Friday, March 27, 2015

The GM Buyback: Beyond the Hysteria!

Here is a script for a movie about the evils of stock buybacks, with the following players. The victim is an well-managed company in a business with significant growth opportunities and profit potential. The company has delivered products that its customers love, while paying its workers top-notch wages & benefits and invested heavily and prudently in its future. The villain is an activist investor, and for added color, let's make him greedy, short term and a speculator. In the story, he forces the  company to redirect money it would have spent on more great investments to buy back stock. The white knight can be a regulator, the government or a noble investor (make him/her successful, wealthy and socially conscious, i.e., Buffett-like) who rides in and saves the hapless company from the villain and stops the buyback. The story ends happily, with the defeat and humiliation of the activist investor, and the moral  is that stock buybacks are evil (and need to be stopped). As you read some of the over-the-top responses to GM's buyback, such as this one, you would not be alone in thinking that you were reading about the mythical company in the movie. But given GM's history and current standing, do you really want to make it the basis for your case against buybacks? 

GM is not well managed now, and has not been so, for a long time
Is GM a well managed firm? The answer might have been yes in 1925, when GM was the auto industry's disruptor, challenging Ford, the established leader in the business at the time. It would have definitely been affirmative in 1945, when Alfred Sloan’s strategy of letting GM's many brands operate independently won the automobile market race for GM, and it was the largest and most profitable automobile company in the world. It may have still been positive in 1965, when GM was on top of the world, a key driver of the US economy and US equity markets. 

By 1985, the bloom was off the rose, as GM (and other US auto makers) were late to respond to the oil crisis and had let Japanese car makers not only take market share but also the mantle of reliability and innovation. In 2005, GM remained the largest car maker in the world, but it was in serious financial trouble, with an ageing customer base and huge legacy costs, from promises made to employees in good times. In 2008, the problems came to a head during the financial crisis, as GM had trouble  making its debt payments, attracted government attention and a bailout. As part of the bargain, equity investors in GM were wiped out and lenders had to accept significantly less than they had been promised. If the objective of the bailout was GM's survival, it worked, as the company was able to reverse a steep drop in revenues (in 2008) and start making profits again. That recovery came at a significant cost to taxpayers, who lost $11.2 billion in the bailout.

GM was able to go public again in 2010 and since it is the new version of the company that is buying back stock and it would be unfair to burden the incumbents with the mistakes of prior managers, I focus the bulk of my attention on how well the management of this new incarnation has done in its stewardship of the company. The picture below captures the new GM's evolution as a company over the last five years:
The New GM: Investment, Revenues and Profits from 2010-2014
GM has been reinvesting actively since it went public again in 2010, adding almost $25.5 billion in investments (in plant, equipment and working capital) to it base. The good news is that revenues have gone up, albeit at an anemic rate (3.56% a year between 2010 and 2014) but the bad news is that these increasing revenues have been accompanied by declining profitability. Even in 2011, the best of the five years in terms of profitability, GM's return on capital of 6.86% lagged its cost of capital.

Does this imply that the existing management of GM is not up to the task? Not necessarily, since they were dealt a bad hand to begin with. They were saddled with brand names that evoke nothing but nostalgia, a cost structure that put them at a disadvantage (still) relative to other automobile companies and a legacy of past mistakes. At the same time, there is little that this management has done that can be viewed as visionary or exciting in the years since the IPO (in 2010). In fact, the end game for the new GM seems to be the same one that doomed the older version of the company: a fixation on market share (and number of cars sold), a desire to be all things to all people and an inability to admit mistakes. In the last two years, GM’s fumbling response to its "ignition switch" problem seem to have pushed GM back into the  “troubled automobile company” category again. The bottom line is that the best case that you can make for GM's current management is that it is a "blah" management,  keeping the company alive and mildly profitable. The worst case is that this is still a management stuck in a time warp and in denial over how much the automobile business has changed in the last few decades and that it is only a matter of time before the government is faced again with the question of whether GM is too "big to fail".

The auto business a bad one, with disruption around the corner
My measure of the quality of a business is simple and perhaps even simplistic. In a good business, the companies collectively in that business should be able to generate a return on capital that exceeds the cost of capital (based on the risk in the business) and the “best” companies in the business should earn significantly more than their costs of capital. The auto business fails both tests. In my most recent data update in January 2015, I computed the aggregated return on capital at auto companies globally (about 125+) in the trailing 12 months leading into January and arrived at 6.47%, a little more than 1% below the collective cost of capital of 7.53% that I computed for auto companies. Lest this be viewed as an outlier, the table below summarizes the aggregated return on capital and cost of capital for companies in the global automobile business each year for the last ten years:

If you are wondering whether this collective miasma is caused by the laggards in the group, I isolated the twenty largest automobile companies in the world in 2015 and estimated profitability and leverage numbers for them in March 2015:

Note that, if anything, the return on capital (which is based on operating income and invested book capital) is biased towards making a company look better than it really is (largely because accountants are quick to write off mistakes), but even on this measure, only one of the ten largest companies (Audi) earned a return on capital that is higher than its cost of capital in 2014. In fact, mass-market auto companies like Volkswagen, Toyota and Ford have abysmal returns on capital, suggesting that the club that GM is trying to rejoin is not an attractive one. The typically large automobile company in 2015 is a highly levered behemoth, which struggles to earn enough to cover its cost of capital in a market with anemic revenue growth. 

Given that the business model for automobile companies seems to have broken down, it should come as no surprise that the business is being targeted for disruption. While I have argued against the pricing premiums that the market is paying for Tesla, it is undeniable that it's entry into the market has speeded up the investments that other auto makers are making in electric cars. Given their track record of poor profitability, I would not be surprised if the next big disruption of this market comes from companies in healthier businesses and that will bring more pressures on existing automobile companies. If there is a light at the end of this tunnel for incumbent automobile companies, I don't see it.

A GM Buyback: Value Effects?
In an earlier post on buybacks, I used a picture to illustrate how a buyback may affect value and I think that picture can help in assessing the GM buyback:

Looking at the picture, I can see why activist investors were pushing GM to return more cash. It is a middling company in a bad business, where even the very best companies struggle to earn their costs of capital. Since it is possible that I am blinded by my stockholder-focus, I considered what GM could have done with the $5 billion, instead of buying back stock.
  1. Invest the cash: GM could have invested the cash back into the auto business, but given the state of the business and the returns generated by players in it, this effectively throws good money after bad. In fact, looking at how little the $25.5 billion in reinvestment has done for GM in the last five years, I think a stronger argument can be made that they would perhaps have been better off not investing that money and returning it to stockholders as well. 
  2. Hold the cash or pay down debt: Auto companies are natural cash hoarders, arguing that as cyclical companies, they need the cash to survive the next recession or downturn. In fact, that argument seems to have added resonance at a company like GM, which has just come out of a near-death experience with default. At the risk of sounding heartless, I would counter that survival for the sake of survival makes little sense. A corporation is a legal entity and there is a corporate life cycle, a time to be born, a time to grow, a time to harvest and finally a time to shut down. If your response is that you cannot let that happen to an American icon like GM, there was a time when Xerox was so dominant in its business that it's corporate name  became synonymous with its product (copies) and Eastman Kodak was the 'camera' company, but pining for those days will not bring them back. The actions driven by the "too big to fail" ethos have cost the taxpayers $11 billion already. Do you really want to do this a second time around with GM?
  3. Return the cash to other stakeholders (labor, the government): You can argue that my view of buybacks fails to take into account the interests of other stakeholders in the firm, its workers, its suppliers and perhaps even the government. It is true that GM could use the $5 billion to give its workers raises and replenish their pensions. That will be good news for those workers, but doing so will only push down the measly return on capital that GM is currently earning, make future access to capital (debt or equity) even more difficult, and set the company on the pathway to financial devastation.
The Root of the Disagreement
There are "corporate finance" reasons for arguing against buybacks in some companies and they include concerns about damaging growth potential (where buybacks come at the expensive of good investments), about timing (when companies buy back shares when prices are high, rather than low) , or managerial self-interest (if buybacks are being used to push up stock prices ahead of option exercises). Since it is almost impossible to use any of these with GM, those arguing against a GM buyback are really against all stock buybacks, no matter who does them. While I don't agree with these critics, I think that there is a simple way to understand the vehemence of their opposition and it is rooted in ideology and philosophy, not finance.  If you believe, as I do, that as a publicly traded automobile company, GM's mission is to take capital from investors and generate higher returns for them that they could have made elsewhere, in investments of equivalent risk, with that money, you can justify the buyback and perhaps even argue that it should be more. If you believe that GM's mission as a car company is to build more auto plants and produce more cars, hire more workers and pay them premium wages and save the cities of Flint and Detroit from bankruptcy (as a side benefit), this or any buyback is a bad idea. In fact, it is not just buybacks that you should have a problem with but any cash returned (including dividends) to investors, since that cash could have been used more productively (with your definition of productivity) by the company. It is also extremely unlikely that you will find anything that I have to say about buybacks to be persuasive since we have a philosophical divide that cannot be bridged. So, its best that we agree to disagree!

Past posts on buybacks

  1. Stock Buybacks: What is happening and why (January 25, 2011)
  2. Buybacks and Stock Prices: Good news or bad news (January 25, 2011)
  3. The Shift to Buybacks: Implications for Investors (February 1, 2011)
  4. Stock Buybacks: They are big, they are back and they scare some people (September 22, 2014)

Friday, March 20, 2015

Illiquidity and Bubbles in Private Share Markets: Testing Mark Cuban's thesis!

It looks like Alibaba is investing $200 million in Snapchat, translating (at least according to deal watchers) into a value of $15 billion for Snapchat,  a mind-boggling number for a company that has been struggling to find ways to convert its popularity with some users (like my daughter) into revenues. While we can debate whether extrapolating from a small VC investment to a total value for a company make sense, there are two trends that are incontestable. The first is that estimated values have been climbing at exponential rates for companies like Uber, Airbnb and Snapchat. In venture capital lingo, the number of unicorns is climbing to the point where the name (which suggests unique or unusual) no longer fits. The second is that these companies seem to be in no hurry to go public, leaving the trading in the private sharemarket space. These rising valuations in private markets led Mark Cuban to declare last week that this "tech bubble" was worse (and will end much more badly) than the last one (with dot-com stocks). In the article, Cuban makes four assertions: (1) There is a tech bubble; (2) A large portion of the tech bubble is in the private share market which is less liquid than the public markets; (3) The bubble will be larger and burst more violently because of the absence of liquidity; and (4) This bubble is worse than the dot-com bubble, though it not clear on what dimension and from whose perspective. In his trademark fashion, Cuban ends his article with a provocative questions,  "If stock in a company is worth what somebody will pay for it, what is the stock of a company worth when there is no place to sell it ?" I like Mark Cuban but I think that he is wrong on all four counts.

This is not a tech bubble
In my last post, I took issue with the widespread view that the rise in stock prices from the depths of 2008 has been largely due to tech companies using a simple statistic: the proportion of overall equity market capitalization in the United States coming from tech stocks. Unlike the 1990s, when tech companies climbed from single digits in 1990 to almost 30% of the overall market capitalization by the end of 1999, tech stocks collectively have stayed at about 20% of the overall market.

Tech stocks in S&P 500
There are other indicators that also support the argument that this is not a tech bubble, since a bubble occurs when market prices disconnect from fundamentals. Unlike the 1990s, the market capitalization of technology companies in 2014 is backed up by operating numbers that are commensurate with value. In the figure below, I compare tech companies to non-tech companies on market values (enterprise and equity) as well as on operating statistics such as revenues, EBITDAR&D, EBITDA, operating income and net income, across the entire US market (not just the S&P 500):
Tech vs Non-tech companies in US market (Source: Cap IQ)
One measure of whether a sector is in a bubble is if it accounts for a much larger share of overall market value than it delivers in revenues, earnings and cash flows. In February 2015, tech companies account for about 13.84% of overall enterprise value and 19.94% of market capitalization and they hold their own on almost every operating metric. While tech companies generate only 11% of overall revenues, they account for 19.99% of EBITDA+R&D, 17.93% of operating income and 16.46% of EBITDA, all much higher than tech's 13.84% share of enterprise value, and 18.65% of net income, close to the 19.94% of overall market capitalization. On the cash flow measure, tech firms account for almost 29% of all cash flows (dividends and buybacks) returned to investors, much higher than their share of market capitalization. To provide a contrast, in 1999, at the peak of the dot-com bubble, tech firms accounted for 30% of overall market capitalization but delivered less than 10% of net income and dividends & buybacks. That was a bubble!

Note, though, that this is not an argument against a market bubble but one specifically against a collective tech bubble. If you believe that there is a bubble (and there are reasonable people who do), it is either a market-wide bubble or one in a specific segment of the tech sector, say baby tech or young tech. In my earlier post, I broke tech companies by age and noted that young tech companies are richly priced. If Cuban's assertion is that young tech companies are being over priced, relative to fundamentals and potential earnings/cash flows, it is a more defensible one, and if it is just about young tech companies in the private share market, it may even be a likely one. Even on that front, though, the question remains whether this over pricing is a tech phenomenon or a young company phenomenon.

Illiquidity is a continuum 
Cuban's second point is that this bubble, unlike the one in the nineties, is developing in private share markets, where venture capitalists, institutional investors and private wealth funds buy stakes of private businesses and that these private share markets are less liquid than publicly traded companies. While the notion that public markets are more liquid than private ones is widely held and generally true, illiquidity is a continuum and not all private markets are illiquid and not all publicly traded stocks are liquid. 

The private share market has made strides in the last decade in terms of liquidity. NASDAQ's private market allows wealthy investors to buy and sell positions in privately held businesses and there are other ventures like SecondMarket and Sharespost that allow for some liquidity in these markets. To those who would argue that this liquidity is skin deep and will disappear in the face of a market meltdown, you are probably right, but then again, what makes you believe that public markets are any different? While it is true that some of the big names in technology have high trading volume and deep liquidity, many of the smaller technology companies often have two strikes against them when it comes to liquidity:
  1. Low Float: The proportion of the shares in these companies that are traded is only a small proportion of the overall shares in the company. Just to illustrate, only 10.5% of the shares in Box, the latest technology listing, are traded in the market and small swings in mood in this market can translate into big price changes. Looking across all stocks in the market, the notion that young tech companies tend to have lower floats is backed up by the data:
    Source: S&P Capital IQ (February 2015 data)
  2. Here today, forgotten tomorrow: The young tech space is crowded, and holding investor attention is difficult. Consequently, while many young tech companies go public to high trading volume, that volume drops off in the weeks following as new entrants draw attention to themselves, as evidenced by the trading activity on Box:
    Box: Stock Price & Volume (Yahoo! Finance)
The bottom line is a simple one. The liquidity in tech companies in public markets is uneven and fragile, with heavy trading in high profile stocks, in good times, and around earnings reports masking lack of liquidity, especially when you need it the most.  While Mark Cuban worries about the illiquidity of the private share market, I am not sure that it is any more illiquid than the public markets in dot-com stocks were in the 2000, as the market collapsed.

Liquidity can feed bubbles
Let us, for purposes of argument, accept that Mark Cuban was talking about baby tech companies in the private share market and that he is right about the private share market being less liquid than public markets, is he right in his contention that bubbles get bigger and burst more violently in less liquid markets? Intuitively, his contention makes sense. With start-ups and very young companies, it is a pricing game, not a value game, and that price is set by mood and momentum, rather than fundamentals (cash flows, growth or risk). If you cannot easily trade an asset, it would seem logical to assume that any shift in mood or momentum in this market will be accentuated. If you bring them together in a private share market, you should have the ingredients for a bigger bubble, right?

My intuition leads me down the same path, but if there is a lesson that I have learned from behavioral finance, it is that your intuition is not always right. Some of the most interesting research on bubbles, on what allows them to form, and causes them to burst, comes from experimental economics. Vernon Smith, who won a Nobel Prize in Economics for his role in developing the field, has run a series of experiments where he illustrates that adding liquidity to a market makes bubbles bigger, not smaller. To illustrate, he (with two co-authors) ran a laboratory market, where participants traded a very simple asset (that paid out an expected cash flow of 24 cents every period for 15 periods, giving it a fair value of $3.60 at the start of the trading, dropping by 24 cents each period).  Not only did they find bubbles forming in this market, where the price increased to well above the fair value in the intermediate periods, but that these bubbles were bigger and lasted longer, when they gave traders more money (liquidity) to trade in the market:

In addition, they found that adding liquidity made the bubble bigger earlier in the game. (I strongly recommend this paper to anyone interested in bubbles, because they also explored the effects of adding price limits (like futures markets do), short sales restrictions and experience.) Extrapolating from one experimental study may be dangerous, but if this study holds true, the fact that the private share market is less liquid than a public market may be a check on the market's exuberance, and especially so for young start-ups. Put differently, if liquidity adds to bubbles, Uber, Airbnb and Snapchat would be trading at even higher prices in a public market than they are in the private share markets today.

If you are struggling with the question of why liquidity adds to market bubbles, let me offer one possible explanation. A market bubble needs a propagating mechanism, a process by which new investors are attracted into the market to keep the price momentum going (on the way up) and existing investors are induced to flee (on the way down). In a public market, the most effective propagating mechanism is an observable market price, as increases in the price draw investors in and price declines chase them out. If you add, to this phenomenon, the ease with which we can monitor market prices on our online devices (rather than wait until the next morning or call our brokers, as we had to, a few decades ago) and access to financial news channels (CNBC, Bloomberg and Fox Business News, to name just the US channels) which expound and analyze these price changes, it is no surprise to me that bubbles have steeper upsides and downsides today than they used to. In a private market, we hear about Uber, Airbnb and Snapchat's valuations only when venture capitalists invest in them and our inability to trade on these valuations may be a restraint on their rising. 

A big bubble is not necessarily a bad one
The final component of Mark Cuban's thesis (though I believe that the first three are flawed) is that this bubble is "worse" than prior bubbles. But what is it that makes one bubble worse than another? To me, the cost of a bubble is not whether those invested in the bubble lose money but whether others who are not invested in the bubble are forced to bear some costs when the bubble bursts. It is that spillover effect on other players that we loosely call systemic risk and it is the magnitude of these systemic costs which made the 2007-08 banking bubble so costly.

With this framework in mind, is this young (baby) tech bubble more dangerous than the one in the late nineties? I don't see why. If the bubble bursts, the immediate losers are the wealthy investors (VCs, private equity investors, and private banking clients) who partake in the private share market. Not only can they afford the losses, but perhaps they need a sobering reminder of why they should not let their greed get ahead of their common sense. In a public market collapse, there will be far more small investors who are hurt, and though they deserve the same wake-up call as wealthier investors, they may less equipped to deal with the losses. This could change if institutions that have no business playing in the private share market (like university endowments and public pension funds) decide to invest big amounts in it and screw it up big time.

It is true that there will be side costs, as there are in any bubble. First, when a bubble bursts, the lenders/banks that lent money to companies in the bubble will feel the pain (which does not bother me) and then pass it on to taxpayers (which does). Since young tech companies are lightly levered, these costs are likely to be small.  Second, the bursting of a bubble can have consequences for governments that collect tax revenues from these companies (corporate tax), their employees  (income tax) and investors (dividends & capital gains taxes). Again, since young tech companies are money losers, the vast majority of employees settle for deferred compensation and investors in private markets don't cash out quickly, the tax revenue loss will be contained. Third, every burst bubble carries consequences for the real estate in the region (of the bubble). So, yes, the Bay Area will see a drop in real estate value, and is that a bad thing? I don't think so, since anyone in that area, who is not part of the tech boom, has been reduced to living in cardboard boxes. Finally, I believe that the collapse in the private share market, if it happens, will follow a collapse of young tech companies in the public markets (Facebook, Twitter, Box, Linkedin et al.), which I will take as an indication that it is public markets that lead the bubble, not private markets. 

If this is a bubble, I don't see why its bursting is any more consequential or painful than the implosion of the dot-com bubble. There will undoubtedly be books written by people who claimed to see it coming (perhaps Mark Cuban is vying for a front spot), warnings from the Merchants of Doom (you know who they are) pointing out that this is what happens when greed runs its course and there will be government/market/regulatory action (almost all of it bad, and most of it ineffective) to stop something like this from happening again. So, don't be surprised to see curbs on private share markets or on institutions investing in these markets, as if those curbs will stop the next bubble from occurring. 

Bottom line
Mark Cuban's entry into the ranks of the very rich was greased by the 1990s dot-com boom where he built a business of little value, but sold at the right time . Since that is how you win at the pricing game, I tip my hat to him. For him to point fingers at other people who are playing exactly the same game and accuse them of greed and short-sightedness takes a lot of chutzpah. In fact, Cuban's assertion about this being a worse bubble than the dot-com bubble gives us some insight into one very self-serving way to classify bubbles into good and bad ones. A good bubble is one where you are making money of the excesses and a bad one is one where other people are making money (or more money than you are) from the over pricing. If Cuban is serious about staying out of bubbles, he should look at the largest investment in his portfolio, which is in a market where prices have soared, good sense has been abandoned and there is very little liquidity. In a market where the Los Angeles Clippers are priced at $2 billion and the Atlanta Hawks could fetch a billion, the Dallas Mavericks should go for more, right?

Thursday, February 26, 2015

The Aging of the Tech Sector: The Pricing Divergence of Young and Old Tech Companies

As the NASDAQ approaches historic highs, Apple’s market cap exceeds that of the Bovespa (the Brazilian equity index) and young social media companies like Snapchat have nosebleed valuations, there is talk of a tech bubble again. It is human nature to group or classify individuals or entities and assign common characteristics to the group and we tend to do the same, when investing. Specifically, we categorize stocks into sectors or groups and assume that many or most stocks in each group share commonalities. Thus, we assume that utility stocks have little growth and pay large dividends and commodity and cyclical stocks have volatile earnings largely because of macroeconomic factors. With “tech” stocks, the common characteristics that come to mind for many investors are high growth, high risk and low cash payout. While that would have been true for the typical tech stock in the 1980s, is it still true? More specifically, what does the typical tech company look like, how is it priced and is its pricing put it in a bubble? As I hope to argue in the section below, the answers depend upon which segment of the tech sector you look at.

A Short History of Tech Stocks
My first foray into investing was in the early 1980s, as the market started its long bull market run that lasted for almost two decades. In 1981, the technology stocks in the market were mainframe computer manufacturers, led by IBM and a group of smaller companies lumped together as the seven dwarves (Burroughs, Univac, NCR, Honeywell etc.). Not only were they collectively a small proportion of the entire market, but of the list of top ten companies, in market capitalization terms, in 1981, only one (IBM) could have been categorized as a technology stock (though GE had a small stake in computer-related businesses then):

During the 1980s, the personal computer revolution created a new wave of technology companies and while IBM fell from grace, companies catering to the PC business such as Microsoft, Compaq and Dell rose up the market cap ranks. By 1991, the top ten stocks still included only one technology company, IBM, and it had slipped in the rankings. However even in 1991, technology stocks remained a small portion of the market, comprising less than 7% of the S&P 500. During the 1990s, the dot-com boom created a surge in technology companies and their valuations, and while the busting of that boom in 2000 caused a reassessment, technology has become a larger piece of the overall market, as evidenced by this graph that describes the breakdown, by sector, for the S&P 500 from 1991 to 2014:

Market Capitalization at the end of each year (S&P Capital IQ)
There are two things to note in this graph. 
  1. The first is that technology as a percentage of the market has remained stable since 2009, which calls into question the notion that technology stocks have powered the bull market of the last five years. 
  2. The second is that technology is now the largest single slice of the equity market in the United States and close to the second largest in the global market. So what? Just as growth becomes more difficult for a company as it gets larger and becomes a larger part of the economy, technology collectively is running into a scaling problem, where its growth rate is converging on the growth rate for the economy. While this convergence is sometimes obscured by the focus on earnings per share growth, the growth rate in revenues at technology companies collectively has been moving towards the growth rate of the economy.
The Diversity of Technology
As technology ages and becomes a larger part of the economy, a second phenomenon is occurring. Companies within the sector are becoming much more heterogeneous not only in the businesses that they operate in, but also in their growth and operating characteristics. To see these differences, let’s start by looking at the sector and its composition in terms of age at the start of 2015. In February 2015, there were 2816 firms that were classified as technology companies, just in the United States, accounting for 31.7% for all publicly traded companies in the US market. Some of these companies have been listed for only a few years but others have been around for decades. Using the year of their founding as the birth year, I estimated the age for each company and came up with the following breakdown of tech stocks, by age:

Age: Number of years from founding of company to 2015
Note that 341 technology companies have been in existence for more than 35 years and an additional 427 firms have been in existence between 25 and 35 years, and they collectively comprise about 41% of the firms that we had founding years available in the database. While being in existence more than 25 years may sound unexceptional, given that there are manufacturing and consumer product companies that have been around a century or longer, tech companies age in dog years, as the life cycles tend to be more intense and compressed. Put differently, IBM may not be as old as Coca Cola in calendar time but it is a corporate Methuselah, in tech years.

The Pricing of Technology
The speedy rise of social media companies like Facebook, Twitter and Linkedin from nothing to large market cap companies, priced richly relative to revenues and earnings, has led some to the conclusion that this rich pricing must be across the entire sector. To see if this is true, I look at common pricing metrics across companies in the technology sector, broken down by age.
Pricing as of February 2015, Trailing 12 month values for earnings and book value
To adjust for the fact that cash holdings at some companies are substantial, I computed a non-cash PE, by netting cash out of the market capitalization and the income from cash holdings from the net income. While it is true that the youngest tech companies look highly priced, the pricing becomes more reasonable, as you look across the age scale. For instance, while the youngest companies in the tech sector trade at 4.34 times revenues (based upon enterprise value), the oldest companies trade at 2.44 times revenues. 

How do tech companies measure up against non-tech companies? After all, any story that is built on the presumption that tech companies are the sources of a market bubble has to backed up by data that indicates that tech companies are over priced relative to the rest of the market. To answer this question, I looked at the youngest (<10 and="" companies="" oldest="" tech="" years="">35 years) relative to the  youngest (<10 and="" companies:="" div="" non-tech="" oldest="" years="">
Based on  February 2015 Pricing & Trailing 12 month numbers: 2807 US technology and  6076 non-technology companies.
The assessment depends upon what part of the technology sector you are focused on. While the youngest tech companies trade at much higher multiples of revenues, earnings and book value than the rest of the market, the oldest tech companies actually look under priced (rather than over priced) relative to both the rest of the market and to the oldest non-tech companies. In fact, even focusing just on the youngest companies, it is interesting that while young tech companies trade at higher multiples of earnings (EBITDA, for instance) than young non-tech companies, the difference is negligible if you add back R&D, an expense that accountants mis-categorize as an operating expense.

Does this mean that you should be selling your young tech companies and buying old tech companies? I am not quite ready to make that leap yet, because the differences in these pricing multiples can be partially or fully explained by differences in fundamentals, i.e., young tech companies may be highly priced because they have high growth and old tech companies may trade at lower multiples because they have more risk and tech companies collectively may differ fundamentally from non-tech companies.

The Fundamentals of Tech Companies
There are three key fundamentals that determine value: the cash flows that you generate from your existing assets, the value generated by expected growth in these cash flows and the risk in these cash flows. Again, rather than look at tech stocks collectively, I will break them down by age and compare them to non-tech stocks.

a. Cash Flows and Profitability
To measure profitability, I looked at two statistics, the percentage of money making companies in each group and the aggregate profit margins (using EBITDA, operating income and net income):

Young technology companies are far more likely to be losing money and have lower profit margins that young non-technology companies, even if you capitalize R&D expenses and restate both operating and net income (which I did). At the other end of the spectrum, old technology companies are much more profitable, both in terms of margins and accounting returns, than old non-technology companies, adding to their investment allure, since they are also priced cheaper than non-technology companies.

b. Growth – Level and Quality
To test the conventional wisdom that technology companies have higher growth potential than non-technology companies, I looked at both past and expected future growth in different operating measures starting with revenues and working down the income statement:

The results are surprising and cut against the conventional wisdom, on most measures of growth. Young non-technology companies have grown both revenues and income faster than young technology companies, though analyst estimates of expected growth in earnings per share remains higher for young tech companies. With old tech companies, the contrast is jarring, with historic growth at anemic levels for technology companies but at much healthier levels for non-tech companies, perhaps explaining some of the lower pricing for the former. It is true, again, that the expected growth in earnings per share is higher at tech companies than non-tech companies, reflecting perhaps an optimistic bias on the part of analysts as well as more active share buyback programs at tech companies.

c. Risk – Financial and Market
Are tech companies riskier than non-tech companies? Again, the conventional wisdom would say they are, but I look at two measures of risk in the table below: standard deviation in stock prices and debt ratios across groups:

I get a split verdict, with much higher volatility in stock prices in tech companies, young and old, than non-tech companies, accompanied by much lower financial leverage at tech companies, again across the board, than non-tech companies. As we noted in the earlier table, young tech companies are more likely to be losing money and that may explain why they borrow less, but I think that the high price volatility has less to do with fundamentals and more to do with the fact the investors in young tech companies are too busy playing the price and momentum game to even think about fundamentals. 

d. Cash Return – Dividends, Buybacks and FCFE
In the final comparison, I look at how much cash is being returned in the form of dividends and buybacks by companies in each group, as well as how much cash is being held back in the company as a percent of overall firm value (in market value terms):
FCFE = Cash left over after taxes, debt payments and reinvestment; Firm value = Market Cap + Total Debt; Cash Return = Dividends + Buybacks - Stock Issues

Note that both young tech and young non-tech companies have raised more new equity than they return in the form of dividends and buybacks, giving them a negative cash return yield. Old tech companies return more cash to stockholders both in dividends and collectively, with buybacks, than old non-tech companies. Finally, notwithstanding the attention paid to Apple's cash balance, old tech companies hold less cash than old non-tech companies do. 

In summary, here is what the numbers are saying. Young technology companies are less profitable, have higher growth, higher price risk and are priced more richly than the young non-tech companies. Old technology companies are more profitable, have less top line growth and are priced more reasonably than old non-tech companies. 

Bottom line
The size of the technology sector and the diversity of companies in the sector makes it difficult to categorize the entire sector. In my view, the data suggests that we should be doing the following:
  1. Truth in labeling: We are far too casual in our classifications of companies as being in technology. In my book, Tesla is an automobile company, Uber is a car service (or transportation) company and The Lending Club is a financial services company, and none of them should be categorized as technology companies. The fact that these firms use technology innovatively or to their advantage cannot be used as justification for treating them as technology companies, since technology is now part and parcel of even the most mundane businesses. Both companies and investors are complicit in this loose labeling, companies because they like the “technology” label, since it seems to release them from the obligation of explaining how much they need to invest to scale up, and investors, because it allows them to pay multiples of revenues or earnings that would be difficult (if not impossible) to justify in the actual businesses that these firms are in.
  2. Age classes: We should start classifying technology companies by age, perhaps in four groups: baby tech (start up), young tech (product/service generating revenues but not profits), middle-aged tech (profits generated on significant revenues) and old tech (low top line growth, though sometimes accompanied by high profitability), without any negative connotations to any of these groupings. If we want to point to mispricing, we should be specific about which group the mispricing is occurring. In this market, for instance, if there is a finger to be pointed towards a group, it is not technology collectively that looks like it is richly priced, but baby and young technology companies. By the same token, if you follow rigid value investing advice, where you are told to stay away from technology on the grounds that it is high growth, high risk and highly priced, that may have been solid advice in 1985 but you will be missing your best “value” opportunities, if you follow it now.
  3. Youth or Sector: When we think of start-ups and young firms, we tend to assume that they are technology-based and that presumption, for the most part, is backed up by the numbers. However, there are start-ups in other businesses as well, and it is worth examining when mispricing occurs, whether it is sector or age-driven. It is true that young social media companies have gone public to rapturous responses over the last few years but Shake Shack, which is definitely not a technology company (unless you can have a virtual burger and an online shake) also saw its stock price double on its offering day and biotechnology companies  had their moment in the limelight in 2014, as well. 
  4. Life Cycle dynamics: I have talked about the corporate life cycles in prior posts and as I have noted in this one, there is evidence that the life cycle for a technology company may be both shorter and more intense than the life cycle for a non-technology company. That has implications for how we value and price these companies. In valuation, we may have to revisit the assumptions we make about long lives (perpetual) and positive growth that we routinely attach in discounted cash flow models to arrive at terminal value, when valuing technology companies, and perhaps replace them with finite period, negative growth terminal value models for fading technologies. In pricing, we should expect to see a much quicker drop off in the multiples of earnings that we are willing to pay, as tech companies age, relative to non-tech companies. I will save that for a future post.
I am under no illusions that this post will change the conversation about technology companies, but it will give me an escape hatch the next time I am asked about whether there is a technology bubble. If nothing else, I can point the questioner to this post and save myself the trouble of saying the same thing over and over again. 

Monday, February 23, 2015

DCF Myth 1: If you have a D(discount rate) and a CF (cash flow), you have a DCF!

Earlier this year, I started my series on discounted cash flow valuations (DCF) with a post that listed ten common myths in DCF and promised to do a post on each one over the course of the year. This is the first of that series and I will use it to challenge the widely held misconception that all you need to arrive at a DCF value is a D(iscount rate) and expected C(ash)F(lows). In this post, I will take a tour of what I would term twisted DCFs, where you have the appearance of a discounted cash flow valuation, without any of the consistency or philosophy.

The Consistency Tests for DCF

In my initial post on discounted cash flow valuation, I set up the single equation that underlies all of discounted cash flow valuation:

For this equation to deliver a reasonable estimate of value, it is imperative that it meets three consistency tests:

1. Unit consistency: A DCF first principle is that your cash flows have to defined in the same terms and unit as your discount rate. Specifically, this shows up in four tests:
  • Equity versus Business (Firm): If the cash flows are after debt payments (and thus cash flows to equity), the discount rate used has to reflect the return required by those equity investors (the cost of equity), given the perceived risk in their equity investments. If the cash flows are prior to debt payments (cash flows to the business or firm), the discount rate used has to be a weighted average of what your equity investors want and what your lenders (debt holders) demand or a cost of funding the entire business (cost of capital).
  • Pre-tax versus Post-tax: If your cash flows are pre-tax (post-tax), your discount rate has to be pre-tax (post-tax). It is worth noting that when valuing companies, we look at cash flows after corporate taxes and prior to personal taxes and discount rates are defined consistently. This gets tricky when valuing pass-through entities, which pay no taxes but are often required to pass through their income to investors who then get taxed at individual tax rates, and I looked at this question in my post on pass-through entities.
  • Nominal versus Real: If your cash flows are computed without incorporating inflation expectations, they are real cash flows and have to be discounted at a real discount rate. If your cash flows incorporate an expected inflation rate, your discount rate has to incorporate the same expected inflation rate.
  • Currency: If your cash flows are in a specific currency, your discount rate has to be in the same currency. Since currency is primarily a conduit for expected inflation, choosing a high inflation currency (say the Brazilian Reai) will give you a higher discount rate and higher expected growth and should leave value unchanged.
2. Input consistency: The value of a company is a function of three key components, its expected cash flows, the expected growth in these cash flows and the uncertainty you feel about whether these cash flows will be delivered. A discounted cash flow valuation requires assumptions about all three variables but for it to be defensible, the assumptions that you make about these variables have to be consistent with each other. The best way to illustrate this point is what I call the valuation triangle:

I am not suggesting that these relationships always have to hold, but when you do get an exception (high growth with low risk and low reinvestment), you are looking at an unusual company that requires justification and even in that company, there has to be consistency at some point in time.

3. Narrative consistency: In posts last year, I argued that a good valuation connected narrative to numbers. A good DCF valuation has to follow the same principles and the numbers have to be consistent with the story that you are telling about a company’s future and the story that you are telling has to be plausible, given the macroeconomic environment you are predicting, the market or markets that the company operates in and the competition it faces. 

The DCF Hall of Shame

Many of the DCFs that I see passed around in acquisition valuations, appraisal and accounting  don’t pass these consistency tests. In fact, at the risk of being labeled a DCF snob, I have taken to classifying these  defective DCFs into seven groups:
  1. The Chimera DCF: In mythology, a chimera is usually depicted as a lion, with the head of a goat arising from his back, and a tail that might end with a snake's head. A DCF valuation that mixes dollar cash flows with peso discount rates, nominal cash flows with real costs of capital and cash flows before debt payments with costs of equity is violating basic consistency rules and qualifies as a Chimera DCF. It is useless, no matter how much work went into estimating the cash flows and discount rates. While it is possible that these inconsistencies are the result of deliberate intent (where you are trying to justify an unjustifiable value), they are more often the result of sloppiness and too many analysts working on the same valuation, with division of labor run amok.
  2. The Dreamstate DCF: It is easy to build amazing companies on spreadsheets, making outlandish assumptions about growth and operating margins over time. With attribution to Elon
    Musk, I could take a small, money losing automobile company, forecast enough revenue
    growth to get its revenues to $350 billion in ten years (about $100 billion higher than  Toyota or Volkswagen, the largest automobile companies today), increase operating margins to 10% by the tenth year (giving it the margins of  premium auto makers) and make it a low risk, high growth company at that point (allowing it to trade at 20 times earnings at the end of year 10), all on a spreadsheet. Dreamstate DCFs are usually the result of a combination of hubris and static analysis, where you assume that you act correctly and no one else does.
  3. The Dissonant DCF: When assumptions about growth, risk and cash flows are not consistent with each other, with little or no explanation given for the mismatch, you have a DCF valuation
    where the assumptions are at war with each other and your valuation error will reflect the input
    dissonance. An analyst who assumes high growth with low risk and low reinvestment will get too high a value, and one who assumes low growth with high risk and high reinvestment will get too low a value.  I attributed dissonant DCFs to the natural tendency of analysts to focus on one variable at a time and tweak it, when in fact changes in one variable (say, growth) affect the other variables in your assessment. In addition, if you have a bias (towards a higher or lower value), you will find a variable to change that will deliver the result you want.
  4. The Trojan Horse (or Drag Queen) DCF: It is undeniable that the biggest number in a DCF is the terminal value, and for it to remain a DCF (a measure of intrinsic value), that number has to be estimated in one of two ways. The first is to assume that your cash flows will continue
    beyond the terminal year, growing at a constant rate forever (or for a finite period) and the second is to assume liquidation, with the liquidation proceeds representing your terminal value. There are many DCFs, though, where the terminal value is estimated by applying a multiple to the terminal year’s revenues, book value or earnings and that multiple (PE, EV/Sales, EV/EBITDA) comes from how comparable firms are being priced right now. Just as the Greeks used a wooden horse to smuggle soldiers into Troy, analysts are using the Trojan horse of expected cash flows (during the estimation period) to smuggle in a pricing. One reason analysts feel the urge to disguise their pricing as DCF valuations is a reluctance to admit that you are playing the pricing game.
  5. The Kabuki of For-show DCF: The last three decades have seen an explosion in valuations for legal and accounting purposes. Since neither the courts nor accounting rule writers have a clear
    sense of what they want as output from this process (and it has little to do with fair value), and there are generally no transactions that ride on the numbers (making them "show" valuations), you get checkbox or rule-driven valuation. In its most pristine form, these valuations are works of art, where analyst and rule maker (or court) go through the motions of valuation, with the intent of developing models that are legally or accounting-rule defensible rather than yielding reasonable values. Until we resolve the fundamental contradiction of asking practitioners to price assets, while also asking them to deliver DCF models that back the prices, we will see more and more Kabuki DCFs.
  6. The Robo DCF: In a Robo DCF, the analyst build a valuation almost entirely from the most recent financial statements and automated forecasts. In its most extreme form, every input in a
    Robo DCF can be traced to an external source, with equity risk premiums from Ibbotson or Duff and Phelps, betas from Bloomberg and cash flows from Factset, coming together in the model to deliver a value. Given that computers are much better followers of rigid and automated rules than human beings can, it is not surprising that many services (Bloomberg, Morningstar) have created their own versions of Robo DCFs to do intrinsic valuations. In fact, you could probably create an app for a smartphone or tablet that could do valuations for you..
  7. The Mutant DCF: In its scariest form, a DCF can be just a collection of numbers where items have familiar names (free cash flow, cost of capital) but the analyst putting it together has
    neither a narrative holding the numbers together nor a sense of the basic principles of valuation. In the best case scenario, these valuations never see the light of day, as their creators abandon their misshapen creations, but in many cases, these valuations find their way into acquisition valuations, appraisals and portfolio management.
DCF Checklist
I see a lot of DCFs in the course of my work, from students, appraisers, analysts, bankers and companies. A surprisingly large number of the DCFs that I see take on one of these twisted forms and many of them have illustrious names attached to them. To help in identifying these twisted DCFs, I have developed a diagnostic sequence that is captured visually in this flowchart:

You are welcome to borrow, modify or adapt this flowchart to make it yours. If you prefer your flowchart in a more conventional question and answer format, you can use this checklist instead. So, take it for a spin on a DCF valuation, preferably someone else's, since it is so much easier to be judgmental about other people's work than yours. The tougher test is when you have to apply it on one of your own discounted cash flow valuations, but remember that the truth shall set you free!

  1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
  2. A DCF is an exercise in modeling & number crunching. 
  3. You cannot do a DCF when there is too much uncertainty.
  4. The most critical input in a DCF is the discount rate and if you don’t believe in modern portfolio theory (or beta), you cannot use a DCF.
  5. If most of your value in a DCF comes from the terminal value, there is something wrong with your DCF.
  6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
  7. A DCF cannot value brand name or other intangibles. 
  8. A DCF yields a conservative estimate of value. 
  9. If your DCF value changes significantly over time, there is either something wrong with your valuation.
  10. A DCF is an academic exercise.

Tuesday, February 10, 2015

How low can you go? Doing the Petrobras Limbo!

A few months ago, I suggested that investors venture where it is darkest, the nether regions of the corporate world where country risk, commodity risk and company risk all collide to create investing quicksand. I still own the two companies that I highlighted in that post, Vale and Lukoil, and have no regrets, even though I have lost money on both. At the time of the post, I was asked why I had not picked Brazil’s other commodity colossus, Petrobras, as my company to value (and invest in) and I dodged the question. The news from the last few days provides a partial answer, but I think that the Petrobras experience, painful though it might have been for some investors, provides an illustration of the costs and benefits of political patronage.

Petrobras: A Short History

Petrobras was founded in 1953 as the Brazilian government oil company, and for the first few decades of its life, it was run as a government-owned company from its headquarters in Rio De Janeiro. Until 1997, it had a legal monopoly on oil production and distribution in Brazil, when the domestic market was opened up to foreign oil producers. Petrobras was listed as a public company in 1997 on the Sao Paulo exchange and as a depository receipt on the New York Stock Exchange soon after. The arc of fortunes for the company can be traced in the changes in its market capitalization over time, reported in US dollars in the figure below:
Market Capitalization & Enterprise Value at end of each year
In the last decade, Petrobras has seen both highs and lows, becoming the fifth largest company in the world, in terms of market capitalization, in 2011 and then seeing a precipitous drop off in market prices in the years since. To understand where Petrobras is now and to make sense of where it is going, you have to look at both its rise in the last decade and its fall in this one.

The rise of Petrobras from minor emerging market oil company to global giant between 2002 and 2010 can be traced to three factors. The first was the discovery of major new reserves in Brazil in the early part of the last decade, which catapulted the company towards the top of the list of companies with proven reserves. The fact that these reserves would be expensive to develop was mitigated by a second development, which was the sustained surge in oil prices to triple digit levels for much of the period, making them viable. The third was an overall reduction in Brazilian country risk from the stratospheric levels of 2001 (when the country default spread for Brazil reached 14.34%, just before the election of Lula Da Silva as President) to 1.43% in 2010, when Brazil looked like it had made the leap to almost-developed market status. In 2010, the company signaled that its arrival in global markets and its ambitions to be even more by raising $72.8 billion from equity markets.

The hubris that led to the public offering may have been the trigger for the subsequent fall of the company, which has been dizzying because of the magnitude of the decline, and its speed. After peaking at a market capitalization close to $244 billion in 2010, the company has managed to lose a little bit more than $200 billion in value since, putting it in rarefied company with other champion value destroyers over time. While a large portion of the blame for the decline in the last few months (especially since September 2014) can be attributed to the drop in oil prices, note that Petrobras has already managed to destroy $160 billion in value prior to that point in time.

Petrobras: Governance Structure
To understand the Petrobras story, you have to start with an assessment how the company is structured. When the government privatized the company, it did so with the objective of raising capital for its treasury but it did not want to release control of the company to the shareholders who bought shares in the company. Using "national interest" as a shield, the government devised a game where it would be able to control the company, while raising billions in capital from investors. The basis for that game, and it is not unique to Petrobras, was to create two classes of shares, one with voting rights (common shares) and one without (called preferred shares, in an Orwellian twist), and offering the latter primarily to investors. The government retains control of more than 50% of the voting shares in the company and another 11% is controlled by entities (like the Brazilian Development Bank, BNDES, and Brazil's sovereign wealth fund) over which the government has effective control. Not quite satisfied with this rigging of the game, the government also retains veto power (a golden share) over major decisions.
Shareholding as of February 2015
Using this control structure, the government has created the ultimate rubber stamp board, whose only role has been to protect the government's interests (or more precisely the politicians who comprise the government at the time) at all costs. Brazilian company law does require that the minority shareholders (anybody but the government) have board representatives, but as this story makes clear, these directors are not just ignored but face retaliation for raising basic questions about governance. To be fair to Ms. Dilma Rousseff, government interference has always been the case in Petrobras, and her predecessors have been just as guilty of treating Petrobras as a piggybank and political patronage machine, as she has. Lula, who stepped down with great fanfare, as president just a few years ago was equally interventionist, but high oil prices provided the buffer that protected him from the fallout.

A Roadmap for Value Destruction
Just as looking at companies that have created significant amounts of value over time is enlightening because of the insights you get into what companies do right, Petrobras should become a case study for the opposite reason. Put in brutally direct terms, if you were given a valuable business and given the perverse objective of destroying it completely and quickly, you should replicate what Petrobras has done in five steps.

Step 1 - Invest first, worry about returns later (perhaps never)
Invest massive amounts of money in new investments, with little heed to returns on these investments, and often with the intent of delivering political payoffs or worse. Between 2009 and 2014, Petrobras stepped up its capital expenditures and exploration costs to more than 35% of revenues, well above the 15-20% invested by other integrated oil companies, while seeing its return on capital drop to 5% (even as oil prices stayed at $100+/barrel for the bulk of the period).

Step 2 - Grow, baby, grow, and profitability be damned
Petrobras has grown its revenues from $17.4 billion in 1997 to $135.8 billion in 2014 and displaced Exxon Mobil as the largest global oil producer in the third quarter of 2014, while letting profit margins drop dramatically. The government contributes to this dysfunctional growth by putting pressure on the company to sell gasoline at subsidized prices to Brazilian car owners.

Step 3 - Pay dividends like a regulated utility (even though you are not)
Petrobras has a history of paying large dividends, partly because it had the cash flows to pay those dividends in the 1990s and partly to supports it voting share structure. The preferred (non-voting) shares that the company has used to raise capital, without giving up control, come with dividend payout requirements that are onerous, if you have growth ambitions.

Step 4 - Borrow money to cover the cash deficit
If you want to eat your cake (by investing large amounts to generate growth) and have it too (while paying large dividends), the only way to make up the deficit is to raise fresh capital. In 2010, Petrobras did raise $79 billion in fresh equity but it has been dependent upon debt as its primarily financing in every other year. As a consequence, Petrobras had total debt outstanding of $135 billion at the end of 2014, more than any other oil company in the world.

Step 5 - Destroy value (Mission accomplished)
If you over invest and grow without heeding profitability, while paying dividends you cannot afford to pay and borrowing much more than you should be, you have created the perfect storm for value destruction. In fact, the way Petrobras has been run so defies common sense and first principles in corporate finance, that if I were a conspiracy theorist, I would be almost ready to buy into the notion that this is part of a diabolical plan to destroy the company hatched by evil geniuses somewhere. I have learned through hard experience, though, that you should not attribute to malevolence what can be explained by greed, self-dealing and bad incentive systems.

It is worth noting that none of the numbers in the last section can be attributed to the drop in oil prices. In the most recent twelve month data that you see in these graphs represent the year ending September 30, 2014, and the average oil price during that year exceeded $100/barrel.The government of Brazil, working through the management that they installed at Petrobras, have pulled off the amazing feat of destroying more than $200 billion in value with no help from outside.

A Contrarian Bet?
When a company falls as fast and as far as Petrobras has, it attracts the interests of contrarian investors and the company looks attractive on the surface, at least using some conventional multiples.

Petrobras looks very cheap, at least using equity multiples (PE and Price/Book) but the results are mixed with enterprise value multiples.

All of these multiples are affected by the fact that oil prices have dropped dramatically since the most recent financial statements and that the earnings numbers, in particular, will dive in the coming quarters. Given that Petrobras was already reporting sagging profits, before the oil price drop, I am almost afraid to think of what the numbers will look like at today's oil prices (which are closer to $50)., but I will try anyway. Looking at the annual revenues over time at the company and relating them to the average oil prices each year, here is what I find:
Revenues at Petrobras = -4,619 million + 1276 (Average Oil price during year)     R squared = 92%
Thus, if you assume that the current oil price of $51.69 is close to the average for this year, the normalized revenues for Petrobras will be $61.3 billion, a drop off of about 55% from the $135.8 billion revenues in the 12 months ending September 30, 2014.
Revenues at Petrobras = -4,619 million + 1276 (51.69) = $61,337 million or $61.3 billion
If you apply the operating margin of 10.82% that Petrobras reported in the trailing 12 months to these revenues, you arrive at an operating income of $6,638 million, prior to taxes. At that level of earnings, the value that I get for the company is $62.4 billion, well below the $135.1 billion owed by the company, making its equity worth nothing. In the matrix below, I look at the value per share under different combinations of base year income (ranging from $6,638 million at the low to $28.7 billion at the high) and return on invested capital on new investments (again ranging from a low of 2.67%, with income normalized for low oil prices, to 13.36% as the high):
Assuming no high growth period, stable growth rate of 2% and cost of capital of  11.17%. Adding a high growth period reduces value in all the return on capital scenarios, except one (average over last 10 years)
The red numbers represent the dead zone, where the value of the business is less than the debt outstanding and they dominate the table.  In spite of the reckless abandon shown by its management, there remain some bright spots, if you are an optimist. The first is that the company is one of the largest oil producers in the world and if oil prices rebound, they will see a jump in revenues. The second is that the exploration and investments over the last decade have given the company the fifth largest proven oil reserves in the world, though the proportion of these reserves that will be viable at today's oil prices is open to question. The third is that if the Brazilian government stops pulling the strings and management stops its self destructive behavior, profit margins and returns will improve. In the most optimistic spin, you can assume that Petrobras will be able to keep its trailing 12-month intact at $135.8 billion, improve its operating margin to the 21.1% that it earned in 2010 and its return on capital to 13.36% (10-year average), while reducing its debt ratio to 43.5% (average over last 5 years). With those assumptions, which border on fantasy, Petrobras would be worth $8.11/share (R$ 22.55/share) well above the current stock price of $3.28/share (R$ 9.12/share).  You are welcome to try out different combinations of your assumptions in this spreadsheet and see what you get.

Unsolicited (and perhaps unwelcome) advice for a new CEO

A couple of weeks ago, Ms. Maria das Gracas Foster, Petrobras CEO since February 2012, stepped down, and the Brazilian government announced that it has chosen Mr. Aldemir Bendine, former head of Banco do Brazil, as the next CEO. The market response was almost universally negative, partly because Mr. Bendine does not have any experience in the oil business and partly because there is no trust left in the Brazilian government. I do not know Mr. Bendine and it would be unfair of me to tar him as a government stooge, just because he was appointed by the government. In fact, I am willing to not only cut him some slack but to also provide advice on what he should do in the coming weeks. Here are my suggestions:
  1. Hire a chief operating officer who knows the oil business and turn over operating responsibilities to him.
  2. Fire anyone in the top management who has any political connections. That may leave lots of empty offices in Petrobras headquarters, but less damage will be done by no one being in those offices than the current occupants.
  3. Side with directors for the minority stockholders and push for a more independent, accountable board.
  4. Refuse to go along with the cap on gasoline prices for Brazilian consumers, a subsidy that has already cost the company $20-$25 billion between 2011 and 2013. With oil prices low, the consumer backlash will be bearable.
  5. Push openly for a move to one class of shares with equal voting rights. Accompany this action by cutting dividends to zero.
  6. Clean up the investment process with less auto-pilot exploration, production that is in line with oil prices and less focus on growth, for the sake of growth.
  7. Start paying down your debt.
What is the worst that can happen to you? If the government is set on a path of self-destruction, you will be fired. If that happens, wear it as a badge of honor, since your reputation will be enhanced and you will emerge looking like a hero.  If you go along with the status quo, you will preside over the final destruction of what was Brazil’s crown jewel and face the same fate as your predecessor.  Unless the new CEO can come up with a way to remake the company,  my guess is that, at least for the next few months, here is the song that will be playing out in the market:

Final Thoughts
There are always lessons to be learned from every calamity and Petrobras qualifies as a calamity. The first is to recognize that there every reason to be skeptical when politicians claim "national interest" and meddle incessantly in public corporations. In most cases, what you have are political interests which may or may not coincide with national interests, where elected politicians and government officials use stockholder money to advance their standing. The second is that those who have labeled "value maximization" as the "dumbest idea" and pushed for stakeholder wealth maximization, a meaningless and misguided objective that only strategists and Davos organizers find attractive, as an alternative, should take a close look at Petrobras as a case study of stakeholder wealth maximization gone amok. In the last five years, Petrobras has enriched countless politicians and politically connected businesses, subsidized Brazilian car owners and provided jobs to tens of thousands of oil workers, leaving stockholders on the outside looking in. Anyone who argues that this is a net good for Brazil has clearly not grasped the damage that has been done to the country in the global market place by this fiasco.

Corruption update: I have been asked by many of you as to why have sidestepped the corruption stories that have been swirling around the company. I did so, not because I want to avoid controversy (which I don't mind at all) but because I thought that at least in this case, being subtle delivers the message about political game playing better than brute force. At Petrobras, I treat corruption as a really bad investment with horrible returns to stockholders, but I believe that with its management structure, the company was destined for trouble, and that the corruption just greased the skids.


  1. Petrobras valuation spreadsheet