Toshiba Corporation (TYO: 6502) – market cap as of 30/09/2017: ¥1.33 trillion

Introduction

On September 28, 2017, Toshiba announced an agreement with Bain Capital to sell its memory chip business for $17.7bn. It was also announced that Bain Capital will create a special purpose entity to buy Toshiba’s division, which will be called Pangea. This consortium will be made up of several companies, among which famous names like Apple, Seagate Technology, Hoya, Kingston Technology, SK Hynix and Dell.

Western Digital, one of the largest hard disk manufacturers in the world, is taking legal actions to block the deal, claiming that Toshiba is not respecting their partnership. Because of this issue, the deal could close after the date originally planned by the companies (i.e. March 2018).

About Toshiba Corporation

Toshiba Corporation is a Japanese multinational conglomerate headquartered in Tokyo. Currently it has 153,492 employees. Toshiba reported revenues for $52.24bn in 2016, down 7.8% with respect to 2015.

Its products and services include information technology and communications equipment and systems, electronic components and materials, power systems, industrial and social infrastructure systems, consumer electronics, household appliances, medical equipment, office equipment, as well as lighting and logistics. Toshiba is divided into four business units: Digital Products Group, Electronic Devices Group, which incorporates the Memory division, Home Appliances Group and Social Infrastructure Group. The proceeds earned from the acquisition will be used to repair the recently poor financial results, following a disastrous project on nuclear power in the United States. Indeed, the episode threatened to bankrupt the company.

About Bain Capital

Bain Capital is a global alternative investment firm founded in 1984 and based in Boston, Massachusetts. It specializes in private equity, venture capital and credit products. Bain Capital invests across a range of industry sectors and geographic regions. Currently the company has more than 900 employees worldwide and assets under management of c. $75bn. Today, Bain Capital operates a fully-fledged Japanese investment platform with 35 investment professionals based in their Tokyo office.

Industry Overview

Over the past decades, the semiconductor industry as a whole has been characterized by three key features: steeply increasing revenues, swelling capex and R&D costs, and growing concentration.

The need for ever-greater investments to sustain innovation has been a constant feature of the semiconductor industry in recent years – hence, the climbing R&D spending figures. As a percentage of revenues, R&D spending in this field, at around 19% of sales, is higher than in any other industry. R&D efforts have been aimed at sustaining the industry’s rapid technological innovation, perhaps best expressed by the often-quoted and often misunderstood Moore’s Law, which postulates that the number of transistors on a single computer chip doubles every 24 months. In recent years, it has become apparent that keeping up with this pace requires an exponentially growing spending. As a result, the semiconductor industry has been requiring huge amounts of capital to support both growth and technological progress.

Along with investments, industry revenues have been growing at a sustained pace for 40 years, with global sales increasing at an average compound annual growth rate (CAGR) of about 9% per year. Growth has been fueled by the steady demand for chips in smartphones, computer servers and other electronics, as well as the development of new major applications in more traditional markets such the automotive and the industrial ones (including infrastructure, rail services, the military, fossil and regenerative energy, smart grids).

Focusing on the memory chip manufacturing segment of the semiconductor industry, of which Toshiba has long been one of the leaders, we find a sector dominated by a handful of companies. Since, much like the rest of the industry, the segment requires massive amounts of investments, only a few companies are able to keep up as giants like Samsung Electronics roll out big capital spending plans. The combined market share of three market leaders, Samsung, Toshiba/Western Digital, and Micron/Intel covers almost 90% of worldwide production capacity. High R&D spending increases entry barriers, thus reducing the threat of new entrants.

Lastly, competitive pressure and ever-increasing costs have prompted companies operating in the industry to specialize in individual elements of the value chain. Hence, there are now fabless companies, who design chips but have no manufacturing plants, and foundries, that specialize in semiconductor production.

Deal Structure

The deal, which can be marked as one of the biggest private equity-led buyouts since the end of the financial crisis, is very complex. On the one hand, what makes it so intricate is the number of parties involved in it. The special purpose company used to carry out the deal is indeed backed by several firms. Under the agreement, Bain, Toshiba, SK Hynix and Japan’s Hoya will pay about $8.5bn for common and convertible stocks, while Apple, Dell, Kingston Technology and Seagate Technology will spend about $4bn for convertible and non-convertible preferred stocks. The special purpose entity making the acquisition will receive also about $5.4bn in loans.

Another source of complexity can be found in both antitrust scrutiny and legal action at the hand of Toshiba’s joint venture partner in the chip-making business, Western Digital. First, Toshiba’s chip business has the second-largest market share by revenue after Samsung and a sale of such a big business is normally reviewed intensively by antitrust authorities of various nations. Moreover, the involvement of SK Hynix, the 5th memory chip maker in the world, represents a hurdle for antitrust approval. Thus, to ease antitrust concerns, SK Hynix will be “firewalled” from accessing Toshiba’s proprietary information and will not be allowed to own more than 15% of the voting rights in Pangea or Toshiba Memory Corporation for a period of 10 years. Second, a legal dispute with joint venture partner Western Digital – which was also one of the losing bidders – could complicate matters as the company will head to international arbitration in order to see upheld the right to veto the sale of the chip unit.

The target closing is March 31, 2018, as that is the last day to keep Toshiba Corporation from delisting from the Tokyo Stock Exchange and possibly filing for bankruptcy.

Deal Rationale

The highly awaited sale of Toshiba’s memory chip unit to the Bain led-consortium closes a months-long saga in which some of the world’s largest private equity and technology firms have been battling under the supervision of the Japanese government to assume control of the unit. The motives behind each of the party involved were many and diverse.

Toshiba, the seller, put the division up for sale out of sheer necessity. In February, the company reported a $6.3bn write-down in its nuclear power division, after the operations of Westinghouse, its American subsidiary, run into massive cost overruns. The company put off its earnings release for the third fiscal quarter until April, when it published an unaudited version, since its auditor, PwC, refused to sign them off. Toshiba’s paramount concern at the time was to avoid de-listing from the Tokyo Stock Exchange, an event whose most likely consequence was Toshiba’s bankruptcy. The Japanese firm thus decided to put its crown jewel up for sale to offset the losses. Its memory division operates in an industry where in the past two years over demand and supply shortage have sent prices soaring. As a result, Samsung, the industry leader, overtook Apple to become the world’s most profitable tech company and SK Hynix, the fifth largest player, quadrupled its quarterly earnings in the first half of the year. The memory unit was thus an attractive proposition for investors, setting off a bidding war and eventually fetching $17.7bn, 3 more than the $14bn expected in February. Toshiba will thus lose a key driver of revenue growth, but it will also avoid bankruptcy. Furthermore, thanks to its stake in the Pangea, it will still be able to enjoy some of the financial proceeds from the unit.

By inking this deal, Bain Capital, the main buyer, made an investment into a company whose earnings growth, with the right spending, will be in the double or even triple digits for the foreseeable future, thanks to the soaring memory prices. As soon as the deal closed, it was reported that the private equity firm was looking to 2020 as a date for a possible IPO. Bain was rewarded after months spent fending off competition from rival private equity firm KKR, who had teamed up with Western Digital, and Hon Hai Precision industry Co – commonly known as Foxconn – who had made up to $27bn in preliminary bids.

The acquisition was backed by a handful of US technology companies, including Apple, Dell and Seagate Technology. Under the terms of the agreement, the companies will not be able to exercise control over Pangea. Also, they are not looking to access Toshiba’s technology. Hence, the reasonable question: why did they collectively splurge over $4bn on this deal? The answer is, again, to be found in the supply-and-demand dynamics of the memory industry. Supply shortages and rampant demand have sent prices soaring. DRAM prices, for instance, were up 45% YOY in the first quarter of 2017. In this context, US tech hardware giants feared that the loss of one of the industry’s main suppliers would worsen the price outlook. To vigorously compete, Toshiba’s unit had to be rescued and supplied with a significant amount of capital. For US tech giant Apple, this deal is also crucial to keep in check its main rival in the hardware sector, Samsung, who is also by far the market leader in the memory industry with over 40% market share. By propping up Toshiba, Apple hopes to lessen its dependence on a rival who had has also been a key supplier of components for its products.

Lastly, politics did not sit on the bench. The Japanese government supervised and influenced the entire process. Its paramount concern was to prevent Toshiba’s technology from falling into Chinese hands, which explains the rejection of the $27bn bid spearheaded by Foxconn, a Taiwanese company with a heavy Chinese presence. While the consortium did not include in any meaningful way Japanese entities other than Toshiba itself, the deal included a “firewall clause” which prohibits South Korea-based SK Hynix from accessing Toshiba’s tech. Also, US entities, while significant in terms of capital contributions, are not allowed to exercise control over Pangea.

Market Reaction

After the huge $4.3bn loss reported on December 26, 2016, by Westinghouse – Toshiba’s US nuclear unit – Toshiba’s stock price plunged to about $15 per share, wiping more than 30% of its market cap.

In the following months, with Westinghouse filing for bankruptcy and the rumors of a possible sale of the chip-making unit, the stock was not able to re-gain the trust of the investors. Indeed, analysts are still worried about both the scheduled timeline of the deal, which must be completed by March 31, 2018, and the possible future of the company itself. Analysts’ main concern is a possible scenario in which Toshiba, once deprived of its chip-making jewel, will be unable to grow, thus becoming a zombie-like firm.

In recent days, Toshiba has been trading around the $16 mark, after having re-gained much of the 8% drop in value following the announcement of the sale to the Bain-led consortium.

Advisors

Goldman Sachs and Nomura Securities acted as financial advisors to Toshiba. Bain was advised by Mitsubishi UFJ and Morgan Stanley.

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