Wednesday, February 26, 2014

If we don't do it, our competitors will! Defensive Dealmaking or Panicky Preemption?

My last post on Facebook’s acquisition of Whatsapp brought a whole host of responses, some of which took issue with my argument that it is easier to explain the deal using pricing metrics, especially ones that are used in the social media sector (# users) than with valuation models or logic. One of the arguments made by some of the commenters was that I was missing the real reason for the deal, which was that it was a defensive maneuver by Facebook, designed to both protect its profitability and to keep a prime competitor (Google) from acquiring Whatsapp. Many of these commenters also emphasized that these defensive deals cannot be assessed using conventional valuation techniques and that we have to trust management to make the right judgments on them. I don't have a bone to pick with the logic of defensive deal making, but as a valuation person, I don't agree with the claim that defensive deals cannot be valued. If preemption is the primary rationale behind an action, I believe that it not only can be valued but it should be valued. 

A Valuation View of Preemptive Actions
If you adopt a stilted  view of valuation models (and DCF, in particular), it is possible that preemptive actions cannot be valued. However, I would argue that conventional discounted cash flow models provide more than enough flexibility to value preemption in all of its forms. To illustrate, let me set up a simple example. Let’s assume that Company A has $10 million in after-tax income (and cash flow) that it expects to generate in perpetuity on invested capital of $50 million and that it has a cost of capital of 10%. This company can be valued as a standalone entity at $100 million.
Value of company (stand alone) = $10/.10 = $100 million
Now, assume that this company is faced with Company B, a young company that has a product that has no revenues right now, but if allowed to develop or in the hands of a competitor, could eat into Company A’s market and lower its after-tax cash income to $ 6 million. Even though company B has little income potential on its own, company A should be willing to pay up to $40 million to acquire it.
Value of preemption = Lost after-tax CF/ Cost of capital = (10-6)/.10 = $40 million

I know that you are looking at this example and arguing that it is far too simplistic to be used to explain Facebook’s acquisition of Whatsapp. While estimating the cash flows may be more complex with Facebook, you are, in effect, making the same argument. In fact, working through my discounted cash flow valuation of Facebook, I can work out the impact of that a potential competitor will have on the company's revenue/margins and the value of those cash flows, and by extension, how much Facebook should be willing to pay to remove that competitor from the game.

The table, while looking at a wide range of outcomes, does provide some interesting insights into Facebook's vulnerabilities. First, the company's value is far more sensitive to margin erosion than it is to revenue loss, partly because the company has astounding high pre-tax operating margins (about 50%). Second, there are clearly combinations of revenue decline/margin drop that yield values greater than $19 billion. Note that this number will not be the total value of Whatsapp because it does not include the direct income and cash flows that you can generate from Whatsapp's business. You are welcome to try your hand on my spreadsheet that builds off the Facebook base case valuation to compute the effect on value of declining revenues and dropping margins.

Defensive Value Creation: Necessary & Sufficient Conditions
While it is easy to construct discounted cash flow valuations to justify acts of preemption, there are four conditions that have to be met for preemptive spending  to be justified.
  1. The business you are defending is worth defending: Acting in defense of a business makes sense only if that business is a good one, and the measure of a good business is whether it generates returns on invested capital that exceed the cost of funding that business. If you own or run a bad business, spending money to defend that business strikes me as a pointless and expensive exercise. Lest this sounds like a weak precondition, note that by my calculations in 2013, about 60% of all listed companies (40,000+) globally generated returns that were below their costs of capital, and more than a third of them under performed by substantial margins (>5%).

  2. The threat is real, not imaginary: Spending preemptively to ward off a threat makes sense only if the revenue loss/ margin decline that is anticipated is real and is not just in the fevered imagination of the top management. While you can argue that this is a business judgment that should be left to the top managers of a firm, a paranoid CEO, egged on by “strategic” consultants and aided and abetted by bankers, eager to get the deal done, will find a hundred potential threats for every real one.
  3. The preemptive action is the most efficient (and cheapest) way to ward off the threat: Even if the threat is to a valuable business and is imminent, there may be less expensive and simpler ways to deal with the the threat then the chosen action. Thus, if you can acquire a technology from a company or exclusive licensing rights for a billion, you should not be spending $10 billion to buy the whole company.
  4.  The threat is unique and not easily recreated: Spending money to eliminate a potential threat makes sense only if the threat is unique and not replicated easily/quickly. If the threat can be replicated easily, the spending company will find itself repeatedly spending larger and larger amounts of its depleting stock to make subsequent threats go away. These are companies with fragile business models with shallow ditches rather than competitive moats separating them from mediocrity.
The question on the Facebook/Whatsapp deal is whether these conditions are met. As I see it, the first condition is easily met since Facebook clearly has a very profitable (and high return) business to defend. On the second and third, Facebook investors are, in effect, trusting Mark Zuckerberg's judgment that Whatsapp is a platform that may threaten Facebook's profitability and that buying out the company for $19 billion is the cheapest way to avoid that threat. It can be argued that he has earned their trust with the company's performance over the last two years.  It is the fourth condition that should be most worrisome to Facebook investors. While Whatsapp may be a truly unique platform, the price tag on this deal is sure to entice young programmers, huddled around tables in Mumbai, Moscow and Menlo Park, to come up with new ways to breach Facebook defenses, knowing that they too will become wealthy beyond their wildest dreams, if they succeed. Looking at Facebook's short history, the price of preemption seems to be escalating at an exponential rate, going from $1 billion for Instagram more than a year ago to $ 3 billion for an attempted (and failed) acquisition of Snapchat to $19 billion for Whatsapp. (I know... I know.... There might have been other motives for the Instagram and Snapchat acquisition bids, but the price tag is climbing).

The Preemptive Strategic Stupidity (PSS) Syndrome
For every company that comes out ahead, in terms of value, with a preemptive strike, there are probably a dozen that end up worse off, often because they have bought into three adages that we accept as conventional wisdom. One is that companies have to do whatever they need to do to survive, as if survival is the be all and end all of business. The second is that doing nothing is not an option or that it is always the worst option. The third is that if you don't act, your competitors will and that their actions will hurt you more, even if those actions are not sensible. At the risk of getting some blowback from readers, here are my adaptations of these adages:
  1.  Survival is not the end game: As I have noted in my prior posts, there is no glory in growth for the sake of growth or business survival for the sake of survival. A business is a commercial enterprise and if you cannot generate sufficient returns, given the risk you face and the capital you have invested, you should shut the business down. 
  2. Doing nothing is not only an option but it may sometimes be a better one than doing something: We live in a world where activity is not only prized more than inactivity, but one in which there is far more money to be made by people from promoting activity (consultants, bankers) than from promoting inactivity. At the risk of sounding like stodgy, I believe that it is better sometimes to do nothing instead of doing something, especially if that something is ill advised or expensive.
  3. If your competitors are planning on doing something stupid, let them do it: If your competitors want to overpay for companies or take investments that generate substandard returns, your best option is often to let them do it. Especially with acquisitions, the winners of the deal making contest are not necessarily winning for their stockholders:
    This graph looks at winners and losers in multiple-bidder acquisitions and looks at the returns that investors would have made in the 40 months after the deal is done. The stock price, on average, declines by about 35% in the deal winners and increases by 25% in the deal losers in that period. 
Wrapping up
Companies often justify paying too much on acquisitions or making bad investments by using the preemption argument: if we don't do it, we will be hurt more than if we do. While that argument sometimes has economic merit, it deserves to be scrutinized just as much as any other investment decision. The tools for assessing the financial impact of these decisions not only exist but are straightforward. It is the will to make the assessment that is lacking at most businesses.

While I have framed this post in terms of the Facebook/Whatsapp deal, I continue to believe what I said in my first post. I don't think that Facebook's management is doing this deal for defensive reasons or because they have explicit plans for generating value, at least as of now. It is Whatsapp's large, growing and engaged user base that makes it so attractive to Facebook, especially given how much the market is pricing all of those factors. You may find it difficult to believe that someone as smart as Mark Zuckerberg would pay $19 billion without a clear vision of how he plans to make money off the deal, but I don't. 

Thursday, February 20, 2014

Facebook buys Whatsapp for $19 billion: Value and Pricing Perspectives

This week, I was at the Tuck School of Business at Dartmouth, talking about the difference between price and value. I built the presentation around two points that I have made in my posts before. The first is that there are two different processes at work in markets. There is the pricing process, where the price of an asset (stock, bond or real estate) is set by demand and supply, with all the factors (rational, irrational or just behavioral) that go with this process. The other is the value process where we attempt to attach a value to an asset based upon its fundamentals: cash flows, growth and risk. For shorthand, I will call those who play the pricing game “traders” and those who play the value game “investors”, with no moral judgments attached to either. The second is that while there is absolutely nothing wrong or shameful about being either an investor  (No, you are not a stodgy, boring, stuck-in-the-mud old fogey!!) or a trader (No, you are not a shallow, short term speculator!!), it can be dangerous to think that you can control or even explain how the other side works. When you are wearing your investor cape, you can be mystified by what traders do and react to, and if you are in your trader mode, you are just as likely to be bamboozled by the thought processes of investors. So, at the risk of ending up with a split personality, let me try looking at Facebook’s acquisition of Whatsapp for $19 billion, with $15 billion coming from Facebook stock and $4 billion from cash, using both perspectives.

The Investor/Value View
I will start wearing my value cap, mostly because I feel more comfortable in it and partly because I understand it better. Looking for fundamentals to justify the price paid but I realized very quickly that this would not only be futile but frustrating and here is why. To justify a $19 billion value for a company in equity markets today, you would need that company to generate about $1.5 billion in after-tax income in steady state. 
Value of equity = $19 billion
Implied required return on equity, given how stocks were priced on 1/1/14 = 8.00% (a 5% equity risk premium on top of a 3% risk free rate)
Steady state earnings necessary to justify value = $ 19 billion *.08 = $1.52 billion
Steady state pre-tax earnings needed to justify value, using an effective tax rate of 30%= $1.52 billion/(1-.30) = $2.17 billion
That would translate into pre-tax income of about $2.2 billion and it is a lowball estimate of break even earnings, since the break even number will increase, the longer you have to wait for steady state and the more risk there is in the business model. Using a 10% required return (reflecting the higher risk) and building in a waiting period of 5 years before the income gets delivered increases the break-even income to $4.371 billion. You can try the spreadsheet with your inputs, if you so desire, to see what your break-even earnings estimate will be.

There are three pathways to delivering these break-even earnings:
  1. If the company continues its current business model of allowing people to try the app for free in the first year and charge them a dollar a year after that (99 cents) and has zero operating costs (completely unrealistic, I know), you would need about 2.5 billion people using the app on a continuing basis.  
  2. It is possible that the app is so good that you could charge more per year and not lose customer. At their existing user base of 450 million, that would translate into about $5/year  per user, if you have no costs, and more, if you have costs (which you clearly will).
  3. The value may be in the form of advertising revenues from Whatsapp’s users but that will be tricky. On the home page for the app, here is what the app’s developers say about advertising:

While they may not be legally bound by this statement, it will be awkward to walk it back and start sending text ads. However, there is a back door that Facebook may be able to user, if they can draw Whatsapp’s users (who tend to be younger) into the Facebook ecosystem and advertise to them there. Whatever the model, though, you would still have to generate at least $2.2 billion in after-tax income from advertising to Whatsapp users to break even.

As an investor, the fact that a significant portion of Whatsapp's customer is teenagers is terrifying as a business proposition. While it is unfair to generalize based on anecdotal evidence, as the father of four children, two of whom used to be teenagers and two of whom are in the full throes of the disease (with symptoms ranging from extreme self-centeredness to volatile mood swings), it seems to me that the only group that is less dependable (and predictable) than teenagers is a group of teenagers who text a lot.

At this stage, if you are an investor, you have two choices. The first and less damaging one is to accept that social media investing is not your game and move on to other parts of the market, where you can find investments that you can justify with fundamentals. The second is to go from frustration (at being unable to explain the price) to righteous anger or indignation about bubbles, irrationality and short term traders to trading on that anger (selling short). I would strongly recommend that you not go down this path, since it will not only be damaging to your physical health (it is a sure fire way to ulcers and heart attacks) but it may be even more so for your financial health. While you may be right about the value in the long term, the pricing process rules in the near term. 

The Trader (Pricing) View
Wearing my trading hat, though, the Facebook acquisition for Whatsapp may not only make complete sense, but it may actually be viewed as a positive. To understand why, I had to change my mindset from thinking about fundamentals (earnings/cashflows, growth and risk) to focusing on what the market is basing its price on. To find that “pricing” variable, I looked at the market prices of social media company, multiple measures of their success/activity and tried to back out the drivers of both price differences and price movements.

These companies have different business models and may even be in different businesses but remember that the pricing game may not be about what you and I (as investors) think makes sense but what traders care about. Though the two (what makes sense and what markets focus on) may sometimes converge, they don’t have to, at least for the moment. My simplistic attempt at making sense of market prices was to look at the correlation between the market's assessment of corporate values and each of the measures for which I had data:

Based on this correlation matrix, here are the conclusions I would draw:
  1. Number of users is the dominant driver: The key variable in explaining differences in value across companies is the number of users. While the value side of you may be telling you that you cannot pay dividends or buy back stock with users (you need cash flows), remember that the pricing game is not about what you or I think makes sense but what traders care about. This is reinforced by market reactions to earnings announcements, with Zillow seeing its stock price climb 12% when it reported earnings on February 14, 2014, primarily on the news that they added more users than expected and Twitter seeing its stock price drop 25% last week, again primarily on news that the user base grew less than expected.
  2. User engagement matters: The value per user increases with user engagement. Put different, social media companies that have users who stay on their sites longer are worth more than companies where users don’t spend as much time. While making comparisons across companies is difficult, since each company often has its own "measure" of engagement, there is evidence that markets care about this statistic. For instance, another reason Twitter was punished after its last report was that investors believed that the "timeline views per average user" and the "revenues per 1000 timeline views" reported the company were lower than they had anticipated.
  3. Predictable revenues are priced higher than more diffuse revenues: Some of the companies on this list derive revenues entirely from advertising, some from a mix of advertising and subscriptions and some from just subscriptions. In fact, some like Zynga make their revenues from retailing (in game purchases). While the sample is too small to draw strong conclusions, the value per user of $577 attached to Netflix's users suggests that the market values predictable subscription revenues more than uncertain advertising or retail revenue.  
  4. Making money is a secondary concern (at least for the moment): Markets (and investors) are not completely off kilter. There is a correlation between how much a company generates in revenues and its value, and even one between how much money it makes (EBITDA, net income) and value. However, they are less related to value than the number of users.
So, what's next?
Following in the footsteps of my favorite baseball general manager, Billy Beane, its time to play some Moneyball, where we let the data drive our actions, rather than our intellects. Here is what I take out of these numbers:
  1.  If you are an investor, stop trying to explain price movements on social media companies, using traditional metrics – revenues, operating margins and risk. You will only drive yourself into a frenzy. More important, don’t assume that your rational analysis will determine where the price is going next and act on it and trade on that assumption. In other words, don’t sell short, expecting market vindication for your valuation skills. It won’t come in the short term, may not come in the long term and you may be bankrupt before you are right.
  2. If you are a trader, play the pricing game and stop deluding yourself into believing that this is about fundamentals. Rather than tell me stories about future earnings at Facebook/Twitter/Linkedin, make your buy/sell recommendation based on the number of users and their intensity, since that it what investors are pricing in right now.
  3. If you are a company and you want to play the pricing game, I think that the key is to find that "pricing variable" that matters and try to deliver the best results you can on that variable.
Returning to the Facebook/Whatsapp deal, it seems to me that Facebook is playing the pricing game, and that recognizing that this is a market that rewards you for having a greater number of more involved users, they have gone after a company (Whatsapp) that delivers on both dimensions. Here is a very simplistic way to see how the deal can play out. Facebook is currently being valued at $170 billion, at about $130/user, given their existing user base of 1.25 billion. If the Whatsapp acquisition increases that user base by 160 million (I know that Whatsapp has 450 million users, but since its revenue options are limited as a standalone app, the value proposition here is in incremental Facebook users), and the market continues to price each user at $130, you will generate an increase in market value of $20.8 billion, higher than the price paid. Are there lots of "ifs" in this deal? Sure, but it does simplify the explanation. 

Are there dangers in this deal? Of course! First, it is possible (and perhaps even probable) that the market is over estimating the value of users at social media companies across the board. However, Facebook has buffered the blowback from this problem by paying for the bulk of the deal with its own shares. Thus, if it turns out that a year or two from now that reality brings social media companies back down to earth, Facebook would have overpaid for Whatsapp but the shares it used on the overpayment were also over priced. Second, as social media companies move up the life cycle, the variable(s) that even traders user to price companies will change from number of users/user intensity to revenues, earnings and cash flows. When that happens, there will be a repricing of social media companies, with those that were most successful in turning users into revenues/earnings being priced higher. This, after all, is what happened in an earlier iteration with dot com companies that went from being priced based on website visitors (analogous to number of users) to being priced based on how long those visitors looked at your website (paralleling user intensity) to how much they generated in revenues before settling into earnings. The problem for companies (and investors) is that these transitions happen unpredictably and that markets can shift abruptly from focusing on one variable to another. For Facebook, the path to success with this deal is therefore simple, albeit not easy. Start by trying to attract Whatsapp users to the Facebook ecosystem, and hope and pray that the market's focus stays on the number of users for the near term. Follow up by trying to monetize these users, with advertising revenue being the obvious front end but perhaps other sources as well.

Closing Thoughts
My experience with markets has been that no one has a monopoly on virtue and good sense and that the hubris that leads to absolute conviction is an invitation for a market take-down. To investors who view deals like the Whatsapp acquisition as evidence of irrational exuberance, remember that there are traders who are laughing their way to the bank, with the profits that they have collected from their social media investments. Similarly, for traders who view fundamentals and valuation as games played by eggheads and academics,  recognize that mood and momentum may be the dominant factors driving social media companies right now, but markets are fickle and fundamentals will matter (sooner or later).

Tuesday, February 18, 2014

Comcast bids for Time Warner Cable: Synergy, Reverse Synergy or Ego Trip?

In December 2012, I did a series of posts on acquisitions that reflected my dyspeptic view of their impact on value. In perhaps a test of my cynicism about the M&A process, Comcast last week announced that it was making an offer to buy the equity in Time Warner Cable for $45.2 billion. As the two largest players in the market contemplated consolidating their cable operations, “synergy” reared its head again as a potential rationale for the premium being paid by Comcast for TWC's shares, just as consumer groups and anti-trust regulators warily eyed monopoly power. While the market's initial reaction to the announcement was not favorable to Comcast, it does provide a test case of how synergy affects value and what acquirers should pay for it.

The status quo: Comcast and TWC
The first step in assessing the merger is to go back and look at the state of play at the two companies, run independently, prior to the acquisition bid. Using the 2013 financial statements that are available for both firms, that is where I started the analysis.

Financial Mix & Cost of Capital
Both firms use debt widely to fund their capital needs, though Time Warner is a heavier user, in proportional terms:

To compute the cost of capital, I incorporated two additional inputs. The first was a beta(s) for the business(es) that these companies were in, which in conjunction with estimated values for each business, yielded business (asset) betas of 0.896 for Comcast (because it derives a significant portion of its revenues from broadcasting, through its ownership of NBC) and 0.71 for TWC.

The second were the bond ratings for the two firms: Moody's gave Comcast a bond rating of A3 (with a default spread of 1.30% associated with it) and TWC a bond rating of Baa2 (with a default spread of 2.25% over the risk free rate).

Operating Cash flows & Expected Growth
To estimate the cash flows generated by the two firms, I worked with the 2013 financial statements that were released recently by both companies. The values are summarized below:

Note that the numbers are adjusted for the capitalizing of leases. Both firms generated healthy cash flows in 2013.
 Rather than make the expected growth my estimate, I tied it to how much the companies were reinvesting and how well they were going so, captured in the reinvestment rate (the proportion of the after-tax operating income being put back in the business) and the return on invested capital in 2013:

Based on the 2013 numbers, Comcast is investing a healthy portion of its after-tax operating income back into the company (perhaps in NBC Universal) and can be expected to grow 5.10% a year. TWC seems to be just maintaining its capital base (with a reinvestment rate of only 5.88%) and its expected growth is minimal (0.61% a year).

To complete the valuation, I bring these inputs together, giving both companies a five year transition period period, before putting them in stable growth. The growth rate during the stable growth period is set to 2.75% and both firms are assumed to generate a 9% return on capital in perpetuity. The valuations of the two companies as stand alone companies is presented below:

Based on my estimates, it looks like Comcast was over valued by about 7.1% prior to this deal and Time Warner was undervalued by about 12.6%.

These stand alone valuations also provide us with a measure of what the combined firm's operating assets would be worth, if there were no synergy, since values are additive. 
Combined firm's operating asset value (no synergy) = $176,574 + $72,827 = $249,409 million
This is the base value that we can compare the value of the combined firm, with any foreseen synergy.

Synergy Potential
Is there potential for synergy in this merger? There is always in some potential in almost every merger, especially if you cast your net wide to include both financial and operating synergies. With

Financial synergy
With financial synergies, you are looking at the possibilities of recapitalizing the combined firm to generate a cost of capital that would be lower than the one you would arrive at by just aggregating the existing capital mixes of the two firms.. Looking at the combined firm, there seems to little potential for significant changes in value from altering financing mix. Both companies use healthy amounts of debt, with Time Warner perhaps a little over levered and Comcast a little under levered. At best, the combined firm may be able to generate marginal savings on its cost of debt and perhaps a slightly higher debt ratio than 30.3%, which is the combined firms aggregated statistic.

Operating synergy
With operating synergies, you can roam wider and look for the potential for added value by either operating income in the near term, increasing expected growth or both.
I. Operating income
  1. Increased revenues: On the cable part of the business, this would mean increasing cable or broadband bills at a rate higher than they would have, if they remained independent firms. While there has been some talk (from analysts) of this happening, the combined firm will be stymied by two factors. The first is that the regulatory authorities will be reviewing the effects on competition of this merger and it is very likely that increasing bills right after a merger will be viewed as a monopolistic act. The second is that while there is some talk about the absence of competition, it is worth noting that ___ of Americans under the age of 30 no longer have cable and are increasing getting their entertainment from Hulu, Netflix and other providers though they are still dependent on broadband. Increasing cable rates will only accelerate that flight. We will assume that there will be no near term increase in the combined firm's base revenues.
  2. Higher operating margins: For the combined firm to be able to increase margins, it has to be able to cut costs. To the degree that they have overlapping costs, that is certainly feasible but large portions of their businesses do not overlap and cost cuts are likely to be difficult. In addition, both firms are reporting healthy operating margins, in excess of industry averages, removing the easy cost cuts that may have existed, if one or both firms had bloated cost structures. We will assume that the combined firm's pre-tax operating margin will increase slightly from 21.50% to 21.75%.
  3. Lower effective tax rates: Both firms pay 32-33% of their income in taxes, much higher than the average effective tax rate across all US companies (closer to 28%). However, one reason that they pay these higher taxes (and may be unable to change easily) is that they generate the bulk of their income in the United States. We will assume that there is no potential for tax savings at the combined firm.
II. Expected Growth
The framework for estimating growth that we used for the standalone valuations was based upon how much the firms were reinvesting (the reinvestment rate) and the return that they generated on that invested capital. To the extent that the combined firm is able to reinvest more or reinvest better, it may be able to deliver synergy from growth.
  1. Reinvestment rate: The aggregated reinvestment rate for the combined firm is 41.45%, weighed down by the low reinvestment at Time Warner Cable. While we have no basis for the contention, it is possible that the low reinvestment at TWC may be driven by capital constraints and that Comcast may be able to reinvest more, though the nature of the cable business will restrict how much. We will assume that the reinvestment rate for the combined firm will be 45%, up from 41.45%.
  2. Return on capital: The aggregated return on capital for the combined firm is 9.68%. While there may be some marginal benefits from the merger, we will assume that the increased reinvestment will act as a counter weight. We will leave the return on capital unchanged at 9.68% for the combined firm.
Valuing Synergy
            With the marginal change in capital structure and a slight increase in pre-tax operating margins, we re-estimated the value for Comcast/TWC, relative to the status quo value:

The good news is that even small changes in operating margin or tweaks in the cost of capital translate into large changes in combined value. With the changes I assumed, the increase in value at the combined firm is $4.82 billion, an increase of 1.9% over the status quo (no synergy) combined value. The bad news is that even these small changes will take effort and time. The former will require commitment on the part of Comcast’s management (and accountability) and the latter will reduce the value of the synergy (by the time value factor). In the graph below, I summarize the value of synergy as a function of the improvement in operating margin and the number of years spent waiting for synergy to show up.

I am not a Comcast stockholder, but if I were, this analysis would leave me feeling a little more comfortable with the acquisition than I would have been a few days ago. The under valuation of Time Warner (at least based on my estimates) in conjunction with even small improvements in operating margins provide enough surplus to cover the premium. In fact, the under valuation of TWC prior to the merger (at least based on my estimates) provides some buffer for Comcast. In fact, the numbers can also be used to make a judgment on whether Comcast's stockholders are begin ill served by the proposed exchange ratio on this deal. 
Intrinsic value per share (Comcast) = $130,303/ 2606.5 = $49.99/share
Intrinsic value per share (TWC) = $47,585/ 277.9 = $171.23/share
Intrinsic exchange ratio = $171.23/ $49.99 = 3.43 Comcast shares/ TWC share
At the proposed exchange ratio of 2.875 Comcast shares/TWC share, the deal is tilted in favor of Comcast shareholders, at least based on my estimates.

The bottom line is that while this is a high-priced deal and there is plenty that can go wrong (from a regulatory and business standpoint) in the future, it does not strike me as a value destructive deal and may, in fact, create value for Comcast stockholders. As always, please do feel free to download the spreadsheet that I used to value the synergy, tweak it or modify it and come up with your own assessments that you can put into this shared Google spreadsheet.

The market’s view
When large acquisitions are announced, it is natural to focus attention on the target company and shareholders in that company are generally celebrants. This acquisition was no exception, as TWC’s market capitalization increased by $2,779 million on the announcement of the merger, an increase of 7.4% over the pre-merger value, but well below Comcast's offer of $45.2 billion. To me the more interesting side of the action is on the acquiring firm, since stockholders  in the firm get a chance to pass judgment on  whether they see themselves as winners or losers, from the deal. In this merger, Comcast’s market cap dropped by $4,509 million, a decline of 3.13% in value. In sum, if you combine the market capitalizations of the two companies, there was a decline in $1,730 million in value after the announcement. 

I don't know whether this reflects pessimism on whether the regulators will allow the merger to go through or synergy benefits, but it does seem like the reaction is not warranted by the facts.

Bottom line
I continue to believe that growing by acquiring publicly traded companies at a premium is a difficult game to win. However, I also believe that some acquisitions can create value, if you can target under valued firms and generate some synergy benefits in the process.
  1. Spreadsheet to value Comcast/TWC merger synergies
  2. My paper on valuing synergy
  3. Google shared spreadsheet on synergy value

Thursday, February 13, 2014

Stock-based Employee Compensation: Value and Pricing Effects

In my last post on Twitter, I argued that the firm's claim that it actually made money in the last quarter of 2013 was fiction. That may sound like an exaggeration, since the company is transparent about the adjustments that it made to get to its adjusted numbers and the practice it uses is widespread not just among companies, trying to better a better face on their operating results but also among analysts who track these companies. In particular, the biggest factor in the earnings transformation was the company's treatment of stock-based employee compensation, which was added back to arrive at the adjusted earnings.

From GAAP Earnings to Adjusted Earnings: The Twitter Adjustments
To get from their reported losses to profits and from reported EBITDA to Adjusted EBITDA, Twitter made the following adjustments:

Twitter's adjustments shifted a fairly substantial loss exceeding half a billion into both net profits ($9.774 million) and positive EBITDA ($44,745) in the fourth quarter.

The dominant add-back in both adjustments is the stock-based compensation of $521.2 million and while it may be sanctioned by accountants, I am struggling with the logic of why. Attempting to give Twitter, the benefit of the doubt, the rationale for adding back the expense to get to adjusted EBITDA is that it a non-cash expense (though I will take issue with that claim later in this post), but that cannot be the rationale for adding it back to get to net profit, since net profit is an accounting earnings number, not a cash flow. One possible explanation that can be offered (and it is a real stretch) is that Twitter views stock-based compensation as an extraordinary expense that will not recur in future years and that the adjusted net income should therefore be viewed as a measure of continuing income.  I will believe this explanation, if I see Twitter stop using stock-based compensation, but I don't see how they can afford to. They have a lot of employees, some of whom are highly paid, and they cannot afford to pay them cash. The other explanation is that the adjusted net income is being divided by the fully diluted number of shares outstanding, which includes the shares that are being offered as compensation. This "consistency" argument is used by many analysts, and while it may offer the fig leaf of matching , it is an extremely sloppy way of dealing with stock-based compensation.

Stock-based Employee Compensation: A long & tortured road
To understand where we are with stock-based compensation, let's start with a quick review of its history. While businesses with cash flow problems have always used equity based compensation to attract employees, there was a quantum leap in the use of stock-based compensation by publicly traded companies in the 1990s, driven partly by bad legislation (limiting executive compensation), partly by the entry of young, technology firms into the public market place and partly by bad accounting practices. 

In particular, accounting rules allowed companies to grant options to employees and show no cost, at the time of the grant, if the options were at the money. Not surprisingly, companies treated as options as free currency and gave away large slices of equity in themselves to employees (and, in particular, to the very top employees), while claiming to be spending no money. If and when the options were exercised later, companies would report a large expense (reflecting the difference between the stock price at the time of the exercise and the exercise price) and show that expense either as an extraordinary expense in the income statement or adjust the book value of equity for it. 

After a decade of fighting to preserve this illogical status quo, the accounting rule makers finally came to their senses in 2006 and changed the rules on accounting for option grants. Companies were required to value options, as options, at the time of the grant and expense them at the time (with the standard accounting practice of amortizing or smoothing out softening the blow). This is the law that is triggering the large stock-based employee option expenses at Twitter and other companies like it, that continue to compensate employees with equity. It is worth noting that the change in the accounting law has also resulted in many companies moving away from options to restricted stock (with restrictions on trading for a few years after the grant), since there is no earnings benefit associated with the use of options any more.

Stock-Based Compensation: Expense or not? Operating or Capital? Cash or non-cash?
Stock-based compensation is embedded in  many US corporations and it is increasingly finding a place in companies that are incorporated in other countries as well. Two decades after they became part of the landscape, there still seems to be a lot of confusion about their place in the financial statements and how exactly they should  be viewed.

1. Is it an expense?
This is an easy one. Of course! If you look at why and where companies use stock-based awards, it is more used early in a company's life cycle and it is used to compensate employees. As Warren Buffet is famously quoted as saying, "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?"

The timing of the expense is also clear. It is at the time of the grant, and arguments that use uncertainty about whether these options will be exercised in the future to justify not expensing them are specious. We are uncertain about almost everything that has to do with the future, but that does not stop us (or should not stop us) from making our best estimates at the time that we encounter them.

2. Is it a capital or operating expense?
This is trickier, since it really depends upon who gets the options and what function they play at the company in question. In the case of Twitter, for instance, the bulk of the options were granted to employees in the R&D department:

An argument can be made that R&D expense is a capital expense, not an operating one, and that it should treated as such. I concur with the sentiment (though I don't know the classification system that Twitter used to determine the breakdown of stock-based compensation). and I did capitalize R&D expenses in my Twitter valuation. However, that does not give you a license to just add back the expense, since capitalizing it will result in an asset that has to be depreciated; see this paper that I have on capitalizing R&D, if you are interested. Thus, if Twitter wanted to use this rationale, it should have added back just the R&D portion of the stock-based compensation and then subtracted out the depreciation on the synthetic asset it creates. 

3. Is it a non-cash expense?
Many equity research analysts seem to think so, but then again, their judgment on a number of fundamental valuation issues remains questionable. Let's be clear on what it is not. It is not an expense like depreciation, which is truly non-cash and should be added back to get to cash flow. It is closer in spirit to an in-kind compensation than a non-cash compensation. To explain my reasoning, let me use an analogy. Let's assume that you own and run a business that has an overall value of $100 million and generates $10 million in annual income. Let's assume that you hire me as your manager and that  my compensation is $1 million and that rather than pay me with cash, you give me 1% of the business as compensation (1% of $100 million is $ 1 million). While you may maintain the fiction that this is a non-cash expense and that your income is still $10 million, you are now entitled to only 99% of that income in perpetuity. In effect, your share of the business is worth less and it will get even smaller over time, if you continue to compensate me with equity.

I would argue that as common stockholders in any company that grants options or restricted stock to its employees, we are in exactly the same position. The stock-based compensation may not represent cash but it is so only because the company has used a barter system to evade the cash flow effect. Put differently, if the company had issued the options and restricted stock (that it was planning to give employees) to the market and then used the cash proceeds to pay employees, we would have treated it as a cash expense.

In closing, then, we have to hold equity compensation to a different standard than we do non-cash expenses like depreciation, and be less cavalier about adding them back. To those analysts who argue that using the diluted number of shares to compute per share numbers will take care of the problem, my response is that it will do so only by accident (as I hope to show at the end of this post).

Stock-based Compensation and Value
In discounted cash flow valuation, the safest way to deal with stock-based compensation is to recognize its two-layered impact on value per share:
a. Continuing Earnings/cash flow impact: If you are valuing a company that is expected to continue paying its employees with options and/or restricted stock, your forecasted earnings and cash flows for the company will be lower than for an otherwise similar company that does not follow the same practice. These lower cash flows will reduce the value of the business and equity today.
b. Deadweight effect of past compensation: If a company has used options in the past to compensate employees and these options are still live, they represent another claim on equity (besides that of the common stockholders) and the value of this claim has to be netted out of the value of equity to arrive at the value of common stock. The latter should then be divided by the actual number of shares outstanding to get to the value per share. (Restricted stock should have no deadweight costs and can just be included in the outstanding shares today).
While it may seem like you are double counting options, by first reducing earnings for their grants, and then again reducing the overall value of equity for outstanding options from the past, you are not. In fact, if a company stops using equity-based compensation after years of option grants, the first effect (on earnings/cash flows) will stop but the second effect will continue until all of the options either expire or are exercised.

If you look at my Twitter valuation in February 2014, you will see both effects in play. Since I don't follow Twitter's practice of adding back stock-based compensation, I forecast losses/negative cash flows for the company for the first few years before the scaling effects kick in: as revenues get larger, employee compensation will become a smaller percentage of those revenues (just like other fixed costs). The value that I get for the operating assets today incorporates these negative cash flows and is thus lower because of the generous stock-based compensation at Twitter. Once I get the value of the operating assets, I deal with the deadweight cost of past option grants by valuing the 42.71 million options outstanding at $2.182 billion, primarily because the options have an average exercise price of $1.84 (well below the current stock price) and subtracting this value from the overall value of equity of $13.6 billion, before dividing by the actual number of shares (including restricted shares) of 555.2 million. 

Stock-based Compensation & Pricing
If you are a fan of using multiples and comparables, you are probably congratulating yourself at this point for having avoided the complications that ensue from stock-based  compensation in intrinsic valuation. However, you would be celebrating too early. All multiples are affected by stock-based compensation, in small and big ways. Assume, for instance, that you are comparing PE ratios across technology firms that are big users of stock-based compensation. At the risk of stating the obvious, the PE is the market price divided by the earnings per share, but the per-share values can be impacted by how they are computed. Assume, for instance, that analysts are computing earnings per share  by adding the stock-based compensation to the stated earnings and then dividing by the fully diluted number of shares and that you are comparing three companies.  All three companies have 10 million shares outstanding, trading at $10/share currently and their GAAP net income is $10 million.  The first pays $ 5 million in cash compensation and uses no stock-based compensation, the second grants 2 million at-the money options with a value of $5 million to compensate employees and the third has set aside 0.5 million restricted shares with a value of $5 million to compensate employees.  The table below computes and compares their PE ratios, using the standard (dilution-based approaches):


Based on this comparison, company C would look cheapest and company A most expensive but only because of the way that we deal with stock-based compensation. In fact, the biases become worse as companies continue to grant options and the disparity between primary and diluted shares grows.

So, what should you do, if you have to use multiples? First, stop adding back stock-based compensation to net income. There is no logical or financial rationale for doing so. Second, stop playing around with the denominator. If there are shares outstanding, restricted or not, count them. If there are options outstanding, value them and add them to the numerator (the market capitalization) and don't adjust the shares outstanding for in-the-money, at-the-money or out-of-the-money options. 
Option-adjusted PE = (Market capitalization + Estimated value of options outstanding)/ GAAP Net Income
The same rationale applies if you are using EV/EBI/TDA or price to book ratios. 

Bottom line
Analysts, accountants and appraisers seem to still be struggling with how best to deal with stock-based compensation, whether in the form of options or restricted stock. I think the answers lie in going back to basics. There are no free lunches and if a company chooses to pay $5 million to an employee, that will affect the value of my equity, no matter what form that payment is in (cash, restricted stock, options or goods). There are reasons why one form may be better for some companies and another for different companies but these should not be cosmetic or based on adjustments (real or imaginary) that companies and analysts may make to earnings and per share values.