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Morningstar | SoftBank’s Underlying Results Disappoint; FVE Decreased to JPY 12,000 on Domestic Telecom. See Updated Analyst Note from 05 Nov 2018

Softbank’s underlying first-quarter fiscal 2018 (quarter-ending June 2018) result was slightly below expectations with revenue up 6.4%, but underlying operating earnings were down 7%, ex-SoftBank Vision and Delta Funds, using the old accounting standard. The reductions in the operating profit from Yahoo Japan, Brightstar, and other segments were the main drivers of the consolidated operating profit decline and Rakuten’s potential entry into the Japanese telecom market and NTT DoCoMo’s planned price reductions could further dampen prospects in the domestic telecom business, at least in the short term.

We make minor changes to our consolidated business forecasts with our fair value estimate decreased to JPY 12,000 from JPY 12,600 per share primarily on the back of a slight downgrade in our outlook for the domestic telecom business as well as Yahoo Japan, Brightstar, and other segments. Our no-moat rating is also retained as we rate SoftBank as an investment holding company rather than an operating company. While the weighted average moat weighting of the companies currently in the company’s portfolio would point toward a narrow moat company, we do not have confidence that SoftBank will continue to hold these companies over a 10-year period. The stock looks undervalued at current levels with investors seemingly applying a discount to plausible sum-of-the-parts valuations on uncertainty about what the business might buy next and the sudden drop in Alibaba’s share price.

SoftBank’s investment in wide-moat Alibaba is by far its most valuable asset, representing around one third of its value at current prices; however, it is accounted for as an investment therefore its results do not hit the earnings statement. Uncertainty about China and global macro conditions continue to weigh on Alibaba’s stock price with the stock now trading 38% below our fair value estimate. However, in our view, second-quarter revenue growth of 54% reinforces the resiliency of the firm's business model, regardless of economic backdrop. Share price appreciation may be difficult until U.S.-China trade tensions subside, but we believe investors should focus on three positives from the quarter. First, Alibaba has developed a sensible game plan for difficult macro conditions, including the temporary suspension of certain merchant fees on its Taobao platform. While we appreciate investor concerns about this decision--the fee suspension will negatively affect Alibaba's higher-margin core commerce platform--our research has shown that economic downturns have historically offered e-commerce platforms an opportunity to lock in new buyers and sellers, both of which then engage in other higher-margin products and services when economic conditions stabilize. We expect a similar scenario to play out with Alibaba. Second, the Chinese consumer is relatively healthy, backed by wage growth, solid household balance sheets, and access to consumer credit. Third, ancillary businesses like the combined Ele.me/Koubei, New Retail/Hema, and cloud computing have shifted Alibaba away from being a consumer discretionary story and offer exposure to more resilient consumer and business staples. While Alibaba cut its full-year revenue outlook to CNY 375 billion-383 billion (50%-53% growth year over year versus its initial outlook for 60%) due to fee adjustments, we expect future merchant/user engagement to offset these headwinds, leaving our five-year gross merchandise volume and China retail revenue growth targets of 30% and 38% in place. We plan to cut our fiscal 2019 EBITDA margin forecast to the mid-20s but still see long-term targets in the low- to mid-30s as valid. We're not planning changes to our USD 240 fair value estimate for the standalone Alibaba business.

Softbank’s 85%-owned Sprint returned to net postpaid phone customer losses during its fiscal second quarter, reflecting increased defections as promotional discounts expire and there is a pullback in promotional offers. We expect Sprint will continue to struggle to balance growth and profitability on its own, with a network that lags its rivals and a core brand that has suffered reputationally for a decade. We are maintaining our USD 5.75 fair value estimate for the stand-alone business and no-moat rating. We believe Sprint’s stand-alone fair value is well below its current stock price, with significant upside should the proposed T-Mobile merger close. At this point, we believe gauging the prospects for regulatory approval of the merger is difficult. Sprint lost 34,000 net postpaid phone customers during the quarter, its first net loss in more than three years. The heavy promotions that attracted customers in the past, such as half off competitor rates and free additional lines, are steadily expiring, pushing customers to leave. Monthly phone customer churn hit 1.73%, up from 1.59% a year ago and far higher than the other national carriers (T-Mobile, the next highest, reported 1.02%). In our view, a significant portion of customers have chosen Sprint primarily based on price and will quickly switch to carrier with a better network as the pricing gap narrows. Sprint did see a nice uptick in average revenue per customer, enabling wireless service revenue to hold roughly flat year over year, adjusted for accounting changes. Sprint has been quick to trumpet multiyear record profitability numbers, but much of this improvement is the result of continued adoption of phone leasing plans, a shift in the number of new customers taking phone installment plans, and accounting changes. Looking at cash flow, as we define it, the firm was roughly break-even during the quarter. The cash flow result comes despite a step up in network spending to USD 1.1 billion from USD 549 million a year ago. Sprint expects network spending to take another step up during the second half of fiscal 2018, though it did trim its capital budget for the year to USD 5.0 billion-USD 5.5 billion from USD 5.0 billion-USD 6.0 billion. We continue to believe Sprint’s current network and spectrum position necessitate higher levels of spending if it hopes to keep pace with rivals’ plans. A merger with T-Mobile would, of course, completely change that equation. Unfortunately, we see the chance of regulatory approval for the merger at only 50%.

The domestic telecom business showed decent revenue generation with revenue up 5.2% (after 5.4% in the first quarter) but margins reduced slightly with EBITDA rising 0.4% and EBIT rising 1.4%. The company will be proceeding with the IPO of the domestic telecom business. We note that the recent performance has been below its competitors and Rakuten has also announced its intention to launch mobile network service in Japan in 2019. While we doubt if Rakuten will be successful in building a scale business, it may well launch and cause some serious pricing pressure for as long as it is in the market. We also saw NTT DoCoMo announce the introduction of new lower price plans from the June 2019 quarter which would lower NTT DoCoMo’s profit so that it would only reach current levels again in fiscal 2023. While we don’t necessarily expect Softbank’s telecom business will be as impacted as NTT DoCoMo, we would expect an impact on the other operators from the leading operator in the market lowering its prices. Softbank indicated that it had already cut its prices and offered separated handset and service plans as requested by the Government. It would also be cutting costs in the domestic telecom business with a target of reducing headcount by 40% over the next two to three years. It explained that it would redeploy displaced workers in SoftBank Vision Fund companies to side-step the difficulties of making workers redundant in Japan. It continues to target growth in both revenue and profit from the business, but this is not an ideal industry backdrop in which to launch a float.

Yahoo Japan reported revenue growth of 8.3% but operating income decline of 16.9%. Its core e-commerce business grew revenues at 12.8% with operating income declining by 7.6%. Yahoo Japan’s media business revenue increased 4.8% from the previous year, driven by the 13.2% growth of its paid search advertising revenue, as the company has redesigned the portal site, which contributed improving ads performance. Meanwhile, the operating income of the media business dropped 5.2% from the previous year, owing to the increasing promotion costs. We trimmed our fair value estimate for Yahoo Japan to JPY 400 from JPY 420 post the result, as we are concerned about the increasing costs, and lowered our operating margin assumptions as a result.

ARM Holdings, the U.K.-based semiconductor design business, contributed JPY 50.2 billion to revenue (an increase of 12%) but a loss of JPY 3.9 billion to operating profit in the September quarter. Softbank seems to be increasing its investment into ARM to support its very bullish views on the long-term growth prospects for this business. With limited disclosure, it is difficult for us to assess whether this investment is justified. 65% of its revenue comes from technology royalties with another 25% coming from technology licensing.

With respect to Saudi Arabia and its potential impact on Vision Fund activities, Softbank indicated that it was already committed to investing the first Vision Fund funds and would continue to do so. However, the raising of further funds from Saudi Arabia would be put on hold until the outcome of investigations into the killing of Jamal Khashoggi was finalized. These comments are as we expected. We don’t believe they will sway potential investees from their existing positions going into the investor call--some are likely to accept Vision money and others are likely to not. The Vision Fund had USD 91.7 billion of committed funds with USD 23.8 billion of that invested and USD 2.5 billion returned to LPs this quarter from the sale of Flipkart.