Nov 112011

Japanese optics group Olympus (JP:7733) has finally admitted that more than US$1bn in payments for acquisitions were not what they appeared to be. The twist in the tail is that these weren’t bribes or payments to cronies, but rather an attempt to cover up losses on investments dating back to the 1990s.

The revelation didn’t surprise me as much as most. That’s not because I have inside knowledge on Japanese corporate malfeasance, but because I’d seen an excellent analysis of the Olympus scandal on the Nihon Cassandra blog that anticipated exactly this development. (Add this blog to your reading list – it’s infrequently updated, but one of the best out there.)

I almost wrote about this last week, but decided it was of too limited interest. But with the stock still in freefall (it’s down 80% since mid October), I’m starting to wonder if this is a good opportunity to invest – or whether it risks being an effort to catch a falling knife.

How to hide your losses for two decades

To put Olympus in context, back in the 1980s, Japanese companies from all parts of industry became very keen on zaitech (financial engineering). At that time, the bubble mania meant that firms could obtain almost free financing through a combination of bonds and warrants. Indeed, I’ve been told that by throwing a cross-currency basis swap into the mix, it was sometimes possible to get paid to borrow.

Unfortunately, the companies didn’t necessarily have much to do with this easy money, so they stuck it straight back in stocks, bonds and property. When the bubble burst, they were facing losses on these and still had to repay the debt.

Rather than own up to this, they tried to smuggle the losses out the back door (a practice known as tobashi or ‘fly away’). The failed investments could be swapped for ‘repair bonds’, which had the same apparent value as the original investments, but in practice would eventually be worth much less than its carrying value.

A lot of firms did this. Some of them got caught very publicly, some of them probably got away with it. But two decades after the bubble burst, it seemed that the last of these losses should be out of the way. Until the Olympus news broke.

So unless there is much, much more to this story that’s not yet been told, there’s nothing especially odd about what Olympus has done. It’s only that this is coming out in 2011, rather than 2003 or 1997.

The question now is what does this mean for a) corporate Japan and b) Olympus?

On the first point, I’m not convinced that it means as much as many commentators say. This is not a new problem, but an old one.

Companies aren’t doing the same today. The party is long over and the Olympus story is just a matter of sweeping out the debris.

Hopefully, we might see some more measures to improve corporate governance. But I wouldn’t expect them to be revolutionary. And in the long run, I wouldn’t expect the affair to change attitudes towards investing in Japan that much.

A half-great business

When it comes to Olympus itself, things could be more interesting. Unlike a lot of financial frauds, this does not suggest the company itself is a shell. Olympus is a very real business and in part a very successful one.

Most consumers will know it for its cameras. Medical professionals will know it for its imaging systems. The former has a higher profile, but the latter has a lot more value.

The divisions are:

-Medical Systems. Olympus is the world leader in gastrointestinal endoscopes, with a 70% market share. That accounted for ¥355bn in sales (42% of revenue) last year and ¥69bn of operating income last year

-Imaging Systems. This is the camera business, which is a drag on the firm. It accounted for ¥131bn in sales (15%), but an operating loss of ¥15bn

-Information and Communication. This is mostly a mobile handset business, which accounted for ¥210bn (25%) of revenue, but just ¥5bn of operating profit – not impressive

-Life Science and Industrial Systems. Microscopes – for biological and industrial testing uses – add ¥101bn of sales (12%) and ¥9bn of operating profit

-Others. The balance is essentially early stage commercialisation of new technologies and business lines, amounting to ¥50bn in sales (6%) and an operating losses of ¥4bn

Recent results have not looked encouraging; overall sales were down 4% to ¥847bn last year and operating income down 41% to ¥35bn. Net income was down 85% to ¥7bn.

That looks pretty awful, although there are extenuating circumstances: the strong yen (a problem for most Japanese manufacturers), the sale of a non-core business and the poor performance of the camera division.

The balance sheet is not a thing of beauty either: ¥650bn of debt and equity of ¥166bn is more top heavy than ideal, at a debt/equity ratio of 3.9 times. Add cash and near cash of ¥214bn and that comes down to 2.6 times – still steep. Olympus remains more leveraged than many of its peers, assuming the balance sheet numbers can be trusted at all.

Overall, Olympus is not something I’d look at normally – but an event like this is another story. The endoscopy unit is an outstanding business and the smaller life science and industrial systems arm is also solid. These have real value that isn’t reflected in what’s going on.

Putting a price on Olympus

So what might it be worth when the dust clears?

Reported EPS was ¥27.5 in 2011, ¥177 in 2010, -¥429 in 2009, ¥214.5 in 2008 and ¥177 in 2007.  Last year was clearly depressed, the previous year included the sale of the diagnostics business, 2009 was affected by the financial crisis and major asset writedowns (potentially including many linked to the scandal), while I would take 2007 and 2008 as peak cycle earnings.

I don’t know Olympus well enough to model earnings in detail, but taking the 2010 figure ex-sale gains as a reasonable starting point, I’d guess ¥85 should be a pretty conservative estimate for through-cycle earnings. On a current share price of ¥460, that’s a p/e of about five.

Put another way, that assumes normal EBITDA of around ¥100bn. With ¥650bn of debt, cash of about ¥214bn and a market cap of ¥125bn, enterprise value is around ¥560bn.  That’s an EV/EBITDA multiple of about 5.5.

Without question, that looks cheap, even giving it any governance discount you like. Ascribing no value at all to the rest of the business, the endoscopy unit alone should make the shares worth twice what they are now.

At this point, I was very tempted. But there are obviously risks – at least four that I can see at present.

-Olympus could be delisted – it has until December 14 to produce an earnings report or will automatically go on a shortlist for deletion within a month. Even if it manages this, it could be punitively removed from the Tokyo Stock Exchange in any case.

On the facts at present, delisting would be an insane response to a scandal of this type, hurting shareholders more than the original fraud. But that doesn’t make it impossible.

-We don’t know what else could be lurking in the balance sheet or on the income statement. If management have been falsifying assets, they could have been falsifying business income, although this would seem to be out of line with the original fraud.

-The company could be sued by investors aiming to recover their losses. I’d assume some level of lawsuits are certain, but it’s hard to know how damaging they would be. Japan is not America, class action shareholder lawsuits do not occur at the slightest pretext (not that this is a slight pretext)

-Financing could get tight if worried lenders pull lines of credit and bondholders demand to be repaid due to breached covenants. This is possible, but my guess is that if Olympus can reassure the major Japanese banks that its business is fundamentally sound, they will support it.

Assume 100% downside risk

The worst-case scenario is probably some combination of these. Olympus delists, funding gets squeezed, it’s pressured to sell off the endoscopy unit – probably to a rival at a firesale price – and lawsuits pile up.

In that case, shareholders are left holding unlisted stock and with little idea what they’ll get back once creditors and lawyers have had their cut. I would not be optimistic about recovering ¥460 per share from that kind of feeding frenzy. In fact, I would not be optimistic about recovering anything.

But if Olympus survives as a listed company, it should be a good trade from here. Yes, it will be tainted – but it’s been beaten down so much that it could still double or more and still be cheap enough to carry a badge of dishonour. And my instinct is that it does have a decent chance of survival.

When major firms are in crisis, there is always speculation about they can remain intact. That frequently looks misplaced afterwards – see the talk that Deepwater Horizon could mean the end for BP as an example. It’s hard to think of a major firm that went under like this, other than when it was revealed as an outright fraud.

But I’m not quite as confident in my assessment of this as I’d like to be. I don’t have enough grasp of how these scandals play out in Japan (versus the UK, the US or most of Europe) to be comfortable with my assumptions. I would be much more comfortable if I were confident the stock would remain listed.

So for now, I’m keeping an eye on it. If the situation looks any clearer, especially with regard to delisting, I may be tempted to invest.

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