Rakuten | Japan's Amazon?
Value Hiding In Plain Sight, Or A Value Trap?
Disclaimer: The author has no position in Rakuten, but may do so in future. This post is for informational purposes only and should not be construed as investment advice. Conduct your own due diligence and seek professional investment advice before making any investment decisions.
The Company
Rakuten, often referred to as "the Amazon of Japan," has a rich history that spans over two decades. The company was founded in 1997 by Hiroshi Mikitani, who remains its CEO to this day. Its corporate mission is to empower people and society through the Internet.
Mikitani, a Harvard Business School graduate, started Rakuten as an online marketplace, initially named MDM, Inc. The company quickly gained traction and was renamed Rakuten in 1999, which means "optimism" in Japanese.
The name is apt as the company has grown on optimism which has spurred Mikitani to constantly explore new frontiers. This is how Rakuten has constantly grown its top line and that trend is unlikely to end any time soon, particularly when one considers the huge opportunity in Japan's burgeoning digital transformation.
Despite consistent revenue growth over 27 years, Rakuten's stock trades at just 0.6x price-to-sales ratio, which suggests that it may be significantly undervalued. As a leading online conglomerate with significant growth potential and some interesting new dimensions, why is Rakuten capitalized at such a low multiple of sales?
The issue is that the company is arguably misunderstood, and this is partly due to its huge investment into the new telecom segment of the business. Developing its mobile network has been a strategic long-term move and despite the initial capital intensity of establishing the infrastructure, once that is done the business will experience significant operating leverage. This one requires an intelligent long-term mindset rather than the short-termist focus on quarterly earnings favoured by most Wall Street types.
The History
Initially, Rakuten Ichiba was an Internet shopping mall, a concept not too dissimilar to Shopify. It was aimed at business owners who were not necessarily Internet-savvy being offered a platform that enabled people skilled in retail to open their own online shops.
From its humble beginnings as an e-commerce platform, it rapidly expanded its services and reach into a diverse array of one-stop online services. In the early 2000s, the company moved into financial services, launching Rakuten Securities in 2003 and acquiring a credit card company in 2005. This marked the beginning of Rakuten's strategy to create a comprehensive ecosystem of services for its customers, similar to the approaches of Amazon and Alibaba.
Throughout the 2000s and 2010s, Rakuten continued to grow both organically and through strategic acquisitions. The company further expanded into digital content pushing into eBooks and eReading, travel services, insurance and even professional sports, acquiring the Tohoku Rakuten Golden Eagles baseball team in 2004.
Expansion
Until 2012 the company maintained high gross margins averaging over 75%, but in its 2012 annual report, it stated that this year was, “the starting point for our evolution into a truly global company", increasing costs associated with international expansion efforts which impacted profitability.
Rakuten made significant moves by acquiring e-commerce platforms in other countries, including Buy.com in the US (later rebranded as Rakuten.com) and Play.com in the UK (rebranded Rakuten.co.uk).
In 2014, Rakuten made its first foray into the telecommunications sector by becoming a mobile virtual network operator (MVNO) in Japan. However, the company's ambitions in this space were much larger. In 2018, Rakuten announced its plans to become Japan's fourth major mobile network operator, a move that surprised many in the industry.
By entering the telecom sector, Rakuten envisions a future where mobile connectivity seamlessly integrates with e-commerce, financial services, and digital content. This strategic move positions Rakuten not just as a diverse internet services company, but as a pioneering force in the convergence of digital commerce and telecommunications. More particularly, it forms part of Rakuten's broader strategy to expand its digital ecosystem and capitalize on Japan's shift towards digitalization.
On this note it is important to understand that Japan has been behind the most other major economies in terms of embracing technological advancements including ecommerce, cashless payments and software-as-a-service. Both in the retail and enterprise segments of the market, digital adoption has been slow. But that is now changing and Rakuten sits at the heart of this shift and stands to be a primary beneficiary of the evolutionary process.
The decision to enter the telecom sector as a full-fledged mobile network operator was strategic and synergistic with Rakuten's existing businesses. It provides another customer touchpoint, improving access to data, and enabling cross-selling of services. The company leverages its existing customer base of over 100 million members in Japan to cross-sell mobile services. Since the mobile service will help drive engagement with Rakuten's other offerings, a fly-wheel effect is created. This is how the company saw mobile connectivity as a central piece in its eco-system, allowing it to offer a more integrated experience to its customers, almost a one-stop shop, all unified under the Rakuten brand. The company's reward program, which allows customers to use points earned while using its services, further reinforces these synergies.
This is not without precedent. Alibaba, although not a traditional telecom operator, has made strategic investments in telecom-related startups and technologies that complement its existing offerings. It also offers cloud infrastructure, Internet-of-Things (IOT) services and edge computing to help streamline the operations of existing telecoms operators. Similarly, through Amazon Web Services (AWS), Amazon offers cloud-based telecommunications services, including Amazon Connect (a cloud contact center service) and Amazon Chime (a communications service for video conferencing, voice calls, and messaging). It also now has Project Kuiper, which is Amazon's initiative to launch a constellation of low Earth orbit (LEO) satellites to provide broadband internet access globally which is likely to include mobile communications. Additionally, Amazon has partnered with telecom companies and some mobile carriers to offer plans that include Amazon Prime subscriptions.
The plan seems to be working. For instance, 35% of Rakuten Mobile subscribers who had never used any other Rakuten service before are now using Rakuten Ichiba, the flagship e-commerce service. This all supports the business thesis that telecom expansion is an important piece of the eco-system jigsaw puzzle for Rakuten.
Rakuten's approach to building its mobile network was revolutionary. The company opted for a fully virtualized, cloud-native network architecture, which was the first of its kind in the world. This innovative approach allowed Rakuten to build and operate its network more efficiently and at a lower cost than traditional telecom companies.
Rakuten is now exporting its 5G technology to other countries, with contracts like the one with 1&1 AG in Germany valued at over $2 billion.
Valuation
In its attempt to break into the telecoms sector, it embarked on what it described in its financial reports as "hefty investment" in building mobile base towers across Japan. This naturally hit profitability for many years. Concurrently, in an attempt to disrupt the market and gain market share, it began offering cheap telecom plans to poach customers from established competitors. While both of these initiatives are investments for the long-term prosperity of the company, in the short term they compound to produce significant operating losses.
To make matters worse, Rakuten has accumulated a substantial debt of ¥1.79 trillion, with ¥769 billion due in the next two years. To address this financial challenge, the company has been selling stakes in its various businesses. For example, Mizuho recently increased its investment in Rakuten Securities from 20% to 49%, providing Rakuten with ¥87 billion, but this only made a small dent in the overall debt position.
Although cost cutting and efficiency measures are underway, which ought to help improve margins and further reduce the debt, the company's goal to "self-fund" its cash needs starting in 2024 now seems optimistic, as the non-fintech funding gap could surpass ¥600 billion by 2026. However, this shortfall may be partially offset by additional asset monetization plans of up to ¥300 billion.
It should be noted that on 26th February, having affirmed the company’s BB rating, the S&P credit rating agency issued a negative outlook reflecting the ‘risk’ of deteriorating liquidity. Consequently, the company's bonds and credit default swaps indicated ongoing investor wariness about its financial situation.
This led to a deal announced in August in which Rakuten Mobile will raise up to ¥300 billion ($2 billion) in funds by way of sale and leaseback of a portion of its mobile network assets via the Macquarie Asia-Pacific Infrastructure Fund. This has improved the company’s financial position.
Fortunately for the Rakuten Group, it has the scale to deal with Rakuten Mobile’s losses, but more importantly, it reported record first-quarter revenues of ¥513.6bn ($3.3bn), up by almost 9% year on year.
In terms of TAM, while Rakuten Mobile currently has 6.8 million customers, rivals NTT Docomo have almost 90 million mobile customers, while KDDI has almost 68 million. Gaining 5% of each of its rivals customers by offering a better and cheaper service would more than double Rakuten’s customer base. This should be achievable, particularly when one considers that Rakuten already has 100 million non-mobile customers ripe to be sold their new cost effective mobile service.
So sentiment is very mixed. This has negatively impacted the market’s valuation of the Rakuten business, but is this a reasonable response? Has it created an investment opportunity for the bold and the brave?
Rakuten Mobile could grow its market share from about 4% to 10% within a few years. If this growth occurs, analysts estimate it could potentially double the parent group's enterprise value. In fact, accelerating subscriber growth could make the network profitable on an EBITDA basis by the year-end. So are we now at a key inflection point for Rakuten?
Rakuten’s non-fintech EBITDA, which mainly comprises EBITDA from its internet services and mobile business, turned positive in the fourth quarter of 2023, helped by steadily narrowing EBITDA losses from the mobile business and a 77% year-over-year increase in internet services EBITDA (the red bars on the chart below are the blended EBITDA numbers, having combined the two blue values). If mobile EBITDA turns positive this year, the entire profile of the business appears differently.
In the first quarter of 2024, Rakuten reported revenues of ¥62 billion ($396m), up by 7.1% year on year, and an operating loss of ¥73 billion ($469m) - an improvement of about 25% compared with a year earlier. EBITDA came in at a loss of ¥33.5 billion ($217m) for the quarter, an improvement of 46% compared with a year earlier. Growth is slow and steady, but most importantly, these numbers suggest that operating leverage is in evidence. As the top line grows, the margins further down the income statement are seeing accelerated improvements.
Conclusion
Rakuten presents a complex investment case, with both compelling opportunities and significant challenges. On the bullish side, the company boasts a diverse business portfolio spanning e-commerce, fintech, mobile communications, and digital content, providing multiple avenues for growth and revenue diversification. With a strong cash position of ¥5.9 trillion and a stock that analysts suggest may be undervalued by 37%, Rakuten offers potential for price appreciation. The company's mobile segment is showing promising growth, and its venture capital arm, Rakuten Capital, has made strategic investments in over 70 companies globally, potentially setting the stage for future returns.
However, the bear case for Rakuten is equally substantial. The company faces a large debt position raising legitimate questions about long-term financial stability. Analysts have consistently downgraded their earnings expectations over the past year, and there's a lack of consensus on future sales estimates, indicating uncertainty about the company's growth trajectory.
Ultimately, investing in Rakuten requires carefully weighing its growth potential against its current financial challenges. The company's ability to leverage its diverse business model and improve profitability will be crucial in determining its future success.
The share price is already up 52.4% this year so far:
But they trade at at less than 50% of where they traded back in 2015:
Is this value hiding in plain sight, or is it a value trap? At the moment, this is in my too difficult bucket, but deserves a place on my watchlist. If the uptake of its mobile service gains momentum, which is highly probably, I may look-back with regret at not having taken a position at this time. However, I am happier with that risk than throwing caution to the wind and rolling the dice now.
it would be great to see a pro-forma financial snapshot with 3 development scenarios