Description

Thesis:

HCM SaaS business with verifiably attractive unit economics trading at a large discount to US peers (Kaonavi 2.6x EV/rev 2023E vs. US comps at 4.6-10.0x), yet growing faster than US peers (Kaonavi 2023E +29% vs US comps 2023E at +20-28%) – with better disclosure of unit economics and without any egregious stock comp dilution.  Management owns 32.7% so they are very aligned.  Moreover, Kaonavi guides for harvest years in CY2023 and 2024 with significant margin expansion toward an ultimate target of 30% OPM – with this phase being accompanied by a promotion of the COO to co-CEO signifying the importance of the coming monetization phase.

Business Description:

Pure play Talent Management SaaS model focusing on SMBs with 100-1000 employees. 100% revenues from Japan.  Talent Management is a subcategory of HCM software with the following attributes:

Fees are monthly, charging more per seat for more features, and tied to the number of seats.  So Kaonavi benefits as its existing clients grow.

Unit Economics - Customer LTV Section:

Same-client revenue growth embedded in the model can be further demonstrated by Kaonavi’s impressive ARPU progress:

Historically, this ARPU growth has been driven by seat growth at existing clients and more new customers being overweight the upper end of the 200-900 employee range of their core target market.  I have been following the company for two years and my enthusiasm was constrained because of management’s historical lack of emphasis on up-selling and cross-selling – due to the wide open greenfield nature of customer acquisition right now.  Given that the new customer acquisition program looks as health as ever, I am encouraged that up-selling and cross-selling is now a point of emphasis now because the historical drivers of ARPU remain:

If successful, this has positive implications for already excellent unit economics via a tailwind to customer LTV.  I am optimistic about low hanging fruit here (i.e. easy early wins) because this has been a somewhat ignored area in the past.  Over the medium term, they’ll need to prove that they can build a cross-selling engine that extends beyond the early win phase.

So how about churn?  Kaonavi’s churn partly supports my view that this is a healthy and strong B2B SaaS business. Note how churn increased only moderately during the pandemic and is now improving post pandemic with most recent monthly churn implying 7% annualized churn, which SaaS observers will recognize as very healthy:

They don’t disclose net revenue retention, but after playing the over-under game with the company, I estimate that it’s 99% +/- 3%.  This is because the 12% ARPU growth is partly driven by bringing on new clients that are simply larger, which comes on top of organic ARPU growth of existing clients.  This level of revenue retention is consistent with global HCM SaaS peers (range 92-100%).

Using LTV to Triangulate Cheapness:

The LTV nature of the write-up thus far goes beyond emphasizing the underlying quality of the business.  I want to use it for a further triangulation of cheapness: EV/Standstill EBIT.  This is where the retention estimate helps because they could keep revenues ~flat with zero marketing spend (i.e. can be defined as standstill EBIT).  Marketing spend has a bit of a nuance because the “marketing related expenses” in their slide does not incorporate sales & marketing personnel.  You can get to the true marketing expense using the LTV/CAC disclosure.  So I estimate marketing expenses including sales & marketing personnel were 1.9bn in CY2021.  Reported EBIT of 174m in CY2021 with 1.9bn added back, yields a standstill EBIT of 2.1bn trailing.  For the current year (CY2022), I estimate that their guidance implies 2.5bn of standstill EBIT.  Relative to current EV of 20.5bn, Kaonavi is trading at 8.2x current year standstill EBIT.

I have done this a different way by explicitly calculating an NPV of existing customers and this calculation together with the 8.2x EV/standstill EBIT both support the following statement: the current share price ascribes roughly zero value for the NPV of future customers.

So it is very important to determine whether future customer additions can be made with an IRR above the cost of capital.  Because in this framework, the customer acquisition program forms the upside in the stock.

Customer Acquisition Returns:

Critically, Kaonavi’s disclosure is exemplary in detailing its customer acquisition program and allows investors to verify attractive unit economics well above the cost of capital:

Congrats to them, but 8.6x is very high. I consider it temporary and am unwilling to bank on this as a sustainable situation.  Historical LTV/CAC cycle of 5-9x suggests 7x is the historical mid-cycle figure.  I assume maturation of the industry and normal competitive dynamics make 6x a reasonable assumption for mid-cycle over the next cycle, but let me use 5.5x to inject conservatism for unknowables.  Given a favorable competitive environment (duopoly where both players have greenfield and don’t need to be aggressive to grow) and given that 5.5x is the lowest L12m historical numbers, it’s hard to argue that 5.5x is anything other than conservative.  

The IRR of a 5.5x LTV/CAC on a gross profit basis is 51% and the IRR all-in after incorporating an incremental 284m of fixed costs needed to service the 2022 cohort is 28%.  Note that the incremental fixed costs assumes 23% growth (midpoint of their guidance on personnel cost growth), but the upcoming harvest phase suggests lower fixed cost growth in the future, so my 23% growth for this cohort conservatively includes fixed cost front loading to service the coming CY2023 and CY2024 harvest phase.  Given the multiple forms of conservatism, I see 28% all-in IRR as a minimum.  

This is an important calculation. They have an underpenetrated TAM in Japan, so the reinvestment runway is long.  If one believes that they are investing at 28% IRR (minimum; likely will be higher) with a long runway, then the value of future customers is quite high and we should want them to reinvest rather than show profits for the sake of.

So, I think it’s rational that they continue to emphasize a heavy reinvestment profile as compared to their 30% OPM ambition:

Candidly, the high operating leverage implied for 2024 in the chart above is higher than I am comfortable assuming.  However, since their investments return IRR > WACC, I am comfortable if they decide to prioritize the 10bn in revenue, in which case I’d expect them to report an OPM closer to 20% in 2024 (this is 2bn in EBIT and stock current trades at 10x this 2024E).  Hitting both targets in 2024 is a bull case IMO, but if it happens, stock is currently trading at 6.7x on this bull case.

Competitive Landscape:  

Middle market talent management software is a duopoly serviced by Kaonavi (differentiation is simplicity and ease of use) and Talent Palette (differentiation is data visualization and customization).  The leaders revenue bases are quite close with JPY 1.25bn for Kaonavi during the most recent quarter and 1.15bn for Talent Palette.  The #3 player in SMB Talent Management HR Brain does not have figures, but web traffic suggests it is far smaller than the two leaders and not gaining ground materially.  Kaonavi reports not seeing Workday in pitches due to Workday’s focus on Enterprise scale customers.  Interestingly, Kaonavi has more Google Search interest than Workday in Japan – which shows their SMB focus requires them to cast a wider net and also shows they have built a real national brand.  Talent Palette’s growth plan calls for 35% growth next year and Kaonavi’s guidance calls for 29% growth.  Kaonavi reports a lack of fierce competition with Talent Palette, substantiated by ARPU strength for both players in the context of high growth in customer adds for both players.  

The explanation for this is the underpenetrated TAM.  Kaonavi estimates its Talent Management TAM is JPY 200bn, so adding together Talent Palette’s JPY 4.6bn current annual rev run rate and Kaonavi’s JPY 5.0bn current annual rev run rate means the SMB SaaS duopoly is still only 5% penetrated into its TAM. Both players’ biggest competitor is the excel-based, manual systems common in SMB legacy Talent Management practices.  This is the main source of market share gains – so today it’s a growing pie game rather than a piece-of-the-pie game seen in more mature industries.  Tons of greenfield customers available means muted pricing pressure and this characterization is further substantiated by Talent Palette’s parent IPO last year having little to no impact on Kaonavi’s growth or unit economics. This smooth sailing competitive environment needs to be monitored because it won’t last forever, but given the low TAM penetration and dearth of evidence of fierce competition to date, I assume there are multiple years remaining in this greenfield environment – Japan is a bit behind the US in SaaS penetration.

Valuation:

I assume 26% average revenue growth out to 2025 with 21% OPM in 2025.  Capping 2.4bn in 2025E EBIT at 22x is the same as capping the 2025E revenue at 4.4x (vs comps trading between 4.6-10x 2023E with growth 20-35% estimates in 2023E).  PV of fair value is JPY 3750/sh, or 90% upside.  This equates to 35% expected IRR over 3 years.  To triangulate against longer term forecasts, the aforementioned PV of fair value is found by growing 2026-2030 at 17% down to 8% growth with 30% terminal OPM in 2030 -- with that 2030 EBIT capped at 13x.     

Risks:

*Competition - Smooth sailing today, but eventually will become more fierce as the TAM gets penetrated.  But the low churn lock-in dynamic means existing customers are quite reliable, as are customers to be acquired in the next few years.  i.e. Recurring business model definitely helps mitigate.

*Trading liquidity - Trades like a micro cap given management ownership constrains free float

*Continued Yen weakness - Plenty of yen hedging options available 

Catalyst

*Ongoing 25-30% growth is likely to be a catalyst given the already low rev multiple

*The revenue multiple could also expand toward or into the 5-10x range of peer

*Upcoming margin expansion phase will allow more fundamentally based investors to ascribe a fair value based on profits rather than revenues