Decline and Denial: Thoughts on Blackberry Endgame and Microsoft as Value Trap

The last few days have been filled with reminders for me of both the destructive and the redemptive powers of life. The weekend started with a family outing to a Yankee game. As a fan, it was wrenching to see Mariano Rivera and Andy Petite, two players who I have watched for almost two decades, pitch for the final time in Yankee stadium, but it was redeemed at least partially by a young Yankee pitcher, Ivan Nova, pitching a complete game on Saturday. Yesterday was my birthday, a joyous day marred only by the realization that putting as many candles on the cake as my age merited would likely set off fire alarms. Before I could feel sorry for myself, though, my eighteen-year old daughter, a freshman in college, called, exhilarated about getting a hundred on her first college exam. Towards the end of the day, the story that Blackberry had an offer to be taken private by Fairfax Financial for $4.7 billion crossed the newswires, an occasion for mourning not just by longtime Blackberry users but for anyone who appreciates life changing technologies, but that story was accompanied by one from Apple, announcing that the company had sold nine million iPhones over the weekend. 

A Life Cycle view of Business

A Chinese saying, that we are all born, grow old, get sick and the die (生, 老, 病, 死 ), which provides an unvarnished assessment of the cycle of human life, can be extended to businesses as well. Businesses too are born, grow with vigor, mature, decline and die; some, of course, die early and never see growth and some live longer, more productive lives. If the fundamentals of corporate finance can be boiled down to a investment choices of a business (the investment decision), how those choices are financed (the financing decision) and how and when cash is returned to the owners of businesses (the dividend decision), those decisions can be framed in terms of the business life cycle:

The business life cycle also shapes how we approach valuation, with the principles not changing, but the focus shifting at each stage of the cycle. When valuing young, growth companies, the drivers of value are almost invariably in the investment choices that the company makes and the effects of those choices on both growth and profitability. Thus, with Tesla and Facebook, it is the revenue growth and target operating margins that determine value and not how much debt they have in their capital structure or how much they pay in dividends. When valuing mature companies, the focus in valuation changes to valuing existing assets (and their earning power) and to the effects on value of better financing and dividend choices. Thus, for Apple, as much of the discussion of value is focused on whether the company will gain from its use of debt and buying back stock as it is on the future growth of the company. When valuing declining companies, the focus is on winding down portions of existing businesses, while repaying debt due and returning as much cash as possible, in a timely fashion, to stockholders. In my December 2011 post on Blackberry, I estimated a value of about $ 9 billion for the company, on the assumption that the best course for the firm was to narrow its focus to a niche product (I called it the Blackberry Boring, a phone for security-conscious corporates that would prevent games, apps or other distractions from getting in the way of employees checking their email) and liquidate itself over time (five years) in an orderly fashion. I followed up by looking at Blackberry (RIM) and Nokia as potential contrarian plays in June 2012, but luckily, I went with Nokia as my pick. That option play paid off partially because Nokia recovered from its lows but the big payoff came, ironically, when Microsoft bought them early this month.

Reactions to Decline: Anger, Denial and Acceptance

If aging is part of being human, it is just as human to fight aging and businesses seem to follow the same script. Rather than accept maturation and decline as inevitable parts of the business life cycle, businesses seem to go through their version of the stages of grief, starting with anger (at markets), denial (about being mature or in decline) and final acceptance. 

Stage 1: Anger

When growth companies transition to becoming mature companies, the market responds by lowering the multiples that they are willing to pay for earnings and some investors demand that the company behave like a mature company, borrowing more and returning more cash to its stockholders (in dividends and buybacks). In many of these companies, managers respond first by accusing markets (and by extension, their own investors) of being short term and ignorant of the facts. While that characterization may fit some (or even many) investors, it still remains true that markets are often more perceptive than managers are. 

Stage 2: Denial
Managers, angry at investors for treating their companies as mature or declining, make it their mission to prove the world wrong by going for more growth, and in the process, often do further damage to themselves and their investors. The impetus to fight maturation and decline is fed by four factors:

1. The emotional connection: In the midst of the Second World War, when it was clear that Britain could no longer hold on to its far flung colonies, Winston Churchill was quoted as saying that "I have not become the King's First Minister in order to preside over the liquidation of the British Empire." Many managers at iconic companies that have fallen into decline tend to go along with this sentiment, especially if (like Churchill) they were involved in building up the companies in the first place. That explains why a Michael Dell would leave a comfortable retirement in 2007 to return to his namesake company as CEO, in a futile attempt to turn the company around. 
2. Fountain of youth ecosystem: Just as there is a lucrative ecosystem that makes money of the desire to stay young (cosmetic surgery, magic supplements, hair transplants etc.), there is an even more lucrative ecosystem of bankers, consultants and turnaround experts who promise mature and declining companies that they will lead them back to everlasting growth. They play to management egos and offer them hope, while eating through billions of dollars of stockholder money, with little to show for it.
3. Analyst Growth Obsession: Many equity research analysts are obsessed with earnings growth, judging companies on how much they grow rather than on how much value that growth adds. Thus, a declining company that invests badly to grow at a low rate is viewed as better than a declining company that shrinks, while paying out large dividends. Not surprisingly, managers feel the need to feed this obsession for growth.
4. The PR problem: If your business is declining and your growth prospects don't look good, the right thing for you to do as a top management is to accept that reality, convey it to your employees and start shrinking the business. However, that is not painless and people will lose jobs, employees will see their paychecks shrink and customers will lose their favorite products. If you are in the public eye, you (as the CEO) will be labeled a Scrooge or worse. It is no wonder, therefore, that companies that are serious about facing up to decline prefer to do so as private businesses rather than as public companies.

While denial is understandable, it is also costly to investors. As I have noted in a prior post, growth can be value destructive, if it is expensive. In fact, to illustrate the effects of “value destroying” growth, I have taken a base case of a mature company, with no growth prospects and $100 million in after-tax earnings that pays out its entire earnings as cash flows. If you attach a cost of capital of 10% for this company, its value is $ 1 billion (=$100 million/.10). Now assume that the managers of this company decide to push for growth, though that growth requires them to invest immense amounts of capital (in acquisitions, R&D and new projects) with a return on capital of 5%. In the figure below, I have the value of the company at different growth rates. 

You can consider the difference between $1 billion and the estimated value of a company at any given growth rate to be the cost of denial to investors in the company. Thus, at a 5% expected growth rate, the value of the company is $792.47 million and the cost of denial by managers (and for stockholders) is $207.53 million. (You can play with the spreadsheet by clicking here).

This analysis should open investors eyes to a clear and an ever-present danger when investing in mature and declining companies that look cheap (on a value basis or even based on a PE or PBV ratio). Those companies are cheap, only if their managers don’t try too hard. In fact, the more activity there is on the part of management to "fix" the growth problem, the less cheap the companies become. To me, this is the key to understanding “value traps”, companies that look cheap on every metric but stay cheap forever. To offer you three examples, consider Cisco, Microsoft and Merck’s stock prices over the last decade:

These are companies that I have seen tagged as cheap companies repeatedly over the last ten years, but none of them would have delivered much in terms of returns. These three companies had management teams that have tried  hard to return them to growth status, spending billions of dollars in that venture: Merck in R&D, Cisco on acquisitions and Microsoft on “new” products. I know that I have the benefit of hindsight here, but I would wager that investors in these companies would have been better served, if they had lowered their sights on growth and focused on delivering the most earnings from existing investments and returning the cash back to stockholders. 

I decided to take a shot at valuing Microsoft by breaking it down into the value of assets in place (Microsoft Office and Windows, for the most part) and expected value of growth. In the fiscal year ended June 30, 2013, Microsoft reported $26,764 million in pre-tax operating income on revenues of $77,849 million; revenues increased by 5.60% over the previous year but operating income was down 4.26%. Using the company's effective tax rate of 19.2% for the year and attaching a cost of capital of 8% to the company (in the 60th percentile of US companies), you can value Microsoft assuming no growth in the future:

Value of assets in place (with no growth, no reinvestment) = $26,764 (1-.192)/ .08 = $270,316 million

Adding their cash balance of $ $77,022 million on June 30 to this value and subtracting out the debt outstanding of $15,600 million yields an estimated value of equity of $331,738 million, about $61,198 million higher than the market cap of $270,540 million. Put briefly, assuming no growth in earnings, Microsoft is worth about 22% more than its market capitalization. You can take give the spreadsheet a try, if you are so inclined. (I know that I may be overstating the value of assets in place by assuming that Office and Windows will generate earnings in perpetuity, but using a fifteen-year annuity yields a value close to the market price.)

It is no wonder then that Microsoft keeps looking cheap using all the standard metrics (PE, EV/EBITDA etc,) but there may be a core problem that we are ignoring. For most of the last twenty years, Microsoft has spent billions on new technologies and products and has little to show for it. While it is difficult to isolate the return on capital on just these new investments, it is quite clear that it has been less than the cost of capital. I think I am being generous to Microsoft in assuming that its'  new ventures have earned an average return on capital of 6%, but with that assumption, it is quite clear that if Microsoft continues to keep trying for growth, it will be value destructive, as shown in the figure below:

The intrinsic value of Microsoft drops with every increment in growth and at a growth rate of 7% for the next decade, the intrinsic value converges on the actual market price. This may explain the horrific reaction that the market had to Microsoft's announcement that it would acquire Nokia for $7.2 billion, and Microsoft's market capitalization dropped by more than $15 billion. It may not have been the acquisition per se that triggered the drop off but the signal that it sent to investors that Microsoft with its new CEO (from Nokia) would keep trying to grow. The best news, if you buy int this analysis and you are a Microsoft investor, would be an announcement by the firm that they are disbanding their R&D department, stopping all new product development and appointing Larry the Liquidator as their new CEO.

Stage 3: Acceptance

Ultimately, no matter how hard you fight aging, reality sets in. For individuals fighting middle age, the moment of awakening may be a torn muscle from trying to run a fast break on a basketball court, but for businesses, it may take a longer time. In some cases, it may require pressure from activist investors and in some, a new top management who has no emotional connection to the company's history. In some, though, it will be forced upon the business by external factors, difficulty making a debt payment or an inability to retain employees. 

What form will acceptance take? If the business is mature, it will start behaving like a mature firm, tilting its capital structure towards more debt and increasing cash returned to investors. For many followers of Apple, that capitulation seemed to happen in their March earnings report, where the company ratcheted down its forecasted growth, announced its first debt issue and increased its stock buybacks. 

If the business is in decline, it may be the acceptance that the future will not only be less rosy than the past but also a plan for gradual or partial liquidation. That, to me, seems to be the message in the proposed Blackberry deal. Fairfax Financial is the largest stockholder in Blackberry and its chief executive, Prem Watsa, has been labeled the “Canadian Buffett”. His plans seem to be to focus on Blackberry’s business services and to throw in the towel on the smartphone and tablet businesses. Will he succeed? I hope so but I think he has his work cut out for him. The company has done significant damage to its orderly liquidation prospects in the two years since my last valuation and it may be too late to turn this ship around.

It's really not too bad

On a personal note, I am older today than I was yesterday but given the alternative, I am okay with that. I really don't want to be eighteen, twenty three or twenty five again, not because those were not great years, but so was my most recent year. I could tell you that I know more today than I did three decades ago, but that is really not true, but I do know more about what I don't know today than I did three decades ago (if that makes any sense). Keeping with the theme of this post, I know that my Tesla/Facebook days are way in my past (I am not sure that I had them), that my Google days are in my rearview mirror, that I am probably in the Apple days of my existence (which is really not too bad) and that I will one day be in my Blackberry/Microsoft phase of life. I can only pray that when that phase arrives,  I will have the grace to do an orderly winding down of my activities and not keep reaching back in time for the glory of bygone days. In the meantime, I will get my revenge on time by using it as productively as I can.

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Twitter announces IPO: The Pricing Game begins

I have a Facebook account, but I almost never post. I also have a Linkedin account, but it is a not premium, largely because I am not that interested in finding out who is looking at my profile or endorsing me (often for skills I don't have). I do have a Twitter account and while I don’t post very often, I just like the ease with which it lets me bug thousands of people. All of this is of course a lead in to the story that I am sure will dominate the financial news for the next few weeks: Twitter is planning its initial public offering and everyone has an opinion on what it will be priced at.

While I will try to value Twitter when the time is right, I am going to use this post to price Twitter, not value it, for three reasons. First, Twitter’s financial statements are still inaccessible, a consequence of the JOBS Act (passed last year) that allows “emerging companies” (with revenues < $1 billion) to use a confidential process for filing with the SEC. Unlike some who are worked up about the resulting lack of transparency, I am not in high dudgeon about this non-disclosure. The company will have to provide a full prospectus a few weeks before the shares are priced (and offered) and there will be plenty of time for me to do my due diligence. Second, the lead investment bank (Goldman Sachs) will be pricing the company for the offering, not valuing it, and I want to use this post to take a look at that process. Third, if you choose to play this IPO game, to win, you have to be able to play the pricing game well, not get the value right. 

The tools/inputs of Pricing
To value a business, you start with raw data from a company’s financial statements, draw on measures of risk and operating efficiency for the business in which it operates, make estimates for the future and use a valuation model (with my preference being for a discounted cash flow (DCF) model). To price a company, you draw on a different set of inputs and tools, with the following standing out:

1. Current price: This may sound circular but the key input into the pricing process is the current price of the asset. After all, in pricing, you are accepting the market’s judgment of price as the only number that ultimately matters. With publicly traded companies, this dependence on the price takes the form of charts and technical indicators, which can then be mined for clues about future price movements.  Looking at a still private company like Twitter, this approach may seem like a non-starter, since it has no public market, but there have been transactions in the past that provide clues about its price. Some of these transactions involve venture capital investments, where you can extrapolate from the investment and the share of the company received by the venture capitalist to the overall price of the company is. Others involve private sales by one investor to another, where again the transaction price provides clues as to the the overall price. The following graph, drawn mostly from a Wall Street Journal news story on the company, imputes prices for Twitter based upon trades over the last few years on the company’s equity.

Note that the imputed price of equity in Twitter was $100 million in 2008 and that the price has surged over the last three years, rising from $ 1 billion in late 2009 to $ 9 billion early this year and $10.5 billion a week ago. Much of the surge occurred in the latter half of 2011, after Linkedin went public to a rapturous market response in May of that year.

Is it okay to extrapolate from isolated transactions to overall price? Yes and no. There is information in the transactions but the price estimate can be skewed by three factors. The first is that the transactions may not be at arms length, resulting in a price that has less to do with what the transactors think the business is worth to them and more to do with side objectives (control, taxes). The second is that even in an arms length transaction, the value that you impute may not be reflective of the fair price for a publicly traded company but may reflect instead the pricing of a private, illiquid business (which is lower). The third is unless the most recent transactions occurred very recently, the price you get is stale and will have to get updated to reflect both market and sector developments. With Twitter, none of these concerns rise to a serious level: the venture capital transactions are motivated by profit, the company has been priced as company that will go public for the last two or three years and there are at least two recent transactions from this year. The first reflects the sale of 15% of the company to Blackrock, with an imputed price of $9 billion for the company. That transaction was in January 2013 and both the market and social media companies have risen in price, since then; the S&P 500 is up 20%  since January and Facebook & Linkedin, the two social media companies that are viewed as closest to Twitter, have gone up even more over the same time period (Linkedin has doubled and Facebook has gone up about 67%). Applying even the market change (20%) to Twitter would yield a value of $10.8 billion, and applying the social media appreciation number would increase that value to $16-$18 billion.  In September 2013, just a few days ago, Twitter bought MoPub, a mobile advertising exchange, and issued stock to cover the transaction cost. Imputing the value of Twitter from the share issue leads to an imputed price for Twitter estimate of at least $10.5 billion. Thus, just based on these two private transactions, the price of Twitter should be at least $10.5 billion and perhaps a bit more.

2. Relative value: The other commonly used tool in pricing is relative value, where you set the price for an asset by looking at the prices at which comparable companies are traded at in the market. The process of applying this approach to price a company like Twitter can be complicated by two factors. 

a. Scaling variable: Since the units into which you divide value (number of shares) is by its nature arbitrary, you need to scale the price to a common variable. That, of course, is the role of a multiple, whether it be PE, Price to Book or EV/Sales. In the context of young, growth companies, where earnings and cash flows are often negative and book value is meaningless, analysts either focus on revenues, and/or scale the price to some measure of operating success (users, subscribers etc). With Twitter,  a revenue multiple can be utilized to estimate value, even if its financial statements report a net loss or EBITDA for the year. The table below provides the multiples estimated in September 2013 for Facebook and Linkedin in the first two rows, as well as a broader sample of firms that loosely derive their revenues from online services (though some like Netflix are subscription based and some like Pandora get a mix of advertising and subscription based revenue):

All the normal caveats apply. The accounting numbers reflect trailing 12 month estimates, but in companies like these, these numbers will change dramatically from period to periods, as will the number of users and employees. The number of users disguises wide differences among them, with heavy, mild and completely idle users aggregated together and sometimes double or triple counted. The value per users will be skewed by differences in business models, with companies like Netflix that have subscription based revenues registering much higher values.

Even with the very limited public numbers that you have for  Twitter, you can start estimating prices, using these multiples. For instance, if the news stories that peg Twitter's most recent twelve-month revenues at $583 million are right, you could apply the revenue multiple of 17.45, that its two closest competitors ($FB & $LNKD) trade at, to arrive at a value of $10.17 billion, fairly close to the most recent transaction price. (Twitter's cash balance would have to be added to this number to get to a market capitalization.) 

Twitter's estimated enterprise value = $583 * 17.45 = $10.17 billion

Before you get too excited about this convergence, recognize that applying the median EV/Sales ratio of 8.67 for the social media medley to Twitter's revenues yields a value of $5.05 billion, making the $10 billion plus numbers being bandied about look awfully high. 

Twitter's estimated enterprise value = $583 * 8.67 = $5.05 billion

Just to round out the estimates, you could always apply the multiple of $130.32/user that investors are paying collectively for Linkedin and Facebook to Twitter's 240 million users (I have seen wildly varying estimates of this number with some estimates ranging up to 500 million) yields a price of close to $25 billion.  

Twitter's estimated market capitalization = $130.32 * 240 = $24.4 billion
I have estimated a range of prices for Twitter based upon the different combinations (multiple, choice of comparable firms, averaging approach):

Which one of these is the right price? That depends on what your priors are about Twitter and perhaps what you are trying to convince me to do. If you believe that it is a great company that will also be a great investment, you will go with the combinations that yield the higher number. If you are convinced that this is the next bubble that will burst, you will use the lowest values to justify selling short or warning people away from the company. It is no wonder that equity salespeople latch on to this approach. All you have to do is find the right mix of multiple and comparable firms and you can back up any sales pitch (that the company is cheap, expensive or correctly priced) you want to make about any company. If you are on the other side of this sales pitch, it has be caveat emptor.

b. Current versus Forward Numbers: To the extent that your multiples are skewed or meaningless because current values for earnings, book value and capital expenditures are small and meaningless (in terms of forecasting future values), you can try to forecast the values for each of these items and apply a multiple (based usually on what other publicly traded companies are trading for today) to get the estimated value in the future. Getting from that future value to value today can be dicey, as I illustrated in my last post on Tesla, as risk, time value and dilution all eat into the terminal value. It is also worth noting that while this may be easy to do for a young growth company in a sector where most of the competitors are mature, it will be difficult to do with Twitter, where the lead competitors, Facebook and Linkedin, are also in high growth and will change over time.

The Drivers of Price
Just as the tools and drivers of pricing are different from those of value, the drivers of price vary from the drivers of value. Thus, while value is determined by cash flow, growth potential and risk, price is determined by a different set of variables:

1. Momentum/Mood: Much as intrinsic value investors tend to disdain momentum, it remains true that momentum is one of the most powerful forces driving returns with stocks. Studies indicate that over shorter time periods, momentum based investing often delivers much better results than fundamental based investing. For some stocks, especially those in "hot' sectors, momentum is the key driver of prices, drowning out news about the fundamentals.
2. Incremental news: Once you accept the pricing proposition that the market price is what it is, the key to winning at the pricing game becomes forecasting changes in price rather than assessing whether the current price is right. As a consequence, your focus on news stories will become incremental and each news story will be assessed in terms of how it will change the price, rather than how it will affect overall value. 
3. Liquidity: If you invest based on long term value, you can afford to put liquidity on the back burner for two reasons. First, the cost of illiquidity (higher transactions costs) can be spread over your long holding period, reducing its impact on your returns. Second, since you are not investing on momentum and not as dependent on timely trades for your profits, you can afford to wait to buy or sell, rather than have to do so in the middle of market chaos. If you are trying to make money on pricing, liquidity or the lack of it can not only make the difference between making and losing money, but in extreme cases, can lead to disaster (especially if you have a pricing strategy accompanied with high high leverage). 

The Dangers of Pricing
The pricing game can generate large profits in short periods but it comes with a warning label. It is not for the faint hearted, since it is accompanied by risk. The market can make mistakes in the aggregate:

1. Markets can be wrong in the aggregate: I know that active investors view those who believe that markets are efficient (I don’t…) as eggheads or worse. It is worth noting, though, that many of these same active investors are “pricers”, who pick stocks based upon multiples and comparable firms. In effect, they are assuming that markets are right in the aggregate, but make mistakes on individual companies, which would make them semi-believers in market efficiency. If markets are wrong in the aggregate, you can be right in your relative assessment (that a stock looks cheap relative to its competitors) and still lose large amounts (if they are all over priced).
2. Mood shifts (inflection points): To the extent that price is driven by momentum and mood, shifts in that mood can very quickly turn profits to losses. The key to winning at the game therefore becomes detecting inflection points (where positive momentum turns to negative momentum) and altering your investment strategy. This is the promise of charting and technical analysis, where price and volume patterns yield clues about future momentum shifts. Even the best indicators, though, often fail at this task. It is also worth noting that momentum is fragile and based partly on illusions. If bankers show contempt for the process and its players (as I think Facebook and its bankers did at the time of their IPO), the momentum may very well shift.
3. Taxes and transactions costs: As a general proposition, playing the pricing game requires you to have a shorter time horizon and to trade without regard to tax consequences. Thus, if you buy a momentum stock and profit over the ten months that you hold it but you detect a shift in momentum, you will sell the stock and take your profits, even though you face a much tax bill as a US investor (if you had held for a year, you could have qualified for capital gains). 
4. Implied assumptions: Many analysts and investors who use multiples justify that usage by arguing that intrinsic valuation require too many assumptions and that pricing/relative valuation does not. I would argue that any multiple has embedded in the same assumptions but that they are more implicit than explicit. Take Twitter, where the key assumptions are about how much revenues will have to grow and what the target operating margins will be on these revenues. In the table below, I have estimated the multiple of revenues that you would be willing to pay for any company, given how your expect revenues to change over the next ten years and the operating margin in year 10. For simplicity, I have left the risk (cost of capital) and quality of growth (reinvestment) unchanged. (My hypothetical company had a cost of capital of 12% to start, moving towards an 8% cost of capital in perpetuity and a return on capital in 12% after year 10.)

This table can be used in two ways. If you believe, for instance, that Twitter's revenues will increase ten-fold (from $538 million to $5.38 billion) over the next decade and that its target margin will approach 30%, you would be willing to pay 12.71 times Twitter's current revenues for the company (12.71*583 = $7,409 million). Conversely, if you are intend to pay 20 times current revenues (about $11.6 billion) for Twitter, you would need revenues to increase fifteen-fold over the next decade and margins to converge to about 32% in year 10. (I will update this table when Twitter's financial statements come out.)

A Cynical View of the Twitter IPO Pricing Game

If you decide to play the pricing game, you will have lots of company. In fact, I would argue that much of what passes for valuation in investing is pricing. In an IPO, in particular, how a company is priced for a public offering and what happens in the after market, at least in the months following the offering has more to do with pricing than value.

So, here is my take on what will happen. Goldman Sachs will start with the latest transaction value for Twitter, approximately $10.5 billion, and adjust it up for the improvement in both the overall market and in social media companies (especially Facebook) since the start of the year. They will then create a sales pitch for that value, using the pricing of other social media companies (Facebook and Linkedin, in particular) to argue that Twitter is a bargain at their estimated price. (My guess is that they will focus on the number of users and how Twitter looks like a bargain on that basis.) That sales pitch will be tried out on institutional investors for effect, with the salespersons’ ears especially attuned to either too much enthusiasm from these investors (a sign that the price was set too low) or to little (a signal that it is et too high). The institutional investors, not having a clue about the fair value of Twitter, will talk to each other and ratchet up or down their own enthusiasm based upon what they sense in their compatriots. The investment bank, having tweaked the price based on investor reactions will then do a discounted cash flow valuation, reverse engineered to deliver that price as the final value. (A good test of their valuation skills will be in how well they hide this reverse engineering to make it look like the valuation led to the pricing rather than the other way around). Finally, having learned from the Facebook fiasco that it is better to under price rather than over, they will knock off about 15% off their estimated price/value to set the offering price. At the risk of being hopelessly wrong in hindsight, I would be very surprised if I saw Twitter priced lower than $10 billion or higher than $15 billion, unless there is a major market disturbance. (As a point estimate, I would guess that it will be priced around $12 billion. In fact, let's start a shared Google spreadsheet of our price guesses. They are based on nothing more than rumor and minimal information, but why let that stop us?)

Am I being cynical? Perhaps, but I think we would all be better served if the process was stripped off its veneer of value. If we honestly faced up to the reality that this is an exercise in pricing and not valuation, the bankers can dispense with their quasi DCF models that they have no belief in, focus on pricing the stock and recognize that they will be judged on their pricing and deal making skills, not their valuation expertise. The issuing companies will recognize that their role in the process is to act as facilitators in the marketing, packaging the company like a shiny present and providing incremental news that pushes the price in the right direction. The investors who decide to play the IPO game or invest in the after market will not waste their time and resources estimating value, since their success or failure will come from how well they gauge momentum shifts and time their exits. I will value Twitter, when the financials are released and the time is right, but my advice to you is that you ignore my valuation, if you are playing the IPO game. The market for Twitter will little note nor long be concerned with my or anyone else’s assessment of value.

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Many a slip between the cup & the lip: From forward value to value per share today

Valuing young, growth companies is never easy to do but it is well worth doing, partly because it forces you think through the business that the firm is in and what it is doing (or needs to do) to succeed. I know that many of you disagreed with my assumptions on the Tesla valuation and this post is not meant to refight that battle. There is one aspect of the Tesla valuation that I would like to focus on, not so much because of what it says about Tesla but for the more general lessons about what drives the value per share at young companies.

In the Tesla valuation, I made the judgment that Tesla would have Audi-like revenues and Porsche-like margins to conclude that the equity was worth $8.15 billion today. That puzzled a lot of people, since Audi currently has a market cap of $33 billion and that market cap would be even higher if the company commanded Porsche-like margins. So, why is my value for Tesla's equity so low today?

If you revisit my valuation and check the value that I have attributed to Tesla in year 10 (the year that I see them having Audi-like revenues and Porsche-margins), you will see an estimated value of $68.27 billion. To get from that expected value for a business in the future, estimated either using a DCF model like I did or by applying a multiple on earnings as many venture capitalists becomes a value today, you have to take into account the following “drags” on value:

1. Time value of money: Every finance/investments class begins with the proposition that a dollar today is worth more than a dollar ten years from now and that principle should not be abandoned when doing valuation. Thus, even if I take the unrealistic view that Tesla’s value in year 10 is guaranteed, I would have to discount that value back at the US T.Bond rate of 2.75% (at the time the valuation, used as the risk free rate) to arrive at the value today:

Estimated value for Tesla in year 10 = $68.27 billion

Present value of $68.27 billion @ 2.75% = $52.05 billion

Drag on value from time value of money = $68.27 - $52.05 billion = $16.22 billion

2. Business Risk adjustment: An uncertain dollar in the future is worth even less than a certain dollar at the same point in time, which is the logic behind using a risk-adjusted discount rate. In the case of Tesla, I used a cost of capital of 10.03% for the first five years, reflecting its mixed exposure to the automobile and technology businesses, and scaled that cost of capital down to 8% in year 10. The net effect is that a dollar in expected cash flow in year 10 is worth only about 40.65 cents today. Think of this as the compensation that you are asking for as an investor for the uncertainties and disappointments that will come over the next decade.

Present value of $68.27 billion @ 2.75% = $52.05 billion
Present value of $68.27 billion @ risk adjusted cost of capital = $27.75 billion

Drag on value from risk adjustment = $52.05 billion - $27.75 billion = $24.30 billion

3. Dilution/Reinvestment adjustment: Increasing revenues over time will require reinvestment. In the case of Tesla, that is the purpose of the sales to capital ratio of 1.41, requiring the company to reinvest a dollar in capital (in R&D, infrastructure, plant & equipment and acquisitions) for every $1.41 in revenues every year for the next decade. This reinvestment creates negative cash flows (for much of the next decade), which in turn will have to be financed with either new debt issues or new equity issues. I am assuming that much of the financing in Tesla will come from new equity (by assuming a debt ratio of only 2.6% in my cost of capital computation), which will raise the share count in the company. This is of course the proverbial dilution bogey man, and in the valuation, this is captured by the present value of the cash flows over the next decade. 

PV of terminal value discounted @ risk adjusted cost of capital = $27.75 billion

PV of expected cash flows @ risk adjusted cost of capital for next 10 years = $14.94 billion

Value of business after adjusting for the dilution = $ 27.75 billion - $14.94 billion = $12.81 billion

Drag on value from dilution = $14.94 billion

4. Failure Risk adjustment: Even the most promising growth companies face challenges to survival and don't have the wherewithal to survive a large shock either at the company level (a lawsuit) or at the macro level (a banking crisis, a severe recession). While I think highly of Tesla, I do think that there is  a residual risk of 10% that the firm will not make it, and if it fails, the proceeds it will get for its technology will be only 50% of the estimated value (since your bargaining position is shot).

Value of business before adjusting for failure risk = $12.81 billion

Value of business after adjusting for failure risk = $ 12.17 billion

Drag on value from failure risk = $0.64 billion

5. Net Debt adjustment: The equity investors in a business have to take into account the debt outstanding in the business, since they are entitled to only the residual claim. This can be partially offset by the cash balance that the business has, which has not been counted in the value so far. In the case of Tesla, the debt and cash balances from the most recent annual report yield a net debt value of $0.37 billion. (That may be outdated already since Tesla's cash balance has climbed and it has repaid its loan from the Department of Energy. However, the effect of updating this number will neither make nor break this valuation).

Value of business after adjusting for failure risk = $12.17 billion

Value of equity after net debt adjustment = $11.80 billion

Drag on value from net debt = $0.37 billion

6. Option overhang: The equity in a company has to be shared by the common stockholders in the company with employees (and others) who have options that have been granted to them over time by that company. With Tesla, this is a significant factor affecting the value of common stock, since the company has 25.06 million options with an average strike price of $21.20 (well below the current stock price). The value of these options is approximately $3.65 billion.

Value of equity after net debt adjustment = $11.80 billion

Value of equity after option overhang adjustment = $8.15 billion

Drag on value from employee/management options = $3.65 billion

Bringing together all of these adjustments into one picture shows the cumulated effect of all of these drags on value, reducing the estimated value of $68.27 billion in year 10 for the business to the $8.15 billion in value for equity today.

I don't intend to rekindle debates about Tesla's value but almost all of the arguments that I have heard from those who believe that Tesla is worth more than I do can be crystallized into one of these adjustments:

1. Operating value in year 10 is too low: If you believe that Tesla is capable of generating much higher revenues than I have estimated, while maintaining high margins, you are, in effect, arguing that the terminal value of $68.27 billion (that I estimated) is too low and that you think that Tesla will have a higher value in year 10.
2. Business risk adjustment is too high: Some of you have argued that Tesla's business model may expose them to less risk. While I don't quite understand the full details of this argument, it is a an argument for a smaller risk adjustment than the $24.3 billion than I have made. Note that even giving Tesla the cost of capital of a low risk US company (8%) all the way through results in a risk adjustment of $20.4 billion. In the same vein, you may not feel that there is any chance of Tesla failing and eliminate that adjustment as well. You may, of course, take the view that Tesla is a riskless investment and eliminate this adjustment entirely.
3. Dilution/ Reinvestment: This may be the area where there is the most room for disagreement. My assumptions about reinvestment are animated by my view that Tesla is an automobile company and that scaling up will eventually require large investments in plant and equipment. The counter argument that I have heard from some is that Tesla can develop a model where it licenses technology or focuses on power train/battery sales rather than car sales. That may very require less reinvestment than I have assumed and create much smaller drag on value. 

You may not believe me but I really have no desire to talk you out of investing in Tesla and I certainly have no interest in pushing the stock price down.  If you do make the choice of investing in Tesla, though, I would like you to engage in this debate about value and think through the assumptions that you are making and whether you are comfortable with them. You don't have to convince me. All you have to do is convince yourself that you are making a good investment.

Steering the discussion away from Tesla, this decomposition does provide some general lessons or propositions about investing in and valuing young companies. 

1. Be wary of per share values: While equity research analysts and investors are fond of focusing on earnings per share and other per share metrics, you have to be cautious about any per share values with young, growth companies, where the share count is a moving target.
2. Forward values are misleading: Another favored technique used by analysts in valuing young, growth companies is to forecast out earnings in a future period and applying a multiple to these earnings to estimate a forward value. That forward value is often used to back out the return you will make if you invest in the company today, at its current value. This misses the dilution effect that is part of investing in a young, growth company and the potential for failure.

In the months to come, I will value other young, high growth companies (Linkedin, Amazon and Netflix are on my list of must-do valuations) and I will try to present this terminal value decomposition with each of them. 

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Love the company! Love the product! Love the stock? An Update on Apple

My first computer was a Mac 128K. I was a budget-constrained doctoral student from UCLA, teaching my very first class at UC Berkeley. At $2,500, in 1984 dollars, it consumed all of my discretionary income for that year, but it was love at first sight. Having sampled what the PC world had to offer, with its collection of geek speak and inscrutable illogic, I was dazzled by the human interface of the Mac and impressed with the creative spirits that ran the company (Steve Jobs & Steve Wozniak). Suffice to say, I was a Jobs fan, before it was fashionable to be one.

As I watched the evolution of the Mac through the decade, I learned some lessons that I have tried to hold on to in my investing and that came to mind last week, as I read some of the comments on my Tesla valuation.

1. Even great CEOs have their blind spots: The success that Steve Jobs had at Apple, in his second coming as CEO, had made us forget his missteps in his first iteration as Apple's head. His creativity and focus were still there in the 1980s but I think that his zeal to put his personal imprint on style and features overwhelmed any sense of what the market wanted or needed at the time. The Mac Lisa, in my view the most ungainly of Apple computers ever, stands as testimonial to that era and to Job's lack of market discipline.
2. The best technology does not always win: Much as I would like to believe that the best technology wins out in the market place, I learned to my consternation that this was not always the case. After all, not only did Microsoft win the operating system battle against Apple, with a vastly inferior system (in my biased view) but VHS beat out beta in the videotape stakes. Success in the market place requires a lot more than a good product: a recognition of what it is the market wants, good timing and good luck!
3. Good companies are not always good investments: When I an enamored about a company, I have to remind myself to separate my views of a company from my views of its stock as an investment. After all, the evidence from history is sobering. As I noted in this earlier post on value investing, the better regarded a company is by the market place, the worse it is as an investment. 
4. It is difficult to maintain distance when you love a company and its products: Much as I would like to be objective and unbiased, I am human. When I value a company, I start with preconceptions and views that find their way into my numbers, no matter how hard I try. As I noted in this very first post I had on Apple from early last year, all that I can do is be transparent about my biases and let you make your own judgments on whether you buy into my assumptions.

I have a long and complicated relationship with Apple, both as a user and as an investor. As a user, I have bought almost every version of the Mac (except for the Lisa) that has come out since 1984 and will probably add the new version of the Mac Pro to the list this fall. As an investor, I steered away from Apple as an investment through the much of the 1980s and 1990s, partly because I knew that my bias would blind me to the facts. In 1997, I succumbed and bought Apple stock (the split adjusted price was just over $5) just as the company faced its darkest days, as questions mounted about whether the company would make it in a world where Microsoft seemed to have won the PC wars. I would love to tell you that I bought the stock for intrinsic value reasons (because it would make me look good) but as I noted in a post from a little over a year ago, I did not. Instead, I bought the stock out of compassion and loyalty, the former driven by the feeling that the stock may not make it and the latter by the joy its products had delivered to me over time.  That “charitable” contribution turned into my best investment ever, a fact I remember whenever I have moments of hubris about my valuation skills. 

That investment stayed in my portfolio until April 2012, when the company’s stock price hit $600 and the market cap looked like it would climb inexorably towards a trillion, I revalued the company (as I am wont to do with every company in my portfolio, at regular intervals). While the value I obtained was close to $700, I decided that it was time for me to cash out, even though the company was undervalued (at least based on my assessment). I justified  that decision in my post on Apple at the time, arguing that the momentum investors who had come into Apple had made it a pricing play and that I was not skilled at that game. In late August 2012, as the hype for the iPhone 5 built up and the stock price hit $700, I posted a valuation of just the iPhone franchise and argued that it was the most valuable franchise in history. 

Early this year, as Apple’s stock price converged on $450, I revisited my Apple valuation to see if I could justify the sudden and dramatic loss of almost $200 billion in market capitalization from a value perspective. Even allowing for the tighter margins and the stronger competition (from Android phones) my assessment of value for Apple was about $600. Arguing that the price drop had driven some (but not all) of the price and momentum players of the game, I made the decision to become an Apple stockholder again. As I made that decision, I wondered how much of it was driven by my residual bias towards the company and its products.

In May 2013, after feeling some outside pressure from activist investors and their proposals for enhancing price (with David Einhorn’s well publicized push for the company to issue preferred stock, which I responded to in this post), the company announced its intentions to borrow money for the first time in its history and to augment its stock buybacks. I argued at the time that while these actions would have a relatively small impact on value, which I estimated to be $588 at the time, they might be the catalysts that caused the price to move towards the value.

I was clearly way too optimistic, since the stock continued its descent hitting a low of $385 in April. As the price dropped, I did hear from a lot of the readers of my blog post, asking me whether I was reconsidering my decision. The essence (and appeal) of value investing to me is that if you buy a company for its capacity to deliver cash flows to you as an investor, the fact that the market moves against you should change nothing. I would be lying if I said that I was unaffected by the price moving in the wrong direction, but Apple stayed in my portfolio. In the last few weeks, we have seen a piling on of big name investors (Carl Icahn, Leon Cooperman) into Apple and the stock price has risen back to close to $500. To those who have asked me how that has affected my value, I would argue that nothing that Mr. Icahn had said since he took his stake in the company is a revelation that changes my fundamental assessment of value.

Apple’s big announcement date is tomorrow, at 10 am. If you are investor (long or short, potential or current), here are my suggestions. 

1. Ignore the lead-up to the announcement, with the rumors, stories and opinion that you will see thrown around. Much of it is hot air with no effect on value. 
2. If you can avoid it (and it will be tough to do so), don’t watch or listen in on the Apple announcement and try not get caught up in the frenzied trading that will inevitably follow. 
3. I updated my valuation of Apple to reflect the financials as they stand today. Incorporating the information in the last annual report and markets (US treasury bond and equity) as they stand today, my estimate of value is $617, about 4% higher than my estimate in April 2013. A factor contributing to the increased value per share is the decline in the number of shares outstanding from 939.6 million to 908.4, a logical consequence of Apple's aggressive stock buyback program. 

Once you have the details of the announcement, go through the news stories with a singular focus on how they will impact Apple’s revenue growth path, operating margins and investment requirements for the future. The key is to not only separate the wheat (information) from the chaff (distractions) but also to work out the consequences for value.

As an Apple investor, I will be doing the exercise as well to see the implications for my Apple holding. While it is always dangerous to prejudge a news story, I don’t think that anything that comes out tomorrow will be game changer when it comes to value, though it may very well move the price (and I have absolutely no idea in which direction), especially if, as is rumored, it will revolve primarily around the iPhone and the iPad. As I noted in my last post on Apple, I believe that Apple’s value creation over the last decade has come from its capacity to disrupt existing businesses and that Apple is now too large a player in both the smartphone and tablet businesses to be a disruptor. In fact, I think that they face a bigger risk in both businesses of someone else disrupting their cash cows. It would be exciting and potentially value changing if Apple announced a new market that they were planning to enter that no one expected them to. In my last post on Tesla, I argued that one of the potential positive scenarios for a Tesla bull was a strategic buyer who would be able to pay a premium over $20 billion. While I named automobile companies as potential buyers, there is no reason why that buyer cannot be a technology company with a large cash balance. Apple clearly has the cash and if it can figure out a way to bring Elon Musk on board, it may have found a new market to disrupt. The Tesla iCar? Probably no chance of it happening, but I can still dream, can’t I?

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Tesla: A Follow up

My post on Tesla must have touched some nerves because I got more than my usual share of backlash from Tesla bulls. While some of it was just vitriol, many contained interesting counter arguments to mine. I thought it  would be useful to play devil’s advocate and present the case for being bullish on Tesla. I have to tell you that I was not able to convince myself but I may convince you.

Before I make the case for Tesla bulls, I would like to be clear on two points. First, I have no economic or emotional stake in the outcome of the valuation. I don't have a short position on the stock, and don’t plan to, and I have never owned Tesla and don’t regret missing out on the run-up either. Second, notwithstanding the hyperbole that has prefaced some of the press descriptions of my post, I don’t consider myself a valuation guru, expert or prognosticator.  If you are bullish on Tesla, I don’t view you as a sucker or a dunce and I can think of at least three justifications for your bullishness. 

A. Tesla has viable paths to higher value: In presenting my estimate of value for Tesla, I thought I was fairly explicit that it was “my” valuation and not “the” valuation of Tesla. One reason I posted my spreadsheet and left it open, for you the change, is because I understand that there are and always will be differences of opinion on the future of a company, especially one as explosive as Tesla. As I see it there are three possible paths to a value higher than the current price. 

1. The disruptor: It is possible that Tesla is one of those rare companies that disrupts an entire business and changes the definition of what comprises success. Just as Amazon upended the retail business and Apple the smart phone business in the last decade, it is possible that Tesla will create a new paradigm for a successful automobile company: a company that generates Ford-like revenues with Porsche-like margins. (My valuation for Tesla, the disruptor)
2. The power train/battery master: I may have misclassified Tesla as an automobile company and that it’s real innovations are in the power train and battery technology that will make electric cars viable. Ted Lim, one of the commenters on my Tesla post brings a great deal more knowledge than I do to this possibility and he points out the potential for Tesla to become the supplier  to other automakers making electric cars. The potential market for batteries and other original equipment may be smaller than for cars but the margins may be better. (My valuation for Tesla, the OEM company)
3. The "first mover": If Tesla is more technology than automobile company, there is the possibility that if it can establish itself as the leader in the business, there may be a tipping point, where size feeds itself. In practical terms, you are arguing that if Tesla charging and service stations are more extensive than the competitors, buyers of electric cars will be more likely to buy Teslas, thus making it the "electric car" company. (My valuation for Tesla, the network winner).

While I view these paths as narrow and difficult to sustain, I can see why others have a different point of view. There is one note of caution I would add about profitability. Some of you have pointed out that Tesla already has a 25% profit margin and that my assumption that it will generate a pre-tax margin of 12.5% is therefore way too pessimistic. There are two reasons to not get carried away with the current margin. The first is that margin that Tesla is reporting is a gross profit margin, which is significantly higher than an operating margin or a net margin; there is many a cost between the gross and the net. The second is that having a high gross margin, when you are selling relatively few cars at a high price is easier to do than maintaining that margin as you scale up. 

2. Tesla is a pricing game, not a value proposition: When stocks are up four fold or five fold, as Tesla has over the last year, they attract a different class of investors and what happens to the stock price may be more a reflection of what I call the pricing game, rather than underlying value. In two earlier posts, one after the Facebook IPO and one early this year on Apple, and argued that the pricing game is characterized by two features. The first is the ebb and flow of momentum will cause prices to move with investor mood shifts; remember how quickly the momentum game shifted against Apple in September 2012. The second is the supremacy of “incremental information”, where small pieces of news, that have little effect on long term value, have an outsized effect on price. Thus, the story that Elon Musk (who has been masterful at directing the price game to Tesla’s benefit) will be driving across the country in a Tesla S (to show that the car has the range to do so) will get news coverage and may affect the stock price. While I am a believer in long term investing based on value, I have a great deal of respect for the pricing game and recognize the dangers of getting in the way of momentum, at least in the near term. I also know that there are others who are far better than I at playing this game and don’t begrudge them their profits. Thus, if you have been playing this game with Tesla for the last year, you not only have the profits to show for it but also my respect. 

3. There may be a “strategic” buyer for Tesla: This may be cynical of me, but I think of strategic buyers as buyers who first decide that they absolutely have to buy a company and then come up with a price to make that a reality. Since the decision to buy is made before the price is set, it should come as no surprise that strategic buyers tend to pay too much. In the context of Tesla, it is obvious that every large automobile company wants to be the winner in the "electric car" race and will invest large amounts to succeed. While Toyota, Daimler and Ford may all be trying to do this internally, at the moment, history also tells us that patience is not a strong suit in most corporate boardrooms and that one of these companies will probably feel the urge to move faster and spend more. At a market cap of $20 billion, Tesla may seem to be too large a target but as I noted in a series of posts last year, good sense seems to go out of the window in the acquisition process, and more so with large acquisitions than small ones. If Tesla is acquired, you can rest assured that Mr. Musk will extract a significant premium over the market price, even if that price itself is substantially higher than value, and that the acquiring company (and its bankers) will come up with nice buzzwords (control, synergy) to explain it away. 

I hope this post does not come through as defensive. I stand behind my judgment of value for Tesla in the my last post, but all I would take out of that valuation is that I would not buy Tesla at today’s price. Given my fear of getting whipsawed in the momentum game, I would not sell short either. It was not meant to be investment advice.  I am a firm believer that investors have to take responsibility for their own choices and I will respect yours. Thus, if you are a long-term investor in Tesla, because you believe that there are viable pathways to a value higher than the price, I understand your motives. If you are a trader who is playing the pricing game with the stock, I can tell you that I wish I could play that game as well as you do, but I stink at it. So, I won't even try. In closing, though, if you are a Tesla bull and you feel threatened by a blog post from me, I think you may be a lot less secure in your bullishness than you think. 

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Valuation of the week 1: A Tesla Test

I taught the first session of my valuation class, that I previewed in my last post, today. As part of that class, I do what I call a “valuation of the week”, where I pick a company and value it and then post both my valuation (with the spreadsheet and the raw data that I used) and a shared Google spreadsheet for anyone who wants to take my valuation and make it their own (by changing the assumptions). I do this for two reasons. First, I believe that you learn valuation by valuing real companies in real time, not by talking about valuation or reading about it. Second, from a purely selfish standpoint, I pick the companies that I find interesting as potential investments or as real world case studies for my valuations of the week. I find the “crowd valuation” that emerges from this process to be useful in reassessing my own valuations.

As my first valuation of the week, I picked Tesla, for three reasons. First, as a technology company in an otherwise capital-intensive, mature business (the automobile manufacturing business), it stands out. Second, the company has a charismatic CEO, Elon Musk, an ambitious man (and I don’t mean that in a negative sense) with a great deal of imagination. Third,  the stock has taken off in the last year, up more than 500%, fueled by both positive news on the product front as well as on the financial front (increasing revenues, declining losses, paying down of debt). 

At its current stock price of $168.76/share, the market capitalization for the company is more than $20 billion. The question for investors, both in and out of the stock, is not whether the company was a good investment over the last year (of course, it was) but whether it is a good investment today. You can download the most recent annual and quarterly reports for the company.

Using the standard metrics, the company seems  over valued. With revenues of $1.33 billion and an operating loss of -$217 million over the last twelve months, it seems absurd to attach a value of more than $20 billion to the company. At close to 15.4 times revenues, Tesla is being valued more like a young technology company than an automobile company. However, these standard metrics are also often misleading with young companies, since value should be driven not by revenues and earnings today but by expectations for these values in the future.

Expected Revenues

For Tesla to be able to deliver value as a company, it is clear that it has to scale up revenues. On the good news front, the company has had a good year, with the revenues in the first six months of 2013 of $956 million representing a surge from revenues of $41 million in the first six months of 2012. While growth will get more difficult as the company continues to become larger, the question of how difficult cannot be answered until we define the potential market for the company. If we define it narrowly as electric/hybrid cars, the market is small (even though it is growing) and the potential revenues will have to reflect that. If we define it more broadly as the automobile market, the market is a huge one and Tesla’s potential revenue expands accordingly. 

Since the line between electric, hybrid and conventional automobiles is a fuzzy one, which will get fuzzier over time, I will take the view (optimistic, perhaps) that Tesla is an automobile company that happens to specialize in electric cars and measure its potential revenues by looking at the biggest automobile companies today. 

Based on revenues, the biggest companies are those that offer the full range (from luxury to mass market) of automobiles. It is true that BMW and Daimler make the top ten list, but they sell far more than just luxury cars. In valuing Tesla, I am going to assume (and I am sure that some of you will disagree) that success will bring them revenues close to those delivered by a company like Audi ($64 billion). While it is conceivable that Tesla’s revenues could approach those of the auto giants ($100 billion plus), I think the revenue growth required to get to those levels would be incompatible with the high operating margins that I will be assuming for Tesla. Assuming that Tesla stays making just electric cars, this forecast is an optimistic one, insofar as it assumes a rapid expansion in the electric car portion of the automobile market.

Profitability

The second piece of the puzzle in Tesla becoming a valuable company is that it has to become profitable. Based on the reported loss of $216.72 million over the last twelve months, the pre-tax operating margin for the company is -16.31%. It is true that this paints too dire a picture of the company because the company did spend $306 million in R&D over the same twelve month period. Assuming a three-year lag, on average, between R&D expenditures and commercial payoff, and capitalizing R&D does reduce the operating loss to about -$21.86 million (resulting in an after-tax operating margin of -1.64%).

To get a sense of what the Tesla's operating margin will be, assuming it makes it as a successful company, I estimated the pre-tax operating margins of all publicly traded automobile companies globally, dividing the operating income from the most recent 12 months by the revenues over that period for each company. Since automobile companies have volatile earnings, I also computed a normalized pre-ta operating margin for each company by looking at the aggregate operating income over the last decade, as a percentage of aggregate revenues over that period. The distribution of the both measures of operating margin (the 2013 value and the average from 2003-2012) is shown below:

Note that the sector has low pre-tax operating margins, with the median value of less than 5%. Companies at the 75% percentile generate margins of between 7.5% and 8.5% and there are a few companies that generate double digit margins.  One of the outliers is Porsche which reported a pre-tax operating margin of close to 16% in 2013, though its ten-year aggregate margin is closer to 10%. You can download the dataset that includes the key numbers for all auto companies by clicking here.

For Tesla, we will assume that its focus will continue to be on high-end automobiles and that is margins will converge towards the higher end of the spectrum. In fact, I am assuming that the technological and innovative component that sets Tesla apart will allow it to deliver a pre-tax operating margin of 12.50% in steady state, putting it in the 95th percentile of auto companies (and closer to the margin for technology companies). I will assume that the margin improvements occur over time, with the biggest  improvements happening in the near years. The figure below captures the forecasted operating income and margin, by year, in my valuation of Tesla:

Based on my estimates, Tesla will generate more than $8 billion in operating income by year 10, making it more profitable than all but three other automobile companies today (Toyota, Volkswagen and BMW). 

Investment Requirements

Growing revenues roughly sixty fold and improving operating margins to match the most profitable companies in the sector will require reinvestment. Some of it will take the form of additional R&D, as Tesla tries to keep its competitors at bay, and some of it will have to be in more conventional assembly lines and factories, as production gets ramped up. Over time, I believe that the latter component will come to dominate the former.

In my forecasts, I have assumed that Tesla will have to invest about a dollar in capital (in either R&D or plant/equipment) for every additional $1.41 in revenues. That matches the industry average of the sales to capital ratio of 1.41 for US companies. Since the sales to capital ratio for technology companies is higher (2.66), it is possible that I am over estimating Tesla's reinvestment in the early years. However, the return on invested capital that I obtain for Tesla in steady state (in year 10), based on my estimates of operating income and invested capital, is 11.27%, putting it again at the top decile of automobile companies.

Risk

Tesla is undoubtedly a risky investment and there are three components of risk that I attempted to incorporate in the valuation:

a. Business/ Operating risk: Tesla is exposed to substantial business risk, some coming from macro economic sources (the strength of the economy, inflation, interest rates), some resulting from technological shifts (the winning technology in the electric/hybrid auto business is still to be determined) and still more emanating from the sector (with every major automobile company staking out its claim on this segment of the business). To capture the risk, I assumed that Tesla, as it stands now, exposes investors to a mix of automobile business risk and technology business risk. While I assumed a 60% auto/40% technology mix in arriving at a cost of capital of 10.03%, the value per share that I obtain is not very sensitive to this assumption:

Treating Tesla as a purely automobile company increases its value to about $74.73, whereas treating it as a technology company lowers the value per share to $60.84.

b. Geographic risk: While it is likely that as Tesla grows, it will have to look to emerging and more risky markets, I will assume that its risk exposure for the next decade will come primarily from mature markets, allowing me to use my current estimate of the equity risk premium for the US of 5.8% for the cost of equity/capital computations. 

c. Truncation risk: Tesla, in spite of its lofty market capitalization and recent successes, is still a young, money-losing company. A large shock to its business (from a legal setback, a recession or a sector-wide slowdown) could put the company's survival at risk. While that risk has declined substantially over the last two or three years, I think that it still exists and will attach a probability of 10% to its occurrence. If the company does fail, I will also assume that it will lose a significant portion of its value in a distress sale (receiving only 50% of estimated value).

Loose Ends
As with any young company, there are loose ends to tie up that affect value. In particular, I would point to the following:

a. Subsidized debt: Tesla was the beneficiary of subsidized loans from the DOE, amounting to roughly $465 million. While this loan loomed large two years ago, when Tesla was a smaller company with more default risk, it has faded in importance partly because of Tesla's success (and the resulting access to capital markets). Since Tesla has paid down the loan, it no longer has any effect on value.

b. Net Operating Loss carry forward: At the end of 2012, Tesla had a net operating loss of just over a billion that it is carrying forward. I used the NOL to shelter income from taxes in the early forecast years, pushing up cash flows in those years. As a consequence, Tesla's income is sheltered from taxes for the first six years of forecasts.

c. Management/Employee Options: Of larger import are the management/employee options that Tesla has been generous in granting in the last few years. As of the most recent 10K, the company had approximately 25 million options outstanding, with an average strike price of $21.20 and 7 years left to expiration. Since there only 121.45 million shares outstanding, the value of these deep in-the-money, long term options represents a significant drag on value.

The Bottom line

The ingredients that make a young, money-losing company into a valuable, mature company are no secret: small revenues have to become big revenues, operating losses have to turn to profits, there has to be enough reinvestment (but not too much) to make these changes and the risk has to subside. I am assuming all of these at Tesla but my estimated value per share of $67.12 is well below the market price of $168.76. You can download my valuation spreadsheet by clicking here.

Is the value sensitive to my assumptions? Of course, and especially because Tesla is a young company in transition. In fact, replacing my point estimates for the input variables (revenue growth, target operating margin, sales/capital, cost of capital) with distributions yields a distribution of value for Tesla that reflects my uncertainty about the future:

Note that there are scenarios where the value per share exceeds the current market price ($168.76), but I would add two cautionary notes. First, at least based on my estimates, the probability that the value exceeds the price is small (less than 10%) Second, the combination of outcomes (high revenue growth, high margins and low risk)  that would yield these high values are difficult to pull off. 

You can accuse me of being too pessimistic in my assumptions, but the narrative that underlies my valuation is an optimistic one. I am assuming that Tesla will grow to be as large as Audi, while delivering operating margins closer to Porsche's. Even with these assumptions, I cannot see a rationale for buying the company at today's market price but that is just my personal judgment. You are welcome to disagree. In fact, if you download my valuation and change the key assumptions, please take a minute to report your estimate of value per share in this Google shared spreadsheet. Let's see how the crowd valuation plays out!

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