Thinking points

  • Encourage Technologies (TSE: 3682) is a package software vendor in the security field. Over the last 11 years, ET’s audit trail tool has held the top share (~50%) in the Japanese market for internal control. In recent years, the company has also been focusing on a subscription model by developing cloud-based services.
  • Key challenges include adapting to the changes in internal control processes brought on by the adoption of RPA by client companies and diversifying revenue sources.
  • Key opportunities include the growing need for internal control especially among listed companies and new demand for remote work-based control processes after the  start of the COVID-19 pandemic.
  • At JPY600 per share, ET trades at an adjusted EV/EBIT of 4.6x with a market capitalization of JPY4.0bn.
  • Assuming a fair value EV/EBIT of 2-4x, investors can expect an investment CAGR of between 3.2% to 8.2% over the next 3 to 5 years.

Introduction

Encourage Technologies (TSE: 3682) is a packaged software vendor specializing in the niche areas of internal controls and security. ET has held the top share (~50%) of the Japanese market for the past 11 years in the audit trail tools field. It operates a single-segment operation, with the Packaged Software segment offering software licensing, maintenance services, cloud services, and consulting services.

Source: Kenkyo Investing, based on company data

Business & operating environment

Company History

ET was founded in 2002 by Tatsuya Ishii, the current president, as an IT vendor to meet the rapidly growing need for IT internal control. In the same year, the company launched its first software, Encourage Smart Station (ESS), an integrated process monitoring tool for system operation management. In 2004, the company developed and released their flagship product, ESS REC, a human risk management system. Then in 2015, the company introduced a cloud-based audit trail tool and added a subscription model to its product lineup. 2016 saw the acquisition of system development company Acrotech Inc., and in 2020, the company launched ESS REC NEAO aimed at managing human risks in remote work. ET was first listed in 2013 on the Tokyo Stock Exchange’s Mothers market, which is focused on growth, and then transferred to the First Section of the Tokyo Stock Exchange in 2019.

Industry and Business Model

The cybersecurity solutions industry in Japan, which the company operates in, amounts to ~16bn JPY as of 2020 and has been growing at a CAGR of +12% since 2018 (Deloitte Tohmatsu Mic Research Institution). In addition, the overall security software market is expected to grow at a CAGR of +5.7% from 2020 to 2025 (IDC Japan). The concept of internal control in Japan gained momentum with the revision of the Commercial Code in 2003, followed by the enforcement of the Companies Act and the Financial Instruments and Exchange Act in 2006. This required listed companies to implement internal control reporting systems, which drove a sharp rise in demand for internal control-related services.

Encourage Technologies develops products related to internal controls, provides them to clients on a license or subscription basis, and offers maintenance and consulting services. Financial institutions and IT companies account for over 50% of revenue, and the remaining clients range from manufacturing and telecommunications to government and other industries. Listed companies with strong internal control needs account for 75% of clients. After their introduction, ET products are integrated into the clients’ internal control processes, resulting in a high maintenance and renewal rate of over 95%, along with stable revenue. 

The largest customer is NTT Data (TSE: 9613), which accounts for ~20% of sales. ET entered into a distributor agreement with NTT Data, and NTT Data sells products on behalf of ET.

Source: Kenkyo Investing, based on company data

After enjoying healthy growth in the 2010’s, ET’s sales fell by ~15% YoY in FY03/20 owing to delays in business activities caused by the COVID-19 pandemic. Subsequently, orders for human risk management systems for remote workers have expanded, and Q1 FY03/22 sales rose 5% YoY. The company’s full-year FY03/22 forecast calls for sales to increase by 16% You and operating profit by 53% YoY.

Source: Kenkyo Investing, based on company data

As ET has no interest-bearing debt, its fixed costs have been low, with operating margins averaging around 30% in the 2010s. The company expects stable revenue from maintenance services under existing contracts, and thus has a solid revenue base with an operating margin of around 9% in FY03/21 despite the COVID-19 pandemic.

Shareholders

As of end-March 2021, the company had 6,924,200 shares issued and 209,400 shares in treasury (~3%), putting outstanding shares at 6,714,800 (of which 54,400 were held by ESOP). Foreign shareholders accounted for approximately 5% of all shareholders. The major shareholders are below.

Source: Kenkyo Investing, based on company data

Tatsuya Ishi, the largest shareholder, is the founder and CEO; Yoshihiro Maruyama and Toshiyuki Kato are the past CTO and CFO, respectively. Hikari Tsushin (TSE: 9435) is a major Japanese telecommunication company and one of the leading value-investors in Japan. SOLXYZ (TSE: 4284) is a Japanese system integrator and has a business alliance with ET. Quintet Private Bank is a medium-sized Luxembourg-headquartered wealth manager owned by members of the Al-Thani family of Qatar (Wikipedia).  

The company conducted a stock split in 2018 and repurchased 209,000 shares in 2020 which it has yet to cancel. There are no existing stock acquisition rights. The company has a relatively high dividend payout ratio, targeting a minimum of 33.3%. It has historically paid out around 70-80% since its foundation.

Financials & valuation

  • Encourage Technologies (TSE: 3682) is a package software vendor in the security field. Over the last 11 years, ET’s audit trail tool has held the top share (~50%) in the Japanese market for internal control. In recent years, the company has also been focusing on a subscription model by developing cloud-based services.
  • Key challenges include adapting to the changes in internal control processes brought on by the adoption of RPA by client companies and diversifying revenue sources.
  • Key opportunities include the growing need for internal control especially among listed companies and new demand for remote work-based control processes after the  start of the COVID-19 pandemic.
  • At JPY600 per share, ET trades at an adjusted EV/EBIT of 4.6x with a market capitalization of JPY4.0bn.
  • Assuming a fair value EV/EBIT of 2-4x, investors can expect an investment CAGR of between 3.2% to 8.2% over the next 3 to 5 years.

ET has the largest market share in the niche field of security software, and by integrating its services into the internal control processes of its clients, it has been able to earn stable maintenance service revenues. As a result, although the company’s sales are not large, it has been operating debt-free and is extremely cash-rich, with cash and deposits of JPY3.2bn out of total assets of JPY3.9bn.

Some of the challenges that ET faces include adapting to the changes in internal control processes brought on by the adoption of RPA by client companies and diversifying its revenue source, or in other words, breaking away from its dependence on mainstay products. With regard to RPA in particular, financial institutions, which are the company’s main clients, have been promoting the use of AI in system operations, leading to major changes in the nature of audit trails.

In terms of opportunities, internal control is becoming increasingly important with the revision of the Corporate Governance Code by the Tokyo Stock Exchange, enhancing the demand for ET’s product series. In addition, the pandemic has contributed to an increase in remote work, which has spurred employers to reexamine their internal control systems for remote environments, presenting opportunities for Encourage Technologies to sell remote-focused products .

At JPY600 per share, Encourage Technologies trades at a modest P/B ratio of 1.3x and an adjusted P/E ratio of 29x, with a market capitalization of ~JPY4bn. Assuming stable profits and a fair value EV/EBIT multiple of 2-4x, investors can expect an investment CAGR of between 3.2% and 8.2% over the next 3 to 5 years. The lowest EBIT in the last five years is used for the low end and the FY03/22 company forecast is used for the high end of this estimate.

The bottom line

Encourage Technologies is a packaged software vendor commanding a 50% share of the Japanese audit trail software market. Although the company faces some challenges such as changes in internal control processes of clients with increasing adoption of RPA, it also has tailwinds such as the rising importance of internal control after the Tokyo Stock Exchange’s revision of the Corporate Governance Code. Buying in at JPY600 per share, investors can expect an investment CAGR of between 3.2% and 8.2%, including shareholder returns, over the next 3 to 5 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.