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Buying Warren Buffett, Richard Branson and Steve Jobs at a Discount

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On capital allocators with impressive records

vitaly

By Vitaliy Katsenelson CFA

What would you get if you crossed Warren Buffett, Richard Branson and Steve Jobs? Answer: Masayoshi Son, the Korean-Japanese, University of California, Berkeley–educated founder of one of Japan’s most successful companies, SoftBank Corp.

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interview

[A capital allocator]

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Masayoshi Son

Just like Buffett, Son is a tremendous capital allocator with a very impressive record: Over the past nine and a half years, SoftBank’s investments have had a 45 percent annualized rate of return. A big chunk of this success can be attributed to one stock: Chinese e-commerce giant Alibaba, a $100 million investment SoftBank made in 2001 that is worth about $80 billion today. Though you may put Alibaba in the (positive) black swan column, Son’s success as an investor goes well beyond it — the list of his investments that have brought multibagger returns is very long. Today, at the tender age of 57, he is the richest man in Japan, and SoftBank, which he started in 1981 and owns 19 percent of, has a market capitalization of $72 billion.

Son, like Apple co-founder Jobs, is blessed with clairvoyance. He saw the Internet as an amazing, transformative force well before that fact became common knowledge. In 1995 he invested in a then-tiny company, Yahoo!, earning six times his investment. But he didn’t stop there; he created a joint venture with Yahoo! by forming Yahoo! Japan, putting about $70 million in a company that today is worth around $8 billion. (Yahoo! Japan is a publicly traded company listed in Japan).

What is shocking is that Son saw that the iPhone would revolutionize the telecom industry before Apple announced it or even invented it. See for yourself in this excerpt from an interview with Charlie Rose, where Son describes his conversation with Jobs in 2005 — two years before the iPhone was introduced:

“I brought my little drawing of [an] iPod with mobile capabilities. I gave [Jobs] my drawing, and Steve says, “Masa, you don’t give me your drawing. I have my own.” I said, “Well, I don’t need to give you my dirty paper, but once you have your product, give me for Japan.” He said, “Well, Masa, you are crazy. We have not talked to anybody, but you came to see me as the first guy. I give to you.”

Richard Branson

Similar to Virgin Group founder Branson, who had the testicular fortitude to create Virgin Atlantic Airways in the U.K. to compete against the state-owned behemoth British Airways, Son started two telecom businesses in Japan — one fixed-line and one wireless — with which he challenged the state-owned NTT monopoly. In 2001, disgusted with Japan’s horrible broadband speeds, he convinced the government to deregulate the telecom industry. When no other companies emerged to compete with NTT (I don’t blame them, really), Son took it upon himself to start a fixed-line competitor, Yahoo! BB (Broadband). Thanks to him, now Japan enjoys one of the highest broadband speeds in the world and Yahoo! BB is a leading fixed-line telecom.

It took Son four years to bring his broadband business to profitability. This is how the Wall Street Journal described that period in 2012:

“The problems at the broadband unit contributed to losses for the entire company for four consecutive years. Mr. Son set up an office in a meeting room 13 floors below his executive suite to be closer to the problem unit. He slept in the office at times and routinely summoned executives and partners for meetings late at night. . . . He worked out of the meeting room for 18 months, until the broadband unit had cut enough costs and moved enough customers to more lucrative plans.”

A normal person might have taken a break and enjoyed the fruits of his labor at that point, but not Son. Just as his broadband business went in the black, Son executed on his vision for the Internet and bought Vodafone K.K., a struggling, poorly run wireless telecom in Japan. SoftBank paid about $15 billion, borrowing $10 billion.

Fast-forward eight years, and SoftBank Mobile is an incredible success. It is one of the largest mobile companies in Japan, even faster growing than NTT Docomo (a subsidiary of almighty NTT). Today it spits out about $5 billion in operating profits annually — not bad for a $5 billion equity investment.

Like Branson, Son is a serial entrepreneur who has started multiple, often unrelated businesses and has succeeded a lot more than he has failed. SoftBank has built a robot named Pepper that can read human emotions; and after the earthquake that crippled Japanese power generation, Son started a renewable-energy business.

Son has a very ambitious goal for SoftBank: He wants it to become one of the largest companies in the world. Unlike the average Wall Street CEO, whose time horizon has shrunk to quarters, Son thinks in centuries. I kid you not — he has a 300-year vision for SoftBank. Practically speaking, 300 years is a bit challenging even for long-term investors, but at the core of his vision Son is building a company that he wants to last forever (or 300 years, whichever comes first).

He views SoftBank as an Internet company and is committed to investing in Internet companies in China and India. He thinks that as these countries develop, their GDPs will eclipse those of the U.S. and Europe.

Jobs, Branson, Buffett — it is very rare for somebody to embody strengths of all three of these giants. None of them has the qualities of the other two. Buffett is not a visionary, nor does he want to run the companies in his portfolio. Branson is not a visionary — in his book Losing My Virginity he admits he did not see analog music (CDs) being destroyed by digital music (iTunes) and demolishing his music store business. Jobs probably came the closest, as both a visionary and a business builder, but he was not known for his investing acumen.

You’d think SoftBank would be richly priced to reflect Son’s premium. Wrong! Today its stock is trading at about a 40 percent discount to the fair value of its known assets (SoftBank has about 1,300 investments, many of them not consolidated on its financials).This discount is not rational, but maybe the market thinks Alibaba is overvalued, or it expects the Japanese yen to continue its decline (I would not disagree), and thus wholly owned Japanese telecom businesses are going to be worth less in U.S. dollars. Or maybe SoftBank’s Sprint investment is not going to work out. Oh, I forgot to mention that one — let’s address it next.

SoftBank’s Japanese telecom businesses generate about $6 billion of very stable operating income, but there is little room for growth in Japan. Unable to find anything telecom to buy in Asia, in 2013 the company took advantage of the strong yen and bought 80 percent of Sprint for $21 billion, or $7.65 a share. Sprint is the No. 3 mobile company in the U.S., a market dominated by AT&T and Verizon, which together account for about 75 percent of wireless revenue and more than 100 percent of wireless profits (T-Mobile and Sprint are losing money). If I knew no more than that, I’d say Sprint’s chances of success in the U.S. are slim — after all, it is competing against two very profitable giants.

But I would have said the same thing about SoftBank’s adventure into fixed-line and then wireless in Japan, and I would have been dead wrong. Admittedly, Sprint’s turnaround will not be easy and will be far from linear, and its $30 billion debt load will not help. SoftBank is looking to apply the tremendous experience it gained through a lot of hard work in turning an ailing Vodafone K.K. into one of the best wireless companies in the world.

However, this time around SoftBank is even better equipped to fight its competition: It has lots of experience with 2.5 GHz spectrum in Japan, where its network is several times faster than Verizon’s and AT&T’s networks in the U.S. SoftBank brought 200 engineers from Japan to help Sprint design its new network; the two companies combined have tremendous buying power in equipment, second only to China Mobile. In fact, suppliers Alcatel-Lucent, Nokia and Samsung just agreed to provide Sprint with $1.8 billion in vendor financing. But most important, SoftBank has already had success with a telecom turnaround. It is following the same road map with Sprint that it used in Japan with Vodafone K.K.: improve the network, cut costs, provide better customer service and top all that with cutthroat price reductions.

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investmentcenter5

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Sprint News

Over the past several months, the news flow from Sprint has not been great: It cut guidance, and its stock declined to $4 a share. This may explain why SoftBank’s stock is down; however, even if Sprint meets its maker, the impact on SoftBank should be just $5 a share. Sprint’s $30 billion debt is nonrecourse to SoftBank. Even at current market values, SoftBank’s equity stake in Sprint is worth only $12 billion, while its 32 percent stake in Alibaba is worth $80 billion, and its Japanese telecom businesses are worth about $50 billion (at five times earnings before depreciation and amortization). SoftBank’s stake in Yahoo! Japan is worth north of $8 billion.

Softbank

As part of our investment analysis, we tried to hypothetically kill SoftBank — smother it with a pillow — but we simply could not. We assumed that the yen will depreciate against the dollar to 180 from 120 today, slashing the value of Japanese businesses by a third. Alibaba stock is trading at around $100, about 30 times 2015 earnings forecasts; we took the earnings multiple down to 20 times, pricing the stock at $60. We even assumed SoftBank will have to pay capital gains taxes on selling Alibaba. We halved the price of Sprint’s stock. However, even in this fairly grim scenario we could not get SoftBank’s stock to decline much below its current price of $30. In the worst case we are paying fair value for SoftBank’s assets and get Son’s magic for free. This places no value on his 1,300 other investments, either. Sprint may, by the way, actually work out to be a tremendous success for SoftBank.

There are many ways to look at SoftBank. You can think of it as buying a stock at a roughly 50 percent discount to the market value of its assets or as a way to buy Alibaba at less than half its current price. Alibaba is a great play on China — not the China that builds ghost towns and bridges to nowhere but the Chinese consumer, and not just the Chinese consumer but the Chinese consumer who is spending more and more money shopping online. Alibaba is synonymous with Chinese online shopping, whose growth may accelerate with higher smartphone penetration and, just as important, the ongoing rollout of a fast wireless LTE network.

I’d be remiss if I did not discuss an important asterisk in the ownership of Alibaba. Its shares listed on the NYSE and owned by SoftBank don’t have an economic interest in Alibaba, although, through a stake in a Cayman Islands entity, they have contractual rights to profits from Alibaba China. The latter is owned and controlled by Jack Ma, Alibaba’s founder and CEO. This structure is not a by-product of Ma’s evil intent to steal Alibaba from gullible investors but rather is forced by Chinese law that prohibits foreign ownership in certain industries. There is a risk that the Chinese government might find this structure illegal, but at Alibaba’s size — $240 billion — the company is simply too big to be messed with. China’s economy would pay a huge price if its second-largest public company just disappeared due to a legal technicality. This would also turn into an international public relations nightmare for China, not only with the U.S. but with Japan as well. It would make Ma richer at the expense of U.S. shareholders but also at the expense of SoftBank and Japan’s richest man, Son.

(Those who have a problem with Ma maintaining complete operational control of Alibaba should recall that the phenomenon of founder as benevolent dictator is nothing new — just look at Google. In fact, I’d argue that this control has allowed Ma to sustain his long-term time horizon and this is what has helped Alibaba drive eBay out of China; but that’s a discussion for another time).

Assessment

You can also look at SoftBank as a vehicle through which to invest in emerging markets — not just China but India as well. It is almost like hiring the combination of Buffett, Branson and Jobs to go to work for you investing in markets whose economies in a few decades will surpass that of the U.S., while also investing in a segment of the economy — the Internet — that is growing at a much faster rate than the overall economy. And yes, of course, you have Masayoshi Son, the super-Buffett-Branson-Jobs fusion, making these investments for you. With SoftBank at this valuation, you can forget about your emerging-markets mutual fund.

More: Ode to Steve Jobs

ABOUT

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.

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  1. Innovation is Alive and Well at Apple

    Can Apple still come up with breakthrough innovations? In September Apple introduced an iPhone with 3-D touch, Apple TV that has been turned into a gaming device and a larger iPad with a stylus that will take the tech giant into new niches. These products looked awesome, but they were just improvements. There was nothing groundbreaking about them. Apple’s breakthrough innovation was financial — its new iPhone Upgrade Program, which is ingenious on many levels.

    Let’s briefly summarize that program. If you were to buy an iPhone 6s with 16 gigabytes of memory outright online or at an Apple store, it would cost you $649. The Apple Upgrade Program will provide you free financing on this phone for two years for $32.41 a month. However, the sum of these payments will add up to $778, because it includes AppleCare+, which is mandatory. AppleCare+ is a fancy name for an extended warranty service that really adds three things: It extends your technical support beyond 90 days to two years; it increases the phone warranty from one year to two; and Apple will replace your phone (for a small fee) if you drown it in the toilet or drive over it — the usual stuff we do to our beloved iPhones from time to time.

    But here is the kicker. In 12 months, when Apple comes out with another iPhone (and believe me, they will), you will be able to hand your now “old” (one year, that is) phone back to Apple and get a brand-new one. That will automatically extend your upgrade contract by 24 months, giving you the option to get another iPhone in 12 months, and the cycle will continue. This is a plan that would make even the financial engineers at Goldman Sachs proud.

    Here’s why: The program turns Apple into an iPaaS (iPhone as a Service) company. For $32.41 a month your constitutional right to pursue happiness through ownership of each new iPhone will finally be fulfilled. Consumers are encouraged to upgrade their phone every year instead of every two to three years, singlehandedly pushing up iPhone sales in the U.S. much higher.

    These higher sales will also come with much higher margins. In the current near-zero interest rate environment, financing will cost Apple, let’s say, around 4 percent, or $26 a year (on a $650 phone). Incidentally, Apple raised the price of AppleCare+ by $30, from $99 to $129 a year. This should more than cover the cost of financing for the first year, and if you keep upgrading your phone, you’ll keep buying AppleCare+.

    It gets better. When a customer buys an iPhone through Apple Upgrade, AppleCare+’s so-called attachment rate to that iPhone sale is 100 percent. Apple will not sell you an iPhone without AppleCare+. For iPhones sold by AT&T or even at an Apple store, the AppleCare+ attachment rate is much lower (Apple doesn’t disclose the number). There is certainly value in AppleCare+, but just as with any warranty, its margins are sky-high.

    In 12 months Apple is going to have an inflow of year-old iPhones. My guesstimate is that if you include interest and warranty expenses, the cost of an iPhone traded in mid-contract is somewhere around $260. What will Apple do with millions of used iPhones? It will refurbish them and sell them in emerging markets like Russia and India. A steady inflow of used iPhones will help Apple compete more effectively in emerging markets, which are flooded with much cheaper smartphones. Refurbished iPhones are gateway drugs to new, full-price iPhones. After all, once you go Apple you don’t go back (surveys show that Apple users have 90 percent loyalty). Also, used products are often subject to much lower import tariffs than new products, further lowering the cost. So Apple will be able to sell your iPhone twice.

    Apple Upgrade takes control of the customer away from wireless carriers. It dumbifies and commoditizes their services. Wireless carriers used to be major subsidizers of iPhones, but Apple Upgrade will change that. Carriers locked in consumers to their services for the duration of the contract, but not anymore. Now customers will be locked into Apple, and every 12 months they’ll get to make a decision as to which carrier will be granted the privilege of carrying the bits and bytes generated by their iPhones. Carriers that offer the lowest price will win.

    Apple’s upgrade program is a no-brainer for consumers if — and this is a very significant if — they perceive there is value in what Apple is asking them to pay for: AppleCare+. Just as with the introduction of any new Apple product, the chances of success for the iPhone Upgrade Program are very high but not guaranteed. Still, at least for now the question of whether Apple can still innovate has been answered.

    Vitaliy Katsenelson CFA

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