|Shares Out. (in M):||601||P/E||0||0|
|Market Cap (in $M):||1,100||P/FCF||0||0|
|Net Debt (in $M):||2,000||EBIT||0||0|
|Borrow Cost:||Available 0-15% cost|
We are short shares of Japan Display ('JDI', 6740 in Tokyo). Much like our thesis on Sharp (see the write-up posted previously), Japan Display is highly likely to become structurally impaired by the imminent high-end smartphone OEM shift from LCD to OLED, due to a lack of investment in OLED historically and limited financial and strategic resources today. Compounding the secular threat are company-specific factors: most of JDI's fabs remain sub-scale and uncompetitive; terrible management with frequent turnover and a lack of strategic direction; and most importantly, the particular exposure to small/mid-size panel markets is very high (85% of sales today).
While the stock is not an easy borrow (~10% cost) and the structural impairment view is not particularly novel, we believe there is a high chance of full or substantial equity impairment, either through a formal bankruptcy/restructuring process, or a 'take under' by another competitor like Sharp, in the next 1+ years. We admit this is somewhat priced in but we feel the market does not appreciate the extent of JDI's near-term negative cash flow, investment needs, and lack of strategic options (as we will outline below).
This short may not screen well due to the low headline valuation (~0.4x P/B, ~3x adjusted EV/EBITDA) as well as borrow cost/squeeze risk; we do not expect it to receive a high score on VIC and we understand this kind of trade is not for all investors. Nevertheless we are posting it because, much like long-minded value investors who prefer to buy great businesses at somewhat expensive prices when they are confident in a supportive structural trend, we prefer to short terrible businesses even at low prices where we are similarly convinced in permanent obsolescene and capital impairment. For us this holds true in this case and is thus very much worth the risk/reward.
JDI makes small and mid-size LCD panels at a number of fabs in Japan. The business was cobbled together out of the remnants of Hitachi, Sony, Toshiba, and Panasonic's old LCD panel businesses, and formerly recapitalized by the Innovative Network Corporation of Japan ('INCJ'), a public-private entity tasked with supporting businesses strategic to Japan, to the tune of 200bn JPY (for an 86% stake), in 2011. When the INCJ brought the company public in 2014, they cashed out half their stake for 160bn - though the offering went poorly and subsequent business performance has been abysmal (the original IPO price was 900 JPY/shr). The past three years have produced nothing but net losses, cash burn, frequent large misses on original guidance, and three different Presidents - even as sales have grown substantially (a function of JDI being one of three suppliers of screens for the iPhone).
There are some parallels to Sharp's travails in JDI's story: both companies were saddled with relatively uncompetitive legacy assets and were not well-capitalized enough to make the investments necessary to stay in the game. However, many of JDI's problems the last few years were squarely of their own making, and unrelated to their lack of capital. Simply put, time and again JDI's managers have made the wrong strategic decisions. For example, even when it was becoming somewhat clear (around 2yrs ago) that OLED would be the next technology standard, JDI proceeded with a plan to build a state of the art new G6 LTPS/LCD fab - Hakusan - using most entirely advance receipts from Apple. JDI's former management team (subsequently turfed out) was of the belief that high-end LCD would not only compete with OLED on quality and functionality (they promised bendable LCD, for example), but that OEMs who eschewed OLED would be willing to pay a premium for higher-spec LCD panels even in a market awash with new, 'almost as good' Chinese capacity. Subsequently, they realized they were wrong on both accounts - they couldnt ramp bendable LTPS screens to mass production; and they have been beset by an inability to charge premium prices for their products, in the face of cheaper, 'good enough' competition.
By mid 2016, recognizing at least the partial error of their ways (as Apple and Samsung's OLED investments ramped up), they changed course, realizing they needed to get into OLED more meaningfully. Even then, having almost finished Hakusan (a ~200bn investment), it took them 6months to raise only 75bn in additional funds (once again from the INCJ, as no one else would fund them) - a paltry amount that couldn't build out even 1/3 of a G6 fab doing 25k WPSM for OLED (even assuming they had the necessary R&D budget and IP locked down). But this money, insufficient as it was, was NOT originally earmarked to develop vapor deposition OLED technology (the industry standard method of mass production as used by the likes of Samsung and LG Display), and instead was mostly intended to go towards developing 'printing method' OLED - an alternate, unproven manufacturing technique that apparently offers lower cost of production but has never been successfully ramped to mass production.
Fast-forward another 6-8months, to earlier this year - and the company abandoned the printing OLED project; ditched management (again); delayed (probably forever) the acquisition of a business designed to develop printing OLED ('JOLED'); and instead will shortly announce a full-scale restructuring plan along with, presumably, more resources dedicated to conventional vapor deposition OLED.
Thus today JDI is left with 3-4 small legacy LCD fabs (in the 3-4.5G range), one brand new G6 fab, little/no OLED exposure (one R&D pilot line at one fab), and still with Apple 50-55% of group sales (and mobile-related sales still 85% of group revenues). Not exactly pretty if you think Apple will fully transition to OLED by end 2018/early 2019 (which many, including us, think)...
How much cash do they really need?
So what happens next? Figuring out what happens to JDI, to me, comes down to two simple questions:
- how much capital does JDI realistically need to maintain some semblance of relevance?; and
- are there feasible sources for this capital in the market?
Perhaps unsurprisingly, the answers are "a lot" and "not really", respectively. Let's look at the cash needs first. Below we break down what we think they will need in the next 12 reporting months alone (ie to March 2018):
- Restructuring costs: the co will announce a new business plan in Aug. This will likely include further restructuring measures (impairments to PPE, but also job losses). JDI has 16k total employees (still) so we don’t think 1000 job cuts is unimaginable (in fact one report suggested as many as 30% of employees could be cut). This would likely cost around 10-12bn total (using Japanese norms for severance), plus some cash out of the pension deficit (around 28bn net today), or around 15bn cash out total;
- Advance receipts repayment: all from Apple (179bn), entirely used to build Hakusan (which is now complete and in operation). Thus they need to pay back Apple (though the repayment schedule has not been disclosed). Still, it should be relatively quick as the increase in advance receipts from normalized levels (60-70bn a couple of years ago) to current levels (179bn) happened over two years. Thus we feel a 60bn reduction in cash per year from this is reasonable;
- Increase in R&D – we simply budget a 12bn annual step up (which assumes they use the 45bn ear-marked from the last cap raising, basically over 4yrs). The real needed number is much higher than this, clearly, so we feel this number could be conservative and would have to grow on receipt of any funding but using existing resources this is basically all they can afford;
- New OLED fab cost – this presumes they move to build a new fab (or completely shut/refurbish all production lines at an existing G6 fab). This may not actually happen in the current fiscal year, but surely must be contemplated given the new business plan being drawn up. In any case our total capex for FY17 (around 130bn) does not look unrealistic given past yrs spend when they have been developing new fabs, if indeed they attempt to scale in OLED (which is what they apparently will try to do);
- Short-term debt repayment: Currently short-term debt is 26bn – we imagine this number cannot really grow much because they have been in net losses for 3 straight years (and will be a 4th) meaning this number should actually decline. Banks in Japan are generally very reluctant, if not completely unwilling, to roll short-term debt when annual losses reach three straight years (let alone exceed them) - this is what happened with Sharp a couple of years ago and prompted a liquidity crisis. There is some uncertainty around this number, and we would not be surprised to see the banks balk at rolling any of it at end of next fiscal (ie Mar 18).
All told we think they need ~100bn over the next 12months (versus a mkt cap today of 125bn), see below – the number could be higher if they do attempt to get more seriously into OLED (though of course that is contingent upon finding a partner); it could be lower if they give up OLED (though it doesn’t seem this will be allowed to happen).
|Lower OP ex R&D (-)||-29||19bn -> -10bn on lower sales, util|
|D&A step up (+)||17||start of Hakusan depreciation|
|Increase in R&D (-)||-12||14bn -> 26bn due to OLED needs|
|less maintenance capex||-48||6% capex/sales (likely too low)|
|less OLED new fab cost||-83||250bn over 3yrs (likely low)|
|FCF pre working cap, restructuring costs||-49|
|Reversal of advance receipts (AAPL)||-60||60bn reduction (180bn -> 120bn), could be too low|
|Other working capital||-10||CCC looks v short at the moment|
|Cash restructuring costs||-15||Assume 1000 layoffs, $100k/pp + pension cash out|
|Short term debt repayment||-13||assume half of ST loans don’t roll (losses >3yrs)|
|Total cash flow post W/C, debt =||-147|
|Current cash position||52||Current cash (82bn) less minimum 30bn liquidity buffer|
|Total cash needed =||-95|
Where exactly will this money come from?
Clearly JDI has been a terrible steward both of capital and their own business; it is why they are in the position they are today, and mostly explains why finding further new capital seems very difficult. They have already encumbered themselves with some debt, and as discussed, will find it very difficult to roll what they already have, let alone borrow another 100bn. They have also already tapped Apple (for the Hakusan fab), and given rumors in the press (that Apple will pre-invest in LG Display for an OLED fab), it seems highly unlikely they will also throw more money at the laggard JDI - especially when they havent yet been repaid for the first fab.
That basically leaves three realistic options: the INCJ ponies up, again; JDI finds another third-party investor (eg a Chinese OEM); or they are absorbed by another player. Let's talk about each option in turn.
The first option - the INCJ throwing good money after bad - is somewhat believable. They are a quasi-government entity with the mandate to protect valuable Japanese technology. We certainly would not be surprised if they acquiesced and gave JDI more capital, but we do think they are reaching the end of their tether, for a few reasons:
- they have already provided two bailouts, the last of which (75bn) was very recent (basically 6mos ago) and clearly looks mostly impaired already. At this point the writing is very much on the wall and a third bailout may be one too many (Japan Airlines, for example, didn't get three bailouts...);
- there were rumblings in the press suggesting the INCJ should not just save companies willy-nilly, and that being a 'glorified Apple supplier' (we are paraprhasing) is not sufficient to guarantee Japanese state support;
- the amount of capital realistically needed is not 100bn but much more (witness the amounts Samsung et al are investing into OLED - it is running $8bn a year..>). Thus INCJ must realize that any injection now, even of a relatively large sum, is simply another band-aid solution that will likely only keep the lights on for a couple more years, if that.
Thus, while its possible the INCJ kicks in more money, we believe it is also a decent chance they pull the plug now, or limit the investment to an amount (50bn?) clearly insufficient to change the medium-term outcome here. Importantly, we believe the upcoming new business plan is crucial - it is meant to be announced by August, and we actually do not rule out some more substantive restructuring near-term, as the extent of JDI's capital needs has become quite obvious.
The second option - finding another OEM to pre-fund new OLED development - seems quite unlikely to us. While an outfit like Huawei, or Oppo/Vivo, may theoretically have the interest and the capital, why would they work with a partner who can't even mass produce OLED today? Especially when there are local Chinese panelmakers (eg, BOE and Tianma) who are already building new OLED-dedicated fabs. We simply do not give this outcome much, if any, credence, as it doesn't make commercial sense (even if we assumed the Japanese would let the Chinese in).
On the other hand, we do consider it more likely that the INCJ - fed up with investing more capital - instead gives up and brokers a 'take under' by another panelmaker, probably Sharp. In such a scenario, while the low headline P/B stock price today is a little worrying, ultimately we think in this scenario Sharp would almost have to be paid to take on the JDI capacity, such that any forced transaction would happen at a very low price (much like the Hon Hai acquisition of Sharp last year). Furthermore we question why Sharp would want to do such a move: they are similarly years behind in OLED and would gain only more LCD exposure by buying JDI. It is quite clear that JDI will not be an iPhone supplier for the next-gen OLED phones, for at least 3 years - which means they would simply be acquiring more capacity that would need to find clients (similar to the problem they will face at their own fabs shortly). JDI has too many fabs as it is; there are limited or no synergies to buying more fabs for their own sake (they would need to wait for JDI to massively impair what they have). Whatever they spend on JDI - even if it is all denominated in stock - would surely be better off dedicated to OLED R&D. For now, it appears that Sharp is more interested in investing in Softbank's vision fund, or building new fabs in the US, instead...
Nevertheless we recognize this is one possible outcome, and would likely lead to a near-term positive reaction. However, since this does not solve the fundamental problem for both companies; would likely be denominated in stock; would likely be struck at a much lower value than exists in the market today (I estimate around 100 JPY/share); and would only add to the bearish thesis we already have on Sharp - we are not too uncomfortable with this outcome.
What is JDI actually worth?
Book value is highly misleading in this case as JDI has been a serial destroyer of capital, will lose money and burn cash for the foreseeable future, and, we think, would not see rational buyers pay anywhere near the current price for the assets today. Furthermore all panelmakers (except Sharp) historically trade well below book value given the realities of the industry) so upside here is nowhere near 1x book (even LG Display is at just 0.85x book). The new G6 fab, Hakusan, is nominally worth ~180-200bn, though I think this value will be highly impaired in just a couple of years once OLED goes mainstream so I cannot see anyone paying near theoretical replacement cost for that fab (and anyone who would care is already building their own new fab in China).
Even shutting down JDI would cost considerable cash - since they still have 16k employees (who need severance) and the pension liability alone is 29bn. Frankly I would not be surprised if this was a zero in bankruptcy, and/or restructured in such a way that current equityholders are basically wiped out. As discussed, even in an acquisition scenario, I feel current shareholders (along with the INCJ) would have to accept pennies on the dollar, such that the current price (I currently have it at ~0.7x pro-forma book value, adjusting for restructuring costs) is still probably 50-60% too high.
Near-term earnings are a bit better than the bearish street expects, because the OLED ramp is delayed (this could happen into end 2017 but doesnt change the thesis)
Sharp pays a stupid price with their crazily priced stock (that's why we are short Sharp too)
INCJ throws them another 100bn to waste, at crazy uneconomic terms, and the stock rallies
Somehow they convince Apple or a Chinese OEM to invest in their OLED development
Earnings get progressively worse
New business plan disappoints
No one stumps up new capital
Business either hits a wall late 2018 (or earlier) or an emergency auction process is run and it gets sold to Sharp for pennies