Description

Description

Aucnet is an asset-lite Japanese online B2B auction provider trading at low multiples and with an attractive growth outlook. The business model is similar to KAR Auction Services or Copart, but with more growth prospects from expansion into new fields. The company originally sold used cars via online auctions and has since expanded to smartphones, luxury goods, flowers and more. Each category has potential for growth. More importantly, the entrepreneurial spirit of the company is likely to lead to expansion into new categories and geographies in the future. Recent M&A has been transformational and largely successful. The company trades at 3.8x EBITA currently, while generating an ROIC of 17%. I think a 9.4x EV/EBIT multiple (+94%) is fair and leaves additional upside from future growth.

Why Does This Opportunity Exist?

1. Aucnet has been a beneficiary of COVID due to a spike in demand for luxury goods and online auto auctions. Investors are concerned conditions will worsen as the world normalizes.

2. Aucnet first listed in 2000, but went private through an MBO in 2008. This left a bad taste in investors' mouths as the company was on the verge of restructuring operations to significantly raise profitability. There is some distrust of the management team.

3. Since relisting in 2017, the company missed guidance for 3 consecutive years as the smartphone auction business underperformed expectations.

4. The smartphone auction business is a large driver of profit, but has been volatile depending on sales of the newest iPhone model. New trade-in programs from KDDI should help normalize volumes. 

5. The growth of the business is unpredictable. Aucnet continues to experiment with new business lines and most of them fail, but some of them take off and grow into meaningful earnings drivers.

6. There is a lack of visibility on the mid to long-term growth outlook. The company plans to address this by releasing its first mid-term business plan in February.

7. Japanese investors assign little value to balance sheet cash because it tends not to be used in service of growing the business. Aucnet, however, is likely to use cash for accretive M&A.

Business Description

Auto Auctions - 31% of Sales / 44% of Operating Profit

The Automobile business provides B2B online automobile auctions and related services. In addition to running their own auctions, Aucnet provides the IT infrastructure for online connectivity to independent live auction houses (basically everyone outside of USS 4732 JT) and provides payment settlement services to these houses as well.

In addition, Aucnet provides a repair and certification service for used cars called Aucnet Inspection Service (AIS). For example, a seller might spend $1000 on repairs by AIS, but with the AIS certification, get a sale price $2000 higher at auction, making it a high ROI investment. The AIS brand is well known by buyers and increases the probability that the car will sell since it mitigates the lemon problem. The Japanese automobile market is in a slow, structural decline, but Aucnet has managed to generate some growth by rolling out new value-added services like AIS.

Digital Products (Smartphones) - 18% of Sales / 41% of OP

Aucnet conducts auctions of trade-in smartphones for KDDI, the second-largest carrier in Japan. Aucnet receives success fees based on how high a price they can achieve for the phones. They also provide data cleansing and quality grading for the phones for an additional fee. This business was negatively impacted by lengthening ownership for iPhones (fewer trade-ins) from the time of listing until 2019. However, the company restructured their contract with KDDI to receive 100% of their used phone business (up from ~65% previously). KDDI also introduced incentive programs starting in 2019 that provide large discounts to customers who trade in and upgrade their phones after 2 years. This is starting to result in a large number of phones coming to Aucnet. The release of the first 5G iPhones in late 2020 had a positive impact on trade-in volumes in 2021 as well. However, the iPhone 13 series released last September is disappointing and may negatively impact Aucnet in 2022.

Other carriers use wholesalers to unload trade-ins. Selling to wholesalers results in suboptimal monetization relative to selling via auction. Therefore, I see limited risk of Aucnet losing their business with KDDI. However, the competitive nature of Softbank and Docomo indicates they are unlikely to adopt Aucnet for their phones. Aucnet expanded into the US starting in 2019, aiming to recreate the business model built in Japan. The US is also dominated by wholesalers, and so an opportunity exists for an auction-based player to take share. However, for various reasons, the business faltered and they closed the US operations in 2021.

Consumer Products (Luxury Goods) - 37% of Sales / 17% of OP

The luxury goods auction business had been growing rapidly with high quality Japanese-owned branded goods in high demand by overseas buyers. Aucnet made a transformational acquisition in 2020 when it bought Gallery Rare, a used luxury goods chain, for a mere 0.6bn yen. Gallery Rare had 1.5b in sales and 0.1b in operating profit in the year before being acquired. The business model of a used luxury goods store is challenging because of the massive investment in inventory. However, by combining with Aucnet, low-turnover items can be sold at auction quickly and converted back into cash. In addition to aiding the supply side of the auction business, Aucnet is actively expanding its buyer network internationally, particularly in the US.

Flower Auctions - Undisclosed

Aucnet was operating a small, but profitable, online Dutch-style flower auction business. In 2020 they bought Tokyo Kinuta Kaki, a physical auction house, which gave them access to a wide network of buyers and sellers. In addition, the company bought Gran Bouquet Otaki, an orchid grower, in September 2021. The merger of these online and real auctions and expanding into the upstream production side are likely to generate attractive synergies, similar to the Gallery Rare purchase. The Flower industry had a massive negative impact from COVID-19 (few large-scale weddings, funerals and new business openings), but should normalize in the coming years.

Other Businesses - 13% of Sales / Negative OP (incl Flowers)

In addition to the established earnings drivers, Aucnet has started a number of new ventures centered around their logistics and auction competencies. When I originally invested in the company a few years ago, I thought the medical device auction business had the potential to turn into a major earnings pillar, but in the end this business has largely been thwarted by regulations and business practices of the device makers. On the other hand, luxury goods unexpectedly emerged as a major business line that now accounts for a third of sales. 

The point is, the company takes risks and tries lots of things, but it is nearly impossible to predict which of their moonshots will hit the mark. However, they have a proven track record of building profitable business lines from these ventures. At the moment, their medical business has morphed into an online pharmaceutical conference streaming platform and is growing rapidly. They are also working on a lithium battery recycling business, a motorcycle sharing business, providing their know-how of used products purchase and resale "as-a-service" on a fee basis to companies in various industries, and others. From my perspective, there are a number of major markets that Aucnet has the potential to enter in the future that could also be quite attractive including real estate, art, liquor and NFTs. In addition to the low valuation for existing business lines, potential new markets represent free options for investors.

M&A Track Record

One of the most attractive things about Aucnet is their track record in M&A. They have bought a number of failing businesses in target industries and succeeded in creating synergies by marrying offline and online business models.

Gallery Rare - August 2020 - Aucnet spent 0.6bn to buy Gallery Rare. The company had been generating sales of 8-15b per year and operating profit of about 0.1b. I estimate Aucnet's luxury goods business was generating about 1.4b in sales and 0.4b in OP prior to the acquisition, and this year will make 14.5b sales and 1.4b OP, in my estimate. The 1b increase in OP can mainly be attributed to synergies with Gallery Rare, effectively paying for the purchase in just 1 year.

Tokyo Kinuta Kaki - May 2020 - Aucnet acquired the potted plant physical auction company for an undisclosed sum, but based on later disclosure it appears they paid a negative 0.2b in enterprise value. The owner did not have anyone to take over the business and so came to Aucnet for help. Kinuta had sales of 0.4b and OP of 0.02b in the year before it was acquired. Kinuta has a strong brand in the flower market, and attracts a lot of buyers and sellers. Now Aucnet can leverage those relationships for its online flower auctions as well. Those efforts appear to be showing some positive results as sales in the 3Q for the flower segment rose 7% YoY, the first quarter for which we have YoY comparisons that include Kinuta.

Greenstream International - October 2018 - This is an example of M&A that didn't work. Aucnet bought a nearly-collapsed used phone processor based in Texas to kickstart their entry into the U.S. market. The terms were not disclosed, but I believe GI was not operational at the time and Aucnet only paid the cost of the warehouse / processing facility. Unfortunately, this business did not grow into the major earnings driver I had hoped for as Aucnet was unable to secure sufficient volumes and could not staff their facility due to the “Great Resignation.” They shuttered the business in mid-2021 while they rethink their approach to the U.S. market. Closing this business will eliminate 0.4b in annual costs from 2022.

Estimates

The company estimates OP of 5.6b for 2021 and achieved 4.8b as of the 3Q. I estimate they can reach 6.1b for 2021, expanding to 6.9b in 2022 and continued growth into the future. Goodwill amortization is about 0.1b per year.

Automobiles

This business generally earns operating margins of ~30%. Sales and OP were flat from 2015-2020. In 2021, the company benefited from a surge in used car prices, resulting in higher contract rates and prices at auctions. They are now coming up against the problem of fewer used cars coming to auction and the business is slowing down. I expect they will generate 11.8b in sales and 3.7b in OP for 2021, falling to 11.2b and 3.4b in 2022.

Digital Products (Smartphones)

OP for this business peaked at 3b in 2016, the year before Aucnet's IPO and troughed at 0.9b in 2019. The KDDI trade-in program and strong pricing for used smartphones have been tailwinds in 2021. I expect the smartphone auction business to generate 7b in sales and 3.8b in OP for 2021. The new iPhone model is not making a major splash, and so I expect sales to remain at 7b in 2022, but a slight improvement in OP to 3.9b as the shutdown of the US business eliminates related costs.

Consumer Products (Luxury Goods)

Disclosure of this segment only began in 2020. 2021 was a bumper year for luxury goods. I forecast sales of 14.5b and OP of 1.4b. Aucnet is still working on integrating Gallery Rare. Cost cuts and improved interaction between the online and offline businesses should result in strong growth again in 2022. I estimate sales increase by 10% to 15.9b and OP by 36% to 1.9b.

Other businesses

Motorcycle and flower auctions are only slightly profitable, while other minor business lines are losing money in 2021. I estimate 4.4b in sales and an operating loss of 0.3b for 2021. In 2022, the flower business in particular should rebound strongly, aided by recent acquisitions and a post-COVID normalization for celebrations. I estimate a 47% increase in sales to 6.5b and a swing in OP to a 0.3b profit.

Summary

In sum, the business is forecast to generate 8.7b from business lines for 2021, while corporate overhead costs are estimated at 2.6b, for a net total of 6b. For 2022, I forecast OP of 9.5b and similar overhead costs of 2.6b, for a total of 6.9b (+13%).

Valuation

At the current stock price of 1,595 yen, the company has a market cap of 44.4b. With cash of 19.8b, investment securities worth 1.7b (including the tax liability on unrealized gains), no debt and minority interest of 0.3b, the enterprise value comes to 23.2b. Goodwill amortization is about 0.1b per year. The stock trades at 3.8x my estimate of EBITA for 2021, and 3.3x my 2022 estimate.

Intrinsic Value:

Autos - I assign an 8x valuation for the auto business reflecting the muted growth outlook = 8 x 3.4b = 27.2b

Digital Products (Smartphones) - 8x reflecting the volatility of the business = 8 x 3.9b = 31.2b

Consumer Products (Luxury) - 15x reflecting the high growth and ongoing profitability improvement = 15 x 1.9 = 28.5b

Others (Flowers, Motorcycles, etc.) - 8x due to the increasing attractiveness of the flower business, offset by the weaker motorcycle business = 8 x 0.3 = 2.4b

Business value totals 89.3 and a combined EBIT multiple of 9.4x. I subtract the 2.6b corporate overhead costs capitalized at the same 9.4x multiple (-24.4b) for a total business value of 64.9b yen. Net financial assets sum to 21.2b, giving a total fair value estimate of 86.1b (3,097 yen per share), or 94% upside from the current share price.

Comps

Auto Auctions

CPRT US - Copart - the most similar in business model to Aucnet with a pure online auto auction business - 24x estimated EBIT

4732 JT - USS - the largest physical auction provider in Japan, trades at 9.1x

KAR US - Kar Auction Services - US auctioneer - 20x

IAA US - Insurance Auto Auctions - US auctioneer - 18x

RBA CN - Ritchie Brothers Auctioneers - Canadian construction equipment auctioneer - 26x

Luxury Goods

7685 JT - Buysell Technologies - Japanese used luxury goods auction operator - 21x

POSH US - Poshmark - used luxury goods marketplace - loss-making

BID US - Sotheby's - art and high end good auctioneer was sold in 2019 to an entity controlled by Patrick Drahi at a 22x EV/EBIT valuation

General Auctions

EBAY US - Ebay - 13x

MELI US - Mercado Libre - 133x

Auction Infrastructure

ATG LN - Auction Technology Group - provides auction infrastructure as a service to partner companies - 26x

Management

The company was founded in 1984 by Sadataka Fujisaki as a used car auction platform. The founder tragically died a few years later and was succeeded by his younger brother Kiyotaka Fujisaki. Kiyotaka led the company throughout the 1990s, transforming it into an online auction house and entering new markets including flowers, PCs, and motorcycles. In 2020, Kiyotaka's title changed from "President" to "Chairman / CEO" and Shinichiro Kiyotaka, the son of the founder, assumed the role of "President / COO." The Fujisaki family maintains control of the company through Flex Corporation (41% ownership), controlled by Shinichiro and his mother, and Namai Asset Management (6.8%), controlled by Kiyotaka. Shinichiro and his brother, also own 3% in their own names, for total holdings by family members of 54%.

I was initially skeptical of Shinichiro taking over the position of president as he is still young (46). His uncle, Kiyotaka, did such a phenomenal job growing the business that I wanted him to hang around as long as possible. However, the transition seems to have kick-started an acceleration in activity, including major acquisitions such as Gallery Rare and Kinuta, as well as new business ventures such as lithium battery recycling, tie-ups with Senshukai, a partnership with Tokyo University and others.

Risks

1. The automobile auction market is in long term decline in Japan due to the shrinking and aging population. Aucnet has thus far done a heroic job of growing this business, but their primary competitor, USS, is intent on continuing to take market share. I estimate this business will start to decline in the next few years.

2. The smartphone auction business is dependent on the popularity of new iPhones driving trade-ins and failure by Apple to launch innovative new products is a constant risk.

3. The company spends a lot of money on new ventures which tend to be loss-making until they gain scale. At least some of these need to succeed, or the ongoing losses of more than 1b per year (included in corporate overhead costs) will simply be a drag.

4. The company has 20b in balance sheet cash. It wants to use this for growing the business rather than paying out to shareholders. So far, M&A has been successful, but it is possible they will commit a major error in M&A and destroy a significant amount of value.

Disclaimer

I do not hold a position with the issuer such as employment, directorship, or consultancy

.I and/or others I advise hold a material investment in the issuer's securities.The information contained in this VIC writeup is strictly for informational purposes only and is not a recommendation to buy or sell the securities noted in this article (the “Security”). 

The information has been obtained from or is based upon sources believed to be reliable but is not guaranteed as to its accuracy, adequacy, or completeness. Liability for errors or omissions is expressly disclaimed. The information is provided without obligation and on the understanding that any person or entity who acts upon it does so entirely at their own risk. The author or his or her respective employer or employer’s clients, affiliates, officers, managers and directors, may or may not hold positions in the Security. These parties may trade the Security at any time, without notification to this community, and will not disclose this information to this community.

Catalyst

1. The release of the first ever midterm plan in February 2022 should build expectations for continuous profit growth

2. M&A - especially if it occurs in the luxury goods segment

3. Raising the dividend payout ratio beyond the current 30% level