Aswath Damodaran's Blog, page 15

December 19, 2019

A Teaching Manifesto: An Invitation to my Spring 2020 classes

If you have been reading my blog for long enough, you should have seen this post coming. Every semester that I teach, and it has only been in the spring in the last few years, I issue an invitation to anyone interested to attend my classes online. While I cannot offer you credit for taking the class or much direct personal help, you can watch my sessions online (albeit not live), review the slides that I use and access the post class material, and it is free. If you are interested in a certificate version of the class, NYU offers that option, but it does so for a fee. You can decide what works for you, and whatever your decision is, I hope that you enjoy the material and learn from it, in that order.
The Structure
I will be teaching three classes in Spring 2020 at the Stern School of Business (NYU), a corporate finance class to the MBAs and two identical valuation classes, one to the MBAs and one for undergraduates. If you decide to take one of the MBA classes, the first session will be on February 3, 2020, and there will be classes every Monday and Wednesday until May 11, 2020, with the week of March 15-22 being spring break. In total, there will be 26 sessions, each session lasting 80 minutes. The undergraduate classes start a week earlier, on January 27, and go through May 11, comprising 28 sessions of 75 minutes apiece. The Spring 2020 Classses: With all three classes, the sessions will be recorded and converted into streams, accessible on my website and downloadable, as well as YouTube videos, with each class having its own playlist. In addition, the classes will also be carried on iTunes U, with material and slides, accessible from the site. The session videos will usually be accessible about 3-4 hours after class is done and you can either take the class in real time, watching the sessions in the week that they are taught, or in bunches, when you have the time to spend to watch the sessions; the recordings will stay online for at least a couple of years after the class ends. There will be no need for passwords, since the session videos will be unprotected on all of the platforms. The (Free) Online Version: During the two decades that I have been offering this online option, I have noticed that many people who start the class with the intent of finishing it give up for one of two reasons. The first is that watching an 80-minute video on a TV or tablet is a lot more difficult than watching it live in class, straining both your patience and your attention. The second is that watching these full-length videos is a huge time commitment and life gets in the way. It is to counter these problems that I created 12-15 minute versions of the each session for online versions of the classes. These online classes, recorded in 2014 and 2015, is also available on my website and through YouTube, and should perhaps be more doable than the full class version.The NYU Certificate Version: For most of the last 20 years, I have been asked why I don’t offer certificates of completion for my own classes and I have had three answers. The first is that, as a solo act, I don’t have the bandwidth to grade and certify the 20,000 people who take the classes each semester. The second is that certification requires regulatory permission, a bureaucratic process in New York State that I have neither the stomach nor the inclination to go through. The third is, and it is perhaps the most critical, is that I am lazy and I really don't want to add this to my to-do list. One solution would be to offer the classes through platforms like Coursera, but those platforms work with universities, not individual faculty, and NYU has no agreements with any of these platforms. About three years ago, when NYU approached me with a request to create online certificate classes, I agreed, with one condition: that the free online versions of these classes would continue to be offered. With those terms agreed to, there are now NYU Certificate versions of each of the online classes, with much of the same content, but with four add ons. First, each participant will have to take quizzes and a final exam, multiple choice and auto-graded, that will be scored and recorded. Second, each participant will have to complete and turn in a real-world project, showing that they can apply the principles of the class on a company of their choice, to be graded by me. Third, I will have live Zoom sessions every other week for class participants, where you can join and ask questions about the material. Finally, at the end of the class, assuming that the scores on the exams and project meet thresholds, you will get a certificate, if you pass the class, or a certificate with honors, if you pass it with flying colors. The Classes I have absolutely no desire to waste your time and your energy by trying to get you to take classes that you either have no interest in, or feel will serve no good purpose for you. In this section, I will provide a short description of each class, and provide links to the different options for taking each class.
I. Corporate Finance
Class description : I don’t like to play favorites, but corporate finance is my favorite class, a big picture class about the first principles of finance that govern how to run a business. I will not be egotistical enough to claim that you cannot run a business without taking this class, since there are many incredibly successful business-people who do, but I do believe that you cannot run a business without paying heed to the first principles. I teach this class as a narrative, staring with the question of what the objective of a business should be and then using that objective to determine how best to allocate and invest scarce resources (the investment decision), how to fund the business (the financing decision) and how much cash to take out and how much to leave in the business (the dividend decision). I end the class, by looking at how all of these decisions are connected to value.

Chapters: Applied Corporate Finance Book, Sessions: Class sessionI am not a believer in theory, for the sake of theory, and everything that we do in this class will be applied to real companies, and I will use six companies (Disney, Vale, Tata Motors, Deutsche Bank, Baidu and a small private bookstore called Bookscape) as lab experiements that run through the entire class.

I say, only half-jokingly, that everything in business is corporate finance, from the question of whether shareholder or stakeholder interests should have top billing at companies, to why companies borrow money and whether the shift to stock buybacks that we are seeing at US companies is good or bad for the economy. Since each of these questions has a political component, and have now entered the political domain, I am sure that the upcoming presidential election in the US will create some heat, if not light, around how they are answered.
For whom?
As I admitted up front, I believe that having a solid corporate finance perspective can be helpful to everyone. I have taught this class to diverse groups, from CEOs to banking analysts, from VCs to startup founders, from high schoolers to senior citizens, and while the content does not change, what people take away from the class is different. For bankers and analysts, it may be the tools and techniques that have the most staying power, whereas for strategists and founders, it is the big picture that sticks. So, in the words of the old English calling, "Come ye, come all", take what you find useful, abandon what you don't and have fun while you do this.
Links to Offerings
1. Spring 2020 Corporate Finance MBA class (Free)Webpage for the class My website & streaming YouTube Playlist iTunes U class (Download the iTunes U app and use enroll code of FLJ-MLN-XZL)2. Online Corporate Finance Class (Free)
My website & streaming YouTube Playlist iTunes U class (Download the iTunes U app and use enroll code of HAS-CCR-FRA)3. NYU Certificate Class on Corporate Finance (It will cost you...)
NYU Entry Page II. Valuation
Class description: Some time in the last decade, I was tagged as the Dean of Valuation, and I still cringe when I hear those words for two reasons. First, it suggests that valuation is a deep and complex subject that requires intense study to get good at. Second, it also suggests that I somehow have mastered the topic. If nothing else, this class that I first taught in 1987 at NYU, and have taught pretty much every year since, dispenses with both delusions. I emphasize that valuation, at its core, is simple and that practitioner, academics and analysts often choose to make it complex, sometimes to make their services seem indispensable, and sometimes because they lose the forest for the trees. Second, I describe valuation as a craft that you learn by doing, not by reading or watching other people talk about it, and that I am still working on the craft. In fact, the more I learn, the more I realize that I have more work to do. This is a class about valuing just about anything, from an infrastructure project to a small private business to a multinational conglomerate, and it also looks at value from different perspectives, from that of a passive investor seeking to buy a stake or shares in a company to a PE or VC investor taking a larger stake to an acquirer interested in buying the whole company.

Finally, I lay out my rationale for differentiating between value and price, and why pricing an asset can give you a very different number than valuing that asset, and why much of what passes for valuation in the real world is really pricing.

Along the way, I emphasize how little has changed in valuation over the centuries, even as we get access to more data and more complex models, while also bringing in new tools that have enriched us, from option pricing models to value real options (young biotech companies, natural resource firms) to statistical add-ons (decision trees, Monte Carlo simulations, regressions).
For whom?
Do you need to be able to do valuation to live a happy and fulfilling life? Of course not, but it is a skill worth having as a business owner, consultant, investor or just bystander. With that broad audience in mind, I don't teach this class to prepare people for equity research or financial analysis jobs, but to get a handle on what it is that drives value, in general, and how to detect BS, often spouted in its context. Don't get me wrong! I want you to be able to value or price just about anything by the end of this class, from Bitcoin to WeWork, but don't take yourself too seriously, as you do so.
Links to Offerings 1a. Spring 2020 Valuation MBA class (Free)Webpage for the class My website & streaming YouTube Playlist iTunes U class (Download the iTunes U app and use enroll code of FSN-WWJ-RAH)1b. Spring 2020 Valuation Undergraduate class (Free)Webpage for the class My website & streaming YouTube Playlist iTunes U class (Download the iTunes U app and use enroll code of ENT-ZXA-JYL)2. Online Valuation Class (Free)My website & streaming YouTube Playlist iTunes U class (Download the iTunes U app and use enroll code of K7X-VD9-5KE)3. NYU Certificate Class on Valuation (Paid)
NYU Entry Page III. Investment Philosophies
Class description: This is my orphan class, a class that I have had the material to teach but never taught in a regular classroom. It had its origins in an couple of observations that puzzled me. The first was that, if you look at the pantheon of successful investors over time, it is not only a short one, but a diverse grouping, including those from the old time value school (Ben Graham, Warren Buffett), growth success stories (Peter Lynch and VC), macro and market timers (George Soros), quant players (Jim Simon) and even chartists. The second was that the millions who claim to follow these legends, by reading everything ever written by or about them and listening to their advice, don’t seem to replicate their success. That led me to conclude that there could be no one ‘best’ Investment philosophy across all investors but there could be one that is best for you, given your personal makeup and characteristics, and that if you are seeking investment nirvana, the person that you most need to understand is not Buffett or Lynch, but you. In this class, having laid the foundations for understanding risk, transactions cost and market efficiency (and inefficiency), I look at the entire spectrum of investment philosophies, from charting/technical analysis to value investing in all its forms (passive, activist, contrarian) to growth investing (from small cap to venture capital) to market timing. With each one, I look at the core drivers (beliefs and assumptions) of the philosophy, the historical evidence on what works and does not work and end by looking at what an investor needs to bring to the table, to succeed with each one.

I will try (and not always succeed) to keep my biases out of the discussion, but I will also be open about where my search for an investment philosophy has brought me. By the end of the class, it is not my intent to make you follow my path but to help you find your own.
For whom?
This is a class for investors, not portfolio managers or analysts, and since we are all investors in one way or the other, I try to make it general. That said, if your intent is to take a class that will provide easy pathways to making money, or an affirmation of the "best" investment philosophy, this is not the class for you. My objective in this class is not to provide prescriptive advice, but to instead provide a menu of choices, with enough information to help you can make the choice that is best for you. Along the way, you will see how difficult it is to beat the market, why almost every investment strategy that sounds too good to be true is built on sand, and why imitating great investors is not a great way to make money.

Links to Offerings
1. Online Investment Philosophies Class (Free)My website & streaming YouTube Playlist iTunes U (Download the iTunes U app and use enroll code of J6Z-AD7-NX3)2. NYU Certificate Class on Valuation (Paid)NYU Entry Page (Coming soon)ConclusionI have to confess that I don't subscribe to the ancient Guru/Sishya relationship in teaching, where the Guru (teacher) is an all-knowing individual who imparts his or her fountain of wisdom to a receptive and usually subservient follower. I have always believed that every person who takes my class, no matter how much of a novice in finance, already knows everything that needs to be known about valuation, corporate finance and investments, and it is my job, as a teacher, to make him or her aware of this knowledge. Put simply, I can provide some structure for you to organize what you already know, and tools that may help you put that knowledge into practice, but I am incapable of profundity. I hope that you do give one (or more) of my classes a shot and I hope that you both enjoy the experience and get a chance to try it out on real companies in real time.

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Published on December 19, 2019 13:30

November 19, 2019

Regime Change and Value: A Follow up Post on Aramco

In my post from a couple of days ago, I valued Aramco at about $1.65 trillion, but I qualified that valuation by noting that this was the value before adjusting for regime change concerns. That comment seems to have been lost in the reading, and it is perhaps because (a) I made it at the end of the valuation and (b) because the adjustment I made for it seemed completely arbitrary, knocking off about 10% off the value. Since this is a issue that is increasingly relevant in a world, where political disruptions seem to be the order of the day in many parts of the world, I thought that a post dedicated to just regime changes and how they affect value might be in order, and Aramco would offer an exceptionally good lab experiment.
Going Concern and Truncation RisksRisk is part and parcel of investing. That said, risk came come from many sources and not all risk is created equal, to investors. In fact, modern finance was born from the insight that for a diversified investor, it is only risk that you cannot diversify away, i.e., macroeconomic risk exposure, that affects value. In this section, I want to examine another stratification of risk into going concern and truncation risk that is talked about much less, but could matter even more to value.
DCF Valuation: A Going Concern Judgment The intrinsic value of a company has always been a function of its expected cash flows, its growth and how risky the cash flows are, but in recent decades a combination of access to data and baby steps in bringing economic models into valuation has resulted in the development of discounted cashflow valuation as a tool to estimate intrinsic value. Put simply, the discounted cash flow value of an asset is:

Extended to a publicly traded company, with a potential life in perpetuity, this value can be written as:

If you are a reader of my posts, it should come as no mystery to you that I not only use DCF models to value companies, but that I believe that people under estimate how adaptable it is, usable in valuing everything from start ups to infrastructure projects. There is, however, one significant limitation with DCF models that neither its proponents nor its critics seem be aware of, and it needs to be addressed. Specifically, a DCF is an approach for valuing going concerns, and every aspect of it is built around that presumption. Thus, you estimate expected cash flows each year for the firm, as a going concern, and your discount rate reflects the risk that you see in the company as a going concern. In fact, it is this going concern assumption that allows us to assume that cash flows continue for the long term, sometimes forever, and attach a terminal value to these cash flows.
Truncation Risks If you accept the premise that a DCF is a going concern value, you are probably wondering what other risks there may be in investing that are being missed in a DCF valuation. The risks that I believe are either ignored or incorrectly incorporated into value are truncation risks. The simplest way of illustrating the difference between going concern and truncation risks is by picking a year in your cash flow estimation, say year 3. With going concern risk, you are worried about the actual cash flows in year 3 being different from your expectations, but with truncation risk, you are worried about whether there will be a year 3 for your company.
So, what types of risk will fall into the truncation risk category? Looking at the corporate life cycle, you will see truncation risk become not just significant, but is perhaps the dominant risk that you worry about, age both ends of the life cycle. With start ups and young companies, it is survival risk that is front and center, given that approximately two thirds of start ups never make it to becoming viable businesses. With declining and aging companies, especially laden with debt, it is distress risk, where the company unable to meet its contractual obligations, shutters its doors and liquidates it assets. Looking at political risk, truncation risk can come in many forms, starting with nationalization risk, where a government takes over your business and pays you nothing in some cases and less than fair value in the rest, but extending to other expropriation risks, where you still are allowed to hold equity, but in a much less valuable concern.
Since truncation risk is more the rule than the exception, and it is the dominant risk in some companies, you would think that investors and analysts valuing these companies will have devised sensible ways of incorporating the risk, but you would be wrong.
The most common approach to dealing with truncation risk is for analysts to hike up the discount rate, using the alluring argument that if there is more risk, you would demand a higher return. The problem, though, is that this higher discount rate still goes into a DCF where expected cash flows continue in perpetuity, creating an internal contradiction, where you increase the discount rate for truncation risk but you do nothing to the cash flows. In addition, the discount rate that these analysts use are made up, higher just for the sake of being higher, with no rationale for the adjustment. With venture capitalists, this shows up as absurdly high target rates of 40%, 50% or 60%, fiction in a world where these VCs actually deliver returns closer to 15-20%. Discount rates are blunt instruments and are incapable of carrying the burden of truncation risk, and should not be made to do so.Some analysts take the more sensible approach of scenario analysis, allowing for good and bad scenarios (including failure or nationalization) but never close the loop by attaching probabilities to the scenarios. Instead, they leave behind ranges for the value that are so wide as to be useless for decision making purposes. My suggestion is that you use a decision tree approach, where you not only allow for different scenarios, but you make these scenarios cover all possibilities and then attach a probability to each one. In the case of a start up, then, your two possible outcomes will be that the company will make it as a going concern and that it will not, and you will follow through with a DCF, with a going concern discount rate, yielding the value for the going concern outcome, and a liquidation providing your judgment for what the company will be worth, in the failure scenario:

Since you have probabilities for each outcome, you can compute an expected value. If you do this, you should expect to see discount rates for companies prone to failure (young start ups and declining firms) be drawn from the same distribution as that for healthy companies, but the adjustment for failure will be in the post-DCF adjustments. Put more simply, you should see 12-15% as costs of capital for even the riskiest start-ups, in a DCF, never 40-50%, but your post value adjustments for failure and its consequences will still take their toll.
The Aramco Valuation: Bringing in Truncation Risk In my last post, I valued Aramco in a DCF, using three measures of cash flows from dividends to potential dividends to free cash flows to the firm and arrived at values that were surprisingly close to each other, centered around $1.65 trillion, for the equity. Note, though, that these are going concern values, and reflect the expectation that while there may be year to year changes in cash flows, as oil prices changes, management recalibrate and the government tweaks tax and royalty rates, the company will be a going concern and that it will not suffer catastrophic damage to its core asset of low-cost oil reserves. For many investors in Aramco, the prime concern may be less on these fronts and more on whether the House of Saud, as the backer of the promises that Aramco is making its investors, will survive intact for the next few decades.
DCF Valuation: Going Concern Risk Reviewing my discounted cash flow valuations of Aramco, you will notice that I began with a risk free rate in US dollars, because my currency choice was that currency. I then adjusted for risk, using a beta for Aramco, based upon REITs/royalty trusts for the promised dividend model and integrated oil companies for the potential dividends/free cash flow models, and an equity risk premium for Saudi Arabia of only 6.23%, with a country risk premium of 0.79% estimated for the country added to the mature market premium estimated for the US. The end result is that I had costs of equity ranging from 4.82% for promised dividends to 8.15% for cash flows.
The biggest push back I have had on my valuations is that the cost of equity seems low for a country like Saudi Arabia, and my response is that you are right, if you consider all of the risk in investing in a Saudi equity. However, much of the risk that you are contemplating in Saudi Arabia is political risk, or put more bluntly, the risk of regime change in the country, that could have dramatic effects on value. In fact, if you remove that risk from consideration and look at the remaining risk, Aramco is a remarkably safe investment, with the safety coming from its access to huge oil reserves and mind-boggling profits and cash flows. The DCF values that I have estimated, centered around $1.65 trillion, are therefore values before adjusting for the risk of regime change.
Regime Change Concerns If you invest in Aramco, you clearly have an interests in who rules and runs the country, since every aspect of your valuation is dependent on that assumption. If the House of Saud continues to rule, I believe that the company will be the cash cow that I project it to be in my DCF and the values that I estimated hold. If the Arab spring comes to Riyadh and there is a regime change, the foundations of my value can either crack or be completely swept away, with cash flows, growth and risk all up for re-estimation. In fact, to complete my valuation, I need to bring both the probability of regime change and the consequences into my final valuation:

Consider the most extreme case. If you believe that regime change in imminent and certain, and that the change will be extreme (with equity being expropriated and Aramco being brought back entirely into the hands of the state), my expected value for equity becomes zero:

If at the other extreme, you either believe that regime change will never happen, or even if it does, the new regime will not want to hurt the goose that lays the golden eggs and leaves existing terms in place, the value effect of considering regime change will be zero. The truth lies between the extremes, though where it lies is open for debate. I believe that there remains a non-trivial chance (perhaps as high as 20%) that there will be a regime change over the long term and that if there is one, there will be changes that reduce, but not extinguish, my claim, as an equity investor, on the cash flows.

That, in an entirely subjective nutshell, is why I think Aramco's equity value is closer to $1.5 trillion than $1.7 trillion. As with all my other valuations, I understand that your judgments on Aramco will be different from mine, but I think that the disagreements we have are not so much on the going concern estimates of cash flows and risk but on the likelihood and consequences of regime change.
Democracies versus AutocraciesI am not a political scientist, but I have always been fascinated by the question of how political structure and economic value are intertwined. Specifically, would you attach more value to a company or project operating in a democracy or in an autocracy? The approach that I have described in this post to deal with going concern and regime change risk allows me one way of trying too answer the question. Democracies are messy institutions, where governments change and policies morph, because voters change their minds. Put simply, a democracy generally cannot offer any business iron clad guarantees about regulations not changing or tax rates remaining stable, because the government that offers those promises first has to get them approved by legislatures, often can be checked by legal institutions and, most critically, can be voted out of office. Consequently, companies operating in democracies will always complain more about the rules constantly changing, and how those changing rules affect cash flows, growth and risk. Autocracies offer more stability, since autocrats don't have to get policies approved by legislators, often are unchecked by legal institutions and don't have to worry about how their decision poll with voters. Companies operating in autocracies can be promise rules that are fixed, regulations that don't change and tax rates that will stay constant. The catch, though, is that autocracies seldom transition smoothly, and when change comes, it is often unexpected and wrenching.In valuation terms, democracies create more going concern risk and autocracies create more worries about regime change. The former will show up as higher discount rates in a DCF valuation and the latter as post-DCF adjustments. While I prefer democracies to autocracies, there is no way, a priori, that you can argue that democracies are always better than autocracies or vice versa, at least when it comes to value, and here is why:The going concern risk that is added by being in a democracy will depend on how the democracy works. If you have a democracy, where the opposing parties tend to agree on basic economic principles and disagree on the margins, the going concern risk added will be small. In the United States, in the second half of the last century, both parties (Republicans and Democrats) agreed on the fundamentals of the economy, though one party may have been more favorable on some issues, for business, and less favorable on other issues. In contrast, if you have a democracy, where governments are unstable and the opposing parties have widely different views on the very fundamentals of how an economy should be structured, the effect on going concern risk will be much higher. The regime change risk in an autocracy will vary in how the autocracy is structured and how transitions happen. Autocracies structured around a person are inherently more unstable than autocracies built around a party or ideology, and transitions are more likely to be violent if the military is involved in regime change, in either direction. In addition, violent regime changes feed on themselves, with memories of past violent meted out to a group driving the violence that it metes out, when its turn comes.In summary, when you are trying to decide on whether a business is worth more in a democracy than in a dictatorship, you are being asked to trade off more continuous, going concern risk in the former for the more stable environment of the latter, but with more discontinuous risk. I have deliberately stayed away from using specific country examples in this section, because this argument is more emotion than intellect, but you can fill your own contrasts of countries, and make your own judgments.
ConclusionI have often described valuation as a craft, where mastery is an elusive goal and the key to getting better is working at doing more valuation. I am glad that I valued Aramco, because it is an unconventional investment, a company where I have to worry more about political risks than economic ones. The techniques I develop on Aramco will serve me well, not only when I value Latin American companies, as that continent seems to be entering one of its phases of disquiet, but when I value developed market companies, as Europe and the US seem to be developing emerging market traits.

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Published on November 19, 2019 15:16

November 18, 2019

A coming out party for the world's most valuable company: Aramco's long awaited IPO!

In a year full of interesting initial public offerings, many of which I have looked at in this blog, it is fitting that the last IPO I value this year will be the most unique, a company that after its offering is likely to be the most valuable company in the world, the instant it is listed. I am talking about Aramco, the Saudi Arabian oil colossus, which after many false starts, filed a prospectus on November 10 and that document, a behemoth weighing in at 658 pages, has triggered the listing clock.

Aramco: History and Set Up
Aramco’s beginnings trace back to 1933, when Standard Oil of California discovered oil in the desert sands of Saudi Arabia. Shortly thereafter, Texaco and Chevron formed the Arabian American Oil Company (Aramco) to develop oil fields in the country and the company also built the Trans-Arabian pipeline to deliver oil to the Mediterranean Sea. In 1960, the oil producing countries, then primarily concentrated in the Middle East, created OPEC and in the early 1970s, the price of oil rose rapidly, almost quadrupling in 1973. The Saudi Government which had been gradually buying Aramco’s assets, nationalized the company in 1980 and effectively gave it full power over all Saudi reserves and production. The company was renamed Saudi Aramco in 1988.
To understand why Aramco has a shot at becoming the most valuable company in the world, all you have to do is look at its oil reserves. In 2018, it was estimated that Aramco had in excess of 330 billion barrels of oil and gas in its reserves, a quarter of all of the world’s reserves, and almost ten times those of Exxon Mobil, the current leader in market cap, among oil companies. To add to the allure, oil in Saudi Arabia is close to the surface and cheap to extract, making it the most profitable place on oil to own reserves, with production costs low enough to break even at $20-$25 a barrel, well below the $40-$50 break even price that many other conventional oil producers face, and even further below the new entrants into the game. This edge in both quantity and costs plays out in the numbers, and Aramco produced 13.6 million barrels of oil & gas every day in 2018, and reported revenues of $355 billion for the year, on which it generated operating income of $212 billion and net income of $111 billion. In short, if your complaint about the IPOs that you saw this year was that they had little to show in terms of revenues and did not have money-making business models, this company is your antidote.
Aramco, Saudi Arabia and the House of Saud!
The numbers that are laid out in the annual report are impressive, painting a picture of the most profitable company in the world, with almost unassailable competitive advantages, investors need to be clear that even after its listing, Aramco will not be a conventional company, and in fact, it will never be one. The reason is simple. Saudi Arabia is one of the wealthier countries in the world, on a per capital basis, and one of the 20 largest economies, in terms of GDP, but it derives almost 80% of that GDP from oil. Thus, a company that controls those oil spigots is a stand in for the entire country, and over the last few decades, it should not surprise you to learn that the Saudi budget has been largely dependent on the cash flows it collects from Aramco, in royalties and taxes, and that Aramco has also invested extensively in social service projects all over the country. The overlap between company and country becomes even trickier when you bring in the Saudi royal family, and its close to absolute control of the country, which also means that Aramco’s fortunes are tied to the royal family’s fortunes. It is true that there will still be oil under the ground, even if there is a change in regime in Saudi Arabia, but the terms laid out in the prospectus reflect the royal family’s promises and may very well be revisited if control changed. Should this overlap between company, country and family have an effect on how you view Aramco? I don’t see how it cannot and it will play out in many dimensions:Corporate governance: After the IPO, the company will have all the trappings of a publicly traded company, from a board of directors to annual meetings to the rituals of financial disclosure. These formalities, though, should not obscure the fact that there is no way that this company can or ever will be controlled by shareholders. The Saudi government is open about this, stating in its prospectus that “the Government will continue to own a controlling interest in the Company after the Offering and will be able to control matters requiring shareholder approval. The Government will have veto power with respect to any shareholder action or approval requiring a majority vote, except where it is required by relevant rules for the government.” While one reason is that the majority control will remain with the government, it is that it would be difficult to visualize and perhaps to dangerous to even consider allowing a company that is a proxy for the country to be exposed to corporate control costs. After all, a hostile acquisition of the company would then be the equivalent of an invasion of the country. The bottom line is that if you invest in Aramco, you should recognize that you are more capital provider than shareholder and that you will have little or no say in corporate decision making.Country risk: Aramco has a few holdings and joint ventures outside Saudi Arabia, but this company is not only almost entirely dependent on Saudi Arabia but its corporate mission will keep it so. Put differently, a conventional oil company that finds itself overdependent on a specific country for its production can try to reduce this risk by exploring for oil or buying reserves in other countries, but Aramco will be limited in doing this, because of its national status.Political risk: For decades, the Middle East has had more than its fair share of turmoil, terrorism and war, and while Saudi Arabia has been a relatively untouched part, it too is being drawn into the problem. The drone attack on its facilities in Shaybah in August 2019, which not only caused a 54% reduction in oil production, but also cost billions of dollars to the company was just a reminder of how difficult it is to try to be oasis. On an even larger scale, the last decade has seen regime changes in many countries in the Middle East, with some occurring in countries, where the ruling class was viewed as insulated. The Saudi political order seems settled for the moment, with the royal family firmly in control, but that too can change, and quickly.In short, this is not a conventional company, where shareholders gather at annual meetings, elect boards of directors and the corporate mission is to do whatever is necessary to increase shareholder well being, and it never will be one. For some, that feature alone may be sufficient to take the company off their potential investment list. For others, it will be something that needs to be factored into the pricing and value, but at the right price or value, presumably with a discount built in for the country and political risk overlay, the company can still be a good investment.
IPO Twists
Before we price and value Aramco, there are a few twists to this IPO that should be clarified, since they may affect how much you are willing to pay. The prospectus, filed on November 10, sheds some light:Dividends: In the ending on September 30, 2019, Aramco paid out an ordinary dividend of $13.4 billion, entirely to the Saudi Government, and it plans to pay an additional interim dividend of at least $9.5 billion to the government, prior to the offering. The company commits to paying at least $75 billion in dividends in 2020, with holders of shares issued in the IPO getting their share, and to maintaining these dividends through 2024. Beyond 2024, dividends will revert back to their normal discretionary status, with the board of directors determining the appropriate amount. As an aside, the dividends to non-government shareholders will be paid in Saudi Riyal and to the government in US dollars.IPO Proceeds: The prospectus does not specify how many shares will be offered in the initial offering, but it is not expected to be more than a couple of percent of the company. None of the proceeds from the IPO will remain in Aramco. The government will redirect the proceeds elsewhere, in pursuit of its policy of making Saudi Arabia into an economy less dependent on oil.Trading constraints: Once the offering is complete, the shares will be listed on the Saudi stock exchange and its size will make it the dominant listing overnight, while also subjecting it to the trading restrictions of the exchange, including a limit of a 10% movement in the stock price in a day; trading will be stopped if it hits this limit.Inducements for Saudi domestic investors: In an attempt to get more domestic investors to hold the stock, the Saudi government will give one bonus share, for every ten shares bought and held for six months, by a Saudi investor, with a cap at a hundred bonus shares.Royalties & Taxes: In my view, it is this detail that has been responsible for the delay in the IPO process and it is easy to see why. For all of its life, Aramco has been the cash machine that keeps Saudi Arabia running, and the cash flows extracted from the company, whether they were titled royalties, taxes or dividends, were driven by Saudi budget considerations, rather than corporate interests. Investors were wary of buying into a company, where the tax rate and the royalties were fuzzy or unspecified and the prospectus lays out the following. First, the corporate tax rate will be 20% on downstream taxable income, though tax rates on different income streams can be different. The Saudi government also imposes a Zakat, a levy of 2.5% on assessed income, thus augmenting the tax rate. In sum, these tax rate changes were already in effect in 2018, and the company paid almost 48% of its taxable income in taxes that year. Second, the royalties on oil were reset ahead of the IPO and will vary, depending on the oil price, starting at 40% if oil prices are less than $70/barrel, increasing to 45% if they fell between $70 and $100, and becoming 80% if the oil price exceeds $100/barrel. A Pricing of Aramco
The initial attempts by the Saudi government to take Aramco public, as long as two years ago, came with an expectation that the company would be “valued” at $2 trillion or more. Since the IPO announcement a few weeks ago, much has been made about the fact that there seem to be wide divergences in how much bankers seem to think Aramco is worth, with numbers ranging from $1.2 billion to $2.3 trillion. Before we take a deep dive into how the initial assessments of value were made and why there might be differences, I think that we should be clear eyed about these numbers. Most of these numbers are not valuations, based upon an assessment of business models, risk and profitability, but instead represent pricing of Aramco, where assessment of price being made by looking at how the market is pricing publicly traded oil companies, relative to a metric, and extending that to Aramco, adjusting (subjectively) for its unique set up in terms of corporate governance, country risk and political risk. In the table below, I look at integrated oil companies, with market caps in excess of $10 billion, in October 2019, and how the market is pricing them relative to a range of metrics, from barrels of oil in reserve, to oil produced, to more conventional financial measures (revenues, earnings, cash flows):

Download spreadsheetThe median oil company equity trades at about 13 times earnings, and was a business, at about the value of its annual revenues, and the market seems to be paying about $23 for every barrel of proven reserves of oil (or equivalent). In the table below, I have priced Aramco, using all of the metrics, and at the median and both the first and third quartiles:

You can already see that if you are looking at how to price Aramco, the metric on which you base it on will make a very large difference: If you price Aramco based on its revenues of $356 billion or on its book value of equity of $271 billion, its value looks comparable or slightly higher than the value of Exxon Mobil and Royal Dutch, the largest of the integrated oil companies. That pricing, though, is missing Aramco’s immense cost advantage, which allows it to generate much higher earnings from the same revenues. Thus, when you base the pricing on Aramco’s EBITDA of $224 billion, you can see the pricing rise to above a trillion and if you shift to Aramco’s net income of $111 billion, the pricing approaches $1.5 trillion. The pricing is highest when you focus on Aramco’s most valuable edge, its control of the Saudi oil reserves and its capacity to produce more oil than any other oil company in the world. If you base the pricing on the 10.3 billion barrels of oil that Aramco produced in 2018, Aramco should be priced above $1.5 trillion and perhaps even closer to $2 trillion. If you base the pricing on the 265.9 billion barrels of proven reserves that Aramco controls for the next 40 years, Aramco’s pricing rises to sky high levels.If you are a potential investor, the pricing range in this table may seem so large, as to make it useless, but it can still provide some useful guidelines. First, you should not be surprised to see the roadshows center on Aramco’s strongest suits, using its huge net income (and PE ratios) as the opening argument to set a base for its pricing, and then using its reserves as a reason to augment that pricing. Second, there is a huge discount on the pricing, if just reserves are used as the basis for pricing, but there are two good reasons why that high pricing will be a reach:Production limits: Aramco not only does not own its reserves in perpetuity, with the rights reverting back to the Saudi government after 40 years, with the possibility of a 20-year extension, if the government decides to grant it, but it is also restricted in how much oil it can extract from those reserves to a maximum of 12 billion barrels a year.Governance and Risk: We noted, earlier, that Aramco’s flaws: the government’s absolute control of it, the country risk created by its dependence on domestic production and the political risk emanating from the possibility of regime change. To see how this can affect pricing, consider how the five companies on the integrated oil peer group that are Russian (with Gazprom, Rosneft and Lukoil being the biggest) are priced, relative to the global average:

Russian oil companies are discounted by 50% or more, relative to their peer group, and while Saudi Arabia does not have the same degree of exposure, the market will mete out some punishment.
A Valuation of AramcoThe value of Aramco, like that of any company in any sector, is a function of its cash flows, growth and risk. In fact, the story that underlies the Aramco valuation is that of a mature company, with large cash flows and concentrated country risk. That said, the structuring of the company and the desire of the Saudi government to use its cash flows to diversify the economy play a role in value.
General Assumptions
While I will offer three different approaches to valuing Aramco, they will all be built on a few common components.

First, I will do my valuation in US dollars, rather than Saudi Riyals, since as a commodity company, revenues are in dollars and the company reports its financials in US dollars (as well as Riyal). This will also allow me to evade tricky issues related to the Saudi Riyal being pegged to the US dollar though the reverberations from the peg unraveling will be felt in the operating numbers. Second, I will use an expected inflation rate of 1.00% in US dollars, representing a rough approximation of the difference between the US treasury bond rate and the US TIPs rate. Third, I will use the equity risk premium of 6.23% for Saudi Arabia, representing about a 0.79% premium over my estimate of a mature market premium of 5.44% at the start of November 2019. Finally, rather than use the standard perpetual growth model, where cash flows continue forever, I will use a 50-year growth period, representing the fact that the company's primary asset, its oil reserves, are not infinite and will run out at some point in time, even if additional reserves are discovered. In fact, at the current production level, the existing reserves will be exhausted in about 35 years.
Valuation: Promised Dividends
While the dividend discount model is far too restrictive in its assumptions about payout to be used to value most companies, Aramco may be the exception, especially given the promise in the prospectus to pay out at least $75 billion in dividends every year from 2020 and 2024, and the expectation that these dividends will continue and grow after that. There is one additional factor that makes Aramco a good candidate for the dividend discount model and that is the absolute powerlessness that stockholders will have at the company to change how much it returns to shareholders. To complete my valuation of Aramco using the promised dividends, I will make two additional assumptions:

Growth rate: I will assume a long term growth rate in dividends set equal the inflation rate, and since this valuation is in US dollars, that inflation rate will be 1%.Discount rate: Rather than use a discount rate reflecting the risk of an oil company, I will be one that is closer to that demanded by investors in REITs and oil royalty trusts, investments where the bulk of the returns will be in dividends and those dividends are backed up by asset cash flows.The valuation picture is below:

Download spreadsheetBased upon my assumptions, the value of Aramco is about $1.63 trillion. Seen through these lens, this stock is a dressed-up bond, where dividends will remain the primary form of return and there will be little price appreciation.
Valuation: Potential Dividends
The reason that dividend discount models often fail is because they look at the actual dividends paid and don’t factor in the reality that some companies pay out more than they can afford to do in dividends, in which case they are unsustainable and will fall under that weight, and some companies pay too little, in which case the cash that is paid out accumulates in the firm as a cash balance, and equity investors get a stake in it. While I noted that Aramco has signaled that it will pay at least $75 billion in dividends over the next five years, it has not indicated that it will cease investing and with potential dividends, you value the company based upon its capacity to pay dividends, rather than actual dividends. In computing the potential dividends, I assumed that the company would be able to grow earnings at 1.80% a year, and be able to do so by continuing to generate sky high returns on equity (its 2018 return on equity was about 41%). However, the shift from promised dividends to potential dividends will also expose investors to more of the risk in an integrated oil company and I adjust the cost of equity accordingly:

Download spreadsheetThe value of equity, using potential dividends, is $1.65 trillion, reflecting not only Aramco’s capacity to pay much higher dividends than promised but also the higher risk in these cash flows.
Valuation: As a BusinessWhen you value a business, you effectively allow for the options that the firm has to make changes to how much and where it invests, how it finances it business and how much it pays in dividends. One reason that this may provide only limited benefits in the Aramco case is that the company is significantly constrained, both because of its ownership and governance structure as well as its mission, on all three dimensions. Thus, it is likely that Aramco will remain predominantly a fossil fuel company, tethered to its roots in Saudi Arabia, is unlikely to alter its policy of being predominantly equity funded and its dividend policy is sticky even at as it starts life as a public company. Following through with these assumptions, I assumed that the debt ratio for Aramco will stay low at 1.80% of overall capital, as will the cost of debt at 2.70%, in US dollar terms, based upon its bond rating. To get the reinvestment, I switch to using the return on capital of 44.61% that the company generated in 2018, as my base:

Download spreadsheetAdding the cash and cross holdings and then subtracting out the debt and minority interests in the company yields an equity value of $1.67 trillion, that is close to what we obtained with the FCFE model, but that should not be surprising, given that the company has so little debt in its capital structure.
Final Valuation Adjustments
In summary, what is surprising about the valuations of Aramco, using the three approaches, is how close they are in their final assessments, all yielding values around $1.65 trillion. That said, there are three additional considerations that none of these models have factored in.

Political Risk: While these models adjust for country risk in Saudi Arabia, I have used the default spread of the country as a proxy, but that misses the risk of regime change, a discontinuous risk that will have very large and potentially catastrophic effects on value. While you may believe that this risk is low, it is definitely not zero. Upside limits: When you invest in any large integrated oil company, you are making a bet on oil prices, with the expectation that higher oil prices will deliver higher income and higher value. While that assumption still holds for Aramco, the royalty structure that the Saudi government has created, where the royalty rate will climb from 40% at current oil prices to 45% if they rise above $ 70 and 80% if they rise above $100/barrel will mean that your share of gains, as an equity investor, on the upside will be capped, dampening the value today.Price setter/taker: While the largest publicly traded oil companies in the world are still price takers, Aramco has more influence on the oil price than any of them, as a result of Saudi Arabia's role in the oil market. Put simply, while the power of the Saudi government to set oil prices has decreased from the 1970s, it does continue to wield more influence than any other entity in this process.The first two factors are clear negatives and should lead you to mark down the value of Aramco, but the third factor may help provide some downside protection. Overall, I would expect the value of equity in Aramco to be closer to $1.5 trillion, after these adjustments are made. (I am assuming a small chance of regime change, but if you attach a much higher probability, the drop off in value will be much higher).
Aramco: To invest or not to?
Over the weekend, we got a little more clarity on the IPO details, with a rumored pricing of $1.7 trillion for the company's equity and a planned offering of 1.5% of the outstanding shares. That price is within shouting distance of my valuation, and my guess is that given the small size of the offering (at least on a percentage basis), it will attract enough investors to be fully subscribed. At this pricing, I think that the company will be more attractive to domestic than international investors, with Saudi investors, in particular, induced to invest by the company's standing in the country. It will be a solid investment, as long as investors recognize what they are getting is more bond than stock, with dividends representing the primary return and limited price appreciation. They will have no say in how the company is run, and if they don't like the way it is run, they will have to vote with their feet. If they are worried about risk, the research they should do is more political than economic, with the primary concerns about regime stability. The one concern that you should have, if you are a Saudi investor, with your human capital and real estate already tied to Saudi Arabia's (and oil's) well being, investing your wealth in Aramco will be doubling down on that dependence.
In case you care about my investment judgment, Aramco is not a stock for me for two reasons. First, I am lucky enough not to be dependent on cash flows from my investment portfolio to meet personal liquidity needs, and have no desire to receive large dividends, just for the sake of reaching them, since they just create concurrent tax burdens. Second, if I were tempted to invest in the company as a play on oil prices, the rising royalty rates, as oil prices go up, imply that my upside will be limited at Aramco. Finally, it is worth noting that this company will be the ultimate politically incorrect investment, operating both as a long term bet on oil, in a world where people are as dependent as ever on fossil fuels, but seem to be repelled by those who produce it, and as a bet on Saudi royalty, an unpopular institution in many circles. As a consequence, I am willing to bet that not too many college endowments in the United States will be investing in Aramco, and even conventional fund managers may avoid the stock, just to minimize backlash. I don't much care for political correctness nor for investors who seem to believe that the primary purpose of investing is virtue signaling, and I must confess that I am tempted to buy Aramco just to see their heads explode. However, that would be both petty and self-defeating, and I will stay an observer on Aramco, rather than an investor.
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Published on November 18, 2019 13:26

November 15, 2019

The Softbank-WeWork End Game: Savior Economics or Sunk Cost Problem?

Since my pre-IPO post on WeWork, where I valued the company ahead of its then imminent offering, much has happened. The company’s IPO collapsed under the weight of its own pricing contradictions, and after a near-death experience, Softbank emerged as the savior, investing an additional $ 8 billion in the company, and taking a much larger stake in its equity. As the WeWork story continues to unfold, I am finding myself more interested in Softbank than in WeWork, largely because it’s actions cut to the heart of so many questions in investing, from how sunk costs can affect investing decisions, to the feedback effects from mark-to-market accounting, and finally on the larger question of whether smart money is really smart or just lucky.
WeWork: The IPO Aftermath
It has been only a few weeks since I valued WeWork for its IPO, but it seems much longer, simply because of how much has changed since then. As a reminder, I valued WeWork at about $10 billion pre-money, and $13.75 billion with the anticipated proceeds of $3.5 billion added on. I also argued that this was a company on a knife’s edge, a growth machine with immense operating and financial leverage, where misstep could very quickly tip them into bankruptcy, with a table illustrating how quickly the equity slips into negative territory, if the operating assumptions change:

Download spreadsheetSoon after my post, the ground shifted under WeWork, as a combination of arrogance (on the part of VCs, bankers and founders) and business model risks caught up with the company, and the IPO was delayed, albeit reluctantly by the company. That action, though, left the company in a cash crunch, since it had been counting on the IPO to bring in $3 billion in capital to cover its near-term needs. In conjunction with a loss of trust in the top management of the company, created a vicious cycle with the very real possibility that the company would implode. As WeWork sought rescue packages, Softbank offered a lifeline, with three components to it:Equity Buyout: A tender offer of $3 billion in equity to buy out of existing stockholders in the firm to increase its share of the equity ownership to 80%. In an odd twist, Softbank contended that, after the financing, “it will not hold a majority of the voting rights… and does not control the company… WeWork will not be a subsidiary of Softbank. WeWork will be an associate of Softbank”. I am not sure whether this is a true confession of lack of control or a ploy to keep from consolidating WeWork (and its debt load) into Softbank's financials.Added Capital: Softbank would provide fresh debt financing of $5 billion ($1.1 billion in secured notes, $2.2 billion in unsecured notes and $1.75 billion as a line of credit) and an acceleration of a $1.5 billion equity investment it had been planning to make into WeWork in 2020, giving WeWork respite, at least in the short term, from its cash constraints.Neutering Adam Neumann (at a cost): The offer also includes a severing of Adam Neumann’s leadership of the company, in return for which he will receive $1 billion in cash, $500 million as a loan to repay a JP Morgan credit line and $185 million for a four-year position as a consultant. I assume that the consulting fee is more akin to a restraining order, preventing him from coming within sighting distance of any WeWork office or building.Since that deal was put together, the storyline has shifted, with Softbank now playing the lead role in this morality play, with multiple questions emerging:What motivated Softbank to invest so much more in a company where it had already lost billions? Some are arguing that Softbank had no choice, given the magnitude of what they had invested in WeWork, and others are countering that they were throwing good money after bad. With mark-to-market rules in effect at Softbank, how will accountants reflect the WeWork disaster on Softbank’s books? I think that fair-value accounting is neither fair nor is it about value, but the WeWork write down that Softbank had to take is a good time to discuss how fair-value accounting can have a feedback effect on corporate decision making.Is Masa Son a visionary genius or an egomaniac in need of checks and balances? A year ago, there were many who viewed Masa Son, with his 300-year plans and access to hundreds of billions of dollars in capital, was a man ahead of his time, epitomizing smart money. Today, the consensus view seems to be that he is an impulsive and emotional investor, not to be trusted in his investment judgments. The truth, as is often the case, lies somewhere in the middle.Since Softbank is a holding company, deriving a chunk of its value from its perceived ability to find start-ups and young companies and convert them into big wins, how will its value change as a result of its WeWork missteps? To answer this question, I will look at how Softbank’s market capitalization has changed over time, especially around the WeWork fiasco, and examine the consequences for its Vision fund plans. Sunk Cost or Corporate Rescue!
In the years that WeWork was a private company, Softbank was, by far, the largest investor in the company. In August 2019, when the IPO was first announced, Softbank had not only been its largest capital provider, investing $7.5 billion in the company, but had also supplied the most recent round of capital, at a pricing of $47 billion. That lead-in, though, raises questions about the motives behind its decision to invest an extra $ 8 billion to keep WeWork afloat. It’s a corporate rescue: There are some who would argue that Softbank had no choice, since without an infusion of capital, WeWork was on a pathway to being worth nothing and that by investing its capital, Softbank would avoid that worst-case scenario. In fact, if you believe Softbank, with the infusion, WeWork has a pre-money value of $8 billion, with the infusion, and while that is a steep write down from the $47 billion pricing, it is still better than nothing. Good money chasing bad: The sunk cost principle, put simply, states that when you make an investment decision, your choice should be driven by its incremental effects and not by how much you have already expended leading up to that decision. In practice, though, investors seem to abandon this principle, trying to make up for past mistakes by making new ones. In the context of Softbank’s new WeWork investment, this would imply that Softbank is investing $ 8 billion in WeWork, not because it believes that it can generate more than amount in incremental value from future cash flows, but because it had invested $7.5 billion in the past.So, how do you resolve this question? As I see it, the Softbank rescue of WeWork may have helped it avoid a near term liquidity meltdown, but it has not addressed any of the underlying issues that I noted with the company’s business model. In fact, it has taken a highly levered company whose only pathway to survival was exponential growth and made it an even more levered company with constrained growth. In fact, Softbank has been remarkably vague about the economic rationale for the added investment and their story does not hold up to scrutiny. I do realize that Masa Son claims that “(t)he logic is simple. Time will resolve . . . and we will see a sharp V-shaped recovery,” in WeWork, but I don’t see the logic, time alone cannot resolve a $30 billion debt problem and there are enough costs in non-core businesses to cut to yield a quick recovery. At least from my perspective, Softbank’s investment in WeWork is good money chasing bad, a classic example of how sunk costs can skew decisions. To those who would counter that Softbank has a lot of money to lose and smart people working for it, note that the more money you have to lose and the smarter people think they are, the more difficult it becomes to admit to past mistakes, exacerbating the sunk cost problem. In fact, now that Softbank will have more than $15 billion invested in WeWork, they have made the sunk cost problem worse, going forward.
Accounting Fair Value
I understand the allure of fair value accounting to accountants. It provides them with a way to update the balance sheet, to reflect real world changes and developments, and make it more useful to investors. The fact that it also creates employment for accountants all over the world is a bonus, at least from their perspective. I think that the accounting response to Softbank’s WeWork mistake illustrates why fair value accounting is an oxymoron, more likely to do damage than good:It is price accounting, not value accounting: In Softbank’s latest earnings report, we saw the first installment of accounting pain from the WeWork mistake, with Softbank writing down its WeWork investment by $4.6 billion and reporting a hefty loss for the quarter. The reason for the write-down, though, was not a reassessment of WeWork’s value, but a reaction to the drop in the pricing of the company’s equity from the $47 billion before the IPO to $8 billion after the IPO implosion. With Softbank supplying the pricing: If you are dubious about the use of pricing in accounting revaluations, you should even more skeptical in this case, since Softbank was setting the pricing, at both the $47 billion pre-IPO, and the $8 billion, post-collapse. As I noted in the last section, there is nothing tangible that I can see in any of Softbank’s numerous press releases to back these numbers. In fact, if WeWork had not been exposed in its public offering, my guess is that Softbank would have probably invested more capital in the company, marked up the pricing to some number higher than $47 billion and that we would not be having this conversation.Too little, too late: As is always the case with accounting write-downs and impairments, there was very little news in the announcement. In fact, given that the write down was based upon pricing, not value, the market knew that a write off was coming and approximately how much the write off would be, which explains why even multi-billion write offs and impairments usually have no price effect, when announced. Incidentally, the accountants will offer you intrinsic valuations (DCF) to back up their assessments, but I would not attach to much weight to them, since they are what I call “kabuki valuations”, where the analysts decide, based on the pricing, what they would like to get as value, and then reverse engineer the inputs to deliver that number.With dangerous feedback effects: If all fair value accounting did was create these write downs and impairments that don’t faze investors, I could live with the consequences and treat the costs incurred in the process as a jobs plan for accountants. Unfortunately, companies still seem to think that these accounting charges are news that moves markets and take actions to minimize them. In fact, a cynic might argue that one motivation for Softbank’s rescue of WeWork was to minimize the write down from its mistake. I am not a fan of fair value accounting, partly because it is a delayed reaction to a pricing change and is not a value reassessment, and partly because companies are often tempted to take costly actions to make their accounting numbers look better.
Smart Money, Stupid Money!
I hope that this entire episode will put to rest the notion of smart money, i.e., that there are investors who have access to more information than we do, have better analytical tools than the rest of us and use those advantages to make more money than the rest of us. In fact, it is this proposition that leads us to assume that anyone who makes a lot of money must be smart, and by that measure, Masa Son would have been classified as a smart investor, and wealthy investors funneled billions of dollars into Softbank Vision funds, on that basis. I am not going to argue that the WeWork misadventure makes Masa Son a stupid investor, but it does expose the fact that he is human, capable of letting his ego get ahead of good sense and that at least some of his success over time has to be attributed being in the right place at the right time.
So, if investors cannot be classified into smart and stupid, what is a better break down? One would be to group them into lucky and unlucky investors, but that implies a complete surrender to the forces of randomness that I am not yet willing to make. I think that investors are better grouped into humble and arrogant, with humble investors recognizing that success, when it comes, is as much a function of luck as it is of skill, and failure, when it too arrives, is part of investing and an occasion for learning. Arrogant investors claim every investing win as a sign of their skill and view every loss as an affront, doubling down on their mistakes. If I had to pick someone to manage my money, the quality that I would value the most in making that choice is humility, since humble investors are less likely to overpromise and overcommit. I think of the very act of demanding obscene fees for investment services is an act of arrogance, one reason that I find it difficult to understand why hedge funds are allowed to get away with taking 2% of your wealth and 20% of your upside.
Leading into the WeWork IPO, the question of where Masa Son fell on the humility continuum was easy to answer. Anyone who makes three hundred year plans and things that bigger is always better has a God complex, and success feeds that arrogance. I would like to believe that the WeWork setback has chastened Mr. Son, and in his remarks to shareholders this week, he said the right things, stating that he had “made a bad investment decision, and was deeply remorseful”, speaking of WeWork. However, he then undercut his message by not only claiming that the pathway to profit for WeWork would be simple (it is not) but also asserting that his Vision fund was still better than other venture capitalists in seeking out and finding promising companies. in my view, Masa Son needs a few more reminders about humility from the market, since neither his words nor his actions indicate that he has learned any lessons.
Softbank: The WeWork Effect
WeWork may have been Masa Son’s mistake, but the vehicle that he used to make the investment was Softbank, through the company and its Vision fund. As WeWork has unraveled, it is not surprising that Softbank has taken a significant hit in the market.

Note that Softbank has lost more than $15 billion in value since August 14, when the WeWork IPO was announced, and much of that loss can be attributed to the unraveling of the IPO, and how investor perceptions of Masa Son’s investing skills have changed since.

The knocking down of Softbank’s value by the market may strike some of you as excessive, but there is reason that Softbank’s WeWork investment has ripple effects. Softbank may be built around a telecom company, but like Berkshire Hathaway, the company that Masa Son is rumored to admire and aspire to be, it is a holding company for investments in other companies. In fact, its most valuable holding remains an early investment in Alibaba, now worth tens of billions dollars. While Alibaba is publicly traded and its pricing is observable, many of Softbank’s most recent investments have been in young, private companies like WeWork. With these investments, the pricing attached to them by Softbank, in its financials, comes from recent VC funding rounds and their valuations reflect trust in Softbank’s capacity to pick winners and the WeWork meltdown hurts on both counts. First, investors are more wary about trusting VC pricing, especially if Softbank has been a lead investor in funding rounds, since that is how you arrived at the $47 billion pricing for WeWork in the first place. Second, the notion of Masa Son as an investing savant, skilled at picking the winners of the disruption game, has been damaged, at least for the moment and perhaps irreparably. The easiest way to measure how investor perceptions have changed is to compare the market capitalization of Softbank to its book value, a significant proportion of which reflects its holdings, marked to market:

Investors have been wary of Softbank’s investing skills, even before the WeWork IPO, but the write offs on Uber and WeWork has made them even more skeptical, as the price to book ratio continues its march towards parity, with the market capitalization at 123% of the book value of equity in November 2019. In fact, if you focus just on Softbank’s non-consolidated holdings, public and private, note that the market capitalization of Softbank now stands at 73% of the value of just these holdings, most of which are marked to market. Put simply, when you buy Softbank, you are getting Uber and Alibaba at a discount on their traded market prices, but before you put your money down on what looks like a great deal, there are two considerations that may affect your decision. The first is that the company has a vast amount of debt on its balance sheet that has to be serviced, potentially putting your equity at risk, and the second is that you are getting Softbank (and Masa Son) as the custodian of the investments. If you have lost faith in Masa Son’s investing judgments (in people and in companies), you may view the 27% discount that the market is attaching to Softbank’s holdings as entirely justifiable and steer away from the stock. In contrast, if you feel that WeWork was an aberration in an otherwise stellar investment picking record, you should load up on Softbank stock. As for me, I don’t plan to own Softbank! I don't like grandiosity and Masa Son seems to have been soaked in it.

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mso-level-tab-stop:none; mso-level-number-position:left; text-indent:-.25in;} @list l3:level9 {mso-level-number-format:roman-lower; mso-level-tab-stop:none; mso-level-number-position:right; text-indent:-9.0pt;} </style></div><b>Blog Posts</b><br /><ol style="text-align: left;"><li><a href="http://aswathdamodaran.blogspot.com/2... Story to Meltdown in Motion: The Unraveling of the WeWork IPO</a></li><li><a href="http://aswathdamodaran.blogspot.com/2... Costs and Investing</a></li></ol></div>

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Published on November 15, 2019 05:14

October 18, 2019

Disrupting the IPO Process: Challenging the Banker-run Going-Public Model!

In the age of disruption, where young companies are challenging the status quo and upending conventional businesses, it was only a matter of time before they turned their attention to the process by which they are taken public. For decades, the standard operating procedure for a company going public has been to use a banker or a banking syndicate to market itself to public investors at a “guaranteed” price, in return for a sizeable fee. That process has developed warts along the way but it has remained surprisingly stable even as the investing world has changed. In the aftermath of some heavily publicized let downs in the IPO market this year, with the WeWork fiasco topping off the bad news, there is now an active and healthy discussion about how companies should make the transition to being public. Change may finally be coming to the going-public game and it is long overdue.
Going Public? The ChoicesWhen a private company chooses to go public, there are two possible routes that it can take in making this transition. The more common one is built around a banker or bankers who manage the private to public transition:

There is an alternative, though it seems to be seldom used, which is to do a direct listing. In this process, a private company lets the markets set the price on the offering date, skipping the typical IPO dance of setting an offer price, which in retrospect is set too low or too high.

The company still has to file a prospectus, but the biggest difference is that it cannot raise fresh capital on the offering date, though existing owners can cash out by selling their shares. That is not as much of a problem as it sounds, since the company can choose to raise cash in a pre-listing round from interested investors, or to make a secondary offering, in the months after it has gone public. In fact, one advantage that direct listing have is that there is no lock-up period, as there is with conventional IPOs, where private investors cannot sell their shares for six months after the listing. If you are interested in the details of a direct listing, this write-up by Andreesen Horowitz sums it up well. Let’s be clear. If this were a contest, the status quo is winning, hands down. While there have been a couple of high-profile direct listings in Spotify and Slack, the overwhelming majority of companies have chosen the status quo. Furthermore, the status quo seems to be global, indicating either that the benefits that issuing companies see in the banker-based model apply across markets or that the US-model has been adopted without questions in other markets.
The IPO Status Quo: The Pros and ConsTo understand how the status quo got to be the standard, it makes sense to look at what issuing companies perceive to be the benefits of having banking guidance, and weigh them off against the costs. In the process, we will also lay the foundations for examining how the world has changed, and why the status quo may be under threat.
The Banker's caseLooking at the status quo picture that I showed in the last section, I listed the services that bankers offer to issuing companies, starting with the timing and details of the offering, all the way through the after-market support. At the risk of sounding like a salesperson for bankers, let’s see what bankers bring, or claim to bring, to the table on each of the services:Timing: Bankers would argue that their experience in financial markets and their relationship with institutional investors give them the insights to determine the optimal timing window for a public offering, where the investment stars are aligned to deliver the highest possible price and the smoothest post-market experience.Filing/Offering Details: A prospectus is as much legal document as it is information disclosure, and past experience with other initial public offerings may allow bankers to guide companies in what information to include in the prospectus and the language to use to in providing that information, as well as provide help in navigating the regulatory rules and requirements for public offerings.Pricing: It is on this front where bankers can claim to offer the most value added for three reasons. First, their knowledge of public market pricing can help them bridge the gap with the private market pricing preceding the offering, and in some cases, reduce unrealistic expectations on the part of VCs and founders. Second, they can help frame the offer pricing by finding the best metric to scale the pricing to and identifying the peer group that investors will use in public markets. Third, by reaching out to investors, bankers can not only gauge demand and fine tune the pricing but also isolate concerns that investors may have about the company. Selling/Marketing: To the extent that multiple banks form the selling syndicate, and each can reach out to their investor clientele, bankers can expand the investor base for an issuing company. In addition, the marketing that accompanies the road shows can market the company to the larger market, attracting buzz and excitement ahead of the offer date. Underwriting Guarantee: At first sight, the underwriting guarantee that bankers offer seems like one of the bigger benefits of using the banking-run IPO model, but I am afraid that there is less there than meets the eye, since the guarantee is set first and the price is not set until just before the offering, and it can be set below what you believe investors would pay for the stock. In fact, if you believe the graph on offer day price performance that I will present in the next section, the typical IPO is priced about 10-15% below fair price, making the guarantee much less valuable.After-market Support: Bankers make the case that they can provide price support for IPOs in the after-market, using their trading arms, sometimes with proprietary capital. In addition, researchers have documented that the equity research arms of banks that are parts of IPO teams are far more likely to issue positive recommendations and downplay the negatives.At least on paper, bankers offer services to issuing companies, though the value of these services can vary across companies and across time.
The Bankers’ CostsThe banking services that are listed above come at a cost, and that cost takes two forms. The first and more obvious one is the banker’s fees for the issuance and these costs are usually scaled to the issuance proceeds. They can range from 3% to more than 8% of the proceeds, with the percentage costs increasing for smaller issuers:

While issuance costs do decrease for larger issuers, it is surprising that the drop off is not more drastic, suggesting either that costs are more variable than fixed or that there is not much negotiating room on these costs. To provide an example of the magnitude of these costs, the banking fees for Uber’s IPO amounted to $105 million, with Morgan Stanley, the lead banker, claiming about 70% of the fees.

There is a second cost and it arises because of the way the typical IPO is structured. Since investment banks guarantee an offering price, they are more inclined to underprice an offering than over price it, and not surprisingly, the typical IPO sees a jump in the price from offer to opening trade on the first day of trading:

Source: Jay Ritter, University of FloridaThus, the median IPO sees its stock price jump about 15% on the offering date, though there are some companies where the stock price jump is much greater. To provide specific examples, Beyond Meat saw a jump of 84% on the offering date, from its offer price, and Zoom’s stock price at the end of its first trading day was 72% higher than the offering price. Note that this underpricing is money left on the table by issuing company’s owners for the investors who were able to get shares at the offering price, many preferred clients for the banks in the syndicate. In defense of banks, it is worth noting that many issuing company shareholders seem to not just view this “lost value” as part of the IPO game, but also as a basis for subsequent price momentum. That argument, though, is becoming increasingly tenuous since if it were true, IPOs, on average, should deliver above-average returns in the weeks and months after the offering date, and they do not. If momentum is the rationale, it should also follow that newly listed stocks that do well on the offering date should deliver higher returns than newly listed stocks that do badly and there is no evidence of that either.
Revisiting the IPO ProcessGiven the costs of using banks to manage the going-public process, it is surprising that there have not been more rumblings from private market investors and companies planning to go public about the process. After the WeWork and Endeavor IPO debacles, the gloves seem to have come off and the battle has been joined.
The Bill Gurley Case for Direct ListingsBill Gurley has often been an atypical venture capitalist, willing to challenge the status quo on many aspects of the VC business. For many years now, he has sounded the alarm on how private market investors have paid too much for scaling models and not paid enough attention to building sound businesses. In the last few months, he has been aggressively pushing young companies to consider the direct listing option more seriously. His primary argument has been focused on the underpricing on the offering date, which as he rightly points out, transfers money from private market investors to investment bankers' favored clientele. In fact, he has pointed to absurdity of paying for an underwriting pricing guarantee, where the guarantors get to set the price much later, and are open about the fact that they plan to under price the offering. I don’t disagree with Bill, but I think that he is framing the question too narrowly. In fact, the danger with focusing on the offer day pricing jump runs two risks.
The first is that many issuing companies not only don’t seem to mind leaving money on the table, but some actively seem to view this under pricing as good for their stock, in the long term. After all, Zoom's CFO, Kelly Steckelberg seemed not only seems untroubled by the fact that Zoom stock jumped more than 70% on the offering date (costing its owners closer to $250-$300 million on the offered shares), but argued that that Zoom “got the most added attention in the financial community,” and even picked up business from several of its IPO banks who she said are “trialing or have standardized on Zoom now.” The second is that Gurley's critique seems to suggest that if bankers did a better job in terms of pricing, where the stock price on the offer date is close to the offer price, that the banker-run IPO model would be okay. I think that a far stronger and persuasive argument would be to show that the problem with the banking IPO model is that changes in the world have diluted and perhaps even eliminated that value of the services that bankers offer in IPOs, requiring that we rethink this process.The Dilution of Banking ServicesIn the last section, in the process of defending the banker presence in the IPO process, I listed a series of services that bankers offer. Given how much the investing world, both private and public, has changed in the last few decades, I will revisit those services and look at how they have changed as well:No timing skills: To be honest, no one can really time the market, though some bankers have been able to smooth talk issuing companies into believing that they can. For the most part, bankers have been able to get away with the timing claims, but when momentum shifts, as it seems to have abruptly in the last few months in the IPO market, it is quite clear that none of the bankers saw this coming earlier in the year.Boilerplate prospectuses: When I wrote my post on the IPO lessons from WeWork, Uber and Peloton, I noted that these three very different companies seem to have the same prospectus writers, with much of the same language being used in the risk sections and business sections. While the reasons for following a standardized prospectus model might be legal, the need for banking help goes away if the process is mechanical.Mangled Pricing: This should be the strong point for bankers, since their capacity to gauge demand (by talking to investors) and influence supply (by guiding companies on offering size) should give them a leg up on the market, when pricing companies. Unfortunately, this is where banking skills seem to be have deteriorated the most. The most devastating aspect of the WeWork IPO was how out of touch the bankers for the company were in their pricing:

Source: Financial TimesI would explain this pricing disconnect with three reasons. The first is that bankers are mispricing these companies, using the wrong metrics and a peer group that does not quite fit, not surprising given how unique each of these companies claims to be. The second is that the bankers are testing out prices with a very biased subset of investors, who may confirm the mistaken pricing. The third and perhaps most likely explanation is that the desire to keep issuing companies happy and deals flowing is leading bankers to set prices first and then seek out investors at those prices, a dangerous abdication of pricing responsibility.Ineffective Selling/Marketing: When issuing companies were unknown to the market and bankers were viewed as market experts, the fact that a Goldman Sachs or a JP Morgan Chase was backing a public offering was viewed as a sign that the company had been vetted and had passed the test, the equivalent of a Good Housekeeping seal of approval for the company, from investors' perspective. In today’s markets, there have been two big changes. The first is that issuing companies, through their product or service offerings, often have a higher profile than many of the investment banks taking them public. I am sure that more people had heard about and used Uber, at the time of its public offering, than were aware of what Morgan Stanley, its lead banke, does. The second is that the 2008 banking crisis has damaged the reputation of bankers as arbiters of investment truths, and investors have become more skeptical about their stock pitches. All in all, it is likely that fewer and fewer investors are basing their investment decision on banking road shows and marketing.Empty guarantee: Going back to Bill Gurley’s point about IPOs being under priced, my concern with the banking IPO model is that the under pricing essentially dilutes the underwriting guarantee. Using an analogy, how much would you be willing to pay a realtor to sell a house at a guaranteed price, if that price is set 20% below what other houses in the neighborhood have been selling for? What after-market support? In the earlier section, I noted that banks can provide after-issuance support for the stocks of companies going public, both explicitly and implicitly. On both counts, bankers are on weaker ground with the companies going public today, as opposed to two decades ago. First, buying shares in the after-market to keep the stock price from falling may be a plausible, perhaps even probable, if the issuing company is priced at $500 million, but becomes more difficult to do for a $20 billion company, because banks don’t have the capital to be able to pull it off. Second, the same loss of faith that has corroded the trust in bank selling has also undercut the effectiveness of investment banks in hyping IPOs with glowing equity research reports. Summing up, even if you believed that bankers provided services that justified the payment of sizable issuance costs in the past, I think that you would also agree that these services have become less valuable over time, and the prices paid for these services have to shrink and be renegotiated, and in some cases, entirely dispensed with.

Why change has been slow
Many of the changes that I highlighted in the last section have been years in the making, and the question then becomes why so few companies have chosen to go the direct listing route. There are, I believe, three reasons why the status quo has held on and that direct listings have no become more common.Inertia: The strongest force in explaining much of what we see companies do in terms of investment, dividend and financing is inertia, where firms stick with what's been done in the past, partly because of laziness and partly because it is the safest path to take.Fear: Unfounded or not, there is the fear that shunning bankers may lead to consequences, ranging from negative recommendations from equity research analysts to bankers actively talking investors out of buying the stock, that can affect stock prices in the offering and in the periods after.The Blame Game: One of the reasons that companies are so quick to use bankers and consultants to answer questions or take actions that they should be ready to do on their own is that it allows managers and decisions makers to pass the buck, if something goes wrong. Thus, when an IPO does not go well, and Uber and Peloton are examples, managers can always blame the banks for the problems, rather than take responsibility.I do think that at least for the moment, there is an opening for change, but that opening can close very quickly if a direct listing goes bad and a CFO gets fired for mismanaging it.

The End Game
As the process of going public changes, everyone involved in this process from issuing companies to public market investors to bankers will have to rethink how they behave, since the old ways will no longer work.

Issuing companies (going public) Choose the IPO path that is right for you: Given your characteristics as a company, you have to choose the pathway, i.e., banker-led or direct listing that is right for you. Specifically, if you are a company with a higher pricing (in the billions rather than the millions), with a public profile (investors already know what you do) and no instantaneous need for cash, you should do a direct listing. If you are a smaller company and feel that you can still benefit from even the diminished services that bankers offer, you should stay with the conventional IPO listing route.If you choose a banker, remember that your interests will not align with those of the bankers, be real about what bankers can do for you and negotiate for the best possible fee, and try to tie that feee to the quality of pricing. If I were Zoom's CFO, I would have demanded that the banks that underpriced my company by 80% return their fees to me, not celebrated their role in the IPO process.If you choose the direct listing path, recognize that the public market may not agree with you on what you think your company is worth, and not only should you accept that difference and move on, you should recognize that this disagreement will be part of your public market existence for your listing life. In either case, you should work on a narrative for your company that meets the 3P test, i.e., is it possible? plausible? probable? You are selling a story, but you will also have to deliver on that story, and overreaching on your initial public offering story will only make it more difficult for you to match expectations in the future. Investors
Choose your game: In my last post, I noted that there are two games that you can play, the value game, where you value companies and trade on the difference, waiting for the price to converge on value and the pricing game, where you buy at a low price and hope to sell at a higher one. There is nothing inherently more noble about either game, but you should decide what game you came to play and be consistent with that choice. In short, if you are a trader, stop pondering the fundamentals and using discounted cash flow models, since they will be of little help in winning, and if you are an investor, don't let momentum become a key ingredient of your value estimate.Keep the feedback loop open: Both investors and traders often get locked into positions on IPOs and are loath to revisit their original theses, mostly because they do not want to admit mistakes. With IPOs, where change is the only constant, you have to be willing to listen to people who disagree with you and change your views, if the facts merit that change.Spread your bets: The old value investing advice of finding a few good investments and concentrating your portfolio in them can be catastrophic with IPOs. No matter how carefully you do your homework, some of the investments that you make in young companies will blow up, and if your portfolio succeeds, it will be because a few big winners carried it. Stop whining about bankers, VCs and founders: Many public market investors seem to believe that there is a conspiracy afoot to defraud them, and that bankers, founders and VCs are all part of that conspiracy. If you lose money on an IPO, the truth is that it may not be your or their faults, but the consequence of circumstances out of anyone's control. In the same vein, when you make money on an IPO, recognize that it has much to do with luck as with your stock picking skills. Bankers Get real about what you bring to the IPO table: As I noted before, public and private market changes have put a dent on the edge that bankers had in the IPO game. It behooves bankers then to understand which of the many services that they used to charge for in the old days still provide added value today and to set fees that reflect that value added. This will require revisiting practices that are taken as given, including the 6-7% underwriting fee and the notion that the offer price should be set about 15% below what you think the fair prices should be.Speak your mind: If one of the reasons that the IPOs this year have struggled has been a widening gap between the private and public markets, bankers can play a useful role in private companies by not only pointing to and explaining the gap, but also in pushing back against private company proposals that they believe will make the divergence worse. Get out of the echo chamber: An increasing number of banks have conceded the IPO market to their West Coast teams, often based in Silicon Valley or San Francisco. These teams are staffed with members who are bankers in name, but entirely Silicon Valley in spirit. It is natural that if you rub shoulders with venture capitalists and founders all day that you relate more to them than to public market investors. I am not suggesting that banks close their West Coast offices, but they need to start putting some distance between their employees and the tech world, partly to regain some of their objectivity. YouTube Video
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Published on October 18, 2019 12:53

October 11, 2019

IPO Lessons for Public Market Investors

This year, I have found myself returning repeatedly to the IPO well, as high profile companies have chosen to go public, and like a moth to a flame, I have been drawn to value them. There was much enthusiasm at the start of 2019 that this would be a blockbuster year for IPOs, not just for the companies going public, but also for public market investors who would now get a chance to own pieces of companies which had made venture capitalists and private market investors rich, at least on paper. While many of these companies, with the exception of WeWork, have gone public and raised large amounts of capital, many of the new listings have disappointed in the after market. The WeWork fiasco, while creating vast collateral damage, has also created healthy discussions about how venture capitalists price private companies and whether public market investors should base their pricing of the latest VC rounds, whether the IPO process itself is in need of a change, what the share count that we should be using in computing market capitalization at these young companies and whether investors should even enter this space, where uncertainty abounds and cash burn is more the rule than the exception.
An 2019 IPO Pricing RetrospectiveIt is estimated that nearly 200 companies will go public this year, an increase of about 5% over last year's 190 IPOs, but still well below the 547 companies that went public in 1999. The first half of the year was a good one for investors in these IPOs, but investors have soured on these companies in the last few months. One way to measure the performance of these young companies in the after market is to look at how the Renaissance IPO ETF, a fund that tracks larger initial public offerings and weights them based upon free float, has done over the course of the year:

Since the fund tracks IPOs for 500 trading days after the listing date, it is not quite a clean measure of this year's IPOs, but it is a good proxy. Notwithstanding all of the negative press you may have read about IPOs in the last few weeks, and third quarter damage, the Renaissance ETF IPO has outperformed the market over the course of this year.

To take a closer look at a subset of these IPOs, I focused on seven of the offerings this year - Uber, Lyft, Pinterest, Slack, Levi Strauss, Peloton and Beyond Meat - and looked the performance of each of these stocks since the opening trade on the offering date:

To compare the performance of these offerings, I standardized performance by looking at how much $100 invested in each stock at the open price on the first trading day would have done, in periods ranging from a day to the year to date:

I have tracked the returns that investors would have earned if they had invested at the offer price and at the open price on the first trading day. Note first that five of the seven stocks registered a jump in excess of 20%, comparing the open price to the offer price, when they started trading. Looking at the returns in the year to date, the outlier is Beyond Meat, on an almost unbelievable run from its offer price, but of the remaining six stocks, only Pinterest has gone up, relative to it first trade price. Uber, Lyft and Slack have been awful investments, though if you had received Slack shares at the offer price, the pain would be more bearable. Even Levi Strauss, not a young or a tech company, has seen rough going in the months since its initial public offering. Peloton has been listed only ten trading days, but it has to hope that the worst is behind it. What does this all mean? First, in spite of recent setbacks, investors in IPOs collectively have done reasonably well over the course of the year, but only if they spread their bets. Second, in the midst of this good news, some of the most hyped IPOs have had difficulty gaining traction, and since these companies attract the most attention from investors and the financial press, they are contributing to the perception that investing in IPOs has been a loser's game this year.
IPO Lessons for Public Market InvestorsIn my post on the Peloton IPO, I opined on how venture capitalists price companies and how the pressures that they have put on companies to scale up quickly, often without paying heed to building good business models, is playing out. In this one, I would like to look at the public market side of the IPO process, again looking for common threads.

1. It stays a pricing gameAt the risk of repeating myself, the price of an asset and its value are determined by different forces and estimated using different tools. and while they may be good estimates of each other in an efficient market, they can diverge, creating both opportunities and dangers for investors:

It is not just venture capitalists that play the pricing game. Most public market investors do as well, and this is particularly true when companies first go public for three reasons:The IPO process: The IPO process is one of gauging demand and supply and setting a price based on that assessment, not estimating the value of businesses. It is the job of the bankers managing the process is to make this judgment, usually based upon the responses they get from their investor clientele. Thus, it should be not surprising that the bulk of the backing for an offering price comes from finding a pricing metric (revenue multiple, user value etc.) and relevant comparable firms (a subjectively judgment). Self Selection: The players who get drawn into the IPO game tend to be those with shorter time horizons who feel that their strength is in riding momentum, when it exists, and detecting shifts, before the rest of the market does. In short, the IPO market is built for traders, not investors.Type of companies: Most initial public offerings tend to be of firms that are younger and often less formed than their more seasoned public counterparts. Consequently, more of their value lies in the future and there is more uncertainty in assessing numbers, leading investors to abandon these stocks, claiming that there is too much uncertainty, giving pricing almost all of the stage.So what if the IPO market is a pricing game? First, trying to use value tools (like DCF) or fundamentals to explain IPO pricing, and what causes these prices to move on a day-to-day basis in the after market is a recipe for frustration. The nature of the pricing game is that mood and momentum can not only cause these companies to be priced at numbers very different from value, but also cause price movements on trivial, perhaps even irrelevant, news stories. Second, playing the momentum game is akin to riding on the back of a tiger, with the danger being that you will be consumed, if the game shifts. Take a look at Beyond Meat's price movements over the course of this year, since its IPO, and you can see how quickly momentum can shift in a stock, and the decisive effects it has on pricing.

2. On a shaky baseIn the pricing game, you estimate how much to pay for a company by looking at how similar companies are being priced by the market, usually scaling price to a common metric like earnings, book value or revenues, as well as its own pricing history. With initial public offerings, this process gets more difficult for two reasons:Peer Group Framing: With most public companies, a combination of the company's operating history and market learning leads to a consensus on what its peer group should be, for pricing purposes. Thus, when pricing Coca Cola or Adobe, investors tend to agree more than they disagree about what companies to put into the peer group for comparison. For many IPOs, especially built around new business models and practices, there is much more confusion about what grouping to put the company into. Not surprisingly, the IPOs try to influence this choice by framing themselves as being in businesses that will deliver a higher pricing, explaining why almost every one of them likes to use the word "tech" in its description.Past Pricing History: Unlike publicly traded companies, where there is a market price history, the only price history that you have with IPOs is from prior VC rounds. To understand this may be problematic, let me focus on the seven IPOs I highlighted in the last section and provide information on the private investor funding of each, leading into the IPO:

Source: Crunchbase, Yahoo! FinanceNote three problems with using this information as a basis for public market pricing. First, in most cases, the pricing for the company is extrapolated from a small VC investment. With Lyft, for instance, the estimated pricing of $14.5 billion from the most recent round was extrapolated from an investment of $600 million for the company for a 4.1% share of the company. Second, this problem is worsened by the fact that VC investors can and usually do negotiate for post-investment protections, when they invest. For instance, ratchets allow VCs to adjust their ownership stake in a company upwards, if a subsequent funding round is based upon a lower pricing for the company. In effect, VCs are being provided with options, and as I noted in this post on unicorns, the presence of these additional features makes simplistic extrapolation to pricing from a VC investment almost impossible to do. Third, even if the pricing is correctly extrapolated from the last VC investment, all you need is one over optimistic venture capitalist to push the pricing beyond reasonable bounds. In the case of WeWork, it can be argued that much of the surge in pricing in the company came from Softbank's continued investments in the company and not a reflection of consensus among venture capitalists.In the traditional IPO model, where investment bankers form a syndicate to sell the shares at a pre-set offer price, it can be argued that the primary service that bankers provide, if they do their job well, is to use their access to public investors to fine tune the pricing. This year's experiences with Peloton and Uber, where the stock price dropped on the offer day, and with WeWork, where the pricing estimates imploded to the point of imperiling the public offering, has led some founders and venture capitalists to question whether it is worth hiring bankers in the first place.
3. With an unstable share count
We all know the process for estimating market capitalization for a firm, and it involves taking the stock price and multiplying by the number of shares outstanding. For most publicly listed firms, that calculation should yield a value fairly close to the truth, but IPOs are different for two reasons. First, an overwhelming number in recent years have had two classes of shares (sometimes three) with different voting rights and being sloppy and missing an entire share class will cause devastating errors in computation. Second, most of these companies are young and cash-poor, and they have chosen to compensate employees with equity, either in the form of restricted shares and options. The way in which investors and analysts deal with these employee equity claims ranges from the abysmal to the barely acceptable, again with significant consequences. Let's take the Peloton case, where the company in its final prospectus listed itself as having 41.8 million class A shares, with lower voting rights, and 235.9 million class B shares, with higher voting rights, after its IPO, yielding a total share count of 277.7 million shares. That is the share count that has been used by journalists in writing about the offering and by most of the data services since, in estimating the implied pricing of $8.1 billion for the company, at the offer price of $29. That is patently untrue, and the reason is in the same prospectus, where Peloton states that "the number of shares..... does not include:64,602,124 shares of our Class B common stock issuable upon the exercise of options to purchase shares of our Class B common stock outstanding as of June 30, 2019, with a weighted-average exercise price of $6.71 per share; 883,550 shares of our Class B common stock issuable upon the exercise of options to purchase shares of our Class B common stock granted between June 30, 2019 and September 10, 2019 with a weighted-average exercise price of $23.40 per share; 240,000 shares of our Class B common stock issuable upon the exercise of a warrant to purchase Class B common stock outstanding as of June 30, 2019, with an exercise price of $0.19 per share;"Focus on just the first bullet, where Peloton admits that there 64.6 million options, with an exercise price of $6.71. Given that the offer price was $29/share and the open price was $27, is there any doubt that at some point in time, sooner rather than later, these options will get exercised and become shares? In fact, in what universe can you ignore these options in estimating market capitalization? The reason this practice can lead to dangerous mis-pricing is simple. Let's assume that the Peloton bankers came to the conclusion that $8.1 billion was a reasonable value to attach to its equity, based upon past VC rounds and peer group pricing. To get to an offer price, they cannot divide that number by just the shares outstanding (277.7 million), since that will treat the options as worthless. In my valuation of Peloton, I did what I think should always be done, which is to value the options as options, which allows me to include at-the-money and out-of-the-money options, as well as time value, net that option value from my equity value and then divide by the 277.7 million shares. If you find option pricing models too opaque, here is a simpler way to get to value per share from the estimated equity value:

Thus, if the Reuters story quoted above is correct in its judgment that the bankers wanted to price Peloton at $8.1 billion, the estimated offer price per share, counting only the 64.6 million additional options would have been:

Alternatively, it is possible that this was a journalistic error in extrapolation and that the bankers took options into account and meant to price it at $29/share, in which case the implied market capitalization for Peloton at the $29 offer price, using the exercise proceeds short cut, would have been:Implied Market Cap at $29/share = 277.7 * $29 + 64.6* ($29 - 6.71) = $9.5 billion
To see why this matters, any enterprise value or pricing multiple that you compute for Peloton should be based upon the $9.5 billion estimate, not the $8.1 billion, if the stock was trading at $29. I think that we are generally sloppy in market capitalization calculations, but that sloppiness has much bigger consequences with IPOs. So, as investors, we should follow the Russian adage of "trust, but verify", when it comes to share count.
4. And a Bar Mitzvah Moment waiting!
At this stage, I don't blame you if you are puzzled by how I approach IPOs. As soon as an IPO is announced, I use the prospectus to value the company, but I just confessed earlier that the IPO market, at listing and in the periods afterwards, is a pricing game, not a value game. So, why bother with a DCF in the first place?

If your intent is to trade IPOs, you should not care about value, but mine is different. I consider myself an investor, not a trader, not because it is a more noble calling but because I am a terrible trader. As an investor, I have faith that when investing in equity in a business, there will eventually a reckoning, where price converges on value. I use the word "faith" because there is no mechanism that guarantees this convergence.Young companies that go public are often adept at playing the pricing game, delivering more users, subscribers or revenues, if that is what the pricing gods want, and their stock prices often continue to rise, even though their fundamentals don't merit it. It is my belief that each of these companies will face what I call a "Bar Mitzvah" moment, where the market, hitherto focused on magical metrics, asks the company about its pathway to profitability. As I look back over time, the very best of these companies, and I would include Facebook, Google and Amazon in this grouping, are ready for this moment, since they have been building viable business models, even as they delivered on market metrics. Many of these young companies, though, seem unready for this question, and the market punishes them, as was the case with Twitter in 2014.

Go where it is darkest!Even if you accept my proposition that price eventually converges to value, if you subscribe to old time value investing, you are probably wondering why I would want to try to put my money at risk, investing in these young companies, when it is so much easier to value mature companies like Philip Morris and Coca Cola. I don't disagree with you on your premise that there is a great deal more uncertainty in valuing Uber than in valuing Coca Cola, but I believe that the payoff to imprecisely valuing Uber is greater than the payoff to precisely valuing Coca Cola. After all, what made Coca Cola easy for you to value also makes it easy for other investors to do as well, and the uncertainty that scares you with Uber is scaring most investors away from even trying. It is for that reason that I value companies at the time of their public offerings, and repeatedly thereafter, hoping that I am able to get in at the right price. Here are my estimates of value for the companies on my list at the time of the IPO, with updates on both value and price as trading has continued: table.tableizer-table { font-size: 12px; border: 1px solid #CCC; font-family: Arial, Helvetica, sans-serif; } .tableizer-table td { padding: 4px; margin: 3px; border: 1px solid #CCC; } .tableizer-table th { background-color: #104E8B; color: #FFF; font-weight: bold; }

Levi StraussLyftPinterestBeyond MeatUberSlackPelotonIPO Value $24.23 $58.78 $25.08 $46.88 $32.91 $20.59 $19.35 IPO Offer Price$17.00 $72.00 $19.00 $25.00 $45.00 $26.00 $29.00 IPO Open Price$22.22 $87.33 $23.75 $46.00 $42.00 $38.50 $27.17 % Difference-8.30%48.57%-5.30%-1.88%27.62%86.98%40.41%
Updated Value$26.59 $54.38 $26.17 $47.41 $35.42 $24.34 $19.35 Price on 8/10/19$18.96 $38.66 $25.63 $142.73 $29.28 $25.70 $23.21 % Difference-28.69%-28.91%-2.06%201.05%-17.33%5.59%19.95%SpreadsheetDownload Download Download Download Download Download Download
At the time of the offering, relative to the open price, only Levi Strauss looked mildly under valued, Beyond Meat was at close to fair value and the other companies all looked over valued. Since the offering, each of these companies has released earnings reports and I updated the treasury bond rates and equity risk premiums in all of the valuations. With Uber and Lyft, the added perturbation comes from legislation passed by the state of California, requiring that drivers be treated as employees, an assumption that I had already built into my valuation, but one that seemed to catch the market by surprise. Incorporating the price changes at all of the companies, and reflecting my updated valuation stories for the companies, Levi Strauss has become more under valued, Uber and Lyft have moved from being over to under valued, Slack and Peloton have converged on value and Beyond Meat has become significantly overvalued. Levi Strauss's most recent earnings report was not well received by the market, with the stock dropping 1.1% to $18.96. I see its fundamentals justifying a higher value and I bought shares at $18.96.I have gone back and forth on whether to buy Uber, Lyft or both. Lyft looks more under valued, but Uber offers more upside, given its global ambitions. In addition, I prefer Uber's single class of shares to Lyft's multiple voting right classes, and these factors tilted me to buying the latter at $30/share. Slack and Pinterest are getting close to fair value as their prices have drifted down and Peloton has become less over valued but still has room to fall. For the moment, I will add these companies to my watch list, and track their pricing.With my story for Beyond Meat, I find the price almost unreachable with any story that I craft, and while this was the same conclusion that I drew a few months ago, this time, I tried shorting the stock at $142, but was unable to get my trade through. I fell back on buying put options at a 120 strike price, expiring on December 20, 2019, paying a mind-bending time premium for a two-month option. While the stock has been resistant to the laws of gravity (or value) for must of its listed life, I believe that there are two things that have changed that make this a good time to make this short term intrinsic value bet. One is the listing of Impossible Foods gives investors not just another way of making a macro bet on veganism, but also an easy comparison on pricing. The other is the decision by Beyond Meat to issue 3.25 million shares a few weeks ago, with 3 million shares coming from insiders, suggests that the firm itself may think its stock is over priced.Some of my bets will go wrong, and if they do, I am also sure that some of you will point them out to me, and I am okay with that. That said, I hope that you make your own judgments on these companies, and you are welcome to use my spreadsheets (linked both above and below) and change the inputs that you disagree with, if that helps.
YouTube Video

Valuation Spreadsheets

Levi Strauss (October 8, 2019)Lyft (October 8, 2019)Pinterest (October 8, 2019)Beyond Meat (October 8, 2019)Uber (October 8, 2019)Slack (October 8, 2019)Peloton (September 28, 2019)LinksTwitter: Why a good trade can be a bad investment?Twitter's Bar Mitzvah: Is social media coming of age?

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Published on October 11, 2019 14:18

October 1, 2019

US Equities: Resilient Force or Case Study in Denial?

As readers of this blog know, I don't write much about whether stocks collectively are over or under priced, other than my usual start of the year posts about markets or in response to market crisis. There are two reasons. The first is that there is nothing new or insightful that I can bring to overall market analysis, and I generally find most market punditry, including my own, to be more a hindrance than a help, when it comes to investing. The second is that I am a terrible market timer, and having learned that lesson, try as best as I can to steer away from prognosticating about future market direction. That said, as markets test their highs, talk of market bubbles has moved back to the front pages, and I think it is time that we have this debate again, though I have a sense that we are revisiting old arguments.
Who are you going to believe?One reason that investors are conflicted and confused about what is coming next is because there is are clearly political and economic storms that are on the horizon, and there seems to be no consensus on what those storms will mean for markets. The US equity market itself has been resilient, taking bad macroeconomic and political news in stride, and a bad day, week or month seems to be followed by a strong one, often leaving the market unchanged but investors wrung out. Investors themselves seem to be split down the middle, with the optimists winning out in one period and the pessimists in the next one. One measure of investor skittishness is stock price variability, most easily measured with the VIX, a forward-looking estimate of market volatility:

Here again, the market's message seems to be at odds with the stories that we read about investor uncertainty, with the VIX levels, at least on average, unchanged from prior years. If you follow the market and macroeconomic experts either in print or on the screen, they seem for the most part either terrified or befuddled, with many seeing darkness wherever they look. As in the Christmas Carol, the ghosts of market gurus from past crises have risen, convinced that their skill in calling the last correction provides special insight on this market. In the process, many of them are showing that their success in market timing was more luck than skill, often revealing astonishing levels of ignorance about instruments and markets. (At the risk of upsetting those of you who believe these gurus, GE is not Enron and index funds are not responsible for creating market bubbles...)
Stock Market - Bubble or not a bubble? Point and Counter Point!Why do so many people, some of whom have solid market pedigrees and even Nobel prizes, believe that markets are in a bubble? The two most common explanations, in my view, reflect a trust in mean reversion, i.e., that markets revert back to historic norms. The third one is a more subtle one about winners and losers in today's economy, and requires a more serious debate about how economies and markets are evolving. The final argument requires that you believe that powerful rate-setting central bankers and market co-conspirators have artificially propped up stock and bond prices. With each argument, though, there are solid counter arguments and in presenting both sides, I am not trying to dodge the question, but I am interested in looking at the facts.
Bubble argument 1: Markets have gone up too much, in too short a period, and a correction is dueThe simplest argument for a correction is that US equity markets have been going up for so long and have gone up so much that it seems inevitable that a correction has to be near. It is true that the last decade has been a very good one for stocks, as the S&P 500 has more than tripled from its lows after the 2008 crisis. While there have been setbacks and a bad period or two in the midst, staying fully invested in stocks would have outperformed any market timing strategy over this period.

Is it true that over long time periods, stocks tend to reverse themselves? Yes, but when and by how much is not just debatable, but the answers could have a very large impact on anyone who decides to cash out prematurely. The easy push back on this strategy is that without considering what happens to earnings or dividends over the period, no matter what stock prices have done, you cannot make a judgment on markets being over or under priced.
Counter Argument 1: It is not just stock prices that have gone up...If stock prices had jumped 230% over a period, as they did over the last decade, and nothing else had changed, it would be easy to make the case that stocks are over priced, but that is not the case. The same crisis that decimated stock prices in 2008 also demolished earnings and investor cash flows, and as prices have recovered, so have earnings and cash flows:

Notice that while stocks have climbed 230% in the ten-year period since January 1, 2009, earnings have risen 212% over the same period, and cash flows have almost kept track, rising 188%. Since September 2014, cash flows have risen faster than earnings or stock prices. It is possible that earnings and cash flows are due for a fall, and that this will bring stock prices down, but it requires far more ammunition to be credible.
Bubble Argument 2: Stocks are over priced, relative to history, and mean reversion worksThe second argument that the market is in a bubble is more sophisticated and data-based, at least on the surface. In short, it accepts the argument that stocks should increase as earnings go up, and that looking at the multiple of earnings that stocks trade at is a better indicator of market timing. In the graph below, I graph the PE ratio for the S&P 500 going back to 1969, in conjunction with two alternative estimates, one of which divides the index level by the average earnings over the prior ten years (to normalize earnings across cycles) and the other of which divides the index level by the inflation-adjusted earnings over the prior ten years.

Download raw data on PE ratiosNote that on October 1, 2019, all three measures of the PE ratios for the S&P 500 are higher than they have been historically, if you compare them to the median levels, with the PE at the 75th percentile of values over the 50-year period, and normalized PE and CAPE above the 75th percentile. Proponents then complete the story using one of two follow up arguments. One is that mean reversion in markets is strong and that the values should converge towards the median, which if it occurs quickly, would translate into a significant drop in stock prices (35%-40% decline). The other is to correlate the l PE ratio (in any form) with stock returns in subsequent periods, and show that higher PE ratios are followed by weaker market returns in subsequent periods.
Counter Argument 2: Stocks are richly priced, relative to history, but not relative to alternative investments todayIf you are convinced by one of the arguments above that stocks are over priced and choose to sell, you face a question of where to invest that cash. After all, within the financial market, if you don't own stocks, you have to own bonds, and this is where the ground has shifted the most against those using the mean reversion argument with PE ratios. Specifically, if you consider bonds to be your alternative to stocks, the drop in treasury rates over the last decade has made the bond alternative less attractive. In the graph below, I compare earnings yields on US stocks to T.Bond rates, and include dividend and cash yields in my comparison:

Download raw data on yields and interest ratesIn short, if your complaint is that earnings yields are low, relative to their historic norms, you are right, but they are high relative to treasury rates today. To those who would look to real estate, a reality check is that securitization of real estate has made its behavior much closer to financial markets than has been historically true, as can be seen when you graph capitalization rates (a measure of required return for real estate equity) against equity and bond rates.
Bubble Argument 3: The market is up, but the gains have come from a few big companiesIn a version of the glass half-empty argument, there are some who argue that while US stock market indices have been up strongly over the last decade, the gains have not been evenly spread. Specifically, a few companies, primarily in the technology space, have accounted for a big chunk of the gain in market capitalization over the period. There is some truth to this argument, as can be seen in the graph below, where I look at the FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) stocks and the S&P 500, in terms of total market capitalization:

As you can see, the last decade has seen a phenomenal surge in the market capitalizations of the FAANG stocks, with the $3.15 trillion increase in their market capitalizations alone explaining more than one-sixth of the increase in market capitalization of the S&P 500. In the eyes of pessimists, that gives rise to two concerns, one relating to the past and one to the future. Looking back, they argue that many investors have been largely left out of the market rally, especially if their portfolios did not include any of the FAANG stocks. Looking forward, they posit that any weakness in the FAANG stocks, which they argue is largely overdue, as they face pressure on legal and regulatory fronts, will translate into weakness in the market.
Counter Argument 3: The market reflects changes in how markets and economies work
The concentration of market gains in the hands of a few companies, at least at first sight, is troublesome but it is not new. There have been very few bull markets, where companies have shared equally in the gains, and it is more common than not for market gains to be concentrated in a small percentage of companies. That said, the degree of concentration is perhaps greater in this last bull run (from 2009 to 2019), but that concentration represents forces that are reshaping economies and markets. Each of the companies in the FAANG has disrupted existing businesses and grabbed market share from long-standing players in these businesses, and the nature of their offerings has given them networking benefits, i.e., the capacity to use their rising market share to grow even faster, rather than slower. It is this trend that has drawn the attention of regulators and governments, and it is possible, maybe even likely, that we will see anti-trust laws rewritten to restrain these companies from growing more or even breaking them up. While that would be bad news for investors in these companies, those rules are also likely to enrich some of the competition and push up their earnings and value. In short, a pullback in the FAANG stocks, driven by regulatory restrictions, is likely to have unpredictable effects on overall stock prices.
Bubble Argument 4: Central banks, around the world, have conspired to keep interest rates low and push up the price of financial assets (artificially) As you can see in the earlier graph comparing earnings to price rates to treasury bond rates, interest rates on government bonds have dropped to historic lows in the last decade. That is true not just in the US, but across developed markets, with 10-year Euro, Swiss franc and Japanese Yen bond rates crossing the zero threshold to become negative.

If you buy into the proposition that central banks set these rates, it is easy to then continue down this road and argue that what we have seen in the last decade is a central banking conspiracy to keep rates low, partly to bring moribund economies back to life, but more to prop up stock and bond prices. The end game in this story is that central banks eventually will be forced to face reality, interest rates will rise to normal levels and stock prices will collapse.
Counter Argument 4: Interest rates are low, but central bankers have had only a secondary roleConspiracy theories are always difficult to confront, but at the heart of this one is the belief that central banks set interest rates, not just influence them at the margin. But is that true? To answer that question, I will fall back on a simple measure of what I call an intrinsic risk free rate, constructed by adding the inflation rate to the real growth rate, drawing on the belief that interest rates should reflect expected inflation (rising with inflation) and real interest rates (related directly to real growth).

Download raw data on interest rates, inflation and growthLooking back over the last decade, it is low inflation and anemic economic growth that have been driving interest rates lower, not a central banking cabal. It is true that at the start of October 2019, the gap between the ten-year treasury bond rate and the intrinsic risk free rate is higher than it has been in a long time, suggesting that either Jerome Powell is a more powerful central banker than his predecessors or, more likely, that the bond market is building in expectations of lower inflation and growth.
Implied Equity Risk Premiums: A Composite IndicatorDid you think I would have an entire post on stock markets, without taking a dive into implied equity risk premiums? Unlike PE ratios that focus just on stock prices or treasury bond rates that focus just on the alternative to stocks, the implied equity risk premium is a composite number that is a function of how stocks are priced, given cash flows and expected growth in earnings, as well as treasury bond rates. In my monthly updates for the S&P 500, I compute and report this number and as of October 1, 2019, here is what it looked like:

Download spreadsheet
The equity risk premium for the S&P 500 on October 1, 2019, was 5.55%, and by itself, you may not know what to do with this number, but the graph below shows how this number has changed between 2009 and 2019:

Download historical ERPThere are two uses for this number. First, it becomes the price of equity risk in my company valuations, allowing me to maintain market neutrality when valuing WeWork, Tesla or Kraft-Heinz. In fact, the valuations that I will do in October 2019 will use an equity risk premium of 5.55% (the implied premium on October 1, 2019, for the S&P 500) as my mature market premium. Second, though I have confessed to being a terrible market timer, the implied ERP has become my divining rod for overall market pricing. An unduly low number, like the 2% that I computed at the end of 1999 for the S&P 500, would represent market over-pricing and a really high number, such as the 6.5% that you saw at the start of 2009, would be a sign of market under-pricing. At 5.55%, I am at the high end of the range, not the low end, and that backs up the case that given treasury rates, earnings and cash flows today, stock prices are not unduly high.
My Market View (or non-view)I am neither bullish nor bearish, just market-neutral. In other words, my investment philosophy is built on valuing individual companies, not taking a view on the market, and I will take the market as a given in my valuation. Does this mean that I am sanguine about the future prospects of equities? Not in the least! With equities, it is worth remembering that the coast is never clear, and that the reason we get the equity risk premiums that I estimated in the last section is because the future can deliver unpleasant surprises. I can see at least two ways in which a large market correction an unfold.

An Implosion in Fundamentals
Note that my comfort with equities stems from the equity risk premium being 5.55%, but that number is built on solid cash flows, a very low but still positive growth in earnings and low interest rates. While the number is robust enough to withstand a shock to one of these inputs, a combination that puts all three inputs at risk would cause the implied ERP to collapse and stock pricing red flags to show up. In this scenario, you would need all of the following to fall into place:Slow or negative global economic growth: The global economic slowdown picks up speed, spreads to the US and become a full-fledged recession.Cash flow pullback: This recession in conjunction causes earnings at companies to drop and companies to drastically reduce stock buybacks, as their confidence about the future is shaken.T. Bond rates start to move back up towards normal levels: Higher inflation and less credible central banks cause rates to move back up from historic lows to more "normal" levels.I can make an argument for one, perhaps even two of these developments, occurring together, but a scenario where all three things happen is implausible. In short, if economic growth collapses, I see it as unlikely that interest rates will rise.
A Global Crisis with systemic after shocks
There is no denying that there are multiple potential crises unfolding around the world, and one of these crises may be large enough, in terms of global and cross sector consequences, to cause a major market pull back. It is unclear what exactly equity markets are pricing in right now, but the triggering mechanism for the meltdown will be an "unexpected" crisis development, leading equity risk premiums to jump to higher levels, as investors reassess market-wide risk. For the crisis to have sustained consequences, it has to then feed into economic growth, perhaps through a drop in consumer and business confidence, and also into earnings and cash flows. After a decade of false alarms, investors are jaded, but the crisis calendar is full for the next two months, as Brexit, impeachment, Middle East turmoil and the trade war will all play out, almost on a daily basis.
Bottom Line
I am not a macroeconomic forecaster, and I am going to pass on market timing, accept the fact that the markets of today are globally interconnected and more volatile than the markets of the last century, and stick to picking stocks. I hope that my choice of companies will provide at least partial protection in a market correction, but I know that if the market is down strongly, my stocks will be, as well. I know that some of you will disagree strongly with my market views, and I will not try to talk you out of them, since it is your money that you are investing, not mine, and your skills at market/macro forecasting may be much stronger than mine. If you are a master macroeconomic forecaster who believes that a perfect storm is coming where there is a global recession with a drop in earnings and a loss or corporate confidence (leading to a pull back on buybacks), perhaps accompanied by high inflation and high interest rates, you definitely should cash out, though I cannot think of a place for that cash to go, right now.
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Linked DatasetsPE ratios for the S&P 500 Stock Yields and Interest Rates: US Intrinsic Riskfree versus 10-year T.Bond Rate Historical Implied Equity Risk Premiums: USLinked Spreadsheets

Implied Equity Risk Premium Calculator (October 1, 2019)

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Published on October 01, 2019 15:34

September 17, 2019

Insights on VC Pricing: Lessons from Uber, WeWork and Peloton!

As a confession, I started this post intending to write about Peloton, the next big new offering hitting markets, but I got distracted along the way. As I read the Peloton prospectus, with the descriptions of its business, its measure of total market size and its success at scaling up revenues accompanied by large losses, I had a feeling of déjà vu, since other prospectuses that I had read this year from Lyft, Uber, Slack, Pinterest and, most recently, WeWorks, not only shared many of the same characteristics, but also used much of the same language. I briefly considered the possibility that these companies were using a common prospectus app, where given a bare bones description, a 250-page prospectus would be generated, complete with the requisite buzz words and corporate governance details. Setting aside that cynical thought, I think it is far more likely that these companies are emphasizing those features that allowed them to get to where they are today, and that examining these shared features should give us insight into how venture capitalists price companies, and the dangers of basing what you pay on VC pricing. To keep my write up from becoming too long (and I don't think I succeeded), I will use only Uber, WeWork and Peloton to illustrate what I see as the commonalities in their investment pitches, when I could have spread my net wider to include all IPOs this year.
1. Unbounded Potential MarketsIt is natural that companies, especially early in their lives, puff up their business descriptions and inflate their potential markets, but the companies that have gone public this year seem to have taken it to an art form. Lyft, which went public before Uber, described themselves as a transportation company, a little over-the-top for a car service company, but Uber topped this easily, with their identification as a personal mobility company. WeWork, in its prospectus, steers clear of ever describing itself as being in real estate, framing itself instead as a community company, whatever that means. Peloton, in perhaps the widest stretch of all, calls itself a technology, media, software, product, experience, fitness, design, retail, apparel and logistics company, and names itself Peloton Interactive for emphasis. In conjunction with these grandiose business descriptions, each of the company's IPOs also lists a total addressable or accessible market (TAM) that it is targeting. While this is a measure, initiated with good sense , it has become a buzzword that means close to nothing for these young companies. In the picture below, I have taken the total market descriptions given in the Uber, WeWork and Peloton prospectuses:

If you believe these companies, Uber's TAM is $5.71 trillion spread across 175 countries, and obtained by adding together all passenger vehicle and public transport spending, WeWork is looking at $3 trillion in office space opportunities and Peloton believes that it can sell its expensive exercise bikes and subscriptions to 45 million people in the US and 67 million globally.
It is no secret that my initial valuation of Uber used far too cramped a definition of its total market, and Bill Gurley rightly pointed to the potential that these companies have to expand markets, but defining the market as broadly as these companies makes a mockery of the concept. In fact, I will draw on a 3P test that I developed in the context of converting stories to numbers, to put these TAM claims to the test;

With Uber, for instance, my initial estimate of the car service market in June 2014, while defining the magnitude of the car services market then, was a constrained TAM and, in hindsight, it proved far too limited, as Uber's pricing and convenience drew new customers into the market, expanding the market significantly. It is a lesson that I have taken to heart, and I do try to give disruptive companies the benefit of the doubt in estimating TAM, erring more towards the expanded TAM definition. That said, the total market claims that I see outlined in the prospectuses of the companies that have gone public this year, while perhaps meeting the possible test, fail the plausible and probable tests. That TAM overreach makes the cases for these companies weaker, rather than stronger, by making them less credible.
2. All about Scaling (in dollars and units)All of the companies that have gone, or are planning to go, public this year are telling scaling up stories, with explosive growth in revenues and talk of acceleration in that growth. On this count, the companies are entitled to crow, since they have grown revenues at unprecedented rates coming into their public offerings.

In short periods, these companies have grown from nothing to becoming among the largest players in their markets, at least in terms of revenues. While this focus on revenue growth is not surprising, since it is at the heart of their stories, it is revealing that all of the companies spend as much, if not, more time talking about growth in their revenue units (Uber riders, WeWork members and Peloton subscribers).

In fact, each of these companies, in addition to providing user/subscriber members, also provide other eye-popping numbers on relevant units, Uber on drivers and rides taken, WeWork on cities and locations and Peloton on bikes sold. I understand the allure of user numbers, since the platform that they inhabit can be used to generate more revenues. That is implicitly the message that all these companies are sending, and I did estimate a lifetime value of an Uber rider at close to $500 and I could use the model (described in this paper) to derive values for a WeWork member or a Peloton subscriber. After all, the most successful user-based companies, such as Facebook and Amazon Prime, have shown how having a large user base can provide a foundation for new products and profits. However, there are companies that focus just on adding users, using badly constructed business models and pricing products/services much too cheaply, hoping to raise prices once the users are acquired. MoviePass is an extreme example of user pursuit gone berserk, but it had no trouble attracting venture capital money, and I fear that there are far more young user-based companies following the MoviePass script than the Facebook one.
3. Blurry Business Models and Flaky Earnings MeasuresMost of the companies that have gone public this year have entered the public markets with large losses, even after you correct for what they spend to acquire new users or subscribers. For some investors, this, by itself, is sufficient to turn away from these companies, but since these are young companies, pursuing ambitious growth targets, neither the negative earnings, nor the negative cash flows, is enough to scare me away. However, there are two characteristics that these companies share that I find off putting:Pathways to Profitability: As money losing companies, I had hoped that Uber, WeWork and Peloton would all spend more time talking, in their investor pitches, about their existing business models, current weaknesses in these models and how they planned to reduce their vulnerabilities. With Uber and Lyft, the question of how the companies planned to deal with the transition of drivers from independent contractors to employees should have been dealt with front and center (in their prospectuses), rather than be viewed as a surprise that no one saw coming, a few months later. With WeWork, their vulnerability, stemming from a duration mismatch, begged for a response, and plan, from the company in its prospectus, but none was provided. In fact, Peloton may have done the best job, of the three companies, of positioning themselves on this front, with an (implicit) argument that as subscriptions rise, with higher contribution margins, profits would show up.Earnings Adjustments: As has become standard practice across many publicly traded companies, these IPOs do the adjusted EBITDA dance, adding back stock-based compensation and a variety of other expenses. I have made my case against adding back stock-based compensation here and here, but I would state a more general proposition that adding back any expense that will persist as part of regular operations is bad practice. That is why WeWork's attempt to add back most of its operating expenses, arguing that they were community related, to get to community EBITDA did not pass the smell test.In summary, it is not the losses that these companies made in the most recent year that are the primary concern, it is that there seems to be no tangible plan, other than growth and hand waving on economies of scale, to put these companies into the plus column on profits.
4. Founder Worship and Corporate DictatorshipsSome time in the last two decades, newly public companies and many of their institutional investors seem to have lost faith in the quid quo pro that has characterized public companies over much of their history, where in return for providing capital, public market investors are at least given the semblance of a say in how the company is run, voting at annual meetings for board directors and substantive changes to the corporate charter. The most charitable characterization of the corporate governance arrangement at most newly minted public companies is that they are benevolent dictatorships, with a founder/CEO at the helm, controlling their destiny, and with no threat of loss of power, largely through super-voting right shares. In fact, most of the IPO companies this year have had:Shares with different voting classes: With the exception of Uber, every high profile IPO that has hit the market has had multiple classes of shares, with the low-voting right shares being the ones offered to the market in the public offering and the high voting right shares held by insiders and the founder/CEO. It is also revealing that Uber was also one of the few companies in the mix where the founder was not the CEO at the time of the IPO, after the board, pressured by large VC investors, removed Travis Kalanick from atop the company in June 2017, in the aftermath of personal and corporate scandals. Captive boards of directors: I am sure that the directors on the boards of newly public companies are there to represent the interests of investors in the company and and that many are well qualified, but they seem to do the bidding of the founder/CEO. The WeWork board seems to have been particularly lacking in its oversight of Adam Neumann, especially leading up to the IPO, but it is probably not an outlier.Complex ownership and corporate structures: When private companies go public, there is a transition period where shares of one class are being converted to another, some options have forced exercises and there are restricted share offerings that ripen, all of which make it difficult to estimate value per share. It does not help when the company going public takes this confusion and adds to it, as WeWork did, with additional layers of complex organizational structure.In many of the companies that have gone public this year, it is quite clear that the company's current owners (founder and VCs) view the public equity market as a place to raise capital but not one to defend or debate how their companies should be run. Put simply, if you are public market investor, these companies want your money but they don't want your input. When faced with that choice with Alibaba, I characterized this as Jack Ma charging me five-star hotel prices, when I check in as an investor in his company, but then directing me to stay in the outhouse, because I was not one of the insiders.
Reverse Engineering the VC GameEvery company that has come down the IPO pipeline this year has been able to raise ample capital from venture capitalists on its journey, with contributions coming from some public investor names (Fidelity and T.Rowe Price, to name just two). The fact that almost every company that went public this year framed its total market as implausibly big, emphasized how quickly it has scaled itself up, both in terms of revenues and users/subscribers, glossed over the flaws and weaknesses in its business model, and had shares with different voting rights suggests to me that this is behavior that was learned, because venture capitalists encouraged and rewarded it. Bluntly put, the pricing offered by venture capitalists for private companies must place scaling success over sound business models, over-the-top total addressable markets over plausible ones and founder entrenchment over good corporate governance.
In almost every IPO this year, the basis for at least the initial estimate of what the company would get from the market was the pricing at the most recent VC round, about $66 billion for Uber, $47 billion for WeWorks on the Softbank investment and about $4.2 billion at Peloton. The strongest sales pitch that the company and its bankers seem to be making is that venture capitalists are smart people who know a great deal about the company, and that you should be willing to base your pricing on theirs. This is not very persuasive, because, as I noted in this post, VCs price companies, they don't value them, and the pricing ladder, while it can lead price up, up and away, can also bring price down, when the momentum shifts.
This is not meant to be a broadside against all of venture capital. As with other investor groups, I am sure that there are venture capitalists who are sensible and unwilling to go along with these bad practices. Unfortunately, though, they risk being priced out of this market, as a version of Gresham's law kicks in, where bad players drive out good ones. In fact, since VC pricing takes its cues from public markets, it will interesting to see if the WeWork fiasco works its way through the VC price chain, leading to a repricing of companies that emphasize revenue scaling over all else.
A Peloton ValuationSince I started this post intending to value Peloton, I might as sell include my valuation of the company, especially since the company has released an updated prospectus with an estimated offering price of $26 to $30 per share. The company posits that there will 277.76 million shares outstanding (across voting share classes), but it also very clearly states that this does not include the 64.6 million options outstanding.
Business Model and Accessible MarketThe Peloton product offerings started with an upscale exercise bike, but has since expanded to include an even more expensive treadmill; the bike currently sells for about $2,250 and the treadmill for more than $4,000. In fact, if that is all that the company sold, it would have been competing in a constrained fitness product market with other exercise equipment manufacturers (Nautilus, Bowflex, NordicTrack, Life, Precor etc.). The company's innovation is two fold, first focusing on the upper end of the market with a very limited product offering and then offering a monthly subscription to those who bought, where you can take online classes and access other fitness-related services, with a monthly subscription fee of $40/month. In 2018, Peloton expanded its subscription service to non-Peloton fitness product owners, charging about $20 a month, with a membership count of 100,000 in 2018. The growth in the subscription portion of the business can be seen in the graphs below:

The fitness market that Peloton is going after is large, but splintered, currently with gyms, both local and franchised, and fitness product companies all competing for the pie. In 2019, it was estimated that the total market for fitness products was $30 billion in the United States and close to $90 billion globally. That said, harking back to our discussion of probable and plausible markets, Peloton is trying to draw people into this market who may otherwise have stayed away and getting existing customers to pay more, hoping to expand the market further.
Valuation Story and NumbersI am way too cheap to own a Peloton, but my conversations with Peloton owners/subscribers suggests to me that they have created a loyal customer base, perhaps unfairly likened to a cult. They rave about the online classes and how they keep them motivated to exercise, and while I take their praise with a grain of salt, it is quite clear that the company's online presence is not only polished but looks amazing on the high resolution TV screens that are built into their bikes and treadmills. In my story, I assume that the total accessible market will grow as Peloton and other new entrants into the subscription model draw in new customers, and that Peloton's allure will last, allowing it to grow its revenues over time to make it one of the bigger players in the fitness game. In my base case valuation, I see Peloton's subscription model as their ticket for future growth, pushing revenues by year 10 for the company to just above $10 billion, a lofty goal, given that the largest US fitness companies (gyms and equipment makers) have revenues of $2-$3 billion. I also believe that the shift towards subscriptions will continue, allowing for higher margins and lower capital investment than at the typical fitness company. My valuation is pictured below:

Download spreadsheetMy equity value is $6.65 billion, but in computing value per share, I have to consider the overhang of past option issuances at the company; there are 64.6 million options, with an average strike price of $6.71, outstanding in addition to the 277.76 million shares that the company puts forward as its share count. Valuing the options and netting them out yields a value per share of $19.35, about 20% below the low end of the IPO offering. That does bring me closer to the initial offering price than I got with either my Uber or WeWork valuations, though that is damning Peloton with faint praise. The magnitude of options outstanding at Peloton make it an outlier, even among the IPO companies, and I would caution investors to take these options into account, when computing market capitalizations or per share numbers. For instance, this Wall Street Journal report this morning, after the offering price was set at $26-$29/share, used the actual share count of 277.76 million shares to extrapolate to a market capitalization of $8 billion, at the upper end of the pricing range. That is not true. In fact, if you pay $29/share, you are valuing the equity in this company at more $9.5-$10 billion, with the options counted in.
Is there a great deal of uncertainty embedded in this valuation? Of course! While some argue that this is reason enough to either not invest in the company, or to not do a discounted cash flow valuation, I disagree. First, at the right price, you should be willing to expose yourself to uncertainty, and while I would not buy Peloton at $26/share, I certainly would be interested at a price lower than $19.35. Second, the notion that the value of a business is a function of its capacity to generate cash flows is not repealed, just because you have a young, high growth company. If your critique is that my assumptions could be very wrong, I completely agree, but I can still estimate value, facing up to that uncertainty. In fact, that is what I have done in the simulation below:

In terms of base numbers, the simulation does not change my view of Peloton. My median value is $18.30, with the tenth percentile at close to zero and the ninetieth percentile at $38.42, making it still over valued, if it is priced at $26/share. The long tail on the positive end of the distribution implies that I would buy Peloton with a smaller margin of safety than a more mature company, because of the potential of significant upside. (I have a limit buy, at $15/share. Given the offering price of $26-$29, there is little chance that it will execute soon, but I can play the long game).
A RequiemThe flood of companies going public, and their diverse businesses, has made for interesting valuations, but there are also more general lessons to be learned, even for those not interested in investing in these companies. First, our experiences with these IPOs should make it clear that it is the pricing game that dominates how numbers get attached to companies, and that is especially true for IPOs, not just on the offering day, but in the VC rounds leading up to the offering, and in the post-offering trading. Second, to the extent that the pricing game becomes centered on intermediate metrics, say revenue growth or on users or subscribers, it can lead companies astray, as they strive to deliver on those metrics, often at the expense of creating viable business models, and the pricing players (VCs and public investors) can get blindsided when the game changes. As I noted in my long-ago post on Twitter, these companies will face their bar mitzvah moments, when markets shift, often abruptly, from the intermediate users to the end game of profits, and many of these companies will be found wanting.
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LinksValuation of Peloton (September 16, 2019)Posts on IPOs this yearLyft: The First Ride Sharing IPO Uber's Coming Out Party: Personal Mobility Pioneer or Car Service on Steroids Meatless Future or Vegan Delusions? The Beyond Meat Valuation Runaway Story or Meltdown in Motion: The Unraveling of the WeWork IPOPosts on Venture Capital

Venture Capital: It is a pricing, not a value, game!

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Published on September 17, 2019 16:31

Insights on VC Pricing: Lessons from Uber, WeWorks and Peloton!

If you believe these companies, Uber's TAM is $5.71 trillion spread across 175 countries, and obtained by adding together all passenger vehicle and public transport spending, WeWork is looking at $3 trillion in office space opportunities and Peloton believers that it can sell its expensive exercise bikes and subscriptions to 45 million people in the US and 67 million globally.
It is no secret that my initial valuation of Uber used far too cramped a definition of its total market, and Bill Gurley rightly pointed to the potential that these companies have to expand markets, but defining the market as broadly as these companies makes a mockery of the concept. In fact, I will draw on a 3P test that I developed in the context of converting stories to numbers, to put these TAM claims to the test;

With Uber, for instance, my initial estimate of the car service market in June 2014, while defining the magnitude of the car services market then, was a constrained TAM and, in hindsight, it proved far too limited, as Uber's pricing and convenience drew new customers into the market, expanding the market significantly. It is a lesson that I have taken to heart, and I do try to give disruptive companies the benefit of the down in estimating TAM, erring more towards the expanded TAM definition. That said, the total market claims that I see outlined in the prospectuses of the companies that have gone public this year, while perhaps meeting the possible test, fail the plausible and probable tests. That TAM overreach makes the cases for these companies weaker, rather than stronger, by making them less credible.
2. All about Scaling (in dollars and units)All of the companies that have gone, or are planning to go, public this year are telling scaling up stories, with explosive growth in revenues and talk of acceleration in that growth. On this count, the companies are entitled to crow, since they have grown revenues at unprecedented rates coming into their public offerings.

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Published on September 17, 2019 16:31

September 9, 2019

Runaway Story or Meltdown in Motion? The Unraveling of the WeWork IPO

In a year full of high-profile IPOs, WeWork takes center stage as it moves towards its offering date, offering a fascinating insight into corporate narratives, how and why they acquire credibility (and value) and how quickly they can lose them, if markets lose faith. When the WeWork IPO was first rumored, there was talk of the company being priced at $60 billion or more, but the longer investors have had a chance to look at the prospectus, the less enthusiastic they seem to have become about the company, with a news story today reporting that the company was looking at a drastically discounted value of $20 billion, which would make Softbank, the biggest (and most recent) VC investor in WeWork, a big loser on the IPO. Before I set my thoughts down on WeWork, I will confess that I have never liked the company, partly because I don't trust CEOs who seem more intent on delivering life lessons for the rest of us, than on talking about the businesses they run, and partly because of the trail it has left of obfuscation and opaqueness. That said, I don't believe in writing hit pieces on companies and I will bend over backwards to give WeWork the benefit of the doubt, as I wrestle not only with its basic business model but also with converting that model into a story and numbers.
The WeWork Business Model: A Leveraged Bet on Flexibility
The WeWork business model is neither new, nor particularly unique in its basic form, though access to capital and scaling ambitions have put that model on steroids. That said, most traditional real estate companies that have tried the WeWork business model historically have abandoned it, for micro and macro reasons, and the test of the WeWork model is whether the advantages it brings to the table, and it does bring some, can help it succeed, where others have not.
The Business Model
Most businesses need office space and the way in which that office space is created and provided has followed a standard script for decades. The owner of an office building, who has generally acquired the building with significant debt, rents the building to businesses that need office space, and uses the rent payments received to cover interest expenses on the debt, as well as the expenses of operating the building. As economies weaken, the demand for office space contracts, and the resulting drop in occupancy rates in office buildings exposes the owner to risk. Prudent real estate operators try to buy buildings when real estate prices are low, and sign up credit worthy tenants with long term leases when rental rates are high, thus building a profitability buffer to protect themselves against downturns, when they do come. Even with added prudence, commercial real estate has always been a boom and bust business and even the most successful real estate developers have been both billionaires and bankrupt (at least on paper), at different points of their lives.
The WeWork business model puts a twist on traditional real estate. Like the conventional model, it starts by identifying an attractive office property, usually in a city where office space is tight and young businesses are plentiful. Rather than buying the building, WeWork leases the building with a long term lease, and having leased it, it spends significant amounts upgrading the building to make it a desirable office space for the Gen-X and Gen-Y workers, brought up to believe in the tech company prototype of a cool office space. Having renovated the building, WeWork then offers office space in small units (you can rent just one desk or a few) and on short term contracts (as short as a month). For a given property, if things go according to plan, as the building gets occupied, the excess of rental income (over the lease payment) is used to cover the renovation costs, and once those costs get covered, the economies of scale kick in, generating profits for the company. The steps in the WeWork business model are captured in the picture below:

If you buy into the company’s spin, as presented in its prospectus, the strengths it brings to each stage in the process are what sets it apart, allowing it to win, where others have failed before. In fact, the company is explicitly laying the foundations for this argument with two graphs in its prospectus, one of which maps out its time frame from signing to filling a location and the other which presents a picture, albeit a little skewed, of the profitability of each location, once stable.

Prospectus: Pages Note that all we have is the company's word on the timing and its definition of contribution margin plays fast and loose with operating expenses. To illustrate how the WeWorks model works, consider 600 B Street in San Diego, which is an office building that WeWork acquired, renovated and opened in 2017:

In 2019, WeWork claimed that the building was mostly occupied, which should mean that the renovation costs are being recouped, but since the company does not reveal per-building numbers, it is impossible to tell what the company's financials are just on this building.
The Model Trade off The model's allure is built on three factors. The first is the WeWork look, with open work spaces, cool lighting and lots of extras, that the company has worked on building over its lifetime and presumably is able to duplicate in a new building, with cost savings and quickly. The second is the WeWork community, where the company supplements its cosmetic features with add-on services that range from business networking to consulting services and seminars. The third is its offer of flexibility to businesses, especially valuable at young companies that face uncertain futures but increasing becoming so even at established companies that are experimenting with alternate work structures. Presumably, these businesses will be willing to pay extra for the flexibility and WeWork can capture the surplus. The model's weakness lies in a mismatch that is at the heart of the business model, where WeWork has locked itself into making the renovation costs up front and the lease payments for many years into the future, but its rental revenues will ebb and flow, depending upon the state of the economy. In fact, the numbers in WeWork’s own prospectus give away the extent of this mismatch, with lease commitments showing an average duration in excess of 10 years, whereas its renters are locked into contracts that average about a year in duration, which I obtained by dividing the revenue backlog by the revenue run rate. This mismatch is not unique to WeWork. You can argue that hotels have always faced this problem, as do the owners of apartment buildings, but WeWork is particularly exposed for four reasons:Own versus lease: There is an argument to be made that owning a property and leasing it is less risky than leasing the property and then sub-leasing it, and it is not because buying a property does not give rise to fixed costs. It does, in the form of the debt that you take on, when you buy the property, but borrowing & buying comes with two advantages over leasing. First, when buying a property, you can decide the proportion of value that comes from equity, allowing you to reduce your financial leverage, if you feel over exposed. Second, if the property value of a building rises after you have bought it, the equity component of value builds up implicitly, reducing effective leverage, though if property values drop, the reverse will occur.Explosive growth: As we will see in the next section, WeWork does not just have a mismatched model, it is one that has scaled up at a rate that has never been seen in the real estate business, going from one property in 2010 to more than 500 locations in 2019, adding more than 100,000 square feet of office space each month. This global growth has given rise to gigantic lease commitments, which combined with its operating losses in 2018, make it particularly exposed.Tenant Self-selection: By specifically targeting young companies and businesses that value flexibility, the company has created a selection bias, where its customers are the ones most likely to pull back on their office rentals, if there is a downturn.Lack of cost discipline: Companies that have historically been exposed to the mismatch problem have learned that, to survive, they need to have cost discipline, keeping fixed cost commitments low and adjusting quickly to changes in the environment. While it is possible that WeWork is secretly following these practices, their prospectus seems to suggest that they are oblivious to their risk exposure.It is worth noting that the WeWork business model has been tried in real estate before, with calamitous results. As Sam Zell, a billionaire with deep roots in real estate, noted on CNBC, on September 4, 2019, not only did he lose money investing in a business model like this one in 1956, but every company in the office space subletting space that existed then went out of business.

The Back StoryTo understand where WeWork stands today, I started with the prospectus that the company filed on August 14. While this filing may be updated, it provides a basis for any story telling or valuation of the company.

1. Operations
The financials reported in a company clearly paint a picture of growth in the company, as can be seen on almost every operating dimension (cities, locations, tenants, revenues).

While the growth represents the good news part of the story, there is bad news. Accompanying the growth in locations and revenues are losses that have grown to staggeringly large amounts by 2018.

EBITR= EBIT + Lease Expense, EBITR&PO = EBITR + Non-lease pre-opening expensesOne argument that the company may make for its losses is that they are after operating lease expenses (which are financial expenses, i.e., debt) and pre-opening location expenses (which are capital expenses). Adjusting for these expenses make the losses smaller, but they still remain daunting.
2. Leverage: The Leasing MachineThe WeWork business model is built on leasing properties, often for large amounts, with a long-period commitment, and not surprisingly, the results are manifested in lease commitments that represent a mountain of claims that the company has to cover before it can generate income for equity investors. The graph below captures the lease commitments that WeWork has contractually committed itself to for future years, and how much these commitments represent in equivalent debt:

ProspectusBrought down to basics, WeWork is a company that had $2.6 billion in revenues in the twelve months ending in June 2019, with an operating loss of more than $2 billion during the period, and debt outstanding, if you include the conventional debt, of close to $24 billion. Note that this leverage is built into the business model and will only grow, as the company grows. The hope is that as the company matures, and its leaseholds age, they will turn profitable, but this is a model built on a knife’s edge that, by design, will be sensitive to the smallest economic perturbations.
3. Issuance DetailsTo value an initial public offering, you need three additional details and at the moment, information on at least two of the three details is not fully disclosed, though it will be made public before the offering.
Magnitude of Proceeds: While the company has not been explicit about how much cash it plans to raise in the IPO, rumors as recently as last week suggested that it was planning to raise about $3.5 billion from the offering. Of course, that was premised on a belief that the market would price their equity at about $45-$50 billion and that may change, now that there are indications that it may have to settle for a lower pricing.Use of Proceeds: In the prospectus (page 56), the company says that it intends to use the net proceeds for general corporate purposes, including working capital and capital expenditures. In effect, there seem to be no plans, at least currently, for any of the existing equity owners of the firm to cash out of the firm, using the proceeds. Dilution: There will be additional shares issued to raise the planned proceeds, and the offering price will determine the share count. There will be circularity involved, because the proceeds, since they will stay in the firm, will increase the value of the firm (and equity) by roughly the amount raised, and thus the value per share, but the value per share itself will determine how many additional shares will be issued and thus the share count.I will do my initial valuation with the rumored $3.5 billion proceeds amount and use the estimated value per share to adjust share count, but these numbers will need to be revisited, once there is more concrete information.

4. Corporate Governance: Founder Worship and ComplexityIn keeping with what has become almost standard practice for companies going public in the last decade, WeWork has muddied the corporate governance waters by creating both a complex holding structure and share classes with different voting rights. Let's start with the holding structure for the company:

Prospectus: PageIn particular, note the carve out of a separate company (ARK) which will presumably buy real estate and lease it back to We and the region-specific joint ventures, where the company collects management fees. I am not quite sure what to make of the partnership triangle at the center, where it looks like the company will be partnering with it's own managers (with the founder/CEO presumably leading the way) to run WeWork Company. I have to compliment the company's owners and bankers, and it is a back-handed compliment, for managing to create more complexity in a couple of years than most companies can create in decades. Some of this complexity is probably due to tax reasons, in which case the company is behaving like other real estate ventures in putting tax considerations high up on its list of decision-drivers. Some of the complexity is to protect itself from the downside of its own lease-fueled growth, where the company can maintain the argument that since its leases are at the property-level, and the properties are structured as nominally stand-alone subsidiaries, it is less exposed to distress. That is fiction because a global economic showdown will lead to failures on dozens, perhaps hundreds, of lease commitments at the same time, and there is no protective cloak for the company against that contingency. A great deal of the complexity, though, has to do with the founder(s) desire for control and potential conflicts of interests, and investors will have to take that into account when valuing/pricing the company.
On the governance front, the company’s voting structure continues the deplorable practice of entrenching founders, by creating three classes of shares, with the class A shares that will be offering in the IPO having one twentieth the voting rights of the class B and class C shares, leaving control of the company in the hands of Adam Neumann. In fact, the prospectus is brutally direct on this front, stating that “Adam’s voting control will limit the ability of other stockholders to influence corporate activities and, as a result, we may take actions that stockholders other than Adam do not view as beneficial” and that his ownership stake will result in WeWork being categorized as a controlled company, relieving it of the requirement to have independent directors on its compensation and nominating committees.
Valuing WeWorkAs I mentioned at the top of this post, I fundamentally mistrust the company, but I am not willing to dismiss its potential, without giving it a shot at delivering. In creating this narrative, I am buying into parts of the company’s own narrative and here are the components of my story:WeWork meets an unmet and large need for flexible office space: The demand comes both younger, smaller companies, still unsure about their future needs, and established companies, experimenting with new work arrangements. There is a big market, potentially close to the $900 billion that the company estimates.With a branded product & economies of scale: The WeWork Office is differentiated enough to allow them to have pricing power, and higher margins.And continued access to capital, allowing the company to both fund growth and potentially live through mild economic shocks. That access, though, will be insufficient to tide them through deeper recessions, where their debt load will leave them exposed to distress.This story translates into three key operating inputs:Revenue Growth: I will assume that revenues will grow at 60% a year, for the next five years, scaling down to stable growth (set equal to the riskfree rate of 1.6%) after year 10. If this seems conservative, given their triple digit growth in the most recent year, using this growth rate results in revenues of approximately $80 billion in 2029.Target Operating Margin: Over the next decade, I expect the company’s operating margins to improve to 12.50% by year 10. That is much higher than the average operating margin for real estate operating companies and higher than 11.04%, the average operating margin from 2014-2018 earned by IWG, the company considered to be closest to WeWork in terms of operating model. For those of you persuaded by the company’s argument that its locations make a 25% contribution margin, note that that measure of profitability is before corporate expenses, stock-based compensation and capital maintenance expenditures.Reinvestment Needs: The business will stay capital intensive, economies of scale notwithstanding, requiring significant investments in new properties and substantial ones in aging properties to preserve their earning power. I will assume that each dollar of additional capital invested into the business will generate $1.68 in additional revenues, again drawing on industry averages. (Currently, WeWork generates only 11 cents in revenues for every dollar invested, but in its defense, many of its locations are either just starting to fill or are not occupied yet.)From my perspective, this seems like an optimistic story, where WeWork generates pre-tax operating income of 10.07 billion on revenues of $80.5 billion in 2029, generating a 26.61% return on capital on intermediate capital investments. Allowing for a starting cost of capital of about 8%, the resulting value for the operating assets is about $29.5 billion, but before you decide to put all your money in WeWork, there are two barriers to overcome:Possibility of failure: The debt load that WeWork carries makes its susceptible to economic downturns and shocks in the real estate market, and the cost of capital, a going concern measure of risk, is incapable of capturing the risk of failure embedded in the business model. I will assume a 20% chance of failure in my valuation, and if it does occur, that the firm will have to sell its holdings for 60% of fair value.Debt load: As I noted in the last section, the company has accumulated a debt load, including lease commitments, of $23.8 billion. Adjusting for these, the resulting value of equity is $13.75 billion, and with my preliminary assessment of shares outstanding, translates into a value per share of about $26/share.

Download spreadsheetI am sure that I will get pushback from both directions, with optimists arguing that the unmet demand for flexible office space in conjunction with the WeWork brand will lead to higher revenue growth and margins, and pessimists positing that both numbers are overstated. In response, here is what I can offer:

If you are puzzled as to why the equity value changes so much, as growth and margins change, the answer lies in the super-charged leverage model that WeWork has created. To the question of whether WeWork could be worth $40 billion, $50 billion or more, the answer is that it is possible but only if the company can deliver well-above average margins, while maintaining sky-high growth. That would make those values improbable, but what should terrify investors is that even the $15 or $20 billion equity values require stretching the assumptions to breaking point, and that there are a whole host of plausible scenarios where the equity is worth nothing. In fact, there is an argument to be made that if you invest in WeWork equity, you are investing less in an ongoing business, and more in an out-of-the-money option, with plausible pathways to a boom but just as many or even more pathways to a bust.
Storytelling's Dark Side: The Meltdown of Runaway StoriesValuation is a bridge between stories and numbers, and for young companies, it is the story that drives the numbers, rather than the other way around. This is neither good nor bad, but a reflection of a reality which is that bulk of value at these companies comes from what they will do in the future, rather than what they have done in the past. That said, there is a danger when stories rule, and especially so if the numbers become props or are ignored, that the pricing that is attached to a company can lose its tether to value. In 2015, I used the notion of a runaway story to explain why VC investors pushed up the price of Theranos to $9 billion, without any tangible evidence that the revolutionary blood testing, that was at the basis of that value, actually worked. In particular, I suggested that there are three ingredients to a runaway story:

With Theranos, Elizabeth Holmes was the story teller, arguing that her nanotainers would upend the (big) blood testing business and in the process, make it accessible to people around the world who could not afford it. Investors, Walgreens and the Cleveland Clinic all swooned, and no one asked questions about the blood tests themselves, afraid, perhaps, of being viewed as being against making the world a healthier place. For much of its life, WeWork has had many of the same ingredients, a visionary founder, Adam Neumann, who seems to view the company less as a business and more as a mission to make the business world a little more equal by giving the underdogs (young start-ups, entrepreneurs and small companies) a base, at least in terms of office space and community support, to fend off bigger competitors. It is no surprise, therefore, that the company describes its clients as community and members and that the word "We" carries significance beyond the company name. Along the way, the company was able to get venture capitalists to buy in, and the pricing of the company reflects its rise:

Add captionThe list of investors includes some big names in the VC and money management space, indicating that the runaway story’s allure is not restricted to the naïve and the uninitiated. Note also that one of the last entrants into the capital game was Softbank, providing a capital infusion of $2 billion in January 2019, translating into a pricing of $47 billion for the company's equity. In sum, Softbank’s holdings give it 29% of the equity in the company, larger even than Adam Neumann’s share.
As we saw with Theranos, in its rapid fall from grace, there is a dark side to story companies and it stems from the fact that value is built on a personality, rather than a business, and when the personality stumbles or acts in a way viewed as untrustworthy, the runaway story can quickly morph into a meltdown story, where the ingredients curdle:

Once investors lose faith in the narrator, the same story that evoked awe and sky-high pricing in the runaway model starts to come apart, as the flaws in the model and its disconnect with the numbers take center stage. With WeWork, the shift seems to have occurred in record time, partly because of bad market timing, with the macro indicators indicating that a global economic showdown may be coming sooner rather than later, and partly because of its own arrogance. In fact, if you were mapping out a plan for self-destruction, the company has delivered in spades with:CEO arrogance: For someone who is likely to be a multi-billionaire in a few weeks, Adam Neumann has been remarkably short sighted, starting with his sale of almost $800 million in shares leading into the IPO, continuing with his receipt (which he reversed, by only after significant blowback) of $6 million for giving the company the right to use the name “We”, and the conflicts of interest that he seems to have sowed all over the corporate structure. Accounting Game playing: WeWork’s continued description, with more than a 100 mentions in its prospectus, of itself as a tech company is at odds with its real estate business model, but investors would perhaps have been willing to overlook that if the company had not also indulged in accounting game playing in the past. This is after all the company that coined Community EBITDA (https://www.bloomberg.com/opinion/art...), an almost comically bad measure of earnings, where almost all expenses are added back to derive arrive at earnings. Denial: Since even a casual observer can see the mismatch that lies at the heart of the WeWork business model, it behooves the company to confront that problem directly. Instead, through 220 pages of a prospectus, the company bobs and weaves, leaving the question unanswered.While these are all long standing features of the company, I think that if pricing is a game of mood and momentum, the mood has darkened during this period, and it came as no surprise when rumors started a couple of days ago that the company was considering slashing its pricing to $20 billion a lower. That is an astounding mark down from the initial pricing estimate, but it suggests that the company and its bankers are running into investor resistance.
What is the end game?As WeWork stumbles its way to an IPO, with the very real chance that it could be pulled by its biggest stockholders (Neumann and Softbank) from a public offering, the question of what to do next depends upon whose perspective you tak.If you are a VC/equity owner in WeWorks, your choice is a tough one. On the one hand, you may want to pull the IPO and wait for a better moment. On the other, your moment may have passed and to survive as a private company, WeWork will need more capital (from you).As an investor, whether you invest or not will depend on what you think is a plausible/probable narrative for the company, and the resulting value. I would not invest in the company, even at the more modest pricing levels ($15-$20 billion), but if the price collapsed to the single digits, I would buy it for its optionality.If you are a trader, this stock, if it goes public, will be a pure pricing game, going up and down based upon momentum. If you are good at sending momentum shifts, you could take advantage. If you are a founder/CEO of a company, the lesson to be learned from this IPO is that no matter how disruptive you may perceive your company to be, in a business, there are lessons to be learned from looking at how that business has been run in the past. The saying that those who do not know their history are destined to repeat it seems apt not just in politics and public policy, but also in markets, as companies rediscover old ways to make make money, and then find anew the flaws that put an end to those ways.
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Published on September 09, 2019 12:27