Friday 26 May 2017

Toshiba: From nuclear renaissance to nuclear nightmare

“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:

Glencore – In late 2015, the commodity price slump along with high debt load drove Glencore’s shares down by 87% from its 2011 IPO price. However, superior execution by a strong management and recovery in commodity prices has meant that an investor in late 2015 or early 2016 would have made 3x to 4x return.

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. 

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:
Yen in billions
Pensions liability
Net current liabilities
Westinghouse parent company guarantee
Cost of paying out on the Westinghouse Puts
Total Liabilities

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:
Yen in billions
Investments (net of Yen 175.6 billion loan to Westinghouse
Implied value of NAND, nuclear and the rest of Toshiba based on current share price
Total Assets
Total Liabilities
Net Asset Value
Number of shares outstanding
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.

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
Yen in billions
Investments (net of Yen 175.6 billion loan to Westinghouse
Nuclear less Westinghouse
Rest of Toshiba
Total Assets
Total Liabilities
Net Assets
Shares outstanding in billions
Value per share in Yen
Current share price (@26/05/2017)
Downside to current share price
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.


  1. Hey, really good analysis! As additional Upside one could think of Toshiba putting more of its many business units for sale, I guess some are good value while others are so crappy it would benefit the company to get rid of it. I do not know if this is realistic, but still an option. But I also agree that it looks to expensive if debt is taken into account (which the japanese market maybe is not doing fully).

  2. Hi Tobi, Thanks for reading and for the feedback. It is certainly an interesting situation. One that seems to be going the other way of the back of the NAND sale news. I think this is one that will play over a few years - it will be interesting to see where Tosh is 2/3 years' time.

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