First Mover Advantages and Disadvantages

In Joe's last post The Price is Right he questioned the pricing of Uber, noting:

"Uber’s price is being justified on a winner- take- all, first mover, basis. I wonder, however, about the economic validity of this agreement. The industry entry barriers seem porous, switching costs for both users and drivers are low and international competition exists. "

Indeed, in a paper two colleagues and I published in the Review of Financial Studies, we do  find that the first acquiring firm in an industry after a long dormant period without acquisition activity earns abnormally positive returns.  We are quite skeptical of the first mover - or low hanging fruit argument, however, noting:

"Cottrell and Sick (2001), and Schnaars (1994) examine first-mover advantages and disadvantages, noting numerous cases in which the imitator ultimately gains the advantage over the first mover. Examples from the software industry include the success of the VHS tape format over Betamax, IBM following Apple, and Excel following VisiCalc. Cottrell and Sick (2001) also note the phenomena in the motorcycle industry with Yamaha, Kawasaki, and Suzuki successfully following Harley Davidson, and the Indian and European models."

The question is whether Uber can maintain a sustainable comparative advantage.  It's an open question, but my instincts align with Joes.  

All the best,

Ralph


References

Cottrell, T., and G. Sick. 2001. First-Mover (Dis)advantage and Real Options. Journal of Applied Corporate Finance 14: 41-51.
Schnaars, S. 1994. Managing Imitation Strategies: How Later Entrants Seize Markets From Pioneers. The Free Press, New York.

The Price is Right or Is It?

The latest financing round values Uber at more than $40B. Uber’s transaction volume is around $2B of which their take is 20% or $500MM. Yes its revenues are doubling each year over its short existence. Still this seems richly priced. How long and fast can they grow, and when do they start earning a return? Keep in mind Uber’s value exceeds that of Aetna, CBS and KKR among others. Uber’s price is being justified on a winner- take- all, first mover, basis. I wonder, however, about the economic validity of this agreement. The industry entry barriers seem porous, switching costs for both users and drivers are low and international competition exists. Furthermore, as the Wall Street Journal notes, some smaller tech firm valuations have recently fallen prior to their planned IPOs. So, is Uber immune to such a reversal?

Some VC observers like Play Bigger Advisors have tried to explain away a possible bubble by inventing a new metric- Time to Market Cap (TTMC). They believe special firms like Uber represent mythical Unicorns endowed with unique market characteristic justifying what at first glance appear to be nose-bleed valuations. Past Unicorns included Apple, Microsoft and Google who capture a disproportionate share of their market categories. They cite the TTMC of $1B for Unicorns has fallen from 8.5 years in 2000/2003 to now just under 3 years. VC are focusing on a few winner Unicorns with big investments and driving up their values. Conversely, they are pulling back from losers referred to in the Wall Street Journal article just as quickly. Therefore, they conclude there is no bubble.

This sounds like another version of the “This Time Is Different” justification. How do you operationalize the invest in winners (Unicorn) strategy? Is it like buy low and sell high? Can TTMC slow down and mean revert? The problem with these types of relative value approaches is they lack an intrinsic value anchor. They can quickly degenerate into a herding or momentum investment strategy. Over optimistic investors ignoring the base case who have excess liquidity and are eager to invest will keep pushing prices higher until there is no one left who believes and the process corrects. The price is right, but which one-the price going up or the price coming down? Finding mythical Unicorns may be more difficult than thought. Even if you do, at what price does investing in Unicorns cease making sense?

j

Choose Wisely

I am fascinated with the technology industry-not because of the technology itself, but the pace of industry change. Company life cycles are measured in years compared to decades in other industries. The half life of T (The competitive advantage period) is frequently less than 5 years. This allows us to observe and study how firms are handling maturity. The basic choice is to grow old gracefully by curtailing investments and returning excess cash to shareholders, or try to spend your way back growth.

This was best put by Google’s Larry Page FT who stated his firm, although still growing, risks irrelevancy if it is unable to keep pace with market developments. He hinted at setting up a holding company structure to make diversifying bets (acquisitions) like Warren Buffett’s Berkshire Hathaway. Firms like IBM and Microsoft have chosen to age gracefully and return cash to shareholders who are then free to find the next tech generation of winners. Others, such as Facebook, are seeking transformational M&A to retain their growth status. The problem firms like Google and Facebook who chose to fight aging is they risk an arms race with other cash rich tech competitors battling for supremacy in an evolving digital environment. This leads to ill advised over priced transactions like Hewlett Packard experienced in its 14 year computer adventure which it recently decided to end thru a spin-off of its disparate divisions.

Tech firms considering reinventing themselves by acquiring should consider the following:

1)     What is strategic motivation? Growth alone should be a consequence of strategy not a strategy itself. What competitive advantage in terms of products, technology, market extension, pricing power, or cost advantages are to be gained?

2)     Are there alternatives to acquiring (i.e. internal development)?

3)     Can you identify appropriate targets? These include targets that can exploit market developments-quickly and efficiently scale operations. You acquire firms not technology.

4)     Can you acquire at a reasonable price (i.e. not overpay relative to value)?

It is difficult to value early stage or rapidly growing targets, which often lack an intrinsic value. Rather, their price is determined by what buyers are willing to pay based on current, potentially overheated, market conditions. The lack of an intrinsic value anchor makes such transactions prone to be over priced. Buffett believes firms lacking an intrinsic value are worth only what some other buyer is willing to pay for them. Hence he believes they are speculative and not long term investments. This is the reason he avoids tech firms now just as he did during the 1990s dotcom boom.

You can inject an element of discipline thru a reverse engineering process. This involves solving for the level of sales and profits needed in 5-10 years to justify the offer price. Keep in mind the caveats. First growth requires investments (CAPEX, R&D and working capital). This investment reduces free cash flows and ultimate value. Second time is not your friend. The more distant the cash flows either initially planned or due to delays, the lower the value. See my previous post applying this approach to the Facebook-Whatsapp Acquisition. Whatsapp reported 1H14 sales of around $15mm and a loss of $235mm. They claim the potential still remains, but realization is delayed. The potential growth needed is huge and preliminary results are not encouraging.

J

Leap of Faith M&A: Mind the Gap

There is an Interesting Post on the difficulty in valuing tech M&A targets highlighting the Facebook-Whatsapp acquisition. We previously discussed the Transaction offering some tentative observations. I agree trying to value or price early stage targets with no earnings is difficult. I, however, strongly disagree with the assertion that such deals cannot be analyzed and we should rely on the judgment of successful entrepreneurs like Facebook’s Zuckerberg because tech is different and not subject to the laws of economics. I am always suspicious relying upon “great men” because of the difficulty distinguishing between luck and skill. Besides, the jury is still out on how this acquisition performs. Furthermore, the “they can afford it anyway” argument made in the FT post is dangerous-I think Hewlett Packard blew itself up using such an affordability argument in its disastrous acquisition program.

The tech “is different” canard was used during the 1990s dot.com boom, and did not have a happy ending-remember EToys and Pets.com? Early start-ups without sales, let alone earnings, lack intrinsic value and are difficult to evaluate. Their price depends on what buyers are willing to pay. The absence of a valuation anchor means tech is subject to substantial mispricing risk. Option pricing methods can help analyze such situations.

Option pricing methodology is tricky and subject to misuse - akin to trying to value lottery tickets. The keys to option value include

1)     Skill: does the acquirer have the skill to develop? Many tech investors (Venture Capitalists) acquire not to develop, but to hold a portfolio of deeply out-of-the money options and hope for the best on one of the investments.

2)     Exclusivity: does the option offer exclusive rights to the acquirer e.g. R&D, patents, etc.? If not it has no value.

3)     Sustainability: how long do the benefits last - what is the “T” or product life cycle?

The keys in tech M&A, just like in regular M&A, are the ability to identify winners in advance and acquire them at a reasonable price. 

The complications in tech M&A are

1)     The story (sizzle) dominates while the numbers (performance) lags.

2)     New metrics cloud the analysis. Remember “it is the cash stupid”!

3)     Paradigm shifts occur - AKA  _hit happens.

4)     Information is lacking.

Acquirers must guard against the growth trap of assuming rich future follow-on investment opportunities that can justify anything. The problem is the future opportunities fail to deliver sufficient returns. This is especially true in the tech area with its short product life cycles.

Beware the “this time is different” justification for tech M&A. All investments, tech included, have to produce sufficient cash at some time to offset the current investment. Tech is difficult, but not impossible to evaluate given the information uncertainties and short product life cycles. Nonetheless, that does not justify taking a leap of faith. Keep in mind the difference between flying and falling - at first not much, but then a lot. The same is true for leap of faith M&A.

j

How Do I Pay: Stock, Cash or Combination?

The selection of the acquisition payment currency has important implications for both the seller and buyer. So far in this century about 55% of deals are cash, 23% combination and 22% stock. The proportion of cash and combination deals has increased since the elimination of Pooling of Interests accounting in 2001. Like all M&A items, the selection is negotiated and depends on the relative points of views of the buyer and seller regarding whether the risks and rewards of the acquisition should be shared. The simplest approach is use cash, but sometimes that is not always possible.

Buyer considerations regarding the use of stock in whole or part include the following:

1)   Valuation: consider not only the seller’s valuation, but also that of the buyer’s post transaction value to gauge the exchange ratio impact. The buyer should never use its shares if it believes them to be undervalued; whereas, it should use its shares if it believes them to be over-valued and the seller will accept them. An extreme example of this is AOL’s purchase of Time Warner.

2)   Synergy Risk: use cash if synergy risk is deemed low to keep the upside and stock if high to share the risk. Facebook’s recent high priced acquisitions are primary stock transactions. This helps cushion the downside should the early stage technology targets fail to work out as planned.

3)   Market Risk: if shares are used then you need to decide who bears the market risk of the shares changing price after the offer is made but pre close. The options include a fixed price deal where the buyer assumes the risk, a fixed share arrangement where the seller takes the risks or using collars and caps to share the risk. (See our post Acquisition Risk, Collars, and the Comast Time Warner Deal.)

4)   Dilution: this includes both ownership and earnings dilution. Whenever new shares are issued the relative ownership positions of existing shareholders declines. This can be an important control issue for middle market firms and argue for a cash deal. Buyer earnings and earnings per share (EPS) always increase in a debt financed cash transaction provided the target’s earning exceed the incremental after tax interest cost on the debt. In stock transactions the new shares issued can cause a decline (dilution) in EPS if the seller’s price-earnings ratio exceeds that of the buyer. Over time, the EPS dilution should decline as earnings grow. Usually, buyers prefer a breakeven dilution of 2-3 years.

5)   Taxes: the buyer prefers a taxable transaction involving all or a substantial portion of the price to be in cash. This allows the write-up of the assets acquired by the buyer and higher future tax deductions. Other considerations include changing tax domicile to lower tax rates as in the Pfizer-AstraZeneca  bid.

6)   Credit Rating: debt financed cash transactions impact the buyer’s target debt rating.

Seller considerations include:

1)   Valuation: the seller needs to value the buyer’s shares on a post acquisition basis to determine what if any premium it actually receives. This means doing due diligence on the buyer. These valuation issues explain why targets in hostile takeovers prefer cash over stock as AstraZeneca is now demanding from Pfizer. Remember the old joke - daddy I sold my bike for $20,000- I traded it for 2 $10,000 marbles. The value of marbles, like the buyer’s shares, is an opinion. Cash, however is a fact.

2)   Taxes: sellers can defer capital gains taxes if the transaction is structured as a tax free share exchange. Unfortunately, this has negative tax implications for the buyer which will probably be reflected in the offer price.

3)   Liquidity: the focus is on the float of the shares to be received, lock-ups and registration rights.

Bottom line for me is the KISS principle (keep it simple stupid). It is usually cheaper for the buyer to pay in cash. This may reflect Warren Buffett’s apparent preference for cash purchases. Sellers will have an easier task of evaluating the offer and less risk in cash deals. Thus, being a simple guy, I recommend cash transactions whenever possible. If not using cash, be sure you are at least as smart as the other side.

J