Description

BUSINESS

For some background on EMS we refer to an excellent write-up by gvinvesting posted here some 2 years ago.

EMS has several businesses with decent potential but that contribute little to current earnings. For this write-up we will focus on where the value is today, the main pharmacy recepty systems business. This software manages the insurance disbursements and provides patient history data to pharmacies in Japan. Customers pay JPY 1.5m upfront for hardware and the installation of software, a monthly base fee of JPY 15k, plus a fee per transaction averaging another JPY 15k per month. An increasing number, currently 70% of the client base, subscribe to this product. The remaining 30% use a standard service without patient history data at a reduced monthly base fee of JPY 8k.

The churn rate is below 4% and mostly occurs due to pharmacies that either close down or have to switch because of M&A related reasons. Similar businesses in Europe such as Compugroup (COPMX,A:GER), Cegedim (CGM:PAR) and Pharmagest (PHA:PAR) benefit from similar low churn rates; a very attractive characteristic of this type of businesses. EMS’ clients are very sticky because the software is critical to the day-to-day operation of a pharmacy. Japanese pharmacists are generally not IT savvy and worry about losing historical data stored on EMS’ servers if they would consider switching to a competitor.

Approx. 100 companies provide software for pharmacies in Japan, most of them are therefore very small local companies. The largest competitors, subdivisions of Panasonic Healthcare and Mitsubishi Electronics, with market shares of respectively 18% and 13% are not growing, have no internal salesforce and offer no cloud-based solutions yet. Except for a few smaller competitors, EMS is still the only cloud-based product in this market.

EMS launched its ASP (Application Software Provider) model in 2008 and has now completed the migration of its customers to the cloud. The salesforce is no longer focused on managing the migration process and is now focused on growing sales. The company believes that recent government measures to reduce the cost of health care will lead to a further consolidation of the market. The review of lower drug prices and disbursements are putting more pressure on the pharmacies revenues. Pharmacies are encouraged to extend their role as provider of minor health support which requires medical records for each customer. Today, EMS’ systems can provide most of the functionality required and they believe this can increase their market share from 33% today to 50% in a few years; an ambitious goal. In Europe, we have seen a concentration of market share with the largest players when the use of IT increased for healthcare participants. Smaller software companies tend to slowly disappear as they’re unable to meet the nationally imposed requirements in terms of functionality, safety etc... A similar evolution seems likely in Japan and EMS believes that in a few years the number of competitors will be reduced to about 10 from approx. 100 today. EMS also sees an opportunity to take market share from Mitsubishi Electronics because it’s a loss-making business that has under-invested in their pharmacy software business. The company has therefore decided to lower its introductory base fee by 10% in January of this year; a decision that could initially lower the revenues from the recepty business by 2-2.5%. Although this decision could be a defensive move to counter the pressure on its clients’ revenues, EMS explained to us they reduced prices as an offensive move to gain market share.

VALUATION

Property

EMS owns the Shin-Osaka Brick building described in detail by gvinvesting’s write-up. It’s a high-quality building, designed by an established architect and is located right next to the main train station in Osaka. The company occupies just 2 floors and rents out the remaining 13 on commercial terms. We valued the property at a cap rate of 5.5%; a level we believe to be conservative. Cap rates have been declining for several years and CBRE research indicates an average cap rate of 5.35% for this type of office building in Osaka. Deutsche Bank research indicates similar cap rates for office properties in Osaka. A local Japanese friend with knowledge of the Osaka real estate market told us he believed a cap rate of 5% is conservative considering the quality and the location of EMS’ property.

http://www.cbre.co.jp/EN/aboutus/mediacentre/mediaarchives/Pages/CBRE-Releases-Q2-2016-Japan-Investment-MarketView.aspx

http://realestate.deutscheam.com/content/_media/Deutsche_AM_Japan_Quarterly_Report_Q4_2016.pdf

The CEO explained to us that he had decided to make the property investment because of an opportunity to buy land at an attractive price. Although far in excess of the company's requirements, he believed that the investment, financed at the time by a combination of shares issued at 23x trailing earnings and bank debt, was likely to generate an attractive return. Owning this investment property depresses the company’s ROE. Although we’re not speculating on a sale, the CEO told us he now better understands that equity markets are unlikely to give the company credit for owning this investment property.

Operating Business

The management released its medium-term business plan in May 2016. The company sees revenues growing at 2.7%p.a. for the next 2 years without taking into account any market share gains. Operating profits are expected to grow at 5.4% p.a. as margins improve from 15.2% to 16%. The business plan assumes stable operating margins for the dispensing systems at 18.1%, with the margin improvement coming from businesses that currently generate negligible profits such as medical systems (hospitals), a business which is being restructured, and new software for nursing homes.

For the current fiscal year ending March 2017 the company guided for JPY 13.99b revenue and JPY 2.1b operating profit. Dispensing Systems (pharmacy recepty software) was expected to generate JPY 1.99b operating profit on revenue of JPY 10.99b.

A few days ago, EMS released its Q3 results stating that no new guidance will be provided in the current uncertain market environment. We understand this to be related to the uncertain impact of recent government measures combined with EMS’s new aggressive pricing policy we described above. However, as a result of modest revenue growth and substantial cost saving initiatives Dispensing Systems already generated JPY 1.87b in operating profits at a 23.3% margin for the first 9 months of the year; 94% of the full year guidance issued in May 2016. We therefore believe that a valuation based on March 2017 guidance is conservative and EMS is highly likely to significantly out-perform guidance. Pharmacies’ revenues have been under pressure for a while and EMS’ new pricing policy will impact revenues with less than 2.5%. We see no developments that merit a downward revision of EMS’ short term and medium term earnings power. Please also note that the company will have to issue new guidance if it believes the results will exceed previous guidance with at least 30%.

Net of excess property and cash, EMS currently trades at 10x current-year after tax earnings based on guidance and a lower multiple on expected earnings . We find this valuation very attractive for a business with the defensive qualities we described. The business generates high operating margins, benefits from operating leverage and several growth drivers. This growth can originate from several sources such as:

• Market share gains, as the company offers the best product in a consolidating market
• FY2017 benefited for the first time from customers from the large COSMO acquisition being migrated onto the EMS platform. EMS targets to transfer 500 clients per year of COSMO’s 2600 customer base.
• Increased sales from the (equity) alliance with Medipal, 1 of 4 large drug distribution companies in Japan. Medipal uses EMS’s recepty software in their solution that integrates distribution and disbursements and is marketing this to its large client base. Japanese pharmacies use different software for POS, inventory management and disbursements and the EMS/Medipal alliance is far ahead of any competitor in the development of a more integrated solution.
• Continued acquisition of smaller competitors

MANAGEMENT

The founder/CEO, Mr Kozo Kunimitsu, and his family still own 38% of the company. We were able to spend some time with the CEO and a number of senior executives during our visit to the company and found them to be transparent and forthcoming. They agreed with us that the valuation of the company was too low and that the equity markets were giving little value to the excess assets. However, the focus for allocating capital would be on taking advantage of the growth opportunities we described and which they see for their business.

We view the CEO’s capital allocation track record not as perfect but acceptable to us:

1. Investment Property: financing and timing have made this a decent investment. We don’t like a software company owning excess real estate but there’s a decent chance that the property will be sold one day.
2. Cosmo acquisition: economics will depend on how many of clients will be transferred to the EMS platform. Although this has taken longer than expected, 500 transfers took place last year and EMS believes they can continue to transfer 500 Cosmo clients per year.
3. Medipal alliance is performing in line with expectations
4. Share issuance/buy-backs: historically EMS has issued shares at a relatively high valuation in 2006 and bought back shares at attractive levels in 2010 and 2011. Shares issued for the Medipal alliance were an exception because the valuation of EMS was low at the time. However, EMS believes that the benefits of the Medipal alliance justified the transaction.
5. Pricing discipline: the CEO has talked about several acquisitions he walked away from because the price was too high.

Links

Annual Report FYE 03/16 (english): http://www.emsystems.co.jp/image/info/ir/irnews/2016/20160616.pdf

First Quarter Report FY17 (english): http://www.emsystems.co.jp/image/info/ir/irnews/2016/20160908.pdf

Second Quarter Report FY17 (english): http://www.emsystems.co.jp/image/info/ir/irnews/2016/20161219-01.pdf

Third Quarter Report FY17 (Japanese-only for now): http://www.emsystems.co.jp/image/info/ir/irnews/2017/20170217.pdf

Medium-term Business Plan (Japanese-only): http://www.emsystems.co.jp/image/info/ir/irnews/2016/20160513-02.pdf

IR Website: http://www.emsystems.co.jp/information/irnews.html

Catalyst

• Full year results to March 2017 exceed guidance
• Accelerating market share gains when the market consolidates as a result of recent government decisions to increase/enforce the use of IT in health care
• With migration to the cloud completed and with the benefit of strategic decisions such as the Cosmo acquisition and the Medipal alliance, future benefits to the operating results will expose the under-valuation and convince the market of the very attractive characteristics of this business
• A sale of the investment property