Description

TKC is a domestically-focused Japanese supplier of tax system software to small accounting firms (B2B) and local municipalities.  The business has many of the typical attractive characteristics unique to vertical market software companies, including a high level of recurring revenue and double digit EBIT margins in its core business. 

Ignoring the print business which is small and breakeven, the core business of TKC is providing software to small accounting firms staffed by TKC members (which I will get to later).  To clarify, these members don’t work at SMES, but rather work at small accounting firms that use TKC software on a daily basis.  Of the 72,438 (http://www.nichizeiren.or.jp/eng/index.html) registered accounting firms, TKC has 10,800 individual members, making TKC the market leader with 14% penetration.  With respect to actual offices, TKC has 8,900 customers, giving the company 29% market share as measured in this manner. 

On a look-through basis, TKC software is ultimately used by 575k corporations, the vast majority of which are SMEs.  That said, larger corporations also use several TKC software modules relating to consolidation, tax, and electronic filing such that 100% of the top 100 Japanese corporations use one or another TKC system.  If one wants to look at publicly listed competitors in Japan, JDL (6935) and MJS (9928) would be peers.

As to why accountants use TKC software, it speeds up document preparation, reduces the likelihood of mistakes, and adds credibility.  Moreover with over 1,700 local municipalities in Japan, TKC is one of a handful of companies that can supply software to ensure local tax reporting requirements are met in an efficient and cost effective manner, and the same would go for ever-changing federal tax requirements.

Getting more technical, TKC’s system requires that customers enter data on a monthly basis, and once the books have been closed, historical entries cannot be altered.  This means that neither the enduser nor TKC can manipulate the financials in a fraudulent manner after-the-fact, which provides significant confidence to potential lenders when they see that statements have been prepared via TKC.

The company tries to recruit new accountants out of school to become TKC members, and hence once accountants have been trained up and indoctrinated in the “TKC way” they are unlikely to switch providers.  In fact, while rather confusing, the members actually belong to a not-for-profit entity (TKC Federation) whose goal is to continually raise the quality of work performed by TKC members.  Unsurprisingly, the TKC Federation was started by the founder of the company at the same time as the corporate entity.  Moreover, TKC Federation is a shareholder in TKC opco, and uses dividends from opco to provide loans to accounting students and support the non-profit organization.

Back to the business, the software can be bought out-right (think on-premise like) or rented (think SAAS like).  At the moment the revenue mix is 30% sale/70% rental, with the company envisioning that the rental portion will increase over time.  The core accounting business generated a 13.5% EBIT margin during the last fiscal year which is optically dampened by depreciation being greater than capex due to a significant expansion program over the past few years.

Going forward the company targets to increase the number of users to 10k offices (8,900 right now) and 15k users (10,800 right now), though I would view this as an aspirational goal.  However the real kicker here is that the government is rolling out the “Social Security and Tax Number System” (aka My Number) in October 2015 that will radically alter the flow of information of both private companies and individuals on a go-forward basis.  Both large and small corporations will have to make significant investments to support this new system, and it would seem reasonable that as a supplier of software to these customers, TKC is in a good position to benefit from increased IT spend to support the new system.

Lastly, capital allocation is better than average as it goes for Japan, but not quite exemplary.  You currently get a 2.5% dividend yield, and a glance at historical financials will reveal the company has repurchased shares in 5 of the past 7 years, with very notable purchases in 2008/2009 respectively.  I have visited the company multiple times in Tokyo, and they told me they are sensitive to the stock price when considering share repurchases, which I guess is a good thing.

As for valuation, the group forecast is for Y6.3bn this year, which would be up 2.1% from last year.  Using EBIT as a proxy for pre-tax cash flow (ignoring the fact that depreciation is greater than capex), the valuation is a mid-teens p/e and an EV/EBIT of about 5.5x since the balance sheet is cashed up.

Given potential for future earnings growth from My Number roll-out, reasonable history of capital allocation, sticky customer base with high quality recurring revenue, and a not egregious valuation, this strikes me as a reasonable proposition.

Catalyst

Rollout of My Number which should lead to several years of earnings growth.

Further improvement in captial allocaiton (touch wood).