Description

Temairazu: Unlocking the Potential of a Japanese Hidden Gem

Temairazu is a pure play high-quality vertical SaaS, boasting an EBIT growth rate of 18% CAGR over the past 7 years. Despite this impressive performance, it remains relatively undervalued, trading at just 11 x EV/EBIT or 20 x P/E, presenting an interesting opportunity for prospective investors.

With the prospect of upcoming improvements in shareholder returns, could this Japanese hidden gem capture your attention?

Software Opportunities in Japan

Before delving into Temairazu's specifics, let's take a broader look at Japan's software sector.

Japan stands out with a 3.6x higher number of listed companies compared to the US or other Western markets relative to its economic size. This abundance provides a fertile ground for small-cap opportunities, as the listing requirements are lenient and consolidation remains weak.

In sectors like accounting software, for instance, Japan hosts a multitude of competitors, both newcomers like Free and Money Forward, and established players such as OBIC Business Consultants, Miroku Jyoho Service, TKC and PCA.

While Western markets often witness dominance by a single local player, Japan's landscape features numerous listed companies, each often maintaining stable market shares within their respective niches.

This unique dynamic allows us to get direct access to these investments as public investors and Temairazu is only one among the many opportunities we see in the Japanese software sector currently.

Mission-critical Software for the Hotel Industry

Established in 2003 and restructured in 2007 under the current founder and CEO's leadership, Temairazu specializes in mission-critical software solutions for the hotel industry. Its flagship offering, Channel Manager, empowers hotels to efficiently manage room inventories across various sales channels, optimizing occupancy rates and pricing strategies.

In Japan's fragmented lodging market, characterized by a multitude of travel booking sites and independent hotel chains, tools like Channel Manager and its counterpart from Seanuts, a subsidiary of Recruit, are indispensable for hotel operators. Acting as gateways, these platforms ensure the integrity of room inventories, minimizing the risk of double-bookings.

We estimate that the market for this gateway functionality is split evenly between Seanuts and Temairazu, although the former was the first to market and has maintained higher ARPU to this day. Rakuten is a distant third competitor, mainly in the bed & breakfast category.

Business Model and Product Roadmap

Key to Temairazu's success are the attributes of high-quality vertical software: their mission-critical nature, limited costs as percentage of revenues and tight integration with back office functions. Channel Manager fits the bill in all these key aspects and therefore has a high-switching cost moat which translates in very low gross churn, communicated quarterly by the company.

Because of the long-term collaborative nature of its commercial relationships with lodging customers, feedback is efficiently integrated in its product roadmap and R&D spend is reasonable, yielding stable Gross Margins of 92%.

Similarly, as a B-to-B offering with stable customer relationships, sales and marketing costs are low and predictable leading to EBIT margins increasing from 20% in 2015 when revenue started to accelerate to over 60% by 2018. The fact that the company was able to keep its EBIT margin growing through the COVID disruption tells you a lot about its sticky, mission-critical nature.

For revenue and earnings growth going forward, the company benefits from a revenue model which include a fixed monthly fee together with additional variable fees based on the number of bookings made through its Channel Manager. In FY23, fixed/variable income breakdown was 80%/20%.

The hotel industry has not yet fully recovered from COVID, providing some demand tailwinds, partly because of supply. It is not rare to find hotels in Japan which cannot operate at full capacity because of the lack of staff.

In order to tap the smaller customers segment, the company launched a tiered pricing and introduced Temairazu “mini” in Marc 2020 targeting mom-and-pop lodging operators.

A recent addition to Temairazu's portfolio is a new module boasting enhanced yield management functions. Leveraging cross-selling opportunities and a differentiated pricing strategy based on the number of nights booked rather than just per booking blocks, this module promises to further augment the company's revenue streams.

Thanks to these initiatives and the scaling benefits of strong take-up of its software, Temairazu was able to grow earnings at 18% CAGR over the past 7 years. This period obviously includes the COVID lockdowns.

Corporate Governance and Capital Allocation

Throughout, the company has had a history of conservative annual guidance, with actual results modestly beating guidance most of the time, expect in FY2023 where results were 17% higher. This is a good sign of the stability of its customer base and the low competitive intensity in its niche.

Watanabe Tetsuo, the founder and chairman, owns a 60% stake. Encouragingly, he sold a 14% stake in March 2020 to expand its investor base while increasing stock liquidity which currently stands at USD$1M a day. His ownership has been stable since then.

Watanabe San pivoted to the Channel Manager opportunity through the acquisition of Plus Alpha Inc for JPY420M for ~6x EV/EBIT  in FY07, but then divested two additional businesses acquired for JPY120mn in FY08/09, showing good capital allocation skills.

Temairazu generates strong free cash flow which have not been matched by high shareholder returns, leading to JPY5B accumulating on its balance sheet and depressing ROE in the process. In fact, the company only sports a 16% ROE currently when its “adjusted ROE” is closer to 185%. We come up with our adjuster ROE by assuming that management keeps 1 year of operating expenses on its balance sheet and distributes the excess cash.

Put another way, it would take an annual 100% dividend payout ratio until 2028 to bring its ROE to 30%, highlighting both the strength of its growing cash flows and the room for improvement compared to the current measly 23% payout ratio.

Encouragingly, larger Japanese companies have by and large started implementing improved shareholder returns and we see this movement  trickling down to smaller companies. For instance, another software company, PCA Corp (9629 JP), implemented in February a targeted ROE through a100% payout ratio using the same logic. The announcement was quickly followed by a 40% jump in PCA Corp's share price.

It should be noted that the company has good English disclosure and an IR point of contact. Watanabe san is approachable and made himself available for a video call and a company visit.

Catalysts & Risks

We think that it is likely that the company improves its payout ratio over the next 6 months. There is a strong positive correlation in Japan between dividend payout ratio and PE ratio. Please contact us if you would like more information on our study.

The valuation gap between Temairazu’s 22x PE and 10 x EV/EBIT ratios and its international comparables growing at a similar rate, such as Nemetschek with a PE of 63x, remains supportive of a rerating.

In the meantime, continued EBIT growth and strong operational performance are expected to drive share price appreciation irrespective of an valuation ratio increase.

If COVID could not make a dent in this travel-related business, I am at a loss to find meaningful business risks facing the company at this stage.

Catalyst

We think that it is likely that the company improves its payout ratio over the next 6 months. There is a strong positive correlation in Japan between dividend payout ratio and PE ratio. Please contact us if you would like more information on our study.

The valuation gap between Temairazu’s 22x PE and 10 x EV/EBIT ratios and its international comparables growing at a similar rate, such as Nemetschek with a PE of 63x, remains supportive of a rerating.