Share Count Confusion: Dilution, Employee Options and Multiple Share Classes!

In my last post, just about four weeks ago, I valued Tesla, and as with all of my Tesla valuations, I got feedback, much of it heated. My valuation of Tesla was $186, in what I termed my base case, and there were many who disputed that value, from both directions. There were some who felt that I was being too pessimistic in my assessments of Tesla's growth potential, but there were many more who argued that I was being too optimistic. In either case, I have no desire to convert you to my point of view, since the essence of valuation is disagreement. In the context of some of these critiques, there was discussion of how my valuation incorporated (or did not incorporate) the expected dilution from future share issuances and what share count to use in computing value per share. Since these are broader issues that recur across companies, I decided to dedicate a post entirely to these questions.

Share Count and Value Per Share

There was a time, not so long ago, when getting from the value of equity for a company to value per share was a trivial exercise, involving dividing the aggregate value by the number of shares outstanding.

Value per share = Aggregate Value of Equity/ Number of Shares outstanding

This computation can become problematic when you have one or more of the following phenomena:

1. Expected Dilution: As young companies and start-ups get listed on public market places, investors are increasingly being called upon to value companies that will need to access capital markets in future years, to cover reinvestment and operating needs. To the extent that some or all of this new capital will come from new share issuances, the share count at these companies can be expected to climb over time. The question for analysts then becomes whether, and if yes, how, to adjust the value per share today for these additional shares.
2. Share based compensation: When employees and managers are compensated with shares or options, there are three issues that affect valuation. The first is whether the expense associated with stock based compensation should be added back to arrive at cash flows, since it is a non-cash expense. The second is how to adjust the value per share today for the restricted shares and options that have already been granted to managers. Third, if a company is expected to continue with its policy of using stock based compensation, you have to decide how to adjust the value per share today for future grants of options or shares.
3. Shares with different rights (voting and dividend): When companies issue shares with different voting rights or dividends, they are in effect creating shares that can have different per-share values. If a company has voting and non-voting shares, and you believe that voting shares have more value than non-voting shares, you cannot divide the aggregate value of equity by the number of shares outstanding to get to value per share.

Note that while none of these developments are new, analysts in public markets dealt with them infrequently a few decades ago, and could, in fact, get away with using short cuts or ignoring them. Today, they have become more pervasive, and the old evasions no longer will stand you in good stead.

Expected Dilution

The Change: An investor or analyst dealing with publicly traded companies in the 1980s generally valued more mature companies, since going public was considered an option only for those companies that had reached a stage in their life cycle, where profits were positive (or close) and continued access to capital markets was not a prerequisite for survival. Young companies and start-ups tended to be funded by venture capitalists, who priced these companies, rather than valued them. In the 1990s, with the dot com boom, we saw the change in the public listing paradigm, with many young companies listing themselves on public markets, based upon promise and potential, rather than profits or established business models. Even though the dot com bubble is a distant memory, that pattern of listing early has continued, and there are far more young companies listed in markets today. An investor who avoids these companies just because they do not fit old metrics or models is likely to find large segments of the market to be out of his or her reach.

The Consequence: If you are valuing a young company with growth potential, you will generally find yourself facing two realities. The first is that many young companies lose money, as they focus their attention on building businesses and acquiring clientele. The second is that growth requires reinvestment, in plant and equipment, if you are a manufacturing company, or in technology and R&D, if you are a technology company. As a consequence, in a discounted cash flow valuation, you can expect to see negative expected cash flows, at least for the first few years of your forecast period. To survive these years and make it to positive earnings and cash flows, the company will have to raise fresh capital, and given its lack of earnings, that capital will generally take the form of new equity, i.e., expected dilution, which, in turn, will affect value per share.

The Right Response: If you are doing a discounted cash flow valuation, the right response to the expected dilution is to do nothing. That may sound too good to be true, but it is true, and here is why. The aggregate value of equity that you compute today includes the present value of expected cash flows, including the negative cash flows in the up front years. The latter will reduce the present value (value of operating assets), and that reduction captures the dilution effect. You can divide the value of equity by the number of share outstanding today, and you will have already incorporated dilution. 

I know that it sounds like a reach, but let me use my base case Tesla valuation to illustrate. In the table below, I have my expected cashflows for the next 10 years, with the terminal value in year 10.

Download Tesla Valuation and Dilution Spreadsheet 

The present value of the expected cash flows across all 10 years is $41,333 million, and netting out debt and adding back cash, yields an equity value of $33,124 million; the value per share is $189.23. However, this value includes the present value of expected cash flows from years 1 through 8, which are negative in my forecast,s and have a present value of $16,157 million. If these cash flows had not been considered, the value of the operating assets would have been $57,490 million and the value of equity would have been $48,282 million, a value per share of $284.41. In effect, we have applied a 33.46% discount to value, for future dilution. 

Implicitly, I am assuming that the firm will fund 88.06% of its capital needs with equity, consistent with the debt ratio that I assumed in the DCF, and that the shares will be issued at the intrinsic value per share (estimated in the valuation), with that value per share increasing over time at the cost of equity. That may strike some as unrealistic, but it is the choice that is most consistent with an intrinsic valuation. If Tesla is able to issue shares at a higher price (than its intrinsic value), we will have under estimated the value per share, and if it has to issue shares at a price lower than its intrinsic value, we will have over estimated value. There is one final reality check. While we have implicitly assumed that Tesla will have access to capital markets and be able to raise capital, there is a chance that capital markets could shut down or become inaccessible to the firm. That risk is not in the discounted cash flow valuation and has to be brought in explicitly in the form of a chance of failure. In my base case valuation, it is one of the reasons that I attached a chance of failure (albeit a small one of 5%) to the company.

A Viable Alternative: There is an alternative approach, where you forecast the number of shares that will be issued in future years to cover the negative cashflows, and count them as shares outstanding today. If you use this approach, you should set the cash flows for the negative  cash flow years to be zero. The peril in this approach is that there is a circularity that can cause your valuations to become unstable, since you will need to forecast a price per share in future years to get an estimate of value per share today. To illustrate this process, assume that you believe that the issuance price for Tesla for the new shares will be $200, with a price appreciation of 9% a year for the next 8 years. The table below computes the new shares that will need to be issued each year, assuming that 88.06% of capital comes from equity, and the dilution that will result as a consequence:

Download dilution spreadsheet

Note that, with the assumptions about the issuance price of $200, Tesla will issue 69.35 million shares over the next eight years. Adding that to the current share count of 169.76 million shares yields total shares outstanding of 236.85 million shares. If you set the cash flows in years 1-8 to zero and compute the value of equity, you arrive at a value of equity of $48,282 million, which can be divided by the 239.11 million shares to arrive at a value per share of $201.92. This is slightly higher than the value that I obtained in the cash flow approach, but it is partly because I have assumed an issuance price that is higher than the intrinsic value.

But Never Do This: Reviewing the two approaches, you can either incorporate the present value of the negative cash flows into the value of operating assets today and use the current share count, in estimating value per share, or you can try to forecast expected future share issuances and divide the present value of only positive cash flows by the enhanced share count to get to value per share. You cannot do both, because you are then reducing value per share twice for the same phenomenon, once by discounting the negative cash flows and including them in value and then again by increasing the share count for the shares issued to cover those negative cash flows.

Share Based Compensation (SBC)

The Cause: Over history, businesses have used equity to compensate employees, either to align incentives or because they lack the cash to pay competitive wages. That said, the use of share based compensation exploded in the 1990s due to two reasons. The first was an ill-conceived attempt by the US Congress to put a cap on management compensation, while not counting options granted as part of that compensation. Not surprisingly, many firms shifted to using options in compensation packages. The second was the dot com boom, where you had hundreds of young companies that had sky high valuations but no earnings or cash flows; these companies used options to attract and keep employees. Aiding and abetting these firm, in this process were the accountants, who chose not to treat these option grants as expensed at the time they were granted, and thus allowed companies to report much higher income than they were truly earning.

The Consequence: As companies shifted to share based compensation, there were two side effects that analysts had to deal with, when valuing them. The first was the drag on per-share value created by past option and share grants to employees, with options, in particular, creating trouble, since they could create dilution, if share prices went up, but could be worthless, if share prices dropped. The second was the question of how to factor in expected option and share grants in the future, since the value of these grants would be affected by expected future share prices. As with the dilution question, analysts faced a circular reasoning problem, where to value a share today, you had to make forecasts of the value per share in future years.

The Right Response: To deal with share based compensation correctly, you have to break it down into two parts:

1. Past option and share grants: If you own shares in a company, the shares and options granted by the firm in prior years to employees represent claims on the equity, that reduces your value per share. The shares issued in the past are simple to deal with, since adding them to the share count will reduce the value per share today. The fact that employees have to vest (which requires staying with the firm for a specified time period) and that the shares have restrictions on trading can make them less valuable than unrestricted shares, but that is a relatively small problem. The options that have been granted in the past are a bigger challenge, since they represent potential dilution, but only if the share price rises above the exercise price. Option pricing models are designed to capture the probabilities of  this happening and can be used to value options, no matter how in or out of the money the options are. In an intrinsic valuation, you should value these options first (using an option pricing model) and net the value out of the estimated value of equity, before dividing by the existing share count :

• SBC Adjusted Value per share = (DCF Value of Equity - Value of Employee Options)/ Share count today including restricted shares

Note that the shares that will be created if the options get exercised should not be included in share count, in this approach, since that would be double counting.

2. Expected future grants: To the extent that a company is expected to continue to compensate its employees with options or restricted shares in future years, the most logical way to deal with these grants is to treat them as expenses in future years, and reduce expected income and cash flows. Rather than grapple with expected future share prices, you should estimate the expenses (associated with SBC) as a percent of revenues, and use that forecast as the basis for expenses in the future. Until accounting came to its senses in 2004 and required companies to expense share based  compensation at the time of grant, this was an onerous exercise for analysts, since it required estimating the value of option and share grants in past years to get historical numbers on the value of SBC grants. With the prevalent accounting rules in both GAAP and IFRS, the earnings that you see for companies should already be adjusted for SBC expenses and reported income should therefore give you a fair basis for forecasting. (The operating and net margins that I report by sector, on my website, are margins after stock based compensation expenses). At first sight, it may seem like double counting to lower future earnings because you expect option and share grants in the future, and then again lower the value of equity that you obtain by the value of options that are already outstanding. It is not, since we are dealing with two separate issues. A company that has had a history of stock based compensation, but has decided to suspend using SBC in the future, will be affected by only the second adjustment, whereas a company that has never used share based compensation in the past but plans to use it in the future, will be affected only by the former. A company that has share based compensation in its past and expects to use it in the future will be affected by both adjustments.

Tesla uses stock based compensation, and its most recent annual and quarterly statements provide a measure of the magnitude.

Tesla 10K for 2017 and Tesla 10Q, First Quarter 2018

The compensation can take the form of restricted stock or options, and the annual filing provides the cumulative effect of this share based activity. At the end of 2017, according to Tesla's 10K, the company had 10.88 million options outstanding, with a weighted average exercise price of $105.56 and a weighted average maturity of 5.30 years and 4.69 million restricted shares. The restricted shares are already included in the share count of 169.76 million shares, but the options need to be accounted for. We value the options, using a modified version of the Black-Scholes model, to arrive at a value of $2,927 million. Netting this value out of the value of equity that we obtained from the cash flows allows us to get to a corrected value per share:

Download Tesla valuation

The value per share, after adjusting for options, is $171.99. There is an elephant in the room in the form of a gigantic grant of 20.26 million shares to Elon Musk, with the issuance contingent on meeting operating milestones (revenues and adjusted EBITDA) and market milestones (market capitalization). The complexity of the vesting schedule on this grant makes it difficult to value using option pricing models, but the effect of this looming grant is to lower value per share today and here is why. If Tesla succeeds in growing revenues and turning to profitability, these option grants will vest, creating large expenses in the year in which that occurs and putting downward pressure on margins. In making my forecasts of future margins for Tesla, I have been more conservative at least in the early years, simply for this reason.

A Sloppy Alternative: There is an alternative approach to deal with options outstanding from past grants. They value options at their exercise value, i.e., the difference between the stock price and strike price today, and ignore out of the money options. This is called the treasury stock approach and the value of equity per share in this approach can be written as follows:

Treasury Stock Value per share = (DCF value of equity + Exercise Price * # Options outstanding) / (Share Count today + Options Outstanding)

By ignoring the time premium on options, this approach will over value shares today and by ignoring out of the money options, you exacerbate the problem. In the case of Tesla, using the exercise stock approach would yield the following value per share:

Treasury Stock Value per share (Tesla) = ($32,124 + $105.56 * 10.88) / (169.76 + 10.88) = $184.19

The analysts who use this approach often justify it by arguing that option pricing models can yield noisy estimates, but even the worst option pricing model will outperform one that assumes that options trade at exercise value.

And Nonsensical Practices: There are two woefully bad practices, when it comes to stock based compensation, that should be avoided. The first is to just adjust the share count for options  outstanding and make no other changes. In this "fully diluted" approach, you are counting in the dilution that will arise from option exercise but ignoring the cash that will come into the firm from the exercise.

• Fully Diluted Value per share =  DCF value of equity / (Share Count today + Options Outstanding)

With Tesla, for instance, this approach would yield the following:

• Fully Diluted Value per share (Tesla) = $32,124/ (169.76 + 10.88) = $177.83

This approach will yield too low a value per share, and especially so if you count out of the money options as well in the denominator. The second and even more indefensible practice is to add back share based compensation to earnings to get to adjusted earnings. The rationale that is offered for doing so is that share based compensation is a non-cash expense, a dangerous bending of logic, since it allows companies to use in-kind payments (shares, services) to evade the cash flow test. Using this logic, Tesla would add back the $141.6 million they had in share-based compensation expenses to their income in the first quarter of 2018 and report lower losses. Carried into future forecasts, this will inflate future earnings and cash flows, pushing up estimated value. Since these two bad practices push value away from fair value in different directions, the only logic for their continued use is that, in combination, the mistakes will magically offset each other. Good luck with that!

Shares with different rights

The Cause: Founders and families who take their companies public have always wanted to have their cake and eat it too, and one way in which they have been able to do so is by creating different share classes, usually built around voting rights. The founder/family hold on to the higher voting right shares and thus maintain control of the company, while selling off large shares of equity to the public, and cashing out. In the United States, shares with different voting rights were rare for much of the last century, primarily because the New York Stock Exchange, which was the preferred listing place for companies, did not allow them. Again, the tech boom of the 1990s changed the game, by making the NASDAQ, which had no restrictions on shares with different voting rights, an alternative destination, especially for large technology companies. The floodgates on shares with different voting rights opened up with the Google listing in 2004, and the Google model, with shares with different voting rights, has become the default model for many of the tech companies that have gone public in the last decade.

The Consequence: When you have different classes of shares, with different voting rights, you have two effects on value. The first is a corporate governance effect, since changing management becomes much more difficult, and that can affect how you value and view badly managed firms. The second is a unit problem, since a voting right share and a non-voting right share represent different equity claims and cannot be treated as having the same value. Thus, you can no longer divide the aggregate value of equity by the total number of shares outstanding.

The Right Response: When valuing firms with different voting rights, you have to deal with it in two steps. When valuing the firm, you have to incorporate the fact that changing management is going to be more difficult to do in your estimates. Thus, if you firm borrows no money (even though it can lower its cost of capital by moving to an optimal or target debt ratio fo 40%), you should leave the debt ratio at zero rather than change it. This will lower the value that you estimate for the operating assets and equity in the firm. Once you have the value of equity, you will have to make a judgment on how much of a premium you would expect the voting shares to trade at, relative to non-voting shares, in one of two ways. In the first, you can look at studies of voting shares in publicly traded companies in the US and Europe, which find a premium of between 5-10% for voting shares, and use that premium as your base number. In the second, you can use an approach that uses intrinsic valuation models to estimate the premium, which I describe in my paper on valuing control. Once you have the estimate, you can use algebra to complete your estimate of value per share. 

Value per non-voting share = Aggregate Value of Equity/ (# Non-Voting Shares + (1+ Voting Share Premium) # Voting Shares)

For example, if the value of equity is $210 million, there are 50 million non-voting shares and 50 million voting shares and the voting share premium is 10%, your value per non-voting share will be:

Value per non-voting share = 210/ (50+ 1.1*50) = $2.00/share

Value per voting share = $2.00 (1.10) = $2.20/share

The Bottom Line

I know that some of you will view this post as nit-picking, but you will be surprised at how much of an effect on value you can have by not being careful about share count. Those of you who use multiples (PE, EV/EBITDA) may be secretly happy that you don't have to deal with the issues of share count, since you don't do discounted cash flow valuations. Unfortunately, that is not true. Dilution, share based compensation and shares with different rights are just as much an issue when you compare multiples across companies, and ignoring them or using short cuts (like full dilution) will only skew your comparisons and lead to mis-pricing stocks. I would suggest four general rules:

1. Aggregate versus Per-share numbers: Given how dilution and options can play havoc with share count, it is better to use aggregate than to use per share numbers, in valuation and in pricing. Thus, to obtain PE, divide the market capitalization of the company by its total net income, rather than price per share by earnings per share.
2. When SBC is rampant, control for differences: If the use of restricted stockand options vary widely across sector, you need to control for those differences when comparing pricing in the sector. If you do not, companies that have large option overhangs will look cheap, relative to those that do not.
3. Don't use SBC adjusted earnings: Adjusting earnings and EBITDA, by adding back stock based compensation, is an abomination, used by desperate companies and analysts to show you that they are making money, when they are not even close. Don't fall for the sleight of hand.
4. With forward multiples, check on and control for dilution: Analysts, when valuing young companies, often divide today’s market capitalization or enterprise value by expected revenues or EBITDA in the future. The dilution that will be needed to get to future EBITDA has to be brought into the equation.

YouTube Video


Spreadsheets

1. Tesla Valuation (June 2018)
2. Tesla Dilution 

Blog Posts on Tesla

1. A Tesla  2017 Update: A Disruptive Force and a Debt Puzzle
2. Twists and Turns in the Tesla Story: A Boring, Boneheaded Update!

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.

YouTube Video


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

User and Subscriber Businesses: The Good, the Bad and the Ugly!

In a series of posts over the course of the last year, I argued that you can value users and subscribers at businesses, using first principles in valuation, and have used the approach to value Uber riders, Amazon Prime members and Spotify & Netflix subscribers. With each iteration, I have learned a few things about user value and ways of distinguishing between user bases that can create substantial value from user bases that not only are incapable of creating value but can actively destroy it. I was reminded of these principles this week, first as I wrote about Walmart's $16 billion bid for 77% of Flipkart, a deal at least partially motivated by shopper numbers, then again as I read a news story about MoviePass and the potential demise of its "too good to be true" model, and finally as I tripped over a LimeBike on my walk home. 

User Based Value

My attempt to build a user-based valuation model was triggered by a comment that I got on a valuation that I had done of Uber about a year ago on my blog. In that post, I approached Uber, as I would any other business, and valued it, based upon aggregated revenues, earnings and cash flows, discounted back at a company-wide cost of capital. I was taken to task for applying an old-economy valuation approach to a new-economy company and was told that that the companies of today derive their value from customers, users and subscribers. While my initial response was that you cannot pay dividends with users, I realized that there was a core truth to the critique and that companies are increasingly building their businesses around their members. 

Consequently, I went back to valuation first principles, where the value of any asset is a function of its cashflows, growth and risks, and adapted that approach to valuing a user or subscriber:

To get from the value of existing users to the value of an entire company, I incorporated the value effect of new users, bringing in the cost of acquiring a new user into the value:

I applied closure by consider all corporate costs that are not directly related to users or subscribers in a corporate cost drag, a drag because it reduces the value of the business:

Cumulating the value of existing and new users, and netting out the corporate cost drag yields the value of operating assets, i.e., the same value that you would derive by discounting the free cash flows to the entire business by its overall cost of capital. You would still need to clean up, by adding in cash, netting out debt and dealing with outstanding options, but that process is the same in both models.

I would hasten to add that a user-based value model is not a panacea to any of the valuation challenges that we face with young, user-based companies. In fact, the difficulties with obtaining the raw data needed on user renewal rates and acquisition costs can be so daunting that any potential advantages that you obtain by looking at user-level value can be drowned out by noise. It is also worth emphasizing that its user-focus notwithstanding, this model is grounded in fundamentals, with value coming, as it always does, from cash flows, growth and risk. I am still learning about this model, but I have put down what I have learned over the last year, when valuing Uber, Amazon Prime and Netflix, into a paper that you can download, read and critique.

Good, Bad and Indifferent User-based Models

One of the motivations for my user-focused valuation was based upon casual empiricism. In my view, many venture capitalists and public investors are pricing user-based companies on user count, with only a few seriously trying to distinguish between good, indifferent and bad user-based models. One of the bonuses of using a user-based model is that it provides a framework for differentiating between great and mediocre user-based companies.

Drivers of Value

A standard critique that old-time value investors have of user-based companies is that they all lose money, but that is not true. There are user-based companies that make money, but it is also true that the user-based model is still in its infancy and that many user-based companies are young, and therefore lose money. That said, there are elements of the cost structure that you can look at, to make judgments on which user-based companies are most likely to grow out of their problems and which ones are just going to grow their problems.

a. Cost Structure: Most young, user-based companies lose money but at the risk of sounding unbalanced, there are good ways to lose money and bad ones, from a value perspective. 

1. Servicing Existing Users versus New User Acquisition: From a value perspective, it is far better for a company to be losing money, because it is spending money trying to acquire new users, than it is to be losing money, because it costs so much to service existing users. The latter signals a bad business model, at least for the moment, whereas the former offers a semblance of hope.
2. Fixed versus Variable Costs: For mature companies with established business models, it is better to have a more flexible cost structure (with more variable costs and less fixed costs). With money-losing, high-growth companies, the reverse is true, since it is the fixed cost portion that yields economies of scale, as the company grows.

b. Growth: Repeating a value nostrum, growth is not always value-creating and not all growth is created equal.

1. Existing versus New Users: A user-based model, where you can grow cash flows from existing users is more valuable, other things remaining equal, than a user-based model that is dependent on adding new users for growth. The reason is simple. Since a company already has expended resources to get existing users, any added revenue it derives from them is more likely to flow directly to the bottom line. Adding new users is more expensive, partly because it costs money to acquire them, but also because new users may not be as active or lucrative as existing ones.
2. Cost of New User Acquisition: This is a corollary of the first proposition, since the value of a new user is net of user acquisition costs. Consequently, user-based companies that are more cost-efficient in adding new users will be worth more than user-based companies that spend considerable amounts on promotion on marketing, to the same end.  

This contrast is best illustrated by looking at Netflix and Spotify, both subscriber-based companies, but with very different models for paying for content. Netflix pays for content as a fixed cost, and derives economies of scale, when it adds fresh subscribers, whereas Spotify pays for content, based upon how much subscribers listen to songs, making it a variable and existing user based cost. As a result, Netflix derives much higher value from both existing and new subscribers:

	Netflix	Spotify
Number of Subscribers	117.6	71
Annual Revenue/Subscriber	$         113.16	$         77.63
Subscriber Service Expenses (as %)	18.90%	79.24%
CAGR in subscriber count	223.93%	369.86%
Value per Existing Subscriber	$         508.89	$       108.65
Cost of acquiring New Subscriber	$         111.01	$         27.30
Value per New Subscriber	$         397.88	$         81.35
Value of all Existing Subscribers	$    59,845.86	$    7,714.28
+ Value of all New Subscribers	$  137,276.49	$  20,764.56
- Corporate Cost Drag	$  111,251.70	$  13,139.75
=Value of Operating Assets	$    85,870.65	$  15,339.10

c. Revenue Models: There are three user-based models, the first is the subscription-based model (that Netflix uses), the second is the advertising-based model (that Yelp uses) and the third is a transaction-based model (that Uber uses). There are companies that use hybrid versions, with Amazon Prime (membership fees and incremental sales) and Spotify (Subscription plus Advertising) being good examples. Each model comes with its pluses and minuses. 

1. Subscription models tend to be stickier (making revenues more predictable) but they offer less upside potential (it is difficult to grow subscription fees at high rates).
2. Advertising models scale up faster, since they require little in capital investment and adding new users is easier (since they free), but revenues are heavily driven by user intensity (how much time you can get users to stay in your ecosystem) and exclusive data (collected in the course of usage).
3. Transaction models are the riskiest, since they require users to use your product or service, but they also offer the most upside, since your upside is less constrained. Amazon Prime's value, in my view, does not stem primarily from the subscription revenues of $99/year but from Amazon's capacity to sell Prime members more products and services.

While no model dominates, picking the wrong revenue model can quickly handicap a business. For instance, using a subscription-based model for a transaction business, where usage varies widely across users, can result in self-selection, where the most intense users choose the subscription-based model to save money, and less intense users stay with a transaction-based model.

Differentiating across User-based Models

With the user-based framework in place, we can start distinguishing between user-based companies. Using existing user value and new customer acquisition costs as the dimensions, we can derive a matrix of companies that go from user-value stars to user-value dogs.

While the combination of high user value with low user acquisition costs may sound like a pipe dream, it is what network benefits and big data, if they exist, promise to deliver. 

• Network benefits refer to the possibility that as you grow bigger, it becomes easier for you to get even bigger, making it less costly to acquire new users. That is the promise of ride sharing, for instance, where as a company gets a larger share of a ride sharing market, both drivers and customers are more likely to switch to it, the former, because they get more customers and the latter, because they find rides more quickly.
• Big data, in a value framework, offers user-based companies an advantage, since what you learn about your users can be used to either sell them more products or services (if you are a transaction-based company), charge them higher premiums (if you are subscription-based) or direct advertising more effectively (if advertising-based). 

Many user-based companies aspire to have network benefits and to use data well, but only a few succeed.

The Pricing Game

As I look at user-based companies, some of which are being priced at billions of dollars, I am struck by how few of them are built to be long term businesses and how many of them are being priced on user numbers and buzz words. Using the framework from the last section, I would like to develop some common features that bad user-businesses seems to share in common and use one high profile examples, MoviePass , to make my case.

Mediocre User-based Companies
Given that so many young companies market themselves, based upon user and subscriber numbers, and that some of them can become valuable companies, are there signs that you can look for that separate the good from the mediocre companies? I think so, and here are a few red flags:

1. All about users, all the time: If the entire sales pitch that a company makes to investors is about its user or subscriber numbers, rather than its operating results (revenues and operating profits/losses), it is a dangerous sign. While large user numbers are a positive, it requires a business model to convert these users into revenues and profits, and that business model will not develop spontaneously. Companies that do not work on developing viable business models go bankrupt with lots of users.
2. Opacity about user data: It is ironic that companies that market themselves to investors, based upon user numbers, are often opaque about key dimensions on users, including renewal (churn) rates, user behavior and side costs related to users. The companies that are most opaque are often the ones that have user models that are not sustainable.
3. Bad business models: If having no business model to convert users to operating results is a bad sign, it is an even worse sign when you have a business model that is designed to deliver losses, not only in its current form, but with no light at the end of the tunnel. That is usually the consequence of having losses that scale up as the company gets bigger, because there are economies of scale. 
4. Loose talk about data: The fall back for many user based companies that cannot defend their business models is that they will find a way to use the data that they will collect from their users to make money in the future (from targeted advertising or additional products and services), without any serious attempt to explain why the data will give them an edge.
5. And externalities: Many user based companies argue that their "innovative" twists on an existing business will both expand and alter the business, leading to benefits for other players in that business, who, in turn, will share their benefits with the user based companies.

The bottom line is simple. It is easy to build user numbers, if you sell a product or service at way below cost, but if your objective is build a long-standing user-based companies, you need a pathway to profitability that is defined early and worked on continuously.

MoviePass: Too Good to be True? 

If you subscribe to MoviePass, for a monthly subscription of $10, you get to watch one theatrical movie, every day, for the entire month. Given that the average price of a theater ticket in the US is $9, this sounds like an insanely good deal, and for an avid movie goer, it is, and the service had two million subscribers in May 2018. MoviePass, though, pays the theaters for the tickets, creating a model that is more designed to drive it into bankruptcy than to deliver profits.

MoviePass Economics

When confronted by the insanity of the business model, Mitch Lowe, the CEO of MoviePass, argued that after an initial burst, where subscribers would see four or five movies a month, they would settle into watching a movie a month, allowing the service to break even. Since Mr. Lowe is a co-founder of Netflix and a former CEO of Redbox, I will concede that he knows a lot more about the movie business than I do, but this is an absurd rationale. If the only way that your service can become viable is if people don't use it very much, it  is not much of a service to begin with.  

In its early days, MoviePass seemed to be trying to build a viable business model, and acquired some high profile venture capital investors, but it was eventually acquired by Helios and Matheson, a data analytics firm, in a  transaction in August 2017. It is Helios and Matheson, intent on giving both data and analysis a bad name, that instituted the $10 a month for a movie-a-day subscription. The subscription worked in delivering users but it, not surprisingly, came with large losses. As MoviePass has continued to burn cash (more than $20 million a month by April 2018), the share price of Helios and Matheson has collapsed, in a belated recognition of its non-viable business model.

Adding to the sense that no one in this company has a grip on reality, Ted Farnsworth, the CEO of Helios and Matheson, argued that the service would continue and had acquired a $300 million line of credit. Since his backing for this line of credit was that he could issue the remaining authorized shares at the current market price, this indicates either extreme ignorance (potential equity issues don't comprise a line of credit) or unalloyed deception, neither of which is a quality that builds trust. Along the way, there have been other attempts to rationalize the model, including the possibility of using the data collected from subscribers to target advertising and the sharing of additional revenues generated by theaters and studios from more movie going. There is nothing exclusive about the data that will be collected from MoviePass subscribers and it is unlikely that theaters and small studios, already on the brink financially, will be willing to share their revenues. In short, this is a bad business model hurtling to a bad end, and the only question is why it took so long.

The Bottom Line

To build a good user-based business, you have to start with the common sense recognition that users are not the end game, but a means to an end. Unfortunately, as long as venture capitalists and investors reward companies with high pricing, based just upon user count, we will encourage the building of bad businesses with lots of users and no pathways to becoming successful businesses.

YouTube Video


Paper on User Based Value

1. Going to Pieces: Valuing Users, Subscribers and Customers

Blog Posts on User-based Value

1. Valuing Uber Riders
2. Valuing Amazon Prime Members
3. Valuing Spotify Subscribers
4. Valuing Netflix Subscribers

Walmart's India (Flipkart) Gambit: Growth Rebirth or Costly Facelift?

On May 9, 2018, Walmart confirmed officially what had been rumored for weeks, and announced that it would pay $16 billion to acquire a 77% stake in Flipkart, an Indian online retail firm, translating into a valuation of more than $21 billion for a firm founded just over ten years ago, with about $10,000 in capital. Investors are debating the what, why and what next on this transaction, with their reactions showing up in a drop in Walmart’s market capitalization of approximately $8 billion. For Indian tech start-ups, the deal looks like the Nirvana that many of them aspire to reach, and this will undoubtedly affirm their hopes that if they build an India presence, there will be large players with deep pockets who will buy them out.

The Players

The place to start, when assessing a merger or an acquisition, is by looking at the companies involved, both acquiring and target, before the deal. It not only provides a baseline for any assessment of benefits, but may provide clues to motives.

a. Flipkart, an Amazon Wannabe?

Of the two players in this deal, we know a lot less about Flipkart than we do about Walmart, because it is not publicly traded, and it provides only snippets of information about itself. That said, we can use that information to draw some conclusions about the company:

1. It has grown quickly: Flipkart was founded in October 2007 by Sachin and Binny Bansal, both ex-Amazon employees and unrelated to each other, with about $6000 in seed capital. The revenues for the company increased from less than $1 million in 2008-09 to $75 million in 2011-12 and accelerated, with multiple acquisitions along the way, to reach $3 billion in 2016-2017. The revenue growth rate in 2016-17 was 29%, down from the 50% revenue growth recorded in the prior fiscal year. Flipkart’s revenues are shown, in Indian rupees, in the graph below:
   
2. While losing lots of money and burning through cash: As the graph above, not surprisingly, show, Flipkart lost money in its early years, as growth was its priority. More troubling, though, is the fact that the company not only continues to lose money, but that its losses have scaled up with the revenues. In the 2016-17 fiscal year, for instance, the company reported an operating loss of $0.6 billion, giving it an operating margin of minus 40%. The continued losses have resulted in the company burning through much of the $7 billion it has raised in capital over its lifetime from investors. 
3. And borrowing money to plug cash flow deficits: Perhaps unwilling to dilute their ownership stake by further seeking equity capital, the founders have borrowed substantial amounts. The costs of financing this debt jumped to $671 million in the 2016-17 fiscal year, pushing overall losses to $1.3 billion. Not only are the finance costs adding to the losses and the cash burn each year, but they put the company’s survival, as a stand-alone company, at risk.
4. It has had issues with governance and transparency along the way: Flipkart has a complex holding structure, with a parent company in Singapore and multiple off shoots, some designed to get around India’s byzantine restrictions on foreign investment and retailing and some reflecting their multiple forays raising venture capital.

While the defense that will be offered for the company is that it is still young, the scale of the losses and the dependence on borrowed money would suggest that as a stand-alone business, you would be hard pressed to come up with a justification for a high value for the company and would have serious concerns about survival. 

b. Walmart, Aging Giant?

Walmart has been publicly traded for decades and its operating results can be seen in much more detail. Its growth in the 1980s and 1990s from an Arkansas big-box store to a dominant US retailer is captured below:

That operating history includes two decades of stellar growth towards the end of the twentieth century, where Walmart reshaped the retail business in the United States, and the years since, where growth has slowed down and margins have come under pressure. As Walmart stands now, here is what we see:

1. Growth has slowed to a trickle: Walmart’s growth engine started sputtering more than a decade ago, partly because its revenue base is so overwhelmingly large ($500 billion in 2017) and partly because of saturation in its primary market, which is the United States. 
2. And more of it is being acquired: As same store sales growth has leveled off, Walmart has been trying to acquire other companies, with Flipkart just being the most recent (and most expensive) example. 
3. But its base business remains big box retailing: While acquiring online retailers like Jet.com and upscale labels like Bonobos represent a change from its original mission, the company still is built around its original models of low price/ high volume and box stores. The margins in that business have been shrinking, albeit gradually, over time.
4. And its global footprint is modest: For much of the last few years, Walmart has seen more than 20% of its revenues come from outside the United States, but that number has not increased over the last few years and a significant portion of the foreign sales come from Mexico and Canada. 

Looking at the data, it is difficult to see how you can come to any conclusion other than the one that Walmart is not just a mature company, but one that is perhaps on the verge of decline.

Very few companies age gracefully, with many fighting decline by trying desperately to reinvent themselves, entering new markets and businesses, and trying to acquire growth. A few do succeed and find a new lease on life. If you are a Walmart shareholder, your returns on the company over the next decade will be determined in large part by how it works through the aging process and the Flipkart acquisition is one of the strongest signals that the company does not plan to go into decline, without a fight. That may make for a good movie theme, but it can be very expensive for stockholders.

The Common Enemy

Looking at Flipkart and Walmart, it is clear that they are very different companies, at opposite ends of the life cycle. Flipkart is a young company, still struggling with its basic business model, that has proven successful at delivering revenue growth but not profits. Walmart is an aging giant, still profitable but with little growth and margins under pressure. There is one element that they share in common and that is that they are both facing off against perhaps the most feared company in the world, Amazon. 

a. Amazon versus Flipkart: Over the last few years, Amazon has aggressively pursued growth in India, conceding little to Flipkart, and shown a willingness to prioritize revenues (and market share) over profits:

Source: Forrester (through Bloomberg Quint)

While Flipkart remains the larger firm, Amazon India has continued to gain market share, almost catching up by April 2018, and more critically, it has contributed to Flipkart’s losses, by being willing to lose money itself. In a prior post, I called Amazon a Field of Dreams company, and argued that patience was built into its DNA and the end game, if Flipkart and Amazon India go head to head is foretold. Flipkart will fold, having run out of cash and capital.

b. Amazon versus Walmart: If there is one company in the world that should know how Amazon operates, it has to be Walmart. Over the last twenty years, it has seen Amazon lay waste to the brick and mortar retail business in the United States and while the initial victims may have been department stores and specialty retailers, it is quite clear that Amazon is setting its sights on Walmart and Target, especially after its acquisition of Whole Foods. 

It may seem like hyperbole, but a strong argument can be made that while some of Flipkart and Walmart’s problems can be traced to management decision, scaling issues and customer tastes, it is the fear of Amazon that fills their waking moments and drives their decision making.

The Pricing of Flipkart

Walmart is just the latest in a series of high profile investors that Flipkart has attracted over the years. Tiger Global has made multiple investments in the company, starting in 2013, and other international investors have been part of subsequent rounds. The chart below captures the history:

Barring a period between July 2015 and late 2016, where the company was priced down by existing investors, the pricing has risen, with each new capital raise. In April 2017, the company raised $1.4 billion from Microsoft, Tencent and EBay, in an investment round that priced the company at $11 billion, and in August 2017, Softbank invested $2.5 billion in the company, pricing it at closer to $12.5 billion. Walmart’s investment, though, represents a significant jump in the pricing over the last year. 

Note that, through this entire section, I have used the word “pricing” and not “valuation”, to describe these VC and private investments, and if you are wondering why, please read this post that I have on the difference between price and value, and why VCs play the pricing game. Why would these venture capitalists, many of whom are old hands at the game, push up the pricing for a company that has not only proved incapable of making money but where there is no light at the end of the tunnel? The answer is simple and cynical. The only justification needed in the pricing game is the expectation that someone will pay a higher price down the road, an expectation that is captured in the use of exit multiples in VC pricing models. 

The Why?

So, why did Walmart pay $16 billion for a 70% stake in Flipkart? And will it pay off for the company? There are four possible explanations for the Walmart move and each comes with troubling after thoughts. 

1. The Pricing Game: No matter what one thinks of Flipkart’s business model and its valuation, it is true, at least after the Walmart offer, that the game has paid off for earlier entrants. By paying what it did, Walmart has made every investor who entered the pricing chain at Flipkart before it a “success”, vindicating the pricing game, at least for them. If the essence of that game is that you buy at a low price and sell at a higher price, the payoff to playing the pricing game is easiest seen by looking at the Softbank investment made just nine months ago, which has almost doubled in pricing, largely as a consequence of the Walmart deal. In fact, many of the private equity and venture capital firms that became investors in earlier years will be selling their stakes to Walmart, ringing up huge capital gains and moving right along. Is it possible that Walmart is playing the pricing game as well, intending to sell Flipkart to someone else down the road at a higher price?

My assessment: Since the company’s stake is overwhelming and it has operating motives, it is difficult to see how Walmart plays the pricing game, or at least plays it to win. There is some talk of investors forcing Walmart to take Flipkart public in a few years, and it is possible that if Walmart is able to bolster Flipkart and make it successful, this exit ramp could open up, but it seems like wishful thinking to me.

2. The Big Market Entrée (Real Options): The Indian retail market is a big one, but for decades it has also proved to be a frustrating one for companies that have tried to enter it for decades. One possible explanation for Walmart’s investment is that they are buying a (very expensive) option to enter a large and potentially lucrative market. The options argument would imply that Walmart can pay a premium over an assessed value for Flipkart, with that premium reflecting the uncertainty and size of the Indian retail market.
My assessment: The size of the Indian retail market, its potential growth and uncertainty about that growth create optionality, but given that Walmart remains a brick and mortar store primarily and that there is multiple paths that can be taken to be in that market, it is not clear that buying Flipkart is a valuable option.

3. Synergy: As with every merger, I am sure that the synergy word will be tossed around, often with wild abandon and generally with nothing to back it up. If the essence of synergy is that a merger will allow the combined entity to take actions (increase growth, lower costs etc.) that the individual entities could not have taken on their own, you would need to think of how acquiring Flipkart will allow Walmart to generate more revenues at its Indian retail stores and conversely, how allowing itself to be acquired by Walmart will make Flipkart grow faster and turn to profitability sooner.
My assessment: Walmart is not a large enough presence in India yet to benefit substantially from the Flipkart acquisition and while Walmart did announce that it would be opening 50 new stores in India, right after the Flipkart deal, I don’t see how owning Flipkart will increase traffic substantially at its brick and mortar stores. At the same time, Walmart has little to offer Flipkart to make it more competitive against Amazon, other than capital to keep it going. In summary, if there is synergy, you have to strain to see it, and it will not be substantial enough or come soon enough to justify the price paid for Flipkart.

4. Defensive Maneuver:Earlier, I noted that both Flipkart and Walmart share a common adversary, Amazon, a competitor masterful at playing the long game. I argued that there is little chance that Flipkart, standing alone, can survive this fight, as capital dries up and existing investors look for exits and that Walmart’s slide into decline in global retailing seems inexorable, as Amazon continues its rise. Given that the Chinese retail market will prove difficult to penetrate, the Indian retail market may be where Walmart makes its stand. Put differently, Walmart’s justification for investing in Flipkart is not they expect to generate a reasonable return on their $16 billion investment but that if they do not make this acquisition, Amazon will be unchecked and that their decline will be more precipitous.
My assessment: Of the four reasons, this, in my view, is the one that best explains the deal. Defensive mergers, though, are a sign of weakness, not strength, and point to a business model under stress. If you are a Walmart shareholder, this is a negative signal and it does not surprise me that Walmart shares have declined in the aftermath. Staying with the life cycle analogy, Walmart is an aging, once-beautiful actress that has paid $16 billion for a very expensive face lift, and like all face lifts, it is only a matter of time before gravity works its magic again.

In summary, I think that the odds are against Walmart on this deal, given what it paid for Flipkart. If the rumors are true that Amazon was interested in buying Flipkart for close to $22 billion, I think that Walmart would have been better served letting Amazon win this battle and fight the local anti-trust enforcers, while playing to its strengths in brick and mortar retailing. I have a sneaking suspicion that Amazon had no intent of ever buying Flipkart and that it has succeeded in goading Walmart into paying way more than it should have to enter the Indian online retail space, where it can expect to lose money for the foreseeable future. Sometimes, you win bidding wars by losing them!

What next?

In the long term, this deal may slow the decline at Walmart, but at a price so high, that I don’t see how Walmart’s shareholders benefit from it. I have attached my valuation of Walmart and with my story of continued slow growth and stagnant margins for the company, the value that I obtain for the company is about $63, about 25% below its stock price of $83.64 on May 18, 2018.

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In the short term, I expect this acquisition to a accelerate the already frenetic competition in the Indian retail market, with Flipkart, now backed by Walmart cash, and Amazon India continuing to cut prices and offering supplementary services. That will mean even bigger losses at both firms, and smaller online retailers will fall to the wayside. The winners, though, will be Indian retail customers who, in the words of the Godfather, will be made offers that they cannot refuse! 

For start-ups all over India, though, I am afraid that this deal, which rewards the founders of Flipkart and its VC investors for building a money-losing, cash-burning machine, will feed bad behavior. Young companies will go for growth, and still more growth, paying little attention to pathways to profitability or building viable businesses, hoping to be Flipkarted. Venture capitalists will play more pricing games, paying prices for these money losers that have no basis in fundamentals, but justifying them by arguing that they will be Walmarted. In the meantime, if you are an investor who cares about value, I would suggest that you buy some popcorn, and enjoy the entertainment. It will be fun, while it lasts!

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Data Links

1. Walmart Valuation - May 2018