The Hidden Dangers of SoftBank's Lavish Tech Investment Strategy
WHY YOU SHOULD CARE
Because the Japanese investment giant is valued less than the sum of its parts.
By Jonathan Guthrie and Sujeet Indap
The “singularity” is the theoretical point at which machines can outthink humans and technological change becomes unstoppable. It justifies breakneck investment in businesses with disruptive potential, according to Masayoshi Son, founder and CEO of Japanese tech group SoftBank.
“This is the biggest revolution in human history,” Son told analysts in August. “Artificial intelligence will change or will redefine all the industries … the winners in AI will be winners in the future.”
For the moment, the real singularity is Son. As an iconoclast from consensual Japan, he embodies big contradictions. Fans see him as a tech investment genius. Some traditionally minded Tokyo businesspeople dismiss him as a reckless chancer.
SoftBank hopes to undercut hostility with one of the largest-ever initial public offerings. Last month the group floated a Japanese mobile phone operation with a mooted equity value of more than $60 billion. Executives believe this will reassure investors about the debts carried by the business and trigger a re-rating.
[Son] is extremely bullish and rarely mentions negatives. Investors are wary of what is not being talked about.
Dan Baker, analyst, Morningstar
SoftBank is the world’s largest focused tech investor. Yet for all Son’s futuristic talk, it sometimes buys relatively mature businesses. Son and his fans believe it takes no unhedged risks. Critics decry it in the terms Warren Buffett once reserved for derivatives: as a financial weapon of mass destruction. SoftBank’s credibility problem is reflected in a big gap between the value of its investments and the price of its shares.
“They are the buyer of first resort,” says one Asia fund manager, reflecting on the group’s fondness for snapping up shares in well-hyped tech plays, such as Uber and WeWork. “They always want to supersize their investments. They have an issue finding companies willing to take the amounts of money they want to hand out.”
The flotation will bring greater clarity to a tangled structure that reflects Son’s restless quest for innovation rather than any conventional corporate strategy. But a Financial Times analysis suggests the move could heighten risks for SoftBank’s shareholders and lenders rather than dampen them. Dangers are already understated by the group’s optimistic account of its own finances.
The technological evangelism of Son divides opinion. “He is a visionary,” says Dan Baker, an analyst at Morningstar who rates the company a buy. “He is extremely bullish and rarely mentions negatives. Investors are wary of what is not being talked about.”
These include “complexity, opacity and leverage,” according to Chris Hoare of New Street Research. Even compiling a sum-of-the-parts valuation — a simple exercise for most conglomerates — is tricky for SoftBank. But the discount between the impressive value of the group’s investments and its lowly Tokyo-listed shares is over 60 percent, according to FT analysis of S&P Global data.
The chasm is hardly flattering for Son. It implies his investment skills — or a perceived lack of them — have a negative impact equivalent to $148 billion. The boss of a quoted private equity group in the U.S. or U.K. could be fired for a discount as big as this.
One part of the calculation involves nothing harder than totting up the value of stakes in listed companies such as Yahoo Japan and Sprint, the U.S. telecommunications business. Another part requires bold assumptions. FT followed the lead of many analysts in knocking 30 percent off the $100 billion market value of a stake in Chinese e-commerce group Alibaba — SoftBank’s key asset — to allow for tax on any sale. FT assumed Arm, a chip designer, is worth the full $32 billion SoftBank shelled out for it. By some measures, SoftBank overpaid for the U.K. business, a mature supplier to smartphone makers that has much to prove in a nascent métier: the internet of things.
Deeper controversy bedevils SoftBank’s $97 billion Vision Fund. Saudi Arabia, its largest backer, lost much of its cachet as an investment partner after its agents murdered journalist Jamal Khashoggi in Turkey in October. Some analysts fear Silicon Valley startups will now spurn Vision Fund financing on ethical grounds. Keeping track of SoftBank’s contribution to the fund is a more prosaic difficulty. FT went with the company’s most recent official valuation of $35.8 billion, implying a jump of almost $8 billion in a few months, though the real value of the shares is in the eye of the beholder.
Paradoxically, the higher the number SoftBank puts on these stakes, the greater the dismaying share price discount. No wonder Son is trying to address this. We value SoftBank’s investments at a total of $235 billion, while its market worth is just $85 billion. The difference is partly explained by SoftBank’s substantial net debts but the protection these receive is more fragile than fans acknowledge.
The flotation of the Japanese mobile business is the first step in a plan to lift market capitalization. It works brilliantly on paper, inspiring Bernstein analyst Chris Lane to describe it as “alchemy.” Transmuting base metal into gold may be harder in practice.
In the eyes of most Japanese consumers, SoftBank is a mobile phone company with a newsworthy entrepreneur attached. The household name, combined with fat dividends, should lure retail investors. That has emboldened SoftBank Group and its legions of bankers to attach an aggressive float price to the unit. At 1,500 yuan ($13.20) per share, the telecom company would have an equity value of $64 billion.
The sale of a 37 percent stake for $23.3 billion should hopefully increase SoftBank’s market worth by the same amount. An optimist would expect the shareholding in the mobile operator retained by SoftBank to be priced into its market worth in a similar way.
The gap between the parent’s implicit and market values should narrow as a result. This contraction would be helped by a change in stock analysts covering SoftBank from earnings-obsessed Japanese telecoms specialists to asset management analysts, some of them based in the tech-friendly U.S.
There are three caveats. First, the re-rating of the retained stake is conjectural, until shares in the phone unit start to trade. Second, Son is likely to sink at least half the IPO proceeds into new tech investments, where their value will once again become opaque.
The third caveat is the most significant. The mobile operator is coming to the stock market when a telecoms price war in Japan is threatening to erupt.
SoftBank Group’s racy pricing of shares in its subsidiary is only justifiable if fat dividends from the latter are sustainable. The mobile operator should be able to keep a pledge to pay out 85 percent of net income. But that will count for little if net income itself is tumbling.
The problem would be more acute for SoftBank Group than the consequent reduction in the value of its shareholding in the phone unit. SoftBank is heavily dependent on cash flows from Japanese mobile phone charges to service its $130 billion net debt mountain.
About a quarter of that debt is the result of a sally into U.S. telecoms. In 2012, SoftBank spent $20 billion to buy 70 percent of the shares of Sprint. Son’s plan was to create a telecoms juggernaut to challenge AT&T and Verizon. He hoped to merge Sprint with T-Mobile. But an exercise in empire building became a lesson in humility.
Trust busters blocked the merger. Subsequent events have ominous parallels with the Japanese telecoms industry today. T-Mobile simplified and lowered mobile phone pricing. Tens of millions of subscribers defected from AT&T, Verizon and Sprint. T-Mobile shares leaped by 120 percent in the three years to the end of 2017. In that time, Sprint’s more volatile stock rose just 42 percent. Sprint’s debt of over $37 billion prompted fears of bankruptcy.
The advent of a more business-friendly era in the U.S. under President Donald Trump encouraged Sprint and T-Mobile to resurrect their merger plan. The new deal terms betray the divergence in the fortunes of the two partners. T-Mobile is now taking over Sprint. SoftBank would go from owning 83 percent of Sprint to just 27 percent of the new T-Mobile.
Incongruously, the group is happy to include the earnings of subsidiaries and affiliates in its own profits.
The chances of U.S. competition regulators approving the all-stock deal this time are put at no better than 50-50 by analysts. If the deal goes through, it would reduce pressure on Sprint’s balance sheet. The estimated annual free cash flow of the combined business would be almost $12 billion. A key measure of indebtedness — the ratio of net debt to earnings before interest, taxes, depreciation and amortization (EBITDA) — would be less than three times at the new T-Mobile.
The takeover would also lighten SoftBank’s bloated net debts to the tune of $32 billion. Accounting rules would permit the group to “deconsolidate” these, which means they would no longer appear on SoftBank’s balance sheet.
SoftBank already tends to discount Sprint’s debts when challenged on the scale of its liabilities, as do some bullish analysts. This is just one of the ways it downplays borrowings that surpass those of many developing economies.
The justification is that Sprint’s debts are “non-recourse,” which means SoftBank is not liable for them if its subsidiary defaults. SoftBank is likely to apply the same logic to the mobile phone unit’s $30 billion of net borrowings after the IPO. This treatment does wonders for that important net debt-to-EBITDA metric. The ratio falls from the official level of about five times, which looks steep, to just over three times, which is a lot more comfortable.
Incongruously, the group is happy to include the earnings of subsidiaries and affiliates in its own profits. All the earnings of Sprint and Yahoo Japan go into the pot. SoftBank owns less than half of the quoted internet group’s shares, but this is deemed to give it control.
Even a quarter of Alibaba’s profits are included, on the arguable basis that SoftBank has a significant influence on the policies of the Chinese group.
This is permissible under Japanese accounting rules. But the inclusions undercut the assumption of some investors that EBITDA is a useful measure of SoftBank’s cash earnings. Few of the companies in SoftBank’s portfolio pay meaningful dividends. Very little of the group’s reported net income of $9.8 billion in 2017–18 passed through its hands in the form of hard cash.
Strip out the forecast earnings, as well as the borrowings, of SoftBank’s big investments and net debt to EBITDA soars to over 10 times. Even a U.S. leveraged buyout specialist would regard this as steep. Strip out the earnings of the mobile phone unit too, to reflect the impending IPO, and SoftBank would be making a loss in some scenarios.
In fairness, the group weaves no cloak of mystery around its accounting policies or its attitudes to risk. SoftBank would like to be better understood. It is an article of faith at the company — and among many debt and equity analysts — that borrowings are comfortably offset by valuable investments, particularly the stake in Alibaba. Son is wont to joke that “SoftBank has no net debt.”
That share price discount also covers a lot of downside in advance, leaving plenty of potential for capital gains. Hoare says: “You are buying the shares at 60 cents on the dollar, and that dollar could double in value.”
SoftBank shares are highly sensitive to moves in tech stocks. Even privately held businesses such as Uber are sometimes valued in relation to these. If long-term past performance is any guide, a three-fifths rise in new economy stocks could lift SoftBank’s shares over four-fifths. That troubling discount would shrink significantly.
The corollary is that if tech and telecom stocks fell by just under a half, it would theoretically cut the value of SoftBank’s investments to below that of its consolidated debt. The group’s illiquid tech stakes would become hard to sell in a much smaller rout.
Bulls believe in Son’s singularity as a tech visionary, as exemplified by his inspired purchase of a stake in Alibaba when it was an obscure startup. Bears shy away from SoftBank’s key person risk, its impulsive rolls of the dice and big debts. They worry that another definition of a singularity would apply to SoftBank in a market rout: a black hole in space, sucking in and crushing everything in its path. They are right to do so.
Read more: The surprising link between ghosts and cheap rent in Japan.
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