Monday, January 20, 2014

There Goes the Nest (Labs) Egg?

Last week Google (GOOG) announced the acquisition of privately owned Nest Labs (Nest) for $3.2B (see Acquisition). The interesting thing for me is not the size, but the eye-popping valuation. I understand Venture Capital (AKA VC or Adventure Capital) is different.  Nonetheless, a multiple of 10-20X sales (depending on which sales figure you use) for a 4 year startup makes me wonder just how different it can be and still make financial sense.

Valuation is based on the higher of cost, going concern (intrinsic or DCF) or third party (multiples) measures. The measure used depends on the life cycle of the firm and its industry. VC projects typically use a form of the third party approach (dependent on what buyers are willing to pay) given the rapidly growing nature of both the firm and its industry and lack of positive cash flow. In fact they frequently have negative cash flow (AKA burn rate) and are dependent on new rounds of financing to exist.
The VC valuation approach involves five steps:

1)   A multiple is selected e.g. sales.
2)   An estimate of the future market size in say 5 years is chosen.
3)   The firm’s future market share in 5 years is used to determine its sales.
4)   The multiple is applied to the sales estimate to determine the future value. Currently for hardware firms 2-4X is used. Software and social media firms receive a higher multiple in the 10-20X range. Yes, I recognize this very imprecise, but that is why VC firms require such high returns.
5)   The quasi future terminal value calculated in # 4 above is then discounted back to the present using a (high-very high) hurdle rate. This value can be used to determine the target’s M&A price or by investors to determine their required ownership percentage for an investment in the firm.

Nest makes “smart” thermostats allowing the remote control of your home temperature.  Additionally, they can be linked with other instruments. This last networking feature seems to be Nest’s value proposition. The 2012 financing round provided an implied value of $800mln based on the approach outlined above. An uncompleted YE 2013 financing round supposedly valued it at $2B.
Its sales are estimated at 50,000 units per month (600,000 p.a.) with an average price of $250 per units. Sales are expected to reach 1,000,000 units p.a. soon. The total market is estimated at around 90mln units. An issue is whether the sales and margins can be achieved once competitors are considered. Remember, you should evaluate companies not industries. As Buffett notes you cannot earn superior returns by investing in economy transforming sectors (e.g. the 1990s Dotcom delusion). Based on the financing rounds or the multiples of future sales for similar firms, Nest received a rich price. They got tomorrow’s price today.

Google with its $57B cash balance could clearly afford the price. The question, however, is should they have paid the price. Google’s growth has been slowing, while its cash pile has been growing. They have become the most acquisitive tech firm with over $17B of acquisitions in the past 2 years. This exceeds the combined value of all acquisitions by Apple, Microsoft, Yahoo, and Amazon over the same period. The common theme is data (AKA the internet of things) to justify the disjointed acquisitions which include the successful YouTube to the less successful Motorola.
This looks to me like another maturing tech firm, Google, trying to regaining its mo-jo thru over priced unfocused acquisitions justified as a long-term strategy. We have seen this movie before-Hewlett Packard. Maybe I am being too harsh, but maybe not. Let’s keep an eye on Google.


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