Nomura Update

Last November, I wondered if Nomura should abandon their global ambition and just focus on their domestic business.  I have thought that for a long time since they have run into problem after problem over the years in their overseas business.

The recent insider trading scandal forced the resignations of the CEO and COO and the new CEO is someone who comes up from the domestic sales business and the talk is that they will be scaling back their global operations.  I do think that's not a bad idea at all.   The CEO/COO that resigned were responsible for the Lehman acquisition too, which seems not to be turning out too well.

Anyway, here is an update of the tables I showed last year.

First, this is the GAAP data from their 20-F filings through the end of March 2012:




For the full year ended 2012, they managed an ROE of 0.6%.  Since the end of the crisis, they have not been able to post any earnings to speak of.  The average ROE since 2000 has been 3.01%.

Global Nightmare
OK, so here's the big problem.  Below is the pretax profits by region since the year 2000 through the end of March 2012.

Check it out:

So their non-Japan business lost money in 10 out of the last 13 years.  It is absolutely mindboggling.  I took a quick look at Goldman Sachs and they didn't lose money in Europe last year. 

OK, so last year was bad for Europe, and yes, 2008/2009 was the financial crisis. But even without those years, look at how often they lose money overseas.  During the bubble period of 2004-2007, they still lost money in their international business.  What the heck is going on?!   And the Asia region has been doing well too over the past 10, 15 years and Nomura has been active there, and yet there are no profits from that region either.

Look at the right-hand column labeled "Japan".  The Japan business has been profitable in 11 of the past 13 years despite the lost decades in Japan, ongoing bear market etc.  Conditions are horrible in Japan for the financial markets, and yet they have been profitable in just about every single year over that time period.

I haven't worked out the figures, but there is no doubt that Nomura would be a much more valuable business if they didn't bother trying to expand globally.  They would require much less capital so their returns on capital would have been higher, they would have avoided the hugely dilutive capital raise after the financial crisis etc.

Why Do They Fail Consistently Overseas?
I really haven't done research on this, but my impression is that one major problem is that Nomura tries to keep too much control of their overseas operations.  For example, the CEO of Nomura in the U.S. is an expat from Japan.  This has been the case for most of the time Nomura has operated in the U.S.  

This may be the same with Toyota and Honda, for example, but there is a major difference.  In the case of Toyota, when they come to the U.S., it is the Japanese headquarters that has the skill, knowhow etc. to run the business; the factories etc.  This is why it's totally fine to have Japanese employees come to the U.S. to run factories here; they are implementing the knowledge used in the Japanese factories which is their strength.

In financial services, for the most part, this is not the case.  The financial industry in Japan is way behind the financial industry in just about any other developed country.  You can't have someone without the skills and experience try to run an operation here and think it will work.  It won't.  The proof is in the above table.

Didn't Einstein say that insanity is doing the same thing over and over and expecting a different result?  Nomura is insane.  Really.

I may be wrong, but I think the European banks in the U.S. finally started to succeed only when they abandoned that and gave authority to the locals.  They stopped trying to co-CEO and even co-head every division with someone from Germany, for example.

So?
So anyway, I don't mean to pick on these Japanese companies.  Of course I would love to find a reason to buy these stocks as they are cheap (nominally).  As I said before, I have been wanting to be bullish on Japan for a long, long time.  That's why I still keep looking, and I will keep looking at these large names (more to chew on than smaller companies where I may not have much information and therefore not much to say even if they may be reasonable investments).

I think the best scenario for Nomura is to focus on their domestic business and eventually be bought out by a large international bank that might want exposure in Japan (more likely is that they merge with a Japanese bank to create a Japanese version of JPM).  This won't happen until Nomura cleans up their global operations (which may be very costly to unwind with severances, buying out contracts, unwinding legacy private equity positions and other investments etc.). 

Some things just seem so simple and yet seemingly rational people will just not act rationally.

Olympus, Nomura, Sony: What's Wrong with Japan

So we see every day why Japan has so much trouble getting out of it's long slump.  There was an article recently talking about how the lost decade in Japan is actually a myth, and that the reality is that Japan has done better than we all think since the bubble popped in 1990.  Yes, Japan has low unemployment, earnings are up and the economy avoided a depression, but that was done pretty much by government debt spending.

I wouldn't be too proud of that. 

Anyway, recent headlines further highlight the disfunction of corporate Japan.  We painfully realized how incompetent the government was in handling the earthquake and nuclear crisis last year and corporate Japan continues to shock us observers with truly bizarre developments.

Olympus sued current and former executives and directors for failing to deal with the fraud but strangely kept them on board.  Apparently, there is no support in Japan from shareholders to fire the board or replace the senior management.  How can this be?  It doesn't make any sense at all.  Woodford just gave up completely.  I don't know if he is the right guy or not, but the fact that there was no support for him in Japan and full support for current board and management is mind-boggling.

Nomura today also lost Jasjit Bhattal, the head of Nomura's global business apparently because Tokyo resisted Bhattal's call for deeper cuts in global operations (shutting unprofitable businesses, getting out of unprofitable countries etc...).  This is really bizarre too because I would think that more often, a head of a business would want to expand more than headquarters feels comfortable with and they leave.  Most bosses are empire-builders; they want to expand their empires, cost and risk be damned.  And Bhattal wanted to *shrink* and Tokyo said no, lol. Only in a Japanese company can this happen (?).

I have no idea if Bhattal is any good or not, but I get the sense that this is typical Japanese corporate mentality to resist change and resist firing people.  Also, Japanese are notoriously bad at cutting losses and admitting defeat (look at Olympus!).  They are also more concerned with market share and status than profitability (statements to the contrary notwithstanding).  You can be sure there are turf war issues too; intense lobbying by heads of unprofitable businesses to keep them going.

I don't know if this means that the Lehman purchase was a complete failure, but I bet that deep cuts would have been interpreted as such which probably scare the heck out of senior management in Tokyo.

Anyway, this is not a good development, I don't think. 

Nomura's legacy of failing internationally seems to be continuing and this might just be the latest iteration of it.

I still think for Nomura to realize value, they should focus on the domestic business and then eventually team up with a strong international bank.  Of course, this will never happen for the reasons I stated before.

Similar to this was the Sony comments that they will never exit the TV business because the engineers are very proud of their work.

I truly wish Japanese companies would really stop thinking this way and focus on profitability, returns on capital and things like that.  As Jack Welch says, firing people might be unpleasant and short term bad for the fired, but over the long haul it is good for everyone; the company (as they can cut cost and reduce the odds of bankruptcy which would be bad for everybody and reallocate resources to productive areas) , the fired employee (that can go out and find something that they can do productively instead of becoming corporate zombie employees like so many salarymen in Japan) and even the economy (as the newly unemployed find productive things to do including starting ventures.  Also more frequent firings would by necessity increase labor mobility).

Japan has a long, long way to go...   

*sigh*

Possible Downgrade of Nomura's Credit

Moody's announced that they may downgrade the long term credit rating of Nomura Holdings one notch to one notch above junk level.  This really could be lights out for Nomura (as an independent entity, at least).

I don't know if this means Nomura will end up bankrupt, but this is really bad news if the downgrade actually happens (a single downgrade won't bankrupt the company, but the jitteriness of markets will make it difficult).  As I said in my previous post (How Do You Solve a Problem Like Nomura),  one big issue with them is their big move into global markets and my concern was their history of losses and failure in previous attempts at globalization. 

Apparently, Moody's is very worried about this too.  On a balance sheet and capital ratio basis, Nomura seems pretty sturdy, with capital ratios close to 20%.  But I think the constant losses overseas and their big expansion, doubling down (or more) into an area that has been a source of big losses for them over the years is very scary.

Now, this credit downgrade wouldn't matter so much if Nomura was more a domestic business.  Japanese institutions are not so sensitive to the ratings of Moody's or S&P, nor are individual investor clients at their retail branches.

But since they are expanding rapidly globally in the wholesale markets, credit ratings are much, much more critical as clients are sophisticated institutional investors and they do tend to be highly sensitive to credit ratings.  This is even truer today after Lehman, Bear Stearns (and the problems of unwinding trades, getting prime brokerage account assets transferred) and of course the recent MF Global makes things much worse.

Here is a look at the long term credit ratings of the major global investment banks:

                                         Moody's               S&P           Fitch
Deutsche Bank                  Aa3                       A+             AA-
UBS                                  Aa3                       A+             A
Goldman Sachs                 A1                        A               A+
Morgan Stanley                A2                         A               A
J.P. Morgan                      Aa3                       A+             AA-
Merrill Lynch                   Baa1                     A                A+
Nomura                           Baa2                     BBB+

This is obviously problematic for many reasons.  Of course, the first issue is funding cost.  For investment banks, funding is everything.  If you don't have good funding in such a highly competitive, low margin business, you are not going to do too well.

Second of all, for derivatives, repos and other businesses that involve a counterparty, Nomura is not going to be an attractive counterparty.  Counterparties will demand more collateral or less favorable terms. 

Also, even clients that don't get into a counterparty situation with Nomura (such as repos or swaps and other derivatives) may not want to have too much assets in their accounts held there, whether it be in regular accounts, or especially in prime brokerage type accounts. 

This wouldn't have been as much of an issue a few years ago, but especially after the Lehman prime brokerage fiasco and the current MF Global mystery (of missing $600 million in customer funds), I think clients are much more sensitive to these things.


Nomura is going global to compete with the other global investment banks head-on.  But look at the above credit ratings.  Why would someone deal with Nomura when they can get Aa3 counterparties?  What can Nomura offer that the other banks can't that would make it attractive to deal with a lesser credit?  Investment banking is a highly competitive business where only the top players earn profits over time, and I would think this credit rating gap is a huge disadvantage in that situation.



In the end, things may turn out OK, but Nomura sure picked a tough time to go all out expanding globally.  The downgrade may not occur, but even if it doesn't, there doesn't seem to be much margin for error.  Any more surprises to the downside can really be the end of this company.

Having said that, bankruptcy probably won't happen; it will probably be merged with someone given how Japanese regulators have dealt with weak banks over the years. 

As I said in my other post, I really think the best solution is for Nomura to become the Japanese arm of a major global institution.  The domestic operation is a great business that could add a lot of value to a global major.

But of course, that will never happen.

How Do You Solve a Problem Like Nomura?

The title is meant to be sung in the melody of the Sound of Music song, "Maria".

Nomura just announced a loss for the first half of fiscal 2012 and a major restructuring.  I guess the Lehman purchase isn't really working out.  I have to say that this was actually not a bad idea, to buy a business from a failing company at the bottom of a cycle.

My only concern, however, is that these Japanese financial companies, for whatever reason, have failed so far in overseas ventures for the most part.  They have tried to build up the U.S. business numerous times over the years and it always seemed to end in tears.  In the early 1990s, they did really well in the commercial mortgages market until they blew up.  In the late 90s they again built up the U.S. business only to have it fall apart after the 1999/2000 peak again.

They have been rapidly expanding in the U.S. again since the crisis.  We have yet to see if this is going to work out over time.

Anyway, Nomura is an interesting situation for many reasons.  One of them is that it sort of illustrates what has been wrong with the Japanese equity market.  Below is the stock price and book value per share of Nomura (in Japanese yen) since 2000.

Nomura Stock Price and Book Value Per Share

You will notice that despite the bad economy over there and stock market, Nomura has been trading way above book value for most of that time.  

Here is the P/B ratio over this time period:

Nomura Stock Price-to-Book-Value-Per-Share Ratio 

In 2000, it was trading at over 4.5x book value.  Even after the internet bubble popped, Nomura traded at arouind 2x book until the financial crisis in 2008.

Of course, many U.S. financials traded at way over book value too in the 2000s until the financial crisis hit.  But at least they were earning some decent returns on capital, even though it turns out that in some cases those returns weren't 'real' (they gave it back and then some in the 2008/2009 collapse).

Let's look at the fundmantals of Nomura over this time period.

This is the data pulled from Nomura's 20-F filings (so are U.S. GAAP based) of the basic fundamental figures. 

In the past ten years, they have earned a return on equity (ROE) of only 3.2%.  Of course, this includes their 40% loss in 2009 due to all sorts of problems.  This is when many Japanese institutions were feeling good about not owning subprime mortgages.  Well, some of these (Nomura) still had to take huge writedowns on private equity holdings and other disasters.

If you exclude that as a fluke (better not to, but let's be generous for a moment), their ROE would still be only 7% or so.    From 2000 up until 2007, the ROE was 9.6%, which is reasonable for a Japanese company and I think close to management's goal of earning 10% ROE over time.

The average P/B ratio of Nomura from 2000-2010 was around 2x book.  The average p/e ratio is 24x and the average dividend yield is 1.6%.

Is this cheap?  Look at the above table and see the ROE, p/b ratio and p/e ratios since 2000 through 2010.  I think this is one reason why the Japanese stock market has been such a horrible performer.
Despite awful conditions, the stock market really never got cheap.  

This is a big contrast to the U.S., where companies like GS and JPM, as I stated before, are trading at or below tangible book value so soon after the crisis begun.  It has taken the stock market in Japan 20 years to take the stock price of Nomura to below book value.   Twenty years!

And it took a financial crisis that cut the book value per share of Nomura almost in half to take the p/b ratio down to book value, and another semi-crisis to take it down to where it is now at 50% of BPS.

Of course, the next question is if that is cheap.  If Nomura does succeed in realigning the business and starts to generate 10% ROE over time, Then Nomura is certainly worth book value or more. 

However, what is worrisome is that they are attempting to expand their business globally; something they haven't been able to do successfully in the past. 

Also the 9.6% ROE they earned in the period 2000-2007 seems decent, but with the giant loss they incurred in 2008 (year-ended March 2009), it seems the 9.6% ROE may have been achieved with excessive risk.  Of course, it can be excess risk or simply poor risk management.  It doesn't matter which one it is because either way the end result is the same for shareholders.

So it is a good question whether Nomura can achieve a 10% ROE going forward.

Why am I doubtful of Nomura success overseas?  The people in power tend to be highly educated and intelligent, but they operate in a country that is highly regulated with excessive protection for domestic companies.  This may be good for the domestic businesses, but this is bad for development of the industry itself.

This has worked well for manufacturers (where a protected domestic market allowed auto companies to reinvest and improve quality etc...), but this has not been good for the financial industry.

Nomura has been recommended on and off over the years by many people, but mostly as a play on a comeback in the Japanese stock market, the one market with the longest bear market and often gets categorized as the least popular major market.

If Japan does enter a bull market, Nomura will certainly benefit as they do have a very strong franchise domestically.  Their domestic business is very good, there is no doubt about that.

But recent moves by management makes this a global expansion play.  The stock price may hinge, over time, more on whether they succeed in this global expansion. 

The table below shows the large growth in number of employees and shows that most of this growth has come outside Japan (from the 2011 annual report):

Number of employees 2007 - 2011

The total number of employees has grown 60%, or 10,000 employees since 2007 (which was a peak in the global economy).   Of that, around two thousand were in Japan, so 80% of the employee headcount growth has come from overseas.  This is a huge bet.

The following shows the number of companies in the global research coverage which show that Nomura is serious about global expansion:

Maintaining research coverage is very expensive.  This growth in the fixed cost base must be accompanied by growth in revenues, or else large losses will result.  Operating leverage works both ways when you increase your fixed cost base, so it may increase earnings volatility too, especially when you are not the dominant player.  In the investment banking business, only the top tier players tend to make money.  We will see if Nomura can break into that.  What looks like a good move to diversify away from the domestic business can actually become a nightmare if revenues don't pick up.

But let's look at how Nomura has done internationally.  Thanks to the SEC required 20-F, regional revenues and pretax income must be reported.   Here are the historical figures going back to the year 2000.  They are the pretax income figures by region:

What this table shows is staggering.  I grabbed these numbers from the various 20F's from the last ten years; sometimes earnings are reallocated and changed depending on which 20F you looked at but I didn't 'fix' any of that as they were small and didn't change the conclusion or message of this table (for example, the 2008 income before tax for a region may differ on the 2008 20-F and then later on the 2010 20F (as they show figures for the past three years)).

Since 2000, Nomura has lost 854 billion yen in their non-Japan business.  Yes, the 2008 and 2009 financial crisis accounts for much of that.  But even before the crisis, you will notice that Nomura has lost money in almost every single year.

On the other hand, Nomura has made money in their domestic business in just about every year despite the long bear market, or at the very least non-bull market in the Japanese stock market.

Even the Asia business didn't do too well even though there was a big boom in Asia during most of this period.  How can say you are getting involved in Asia and not make money in a booming economy? 

There was a tremendous global boom between 2002-2007 or so, and yet their overseas business didn't make any money even in those "boom" years.  This is truly baffling.  How can this be?  Poor management?

I tend to think that Nomura stock would be much more valuable if they just simply dropped their global plans.  Obviously, they would have been better off in the past ten years, at least.

So what is the domestic business worth?  

Just for fun, since Nomura will not drop their global plan for various reasons (even though every few years, they do tend to de-emphasize it only to try to reenter at another later date.  Even in the best days of Nomura in the 80s, they failed to make any headway as a global investment bank), let's look at what the domestic operations is worth.

The domestic business earned an average of around 200 billion yen per year.  Using a 40% tax rate, you get 120 billion in net income.   With 3.7 billion shares outstanding, that comes to around 32 yen per share.  At 10x, Nomura's domestic business is worth 320 yen/share.

In a more normal market, it looks like Nomura's domestic business can earn 300-400 billion yen pretax.  Let's say 300 billion.  Doing the above exercise gets you to 486 yen per share, which is higher than the current 290 yen per share it is trading at now.  So all that needs to be done is for markets to stabilize, and for Nomura to just break even on their non-Japan business.

Of course, I have always thought the best option for Nomura is to sell itself to a global investment bank that wants to do business in Japan.  Since they have a great franchise domestically and seem to not be able to succeed internationally, it only makes sense for Nomura to become the Japan arm of a major global bank.

But Nomura management would probably never allow that as that would mean they would be reporting to someone else, and also the Japanese regulators would probably not allow that either as Nomura is Japan's largest independent investment bank.   So unfortunately, that would never happen.

Nomura is currently trading at half of BPS which is nominally cheap.  But I think there are many better opportunities out there in the financials; companies with better ROE histories etc...

On any bounce in the Japanese stock market, though, this is a major player so it will go up.  I just don't see it as that exciting due to the above, global expansion issues.