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Morningstar | Nomura's Core Domestic Unit NSC Falls to Operating Loss for First Time in CEO Nagai's Tenure

We adjust our fair value estimate for Nomura from JPY 543 to JPY 527 and from USD 5.00 to USD 4.70. We continue to value the firm at 0.70 times book value, based on assumed cost of equity of 8.5% and long-term ROE of around 6%. We have a no-moat rating on Nomura but believe its domestic retail and asset-management businesses are moaty. If Nomura were to pare back its overseas operations more radically and adopt a business model similar to that of smaller rival Daiwa Securities, we might consider assigning it a narrow moat.

With the bulk of the charges already recognized in the fiscal third quarter reported three months ago, Nomura’s full-year loss of JPY 100 billion--its first red ink in a decade on an annual basis--is little surprise. Still, its fiscal fourth-quarter release did reveal key facts deepening our understanding why Nomura finally decided to bite the bullet and write off the overseas assets acquired from the Lehman bankruptcy estates in 2008-09. The removal of this goodwill from Nomura’s balance sheet gives it the option to exit various overseas businesses for good without needing to incur huge further write-downs, though it still appears hedged on whether it wants to cut as much as we want it to.

A key point revealed April 25, in our view, is that core domestic entity Nomura Securities Co. (NSC) dropped to a quarterly operating loss for the first time in Nagai’s seven-year tenure. Until now, NSC steadily delivered profits thanks to the enduring strength of Nomura’s retail business. The fact that domestic retail profitability deteriorated to the degree that it could fall below break-even is likely related, in our view, to management’s recent urgency to do more to revamp the overseas business and may also help explain why the board decided earlier this year to extend CEO Koji Nagai’s term provisionally rather than promoting one of his deputies and letting Nagai graduate to the post of chairman.

In 2017, Nagai promoted Toshio Morita as head of NSC and Kentaro Okuda as head of the Americas business presumably because they were candidates to be next CEO, but it is now indisputable that both NSC and overseas have significant issues outstanding that the responsible managers have not yet been able to resolve.

Some of the problems in domestic retail this quarter were, in our view, merely cyclical. Despite the global stock rebound, the January to March period was an awful quarter for all of the Japanese brokers that have reported so far in part because of the poorly performing Softbank Corp. IPO, which was aggressively marketed to new potential investors by underwriters including Nomura, hurt individual-investor willingness to interact with brokers. Even the Internet brokers that did not underwrite the deal all reported low trading volumes and even weaker results than in the December quarter.

Some of the problems in domestic retail are more fundamental. The Internet brokers, which have dominated individual trading volumes since the mid-2000s, have started to take larger market shares in term of client assets, as well. In the past few years Nomura has often reported net outflows of client assets when Internet brokers and bank-related securities firms were all reporting steady inflows. It seems that Nomura’s richer and older client base now presents a risk of it losing assets when clients pass away and their heirs liquidate or move the assets to a custodian charging lower fees than Nomura. We view Nomura’s brand name as a significant intangible asset that could underpin an economic moat, but the strength of the asset seems to be gradually fading unless Nomura does more to adapt to the preferences of a younger generation. We note that Nomura started its own online unit in 2006 to much fanfare but closed it in 2009 because of fears of cannibalizing the high-margin business of its brick-and-mortar branches.

For the time being, Nomura remains a work in progress. We believe it is a firm that could earn a much higher ROE than the 6% we assume for the long term if it were to scale back its overseas business significantly while preventing its valuable domestic retail and asset-management franchise from being disrupted by technology. What remains unclear is management’s willingness to tackle the issues with more than a reactive approach.