Description

Another Software Hidden Gem in Japan.

Argo Graphics is a strategic reseller of industrial CAD and semicondutor fab ERP software for Dassault Systems and IBM in Japan. 

Despite a 18% EBIT CAGR growth trajectory over the past 7 years, Graphics maintains a modest valuation of 6x EV/EBIT and 13x P/E, providing an attractive opportunity for investors.

We think the company may announce better than guided Fiscal 2023 (ending in March 2024) results in May together with an improvement in its shareholder returns strategy.

Computer Aided Design industry

The CAD software industry is renowned for its strong business attributes: it offers mission-critical, sticky software with a growing TAM and considerable pricing power. Moreover, it benefits from robust network effects, serving as the common language for design professionals worldwide.

ScullyJRR provided an excellent analysis of AutoDesk's competitive advantages in a detailed write-up dated November 30th, 2023. While our Japanese pick is associated with AutoDesk's French arch-competitor, Dassault Systems, we recommend our readers review this in-depth analysis to gain a better understanding of the industry's business model and potential for long-term growth.

We particularly found the explanations of Network Effects and Switching Costs, and their implications for Pricing Power, insightful. These dynamics are directly applicable to Argo Graphics, evidenced by the similar 6% revenue increases observed over the past three years. Such price raises are uncommon in the Japanese software landscape, where participants have yet to fully leverage their pricing power.

Dassault Systems’ success come from pushing the boundaries of CAD functionalities to englobe the whole Product Lifecycle Management, widening its moat in the process.

History and Positioning

Argo Graphics was founded in 1985 with funding from Argo21, Seiko Instruments, and Sony, initially operating as a software and hardware reseller. In 2007, Argo21 was acquired by Canon Marketing Japan and the company managed to move their stake to SCSK, a company affiliated to Sumitomo, which now holds a 26% stake. 

The company rapidly shifted its focus to the Product Lifecycle Management (PLM) sector, emerging as the leading reseller of Dassault System CATIA's solution for industrial clients. It is also the main reseller of IBM's MES solution for semiconductor fabs. Over time, Argo Graphics expanded its capabilities, incorporating high-speed processing capabilities both on-site and through its proprietary data-center infrastructure.

Presently, Argo Graphics' major clients include Honda Group (PLM), accounting for 14% of revenues, and Kioxia Group (formerly Toshiba, MES), contributing 10% of revenues. It has a 40% wallet share of Dassault Systems revenue in Japan which has been increasing, while Dassault Systems Japan’s own direct channel accounts for 20%. Argo Graphics represents 90% wallet share of IBM’s MES platform SiView in Japan.

For a good overview of the company's positioning and value proposition, refer to the slide below taken from their corporate presentation:

The product and revenue mix is well balanced with recurring (stock-based) revenues  accounting for about half of revenue and software split three-way between PLM (Dassault Systems), High-Performance Computing (using their own data center) and IBM’s MES solutions.

Churn is extremely low to non-existent and Gross Margins vary between 30% for large auto clients to 25% for semiconductor fab ones.

A Growth Story

Over the past 7 years, revenues have maintained a steady growth trajectory with a 7% Compound Annual Growth Rate (CAGR), while Earnings Before Interest and Taxes (EBIT) have experienced robust expansion at an 18% CAGR. This growth has been fueled by ascending gross margins and a remarkable rise in operating margins, which have doubled from 6% to the current 12%.

Interestingly, earnings have grown quicker than Dassault System, which has registered a 10% EBIT CAGR over the same period. Gross Margins are of course higher at Dassault System (84% vs 27%) but there is clearly a lot to be said about operating close to customers.

For those interested in Argo Graphics, we recommend reviewing the insights shared during Dassault Systems Capital Markets Day 2023, held in June 2023 (https://investor.3ds.com/capital-markets-day-2023). This event encapsulates the company's achievements over the past 5 years and articulates a compelling roadmap for the next five-year period, aiming to double EPS once again. Most of the product and service growth initiatives will also positively impact Argo Graphics, as it has already done this year with the rollout of its CATIA v6 version, which adds features and new modules to the core offering.  

In addition, anyone who has read Chip War from Chris Miller will not be surprised to learn that semiconductors fabs are being built at speed in Japan, including 2 from TSMC, one in Kyushu in the South and the new one in Hokkaido in the North. The company should be a direct beneficiary from these investments.

There is a lot less public information available about IBM’s SiView pricing but here is a good overview of the product functionality and track record:

https://www.ibm.com/products/siview

We think that it can be seen as ERP for large semiconductor fabs which handles the whole ordering-to-production process, making it very much mission-critical.

Active Bolt-on Acquisitions Program

Argo Graphics has deftly added bolt-on acquisitions over the years to either complement its offering or acquire scarce engineering resources. It then gives them a great amount of autonomy and even breaks down financial results at the subsidiary level in their corporate presentation, years after their acquisition. As a whole, these group companies account for about 20% of revenues and EBIT and have clearly been accretive to earnings.

These small companies were acquired at low valuation and haven’t made a dent in the cash accumulated by the companies over the years.

A low dividend payout ratio of 30% has not helped the situation, a common instance in Japanese small caps.

Capital Allocation

The reported 14% ROE of the company is very low and stagnant, especially if we compare it to its growing 60% adjusted-ROE which we calculate by leaving only 3 months worth of operating costs on the balance sheet and assuming that the excess cash is distributed.

To ever hope of closing the gap between the two, and if EBIT keeps growing at 10% a year, the company would have to move to a 100% payout ratio and initiate an active share buyback program. The fact that Dassault Systems have a Return on Tangible Equity of 45% should be a good indicator to management, although some of the intangibles assets are clearly needed to run the business. 

Latest Developments

Although the company had guided for a flat revenue and earnings for FY2023-24 (ending in March 2024), it posted a 13% jump in revenue and 20% for EBIT for Q2FY23-24 at its October 2023 earnings announcement which then grew to a 27% growth in revenue and 44% for the first 9 months of FY23-24 in January 2024.

At the same time, the company changed its guidance for the full year, by then only a quarter away, and added 5% to revenue and 14% EBIT to its previous flat annual guidance. This would imply a negative Q4, which has never happened to the company. On the contrary, Argo Graphics over the past few years has given very conservative guidance, and beaten it.

One would have to go back to FY2014 or FY2016 to see any major disappointment.

Catalysts

The drivers for what we think will be a better FY2023-24 results than initially guided for were the new version roll-out and added features of Dassault CATIA v6. We think that new contracts for IBM’s MES systems could also materialize as new semiconductors fabs are being put into service.

Despite a 18% EBIT CAGR growth trajectory over the past 7 years, Graphics maintains a modest valuation of 6x EV/EBIT and 13x P/E, providing an attractive opportunity for investor. The average daily volume is currently only $1M but with a market cap of $600M and a float of 68%, it could grow to multiples of it as this hidden gem gets discovered.

It is quite telling that valuations ratios have remained flat or even decreased slightly over the past 7 years in the face of such dependable growth. In fact, Argo Graphics has managed to compound its share price at 20% a year for the past 10 years (in JPY) and still trades at a very reasonable valuation. Almost all returns so far have come from earnings growth!

Risks

We think that the main risk is that the company does not announce an improved shareholder returns plan at its annual results in May.

It has a pretty good track record on its bolt-on M&A program but we think that it is very unlikely that they can roll it out at scale. In the meantime, the company’s balance sheet has to absorb $25 to $50M of free cash flow a year, depressing its ROE even more.

Catalyst

The drivers for what we think will be a much better FY2023-24 results than initially guided for were the new version roll-out and added features of Dassault CATIA v6. We think that new contracts for IBM’s MES systems could also materialize as new semiconductors fabs are being put into service.

Despite a 18% EBIT CAGR growth trajectory over the past 7 years, Graphics maintains a modest valuation of 6x EV/EBIT and 13x P/E, providing an attractive opportunity for investor. The average daily volume is currently only $1M but with a market cap of $600M and a float of 68%, it could grow to multiples of it as this hidden gem gets discovered.

It is quite telling that valuations ratios have remained flat or even decreased slightly over the past 7 years in the face of such dependable growth. In fact, Argo Graphics has managed to compound its share price at 20% a year for the past 10 years (in JPY) and still trades at a very reasonable valuation. Almost all returns so far have come from earnings growth!