Nec Electronics Corporation

INTRODUCTION

In early July 2007, the New York based hedge fund Perry Capital proposed to raise its stake in NEC Electronics Corporation (NECE), the then publicly listed subsidiary of Japanese conglomerate, NEC Corporation, from 4.8 percent to 25 percent. The offering was ¥5,000 a share, at about 60 percent premium. Perry's investment in NECE traced back to late 2005, the year its first exposure to Asian markets, with the initial investment cost at around ¥3,200 a share. Perry believed the intrinsic value of NECE was to release after restructuring its business strategy, albeit NECE was expected a loss in FY2005. This paper studies the investment of Perry Capital in NECE, and particularly looks at Perry's consideration to increase its stake in NECE to 25% at that time.

INVESTMENT OPPORTUNITIES IN JAPAN

As shown in Exhibit 1, the long-lasting deflationary Japanese economy since 1997 probably comes to an end with its CPI rebounded from negative in 2006. At the same time, Bank of Japan has loosed its monetary policy by raising the interest rate above zero since 2006. These two data suggest that Japanese economy is pending an exit from the lost decade. Looking at the Nikkei 225 index shown in Exhibit 2, the bullish trend since 2003 shows the investors are optimistic towards companies' future 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. Moreover, Japan's export industries have been performing well due to its weak currency.

Perry's investment in NECE can be a sensible move as Japan is one of the leading countries in producing innovative technological products. In 2007, Japanese high-tech products secure a significant market share in the world. These industries include automobile, IT, communications, mechanism and robot, new materials, etc . In addition, Japanese firms allocate significant amount of resources in their product R&D area, the efforts paid in improving product quality and promoting innovation enhance Japanese firms' competitive strength overtime.

Essentially, Perry's investment philosophy is looking at the fundamental of the company, building good relationship with the management, investing in good company, and possibly keeping its portfolio beta at a considerably low level. As Perry's portfolio has been performing well since its inception, the venture into Japanese market is compliant with its investment strategy, where stocks in Japanese market produce reliable streams of cash flow, and more importantly, there are valuable cheap stocks to pick in Japanese market, these characteristics are aligned to Perry's taste.

CHALLENGES TO INVEST IN JAPAN

The first time venture suggests Perry is novel to the Japanese market. As the probability of success of Perry's investment in NECE highly depends on the assumption made to restructure NECE's business division, Perry must convince the parent 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 will become a separate entity from its parent company upon listing, it is questionable whether the parent company will longer treat the two different entities equivalently. For instance, will the parent company shift the loss-making divisions to its subsidiary, which then can help the parent company to get rid of loss at the expense of its subsidiary's financial report?

Furthermore, Japan's system of corporate governance is said lacks of effective protection to minority shareholders. Controlling shareholders in Japan are not required to prove that their dealings with the company are fair, and self-dealing is not formally defined by law. Furthermore, in Japanese model of stakeholder capitalism, management could be entrusted to safeguard the interest of a range of key shareholders, rather than focusing more narrowly on maximizing returns to shareholders, which might weaken minority shareholders' power in deciding an important issue.

FUNDAMENTAL VALUE OF NEC ELETRONICS CORPORATION

Perry team made a few assumptions 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 other years. Team Perry used an approach that employed EBITDA multiples for each segment: MCU, CCD and Communications. We use the information from exhibit 7 and exhibit 8 to infer the fundamental value from 2004 to 2007 and future. We then make inference on value of NECE based on 03/2006 and 03/2007 values. Note that information from exhibit 6 and 8 are from 2007.

Fundamental Value of NECE at 03/2007

Assumptions used in valuing MCU division:

MCU is able to match the average EBIT margins of comparable firms, which is 17.70%.

15% of the ¥83 billion depreciation cost is attributed to MCU for the next few years.

A conservative approach of 9 times EBITDA multiples is used.

Assumptions used in valuing CCD division:

EBIT margins of the remaining business are 5%.

45% of the ¥83 billion depreciation cost is attributed to MCU for the next few years.

7 times of the EBITDA multiples is used.

Assumptions used in valuing communications division:

EBIT margins could be negative.

To avoid loss, exiting this line is an attractive option.

Estimated cost of exit at most ¥100 billion.

The fundamental value of NECE on 03/2007 is the summation of each division's fundamental value:

At the fundamental of ¥5,800, it seems that Perry team bought NECE at a good bargain, with the purchasing price throughout 2006-2007 at between ¥3,000 - ¥3,500 per share.

Using the same methods and assumption, we calculated the values of NECE for other years.

2004 2005 2006 2007 2008E 2009E 2010E

Value of MCU 384.453 401.976 387.639 422.685 435.429 449.766 476.847

Value