SoftBank Group: Massive Discount To NAV Sends A Warning To Tech Investors (OTCMKTS:SFTBY)

perrygerendayThe liabilities are always 100% good. It’s the assets you have to worry about. – Charlie Munger It does not matter how many Nobel Prizes have been given to economists working on the efficient market hypothesis, we have seen too many market inefficiencies to believe the market is a near perfect valuation mechanism. From blank check companies (SPACs), which are basically a pot of money, trading at high premiums to their NAV even before they have found a merger target, to GameStop (GME) adding billions to its market capitalization because a famous internet guy tweeted an enigmatic image. Perhaps one of the best examples of market inefficiency is when investors get confused and buy the wrong company, as happened when many put purchase orders for a small company called Zoom Technologies, when they wanted to buy shares in Zoom Video Communications (ZM). That shows the level of detailed, thorough, and expansive due diligence some market participants perform before making investment decisions. Still, we believe that stocks and bonds can remain grossly mispriced only for a limited time, and we are big believers in Benjamin Graham’s maxim that “…in the short term the market is a voting machine, in the long term it is a weighing machine”. We also believe you will get different levels of market efficiency depending on the investment base, with a company like Berkshire Hathaway (BRK.A)(BRK.B) more likely to be reasonably priced compared to one where meme-stock traders are big participants. With this in mind, we would like to talk about the curious case of SoftBank Group’s (OTCPK:SFTBY)(OTCPK:SFTBF) massive NAV discount. This is an instance where the market is clearly wrong one way or another, either SoftBank is absurdly undervalued, or its biggest investment ARM Holdings (ARM) is grossly overvalued. We believe it is probably the latter, and this sends a powerful message to tech investors that some companies are clearly in bubble territory. Understanding SoftBank Group In its most basic form, SoftBank Group is relatively easy to understand. It has become basically a holding company of technology and telecommunications investments, many of which are public. It also has a significant part of its capital in venture capital funds that it operates, called the Vision Funds and the LatAm Fund. The company explicitly tells investors that the best way to value the company is to take the equity value of its holdings, subtract net debt at the holding level, and that gives you the NAV at which shares are supposed to trade. It is not uncommon for conglomerates, holding companies, and closed-end investment funds to trade at a 10-20% discount to NAV. SoftBank Group Investor PresentationWhat is remarkable in SoftBank’s case is that its shares are currently trading around ¥‎7,868, despite the NAV per share based on the last financial report from the company being ¥‎18,961. The company even has a dedicated page on its website where investors can check the most recent NAV estimate, or some of the parts (SOTP) valuation. In other words, the NAV discount is approximately 60%, which is rather extreme. One important thing to note is that SoftBank does not have anything close to the retail investor following that ARM and other SoftBank investments have, such as DoorDash (DASH). We therefore see the massive NAV discount as a warning from institutional investors that many of SoftBank’s investments are grossly overvalued. SoftBank IR Website SoftBank IR WebsiteAnother important factor at play has been the depreciation of the Japanese Yen (FXY), as SoftBank has most of its debt denominated in its home currency. Between the surge in ARM shares and the depreciation of the Japanese Yen, SoftBank’s NAV basically doubled. SoftBank Group Investor PresentationMain Equity Holdings We believe the telecommunication investments are probably reasonably valued, which are mostly T-Mobile (TMUS), Deutsche Telekom (OTCQX:DTEGY), and SBKK (OTCPK:SOBKY). Unfortunately, these make less than 20% of SoftBank’s investments. As recently as June 2024, ARM Holdings was responsible for the majority of the equity holdings value, with the Vision Funds representing another ~25%. The Vision Funds have a mix of public and private companies, with some of the largest public investments being DoorDash and Coupang (CPNG). To be fair to the company, we have to give them credit for some smart moves it made such as selling its massive Alibaba (BABA) stake at relatively good prices, and selling Sprint to Deutsche Telekom with a clause that included that they would get extra shares if T-Mobile’s share price exceeded a certain price, which it did and resulted in SoftBank basically acquiring an extra 48.8 million T-Mobile shares for no additional consideration. Still, there is an enormous difference between the current market cap of roughly ¥‎11.5 trillion and the estimated NAV by the company of ¥‎34 trillion as of June 20, 2024. We believe this valuation gap is a warning to tech investors that many institutional investors see excessive valuations in many tech companies, especially the ones that have benefited from artificial intelligence excitement, such as ARM Holdings. SoftBank Group Investor PresentationARM’s Valuation There are multiple things to be excited about when talking about ARM, it has maintained its dominance over the smartphone market and is quickly making inroads into the data center and growing its Internet of Things (IoT) share as well. That said, we believe its valuation is significantly higher than what fundamentals justify. This is probably the result of a combination of a low float, as SoftBank still has a majority holding, and investor excitement about artificial intelligence. It is important to remember that just a few years ago, NVIDIA (NVDA) was offering $40 billion to acquire the company, with the acquisition ultimately failing due to regulatory issues. For perspective, the current market cap is roughly 3x higher, and NVIDIA would have gotten some additional benefits such as potential synergies and the benefit of controlling one of the most used computing architectures, moving its development to benefit NVIDIA’s technology goals. While ARM is ubiquitous and gaining share in many of its end-markets, this has been possible in part by charging a relatively low royalty rate. Investors should remember that there are open source alternative such as RISC-V, and customers can use this as leverage to negotiate lower royalty rates with ARM. One company known for tough negotiations with its suppliers is Apple (AAPL), and reportedly it used the RISC-V threat another tactic to pay tiny royalties to ARM, reportedly less than 30 cents per device. SoftBank is understandably not happy with the situation, with CEO Masayoshi Son reportedly complaining that Apple paid more for the piece of plastic that protects the screens of new iPhones than it did to license Arm’s intellectual property. In other cases, disagreements over licensing terms have resulted in legal battles with customers, such as with Qualcomm. The takeaway is that while ARM’s architecture might continue to gain market share, the company has to spend significant amount on R&D and gets relatively low royalties in return. SoftBank Group Investor PresentationIf we look at ARM’s financials, there are some interesting findings. As expected, revenue has been growing at a healthy rate, and recently accelerated. However, we find the company’s operating margin surprisingly low for its IP licensing business model. Still, we see ARM as a high-quality business with a long growth runway. The problem we find is the stretched valuation multiples. Its trailing twelve months Price/Earnings ratio is in the triple digits, and even its forward estimated Price/Earnings (GAAP) is currently about 133x, several times higher compared to the Information technology sector median of 27.49x. Assuming a valuation multiple closer to its information technology peers, ARM is overvalued by more than 4x. Based on what NVIDIA was willing to pay a few years ago, the company would be overvalued by a factor of about 3x. Analysts like Morningstar’s (MORN) Javier Correonero estimate fair value around $66 per share, implying almost a 2x overvaluation. Data by YChartsPerhaps most striking of all is that the company is guiding for FY2025 revenue of up to $4.1 billion, which seems like not enough to support a market cap of close to $120 billion. Especially when we consider the company’s operating margin is below 20%. SoftBank Group Investor PresentationVision Funds We think many investors are probably also discounting the value of the company’s Vision Funds. SoftBank tends to invest in some of the hottest sectors, usually at high valuations, and there are many instances where it became clear the company could have done a better job with its due diligence. Perhaps the best example is WeWork, but there are several others like Greensill, Wag!, Silicon Valley-based robotic pizza-making Zume, to name a few. To be fair, it has also had some remarkable successes, including DoorDash and Coupang. Still, with the company focused on the artificial intelligence theme many of its investments are being done in company’s having significant cash-burns and a relatively small probability of successes. Perhaps the best example is autonomous driving, where the company has made several significant investments, but so far, these startups are generating negligible revenue, are spending huge amounts on R&D, and their potential success lies well into the future. SoftBank Group Investor PresentationOne peculiarity of the Vision Funds is that they tend to keep some of their investments long after they IPO. We are not sure this has been the best strategy, as many of its holdings are trading at a significantly lower valuation compared to the peak valuation they reached previously. For example, at one point the DoorDash investment was worth around $84 billion, and now it has gone down significantly. Still, even at today’s lower price we are not convinced DoorDash is properly valued as it remains unprofitable and its revenue growth rate has collapsed. SoftBank Group Investor PresentationWe are even more skeptical about the private investments, even though there are some famous unicorns in the portfolio, including TikTok’s owner ByteDance and UK fintech Revolut. We are particularly pessimistic about investments like DiDi Autonomous, and buy-now-pay-later fintech Klarna whose value might suffer significantly if the economy enters recession and consumer defaults increase. SoftBank Group Investor PresentationThe combined Vision Funds and LatAm funds had a combined cumulative gross investment loss as of March 31st, 2024. We find this surprising given the benefit of investor excitement towards AI startups, and worry losses will significantly increase in a recession, once investors pay more attention to cash burn and whether some of these companies have realistic paths towards profitability. SoftBank Group Investor PresentationBorrowings Mostly in Japanese Yen Another factor to take into consideration is that the company mostly borrows in Japanese Yen, but most of its assets are denominated in currencies like the dollar and the euro. The company’s NAV therefore benefits from Yen depreciation, which has been very significant in the last couple of years, and only recently did the trend start to reverse. Data by YChartsCredit Rating In theory, the company has a relatively low loan-to-value, but if the assets are overvalued, the real leverage could be actually meaningfully higher. This is perhaps why rating agencies seem to diverge on their opinions, with the Japanese rating agency JCR recently upgrading the company’s credit rating, while S&P Global (SPGI) actually decreased their rating last year. SoftBank Group Investor PresentationValuation The current massive discount to NAV already reflects most of the concerns we have regarding ARM Holdings and the Vision Funds, with the market appearing to value the assets at less than half their carrying value and adding an additional conglomerate discount. We currently view shares as a “Hold”, but worry that SoftBank could see additional downside if the current trend away from overvalued AI companies continues, as well as the potential for capital mis-allocation, and other risks we detail in the next section materialize. Risks While the current discount to NAV mitigates risks for investors, there are other potential problems. This includes Founder & CEO Masayoshi Son pledging a significant portion of his SoftBank shares as collateral for loans to co-invest directly in the Vision Funds and other ventures. Should there be a significant market crash, he could receive a margin call forcing the selling of his shares at possibly the worst time, and further driving down the share price of SoftBank shares. Another important issue, and this is why many conglomerates trade with a discount, is that there is a risk he might sell some investments to re-invest in ventures that most investors might not actually find appealing. Specifically, Masayoshi Son has recently been saying that SoftBank was founded to realize Artificial Super Intelligence (ASI), which he defines as 10,000x “human wisdom”. This could result in SoftBank monetizing some of its more stable investments, perhaps the telecom stakes, to invest in long-shots in AI and quantum computing startups. These would probably be long-shots, where they could deliver impressive returns if successful, but with the most likely outcome being failure. We see a similar risk with the autonomous driving investments, they could unlock massive opportunities, but most experts agree that success will be extremely hard. There are upside risks too, and we do not think SoftBank is a particularly attractive short either. The biggest upside risk we see is if the company was able to monetize some of its overvalued investments at close to current market prices, and then use that capital to aggressively buyback shares. That would be extremely accretive to NAV, and if it were to happen, it would probably change our opinion with respect to the shares. Conclusion SoftBank Group is trading at a massive discount to NAV, and we think tech investors should take it as a warning that perhaps the AI excitement has gone too far with respect to companies like ARM Holdings. With close to 80% of its value depending on ARM and the Vision Funds, we believe a market downturn will be particularly hard on SoftBank. The current NAV discount mitigates this risk, as it seems, many of its investors are already factoring this to a certain degree. Additional risks include potential margin calls from pledged shares, and selling some of the more stable investments like the telecom stakes to double-down on high-risk startups. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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