CenturyLink: Bond with an equity kicker

Keith Meister of Corvex Management presented his thesis on CenturyLink at the Sohn Investment Conference back in May 2017. The essence of his thesis was that CenturyLink (CTL), with a dividend yield then of 9.2%, was a credit investment with equity upside. What has changed since then? The market now offers the stock at an even better yield of 11.35%, and the equity kicker still exists. It is even more of a buy than it was back in May.

The bears will rightly point out that the high yield is a reflection of the credit risk and the dividend may not be secure. But I disagree. The clincher is the merger between CTL and Level3 which is set to complete by the end of October 2017 and will be truly transformative for the combined group. Once things settle down post-merger, the market’s focus should turn to the substantial benefits this merger offers for the combined new group.  

Below is a list of my investment pros and cons for CTL. My free cash flow forecast and valuation analysis is included below.

Pros	Cons
11.35% dividend yield Based on forecast free cash flows (provided below), I believe that the dividend is secure and management have made their intention of retaining the dividend clear. The current yield is ~930bps above the 10 year treasury and also significantly above peers.	Competition and revenue pressure intensifies Competition in intense and it has been showing in the declining revenues at CTL. While Level3 offers a better revenue mix and growth, it will be key for the combined group to arrest revenue decline and stabilise. Any sign of integration risk could make enterprise customer nervous.
Transformative merger with Level3 But for the merger with Level3, I wouldn’t be recommending CTL. The merger offers the following benefits: -          scale to compete effectively (CTL+L3 will be the second largest domestic communications provider serving enterprise customers with significant network); and with demand for data set to explode, the combined group should be well set to capitalise. -          Post-merger, the group should be well positioned in the growing enterprise services market, with enterprise revenues constituting a growing percentage of sales. This should help offset the declining legacy segment.   -          Significant synergies on offer: to the tune of $850m of operating synergies and $125m of capex synergies, giving further boost to free cash flows. -          Level3’s ~$10 billion of NOLs should substantially reduce cash taxes for the combined group, again a positive for free cash flows. All of the above means an improved EBITDA margin, better free cash flows, and most importantly, an improved dividend coverage securing the current yield.	Integration risk The investment case for CTL is predicated on a successful merger and integration with Level3. It will be important that the group achieves revenue stabilisation, projected synergies and cash tax benefits indicated by the merger. That said, I note that most analyst expect managements projected synergies to be on the conservative side and achievable.   It is worth noting here that the market seems to be linking CTL with what’s happened to Frontier Communications Inc. Frontier was another high yielding stock which was all set to take-off after its acquisition of Verizon’s nonwireless services in 2016. But a disastrous integration resulted in massive loss of customers. The stock tanked and dividend was cut. CTL’s current share price is a reflection of market’s nervousness owing to this recent event with Frontiers. The advantage for CTL and Level3 is a management team who have rolled up and successfully implemented several acquisitions in the past with success.
Cheap to peers; should rerate down the line CTL trades well below peers: peers trade at 7.3x FY18(E) EV/EBITDA whereas CTL+L3 is at ~6.5x; and peers trade at ~14x FY18(E) Price/FCF whereas CTL+L3 is at ~7.6x. In addition, CTL's dividend yield of 11.3% is a spread of ~9.3% over ten year treasury. Once the merger with Level3 is cemented, market’s focus should return to the positives for the combined group and the stock should rerate.	Legacy business declines at a faster pace The emergence of wireless has been detrimental to CTL’s fixed-line business. The number of fixed-lines CTL offers has been declining steadily over the years and there is no doubt that fixed-line and all the revenue streams attached to it will slowly wither and die. If the decline is dramatic, it will impact free cash flows. The key is the shift to enterprise and strategic revenue mix offered by L3, it will be important and the decline in legacy revenues is offset by enterprise.

Valuation analysis

Using a combination of peer multiple, dividend yield, and discounted cash flow analysis, I get a per share value for CTL of $28.6 per share, equating to a return of ~50% based on the current share price of $19.03.

CTL+L3 proforma forecast

Ladbrokes Coral Group: Lame duck or a smart bet?

Lame duck, in literal sense, refers to a duck unable to keep up with its flock. Market sure thinks that the Ladbrokes Coral Group (LCL) - the second largest gambling operator globally in terms of net revenue - is a lame duck. LCL lags its peers by a big margin - trading at 7.4x FY18 consensus EPS (peers trade at 13x), under 6x FY18 forecast EBITDA (peers are at 9x), and at 11.12% FY18 forecast free cash flow yield (peers are at 8.5%). If LCL were to match its peers, its shares should be around ~£2, which at the current share price of £1.2 implies a discount to peer multiple of ~40%. For the second largest operator in the sector, LCL sure looks cheap (see key stats below).

But, there is a reason for market’s concern. The UK’s Department for Culture, Media and Sport (DCMS) is carrying out a review of the perceived harm caused by fixed-odds betting terminals (FOBTs or B2 machines in technical jargon) – these are gaming machines within betting shops which offer games like roulette and have acquired an infamous reputation as the “crack cocaine” of gambling. FOBTs currently allow a bet of up to £100 per game every 20 seconds, although in practice the average bet tends to be a lot lower and there already is strict self-regulation where bets over £50 are heavily policed. However, FOBTs have a bad name and the DCMS is set to publish its Triennial review in October 2017 where it will likely recommend restrictions on them, including a cut to the maximum stake per bet. Rumours are that the review will contain four options for FOBTs: status quo, max stake cut to £30 per bet, max stake cut to £20 per bet and max stake cut to £2 per bet. In all likelihood, the eventual outcome, after a period of consultation, will be a cut to the maximum stake per bet of a material number. Analysts predict that a cut to FOBTs max stake to £2 per bet could result in LCL’s revenues falling by £450m per annum, and a cut of £20 or £30 lead to LCL’s revenues falling by ~£90m.  The market clearly is concerned and appears to be pricing in a bad outcome.

However, based on the price targets of 17 analysts who cover LCL, the market appears to be pricing in too much of a discount.

If the median estimate of the 17 analysts offering a target price for LCL is to be believed, the current share price offers a ~33% upside over the next 12 month period. This is worth looking into in a bit more detail.

Breaking down LCL

In addition to its UK retail estate which is in the eye of the regulator, LCL has a fairly decent European retail estate and a strong growing Digital platform. Both European retail and Digital divisions combined delivered ~37% of the group’s revenue in FY16; this is set to grow with Digital continuing to perform very well operationally. None of these divisions are impacted by any changes to the FOBT regulations.

Applying peer multiple of 7x EBITDA to the European retail division and 12x EBITDA to the Digital division’s forecast FY18 numbers, the UK retail estate trades at a paltry 1.3x forecast FY17 EBITDA (see table below). This implies that the market expects a disastrous outcome for the UK retail estate revenue and profitability going forward. 

UK Retail estate and FOBTs

LCL’s UK retail estate generates revenues from both over the counter (OTC) bets on sporting events and from machines (both FOBTs and B3 machines). Both OTC and B3 machine revenues are not the subject of the regulatory review. Based on available historic results for the combined group, LCL derives ~35% of its total revenues from gaming machines in its UK retail estate; based on management’s recent presentation, approximately 67% of machine revenue comes from FOBTs (B2 machines) which are subject of the review; the rest of LCL’s machine revenue come from B3 gaming machines where the max stake is currently at £2 per game and is not subject to the regulatory review. Therefore, ~25% of LCL’s revenue is at risk [35% machine revenues x ~70% B2 revenue] from the impending regulation on FOBTs (this can’t be strictly true as there will be a number of shops where the machine revenue partly subsidises the OTC business without which the shops will be loss making and need to shut resulting in a reduction of a part of OTC revenues, but for the purposes of our analysis I am solely focusing on the direct FOBT revenues which is at risk from the regulation).

25% of LCL’s revenue equates to ~£530m based on an average of last two year’ results. How much of the £530m is at risk if the maximum stake falls to £2 or £20 or £30? Management do not give this information or provide sufficient background information for us to be able to estimate this precisely. However analysts have forecast a fall in LCL’s revenues of £450m if the FOBT max stake is cut to £2 and a fall in LCL’s revenues of ~£87m if the FOBT max stake is cut to £20/£30.

I think the analyst forecast makes sense in both scenarios.

Data from the UK’s Gambling Commission shows that a B3 machine, which has a max £2 stake per bet, yields roughly 30% what a B2 (FOBT) machine does. Therefore, if the FOBT stake is cut to £2 and all of LCL’ machines (regulation restricts 4 machines per shop equating to 14.6k machines in total across LCLs 3,660 shops) lose 70% of their yield, the revenues would drop by ~£380m; add a trimming to the shop estate of ~5-10%, the total revenues would drop by ~£450m under a £2 FOBT scenario.

As for the analyst forecast of ~£87m drop in revenues if the max FOBT stake is cut to between £20/£30, this one is more difficult to reconcile. Detailed information on the gross yield per machine per stake bet is not available. The best stat I could find was from a report published by Responsible Gambling Trust in 2016 that uncovered data on FOBTs. The report found that the average bet on a FOBT was £8.17 across a total of 9.2 million bets sampled (which is a fairly large sample size). The report found that the average max stake bet lost 50% more per bet (£15.39 per gambling session) compared to a non-max stake bet, which lost £10 per gambling session. Using these stats, and assuming just over 30% of the losses are incurred by players betting max stake bets, one can work out a loss in revenue of ~£85m for a cut in max stake to £20/£30. Another study by RGT which surveyed 4001 loyalty cardholders found that ~16% players placed max stake bets, therefore assuming 30% of losses are incurred by max stake bets appears more than prudent (that said, not sure if a max stake player would necessarily respond to a survey in the affirmative). Broadly, the prediction of revenues falling by ~£87m for a £20/£30 FOBT scenario also appears reasonable.

Applying peer multiple to the FY18 EBITDA forecast for both my worst case (max stake cut to £2) scenario and my base case (max stake cut to £20) results in a per share value of £1.47 and £1.62 respectively. This represents an upside to current share price of 22-35% (see table below).  

FCF forecast and DCF valuation for base case and worst case

Below, I present my DCF valuation for LCL using a WACC of 8.8% and nil terminal growth rate.

Valuation summary

Risks

-          European retail and Digital don’t perform as expected

-          Revenue and margin fall due to FOBT regulation are more severe than forecast

Additional potential upside

-          GVC, the online gambling group, has previously shown interest in LCL and rumours of GVC’s continued interest in LCL have been doing rounds lately. GVC will likely wait for the outcome of the FOBT review before making a move, but its interest provides downside protection and potentially an upside if the FOBT review outcome ends up in the base case scenario.

-         My forecast above assumes that any reduction in FOBT stakes will take effect from FY18 onwards; it is highly likely that the period of consultation will mean that the effect of a stake reduction is likely to kick in later or from FY19, which should be an upside to my forecast. This will also allow the company sufficient time to cut overheads and shops (with an average lease length of ~3.5 years and well negotiated terms for lease breaks according to management, the company has good flexibility). 

Hudson Bay: Activist play

Hudson Bay (HBC), the Canadian listed diversified global retailer has come under attack from activist investor, Land and Building Investment Management (L&B). L&B says that HBC, ostensibly a retailer, is in reality a real estate company and should behave like one. The gist of L&B’s thesis is that HBC’s real estate is worth a lot more if put to the right use; but HBC’s management, by focusing on its retail business, is fighting a losing battle.

There is some merit to L&B’s miff - HBC’s share price has fallen over 51% in 2 years, from a high of C$28.40 in mid-June 2015 to the current C$11.12. Over this period, HBC has expanded its retail operations into Europe through a major acquisition and increased store count by almost 50%. The expansion in retail operations has coincided with the tanking share price.

L&B has laid out its case in two letters to HBC. L&B says that HBC’s management needs to focus on unlocking value from its core real estate portfolio instead of throwing good money in the losing retail business. HBC’s own valuation (backed by lenders and in part by investment from savvy JV partners) shows its core real estate portfolio being worth C$35 per share net of debt. This is over 3 times its current share price. Having read L&B’s two letters, I was reminded of two classic scenes from the movie ‘Other People’s Money’ – the first where Danny De Vito’s corporate raider (“Larry the Liquidator”) enthusiastically explains to the management of New England Wire & Cable Company that its hidden assets are worth 2.5x its current share price; and the second where Danny De Vito’s character argues his case in front of the shareholders of New England Wire & Cable.

HBC’s real estate

Unlike most traditional retail operations, HBC owns majority of the real estate occupied by its various retail banners. And this is a quality real estate portfolio in good locations which can be put to alternate use. This gives HBC an edge – even if its retail operations tank, it still has option value in its real estate portfolio. But HBC’s shares currently trade at ~70% discount to HBC’s C$35 per share real estate value. This implies that either the market has failed to acknowledge the value inherent in HBC’s real estate portfolio, or that the market thinks HBC will continue to burn cash in a losing retail battle, with the traditional brick & mortar model in secular decline, never being able to unlock the value in its real estate.

The table below summarises HBC’s real estate value

Below, I have calculated per share value of HBC’s real estate portfolio for various Cap Rate and NOI scenarios. As can be seen, NOI's need to fall by ~40% to justify the current share price.

A point worth noting here is that HBC has debt attached to its retail business, per my calculation, this was C$12 per share at the end of 1^st Quarter 2017. Even assigning nil value to HBC’s retail operation and assuming that the debt of ~C$12 a share in its retail business eats into the value of HBC’s real estate, gives a net equity value per share for HBC’s real estate portfolio of C$ 22.33 (or 2x current share price).  

Value unlock potential for HBC’s real estate

HBC’s 100% owned estate in 611 5^th Avenue (the Saks Fifth Avenue Store) and 424 5^th Avenue (Lord & Taylor store) are alone worth ~C$18 a share (net of debt). Both of these stores are in fantastic locations near the Rockefeller Center in Manhattan, one of the most sought after real estate in New York. As L&B points out in its letter, there is no reason why this estate cannot be put to better alternate use and be more valuable – e.g. as a mix of retail, commercial and residential units or even as a hotel or an office block.

The rest of HBC’s core real estate is in two JVs where HBC is the majority partner along with savvy real estate players - Simon Property Group and the Canadian REIT, RioCan. HBC’s share of equity value in the two JV’s add up to C$17 a share.

Given the quality of HBC’s estate, there must be a number of different ways in which value can be unlocked. There is no reason why HBC needs to tie its estate down to its retail banners, particularly if they can be put to more valuable alternate use.

The big danger is if HBC’s retail operations end up sinking the value of its real estate.

HBC’s retail business

HBC’s retail portfolio includes ten different retail banners operating in formats ranging from luxury to premium department stores to off price fashion stores. It has more than 480 stores and over 66,000 employees across North America and Europe. In one of its recent investor presentations, it sees itself as a global aggregator in the retail sector, with acquisitions being a big play.

But like for most traditional brick & mortar retailers, things have not been rosy for HBC.

Falling Sales: Comparable sales growth, which measures sales growth in stabilised stores, has been negative over the last three quarters, averaging a negative 3.8% each quarter. Even before the negative trend, comparable sales growth had started falling drastically for a couple of quarters.

Falling profitability: With falling sales comes fall in profitability. To calculate the profitability of HBC’s retail operations, I have backed out the estimated cash rents paid to 3^rd parties, to HBC’s two JVs and the implied cash rents on HBC’s NY 5^th Avenue estates. 

As can be seen in the table above, if the current trend in comparable sales decline continues, I expect HBC’s retail operations to be in negative EBITDA territory over the next twelve months and for FY18. HBC recently announced a major restructuring plan in its retail operation to generate C$350m in annual cost savings from FY18 onwards, and even assuming the plan succeeds in generating the estimated savings, I expect the retail business to be in negative EBITDA territory in FY18 unless comparable store sales decline is not arrested.

Ambitious but imprudent Capex plan given current situation: HBC intends to spend C$1 – 1.12 billion in gross capex for FY17 with net capex spend after landlord incentives estimated at C$450 – 550 million. Initiatives include opening 31 new stores across the company’s various banners and a major refurbishment of its Saks 5^th Avenue estate. When comparable store sales are tanking as it is, the proposed capex initiatives may be a cash burn with no return. In addition, the company continues to tout itself as a major aggregator in the retail space via acquisitions, further increasing the risk of cash burn.

Pressure on cash flow and debt: The falling comparable store sales and profitability, combined with an ambitious capex and store expansion plan doesn’t bode well for free cash flows.

The real danger, if the company continues in its current path and its retail sales and profitability continue to decline, is that shareholders realise no value from its real estate portfolio. Based on my estimates HBC could burn through ~C$450 - C$500 million in cash per annum (particularly if it continues with its growth capex spend) resulting in the net debt attached to its retail operations continuing to grow and ultimately eating away at the value attached to its real estate. For example, net debt in its operating business was C$1.5 billion at the end of FY16 (or C$8.2 per share); at the end of 1^st Qtr 2017 this number had increased to C$2.3 billion (or C$12 per share); and if cash burn continues without any improvement in retail sales or profitability, net debt attached to HBC’s operations could hit C$3.6 billion at the end of FY18 (or C$ 20 per share).

The risk is that cash burn and increasing debt load attached to the retail operations will eat away at whatever value the company can salvage from its real estate, particularly if the management continues in its current spending path with no reversal in sales and profitability trend.

Go forward scenarios

In my opinion, one of the following scenarios could play out at HBC:

- One scenario is that the company decides to play ball (or is left with no option but to) with the activist, implementing L&B’s asks. This will mean monetizing its NY 5^th Avenue real estate by putting it to alternate use, exiting from Europe by selling its operations and/or real estate there, monetising its real estate JV interests, reducing its growth capex and retail expansion plans and considering a management led buyout (management currently own ~20% of the company). This scenario has the potential to generate in excess of 2x return on current share price.  

- The other scenario is where the company continues in its current path, with a focus on its retail banners; comparable store sales continue to falter and retail burns through cash, increasing net debt. With no sight of a plan to unlock value, the market will continue to punish the share price. Such a scenario will not be sustainable for long and the board will need to reconsider L&B’s ask eventually. However, in this scenario, the path to unlocking value will be prolonged and painful.

Clearly, for this situation to work in the favour of the shareholders, time and execution is of the essence. In particular, HBC cannot continue burning cash and adding debt for too long trying to turn around its retail business. HBC’s Canadian retail business is valuable, but its US and European banners are a drag.  The sooner HBC realises this, the better for shareholders. 

At current share price, and given the activist’ involvement, the probability of shareholders realising a 2x return over the next 3 – 5 years look decent. Market’s significant discount to underlying real estate value implies a worst case scenario; L&B’s involvement and HBC’s quality real estate portfolio should protect shareholders from the worst case.  

ABRACADABRA: Altaba

Yahoo is no more. Having sold its core business to Verizon, all that’s left is a stub, now called Altaba. You can think of Altaba as a magic box containing some goodies and some baddies. Goodies are: the 15.4% stake in Alibaba, 35.5% stake in Yahoo Japan, cash & securities, and some legacy intellectual property and other assets. Baddies are: the deferred tax liability on the pregnant gain attached to its holdings in Alibaba and Yahoo Japan, potential liabilities from class action claims, and a bit of debt & other liabilities.

I estimate asset value per share for Altaba of $86; the current share price is $57.23, equating to a 33% discount to asset value. The market expects the baddies to eat away $28.78 per share of value. After you take out Altaba’s known debt and other liabilities, the market discount works out to be $26.56 per share.

The question is if the market discount is mispriced? 

Altaba’s liabilities

Altaba’s material liabilities fall within the three main buckets: Deferred tax liabilities; Class Action Claims; and debt and other liabilities.

Deferred tax liabilities attached to Altaba's investments in Alibaba, Yahoo Japan and the other assets is significant. Yahoo had invested in Alibaba and Yahoo Japan at a very early stage and the gain since then has been astronomical. Based on the 36.5% effective tax rate used by Altaba, and using information in the legacy Yahoo financial statements for cost basis in in Alibaba and Yahoo Japan shares, the potential tax deferred liability works out in the region of ~$23 billion or ~25.64 a share. My calculation is a conservative estimate and assumes no cost base for the intellectual property or other assets; the actual liability if full tax is paid on all of the assets, is likely to be lower assuming Yahoo had some cost base on its other assets.  

Based on the estimated deferred tax liability, if all of Altaba’s gain is taxed, then the market’s opinion of value is more or less correct. However, two factors could materially reduce Altaba’s tax burden:
1) any reduction in the US corporate tax rates under the Trump tax reform should be a clear upside for Altaba; and
2) the way Altaba’s goes about monetizing its assets could materially reduce its tax burden (in particular, on the Alibaba shares).

On the tax reform front, there is no way to clearly predict the outcome or timing. But the odds look good any reform is likely result in a reduced US corporate tax rate; may be not the 15% the Trump administration wants or even the 20% Paul Ryan has spoken about, but there is a good chance of the rate falling to to 25%. Now the timing of when this happens is anybody’s guess, but many predict a good chance of the tax reforms happening in FY18.

Whilst the tax reform is not in Altaba's control, it has some things it could control to reduce the tax burden. The best case scenario would be something as follows:

1. Altaba first sells all of its intellectual property and other assets in a taxable transaction;

2. It then sells its 35.5% Yahoo Japan stake in either a taxable transaction, or, if a deal could be reached with Yahoo Japan, then look to achieve this via a tax free cash-rich split. A cash-rich split could be structured via Yahoo Japan transferring a subsidiary containing ~67% of the agreed price in cash and ~33% the price in an operating asset currently held by Yahoo Japan in exchange its 35.5% shares held by Altaba. There should be appeal in structuring the sale as a cash-rich split for both parties, provided they are able to meet the strict conditions under the US tax code. The appeal for Altaba is clearly in achieving a higher cash outcome than if the sale is fully taxed, and the appeal for Yahoo Japan is in buying back its shares at a discount to open market value.

3. Finally, having sold all its assets bar its 15.4% Alibaba stake, Altaba could do a deal with Alibaba to buy out Altaba in exchange for issue of new Alibaba shares. Such a transaction shouldn’t trigger the tax on the latent gain inherent in Altaba’s Alibaba shares. There should be clear appeal for Alibaba to do a deal on the basis that it could buyout its shares at a decent discount.

Altaba's board has indicated that it would seek to monetise its other assets before monetising its Alibaba stake, so the above scenario is not unreasonable. 

The table below shows my estimate for Altaba’s tax liability under the various scenarios.

As can be seen, reduction in tax rates and/or mitigating tax on the Alibaba stake (and potentially on Yahoo Japan stake) offer significant cash tax savings for Altaba.

Class Action Claims: The other big unknown for Altaba is the quantum of exposure on the various legal claims its faces related to security breaches. Altaba obviously hasn’t disclosed a number for the contingencies. One thing we do know is that as part of its deal to sell its core business to Verizon, Yahoo agreed to be responsible for 50 percent of any cash liabilities incurred post-closing related to non-SEC government investigations and third-party litigation related to the breaches. Liabilities arising from shareholder lawsuits and SEC investigations will continue to be the responsibility of Yahoo, now Altaba. Verizon chipped $350m from its agreed price for the legal contingencies. If one assumes that Verizon did its due diligence and its price chip was a reasonable estimate for potential liabilities faced by Yahoo for the non-SEC government investigation and third party litigation, then Altaba has $350m exposure on these. Now, there is no way of knowing what the quantum of exposure will be on the shareholder lawsuits and SEC investigations, but assuming that these are 3 times that of the non-SEC and third-party litigation, then the total exposure faced by Altaba would be in the region of $1.5 billion (or $1.67 per share).

Debt and other liabilities: Based on filings Altaba has ~$2.2 per share of other liabilities, including its convertible loan notes.

Discount: In addition to the above liabilities, one also ought to build in a discount for the stub. In the scenario where Alibaba sells all of its assets in a fully taxable transaction, this discount should account for any costs at the Altaba level - e.g. advisor’s fees and management compensation. I expect this to be ~1% to 2% max. However, in the event Altaba does a deal with Yahoo Japan and/or Alibaba, it is most likely that they will want a reasonable discount for the deal (likely 10% - 15%). 

Valuation

Accounting for the various scenarios, I calculate an intrinsic value per share for Altaba of between $69 and $74. This would equate to a return in the region of 22% to 30% on current price.

Risk

One material downside risk for a Altaba shareholder is that the shares are heavily exposed to Alibaba; and Alibaba is by no means cheap, trading ~60 times TTM PE. This exposure could be reduced by shorting Alibaba (each Altaba share holds ~0.43 Alibaba). However, shorting Alibaba could be a risky proposition given Jack Ma’s track record of smashing growth estimates every investor day. The average price target for Alibaba from 43 analysts tracking the share is $167 against its current share price of $151 and most have a Buy or a Strong Buy rating. Having Alibaba exposure via Altaba may well be worth it given the current significant discount at which Altaba trades and all the different ways in which value could unlock. 

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. 

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.