Description

Noritsu Koki is an under-the-radar Japanese company that owns a globally dominant DJ equipment and software business. We believe it is a timely opportunity to buy this high-quality stock that is down 15% in the past week due to the Japanese market correction. The stock is cheap trading at 7.6x P/E and 2.8x EV/EBITA on 2024 estimates. We believe the company’s earnings announcement at the end of this week may provide a strong near-term catalyst.

Background

Noritsu Koki (“NK”) was established in 1956 and initially focused on the manufacture of photo processing equipment and related businesses. The photo processing business grew into a global industry leader but unsurprisingly ran into structural challenges in the late 1990s with the advent of digital photography. The previous management team spun out the photo processing business in 2011 and transitioned into a holding company. They then conducted M&A to assemble a conglomerate with ownership in around 40 businesses. The M&A was unfocused and unsuccessful.

The current CEO, Ryukchi Iwakiri, became President in June 2018. He conducted a strategic review and determined that the company should streamline and focus on owning a small number of niche businesses with leading market share. He decided to divest most businesses that had been acquired. Only one of the businesses from the 2018 portfolio, Teibow, remains. Teibow, which was acquired in January 2015, is a market leader in pen nibs. The other two businesses currently owned by NK, AlphaTheta and JLab, were acquired in 2020 and 2021 respectively.

NK acquired AlphaTheta from KKR and Pioneer in April 2020 for JPY 65 billion (US$ 600m). KKR previously acquired 85% of Pioneer DJ from Pioneer Corp in March 2015 for JPY 59 billion (US$ 550m) and then renamed the company AlphaTheta prior to the sale to NK. Pioneer was subsequently bailed out by Baring Private Equity Asia in March 2019 and delisted from the Tokyo Stock Exchange.

NK acquired JLab from a private equity consortium for JPY 35 billion (US$ 320m) in May 2021. JLab is a branded earbud, headphone, and computer peripheral company focused on the under $100 price segment. JLab’s performance has been mixed since the acquisition but recent results have been more encouraging. Management is attempting to expand the product portfolio in more computer peripherals akin to Logitech, and to expand beyond the current US-centric business.

This write-up will focus on AlphaTheta, which accounted for 57% of sales and c.75% of EBIT in 2023, and 69% of sales and 83% of EBIT in Q1 2024.

NK is 48% owned by the founding family, which is no longer involved in the business.

AlphaTheta

AlphaTheta controls a dominant 70% market share in the DJ hardware market and 30% share in the DJ software market. AlphaTheta’s sales are predominantly derived from the Pioneer DJ brand, which has been built over the past 30 years after the launch of the inaugural CDJ digital music player in 1994.  The company also launched a new high-end AlphaTheta consumer hardware brand last year to expand into related music hardware product categories.

AlphaTheta is a global business with a 2023 sales split of 46% EMEA (mostly Europe), 35% Americas (mostly US), 5% Japan, 5% China, and 8% Asia ex-Japan & China. The regional sales split is driven by the relative popularity of DJ culture and consumer purchasing power in each country. Management believes that Europe and the US should continue to generate steady growth, while emerging markets such as China have significant growth potential if DJ culture continues to gain popularity.

DJ Industry

The DJ industry roots began in the analog world of turntables and analog mixers, but the market today is overwhelmingly digital. The industry can be divided into DJ hardware and DJ software. AlphaTheta is the only major industry player that is owned by a public company, so industry data is hard to find but we use various industry sources to conclude that AlphaTheta controls c.70% market share in the DJ hardware market and c.30% market share in the DJ software market.

The industry can be further subdivided by customer segments including venue owners (festivals, clubs, bars & lounges), professional DJs, semi-professional mobile DJs (playing small parties, weddings, etc.), and hobby/bedroom DJs. We understand that most of the industry growth in recent years is being driven by growth in the hobby/bedroom and semi-professional market segments due to the growing popularity of DJ culture. The venue and professional segments are mainly driven by replacement demand (typically 3-5 years for equipment) but also growth in pricing and mix. Management estimates that the venue and professional market accounts for around 20-30% of the total market size.

DJ Hardware

More than 90% of AlphaTheta’s revenue is DJ hardware and we believe the total industry has a similar revenue split between hardware and software. There are several subcategories of hardware that deserve a brief description:

•  DJ controllers – this is typically an entry level product that must be used with a laptop and DJ software. Controller prices range from around $100 to more than $2k for very high-end systems. (https://www.sweetwater.com/c1158--DJ_Controllers)

• All-in-one DJ controllers – this is also a common entry level product that can be used either with a laptop and DJ software or standalone with an external USB drive. As the name implies, it can be used as a standalone unit because it does not require a laptop and has an integrated mixer and digital music players. All-in-one controller prices range from $500 to more than $4k.

• DJ Mixers – a professional grade electronic or analog mixer used to mix audio inputs and volume control for two or more external music sources. Mixers do not require a laptop but must be used with at least two external music players. Prices start at $100 but typically range from $300 to $3k. (https://www.sweetwater.com/c656--DJ_Mixers)

• DJ Media Players – a device that plays and modifies digital music. DJ Media Players are connected to a mixer. Prices start from $200 but typically cost $500 to $2.5k. Pioneer’s latest CDJ offering, CDJ-3000, retails for around $2.5k. (https://www.sweetwater.com/c654--DJ_Media_Players)

• Other – other categories include analog and digital turntables, headphones, samplers, digital keyboards, MIDI controllers, and speakers. These are not important categories for AlphaTheta.

AlphaTheta’s Pioneer DJ brand is estimated to control c.70% of the DJ hardware market. Competitors include US-based InMusic Brands with c.20% share (Denon DJ, Rane, and Numark brands), Germany-based Native Instruments with c.6% share (Traktor and Native Instruments brands), and a handful of other companies with 2% or less share.

Pioneer DJ’s competitive advantages include a well-known and long-standing brand name, a well-integrated hardware and software platform (more on Pioneer’s Rekordbox software later), and consistent R&D spend which allows Pioneer to release new equipment and software features ahead of the competition. AlphaTheta spent more than $40m on R&D in 2023, equivalent to 12% of sales and more than any competitor’s revenue except for InMusic. There is also an inherent advantage in being recognized as the industry standard brand because learning to use DJ hardware requires an investment of both time and money. Pioneer DJ hardware enjoys premium pricing for all these reasons.

DJ equipment distribution varies by region, but the sales channels are typically the same as for other musical instruments. The US musical instrument retail market is consolidated with Guitar Center having #1 share and several ecommerce sites such as SweetWater also having significant share. Amazon sells DJ hardware but does not have a significant market share. The European market is more fragmented and dominated by smaller retailers. AlphaTheta management has very good visibility on sell-through and inventory levels at the large retailers in the US and China, while insights into European inventory and sell through is collected from sales staff conversations with small retailers.

DJ Software

DJ Software is used to organize digital music, prepare for music performances, and used in tandem with DJ controllers or other DJ hardware. We estimate that Rekordbox (owned by AlphaTheta) and Serato each have c.30% of the DJ software market as measured by active users. Other competitors include VirtualDJ (14%), Traktor (10%), Engine DJ owned by InMusic (7%), and several other players with less than 3% share. Only AlphaTheta, Traktor, and InMusic produce both DJ hardware and DJ software.

DJ Software is essential for any DJ using digital music. It is a sticky product with high switching costs because 1) learning how to use DJ software requires a large time investment and 2) the process of migrating a large digital music library from one software platform to another can be a very time intensive process. DJ software must be compatible with the DJ hardware if the DJ is using a laptop to play (i.e. compatibility is essential when using a DJ controller which most bedroom/hobby DJs use).

Industry data is limited but we believe that Rekordbox and Serato have been consolidating software market share at the expense of Traktor and other small competitors. Serato has a strong user base in North America dating back to its origins in the US hip-hop DJ scene. It remains particularly popular with hip-hop, scratch, and multi-genre DJs. Rekordbox has a higher market share outside of North America and benefits from its seamless compatibility with Pioneer hardware. Serato does not produce its own hardware, but it does cooperate with multiple hardware manufacturers including Pioneer to produce Serato compatible hardware.

Rekordbox offers a free version of the software and subscription versions that unlock more features and include cloud storage options that allow a user to instantly access their music library on any wired Pioneer hardware. Monthly subscriptions range from $9 to $30 per month with discounts available for annual subscriptions (https://rekordbox.com/en/plan/). Rekordbox had 820k MAU as of the end of March 2024, which was +28% y/y and +3.8% q/q. Management does not disclose the paying user ratio, but we estimate it is a mid-single digit % of total MAU. Management is aiming to increase paying MAU by leveraging its dominant hardware market share, improving software functionality for paid subscriptions, and reducing cancellation rates. The low paying user ratio suggests that the free version of the software is adequate for most DJs which is consistent with feedback from industry contacts.

Serato offers both free and paid versions of Serato software. The two paid versions of Serato are available for a subscription of $10 or $15 per month, or for purchase for $249 or $449. Industry feedback suggests that the free version of Serato is inadequate for most DJs and therefore Serato’s paying user ratio is probably higher than Rekordbox. We understand that Serato had sales and EBIT of approximately $26m and $7m respectively in 2022.

NK management announced the acquisition of New Zealand-based Serato for $70 million in July 2023. However, the deal was abandoned on July 18, 2024, due to unfavorable rulings from competition authorities in New Zealand and the UK. Although the failure to close this acquisition is disappointing and may have accounted for the moderate stock price weakness in the second half of July, we do not think it will have a significant negative impact on the business and the acquisition was not factored into NK’s guidance. Moreover, the ruling by the competition authorities is further evidence of AlphaTheta’s dominant market position.

Management is aiming to increase recurring software revenue. We believe that pricing, market share, and increasing the paying user ratio could all drive revenue growth. We also believe that the free version of Rekordbox offers too many of the essential features, and management might consider limiting access to new software features in the free version. Interestingly, the latest version of Rekordbox released this year is not compatible with some of Pioneer’s older hardware models. This might indicate a new strategy to accelerate the hardware replacement cycle.

AlphaTheta Financials

Below is a summary of AlphaTheta’s financials including the most recent quarter. Volume and price/mix have been significant drivers of revenue and profit growth in recent years. FY23 sales grew c.30% in c.c. with more than 10% volume growth. Q1 2024 results grew c.66% in c.c. with +18% volume growth and +48% benefit from pricing and mix.

AlphaTheta is currently experiencing booming demand for DJ equipment. Q1 sales and EBITDA for AlphaTheta jumped +77% (+66% in c.c.) and +152% y/y (+136% in c.c.). Based on our discussions with management and retailers, we believe that the results benefited from very strong demand and increased inventory stocking. AlphaTheta’s production was unable to keep pace with demand from 2020.

We assume that growth will moderate for the remainder of the year because Q1 benefited from some inventory stocking. However, management’s guidance for +15% growth in 2024 revenue and EBITDA seems very conservative. The Q1 achievement ratio of full year upwardly revised guidance was 32% for sales and 44% for EBITDA. Over the past 3 years, Q1 accounted for an average of 24% of full year sales and 31% of EBITDA for AlphaTheta.

Valuation

NK trades at 9.3x 2023 P/E and 7.6x P/E on our 2024 estimates. NK is cash generative and has net cash of $250m on the balance sheet. NK trades at only 4.0x 2023 EV/EBIT and 2.8x EV/EBIT on 2024 estimates. These are cheap absolute multiples for a dominant, growing niche business.

There are no listed DJ industry comps but Japanese musical instrument peers trade at premiums of 20-70% on P/E and more than 100% on EV/EBITA.

We think this valuation discount may exist for several reasons including:

•  Lack of investor understanding of the DJ industry and lack of public comps

•  Limited sell side coverage. Only Nomura and Shared Research (https://sharedresearch.jp/en/companies/7744) cover the stock.

• Amortization expenses due to acquisition accounting reduce reported operating profit by c.20%

Risks

•  Consumer recessions in key geographies could hurt demand for DJ hardware, which accounts for more than 90% of AlphaTheta revenue.

• Decline in the popularity of DJ culture or electronic music.

• Market share loss in DJ hardware or software market

• FX: NK reports in JPY but generates 90% of sales overseas, of which 39% is from the US and 30% is from Europe. There is some natural hedging related to USD denominated procurement costs and therefore NK is only a moderate beneficiary of the weak yen. Management estimates that a 1 yen depreciation vs. the US$ increases EBITDA by 0.5% and a 1 yen depreciation vs. the EUR increases EBITDA by 0.90%.

Catalyst

Earnings on August 9, increased awareness from buy and sell-side, possible take-private or acquisition target, rebound in oversold Japanese market