Description

I am about to get out on very thin ice.  I am a value investor, but I’ll probably get banned from value community for I am about to say: current valuations don’t mean much for companies in industries that are entering an exponential growth phase.  As I type this I catch myself thinking that it sounds so “dot-commish.”  I think I start respecting myself a little bit less as I write this, but bear with me as I try to bring this “dot-commish” comment back into a more familiar value framework.

Wall Street hates Softbank’s purchase of ARM Holdings for $32 billion.  48 times earnings!  A 43% premium to an already richly priced stock! Softbank doesn’t have any synergies with ARM Holdings – there are no costs to cut or additional revenues to capture by adding ARM to Softbank’s existing businesses.  Masayoshi Son, Softbank’s founder and CEO and the reason we own Softbank stock, is not liked today.  I heard this (understandable) reaction from a friend about Mr. Son and the ARM purchase: “a bored rich man who needs to spend because he has too much.”

To understand this purchase we need to try to come to terms with Mr. Son’s investment strategy and his mental models that have turned him into the richest person in Japan. 

Mr. Son is a master of exponential (nonlinear) thinking.  If you examine his past investments, he identified industries that went from high but linear growth into the exponential growth phase – where the rate of growth is accelerating. 

Mr. Son has done it over and over again over the last forty years.  It started with PCs in the ’70s when he built a software distribution business in Japan to capitalize on PC growth entering the accelerating phase.

He saw the inflection point of internet growth in the ’90s and bet on Yahoo and created Yahoo! Japan (a joint venture with Yahoo). 

In the early 2000s he saw e-commerce and the internet taking off in China and invested in Alibaba, turning his $2o million investment into $60 billion today.

Mr. Son had the insight that the growth of wireless, which was already growing nicely, was about to accelerate due to the popularity of smart phones.  True story: he went to Steve Jobs with a drawing of on iPod with a superimposed dialing pad, and asked him to make a smart phone.  This was before Apple even announced plans to make a smart phone. 

More importantly, to capitalize on this insight he bought the worst-run wireless mobile career in Japan (a very unpopular move at the time) and turned it into the best one – a huge source of Softbank’s cash flows today.

In 2013, he thought the growth rate of mobile games –which again were growing nicely – would accelerate as smart phone processing power and video capabilities got better and smart phone adoption increased.  To capitalize on this trend, Softbank bought into Supercell at a $3 billion valuation and sold out in 2016 at more than 3x the initial valuation. 

Identifying industries that are entering into the exponential growth phase is difficult enough, but acting on the insight is even more difficult.  I remember looking at a report on Apple in 2009, analyzing its potential market size, assigning a conservative market share to the iPhone, and basically saying that over the next several years iPhone sales could accelerate (or continue at the then-current rate of 30% or so) and reach $100 billion from under $20 billion in 2009. 

I saw the logic in the analysis, but it was difficult for me (and, I think, for most people) to mentally process a high growth rate going exponential.  By the way, iPhone sales reached $155 billion in 2015.  

Mr. Son has proved over the years that he is good at both identifying and acting on exponential growth. 

I think investing at the pivot point when growth rates accelerate is even more difficult for value investors (present company included). 

As revenue growth accelerates, costs usually don’t grow as fast and therefore earnings grow at even faster rate than revenues – now earnings growth is truly exponential.  This dynamic creates a lot of value, which our linear brains may or may not process.

In 2009 Apple was not statistically cheap – it already had a high statistical valuation.  It was hard for a value investor to see a margin of safety.  In 2009 the stock was at about $29, or 22 times 2009 earnings.  In hindsight it was cheap – in 2010 Apple earned $2.20. Fast-forward another year, and $29 was a steal – in 2011 it earned $4.01 (I am not even counting the cash Apple had on the balance sheet). 

This brings us to ARM Holdings, which designs processors and then licenses them.  Unlike a traditional semiconductor company, ARM doesn’t manufacture or even outsource the manufacturing of processors. 

Companies like Apple, Qualcomm, Broadcom, and many others have an architectural license – they license ARM’s platform and then build their processors on top of it, thus turning ARM’s base design into an operating system for processors.  ARM’s platform allows Qualcomm’s processor to work on Samsung’s phone and to be interchangeable with Samsung’s own ARM-based processor.  As architectural license holders pour billions into R&D of their ARM-based processors, they increase the value of ARM’s ecosystem and thus widen ARM’s competitive advantage.  Today 97% of mobile devices run on ARM-based processors. ARM keeps its royalties rate very low – it makes a few pennies on each processor sold.

Mr. Son has admired ARM’s business from afar for ten years.  He said that if Softbank was not burdened with the Sprint turnaround, he would have tried to buy ARM sooner.  Recently Softbank raised $10 billion of cash by selling down its stake in Alibaba and about $8 billion by selling its ownership in Supercell – a gaming company – to Tencent.  These transactions gave Softbank dry powder to make the ARM acquisition. 

Mr. Son believes we are the inflection point where growth of Internet of Things (IoT) devices is about to enter the exponential growth phase.  There are seven billion people in the world today.  In 2015 ARM sold 15 billion processors –about 2 processors per person.  By 2020 ARM expects to sell 75 billion processors – a fivefold increase.

But that is just the start.  According Mr. Son, in the long run we are going to 100s if not 1000s of processors per person.  Cars, street lights, home appliances, patients in the hospital – everything will be connected to the internet. 

Cows will become IoT.  They’ll have a sensor on their bodies telling the farmer when to milk or whether a cow is sick.  A sensor with GPS will show the location of every cow in the field, viewable on an iPad.  I don’t know the first thing about cows, and I came up with these ideas in two minutes.  Can you imagine the real IoT applications that lie ahead, created by people who actually know things about cows and farming?  (I was half joking when I wrote it, but “connected cow” is part of the future – check this out.)

All of those “things” will need processors, and ARM is well positioned to be the one designing them and collecting pennies from each one of them.

ARM is better off being a Softbank company then being a public company.  IoT will require significant investment, which maybe penalize ARM’s short-term earnings.  Mr. Son doesn’t care about short-term – remember, he has a 300-year plan for Softbank.  In fact, Mr. Son has agreed to double ARM’s workforce in the UK over the next five years. 

Now let’s get to ARM’s price.  In 2016 the company should produce revenues of $1.6 billion and earnings of $660 million.  Let’s say that by 2020 the number of ARM processors goes up fivefold but the price of each processor (and thus the royalty fee) declines by 50%.  ARM’s revenues would be up 3x to $4.8 billion.  We assume that, as promised, Mr. Son will double ARM’s R&D; thus we get earnings after tax of $2.8 billion.  In other words, Softbank paid less than 12 times earnings for this company, which in 2020 will still be just in the early stages of explosive growth.  If that scenario plays out, Mr. Son probably created at least $10 of value per Softbank share by making the ARM acquisition.

Mr. Son has a tremendous investment track record, but he is not infallible.  He bought Sprint in hopes of merging with T-Mobile, cutting costs, and doing with the combined company what he did with Vodafone Japan.  Mr. Son miscalculated: US regulators have blocked this merger, and T-Mobile’s CEO ended up being a marketing genius and has taken market share from Sprint. 

Last year Mr. Son became Sprint’s Chief Network Officer.  His goal it to improve Sprint’s network while spending a fraction of what competitors are spending.  Mr. Son has said recently that Sprint will stop bleeding cash and will turn cash flow positive in 2016.  But Mr. Son is the first one to admit that the purchase of Sprint was a mistake.

What if?  What if the purchase of ARM was a mistake?  What if ARM continues to grow 15% a year over the next 4 years?  Then its earnings will be $1.2 billion, and at 19 times earnings it will be worth $23 billion.  Mr. Son will have overpaid by $8 billion, which will equate to the 43% premium he paid over the last quoted price, destroying about $4 of value per share.  In our sum of parts analysis, we get a conservative value north of $40-50 a share.  Therefore, even in the worst case, Softbank is undervalued. 

Exponential growth is born in the eye of a perfect storm – when independently insignificant factors collide.  Advances in big data, the proliferation of the cloud, miniaturization of low-powered processors (and a decline in their price), a drastic improvement in wireless internet that will only get better with 5G, the ubiquity of smart phones and smart devices –each one of these, independently, probably would not matter that much for IoT.  But together they become a significant accelerator for the entrance of IoT into the exponential growth phase.

When you buy Softbank stock you bet on the jockey.  And this jockey’s interests are aligned with those of Softbank’s shareholders.  Mr. Son owns 20% of Softbank shares; therefore, each acquisition he makes is not paid for with monopoly money but with his own.  Over the last 35 years he has made many decisions that at the time were unpopular and appeared to be unorthodox but that turned out to be tremendous home runs. 

This time is no different.  His track record has bought him the benefit of the doubt on the ARM acquisition.  If he made a mistake, he may have destroyed $4 of Softbank’s value, but at Softbank’s current undemanding valuation, I could even live with that outcome. 

P.S. Let me address the elephant in the room – Softbank’s debt.  I keep seeing media saying that Softbank has $110 billion of debt.  Factually this number is accurate, but in reality the number overstates Softbank’s debt by about 100%. 

As of last quarter, when the debt number shifted somewhat after the ARM acquisition, Softbank did have about $110 billion of debt.  However, $33 billion was Sprint’s debt.  Softbank owns over 80% of Sprint, and thus this debt consolidated on Softbank’s balance sheet.  However, if Sprint were to go bankrupt, Softbank would not be responsible for any of that $33 billion. 

Also, Softbank has $21 billion of cash.  Thus Softbank’s net debt position is closer to $56 billion.  Softbank’s Japanese telecom business produces about $7 billion of operating income (and $11 billion of EBITDA).  Though $54 billion is a lot of billions, in relation to Softbank’s earnings power it is a reasonable amount; and once you account for a variety of other Softbank assets, that number is even less significant. 

Catalyst

Over the last 35 years he has made many decisions that at the time were unpopular and appeared to be unorthodox but that turned out to be tremendous home runs. 

This time is no different.  Mr. Son's track record has bought him the benefit of the doubt on the ARM acquisition.  If he made a mistake, he may have destroyed $4 of Softbank’s value, but at Softbank’s current undemanding valuation, I could even live with that outcome.