Softbank's Aggressive Accounting

Critics are wondering if the Japanese telecom powerhouse underestimated its assets after its Vodafone purchase to show bigger profits

Has Softbank (SFTBF) used aggressive accounting to boost its quarterly earnings? Some analysts say the Japanese Internet and telecom giant recently took a big write-down of assets without telling shareholders. And in recent weeks, both analysts and investors have been demanding answers from the company, alleging everything from questionable bookkeeping to an overpayment for Vodafone (VODPF) in the $15 billion purchase in March of the British company's business in Japan.

The attacks began not long after Softbank announced first-quarter earnings on Aug. 8. For the April to June period, the Tokyo-based company reported that operating profits had jumped to $478 million, from a $27-million loss in 2005, on a near-doubling of revenues to $4.3 billion. Much of the gains were due to the wireless business, which had profit margins of 3.2% under Vodafone but 11.7% under Softbank.

GOODWILL AND GOOD NUMBERS.

  It was an impressive feat. Though Vodafone's Japanese unit had been profitable, it had recently suffered a decline in customers and had lower revenues per customer than its competitors. That made it hard to believe Softbank chief executive Masayoshi Son had suddenly found a way to fatten the unit's profit margins.

Among the skeptics, Lehman Brothers (LEH) analyst Nicholas Spratt was the most vocal. In an Aug. 17 report, Spratt figured the company booked a write-down of $4.4 billion worth of infrastructure assets. Vodafone had valued the unit's servers, transmission towers, and other high-tech equipment at $9 billion. That meant Softbank had cleaved in half the value of the assets, and that the $15 billion it had paid for Vodafone's business amounted to nearly four times the value of the assets, Spratt wrote.

On its balance sheet, Softbank accounted for part of the total write-down as goodwill. And since companies can amortize goodwill costs over 20 years, vs. the 10 years they can depreciate the cost of fixed assets, the accounting change lowered Softbank's costs dramatically.

DIFFERENT STANDARDS.

  It's unlikely that Softbank broke any laws—and the company says that it has followed standard accounting practice. Aggressive accounting is a common feature of corporate earnings, and most analysts say they had expected the company to reassess the value of its fixed assets. But what angered so many was the size of the hit Softbank took and the fact that the company hadn't alerted the public about it.

Such disclosure problems remain a big complaint of Western investors in Japan. Despite legal revisions aimed at making Japanese companies more transparent for shareholders, "disclosure standards in Japan are so much lower than in the U.K. or the U.S.," says Simon Learmount, deputy director of the University of Cambridge's Judge Business School.

For its part, Softbank has not said whether Spratt's conclusions are right or wrong. However, the company says that it has "revalued" about $3 billion worth of assets, including about $1.6 billion classified as goodwill, mostly to account for aging 3G telecom equipment. Softbank spokesman Takeaki Nukii, in an e-mail to BusinessWeek, points out that the move got approval from independent auditors at Deloitte Touche Tohmatsu.

SATURATED MARKET.

  Nukii also defended the deal with Vodafone, saying Softbank felt the price was justified because the company won't have to start its wireless business from scratch. Softbank has explained the changes to individual brokerage analysts and recently held two special sessions for investors.

Cutting costs might have been Softbank's main motivation, analysts say. Softbank's purchase of Vodafone's unit made it Japan's third-biggest carrier, with a market share of around 17%. NTT DoCoMo (DCM) has 56% and KDDI has 24%.

But in a saturated market of 90 million cell phone users, Softbank could struggle to win new customers from its bigger telco rivals. And given its small customer base of 15 million, the spotty coverage of its nationwide cellular network, and its weaker brand, Softbank will have to invest huge sums in equipment, new handsets, advertising, and services in the coming months.

BUYING THE VISION.

  By writing off Vodafone's assets now, Softbank removed a future burden on profits. Creditors are expected to view that positively as they consider extending Softbank's one-year bridge loan by September. It's also important because the company is expected to introduce cut-rate fees as new rules in October let mobile-phone users change carriers while keeping their existing phone numbers.

For Japanese individual investors, it's been a wild ride. Since Spratt's report, Softbank's shares have shed nearly 15% while DoCoMo shares have been flat and KDDI's have risen 4%. Individual investors own a sizable chunk of Softbank's shares, but few were privy to the discussions between analysts and company execs. Many individuals who own Softbank's stock have bought into Son's vision for expanding his multibillion-dollar cyber-empire, and have helped keep Softbank's shares at lofty levels.

Softbank stock currently trades at nearly 38 times earnings, twice that of KDDI and DoCoMo. Merrill Lynch Securities (MER) analyst Yasumasa Goda, who forecast a 78% rise in operating profit to $950 million on sales of $22 billion this fiscal year through March, 2007, cautioned in a recent report that the company's share price "relies heavily on expectations."

"HARDER TO ASSESS".

  Even analysts who have scrutinized Softbank's myriad businesses—which include more than 120 subsidiaries such as popular Net portal Yahoo Japan, smaller equity stakes in 65 other companies, and indirect investments in hundreds of tech firms worldwide—find it a challenge to assess the company's worth.

In an interview that ran in the Japanese financial daily Nihon Keizai Shimbun on Aug. 28, Softbank's accounting manager, Kazuko Kimiwada, acknowledged that the company's earnings had "become complex and harder to assess," adding: "And since we do not issue earnings forecasts, this has contributed to the broad range of analysts' projections." (While many Japanese companies have started issuing earnings forecasts, Softbank has stuck with the traditional practice in Japan of avoiding such predictions.) Small wonder that few insurers, pension funds, and other institutional investors own the stock.

It's not clear which side Japanese investors are on, but in the past they have taken aim at brokerages. In July, after Merrill Lynch's Goda rated the stock a "sell" in his first report on the company, the brokerage's Tokyo office was deluged by hundreds of calls over several days. Investors vented against Western brokerages for taking advantage of Japanese investors.

It's serious enough that when a photo of one of the brokerage's analysts, who'd been mistaken for Goda, appeared on an Internet bulletin board, says spokesman Takayuki Inoue, Merrill Lynch temporarily added security guards and hired a car and a bodyguard for the analyst.