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

Getting Real: Real Options and M&A

Facebook is at it again. Following up on their February Whatsapp announcement- they now plan on a $2B purchase of Oculus. This new transaction is even more difficult to justify using traditional valuation methods as Oculus is an early stage virtual reality firm with no customers or revenues. It is tempting to write it off as an unjustified irrational bubble. In fact, the initial market reaction was negative. Alternatively, the problem may be with the traditional Discounted Cash Flow (DCF) methodology used to value Oculus and other early stage firms. 

DCF was designed for mature assets with identifiable bond like cash flows from an installed asset base. Growth can be considered in the relatively short forecast period before it decays into a steady state terminal value. It is less well suited for evaluating the entry and exploitation of attractive new markets thru the acquisition of rapidly growing targets. In these instances, cash flows from installed assets, often negative, are of secondary importance. The real value is in the follow-on growth investments. Failure to consider this fact under values the target.

DCF views targets as independent projects based on passively managed identifiable cash flows. It ignores the sequential interdependence among projects, and management’s ability to revise the investment profile so as to increase value. It is like trying to value a convertible bond focusing only on the coupon while ignoring its option value. Real Option Valuation (ROV) provides a means of thinking about the alternative supplemental option value sources, and helps close the gap between strategy and finance.  The gap is illustrated as follows:

1) Financial analysis is frequently overridden for strategic reasons
2) Strategic considerations such as diversification at the firm level are ignored by finance
3) Overvaluation based on DCF methodology is deemed irrational. Markets and managers may, however, recognize hidden value
4) Uncertainty increases option value unlike in DCF where uncertainty reduces value
5) Option like investments have a time value even if their intrinsic value is zero (i.e. out of the money)
6) Bastardized DCF methods like the Venture Capital Method way of evaluating start-ups which relies on ad hoc high discount rates to evaluate uncertain cash flows
7) Questionable synergies-synergies can be viewed as a crude ROV

ROV is best limited to smaller private targets with limited comparables. Value for these firms depends more on future market developments and management’s reaction to them not existing operations. They have a small chance of large payoffs (i.e. right skewed distributions with winner take all characteristics). Frequently missed is management’s ability to actively manage the target after the acquisition to change its value from the following actions:

1) Delay further investments while it moves up the learning curve. Competition can, however, reduce the option value of waiting in the fast changing tech world.
2) Scale back investments should growth slow
3) Expand investments if growth accelerates
4) Abandonment or put options to truncate losses if the market fails to materialize

Care is needed when dealing with ROV as it can used, just like DCF, to justify overpaying. Some investors are wondering if Facebook’s acquisition spree, which could be viewed as a complement to internal R&D, is beginning to look like Hewlett Packard.Thus, it should be used to supplement not replace DCF only in narrow circumstances satisfying at least the following:

1) The option must be exclusive like a patent. If everyone has it then no one has it.
2) Make sure it is an option not just an opportunity. This means identifying the underlying asset and the payoff contingency
3) Limit to very early targets-more relevant for Facebook than General Motors
4) Management has the ability to exercise successfully the option
5) The option is not over priced
6) There is some rational expectation of future cash flow

If the only tool you have is a hammer, then everything looks like a nail. You now have another tool in your valuation toolbox. Chose and use wisely.

j