Amazon: Glimpses of Shoeless Joe?

It was just over two weeks ago that I started my posts on the FANG stocks, starting with Facebook, which I decided to buy, because I felt that notwithstanding its current pariah status, its user base was too valuable to pass by, at the prevailing market price. I then looked at Netflix, a company that has shown a remarkable ability to adapt to the challenges thrown at it, while changing the entertainment business, but is, at least in my view, in a content cost/user cycle that will be difficult to break out of. With Alphabet, the cash cow that is its advertising business is allowing it to invest in the big new markets of tomorrow, and even with low odds and very little substance today, these bets can make or break the investment. That leaves me with the longest listed and perhaps the most intriguing of the four stocks, Amazon, a company whose reach seems to expand into new markets each year. 

Revisiting my Amazon past
I valued Amazon for the first time in 1998, as an online book retailer, and much of what I know about valuing young companies today came from the struggles I went through, modifying what I knew in conventional valuation, for the special challenges of valuing a company with no history, no financials and no peer group. Out of that experience was born a paper on valuing young companies, which is still on my website and the first edition of the Dark Side of Valuation, and if you want to see some horrendously wrong forecasts, at least in hindsight, you can check out my valuation of Amazon in that edition. 

While I had a tough time justifying Amazon’s valuation, in its dot-com days, I always admired the company and the way it was managed. When I was put off balance by an Amazon product, service or corporate announcement, I re-read Jeff Bezos’ letter to Amazon shareholders from 1997, because it helped me understand (though not always agree with) how Amazon views the business world. In that letter, Bezos laid out what I called the Field of Dreams story, telling his stockholders that if Amazon built it (revenues), they (the profits and cash flows) would come. In all my years looking at companies, I have never seen a CEO stay so true to a narrative and act as consistently as Amazon has, and it is, in my view, the biggest reason for its market success.

I have valued Amazon about once a year every year over its existence, and I have bought Amazon four times and sold it four times in that period. That said, there are two confessions that I have to make. The first is that I have not owned Amazon since 2012, and have thus missed out on its bull run since then. Second, through all of this time, I have consistently under estimated not only the innovative genius of this company, but also its (and its investors') patience. In fact, there have been occasions when I have wondered, staying true to my Field of Dreams theme, whether Shoeless Joe would ever make his appearance. 

Amazon’s Market Cap Rise

Amazon’s rise in market capitalization has had more ups and downs than either Google or Facebook, but it has been just as impressive, partly because the company came back from a near death experience after the dot-com bust in 2001.

The more remarkable feature of Amazon’s rise has been the debris it has left in its wake, first with brick and mortar retail in the United States, but more recently in almost every business it has entered, from grocery retail to logistics. These graphs, excerpted from a New York Times article earlier this year, tells the story:

I know that this picture is probably is too compressed for you to read, but suffice to say that no company, no matter how large or established it is is safe, when Amazon enters it's market. Thus, while you can explain away the implosion of Blue Apron, when Amazon entered the meal delivery business, by pointing to its small size and lack of capital, note that the decline in market value at Kroger, Walmart and Target on the date of the Whole Foods acquisition was vastly greater in dollar value terms, and these firms are large and well capitalized. It is also worth noting that the decline in market cap is not permanent and that firms in some of the sectors see a bounce back in the subsequent time periods but generally not to pre-Amazon entry levels.  If Amazon represents the light side of disruption, the destruction of the status quo and everything associated with it, in the businesses that it enters, is the dark side.

Amazon: Operating History and Model

Rather than provide an involved explanation for why I call Amazon a Field of Dreams company, I will begin with a chart of Amazon's revenues and operating income that will explain it far more succinctly and better:

Amazon has clearly delivered on revenue growth, as its revenues have gone from $1.6 billion in 1999 to $177 billion in 2017, but its margins, after an initial improvement, went through an extended period of decline. In most companies, this would be viewed as a sign of a weak business model, but in the case of Amazon, it is a feature of how they do business, not a bug. In effect, Amazon has extended its revenue growth by expanding into new businesses, often selling its products (Kindle, Fire, Prime) at or below cost.  That, by itself, is not unique to Amazon, but what makes it different is that it has been able to get the market to go along with its "if we build it, they will come" strategy.

The mild uptick in profitability in the last three years has been fueled by Amazon's web services (AWS) business, offering cloud and other internet related services to other businesses, and that can be seen in the graph below, showing revenues and operating profits broken down by segment:

Amazon 10K

Over the last five years. AWS has accounted for an increasing slice of revenues for Amazon, but it is still small, accounting for 10% of all revenues in 2017. On operating income, though, it has had a much bigger impact, accounting for all of Amazon's profitability in 2017, with AWS generating $4,331 million in operating profits and the rest of Amazon, reporting an operating loss of $225 million.

To back up my earlier claim that Amazon's low profits are by design, and not an accident, let's look at two expenses that Amazon has incurred over this period that are treated as operating expenses, and are reducing operating profit for the company, but are clearly designed as investments for the future. The first is in technology and content, which include the investments in technology that are driving the growth in the AWS business and content, for the media business. The second is in net shipping costs, the difference between what Amazon collects in shipping fees from its customers and what it pays out, which can be viewed as the investment is making in building up Amazon Prime.

Amazon 10K

Not only are the technology/content and net shipping costs a large portion of overall expenses, amounting to 18.32% of revenues in 2017, but they have increased over time. The operating margin for Amazon would have been over 20%, if it had not incurred these expenditures, but with those higher, the company would have had far less revenues, no AWS business and no Amazon Prime today. To value Amazon today, I think it makes sense to break it up into at least three parts, with the first being its retail/media business globally, the second its AWS business and finally, Amazon Prime. In the table below, I attempt to deconstruct Amazon's numbers to estimate how much each of these arms is generated as revenues and created in operating expenses in 2017, as a prelude to valuing them.

Note that I had to make some estimates and judgment calls in allocating revenues to Amazon Prime, where I have counted only the incremental revenues from Amazon Prime members, and in allocating content costs. For Amazon Prime, for instance, I have used an assumption that Prime members spend $600 more than non-Prime members, to estimate incremental revenues, and added the $9.7 billion in subscription premiums that Amazon reported in 2017. The net shipping costs have been fully allocated to Amazon Prime and all of the operating expenses that Amazon reported for AWS are assumed to be technology and content. The remaining expenses are allocated across AWS and Amazon Retail/Media, in proportion to their revenues. In my judgment, both Amazon Retail/Media and AWS generated operating profits in 2017, but the latter was much more profitable, with a pre-tax operating margin of 24.81%. Amazon Prime was a money loser in 2017, but its margins are less negative than they used to be, and at 100 million members, it may be poised to turn the corner.

Amazon Business Model

If there are any secrets in Amazon's business model, they are dispensed when you read Amazon's 10K, which is remarkably forthcoming about how the company approaches business. In particular, the company emphasizes three key elements in its business model:

1. Focus on Free Cash Flow: I tend to be cynical when companies talk about free cash flows, since most use self serving definitions, where they add "stuff" to earnings to make their cash flows look more positive. Amazon does not seem to take the same tack. In fact, it not only nets out capital expenditures and working capital needs, as it should, but it even nets out acquisitions (such as the $13.2 billion it spent on Whole Foods) to get to free cash flow.
2. Manage working capital investment: Perhaps remembering times as a start-up when mismanaging inventory brought it to its knees, the company is focused on keeping its investment in working capital as low as possible, though that does sometimes involve strong arming suppliers.
3. Use Operating leverage: Amazon is clearly conscious about its cost structure, recognizing that its revenue growth can give it significant advantages of economies of scale, when it comes to fixed costs.

There are two additional features to the company that I would add, from my years observing the company.

1. Patience: I have never seen a company show as much patience with its investments as Amazon has, and while there are some who would argue that this is because of it's large size and access to capital, Amazon was willing to wait for long periods, even when it was a small company, facing a capital crunch. I believe that patience is embedded in the company's DNA and that the Bezos letter in 1997 explains why.
2. Experimentation: In almost every business that Amazon enters, it has been willing to try new things to shake up the status quo, and to abandon experiments that do not work in favor of experiments that do.

There is no scarier vision for a company than news that Amazon has entered its business. If you are in that besieged company, how do you survive the Amazon onslaught? We know what does not work:

1. Imitation: You cannot out-Amazon Amazon, by trying to sell below cost and wait patiently. Even if you are a company with deep pockets, Amazon can out-wait you, since it is not only how they do business and they have investors who have accepted them on their terms.
2. Cost Cutting: There are companies, especially in the US brick and mortar retail space, that thought they could cut costs, sell products at Amazon-level prices and survive. By doing so, they speeded their decline, since the poorer service and limited inventory that followed alienated their core customers, who left them for Amazon.
3. Whining: Companies under the Amazon threat often resort to whining not only about fairness (and how Amazon breaks the rules) but also about how society overall will pay a price for Amazon domination. There are seeds of truth in both argument, but they will neither slow nor stop Amazon from continuing to put them out of business.

While there is no one template for what works, here are some strategies, drawn from looking at companies that have survived Amazon, that improve your odds:

1. Tilt the game: You can try to get governments and regulators to buy into your warnings of monopoly power and societal demise and to regulate or restrict Amazon in ways that allow you to continue in business. 
2. Play to your strengths: If you have succeeded as a company before Amazon came into your business, you had competitive advantages and core customers who generated that success. Nourishing your competitive advantages and bringing your core customers even closer to you is key to survival, but that will require that you live through some financial pain (in the form of higher costs).
3. And to Amazon's weaknesses: Amazon's favored markets have high growth and low capital intensity, and when they get drawn into markets that demand more capital investment, like logistics, it is because they were forced into them. If you can move the terrain to lower growth, higher capital intensity businesses, you can improve your odds of surviving Amazon.

None of these choices will guarantee success or even survival, and there are times where you may have to seek partnerships and joint ventures to make it through, and if all else fails, you can try some witchcraft.

Valuing Amazon

In my prior iterations, I tried to value Amazon as a consolidated company, arguing that it was predominantly a retail company with some media businesses. The growth of AWS and the substantial spending on Amazon Prime has led me to conclude that a more prudent path is to value Amazon in pieces, with Amazon Retail/Media, AWS and Amazon Prime, each considered separately.

1. Amazon Retail/Media

To value the heart of Amazon, which still remains its retail and media business, I used the revenues and operating margin that I estimated based upon my allocation at the end of the last section as my starting point, and assumed that Amazon will be able to continue growing revenues at 15% a year for the next five years, while also improving its operating margin (currently 9.09%, with technology and content costs capitalized) to 12%. The revenue growth assumption is built on Amazon's track record of being able to grow and the improved margin reflect expected economies of scale. The resulting value is shown below:

Download spreadsheet

Based upon my assumptions, the value that I attach to the retail/media business is about $289 billion. The key driver of value is the operating margin improvement, built into the story.

2. AWS

If Amazon's reported numbers are right, this division is the profit machine for the company, generating an operating margin of close to 25%, while revenues grew 42.88% in 2017. While I believe that this business will stay high growth and profitable, it is also one where Amazon faces strong competitors in Microsoft and Google, just to name two, and both revenue growth rates and margins will come under pressure. I assume revenue growth of 25% a year for the next 5 years, with operating margin declining to 20% over that period. The value is shown below:

Download spreadsheet

The value that I estimate for AWS is about $139 billion. The key for value creation is finding a mix of revenue growth and operating margin that keeps value up, since going for higher growth with much lower margins will cause value to dissipate.

3. Amazon Prime

To value Amazon Prime, I use the same technique that I used last year to value it, starting with a value of a Prime member, and building up to the value of Prime, by forecasting growth in Prime membership and corporate costs (mostly content). I updated the Prime membership number to 100 million (from the 85 million that I used last August) and used the 2017 financial statements to get more specific on both content costs and on the cost of capital. The value is shown below:

Download spreadsheet

Based upon the layers of assumptions that I have made, especially on shipping costs growing at a rate lower than membership rolls, the value that I estimate for Amazon Prime is about $73 billion. The key input here is shipping costs, since failing to keep it in control will cause the value to very quickly spiral down to zero.

Amazon, the Company

With all three pieces completed, I bring them together in my valuation of the company, incorporating the total debt outstanding in the company of $42,730 (including capitalized operating leases) and cash of $30.986 million, to arrive at a value per share of $1019.

At $1,460/share, on April 25, the stock is clearly out of my reach right now. Given that I have not been able to justify buying the stock at any time in the last five years, as it rose from $250/share to $1500, my suggestion is that you do you don't take my word, and that you make your own judgment. You can download the spreadsheets that I have for Amazon Retail/Media, AWS and Amazon Prime at the end of this post, and change those assumptions of mine that you think are wrong.

Investment Judgment

The FANG stocks represent great companies, but of the four, I think that Amazon has the most fearsome business model, simply because its platform of disruption and patience can be extended to almost any other business, one reason why every company should view Amazon as a potential competitor. I know that the old value adage is that if you buy quality companies and hold them forever, they will pay for themselves, but I don't believe that! There are good companies that can be bad investments and bad companies that can be terrific investments, as I noted in this post. Amazon has fallen into the first category for much of the last five years and continues to do so, at today's market price. But good things come to those who wait, and I know that there be a time and a price at which it will be back in my portfolio.

Post-post Update: I deliberately posted this before the earnings report, and the report that came out about two hours after the post was a blockbuster, with higher revenue growth than expect, a doubling of net income and an increase in the stock price of close to $100/share in the after market. Incorporating the effects into the valuations will have to wait until the full quarterly report is available, but the biggest part of the report,  for me, was the increase in Prime Membership fees to $119/year. You can modify the Amazon Prime valuation spreadsheet to reflect the increase in membership feels to $119/year (from $99/year). Doing so increases the value of Prime to almost $116 billion, increasing value per share by almost $100/share.

YouTube Video


Data Links

1. Amazon 10K
2. Valuation of Amazon Retail/Media
3. Valuation of AWS
4. Valuation of Amazon Prime

Related Blog Posts

1. Deconstructing Amazon Prime (October 2017)
2. Explaining a Paradox: Why Good (Bad) Companies can be Bad (Good) Investments!

Blog Posts on Tech Takedown

1. Come easy, go easy: The Tech Takedown!
2. Facebook: Friendless, But Still Formidable!
3. Netflix: The Future of Entertainment or House of Cards?
4. Alphabet Soup: Google is Alpha, but where are the Bets?
5. Amazon: Glimpses of Shoeless Joe!

A Tesla 2017 Update: A Disruptive Force and a Debt Puzzle!

These are certainly exciting times for Tesla. The first production version of the Tesla 3 was unveiled on July 28, with few surprises on the details, but plenty of good reviews. Elon Musk was his usual self, alternating between celebrating success and warning investors in the stock that the company was approaching "manufacturing hell", as it ramps up its production schedule to meet its target of producing 10,000 cars a week. It is perhaps to cover the cash burn in manufacturing hell that Tesla also announced that it planned to raise $1.5 billion in a junk bond offering. Investors continued to be unfazed by the negative and lapped up the positive, as the stock price soared to $365 at close of trading on August 9, 2017. With all of this happening, it is time for me to revisit my Tesla valuation, last updated in July 2016, and incorporate, as best as I can, what I have learned about the company since then.

Tesla: The Story Stock

I have been following Tesla for a few years and rather than revisit the entire history, let me go back to just my most recent post on the company in July 2016, where I called Tesla the ultimate story stock. I argued that wide differences between investors on what Tesla is worth can be traced to divergent story lines on the stock. I used the picture below to illustrate the story choices when it comes to Tesla, and how those choices affected the inputs into the valuation.

In that post, I also traced out the effect of story choices on value, by estimating how the numbers vary, depending upon the business, focus and competitive edge that you saw Tesla having in the future:

With my base case story of Tesla being an auto/tech company with revenues pushing towards mass market levels and margins resembling those of tech companies, I estimated a value of about $151 a share for the company and my best case estimate of value was $316.46.

Tesla: Operating Update

If you are invested in or have been following Tesla for the last year, you are certainly aware that the market has blown through my best case scenario, with the stock trading on August 9, at $365 a share, completing a triumphant year in markets:

As Tesla's stock price rose, it broke through milestones that guaranteed it publicity along the way. It's market capitalization exceeded that of Ford and General Motors in April 2016, and in June 2016, Tesla leapfrogged BMW to become the fourth largest market cap automaker in the world, though it has dropped back a little since. It now ranks fifth, in market capitalization, among global automobile companies:

Largest Auto Companies (Market Capitalization) on August 9, 2017

While Tesla's market cap has caught up with larger and more established auto makers, its production and revenues are a fraction of theirs, leading some to use metrics like enterprise value per car sold to conclude that Tesla is massively over valued. I don't have much faith in these pricing metrics to begin with, but even less so when comparing a company with massive potential to companies that are in decline, as I think many of the conventional auto companies in this table are currently.

As I noted at the start of the post, it has been an eventful year for Tesla, with the completion of the Solar City acquisition, and the Tesla 3 dominating news, and its financial results reflect its changes as a company. In the twelve months ended June 30, 2017, Tesla's revenues hit $10.07 billion, up from $7 billion in its most recent fiscal year, which ended on December 31, 3016; on an annualized basis, that translates into a revenue growth rate of 107%. That positive news, though, has to be offset at least partially with the bad news, which is that the company continues to lose money, reporting an operating loss of $638 million in the most recent 12 months, with R&D expensed, and a loss of $103 million, with capitalized R&D. The growth in the company can be seen by looking at how quickly its operations have scaled up, over the last few years:

Tesla's growth has not just been in the operating numbers but in its influence on the automobile sector. While it was initially dismissed by the other automobile companies as a newcomer that would learn the facts of life in the sector, as it aged, the reverse has occurred. It is the conventional automobile companies that are, slowly but surely, coming to the recognition that Tesla has changed their long-standing business. Volvo, a Swedish automaker not known for its flair, announced recently that all of its cars would be either electric or hybrid by 2019, and Ford's CEO was displaced for not being more future oriented. A little more than a decade after it burst on to the scene, it is a testimonial to Elon Musk that he has started the disruption of one of the most tradition-bound sectors in business.

Tesla: Valuation Update

The production hiccups notwithstanding, the company continues to move towards production of the Tesla 3, with the delivery of the handful to start the process. There is much that needs to be done, but I consider it a good sign that the company sees a manufacturing crunch approaching, since I would be concerned if they were to claim that they could ramp up production from 94,000 to 500,000 cars effortlessly.  My updated story for Tesla is close to the story that I was telling in July 2016, with two minor changes. The first is that the production models of the Tesla 3 confirm that the company is capable of delivering a car that can appeal to a much broader market than prior models, putting it on a  pathway to higher revenues. My expected revenues for Tesla in ten years are close to $93 billion, a nine-fold increase from last year's revenues and a higher target than the $81 billion that I projected in my July 2016 valuation. Second, the operating margins, while still negative, have become less so in the most recent period, reducing reinvestment needs for funding growth. The free cash flows are still negative for the next seven years, a cash burn that will require about $15.5 billion in new capital infusions over that period. With those changes, the value per share that I estimate is about $192/share, about 20% higher than my $151 estimate a year ago, but well below the current price per share of $365.

Download spreadsheet

As with every Tesla valuation that I have done, I am sure (and I hope) that you will disagree with me, with some finding me way too pessimistic about Tesla's future, and others, much too optimistic. As always, rather than tell me what you think I am getting wrong, I would encourage you to download the spreadsheet and replace my assumption with yours. I think I am being clear eyed about the challenges that Tesla will face along the way and here are the top three: 

1. Can Tesla sell millions of cars? One of Tesla's accomplishments has been exposing the potential of the hybrid/electric car market, even in an era of restrained fuel prices. That is good news for Tesla, but it has also woken up the established automobile companies, as is evidenced by not only the news from Volvo and Ford, but also in increased activity on this front at the other automobile companies. In my valuation, the revenues that I project in 2027 will require Tesla to sell close to 2 million cars, in the face of increased competition.
2. Can it make millions of cars? Tesla's current production capacity is constrained and there are two production tests that Tesla has to meet. The first is timing, since the Tesla 3 deliveries have been promised for the middle of 2018, and the assembly lines have to be humming by then. The second is cost, since a subtext of the Tesla story, reinforced by hints from Elon Musk, is that the company has found new and innovative ways of scaling up production quickly and at much lower costs than conventional automobile companies. 
3. Can it generate double digit margins? In my valuation, I assume an operating margin of 12% for Tesla, almost double the average of 6.33% for global auto companies. For Tesla to generate this higher margin, it has to be able to keep production costs low at its existing and new assembly plants and to be able to charge a premium price for its automobiles, perhaps because of its brand name. 

Tesla has shown a capacity to attract and keep customers and I think it is more than capable of meeting the first challenge, i.e., sell millions of cars, especially since its competition is saddled with legacy costs and image problems. It is the production challenge that is the more daunting one, simply because this has always been Tesla's weakest link. Over the last few years, Tesla has consistently had trouble meeting logistical and delivery targets it has set for itself, and those targets will only get more daunting in the years to come. Furthermore, if its production costs run above expectations, it will be unable to deliver on higher margins. To succeed, Tesla will require vision, focus and operating discipline. With Elon Musk at its helm, the company will never lack vision, but as I argued in my July 2016 post, Mr. Musk may need a chief operating officer at his side to take care of delivery deadlines and supply chains. 

Financing Cash Burn: Tesla's Odd Choice

There is much to admire in the Tesla story but there is one aspect of the story that I find puzzling, and if I were an equity investor, troubling. It is the way in which Tesla has chosen to, and continues to, finance itself. Over the last decade, as Tesla has grown, it has needed substantial capital to finance its growth. That is neither surprising nor unexpected, since cash burn is part of the pathway to glory for companies like Tesla. However, Tesla has chosen to fund its growth with large debt issues, as can be seen in the graph below:

That debt load, already high, given Tesla’s operating cash flows is likely to get even bigger if Tesla succeeds in its newest debt issue of $1.5 billion, which it is hoping to place with an interest rate of 5.25%, trying to woo bond buyers with the same pitch of growth and hope that has been so attractive to equity markets. That suggests that those making the pitch either do not understand how bonds work (that bondholders don't get to share much in upside but share fully in the downside) or are convinced that there are enough naive bond buyers out there, who think that interest payments can be made with potential and promise.

But setting aside concerns about bondholders, the debt issuance makes even less sense from Tesla's perspective. Unlike some, I don’t have a kneejerk opposition to the use of debt. In fact, given that the tax code is tilted to benefit debt, it does make sense for many companies to use debt instead of equity. The trade off, though, is a simple one:

If you look at the trade off, you can see quickly that Tesla is singularly unsuited to using debt. It is a company that is not only still losing money but has carried forward losses of close to $4.3 billion, effectively nullifying any tax benefits from debt for the near future (by my estimates, at least seven years). With Elon Musk, the largest stockholder at the company, at the helm, there is no basis for the argument that debt will make managers more disciplined in their investment decisions. While the benefits from debt are low to non-existent, the costs are immense. The company is still young and losing money, and adding a contractual commitment to make interest payments on top of all of the other capital needs that the company has, strikes me as imprudent, with the possibility that one bad year could put its promise at risk. Finally, in a company like Tesla, making large and risky bets in new businesses, the chasm between lenders and equity investors is wide, and lenders will either impose restrictions on the company or price in their fears (as higher interest rates). So, why is Tesla borrowing money? I can think of two reasons and neither reflects well on the finance group at Tesla or the bankers who are providing it with advice.

1. The Dilution Bogeyman: The first is that the company or its investment bankers are so terrified of dilution, that a stock issue is not even on the table. Once the dilution bogeyman enters the decision process, any increase in share count for a company is viewed as bad, and you will do everything in your power to prevent that from happening, even if it means driving the company into bankruptcy. 
2. Inertia: Auto companies have generally borrowed money to fund assembly plants and the bankers may be reading the capital raising recipe from that same cookbook for Tesla. That is incongruent with Elon Musk’s own story of Tesla as a company that is more technology than automobile and one that plans to change the way the auto business is run.

Tesla’s strengths are vision and potential and while equity investors will accept these as down payments for cash flows in the future, lenders will not and should not. In fact, I cannot think of a better case of a company that is positioned to raise fresh equity to fund growth than Tesla, a company that equity investors love and have shown that love by pushing stock prices to record highs. Issuing shares to fund investment needs will increase the share count at Tesla by about 3-4% (which is what you would expect to see with a $1.5 billion equity issue) but that is a far better choice than borrowing the money and binding yourself to make interest payments.  There will be a time and a place for Tesla to borrow money, later in its life cycle, but that time and place is not now. If Tesla is dead set on not raising its share count, there is perhaps one way in which Tesla may be able to eat its cake and have it too, and that is to exploit the dilution bogeyman's blind spot, which is a willingness to overlook potential dilution (from the issuance of convertibles and options). In fact, why not issue long term, really low coupon convertible bonds, very similar to this one from 2014, a bond only in name since almost all of its value came from the conversion option (which is equity with delayed dilution)?

Conclusion

The Tesla story continues to evolve, and there is much in the story that I like. It is changing the automobile business, a feat in itself, and it is starting to deliver on its production promises. The next year may be manufacturing hell, but if the company can make its through that hell and find ways to deliver the tens of thousands of Tesla 3s that it has committed to delivering, it will be well on its way. I still find the stock to be too richly priced, even given its promise and potential, for my liking, but I understand that many of you may disagree. That said, though, I do think that the company's decision to use debt to fund its operations makes no sense, given where it is in the life cycle.

YouTube Video

Previous Blog Posts

1. Tesla: It's a story stock, but what's the story? (July 2016)

Spreadsheet Attachments

1. Tesla Valuation: August 2017
2. Tesla Valuation: July 2016

The Trump Effect on Markets: A Financial (not a Political) Analysis!

I have political views, but I try to keep them out of my classes and my blog posts. I teach and write about corporate finance/valuation, not political science, and I don't think it is fair to subject my students or readers of this blog to my views on politics. I would be committing malpractice, though, if I avoid talking about Tuesday's election, since it does have consequences for investing. That said, I know that nerves are exposed and emotions are raw and I want (perhaps unsuccessfully) to stay away from the hot-button issues and focus, as best as I can, on the investment implications of a Trump Presidency. As I started writing, I realized that I was repeating almost word for word what I had written in June, after UK voters voted for Brexit. Consequently, I decided to go back and copy the Brexit post, change "Brexit" to "Trump Election", to see how close they were.  The changes are in red and the replaced words are crossed out. You can be the judge on the parallels!

There are few events that catch markets by complete surprise but the decision by British US voters to leave the EU elect Donald Trump as President comes close. As markets struggle to adjust to the aftermath, analysts and experts are looking backward, likening the event to past crises election surprises and modeling their responses accordingly. There are some who see the seeds of a market meltdown, and believe that it is time to cash out of the market. There are others who argue that not only will markets bounce back but that it is a buying opportunity. Not finding much clarity in these arguments and suspicious of bias on both sides, I decided to open up my crisis survival kit, last in use in August 2015, in the midst of another market meltdown.

The Pricing Effect

I am sure that you have been bombarded with news stories about how the market has reacted to the Brexit vote Trump Election and I won't bore you with the gory details. Suffice to say that, for the most part, it has not followed the crisis rule book: Government bond rates in developed market currencies (the US, Germany, Japan and even the UK) the United States have dropped risen, gold prices have risen stayed flat, the price of risk has increased decreased and equity markets have declined risen. The picture below captures the fallout of the vote across markets:

As the election results came out on Tuesday night, the immediate market reaction was dire, with Dow futures dropping almost 800 points, triggering circuit breakers. By Wednesday morning, though, the panic seemed to have subsided and the market effect in the two days since the election have been not just benign, but positive. I know that it is early and that much can happen in the next few weeks to spook markets again, but as things stand now, here is what we see. Rates on US treasuries have risen sharply, with interpretations varying depending upon your election priors, with those negatively inclined to Trump viewing the rise as a sign that foreign buyers are pulling out the market, leery of his comments about  and those positively inclined arguing that the rise reflects expectations of higher growth in the future. The dollar has held its own against other currencies and the fear indices (gold and the VIX) have fallen since Tuesday, with the VIX dropping dramatically. US stocks have risen in the two days since the election, with small cap stocks in Russel 2000 rising more than the large cap stocks. If you are puzzled by the NASDAQ's inability to join the rally, you can see why when you look at the returns across the S&P sectors:

	Last 5 days	Last 3 months	YTD (2016)
Consumer Discretionary	2.46%	-2.57%	1.05%
Consumer Staples	-0.88%	-4.97%	2.95%
Energy	3.80%	3.50%	16.79%
Financial Services	6.48%	7.46%	6.38%
Financials	6.71%	6.70%	7.77%
Health Care	6.20%	-5.36%	-1.74%
Industrials	5.59%	2.23%	12.58%
Materials	4.39%	-0.94%	11.15%
Real Estate	0.40%	-12.21%	-3.83%
Technology	1.37%	0.45%	10.55%
Utilities	-1.17%	-6.59%	9.43%
S&P 500	3.11%	-0.85%	5.84%

The stock market rise in the last few days has been uneven with consumer staples, utility, technology and real estate stocks (ironically) lagging and financial firms, health care and industrials doing well. Though it is dangerous to try to create full-blown stories based on stock market behavior over a few days, it seems likely that the rally in financials and pharmaceuticals can be traced as much to expectations about what Trump has said he will do (repeal Obamacare, for instance) as to relief that some of the regulations/restrictions that Clinton had proposed (on pharmaceutical pricing and more constraints on banks) would not longer be on the table. The decline in utilities can be attributed to rising interest rates but the swoon in tech stocks bears watching, since it could be an indication that tech companies, who strongly backed Clinton, may face headwinds in a Trump administration. 

The Value Effect

As markets make their moves, the advice that is being offered is contradictory. At one end of the spectrum, some are suggesting that Brexit Trump election could trigger a financial crisis similar to 2008, pulling markets down and the global economy into a recession, and that investors should therefore reduce or eliminate their equity exposures and batten down the hatches. At the other end are those who feel that this is much ado about nothing, that Brexit will not happen or that the UK will renegotiate new terms to live with the EU and that investors should view the market drops as buying opportunities the Trump effect can be more positive than negative, with changes in taxes and regulations offsetting any negative consequences from his trade policies. Given how badly expert advice served us during the run-up to Brexit the Trump election, I am loath to trust either side and decided to go back to basics to understand how the value of stocks could be affected by the event and perhaps pass judgment on whether the pricing effect is under or overstated. The value of stocks collectively can be written as a function of three key inputs: the cash flows from existing investment, the expected growth in earnings and cash flows and the required return on stocks (composed of a risk free rate and a price for risk).  The following figure looks at the possible ways in which Brexit the Trump presidency can affect value:

I know the perils of assuming that campaign promises and rhetoric will become policy, but broadly speaking, you can outline the possible consequence for companies of Trump's proposed policy changes. The biggest and potentially most negative effect would come from his trade policies, where protectionist policies can and will draw protectionist responses from other countries, putting global trade and growth at risk. Trump has been ambivalent about both the Federal Reserve's interest rate policies and financial markets, arguing that the Fed has played politics with interest rates and that financial markets are in bubble territory. It will be interesting to see whether the FOMC, when it meets in December, takes into account the election results, in making its widely telegraphed decision to raise rates (at least the ones that it controls). Trump has proposed major changes to both corporate and individual tax rates, and if Congress goes along even part way, you can expect to see a lower corporate tax rate accompanied by inducements to bring the $2.5 trillion in trapped cash that US companies have in other markets.

There is also likely to be sector-specific fall out from other Trump policies, at least in contrast to what these sectors would have faced under a President Clinton. President Trump has prioritized repealing Obamacare and that will have direct consequences for companies in the health care sector, with some benefiting (pharmaceutical companies?) and some perhaps being hurt (insurance companies and hospital stocks?). President Trump's proposal to invest heavily in the nation's infrastructure will benefit the construction, engineering and raw material firms that will construct that infrastructure but he may run into both budgetary constraints (with his tax proposals) and political headwinds (from conservatives in Congress). Finally, President Trump has promise to reduce regulation on business and put in more business-friendly regulators on the regulatory bodies and that will be viewed as good news by banks and fossil-fuel firms that were facing the most onerous of these regulations. The Trump proposals to preserve the entitlement programs, lower taxes and increase infrastructure spending are potentially at war with each other and budget constraints, but that does not mean that significant parts of each one will not become law.

In evaluating these possibilities, I am cognizant of the checks and balances that characterize the US system. Unlike parliamentary systems, where a new government can quickly  rewrite laws and replace old policies, the framers of the US constitution put in a system where power is shared by the executive, the legislature and the courts, making change difficult. Even with Republicans controlling the executive and legislative branches, I am sure that Trump supporters will be frustrated by how slowly things move through the mill and how difficult it is to convert proposals to policies and Trump detractors will learn to love the same filibusters, congressional slowdowns and legal roadblocks that they have inveighed against over the last eight years. 

The Bigger Lessons

It is easy to get caught up in the crisis of the moment but there are general lessons that I draw from Brexit the Trump election that I hope to use in molding my investment strategies.

1. Markets are not just counting machines: One of the oft-touted statements about markets is that they are counting machines, prone to mistakes but not to bias. If nothing else, the way markets behaved in the lead-up to Brexit the election is evidence that markets collectively can suffer from many of the biases that individual investors are exposed to. For most of the last few months, the British Pound Mexican Peso operated as a quasi bet on Brexit the US presidential election, rising as optimism that Remain Clinton would prevail rose and falling as the Leave Trump campaign looked like it was succeeding. There was a more direct bet that you would make on Brexit Trump in a gamblers' market, where odds were constantly updated and probabilities could be computed from these odds. Since Brexit the US election was also one of the most highly polled in history, you would expect the gambling to be closely tied to the polling numbers, right? The graph below illustrates the divide. 
   
   
   
   While the odds in the Betfair did move with the polls, the odds of the Leave camp Trump winning never exceeded 40% in the betting market, even as the Leave camp acquired a small lead in the weeks leading up to the vote the polls got closer in mid-September and in the last week before the election. In fact, the betting odds were so sticky that they did not shift to the Leave side until almost a third of the votes had been counted Trump until late on Tuesday night. So, why were markets so consistently wrong on this vote? One reason, as this story notes,  is that the big bets in these markets were being made by London-based bigger investors tilting the odds in favor of Remain Clinton. It is possible that these investors so wanted the Remain vote Clinton to win that they were guilty of confirmation bias (looking for pieces of data or opinion that backed their view). In short, Brexit Trump reminds us that markets are weighted, biased counting machines, where big investors with biases can cause prices to deviate from fair value for extended periods.
2. No one listens to the experts (and deservedly so): I have never only once before seen an event where the experts were all so collectively wrong in their predictions and so completely ignored by the public. Economists, foreign policy experts and central banks opinion leaders all inveighed against exiting the EU Trump, arguing that is electing him would be catastrophic, and their warnings fell on deaf years, as voters tuned them out. As someone who cringes when called a valuation expert, and finds some of these experts to be insufferably pompous,  I can see why experts have lost their cache. First, in almost every field , expertise has become narrower and more specialized than ever before, leading to prognosticators who are incapable of seeing the big picture. Second, while experts have always had a mixed track record on forecasting, their mistakes now are not only more visible but also more public than ever before. Third, the mistakes experts make have become bigger and more common as the world has become more complex, partly because the interconnections between variables means there are far more uncontrollable elements than in the past. Drawing a parallel to the investment world, even as experts get more forums to be public, their prognostications, predictions and recommendations are getting far less respect than they used to, and deservedly so. Finally, it is time that we that are open about the fact that we are all biased and being smart or an expert does not immunize from bias.
3. Narrative beats numbers: One of the themes for this blog for the last few years has been the importance of stories in a world where numbers have become more plentiful. In the Brexit debate US presidential election, it seemed to me that the Leave side Trump had the more compelling narrative (of a return to an an old Britain America that enough voters found appealing to help him win) and while the Remain side Clinton argued that this narrative was not plausible in today's world, its counter consisted mostly of numbers (the costs that Britain would face from Brexit) inveighing against Trump's character and temperament. Looking ahead to similar referendums elections in other EU countries,  I have a feeling that the same dynamic is going to play out, since few established politicians in any EU country seem to want to make a full-throated defense of being Europeans first the status quo. 
4. Democracy can disappoint (you): The parallels between political and corporate governance are plentiful and Brexit this election has brought to the surface the age-old debate about the merits of direct democracy. While many, mostly on the winning side, celebrate the wisdom of crowds, there are an equal number on the losing side who bemoan the madness and prejudices of crowds.  As someone who has argued strongly for corporate democracy and against entrenching the status quo, it would be inconsistent of me to find fault with the British American public for voting for Brexit Trump.  In a democracy, you will get outcomes you do not like and throwing a tantrum or threatening to move are not democratic responses.  You may not like the outcome, but as an American political consultant said after his candidate lost an election, "the people have spoken... the bastards".

The End Game

I am sure that reading this post, with its crossed-out words and red insertions, has been tiresome, but I also think that the parallels between what happened around Brexit and the US presidential election are too strong for this to be coincidence. Just as technology and social media are upending traditional models in businesses, these two elections are signaling a change in the political game and it is not just politicians, pollsters and political consultants who should be taking notice.

YouTube Video

The Ride Sharing Business: Playing Pundit

This is the third and final post in a series of three on the ride sharing business. In the first, I valued Uber and looked at the evolution of its business over the last 18 months. In the second, I valued Lyft and looked at pricing across ride sharing companies. In this one, I look at the future of the ride sharing business from the perspective of an outsider with no expertise in this business.

In my last two posts, I first valued Uber, with its expansive narrative, and then looked at putting numbers on Lyft's less ambitious storyline. In my Uber post, I argued that the ride sharing market was proving to be bigger, broader and growing faster than I had estimated it would be in June 2014. In the Lyft post, I examined how VCs were pricing ride sharing companies. In this post, I want to complete the story by looking at the current state of the ride sharing market and for scenarios for the market over time, with consequences for investors, car riders and drivers. 

The Ride Sharing Market: The State of the Game

In my posts on ride sharing, I noted that the ride sharing market has grown exponentially in the last two years, drawing in new users and redefining the car service business. That growth can be seen  in multiple dimensions:

1. Anecdotal & Qualitative evidence: I am usually wary about using anecdotal data but I have been keeping tabs on Uber usage in my travels and I have been amazed at the company's global reach. This summer, I did seminars in São Paulo, Moscow and Mumbai, and in each venue, a significant proportion of the attendants had taken Uber to the event. In fact, my children talk about Ubering to destinations unknown, rather than taking a cab, just as xeroxing and googling became synonyms for copying and online searching. 
2. Operating metrics at ride sharing companies: The operating metrics at the ride sharing companies individually, and in the aggregate, back up the proposition that this is a high growth business.

Company	Revenues in 2014	Revenues (2015)	Growth Rate (2015)
Lyft	$125	$300	140.00%
Uber	$400	$2,000	400.00%
Didi Kuaidi	$30	$450	1400.00%
Ola	$50	$150	200.00%
GrabTaxi	$15	$50	233.33%
BlaBlaCar	$30	$72	140.00%

3. Investor expectations: The increases in the values attached to ride sharing companies indicate that investors are also scaling up expectations of future growth in this business. Using Uber's estimated value of $51 billion in its most recent VC funding to illustrate the process, I estimated imputed revenues of $51.4 billion in 2026, which, if you hold its revenue slice share at 15% (my assumption) yields an imputed gross billing of $342.8 billion in 2026. If I repeat this exercise with the other ride sharing companies, the collective revenues being forecast by investors may exceed attainable revenues, an example of what I termed the big market delusion.

Company	Estimated Value (Price)	Revenue Share	Operating Margin	Failure Probability	Imputed Revenue(2026)	Imputed Gross Billing (2026)
Lyft	$2,500	15%	25%	10%	$2,800	$18,665
Uber	$51,000	15%	25%	0%	$51,418	$342,787
Didi Kuaidi	$15,000	15%	20%	0%	$20,044	$133,629
Ola	$2,500	15%	20%	15%	$3,927	$26,183
GrabTaxi	$1,500	10%	20%	15%	$2,392	$23,923
BlaBlaCar	$1,600	12%	20%	10%	$2,392	$19,935
Total	$74,100	NA	NA	NA	$82,974	$565,123

The growth in ride sharing has been accompanied with more intense competition and rising costs, as can be seen in the large and growing operating losses reported by the companies in this business. The reasons for these losses are manifold, as I noted in my Uber post. Some of the costs come from intense competition for drivers and customers, with companies following the Field of Dreams model, that Amazon has used to such effect in the last decade. Some costs come from outside, higher insurance costs and employee expenses, as ride sharing companies go from being fringe players to larger businesses. Some costs flow from legal fights with regulators, licensing agencies and other rule-writers, whose desire to control the business clashes with the market-driven imperatives of ride sharing. The optimistic view is that these costs will become smaller as companies scale up, but will they? As revenues scale up, the number of drivers will increase proportionately, and unless the competition disappears, the costs of fighting for drivers and customers will continue. In brief, the existing ride sharing model looks like a long term money loser, unless something fundamental changes.

 Future Shock

At the risk of playing market prognosticator in a market where I am a novice, I see four possible scenarios that can unfold in this market, all possible, but perhaps not equally probable.

1. Winner-takes-all: The big prize in many technology businesses is that there is a tipping point, where the winner ends up capturing much of the market. That is the template that Microsoft used two decades ago with MS Office to capture the business software business and that Google used to scale the heights of online advertising. The payoff to such a strategy is that you not only control the dominant market share but that you get pricing power (and higher profits). It does seem to be the strategy that Uber is following in the ride sharing business, but there remain three road blocks that may get in the way. First, you have to remove your competitors from the playing field and while Uber had the cash buffer and capital raising upper hand last year, that advantage has narrowed as a result of partnerships and new capital flowing into other ride sharing companies. In a perverse way, Uber's best chance of succeeding at this strategy is if there is a hitch or stop in the flow of capital to tech companies, though that may work against its objective of going public in the near future. Second, you have to navigate your way through the anti trust and monopoly questions that will inevitably follow, not an easy or an inexpensive task, as Google and Microsoft have discovered over the last decade. Third, while technology remains a focal point for ride sharing companies, the car service or logistics business needs physical infrastructure, making it more difficult to preserve global networking benefits.
2. The Losers' Game: While the winner-take-all is alluring, its logical conclusion, if you have multiple players pursuing it, and none winning, is that you can make the business a loser's game, one in which the market grows as promised and companies generate high revenues, but make very little in profits. A big business can sometimes be a bad one, as I noted in this post on bad businesses and why companies in these businesses continue to invest and grow in them.
3. The Divide and Rule Game: As the old colonial empires discovered a few centuries ago, and the Sicilian crime families realized in the late 1920s in the United States, the most profitable end game, when competition is cut-throat (literally), is to negotiate a truce, where the spoils are divided up and each competitor is given control of a segment. In the ride sharing market, if the business boils down to two or three large players, they may be able carve up the global market and each player will get a free run in their carved up portion . This will be, of course, terrible news for drivers and customers and may attract regulatory or legal scrutiny, but for investors collectively, it will be most value-adding scenario. There are two potential weak links. The first is that this truce, by its very nature, will not be a friendly one and small violations can lead to it unraveling. The second is that it rests on the premise that there is no outside party that is powerful enough to step in and take advantage of the soft spots in the market.
4. The Game Changer: I believe that the existing ride sharing model is an unstable one. As I argued in my post on Uber, the very strengths of the models (bare bones infrastructure, drivers as independent contracts and no car ownership) makes it unsustainable in the long term, since ride sharing companies have to compete for drivers on a continuous basis, offering them incentives to switch from competitors, and customers, with special deals. It is therefore likely that a new model will emerge, though it remains an open question of whether it will come from one of the players in the game, or from an outsider. Thus, Uber's hiring of robotics engineers may be a precursor of a different ride sharing game, with driverless cars and infrastructure investments, or it may be Google or Tesla who enter the picture with a different way of operating this business. 

If these scenarios remind you a little little of the prisoner's dilemma, where two rational individuals are given a choice between cooperating and competing, there are parallels. Consider one possible version, where the ride sharing companies globally boil down to two competitors: Uber, as a global ride sharing behemoth, and the Not-Uber, an alliance of  national ride ride sharing companies (Ola+Didi Kuaidi + GrabTaxi + Lyft..). The box below captures the possible outcomes of this game, which will get infinitely more complicated if there is an outsider player lurking on the fringes.

Based on my very limited knowledge of the companies in this space, I would give the highest odds to the ride sharing business becoming a loser's game, attach about equal probabilities to it becoming a winner-take-all or a game changer emerging, and see the least chance that the ride sharing companies will collude to maximize profits and value. There are others, who know more about this business than I do, who see this game evolving differently over time. Mark Shurtleff at Green Wheels Mobility Solutions, the ride sharing expert that I referenced in my last post thinks that I am being too pessimistic on some counts and perhaps too optimistic on others and feels that there are small start ups that are finding a better business model than the big players. There are some who believe that I am underestimating the pull of the familiar and that ride sharing companies, once established, will be difficult to displace. 

The Dance of the Disrupted

In a post from a few months ago, I looked at the the dark side of disruption, i.e., the businesses being disrupted, both with the intent of identifying the businesses most at risk and to look at the stages, at least as I see them, of how the disrupted business deal with the chaos of seeing established business models being upended. Using that five stage process, it seems to me that the taxi cab business is now at an advanced stage:

Stage of disruption	The Taxi Cab Business
1. Denial and Delusion	This is long in the past, but in the first year or two of Uber’s existence, there were many in the conventional car service and taxi cab businesses, who were convinced that not only was this a passing phase, but that no customer in his right mind would want to miss the comfort, convenience and safety of a yellow cab experience. (Irony alert!)
2. Failure and False Hope	With each misstep by a ride sharing company (and Uber in particular), whether it be an employee with a loose tongue or a assault by an Uber driver, the hope that this misstep will put an end to the ride sharing business rises among taxi operators and regulators. However, only the most delusional among these hold on this hope.
3. Imitation and Institutional Inertia	In the mistaken belief that all that separates the ride sharing companies from conventional car service is an app, taxi operators have turned to putting apps in the hands of drivers and customers. At the same time, any attempts to introduce flexibility into the existing car service business are fought by politicians, regulators and some of the operators who benefit from the current structure.
4. Regulation, Rule Rigging and Legal Challenges	This seems to be the place where car service companies are making their stand, aided and abetted by regulators, courts and politics. By restricting or even banning ride sharing, they are slowing it’s growth but as I see it, the fight is on its way to being lost, since it is the customers who ultimately will determine the winner in this game, and they are voting with their dollars.
5. Acceptance and Adjustment	It may be slow in coming, but a portion of the conventional car service business is adjusting to the new reality, sometimes because they realize that it is a fight that is unwinnable and sometimes because the financial hill is getting steeper to climb. This is especially true for cab operators who have borrowed much or most of the money that they used to buy medallions and are discovering that they cannot pay their debt.

So what does the future hold? Will there be no taxi cabs left on the streets of New York, London and Tokyo in a few years? I think that the taxi cab business will shrink, but not disappear, and that it will retain a portion of its business in those public spaces where regulators have the most say, airports, train stations and public arenas. If this is the future, it is also clear that there is more pain to come and it will take the form of continuing decline in taxi cab revenues and market capitalization at these companies. As for the private car service business, it will either adapt and share revenues with the ride sharing companies  (which still needs cars and drivers) or focus on corporate relationships (offering discounted and on-demand services to companies that do not want their employees using multiple ride sharing services). 

Coming soon to a business near you?

As I watch the traditional taxi cab business flailing and ride sharing companies grow at their expense, and am tempted to pass judgment on the inability of those in the business to adapt to the world that they live in, there are two general lessons that come to mind. From the disruptor's standpoint, I think that the success of Uber and its peer group in changing the car service business is a reminder that existing business models can be disrupted in short order by new technologies, but the collective losses reported by these companies are also a reminder that making money on disruption is much more difficult.

Looking at the same process from the perspective of the disrupted, it is a reminder that the pain inflicted on the car service business could very easily be coming to the business that you are in. If you are in the financial services business,  the entertainment business or the health care business, all of which are deserving of disruption, I wonder whether you would react any more rationally than the London cabdrivers who went on strike to stop Uber, and ended up getting many of their customers to try Uber for the very first time. I operate in the education business, a large and extraordinarily inefficient business, and there is no group more resistant to change and more unprepared to adapt than tenured professors at research university. I cannot wait to see this group, convinced of its intellectual superiority and attached to unreal perks (minuscule teaching loads, research assistants and sabbaticals),  go through the throes of disruption.

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Ride Sharing Series (September 2015)

1. On the Uber Rollercoaster: Narrative Tweaks, Twists and Turns
2. Dream Big or Stay Focused? The Lyft Answer!
3. The Future of Ride Sharing: Playing Pundit