Mature Tech: Valuation and Pricing Lessons

Apple’s large price drop and the Google’s large price jump occurred within days of each other. They highlight how challenging tech valuation and pricing can be in a normal trading context let alone in an M&A setting. I find it useful to distinguish the different stages of tech firms to understand the economic dynamics. My scheme is as follows:

1)     Seed: idea stage with no established business model or revenues; private market valuation set by handful of optimists of questionable reliability.

2)     Early: established business model and revenues -profits hopefully to follow e.g. Square; price based on relative value compared to “peers”.

3)     Mature: great returns/profits but growth leveling off e.g. Apple and Google; key drivers are growth and returns.

4)     Old: declining returns with limited if any growth e.g. Hewlett Packard and IBM; focus on shareholder distributions and breakup asset values.

Recently, Apple and Google experienced large stock price swings. GOOGLE increased by 16%+ or $65B on July 17 while Apple fell 7% or $60B four days later. Ralph correctly notes stock prices are based on expectations not actual results.

Expectations are frequently based on extrapolations-sometimes sophisticated, but still extrapolations based on beliefs not facts. Once a new signal (which could be information or noise) is received, investors revise their prior beliefs regarding future operating performance-Bayesian updating or learning. Tech firms are inherently volatile given short product life cycles and their uncertain operating environment. Relatively small changes in expected growth rates can have a huge valuation impact.

Apple, although it had a great quarter, gave revenue guidance that shook investor growth expectations. Specifically, concerns over iPhone, iPad, iWatch and the next “big thing” caused investors to markdown growth estimates. It is still a great firm but was priced too high based on new growth estimates. This raises another issue-will Apple’s management try regain its growth “mojo” through expensive unfocused new product R&D and acquisitions? Remember they have a huge $200B+ cash pile and could do lots of damage. Hopefully activists like Icahn will keep pressuring them to return more cash to shareholders. Interesting to see how their management reacts. The record of aging tech firms refusing to age gracefully like HP is not a happy one.

Google benefited from a “twofer”. They had a better than expected second quarter. They also provided information on improving growth prospects for mobile ads. Equally important, their new CFO provided comforting words on expense and capital discipline. The problem with maturing tech is the discipline to manage the transition from high growth to more modest growth. Managing the transition has an important impact on expectations. Whether Google’s management can deliver on these raised expectations remains to be seen. If they disappoint then expect a subsequent large downward pricing adjustment.

My take is mature tech firms are fraught with agency cost issues which make them difficult to value. They will try to fight the transition to slower growth and try to manufacture growth through undisciplined capital allocation at the expense of returns and value. New management teams unburdened by legacy culture will be needed to avoid Microsoft-Nokia type M&A misadventures.

J                                                                                                

Microsoft’s Nokia Adventure: Ballmer’s Parting “Gift”

Microsoft (MS) announced a $ 7.6B write-off of it disastrous September, 2013 acquisition of Nokia. MS shares were unchanged in a day in which the market faced a large sell-off. The write-off came as no real surprise as the deal was highly suspect from its inception. MS’s shares fell 6% when the deal was originally announced representing an over $15B market capitalization loss. The market was reacting not only to the deal itself, but also the strategic implications of the deal; namely MS’s deepening commitment to the highly competitive devices market and away from its core software business.

Two other strange facts surround the deal. First MS’s CEO, Steve Ballmer had recently announced his planned retirement. The market reacted with a 7%+ jump in MS’s stock on the announcement-not exactly a sterling endorsement of Ballmer’s performance. See Vanity Fair’s article for background on Ballmer’s management history. Next, it was uniting former MS employee Stephen Elop, Nokia’s CEO, with MS. Elop’s performance was equally uninspiring at Nokia as it was facing a rumored bankruptcy after losing billions. I guess you can call it a buddy deal involving the two Steves.

What is surprising is that such a deal championed by an out-going CEO with a checkered record could be approved given widespread apprehension within MS, including from its future CEO Satya Nadella. It essentially is a doubling down on Ballmer’s failed strategy to embed MS’s Windows software in smart phones where it had only a 3% share. MS was going up against Google’s Android and Apple’s IOS and expected to triple its share in 3 years. How it was going to do so with money losing Nokia against well entrenched competitors is the stuff of dreams-or is it nightmares?

I guess we should not be too surprised Nokia was approved given MS’s patchy acquisition record. Remember the $6.2B charge for aQuantive. Also there Ballmer’s $47B abortive Yahoo acquisition where he was saved by Yahoo Jerry Yang’s even bigger ego. MS was suffering from poor board oversight and bad governance. This seems to be endemic to many aging tech firms who use acquisitions in the elusive search for the fountain of youth to regain their mojo.

Ballmer’s Nokia adventure left his successor with both a strategic dilemma and a hemorrhaging acquisition. Their new CEO is addressing these “gifts”. Let’s hope he elects to let MS age gracefully by managing Windows structural decline with increased shareholder distributions instead of engaging in expensive adventures.

j

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

Responding to Low T

The T in question is the Competitive Advantage Period and not testosterone. It is time in which a firm can invest at returns exceeding its cost of capital. T, or moat as used by Warren Buffett, is the driving factor underlying tech firm high valuation multiples. It is based on strategic barriers including technology, First Mover Advantages and regulation. (Also, see our previous post: Find your sustainable competitive advantage.)

It has a dramatic valuation impact as it declines when firms or industries mature. T eventually fades for most industries as they experience Regression to the Mean due to competitive forces such as new entrants and substitutes. Firms like Apple can have several years of remaining T; whereas, firms like Hewlett Packard’s T is largely gone. This fact is reflected in their widely differing valuation multiples. In fact, you can view T as the number of years a firm has before it undergoes a fundamental corporate change like a LBO, recapitalization or sale.

The current flurry of tech related deals presents insights into how firms are handling the rapid changes in T. These firms are based upon rapidly changing technology life cycles, which can be measured in terms of dog years. Firms can respond this development in two distinct manners. The first is to accept and mature gracefully and increase shareholder distributions as IBM has done. 

Alternatively, you could try to adapt by either developing new products like Apple or acquiring new products and technologies as is Facebook –see Crisis. The acquisition approach is to be distinguished from weak acquirers such as Hewlett Packard seeking to hide declining performance.

Tech firms like Google are investing in strategies which just happen to be executed thru acquisitions. Unlike Cisco which pioneered this strategy, these new transactions are much larger. 

The transactions have two objectives. The first is to acquire skills and technologies faster and cheaper than could be internally developed. The second to pick technology winners early and help them develop early as Facebook is doing with its Oculus Acquisition. In these efforts Real Option Valuation is used to supplement traditional Discounted Cash Flow analysis.

There are many risks involved with the acquisition approach. For example can you the right targets? Can you properly execute the transactions? Can you grow the acquired technology fast enough and large enough? How will your competitors respond?

The jury is still out on how this plays out. It is fascinating to watch.

J

Facebook-Whatsapp $19B Acquisition: Dotcom 2.0?

Facebook is acquiring WhatsApp  for $19B of which $15B is in stock. Reaction rages from skepticism-repeat of the 1990s dotcom bubble-to euphoria as a brilliant move. Here are some facts:

1. WhatsApp is a 4 year old firm with 55 employees. It has 450 mln users. If they pay $1 each it will generate sales of $450 mln in 2014.Thus, Facebook is paying a price to sale multiple of over 40 based on trailing number of users.
2. The $19B price exceeds the market value of such well known names as Xerox ($13B) and Nordstrom ($11B).
3. WhatsApp had an implied venture capital value of $1.5B in July, 2013.
4. Google was allegedly prepared to offer $10B for WhatsApp.
5. Facebook has a market value of $170B. The market reacted favorably to announced transaction.
6. Facebook has a price earnings ratio of 55 compared to 23 and 14 for Google and Microsoft respectively.
7. The previous Internet deals exceeding $10B in market value flopped-the biggest being the Time Warner AOL deal.
8. Internet firms have an average life of around 11 years. Thus, Facebook is middle aged.

I understand the difficulty applying traditional valuation techniques like comparable and discounted cash flow to rapidly growing technology based firms. Nonetheless, I continue to rely on the following bedrock principles:

1. Value is an opinion about what you may receive in the future. Price is a fact you pay for now.
2. At some price even an excellent firm becomes a bad investment.
3. Evaluate companies not industries.
4. Beware of cash flow proxy measures like price per user. Eventually, they must tie back to cash.
5. Access the Real Option Value of high growth investments, but be careful and make sure they are options and not just hopes or beliefs.
6. Estimate the performance need to justify the price and determine whether it can be realistically obtained within a reasonable time period.
7. Using stock as the primary form of consideration can help mitigate the acquirer’s risk.
8. Do not forget about time and present values-how long do we have to wait?

Let’s focus on # 6 for now and assume the following:

1. We can value WhatsApp at Facebook’s current Price earnings ratio of 55 in 5 years
2. This implies breakeven profits of $363 MLN are needed in 2019.
3. Assume a 20% net income margin.
4. Required revenues of $1.8B are needed in 2019.
5. The users required to generate that revenue are around 1.8B compared with current 450 MLN users-about 280 MLN new users p.a. are required.

We have ignored the 5 year time lag, ability to scale up and grow that fast and the impact of competitors and new technology on margins. This is of course just one, and a favorable one at that, of many possible scenarios.

The above indicates that while difficult-it is possible the deal could work financially. Facebook’s use of its potentially overvalued stock for over 75% of the purchase price helps cushion the downside. This is similar to what happened to AOL in the Time Warner transaction. Finally the WhatsApp acquisition could be viewed as a defensive or pre emptive transaction to keep Google, Facebook’s arch competitor, at bay. In M&A there are two different types of errors. The first is a type I error in making an over priced acquisition. There is also, however, a type II error from not making a good purchase and suffering possible adverse competitive consequences. The short average internet firm life span of 11 years suggests the cost of inaction - a type II error- outweighs the risk of a type I error.

I am not trying to justify the transaction. Rather, I am trying to understand it. It is a big bet for high stakes. It will be interesting to see how it plays out.

J

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.

J