High and higher: The Money in Marijuana!

In 1992, when Bill Clinton was running for president of the United States, and was asked whether he had ever smoked marijuana, he responded that he had, but that he did not inhale, reflecting the fear that being viewed as a weed-smoker would lay low his presidential ambitions. How times have changed! Today, smoking marijuana recreationally is legal in nine states, and medical marijuana in twenty nine states, in the United States. Outside the United States, much of Europe has always taken a much more sanguine view of cannabis, and on October 17, 2018, Canada will become the second country (after Uruguay) in the world to legalize the recreational use of the product. In conjunction with this development, new companies are entering the market, hoping to take advantage of what they see as a “big” market, and excited investors are rewarding them with large market capitalizations. I have never smoked marijuana, but on my daily walks on the boardwalks of San Diego, I have been inhaling a lot of second-hand smoke, leaving me a little light headed as I write this post. So, read on at your own risk!

The Macro Big Picture
While there is much to debate about how this market will evolve over time, and whether investors and businesses can make money of that evolution, there is one fact that is not debatable. The cannabis market will be a big one, in terms of users and revenues, drawing in large numbers of the population. To get a sense of the growth in this business, consider some nascent statistics from the soon-to-be legalized Canadian recreational market:

1. Lots of people smoke weed: According to the Canadian national census, 42.5% of Canadians have tried Marijuana and about 16% had used it in the recent past (last 3 months), with the percentages climbing among younger Canadians, where one in three being recent users.
2. And spend money to do so: The total revenues from recreational marijuana sales in Canada alone is expected to be $7-8 billion in 2020 and grow at a healthy rate after that. Some of this will represent a shifting from the illegal market (estimated at close to $5 billion in 2017) and some of it will represent new users drawn in its legal status.

There is also information that can be gleaned about the future of this business from the states in the United States that have legalized marijuana.

1. In California, where legalization occurred at the start of 2018, revenues from cannabis are expected to be about $3.4 billion in 2018, but that is not a huge jump from the $3 billion in revenues in the illegal market in 2017. One reason, at least in California, is that legal marijuana, with testing, regulation and taxes, is much more expensive than that obtained in the illegal markets that existed pre-legalization. 
2. In Colorado, where recreational marijuana use has been legal since 2014, the revenues from selling marijuana have increased from $996 million in 2015 to $1,25 billion in 2016 to $1,47 billion in 2017, representing solid, but not spectacular, growth. Marijuana-related businesses in Colorado have benefited from the revenue growth but have, for the most part, been unable to convert that growth into solid profits, partly because of the regulatory and tax overlay that they have had to navigate. 

With the limited data that we have from both Canada and the US states that have legalized marijuana, here are some general conclusions that come to mind.

1. The illegal marijuana market will persist after legalization: The illegal weed business will continue, even after legalization, for many reasons. One is that legalization brings costs, regulations and taxes, which make the cost of legal weed higher than its illegal counterpart. The other is cultural, where a segment of long-time weed smokers will be reluctant to give up their traditional ways of acquiring and using weed. From a business standpoint, this will mean that the legal weed businesses will have to share the market with unregulated and untaxed competitors, reducing both revenues and profitability.
2. There will be growth in recreational marijuana sales, but it will not be exponential: For those who are expecting a sudden surge of new users, as a result of legalization, the results from the parts of the world that have legalized should be sobering. In most of these parts, to the extent that society and law enforcement had already turned a blind eye to enforcing marijuana laws before legalization, there was no sea change in legal consequences from weed smoking. 
3. The medical marijuana market growth will be driven more by research indicating its value in health care than by popularity contests. The bad news is that this will require navigating the time-consuming and cash-burning FDA regulatory approval process but the good news is that once approved, there is less likely to be pushback, cultural or legal, against its use. It is a safe prediction that medical marijuana will be legal in all of the United States far sooner than recreational marijuana.
4. Federal laws matter: If you are a company in the weed business in one of the nine states that has legalized recreational marijuana, you still face a quandary. While your operations may be legal in the state that you operate in, you are at risk any time your operations require you to cross state lines and as we noted with Colorado businesses, when you pay federal taxes. Since most financial service firms operate across state borders and are regulated by Federal entities, it has also meant that even legal businesses in this space have had trouble raising funding or borrowing money from banks.

In spite of all of these caveats, there is optimism about growth in this market, with the more conservative forecasters predicting that global revenues from marijuana sales will increase to $70 billion in 2024, triple the sales today, and the more daring ones predicting close to $150 billion in sales.

The Business Question

If the marijuana market is likely to grow strongly, it should be a good market to operate a business in, right? Not all big businesses are profitable or value creating, since for a big business to be value creating, it has to come with competitive advantages or barriers to entry. If you are an investor in this space, you also have to start thinking about how companies will set themselves apart from each other, once the business matures. To see how companies in this business will evolve, it is important that you separate the recreational from the medical cannabis businesses, since each will face different challenges.

I. Recreational Cannabis
Like tobacco and alcohol, the recreational marijuana business will grow with a wink and a nod towards its  side costs, and potential to be a gateway to more potent and addictive substances. Like tobacco and alcohol, marijuana will face both constraints on who it can be sold to, as well as lawsuits down the road. Before you take issue with me for taking a negative view of marijuana, note that this is not a bad path to follow, given that tobacco and alcohol have been solid money-makers for decades. The question then becomes whether, like alcohol and tobacco, cannabis will become a brand-name driven business, where having a stronger brand name allows the winners to charge higher prices and earn better margins, or whether it devolves into a commodity business, where there is little to differentiate between the offerings of different companies, leading to commoditization and low margins. If it is the former, the most successful businesses in the space will bring marketing and branding skills to the table and if it is the latter, it will be economies of scale, and low-cost production that will be the differentiator.

II. Medical Cannabis
The medical marijuana business will more closely resemble the pharmaceutical business, where you will have to work with health care regulations and economics. Success in this business will come from finding a blockbuster cannabis-based drug that can then be sold at premium prices. If our experience with young pharmaceutical and biotech companies is an indicator, this would suggest that to succeed in this business, a company will need continued access to capital from investors with patience, a strong research presence and an understanding of the regulatory approval process. The company will also generate more value in health care systems where drug companies have pricing power, making the US market a much more lucrative one than the Canadian one. The differences between the two businesses are stark enough that you can argue that it will be difficult for a company to operate in both businesses without running into problems, sooner or later.

Investment considerations

So, should you invest in this business or stay away until it becomes more mature? While there is an argument for waiting, if you are risk averse, it will also mean that you will lose out on the biggest rewards. If you are exploring your options today, you have to start by assessing your investment choices and pick the one that you are most comfortable with.

The Investment Landscape

This is a young and evolving business, with the  Canadian legalization drawing more firms into the market. Not only are the companies on the list of public companies in the sector recent listings, but almost all of them have small revenues and big losses. While that, by itself, is likely to drive away old time value investors, it is worth noting that at a this early stage in the business life cycle, these losses are a feature, not a bug. Looking at just the top 10 companies, in terms of market cap, on the cannabis business, here is what I see:

Largest Publicly Traded Cannabis Companies- October 2018 

Note that the biggest company on the list is Tilray, a company that went publicly only a few months ago, with revenues that barely register ($28 million) and operating losses. Tilray made the news right after its IPO, with its stock price increasing ten-fold in the weeks after, before losing almost half of its value in the weeks after. Canopy Growth, the largest and most established company on this list, has the highest revenues at $68 million. More generally, Canadian companies dominate the list and all of them trade at astronomical multiples of book value.

As new companies flock into the market, the list of publicly traded companies is only going to get longer, and at least for the foreseeable future, most of them will continue to lose money. Adding to the chaos, existing companies that have logical reasons to enter this business (tobacco & alcohol in the recreational and pharmaceuticals in the medical) but have held back will enter, as the stigma of being in the business fades, and with it, the federal handicaps imposed for being in the business. Put simply, this business, like many other young and potentially big markets, seems to be in the throes of what I called the big market delusion in a post that I had about online advertising companies a few years ago.

Trading and Investing

Like all young businesses, this segment is currently dominated by trading and pricing, not investing and valuation. Put differently, companies are being priced based upon the size of the potential market and incremental information. Put simply, small and seemingly insignificant news stories will cause big swings in stock prices. Thus, there is no fundamental rationale you can give for why Tilray’s stock has behaved the way it has since it's IPO. It is driven by mood and momentum. If you are a good trader, this is a great time to play the game, since you can use your skills at detecting momentum shifts to make money as the stock goes up and again as it goes down. Since I am a terrible trader, I will leave it up to to you to decide whether you want to play the game.

If you are an investor, you want to invest on the expectation that there is more value in these companies than you are paying up front, for your equity stake. As I see it, here are your choices:

1. The Concentrated Pick: Pick a stock or two that you believe is most suited to succeed in the  business, as it matures. Thus, if you believe that the business is going to get commoditized and that the winner will be the one with the lowest costs, you should target a company like Canopy Growth, a company that seems to be pushing towards making itself the low-cost leader in the growth end of the business. If, in contrast, you believe that this is a business where branding and marketing will set you apart, you should focus on a company that is building itself up through marketing and celebrity endorsements. To succeed at this strategy, you have to be right on both your macro assessment and your company pick, but if you are, this approach has the potential to have the biggest payoff. 
2. Spread your bets: If your views about how the business will evolve are diffuse, but you do believe that there will be strong overall revenue growth and ultimate profitability, you can buy a portfolio of marijuana stocks. In fact, there is an ETF (MJ) composed primarily of cannabis-related stocks, with a modest expense ratio; its ten biggest holdings are all marijuana stocks, comprising 62% of the portfolio. The upside is that you just have to be right, on average, for this strategy to pay off, but the downside is that these companies are all richly priced, given the overall optimism about the market today. You also have to worry that the ultimate winner may not be on the list of stocks that are listed today, but a new entrant who has not shown up yet. If you are willing to wait for a correction, and there will be one, you may be able to get into the ETF at a much more reasonable price.
3. The Indirect Play: Watch for established players to also jump in, with tobacco and alcohol stocks entering the recreational weed business, and pharmaceutical companies the medical weed business. You may get a better payoff investing in these established companies, many of which are priced for low growth and declining margins. One example is Scott’s Miracle-Gro, for instance, which has a growing weed subsidiary called Hawthorne Gardening. Another is GW Pharmaceuticals that has cannabis-based drugs in production for epilepsy and MS.

It may be indication of my age, but I really don’t have a strong enough handle on this market and what makes it tick to make an early bet on competitive advantages. So, I will pass on picking the one or two winners in the market. Given how euphoric investors have been since the legalization of weed in Canada in pushing up cannabis stock prices, I think this is the wrong time to buy the ETF, especially since sector is going to draw in new players.  That leaves me with the third and final choice, which is to invest in a company that is not viewed as being in the business but has a significant stake in it nevertheless. At current stock prices, neither Scott Miracle-Gro nor GW Pharmaceuticals looks like a good bet (I valued Scott Miracle-Gro at about $55, below its current stock price of $70.), but I think that my choices will get richer in the years to come.  I can wait, and while I do, I think I will take another walk on the boardwalk!

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Twists and Turns in the Tesla Story : A Boring, Boneheaded Update!

There are lots of complaints that you can have about Tesla, but being boring is not one of them. It helps to have a CEO who seems to find new ways to make himself newsworthy, in good and bad ways. In fact, if Tesla were a reality show, the twists and turns in its fate would give it sky-high ratings and put the Kardashians to shame. Consequently, it should comes as no surprise that there is no other company where investors disagree more about the future than Tesla, with bulls finding new reasons for pushing it price up and short sellers picking the stock as their favorite, albeit elusive, target. 

Tracing my Tesla Past

I am often tabbed as a Tesla bear, and while I have never found it to be an attractive investment, I have admired the company, and by extension, Elon Musk, for shaking up the auto business. In my first valuation of Tesla in September 2013, I valued it as a luxury car company that would require large cash infusions to get to steady state. Factoring in the resulting negative cash flows and failure risk, the value per share that I obtained was well below the market price then. In the years since, I have revisited the company many times, and what I have learned about the stock has led me to to call it the ultimate story stock, which is how I described it in a post in 2016, explaining both its price volatility and its capacity to weather bad news. I also argued in that post that investors in Tesla were investing in Elon Musk, not the company, with the company reflecting his strengths, a surplus of vision and out-of-the-box thinking, and his weaknesses, which include an unwillingness to pay attention to operating details and financial first principles in running the company.

While Tesla's consistent failure to deliver on production targets over its lifetime is well documented, its failure to heed financial first principles may be even more damaging to it in the long term, as evidenced in at least two major decisions that the company has made in the last two years.

1. The acquisition of Solar City: In acquiring Solar City, a company where Musk was a lead stockholder and his cousin was CEO, Tesla had to not only overcome the perception of conflicts of interest, but it acquired a company with negative cash flows in a rapidly commoditizing business, not a great fit for a company that had its own cash flow problems.

2. The turn to debt: Tesla's decision to borrow more than $5 billion in September 2017 to fund its capital needs, was almost incomprehensible, given Tesla's standing at the time. As I noted in a post at that time, there was no good reason that could be offered for that borrowing, since none of the usual arguments for debt applied.

• Tesla gets no tax benefits from debt: When a company is losing money, as Tesla was in 2017, there are no tax benefits to borrowing money, and to the argument that they might make money in the future, the response is that it then best to wait until then to borrow money. Borrowing money in anticipation of future profits is not just stupid, but it is dangerous.
• Tesla has easy access to equity capital: It is true that Tesla needed capital to build up its production capacity, especially given its promise to deliver hundreds of thousands of Tesla 3s in 2018, but it is also true that the best way to raise this capital for a company with negative earnings and cash flows and significant growth potential is to use equity, not debt. To the counter that this will cause dilution, it is better to have a diluted share in a much valuable company than a concentrated share of a defaulted entity.
• Musk's control of Tesla is absolute: There is the possibility that the debt issue was motivated by Elon Musk's desire to keep control of Tesla, but given his exalted status with shareholders and a rubber stamp board of directors, I see very little threat to his absolute control from issuing more shares in the company.

In sum, the Solar City acquisition was ill-advised in 2016, and there were no good reasons for the Tesla debt issue in September 2017, suggesting either that the company does not have a functioning CFO in Deepak Ahuja or that Elon Musk is taking on that role as well.

Tesla: News and Data Updates

As I said at the start of this post, the Tesla story is never a dull one and the last few months has brought that lesson home. Not only have their been multiple news stories about the company, but Elon Musk has outdone himself as a newsmaker:

1. Financial filings: There have been three quarterly filings since my last valuation of Tesla and the company has only made the hole it is in, as a result of its operating losses, worse by adding debt to the mix. The chart below captures the trend lines in revenues, operating income and net income for the company on a quarter-by-quarter basis:
   
   Looking at the last three quarterly reports delivered since my last valuation of Tesla, there is little that would lead me to radically reassess what I think about the company. The good news is that revenues continue to grow but the bad news is that losses are growing proportionately, since there is no improvement in margins. Backing up the point made in the last section about the debt issue, Tesla's borrowing has made the hole that the company is in much deeper.
2. Earnings Call: Earnings calls are normally staid affairs, where top managers stick to the script and analysts dance with them, asking questions about operations and seeking guidance on future growth. The Tesla earnings call after the most recent earnings report certainly did not fit this script, since Elon Musk, a few minutes into the call, blew up at at Toni Sacconaghi, a Sanford Bernstein analyst, calling his question about future capital needs "boring and boneheaded". He then proceeded to stop taking questions from analysts entirely and answered only questions posed by investors gathered by a recent YouTube start-up. While the market reaction to the bizarre earnings call was negative, with the stock dropping 5.5%, the stock, as it has so many times before, recovered in the weeks after and climbed to close to all-time highs.
   
3. Other News: In the weeks after the earnings call, Musk has added to the news stories with more announcements, many of them taking the form of tweets. First, he announced that given Tesla's financial constraints, the company would focus. at least for the next few months, on turning out the higher priced version of the Tesla 3, priced at $75,000 rather than the $35,000 base price that he had announced as part of the original rollout. His reasons for doing so, i.e., that shipping the lower cost model would cause Tesla to "lose money and die" suggest that the lower priced version may not be viable in the long term. Second, he also announced that Tesla would lay off 9% of its employees, mostly from the Solar City portion of the company, explaining that the company needed to move towards sustained profitability. 

The need to become "profitable" is one of two constraints that Musk has added to the company's objective, with the other being that the company will be "cash flow positive" by the third quarter. In fact, Musk has been categorical that Tesla will not need to raise capital to cover its investment needs in the near future, in response to stories in the press that Tesla would need to raise between billions to cover its growth plans. In fact, much of Tesla's focus seems to be on delivering one part of a long-standing promise, which is manufacturing 5000 cars from its assembly lines each week, a meager number for most auto makers but driving decision making at Tesla. It is in pursuit of this goal that Tesla has augmented its Fremont plant with additional tented assembly lines, Musk has been "sleeping on the factory floor" and at least partly pulled back on its plan to replace workers with robots.

Tesla's Value Drivers

No matter what your story is for Tesla, the value of Tesla is determined by four big drivers and to help in construction your story, it is worth looking at background:

1. Revenue Growth: In the trailing twelve months, ending March 2018, Tesla had revenues of about $12.5 billion and to justify the market capitalization at which the company trades at currently, these revenues have to grow significantly. To get perspective on how large revenues can become, I looked at the twenty largest auto companies in the world, ranked based upon trailing revenues:
   
   Note that most of the companies on this list are mass market auto companies, with Daimler (arguably) and BMW being the only exceptions. Put differently, the question of whether Tesla will be able to deliver on a $35,000 Tesla 3, now or in the future, becomes central to estimating revenue growth.
2. Operating Margin: No matter how you slice it, Tesla is losing money, and it happens to operate in a sector where profit margins have been under pressure for a while, driven partly by competition and partly by changes in the business itself. In the chart below, I have a distribution of operating margins for global auto companies in June 2018:

   

   Global Auto Data

   Note that the median pre-tax operating  margin for auto companies is only 4.81%, with double digit operating margins putting you at the 80th percentile of all auto companies. It is also worth noting that among the ten largest auto companies, there is not a single one that generates an operating margin higher than 10%; BMW has the highest margin, at 9.89%.
3. Reinvestment: Scaling up revenues will require significant reinvestment, especially in the auto business. One simple measure of this reinvestment is the sales to invested capital ratio, measuring how much revenue a dollar in invested capital generates. Looking at this measure across the global auto business, here is what I see:
   
   Note that the global auto business is capital intensive, with a dollar in capital invested generating only $1.29 in revenue at the median firm, and that Tesla, over its history, has been even more capital intensive, generating less revenue per dollar invested than the typical auto firm, with capital intensity increasing after the Solar City acquisition. Tesla's counter to this has  been that by bringing in technology into assembly lines, they will become more efficient than other auto companies, but that argument has lost some of its luster after the last few months, with Musk openly admitting that the robots that Tesla had hoped to put on the factory floor were not doing their jobs. 
4. Risk: There are two dimensions through which risk affects Tesla's value. The first is the cost of capital, which reflects the operating risk at the company. As an auto company, Tesla is exposed to economic cycles and its cost of capital will reflect that risk:

   

   Global Auto Data

   The second is the risk of failure and distress, and while being a small, money-losing company is one reason for exposure, Tesla has magnified its risk by borrowing billions of dollars. 

Possible, Plausible and Probable Tesla Stories

I have long argued that every valuation tells a story and that one way to check your valuation is to check to pass your story through the 3P test: Is it possible? Is it plausible? Is it probable? If this sounds like a play on words, note that each test sets a higher standard than the previous one. There are lots of possible stories, a subset of plausible stories and an even smaller set of probable stories. 

Tesla is a stock where there are widely divergent stories, with bullish investors telling big stories with happy endings, that deliver large values for the company, and bearish investors pushing much smaller stories, some with bad endings. In this section, I will start by offering some solace for Tesla bulls by looking at a plausible story that delivers a value greater than the current stock price, then argue that Elon Musk's story for the company, or at least the version that he is telling right now,  is an impossible story and close with my (still upbeat) story for the stock and resulting value.

Getting to $400/share: A Plausible Story?

Is it plausible that Tesla, notwithstanding all of the troubles weighing it down, is under valued, at its current stock price of $340/share? Yes, but only it can put together the following results:

1. Increase revenues ten-fold over the next decade: Tesla's current revenues of $12.5 billion will have to increase to $120 billion or more in the next ten years, giving it revenues close to those of BMW today. Assuming an average car price of $60,000, that would translate into 2 million cars sold in year 10, illustrating why the focus on whether Tesla can hit its target of 5,000 cars a week is missing the big picture.
2. Improve operating margins to match the most profitable auto companies: While Tesla scales up its revenues, it will not only have to become profitable (a minimal requirement) but much more so than the typical auto company. In fact, its pre-tax operating margin will climb to 12%, well above the median auto margin of 4.81% or BMW's 9.89%, powered by brand name and pricing power.
3. Invest more efficiently than the sector: To accomplish its objectives of increasing revenues and ramping up profitability, Tesla will have to reinvest and reinvest efficiently, delivering about $2.25 in revenues for every dollar of capital invested, much higher than than the typical auto firm. To provide perspective, Tesla in year 10 will have to deliver BMW-like revenues ($120 billion) with about a third of BMW's invested capital; with the estimated sales to capital ratio, Tesla's invested capital in year 10 will be $64 billion, whereas BMW's invested capital in 2018 was $185 billion).
4. Navigate its way through debt to safety: Finally, as it moves towards becoming a much larger, more profitable firm, Tesla will also have to meet its commitments on current debt and not add to the mix, at least for the near term. In terms of operating risk, Tesla will have to face a cost of capital of 8.29%, in line with the typical auto firm.

Download spreadsheet

With these assumptions in place, the value that I get per share is $412, but as you can see from the assumptions, it would be the equivalent of a Royal Flush in poker. Note also that in this optimistic story, Tesla will have to have to raise $14 billion in fresh capital over the next few years and will not become operating cash flow positive until 2025. I am sure that there are people who will be unfazed by this story, especially if they are true believers in Elon Musk, but I am not one of them.

The Musk Story for Tesla: A Fairy Tale?

With a story stock, it is imperative that you have a CEO who not only is able to get the market to buy into a big story, but one who stays focused and disciplined. To me, there is no better example of how to do this well than Amazon, where Jeff Bezos has been consistent in telling the same story for the company, since its inception in 1997, and delivering on that story. Elon Musk is a gifted story teller, but as the last few months have shown, focus and discipline are not his strong points.

If you are a Tesla investor, your primary concern should be that Musk, with his numerous and often conflicting claims about the company, has muddled the Tesla story and perhaps put the company at risk. If Musk is to be believed, and the company will turn the corner on profitability soon and will not need to go back to capital markets in the near future, while also scaling up production and revenues. While that would be wonderful, from a value perspective, it is fantasy. Put bluntly, there is no chance that Tesla can deliver what it needs to, in terms of scaling up revenues and improving profitability, to justify its market capitalization, without raising new equity along the way. Either Musk knows this, and really does not mean what he says, in which case he is being deceptive, or he does not, in which case he is delusional. Neither is a good character quality in a CEO, especially one at a young company that needs investors on its side.

The fact that Tesla's stock price has remained at elevated levels, and even risen, may lead some to conclude that Musk's behavior has no consequences, but I believe it not only will, but it already has  hurt the company. For instance, I think that Tesla has got a bum's rap for some of the accidents that its cars have been in, either from malfunctioning auto-pilots or combustible cars. However, Tesla's hand is weakened by Elon Musk not only acting as the spokesperson for the company but by his responses, which are a mix of arrogance and victimhood (blaming the media, short sellers and analysts) that sap whatever sympathy bystanders may have for the company.

My Tesla Story in June 2018

My story for Tesla is still an optimistic one, but it is much less so than the Royal Flush story that delivered a value in excess of $400. I do think that Tesla will be able to grow revenues substantially over the next decade and improve margins to rank among the more profitable auto companies. I also think that Elon Musk will back track on his promise of not having to raise fresh capital and that Tesla will invest billions into new plant and equipment, and do so more efficiently than other auto companies, partly because it is not saddled with legacy investments. On the risk front, I am comfortable with assuming that operating risk will stabilize over time, but I do think that the debt burden will pose a danger to survival, at least for the next year or two. Pulling these assumptions together, I revalued the firm at about $186/share.

Download spreadsheet

In this story, Tesla's capital needs will be even higher than under the Royal Flush story, with negative cash flows for the next eight years, and $22 billion in new capital over that period. That may strike some as pessimistic, but notwithstanding all the talk about robots and technology, this remains a capital intensive business. It is entirely possible that over the next few weeks, Tesla might be able to get its production up to 5000 cars a week, using tents and spare parts, but that is not a long term solution. There is no tent big enough to produce 30,000 cars a week, which would be Tesla's target in my story, in year 10. 

Bottom Line

There is no denying the fact that Elon Musk has been central to the Tesla story and that his vision and charisma have been largely responsible for pushing the stock price to its current levels. That said, we are at a point in Tesla's history where I think that the question can be raised as to whether the negatives that Musk brings to the job are starting to catch up with, and perhaps overwhelm the positives. Picking fights with equity research analysts and short sellers may get the blood flowing for Tesla bulls, but they are distractions from what Tesla has to do right now. Promising the market that the company will turn the corner on profitability and be cash flow positive soon may signal Musk's faith in his own story, but they do more harm than good for the company's long term value. I know that it is inconceivable for many investors to think of Tesla without Elon Musk at its helm, but this is a company in clear need of checks and balances, either from a strong management team or a powerful board of directors. Unfortunately, neither exists at the company now, and if you are bullish on Tesla, that should scare you.

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Spreadsheets

1. Auto companies data
2. Tesla - Royal Flush Valuation (June 2018)
3. Tesla - My Valuation (June 2018)

Past posts on Tesla

1. Keystone Kop Valuations: Lazard, Evercore and the TSLA/SCTY deal
2. Tesla: It's a story stock, but what's the story?
3. A Tesla  2017 Update: A Disruptive Force and a Debt Puzzle

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!

Alphabet Soup: Google is Alpha, but where are the Bets?

In my last two posts, I looked first at the turn in the market against the FANG stocks, largely precipitated by the Facebook user data fiasco and then at the effect of the blowback on Facebook's value. I concluded that notwithstanding the likely negative consequences for the company, which include more muted revenue growth, higher costs (lower margins) and potential fines, Facebook looks like a good investment, with a value about 10% higher than its prevailing price. I argued that changes are coming from both outside (regulators and legislation) and inside (to protect data better), and these changes are unlikely to be just directed at Facebook. It is this perception that has probably led the market to mark down other companies that have built business models around user/subscriber data and in these next posts, I would like to look at the rest of the stocks in the FANG bundle and the consequences for their valuations, starting with Google in this one.

The One Number

The value of a company is driven by a myriad of variables that encompass growth, risk and cash flows, which are the drivers of value. In a typical intrinsic valuation, there are dozens of inputs that drive value but there is one variable, that more than any other, drives value and it is critical to identify that variable early in the valuation process for three reasons:

1. Information Focus: We live in a world where we drown in data and opinion about companies and unfocused data collection can often leave you more confused about the value of a company, rather than less. Knowing the key value driver allows you to focus your information collection around that variable, rather than get distracted by the other inputs into value.
2. Management Questions: If you have the opportunity to question management, your questions can then also be directed at the key variable and what management is doing to deliver on that variable. 
3. Disclosure Tracking: If you are invested in a company and are tracking how it is performing, relative to your expectations, it is again easy in today's markets to get lost in the earnings report frenzy and the voluminous disclosures from companies. Having a focus allows you to zero in on the parts of the earnings report that are most relevant to value.

In short, knowing what you are looking for makes it much more likely that you will find it. But how do you identify the key driver variable? In my template, I look for two characteristics:

1. Big Value Effects: Changing your key driver variable should have large effects on the value that you estimate for a business. One of the benefits of asking what-if questions about the inputs into a valuation is that it can allow you to gauge this effect. 
2. Uncertainty about Input: If an input has large effects on value, but you feel confident about it, it is not a driver variable. Conversely, if you have made an estimate of input and are uncertain about that number, because it can change either due to management decisions or because of external forces, it is more likely to be a driver input.

If you accept this characterization, there are two implications that emerge. The first is that the key value driver can and will be different for different companies; a mechanistic focus on the same input variable with every company that you value will lead you astray. The second is that there is a subjective component to your choice, and the key value driver that I identify for a company can be different from the one you choose for the same company, reflecting perhaps the different stories that we may be telling in our valuations. In my just-posted Facebook valuation, I believe that the key variable is the cost that Facebook will face to fix its data privacy problems and it manifests itself in my forecasted operating margin, which I project to fall from almost 58% down to 42%, in the next five years. Note that revenue growth may have a bigger impact on value, but in my judgement, it is the operating margin that I am most uncertain about. I will use this post to value Google and highlight what I believe is the driver variable for the company.

The Alphabet Story

If Facebook is the wunderkind that has shaken up the online advertising business, Google is the original disruptor of this business and is by far the biggest player in that game today. It is ironic that the disruptor has become the status quo, but until there is another disruption, it is Google's targeted advertising model, in world, and its search engine and ad words that dominate this business. Google has had fewer brushes with controversy, with its data, than Facebook, partly because its data collection occurs across multiple platforms and is less visible and partly because it does have a tighter rein on its data. 

1. A Short History

Google has been a rule breaker, right from its beginnings as a publicly traded company. It used a Dutch auction process for its initial public offering, rather than the more conventional bank-backed offer pricing model, and while it has had a few stumbles, its ascent has been steep:

The secrets to its success are neither hard to find, nor unusual. The company has been able to scale up revenues, while preserving its operating margins:

The most impressive feature of Google's operations has been its ability to maintain consistent revenue growth rates and operating margins since 2008, even as the firm more than quadrupled its revenues.

2. The State of the Game

To value Google, we start with the numbers, but in order to build a story we have to assess the landscape that Google faces.

1. A Duopoly: The advertising business, in general, and the digital advertising business, in particular, are becoming a duopoly. In 2017, the total spent on advertising globally was $584 billion, with digital advertising accounting for $228.4 billion. Google's market share in 2017 was 42.2%, and Facebook's market share was 20.9%. Even more ominously for the rest of their competitors, they got bigger during the year, accounting for almost 84% of the increase in digital advertising during the course of the year.
2. Google is everywhere: Google's hold on the game starts with its search engine, but has been enriched by its other products, Gmail, with more than a billion users, YouTube, which dominates the online video space and Android, the dominant smart phone operating system. If you add to this Google Maps, Google shared documents and Google Home products, the company is everywhere that you are, and is harvesting information about you at each step. During the last week, a New York Times reporter downloaded the data that Facebook had on him and while what he found disturbed him, both in terms of magnitude and type, he found that Google had far more data on him than Facebook did.
3. Alphabet is still mostly alpha, very little bet: While Google's decision to rename itself Alphabet was motivated by a desire to let it's non-advertising businesses grow, the numbers, at least so far, indicate limited progress. In fact, if there is growth it has so far come from the apps, cloud and hardware portion of Google, rather than the bets themselves, but Nest (home automation), Waymo (driverless cars), Verily (life sciences) and Google Fiber (broadband internet) are options that may (or may) not pay off big time.

Google 2017 10K

The bottom line is that Google has changed the advertising business  and dominates it, with Facebook representing its only serious competition. It's large market share should act as a check on its growth, but Google has been able to sustain double digit growth by growing the digital portion of the advertising business and claiming the lion's share of that growth, again with Facebook. The wild  card is whether the data privacy restrictions and regulations that are coming will crimp one or both companies in their pursuit of ad revenues. As digital advertising starts to level off, Google will have to look to its other businesses to provide it a boost.

3. The Valuation

As with Facebook, I was a doubter on the scalability of the Google story, but it has proved me wrong, over and over again. In valuing Google, I will assume that it will continue to grow, but I set the revenue growth rate at 12% for the next five years, below the 15% growth rate registered in the last five, for two reasons. The first is that digital advertising's rise has started to slow, simply because it is now such a large part of the overall advertising market. The second is that data privacy restrictions, if restrictive, will take away one of Google's network benefits. I do think that the profitability of Google's businesses will stay intact over time, with operating margins staying at the 27.87% recorded in 2017. With those key assumptions, I value Google at $970, close to the price of $1030 that it was trading at on April 13.

Download spreadsheet

As with my Facebook valuation, each of my key inputs is estimated with error, and capturing that uncertainty in distributions yields the following outcomes:

Crystal Ball used in simulation

No surprises here. The median value is about $957 and at a stock price of $1.030, there is a 65% chance that the stock is over valued. As with Facebook, there is a positive skew in the outcomes, and that skew will get only more positive, if you build in a bigger payoff from one of the bets. 

4. The Value Driver

Google's value is driven by revenue growth and operating margins, and changing one or both inputs has a significant effect on value. 

The shaded cells represent the combinations that deliver values higher than the prevailing stock price of $1,030/share. In my judgment, Alphabet's bigger value driver is revenue growth, not margins, and it is on that input, this valuation will rise of fall. It is my view that while data privacy restrictions will translate into much higher costs for Facebook, partly because it has so little structure currently, it will result in lower growth for Alphabet. If the data privacy restrictions handicap Google so badly that it loses a big part of what has allowed it to dominate digital advertising for the next five years, Google's revenue growth and value will drop dramatically. However, Google is just starting to tap the potential in YouTube, and if it is able to position it as a competitor to Spotify, in music streaming, and Netflix, in video streaming, it could discover a new source of revenue growth, with strong operating margins.

5. The Google Bets
The least substantive part of Alphabet, at least in the numbers, is also its most intriguing from a value standpoint, and that is its investment in the other businesses, comprising the "bet" in Alphabet. Google has spent billions on Waymo, Verily and Nest, three of its higher profile other businesses, and while Waymo and Nest have received considerable public attention, they don't have much in revenues, and lots of losses to show for it. There are three views that one can bring to the Google bets, and which one you adopt will determine in large part, whether you will be tilted towards buy-ing Google:

1. Founder Playthings: The most cynical view is that the billions invested in these businesses are not meant to make money, but instead were directed by founder interests in electric cars, health care technology and home automation. Those who take this view will likely point to Google Glasses, an expensive and ill-fated experiment that ended badly and to the effusive support from Brin and Page for these businesses. If you buy into this this view, not only will these businesses not add value to Alphabet, they will continue to drain value from the company, because of the spending that goes with them.
2. Early Life, Big Market Businesses: The second and more optimistic view is that the Google bets should be viewed more as start-ups in potentially big markets, with industry-leading innovation. This is especially the case with Waymo, which if not at the cutting edge of the driverless car business is very close to it, and if successful, could be an entree into not just the driverless car market but also into ride sharing and car service. You could build business models for Waymo, Verily, Nest and Google Fiber that would resemble the models used to value young start-ups, with a bonus of access to Alphabet capital to survive for long periods, and add this value to the advertising business that remains Google's cash cow.
3. Real Options: The third view, which splits the difference, is that while the bet businesses represent potential, that potential is not only far in the future, but may never materialize, either because of the evolution of technology, regulation or market demand. Thus, driverless cars may never quite make it into the mainstream, either because customers don't trust them or they turn out to be too risky. With this view, you can argue that the Google bets are out-of-the-money options, and since the value of an option is determined by potential revenues and uncertainty about those revenues, they are valuable, even though only one of the bets may pay off and the others will have to be written off.

In my valuation of Alphabet, I have implicitly assumed that the company will continue to spend billions in its bets, by leaving the margin at existing levels; remember that the operating margin of 27.87% is after the company's spending on its bet businesses. By not explicitly giving credit for the revenues that the bet businesses will create, it may seem like I am taking the cynical view of these businesses as playthings, but I am not. Much as I dislike the corporate governance ethos that Brin and Page have brought to Google, and helped to proliferate across the new tech sector with their dicing and slicing of voting rights, I don't see them as individuals who would spend billions on expensive toys. That said, I do think that trying to build business models from scratch, to value Waymo, Verily and Nest is difficult to do right now, given that the markets that they are going after all still in flux. I believe that these investments are options and valuable ones at that, but I will make that claim based upon their underlying characteristics (high variance, big markets) rather than with explicit option pricing models. As an investor, looking at Alphabet, here is how it plays out in my investment decision. My intrinsic valuation for Alphabet is $968, within shouting distance of the company's stock price, and I believe that there is enough option value in the bets, that if the stock is fairly or even under valued at its current price. While I am not yet inclined to buy, I have a limit buy order on the stock, that I had initially set at $950, but have moved up to $1000 after my bet assessment, and I, like many of you, will be watching the market reaction to the Alphabet earnings report on Monday. Perverse though it may sound, I am hoping that there are enough negative surprises in it to cause a price drop that would make my limit buy execute, but if not, it will stay it in place. 

YouTube Video

Data Links

1. Google Valuation - April 2018

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!