Description

Thesis summary:

We are short Sharp, the Japanese consumer electronics + display device company. We believe it is one of the most egregiously over-valued large-cap securities worldwide, and, more importantly, we feel there are numerous near-term catalysts likely to test the lazy bull thesis built around an open-ended restructuring narrative, a temporary surge in panel and TV prices, retail domination of the float, and a tight borrow. We feel a more realistic valuation of the stock would be somewhere around book value – 50-75 JPY/share, or -80% vs current – but even in a more optimistic scenario we struggle to see how the stock is worth more than 200 JPY/share – implying at least 50% downside from the current price.

While the stock is not the easiest borrow (5-6% fee), it is a large cap ($24bn EV) and extremely liquid ($40mm+ ADV), making this an actionable and scalable trade.

Background:

We have followed this company for many years, previously having been short as Sharp endured a number of equity-dilutive restructurings needed to recast a debt-heavy balance sheet and bloated cost structure. This process concluded last year when Hon Hai Group, a Taiwanese contract manufacturer, took a controlling stake in the business by purchasing 66% of the company for JPY 288bn, or 88 JPY/share (as well as injecting 100bn for a convertible preferred stake). Hon Hai promptly installed new managers and began to cut costs, all the while telling investors that Sharp’s key end markets – display panels for smartphones and TVs, as well as other consumer electronics like microwaves, fridges, washing machines, and printers – would somehow return to outsized growth. While sceptical of Hon Hai’s ultimate success, the story had shifted from a balance sheet recapitalization play to more of a valuation call on the restructured forward business, so we covered and initially moved on.

However, the market’s response to Hon Hai’s brief stewardship has been nothing short of incredible, with the stock – newly diluted by a factor of 3  – rallying over 550% to recent levels around 500 JPY/share, all in barely 9 months! The stock has since retreated a bit to 400 JPY/share but even at this level, Sharp’s enterprise value is ~2.45tn JPY (ie, $22.5bn USD), or back above 2007 peak levels – even though sales (-33%) and earnings (EBITDA -75%) remain but a fraction of what they once were. Said another way, Sharp’s new-found premium valuation implied more than double the enterprise value for a business that – even on one-year forward numbers – may generate just one quarter the profits of its direct competitor, LG Display. 

The business today:

It is important to highlight this at the outset: Sharp is not Tesla, Amazon, or Netflix. That is to say, it is not threatening to reshape commerce as we know it; and it is not a beneficiary of some huge, secular, ‘blue sky’ growth opportunity for which no earnings multiple would be too high. Rather, Sharp remains a hodge-podge of mostly-commoditized consumer electronic businesses cobbled around the mainstay Display Device segment (~40% of sales; note this segment also includes LCD TVs as well). Some of the major others are ‘Business Solutions’ – copiers, printers, retail POS systems – at ~15% of sales (but more of operating profit); ‘IoT Communications’ – cellphones, calculators, translators, fax machines (!) – at 10% of sales; and ‘Health and Environment Equipment’ – fridges, white goods, some MRIs, etc – at ~15% of sales. The remaining sales are made up of other semiconductor devices (camera modules, etc) and commoditized solar cells.

Fax machines and fridges – that’s right, this isn’t the Hyperloop, the Gigafactory, or Amazon Prime. Most all of these businesses are commoditized, low operating margin businesses (5-10% OPM) either in structural decline; or GDP+ growers but highly competitive. In most all these segments Sharp is sub-scale (I define this as <5% market share), has under-invested in capex/R&D for years (a legacy of its chronic under-capitalization), and is unlikely to be a secular winner over the long-term.

However, the majority of this writeup will focus on the display devices segment, because this is the segment that will either make or break Sharp – it is the most volatile in underlying profitability; it is the largest component of the overall business; it is by far the most capital-consumptive business that Sharp is involved in; and it is currently undergoing seismic technological change. Simply put, we feel a bet on Sharp is basically a bet on its display business, one way or another, and so it makes sense to focus the majority of our attention here (I would be happy to answer questions re the other segments in the comments).

The Display Segment, and its coming crash (again):

As mentioned, the Display Device segment constitutes around 40% of Sharp’s sales base today. Of this, the LCD TV component – ie, Sharp manufacturing their own branded large-screen TVs – is around 25% of segment sales, while LCD panels – small, medium and large sizes – are around 75% of sales. Thus, pure LCD panel exposure is around 30% of total Sharp sales. In reality, Sharp’s exposure to the LCD panel market is larger, as they still own a minority stake (~25%) in Sakai Display Products, a large-size panel manufacturer they used to control but sold down during their many restructurings over the years. SDP income/losses are reported below the line, but were significant in FY16 (-20bn vs total operating profits of 62bn), even though Sharp goes to significant lengths not to emphasize this exposure. (We shall return to SDP later). 

As you might imagine, the LCD panel industry is a very tough business to be in. It is highly cyclical; largely commoditized; subject to the captive demand of a few very large OEMs; and demands continuous investment in R&D and high capex. Making matters worse, for the last few years the Chinese government has made developing its own LCD supply chain a national priority, such that a huge number of new fabs – financed at uneconomic levels and not driven by natural end-market demand – have been coming, and will continue to come, online. The majority of Chinese players in the industry exhibit low single digit operating margins and do not earn returns above their cost of capital through the cycle. Even the best players in the industry – Samsung Display and LG Display (with the newest fabs and most captive supply) – likely generate only ~10% operating margins at cyclical peaks (ie basically inline or slightly above their cost of capital on a post-tax basis). It should be no surprise that all these names tend to trade well below book value (Japan Display trades at 0.4x book value, while LG Display is at the pointy end of the range at ~1x book value).

Sharp has had a terrible time in the LCD panel industry; it is the main reason why they almost went bankrupt numerous times over the last 3-4 years. They spend $6bn on a new fab (Kameyama no 1) that came online in 2006; we reckon at least 2/3rds of this investment has since been written off. Despite the problems at the first Kameyama plant, they decided to double down and built another multi-billion dollar fab – mostly using Apple to finance through advance receipts of orders – called Kameyama no 2. This plant – along with a few other legacy fabs, mostly old and third/fourth quartile assets – constitute the back-bone of Sharp’s panel business today.

Sharp was done in by a well-worn combination in technology: poor investment timing and commoditization. Years ago – before the likes of AU Optronics, BOE, Tianma, and CEC arrived on the scene – Sharp’s IGZO backplane technology was thought of as the ‘next big thing’ in display technology. There was some hope that it could be used as a higher-quality, battery-life-conserving technology, instead of the then-standard backplanes (amorphous silicon, ‘A-Si’, and low-temperature poly-silicon, ‘LTPS’). But due to some self-inflicted wounds (namely, over-investment at the peak of the cycle), Sharp never had the ability to develop IGZO properly; was beset by yield and production issues; and in the end has bled share at high-quality OEMs (ie, Apple) ever since as the competition caught up and then superseded them on quality.

 The problems facing the company now are three-fold: 1) it is quite clear the premium OEMs are planning to fully shift to OLED; 2) Sharp is many years behind and cannot conceivably compete in OLED, even assuming they had the capital to built out new fabs/production lines; and 3) the outcomes for Sharp if they lose Apple, et al, are likely dire. Let’s look at each point one by one.

1)   Apple is shifting to OLED and this will drive most of the premium smartphone market in the same direction: I will not spend too much time on this as it is fairly common knowledge. Organic light emitting diode (‘OLED’), the next-gen technology, has been commercialized by Samsung and used in their phones exclusive for a couple of years but now Apple is shifting to OLED as well (OLED consumes less power, has brighter colors, a truer black, etc – and now only costs 2x an LCD LTPS screen vs 3-4x a few years ago). This will necessarily hurt Sharp as Apple is still ~20-25% of total company sales (and thus the majority of panel revenue in the display business)

2)   Sharp is far too far behind to compete in OLED and has no hope of catching up: instead of trying to develop OLED, Sharp appears to be following a ‘batten down the hatches’ approach. They do not talk a lot about OLED and when they do they suggest LCD still has a future. More importantly, they aren’t investing much at all in OLED – in FY16, Sharp spent 34bn ($300mm) JPY TOTAL on all display capex, including some minor OLED spend, while total company R&D (comprising all the other crappy consumer electronics and semiconductor products) amounted to just $1bn. Contrast this with Samsung – which spent $8 billion last year, has spent over $20bn developing OLED in past years, and has committed another $8bn in fab capex in the coming year. LG Display, another key competitor, has also spent multi-billions and is on the verge of committing additional multi-billions. I could go on to detail the host of other Chinese panelmakers all spending billions on OLED but the point is pretty clear: it is simply not credible to think Sharp can compete in this space when they have literally under-spent key comps by, cumulatively, tens of billions of dollars

3)   When Sharp loses Apple, they will likely be completely marginalized: Sharp’s argument – such as it is – is that LCD will still have a home in other smartphones for years to come, as a) not every OEM can afford to provision an OLED screen for their phones; and b) even if they could, there is a massive production bottleneck such that only Apple and Samsung will have OLED phones this year (and even then not in all new Apple models). The problem of course with this reasoning is that Apple and Samsung are the only OEMs whose phones command premium ASPs (ie, >$600-700); the average price for all other smartphones is <$300, and indeed the majority of those Chinese OEMs gaining share in the smartphone landscape are priced much lower (of course, the overall global smartphone market has basically stopped growing). In effect, this condemns Sharp to supplying the likes of Xiaomi, Oppo, Huawei, etc – companies whose phone operations are by all accounts barely profitable and whom are notorious for squeezing their suppliers.

This would be bad enough, but it gets worse. Remember how we mentioned that the Chinese government made LCD panels a strategic industry, handing out subsidies to all and sundry? Well, that has meant that a ton of new LCD-dedicated fabs were commissioned in the last 2-3yrs, and the majority of them will hit the market in the next 1-2yrs – right at the moment OLED is driving a shift away from LCD as a technology more generally. Thus – Sharp is likely to find a whole host of new capacity coming online, competing for business at the exact moment it is losing its highest-quality, highest-ASP, most-profitable client to the vicissitudes of technological change.

As a result, unable to invest to catch up, and with a ton of excess capacity from their likely lost Apple business, we fully expect the display device segment to show increasing operating losses from 2H of the current fiscal. Sharp, by contrast, forecasts display devices sales increasing by 25% over the next three years (though no discrete profit guidance has been given). We simply find this incredible (in the worst sense of the word). We do not think it is unrealistic to expect gross sales related to Apple to fall to near zero in 2yrs or so, ie, removing around 25% of total group sales right off the top.

So why has the stock gone up in a straight line?

We have to admit – none of the above is exactly ground-breaking. The shift in display technology, and Sharp’s potential obsolescence, has been well documented by the sell-side (it is a consensus sell) and some of Sharp’s competitors are really suffering (cf. Japan Display). But reading all this, you may be surprised the stock is +400% or so off the lows, and has more than doubled this year; you may be even more shocked at the current valuation (45x P/E, >7x book value, and 15x EV/EBITDA) especially when considering the relative outrageousness versus other display names (generally <10x P/E, <1x book, and <4x EV/EBITDA). Indeed – this is the key question: what has driven such a gargantuan rally, and why is the market so wrong today?

First, the reasons for the rally - there are a few potential explanations:

1)   Restructuring and the nature of ‘quick wins’: when Hon Hai recapitalized Sharp, the business was at its lowest ebb: losses had been endemic for years; morale was terrible; and recent results into the recap had been absolutely abysmal. There had been stories emanating from Sharp of a business in total chaos, with line managers allowed to authorize large purchases up to $1mm USD without oversight; to chronic brain drain, lack of effort, over-staffing, etc. The recapitalization allowed for a number of ‘quick wins’: some layoffs occurred, loss-making units were shuttered, poorly-negotiated supply agreements (eg in the solar business) were recut using Hon Hai’s supply chain muscle; and, in general, morale was improved. The market has overreacted to the cost-cutting driven recovery and now extrapolates a secular growth story where there is instead likely a secular decline;

2)   Cosmetic tricks: in addition to the ‘real’ restructuring, Hon Hai performed a few other cosmetic tricks as well to portray the operating business in a more positive light than we think it deserved:

a.     For example, they changed their pension liability accounting (reducing the survivability estimates in the pension fund from 14yrs to 13yrs), which reduced annual service costs (booked through operating earnings) by 6bn on a like-for-like basis. This seems strange, in a country where life expectancy only continues to increase, and is quite significant versus the underlying business (around 10% of reported EBIT);

b.     Additionally, they cut R&D budget from 130bn to 106bn year-over-year – a 24bn decrease that simply adds back to Operating Profit (R&D is fully expensed) – very significant at 40% of reported EBITD. Again – in an environment where all your competitors are spending much more on R&D, this seems an incredibly short-sighted move and unsustainable;

c.      Finally, they took 20bn of losses in the unconsolidated Sakai Display Products (SDP) division, which we believe is likely masking of losses that would otherwise be felt by the Display Devices division (and hence Operating Profit losses for consolidated Sharp). Here’s how it works: SDP produces large-size TV panels; these are then sold, mostly internally, to the Device division for use in Sharp’s own branded large-size TVs. Since Hon Hai majority owns both Sharp and SDP, if it wanted to dress up Sharp’s operating earnings, it could easily strike the transfer prices at levels favorable to Sharp (who would need to sell its TVs at a profit in end consumer markets) over SDP (who could then suffer operating losses below the line). Hon Hai, of course, is a much bigger entity and can absorb the losses (without reporting the exact breakdown – they don’t even break-out Sharp’s earnings from their own). This explanation makes further sense as it is the only one that explains exactly how SDP lost ~80bn (at 100% ownership) last fiscal year during a massive rally in LCD panel prices (large-size LCD panel prices rose 40-50% yoy over the last 12months through May)

3)   Temporary spike in panel prices: as mentioned above, LCD panel prices (small to medium size) actually rose for sixteen straight months through May 2017 – a function of a shortage of supply as some of Samsung’s fabs were taken out of the market due to their transitioning from LCD to OLED production lines. This undoubtedly drove profitability for Sharp, as it did for the whole space – but production is not only normalizing, as alluded to above, a whole host of new capacity is coming as well;

4)   Temporary spike in LCD TV prices: even though the market for global LCD TVs is stagnant (around 220mm units a year), there was a spike in prices for large-size TVs (where Sharp specializes), again because some capacity was taken out for the conversion to OLED, but also because Sharp decided to stop supplying Samsung with panels and instead hoard inventory (for its own TVs). This seems likely to be penny wise but pound foolish as it means a) they now have a larger inventory position at a moment the market is turning; and b) the TV market is not growing meaning as new capacity comes online they will likely be forced to dump inventory at decreasing prices (something Sharp has done on numerous occasions before);

5)   A large squeeze in the stock: undoubtedly one of the main technical factors during the rally has been the tightness of the borrow. Many hedge funds kept their short positions on through the Hon Hai recapitalization, as that transaction was viewed as a band-aid solution (it was), only to be surprised at the extent of restructuring-driven gains as well as the un-expected rally in panel and TV prices. No doubt this was a very painful short for some (indeed, we covered a small position earlier in the year) – but we feel now the valuation is so egregious, and the catalysts so much clearer and nearer, that risk reward is much more favorable today.

6)   Retail participation in the stock: after the recap, the shares were trading around 100 JPY – perfect territory for the Japanese retail punter, a sizeable market participant and one who tends to traffic in low-priced stocks (cf, Takata). We have spoken to many institutions who know Sharp, and are yet to find one – onshore or offshore Japan – that thought Sharp was an interesting investment at 150 JPY, let alone 400-500 JPY. We believe the retail participation has been partially responsible for the extraordinary rise, since as the name gathered momentum and shorts began to cover, it began to trade in feverish volumes and garnered a following on domestic Japanese stock trading boards (which we monitor). As such we consider a large amount of speculation to be priced into the stock, divorced from underlying fundamentals as we have outlined above

 While this is not a perfect explanation for the rally, we do feel that a number, if not the majority of these points are subject to change in the near-term – and as such we feel now is the right time to re-enter the short in significant size.

Catalysts:

Here are a few of the near-term catalysts as we see them:

1)   Roll-over in LCD panel prices (large and small): this is already happening. June prices for small, medium and large size panels fell for the first time in 17 months. As a large amount of new supply comes online in 2H’17 and through 2018-2019, we expect this to continue (even if the transition to OLED by the high end phone OEMs takes longer to occur);

2)   Roll-over in large size TV prices: Skyworth – one of the larger global Chinese TV OEMs – reported June TV sales -31% year-on-year (and -34% in overseas sales). While monthly results are lumpy, most China TV market analysts feel inventories at retail are high, and again – new supply is likely to come online in the coming 12-18months (pent-up Sharp inventories; new capacity from Chinese/Taiwanese/Korean OEMs);

3)   Potential equity sale by Hon Hai: Sharp has recently applied for relisting to the first section of the Tokyo Stock Exchange (one of the last technical positive catalysts). We do not yet know if they will be approved for relisting (they probably will), but Sharp would be required to have at least 35% of its stock ‘free floating’ to meet TSE rules. As of today, Hon Hai controls are 66% of shares, although their converts are deep in the money such that if those are treated as shares (they may well be), then Hon Hai would potentially need to sell from a few percent of its shares to up to 7-8% of its share in an offering. Since this is still a large amount of stock (Sharp’s market cap is $20bn), and no institutions we think would touch the stock near 400 JPY, this could actually be a meaningful repricing event;

4)   Potential equity issuance to fund an acquisition of Japan Display: Japan Display, the competing panel-maker, is even more distressed and at high risk of bankruptcy since they are so much more dependent on Apple (55% of sales) and just as behind in OLED development. There is some risk that the government will force Sharp to acquire JDI (since the government is a major shareholder in JDI). If Sharp used stock to acquire the business (which I think it would), it would shine a light on how expensive Sharp’s shares are relative to the underlying value of these kinds of assets and, we think, force the market to reprice Sharp. Alternately, JDI’s major shareholder, the INCJ, could simply turn around and dump their new Sharp shares at a huge implied premium to their distressed JDI holding. Either outcome would be bad for Sharp shares.

Valuation:

Frankly I don’t think these assets are worth much more than book value, if that  - indeed, most all other panelmakers trade substantially below book valu. Some of the non-LCD assets may gain higher multiples but being generous and according say 20x P/E on the whole entity would only suggest a stock price of ~180 JPY/share. Book value today is I think ~50-60 JPY/share (on a fully diluted basis). Either way the current price is at least 50% too high, being generous.

Risks: 

1)   Hon Hai continues to use bogus accounting to make Sharp look more profitable than it realistically could be (for example by inter-party transactions that support Sharp at Hon Hai parent’s detriment)

2)   Sharp posts better than expected earnings in the first quarter of the year and retail keeps buying

3)   Sharp does buy JDI at a cheap price and the market assumes they can generate huge synergies and bids up the stock

4)   Other stuff happens

Catalyst

see above