Softbank

The most talked about event in financial news this month had to be the highly anticipated listing of Alibaba. Following the listing the stock went up to the low $90s (from the $68 IPO price), however their largest shareholder Softbank is down about 10% in the same period as people can now buy direct access to Alibaba.

In case you haven’t yet heard of Softbank, it’s a Telco, Internet and media holding company founded by a Korean-Japanese entrepreneur Masayoshi Son, who owns a 19% stake in the business. Softbank is listed in Japan while ADRs also trade on the NYSE. The market cap of Softbank is around $86bn (yes, it doesn’t fall into the usual small cap category but I cannot pass up on a mispricing).

To give you a sense of the background of Softbank, it was founded in 1981 as a software company in Japan. Son’s idea was to create a media ecosystem around the Internet and have various tentacles in certain sectors (Telco, e-commerce, software, gaming etc and now potentially movies – see P.s.).

Softbank has been very acquisitive under Son’s leadership and has been involved in publishing, IT distribution and so on. It was a large investor in Yahoo and eventually started a JV with the company (Yahoo Japan) in 1996. In 2000 it made an investment of $20m in Alibaba, which has to be one of the most remarkable investments in history (current stake value is around $72bn).

One of the most daring investments in corporate Japan had to be Son’s foray into mobile communication with the acquisition of Vodafone’s Japanese operations in 2006. With the initial substantial price-cutting it really upset status quo of the heavily concentrated Japanese wireless market. To note Son has always been an outsider in Japanese business, partly due to his Korean background, but certainly this step made him the least popular person that year in the industry. Interestingly, due to Son’s relationship with Steve Jobs Softbank was the first to sell iPhones/iPads in Japan.

He has proven to be a great capital allocator worthy of the Outsider CEO title, especially in the context of Japanese companies where returns have been largely subdued due to the convoluted corporate structures (keiretsu) and maintenance of status quo vs profits as the MO. All of the above resulted in a 16% compounded total return in Softbank’s share price and growth in book value.

Softbank’s current market cap is around $86bn and estimated NAV around $107bn ($36/ADR and NAV at $45/ADR) for 25% upside (to note I take a 30% tax on the equity investments, which is up for debate).

You can look at Softbank as the following (discussing major holdings):

• Telco business (mobile, fixed, internet), which is expected to generate around $11-12bn in EBITDA in the next fiscal year. Assigning a 5x multiple (roughly in-line with comps) you get around $55-60bn EV
• Investment in Alibaba – at current market it’s worth $72bn ($51bn post tax)
• 80% stake in Sprint, which Softbank acquired in 2013, worth $20bn
• 43% stake in Yahoo Japan, which is worth $9bn
• HoldCo net debt (ex Sprint and Yahoo Japan) of $36bn

If you tot all the above up you get to around $107bn NAV (there are some other small investments as well) or a 25% upside from current. As noted above I assign a 30% tax rate on Alibaba based on a mix of ownership via Japanese and Singaporean subsidiaries. It’s questionable whether one should do it. Softbank said that they don’t expect to sell their holdings so in that case it’s irrelevant (they’ll likely use as collateral for acquisitions). However, if you want to stay on the conservative side you should. If you assume no tax you get to around 50% upside to NAV.

Holding companies are expected to trade at a discount especially if incompetent management runs them and to allow for some tax in the case of asset sale. While the holding structure is certainly a bit complex here that should not deter from the valuation much, as the management is very apt and generated strong returns to shareholders historically. Anybody ever looked at the holding structure of Berkshire with all the insurance companies in the web or John Malone’s alphabet soup of companies? Now that Alibaba is public and there is a public market-clearing price the stake becomes easier to value (though Alibaba’s fundamental value is worth another post for sure) as well as Softbank. I was expecting some volatility in Softbank as Alibaba was going public but as this quiets down we will be back to fundamentals.

Looking at Softbank another way; for the $86bn you get an Alibaba stake that’s worth $51bn (post tax), Yahoo Japan, Sprint and a few other companies for another $33bn, which means that the operating units are valued at $2bn. Last year they generated $11bn in EBITDA (there is about $36bn net debt against it). I’m no genius but this clearly doesn’t make sense.

It is possible that investors are pricing in a drop in Alibaba share price. Alibaba at current market cap makes up 48% of NAV (post tax). Now assuming that the valuation is very much stretched the company would have to see a 40% drop in share price to wipe off any upside in Softbank’s NAV. That would imply Alibaba market cap of around $130bn. If Alibaba falls 20%, roughly to the same valuation before it went public the upside narrows to 13%. If it’s a 30% drop ($160bn valuation) upside is 7%. Assuming, the valuation of the other assets don’t change there is protection on the downside.

Subject to Abenomics, currency movements could impact your investment. You can buy the shares in Japan and hedge the currency or just the ADRs in the US. I normally don’t worry about hedging FX as generally the results are mixed. Figuring out where stock prices will be in 6 months is a difficult enough job not to mention figuring out where currencies will be.

Some risks to consider are: Softbank is very acquisitive and there’ll bound to be failures in the process (currently they have 1,300 investments in a range of companies). Debt levels are very high as a result, though not unmanageable. Developments around Sprint in the US (competitive position, recent M&A news etc). Son is clearly eccentric and has a longer term time horizon than most investors (have you read his 30 year plan)? It’s very encouraging and I certainly prefer this approach but by and large the market doesn’t and there’ll be swings in the share price.

I highly recommend reading further about Softbank and Son. His career, approach to investing and track record are worthy of an Outsider CEO title

Wired

WSJ

Time

Economist

Book about him (it’s translated from Japanese so on occasions a bit hard to understand, nevertheless you get a really good picture of his story)

30 year plan and a 300 year vision

Charlie Rose interview

P.s. It was announced on Monday that Softbank is looking to buy Dreamworks at a c. 50% premium to the closing on Friday. Following the sell-off in Dreamworks earlier in the year I’ve been watching the stock with a potential to add to it. The deal is not done yet and there are some speculations whether it's actually going to happen. Some articles indicate that the discussions are not that serious or there could be other considerations, perhaps a JV between the two companies. Let's see.

Links of interest

Posting has been limited (almost non-existent) lately due to travel and other commitments. While new write-ups are in the process, below are some interesting articles/videos/interviews that I found over the last few weeks and thought were worthwhile to share.

Fireside chat with the Google co-founders

Excerpt from the Berkshire Beyond Buffett book

Article on Buffett and Benjamin Moore

Latest investor meeting transcript of the Sequioa Fund

Q&A with Guy Spear on his most recent book. More on the book here.

How "Focus Investing" can save your portfolio

Article and notes from Mungers Daily Journal annual shareholders' meeting

One of the best articles I've seen recently on human biases when it comes to investing

Interview with the author of Bling Dynasty, on the emerge of the luxury industry in China

More on luxury: Forbes article on Hermes

WSJ profile on Bill Gates' money manager

About this blog and me

After a few write-ups I thought it was worthwhile to give some background, essentially an “about me” missive to shed some light as to how I came to value investing.

I was born in the CEE not too long before the one team, one dream idea of left-wing economic and political cohesion was in its last inning, so capitalism was an acquired taste for me. I got interested in business in high school and read every biography I could find on successful people to learn about their stories. I came across a few articles, then a few books on Buffett and via him I got an introduction to value investing, needless to say I was sold.

After high school I was fortunate enough to study abroad and spend semesters overseas working and studying. I was exposed to many ideas, experiences and people so those years had a tremendous impact on me. I’m very grateful for the people who made it possible and doors it has opened up. I also happened to have acquired a few three-letter qualifications but not one of them helped me make a single dollar in the markets. I believe that investing is "reps and sets" and you’ve to be innately curious; the more situations you see the better you become and not something you learn from textbooks. While he was in a different line of business, Biggie put these ideas very succinctly:

“Gotta try to stay above water y'know. Just stay busy, stay working. Puff told me like, the key to this joint, the key to staying on top of things is treat everything like it's your first project, nomsayin’. Like it's your first day, like back when you was an intern. Like, that's how you try to treat things like, just stay hungry.” - Notorious B.I.G interview sampled on Jay Z’s “My First Song”

I started investing while at university and have been at it since, with the last 4-5 professionally. My investment approach can be characterised as “go anywhere that’s cheap”, regardless of geographies and sectors, but with a bias towards smaller capitalisation companies.

I have a great interest in emerging markets but I’ll not beat up on the things you probably heard about the “emerging billions”, “consumers of the future” and so on. I certainly believe in the underlying trends, however you certainly have to pick your spots, as valuations are not as attractive as say 10-15 years ago. While I claim to have no special insight, I feel that I have a good understanding of the various fundamental drivers given my background as I experienced political and economic changes first hand.

In addition to EM, special situations always have a special place in my heart although from my experience by and large these occur in developed markets. Situations where there are natural/forced sellers such as large company spinning off a small subsidiary, operational/financial difficulties, bankruptcies and so on, create opportunities that attract me. What I like about these cases is that more often that not, you normally have to figure out two or three key factors to understand what causes the mispricing and develop a thesis. If you cannot you pass and go to the next one. As the price movement of these securities is reliant upon certain developments it’ll move less with the general market, which can be great. I do believe it’s important to keep a flexible approach and be able to invest successfully more than one way.

So what can you expect from this blog? A random selection of ideas that I think are interesting and 2-4 write ups a month as well as posts on articles/interviews/videos on investing and business that I think are worthwhile to share. Starting this blog will be a good way for me to keep track of some ideas and to organise my thinking as well as to develop a platform to share and discuss ideas with other like minded investors.

Weekend links

Barry Ritholtz interviews Jim Chanos

Annual letters of Blue Chip Stamps (1978-82) written by Charlie Munger

Barron's profile on Joel Greenblatt

Bloomberg profiles Byron Trott

1976 Buffett letter about GEICO

Great article about Irving Khan

What makes Warren Buffett a great investor?

Remember Hypo Bank of Austria?

A few articles on the coming IPO of Alibaba:

Profile on Joseph Tsai (Ma's right hand man)

Reuters article on Masayoshi San, Jack Ma and Jerry Yang

Links of interest

Joel Greenblatt on small cap stocks

NY Times article on Donald Graham and his plans post Washington Post

Collection of Seth Klarman links

Bill Ackman's 2014 Q2 letter to investors

Carl Icahn on the merits of activist investing

Nice summary on George Soros' investment approach

Peter Lynch speech on the US economy (video from 1994). Some parts are hilarious

Recent Larry Robbins interview (he is the founder of Glenview Capital)

1347 Property Insurance Holdings

PIH is a microcap (c. $50m), recently floated property and casualty insurance company operating in Louisiana, with plans to expand into further coastal states. What got me interested is the valuation gap between PIH and peers and the potential catalysts.

To note, having a very qualitative discussion at this point is perhaps a bit challenging as the company is only two publically disclosed quarterly results into their operations and even those numbers wouldn’t reflect current reality (to note Q2 only came out a few days ago). As there is limited operational information for now, taking a look at the people behind the company is conceivably more important.

To give you some background, PIH was founded by Kingsway Financial (KFS) in 2012 to underwrite insurance in Louisiana that other insurers stayed away from given some of the catastrophes that occurred recently. PIH underwrites both on a take-out basis through Citizens (a state-created, last-resort insurance co in Louisiana) which policies they took on late last year, and also through the usual way of agents etc. As of the most recent quarter the company had a total 16,800 policies in force.

If you haven’t come across KFS yet, have a read at their first shareholder letter to give you a glimpse into their thinking. KFS is a merchant bank/holding co type entity operating mostly in insurance, essentially taking a page out of Buffett and Munger’s book.

KFS is chaired by Joseph Stilwell (20% owner; activist investor) and run by Larry Swets (CEO; insurance industry background); who had the idea to form an insurance company focusing on Louisiana. They eventually recruited Doug Raucy to run PIH, who has worked for Allstate Insurance, founded a few other insurance outfits and seems like a solid operator.

KFS owns around 16% of PIH and Larry Swets is on the board along with another major shareholder of 9%, Gordon Pratt. He is the chairman of PIH with background in insurance and investments and the principal of Fund Management Group (FMG). He previously founded an insurance co with the principals of KFS.

There is also another fund involved by the name of Legion Partners, formed by people with background in money management for the Disney family and Knight Vinke (European activist fund), who disclosed their 8.9% stake via a 13D recently. To me it’s unclear why an activist fund would get involved so early on. The people behind PIH likely have the same interest as them (i.e. shareholder value), but the more the merrier.

PIH’s IPO took place in March this year, when the company raised $15m (net). Then following the IPO the company went to market and raised about $21m (net) as they saw possibilities to put additional capital to work. The follow-on offering’s proceeds were allocated to further capitalise their Louisiana business and to grow in other coastal states (e.g. Florida, Texas and Hawaii initially).

I noted above that results as per the filings wouldn’t reflect status quo. As the company has only been earning premiums on the Citizens take-out policies for a few months they are yet to be fully captured on the income statement. The same goes for policies they wrote organically (11,000 currently vs 8,000 last quarter), which is where the focus and growth are vs take-outs. The impact of this will find its way into retained earnings as the months progress.

Just a word on the Q2 results. Net premiums earned grew 14% to $4.7m from last quarter while the combined ratio increased to 80% vs 45%. Pre-tax profit was $1m vs $2.3m sequentially. The decrease in profitability (and increase in combined ratio) was caused by an increase in expenses to $3.8m vs $1.9m (particularly losses/loss adjustments related to negative weather events and G&A due to the impact of being a public company and some one-offs).

Book value as of Q2’14 was $49m, which reflects the additional capital raise in June. This translates to $7.7 per share, implying price to book of around 1.1x based on recent share price of $8.5. This compares to peers (e.g. homeowner insurance cos like Federated National) of around 2x.

Now it’s reasonable to have a relative discount (perhaps the current is excessive) as the company has limited operating history and given the undiversified Louisiana exposure. Obviously, the major risk with the business is catastrophes, while this is reinsured to a certain extent it’s key to understand the people behind the company and their motivation. Not that they can avoid the risk but how they underwrite is key. Additionally, the company has plans to expand into further states and while diversification can be a good thing it’s important that the principals don’t engage in empire building and lose focus.

I think as the market wakes up to the full potential of the business we could see a potential re-rating. Assuming closing the cap to 2x book would mean share price of $15 and less bullish view of 1.5x around $11, for respective upsides of around 30%-80%. Of course this assumes no major catastrophes in the ensuing quarters.

I believe that this valuation gap can be closed as there are few substantial owners in the business, who understand how capital markets work. In addition, take a look at page 17 of the attached 10Q discussing a performance share agreement between PIH and KFS. Accordingly, KFS would be entitled to 375k shares if the share price hits $12, $15, and $18 (125k at each point). This is substantial relative to their 1m share ownership in PIH thus they have all the incentive to deliver.

Weekend links

New post coming soon but in the meantime a few things to read/watch

All things Charlie Munger

Stan Druckenmiller's Delivering Alpha speech, mostly on the Fed policy

Mohnish Pabrai talk at Google, on his approach as a value investor

Ray Dalio's continuing explanation on the economic machine

A CEO who uses the approach of Graham and Buffett

Rethinking buybacks from the CFO magazine