Ichigo Inc

TSE:2337

Earnings Call Transcript 2019-Q1

[Scott Callon, executive]

Hi, everybody. This is Scott Callon. Thank you so much for joining. I'm joined, as usual, by Dan Morisaku in our Finance Department, who never seems to get to say anything. So let's see if he continues that today.

I'll be working off of the fiscal year '19/2 Q1 corporate presentation that's on our website. And again, thank you very much, everybody, for your time today.

Before I go into the presentation itself, as you know, there has been an incredibly tragic natural disaster in Western Japan, and we do express our deepest condolences to all those who've been affected. It's been the largest series of rainfall and damage that Japan has experienced in several decades.

Let me turn to this -- the quarter's results. I'll start with the summary on Page 6. Look, we think it's our job and, of course, to deliver to all of you a durable earnings model. And by that, we mean that we have substantial security in the profitability of the firm we run. So our stock earnings, sort of the contractual earnings based on asset management contracts, based on rental contracts, are substantially above our fixed expenses. They're actually running 233% above them. And that will persist, and we'll continue to grow that into the future.

On the right side of the page, you can see that the stock earnings growth is happening across the board overwhelmingly and with the big gains in Value-Add and in the Clean Energy business, but all 3 of our businesses are growing.

At the bottom of the page, you can see that we continue to generate high margins on our sales with a gross profit margin in the first quarter of 33%. We are being selective in acquisitions. It's a very strong operating environment. We think we're very well positioned for it. We think there is a lot of very exciting growth in front of us. We also think, along with all those things, simultaneously, we should be cautious in where we buy. And as you know, the overwhelmingly single, dominant and most important criterion for us is can we add value and can we buy an asset at a good price in a place that we can add substantial value.

And so we have been able to buy assets that we think offer substantial upside to our shareholders. And to be clear, that shareholder value comes by creating real economic and societal value by taking assets that are poorly positioned or poorly run or poorly CapEx-ed and bringing them to the quality standards of the 21st century.

In the first quarter itself, we acquired, and this is what we show up in our financial statements, about JPY 7 billion, so at JPY 100 to $1, USD 70 million. We actually contracted for another JPY 20 billion more. So those transactions will close over the next 2 quarters. And so all in, there's about -- there's JPY 27 billion of acquisitions that are done or to be completed.

As you know, we established a new business last year, Ichigo Owners, which serves individuals who want real estate ownership. Historically, we provided real estate services within -- to external parties within our 2 REITs in our YOKO, which is actually -- for YOKO but within Ichigo office, within Ichigo Hotel REITs. This is a business where we acquire assets. And on behalf of real estate owners, sometimes, we sell and just only sell. "Thank you very much, Ichigo. You found a good asset. You added some value to it. We'll take it from you here." In other cases, we have an ongoing asset management relationship with it.

I can tell you, though, that the market is very well bid for real estate assets. And so the idea that we can just pass something through, we'd buy it at X, we sell it for 1.1X is not really possible because X is a high number. And so we need to be buying things and are buying things where it will be a fast value-add process, where we actually are adding value to the assets before we deliver them to end clients. And that's something we're fully capable of doing and we are doing.

But the key difference with Owners, Ichigo Owners, its business model. It's a high-turnover model. We do -- we tend to buy better assets in really good locations. You can see 95% of Ichigo Owners assets we bought at the time are in Central Tokyo. We do a lighter amount of value-add, then we do underwrite to an end client.

Page 7 shows the financial outcomes of Q1: OP, up 90%; net income, up 59%. We did 2 buybacks last year, so there's a little bit of an EPS effect, so we have EPS coming in at plus 60%. Earnings are up across the board, and we're on track to record earnings for the year.

Turning to Page 8. You can see the breakdown, the segment earnings. The one that's down, Asset Management is down 10%. That's on performance fees that we recorded last year and we didn't record -- we're not recording -- certainly didn't record in the first quarter. But the ongoing AM fees are actually up 9% year-on-year. Significant growth, doubled in our earnings in the Value-Add business, year-on-year on both growth in rental income and gains on value-add sales. You can see most of the growth is coming out of the value-add sales activity. It is a wonderful time to be a seller of real estate assets. And then very substantial growth in the Clean Energy business. That's primarily on the coming online of the Ichigo Showamura solar power plant last fall.

Turning to the business model, and I'll go through -- quickly through this, and then we'll -- this is something -- we think it's important to describe what we do and the drivers of our return. So you've seen these charts before. They've been updated for Page 10 and then for the first quarter. It is a business with both stock earnings that are substantially above our fixed expenses and flow earnings, and the flow earnings are primarily profits on value-add real estate sales.

Page 11 shows the appraisal value based on realized gains. I'll turn to -- and the next page is why we think those are extraordinarily conservative. But it is a feature of our business that we affect embedded forward earnings. The gains we realize from our Value-Add activity are recognized on an accounting basis only when we sell an asset. But when we have clearly improved an asset and its NOI is up 20%, 30%, 40%, it is more valuable. And so there is a growing stock. It's kind of a future earnings bank that we build. And look, I mean, if we thought the time was right to sell everything, we could sell everything. There is an ongoing value activity in everything that we do. And we earn good rental income, and the BOJ continues to hoover up JDBs, and there's a shortage of yield assets in the economy. So we have both. We have time on our side in terms of the ongoing rental income contribution from owning assets. We have time on our side from our ongoing value add activity, which continues to improve assets. And we, in fact, have time on our side with the BOJ continuing to pull assets out of their system, driving, therefore, real estate prices up as a substitute yield asset within the Japanese economy.

Page 12 is -- gives you the difference between -- so the previous page, we showed you the unrealized gains, and Page 12 shows you what we actually realized. So in the fiscal year '16/2, we generated 2.2x what the implied kind of unrealized gains were from the appraisal value. And in fiscal year '17/2, that was 1.6x. And the year that has closed in February 2018, it was 4.4x. And the first quarter, we're at 2x. So you average that out, in general, we're getting more than -- not just in general. We are generating 2.5x what the implied appraisal value tells you on the unrealized gains of our book. And we think that is actually a pretty accurate measure of the value creation that has occurred, that is still to be realized.

Page 13 shows our -- the part of our capital structure that's debt. Actually, for the first time here, we're showing not only how long we borrow for but the average remaining loan maturity. We borrow for an average of about 10 years at this point. The average maturity is about 8 years. You can see we continue to have a drop in the level we finance. Not only it's a great time to be a real estate seller in Japan, it's actually a great time to be a borrower. And our credit -- kind of our credit worthiness continues to grow. We continue to borrow at better terms and conditions, not only on the interest rate but broadly across kind of how long we can borrow, the degree of collateralization, et cetera.

Let me turn to Page 15 to touch on both kind of growth in our core business and in new initiatives. The Value-Add business is doing enormously well, and we expect to -- and we're en route to generate what we expect to be at least 24%-plus year-on-year on our stock earnings, meaning the kind of the more fixed earnings and another 19% on the Value-Add -- on the flow earnings. We are being selective on asset acquisitions. You can see on the right hand of the page, we've actually sold slightly more on a fully kind of not just contracted but settled base in the first quarter.

And on the acquisition side, you can see that the -- we're doing -- there's actually more to come. You'll see more hotels and retail coming into the portfolio. That reflects 2 things. Primarily reflects our ability to add value. Those are more complicated assets and, therefore, harder to run well. So we have an ability to manage them more effectively than most market participants.

In the case of hotels, the second issue is there was -- we saw a mispricing of hotel assets based on kind of a not fully realized expectation of what the government's attitude was going to be on minpaku, on Airbnb. And we saw that there had been overdiscounting of the hotel asset class with the surge in inbound and with regulation appearing in June of this year that we felt was actually going to choke down supply of minpaku/Airbnb offers, and that has occurred, which is to say the hotel earnings are going very well. We do expect to do a substantial number of sales of our hotels also in a context where we think we bought them at a good price for our shareholders. And now that people have seen what the minpaku regulation is looking like and the supply impact of that, we're able to sell at a price that reflects the otherwise positive ongoing forward economics.

Page 16 is a Value-Add case. Look, we try to -- we want people to know how we add value. And so we -- on a regular basis, we show you cases. Okay, this is -- here's an asset. This is what we did. And so this is a -- this is Machida, which is a Tokyo -- it's outside of Central Tokyo. It's on the Chuo Line. There was an asset that was kind of bars and offices and kind of all over the block. We looked at it and realized that it can be focused on beauty-centered retail. We made it a much nicer -- we put CapEx in it to make it aesthetically far more pleasing. It had some legal, building code issues. We fixed them. As part of the re-tenanting, of course, the whole view on, hey, this could really work, there's demand in the area for beauty-centered retail was a realization that we could -- that tenants would be willing to pay for that because there's a strong business case that we made for it. So we brought in the tenants.

We do everything we can to try to drive greater value and higher efficiency from the assets we own. So we converted non-revenue-generating common areas into actual space that tenants could have for themselves. We converted unused area to revenue-generating parking.

And the final thing -- and we do this very systematically. You can actually improve quality standards while decreasing cost. It is important to us that we do both. And actually, if we choose between reducing costs and improving quality, we always go for improving quality. But in this case, economies of scale, we have. And if I can put it this way, the professionalism we bring to how to run assets allows us to do both.

Page 17 shows what's happening in Clean Energy. We've taken the Ichigo Green off the page, and we note that there are another 29 megawatts of Ichigo Green assets we manage but that are not on our balance sheet. So the bar graphs show just what we own ourselves. The 82 megawatts, currently under operation. We've got another 66 megawatts that are in development, meaning these have fixed FIT contracts in place. We understand what the economics are going to be. That implies 81% growth off of the existing asset base. There is a pipeline behind this, so this is just everything that's fixed and going to happen. And so as [ data ] says, we're scaling rapidly in Clean Energy. We think there is a very big ongoing opportunity for us in that space.

Page 18 turns to -- and 19 turn to some new initiatives. Quite honestly, we have so many new initiatives. It's a little bit hard to know which ones we should put on the page, meaning there's a significant commitment being reflected in the hiring, including the technology space, for us to develop new businesses that are lighter asset -- non-asset. So a lot of things going on.

But we chose to point you to 2 things that are happening pretty soon. So on Page 18, we're opening our second THE KNOT hotel. We opened the THE KNOT YOKOHAMA in December. THE KNOT TOKYO in Shinjuku is opening on August 8. It is a major, major rework. We put out a release on it yesterday or 2 days ago. We've effectively completely transformed the 40-year-old structure, leaving only the core, did new seismic retrofit, improved everything, the energy-efficient air-conditioning, the waterworks. And so it opens out onto Shinjuku Central Park.

What's interesting to us is that the initial thought was that this was going to primarily be serving Japanese travelers. It's actually getting a huge response from North American, primarily U.S., in terms of what the reservation queue looks like, which is actually not surprising. What's important about THE KNOT offer is that the boutique hotel class doesn't really exist in Japan. And so you have this yawning gap between budget hotels and luxury hotels, and we think this is exactly -- I mean, this is a very big need. So you can take -- so the luxury hotels are charging $300 to $500 a night. The budget hotels are charging kind of $60 to $90 a night. At a boutique hotel, we can charge $115. The economics are really powerful, and it's a much better experience for the hotel guests.

So the second opening of THE KNOT is on August 8. We have plans in place to open up a KNOT in, wait a minute, Hiroshima; Hakata, which is in Fukuoka; and the third one is, I think, Sapporo. So we are en route doing work. At the end of the day, this could very well become a brand business, as I said. At this point, these are our hotels, but THE KNOT could become something that we do licensing for, and it becomes a non-asset business with extremely high returns.

And by the way, I mean, I would point out, the returns running with our own hotel are very high also. But effectively, when it becomes a licensing business, there are reasons from it, and we're very happy with that.

The second thing on Page 19 in terms of new initiative is we are getting close to the launch of our hotel AI system. We will be directing it at our -- primarily at our own assets this -- through this fiscal year. And then we actually expect to turn towards selling it externally sometime next year. That's, of course, dependent upon -- yes, we've done a bunch of work on this, so we're confident it's going to work well. But we -- it is dependent upon it proceeding as planned. And this will be another example of us building out kind of a real estate technology set, putting our -- we could use it ourselves, and the concept is very much kind of an Amazon/AWS concept. But we could use this hotel system ourselves. But the ability to deliver it to all hotel operators across Japan and be able to use their data will make the system more successful. So we think this is a really exciting potential driver, again, of very high returns for our shareholders.

Those are my prepared remarks, and I'm happy to take any and all questions or feedback on any topic. [Operator Instructions]

[William Montgomery, analyst]

So Will Montgomery from CLSA. Just a very specific question on the one Value-Add example you provided. So what were the -- what would you say is the rough IRR on that 3-year project just from a return on equity or cash-on-cash basis? And how is that going to be going forward as well in your estimates?

[Scott Callon, executive]

Will, the IRR was 163%. So that's not typical for us. And actually, I hesitated to use this as an example in case someone asked me what the IRR was, and it's extraordinarily high. That's a function of a couple of things. One is we grew NOI 31%. And so kind of roughly 30% of the return is coming -- well, of course, it's coming from that. The rest is rectifying the asset. It was illegal and it has become legal, so that has -- that's a value driver. We had some improvement in market conditions over the last 3 years is another driver. And the final one is we actually sold it to the owner next door. So there is potential economics to the owner in terms of any sort of future redevelopment. But yes, it was kind of bread and butter of Value-Add for us, buy the asset. And you should know. We constantly -- we always talk to the owner of the next-door asset, meaning the way it works in Japan is it can be very difficult to do redevelopment. There's been loosening in FAR. You really want to have a larger plot rather than a smaller plot. But this had blow out wonderful economics. More typical for us is going to be -- we have very powerful economics. So a 30% to 50% IRR is more typical, but that's what this one was, 163%.

[William Montgomery, analyst]

Okay. Yes, I'm sorry, I did notice back on the portfolio page there, there are the forecast IRR. So you don't really need to answer the second part of my question. The...

[Scott Callon, executive]

Well, the thing I would add is that we almost always beat these IRRs. So this is what the internal guys who are managing the asset are managing, too. So you can add a fair amount to these numbers. It's been the outcome. And part of that, of course, is that market has been good, and we understand that. But part of it is we tend to be conservative about what we think the value-add is and we -- guys who are being measured against this want to beat it, and that's why we end up beating the numbers.

[William Montgomery, analyst]

Okay. The next question. I mean, I think it's fairly well understood, the amount of S class supply coming to the market this year and the next couple of years, and I think you've mentioned in the past that your office portfolio is somewhat protected from that impact. But just curious if you were seeing any -- are you seeing confirmation of that and that your rents, your negotiations are firm? Or are you starting to see any kind of change in market conditions as far as vacancy going forward and rent trends going forward, broadly speaking?

[Scott Callon, executive]

Yes. Japan -- well, thank you. I mean, look, Japan has effectively quasi-rent control, right? So if you're in a rental contract, it's -- I mean, there's a process to raise rents, and -- but it's very difficult to do so. And this is part of the reason why we're value-add real estate owners because we actually seek to add value. We talk to -- tenants up front about it. We'll say, "We're going to give you brand-new air-conditioning systems. And it costs some money, and in return, we'd be grateful if we could raise the rent 5%. Do you agree to that and that's in all of it. So the key -- what happened, Will, that's important is because rents have actually gone up, not for people in place but there's a very, very strong demand for rental for office space, we are, along with every other market, but there's been long vacancy, which is to say, if a tenant moves out, you've died and gone to heaven. Just to be clear, that's a good thing, meaning if a tenant stays in place, you can raise rent 2%, 3%, 4%. I mean -- and typically, if you're doing value-add, you can raise rents more than that based on the agreement with the tenant. But if they actually just moved, then it's like, hey, we can raise the rent 20%, 30%. So the -- it's a way of saying that almost every well-positioned, good asset in a good location, it's got significant upside if there's tenant turnover. Did I answer your question?

[William Montgomery, analyst]

Yes, that's interesting.

[Scott Callon, executive]

Looks like we do have another question from Paul Hogarth.

[Unknown Analyst]

Richard here. I just have a quick question with regard to the storage business, which you discussed in previous presentations. And so how is the business going? And could you give us an update on it, please?

[Scott Callon, executive]

So the question's about the storage business. It's going fine. We wondered whether or not we should stick the storage business as a page in this. And look, I promised you utter transparency. We want to have shareholders and investors who understand the company. And so we hope to give you kind of what you understand to be candor and directness. So let me tell you what's great about storage and what's challenging about storage. For the challenging part, it's easy. The assets are small, and so you really, really need to work to create scale. I'm done with the challenges. What's great about storage is it has -- so there's a little bit of a Japanese context here, where -- by the way, we do entirely -- we do kind of remote -- kind of remotely controlled, fully air-conditioned, security system sensors, smart locks, beautiful kind of storage facilities. And so it's not kind of the U.S.-style drive-up with your pickup truck and you put something in the garage thing. And particularly, it's very suitable for Japan because what's happening is as real estate prices go up and the cost of -- and construction costs go up, the cost for residents are going up. And as much as possible, new residential tenants, they want to actually have space. They also want to have storage space, but they don't really want to eat up living space with storage space. So what's happening is you're seeing brand-new apartments, condos, et cetera, being built with less storage space in the apartment but with storage providers like ourselves nearby. And so that's how you solve for the problem of having to maximize the living space and also having sufficient storage. So it's very little storage penetration in the Japanese market. I mean, kind of order of magnitude is probably less than 10% per capita of, for example, the U.S. There's a lot of growth available. We're growing very, very fast at multiples over the market growth. And we have kind of a wind to our back in terms of the way that Japanese residences are being built out. The other thing I was going to say about storage is once people move their stuff in, they tend not to ever move it out. And so what happens is you fill it over time, and once it becomes full, it becomes very bond-like in terms of economics. I guess you have a question for Dan. He's here. Dan, do you want to add anything on that?

[Dan Morisaku, executive]

Maybe I should add updated number of the units so far. The end of February, we had a 27 facilities and almost 3,600 units. Currently, we have a little over 4,000 units. So we are in pretty good shape on structure looking at the expanded plan, so...

[Scott Callon, executive]

So 3-month growth of 10%-plus.

[Dan Morisaku, executive]

Right.

[Scott Callon, executive]

So we're growing a lot faster than market. One of the things that's the case about storage and part of what explains this is we have good technology. We have good network. We also have capital. So because it does take us time to fill up storage units, generally, kind of there's a J curve and it's like a 2- to 3-year fold before you can have the bond that runs forever. So we like it a lot. The value creation of it is not merely directly from -- we could possibly get to scale, and that could be a storage REIT in the future, et cetera. But the other thing that's been very helpful for us is it's been a way for us to make greater -- kind of run our current assets harder. It's like, wait a minute, we have this building and a storage taking one floor of the building. In turn, the storage in architecture is the optimal usage. So it's been nice to drive additional economics, our wide variety of office and retail and residential assets. Did I answer your question?

[Unknown Analyst]

Yes, yes. Yes.

[Scott Callon, executive]

Okay. I think we're done. Thank you, everybody. It's an honor and pleasure to work for you. We look forward to delivering you some returns that we think you'll be very happy with. Everybody, have a very good day. Thank you.