BABAF - SoftBank's Recent Issues Have Led To Undervaluation

• This year, two major catalysts for SoftBank are the potential sale of the Fortress Investments subsidiary and the Arm IPO.
• This complicated company has faced underperformance over the past few years, especially after the 2020 speculation boom.
• However, if valuation reaches a certain threshold, I suspect the company is a fairly opportune buy as a diversified tech investment.

The Berkshire of the Tech Industry, With Risk

For those who may be unfamiliar with SoftBank Group ( SFTBY ) (SFTBF), I will provide a short summary. The company, led by enigmatic founder Masayoshi Son , is taking a unique approach that is a mix of traditional Japanese “keiretsu” and a western-style holding company. In essence, SoftBank is taking a Berkshire Hathaway-esque approach to private equity and diversification in the communications and technology industries. This began with distributing software in the 90s, then moved to telecommunications in the 2000s after SoftBank acquired Vodafone’s Japanese assets. A research paper in 2001 signaled the importance of SoftBank’s business style as traditional keiretsu failed:

[W]hile the traditional keiretsu system began to unravel, Softbank, ironically, represented a new kind of keiretsu. Paradoxically, during its evolution, Softbank has resembled each of three broad types of traditional keiretsu. Secondly, we attribute Softbank's success to its ability to leverage asymmetries in three types of information: the value-chain asymmetry between software developers and retailers; the financial asymmetry between practices in the US and Japan; and the technology asymmetry between computer products in the US and Japan.

SoftBank's telecom assets became the flagship portfolio for Son during the 2000s, and profits began to be funneled into speculative ventures. One of these includes major ownership of Chinese e-commerce leader Alibaba ( BABA ) leading to a significant return since the early 2000s. Selling shares of BABA over the years has allowed for further speculative bets, and SoftBank remains Alibaba’s largest shareholder at nearly 25%.

This ~$70 billion equity stake is similar to Buffett’s bet on Apple (AAPL), although we know that recent performance of the Chinese firm is quite disappointing (but not bad considering SoftBank invested $20 million in 2000). However, issues with investor sentiment and US-China relations may soon be resolved and BABA can return to historical form. If you invest into SoftBank now, at a $66 billion market cap, you gain these BABA shares for free.

BABA aside, SoftBank is also creating publicity recently due to three major endeavors: the acquisition of semiconductor process research firm ARM and the newly established Vision Funds. Accounting for almost two-thirds of SoftBank’s current net asset value, these three items will likely be the major catalysts for momentum over the coming years.

I will begin by discussing the Vision Funds. These two funds hold a collective of over 400 up-and-coming companies, and SoftBank makes money by supporting development and eventually exiting after the venture enters the public market. The two vision funds, the only major difference being age, hold $30-$40 billion USD in value, and have a lifespan reaching the late 2020s or early 2030s. The investment thesis for each is simple, and as management puts it in the 2021 Annual Report :

SoftBank Vision Funds identify and invest in so-called unicorns, or companies judged to have the potential to become unicorns, from around the world utilizing AI to deliver all manner of technological innovations. We are the world’s largest capital provider in this field, having invested in nearly one-third of the world’s AI unicorns. SoftBank Vision Funds concentrate on the pioneering elements of the Information Revolution and the Internet revolution. We are now invested in 475 companies.

Investing in unicorns is expected to be beneficial in many ways. While the most important reason to support these ventures is to nurture the development of future-focused innovation, there is in fact data that supports solid financial returns. Most important is investor expectations upon going public, and 2020 highlighted how innovation can be valued to the extreme. This led growth equity investments to see a 341% increase in market value over 10 years and unicorns grew from only 269 in 2017 to over 1,000 today. However, investments of these sorts certainly come with volatility and risk.

The risk is most inherent in overall earnings, which before the vision funds were established were relatively stable and increasing. Then the pandemic hit, leading a crazy boom and bust cycle. While holding private companies negates some valuation write-downs, SoftBank has had a significant number of listings in 2020 and 2021, along with the BABA holdings, leading to earnings to extensive losses in 2022. The good thing is that the underlying strength of the company remains strong regardless of the valuation, and SoftBank has many assets to sell or list over the coming years to provide investor cash flows (shareholders are more likely to see buybacks and capital gains than distributions).

So, you may be asking how many so-called unicorns have been listed so far. The answer is 38 through the end of 2021. These include major companies such as Uber ( UBER ), WeWork ( WE ), and Slack ( CRM ), along with companies I have covered 10x Genomics ( TXG ), View ( VIEW ), and Exscientia ( EXAI ). The listings and increases to valuation for some holdings have allowed for a return of $31.3 billion on the vision funds to date. Considering the number of companies left to list remains in the hundreds, I expect a return to profitability as valuations reset. Although, returns may not be as significant as seen during 2020/21, but based on recent market sentiment, it seems investors are looking towards speculative businesses again. Thankfully, having numerous shots on goal helps negate the negative effects of any underperforming listings, such as what happened the first time around with WeWork .

Arm IPO

Another major catalyst alongside the vision funds is SoftBank’s ownership of Arm. Arm is a leader in designing complicated systems of processing circuits for a variety of end uses, including leading in the smart-phone processor market. The acquisition back in 2016 was sizable at $32 billion USD, and SoftBank has been trying to unlock value ever since. According to the recent annual report:

Today, Arm has a 95% market share for main processors in the mobile device market, centered on smartphones...Arm seeks to drive technological innovation in other areas as well. The first concrete example is in cloud computing. Prior to our acquisition of Arm in 2016, Arm had practically no market share in this area. Since our acquisition, however, Arm has focused its R&D on new processor designs for cloud computing. As a result, Amazon Web Services, the world’s No. 1 cloud service provider, has started to deploy Arm technology for its state-of-the-art cloud server chips. Other cloud companies are also starting to deploy Arm technology, and Arm is seeking to continue to grow its market share.

Along with operational improvements, SoftBank was looking for potential suitors over the years. This included a sale to NVIDIA ( NVDA ) that was ultimately blocked by regulators. Now, SoftBank is looking to IPO Arm to the NYSE and LSE, but it seems that the London listing may be off the table as well. Investors and UK residents can blame Boris Johnson and the exit of his administration. While Son favors the US as the main listing site, the UK is still trying to keep a London-listing on the tables for UK-based Arm.

Outgoing Prime Minister Alexander Boris de Pfeffel Johnson viewed Arm as a torchbearer for the British technology industry and felt that Arm shares being taken public again on LSE would raise the global profile of the exchange. Incentives are said to have been dangled in front of SoftBank.

Regardless of what happens, Arm is likely to unlock significant value for SoftBank thanks to strong financial performance. The company has a long pattern of over 30% revenue growth, thanks to long-term royalties of smartphone chip manufacturers licensing out Arm’s systems. As the number of end-uses increases, we should continue seeing this exponential growth in chip sales over time, and in turn, see an increase in stable royalty revenues.

The only issue is that a listing in 2022 would not provide a favorable valuation for this asset, and I would expect SoftBank to wait until investor sentiment improves. In fact, I believe SoftBank may even see a loss if they list the company to market as total revenues have only reached $2.7 billion for FY 2021 compared to the $32 billion acquisition price half a decade ago. I believe a 10x or higher P/S may be a tough ask at the moment, but we will see.

Fortress Sale

One last major catalyst that has arisen over the past few months is the potential sale of the Fortress Investment Group subsidiary. Fortress is a private equity firm based in New York that has over $50 billion in assets and provides services in credit and permanent capital vehicles ( FTAI ) as well. This subsidiary has been busy of late with numerous private market acquisitions, as well as listing multiple acquisition companies to the market ( FVT )( FVIV ).

The company has a major focus on real estate, and I can see why SoftBank is ready to part ways. While some investors believe that having Fortress’ experience aids the Vision Funds, I believe there is little cooperation between the two groups. Further, the recent investments have not been in relation to technology in the slightest. In fact, recent news indicates that Fortress is looking to buy underperforming retail stores in Japan from 7-Eleven’s parent company, Seven & i Holdings ( SVNDY ).

Fortress Investment Group, a SoftBank Group-affiliated investment fund, has obtained the first refusal right in the acquisition of struggling department store unit Sogo & Seibu, owned by Seven & i Holdings, Nikkei has learned.

This $1.5 billion retail deal aside, Fortress may be a profitable sale for SoftBank. Interestingly, the current buyer seems to be a venture-focused firm of the Abu Dhabi sovereign wealth fund, Mubadala Investment. Perhaps one reason why is that Fortress is the owner of numerous travel, leisure, and sporting locations, a new area of investment for the Gulf States. In 2021, Fortress acquired Accordia , Japan’s largest portfolio of golf courses , for $3.5 billion and with the rise of Saudi Arabia-backed LIV, one has to wonder if this is another potential motive. While terms are not listed, I am sure the sale price may be favorable and provide a needed boost to cash flows for 2022.

This is certainly a better outcome than the losses seen with SoftBank’s other controversial investment group SB Northstar who have sold most of their assets for a loss. Per the Financial Times , this event highlights the risks of SoftBank and the volatile leadership of leader Son:

The rapid rise and fall of Northstar has added to longstanding corporate governance concerns at SoftBank over the company’s ability to place adequate checks on its billionaire founder Son. Son holds a third of the unit personally and was the driving force behind its outsized derivative bets on US technology stocks that stunned the market in 2020. In September of that year, the Financial Times unmasked SoftBank as the “Nasdaq whale” that had bought billions of dollars’ worth of US equity derivatives, which other traders blamed for exacerbating big swings in the prices of technology stocks.

Discount to NAV

While there are certainly catalysts for growth, it is little surprise to see SoftBank’s market cap fall over 50% from highs in early 2021. Due to recent performance, Son has been placed in rank with names such as Cathy Woods of ARK ( ARKK ) and Bill Huang of Archegos fame. While I do not believe it is that dire, I expect sentiment will remain poor for some time. Other risks include a loss on the ARM listing and underperforming Vision Fund listings. Therefore, it will be of utmost importance to buy shares at a discount, if you are even interested in the company.

The main benefit of SoftBank at the moment is the significant undervaluation to the current NAV. SoftBank now trades at 0.85x trailing price to book, and this is trading near all-time lows. While the downward trend in valuation has been occurring over the past 20 years, I suspect there may be a rebound if risk is contained and steady operation actions persist. Perhaps even Son’s retirement may be applauded by investors.

Conclusion

At the moment, I believe that investors who want cheap access to innovation and technological advancements can begin adding shares at this level. However, I highly recommend recurring investments to negate volatility to your cost average. Financial stability has slowly been developing thanks to increased diversification of the SoftBank portfolio, and BABA underperformance now holds far less weight than before. If finances improve now that markets are settling, but the price remains in a downward trend, then I may find the opportunity quite compelling. Until then, I will be watching carefully as the details on the ARM IPO come out.

Until then, I will remain on the sidelines as I prefer picking and choosing my own innovative holdings. Feel free to comment your thoughts on the unique asset manager below, and if SoftBank may be a better, passive choice for your investment needs. Thanks for reading.

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