“There is a chronic
culture of lying. We can’t possibly trust such a company. Shame on you.” – An
angry Toshiba shareholder at a recent shareholder meeting.
Toshiba, one of the models of corporate governance for Japan
Inc until two years ago, stands on the brink of possible failure. Toshiba’s
problems began with an accounting fraud identified in FY15 where it was found
that the company had overstated operating profits by $1.2 billion. That issue pales in significance to the crisis facing Toshiba today. Significant cost
overruns in its Westinghouse Nuclear Power Business (Westinghouse), has meant
that Toshiba has had to take a massive Yen 712.5 billion ($6.1 billion)
write-off; it is likely to declare a loss of Yen 1 trillion for FY16, the
largest ever in Japanese corporate history. Shareholder’s equity stands at a
dire negative Yen 540 billion resulting in a shareholder’s equity ratio (net
assets / total assets) of -12.6%. If Toshiba doesn’t cure its broken balance
sheet soon, it will go bust.
Toshiba’s shares are down ~44% since just before the news of
the massive write-off broke in mid-December 2016.
The situation at Toshiba is of interest because similar situations
– large corporate hit by unexpected bad news spooking the market and sparking an
overdone sell-off – have made good returns for contrarian investors. To name a
few recent examples:
BP – In 2010 the Deepwater Horizon incident sent BP’s shares
down by 50% in just under 2 months. A contrarian investor, having done his due
diligence, would have seen value in the shares which subsequently returned 2x
in just over 6 months.
Deutsche Bank – In September 2016 when the US Department of
Justice hit Deutsche Bank with a $14billion fine, its shares were left reeling
and fell below EUR 10 level. The very survival of the bank was put into
question. However, a careful analysis would have revealed that the fine was not
going to be anything like the $14billion; the shares duly returned ~2x in less
than 6 months.
Bombardier – After falling to a historic low of C$0.80 in
early 2016 on fears of being taken out of the Toronto Stock exchange which
resulted in wide spread sell-off by institutions, Bomardier returned 3x in
2016. Again, a careful analysis would have indicated a buy.
But every fall doesn’t indicate a future recovery and there
are cautionary tales too. One can easily ride what appears to be a prospective
recovery plays all the way down. Who can forget Valeant, touted as a recovery
play by so many only to find that it was a ride all the way down.
The question is – is Toshiba a Glencore or is it a Valeant?
Toshiba faces multiple headwinds threatening both its
immediate survival and its longer term prospects even if it manages navigate the
immediate threats:
In the near term Toshiba needs to cure its negative equity
and repair its balance sheet. Failing to do so would be catastrophic – there is
a real risk of Toshiba getting delisted from the Tokyo Stock Exchange (TSE) if it
cannot cure its negative equity by the FY17 (March 2018). And being a capital
intensive business with long working capital cycles and significant capex
needs, Toshiba relies heavily on its banks (a group of 80+ banks) for lifeline.
They will be getting jittery and could pull the plug if they don’t see a cure
to the balance sheet woes (shareholders equity ratio is a key metric for
Japanese banks and they like to see this ratio being at least above 10%;
Toshiba’s negative 12.6% must be alarming).
To add to its balance sheet worries, I don’t think there are
any guarantees that the Westinghouse Nuclear issue is behind Toshiba. In spite
of the massive Yen 712.5 billion write-off, significant contingent liabilities
associated with Westinghouse remain. Toshiba is exposed to an identified parent
company guarantee of Yen 650 billion and it can more or less forget being able
to recover its Yen 176.5 billion of loans to Westinghouse. The identified
contingent liabilities alone add up to Yen 825.6 billion. In addition, two
minority partners in Westinghouse holding 13% have a put option to put their
shares back to Toshiba – I expect this to cost Toshiba an additional Yen 81
billion. But this is unlikely to be the end of the Westinghouse massacre. As
this excellent FT
analysis shows, for a project as complex as Westinghouse, the only certainty
is uncertainty; escalating costs and prolonged deadlines could deal Toshiba
fatal blow. As Georgia Power, a customer of Westinghouse, made it clear in a
statement – it has a “firm and fixed” contract with Westinghouse and expects
Toshiba to employ “all possible means” to deliver the projects on time or it
will hold Toshiba “accountable for their responsibilities under the agreement”.
When Toshiba acquired Westinghouse in 2006 for $5.6 billion, nuclear reactors
were touted as the future and it was going to be an ear of nuclear renaissance.
That dream has now turned into a nightmare for Toshiba.
The only option open to Toshiba to cure its balance sheet is
to sell its crown jewel – the NAND Flash Memory Business (NAND). NAND is
Toshiba’s best asset with good growth prospect and margins. Selling NAND and
loosing nuclear risks leaving Toshiba with a rump of low growth low margin
businesses with little future prospects (the remaining businesses have a
projected margin of 1.4% in FY17 and Toshiba’s own optimistic forecasts for
FY19 show a margin of 5%). But there is no way out of Toshiba other than a sale
of NAND. It is seeking a price of at least Yen 2 trillion from the sale of NAND;
if it can achieve this price, it would certainly cure Toshiba’s balance sheet issues
and take away its immediate survival threats. A recent bid from Western Digital
is reported to be at Yen 2 trillion. This bid has financial support from the
Development Bank of Japan and blessings of the Japanese government which does
not want NAND to fall into the hands of the Chinese or Koreans and supports
Western Digital bid. This news has made the market happy, sending Toshiba’s shares
up by ~11.5% in two days (my ~44% fall since December 2016 is after the recent
rise without which Toshiba would be down by over 50%).
Given the challenges, a bull case can only be made if it can
be established that the sale of NAND will cure Toshiba’s balance sheet, that an
exit from Westinghouse can be achieved without any additional liabilities, and
that what Toshiba is left with after NAND and Westinghouse has enough value.
Valuation
Valuing Toshiba is not easy. Given the hundreds of
businesses Toshiba operates and the significant distress it currently faces, I
don’t think a DCF valuation would return a meaningful result. I have approached
the valuation from a balance sheet angle and try to compare market’s implied
value with my estimate of value.
The first step in the process is to build the liabilities side
of a non-GAAP balance sheet (the GAAP balance sheet is not much use as we want
to now all liabilities – including contingent and off balance sheet). The next
step is to build the asset side, work out the net asset value and arrive at the
value per share.
The liabilities side
of Toshiba’s non-GAAP balance sheet
Some of the liabilities are easy to determine – Toshiba has
Yen 1389 billion of debt, Yen 633.8 billion of pensions liability and Yen
980.05 billion of net current liabilities. But there are some liabilities which
are difficult to estimate – like how exposed Toshiba is on its parent company
guarantee to Westinghouse? At present, based on discloses connected with the
Westinghouse chapter 11 filings, Toshiba has said that it is exposed to Yen 650
billion on its parent company guarantee; but there is a very real risk that
this number could increase. In addition, Toshiba will take a hit on the put
options which the two minority partners in Westinghouse who hold 13% will
exercise to put their shares back to Toshiba. I estimate this to cost Toshiba
Yen 81 billion over the course of FY17. Assuming no additional liabilities on
the Westinghouse side other than the Yen 650 billion, the non-GAAP balance
sheet looks something like this:
Liabilities
|
Yen
in billions
|
Debt
|
1389
|
Pensions liability
|
633.8
|
Net current liabilities
|
980.05
|
Westinghouse parent company guarantee
|
650
|
Cost of paying out on the Westinghouse Puts
|
81.9
|
Total Liabilities
|
3734.75
|
For the asset side of a non-GAAP balance sheet, some of the
assets are easy to determine – I give full credit to Toshiba’s Yen 804.5
billion of cash balance and ~Yen 221.1 billion of investments (these are
securities and loans to affiliates net of the Yen 175.6 billion loan to
Westinghouse which I have assumed is a write-off). Then we have the material
operating assets of Toshiba which I classify into 3 broad buckets – the NAND
business, the remaining nuclear business after Westinghouse, and the rest of
Toshiba. As a first step, it is useful to work out the implied value for these
businesses based on Toshiba’s current share price. Toshiba currently trades at
Yen 258 a share and there are 4.23 billion shares outstanding, giving a market cap
of Yen 1091.34 billion. Based on this, I derive an implied market value for
Toshiba’s operating assets (NAND, nuclear and rest of Toshiba) of Yen 3800.49
billion. The asset side of this balance sheet looks like this:
Assets
|
Yen
in billions
|
Cash
|
804.5
|
Investments (net of Yen 175.6 billion loan to Westinghouse
|
221.1
|
Implied value of NAND, nuclear and the rest of Toshiba based on
current share price
|
3800.49
|
Total Assets
|
4826.09
|
Total Liabilities
|
3734.75
|
Net Asset Value
|
1091.34
|
Number of shares outstanding
|
4.23
|
Current share price
|
Yen
258
|
The next step is to try and determine a value for the three
Toshiba businesses – NAND, nuclear, and the rest and compare this with the
implied value based on current share price.
NAND
Given NAND is up for sale and at least a couple of bids have
been received, the bid prices are my proxy for value. Bain recently bid ~Yen
1137 billion and the latest bid from Western Digital has come in at Yen 2
trillion. Toshiba too has publicly stated that it wishes to achieve a price of
at least Yen 2 trillion. As mentioned previously, the Western Digital bid has
the backing of the Japanese government and the market clearly thinks this is
the one. Whilst there is no ruling out an insanely high bid from the likes of
Hon Hai (there were rumours of Hon Hai bidding Yen 3 trillion for NAND) given
the Japanese governments expressed wish of not wanting NAND falling to the
hands of any other Asian buyer, such a bid succeeding could be low – Toshiba relies
heavily on government support and it may not be able to go against its wishes.
Therefore, a reasonable estimate of value for NAND is Yen 2 trillion. My
forecast FY17 EBITDA for NAND comes at ~Yen 200 billion giving a 10x EBITDA to
NAND which is a reasonable against sector comparables.
Nuclear excluding Westinghouse
The rest of Toshiba’s nuclear business is forecast to
generate EBITDA of ~Yen 40 billion for FY17. EDF trades at ~4.7x FY17 EBITDA,
but EDF is a superior quality business compared to what will be left of Toshiba
post Westinghouse. And Toshiba is likely to fire sell its nuclear remnant once
the dust settles down. I assigning an optimistic 4x EBITDA multiple to Toshiba’s
remaining nuclear business gives it a value of Yen 160 billion.
Rest of Toshiba
The rest of Toshiba is a myriad collection of businesses
from digital services to energy transmission, electronic devices, power
transmission, railway and industry systems, printing systems, public
infrastructure and building facilities. There are literally hundreds of
businesses and it would be impossible to value with any degree of precision without
detailed inside knowledge. What we know is that these are highly capital
intensive businesses with low growth and low margins (for example, Toshiba’s
forecast margins for for this lot for FY17 is 1.4% and even its highly
optimistic – entirely unrealistic in my opinion – FY19 forecast shows a margin
of 5%).
The best comparable for the rest of Toshiba is Hitachi of
Japan which trades at 4.7x forecast FY17 EBITDA. There are strong arguments to
say that the quality of Toshiba’s assets and management deserves a meaningful discount
to Hitachi’s multiple. Based on Toshiba’s forecast FY17 numbers, I get an
estimated FY17 EBITDA for the rest of Toshiba of ~Yen 178 billion. Applying a
4x multiple to this forecast EBITDA gives a value for rest of Toshiba of Yen
622 billion; and applying Hitachi’s 4.7x multiple would give a value of Yen 835
billion. If we take Toshiba’s FY19 forecasts a face value and apply a 4x
multiple to FY19 forecast EBITDA of Yen 357 billion, the value for rest of
Toshiba would be Yen 1428 billion. Taking an average I assign a value of ~Yen
962 billion for the rest of Toshiba which I believe is more than reasonable.
Based on the above estimates, my estimate of intrinsic value
per share for Toshiba comes to Yen 95 to Yen 100 per share which reflects a
~60% downside compared to the current share price of Yen 258.
Intrinsic value
estimate
Assets
|
Yen
in billions
|
Cash
|
804.5
|
Investments (net of Yen 175.6 billion loan to Westinghouse
|
221.1
|
NAND
|
2000
|
Nuclear less Westinghouse
|
160
|
Rest of Toshiba
|
962
|
Total Assets
|
4147.6
|
Total Liabilities
|
3734.75
|
Net Assets
|
412.85
|
Shares outstanding in billions
|
4.23
|
Value per share in Yen
|
97.60
|
Current share price
(@26/05/2017)
|
258
|
Downside to current share
price
|
-62%
|
In my opinion the market is way too complacent and hasn’t fully
appreciated the risks facing Toshiba – it most likely underestimates the risks
on the liabilities side and possibly overestimates the value on the assets
side. In addition, there are significant risks on a number of fronts – e.g.
delisting risk with the TSE, banks pulling the plug, execution risk with NAND
sale, getting auditor sign-off on the accounts, and the very real possibility
of crippling additional liabilities on the Westinghouse side.
A quick rundown of both downside and upside would read as
follows:
Downside risks
1. Liabilities on the Westinghouse Nuclear business turn out
to be greater than the estimated ~850billion; this is a real risk in my
opinion. Such a scenario could be fatal for Toshiba.
2. Toshiba gets delisted from TSE due to any of the
following: if additional write-offs need to be taken due to escalating costs on
Westinghouse and negative equity position weakens; if the NAND sale cannot be
executed or price achieved is lower than expected; if Toshiba doesn't reach a
resolution with it auditor to get its accounts signed off; or if TSE isn't satisfied
that Toshiba's internal controls have improved and are adequate (I pity the TSE
regulator in charge of checking this given this is a business which failed to
notice over $10billion cost overruns on a $25billion original budget on Westinghouse
until after 8 years of running the project and all the while reporting positive
numbers).
3. Longer term, the remaining businesses after the sale of
NAND and loss of Nuclear could well turn out to be low growth poor margin
businesses which do not justify the current market value.
4. Toshiba's lenders pull the plug and Toshiba is left with
no option but to fire sell whatever assets it can, seek government support or
go bankrupt. This scenario will mean a complete write off for current equity
owners but could prove lucrative for distressed debt investors.
5. If Toshiba manages to navigate the immediate risks by achieving
a satisfactory sale of NAND curing its balance sheet, there is a very real
chance of a dilutive equity rise at that point. The market seems to be
completely discounting this possibility. If I were one of Toshiba's banks, I
would certainly be pushing for this.
Upside scenarios
1. Additional liabilities connected with Westinghouse come
in at lower than currently anticipated levels in the unlikely event that
Toshiba manages to negotiate a better deal. I fail to see how this can happen and
why the utilities would ever fall for this given they have Toshiba
contractually bound to a fixed price contract.
2. NAND sale generates a more than expected price. Whilst
there have been rumours of Hon Hai bidding Yen 3 trillion; given the Japanese
government clearly backs the Western Digital bid and has openly expressed its
wish for NAND to not pass to a Chinese or Korean owner, the likely hood of
achieving a significantly higher price than Yen 2 billion is low in my opinion.
3. Toshiba's remaining business - post NAND and Nuclear-
perform better than expected and achieve superior market multiples. Possible
but less likely given history.
In my opinion the downside risks trump the upside. While the
market is optimistic at present (almost euphoric in the last few days on the
back of the NAND bid), there are significant issues Toshiba needs to navigate
and more surprises are likely on the downside. It will only take one or two
downside surprises for the market to turn pessimistic and dump the stock. This
could be an interesting short.
