Description

2930:JP Kitanotatsujin Corporation (Meister in the North) is a rapidly growing ecommerce company that emphasizes subscription sales of internally developed FMCG and household products.  The stock went on an epic run from the start of 2017, rising 2500% to its peak in April 2018 as annual profits quadrupled in less than 18 months and traders pushed the stock from value up to extreme growth multiples.  Now that the stock has lost two-thirds of its peak value as the business continued to grow, it is much more reasonably priced at about 30x FY19 (ending February 2019) earnings and ~20x forward earnings. I think this is an attractive entry point for long-term investors given the current growth trajectory of high-margin subscription revenue and the opportunity the management sees to grow that base another 4-6x over the next five years or so.

The Company’s core business, “J North Farm,” was founder and CEO Katsuhisa Kinoshita’s third attempt at building a sustainable ecommerce business, and consequently the strengths of its business model from the onset were informed by lessons Kinoshita learned from his first two business failures.  On his first attempt, Kinoshita focused on driving near-term sales with promotions and advertising while neglecting the customer experience, a necessary input to gain customer loyalty and benefit from free word-of-mouth advertising. After shutting down his first business, Kinoshita relocated to Hokkaido on his own, determining that the island was an underutilized wealth of natural resources that would be attractive to people in the rest of Japan and Asia if they were made more readily available through the internet.  In his second attempt, Kinoshita took special care to manage customer service and product quality, delivering handwritten notes to customers instructing them how best to enjoy the select specialty regional foods sold through the site. The new approach was initially successful and attracted lots of media attention, which in turn attracted new competitors offering the same products and even copying the look and feel of the original site. As it became clear that a first mover advantage was not enough to avoid fierce competition, Kinoshita determined that the Company would need to develop its own products that were not easily imitated, and thus R&D became a core pillar of the third venture’s strategy.

The Company’s first self-developed product was “Kaiteki Oligo,” a compound of oligosaccharides including an extract from a sugar beet only grown in Hokkaido.  Oligosaccharide is a complex carbohydrate that the digestive system cannot break down, so it passes through to the colon where it functions as a prebiotic, stimulating the growth of bifidobacteria which feed on it.  Bifidobacteria is a beneficial microorganism in the body that naturally decreases with age, which can be a cause of digestive issues linked to aging, namely constipation. While there are numerous oligosaccharide products on the market in Japan, the Company sought to add value beyond existing products through cooperation with university researchers and raw material manufacturers to formulate a better recipe.  The resulting product was exceptionally pure with a more appetizing texture resembling sugar, an important advantage over other products that are more like corn starch or flour, since users normally consume the product daily by adding a spoonful to their coffee or yogurt in the morning. The product was a hit, even life-changing for some who had been looking for a better way to treat their digestive issues for years, and provided the Company with their first major stream of high-margin subscription revenue.

The Company now offers 28 products in the health food, cosmetics and household product categories, and they have successfully diversified away from reliance on sales of Kaiteki Oligo, less than 20% of sales in FY2018 down from 85% in FY2012.  Their consistent success in introducing new products to the market is not just an incredible string of good luck; this is a customer-centric flywheel in action. However, unlike the typical ecommerce flywheel that requires growing scale to drive falling prices, the Company’s reputation for high quality proprietary products and high level of customer service shield it from price competition, and its subscription model with predictable delivery times and inventory requirements reduces the need for investment in logistics and warehousing.  Rather than pass the additional margin onto customers through lower prices, the Company is able to increase their investment in product development, customer service, and user acquisition to accelerate business growth while still maintaining impressive operating margins. The key inputs to the flywheel are as follows:

·       Product development – The Company’s R&D efforts are focused on utilizing quality ingredients to create FMCG and household products that are difficult to imitate, address pressing needs of consumers, and have the potential to be the leading product in their niche market. Test marketing is key in choosing the limited number of products to be commercialized; key requirements are that the effects of a product can be easily experienced and that a product is likely to be purchased repeatedly. All manufacturing is outsourced to carefully selected OEM partners.  Current areas of focus are bodily issues such as constipation, acne, nail care, atopy (skin condition).

·       User acquisition – Advertising expenses focused on more accurate target segments rather than mass marketing.  Extensive data analysis is used to identify the most valuable lifetime customers and direct advertising spend accordingly.  Cost of user acquisition is lowered by positive user reviews and word-of-mouth recommendations.

·       Customer Retention – No expense spared on product quality or customer service.  Customer service reps have external qualifications to provide general health advice and internal qualifications to provide consultation about the Company’s products.  The subscription model requires less advertising expenditure to maintain the same level of sales, less spent on logistics, and allows for optimization of inventory. Lower churn leaves more margin for investments in new product development and user acquisition.  Happy customers generate organic growth through recommendations and existing membership base also serves as potential market for new products.

We can clearly see the flywheel at work in the financials below.  Revenue has grown at a 35% CAGR and EBIT has grown at a 50% CAGR since FY2011 (ending February).  Gross Margins have held steady, now 79%. EBIT Margin has increased from 12% to 28%, even as advertising expense as a percentage of revenue increased from 19% to 33%, with most of that increase occurring since 2016 and driving an acceleration of revenue growth.  SG&A costs, which are relatively fixed, have declined as a percentage of revenue from 43% to 18%:

Management has stated that recurring subscription sales make up 70 to 80% of overall sales.  Taking the midpoint of that range, the sales breakdown would look like this:

About JPY6 billion of cumulative one-off sales have converted to about JPY4.8 billion of subscription sales over this time period.  Looking at it another way, on average, more than 100% of one-off sales convert to subscription sales in the following year.

Comparing my estimate of subscription revenue to number of subscribing members, it appears that monthly ARPU (about $20) is increasing in recent years, which suggests that either a rising proportion of members are subscribing to more than one product or the Company is selling a higher proportion of higher ASP products.  However, acquisition of new members is a stronger driver of revenue growth. Efficiency in terms of sales/employee has notably increased as the business has scaled:

One-off sales as a percentage of advertising expense sharply increased in 2018; the average since 2011 is 102%.  The cyclicality of this metric may be due to the timing of hit products.

The Company’s flagship product, Kaiteki Oligo, has dropped significantly as a percentage of overall sales as growth slowed in FY2014.  The Minnano Hadajunto Series (sugar scrub for atopy) emerged as a hit in FY2013, and 20Nen Hoippu (skin brightening facial cleanser) drove overall growth in FY2016.  The Company stopped providing a product sales breakdown in FY2017 as sales growth accelerated, presumably for competitive reasons or perhaps due to the decreasing importance of any one product.  We can see, however, that Kaiteki Oligo sales have stalled and were less than 20% of revenue in FY2018.

The latest Japan Company Handbook notes that Kateki Oligo is no longer the top seller of the Company, and mentions eye cream as one of the mainline products.  This would be “Eye Kirara,” a cream that improves bags under the eyes, which was launched in mid-2015. The Company noted in a 2016 presentation that this product more than doubled the previous company record for sales within the first five months after launch, originally set by Kaiteki Oligo, despite temporarily running out of stock in the second month due to overwhelming demand.  By November 2015, the annual sales run rate for Eye Kirara was already about 150 million, so it is likely that this product is now one of the best sellers.

In a recent interview, the CEO discussed several of the newer products:

“Our basic stance is to develop and sell products corresponding to what consumers need when they really are in trouble. For instance, “No! No! Smell” is registered as our first quasi-drug product. ‘Rimo Savon’, released in April 2018, is our first household product, a laundry detergent designed with special coating to make it easier to remove pet’s hair, prevents hair from reattaching in the water when washing, and makes it difficult for clothing to attach hair with its special coating technology to prevent static electricity. Our Clear Nail Shot penetration-specialized gel product had achieved sales of more than 650,000 units sold since its release in July 2015, or about one in every 49 seconds.”

Clear Nail Shot carries a higher ASP than the average subscription product, at 2,640 yen per month after the full 20% discount for an annual supply.  650,000 units would amount to at least JPY1.7 billion, and given the relatively small amount of revenue recorded in “Other” in 2016, most of this revenue would have been recorded in FY2017 and onwards.  In January 2018, the Company enlisted celebrity Shinobu Sakagami to endorse the product, so it would have been an area of focus for user acquisition in 2018. I apologize in advance for this link (you can see why people may be embarrassed to buy this product at their local pharmacy). https://www.atpress.ne.jp/news/147676

The Company submits products each year to be evaluated by Monde Selection, an international rating organization for product quality.  The Company’s bestselling products have consistently won awards from this organization… which bodes well for the newer products that were highly rated for the first time in Monde Selection 2018:

Kaiteki Oligo – Grand Gold Award, seven consecutive years

Minnano Hadajunto ~ Ato Care Type – Gold Award, six consecutive years

20Nen Hoippu – Gold Award, six consecutive years

Eye Kirara – Gold Award, three consecutive years

Hyalo Deep Patch – Gold Award, two consecutive years

Wrinky Flat, Build Make 24 – Gold Awards, first year

Clear Foot Veil, Mayme White 60, Luminapeel, Lid Kirara – Silver Award, first year

As the Company’s product offering grows and the number of online advertising mediums continue to increase, the question of where and when to deploy advertising is becoming more complex.  The Company advertises 28 different products through about 40 different distribution channels, which means there are over 1,000 different combinations to activate. The Company uses detailed data analysis to determine the most effective combinations to use, currently putting about 200 combinations in operation.  In order to increase operational efficiency and optimize the use of more potential winning combinations, the Company has self-developed “Adman,” an advertising operation management software. The software systematizes their in-house advertising management expertise and centralizes their increasingly complex advertising operations.  The software was deployed in FY19 Q2, but was temporarily suspended in Q3 due to operating errors that resulted in some additional advertising expenses that did not increase profits. As a result, Q2 EBIT was lower than expected, although revenue exceeded expectations, and Q3 EBIT could be higher than expected as margins return to normal on higher than expected revenue.  The operating errors have apparently been fixed and the software is back in operation for Q4.

If Adman works as intended, the Company expects a positive impact for the products that have not sold as well to date.  There are also plans in the near-term to combine the software with robotic process automation, which will operate the advertising system 24/7 and free up the Company’s human resources for more creative work.  In the longer term, this is an area where machine learning could have a significant impact in reducing costs and increasing advertising effectiveness. The fact that there are 800 combinations that the Company is not utilizing brings to mind the moment that AlphaGo made a move that no human player would have ever considered, which turned out to be the decisive winning move of the match.

Management first set a goal of JPY10 billion in sales in December 2012, without a specific target date.  The company surpassed JPY700 million in monthly sales in August 2018, or an JPY8.4 billion annual run rate, and based on the current sales trajectory it has nearly reached or surpassed a JPY 10 billion run rate about six years after management’s goal was set.  In May 2018, the medium-term target (again no specific date) was updated to JPY30 to 50 billion annual sales, based on a portfolio of products with sales of JPY1-2 billion each. It looks plausible that the Company can reach this target by the end of FY2024.

My model makes the following assumptions:

·       Gross Margins average 78% (2018 at 80%, 5-yr average 76%)

·       Advertising Expenses average 32.4% of Sales (2018 at 32%, 5-yr average at 22%)

·       New Sales return on Advertising Expense at 80% (5-year average 91%, 2019E 115%)

·       Other Operating Expenses grow at 25% CAGR (5-year average 22.6%, 2019E 33%)

·       Revenue Growth averages 35% (5-yr CAGR 36.5%, TTM 70%)

·       Dividend Payout 32%, Tax Rate 30%

Based on today’s share price of 375 yen and market cap of JPY52.6 billion, I get the following valuations:

My near-term earnings estimates are conservative compared to the one analyst that publicly covers the stock (Quick Knowledge – 2020E EBIT JPY4 billion) and about in line with Toyo Keizai estimates.  Actual results will be more lumpy depending on the timing of marketing pushes for hit products and effectiveness of advertising spend. However, the Company’s ability to convert new customers to members and successfully commercialize new products all but ensures constant sales growth over the medium term.  As the market seems to be reacting short-term to changes in the near-term growth rate, the valuation could certainly drop more from here as growth normalizes. However, management’s decision to increase the ratio of advertising expense to sales could permanently raise normalized revenue growth going forward, so we may see higher troughs in revenue growth compared to the past.  Furthermore, operating leverage will create more margin over time that could be dedicated to advertising, and I have modelled lowered advertising efficiency than we have seen in the past, so growth could conceivably be higher (with 2024E sales hitting management’s JPY 50 billion target).

Management’s revenue target implies about 1% market share in the Japanese Food and Personal Care e-commerce market by 2024.  The targets do not take into account the potential for international expansion or M&A. A sales office has been opened in Taiwan to tap the Chinese market, which seems to have a healthy appetite for Japanese consumer products when the countries are not fighting about something.  How large can this get in 10-20 years? I think the appropriate answer is who knows… Kao, Japan’s answer to P&G, generates about 200x more sales and is still growing. Perhaps their strategy will broaden over time to reach a mass market, but for now it seems there is plenty of runway for rapid and profitable growth in niche markets, with limited competition.  I’ll stop short of any precise predictions, but I think the business has the potential to compound at 30%+ for the next 5+ years, and the stock should eventually start moving in the same direction.

A few more relevant notes that didn’t find their way into the write-up:

The Company repurchased 700,000 shares for JPY384m in late August.  Their reasoning was that the stock was cheap in the context of future business developments and trends.  The stock had fallen from its high by 50% at that point and has fallen another 30% since. Dividend payout ratio is set at at least 30%, and the CEO prioritizes profitability and quality growth.  I don’t think there is any issue with capital allocation here.

One advantage of being so profitable is that the Company can afford to increase salaries to attract and retain more talented employees.  In 2018, they raised the starting salary for new graduates 36%, which is now the third-highest in Japan. They also increased salaries across the board by an average of 21% in 2017.  This is even more attractive considering that cost of living in Sapporo is about 15% cheaper than Tokyo, with average rents about 50% cheaper.

The shareholder base saw a huge increase in number of shareholders in FY 2018, up to 31,000 from about 9,000 from the year before.  This was because the Company started including a gift of one month’s supply of Kaiteko Oligo along with the normal cash dividend to any shareholder with at least 100 shares.  The cash value of this gift is currently about 7.5% of the value of 100 shares today, so even at the higher prices at the start of 2018, the implied yield was pretty good for Japan.  This phenomenon of retail investors buying stocks for gifts can cause stocks that give gifts to drop more than average after ex-dates. The unusually high number of retail shareholders in the stock, especially for a Japanese small cap could potentially drive extreme moves in one direction or the other.

The CEO has an inspiring story. CEO Interview:

https://bambooinnovator.com/2018/10/20/kitanotatsujin-tse-2930-meister-in-the-north-japans-most-profitable-specialty-ecommerce-platform-h-e-r-o-innovators-insights-from-ceo-katsuhisa-kinoshita-h-e-r-o-heartware-22/

There is English research available. Fisco Report (English):

https://www.kitanotatsujin.com/wp/wp-content/uploads/2018/12/ar20181205.pdf

You can use Google translate to research the various products and user reviews in the product forums.  J North Farm:

https://www.kaitekikobo.jp/

Catalyst

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