Come easy, go easy: The Tech Takedown!

If there is one thing that I have learned about markets over the years, it is that they have a way of leveling egos and cutting companies and investors down to size. The last three weeks have been humbling ones for tech companies, especially the big four (Facebook, Amazon, Netflix and Alphabet or FANG) which seemed unstoppable in their pursuit of revenues and ever-rising market capitalizations, and for tech investors, many of whom seem to have mistaken luck for skill. Not surprisingly, some of the cheerleaders who were just a short while ago telling us that nothing could go wrong with these companies are in the midst of a mood shift, where they are convinced that nothing can go right with them. As Mark Zuckerberg gets ready to testify to Congress, amidst calls for both regulating and perhaps even breaking up tech companies, it is time to take a sober look at where we stand with these companies, what the last three weeks have changed and the consequences for investment decisions.

The Rise of Facebook, Amazon, Netflix and Google (FANG)

The outsized attention paid to the FANG (Facebook, Amazon, Netflix and Google) stocks sometimes obscures how young these companies are in the public market place. Amazon, a company that I valued as an online, book retailer in 1998, a year after its listing, is the granddaddy of the group. The Google IPO , remembered primarily because of its use of a Dutch auction, instead of a banker, to set its offering price was in 2004, but you probably completely missed the Netflix IPO two years earlier in 2002, and Facebook, the youngest of the four, went public in 2012. The growth in market capitalization at these companies is the stuff of investing legend and the table below shows how they have almost tripled their contribution to the overall market capitalization of the S&P 500 between 2012 and 2017 (with all numbers in billions of US $):

At the end of the 2017, Amazon, Google and Facebook were three of the ten largest market capitalization companies in the world.

The role that the FANG companies have played in driving US equities can be best seen with a different lens, by looking at the total change in the market capitalization of the S&P 500 and how much of that change can be attributed to the rising values of just these four companies:

To add weight to these numbers, consider these facts. The four companies that comprise FANG added almost $1.7 trillion in market capitalization over these five years and accounted for one-sixth of the increase in value for the entire index. Put simply, if you were a large-cap US portfolio manager and you held none of these stocks between 2013-2017, it would have been very, very difficult, if not impossible, to beat the S&P 500 over this period.

A Reversal in Fortunes for the FANG stocks

It is the sustained success of these companies that has made the last few weeks so trying for investors in them and so unsettling for market watchers. While these stocks went through the same ups and downs that the rest of the market was going through in February, it was in the middle of March that they became the central story, with the revelations from Cambridge Analytica, a data analytics and consulting firm, that they had harvested data on about 50 million Facebook users (a number that has since been increased to 87 million) for use in political and commercial campaigns. The political firestorm that followed has not only hurt Facebook, but the other three companies as well, and the graph below chronicles the damage in the days since the news story was released:

The numbers are staggering, at least in absolute terms. Collectively, the FANG stocks  lost $282 billion in market capitalization between March 15 and April 2 and contributed significantly to the drop in US equity markets over that period. To put that in perspective, the market capitalization lost in just these four companies in about two weeks was greater than the total value all crypto currencies (Bitcoin and all its relatives) as of the start of April of 2018, perhaps suggesting that we have been letting ourselves get distracted by penny change, when dollars are at stake. It is also interesting that while much of the attention has been directed at Facebook, which lost 15% of its value in just over two weeks, the three other stocks each lost about 12% of their value.

Speaking of perspective, though, investors in these four stocks should consider another fact before they complain too much about being punished by the market. Even with the losses through April 2 incorporated, the collective market value of these companies remains about $400 billion higher than it was a year ago, on April 3, 2017. 

The bottom line is that two weeks of market pull backs cannot take away from the longer term success at these companies. If this is what failure looks like, I would love to see more of it in my portfolio.

The Fang Story Line

To understand both the rise and recent pullback, let's look at what these four companies have in common. As I see it, here are the salient features:

1. Scaling Success: Each of these companies has been able to keep revenue growing rapidly, even as they scale up and acquire larger market share. In effect, they have been able to deliver small company growth rates, while becoming monoliths.
   
   This success of these companies at delivering high growth, as they have become bigger, have some led some to rethink long-held beliefs about the limits of growth.
2. Bigger Slice of a Bigger Pie: All four of these companies have also been able to change the businesses that they have entered, increasing the size of the total market by attracting new customers, while also changing the way business is run to their benefit. With Google and Facebook, that business is advertising, with Netflix, it is entertainment, and with Amazon, it is just about any business it enters, from retailing to entertainment to cloud services. In each of these businesses, they have not only made the pie bigger but also increased their slice of it, quite a feat!
3. Promise of Profitability: Alphabet and Facebook are money-making machines, with very high profit margins; Facebook's margins are among the highest among large market capitalization companies and Google's are in the top decile.
   
   Amazon has lagged on profitability historically, but it seems to be showing progress in the last few years, and Netflix still struggles to generate decent profit margins. The low margins that these companies show are deceptively low because they are low, after expensing what would be business building or capital expenditures in most other companies - $22.6 billion in technology and content at Amazon and almost $8 billion in content costs at Netflix. 

If, in 2008, you had described the trajectories that these companies would go through, to get to where they are today, I would have given you long odds on it happening. To the question of how they pulled it off, I would point to three factors;

1. Centralized Power: These companies are more corporate dictatorships, than corporate democracies. All four of these companies continue to be run by founder/CEOs, whose visions and narratives have focused these companies; Brin and Page, at Alphabet, Zuckerberg, at Facebook, Bezos at Amazon and Hastings at Netflix, have unchallenged power at these companies, and the only option that shareholders who disagree with them have is to sell and move on. 
2. Big Data: While big data is often a buzz word thrown into conversations where it does not belong, these four companies epitomize how data can be used to create value. In fact, you can argue that what Google learns from our search behavior, Facebook from our social media interactions, Netflix from our video watching choices and Amazon from our shopping carts (and Alexa) is central to these companies being able to scale up successfully and change the businesses they are in. Google and Facebook use what they learn about us to allow companies to target their advertising, Netflix develops content that reflects our watching preferences and Amazon uses our shopping history and Prime membership to run circles around its competitors.
3. Intimidation Factor: There is one final intangible in the mix and that is the perception that these companies have created in regulators, customers and competitors that they are unstoppable. Advertisers facing off against Google and Facebook increasingly settle for crumbs off the table,  convinced that they cannot take on either company frontally, the entertainment business which once viewed Netflix as a nuisance has learned not only to live with the company but has adapted itself to the streaming world and Amazon's entry into almost any business seems to lead to a negative reassessment of the status quo in that business.

In short, if you were an investor in any of these companies until three weeks ago, the story that you would have used to justify holding them would have been that they were juggernauts headed for global domination, and valued accordingly.

Story Break, Recalibration or Tweak?

If you have read my prior posts on valuation, you know that I am a great believer that stories hold together valuations, and that it is changes to stories that change valuation. It is still early, but the question that investors face is whether what has happened in the last three weeks has changed the story dynamics fundamentally at these companies.  At the very minimum, we have at least noticed that the strengths that we noted in the last section come with accompanying weaknesses

1. CEO heads cannot roll: Unlike traditional companies facing crises, where CEOs can be offered by a board of director as a sacrificial offering to calm investors, regulators or politicians, the FANG companies and their CEOs are so intertwined, with power entrenched in the current CEOs, this option is off the table. Even if Mark Zuckerberg performs like Valeant's Michael Pearson did in front of a congressional committee next week, he will still be CEO for the foreseeable future, an advantage that having voting shares and controlling more than 50% of the voting rights gives him.
2. The Dark Side of Sharing: I don't know what we, collectively as users of these companies' products and services, thought they were doing with all of the information that we were sharing so willingly with them, but until the last few weeks, we were able to look the other way and assume that it would be used benevolently. The Facebook fiasco with Cambridge Analytica has pushed some of us out of denial and perhaps into a reassessment of how we share data and how that data is used. It has also created a firestorm about data sharing and privacy that may result in restrictions in how the data gets used.
3. No Friends: When other companies feel threatened by your success and growth, it should come as no surprise that many of them are cheering, as you stumble. From Elon Musk shutting down Tesla's Facebook presence] to Tim Cook castigating Google and Facebook for misusing data, there seems to be a desire to pile on. Musk has far bigger problems at Tesla than it's Facebook page, and Cook should be careful about throwing stones from a glass house, but watching the FANG companies squirm is evoking joy in the boardrooms of its competitors.

So, what now? As I see it, there are three ways to read the tea leaves, with the effects on value ranging from very negative to non-existent.

1. Second Thoughts on Sharing: It is possible that the news stories about how exposed we have left ourselves, as a consequence of our sharing, will lead us to all to reassess how much and how we interact online. That would have significant consequences for all of the FANG stocks, since their scaling success and business models depend upon continued user engagement. 
2. Tempest in a teapot: At the other end of the spectrum, there are some who argue that after the Zuckerberg testimony, the story will blow over and that not only will the companies revert back to their old ways, but that they will continue to accumulate users and grow revenues, while doing so.
3. Data Protections: The third possibility lies somewhere between the first two. While the news stories may have little effect on how people use these companies' products and services, there may be new restrictions on how the data that is collected from their usage is utilized by the companies. That would include not only privacy restrictions, similar to those already in place in the EU, but also regulations on how the data is collected, stored and shared. In addition, the companies themselves may feel pressure to change current business practices, which while profitable, have left data vulnerabilities. 

I don't buy into either of the first two scenarios. I think that we are too far gone down the sharing road to reverse field, and that while we will have a few high profile individuals signal their displeasure by abandoning (or claiming to abandon) a platform, most of us are too attached to Google search, our Facebook friends, watching Black Mirror on Netflix and the convenience of Prime to throw them overboard, because our privacy has been breached. In fact, I would not be surprised if Facebook usage has gone up in the days since the crisis, rather than down. 

I also think that assuming that these stories will pass with no effect is a mistake, since there are changes coming to these firms, from within and without, that will have value consequences. To illustrate, Facebook has already announced that it will stop using data from third party aggregators to supplement its own data in customer targeting, because of data concerns, and I am sure that there are more changes  coming, many of which will increase Facebook's costs and crimp revenue growth, and through those changes, the value that we attach to Facebook. I also believe that you will see more restrictions on the use of data and that these rules will also have an effect on costs, growth and value. Rather than extend this post further, by looking at the impact of these changes, I will be using my next post to update my stories and valuations of Facebook, Amazon, Netflix and Google. If you want a preview, suffice to say that I am back to being a Facebook shareholder, that I am close to becoming a Google shareholder for the first time and that Amazon and Netflix remain out of my reach. 

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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!

Spotify Loose Ends: Pricing, User Value and Big Data!

In my last post, I valued Spotify, using information from its prospectus, and promised to come back to cover three loose ends: (1) a pricing of the company to contrast with my intrinsic valuation, (2) a valuation of a Spotify subscriber and, by extension, a subscriber-based valuation of the company, and (3) the value of big data, seen through the prism of what Spotify can learn about its subscribers from their use of its service, and convert to profits.

1. The Pricing of Spotify

I won't bore you by going through the full details of the contrast that I see between pricing an asset and valuing it, since it has been at the heart of so many of my prior posts (like this, this and this). In short, the value of an asset is determined by its expected cash flows and the risk in these cash flows, which you can estimate imprecisely using a discounted cash flow model. The price of an asset is based on what others are paying for similar assets, requiring judgments on what comprises similar.  My last post reflected my attempt to attach an intrinsic value to Spotify, but the pricing questions for Spotify are two fold: the companies that investors in the market will compare it to, to make a pricing judgment, and the metric that they will base the pricing on.

Let's start with the simplest version of pricing, a one-on-one comparison. With Spotify, the two companies that are likeliest to be offered as comparable firms are Pandora, a company that is in the same business (music streaming) as Spotify, deriving its revenues from advertising and subscription, and Netflix, a company that is also subscription-driven, and one that Spotify would like to emulate in terms of market success. Since Spotify and Pandora are reporting operating losses, there are only three metrics that you can scale the pricing of these companies to: the number of subscribers, total revenues and gross profits. I report the numbers for all three companies in the table below, in conjunction with the enterprise values for Pandora and Netflix:

For Pandora and Netflix, the numbers for users and revenues/profits come from their most recent annual reports for the year ending December 31, 2017, and for Spotify, the numbers are from the prospectus covering the same year. To use the numbers to price Spotify, I first estimate pricing multiples for Pandora and Netflix. and then use these multiples on Spotify's metrics:

To illustrate the process, I price Spotify, relative to Pandora and based on subscribers, by first computing the enterprise value/subscriber for Pandora (EV/Subscriber= 1135/74.70 = 15.19). I then multiply this value by Pandora's total subscriber count of 159 million to arrive at a pricing of $2,416 million for Spotify. I repeat this process for Netflix, and then repeat it again with both companies, using revenues and gross profit as my scaling variables. The table of pricing estimates that I get for Spotify explains why those who are bullish on the company will try to avoid comparisons to Pandora and encourage comparisons to Netflix. If, as is rumored, Spotify's equity is priced at between $20 and $25 billion, it will look massively over priced, if compared to Pandora, but be a bargain, relative to Netflix. As you can see, each of these comparisons has problems. Spotify not only has a more subscription-based revenue model than Pandora, yielding higher overall revenues, but its more global presence (than Pandora) has insulated it better from competition from Apple Music. Netflix has an entirely subscription-based model and generates more revenues per subscriber, while facing less intense competition.  The bottom line is that the pricing range for Spotify is wide, because it depends on the company you compare it to, and the metric you base the pricing on. That may come as no surprise for you, but it will explain why there will wide divergences in pricing opinion when the stock first starts to trade, resulting in wild price swings. If you are not adept at the pricing game, and I am not, you should stay with your value judgment, flawed though it might be. I will consequently stick with my intrinsic value estimate for the equity in the company.

2. A Subscriber-Based Valuation of Spotify

Last year, I did a user-based valuation of Uber and used it to understand the dynamics that determine user value and then to value Amazon Prime. That framework can be easily adapted to value Spotify subscribers, both existing and new. To value Spotify's existing subscribers, I started with the base revenue per subscriber and content costs in 2017, made assumptions about growth in each item and used a renewal rate of 94.5%, based again upon 2017 numbers (all in US dollar terms):

Download spreadsheet

Note that revenues/subscriber grow at 3% a year, faster than the growth rate of 1.5%/year in content costs, reducing content costs to 70% of subscriber revenues in year 10, consistent with the assumption I made in the top down valuation in the last post. The value of a premium subscriber, allowing for the churn in subscriptions (only 43% make it through 15 years) and reduced content costs, is $108.65, and the total value of the 71 million premium subscriptions works out to about $7.7 billion.

To estimate the value of new users, I first had to estimate how much Spotify was spending to acquire a new user. To obtain this value, I took the total marketing costs in 2017 (567 million Euros or $700 million) and divided that by the number of new subscribers added in 2017:

Cost of acquiring new user = 700 / (71 - 48*.945) = $27.30
While the number of premium subscribers grew from 48 million to 71 million, I reduced the former value by the churn reported (5.5% of subscribers canceled in 2017). The value of new subscribers then can be computed, assuming that the number of net subscribers grows 25% a year from years 1-5, 10% a year from years 6-10 and 1% a year thereafter (The weakest link in this calculation is the churn rate, which as some of you pointed out is measured in monthly terms. I read this section of the prospectus multiple times to get a better sense of renewal and cancellation rates and here is what I get out of that reading. If the true monthly churn rate is 5.5%, the annual churn rate should more than 50%, meaning that 25 million of the 48 million subscribers that Spotify had at the start of the year left during the year. I don't think that happened, because the total subscribers would not have jumped to 71 million. My guess is that the monthly churn rate reflects how new subscribers become established subscribers, with many trying the service for a month, dropping it, and then coming back again. The annualized churn rate is probably closer to 15%-20% overall and much lower for established Spotify subscribers. I considered using a lower renewal rate in the early years and increasing it in later years, but gave up on it since my information is still hazy. I do believe that will be a key factor in whether Spotify can deliver value, and while the trend lines on the churn rate are good, they need to make their subscribers as sticky as Netflix has made its subscribers.)

Download spreadsheet

In valuing the cash flows from new users, I use a 10% US$ cost of capital, the 75th percentile of global companies, reflecting the higher risk in this component of Spotify's value, and derive a value of about $13.6 billion for new users. (I thank the readers who noticed that I was misestimating my subscriber count, starting in year 2. The numbers should now gel, with the growth rate in net subscribers matching up.)

Spotify does get about 10% of its revenues from advertising, and I will assume that this component of revenue will persist, albeit growing at a lower rate than premium subscription revenues; the revenues will grow 10% a year for the next ten year and content costs attributable to these revenues will also show the same downward trend that they do with premium subscriptions. The value of the advertising revenues is shown to be about $2.9 billion:

Download spreadsheet

The final component of value is mopping up for costs not captured in the pieces above. Specifically, Spotify has R&D and G&A costs that amounted to 660 million Euros in 2017 (about $815 million), which we assume will grow 5% a year for the next 10 years, well below the growth rate of revenues and operating income, reflecting economies of scale. Allowing for the tax savings, and discounting at the median cost of capital (8.5%) for a global company, I derive a value for this cost drag:

Download spreadsheet

The value for Spotify, on a user-based valuation, can then be calculated, adding in the cash balance (1,5091.81 million Euros or $1,864 million) and a cross holding in Tencent Music that I had overlooked in my DCF (valued at 910 million Euros or $1,123 million), and netting out the equity options outstanding (valued at 1344 million Euros or $1660 million):

Download spreadsheet

The operating asset value is slightly lower than the value that I obtained in my top-down DCF (by about a billion), and there are two reasons for the difference. The first is that I did not incorporate the benefits of the losses that Spotify has to carry forward (approximately $1.7 billion) in my subscriber-based valuation, with the resulting lost tax benefit at a 25% tax rate, of about $300 million. The second reason is that I used a composite cost of capital of 9.24% on all cash flows in top down valuation, whereas I used a lower (8.5%) cost of capital for existing users and a higher (10% cost of capital) for new users; that translates into about $600 million in lower value. The value of equity in common stock, the number that will be most directly comparable to market capitalization on the day of the offering, is $19.6 billion.

3. The Big Data Premium?

There is one final component to Spotify's value that I have drawn on only implicitly in my valuations and that is its access to subscriber data. As Spotify adds to its subscriber lists, it is also collecting information on subscriber tastes in music and perhaps even on other dimensions. In an age where big data is often used as a rationale for adding premiums to values across the board, Spotify meets  the requirements for a big data payoff, listed in this post from a while back. It has exclusivity at least on the information it collects from its subscribers on their musical tastes & preferences and it can adapt its products and services to take advantage of this knowledge, perhaps in helping artists create new content and customizing its offerings. That said, I do no feel the urge to add a premium to my estimated value for three reasons:

1. It is counted in the valuations already: In both my top down and user-based valuations, I allow Spotify to grow revenues well beyond what the current music market would support and lower content costs as they do so. That combination, I argued, is a direct result of their data advantages, and adding a premium to my estimated valued seems like double counting.
2. Decreasing Marginal Benefits: The big data argument, even if based on exclusivity and adaptive behavior, starts to lose its power as more and more companies exploit it. As Facebook reviews our social media posts and tailors advertising, Amazon uses Prime to get into our shopping carts and Alexa to track us at home, and uses that data to launch new products and services and Netflix keeps track of the movies/TV that we watch, stop watching and would like to watch, there is not as much of us left to discover and exploit.
3. Data Backlash: Much as we would like to claim victimhood in this process, we (collectively) have been willing participants in a trade, offering technology companies data about our private lives in return for social networks, free shipping and tailored entertainment. This week, we did see perhaps the beginnings of a reassessment of where this has led us, with the savaging of Facebook in the market. 

The big data debate has just begun, and I am not sure how it will end. I personally believe that we are too far gone down this road to go back, but there may be some buyers' remorse that some of us are feeling about having shared too much. If that translates into much stricter regulations on data gathering and a reluctance on our part to share private data, it would be bad news for Spotify, but it would be worse news for Google, Facebook, Netflix and Amazon. Time will tell!

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Data Links

1. Spotify Prospectus
2. Spotify DCF valuation
3. Spotify User-based valuation

Blog Posts

1. Stream On: An IPO Valuation of Spotify

Stream On: An IPO Valuation of Spotify!

In the last few weeks, we have seen two high profile unicorns file for initial public offerings. The first out of the gate was Dropbox, a storage solution for a world where gigabyte files are the rule rather than the exception, with a filing on February 23. Following close after, on February 28, Spotify, positioning itself as the music streaming analog to Netflix, filed its prospectus. With it's larger potential market capitalization and unusual IPO structure, Spotify has attracted more attention than Dropbox, and I would like to focus this post on it.

Spotify: The Back Story

Spotify was founded in 2008 in Sweden, by Daniel Ek and Martin Lorentzon, as a music streaming service. The timing was opportune, since the company caught and contributed to a shift in the music business, as users have moved away from paying for physical (records, CDs) to digital, as evidenced in the graph below:

Source: IFPI

Note that not only has the move towards streaming, in proportional terms, been dramatic, but disruption has come with pain for the music business, with a drop in aggregate revenues from $24 billion in 1999 to about $16 billion in 2016.  In a bright spot, revenues have started rising again in 2016 and 2017, and it is possible that the business will rediscover itself, with a new digital model. Spotify was not the first one in the business, being preceded by both Pandora and Soundcloud, but its success is testimonial to the proposition that the spoils seldom go to the first movers in any business disruption.

The Spotify business model is a simple one. Listeners can subscribe to a free version, with limited customization features (playlists, stations etc.) and online ads. Alternatively, they can subscribe to a premium version of the service, paying a monthly fee, in return for a plethora of customization options, and no ads. The company's standard service cost $9.99/month in the United States in 2018, with a family membership, where up to six family members living at the same address, can share a family service for $14.99/month, while preserving individualized playlists and stations. Prices vary globally, ranging from a high of $16.94 in the UK (for standard service) to much lower prices in Eastern Europe and Latin America. (You can check out the variations in this fascinating link that reports the prices across the world for Spotify, in dollar terms.) Spotify pays for its music content, based upon how often a song is streamed, but the rates vary depending on whether it is on the free or premium service and where in the world, creating some complexity in how it is computed.  To get a sense of where Spotify stands right now and how it got there, I looked the prospectus, with the intent of catching broad trend lines. I came up with the following:

1. Explosive Growth: Spotify is coming off a growth burst, especially since 2015, in both number of users and revenues, as can be seen in the graph below. Revenues have increased from 1.94 billion Euros to 4.09 billion Euros, reflecting both a growth in subscribers from 91 million to 159 million, and a change in the composition, with premium members climbing from about 31% of total subscribers in 2015 to 45% of subscribers in 2017.

   

   Source: Spotify Prospectus
2. Subscription Revenue dominates Ad Revenue: Spotify's focus on improving its premium subscriptions is explained easiest by looking at the breakdown of revenues each year, where subscription revenues have accounted for 90% of revenues each year from 2015 to 2017. The one discordant note is that average revenue per premium subscriber has dropped over the same period 7.06 Euros/month to 5.24 Euros/month, a change that the company ascribes to family memberships, but a problematic trend nevertheless:

   

   Source: Spotify Prospectus

3. Content Costs are coming down: While Spotify insists that it is not scaling back payouts to music labels and artists, the company has been able to lower its content costs as a percent of revenues each year from 88.7% of revenues in 2015 to 79.2% of revenues in 2017. In fact, Spotify has conveyed to investors that its intent is to earn gross margins of 30%-35%, implying that it sees content costs dropping to 65%-70% of revenues. There is an inherent tension here between what Spotify has to convince its investors it can do and what it tells the music industry  it is doing and the tension will only intensify, after the company goes public.

   

   Source: Spotify Prospectus

4. Other costs are trending up: There are three other buckets of cost at Spotify -R&D, Selling & Marketing and G&A- and these costs are not only growing but eating up larger proportion of revenues. If there are economies of scale, as you would expect in most businesses,  they are not manifesting themselves in the numbers yet. The collective load of these expenses are creating operating losses, and while margins have become less negative, it is primarily through the content cost controls.
   
   

   

   Source: Spotify Prospectus

At this stage of its story, Spotify is a growth company with lots of potential (no irony intended) but lots of rough spots to work out.

The Spotify IPO

I have posted ahead of IPOs for many companies in the last decade, ranging from Facebook to Twitter to Alibaba to Snap, but Spotify's IPO is different for two reasons:

1. No Banks: In a typical IPO, the issuing company seeks out an investment bank, which not only sets an offering price (backed up by a guarantee) but also creates a syndicate with other banks  to market the IPO, in roadshows and private client pitches. The Spotify IPO will dispense with the bankers and go directly to the market, letting demand and supply set the price on the opening day.
2. Cashing Out: In most IPOs, the cash that comes in on the offering, from the shares that are bought by the public, is kept in the company, either to retire existing financing that is not advantageous to the firm, or to cover future investment needs. Spotify is aiming to raise about $1 billion from its offering, but none of it will go to company. Instead, existing equity investors in the company will be receiving the cash in return for their holdings.

As a potential investor, I am less concerned about the "no banker" part of the IPO than I am by the "cash out:" part of the transaction: 

• No bankers, no problem: I think that the banking role in IPOs is overstated, especially for a company as high profile as Spotify. Bankers don't value IPOs; they price them, usually with fairly crude pricing metrics, though they often reverse engineer DCFs to back up their pricing. Their guarantee on the offering price is significantly diluted in value by the fact that they set offering prices 10% to 15% below what they think the market will bear, and their marketing efforts are more useful in gauging demand than in selling the securities. From an investor perspective, there is little that I learn from road shows that I could not have learned from reading the prospectus, and there is almost as much disinformation as information meted out as part of the marketing.
• Control or Growth: I find it odd that a company like Spotify, growing at high rates and losing money while doing so, would turn away a billion in cash that could be used to cover its growth needs for the near future. The cashing out of existing owners sends two negative signals.  The first is that they (equity investors who cash out) do not feel that staying on as investors in the company, as a publicly traded entity, is worth it. Since they have access to data that I don't, I would like to know what they see in the company's future. The second is that the structure of the share offering, with voting and non-voting shares, indicates a consolidation of control with the founders, and the offering may provide an opportunity to get rid of dissenting voices.

My Spotify Valuation

In keeping with my view that you need a story to provide a framework for you valuation inputs, and especially so for young companies, I constructed a story for Spotify with the following elements:

1. Continued (but Slower) Revenue Growth: Spotify's success in scaling up over the last three years also sets the stage for a slowing down of growth in the future, with competition for Apple Music (backed by Apple's deep pockets) contributing to the trend. A combination of increases in subscriber numbers and a leveling off and even a mild increase in subscription per member will translate into a revenue growth of 25% a year for the next five years, scaling down to much lower growth in the years after. Since I am projecting revenues for Spotify in 10 years that are larger than the reported global music business revenues today, implicit in this story is the assumption that the music business overall has turned the corner and that aggregate revenues will not only continue to post increases like they did in 2016 and 2017, but that streaming will be the savior of the music business, allowing it expand its reach into emerging markets and pick up more paying customers. 
2. With Reduced Content Costs: Spotify's entire value proposition rests on improved operating margins and a large portion of the improvement has to come from continuing to reduce content costs as a percent of revenues. Since Spotify pays for its content based upon song streams, those savings have to come from either paying less per stream (which is going to and should create push back from labels and artists) or finding ways to create economies of scale on this cost component. In it's defense, Spotify can point to its track record from 2015 to 2017 in reducing content costs. I assume that they can reduce content costs to 70% of revenues, while finding a way to keep artists and labels happy. That is not going to be an easy balance to maintain, especially with the top artists, as evidenced by Taylor Swift's and Jay-Z's decisions to pull their music from Spotify. (I have been told that they have reversed their decisions, but this fight is ongoing.)
3. And Economies of Scale on Other Costs: Of the three other costs, the marketing expenses are the ones most likely to scale down as growth declines, but for Spotify to deliver solid operating margins, it also has to bring R&D costs and G&A costs under control. I may be over optimistic on this front, but here is what my projected values yield for my target operating margin (ten years from now):
   
4. With Limited Capital Investments: Spotify's business model is built for scaling, with little need for capital reinvestment, except for R&D. Consequently, I assume that small capital investments can generate large revenues, using a sales to capital ratio of 4.00 (putting it at the 90th percentile of global companies) to estimate reinvestment.
5. Manageable Operating Risk but Significant Failure Risk: Spotify's subscription based model and low turnover rate among subscribers does lend some stability to revenues, though adding more subscribers and going for growth is a riskier proposition. Overall, allowing for their business mix (90% entertainment, 10% advertising) and their global mix of revenues yields a  cost of capital of 9.24%, at the 80th percentile of global companies; the firm is planning to convert much of its debt into equity at the time of the IPO, giving it a equity dominated capital structure. However, the company is still young, losing money and faces deep pocketed competition, suggesting that failure is a very real possibility. I assume a 20% chance of failure, with failure translating into selling the company to the highest bidder at half of its going concern value.
6. Loose Ends: To estimate equity value in common shares, I add the cash balance of the company of 1.5 billion Euros and a cross holding in Tencent Music (valued at 910 million Euros), ignore the proceeds from the IPO because of the cash-out structure and net out the value of 20.82 million options/warrants outstanding, with an average strike price of 42.56 Euros per share. Dividing the equity value of 16.5 billion Euros by 177.17 million shares (including restricted shares) yields a value per share of 93.40 Euros per share or $115.31. The shares that you will be buying will be non-voting, implying a discount on this number, though how much you discount it will depend on how much you like and trust the company's founders.

The entire picture, with the story embedded in it, is shown below. You can also download the spreadsheet here. (The base year numbers in the prospectus were all in Euros, but all of the valuation inputs (growth, cost of capital) are in US dollars, making it a US dollar valuation. In hindsight, I should have restated the base year numbers in US dollars. While it would not have changed the valuation, it would have reduced currency confusion. Alternatively, I could have valued the company entirely in Euros, with lower growth rates and costs of capital, and arrived at Euro valuation that yield roughly similar results):

Download spreadsheet

It goes without saying, but I will say it anyway, that I made lots of assumptions to get to my value and that you may (and should) disagree with me or some or even all of these assumptions. You are welcome to download the spreadsheet that contains my valuation of Spotify and make it your own.

Bottom Line

There are three elements missing in this post. First, I have argued in my prior IPO posts that what happens after initial public offerings is more of a pricing game than a value game. To those of you who want to play that game, I don't think that this post is going to be very helpful. In my next post, I will look at how best to price Spotify, why you will hear pessimists about the company talk a lot about Pandora and optimists about Netflix. Second, there is the argument that top down valuations, like the one in this post, are ill equipped to value user or subscriber based companies. I will also use the user-based model that I introduced last year to value an Uber rider and an Amazon Prime member to value a Spotify subscriber. Finally, there is the lurking question of what Spotify is learning about its subscriber music tastes and how that data can be used to not only modify its offerings but perhaps create content that is more closely tailored to these tastes. That too has to wait for the next post.

YouTube

Data Links

1. Spotify Prospectus
2. Spotify DCF Valuation

Damodaran Online: There is an App for that!

My posts over the last two months have been heavy, dealing first with my data update from January 2018, and with the market and its volatility in the last few weeks. I felt like taking a break and talking about something lighter and more personal, and giving you an update on my teaching, writing and data plans for this year, with news about an app for the iPhone or iPad that you might (or might not) find useful. I won't fault you if you are not in the least bit interested in what I am doing, and if so, please do skip this post, since it will bore you!

Teaching Update

As some of you may know, I have taught at the Stern School of Business at NYU since 1986, teaching two classes, a Corporate Finance class every spring and a Valuation class every fall and spring. If you have been reading this blog for a while, you also know that I invite the rest of the world to join me in these classes, through a multitude of platforms (iTunes U, Online, YouTube). If you are wondering why you have not received an invite to the classes this academic year, the answer is simple.

I am on sabbatical this academic year, living in California, and will not be teaching at Stern at least through September 2018.  I am enjoying keeping what I call beach bum hours (8.30 am-12.30 pm), but I have to confess that I miss teaching, and my weeks feel unstructured without my Monday/Wednesday classes, but I love teaching too much to take a complete break from it. I continue to teach my compressed valuation classes, trying to fit in everything in my regular classes into one or two days, with stints coming up in Amsterdam (March 7), London (March 8-10), Mumbai (April 19,20), Manila (May 15-16), Bangkok (May 17-18), Warsaw and Prague (June 2018) just in the next few months.

I am also planning on redoing the investments philosophies class that I have only online, but which is showing its age, in the next three months and adding to the in-practice videos that I supplement my valuation and corporate finance classes. 

Research Writing Update

After my most recent post on interest rates and stock prices, I received one response that made me laugh and here is what it said: “Bro, Please stop. get your head out of academia and into reality’. I assume, since I was not this person’s brother, that the “Bro” was an attempt to establish street cred (though I am not sure that it works on this audience), but it was the “academia” part that I found humorous. If I am an academic, I am one in awfully bad standing, since I have not submitted a paper for publication in close to two decades and spend little time at academic conferences.  That said, I love to write and I am continuing to do so on my sabbatical, on several fronts.

• First, there are my blog posts, which I know are way too long and not very frequent, but I try (though I sometimes fail) to not spout off about things I do not understand or know much about. 
• Second, I spent the last few months of last year finishing the third edition of one my books, The Dark Side of Valuation, the first edition of which was born at the peak of the dot com boom, about valuing difficult-to-value companies from start-ups to banks. The book is in its final printing stages and should be available in bookstores shortly (Amazon link). 
• Third, I am turning my attention to what I hope will be my next project, which I hope will become a book, on the difference between pricing an asset and valuing it, a theme that I have mined for multiple posts over the last few years. Fourth, In a couple of weeks, I hope to post the updated installment of my Equity Risk Premium paper, which I first wrote and posted in 2008 (right after the crisis) and have revisited every March since. (Link to 2017 version). Later this summer, I will update my Country Risk Premium paper, focusing more closely just on country risk. (Link to 2017 version) 
• Finally, during the course of the next few months, I will also be taking the work that I have done on valuing users and converting into a paper. 

I will keep you updated as each project is complete.

Data & Tools Update

I maintain a number of data sets on corporate finance and valuation that I update on an annual basis at the start of the year. I wrote a series of posts on what I learned looking at the data this year, in January, and you can read all ten posts, if you are so inclined. 

1. January 2018 Data Update 1: Numbers don't lie, or do they?
2. January 2018 Data Update 2: The Buoyancy of US Equities!
3. January 2018 Data Update 3: Taxing Questions on Value
4. January 2018 Data Update 4: The Currency Conundrum
5. January 2018 Data Update 5: Country Risk Update
6. January 2018 Data Update 6: A Cost of Capital Primer
7. January 2018 Data Update 7: Growth and Value - Investment Returns
8. January 2018 Data Update 8: Debt and Taxes
9. January 2018 Data Update 9: Dividends, Buybacks and Cash Holdings
10. January 2018 Data Update 10: The Price is Right!

While I will not update much of this data during the course of the year, I will continue to post my estimates for the equity risk premium for the S&P 500 at the start of every month, continuing a series that started in September 2008. 

The tools that I offer are three fold.

• First, I have excel spreadsheets for corporate finance and valuatoion, and they are not polished, lacking formatting finesse and macro add-ons, but I view them as raw material that you can mold to your liking. 
•  Second, my YouTube videos are classified by playlists into my class videos, tool videos and blog post videos. 
• Finally, I do have an app for the iPhone and iPad called uValue, that I co-developed with Anant Sundaram, professor at Dartmouth, that does intrinsic valuation. Give it a shot!

You welcome to use these tools, but please recognize that this is all they are, and it is your insight and common sense that will make them shine.

Interface Update

As the material that I have grows, I have struggled with how best to organize it and present it. My website has much of the material but you need to be on a computer, with an internet connection, to access much of it, and finding what you want can be a challenge. I am glad that there are some people who find the material useful and am humbled by their gratitude and their offers to help. To illustrate, a few months ago, I received an email from Taha Maddam, who had used the site, and he offered to create an app that would contain the material. I thanked him, but I pointed out that since the site was not commercial, I could not spend much to make the conversion, but he graciously offered to do it for nothing. Knowing how much work was involved, I did not expect him to follow through, especially since he works full time in Shanghai and has a young family.

Taha surprised me just over a week ago, when he said the app was ready and that I could take it for a spin.  I did and I was dazzled, since it contained all the information in my website, on my blog and on YouTube, in one location. If you have an Apple device (iPhone or iPad), you can download the app either from the app store (type in "Damodaran" in the search box, and it should pop up) or by going to the launching page that Taha has created for the app. If you like our app (while the material is mine, this app is Taha’s doing), please pass on the word and compliment Taha for a job well done. If you are an Android user, I am truly sorry that the app does not work on your devices yet, but I will have to wait on the kindness of strangers, for that to happen. In the meantime, if you can think of what we can add on to the app to make it more useful, please let us know. 

YouTube


Links

1. Launching Page for Damodaran Online App (you can download from here)
2. Damodaran Online Website

Interest Rates and Stock Prices: It's Complicated!

Jerome Powell, the new Fed Chair, was on Capitol Hill on February 27, and his testimony was, for the most part, predictable and uncontroversial. He told Congress that he believed that the economy had strengthened over the course of the last year and that the Fed would continue on its path of "raising rates". Analysts have spent the next few days reading the tea leaves of his testimony, to decide whether this would translate into three or four rate hikes and what this would mean for stocks. In fact, the blame for the drop in stocks over the last four trading days has been placed primarily on the Fed bogeyman, with protectionism providing an assist on the last two days. While there may be an element of truth to this, I am skeptical about any Fed-based arguments for market increases and decreases, because I disagree fundamentally with many about how much power central banks have to set interest rates, and how those interest rates affect value.

1. The Fed's power to set interest rates is limited

I have repeatedly pushed back against the notion that the Fed or any central bank somehow sets market interest rates, since it really does not have the power to do so. The only rate that the Fed sets  directly is the Fed funds rate, and while it is true that the Fed's actions on that rate send signals to markets, those signals are fuzzy and do not always have predictable consequences. In fact, it is worth noting that the Fed has been hiking the Fed Funds rate since December 2016, when Janet Yellen's Fed initiated this process, raising the Fed Funds rate by 0.25%. In the months since, the effects of the Fed Fund rate changes on long term rates is debatable, and while short term rate have gone up, it is not clear whether the Fed Funds rate is driving short term rates or whether market rates are driving the Fed.

It is true that post-2008, the Fed has been much more aggressive in buying bonds in financial markets in its quantitative easing efforts to keep rates low. While that was  started as a response to the financial crisis of 2008, it continued for much of the last decade and clearly has had an impact on interest rates. To those who would argue that it was the Fed, through its Fed Funds rate and quantitative easing policies that kept long term rates low from 2008-2017, I would beg to differ, since there are two far stronger fundamental factors at play - low or no inflation and anemic real economic growth. In the graph below, I have the treasury bond rate compared to the sum of inflation and real growth each year, with the difference being attributed to the Fed effect:

Download spreadsheet with raw data

You have seen me use this graph before, but my point is a simple one. The Fed is less rate-setter, when it comes to market interest rates, than rate-influencer, with the influence depending upon its credibility. While rates were low in the 2009-2017 time period, and the Fed did play a role (the Fed effect lowered rates by 0.77%), the primary reasons for low rates were fundamental. It is for that reason that I described the Fed Chair as the Wizard of Oz, drawing his or her power from the perception that he or she has power, rather than actual power. That said, the Fed effect at the start of 2018, as I noted in a post at the beginning of the year, is larger than it has been at any time in the last decade, perhaps setting the stage for the tumult in stock and bond markets in the last few weeks. 

To examine more closely the relationship between moves in the Fed Funds rate and treasury rates, I collected monthly data on the Fed Funds rate, the 3-month US treasury bill rate and the US 10-year treasury bond rate every month from January 1962 to February 2018. The raw data is at the link below, but I regressed the changes in both short term and long term treasuries against changes in the Fed funds rate in the same month:

Looking at these regressions, here are some interesting conclusions that emerge:

1. Short term T.Bill rates and the Fed Funds rate move together strongly: The result backs up the intuition that the Fed Funds rate and the short term treasury rate are connected strongly, with an R-squared of 56.5%; a 1% increase in the Fed Funds rate is accompanied by a 0.62% increase in the T.Bill rate, in the same month. Note, though, that this regression, by itself, tells you nothing about the direction of the effect, i.e., whether higher Fed funds rates lead to higher short term treasury rates or whether higher rates in the short term treasury bill market lead the Fed to push up the Fed Funds rate. 
2. T.Bond rates move with the Fed Funds rate, but more weakly: The link between the Fed Funds rate and the 10-year treasury bond rate is mush weaker, with an R-squared of 6.7%; a 1% increase in the Fed Funds rate is accompanied by a 0.19% increase in the 10-year treasury bond rate. 
3. T. Bill rates lead, Fed Funds rates lag: Regressing changes in Fed funds rates against changes in T.Bill rates in the following period, and then reversing direction and regressing changes in T.Bill rates against changes in the Fed Funds rate in the following period, provide clues to the direction of the relationship. At least over this time period, and using monthly changes, it is changes in T.Bill rates that lead changes in Fed Funds rates more strongly, with an R squared of 23.7%, as opposed to an R-squared of 9% for the alternate hypothesis. With treasury bond rates, there is no lagged effect of Fed funds rate changes (R squared of zero), while changes in T.Bond rates do predict changes in the Fed Funds rate in the subsequent period. The Fed is more a follower of markets, than a leader. 

The bottom line is that if you are trying to get a measure of how much treasury bond rates will change over the next year or two, you will be better served focusing more on changes in economic fundamentals and less on Jerome Powell and the Fed.

2. The relationship between interest rates and stock market value is complicated

When interest rates go up, stock prices should go down, right? Though you may believe or have been told that the answer is obvious, that higher interest rates are bad for stock prices, the answer is not straight forward. To understand why people are drawn to the notion that higher rates are bad for value, all you need to do is go back to the drivers of stock market value:

As you can see in this picture, holding all else constant, and raising long term interest rates, will increase the discount rate (cost of equity and capital), and reduce value. That assessment, though, is built on the presumption that the forces that push up interest rates have no effect on the other inputs into value - the equity risk premium, earnings growth and cash flows, a dangerous delusion, since these variables are all connected together to a macro economy.

Note that almost any macro economic change, whether it be a surge in inflation, an increase in real growth or a global crisis (political or economic) affects earnings growth, T.Bond rates and the equity risk premiums, making the impact on value indeterminate, until you have worked through the net effect. To illustrate the interconnections between earnings growth rates, equity risk premiums and macroeconomic fundamentals, I looked at data on all of the variables going back to 1961:

Download spreadsheet with raw data

The co-movement in the variables and their sensitivity to macro economic fundamentals is captured in the correlation table. Higher inflation, over this period, is accompanied by higher earnings growth but also increases equity risk premiums and suppresses real growth, making its net effect often more negative than positive. Higher real economic growth, on the other hand, by pushing up earnings growth rate and lowering equity risk premiums, has a much more positive effect on value.

3. Value has to be built around a consistent narrative

In my post from February 10, right after the last market meltdown, I offered an intrinsic valuation model for the S&P 500, with a suggestion that you fill in your inputs and come up with your own estimate of value. Some of you did take me up on my offer, came up with inputs, and entered them into a shared Google spreadsheet and, in your collective wisdom, the market was overvalued by about 3.34% in mid-February. While making assumptions about risk premiums, earnings growth and the treasury bond rate, I should have emphasized the importance of narrative, i.e., the macro and market story that lay behind your numbers, since without it, you can make assumptions that are internally inconsistent. To illustrate, here are two inconsistent story lines that I have seen in the last few weeks, from opposite sides of the spectrum (bearish and bullish).

• In the bearish version, which I call the Interest Rate Apocalypse, all of the inputs (earnings growth for the next five years and beyond, equity risk premiums) into value are held constant, while raising the treasury bond rate to 4% or 4.5%. Not surprisingly, the effect on value is calamitous, with the value dropping about 20%. While that may alarm you, it is unclear how the analysts who tell this story explain why the forces that push interest rates upwards have no effect on earnings growth, in the next 5 years or beyond, oron  equity risk premiums.
• In the bullish version, which I will term the Real Growth Fantasy, all of the inputs into value are left untouched, while higher growth in the US economy causes earnings growth rates to pop up. The effect again is unsurprising, with value increasing proportionately. 

While neither of these narratives is fully worked through, there are three separate narratives about the market that are all internally consistent, that can lead to very different judgments on value.

• More of the same: In this narrative, you can argue that, as has been so often the case in the last decade, the breakout in the US economy will be short lived and that we will revert back the low growth, low inflation environment that developed economies have been mired in since 2008. In this story, the treasury bond rate will stay low (2.5%), earnings growth will revert back to the low levels of the last decade (3.03%) after the one-time boost from lower taxes fades, and equity risk premiums will stay at post-2008 levels (5.5%). The index value that you obtain is about 2250, about 16.4% below March 2nd levels.

  

  Download spreadsheet

• The Return of Inflation: In this story line, inflation returns, though how the story plays out will depend upon how much inflation you foresee. That higher inflation rate will translate into higher earnings growth, though the effect will vary across companies, depending upon their pricing power, but it will also cause T. Bond rates to rise. If the inflation rate in the story is a high one (3% or higher), the equity risk premium may also rise, if history is any guide. With an inflation rate of 3% and an equity risk premium of 6%, the index value that you obtain is about 2133, about 20.7% below March 2nd levels.

  

  Download spreadsheet

• The Growth Engine Revs Up: In this telling, it is real growth in the US economy that surges, creating tailwinds for growth in the rest of the world. That higher real growth rate, while pushing up earnings growth for US companies (to 8% for the near term), will also increase treasury bond rates (to 3.5%), as in the inflation story, but unlike it, equity risk premiums will drift back to pre-2008 levels (closer to 4.5%). The index value that you obtain is about 3031, about 12.7% above March 2nd levels.

  

  Download spreadsheet

• A Melded Version: I believe in a melded version of these stories, where inflation returns (but stays around 2%) and real growth in the economy increases, but only moderately. That will translate into higher treasury bond rates (my guess would be 3.5%), with a proportionate increase in earnings growth (at least in steady state) and an equity risk premium of 5%, splitting the difference between pre-crisis and post-crisis periods. The index value that I obtain, with these assumptions, is about 2610, about 3.1% below March 2nd levels.

Download spreadsheet

You can see, even from this limited list of scenarios, that to assess how stock prices will move, as interest rates change, you have to also make a judgment on why interest rates are moving. An inflation-driven increase in interest rates is net negative for stocks, but a real-growth driven increase in interest rates is a net positive. In fact, the scenario where interest rates go down sees a much bigger drop in value than two of three scenarios, where interest rates rise. 

The Bottom Line

When macro economic fundamentals change, markets take time to adjust, translating into market volatility. During these adjustment periods, you will hear a great deal of market punditry and much of it will be half baked, with the advisor or analyst focusing on one piece of the valuation puzzle and holding all else constant. Thus, you will read predictions about how much the market will drop if treasury bond rates rise to 4.5% or how much it will rise if earnings growth is 10%. I hope that this post has given you tools that you can use to fill in the rest of the story, since it is possible that stocks could actually go up, even if rates go up to 4.5%, if that rate rise is precipitated by a strong economy, and that stocks could be hurt with 10% earnings growth, if that growth comes mostly from high inflation. I also hope that, after you have listened to the narratives offered by others, for what markets will or will not do, that you start developing your own narrative for the market, as the basis for your investment decisions. You've seen my narrative, but I will leave the feedback loop open, as fresh data on inflation and growth comes in, and I plan to revisit my narrative, tweaking, adjusting or even abandoning it, if the data leads me to. 

YouTube Video

Data Links

1. T.Bond Rates, Inflation and Real GDP Growth - 1954-2017
2. Fed Funds Rate and Treasury Rates - 1962-2017
3. T.Bond Rates, Earnings Growth Rates and ERP - 1961- 2017

Spreadsheet Links

1. Intrinsic Valuation Spreadsheet for S&P 500
2. More of the Same: Spreadsheet
3. The Return of Inflation: Spreadsheet
4. The Growth Engine Revs Up: Spreadsheet
5. The Melded Version: Spreadsheet

Blog Post Links

1. Testing Times: Market Turmoil and Investment Serenity