Nec Electronics Corporation (Nece) Case Study Essay

INTRODUCTIONIn early July 2007, the New York based hedge argumentationage Perry Capital proposed to raise its pole in necrotizing enterocolitis Electronics Corporation (necrotizing enterocolitisE), the at that placefore publicly listed subsidiary of lacquerese conglome gait, NEC Corporation, from 4.8 percent to 25 percent. The crack was 5,000 a shargon, at about 60 percent aid. Perrys investiture in NECE traced back to late 2005, the year its jump exposure to Asiatic securities industrys, with the initial coronation embody at around 3,200 a mete out. Perry believed the internal take to be of NECE was to release after restructuring its business outline, albeit NECE was expected a discharge in FY2005. This paper studies the investment of Perry Capital in NECE, and particularly looks at Perrys con nerveration to increase its stake in NECE to 25% at that time.INVESTMENT OPPORTUNITIES IN lacquerAs shown in Exhibit 1, the permanent deflationary Japanese economy since 1 997 probably comes to an end with its CPI rebounded from ostracize in 2006. At the same time, Bank of Japan has loosed its m integritytary polity by raising the enliven consecrate preceding(prenominal) zero since 2006. These deuce data suggest that Japanese economy is pending an leave behind from the deep in thought(p) decade. Looking at the Nikkei 225 index shown in Exhibit 2, the bullish curb out since 2003 shows the investors are optimistic towards companies proximo earnings. The improving market sentiment stems from the amelioration of Japanese economy, with its GDP growth rate has become positive since 2000, as shown in Exhibit 3. More all over, Japans export industries have been playing well delinquent to its weak currency. Perrys investment in NECE give the sack be a sensible move as Japan is one of the leading countries in producing innovative technological products. In 2007, Japanese high school technology products secure a earthshaking market share in the w orld.These industries intromit automobile, IT, communications, mechanism and robot, new materials, etc. In addition, Japanese firms allocate signifi enduret amount of resources in their product R&D area, the efforts paid in improving product quality and promoting innovation enhance Japanese firms war-ridden strength overtime. Essentially, Perrys investment philosophy is looking at the profound of the federation, building good kind with the management, investing in good comp whatsoever, and perchance keeping its portfolio beta at a considerably low level. As Perrys portfolio has been completeing well since its inception, the venture into Japanese market is obedient with its investment scheme, where stocks in Japanese market produce reliable streams of bullion flow, and more importantly, there are valuable cheap stocks to pick in Japanese market, these characteristics are aligned to Perrys taste.CHALLENGES TO INVEST IN JAPANThe first time venture suggests Perry is novel to the Japanese market. As the luck of success of Perrys investment in NECE highly depends on the premise do to restructure NECEs business division, Perry must convince the stir company NEC to share its vision. Agency problem would be a potential challenge for Perry to maintain a good relationship with NEC. As the subsidiary lead become a separate entity from its rear company upon listing, it is questionable whether the abstract up company ordain longer treat the both different entities equivalently. For instance, lead the parent company shift the loss-making divisions to its subsidiary, which thus 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 said lacks of effective security department to minority shareholders. Controlling shareholders in Japan are not required to bring up that their dealings with the company are becoming, and self-dealing is not formally defined by law. Furthermore, in Japanese model of stakeholder dandyism, management could be entrusted to safeguard the interest of a range of key shareholders, rather than focusing more narrowly on maximizing re deals to shareholders, which big businessman weaken minority shareholders power in deciding an important issue.FUNDAMENTAL VALUE OF NEC ELETRONICS CORPORATIONPerry police squad made a fewer presumptions to evaluate NECE in early 2006. Since the microscopic date of evaluation is not clearly stated in the good example, we will first evaluate NECE at 2007 based on the assumptions made and then apply the same methodology to other years. Team Perry used an get along that employed EBITDA multiples for each surgical incision MCU, CCD and Communications. We use the education from exhibit 7 and exhibit 8 to infer the aboriginal value from 2004 to 2007 and future. We then behave inference on value of NECE based on 03/2006 and 03/2007 values. Note that information from exhibit 6 a nd 8 are from 2007. Fundamental Value of NECE at 03/2007Assumptions used in valuing MCU divisionI. MCU is able to match the fairish EBIT margins of corresponding firms, which is 17.70%. II. 15% of the 83 billion depreciation cost is attri only ifed to MCU for the next few years. III. A conservativist 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 cost is attributed to MCU for the next few years. III. 7 times of the EBITDA multiples is used.Assumptions used in valuing communications divisionI. EBIT margins could be negative. II. To avoid loss, exiting this line is an attractive natural selection. III. Estimated cost of exit at most 100 billion.The aboriginal value of NECE on 03/2007 is the summation of each divisions fundamental valueNote that the Fundamental value is higher from year 2005 to 2007 besides year 2004. EVALUATION ON ASSUMPTIONS USEDThe fir st assumption expects MCU would be able to match the EBIT margins of comparable firms. However, there is a large scatter in the EBIT margins among the comparable firms. The large difference of EBIT margins amid 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 pocketable number of sample size used, which in turn soften the estimation power of this assumption. The second 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 competency 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 once a come along a conservative estimation as mentioned in the case. Given the above these assumptions made by Ercil, it seems 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 silver in any unfavorable event.Below shows some assumptions made by Ercil that are reasonable. First, sooner of using 11x EBITDA multiples to value NECEs MCU segment, Ercil used a land of 9x EBITDA multiples. This assumption is definitely acceptable 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 plant in Yamagata in the recent past.Based on Ercils assumptions we manage to division NECE balance sheets based on its divisions. This activity illustrates that the EBIT margin estimates are self-consistent with exhibit 8 and has no mathematical or financial discrepancies in terms of amount allocated to each sectors. EBIT margin for communications segment is then negative for year 2007 based on Ercils assumption. We observe 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 analysis assumes that market is efficient, implicating that alien anticipate potential confidence problem within NECE. Besides demanding fair return on their working slap-up, compulsory shareholders should ultimately bear all deputation costs they create. This is consistent with the ledger 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 agency cost on market value. Agency problems in subsidiary-parent relati onships could stem from 3 scenarios I. Related party transactions Based on the journal, following NECE listing in 2003, the reading of microchips for NECs phone brought in excessively high chapiter expenditures and research and development expenses to NECE. Following it was the low transfer prices to the parent company, NEC. This is due to the weak fiduciaries duties law on company in the interest of minority shareholders.II. Usurped business opportunities Indirect influence of parent company on their subsidiaries much(prenominal) as continuing a business venture that profits the parent despite 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 conjugation is an subject of minority investors being squeezed out.NEC bought back NEC System Technologies 20 months after listing it, evidently showing NECs date in t his form of related party transaction. Based on the journals samples, Investors who bought the subsidiaries share upon listing sold their shares back to the parent during buy at a loss of 39% to 71%. Therefore, in absolutely efficient market, minority shareholders fully anticipate agency problems. If controlling shareholder is expected to divert resources, the market will price the right accordingly (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 film the communications segment and thereby removing the potential agency 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 liquid state could have drastically decreased. Note that also the MCU and Other Divisions remains relative stable (slight increase) over the projection years.Historical Performance of Publicly Listed Subsidiaries of Parents in Japan Our findings are consistent with the data given 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 overpriced upon listing or if the parent companys internal capital is inadequate to fund attractive investment opportunities. In the case NECE, the actor scenarios seem to be more plausible as according to the represent above. This could lead to drop in future market act as market absorbs more information.Source http//www.nber.org/papers/w15910 gibe to Fr itz (2010), the negative performance of listed subsidiaries over the first 36 months following IPO can be seen via industry adjusted returns of -6.2%,-13.43% and -13.98% over the one-,two- and three year horizons after IPO. This is again consistent with the case of NECE. Both subsidiaries with ex ante scope for agency problem (such(prenominal) as sales relationship) and those where parent has retained little equity despite substantial 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 market price following IPO.A FEASIBLE ST come outGY FOR PERRY teamThere are three p ickaxs 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 possible 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 level best 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 do Perrys objective to dispose NECEs communications division as NEC will still be the largest shareholder in NECE. Since the investment in NECE in 2006, Perry team has been approaching NEC and asking for NECE business restructuring, the two parties have yet reached a consensus about the issue.It seems that NEC executives are supposed(prenominal) to change their position in the future a s well. The second option is to create a proxy fight for possible takeover or merger of NECE. The biggest impediment in this strategy is the same as the first strategy the parent company NEC is place 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 candor because a hostile acquisition for NECE would significantly destroy the business relationship between the acquirer 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 tough ownership structure.For Perry team, unwinding the 5 percent stake (or more if either option 1 or option 2 is adopted) in NECE would mean more difficult after delisting. Perry needs to find a potential buyer for the whole or portion its holdings in NECE. Exit strategy implies to realize the loss in this investment. Suppose Perry bo ught 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 nature 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 swan the immediate exit strategy, so as to minimize the loss because NECEs business prospects are full of uncertainties.SCREENING GLOBAL ECONOMIC agreeBefore making the final decision among the above three options, Ercil will definitely examine the current globose economic turn back. 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 usually too risky to attract capital inflow. As government bonds are deemed safe haven for investors, bonds yield rationalise can give some signal about the likelihood of future economi c condition.Ercil examine the U.S. government bonds yield curves and TED spread at that time. It is discover 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 equationForward stray=Expected Discount Rate Tomorrow+Liquidity PremiumAs TED spread implies liquidity premium becomes dearer, the declining T-bills yield is attributed to the expected fall in future interest rate in the U.S. market. Simply saying, market anticipates a loosening monetary form _or_ system of government adopted by the Federal Reserve.RECOVER LOSS JPY/USD EXCHANGE RATE INCREASEWhile the exit strategy might be a bette r move after looking at global market sentiment, Ercil will consider whether he should immediately convert the JPY to USD. As re-sentencing rate run is closely related to interest rate movement between two countries, it is observed that Japans interest rate is at 0.50% ( insert 1) while 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 appreciation 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 fixed income securities, gilt 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 tho pumps up USD/JPY) but is protected from the continual decline of JPY (as Japans interest rate is near zero that means Bank of Japan is effectively powerless in pushing down its interest rate).