Few things can probably be more boring than selling aptitude tests in Japan. This is exactly what the business at SHL-Japan (TSE:4327, Financial) is mainly about.
What is exciting for an investor is the steady increase in both sales and operating income every year for the past decade (see below).
At the same time, the currently $120 million market-cap Japanese micro-cap managed to keep capital expenditure low (less than 3% of yearly revenue), cash generation strong (above 20% free cash flow margins) and returns stably super-normal (between 16% and 21% on equity, with no debt).
With a total staff of approximately 100 employees, SHL-Japan is a licensee of the UK-based SHL Group; it develops and sells the Japanese version of SHL tests to corporations in Japan. The SHL Group is the world’s largest assessment service provider, covering more than 110 countries and 30 languages. The value of these tests lies in measuring job applicants’ personal and intellectual qualities so as to improve the long-term performance of human resources (and hence the productivity of the businesses). The SHL tests are heavily used throughout the recruitment process, and can also be seen in other areas, including internal promotion and placement.
As of fiscal 2019, the business generated 62.8% of its revenue from products (i.e., the aptitude tests), 34.2% from consulting services (which involve customization and analytics) and 3% from training (mostly on-site seminars for managers).
SHL’s test differentiates themselves through their high quality with respect to reliability and the relevance of the test results. While the quality itself can often be a competitive advantage for a product in the short term, the reputation for quality should ensure the sustainability of such an edge in the long run when it comes to the aptitude test market. It would be quite a challenge for newcomers to threaten the leading positions of widely-used test products. Think about the GMAT, GRE and SAT tests in the U.S. education space. In Japan, SHL-Japan and its primary competitor, Recruit Career (a subsidiary of Recruit Holdings (TSE:6098, Financial)), provide test products that dominate the new graduate recruitment niche and have become “the standard” among Japanese companies. Some universities even offer seminars and mock sessions for graduating students to practice and prepare for these tests.
With a reputation-based moat in place at SHL-Japan, investors should not be surprised to see the almost flat-line gross margin and operating margin of the business over the past decade (see below). In the meantime, the company always earned an annual return of above 75% on invested capital.
According to the latest filing, the company targets a dividend payout of around 50%, meaning that nearly half of the annual earnings are retained and reinvested to fuel growth. The management appears to emphasize technology development in terms of capital allocation. The web-based products have been the most significant growth contributor, representing 75% of total sales now (up from 46% in fiscal 2007). Given the operational efficiency provided for the clients, the percentage may go even higher, which would contribute to the margin improvement at SHL-Japan.
At the top line, the market penetration is expected to continue at SHL-Japan. The management thinks a total market share of 50% in the new graduate recruitment space is possible, compared to the current 30% share. The company more than doubled its customer base over the past decade. It aims at a 10% annual increase, leveraging both its own expanding sales forces and third-party channels like Mynavi, which has a 29.3% stake in the company.
The management also cites the chronic labor shortage, aging population and shortening hiring screening period as favorable trends for the business.
Our risk perception of the business at SHL-Japan includes the potential increase in royalty charges as well as the deteriorating job market. In response to the latter, the management stated the following in its IR materials:
“The current stringent situation in which corporate customers are reducing the number of new graduates means relatively larger populations for screening. In other words, the corporate need for “more adequate human resources,” that is, “competent employees who can demonstrate good results soon after joining the company and show an aptitude for the intended job assignments,” has intensified, thereby requiring more appropriate screening tools.”
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We do not own any security mentioned in the article.
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