Description

Step: the best education firm in Kanagawa (maybe Japan?) for < PP&E cost + net cash

Step (ticker: 9795 JP, www.stepnet.co.jp), founded in 1975 by Kyoji and Kikue Tatsui (a husband/wife team) is a Japanese “juku” 塾 (cram school) face-to-face test prep company (group lessons, not 1x1) with 29,467 students across 154 school locations.  Most of Step’s students are middle schoolers trying to test-in to the best high schools in Kanagawa prefecture (i.e. South of Tokyo, home to Yokohama and Kawasaki). Like college in the US, high-school (many of which like have “escalator” arrangements with universities) in Japan is perceived to be a key determinant of a student’s chances of reaching “the good life.”

Useful links:

https://www.stepnet.co.jp/company/data/202203e.pdf

https://www.stepnet.co.jp/company/data/202109e.pdf

https://www.stepnet.co.jp/company/data/2021_company.pdf

VIC parents: remember those initial COVID school closures and how basically nobody got tuition refunded for the lost face-to-face instruction?  Believe it or not, thanks to rainy day cash reserves, Step did refund 90% of tuition for the months of lost face-to-face instruction (even for those lessons where Zoom was an option) because they felt that was the right thing to do for parents.[1]  In an amazing show of boldness, Step launched this refund policy at the start of the pandemic, when there was no vaccine in sight or any idea when government lockdowns might end – one of the most interesting (and successful) marketing ploys we have seen in Japanese small caps in some time.[2] 

As a result, Step’s EBIT declined 28% for one year, but post-COVID customer loyalty has soared, tuition price increases have been no problem, EBIT is back to record highs (42% higher than pre-COVID), market share has likely permanently increased, and more market share has been identified for the taking. 

Yet thanks presumably to ugly headlines about Ukraine and US inflation, Step’s valuation is about the cheapest it’s been in a decade on a trailing P/E (10x), EV/EBIT basis (5.4x) and far cheaper than many peers.[3]  Remarkably, Step is even trading at a discount to a) net cash, plus b) the original replacement cost of their property plant and equipment (mostly school land and buildings).  

Further, Step’s ROE could structurally improve from here thanks to management’s discipline over the last few years to refrain from acquiring more property at elevated prices.[4]  Hence, in our view either a) retained earnings will push cash higher than the current market cap in less than a decade, forcing the market cap to rise or b) more cash will be paid out as dividends than has historically been the case (i.e., a 30% after-tax payout ratio could rise much higher).[5]  

What gives?  Step’s multiples don’t get much love from the stock market, presumably because it doesn’t grow fast enough (1995-2021 EBIT CAGR: 7%) to attract many growth investors.  In fact, Step even refuses to expand to any territories outside their one dominant region (Kanagawa prefecture, home to Yokohama/Kawasaki), which is a fraction of the total size of the national test preparation market.[6]  Likewise, Step doesn’t earn a high enough ROE (1995-2021 average ROE: 10% with almost no debt) to attract many “quality company” investors because the controlling shareholder is strictly “old school” and has long preferred to buy/own the majority of the company’s locations.

Still, our checks over the years show that Step is consistently ranked highly by its employees (most of which are full time career staff) on websites like jobtalk.jp, and its students are consistently accepted to the best high schools in their region.  These are two reasons why Step has been able to increase the number of students, locations, revenues, profits, and dividends for nearly 30 straight years.[7]       

From 1995 to 2021 Step delivered almost uninterrupted revenue and profit growth – as far as we know this is unique among their Japanese publicly traded peers.  In fact, Step’s track record is unique among all Japanese public companies: according to a July 2016 Nikkei Veritas study, Step is one of just 31 publicly listed companies to have grown pre-tax profit every year since August 2008, the month before Lehman collapsed. 

How did they do it?  First, Step maintained an obsessive focus on teachers and students.[8]  By offering above-average salaries, performance bonuses tied to student results, benefits like employee dormitories, and the freedom to customize lesson plans, Step attracted talented full-time teachers that wanted to build long careers helping students gain acceptance to the high school of their choice.  Step teachers are just teachers; they don’t do any marketing and their incentives are solely tied to student performance.

Why does high school matter?  In the Japanese education system, high school matters a lot to a student’s future: the classes taken and friends made will influence the road to university and beyond.[9]  The challenge for high school applicants is that many of the most desirable high schools have their own customized entrance exams and unique admissions quirks based on content that is not normally taught in middle school.  Thus, hiring an experienced test preparation company like Step that a) knows what local high schools are testing for, and b) has a proven track record of getting students accepted, can make a big difference to prospective applicants (see below).[10]  That’s why parents have been happy to pay Step’s monthly tuition rates of JPY 35,000 per student for many years. 

Above: admissions performance versus Kanagawa major rivals Shonan Seminar and Rinkai Seminar

Second, Step refused to even risk diluting their service quality by franchising or expanding beyond their home turf of Kanagawa prefecture, where they have a real competitive advantage.[11]  Kanagawa Prefecture (capital city: Yokohama) is one of the three main suburbs of Tokyo, and according to the latest census data it is one of only nine prefectures out of 47 total to have enjoyed population growth from 2015 to 2020.[12]  Kanagawa parents are sophisticated: they will only pay for their kids to attend test preparation classes at companies that can deliver actual results at schools that are conveniently located.  So even though Step doesn’t advertise much (just 1% of sales), parents consistently choose to send their kids to Step because it has both the academic track record and the conveniently located school real-estate (~40% of which are self-owned).[13] 

We think Step’s approach to real-estate is unique among peers.  Until recently, the company’s policy was to buy as many school locations as it could after paying dividends worth 30% of after-tax profit – even if this policy caps consolidated return on equity at “just” 10%.  Step had two key criteria for new school locations: first, they have to be within a 1.5-kilometer radius of a middle school and second, at least 1,000 total middle school students must exist within that radius.  Such locations were increasingly rare, so from Step’s perspective, even if they continued to pay up to 20x the profit of an average school to own those locations forever, that’s was a great business decision because it locked out the competition.[14] 

Step’s insistence on owning property is likely why its price-to-book multiple hovered at or below 1x since 1995, with scant investor attention along the way, despite their record of consistent growth.  We initially struggled to understand why Step had to own so many schools, too.  But we eventually came around to Step’s point of view after we learned that all of the company’s school properties are clustered in Kanagawa Prefecture by busy train stations within commutable rides to big cities like Kawasaki (population: 1.5 million), Yokohama (population: 3.7 million), and of course Tokyo (population: 14.1 million).  Such well-located properties, which could be repurposed for other industries, are a) definitely worth more than zero, and b) a far better use of capital than hoarding cash like many other Japanese companies.

How much could these properties be worth?  We did not hire an appraiser to investigate, but historical cost as disclosed in the audited accounts is a reasonable conservative guesstimate of value.  As of 30 September 2021, the historical cost basis of Step’s ~60 self-owned land and buildings was JPY 23.6 billion.  This, plus net cash on hand of JPY 7.8 billion, is JPY 31.4 billion versus the current market cap of 28.3 billion.  In other words, real-estate NAV plus retained cash earnings already exceeds Step’s stock price, giving investors today its growing stream of future profits for free.

Above: Step’s overwhelming location advantage in Kanagawa prefecture (~40% of location properties are owned)

Step is already the market leader in test preparation for Kanagawa middle school students applying to high school, and these account for ~70% of the company’s 29,467 total students.   But Step is still an emerging competitor for a) elementary school students applying to middle school, and b) for high school students applying to university.  We believe that Step’s high school business, which grew from 2,398 to 5,515 students between 2009 and 2021, can grow much bigger. 

Why?  90% of Step’s high school students are graduates of Step’s middle school program, but only 20-30% of Step’s graduating middle school students have been converting into Step high school students.  As Step continues to build its reputation among high school students applying to university, this 20-30% conversion ratio could increase (see acceptance records below).  All Step needs to do is convince their existing middle school students, who they see every week for three years, to stick around for three more years of high school.  According to Step’s management, of their existing middle school students that do not eventually convert into high school students, 50% are not converting into high school students at any other test preparation company.  This is a large untapped opportunity.  As a result, Step’s management believes the company can eventually expand to 200 schools within Kanagawa Prefecture, up from just 154 today.  

Above: the number of Step high school students accepted at prestigious universities.  Blue bars include the best public universities like Tokyo University, Kyoto University, Hitotsubashi University, Tokyo Institute of Technology, and other prestigious public universities (including medical schools).  Red bars include Waseda Unversity, Keio University, and Sophia University. Green bars include Tokyo University of Science, Meiji University, Aoyama Gakkuin, Rikkyo University, Chuo University, and Hosei University.

Above: Step’s addressable market in Yokohama and Kawasaki (see page 6), two markets where they have far less market share than they do in their original market of  Fujisawa (24%).

We first visited Step’s headquarters in February 2015.  Since then, we have seen evidence that the company’s control shareholders are aligned with, and care about the returns of, all shareholders.  First, the founders, board, and employee stock ownership program own almost half of the total shares outstanding, and they have increased their stake over time.  Second, excluding capex spent on buying schools, Step has in most years returned nearly 100% of cumulative free cash flow since 1995 to shareholders via dividends and, occasionally, share repurchases. 

We feel we’ve been well compensated for the risk of owning Step shares given their real-estate and low-hanging organic growth opportunity.  Though Step trades at a P/E discount to many peers – even peers with worse records that don’t own any real-estate – it is still operating in an industry facing tough demographics.  As demographics worsen, only test preparation companies with a real edge will thrive, and we’re taking the view that Step can remain one of them.

To recap, these are the reasons why we view Step shares as an attractive opportunity today:

1)    Step’s competitive advantage in Kanagawa is further entrenched post-COVID (word of mouth among parents has improved thanks to the generous COVID refund policy).

2)    Step has earned the right to increase tuition prices, and has been doing so with no effect on demand.[16]

3)    Free-cash flow is piling up, which we believe will increasingly be used for shareholder returns (as opposed to real-estate acquisitions, which management has sworn off for now).

4)    A clear long-term growth runway has been identified in Yokohama/Kawasaki, which could increase total school locations and student population by at least 35% and 29%, respectively.

5)    Valuation multiples are at significant discounts to both peers and the Japanese indices, and the market cap is only giving credit for the hard assets.

Note: it is possible that Step’s forecasted YoY growth for this current year ending September 2022 is not being fully captured by Japanese EPS growth screens.  Why? A recent change in accounting standards (see page 13) understates YoY earnings growth comparisons between the most recently completed year (September 2021) and management forecasts for next fiscal year (ending September 2022).

Some key risks (and mitigating factors) to Step’s business are:

1)    Another pandemic, or a worsening of the current one, leads to more forced school closures.

-       Since COVID Step has developed a sophisticated “e-Step” product that allows for all classes to be viewed online in real-time if a student is absent (so everything is fully hybrid now), but Step does not charge anything for videos. In other words, only face-to-face students get access to the online learning tools.[17]

2)    Regulatory changes to exam schedules and/or content could hurt the business.

-       Step has a) been through this before with no issue, and b) Step’s business is “diversified” across various exams for many different schools. In our view it’s unlikely that the content to all exams for all high schools and universities would suddenly change to make Step’s teaching methods obsolete overnight.   

3)    Kanagawa population growth goes negative, drastically reducing the number of potential students.

-       In our view, Tokyo and its neighboring prefectures (Chiba/Kanagawa/Saitama) have the best chance of keeping severe depopulation at bay – there’s too much economic activity to not be a center of gravity. In any case, Step is currently only serving about 1/10^th the number of potential students in Kanagawa even though they only focus on 8 of the 12 possible student grades. And, as mentioned above, Step can grow revenues meaningfully simply by getting more of its existing middle school students to convert into high school students (that prep for university entrance exams).

4)    Management changes tack and does bad things with the cash to the detriment of shareholders.

-       We would never say never, but given the public track record since 1995 we think this is highly unlikely.

Above: inside a Step classroom

Above: outside a Step location

Catalyst

Further profit and dividend growth

Higher ROEs from better dividend payout (or share repurchase)