- Rakuten's capital allocation for its mobile business is high-risk, resulting in cash burn.
- Management is not being disciplined enough over the pace of capital allocation and is jeopardizing the overall company.
- Underlying fundamentals are set to weaken in our view, resulting in excess leverage. We remain sellers of the shares.
Management's high-risk approach to allocating capital to its mobile business is resulting in cash burn and a high-risk credit profile. Although we believe the market is not pricing in major positive expectations for this, the underlying fundamentals are set to weaken in our view, resulting in a negative capital event. We remain sellers of the shares.
Rakuten Group (OTCPK:RKUNY) 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 a 12.6% market share in domestic e-commerce, steadily losing share against Amazon (AMZN) Japan on 25.7% (source: Euromonitor).
Key financials including consensus estimates
After a 36% drawdown from our last piece in August 2021, we want to re-assess our rating. We focus on the following areas:
- We agree with consensus forecasts that the outlook for FY12/2022 is continued operating losses and major cash burn (excluding financial businesses). However, will there be a major recovery into FY12/2023 as highlighted?
- Assess the credit risk as Rakuten continues to invest in its mobile telecom business.
We will take each one in turn.
Looking at the tea leaves
When we look at consensus estimates, despite expectations of no earnings recovery in FY12/2022 the sell-side is expecting a major recovery in FY12/2023. Historically, the sell-side has underestimated operating losses (versus actual) and has been too optimistic. Things become more contentious with current forecasts, as the mean figure is derived from a large spread in high and low estimates for FY12/2023. The lack of a genuine consensus view shows that earnings visibility at Rakuten remains very low.
Consensus OP estimates (with mean, high, and low values) versus actual
The big swing factor in earnings going forwards is the mobile segment. Disclosure here is limited with only 3 brokers prepared to highlight their expectations. The key question is what are the factors that would drive this recovery?
Consensus mobile segment OP estimates (with mean, high, and low values)
Two positive factors come to mind. Firstly, Rakuten continues to grow its subscriber base for its mobile services which should ultimately result in revenue growth and benefits from rising customer lifetime value. However, after two expensive years the company has attracted just over 5.5 million mobile users, which remains a distant fourth place behind SoftBank (OTCPK:SOBKY) with 26.9 million, 61.4 million at KDDI (OTCPK:KDDIY), and 64.2 million at NTT (OTCPK:NTTYY) - all boasting their version of a sticky user ecosystem. Secondly, with Rakuten's 5G network increasing coverage, the company has stated that roaming fees will decline as partner networks which will happen after Q2 FY12/2022. No doubt cost savings will help to reduce losses, but the key issue remains the lack of customer volume.
To surmise we believe it is too early to bake in recovery in margins in the mobile business. Consequently, we view the mobile business as a continuing liability for the company where the likelihood of commercial success looks limited at best. Investors will have to keep an eye on marketing and Capex costs to assess whether there are any tangible returns for the business - for the last two years, there has been very little. There has also been little progress in terms of Rakuten winning tangible mandates for its Rakuten Mobile Platform.
Next, we look at the credit outlook.
A year of negative FFO and continued cash burn
In July 2021, S&P rated Rakuten as 'BB+' with a negative outlook. There has been no update since, but the outlook for the company's credit appears to have worsened in our view. In FY12/2021 the non-financial business had negative funds from operations (FFO) and a cash burn of JPY463 billion/USD3.7 billion (please see here under 'Full Year and Fourth Quarter 2021 Supplemental Data'). With consensus expecting pro forma cash burn expected to worsen YoY with Capex alone rising to a record JPY461 billion/USD 3.7 billion in FY12/2022, there is a real risk of new financing (either expensive debt or dilutive equity).
Annual Capex trend
Rakuten's options available to shore up its capital base look limited. The obvious option is to sell its 9.2% stake in Lyft (LYFT) which would raise JPY 167 billion/USD1.3 billion pre-tax, but this would not be sufficient and Lyft itself has lost 29% of its value YTD. Other unlisted investments such as Genesis Healthcare (GEN) may have potential for gains in the future but do not look readily available as a source of funds.
Our conclusion here remains as before. Last year, equity financing involved high-profile investors such as Japan Post (OTCPK:JPHLF) and Tencent (OTCPK:TCEHY) providing some respite over credit risk. However, as long as the business burns cash we see the credit profile continue to deteriorate. A poor credit profile would not pass due diligence to win major technology mandates for 5G network platforms.
With no earnings and no underlying free cash flow, investors are set to receive a dividend yield of 0.5%. The yield is not attractive in itself to warrant investment into the shares.
Upside risk comes from major wins in the Rakuten Mobile Platform, as the company's technology is seen as a success in the Japanese market and a proven solution for other carriers to adopt.
The company could seek further equity financing support from friendly investors such as Japan Post. Founder CEO Mikitani is unlikely to sell the business, but there could be speculation over strengthening capital ties here.
Downside risk comes from dilutive financing as the company continues to strategically support growth and investment in its mobile division.
With increasing costs of living and consumer behavior becoming less active, Rakuten's mainstay shopping business may experience a slowdown in growth, similar to Amazon (AMZN) for its Q1 FY12/2022 results.
Although the market is not expecting Rakuten to deliver positive earnings whilst the mobile business scales, it is nevertheless important that management maintains discipline over the pace of capital allocation and not jeopardize the overall company. Unfortunately, we believe this is what is happening, resulting in a high credit risk profile. We reiterate our Sell rating.
This article was written by
Analyst’s 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.
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