This is an illiquid Japanese small cap idea, more suitable for small funds or PAs. GMO Pepabo (3633 JP) owns a stable, growing, and cash-generative web hosting business and an early-stage, rapidly growing e-commerce business, minne (https://minne.com), which is the leading online marketplace for handcrafted goods in Japan (i.e. the Etsy of Japan). The stock corrected more than 40% from its 2015 high and we think at the current share price, you are paying almost nothing for minne. The profitability of the core business is currently obscured by marketing expenses for minne but we think Pepabo’s potential will become clearer in the next 12-18 months when minne’s GMS reaches a larger scale and the drag from marketing expenses fades. We think Pepabo has the potential to double or more if minne can reach a size in Japan which is proportional to Etsy’s size in the US.

 

 

GMO Pepabo (“Pepabo”) was founded in 2001 and was originally named Madame Planning, before changing to Paperboy & Co in 2003 and then finally GMO Pepabo in April 2014. Pepabo is the phonetic spelling of Paperboy, as pronounced by Japanese speakers. Pepabo has been a consolidated subsidiary of GMO Internet (9449 JP) since 2004, and GMO Internet currently owns 64% of Pepabo (including the stake owned by subsidiary GMO Ad Partners). Pepabo IPOed in December 2008.

 

The company’s President, Kentaro Sato, joined Pepabo in 2003 when he was in college, and is only 34 years old now. The Chairman is Masatoshi Kumagai, who is also the founder and President of the parent company, GMO Internet. We think very highly of Sato-san from our meetings with him. We also think very highly of Kumagai-san and the GMO Internet group, and we have been investors in other GMO companies in the past. We think GMO companies are some of the most entrepreneurial, shareholder friendly, and well-managed companies in Japan. For example, GMO Internet recently raised its total shareholder payout ratio (dividends + buybacks) to 50%. Similarly, Pepabo has historically had a 40-50% dividend payout ratio. Pepabo’s dividend was suspended in 2015 due to the early stage minne investment period, which we think makes sense. However, we expect management will return to a friendly shareholder return policy after minne reaches scale. Furthermore, Pepabo just completed a share buyback in Sept-15 which equated to 3.5% of the free float. We don’t think this is a stock where value is likely to be trapped by poor management.

 

 

Pepabo’s core business historically has been providing webhosting, domain registration, and e-commerce tools to small businesses and individuals in Japan. Pepabo management thinks that they have about 50% market share in this target segment of the market, although there isn’t reliable data available. Pepabo’s parent company, GMO Internet, is the largest web hosting service provider in Japan but they don’t really compete directly with Pepabo, because GMO Internet targets large and medium-sized companies and has a higher price point. Pepabo’s hosting services charge a monthly fee which ranges from ¥100-3,950 per month and the e-commerce tools cost ¥1,332-7,800 per month. The hosting services are sold under various brands including Lollipop! and Hetemuru. Domain registration is provided through the Muumuu Domain brand. Ecommerce tools are sold under the Color Me Shop, Goope, and Jugem Cart brands.

 

This is a good business which has steady gross margins of 50-55% and operating margins of 17-20%. Free cash flow conversion is more than 100% of net income because customers pay upfront for the hosting service. Advances Received on the balance sheet is more than 150 days of sales. We don’t expect this business to grow rapidly, but it has compounded topline at 11% p.a. between 2008-2014, and sales grew +13% y/y in the first nine months of 2015. Management expects the business to grow single digits over the medium-term.

 

 

minne is the largest ecommerce site in Japan focused on handcrafted goods. The site was launched in January 2012 and although minne was not the first handcrafted goods site launched in Japan, it became the market leader in 2014 and has further cemented that position in 2015.

 

minne’s website and business model are very similar to Etsy. minne attracts domestic artisans of handcrafted goods who list their items and create stores within the site. minne users are largely female and the majority of the items are clothing, accessories, and miscellaneous items. However, management is targeting to expand more into furniture and vintage items, which carry higher ASPs. There are currently more than 170,000 sellers with over 1.5 million items listed.  Minne charges the seller a transaction fee, which is fixed at 10% of the transaction value. Currently 100% of minne’s revenue is generated from these transaction fees, although we see potential to add revenue streams from other seller services.

 

minne’s GMS (gross merchandise sales) is growing very rapidly. GMS was ¥183m in 2013, ¥1.075b in 2014, and ¥4.46b (US$38m) in 2015. In the most recent Dec-15 quarter, GMS increased 37% q/q and +350% y/y to ¥1,685b. Management targets GMS of ¥10b in 2016 and ¥50-60b ($415-500m) in the medium-term. This latter figure is management’s estimate of the potential market size in Japan, based on Etsy’s US business (Etsy had GMS in the US of $1.76b over the past 12 months through Sept-15, and the US GDP is about 3.5x larger than Japan).

 

One reason minne was able to become the market leader, despite not having a first mover advantage, is that Pepabo already had about 5 million customers using their hosting and ecommerce services, many of whom were natural target users of minne. They were able to market directly to these existing customers and convert them to become minne users. Secondly, minne launched a smartphone app in Oct-13, well ahead of competitor launches which were in late 2014 and 2015. The number of minne downloads reached 1 million in Feb-15, 2 million in May-15, and 4.4 million by the end of 2015. Management targets 10 million downloads by the end of 2016. Third, management emphasized aesthetics and design of the minne site, which is unsurprisingly important to the artisan sellers on the site. Finally, management is now focusing on cementing the #1 position through promotion to accelerate the number of downloads and users as discussed below.

 

minne used to have three handcrafted goods ecommerce competitors in Japan but it acquired one of them last year. In May 2015, Pepabo acquired OC Island, the owner of tetote, the #3 player at the time, for ¥100m. Management estimates there was only a 25% overlap of users between minne and tetote. The two remaining competitors are #2 Creema and #3 iichi. More broadly, Yahoo Japan, Rakuten, and Mercari could be viewed as a potential competitor but they are focused on secondhand goods, not handcrafted goods. Etsy is the largest global handcrated goods competitor but Etsy’s presence and usage in Japan is very limited.

 

minne is small today with estimated 2015 GMS of ¥4.46 billion and revenue of ¥446 million ($3.8 million). This is in part due to the fact that the handcrafted ecommerce business model started more than five years later in Japan than it did in the US. In order to accelerate user adoption, growth, and market share, Pepabo has started advertising and promoting minne more aggressively this year. This is mainly done through TV commercials and online advertising and promotion through social media. 

 

In early September, Pepabo revised down FY15 earnings forecast due to an additional ¥800 million advertising budget for minne, which will take the full year budget to ¥1.68 billion. Some investors may have taken this poorly, but we believe this is positive as it was in part driven by better than expected minne revenue growth and a compelling return on advertising investment. Management is spending about ¥1,331 per minne app download currently. The average user over the past one year (April 2014-2015) is spending ¥8,388, of which minne collects ¥839. Therefore the cost of acquiring a user is paid back in about 2-3 years (after factoring in processing costs). Additionally the payback period is getting shorter because average user spending has increased about 10% today compared to the users acquired back in April 2014.

 

minne generates a gross margin of approximately 50% after processing fees and other costs. Obviously the operating margin is highly negative right now when revenue is ~¥450 million and marketing expense are ~¥1.68 billion. Management is rightly focusing on accelerating growth and cementing a dominant market position right now but we think they will be very focused on profitability in 1-2 years.

 

As mentioned earlier, we believe management has an opportunity to start generating additional revenue streams beyond pure transaction fees. Etsy generates nearly half of revenue from “Seller Services” such as promoted listings, direct checkout, and shipping labels. We believe minne management will eventually start offering other seller services but not until they gain more critical mass and a more dominant market share.

 

 

 

Pepabo has a number of services grouped into the “Community” division which include Jugem (blog service with advertising revenue), Booklog (web bookshelf), and Puboo (e-book publishing platform). Pepabo also launched a high-speed mobile wimax service in November 2014, which charges a monthly fee of ¥3609. Currently these services contribute less than 5% of sales and profit.

 

 

 

We think it makes sense to use a sum-of-the-parts valuation for Pepabo because the core Hosting, Ecommerce tools, and Community businesses are relatively mature and cash generative while minne is a rapidly growing but as of yet unprofitable business.

 

The non-minne business is relatively easy to value. We estimate the FY14 EBIT of Pepabo excluding minne was approximately ¥825m (the group total was ¥724m). In FY15, we estimate Pepabo’s EBIT excluding minne at about ¥900m. We assign an 10.0x EBIT multiple to the FY15 ex-minne EBIT estimate. This equates to about 15x earnings or about a 7-8% FCF yield. Based on this, we arrive at a value of ¥9.0 billion for the non-minne business, or ¥3417 per share. We weren’t able to find a perfect peer group for this business but we think our valuation assumption is relatively conservative. Large peers seem to be valued in the market at 20-30x earnings, based on sell-side analyst sum-of-the-parts estimates for GMO Internet’s infrastructure business and the valuation of GoDaddy in the US.

 

Pepabo also has ¥1.922 billion of cash and short-term bank deposits (as of 9/30/15), which equates to ¥730 per share. As a result, we arrive at a value of ¥4,146 per share for the non-minne business and cash and deposits on the balance sheet. This compares to the current share price of ¥4,720. That implies ¥574 per share for minne, which equates to about US$13m. Therefore, we don’t think it’s an exaggeration to say that the market is not assigning much value to minne currently.

 

Valuing minne is a more challenging exercise because it is an early stage, rapidly growing business which is not yet profitable. But we can look at what the business might be worth if management achieves their goals for the business in the medium-term. Let’s assume that management achieves the low end of their GMS target of ¥50b. This yields transaction sales of ¥5.0b. Let’s also assume that management begins charging for other seller services and achieves 25% of revenue from these services, compared to Etsy which has achieved 50% of revenue from seller services. This leads to a revenue estimate of ¥6.8b. Etsy is trading at a 2015 Price/Sales ratio of 3.5x, which implies a future value of minne of ¥23.8b (~$200m).

 

We think that minne has the potential to be a 20-30% operating margin business when it achieves scale, and marketing expense as a percent of sales declines. If we assume a 20% operating margin on ¥6.7b of sales, we get to an EBIT estimate of ¥1.35b. Japanese internet companies like Rakuten and Kakaku are trading at EV/EBIT multiples of about 20x-25x. If we apply a 20x multiple to Pepabo, we get a future value of minne of ¥27b (~$230m).

 

The average of these two valuation estimates for minne is ¥25.4b (~$215m). If we then assume that it takes four years to achieve these results (2019), and discount the valuation back using a 20% discount rate, we arrive at ¥12.3b, or ¥4650 per share. If we add this to the value of the non-minne business and cash on the balance sheet, we get to approximately ¥8,800 per share which is 86% upside from the current share price. 

 

Investors may believe some of these minne assumptions are too aggressive or perhaps too conservative. However, the point of this exercise is to show that there is currently very little built into the share price for minne, and minne is potentially a very valuable asset. We think this is supported by the importance that the GMO Internet Group is placing on minne. In fact GMO Internet, a $1.5b market cap company, now includes numerous slides on minne in quarterly earnings presentation. Furthermore, sell-side analysts covering GMO Internet are very focused on minne. We think this provides some nice indirect sell-side analyst coverage of the stock, which is unlikely to get its own sell-side coverage until the market cap increases significantly.