DIDIY - SoftBank: Damage Limitation With AI And ARM IPO Prospects But Wait

2023-05-15 07:52:42 ET

Summary

• SoftBank Group Corp. is loss-making but has managed to enforce some damage limitations by shifting to "defense mode".
• Through its holdings, it has also initiated a Japanese ChatGPT project while its Vision Funds provide deep exposure to the AI marketplace.
• Still, the stock is not a buy as there are risks that it will fall further.
• As seen with the monetization of Alibaba, there are other opportunities with the ARM IPO and other ready-for-listing portfolio companies.
• With such potential, it cannot be ignored, but the market seems to be waiting for the CEO himself to come forward in a display of engagement.

SoftBank Group Corp. (SFTBY) whose CEO is Masayoshi Son has just released its FY2022 results which ended in March this year. As pictured below, the negative values for ROI and net income catch the eye, but looking closer to the right, the changes are positive when compared to FY2021 . This is primarily the result of the group being focused on " defense mode " as I will elaborate on as part of assessing whether the stock is a buy, but, since this is the age of generative AI, the aim of this thesis is also to show potential benefit from ChatGPT-style chatbots.

For this purpose, I will consider the companies it holds stakes in like SoftBank Corp (SOBKY) whose CEO is Junichi Miyakawa, Yahoo Japan, and ARM Holdings (ARMHF) together with the investment it has been making in AI through its SVFs (SoftBank Vision Funds) which hold both private and public companies.

The Japanese ChatGPT and ARM

First, there has been widespread enthusiasm stirred by OpenAI's ChatGPT with its easy-to-use interface whereby you can quickly enter a query in a language you commonly use and the system comes up with a detailed answer. This has put the spotlight on Generative AI, whereby one can generate text using intelligent algorithms.

Before ChatGPT it was hard to explain to investors and people in general what Generative AI was and its importance. Now, things are simpler not only for users who do not have to be specialists to benefit from the technology but also for corporations (that can be the clients of SVFs' holdings) who do not want to miss the train. Moreover, after Microsoft (NASDAQ: MSFT ), Alphabet (NASDAQ: GOOG ), Baidu ( BIDU ), and Alibaba ( BABA ), it was the turn of SoftBank's mobile unit SoftBank Corp to initiate a Japanese version of ChatGPT. For this matter, it is working with search engine company Yahoo Japan , which is 60% owned by SoftBank and comes second in that country for market share, behind Google and in front of Bing.

Looking across the AI ecosystem, SoftBank also owns ARM , a chip designer and provider of processor IP or intellectual property. Here, in contrast with Intel's (NASDAQ: INTC ) CPUs which are used to power servers, PCs, and laptops, ARM processors were originally used in smartphones made by Samsung ( SSNLF ) and Apple (NASDAQ: AAPL ) as the company puts a premium on power efficiency. Empowered with this strength, the company also started to venture into servers with its system-on-chip processors as of 2019 with Amazon's (NASDAQ: AMZN ) AWS being one of the first to propose an ARM-based processor as part of its Graviton2 for supporting data centers and cloud workloads.

Thinking aloud ARM's technology should find an appeal for power-intensive AI workloads as compared to conventional processors, it offers 40% better performance for 20% less cost. For this matter, even NVIDIA's (NASDAQ: NVDA ) Grace CPU uses ARM's Neoverse V2 for high performance and power efficiency.

Therefore with ARM, SoftBank is present in the AI chip market which is predicted to grow at a CAGR of 40.5% from 2023 to 2030, when it would be valued at $227.6 billion. Moreover, with its investments in SVF1 and SVF2, SoftBank has access to the application space too. In this context, while the star of the moment is ChatGPT, AI has been present in our lives for years and SoftBank has been investing mainly in start-ups whose solutions embed artificial intelligence and bets on disrupting traditional industries.

Damage Limitation with Defense Mode

However, most of these investments have not proved fruitful, as the conglomerate posted a record loss of 5.3 trillion yen or $39 billion in FY-2022 compared to 3.6 trillion yen in 2021. Still, looking from a consolidated basis, this loss was partially offset by the 4.6 trillion yen gain mainly from Alibaba transactions.

Furthermore, the loss before tax has been reduced from -869.6 trillion in FY-2021 to -400.4 billion in FY-2022 as pictured below. At the same time, there has been an improvement in the loan and cash metrics.

Equally important, since this is a group that also holds stakes in many startups, its SVFs are structured as a fund whose performance is measured by the net asset value. Thus NAV has decreased from $150.8 billion to $105.8 billion during FY2022 or a 31% loss.

Now, compare this to Cathie Wood's ARK Innovation ( ARKK ) which has lost about 40% during the same period and it becomes apparent that despite SoftBank's losses in private startups being worse than expected, it is not necessarily the only one bleeding billions because of a downturn in innovation-geared tech.

Moreover, the group has shifted to defense mode, whereby investments of $3.14 billion in its latest fiscal year represent less than 10% of the $44.26 billion in 2021. Also, companies like Coupang ( CPNG ) and DiDi Global ( DIDIY ) rebounded over the last quarter showing that there are glimmers of hope. Along the same lines, SoftBank has considerably reduced its exposure to China from 50% three years ago to 15% currently, primarily driven by the disposal of the Alibaba stake which generated IRR (internal rate of returns) of 57% over 22 years.

Huge AI Market but Investors Are Unconvinced

The Alibaba deal in a way symbolizes how venture capital in startups works, and, as per Vinod Khosla, famous for being OpenAI's first VC investor, only 10% of investments normally prove successful but these can be enough for an entire portfolio to bear above-market returns. He further adds that 70% of investments are likely to fail entirely with up to 20% possibly reaching some payback.

In this respect, in addition to Generative AI, there are other flavors of artificial intelligence like Recommendation AI where people are suggested items based on past preferences, and analytics AI used for decision support systems in numerous sectors, including healthcare, finance, manufacturing, automation, and transportation. This explains why AI's market size should reach an astronomical $1.8 trillion by 2030 from $208 billion in 2023.

This is a market where SoftBank is adequately positioned with its Vision Funds, especially after shifting to a more offensive mode recently but using a " very selective " approach depending on the investment, positive unit economics, and scaling opportunities. Noteworthy, given that it holds stakes in companies rather than operating them, it can achieve faster monetization, but these also depend on regulations.

Shifting to a cautionary note, the market does not seem convinced about SoftBank's opportunities but appears more focused on losses. Also, with inflation being high globally, there is more preference for value and profitable stocks and here, with its negative EPS figures of -662 yen, the group is not appealing. Furthermore, the $10 billion ARM IPO has failed to instill any enthusiasm among investors, and, on the contrary, the negative market reaction as shown in the orange chart below could be due to the amount being much smaller than the $40 billion Nvidia was ready to disburse for the chips designer back in 2020.

Looking into the rear mirror, the group started underperforming the Invesco QQQ Trust ( QQQ ) as shown in the blue chart at the beginning of February after Q3's earnings call when the group not only reported losses but for the first time, its CEO was absent.

He was also absent for the fourth-quarter call on May 12.

Now, at around $18.25, the share price is currently under the $20 support level, but, based on EV/Sales and EV/EBITDA metrics, the stock is still overvalued with respect to the communications sector, signifying that there is no opportunity at present. It is also suffering on the back of negative earnings, as investors have become much more stringent in a macroeconomic environment where aggressive rate hikes by the Federal Reserve and other central banks now rhythm with higher borrowing costs which affects unprofitable startups to a higher degree.

How to Play the Stock

In these circumstances, the stock can fall further to the $16 level last reached in December 2018 and the only event likely to rekindle investors' appetite for the stock is the ARM IPO where there could be an oversubscription thanks to the potential of a chip design company in the highly valued AI market. This event should also see the participation of SoftBank's CEO.

In this respect, in addition to Amazon, Google, Azure, Cloudflare ( NET ), and others have opted for ARM IP for which they pay fees, but, in return, can design their own processors and subcontract the manufacturing to the likes of Taiwan Semiconductor Company ( TSM ) giving them more control of their value chains.

Apart from ARM, there are other monetization opportunities with late-stage and ready-for-listing portfolio companies valued at $37 billion . Continuing on a positive note, in Q4's earning call, SoftBank's CFO mentioned that Vision Funds included around 500 companies, but that 94% of them are well capitalized, with a 12-month runway.

In conclusion, by going through the ChatGPT venture and the billions of dollars of opportunities of its Vision Funds in AI, this thesis has shown that after improving its balance sheet status SoftBank simply cannot be ignored, especially after dropping by nearly 25% in the last six months while tech-heavy QQQ gained around 13%. In this respect, while the management team clearly prioritizes damage limitation, the use of AI to gain search engine competitiveness, and also to monetize the technology through its Vision Funds, the market still not appears to be convinced. The reason could be that investors are waiting for clear signs of engagement from the CEO himself as he is someone who usually leads from the front. Till then, unless you are a trader looking for opportunistic gains as IPO-related news hit the market, avoid buying the stock.

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