Softbank Group KK: Positive Developments But Risks Remain Significant (OTCMKTS:SFTBF)

Readers of my previous work here on SeekingAlpha may already be aware of my bearish view of SoftBank Group KK (OTCPK:SFTBF;OTCPK:SFTBY). Following strong quarterly results and a massive price hike of its most important subsidiary, the company has recently outperformed both my expectations and the broader market. That notwithstanding, I remain confident that the stock remains overvalued. Below, I will assess recent developments and explain, why I continue to have a bearish stance.

Kindly note that there are two companies with similar names: SoftBank Group, the parent, and SoftBank KK (OTCPK:SFBQF;OTCPK:SOBKY), its telco subsidiary. Following, “SoftBank” will refer to SoftBank Group, unless otherwise stated. “SoftBank KK” refers to the telco subsidiary.

Q3 Takeaways

SoftBank reported a return to profitability in fiscal Q3 – the company’s fiscal year ends March 31^st – with a net profit of ¥950 billion (around $6.36 billion). There is an important one time event to be taken into account: SoftBank received 48.8 shares of T-Mobile US, Inc. (TMUS), representing a market value of close to $7.8 billion, at no consideration. The reason for this windfall was a provision in the merger agreement between T-Mobile and former Softbank subsidiary Sprint Corp. that granted the seller an additional allotment if and once certain valuation thresholds are exceeded. This accounts for a little over a third of the quarterly profit (¥316.1 billion, to be precise).

The remainder of the quarterly profit primarily stems from the Vision Fund segment’s combined $4 billion investment gain. It should be noted, that these are in large part (though, admittedly, not entirely) paper gains in the course of up-rounds and valuation adjustments of private companies. The company particularly highlights a strong performance of ByteDance, in which the Vision Fund 1 invested. For perspective, one should also keep in mind that this gains follows a series of massive losses across the Vision Fund segments in recent years. On a side note, the reorganization of (the former) Z Holdings KK and subsidiaries Line and Yahoo Japan into LY Corp. (OTCPK:YAHOF;OTCPK:YAHOY) was completed during Q3, but I do not expect this to have major valuation impacts. So, all in all, I believe that while undoubtedly strong, the quarterly results should not be overappreciated in the broader context.

Arm Valuation Remains Key

As I have written before, I believe Arm Holdings plc (ARM) to be of paramount importance for the valuation of SoftBank overall. For once, the 90 percent stake in the chip designer is the group’s largest singular asset. As of December 31^st, Arm accounted for about a third of SoftBank’s net asset value. Following the recent share price explosion, it should be closer to half at the time of writing (that, of course, being a momentary picture).

Beyond that, Arm is a focal point in SoftBank’s AI narrative. They refer to it as the “core of (SoftBank’s) AI shift” in their most recent investor presentation (cf p. 29). I do indeed believe the current AI hype to be a large contributor to Arm’s recent performance on the stock market. I also think that there is a lot of irrationality at the moment. Add to that a relatively low freefloat and the potential of an imminent short squeeze. Even with undoubtedly strong Q3 results and a materially improved outlook, I see little fundamental justification for the exuberant price reaction.

If and once SoftBank were to begin reducing its stake, that could easily serve as a material downside catalyst. Now, to be clear, I do not expect SoftBank to fully exit Arm any time soon. Given the focus on AI, I am rather confident that the group will at least maintain a comfortable majority. I would, however, not be surprised to see partial disposals after the lockup period expires on March 12^th. SoftBank has a constant need of liquid funds in order to make investments, while debt funding becomes increasingly burdensome (more on that in a moment). Its main source of cash in meaningful quantities (excluding, of course, borrowing) is the telco business. First, there is its 40.5 percent stake in domestic telco SoftBank KK, which predominantly generates Yen revenues (and, equally if not more importantly, pays its dividends in Yen). T Mobile US, too, has returned to distributing funds to shareholders via dividends, so a low nine-figure dollar amount annually can be expected to come SoftBank’s way from that source (provided the shares are not sold). Arm’s profits and liquidity, meanwhile, while consolidated on the balance sheet, are not fully accessible to the parent, now that Arm has been listed. The fact that Arm does not expect to distribute dividends, leads me to believe that SoftBank is not unlikely to monetize the stake eventually, either by selling part thereof or via lending against it. I discussed this issue in detail previously.

Debt Increasingly Challenging

Interest rates around the globe are considerably higher now than they were for most of the last one and a half decades. While peak rates are likely to have been reached in most of the developed world, Japan is only at the beginning of a tightening cycle. The Bank of Japan, in the person of Vice Governor Shinichi Uchida, has recently all but ruled out rapid rises in interest rates. However, the age of zero-to-negative rates seems poised to come to an eventual end, even in Japan. Also, the flipside of lower interest rates in Japan is additional pressure on the Yen relative to other currencies, the US Dollar in particular. That is bad news for SoftBank, as it devalues its income from SoftBank KK dividends.

All that does not bode well for SoftBank. I think it advisable to take a look at the companies outstanding bonds. Over the course of 2024, ¥850 billion (around $5.7 billion dollar) of Yen denominated are due to mature. Additionally, there are also €638 million and $781 million, respectively of foreign currency bonds.

That means that, presumably, around $7 billion will have to be refinanced, at what is likely to be materially higher interest rates on average (currently, rates are between 1.5 and 4.75 percent on the aforementioned bonds). Also, the Arm acquisition from the Vision Fund is paid in installments over a two-year period, with around $12 billion still outstanding.

SoftBank has also displayed a voracious appetite for bank loans in the past. SoftBank is among the largest investment banking fee payers globally due to its business model. That may help in securing access to borrowers. One very recent example is a $8.5 billion margin loan, secured by Arm shares, that was taken out pre-IPO. It is not entirely impossible that banks may have only agreed to this loan in order to secure a role as underwriter of the biggest IPO of the year. The Financial Times reports an interesting correlation between SoftBank’s lenders and the „army of Arm underwriters“ it hired. For example, the company’s largest lender, Mizuho (MFG), from whom they borrowed more than ¥600 billion at the end of FY2022, was a lead underwriter.

The Underestimated Problem Of The Vision Funds

There is one point about the first Vision Fund, that I feel is often overlooked. That being its funding structure.

While SoftBank itself holds its entire stake in common equity, the remaining shareholders – the largest of which are the Saudi Public Investment Fund (PIF) and the UAE’s Mubadala – hold two thirds of their respective investments in preferred shares with a 7 percent coupon. This does not only mean an outflow of more than 3 billion in order to pay the coupon. It also creates an interesting situation from those investors’ point of view with regard to what happens at the end of the road, so to speak: The fund has a lifespan of 12 years, which may be extended by two.

A 7 percent coupon rate on the preference units, meanwhile, means that over the 12 year fund life returns of 84 percent will be generated on 66.66 percent of the invested capital; 98 percent if extended to 14 years. With around $47.5 billion in preference units, that is around $40 billion to $46 billion in coupon payments. As long as the fund is able to pay back at least the principal on the preferred units (which it will be if the lifetime performance is not materially worse than –50 percent), those shareholders will, on aggregate, not make a loss, even if the common equity in the fund is wiped out. That also takes into account management fees of 1 percent per annum (= about $8.7 to $10 billion overall). In a best case scenario, this kind of capital structure would see SoftBank profit disproportionately from its investing success. Yet on the flipside, it also means that SoftBank essentially ends up holding the bag if things go sideways or down. And, by now, the fund is already entering the second half of its life without having turned an overall profit. I imagine that the mangers of Middle Eastern sovereign wealth funds – who, after all, tend to be rather sophisticated professionals – will think twice about extending the fund or even investing in a follow up vehicle. An indication of this is that SoftBank failed to attract further interest for Vision Fund 2 and consequently decided to go alone for that one.

SoftBank’s involvement in a number of very public failures may further deter potential outside backers. FTX, WeWork (OTC:WEWKQ), Greensill, Katerra – if it is high-profile, remotely tech-related and collapsed, chances are, SoftBank was involved in one form or another. They even held 5 million shares in now bankrupt Signa Sport United NV (SSNUF) (although the amount is, of course, insignificant). To make matters worse, SoftBank has often displayed a habit of throwing good money after bad, the most prominent example being WeWork. A similar, but lesser known, case is mortgage provider Better Home & Finance Holding Co. (BETR). SoftBank and its Vision Fund 2 invested a combined $1.7 billion, despite the mortgage provider already being in trouble, as it could not exit agreed upon contracts. At the time of writing, Better has a total market capitalization of $406 million.

History May Repeat Itself

SoftBank’s most common (and arguably most costly) mistake in the past has been to invest to much money at too late a stage at too high valuations while chasing the latest trends in technology and (purportedly) technology adjacent fields. Right now, it seems SoftBank is all about AI. For example, there are apparently advanced talks regarding a $1 billion in a as of yet conceptual “iPhone of AI”. There may arguably be somewhat of an AI bubble as is. Given the questionable interest from outside backers for another Vision Fund style vehicle, I see a substantial risk of SoftBank borrowing even more in order to make outsized AI bets. Notably, in its most recent investor presentation, SoftBank professes “leveraging debt capacity” as an “action we need now” (cf p. 65). For perspective: the group’s consolidated interest bearing debt exceeded ¥20.1 trillion (around $141 billion) as of December 31^st.

Conflicting Interests

I would also like to briefly allude to certain negative aspects with regards to SoftBank’s corporate governance. There is the issue of billions of loans made to founder and CEO Masayoshi Son. I discussed that in-depth in a prior article, so in the interest of brevity I will allow myself to refer readers to my previous explanations. Suffice it here to say, that there is a clear conflict of interest here. In another instance, the company sold its Korean venture capital arm to an entity controlled by Taizo Son, the brother of SoftBank’s CEO, for an undisclosed amount. The purchase price being undisclosed, it is not possible to assess whether this was, in fact, an advantageous deal for the company. However, this kind of dealings at least merits heightened scrutiny in my opinion. When it comes to such interactions, I would prefer to see maximum transparency with regard to the terms.

Thesis Risk

There are certain risks to my thesis. In the past, SoftBank was able to increase its stock price materially through the use of massive buybacks, which I viewed as “a dangerous gamble” at the time. Given the elevated valuations of everything related to AI, and Arm in particular, SoftBank might be able to conduct another round of buybacks sooner than I anticipate.

Furthermore, the possibility of a “lucky shot” akin to the company’s fortuitous investment in then-nascent Alibaba Group Holding Ltd. (BABA) cannot be entirely ruled out. Nor is there a guarantee against sooner and/or steeper interest rate cuts due to as of yet unforeseen events. Lastly, success with regard to AI investments might reinvigorate interest by sovereign wealth funds and/or other outside backers in a Vision Fund successor.

Conclusion

Despite some positive developments, I believe that SoftBank remains in a very challenging position. I would attribute its recent strong performance in large part to irrational optimism and exuberance fueled by the current AI hype. Arm is momentarily outshining most everything else. I do, however, have sincere doubts about the longevity of this condition. Even raising my price target for Arm by 25 percent to around $40 (which would be ambitious but justifiable, given the strong results and guidance) from what I previously believed to be the upper end of the fair value range, the chip designer remains massively overvalued (in my opinion, the market may continue to disagree in this regard) at the current share price. If and once, Arm falls back to a more realistic price level, I believe that SoftBank’s valuation could take a hit. As any sign of SoftBank’s intention to monetize its shares may very well a catalyst for such realignments, I doubt that the company will be able to fully take advantage of the current exuberance. In the light of positive development and, in particular, the acquisition of billions’ worth of free T-Mobile US shares, I am slightly adjusting my fair value estimate upwards to $34 to $38 per share on an undiluted basis. However, as the stock trades around a quarter higher than when I covered it last, that actually means that the relative downside has actually increased. On a more positive note, the additional T-Mobile US shares and Arm’s strong valuation do reduce the risk of an outright collapse. I am, therefore, raising my rating to sell (from strong sell), despite the uptick in downside potential.

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.