Description

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Pro-Ship (3763 JP) is a very interesting nano cap Japanese firm. The company develops niche accounting software for fixed assets and leased assets management. Its packages (“ProPlus Series”) integrate into wider systems such as ERPs to provide specific accounting functionalities. It is very entrenched, enjoying a large market share (>50%) amongst the largest Japanese firms, with some clients relationship dating more than 30 years. The business should see its growth accelerate in the next few years yet is trading at 9x ex-cash PE. Several facts got me interested in Proship recently:

- industry feedback which showed that Pro-Ship's software is very high quality

- Pro-Ship will benefit from several growth drivers (Japanese firms seeking higher efficiency, implementing on-balance sheet leases and increasingly shifting to IFRS). 

- valuation of several Japanese software editors increased yoy, meanwhile Pro-Ship's valuation became more attractive

- solid backlog

- they just started increasing prices in Japan

- they should have easy comps going forward as Q1/H1 last year saw a 180M JPY non-cash charge hit earnings (due to a pension plan one-off)

At the current valuation I think the probability to lose money is low. We can get such a valuation partly because liquidity is limited. On top of this, they may be an attractive acquisition target for their main shareholder at some point (NSD, which bought a 20% stake from the founding family at around the current price in 2017).

Covid 19 impact: Negligible as of now. Being in IT, the firm is used to remote working. Also, SI activity continues in Japan. So far, no delays have happened.  

I - Brief history  

II - Products & business model

III - Future challenges and future growth  

IV - Governance, capital allocation, valuation & others

I - Brief history

The firm was created in 1969. At the end of the 70s, they started doing consulting & developing several software packages in the accounting niche. At the end of the 90s, several things happened on the accounting front, notably a change in the depreciation method in 1998, and the accounting big bang in 1999-2000 which introduced major changes in J-GAAP. Pro-Ship benefited from this. 

They listed on JASDAQ in 2005 (since then moved to TSE1), and more recently took other steps towards their development:

- 2012: launch of the international version of ProPlus, their mainstay package

- 2013: opened the 1st China office in Shanghai & introduced their lease management package

- 2016: release the v6 of their ProPlus package

- 2017: NSD, a large SIer, took a 20% stake in the company

Since the beginning of their international development, sales have grown by 4% per year (in-line with growth in clients) and we now notice growth accelerating due to several new trends, most importantly the shift to IFRS and the introduction of the new IFRS standard for leases. Penetration of IFRS is still low in Japan (~220 firms only) but is steadily increasing and it will be a growth driver for the firm.

II - Products & business model

Pro-Ship's products are niche packages that plug into clients' systems (like ERPs) to manage specific technical details about their assets. Pro-Ship has several packages, to manage fixed assets (complex depreciation requirements, mass data processing), asset impairment tests, assets under construction management, leased assets and leased agreements management... Their products are available on-premise or in a cloud version, however most clients use the on-premise version as the cloud is not adapted to customized versions, which some clients need. It's important to note that their products are used to answer complex needs, they are not needed in small firms: for this reason Pro-Ship targets firm with sales of at least 400M€. Out of the largest firms in Japan, they have 50%+ share in each industry, steadily increasing. This includes known names like Canon, Sapporo, Rakuten, Shiseido, Kirin, Ryobi... The client mix is split equally between manufacturing & non-manufacturing sectors.

Regarding the business model: they have a license model, with a bit of consulting. 

They have 2/3rd of sales as upfront fees & installation fees. Every year they then get 15% of the license amount as maintenance revenues, which amount to 1/3rd of sales. The license fee varies a lot depending on size of the firm and the amount of fixed assets under management. After 5-6 years, when a new version comes up, they get the license fee again. Distribution is classic, 50/50 SIers vs direct distribution, stable mix. Direct distribution is inbound demand following seminars & consultants' visits. SIers are classic players like TIS.

Pro-Ship's expertise is famous in Japan, they are renowned for having very specialized engineers and an excellent customer service (they give a first answer to more than 99% of clients' requests in less than 1h). The President of NSD, a great SIer which became the top shareholder 2 years ago, took a stake in this company because "Pro-Ship is a top-class company. We liked their solution". The firm is also very lean: It has just 6 person in their admin/company-wide department out of 160. One of their office in China is used to outsource development at a cheap cost while keeping quality under control. I had a bit the same "lean" impression when visiting their head office in Tokyo. For these reasons they manage to get higher profitability than peers (>30% OPM).

Two more things should be mentioned:

- big SIers like NSD foresee programming to become largely automated & it's part of the reason they are taking increasing interest in services & editors like Pro-Ship

- small firms like Pro-Ship have an extremely valuable client base: half of the largest firms in Japan. The interest for cross-selling opportunities for SIers is obvious. 

 One interrogation is a fear that these small players could be attacked by the large ERP players. I think this concern should be mitigated:

- ERP players like SAP have solutions for fixed asset management but they are neither really good neither really flexible. 1/3 of Pro-Ship clients are using SAP for their ERP.

- The argument given by the firm is that developing such product is very low priority for SAP given that the knowledge required is very specialized, changes happen every year and the market is tiny (Pro-ship's sales: ~50M$).

- Even if SAP would develop a product, given the stickiness inherent to this business, we'd likely see a long decline rather than a quick drop in sales.

- Finally, one ERP editor asked Pro-Ship to supply the fixed asset management package for their software on an OEM basis, but Pro-Ship refused. This gives credence to the idea that it's not so easy for them to "go at it alone".

III - Future challenges and  future growth

The firm faces several challenges today.

Firstly, it must keep on developing new products if it wants to grow. As we have seen new versions are a given and generate business but they don't really increase demand per se. In their new MT plan, Pro-Ship explained its new concept of "TEAM", for "Total Enterprise Asset Management". In essence, they are currently developing new products to grow after the demand from IFRS adoption wanes. "TEAM" will be used to address peripheral fields of fixed asset management, like management of physical goods & inventories. They are aware that their edge is in this area & do not intend to address sales or HR: they do not want to compete with ERP players.

Secondly, they have a challenge regarding HR. The firm has been growing but the number of employees decreased over the last 5 years, from 200 to 173 employees. The typical hires are engineers in their mid-thirties. The increase in average age while the employee count decreases indicates that younger employees have been hired elsewhere which is not a good sign. The firm is aware of this and is focusing on making the workplace more attractive as well as increasing wages. Finally, NSD is sending engineers specialized in AI and OCR to Pro-Ship for free, to help them with the development of new products.

What could future growth be? As I'll explain there is little potential for margin expansion, because the company is already very profitable and more so than the industry. So I plan on having profit growth roughly equal to sales growth for now. And I think growth will increase compared to the history. Pro-Ship is currently with several projects. To implement them, they must delay some version upgrades with some clients. Not ideal but still in the category of the "good problems" to have. In the end I think there's a good chance we get better than 4% growth due to:

- the continuing shift to IFRS: just above 200 firms have shifted. But there are 1,380 listed firms with sales above 400M€.

- as we learnt with other firms, Japanese firms lack behind in terms of digitalization. They are investing in IT to catch up, increase efficiencies and fight the very strong labor shortage. The previous BoJ Tankan survey showed that software capex is set to increase 13% overall, and above 20% for small & midcaps (pre-Covid).

- Japan's accounting standards normalizing with IFRS and requiring leases on balance-sheet, see https://asia.nikkei.com/Business/Companies/Japan-to-classify-leases-as-assets-in-line-with-global-standards 

Secondly, regarding margins. Since 2004, they have generated an average GPM of 57%, and an average OPM of 31%. This wasn't done by neglecting R&D as they kept on releasing new products, and R&D averages 6-7% of sales.  They explain their high profitability by the fact that they remained very concentrated on a small market. 2018, with an OPM of 34.5%, was clearly special due to the fact that they had no loss on their projects. Going forward they'll keep on incurring the development costs and will see increasing salary wages to retain talent. On the other hand, they realized they have pricing power with clients, and have just started increasing prices since 2017-2018 (NSD's influence ?). A very quick calculation: 4.4B sales for 1k corporate clients / 4k different entities yields 40k$ per corporate client per year. Not much for a big client managing large assets. So margins will fluctuate based on these 2 factors.

IV - Governance, capital allocation, valuation & others

Governance & capital allocation: The board is composed of Mr. Suzuki from the founding family (now 78) and employees from the firm. Also NSD now has a board seat. 

Capital allocation has been ok historically. They didn't make any bad investment or any bad acquisition. They have a lot of cash but have a decent payout. The payout policy is 30% but they have actually paid more and the effective payout has been increasing. This year we'll get a special dividend for the 50 years since founding. Finally I think NSD can help in this regard, they're a company 10x bigger with very good governance and they're targeting 50% payout for their own firm.

Valuation: cheap by any metric. P/E ex-cash is 9 with reasonable growth. EV/EBIT is <7x this year. For sales growth, I forecast like the firm for this year (+13% sales). After that I forecast 5% yearly growth until 2022, a small premium to the historical growth of 4%. Also to be conservative, I model a scenario where price increases don't compensate for wage increases and make EBIT margin go down from 34.5 to 30% in 2022, just a bit under their long-term average. As said in the intro they have quite some pricing power which they're slowly taking advantage of in Japan.

 Others: there has been a media publication that a man called Ishida Wataru is a shareholder and committed fraudulent behavior & went to jail. He sold a cheating program for video games in Japan and seems to be a business man with not too much ethics. He owns 6.8% of the firm through his company Internal Inc and 2.8% directly. However the firm does not know him and does not work with him, so it does not change the investment thesis. Confirming this point of view, he made shareholder proposals at several AGMs a few years ago to receive a higher dividend but didn't succeed. It seems he's been selling some shares recently.

Catalyst

- continued growth showing up in financial databases, stock appearing as a cheap grower soon

- accounting norm changes in Japan coming in the next years pushing up sales (IFRS, leases on balance sheet)

- easy comps in Q1 due to non-cash pension plan one-off last year

- firm is acquired

- potential shareholder payout improvement