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Son rise, Son set?

Softbank's investment in Yahoo! has been a great insurance policy, but the Internet venture giant can't afford any more rainy days.

Softbank's investment in Yahoo! has been a great insurance policy, but the Internet venture giant can't afford any more rainy days.

By Kevin Hamlin
June 2001
Institutional Investor Magazine

Softbank's investment in Yahoo! has been a great insurance policy, but the Internet venture giant can't afford any more rainy days.

Few companies better defined the New Economy, or benefited more from it, than Softbank Corp., the Japanese Internet financier whose prescient early investments in companies like E*Trade Group and Yahoo! made it a market darling and earned its founder, Masayoshi Son, worldwide media celebrity. For a time, Son ranked as the second-richest person on the planet, after Microsoft Corp.'s Bill Gates. But that brief reign ended when the tech-stock bubble burst. In one savage year Son's personal net worth fell $61.7 billion, to $5.9 billion, while his company's market capitalization plummeted an astounding $159 billion, to $15.5 billion.

How does Son feel now? "Much happier," he insists, casually dressed in beige khakis and a green polo shirt, seated in a 17th-floor conference room at Softbank's headquarters in the Nihonbashi-Hakozakicho business district. A true believer in the power of the Internet to transform society - and create boundless profits - Son claims to subscribe to the view that the market collapse was overdue and, to some extent, fortunate. "At the beginning of last year, it was going too hot, too quickly," he says. "Everything was becoming outrageously expensive for us to make investments. Then, I was becoming a bit worried."

Now, he declares with characteristic bravado, the bedraggled market actually presents opportunities "to increase our investment at a much more reasonable rate." The quickened pace of spending follows a Son-led consortium's $1 billion acquisition last August of the decidedly Old Economy Nippon Credit Bank, since rechristened Aozora Bank. Looking back over the past year, he reflects, "I didn't have that much disappointment."

Son's investors certainly did. So did many of his backers in banking circles. And the doubts raised by the collapse of the Internet sector continue to dog the 43-year-old entrepreneur. Softbank is the world's largest Internet venture capital holding company, but its operations have negative cash flow, and the IPO market it has relied on to raise money is all but closed. Softbank has more than 600 stakes in unlisted companies, fewer than ten of which are profitable, according to a former executive; it must fund many of these investments until the market reopens to Internet entrepreneurs.

Though Softbank is a public company, its finances can be difficult to parse. It won't provide information on its burn rate. Benjamin Wedmore, Internet analyst at HSBC Securities (Japan), estimates that Softbank's U.S. venture capital investments alone soak up $400 million annually. Another analyst figures that the company's nondescript Tokyo headquarters costs $50 million a year. According to Wedmore, Softbank has about $1.96 billion in outstanding debt; $239 million must be repaid this year.

Offsetting the drain of its many investments, Softbank claims a few rock-solid assets, including $1.5 billion in cash and considerable unrealized gains on its portfolio of listed holdings. Even after the Internet debacle, its stakes in some companies remain substantial. The big winner is still Yahoo!, the leading Internet portal; Softbank owns 22.6 percent of Yahoo!, down from 23.2 percent last June.

Early last month the company said that selling ¥36.2 billion ($292 million) of Yahoo! shares and ¥30.8 billion of Cisco Systems' Japanese subsidiary, together with its proceeds from two IPOs, allowed Softbank to record an extraordinary gain of ¥93.5 billion in the fiscal year that ended in March. Group net profits were bolstered by foreign exchange gains caused by a weak yen and more than tripled, to ¥36.6 billion. The extraordinary gains more than offset an extraordinary loss of ¥53 billion caused by the write-down of the value of its unlisted investments. Group revenue slipped 6.2 percent, to ¥397.1 billion.

Softbank has access to $1.5 billion in bank credit lines. No one is quite sure how much money Son's other operations require - the company's lack of disclosure is a sore point with investors - but most equity analysts say cash won't become a big problem for Softbank until 2003 at the earliest.

Still, critics have begun to question Son's vision and management ability, as well as his company's long-term viability. Such skepticism would have been unthinkable a year ago. Since the middle of last year, however, one Wall Street firm after another has downgraded Softbank's stock. (Given the sharp decline in the equity, some analysts have subsequently advocated buying it.) "It's seen as the Internet pioneer, but ultimately it's a very Japanese company," says Wedmore. "Lots of debt, little inclination to go to the market and a founder who wants to control too much."

None of this has shaken Son's faith in his vaunted 100-year master plan, which he's dubbed the "time machine" strategy: spotting the best new Internet business models in the U.S. and importing them to Japan. And he has struck back at the equity analysts who have soured on the Internet. Late last year Son charged that the researchers who had downgraded his company's stock simply didn't understand his corporate strategy. He dismisses the steep fall in Softbank's share price as the result of irrelevant stock market volatility.

"Son's proven himself not just a believer but an absolute fundamentalist," says Thomas Rodes, Internet analyst at Nikko Salomon Smith Barney in Tokyo. "By keeping his conviction, he's been rewarded before. Son will tell you he gets more than 20,000 business plans a year and has more people reviewing more potential business hits than anyone else in the world. This is where he gets into the back of your head and you think, 'Should you bet against that?'"

Judging from Softbank's stock price, many have already bet against that. "Combine the cash flow burn with the lack of exits and the prospect of Son buying up companies that could have no path to profitability, and a lot of people are saying, 'Let's see, if U.S. companies like CMGI are really in trouble, why isn't Softbank?'" says Rodes. Andover, Massachusetts-based CMGI, another leading venture capital investor and Internet incubator, recently reported a second-quarter loss of $2.56 billion following a $2.02 billion write-down of its portfolio. Its stock recently traded at $4.05, down 95.4 percent over the past year.

Softbank, however, isn't CMGI. It has a comfortable financial cushion, thanks to shareholdings in Santa Clara, California-based Yahoo! and its subsidiary, Yahoo Japan Corp., which as of last month were worth a combined $4.4 billion. If Softbank faces a cash crunch, it can sell a chunk of stock.

"Unless Yahoo! in the U.S. and Yahoo Japan fall 60 to 70 percent from here, there should be nothing to worry about," says Stephen McKeever, media and Internet analyst at Lehman Brothers in Hong Kong. Yahoo! now stands at about $20.39. down 86.4 percent from its 52-week high of $150. Yahoo Japan now trades at ¥4.96 million a share, down from more than ¥60 million a year ago.

Other analysts are less sanguine than McKeever. Yahoo Japan is an illiquid stock that trades, on average, just 230 shares a day. At that rate, it would take Softbank a year to sell its holdings.

Kiyohisa Ota, a senior analyst at Merrill Lynch in Japan, says Softbank's situation will become worrisome if Yahoo! shares drop to about $12.75 and Yahoo Japan falls to ¥3.5 million. At those levels, the value of Softbank's stake starts to create "a very risky environment for its debt repayment scenario," says Ota. "If Softbank's share price drops to the ¥3,000 range, then that is a sign that investors are valuing this company as having some risk of bankruptcy." Ota's comments preceded the recent rally of the Nasdaq composite index; Softbank shares traded at ¥5,100 in mid-May.

Most analysts consider Ota's outlook excessively bearish. According to HSBC, Softbank's debt due for repayment in the current fiscal year, ending next March, is ¥29.7 billion; an additional ¥112.2 billion is payable by March 2003. From there it drops sharply. In all, the company has to pay back ¥243.7 billion over the next six years. Son puts Softbank's debt at between ¥186 billion and ¥198 billion but says it's offset by ¥186 billion in cash, making the company "debt-neutral."

Says HSBC's Wedmore: "They are not going to disappear unless they go out there and throw money around in a way that is reckless. The trouble is, that is exactly what they do."

Such recklessness is exemplified, he says, by Softbank Investment Corp., the group's Japanese venture fund. Softbank Investment's 97 employees invested ¥43.7 billion in 177 companies over 152 working days last year, spending an average of $2 million a day, Wedmore's research shows. "That's not investing," he says. "That's writing checks."

Son counters that Softbank Investment's December IPO raised an impressive ¥15 billion. Although the stock plunged 14.7 percent in first-day trading, to ¥1.28 million per share, by late last month it had risen sharply, to ¥2.58 million.

Son's $2 billion in U.S. investments is what worries many observers. The $170 million that Softbank put into All-Advantage, a company that pays Web users to let it track their viewing habits, is now valued at zero by Lehman Brothers. Son also lost on stakes in TV and Web site producer CNET Networks ($172 million), online insurer InsWeb Corp. ($71 million), online health care services provider Healtheon/WebMD Corp. ($35 million), grocery delivery service Webvan Group ($27.4 million) and online superstore ($14.5 million).

In light of these losses, Rodes questions whether Softbank's core strategy of importing U.S. Internet ideas to Japan - the "time machine" - is still viable. It worked well for Yahoo Japan and E*Trade Japan but now seems to be faltering, along with much of the U.S. tech sector.

Ever optimistic, last October Son spent ¥43.1 billion to buy 40 percent of Nihon Ariba, the Japanese subsidiary of Ariba, a U.S. business-to-business software provider. Son considers Nihon Ariba the most significant investment he has made since buying into Yahoo! and E*Trade. While Microsoft provides the operating platform for computers and Yahoo! provides a platform for using the Internet, "Ariba provides a platform and a sort of operating system for any B2B transaction," he says. "We have prospects of about 40 companies out of the top 100 in Japan. If we can bring Ariba into those corporations, the opportunity is huge, tens of billions of dollars in the future."

But when Ariba announced a first-quarter loss of $48.3 million, its share price hit a new low. As of last month Ariba shares traded at $8.05, down 95 percent from their 52-week high of $173.50. That doesn't bode well for Nihon Ariba's operations.

"What's changed is that perhaps now the time machine is working in reverse," says Rodes. "The time machine was supposed to bring credible, proven business models, not those that blow up. Right now, perhaps, the pain being felt in the U.S. hasn't been fully priced into Softbank."

If the time machine stalls, what other options does Son have? Much will depend on whether he can turn around Aozora Bank, which a Softbank-led consortium bought from the government for $1 billion last August. Son is upbeat about the bank's prospects. Based on its run rate between September and February, he says, Aozora is heading for a first-year profit of $200 million to $300 million.

Most analysts believe that Softbank paid a low price for Aozora, whose bad loans had been cleaned up by the government. But Softbank has not yet announced a clear strategy for Aozora except to say that it will focus on lending to the small, entrepreneurial businesses that Japan's bigger banks traditionally have ignored.

Aozora thus remains part of the Softbank betting game. For now most analysts are wagering that at ¥5,100 per share, virtually all of Softbank's short-term upside potential is priced in. Wedmore doesn't share Ota's concerns about Softbank's stock price but reckons that fair value would be closer to ¥2,400. As for the long term, much hinges upon Son's resourcefulness. He's shown that in abundance thus far. When he needed a stock market for young Japanese growth companies, he helped launch Nasdaq Japan. Not long after the IPO market closed down, he bought a bank. And he's already reinvented Softbank once, transforming it from a software and publishing concern into the world's leading Internet holding company.

"What do you have to believe to buy Softbank?" asks Rodes. "First, that the IPO market is going to open and that there will be an appetite for technology stocks. Second, that Yahoo! is a valuable franchise, and, third, that Aozora Bank can be turned around."

Son, for his part, is a man on a mission. "We have to bring this digital revolution to Japan," he says. "When everything gets changed, it becomes much more fun, much more exciting, much more productive."

For the Internet world, everything has changed - for the worse. How soon it may improve is hard to say. One thing is certain: Son and his investors can't set the time machine back to 1999.