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

Tale of two Transactions: Microsoft and Timken

Two very different transactions were announced this week. Microsoft (MS) announced the acquisition of Nokia’s (NK) mobile phone business and related patents Acquisition.  See Ralph’s post for additional insight. MS stock dropped 4.5% for a market value decline of $11B which exceeded the $7.2B purchase price. Timken (TK) agreed to spin-off its steel division after being pressured by shareholders Spin-off. Unlike MS, the market reaction was positive with its shares jumping 9%. Although different in size and industries, both companies faced the same problem; namely, how to best remedy lagging operating and stock price performance. They chose different paths with different initial shareholder value results. Examining these differences may offer some insight into how firms facing this issue can best respond.

 MS purchase appears “cheap” at 0.35% of NK’s revenues compared to comparable transactions selling at 0.77%+ . Nonetheless NK’s business position was weakening and generated large losses. Thus, it seemed more like a rescue to protect MS’s mobile strategy. NK and MS operated under an arrangement whereby NK’s phone would operate using MS’s software system. This collaborative effort had a 3.7% market share in a market dominated by Apple and others. Combining two midgets is unlikely to create a giant. Furthermore, it will probably take considerable additional MS investments to improve the situation. Their ability to gain share against established competitors is likely to be expensive as well. This probably what underlies the large negative response from MS’s shareholders. An additional reason is investor concern about increasing MS’s exposure to the more volatile consumer device market compared to its more stable and profitable corporate business.

Keep in mind as well, that the transaction is proposed by the outgoing CEO Steve Ballmer. When his “retirement” was announced MS’s stock jumped 7%-not exactly an endorsement of his management skills. It appears that Ballmer and MS, who missed the smart phone revolution, are trying to claw their way back-aka fighting the last war. This may be in response to shareholder concerns over MS’s restructuring efforts. Less costly alternatives such as shareholder distributions, break-up via spin-off of its various divisions or waiting for the new CEO to be chosen should have been considered.

TK was suffering from a lagging share price. It tried to justify retaining the steel division based on diversification and synergy reasons before finally agreeing with shareholder activists to spin it off. The significant share price increase upon that announcement reflects shareholder belief in the benefits from increased focus. This includes reduced overhead and improved investment allocation decisions. See Subtraction for a more complete restructuring alternatives discussion. TK’s current CEO, who resisted the spin-off, will retire once the transaction closes.

The transactions represent two very different responses to a similar problem. Initial market response suggests making the empire smaller through a spin-off can make citizen shareholders wealthier compared to an acquisition. Of course, this is not always the case. It does, however, suggest a deeper consideration of management strategy and its value implications before embarking on acquisitions.

J