SFTBY - SoftBank Group Faces Challenges On All Fronts

2023-11-07 23:53:50 ET

Summary

• SoftBank faces challenges due to a changed macro environment and homemade problems.
• Rising interest rates and unfavorable currency exchange rates could lead to materially higher capital costs going forward.
• The bankruptcy of WeWork is likely to result in significant financial losses and might cause reputational damage.
• The valuation of Arm Holdings, is considerably lower than anticipated by Softbank, putting pressure on its share price.

SoftBank Group KK ( OTCPK:SFTBF ; OTCPK:SFTBY ) has a history of evolving business models. Originally a software distributor, it evolved to become a telecom and digital media company and finally a diversified investment holding focused on technology. As such, it is and was both a beneficiary and a symptom of the prolonged period of low-to-negative interest rates following the financial crisis of 08/09.

Now, however, tides have turned once again. Sticky inflation has driven central banks around the world to aggressively tighten the interest rate environment. That, alongside a slew of specific issues of its own making, creates the biggest challenge in decades for Softbank. Below, I will explain my thesis in detail.

Kindly note that there are two companies with similar names: SoftBank Group, the parent, and SoftBank KK ( OTCPK:SFBQF ; OTCPK:SOBKY ), its telco subsidiary. Following, “Softbank” will refer to Softbank Group, unless otherwise stated. “Softbank KK” refers to the telco subsidiary.

WeWork Bankruptcy

Recently, WeWork Inc. ( WE ) filed for bankruptcy in Federal court. Softbank is not only the company's largest shareholder, but its largest creditor at the same time. All in, around $10 billion in credits and equity – some of which had nota bene been written off already – appear to be all but lost for Softbank (on top of what the Vision Fund invested). That does not account for any reputational damage that the high-profile financial disaster may have caused for Softbank as an investor and investee.

The bankruptcy comes at a particularly inopportune time (if there is such thing as a good time for bankruptcy in the first place) for Softbank. In the past, the company has regularly kept WeWork afloat by injecting additional capital. Going forward, they will arguably have more pressure to enact restraint in that regard, given higher overall cost of capital and Softbank’s existing debt load.

Arm Valuation

The WeWork situation is certainly a painful financial blow to Softbank and may end up being even worse for its reputation. Yet, the performance of another investment is much more important in the grand scheme of things. Despite being the biggest IPO of the year, Arm Holdings plc ( ARM ) is valued considerably lower than the $70 billion that SoftBank envisioned. As I have written before , a high valuation for Arm is paramount for Softbank in order to justify its own share price.

At the time of writing, Arm’s market capitalization was close to $55 billion. In other words, SoftBank overpaid significantly (by around 16.4 percent, to be precise) for a 25.1 percent equity stake it acquired from the Vision Fund. Still, Arm trades at rather high earnings and revenue multiples, despite lackluster growth and company specific risks. For a more in depth discussion of Arm and its importance for Softbank, kindly refer to my prior article on that matter. Suffice it here to say, that, by my calculations, Arm would need to be worth around $70 billion (translating to a share price of around $68) in order to justify Softbank’s share price at the time. Personally, I would attribute the - short lived - post-IPO rally mainly to the rather limited number of shares that Softbank sold, rather than to sustainable demand. For the time being, I would rather emphasize the risk of further drops in Arm’s valuation. If Softbank were to monetize further shares after the expiration of the lockup period (March 12 ^th , 2024) that could be a downside catalyst. The fact that Arm does not expect to distribute dividends, leads me to believe that Softbank is not unlikely to monetize the stake eventually, either by selling part thereof or via lending against it. Especially, given that this was its approach to the now largely divested stake it held in Alibaba Group Holding Ltd. ( BABA ).

Macro Environment Poses Challenges

Besides homemade problems, there are also macro headwinds. Presently, I believe that the most significant challenge to Softbank and its business model is the interest rate environment. Money costs money again, and most likely for quite a while.

Softbank, being a Japanese company, has a certain advantage due to being domiciled in the one place within the developed world where rates are still low. But that may change, eventually. Japan may be an island (well several islands, actually) but it is not isolated from global trends. Prime Minister Kishida’s government plans to curb inflation via a ¥13 trillion (in excess of $110 billion) stimulus package . That may work out. Japan has always been rather atypical when it comes to inflation and interest rate environment. But if it does not, I doubt that the BoJ will be able to maintain interest rates at the current level.

And even under the assumption that interest rates in Japan will remain significantly below those of other developed economies, there is trouble ahead for Softbank, as this is a recipe for pressure on exchange rates. The Yen already trades near a three-decade low relative to the Dollar as is. Bear in mind: most of Softbank’s investment activity does not occur in Yen. In this context, I believe it is worth mentioning, that a significant share of Softbank’s outstanding bonds denominates in Euro or Dollar.

Its main source of liquid funds in meaningful quantities (other than borrowing), on the other hand, is its 40.5 percent stake in Softbank KK, a telco company relying overwhelmingly on the domestic market. Its revenues are generated predominantly in Yen. And, equally important if not even more, it pays its dividends in Yen. Yes, Arm, too, is profitable but it pays no dividends. Therefore, its liquidity, while consolidated on the balance sheet, is not fully accessible to the parent, now that Arm is a public entity.

Higher rates are more challenging, the more indebted a company is. And Softbank’s debt is considerable. As of June 30 ^th , Softbank reported ¥6.4 trillion (just shy of $43 billion at current exchange rates) of interest-bearing debt. At the same time, the company had $7.3 trillion (currently around $48.5 billion) of cash and equivalents. In the subsequent quarter, Softbank paid $16.1 billion for a 25.1 percent stake in Arm. After subtracting IPO proceeds in the amount of $5.1 billion, the Arm transaction will have reduced the cash balance by around $11 billion. So, Softbank should have had around 37.5 billion of liquidity prior to any in and outflows in the quarter ended September 30 ^th (numbers due to be released on November 9 ^th ). On the other hand, it reported ¥11 trillion (around $73 billion) of current liabilities. All in all, significantly rising interest expense can be expected going forward, in my view.

That, I believe, is also likely to deprive Softbank of its most effective tool in terms of shareholder value creation for the foreseeable future. For years, much of the stock’s performance has not been driven by the underlying business, but by – admittedly very effective – buybacks. In the absence of meaningful capital costs, that made sense. Now, however, there is a price for this kind of value creation. Effectively, one of the biggest (if not the biggest) buyers of Softbank shares could very well be out of the market for a good while. Naturally, that is not the best news for the future development of the share price.

Risky Loans to Masayoshi Son

Softbank does not only give money to other companies. The company also lends significant sums to its own executives (at favorable terms, one might add). To be perfectly clear, this is not some “dirty little secret”, the company is transparent about this in its financial reporting. Also, there has been media coverage. The Financial Times, for instance, reported in-depth on this matter. Nonetheless, I think it is worth giving these loans some thought when discussing Softbank as an investment.

Most importantly, Softbank granted $5 billion in personal loans to its CEO, Masayoshi Son. He used most of these funds to acquire equity in the Vision Fund 2 and other Softbank sponsored investment vehicles. His personal assets, in turn, consist largely of Softbank equity and stakes in related entities. Notably, Credit Suisse – which had been Mr. Son’s go-to lender in the past – ended the arrangement in 2021. Keen followers of the international banking world may recall, that Credit Suisse – recently absorbed by UBS Group AG ( UBS ) in an emergency transaction put together by the Swiss government - was not particularly famous for its risk aversion in the last years of its independence.

Leaving aside the obvious bad optics of a public company lending money to its own executives at preferential terms, this poses a big risk to the company: a scenario in which the outstanding amount is imperiled is exactly the kind of scenario in which Softbank could least afford to write it off. For shareholders it would be double trouble , as liquidation of Mr. Son’s shares would put further pressure on the stock price (the mandatory reporting of the transaction would all but guarantee additional negative publicity).

With all due respect to the concept of shared pain being half and all, that does not help investors. Also, I think that this creates a further conflict of interest in so far, as it may encourage the CEO to rather bet the farm on a Hail Mary gamble, rather than resizing the company in order to preserve it, if the going gets really tough.

Vision Funds Investments

With Arm and Softbank KK being profitable, yet saturated businesses, Softbank investors must rely on its investment business for growth. And that means, in essence, the Vision Fund segment – which comprises the Vision Funds 1 and 2 as well as the smaller Latin America Fund. Unfortunately, leaving aside WeWork (and the Vision Fund is directly affected by that one, too) this has been the worst performing segment as of late. For FY2023 (ended March 31 ^st ), the segment generated a combined loss of ¥4.4 trillion (around $32 billion at the time).

Many of the Vision Funds’ portfolio companies are not (yet) profitable. In order to keep afloat, let alone grow as expected, they require fresh funds. Meanwhile, in an environment of higher interest rates, credits become increasingly more expensive while venture capital’s relative financial attractiveness decreases. With lower third party investor interest, Softbank faces the dilemma of having to contribute more capital at higher cost or to accept slower growing or even defaulting portfolio companies. Down rounds, on the other hand, may lead to (albeit paper) losses. To make matters worse, the Vision Funds made most of their investments towards the height of the frenzy, and the corresponding high valuations show that all too clearly. This problem is, arguably, more pronounced for the Vision Fund 2 (and that is, unfortunately, the vehicle in which Softbank holds a much greater stake).

That is not to say that everything is great when it comes to Vision Fund 1. Far from it, in fact.

First of all, there is the issue of coupon payments: Outside investors of the Vision Fund 1 hold 62 percent of their investment in preferred units with a 7 percent coupon. That alone are around $2.83 billion in annual coupon payments, which are only partially offset by management fees (approximately around $650 million). So, just to break even, the fund would have to generate annual profits of around $2.2 billion – so far, it has lost money instead, most of the time.

Furthermore, Vision Fund 1 is less diversified among individual companies and has more outsized holdings, such as Arm, WeWork or DiDi Global Inc. ( OTCPK:DIDIY ). Naturally, trouble at one of the larger investments is particularly painful and even relatively strong performances by other, smaller holdings may not entirely offset losses. Notably, there have been several examples of relatively large Vision Fund 1 investments going belly up, such as Greensill and now WeWork.

That notwithstanding, I expect the upcoming results to appear rather positive for the Vision Fund segment at first glance. However, one should keep in mind that there will be a significant profit from the Arm exit. While this profit is real, it is also not quite honest, as it reflects an inflated price paid by Softbank itself to its own fund. Going forward, I would not be surprised if there were further losses for the Vision Funds ahead.

Thesis Risk

Obviously, there is no guarantee that my thesis will be proven correct. In the spirit of transparency, I should mention that I saw Softbank on the brink of collapse once before - and turned out to be wrong. The massive buybacks, which I referred to as “a dangerous gamble” at the time, resulted in significant shareholder value. There may be developments that change the situation in Softbank’s favor.

Among the many investments spread across the Vision Funds, there may indeed be the one company that turns out to be “the next big thing” down the line. If it is a really big thing, that might change the whole equation. A second Alibaba, so to speak. While statistically unlikely, that is not impossible. Also, interest rates could be lowered following events yet unexpected. Just a month ago, who would have foreseen a 9/11 scale terrorist attack on Israel and the resulting oil price spike.

Conclusion

Softbank has built a business model around the availability of nigh unlimited capital. Rising interest rates and more risk averse investors and creditors have made that business model considerably less viable. WeWork is the most extreme symptom of the company’s troubles but neither the only nor the biggest of Softbank’s problems.

Going forward, I expect the considerable debt load and increasing cost related to it to cause significant financial pain. At the same time, the company will need to continue spending in order to enable its portfolio companies to grow and become profitable, if it wants to recoup its investments, let alone generate returns. Furthermore, there are issues such as excessive lending to company executives. That in and of itself is something that I would consider a major red flag.

I, therefore, maintain my overall view of Softbank and reaffirm my medium term price target of $32 to $36 dollar per share. However, I believe that the risk of an outright collapse of the company has increased over the last months. Also, I believe that share buybacks are likely to be off the table for the foreseeable future, due to financial constraints. Thus, I downgrade my rating to a strong sell.

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