Softbank – A great capital allocator and sum of the parts
The long thesis here is basically that Softbank is run by an excellent capital allocator and is trading at a deep discount to its sum-of-the-parts or break-up value. I largely agree, however I want to have greater clarity on how Mr. Son is going to unlock shareholder value over the near-term. Any eminent catalysts over the next 2-3 years would be great for closing the holdco discount gap and consequently increasing the IRR on this investment. But I also wouldn’t worry too much if the stock stays flat in a trading range for a little while. Given Son’s exceptional track record, (I believe Softbank has been able to compound intrinsic value per share at 20%+ since it went public) I think it’s a very high probability that Softbank will continue to compound intrinsic value per share at superior rate of return for a very long time. If we analyze all of Softbank’s major investments since inception, the compounded rate of return has been roughly in the mid 40’s%, driven largely by the investment in Alibaba; Son invested $20MM in Alibaba when the business will still being run out of Jack Ma’s apartment. Talk about a visionary. Even if we exclude Alibaba from the return figures, I believe his track record is still in the low 20’s%. I think how Son runs Softbank is actually quite similar to how Buffet grew Berkshire – intelligently investing all the cash flow from existing cash cow businesses into opportunistic, very long-term investments. I guess for Buffett it was more like investing the low-cost float received upfront from his insurance businesses. For Son his Japanese telecom business is basically the cash cow. I really like how Son is building Softbank’s ecosystem to prosper in the “mobile revolution”. He’s investing in the infrastructure (Sprint), the content via mobile games (Gungho, Supercell), and in the services (Alibaba).
Aside from the typical complex holdco discount, I believe that investors’ worries over the outlook for Sprint and the negative short-term sentiment for Alibaba is why Softbank’s shares are still trading at such a large discount to intrinsic value. But for the enterprising, opportunistic value investor that’s willing to dig through all the moving parts, I believe Softbank is quite cheap.
Domestic Telecom Business: The Japanese wireless industry is basically a 3-player market and although Softbank continues gain incremental market share, it remains third behind its competitors DOCOMO and KDDI. Apparently Son was able to convince Steve Jobs to give him exclusivity in bundling the original iPhone models with wireless plans when they were first released. Along with his foresight in betting on the iPhone, Softbank was able to undercut industry pricing by a large margin which led to huge market share gains. Some analysts were expecting Apple’s iPhone’s handset margins to come down as competitors would eventually catch up and pressure pricing in an increasingly commoditized product; if this were to occur then the telcos would be able to pass on some of these device cost savings to consumers. Despite the increasing competition, the iPhone product lifecycle doesn’t seem to be ending anytime soon and pricing hasn’t been pressured at all. I’m not sure if Apple’s ecosystem will allow them to earn above-average profits for the long-term but what I do know is that Softbank’s customers continue to buy lots of expensive iPhones among all the alternatives. So overall the business remains healthy today. They’re currently #1 in terms of networks speeds and they’ve recently completed a major CapEx upgrade cycle to 4G, so I expect their free cash flow to materially ramp-up over the next several years. Moreover, the industry players have each recently shown signs of ending aggressive promotional pricing, which should further support healthy long-term ARPU growth, or at the very least support stable pricing. I value their wireless business in-line with comps at 6x EBITDA.
Sprint: Sprint definitely has its problems. The US wireless industry remains an extremely competitive 4-player market as T-Mobile and Sprint continue to invest large amounts of capital on upgrading their networks and hurting the overall industry profitability with their deep pricing cuts. I’m not an expert on the US wireless industry so I don’t think I have a huge edge here. Some analysts even believe that Sprint’s equity could be worth $0. Fair enough. Let’s assume Sprint’s equity is worth 0. Worst case scenario, Softbank would inject a little bit more equity capital in a cash-hemorrhaging Sprint. Even under this scenario, my break-up analysis suggests that Softbank’s shares are still worth nearly 15,000 YEN 2 years from now. So whether or not Sprint is successful in reaching minimum efficient scale doesn’t make or break the thesis.
Alibaba: I believe Alibaba’s value is worth much more than the current market cap of Softbank today. I value this business at 25x 2017E EBITDA of $12B, or $300B. As they continue to scale their marketplaces, their operating margins should continue to ramp-up, along with an increasing incremental return on capital. With such a large fixed-cost base, I don’t see how their incremental margins on transaction growth won’t hold up despite the monetization concerns. I also think the fake product concern is short-term in nature. On top, they have a huge payments processing arm in AliPay, an infrastructure-as-a-service (IAAS) business that sells excess cloud capacity, and a logistics joint-venture; this is a monster of a business and likely one of the highest-quality in the world. These guys were basically a start-up that drove eBay’s business out of China. Their end market growth runway is huge, they’re in a net-cash position, and for a monopolistic, asset-light, toll-booth business on China’s growing e-commerce market, I think $120 per share is reasonable. Since Mr. Son is also the largest shareholder of Softbank, I doubt that he would want to incur a large tax hit should he decide to monetize the Alibaba stake with the huge tax basis. I assume, like Yahoo!, that their stake will eventually be spun-off in a tax-efficient transaction, so I apply no after-tax value. I also think the domestic regulatory or currency risk is quite limited. Longer-term I think as the market better appreciates Alibaba’s value it will be a driving force in lifting Softbank’s shares.
If Softbank shares can close 90% of the holdco discount in 2 years, the IRR on this investment will be ~38%. Like most other major non-US currencies, the Yen has been getting annihilated. In terms of structuring this position, I think I’m going to fully hedge out the Yen, and I might even short the proportional Sprint stub. Based on the proportional values of each piece, you can create your own stub if you like.