E-guardian (OTCPK: EGRDF) It seems well positioned to take advantage of the secular growth in social networking services and their use of video content. However, the business model is dependent on human labor which makes it difficult to scale, and in the long run it is exposed to risks of substitution from technology. The stock is trading in fiscal year 2009/2023 at a 17.5 times free cash flow return of 5.2%. These valuations are not being expanded to achieve stable growth expectations but given the challenges to its business model and low R&D spending, we are neutral on stocks.
Founded in 1998 as an online multimedia content developer in Osaka, Japan, E-Guardian expanded into online billboard monitoring services in 2003. The current business model has expanded the subject of censorship, to include software debugging, online platform monitoring, and online customer services Internet and WAF (Web Application Firewall) services. E-Guardian’s primary business segments are social networking support, online gaming support, online advertising compliance checks, and cybersecurity consulting. It has a workforce of 2,167 people but 1,621 working on temporary contracts. Its largest customer in fiscal year 9/2021 was TikTok (BDNCE) which accounted for 18.3% of total sales. Game application support clients include NetEase (NASDAQ: NTES).
Main financial data
Sales for the fiscal year 9/2021 divided by service area
E-Guardian is a small Japanese IT security company with a total routable domestic market of 860 billion yen / 7.5 billion USD – the company’s implied market share is just over 1%. In this article we want to evaluate the following:
- Medium-term growth prospects.
- E-Guardian’s ability to compete with peer SaaS solutions.
We will take each one in turn.
Secular themes of growth in place
IT security encompasses a wide range of problems and solutions, but IDC Japan has estimated that the domestic market will continue to grow at a 6.9% CAGR (CY2020-2025). We believe that more applicable areas of E-Guardian’s business such as social networking have more room for growth due to ever-increasing levels of user activity in both private and corporate communications.
Business in the social support sector has been primarily driven by monitoring video stream contents for compliance (on TikTok), a market that is said to be growing on average by 24% year over year. Other drivers here include e-KYC (Know Your Customer) processes for cashless/digital transactions for “sharing economy” services such as transportation, accommodation, and clothing. There was also a one-time increase in demand driven by online customer support services for COVID-19 vaccination. FY 9/2021 sales in this segment grew by 55.5% YoY and accounted for 53% of total sales.
The remaining business experienced low or negative growth in fiscal year 9/2021. The gaming support business saw sales down 14% year over year as E-Guardian’s domestic mobile game customers lost market share to imported games. Advertising has a relatively small growth of 12% over last year as compliance checks on online ads tend to focus on limited areas such as healthy foods and nutritional supplements. Cyber security made up just 7% of total sales, and although it doubled year-on-year, this was only driven by mergers and acquisitions of WAF JP Secure professionals in October 2020.
We believe E-Guardian will take advantage of the continued secular growth trends in social networking and video content. The company set up an overseas operation in Vietnam to meet Mandarin content to win business in China, and an operation in the Philippines to support English. It also has a strategic priority in creating a SaaS in order to earn subscription-based recurring income. However, with such a large market to tackle and the growing need for online security, we wonder why E-Guardian’s business has grown relatively steadily yet has remained niche. Our conclusions are:
- SaaS solutions now dominate the IT security market – they’re cheaper to run and easily scalable than E-Guardian’s original manual processes.
- Many online media prefer to keep IT security functions internally, thus limiting the E-Guardian instructable market.
We conclude that the company’s growth expectations are lower than those of its end markets. Currently human-monitored video streams may be more effective, but there are substitution risks as technology catches up, and E-Guardian will find it more competitive as it moves into the SaaS market.
Next we look at the competitive landscape in SaaS security solutions.
A very competitive space
There is a growing group of players offering social media monitoring tools. These are not necessarily designed to monitor passive user activity or IT security breaches, but in terms of notifying irregular activity they are useful ways to conduct risk mitigation. Examples of such systems are HootSuite and Keyhole. Traditional IT security companies are also involved in threat detection such as Micro Focus (NYSE: MFGP) and ZeroFox (NYSE: LNFA), as well as emerging social media governance platforms such as Brandle and Meltwater.
Services such as the Content Identifier on YouTube identify and manage the use of copyright. Controls and moderation are usually implemented internally by a combination of human and machine, and over time it is expected that more machine learning will make this check more automated. This poses substitution risks for any service vendor, unless the service is more effective and at an attractive price.
E-Guardian has developed solutions for monitoring automation using in-house tools such as “ROKA SOLUTIONS” to detect inappropriate images, to “Kiducoo AI” that assesses appropriate use of graphics such as product logos. However, if these solutions are truly world class, we believe that E-Guardian will see much greater demand and enjoy significantly higher profitability.
E-Guardian is well capitalized at JPY 3.7 billion / $32 million net cash and has some additional capital to invest in system development. However, it appears that there are no major plans to increase capital expenditures or research and development. Perhaps what puts the company on a relatively weak footing is that R&D spending only accounts for 0.57% of total revenue – this shows us that E-Guardian is far from a technology powerhouse and more of a “structures workshop”. Thus, transforming its business model to a more profitable SaaS will be challenging and disruptive due to its lack of experience.
The stock is trading in fiscal year 2009/2023 at a 17.5 times free cash flow return of 5.2%. These are not expensive valuations but for a human labour-based business model with limited scope potential, stocks seem like a fair value especially for a small capital.
We note with interest that the third largest shareholder is Kabouter Management, a Chicago-based international small-capital firm known for investing in companies seen as undiscovered gems.
Upside risks stem from continued growth in the social support (video content monitoring) business. With more user content uploads and more complex usage, the need for human monitoring will continue to remain high over the medium term.
Successful overseas expansion with cheaper offshoring capabilities can boost sales volume as well as increase profitability. E-Guardian has been able to win major offshore accounts successfully.
The downside risks come from the gradual replacement of the company’s core video streaming monitoring service with technology, rendering their service obsolete.
One controversy highlighted in fiscal year 9/2021 was that a former director of a subsidiary had made unauthorized spending of company money, increasing unauthorized debts and garnishing profits. The company had to restate the accounts reported in the last three years. We conclude here that the quality of management and the external auditor (Taiyo Grant Thornton) is not very high.
E-Guardian appears to be well positioned to benefit from the secular growth of social networking services and the proper use of video content. However, its current business model is highly dependent on human labor which makes it difficult to scale, and in the long run it is subject to substitution risks from technology. Valuations are not being expanded to achieve stable growth expectations, but given the challenges to its business model and low R&D spending, we are neutral on stocks.