.

ERI has expressed interest in M&A deals, and has completed one recently, acquiring a construction software developer in fiscal 2017 and a competing home evaluation company in fiscal 2018. In an interview with Housing Tribune Online (Japanese), ERI COO Akiya Masudo commented that M&A in its core business is more or less settled, and that the company is focusing on expanding infrastructure and energy efficiency related inspections.

Although there are opportunities in Japan’s aging infrastructure and increasing energy efficiency requirements, the company’s core business is still in building inspections and home evaluations, which faces a challenging outlook.

As far as the balance sheet goes, the company is neither particularly healthy or unhealthy with an equity to asset ratio is 0.38. There are no notable undervalue land assets or investment holdings to adjust for. As an aside, the company owns 400 shares in ANA Holdings (TSE: 9202), one of Japan’s major airlines, explaining that the reason for owning shares is to receive shareholder incentives. ANA offers shareholders discounts on domestic flights. With 400 shares, ERI Holdings is entitled to four discounted domestic flights.

Assuming a fair value EV/EBIT of 6x, if ERI Holdings performs in line with historical norms over the next three years, including business performance during the global financial crisis, operating income would come in around 550 million yen ($5 million USD). In this case, share prices may decline to 660 yen, paying out smaller dividends for a three year investment CAGR of -9.9%.

If ERI Holdings maintains performance in line with medium term targets, operating income will come in around 1,200 million yen ($10.9 million USD). In this case, share prices may increase to 1,215 yen, paying out modest dividends for a three year investment CAGR of 12.6%.

Given the construction industry’s long term outlook and ERI Holdings’ historical fluctuation in business performance, there is a real possibility for the company’s operating performance to significantly decline. At the same time, ERI’s M&A efforts and focus on expanding other inspection businesses may pay off, resulting in strong performance and a wider range of investment performance. Overall, investors can expect an investment CAGR of between -9.9% and 12.6%, inclusive of dividends, over the next three years.

The bottom line

ERI Holdings is the market leader in building inspections and home evaluation services in Japan with a 19% share and the only nationwide office network. Its core business faces challenges as the construction industry is expected to decline over the long term. At the same time, the company is focusing on other inspection areas, like infrastructure and energy efficiency inspections, as well as M&A for future growth. As a result, there is a wide range of likely investment performance. Overall, investors can expect an investment CAGR of between -9.9% and 12.6%, inclusive of dividends, over the next three years.


Kenkyo Investing
Kenkyo Investing

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