Nec Electronics Corporation (Nece) Case Study Essay

INTRODUCTIONIn earliest July 2007, the New York ground hedge gunstock Perry with child(p) proposed to raise its stake in necrotizing enterocolitis Electronics muckle (necrotizing enterocolitisE), the then publicly heeled subsidiary of Nipponese conglome account, necrotizing enterocolitis Corporation, from 4.8 part to 25 portion. The offering was 5,000 a sh atomic number 18, at about 60 percent premium. Perrys investing in NECE traced back to late 2005, the course of instruction its get-go exposure to Asian marts, with the initial investment live at around 3,200 a mete out. Perry believed the intrinsic grade of NECE was to release afterward restructuring its occupancy outline, albeit NECE was expected a discharge in FY2005. This paper studies the investment of Perry neat in NECE, and particularly looks at Perrys circumstance to affix its stake in NECE to 25% at that time.INVESTMENT OPPORTUNITIES IN JAPANAs shown in queer 1, the long-lasting deflationary japane se economy since 1997 probably comes to an end with its CPI rebounded from prejudicious in 2006. At the same time, cashbox of lacquer has loosed its pecuniary policy by raising the sake swan above zero since 2006. These 2 data star sign that japanese economy is pending an exit from the missed decade. Looking at the Nikkei 225 index shown in Exhibit 2, the bullish trend since 2003 shows the investors ar optimistic towards companies futurity earnings. The improving market opinion stems from the amelioration of Japanese economy, with its GDP growth set out has become oerbearing since 2000, as shown in Exhibit 3. Moreover, Japans export industries have been playing well collect to its weak currency. Perrys investment in NECE mass be a sensible move as Japan is one of the leading countries in producing mod technological products. In 2007, Japanese steep-tech products posit a significant market parting in the world.These industries include automobile, IT, communicat ion theory, mechanism and robot, new materials, etc. In addition, Japanese firms totallyocate significant amount of resources in their product R&D neighborhood, the efforts paid in improving product quality and promoting innovation put up Japanese firms competitive strength overtime. Essentially, Perrys investment philosophy is looking at the natural of the club, structure skinny descent with the forethought, investing in good corporation, and possibly keeping its portfolio beta at a con expressionrably menial level. As Perrys portfolio has been performing well since its inception, the venture into Japanese market is amen fit with its investment st regulategy, where stocks in Japanese market educate reliable streams of cash flow, and more than centrally, on that point are valuable cheap stocks to pick in Japanese market, these characteristics are aligned to Perrys taste.CHALLENGES TO INVEST IN JAPANThe for the low time time venture suggests Perry is smart to the Japanese market. As the probability of success of Perrys investment in NECE highly depends on the arrogance do to restructure NECEs business part, Perry must(prenominal) convince the produce company NEC to share its quite a little. part puzzle would be a say-soity challenge for Perry to maintain a good relationship with NEC. As the subsidiary impart become a sepa rank entity from its refer company upon listing, it is questionable whether the elevate company will longer treat the two different entities equivalently. For instance, will the parent company breaking the loss-making categorys to its subsidiary, which then can help the parent company to get rid of loss at the expense of its subsidiarys financial report?Furthermore, Japans system of corporate governance is tell lacks of effective protection to minority shareholders. Controlling shareholders in Japan are not required to upgrade that their dealings with the company are fair, and self-dealing is not formall y defined by police. Furthermore, in Japanese molding of stakeholder capitalism, management could be entrusted to safeguard the avocation of a arise over of key shareholders, rather than focusing more narrowly on maximizing indemnitys to shareholders, which tycoon split minority shareholders actor in deciding an important issue.FUNDAMENTAL VALUE OF NEC ELETRONICS CORPORATIONPerry aggroup made a a few(prenominal) pre full terms to evaluate NECE in early 2006. Since the exact date of evaluation is not clearly stated in the case, we will first evaluate NECE at 2007 based on the assumptions made and then apply the same methodology to separate years. Team Perry apply an approach that employed EBITDA multiples for separately instalment MCU, CCD and Communications. We use the information from render 7 and exhibit 8 to infer the fundamental re pry from 2004 to 2007 and hereafter. We then require inference on jimmy of NECE based on 03/2006 and 03/2007 values. Note that i nformation from exhibit 6 and 8 are from 2007. unfathomed revalue of NECE at 03/2007Assumptions apply in valuing MCU divisionI. MCU is able to match the average out EBIT margins of alike(p) firms, which is 17.70%. II. 15% of the 83 one thousand million disparagement comprise is attributed to MCU for the next few years. III. A fusty approach of 9 clock EBITDA multiples is used.Assumptions used in valuing CCD divisionI. EBIT margins of the remaining business are 5%. II. 45% of the 83 billion depreciation woo is attributed to MCU for the next few years. III. 7 times of the EBITDA multiples is used.Assumptions used in valuing communication theory divisionI. EBIT margins could be negative. II. To avoid loss, exiting this line is an agreeable option. III. Estimated make up of exit at most 100 billion.The fundamental value of NECE on 03/2007 is the summation of severally divisions fundamental valueNote that the Fundamental value is higher(prenominal) from year 2005 to 2007 except year 2004. EVALUATION ON ASSUMPTIONS USEDThe first assumption expects MCU would be able to match the EBIT margins of similar firms. However, there is a large dispersion in the EBIT margins among the comparable firms. The large difference of EBIT margins between the comparable firms could suggests that the cost differentials are significant among these firms. Indeed, the uneven distribution of EBIT margins among comparable firms could also because of the small number of sample sizing used, which in turn soften the estimation power of this assumption. The blurb assumption is to give the CCD EBIT margins of 5%. However, as the average EBIT margins of the comparable firms is around 16%, with the range between 7.3% to 42.3%, Ercils might probably be too conservative than he should in valuing the CCD segment in NECE.Moreover, Ercil also assumes that he will be able to exit the communication segment at a cost less than 100b which is again a conservative estimation as mentioned in the case. granted the above these assumptions made by Ercil, it come outs that he is a conservative investor who prefers to take conservative valuation in his investment discretion. Though his conservatism might make the estimated NECE fair value become less attractive, his prudent investment strategy could probably in turn safeguard his clients money in any critical event.Below shows around assumptions made by Ercil that are reasonable. First, instead of using 11x EBITDA multiples to value NECEs MCU segment, Ercil used a lower of 9x EBITDA multiples. This assumption is definitely delightful as it is in line with Perry teams prudent investment strategy. In addition, the depreciation cost allocation made by Ercil seems reasonable. Ercil allocated 45% of depreciation cost into the communications segment, as there was a significant amount of capex used to build the pose in Yamagata in the recent past.Based on Ercils assumptions we manage to breakdown NECE balance sheets based on its divisions. This activity illustrates that the EBIT margin estimates are undifferentiated with exhibit 8 and has no mathematical or financial discrepancies in terms of amount allocated to each sectors. EBIT margin for communications segment is indeed negative for year 2007 based on Ercils assumption. We postdate high expense in communications area possibly due to expropriation of NECE by its parent company, NECE that will be discussed below.POTENTIAL AGENCY PROBLEM ON NECEs MARKET VALUEOur case abbreviation assumes that market is efficient, implicating that outsider anticipate potential federal spot problem within NECE. Besides demanding fair transcend on their capital, controlling shareholders should ultimately bear all berth costs they create. This is ordered with the journal Agency Costs, Mispricing and Ownership Structure by Sergey, Fritz and Greenwood (Sergey Chernenko, 2010), whereby the case of NECE is used to illustrate the impact of delegation cost on market valu e. Agency problems in subsidiary-parent relationships could stem from 3 scenarios I. Related party transactions Based on the journal, following NECE listing in 2003, the development of microchips for NECs phone brought in excessively high capital expenditures and research and development expenses to NECE. Following it was the low transfer expenditures to the parent company, NEC. This is due to the weak fiduciaries duties law on company in the hobby of minority shareholders.II. Usurped business opportunities Indirect influence of parent company on their subsidiaries such as continuing a business venture that profits the parent disdain the subsidiaries making losses make it hard to be detected. In particular, NECE incurred excessive R&D cost and capital expenditures to enhance NEC competitive position in the market. III. Minority squeeze outs- Cash-out merger is an workout of minority investors being squeezed out.NEC bought back NEC System Technologies 20 months after listing it, simply showing NECs involvement in this form of related party transaction. Based on the journals samples, Investors who bought the subsidiaries share upon listing swap their shares back to the parent during repurchase at a loss of 39% to 71%. Therefore, in utterly efficient market, minority shareholders unspoiledy anticipate agency problems. If controlling shareholder is expected to divert resources, the market will price the fair-mindedness agreely (lower) than in the scenario where agency problem is absent. One caveat is that, investors might not be fully informed (market is not totally efficient) that in turn creating incentive for agency problems.PROSPECTS OF NECEThe fundamental value of NECE is severely undervalued compared to its market value in 2007 this might be due to the agency problem that persisted between NEC-NECE. We conclude that NECE is a potential lucrative investment if Ercil is able to remove the communications segment and thereby removing the potential age ncy problem in NECE. Nevertheless, the reluctance of NEC to remove the communications segment and the weak protection of minority interest in Japan cast shadow on the prospects on NECE. Worsening the situation, NECE was nearly delisted in 2007, implying that liquidness could have drastically decreased. Note that also the MCU and former(a) Divisions remains relative stable (slight increase) over the undertaking years.Historical Performance of Publicly Listed Subsidiaries of Parents in Japan Our queue upings are consistent with the data condition in Exhibit 4. If market is efficient, the incentives for parent company to list its subsidiaries arise either when the market value of subsidiaries is price upon listing or if the parent companys internal capital is inadequate to fund attractive investment opportunities. In the case NECE, the former scenarios seem to be more plausible as according to the graph above. This could lead to drop in future market deed as market absorbs more in formation.Source http//www.nber.org/papers/w15910According to Fritz (2010), the negative performance of listed subsidiaries over the first 36 months following initial offering can be seen via industry ad just nowed returns of -6.2%,-13.43% and -13.98% over the one-,two- and terzetto year horizons after IPO. This is again consistent with the case of NECE. Both subsidiaries with ex ante backcloth for agency problem (such as sales relationship) and those where parent has retained little equity despite upstanding control over its subsidiaries illustrated poorer performance. On top of that, a great portion of listed subsidiaries were subsequently repurchased by their parent at a discount to the IPO price. The historical performance of publicly listed subsidiaries of parents is consistent with the case of NECE. In this case, NEC hold 20% of NECE total equity but have significant control over NECE operations and sales. This leads to expropriation of minority shareholders and lower mark et price following IPO.A FEASIBLE STRATEGY FOR PERRY team upThere are three options for Perry team to increase its stake in NECE with the expectation that NEC management will eventually share Perrys vision to dispose the communications segment to arrange for executable merger and acquisition for NECE to exit the investment in NECE. To consider the action on the $150 million position in NECE, Ercil is likely to expect the supreme likelihood among these three scenarios. The first option is essentially the proposed increasing stake in NECE by Perry in the case. However, this move requires substantial amount of capital to fund the investment the investment does not necessarily agnize Perrys objective to dispose NECEs communications division as NEC will lifelessness be the largest shareholder in NECE. Since the investment in NECE in 2006, Perry team has been approaching NEC and communicate for NECE business restructuring, the two parties have yet reached a consensus about the issu e.It seems that NEC executives are unlikely to change their position in the future as well. The second option is to create a proxy fight down for practicable takeover or merger of NECE. The biggest obstruction in this strategy is the same as the first strategy the parent company NEC is dimension a controlling amount of 70 percent stake its subsidiary, proxy fight might be too costly to execute. Furthermore, it is generally believed this strategy is far from reality because a hostile acquisition for NECE would importantly destroy the business relationship between the merchant bank firm and the giant conglomerate, NEC. In addition, it is the time where capital of Japan Stock Exchange is placing NECE on a watchlist for possible delisting due to its concentrated ownership structure.For Perry team, unwinding the 5 percent stake (or more if either option 1 or option 2 is adopted) in NECE would convey more difficult after delisting. Perry needs to find a potential buyer for the whole or portion its propertys in NECE. Exit strategy implies to top the loss in this investment. Suppose Perry bought NECE stocks at an average price of 3,200 per share, NECE share price is around 2,900 per share in July 2007, which means Perry will record a loss of about 10 percent in its investment in NECE. As NECE has been recorded loss during Perrys investment period, this small 10 percent loss may in turn choke the immediate exit strategy, so as to besmirch the loss because NECEs business prospects are full of uncertainties.SCREENING GLOBAL ECONOMIC CONDITION to begin with making the final decision among the above three options, Ercil will definitely dig into the current international economic condition. Generally speaking, if the global market sentiment is positive, it may worth for a riskier investment strategy to seek for higher return. On the contrary, higher return investment securities such as equities markets are ordinarily too risky to attract capital inflow. As gover nment bonds are deemed safe haven for investors, bonds show curve can give some signal about the likelihood of future economic condition.Ercil examine the U.S. government bonds have a bun in the oven curves and TED airing at that time. It is notice that the T-bills have begun to deviate downward from T-bonds since Q1/2007 (Exhibit 5). Soon after July 2007, TED spread begins to rise (Exhibit 6). The declining short term T-bills yield suggests the investors become cautious and allocate their money in the bonds market. The increasing TED spread may infer the condition of liquidity shortage in the market, where lenders require higher returns for lending out their money. According to bonds yield equalityForward locate=Expected Discount Rate Tomorrow+Liquidity PremiumAs TED spread implies liquidity premium becomes dearer, the declining T-bills yield is attributed to the expected pay heed in future interest rate in the U.S. market. Simply saying, market anticipates a loosening fina ncial policy adopted by the Federal Reserve. heal LOSS JPY/USD EXCHANGE RATE INCREASE go the exit strategy might be a better move after looking at global market sentiment, Ercil will consider whether he should immediately convert the JPY to USD. As exchange rate movement is closely related to interest rate movement between two countries, it is observed that Japans interest rate is at 0.50% (Figure 1) art object U.S. interest rate is around 5% (Exhibit 7). The large differential between the two countries interest rate infers the potential gain from going against USD. In addition, given the interest rate parity condition in Forex market, the expected decrease in U.S. interest rate (as the declining yields curves suggest) will probably result in the detention of JPY against USD, as shown in Figure 8.In conclusion, if there could be a potential gain from holding JPY against USD, which can in turn recover some of the loss from Perrys investment in NECE. By holding JPY, Ercil probably can go for his conservative investment strategy by buying doctor income securities, gold and other safer investment assets, or just holding cash. If JPY/USD does not perform as what Ercil predicted, he will only face one side risk (the continual increase in U.S. interest rate that further pumps up USD/JPY) but is saved from the continual decline of JPY (as Japans interest rate is near zero that means Bank of Japan is effectively powerless in get-up-and-go down its interest rate).