Newsletters

Our investment in NS Solutions, a leading IT service company, was the second largest detractor, with a -2% share price decline taking 41bps from performance. Towards the end of the month, NS Solutions reported results which were broadly in line with expectations, with a +3% increase in orders and +13% operating profit growth. Encouragingly, the Company began selling its stake in Recruit Holdings, something we have consistently suggested to management. Trading on an EV/EBIT multiple of 5.9x, one of the lowest in the industry, we are happy holders benefitting from the structural growth in IT services.

NS Solutions was a modest contributor to returns adding 23bps with a +6.0% share price increase. NS Solutions is a subsidiary of Nippon Steel and we have been engaging with management on ways to address the undervaluation and issues that arise from the listed parent/subsidiary structure. We have been sending management detailed presentations on a variety of issues and submitted shareholder proposals last year calling for stock-based compensation, a higher dividend and a share buyback. Although NS Solutions subsequently introduced stock-based compensation, there has been a lack of effort on other areas. NS Solutions is a fantastic company with an exciting growth outlook, and we plan to continue engaging to rectify the undervaluation.

NS Solutions was the largest detractor, with a -10% share price return taking 55bp from performance. Although its quarterly results were lacklustre, they were far from disastrous, with sales and profits growing 5% and 10% YoY, and would be higher than pre-COVID were it not for an especially difficult comparison period. Despite NS Solutions being a leader in digital IT solutions and well placed to benefit from increasing IT expenditure in Japan, its valuation has languished, hampered by an overcapitalised balance sheet and unambitious management team. Given its weak share price and growing profits, NS Solutions’ EV/EBIT multiple fell from 8.6x to 7.0x over the quarter, making it one of the cheapest IT systems integrators in Japan. Last June we submitted shareholder proposals to NS Solution’s AGM seeking a higher dividend, a share buyback and stock compensation. Since then, we have been engaging with both NS Solutions and its parent company, Nippon Steel, and intend to continue doing so ahead of next year’s AGM. NS Solutions’ valuation is remarkable for a company of its size (£2bn) and with strong growth prospects, we are happy to add to our position and increase its weight from the current

NS Solutions was the largest detractor with a share price decline of -9.9% detracting 30bps from performance. The company announced quarterly results that saw sales and profits grow +5% and +10% YoY, although profits remain -7% below pre-COVID levels. We think NS Solutions’ recovery is a matter of when not if, and the company has a huge tailwind from digitalisation demand, most notably from its parent company Nippon Steel. Following our shareholder proposals at NS Solutions’ June 2021 AGM, we have continued to engage with management privately to address a variety of issues including valuation, balance sheet efficiency, employee wellbeing, gender diversity and remuneration. NS Solutions’ 7.2x EV/EBIT valuation stands out as anomalous when compared to peers which trade on 17.0x. We attribute the discount to rectifiable issues rather than business fundamentals and have seen early signs from both NS Solutions and Nippon Steel management that they are open to actioning our proposals.

The second, NS Solutions, opposed our three shareholder proposals seeking a higher dividend, a share buyback, and the introduction of stock-based compensation for management. While we had hoped to reach an agreement on these issues, there was some movement from management as they had already adopted two of our suggestions (adopting an audit committee board structure and publishing mid-term targets for the first time in their history). NS Solutions is a conservative company, and we expect it will take a little more time to come round to our other suggestions.

Pulling Japan’s IT into the 21st century
Japan’s IT systems are outdated, inefficient and in much need of improvement. For example, virtually every government office and company in Japan has a fax machine which relates to Japan’s reliance on the archaic practice of hanko stamps – a stamp required for over 11,000 procedures to sign off documents. During the coronavirus pandemic workers would have to go into the office just to stamp paper documents before either mailing or faxing them – a totally useless task.

High profile events over the quarter, including the Toshiba AGM voting scandal and the TSE shutdown, brought the need for digitalisation to the front of investors’ minds. Toshiba’s voting scandal saw shareholder votes cast at this year’s highly contentious AGM invalidated. The voting system is heavily reliant on counting postal votes, and although they arrived before the deadline the paper votes could not be counted in time. Then, on 1st October, the TSE’s main system failed and the switch to the back-up system malfunctioned, halting trading for the full day – the worst outage since the exchange shifted to an electronic system in 1999.

Suga has placed digitalising Japan’s economy at the centre of his administration. He is legislating for a new digital agency, created a ministerial post for ‘digital transformation’ and appointed a veteran cabinet minister, Taro Kono, to the role of ‘administrative and regulatory reform’. Mr Kono created a system for people to report excessive bureaucracy and within a few hours had received 3,000 emails before he had to suspend the service after being overwhelmed.

For our three IT service providers, this is good for business. AJOT has invested just over 11% of its NAV in DTS Corp, NS Solutions and Kanematsu Electronics (KEL) – all beneficiaries of rising demand for digitalisation. Compared to the US, Japanese companies rely more heavily on the services of third-party IT providers (65% vs 28%). As we approach 2025, a year that METI (Ministry of Economy, Trade and Industry) has coined the digital cliff, Japanese companies will need to increasingly utilise their services.

Our IT service providers are exposed to the same underlying growth trends of the market, yet, for reasons unrelated to their fundamental outlook, trade at steep discounts. DTS, NS Solutions and KEL trade on EV/EBITs of 6.2x, 8.1x and 7.4x, compared to a sector average of 12.9x.

All three companies suffer from inefficient balance sheets, poor shareholder communications, and weak corporate governance. Furthermore, NS Solutions’ & KEL’s valuations suffer from being part of a parent/child ownership structure, which creates a lack of incentive for management and poor protection for minority shareholders.
We are engaging with management to address these issues and we believe if they can be improved in line with our suggestions and the valuation normalises, we could see upsides in the order of 50-100%.

Two recent investments, DTS and NS Solutions, are good examples where we took the opportunity to add to our positions following weaker than anticipated Q1 results. Operating profits fell -22% and -26% respectively, as customers delayed IT investment and existing projects were disrupted by social restrictions. However, we do not believe that the short-term results reflect a change in the appealing long-term prospects for IT service providers.

In 2018 the Ministry of Economy, Trade and Industry (“METI”) warned companies that unless they take action to rectify years of underinvestment in IT systems by 2025, Japan could suffer an economic loss of ¥12 trillion per year, equivalent to 2% of GDP. Currently, 20% of mission critical systems are more than 20 years old (increasing to 60% by 2025) and, as an example of the digital transformation opportunity, an estimated 19% of companies use cloud-based accounting software in Japan compared to 53% and 35% in the USA and UK.

DTS and NS Solutions are well placed to capitalise on the increasing importance of IT investment. Both companies have achieved annualised five-year operating profit growth of more than 10% (12% and 11% respectively) and while we don’t anticipate profit growth to be as strong over the next five years, high-single digit annualised growth should be possible.

Despite the appealing industry dynamics DTS and NS Solutions trade on lowly EV/EBITs of 5.5x and 6.4x. Both companies suffer from inefficient balance sheets, poor shareholder communications, and weak corporate governance. DTS is overlooked by many investors on account of its small size and low level of sell side coverage, and NS Solutions from its parent/child ownership structure with Nippon Steel. These problems are surmountable, and in NS Solutions’ case the parent/child relationship presents an opportunity.

We have been building our investment in DTS and NS Solutions since January and March, and they are now key positions in the portfolio with weights of 4.7% and 4.3%.

Despite the attractive sector backdrop, we were able to identify two IT service companies, DTS and NS Solutions, trading on anomalous valuations of just 6x EV/EBIT with over 40% of their market caps covered by net cash and listed investments. These two companies accounted for 6% of NAV at the end of May.