Introduction
In early July 2007, the New York based hedge fund Perry Capital proposed to raise its stake in NEC Electronics Corporation (NECE), the then publicly listed subsidiary of Japanese conglomerate, NEC Corporation, from 4.8 percent to 25 percent. The offering was ¥5,000 a share, at about 60 percent premium. Perry’s investment in NECE traced back to late 2005, the year its first exposure to Asian markets, with the initial investment cost at around ¥3,200 a share. Perry believed the intrinsic value of NECE was to release after restructuring its business strategy, albeit NECE was expected a loss in FY2005. This paper studies the investment of Perry Capital in NECE, and particularly looks at Perry’s consideration to increase its stake in NECE to 25% at that time.
INVESTMENT OPPORTUNITIES IN JAPAN
As shown in Exhibit 1, the long-lasting deflationary Japanese economy since 1997 probably comes to an end with its CPI rebounded from negative in 2006. At the same time, Bank of Japan has loosed its monetary policy by raising the interest rate above zero since 2006. These two data suggest that Japanese economy is pending an exit from the lost decade. Looking at the Nikkei 225 index shown in Exhibit 2, the bullish trend since 2003 shows the investors are optimistic towards companies’ future earnings. The improving market sentiment stems from the amelioration of Japanese economy, with its GDP growth rate has become positive since 2000, as shown in Exhibit 3. Moreover, Japan’s export industries have been performing well due to its weak currency. Perry’s investment in NECE can be a sensible move as Japan is one of the leading countries in producing innovative technological products. In 2007, Japanese high-tech products secure a significant market share in the world.
The Essay on Investment and Japan
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These industries include automobile, IT, communications, mechanism and robot, new materials, etc. In addition, Japanese firms allocate significant amount of resources in their product R&D area, the efforts paid in improving product quality and promoting innovation enhance Japanese firms’ competitive strength overtime. Essentially, Perry’s investment philosophy is looking at the fundamental of the company, building good relationship with the management, investing in good company, and possibly keeping its portfolio beta at a considerably low level. As Perry’s portfolio has been performing well since its inception, the venture into Japanese market is compliant with its investment strategy, where stocks in Japanese market produce reliable streams of cash flow, and more importantly, there are valuable cheap stocks to pick in Japanese market, these characteristics are aligned to Perry’s taste.
CHALLENGES TO INVEST IN JAPAN
The first time venture suggests Perry is novel to the Japanese market. As the probability of success of Perry’s investment in NECE highly depends on the assumption made to restructure NECE’s business division, Perry must convince the parent company NEC to share its vision. Agency problem would be a potential challenge for Perry to maintain a good relationship with NEC. As the subsidiary will become a separate entity from its parent company upon listing, it is questionable whether the parent company will longer treat the two different entities equivalently. For instance, will the parent company shift the loss-making divisions to its subsidiary, which then can help the parent company to get rid of loss at the expense of its subsidiary’s financial report?
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1.0 Introduction Understanding what motivates people is necessary at all levels of management. Deci, E., Koestner, R. & Ryan, R.M. (1999) had said that motivation is generally linked to reward, and it is widely recognized that reward management is central to the regulation of the employment relationship. The reward system varies from organization to organization, and comes in various and ...
Furthermore, Japan’s system of corporate governance is said lacks of effective protection to minority shareholders. Controlling shareholders in Japan are not required to prove that their dealings with the company are fair, and self-dealing is not formally defined by law. Furthermore, in Japanese model of stakeholder capitalism, management could be entrusted to safeguard the interest of a range of key shareholders, rather than focusing more narrowly on maximizing returns to shareholders, which might weaken minority shareholders’ power in deciding an important issue.
FUNDAMENTAL VALUE OF NEC ELETRONICS CORPORATION
Perry team made a few assumptions to evaluate NECE in early 2006. Since the exact date of evaluation is not clearly stated in the case, we will first evaluate NECE at 2007 based on the assumptions made and then apply the same methodology to other years. Team Perry used an approach that employed EBITDA multiples for each segment: MCU, CCD and Communications. We use the information from exhibit 7 and exhibit 8 to infer the fundamental value from 2004 to 2007 and future. We then make inference on value of NECE based on 03/2006 and 03/2007 values. Note that information from exhibit 6 and 8 are from 2007. Fundamental Value of NECE at 03/2007
Assumptions used in valuing MCU division:
I. MCU is able to match the average EBIT margins of comparable firms, which is 17.70%. II. 15% of the ¥83 billion depreciation cost is attributed to MCU for the next few years. III. A conservative approach of 9 times EBITDA multiples is used.
Assumptions used in valuing CCD division:
I. EBIT margins of the remaining business are 5%. II. 45% of the ¥83 billion depreciation cost is attributed to MCU for the next few years. III. 7 times of the EBITDA multiples is used.
Assumptions used in valuing communications division:
I. EBIT margins could be negative. II. To avoid loss, exiting this line is an attractive option. III. Estimated cost of exit at most ¥100 billion.
The fundamental value of NECE on 03/2007 is the summation of each division’s fundamental value:
The Essay on Forecast Assumptions
How sensitive is return on capital to the forecast assumptions in case Exhibit 8? An increase in cash operating expenses decrease NOPAT, which in turn makes ROC extremely sensitive when this ratio goes up; in general when total operating expenses go up NOPAT goes down, thus ROC goes down. In addition if the COGS increase this drastically drops ROC. The total assets has a big impact on ROC an ...
Note that the Fundamental value is higher from year 2005 to 2007 except year 2004. EVALUATION ON ASSUMPTIONS USED
The first assumption expects MCU would be able to match the EBIT margins of comparable firms. However, there is a large dispersion in the EBIT margins among the comparable firms. The large difference of EBIT margins between the comparable firms could suggests that the cost differentials are significant among these firms. Indeed, the uneven distribution of EBIT margins among comparable firms could also because of the small number of sample size used, which in turn soften the estimation power of this assumption. The second assumption is to give the CCD EBIT margins of 5%. However, as the average EBIT margins of the comparable firms is around 16%, with the range between 7.3% to 42.3%, Ercil’s might probably be too conservative than he should in valuing the CCD segment in NECE.
Moreover, Ercil also assumes that he will be able to exit the communication segment at a cost less than 100b which is again a conservative estimation as mentioned in the case. Given the above these assumptions made by Ercil, it seems that he is a conservative investor who prefers to take conservative valuation in his investment discretion. Though his conservatism might make the estimated NECE fair value become less attractive, his prudent investment strategy could probably in turn safeguard his clients’ money in any unfavorable event.
Below shows some assumptions made by Ercil that are reasonable. First, instead of using 11x EBITDA multiples to value NECE’s MCU segment, Ercil used a lower of 9x EBITDA multiples. This assumption is definitely acceptable as it is in line with Perry team’s prudent investment strategy. In addition, the depreciation cost allocation made by Ercil seems reasonable. Ercil allocated 45% of depreciation cost into the communications segment, as there was a significant amount of capex used to build the plant in Yamagata in the recent past.
Based on Ercil’s assumptions we manage to breakdown NECE balance sheets based on its divisions. This activity illustrates that the EBIT margin estimates are consistent with exhibit 8 and has no mathematical or financial discrepancies in terms of amount allocated to each sectors. EBIT margin for communications segment is indeed negative for year 2007 based on Ercil’s assumption. We observe high expense in communications area possibly due to expropriation of NECE by its parent company, NECE that will be discussed below.
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POTENTIAL AGENCY PROBLEM ON NECE’s MARKET VALUE
Our case analysis assumes that market is efficient, implicating that outsider anticipate potential agency problem within NECE. Besides demanding fair return on their capital, controlling shareholders should ultimately bear all agency costs they create. This is consistent with the journal “Agency Costs, Mispricing and Ownership Structure” by Sergey, Fritz and Greenwood (Sergey Chernenko, 2010), whereby the case of NECE is used to illustrate the impact of agency cost on market value. Agency problems in subsidiary-parent relationships could stem from 3 scenarios: I. Related party transactions: Based on the journal, following NECE listing in 2003, the development of microchips for NEC’s phone brought in excessively high capital expenditures and research and development expenses to NECE. Following it was the low transfer prices to the parent company, NEC. This is due to the weak fiduciaries duties law on company in the interest of minority shareholders.
II. Usurped business opportunities: Indirect influence of parent company on their subsidiaries such as continuing a business venture that profits the parent despite the subsidiaries making losses make it hard to be detected. In particular, NECE incurred excessive R&D cost and capital expenditures to enhance NEC competitive position in the market. III. Minority squeeze outs- Cash-out merger is an example of minority investors being squeezed out.
NEC bought back NEC System Technologies 20 months after listing it, evidently showing NEC’s involvement in this form of related party transaction. Based on the journal’s samples, Investors who bought the subsidiaries share upon listing sold their shares back to the parent during repurchase at a loss of 39% to 71%. Therefore, in perfectly efficient market, minority shareholders fully anticipate agency problems. If controlling shareholder is expected to divert resources, the market will price the equity accordingly (lower) than in the scenario where agency problem is absent. One caveat is that, investors might not be fully informed (market is not totally efficient) that in turn creating incentive for agency problems.
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PROSPECTS OF NECE
The fundamental value of NECE is severely undervalued compared to its market value in 2007; this might be due to the agency problem that persisted between NEC-NECE. We conclude that NECE is a potential lucrative investment if Ercil is able to remove the communications segment and thereby removing the potential agency problem in NECE. Nevertheless, the reluctance of NEC to remove the communications segment and the weak protection of minority interest in Japan cast shadow on the prospects on NECE. Worsening the situation, NECE was nearly delisted in 2007, implying that liquidity could have drastically decreased. Note that also the MCU and Other Divisions remains relative stable (slight increase) over the projection years.
Historical Performance of Publicly Listed Subsidiaries of Parents in Japan Our findings are consistent with the data given in Exhibit 4. If market is efficient, the incentives for parent company to list its subsidiaries arise either when the market value of subsidiaries is overpriced upon listing or if the parent company’s internal capital is inadequate to fund attractive investment opportunities. In the case NECE, the former scenarios seem to be more plausible as according to the graph above. This could lead to drop in future market performance as market absorbs more information.
Source: http://www.nber.org/papers/w15910
According to Fritz (2010), the negative performance of listed subsidiaries over the first 36 months following IPO can be seen via industry adjusted returns of -6.2%,-13.43% and -13.98% over the one-,two- and three year horizons after IPO. This is again consistent with the case of NECE. Both subsidiaries with ex ante scope for agency problem (such as sales relationship) and those where parent has retained little equity despite substantial control over its subsidiaries illustrated poorer performance. On top of that, a great portion of listed subsidiaries were subsequently repurchased by their parent at a discount to the IPO price. The historical performance of publicly listed subsidiaries of parents is consistent with the case of NECE. In this case, NEC hold 20% of NECE total equity but have significant control over NECE operations and sales. This leads to expropriation of minority shareholders and lower market price following IPO.
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A FEASIBLE STRATEGY FOR PERRY TEAM
There are three options for Perry team: to increase its stake in NECE with the expectation that NEC management will eventually share Perry’s vision to dispose the communications segment; to arrange for possible merger and acquisition for NECE; to exit the investment in NECE. To consider the action on the $150 million position in NECE, Ercil is likely to expect the maximum likelihood among these three scenarios. The first option is essentially the proposed increasing stake in NECE by Perry in the case. However, this move requires substantial amount of capital to fund the investment; the investment does not necessarily realize Perry’s objective to dispose NECE’s communications division as NEC will still be the largest shareholder in NECE. Since the investment in NECE in 2006, Perry team has been approaching NEC and asking for NECE business restructuring, the two parties have yet reached a consensus about the issue.
It seems that NEC executives are unlikely to change their position in the future as well. The second option is to create a proxy fight for possible takeover or merger of NECE. The biggest impediment in this strategy is the same as the first strategy – the parent company NEC is holding a controlling amount of 70 percent stake its subsidiary, proxy fight might be too costly to execute. Furthermore, it is generally believed this strategy is far from reality because a hostile acquisition for NECE would significantly destroy the business relationship between the acquirer firm and the giant conglomerate, NEC. In addition, it is the time where Tokyo Stock Exchange is placing NECE on a watchlist for possible delisting due to its concentrated ownership structure.
For Perry team, unwinding the 5 percent stake (or more if either option 1 or option 2 is adopted) in NECE would mean more difficult after delisting. Perry needs to find a potential buyer for the whole or portion its holdings in NECE. Exit strategy implies to realize the loss in this investment. Suppose Perry bought NECE stocks at an average price of ¥3,200 per share, NECE share price is around ¥2,900 per share in July 2007, which means Perry will record a loss of about 10 percent in its investment in NECE. As NECE has been recorded loss during Perry’s investment period, this small 10 percent loss may in turn support the immediate exit strategy, so as to minimize the loss because NECE’s business prospects are full of uncertainties.
SCREENING GLOBAL ECONOMIC CONDITION
Before making the final decision among the above three options, Ercil will definitely examine the current global economic condition. Generally speaking, if the global market sentiment is positive, it may worth for a riskier investment strategy to seek for higher return. On the contrary, higher return investment securities such as equities markets are usually too risky to attract capital inflow. As government bonds are deemed safe haven for investors, bonds yield curve can give some signal about the likelihood of future economic condition.
Ercil examine the U.S. government bonds yield curves and TED spread at that time. It is observed that the T-bills have begun to deviate downward from T-bonds since Q1/2007 (Exhibit 5).
Soon after July 2007, TED spread begins to rise (Exhibit 6).
The declining short term T-bills yield suggests the investors become cautious and allocate their money in the bonds market. The increasing TED spread may infer the condition of liquidity shortage in the market, where lenders require higher returns for lending out their money. According to bonds yield equation:
Forward Rate=Expected Discount Rate Tomorrow+Liquidity Premium
As TED spread implies liquidity premium becomes dearer, the declining T-bills yield is attributed to the expected fall in future interest rate in the U.S. market. Simply saying, market anticipates a loosening monetary policy adopted by the Federal Reserve.
RECOVER LOSS: JPY/USD EXCHANGE RATE INCREASE
While the exit strategy might be a better move after looking at global market sentiment, Ercil will consider whether he should immediately convert the JPY to USD. As exchange rate movement is closely related to interest rate movement between two countries, it is observed that Japan’s interest rate is at 0.50% (Figure 1) while U.S. interest rate is around 5% (Exhibit 7).
The huge differential between the two countries interest rate infers the potential gain from going against USD. In addition, given the interest rate parity condition in Forex market, the expected decrease in U.S. interest rate (as the declining yields curves suggest) will probably result in the appreciation of JPY against USD, as shown in Figure 8.
In conclusion, if there could be a potential gain from holding JPY against USD, which can in turn recover some of the loss from Perry’s investment in NECE. By holding JPY, Ercil probably can go for his conservative investment strategy by buying fixed income securities, gold and other safer investment assets, or just holding cash. If JPY/USD does not perform as what Ercil predicted, he will only face one side risk (the continual increase in U.S. interest rate that further pumps up USD/JPY) but is protected from the continual decline of JPY (as Japan’s interest rate is near zero that means Bank of Japan is effectively powerless in pushing down its interest rate).
