Rakuten: Race Against Time With High Credit Risk

Summary

• We believe Rakuten has a 12 to 16 month window to ramp customer acquisitions for its mobile technology business to generate operating profits by FY22/2023.
• Credit risk is high which may harm prospects to become certified by telco customers.
• We are not confident that Rakuten can execute. With continued cash burn, we reiterate our bearish view.

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Investment thesis

We believe Rakuten Group (OTCPK:RKUNY) has a 12 to 16 month window to ramp customer acquisitions for its Rakuten Mobile Platform business to generate operating profits by FY22/2023. However, credit risk is high which may harm prospects to become certified by telco customers. We reiterate our bearish stance.

Quick primer

Rakuten Group is a Japanese conglomerate with over 70 diverse business lines, ranging from its legacy online shopping operation to personal loans, life insurance, professional sports clubs, e-readers and mobile network/technology businesses. Rakuten has 12.6% market share in domestic ecommerce, steadily losing share against Amazon (AMZN) Japan on 25.7% (source: Euromonitor). In April 2021 a partnership with Japan Post (OTCPK:JPPHY) was announced to boost its domestic logistics capabilities which involved a $2.2 billion share sale (Japan Post taking an 8.3% stake) including co-investors Tencent (OTCPK:TCEHY) and Walmart (WMT).

H1 FY20/2021 sales by segment

Source: Company, created by Karreta Advisors

H1 FY20/2021 operating profit/loss by segment

Source: Company, created by Karreta Advisors

Key financials

Source: Company, Refinitiv, created by Karreta Advisors

Our objectives

Results for Q2 FY20/2021 highlighted continued heavy cash burn (JPY333 billion/$3.0 billion) as the company continues to invest on the Rakuten Mobile Platform - the Open RAN network technology for cloud-based mobile network infrastructure. This high-stakes approach has resulted in Rakuten's first proper client, with Germany's 1&1 AG (part of the United Internet Group AG (OTCPK:UDIRY)) signing up for a contract believed to be worth between JPY 250 billion/$2.2 billion and JPY300 billion/$2.7 billion over a 10 year period.

In this piece we want to assess the following:

• the likelihood that the Rakuten Mobile Platform will be a major earnings driver for the group in the long term.
• impact on the company's credit profile as it continues to invest heavily in its strategy as a mobile network technology provider.

We will take each one in turn.

We need a lot more than 1&1

Rakuten has its first public customer for its Rakuten Mobile Platform and this should be commended. 1&1 is currently Germany's leading MVNO (mobile virtual network operator) with 10.83 million mobile phone contracts, operating primarily in the discount brand sector. As an 'alternative' provider to established peers such as Deutsche Telekom (OTCQX:DTEGY), Vodafone (VOD) and Telefonica O2 (OTCPK:TELDF), it makes sense that it has chosen a low-cost 5G network solution. As its parent United Internet group operates broadband services, server hosting and networking infrastructure services, its level of technology know-how should make it the ideal candidate to roll out an Open RAN network. The implementation of the solution is set to start before the end of this calendar year.

1&1 could become a successful case study to attract more MVNOs to adopt an in-house network solution as opposed to looking for wholesale solutions - as long as they have spectrum access. There are some large MVNOs that may acquire spectrum to run their own networks in the future, as well as satellite-TV providers who already have wireless licenses that could build a nationwide 5G network (DISH (DISH) for example). However, there are issues that may act as a headwind for Rakuten's growth. MVNOs tend to compete on price with no-frills services and if wholesale partners provide value then constructing an in-house network is not high priority. Secondly, 5G is currently on pace to be the fastest-deployed mobile communication standard in history - if Rakuten's technology does not go mainstream soon, it could be left behind. Rakuten CEO Mikitani has stated that they are in "advanced talks" with 27 prospective customers in the US, 22 in the Asia-Pacific region, 19 in Europe, 11 in the Middle East and Africa, and five in Russia - 84 in all.

With Rakuten expecting operating losses to decline into FY21/2022 and to turn profitable in FY22/2023 for the company as a whole, this implies that 2022 will be the key year for account wins. The sales cycle is long for mobile network solutions, and we believe the company has a 12 to 16 month window to execute its strategy.

We believe Rakuten will win more mandates. However, the pace of these wins must visibly pick up or the chances of overall financial success declines. An area of concern is that as an essential service, telecom carriers usually certify technology partners with a track record of successful roll-outs as well as demonstrating financial stability. In the next part, we will see whether Rakuten is seen as an ideal partner from this perspective.

Downgraded to junk rating

July 2021 saw rating agency S&P cut Rakuten's issuer rating to BB+ from BBB-, also lowering its subordinated bonds rating two notches to B+. The outlook for the rating is negative. The key reason is that the anticipated JPY750 billion/$6.8 billion capex for the mobile business will weaken its finances. S&P expects Rakuten's non-financial free cash flow burn to reach over JPY 1 trillion/$9.1 billion in FY21/2022, requiring more debt financing. This is undoubtedly an added complication. With over JPY 1 trillion non-financial debts at Q2 FY20/2021, the company is not well-capitalized.

As risks go Rakuten is not in immediate danger of bankruptcy. Management can still trim assets to raise funds (e.g. Rakuten's 9.6% stake in Lyft (LYFT) is worth $1.7 billion pre-tax), but other assets integral to Rakuten's so-called 'ecosystem' of services and may be harder to dispose of. But if the company wanted to continue down its current path, there will have to be some major capital changes. Both debt and dilutive equity financing look to be on the cards.

The equity financing conducted with Japan Post raised some attention with Tencent's involvement as the Chinese tech giant will become a 3.65% shareholder. Authorities in the US and Japan are said to jointly monitor Rakuten from now on - this could be a soft political statement but just when Rakuten is aiming to drive its telecommunications business (and seeing how Huawei was driven out of 5G), this deal could heighten risks further.

Overall, we believe Rakuten's financial situation is not conducive to striking multi-year multi-million dollar deals. We note certain investment banks have placed Rakuten on the research restricted list.

Valuation

With no earnings and no free cash flow, investors receive a dividend yield of 0.4%. The yield is not attractive in itself.

We have no insight into the technological prowess and value-add of the Rakuten Mobile Platform. However, unless investors firmly believe that this is a world-beating solution, we strongly feel with current valuations there are better options for investment elsewhere.

Risks

Upside risk comes from a series of major mandate wins for the Rakuten Mobile Platform in the next 12 to 16 months, underlining the company's assumption that its loss-making status is temporary.

There is potential for the business to sell assets to raise cash, strengthening the balance sheet. With such a diverse business it is difficult to see which areas are non-core, but stakes in Lyft as well as minor business lines could be sold to raise cash.

Downside risk comes from continued cash burn as the company fails to win new business for its mobile technology. The company may be forced to act, selling down large chunks of the business to stay solvent.

Conclusion

Rakuten winning 1&1 as a customer demonstrates that there is some demand for its technology. However, the size of the deal and the long contract duration proves beyond doubt that scale is required in order for it to be a viable business. With a 12- to 16-month window, we are not confident that Rakuten can execute. With continued cash burn, its financial status is not conducive to obtain certification from carriers. All in all, we believe the credit risk profile remains high and we reiterate our bearish stance.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.