Description

With a $911 million market-cap Daiichikosho Co. (7458.JP), hereafter DK, is an under-followed Japanese entertainment and dining company.

I believe DK's equity is undervalued by around 30% and shares many qualitative similarities with previous VIC write-up Ozeki Co.

DK has four main segments:
1. Sale and leasing of karaoke equipment and karaoke software including content distribution over its network equipment.
2. Operating karaoke parlors and restaurants.
3. Music publishing and music software production.
4. 'Others' - a catch-all segment for mainly peripheray businesses in real estate leasing, karaoke/music satellite broadcasting and mobile phone content distribution services (primarily music/karaoke related content).

The karaoke equipment and the karaoke parlor/restaurant business are the main revenue and profit drivers, contributing 49.5% and 32.4% of top line and 55.8% and 30.6% of non-consolidated EBIT for the nine months ending December 2009, respectively.


KARAOKE EQUIPMENT INDUSTRY
DK is Japan's largest Karaoke equipment maker with approximately 55% market share and around 224,000 of its DAM karaoke machines in use at end-2009.

Over the decade the business has consolidated into a duopoly: with DK as leader and Brother Industries Ltd. (6448.JP) subsidiary X-ing with around 45% following the acquisition of number-two player BMB Corp. (approx. 30% market share prior to acquisition) at end-September 2009.

In an August 2009 interview (Japanese-language only) with local business magazine Economist (not to be confused with the English language weekly) President Wada conceded the Japanese karaoke equipment industry (DK manufactures almost exclusively for the Japanese market) is ex-growth.

Karaoke users in Japan peaked at an annual 60 million in 1994 and has been declining since, to around 46 million in 2008. Over the past three years the level of decline has slowed suggesting a bottoming out of users at around the 45-47 milllion mark.

However, despite the decline the karaoke machine division is a steady cash-cow due to its recurring revenue following a move to network distribution for songs, management focus on margins and DK's market dominance in the space.

While replacement cycles (the company revamps its line-up on a rolling basis, but basically the entire range changes over approximately a three year period) help drive demand Wada also noted this is not the core profit driver for the segment. Rather DK makes money and keeps its user base sticky by charging for the data provision of music from a content library, adding new hit tunes into its network, and bundling this with its propreitary portal/gate-way music and entertainment service for users of its DAM Karaoke machines to connect with other users  (using a platform called DAM Station).

Approximately 45% of the revenue from this segment is from the data element, 30% is from leasing of the DAM karaoke machines and 25% from DAM machine sales.

Part of the bid to capture content revenue has also been a move into the music business:  DK owns two record labels, a publisher and distributor.

In the August interview President Wada mentioned 10 years ago they had about 100 tunes loaded onto their machines, now the number is closer to about 1,000 including recent hits by popular local artist like Perfume. It also has a tie-up with Miyazaki Hayao's Studio Ghibli animation studio - the makers of hit animation films such as Spirited Away (essentially, Ghibli is Japan's equivalent of Pixar) - to distribute Studio Ghibli soundtracks and DVDs.

The benefits of all of the above strategy can be seen in profitability at DK's karaoke equipment and leasing division.

EBIT MARGINS @ KARAOKE MAKERS
12 mo-ending            March 2006      March 2007           March 2008       March 2009        Dec 2009
Daiichikosho            16.1%          12.9%                 17.1%            17.3%             19.2%
Brother Industries      7.4%           3.8%                  2.1%             1.6%              1.2%
(others segment - note this is primarily network karaoke machines but also contains other businesses so is not an exact comp)   
Usen                   13.5%           4.9% (12-mo Aug 2007) 11.6% (~Aug 2008)  N/A    N/A
(after Aug 2008 Usen merged a no. of units and no longer gave a separate breakdown for its karaoke unit)        
The best way to view this segment is as a steady/slow declining profitable cash-cow with annuity-like features.

Karaoke Parlor Industry Overview
As the ranks of karaoke users have thinned out so have the number of establishments and encouraged a trend towards larger establishments with more rooms per establishment (i.e. economies of scale).

Having topped out at 14,810 establishments in 1996 by 2001 there were 11,350 karaoke establishments with an average of 11.9 rooms/booths per establishment equating to a grand total of 135,000 karaoke booths in Japan. By 2007, there were 9,241 establishments and 129,400 rooms or an average of 14 rooms/establishment.

DK is the country's second largest karaoke parlor operator running the Big Echo chain, behind SHiDAX Corp. (4837.JP). As of end-2009 DK had 249 Big Echo stores, up 16 over 2008, and compared to 215 stores in the twelve-months ending March 2006.

Big Echo stores tend to be centrally located in main cities, with a bias towards the Tokyo/Kanto region, which is the country's most affluent area and supported by modest internal migration/population growth. Consequently, Big Echo stores generate a higher spend per customer than comps - Shidax, Round One Corp. (4680.JP), Koshidaka (2157.JP). The only listed large-ish operator that can compare in terms of positioning and spend/customer is Tetsujin Inc (2404.JP) although it fails to match DK in profitability.

Importantly, most of the large chain operators are also customers for DK's DAM Karaoke machines so it still gets to capture revenue from rivals' customer bases.

Restaurant Business
As part of efforts to counter a declining user base the bigger karaoke-chain operators have moved towards an integrated model offering other facilities alongside karaoke, e.g. ten-pin bowling, darts, public bar areas and restaurant and dining facilities. Big Echo outlets will have a full food menu in the karaoke booths and often a restaurant dining area attached so once diners finish their meal they can go and belt out their favorite songs in a private room.

Moreover, DK has been diversifying into restaurants proper. As of end-2009 the company had 94 restaurants offering different dining experiences; up from 48 in March 2006 when it began breaking down details of its restaurant operations in filings. In 2009, DK opened nine new restaurants; restaurant openings have averaged about 10 per annum since 2006 apart from a 19-opening spike in the 12 months ending March 2009. The majority of the restaurants (55 of them) are located in Tokyo, followed by the surrounding Chiba, Kanagawa and Saitama prefectures (14) and then the others are scattered through the country.

In May 2009, the company opened a 600 seat, multipurpose dining (with different branded own-run restaurant chains) and karaoke 8-storey complex in downtown south Tokyo in front of the Shinagawa bullet-train station and business area.

DK doesn't break out profitability of the restaurants as a segment separately, instead bundling it with the Karaoke chain business. However, one can compare DK to SHiDAX, who also has reports revenue and ebit for its restaurant and karaoke chain unit, and see that DK is clearly superior in terms of profitability.

EBIT MARGINS @ KARAOKE PARLOR OPERATORS
12 mo-end             March 2006        March 2007      March 2008      March 2009      Dec 2009
Daiichikosho          9.6%              14.3%           13.8%           13.6%           15.9%
(restaurant & karaoke segment)  
SHiDAX                10.9%             12.6%           11.3%           8.3%    
(Restaurant & Karaoke Business segment) 
Tetsujin              0.1%(~Aug 2006)   6.0%(~Aug 2007) 7.9%(~Aug 2008) 5.7%(~Aug 2009) 
Koshidaka             6.2%(~Aug 2006)   4.7%(~Aug 2007) 5.0%(~Aug 2008) 7.9%(~Aug 2009) 9.6%(~Nov 2009)


Corporate Governance
The founding Hoshi family directly own a 23.6% equity stake, two of whom sit on the board, and other board members own a 0.8% stake (primarily the CEO). Granted, the 0.8% CEO stake is not enormous, but in a country where board members rarely have 'skin in the game' this is better than nothing and combined with the founding family's stake acts as some insurance against the board earmarking capital towards faddish, value destroying ventures and the dilutive equity raisings that follow to patch up the balance sheet.

Management's grasp of capital allocation and by extension shareholder returns I believe is underscored by its share buyback policy: from 2008 when the company's equity began experiencing heavy multiple compression DK has been using excess cash for buybacks. DK's issued share base has contracted by 4.2% from March 2009 to Dec 2009 to 66.67 million shares with the cancellation of 2.93m in stock it has repurchased over the past two years. The buybacks have occured in the Y830-1240 range over the period: the shares are currently trading at Y1260 (April 7 2010).

Following its Oct-Dec 2009 earnings announcement in early Feb 2010 DK has unveiled a further buyback for up to 800,000 shares setting aside up to Y1 billion for the repurchase that will last up till March 23 2010.


Valuation
DK currently trades at:
- EV/Ltm Revenue of 0.5x, prior to the multiple compression post-2008 it went for around 1x between 2004-2008, the six-year average is 0.84x
- EV/Ltm Ebitda of 2.1x; between 2004-2008 it traded nearer 4-5x; the six-year average is 3.8x
- Trailing PER of 6.6x; between 2004-2008 it traded nearer 15x.
- 0.95x PBR; between 2004-2008 it traded nearer 1.4x.
- 7.2x mkt cap/trailing levered FCF

Now consider:
- Using the H2 2009 run-rate the company generated a Greenblatt ROIC of 37%, and posted ROICs of 30%plus through 2008-2009 one of the worst recessionary periods Japan has seen since World War II.
- in the 12-months ending Dec. 2009 the company generated a 15.1% ROE and yet the company continues to trade below book value.
DK's five-year average ROE is 8.9% but this obscures an upward trend over the period - net margin improvement has been the driver in higher ROE while the equity multiplier has trended lower and asset turnover has remained flat. Indeed, management managed to increase gross and ebit margins over 2008-2009 (a period of extreme economic contraction) over the preceding years.

Even factoring in a liquidity discount from a sub-billion dollar market cap and large insider ownership DK appears to be trading at very cheap levels given management's track record.

Assuming by March 2011 (i.e. one-year out and hardly a long term forecast) it can grow revenue to Y130 million (i.e. top line of around 1%); Ebitda of Y31.5bn ; Net Income of Y9-10.3bn (NPM of 7-8%)
If we use the following conservative multiples
a PER of 12-13x we get around Y1,600-2000
EV/Ebitda of 4-5x we get around Y1900-2400
using a PBR of 1.3x we get around Y1,800
So on a one-year out basis the equity lets say DK is worth about Y1,800 that suggests 30% undervaluation for a well-run, non-levered company.

I cross-checked this with a DCF assuming top-line growth of 1.8%, an 11.5% consolidated Ebit margin, 8% discount rate/WACC and a 35% cash tax rate and get just over Y1,800 in equity value.


Why So Cheap?
Frankly, why a company dominant in its main segments and ticking all the right boxes goes for so cheap is a bit odd, but the reasons I can think of:
- 'Japan is a basket case' discount and DK's positioning towards Japanese domestic demand: this seems to be universally applied to any company out of the land of the rising sun, although a recent thawing of sentiment  among international investors is alleviating this.
- Negligible sell-side coverage (even in Japanese): The Japan small-cap rout since early 2006 has dramatically thinned out analyst coverage of DK and investor interest in the space, especially for companies trading sub-$1bn mkt cap.
Over the past five years Macquarie, UBS and Mitsubishi UFJ Securities all covered the company. None of them do so today and although the company has an English language website the information tends to be a tad patchy, thus the company flies under the radar of most foreign investors.
Today only a trifecta of shops - two Japanese-language-only retail brokerages and Nomura - issue sporadic research.
- Poor english language presentation by the company. DK does issue some English language IR information but compared to

RISKS
- in the short-term the football world cup, poor weather or a double-dip recession could all crimp performance. But the company has shown itself adept already at operating under these scenarios.
- A price-war breaking out with Brother Industries on the karaoke machine space.

Catalyst

My guess is there will be a sudden resurgence in interest in small-cap Japan by international investors after the past three/four years of awful performance and more broadly small cap Japan may gap higher, of which DK would be a beneficiary.
An alternative may be for the company to try and take itself private, similiar to moves at Ozeki, or if it gets past the $1bn market cap threshold may be more investors will take notice of it.