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Morningstar | SoftBank’s Underlying Results in Line; Buyback Announced Given Weak Share Price

Softbank’s underlying third-quarter fiscal 2018 (quarter-ending December 2018) result was in line with our expectations with revenue up 4.8%, and underlying operating earnings up 10.4%, ex-SoftBank Vision and Delta Funds. The reductions in the operating profit from Yahoo Japan, Brightstar and Other segments were more than offset by operating profit increases from Softbank Corp and Sprint. We make minor changes to our consolidated business forecasts retaining our JPY 12,000 per share fair value estimate. 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 rating 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 narrow sector focus and leverage within the Vision Fund and some of its subsidiaries.

At the result briefing, management outlined a rough sum-of-the-parts valuation for the company of JPY 21 trillion with nearly 80% of this value underpinned by listed shares owned by the group. Given the current Softbank market capitalization is around JPY 9 trillion, management sees its shares as vastly undervalued and announced a buyback of JPY 600 billion worth of shares (around 6.5% of shares outstanding) running from Feb. 7, 2019 to Jan. 31, 2020. Of the JPY 2 trillion in proceeds from the domestic mobile business float, management will reduce net debt by JPY 700 billion to around JPY 2.9 trillion, allocate JPY 700 billion for investment and use the remaining JPY 600 for the buyback.

Management also highlighted the leveraged nature of the Vision Fund investments. SoftBank holds nearly half of the USD 58.6 billion of equity in the fund with the remaining USD 40 billion in preferred equity with a 7% fixed distribution. Using its investment in NVIDIA as an example management disclosed that it took out a USD 1.7 billion margin loan to fund a USD 2.9 billion initial investment in August 2017. Given the preferred equity component of the initial investment, the true equity in the USD 2.9 billion investment was only USD 0.7 billion. The return on total investment as at end January 2019 was USD5.5 billion with the return on the equity component at USD 3.3 billion for gross equity IRR of 824%. The Fund used a collared transaction to lock in its gains above the current share price which has subsequently declined. This highlights to us the leverage nature of these investments in what is a volatile sector and the difficulty for SoftBank Group investors to understand the returns by following the share prices of invested companies given the option strategies being used.

SoftBank’s investment in wide-moat Alibaba is by far its most valuable asset, representing nearly one half of its value at current prices however it is accounted for as an investment therefore its results do not hit the earnings statement. Despite the recent share price bounce, uncertainty about China and global macro conditions continue to weigh on Alibaba’s stock price with the stock now trading 29% below our fair value estimate. Our positive long-term bias on Alibaba remains intact following its third-quarter result, as the company continues to put up numbers that validate the resiliency of its business model during uneven economic conditions but also the monetization opportunities from the network effect behind our wide moat rating. China skeptics are painting this quarter's 41% top-line growth as a negative--Alibaba's slowest growth quarter since 2016--but we see the trajectory as a positive because Tmall GMV continues to outpace broader China GMV trends (29% versus 24% using iResearch estimates). More importantly, strong results from ancillary businesses like Ele.me/Koubei, and New Retail/Freshippo stores (formerly Hema) validates user engagement trends and signals future monetization opportunities. We retained our USD 240 fair value estimate. We assume that China GDP growth rates slow to the 4% range but still being driven by household consumption rates as opposed to government or export activity. Management reiterated its full-year revenue outlook calling for CNY 375 billion-CNY 383 billion (representing 50%-53% growth year over year), and we leave our five-year GMV and China retail revenue growth targets of 30% and 32% in place.

Softbank’s 85% owned Sprint’s struggles remained on display during its fiscal third quarter, with customer losses constraining growth and renewed network investment pushing free cash flow deep into negative territory. We don’t expect to change our USD 5.75 per share fair value estimate, which reflects a blended view of Sprint as a stand-alone entity and as a part of T-Mobile. We continue to peg Sprint’s stand-alone fair value at about USD 3 per share, though we caution that the firm’s weak financial and competitive position leaves a lot of room for error. Net postpaid phone customer losses, at 26,000 during the quarter, weren’t as bad as we’d feared following strong reports from both Verizon and T-Mobile. In our view, Sprint has bought growth in the past via heavy promotions but subsequently disappointed customers with relatively poor network quality, leaving its brand reputation weak. Sprint increased wireless network spending more than twofold year over year to $1.2 billion during the quarter but we believe that it will continue to struggle to provide broad coverage that matches rivals. With the increase in network spending, free cash flow hit negative $1.5 billion, as we calculate it, during the quarter, the worst result since mid-2015. Sprint management called out competitors Verizon and AT&T for being particularly aggressive with promotions in late 2018 and into 2019, cautioning that wireless service revenue could begin shrinking again if the current pattern holds up. While the wireless industry remains strongly competitive, in our view, we don’t believe the two industry giants have done anything unusual recently. In fact, AT&T pointed to its lack of promotional aggressiveness to explain its soft customer growth, especially in the prepaid segment, and strong segment margins during the quarter. We view Sprint’s comments as posturing for regulators as it walks a fine line between presenting reasonable financial results while making the case for its merger with T-Mobile. Sprint also indicated that the government shutdown hasn’t altered its expected timeline for a ruling on the deal.

The domestic telecom business reported a decent quarter for its first as a separately listed company with revenue up 5.2% and operating profit up 24% although we suspect the comparable quarter last year was particularly weak. SoftBank Group sold a 37% stake in this business at JPY 1,500 per share and the stock has since traded down 12% to JPY 1,322 per share. We value the business at JPY 1,100 per share so believe SoftBank Group sold at a very good price. Rakuten is set 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 l cause some serious pricing pressure for as long as it is in the market. In October 2018, NTT DoCoMo also announced 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 still expect an impact on the other operators from the leading operator in the market lowering its prices to this extent.

Yahoo Japan! reported revenue growth of 5% but operating income decline of 31% and profit decline of 58%. We revised Yahoo Japan’s fair value estimate to JPY 360 from JPY 400, as we consider that its operating margin will be lower than we had anticipated because of increasing costs. Yahoo Japan intends to provide a comprehensive marketing solution to merchandisers in the longer term by integrating its advertisement, e-commerce, and mobile payment businesses, but the related cost seems to be much larger than our original forecast, and as a result, we expect Yahoo Japan’s operating margin to remain flat throughout our five-year forecast period. Yahoo Japan’s operating income has been declining for three consecutive years because of the increasing costs and worsening product mix. However, management’s commitment to maintain at least JPY 140 billion of operating income for the next five years seemed to encourage investors with the stock rising 9% on the day following the result.

ARM Holdings, the U.K.-based semiconductor design business, contributed JPY 54.4 billion to revenue (a decrease of 12%) but a loss of JPY 4.0 billion to operating profit in the December 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.