Description

Koshidaka Holdings [KH] presents an attractive opportunity, one likely misunderstood by the market due to a few structural factors, most crucially that KH has just completed the first spinoff (spinning off Curves Holdings) in the history of the Japanese stock market. Before I get into analyzing the business itself, which I think presents a promising story and attractive valuation, I want to underscore some of the structural factors that I think are combining to result in this opportunity:

1. As mentioned above, this is the first TSE-listed Japanese spinoff. I believe you’re seeing the traditional sell pressure, both in ParentCo (KH) and SpinCo (Curves), and an absence of spin players to smooth out that liquidity demand. In short, the novelty of the spin in this market is likely resulting in lower competition in evaluating the spin

2. The tax basis was apportioned very differently from market cap, with only 10% of the basis being attributed to Curves, and 90% to KH (despite their market caps being similar). So sales of KH allow investors to realize losses, which will drive uneconomic selling in the short-term. Admittedly this tax-motivated selling could continue in the future, closer to the tax year-end, though I think that’s partially offset by the likelihood of the opportunity being better understood by then

3. Speculative: I know of at least one Japanese retail broker that prioritizes selling out “losing” positions first. Given the lack of experience with spinoffs, it seems likely that KH and Curves are being treated as larger losing positions than they actually are, resulting in a disproportionate amount of margin selling (when I describe the business(es) below, this retail interest will make sense)

The business:

Prior to the spin, KH held a few different businesses, only 2 of which are valuable and important for our analysis -- one is a retail karaoke business, running over 500 karaoke outlets throughout Japan, with a well-recognized brand (Manekineko), functioning as the bargain provider; the other is Curves Fitness, the Japanese arm of a chain of fitness centers that cater (almost) exclusively to women, and primarily to the elderly. The stated reasons for the spin are pretty vanilla, basically that:

1. They’d like management of each unit to be able to focus on, and accountable to (incentivized by), their own division. The 2 units are run fairly independently already (indeed, KH only fully consolidated Curves in early 2018)

2. They want to offer investors the opportunity to invest in each business stand-alone

3. Each business has its own growth plans, and they want to empower each unit to grow as it sees fit. The growth has been emphasized more with Curves, though as I discuss below, I think the better growth story is in the Karaoke business. I think there is some chance Curves management is considering raising capital, and KH didn’t want to be saddled with this

A brief intro to the karaoke business itself. The Japanese karaoke experience typically involves a group of friends renting a private room, paying a rental fee that is typically sublinear in the time occupied, ordering food and beverage (often a lot of beverage), and singing karaoke. Simple enough. Part of what distinguishes Manekineko from its competitors is that they allow customers to bring outside food/drink -- this obviously diminishes their revenue opportunity (food/drink are key revenue drivers for these stores), but it’s helped solidify their brand reputation as a fairly priced, trusted venue. Additionally, they do require every patron order at least 1 consumable, which helps balance out the revenue side, and also exposes customers to their menu. One other source of revenue for Manekineko are membership fees, which are relatively small (200 JPY / person), but help drive customer loyalty.

The karaoke industry has been a fairly mediocre one. Industry-wide revenues are relatively flat since 2010, though there’s been slight growth in the past couple years, and consensus seems to be modeling low single digit growth for the next five years. Helpfully, there’s been consolidation in the industry, with weaker and subscale players dropping out of the market, resulting in waning capacity / competition (room count dropping ~1% / year for the past 5 years, and store count much faster, 3% / year for the past 10+ years, part of a scale trend with newer stores being built with more rooms). Competitor Shidax was until recently the 2nd or 3rd largest player, but exited the space in 2018. This has been a boon for KH, both in reducing competition, and leaving behind store locations (many of which were strategically unsound, which helped explain Shidax’s karaoke struggles) from which KH could cherry-pick.

As it stands, KH has roughly 10% of the market (36B JPY of 350B JPY total industry revenues), but that share is up from ~5% 8 years ago with steady growth in between. The only larger player is Big Echo (brand under DaiichiKosho, which has both a karaoke room business and a karaoke equipment business, and was well-written up by THX1138 in 2010). Big Echo operates at the higher end of the market, has grown less quickly (from 12% to 18% in the same timeframe that KH went from 5 to 10%), and commands a much higher valuation (15.5 P/E based on pre-Covid earnings), which admittedly includes the higher margin equipment business, but also incorporates considerably lower growth (i.e., the equipment business has been shrinking since 2016).

KH’s karaoke business has been deploying a very successful, disciplined growth strategy. They’ve been clear about what they’re trying to do and have delivered on it:

1. invest in quality sites, particularly those in and around Tokyo, and specifically near train stations; the willingness to close unprofitable sites

1. Moreover, these new sites are justifying their opening nearly immediately, with KH recouping opening costs (in net income terms) in the first year

2. drive same store sales growth (5% in 2019) with new promotions (increasing utilization of the facilities at non-peak hours with the elderly in the mornings, and teenagers after school) and technology (they have an app for customers with 1.73m users; using tablet service and self-checkout to drive down labor costs)

1. Critically, despite the considerable growth in store count, there’s little evidence of cannibalization, a testament to the discipline in KH’s site choices.

3. Exploit economies of scale (their SG&A has been stable as the top-line grows 10% a year); focus on opening stores with higher room counts (which is only really achievable given the brand strength)

Valuation:

Having hopefully established a plausible base case for why the potential for mispricing is relatively high here, let’s now look into the corroborating evidence for how KH is priced. KH currently trades at 435 JPY / share, corresponding to a 36B JPY market cap, and a TEV of ~38B JPY. Using the current market cap of post-spin Curves, this means that KH’s market cap has roughly halved from an implied 71B JPY immediately pre-spin to its current 36B JPY. Obviously part of this is attributable to the stressed global market backdrop (Japanese equities are down ~5% in the same period), and some seems fairly attributable to sentiment understandably turning against a leisure / entertainment firm in consideration of the risks of sustained coronavirus-induced isolation. But a large portion of this move seems related to the technical factors aforementioned (a lack of event-driven attention due to the lack of historical precedent for Japanese spinoffs; Curves investors exiting KH; uneconomic, i.e., tax and margin-driven selling)

After making adjustments for the Curves spinoff, I see management as guiding to 3.8B JPY FY 2021, or a ~9.5x PE, with equivalent (implied) figures for 2019 as 2.8B JPY (13x). 2015-2019 revenue growth has come in at 20%, 16%, 7%, 8% and 12% respectively, while operating income has grown faster 75% in ‘17, 54% in ‘18, and 43% in ‘19, thanks to the relatively stable capex and SG&A (as discussed above). 

In general, management guidance has been (modestly) conservative, though that has been much truer of the Karaoke segment operating results than the Curves segment, which leaves me to expect greater outperformance of guidance on a go-forward basis.

On a relative basis, a natural point of comparison is to the aforementioned DaiichiKosho (DK), KH’s only larger competitor, which trades at a 1.5x P/B and 16.1x (pre-Covid) P/E multiple (200B JPY market cap). As you’ll recall, DK has 2 major segments, its karaoke equipment and karaoke store businesses, each every similar in size (~60B JPY revenues each; with the equipment business unsurprisingly carrying slightly higher margins, ~20% vs ~15%). While neither segment has experienced particularly notable growth, the equipment business has actually contracted (low-single-digit revenue decline in each of the last 3 years; and operating income dropping 10% in the same timeframe) vs the store business that has grown modestly (low-single-digit annual growth, both top-line and operating income, over the last 4 years). So we take away a couple things from this: 1. Consistent with KH’s market share gains, it’s outgrowing its strongest competitor, which is hardly growing at all; 2. Despite the very different track record of growth, KH is trading at considerably lower multiples. I obviously recognize that DK’s size and business mix could justify a premium, but neither of these factors would seem to overcome the very different growth prospects for the 2 companies (particularly since the somewhat better economics of the equipment business are largely mitigated by its deteriorating market position)

Another reasonable comp for KH is Cashbox Partyworld, a Taiwanese karaoke company running karaoke stores in Greater China, that has been gradually losing market share (and revenue; -6% CAGR in the last 5 years; flat net income), which trades at a 2.1x P/B, 14x (pre-Covid) P/E ratio. It seems appropriate that Cashbox trades lower than DK, given the considerably more competitive environment it faces in Greater China, and accordingly I would expect the market, once having had the opportunity to appropriately digest KH as a karaoke-only business, to value it higher than Cashbox.

My base case for KH is 20% net income growth in ‘21 and 15% net income growth in ‘22, and a re-rating to 15x P/E, for a market cap of ~70B JPY (1.95x current market cap) in 2 years. My pessimistic scenario accounts for no income growth (from a ‘19 baseline), and a conservative 10x P/E multiple to a 34B market cap, implying a 5% decline in 2 years. Again, while these scenarios sound perhaps implausibly rosy, I think that’s primarily a reflection of the novelty of the situation, and the liquidity demand borne from the spin. I actually expect a considerable portion of the multiple expansion to occur in Q4 of 2020 as KH reports as spin-induced selling subsides and KH reports as a standalone karaoke business, more easily comprehended by institutional investors [to support the baseline expectation that the world is structurally predisposed to mis-model this name, try looking in Bloomberg to see the confusing mish-mash of pre- and post- spin stats that make it very difficult to analyze post-spin KH].

A few more encouraging observations:

-- Despite a lack of tailwinds from secular growth in the industry, KH has been a steady secular compounder, with book value per share growing at a ~26% CAGR in the past decade

-- Unlike many Japanese corporates, which can be inscrutable and uncooperative with their shareholders, I’ve found KH communicative and straightforward. They have strong English reporting, with fairly detailed description of the business strategy and prospects

-- Another gotcha with many Japanese investments is capital return, as we see many Japanese value traps with severe cash hoarding problems (or inaccessible value in un-strategic assets, particularly real estate). KH’s recent capital return has not been particularly impressive (a ~2% dividend yield), but again, we are encouraged here as we view that largely as a reflection of the Curves segment’s impact on the overall business. Earlier in KH’s life, when Curves was a non-factor (smaller ownership stake, and smaller enterprise), we saw a dividend yield of 4-8%.

-- Moreover, I see the spin itself as an extremely positive and credible ‘signal’ of shareholder friendliness. Simply put, to those familiar with Japanese corporate governance, it’s not particularly surprising that such spins would be rare, and it’s telling that KH management is willing to shrink its purview and allow each business to focus and flourish independently. I view this very reassuringly for how I expect to be treated as a minority shareholder going forward.

-- Both DK and KH held up relatively well in the ‘08-’09 recession, so the business is not as recession-exposed (which I expect to be a considerable focus for investors in the Epoch of Coronavirus) -- KH grew revenues in periods when Japanese GDP declined 5-10%, and DK revenues were flat in the same.

-- Insiders own about 14% of the company, the bulk of that represented by the impressive Founder/President/CEO/namesake Hiroshi Koshidaka. Although I’d prefer to see a larger stake from management, I’ve really got nothing to point to that suggests a lack of alignment, and his management track record speaks for itself (see the book value CAGR above; he’s overseen a number of wise bolt-on acquisitions in the Karaoke segment; identified and executed the value-enhancing Curves strategy (I confess I don’t have a full understanding of how KH had this Curves opportunity in the first place))

Risks:

-- Oct ‘19 Japan enacted a consumption tax hike from 8 to 10% tax that unfortunately includes karaoke expenses. I expect this to be a modest headwind, and one that hasn’t taken anyone by surprise, so I have no particular reason to doubt management’s guidance in the face of it.

-- There’s clearly been a hit from folks being more reluctant to be out in public in light of the coronavirus impact. Though Japan seems to have navigated the crisis well so far (avoiding more draconian lockdowns while avoiding rapid spread), we do expect consumers to have responded with their own caution, which will continue to mean fewer karaoke outings.

-- International expansion. The company has made modest commitments to establishing and growing an overseas presence, in particular Singapore and Korea. We’re not particularly optimistic about their prospects of reaching scale and achieving the same “brand moat” that they benefit from in Japan. Fortunately, the investments have been minor. We’d be concerned if we saw a considerable ramp into other, more competitive markets (Mainland China in particular). We don’t think this is a particularly likely risk, but one worth flagging.

Catalyst

-- Primarily, relief from the technical / structural / event-driven effects described at top. I think this spin has generated a large imbalance of liquidity demand from sellers, and a dearth of educated buyers, that should stabilize in the coming months.

-- Turning the corner on Covid, and so reporting its first real results as a stand-alone karaoke company in a normalized environment. To be clear, I am ordinarily a bit doubtful of this kind of claim in a spin. Roughly, that spins are such a well-understood phenomenon by sophisticated event-driven investors, that such a naive explanation is unlikely to release value. However, I think the lack of precedent for spinoffs in Japan makes the “naive” interpretation likelier.

-- Not a major driver, but I do expect KH to continue to capitalize on opportunities created from struggling, subscale competitors (as they had with Shidax), by bolting on assets at distressed valuations, and leveraging KH’s best practices and scale

-- Improved prospects for return of capital, given the spin of Curves, resulting in a higher expected dividend (and there’s talk of returning to buybacks, which haven’t been conducted since 2014)