Katitas – flipping attractive
8919:TYO, $1.0bn MC, $5.1m ADVT
Katitas is a house-flipper. It buys second-hand houses, refurbishes them, and sells them on to first-time buyers.
In the US or the UK, this would be a commoditised and competitive model (as Zillow, Redfin and Opendoor hilariously discovered to their cost).
In regional Japan, where Katitas operates, the business is innovative and pro-social, and has sustained double-digit growth for a decade. Katitas is by far the biggest in its industry, with surprising barriers to entry that shut out would-be imitators. Katitas’ competitive advantages support strong returns on invested capital of above 20% .
A recent consumption tax dispute and a property market slowdown have hit Katitas’ profits and injected uncertainty, derating the stock heavily. At the same time, the market has rotated away from Japanese small caps in favour of Nikkei 225 mega names. The result is an attractive entry point into a growth company with a long runway ahead.
Background
Katitas has excellent English-language materials on its investor website. Westerner-friendly profiles in the FT (July 2015) and Bloomberg News (June 2019) give further context.
The company started in 1978 as Yasuragi. The used home purchasing activity began in 1998. Current President and CEO Katsutoshi Arai joined in 2012, and pivoted to buying empty homes directly from owners, rather than in court auctions. Arai changed the company name to Katitas in 2013, and in 2016 he oversaw the acquisition of closest peer REPRICE, which purchases, remodels and resells higher-priced houses in metropolitan areas. In 2017 the private equity owner Advantage Partners sold a 34% stake to Nitori, Japan’s biggest furniture retailer. Katitas was floated on the stock market in December 2017. I visited the company at its Tokyo headquarters in September 2022 and met with Arai-san. I had a strongly positive impression of the business model and the capability of management, though the stock was too expensive to buy at that time.
Country context
Japan’s population is 126 million, of which 37 million live in the Kanto area of greater Tokyo. Away from Tokyo, housing for the other 90 million is inexpensive in the context of regional Japan’s aging and shrinking population.
The key and unique characteristic of Japan’s housing market is that:
“newly-built homes lose value quickly and are rarely used longer than 20 to 25 years before being demolished” [source].
Further,
“Because everyone expects new residences to lose value so rapidly (due to the lack of a secondhand market, among other reasons), for many years developers have had little incentive to build houses that would retain quality in the long term”.
The market for used homes in Japan suffers from Akerlof’s Lemons dynamic. Nobody buys a used home because you can’t trust the quality. The chart below shows that just 15% of housing sales in Japan were for pre-owned houses, compared to over 80% in the US and UK.
In towns across regional Japan, the lack of a market for used homes results in a growing problem of empty houses that blight neighbourhoods.
Business model
Katitas sets out to solve this problem with boots on the ground. Its 600 sales staff are based in 146 branch offices dotted around the country. With great discernment, they select only the most structurally sound used homes for purchase, checking for solid foundations, no roof leaks and no termite damage. Using a proprietary network of contractor partners, Katitas refurbishes the purchased properties to a consistently high standard, including new kitchens, bathrooms and floorplan changes as needed. Katitas then remarkets and sells the attractive and hygienic finished houses with a two-year warranty against defects.
Buyers place their trust in Katitas’ good reputation, and are able to buy a high quality house at a much cheaper price than for a newbuild. Typical customers have a relatively low annual income of Y2m - Y5m ($13k - $33k) and are living in the rented sector prior to their Katitas house purchase. The average Katitas house price of Y16m ($105k) is financed by a mortgage with an affordable monthly payment of Y45k ($300), which is 10% lower than the average regional rental payment, according to Japanese government data shared by Katitas. (See slide below.)
Katitas is by far the biggest player in the house reselling industry, especially in the niche of single-family detached houses. The chart below shows that Katitas and its subsidiary REPRICE sold 16x as many houses as the nearest competitor in this category. (Reselling condo units is more competitive by contrast, due to the lower risks and lower barriers to entry. Condos are built with a longer lifespan, the units are more fungible and buying a used condo unit is more familiar / less scary to the average customer than buying a used house.)
Katitas has grown sales by 12% per year on average over the last six years from FY16 to FY23. This growth has been organic and self-funded from cash flow.
In the earlier period from FY13 to FY16, the topline was flat as new CEO Arai lifted the profit margin from 4% to 10%, in part by transitioning the sourcing from auctions to direct purchase.
A rapid inventory turnover is crucial for capital efficiency. Katitas has sustained a brisk six month average period from purchase to sale completion, which is reflected in the 2x inventory turnover ratio. Note that this average includes some low-priced and light-renovation projects concluded within three or four months, as well as a (hopefully small) number of slow-moving houses that stay on the books for much longer than six months.
The double digit profit margin and 2x inventory turn have supported a ROIC north of 20% for Katitas, in a model with minimal capital expenditure or other capital requirements.
The total number of properties sold per year has risen from 4,402 in FY17 to 6,927 in FY23. Katitas’ average selling price has risen by around 3% per year.
Katitas’s higher prices would not be good news if they reduce affordability. We need to compare the prices to changes in household incomes and the competing selling prices of the newbuild house builders. Nominal wage growth was at least positive in 2022 and 2023, if only by 1% to 2% per year. My chart below shows that Iida and Open House, two big housebuilders, have also increased their average selling prices in recent years. Katitas’ prices are lower than Iida, which sells in suburban areas. Open House is focused on the Tokyo metropolitan area which explains its far higher prices.
Katitas wants to keep increasing the number of houses bought and sold each year, beyond the 7,000 units sold in FY23. How big is the total addressable market?
The slide below identifies 3.61m households matching Katitas’s target customer profile in terms of regional location, annual income and currently living in rental housing. It conservatively assumes only a third of these households have the intention to buy a house, and only 10% of those would transact in any given year, resulting in a TAM estimate of 124,000 houses per year. This implies lots of headroom for growth in terms of potential buyers.
Meanwhile there is no bottleneck on the supply side, given rising numbers of deaths which trigger more empty houses each year. (The majority of houses Katitas purchases are empty, typically due to inheritance.)
Rather, the limiting factor in any given year is the number of sales staff that Katitas can recruit and retain, and their productivity in terms of number of projects each staff can complete per year to necessary quality and profit standards, which currently averages about ten.
Consumption tax dispute
Katitas has been subject to a tax inspection since August 2019. At the heart of the dispute is the fact that land transactions are exempt from the 10% consumption tax, whereas buildings are subject to the tax. The total sale price therefore has to be apportioned between land and building in order to calculate the consumption tax due. Katitas’ calculation method results in a lower consumption tax figure than the method advocated by the tax authorities – see illustration below.
To date, following defeat in an initial lawsuit in May 2023, Katitas has been forced to record extraordinary net losses of Y1.5bn in FY20, Y1.7bn in FY22 and Y3.4bn in FY23 in the form of reassessment penalties covering all historical periods. To give a sense of scale, cumulative net profit was Y36.0bn in the six years as a public company after these extraordinary losses, and would have been Y42.6bn otherwise, so the tax penalties have amounted to a 15% hit. This is painful, but not a dealbreaker: profitability and ROIC still look attractive even at the lower level.
Katitas is appealing to the High Court, with a decision due by the middle of 2024. A possible further appeal to the Supreme Court might take another year, so final resolution might not arrive until 2025. Pending the appeal, and starting from the current fiscal year ending March 2024, Katitas began accruing the extra consumption taxes as per the unfavorable calculation method in its statutory accounts, with a negative impact of c.Y2.2bn / 15% per year on operating profit. This means that even assuming Katitas loses its appeal, it will not incur any further negative impact or extraordinary losses. However, alongside the statutory numbers, Katitas is continuing to present higher adjusted profit figures that reflect its preferred tax calculation.
The bottom line is that the tax dispute has a permanent 15% impact on profits if Katitas lose their appeal. The uncertainty around the dispute has likely hit the stock by more than 15%, in my view, leaving the stock more attractive than before.
Other risk factors
Mortgages. Katitas depends on stable conditions in Japan’s housing and mortgage finance markets in order to keep finding buyers for its refurbished properties promptly and at favorable prices. The Bank of Japan has not yet hiked rates, but is widely expected to end negative rates in April. Mortgage rates for house buyers are currently still expected to remain low, but any big positive surprises to inflation and rates could change that.
Personnel. Sustained double-digit growth requires continued great execution by Katitas. In particular, to deliver both unit growth and profitability, Katitas relies on skilled and diligent sales managers and staff in all of the 146 branch offices. With an 11% annual turnover rate, Katitas needs to keep on recruiting and training new staff who are at least as good as those they replace. Katitas is thoughtful about performance management and incentives. The policy is for the same individual to be responsible for purchase, refurbishment and sale of a given property, in order to increase accountability and allow for transparent measurement of value added by each sales staff. Katitas aims to promote sales staff to branch managers within 3-4 years where suitable.
Profitability and introduction of low-priced product offering
Gross margin has been a key driver of Katitas’ earnings and stock. My chart below shows the quarterly trajectory. From March 2020 to September 2021 the gross margin rose by 300bp. The stock peaked in December 2021, two weeks after Katitas reported its record quarterly gross margin.
The gross margin then fell by 400bp for two years. It bottomed in June 2023, and has recovered in the last two quarters.
The key determinant of gross margin is the renovation cost, which is a higher proportion of total cost than the purchase price. (Katitas is able to buy the empty houses very cheaply.) Inflation in Japan picked up from late 2021, especially in categories related to renovation. This unexpected inflation was a key driver of Katitas’ falling gross margins.
As for the operating margin, this fell to a new quarterly low in June 2023, due to the accrual of additional consumption tax on top of the lower gross margin. The company has implemented countermeasures to restore its profit margin, including price hikes, a revised incentive system for sales staff, and a new low-priced product offering.
The new low-price concept, introduced only within the last 6-9 months, seems to be a major addition to the model. In CEO Arai’s words, the new concept is: “reducing remodeling a little while keeping the products in a price range that customers can afford”. Katitas applies the same careful selection and thorough checks (termites, sound roof etc) at the point of purchasing the property. The new idea is to immediately list it for sale at an affordable price on a nearly as-is basis, without significant remodeling. Absolute gross profit per house is said to be the same, and the percentage gross margin, project completion time and amount of labour involved would all be better, so the new offering is potentially transformative. After four weeks, if the house does not sell at the low price, then it undergoes full remodeling for sale at a higher price as usual.
Low-priced houses already reached 20% of total Katitas sales by Q3. At best, the new low-price offering can expand the total addressable market. However, obvious potential risks include confusion around what the Katitas brand stands for, customer complaints about houses that have not been fully remodeled, and an even lower income customer type that struggles to obtain a mortgage.
The new low-price offering is the main talk of the most recent conference call transcripts, provided on the IR website in English. I’ll be monitoring the development of this strategy closely.
The new measures began to have a visible impact on profitability in the second and third quarters, as can be seen in the chart below.
Most recently, Katitas has warned of a divergence between the mainstay Katitas brand business, which is developing strongly, and REPRICE which is suffering from sharp price cuts made by the competing powerbuilders in response to a deterioration in the housing market. In the call on February 7 2024, the company guided that the full-year OP forecast (for the year to March 2024) would likely be missed by around 10% due to REPRICE’s woes, including a tough fourth quarter in the works as REPRICE is forced to cut prices to clear slow-moving inventory. Sellside estimates were cut by a similar amount.
Frankly, REPRICE has never performed to the same high level as the main Katitas business. Its track record is both lumpier and less profitable on average. It is more exposed to competitor actions and macro fluctuations. REPRICE contributes c.30% of total revenue and c.20-25% of total profits, so its lower quality is a blight on the overall investment case, if not a fatal one.
Forecasts and valuation
I show my forecasts below. FY24E is the trough year, with a weak final quarter currently in progress. I expect a 14% earnings CAGR from FY24-28E, driven by 8% annual unit growth and a degree of margin recovery. My EPS estimates sit inside the low end of the range of consensus for each of the first three forecast years.
Forecast uncertainty is somewhat high, given the need for inflection after the current expected weak quarter. In the mid-term there is scope for upside surprise from unit volumes and/or margins (as well as in the event of a surprise tax victory in court). Clearly any deeper-than-expected margin disappointment to the downside, whether from REPRICE or the core Katitas brand, would be poorly received.
Overall, I consider the stock to be attractively valued at 14.6x Mar’26E P/E, given my high assessment of the underlying quality. I am accumulating a position gradually, as I may be a little early.
The stock now trades at a historically low forward multiple, as my chart below shows.
While Katitas’ self-inflicted earnings disappointments explain much of the stock weakness, there has also been a sharp divergence between the biggest Japanese names (represented by the Nikkei 225 index) and small caps in Japan (represented by the iShares MSCI Japan Small-Cap ETF). My chart below shows a big gap opening up in the last two years, which widened further since the start of 2024. Earnings trends are not so different between Japanese large caps and small caps, so I would expect some mean reversion in the performance gap within my investment time horizon.
