SFTBY - SoftBank Group: Opportunity Remains In Weak Environment

Summary

• SoftBank relies on speculation-friendly markets due to their investments in pre-IPO tech companies.
• As one of the best, and only, ways to gain exposure to start-ups, investors can consider an investment in the firm.
• However, the market is currently unfavorable for the conglomerate as the IPO market slows and valuations fall.
• I suggest investors can take advantage of the weakness to accumulate shares for the future.

Introduction

SoftBank Group ( SFTBY ), led by famous investor Masayoshi Son, is an interesting company that found its roots in telecommunications but is now essentially an asset manager in public and private markets. The firm raises capital and primarily invests in early-stage private tech companies and earns money when those firms IPO at higher valuations. This began in the early 2000s with a timely investment in Alibaba that offered a return in the billions. Over the past few years, SoftBank has been combining these profits with capital raises to form the Vision Funds, and this recycling of capital will provide meaningful returns over a long horizon. The issue is the current market is very poor for this speculative asset class.

This article will discuss the current environment and highlight recent developments. I would also like to note I have written a more detailed article on the past weaknesses of the company, and I would recommend beginning your own research there. In summary, I detailed how various issues led to a steep decline in valuation starting in late 2020, which only seemed to bottom in Fall 2022. Although the share price is up 5-10% from my prior coverage, my conclusion that the investment is undervalued remains. Therefore, my thesis will continue to be that investing in SoftBank now during weakness and undervaluation will bear fruit in the future, but to remain wary of the speculation and volatility.

Recent Developments

The current technology market is quite unique, but bears some similarities to the years after the Dot-com Bubble. 20 years ago was when SoftBank made their first key investments, and the $16 billion in capital raised during 2022 may offer high returns in the future. The key of course will be if SoftBank can continue operating without becoming a risky, debt-heavy company, along with allocating their capital smartly. In terms of smart capital allocation, I will share my thoughts when covering the current assets. However, one major catalyst that is dragging on SoftBank is the long-awaited IPO of the UK’s Arm. Upon a successful conclusion of the Arm saga, I believe both the asset base and managerial sentiment will improve.

In regards to SoftBank’s financials, a recent outlook downgrade by the Japanese Credit Rating Agency in January from A- Positive, to A- Stable suggests that the operating ability of SoftBank is fine, but the market is far too weak to be confident:

JCR in its previous rating review for SBG (announced on November 2, 2021) changed the rating outlook to Positive and stated that continued attention would be paid to SBG’s observance of financial policies and fund management performance. SBG has since been strictly maintaining these policies, including managing LTV below 25% in normal times, and confidence in financial management has thus increased. Meanwhile, the environment for fund investments has deteriorated drastically, and its future is highly unpredictable. Cumulative investment gains/losses on fund investments were negative for the second quarter of the fiscal year ending March 2023 (FY2022). Having announced its policy to be strictly defensive, SBG is determined to be selective in new investments. Accordingly, the amount of investment for the second quarter (3 months) of FY2022 dropped to as low as 300 million US dollars. Based on the above, JCR, while affirming the ratings on SBG, changed the outlook from Positive to Stable.

Although the downgrade is a temporary bearish indicator, this weakness also suggests that the bottom of the cycle is close. Upon a normalization of more risky and speculative assets, or at least a more predictable market, sentiment will improve rapidly. Even over the past month or two, speculative assets have had a resurgence across the market. If this continues, and combined with more conservative management, SoftBank should return to having a positive outlook, earn significant returns on investments made in this market, and return these profits to shareholders. But first, let's look at the current asset base.

Current Assets

As of the last earnings, or calendar year end 2022, SoftBank had 16.9 trillion yen, or $128 billion USD, of equity value, along with additional loans and derivatives. If based on currency of one year ago, the USD valuation would stand at $147 billion. This compares to the current USD valuation of SoftBank of $66 billion. Investors clearly expect the internal valuations to remain high to discount these equity holdings by such a high degree. The current ratio equity value to market cap of 0.52x may seem low, but is above the ratio of 0.37x seen one year ago. This is due to the sell off in Alibaba (BABA) equity and downward rerating of valuations of equity assets.

The fluctuating discount to equity value is an interesting, and difficult to track, factor. However, there's some stability from the 21% of equity being held in more stable telecom assets, T-Mobile ( TMUS ), Deutsche Telekom ( DTEGY ), and SoftBank Corp ( SOBKY ). Then another 43% of the equity is held in the Vision Funds, with over 60% of those assets still not close to maturation or IPO. Therefore, while speculative, organic growth can possibly provide risk-adjusted returns of these funds over the current cost basis. Lastly, we have the two controversial assets, Alibaba and Arm, both of which are the most prominent valuation detractors for SoftBank, but more on that later. For now, I believe that the asset values compared to market cap continue to suggest undervaluation, although this may not appear so as equity valuations continue to fall.

Vision Funds

While the Vision Funds are speculative, there is some order and thought put into the investments. First, SoftBank has a few focus areas where the most capital is deployed: consumer tech, logistics, and frontier tech (innovative tech). These are areas that SoftBank already has extensive experience with, and also offer plenty of secular growth drivers. However, the performance of the funds has been poor over the past year with unrealized losses reaching over 30% YoY. Losses are also now seen across the entire lifetime of both the SVF1 and SVF2, as the fair values are currently down by 15% and 37%, respectively. Only time will tell if the two major funds can ever return to seeing unrealized profits. For now, look for more IPOs (at higher valuations) over the next few years to unlock some of this value.

Arm

The pending IPO of Arm is both a risk and a catalyst for SoftBank. The lofty $32 billion acquisition price a few years ago is certainly at risk in the current market. In fact, SoftBank may even see losses if the IPO occurred right now. However, the other issue is that if they wait, Arm will lose their mystical nature as a secretive and highly valuable company. Therefore, investors are holding their breath until a final decision occurs (or is allowed to occur). As per the JCR report:

Going forward, [SoftBank Group] intends to accelerate the growth strategy of the Arm segment and focus on increasing Arm’s corporate value. Microprocessors designed by ARM have strength in low power consumption, and their market shares for 2021 were 95% in mobile and 63% in IoT. Arm-based chip shipments also keep growing. SBG is constantly working on improving functions as well, and its competitiveness may increase further.

This date suggests that SoftBank can wait to IPO the company in a more favorable environment, and I am sure most investors would agree to earn the best value possible. Financially, one risk is that growth is slowing due to the lack of consumer chips over the past year, although the IoT segment is remaining strong. While profits remain, the single digit growth rate is a big bearish point and another reason to not IPO in 2023. And, with the current nearly 12.0x P/S valuation necessary to earn a slight profit on the investment being a hard ask, investors will likely continue to look unfavorably on SoftBank.

Alibaba

Lastly, the era of having Alibaba as the flagship asset for SoftBank is over as the company has sold over 50% of their equity holdings over the past few years. While some would frown on the low prices SoftBank is selling at compared to 2020, others may agree that Alibaba is extremely risky and continues to fall. As I see it, it is good to sell off risky assets and finding new long-term bets is a better use of the capital. Either way, SoftBank is earning a huge profit after holding Alibaba for 20 years, and any sales price is favorable in generating funds. While the Alibaba era is ending, I look forward to the next asset that rises to the top to fund the next 20 years of investment, continuing the circle of life.

Conclusion

Taking advantage of weakness is the key investment thesis for SoftBank, and that certainly comes with risk. However, I also believe that the exposure to private growth markets is worthwhile, and SoftBank has a management team willing to take calculated risks. And, things may improve in time according to investment advisers, Houlihan Lokey ( HLI ), during their most recent reports:

...[T]he financing market remains challenged. Mid-cap transactions can still get financing, but lenders are more selective. The cost of debt is up significantly and some lenders have opted to sit on the sidelines until they perceive better visibility on the economy. This has resulted in pent-up demand in M&A, which we believe will ultimately be a positive for our business once there is more broad-based confidence in the economy.

While issues of the past may continue to dampen sentiment, investing now on a recurring basis will set up investors nicely for the next bull market. I would not attempt to time any investments, but I certainly feel confident in accumulating at the moment. Just make sure to keep a long mindset, and I would certainly hold for a few years at least. I hope my analysis offers some peace of mind for those who are holding as well.

Thanks for reading.

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