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Japan 2025: Soaring From the Digital Cliff

Japan 2025: Soaring From the Digital Cliff
Japanese companies are facing a critical period.

In 2018, the Ministry of Economy, Trade and Industry (METI) published the results of an investigation into Japan’s digital infrastructure, commonly known as the ‘DX Report’. The conclusion was stark. Japanese companies must invest in new digital technologies and develop innovative business models before 2025 or face major economic losses. The so-called “2025 Digital Cliff”.

 

Japan 2020

The Japanese IT landscape is unusual amongst global developed economies. The average Japanese firm sees IT as a problem to be solved rather than a strategic opportunity. Analysts suggest IT team members are near the bottom of the corporate food chain, responding to directives “thrown over the proverbial wall for IT to execute”.

 

The METI report calls out this problem directly, albeit in more diplomatic language: “Top executives may not strongly support DX, so the company may lack the drive to implement it”.

This apathy towards digital capability filters across the economy. Firms are heavily reliant on external service providers and they retain minimal in-house capabilities. Japanese firms scrape by on highly customised legacy systems that have become the digital equivalent of threadbare . The IT service providers propping it all up shows symptoms of this sickness. Many focus on maintaining traditional accounts, with little appetite for investing in new technologies that their customers are unlikely to purchase.

 

The precipice

It is rare that such wide-scale systemic issues come with a time limit. Aside from Y2K, the economy is used to vague, existential challenges with unspecified points of no return (think the climate crisis or spiralling government debt).

 

METI have identified a cliff edge in 2025 that Japanese companies will plummet off if they do not take serious evasive action – and there will be no safety net to catch them as they fall.

 

Currently, 20% of mission critical systems are older than 20 years, which will increase to 60% by 2025. In 2015, there was a lack of 170,000 IT specialists in Japan. By 2025, this gap will increase to 430,000. The combined effect of these shortfalls will be an economic loss of up to 12 trillion yen per year after 2025 (2% of GDP).

 

If that is not enough to shock the economy into action, there is another milestone (or perhaps a jagged rock) waiting for Japanese firms at the base of the cliff. SAP, the number one market share ERP in Japan, will cease the mainstream maintenance for SAP Business Suite 7 core applications at the end of 2027, with optional extended maintenance until the end of 2030.

 

Something must change… and fast.

 

Call to arms

In the 22 months since METI published this stark warning, we at Asset Value Investors (AVI) have witnessed the IT service sector begin to respond to the call to arms. Market leading players such as NTT Data and Fujitsu Software are reporting 5-year sales growth exceeding 50%.

 

Significant research into new product areas such as cloud-based technologies, and innovation first mindsets are driving the sector forward. Coupled with significant and sustained increases in EBIT margins amongst system integrators, a picture is clarifying of growing demand for digital services that are being delivered with greater efficiency.

 

As an investment firm looking to unlock value in high-quality Japanese businesses, AVI has kept a keen eye on this mobilization and we see significant opportunities emerging.

 

The pot of gold

Much like the California gold-rush, where savvy entrepreneurs made their fortunes providing tools and supplies for the prospectors, it is those providing services that stand to gain from Japan’s rush to digitise. Japanese IT service delivery companies are well placed to cash in from the inevitable tidal wave of demand for IT transformation.

 

DTS is just one of these organisations. The systems integration and “comprehensive information services company” occupy a niche position in the IT service delivery market, serving up high growth and high profitability. There is, however, scope for unlocking greater value in their business. At AVI, we seek out investment opportunities with identifiable catalysts for long-term value – as we discussed in a previous Insight.

 

The company has an exciting future but its balance sheet efficiency, governance standards and current strategy need vital improvement. Despite achieving a 5-year EBIT CAGR of 11%, DTS trades on only a 5.6x EV/EBIT compared to best-in-class peers on 20x.

 

DTS is a prime example of a firm that should be looking to soar from the digital cliff, taking the rest of the Japanese economy with them. Living up to their slogan ‘Delivering Tomorrow’s Solutions’ will require abandoning traditional Japanese risk aversion and refocusing their strategy to embrace high growth products.

 

Even in the context of Covid-19, the risks of withdrawing to safe, predictable products and stable accounts are significant. It is perhaps a bitter pill to swallow for some Japanese firms that the status quo is now far more precarious than change.

 

The path to 2025

METI have made it clear that investment in digital infrastructure is essential. They are warning Japanese firms that they must evolve or face the consequences. Japanese firms have traditionally remained stoic in the face of external pressure. From our experience working with Teikoku Sen-I, Fujitec and other large Japanese firms, we are well aware of the careful, strategic engagement required to spur change. The digital revolution that METI are crying out for is entirely dependent on traditional Japanese business practices evolving across the economy. The message is clear: the digital cliff is coming, so either fly or fall.

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AVI was established in 1985 to manage the assets of one of the oldest listed investment companies in London. Our distinctive approach of investing in family-controlled holding companies, closed-end funds and asset back situations is still a unique combination over 35 years later.

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