A quick note on a high quality SaaS company growing double digits trading at 1.7x NTM Sales and 6.9x EBITDA

Acquisitions in this category abroad have been valued at multiples of this

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Disclaimer: The content on this website is for informational and educational purposes only. Nothing should be considered as investment advice or as a guarantee of profit. Please make sure to do your due diligence. The opinions expressed are those of the author and are subject to change without notice.

Disclosure: The author currently owns shares in the company as of 4 August 2024. The security could be sold at any point in time without prior notice.

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This is another micro-cap idea, sorry if this might be too illiquid for you!

This company was mentioned recently on VIC providing some good detail which I recommend reading. I’ve been following this one since speaking to them earlier this year and also think it’s an interesting name.

I’ll give a quick summary and nuance from my conversation with management including potential risks.

My conclusion remains that the business is cheap – as to when retail investors (who are the only guys that can invest) will realize that… maybe next year?

Long story short this is the typical business that, retail overlooks but I know has strong interest from funds but is currently too small and illiquid. In effect, currently, no investor is there to ‘pass the baton’ to the institutional investors which I think will be valuing this business quite a bit differently. (Microcap Deathtrap).

This seems to have been sold off from a combination of SaaS sell-off; due to a decline in headline earnings from its recent acquisition; and ‘slower’ recent topline.

However, with that being rolled over next year and with conservative assumptions, I think it’s not difficult to get to a 20%+ IRR over the next 5 years.

In a nutshell:

• Low churn biz with 90%+ subscription revenues

• Huge digital tailwind

• Competitively advantaged

• High ROIC (underlying), Profitable, Cash flowing

• Has both double-digit growth + huge margin expansion opportunities

• Founder-led, smart capital allocators

• Trading at 6.9x NTM EBITDA and 1.7x NTM Sales and historic transactions/comps go for way higher - and this is on conservative accounting.

• A potential catalyst is re-accelerating earnings growth next year onwards after one-off costs this year.

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Business Description

CYND ($4256.JP) started in 2011 with their solution Beauty Merit as a reservation management system for beauty salons in Japan. As the pioneer in this vertical, they have scaled to become a full-fledged CRM.

• Mcap: 4.4 billion yen (30mn USD)

• Revenue Growth YoY: +14.7%

• Gross Margin: 75%

• Operating Margin: 8.2%

• EBITDA Margin: 24.5%

Initially starting with hair extension salons they slowly expanded to other types of similar services. Today their TAM is any kind of beauty salon which includes things like hair salons, nail salons, spas and etc. It is estimated that there are 550k businesses in this category in Japan today. Roughly 150k of them use some sort of digital customer acquisition platform. Call it online penetration. This is CYND’s real TAM - which is growing 10-15% a year.

In Japan, we have many customer acquisition platforms acting as a search engine for consumers like Hot Pepper Beauty or Rakuten Beauty (Think of it as foursquare or yelp) and all provide their own reservation capabilities. There are 12 main ones. However, as multi-tenanting for Salons is typical, the issue is that there could be overlaps since these reservations are all on different systems. This is what CYND solves for, by connecting and centralizing the reservations all in one place on beauty merit. Reservations made through other channels as well like Instagram, Line and others are also integrated here. It also processes all payments.

Of the 150k only 12% use a solution like CYND the rest being a greenfield opportunity.

1) the digital penetration is growing 10-15% a year - more salons are starting to list themselves on such acquisition sites.

2) CYND is penetrating more of those which are listing themselves on such sites increasing their current share of 12%.

It’s also worth noting their market leadership, of the top 40 beauty salons by size, CYND is used by 30% of them.

CYND’s platform Beauty Merit has since expanded its functionality to help improve the client relationships for salons becoming a CRM platform—things like accounting, dynamic pricing models, loyalty points management etc. Salons can even develop its own brand ‘mini app’ that customers can book through or integrate booking services through other social media platforms. In other words, they’re becoming more entrenched in the daily operations of its customers. According to CYND it’s customers have seen a 22.3% increase in repeat customers and an 12% increase in average new customers.

This goes without saying in Japan but staff at these shops are generally overstretched, and automating many of these processes can provide significant efficiency gains. Customers have reported an 75% reduction in time spent on reservation and shift management after implementing Beauty Merit.

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Management

At this scale, it’s more important to be comfortable with who’s running the business IMO. I like what I see:

• Management owns 75%+ of the company, young and ambitious. (35 and 38 yo)

• Bootstrapped the business until IPO with just 1 million Yen

• The business was profitable in year 3

• Focused on free cash flow generation > EBITDA

• Capital allocators: preference for debt > equity financing

• So much so they’d be happy to lever up 3-5x Net Debt/EBITDA if necessary and buy back shares

• Strong focus on non-hierarchical, decentralized structure

• Long-term focused: Prefers to keep investing to gain share > post high margins

• Minimal Dilution thus far given co-founders still own >75%. (Thought note that there will be a 7.3% dilution from unvested stock options)

• Conservative in their accounting - No add back of SBC, they don’t capitalize any Sales/R&D despite being a sticky business. Underlying margins therefore should be higher

Their capital allocation is underrated. Whilst investors are complaining they paid a hefty sum to take out their only meaningful competitor Pacific Porter. It’s important to acknowledge they used their richly valued equity capital as currency (valued above the acquisition multiple) and more than half of the acquisition was financed with extremely cheap debt.

• CYND raised equity capital at 12x LTM sales at the peak of the SaaS bubble

• Used that capital to acquire Kanzashi for 8x LTM sales

• More than half of the acquisition was financed by low-cost debt

They’re already at a net cash balance sheet. It’s just been too difficult to buy back shares with the lack of liquidity which is the only problem. (also risks not meeting the listing criteria for the TSE growth).

However, my understanding is that if the opportunity arises they would consider paying out dividends to stoke more retail investor interest at the right moment. (I note this is slightly different from the VIC write-up.) Which makes sense as for now this is the only viable option for capital returns.

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Moat

There’s a good reason to believe they’re not just well entrenched among customers but also have built significant barriers to entry. This is because the customer acquisition platforms have no interest in working with another centralized reservation system - heavily disincentivizing new upstarts to enter the market. Even if one manages by that point CYND would have developed way more functionality. As CYND adds more and more capabilities on its platform to automate the daily operations of its customers this’ll make switching costs higher and higher. As you see below their monthly churn rate has been trending down and they see this trend to continue over time. Main churn is due to salons closing down. Note this is customer churn - and is way below industry churn which is said to be about 10-15% (annual)

So now as the only player that can provide an integrated CRM experience, they’re the only ones that can provide full oversight of the Salon’s customers. This shouldn’t be underestimated as it puts them in a unique position to capitalize on growth in a way only they could do, which is e-commerce.

There’s a unique friction for professional beauty products to be sold online. Firstly professional brands do not want to sell their product through a mass-market retail channel to avoid brand dilution. (Salons also have to agree not to sell products through their Amazon shop for example). Secondly, it is common practice in Japan for the beauty expert whose client buys the product to earn a commission. They are responsible for determining what product is suitable for each client. So an e-commerce channel is only possible if you can tie the client bookings to an employee. This is something now possible thanks to CYND.

Even though this is still in an early stage, CYND has a massive edge in becoming successful with e-commerce for professional beauty care products. Which can increase the TAM and the revenue opportunity significantly.

Some of these professional beauty care companies are listed like Cota (4923) and Milbon (4919).

According to Milbon, the domestic professional haircare market alone is estimated to be 200 billion Yen.

Revenue model for e-commerce for CYND will be a take-rate model so it will be a small % of it but still. These fees will be piled on top of the subscription fees for clients. I got the impression from management that they won’t be raising existing subscription prices for a loooong time. In fact I think their strategy will be focusing more on additional revenue streams rather than simply raising prices.

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Comparing with Temairazu (2477.JP)

This is a close cousin to CYND, it’s a listed company that has been a multi-bagger over the last 10 years. They provide hotel reservation systems in Japan.

Actually, the founders of CYND are both ex-employees there and looks to employ a similar playbook in a different vertical.

In some ways, I think CYND is the better business as it’s applied the learnings of the shortcomings at Temairazu. Nevertheless, this company has been able to expand its operating margin from 6.6% to 73% whilst growing revenues at a 12.8% CAGR over the last 10 years.

To be clear there are some differences to note between the two businesses. Temairazu is a simpler business only focused on reservation management. CYND is a CRM that goes beyond that i.e. way more growth levers. The nature of hotel customers are also different from that of salon customers. Typically Salon customers are more likely to be returning customers than hotels. So the needs in each industry are different. You can also argue salons are more recession-resistant as a result i.e. the end market of salons is more attractive.

Could it reach a 73% operating margin like Temairazu? The unit economics can be different as a result of this divergence and I’m not sure. On the other hand, there is an opportunity for CYND to build out its capability and solve a much more extensive solution so the opportunity to re-invest its capital at attractive returns seems greater.

CYND has already achieved 30% operating margins in the past whilst investing in growth. Management does not see an issue reaching at least 50% in the long term (Remember this biz is doing 8.3% today). I do not think this is an impossibility either given more mature SaaS businesses in Japan are posting operating margins in excess of 50%.

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Valuation

Let’s think for a moment about valuation here. If this was to be acquired how much would it be?

There is precedence abroad for acquisitions of similar businesses and a listed company in Japan I mentioned earlier. The Two acquisitions were by the same PE, which was Vista Equity.

Now, I don’t think CYND would fetch the same multiples as they do because they only operate in Japan, a saturated market and the population is declining. However online penetration among salons is still limited and given tailwinds from this and margin expansion potential, I find the delta between CYND and these transactions too wide.

Comps alone aren’t useful since there’s nuanced differences between each business, but at current 1.9x LTM Sales would it be too difficult to be valued at 4x Sales? That alone is a 100% upside. Assuming a 10-15% revenue CAGR over the next 5 years and the IRR will be well in excess of 20%.

I think they can reasonably compound revenue at 12% a year (potentially higher) which can lead to higher margins in the future. Currently, they’ve given a guidance range for 20-30% EBITDA margins through 03/2027 and a target revenue CAGR of 15%+. So margin expansion is likely to only happen beyond year 3. Though management have made it clear they will continue to re-invest excess cash if they see the opportunity beyond that timeline.

Moreover, their conservatism in accounting means that there is currently no sales and marketing or R&D that’s capitalized, despite being a sticky software business. If you take that into account, it’ll look even cheaper.

So you have a comparatively advantaged, recurring business, earnings grower trading at 10.4x FCF. Does that make sense? I’ll let you decide.

It's actually cheaper if you exclude the one-off office relocation costs which is said to be somewhere between double digit millions and a hundred million JPY. If we assume 75m JPY and adjust for the NTM EV/FCF will be closer to 8.6x.

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Why is it so cheap and what will change?

Several reasons why the stock is down:

• SaaS has been hammered down since 2021 (regardless of profitability)

• Headline earnings growth was negative due to goodwill amortization of Kanzashi + dilution (Group margin from 27.6% to 8.3% YoY and EBIT was -55.1% and Net Profit -55.6%)

• Margin recovery in the core beauty merit business is guided to be muted this year because of office relocation costs.

• Sales growth slow-down which looks even worse after a big bump up during COVID. Not that it isn’t a problem - they’ve had a delay in sales hires, and have had to improve their sales strategy after careful analysis.

What will change:

• Headline earnings growth should start to look much better next fiscal year as one-off costs go away. This would also make ROIC screen better at attracting investors. Office relocation costs are expected to be double digit to a 100m yen this year. Given net income guidance is 40m this year, next year’s net income growth can look pretty explosive.

• Comp base should ease for growth. I’m assuming that if the market here is as large as I understood it, it should provide an opportunity to sustain growth by working through an issue they can internally solve. This requires a belief in management. Adding new revenue streams and the fact that CAC is actually declining slightly should improve the odds.

• As revenue grows should see some operating leverage, there’s a big fixed cost component from goodwill amortization + main cost is personnel.

• Kanzashi has been margin dilutive but CYND has been turning this into a profitable biz, margin improvements here would also lift margins at group lvl.

• An upside opportunity to this is if CYND really proves to be an ‘outsider’ like management team, we may see accretive capital allocation strategies. The fact that Will Thorndike’s fund is invested could mean there could be some strategic engagement here. (As a matter of fact, I have never seen a Japanese company come out with a press specifically announcing a specific fund on their cap table.)

• It’s too early to tell but another wildcard would be if the management proves to be conservative in their guidance. They’ve been able to turn Pacific Porter/Kanzashi profitable since acquiring it and this could continue to improve.

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Risks

• Execution risk of the business i.e. scaling the business successfully. They have made errors in the past for their sales team. → This would likely be my biggest reason to sell - if I see a meaningful deceleration in the next 12-18 months.

• Post-merger integration of Pacific Porter/Kanzashi might be more costly than initially anticipated.

• The company has a risk of being delisted → Currently they meet all criteria except the fact that the float is slightly shy of 25% at the moment. It is likely that management will look to sell some of their holdings to meet that but currently its been very difficult given it is so illiquid.

• Market consolidation of the customer acquisition platforms - thereby bringing down the barriers to entry.

Disclaimer: The content on this website is for informational and educational purposes only. Nothing should be considered as investment advice or as a guarantee of profit. Please make sure to do your due diligence. The opinions expressed are those of the author and are subject to change without notice.

Disclosure: The author currently owns shares in the company as of 4 August 2024. The security could be sold at any point in time without prior notice.

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