Tuesday, October 19, 2021

Triggered Disclosures: Escaping the Disclosure Dilemma

In a post a few weeks ago, I argued that the disclosure process had lost its moorings, as corporate disclosures (annual filings, prospectuses for IPOs) have become more bulky, while also become less informative. I argued that some of this disclosure complexity could be attributed to the law of unintended consequences, with good intentions driving bad disclosure rules, and that some of it is deliberate, as companies use disclosures to confuse and confound, rather than to inform. For those of you who agreed with my thesis, the end game looks depressing, as new interest groups push for even more disclosures on their preferred fronts, with the strongest pressure coming from the environmental, social and governance (ESG) contingent. In this post, I propose one way out of the disclosure dilemma, albeit one with little chance of being adopted by the SEC or any other regulatory group, where you can have your cake (more disclosure on relevant items) and eat it too (without drowning in disclosure). 

The Disclosure Dilemma: Disease and Diagnosis

    For those of you who did not read my first post on disclosures, let me summarize its key points. The first is that company disclosures have become more bulky over time, whether it be in the form on required filings (like annual reports or 10K/10Q filings in the US) or prospectuses for initial public offerings.  The second is that these disclosures have become less readable and more difficult to navigate, partly because they are so bulky, and partly because disclosures with big consequences are mingled with disclosure with small or even no consequences, often leaving it up to investors to determine which ones matter. The net effect is that investors feel more confused now, when investing in companies, than ever before, even though the push towards more disclosures has ostensibly been for their benefit.

    As we look at the explosion of disclosures around the world, there are many obvious culprits. The first is that technology has made it possible to collect more granular data, and on more dimensions of business, than ever before in history, and to report that data. The second is that interest groups have become much more savvy about lobbying regulatory groups and accounting rule writers to get their required data items on the required list. The third is that companies have learned that converting disclosures into data dumps has the perverse effect of making it less likely that they will held accountable, rather than more. That said, there are three other reasons for the disclosure bloat: 

  • The first is the prevailing orthodoxy in disclosure is tilted towards "one size fits all", where all companies are covered by disclosure requirements, even if they are only tangentially exposed. Though that practice is defended as fair and even handed, it is adding to the bloat, since disclosures that are useful for assessing some firms will be required even for firms where they have little informative value. 
  • The second is the notion of materiality, a key component of how accountants and regulators think about what needs to be disclosed.  Using the words of IFRS (1.7), ‘Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity’. As we will argue in the next section, this definition of materiality may be leading to too much disclosure for backward looking items and too little for forward looking items.
  • The third is that the disclosure rule writers happen to be in the disclosure business, and since more disclosure is good for business, the conflict of interest will always tilt toward more rather than less disclosure. No matter how many complaints you hear from accountants and data services about disclosure bloat, it has been undeniable that it has created more work for accountants, appraisers and others in the disclosure ecosystem.
It is quite clear, though, that unless we break this cycle, where each corporate shortcoming or market upheaval is followed by a fresh round of new disclosures, we are destined to make this disclosure problem worse. In fact, there may come a point where only computers can read disclosures, because they are so voluminous and complicated, perhaps opening the door for artificial intelligence or matching learning into investing, but for all the wrong reasons.

Escaping the Disclosure Trap

    There is a way out of this disclosure trap, but it will require a rethink of the status quo in disclosures. It starts first by moving away from "one size fits all" disclosure rules to disclosures tailored to companies, a "triggered" disclosure process, where a company's value story (big market, lots of subscribers) triggers disclosures on the parameters of that story. It extends into materiality, by reframing that concept in terms of value, rather than profits, and connecting it to disclosure, with disclosure requirements increasing proportionately with the value effect. Finally, it requires creating a separation between those who write the disclosure rules and those who make money from the disclosure business.

One size (does not) fit all!

When disclosure laws were first written in the aftermath of the great depression, they were focused on the publicly traded firms of the time, a mix of utilities, manufacturing and retail firms. At the time, the view that disclosure requirements should be general, and apply to all companies, was rooted in the idea of fairness. In the decades since, there have been exceptions to this general rule, but they have been narrowly carved out for segments of firms. For instance, oil companies are required to disclose their ownership of "proven undeveloped reserves", in addition to details about quantity, new investments and progress made during the year in converting those reserves. The disclosure rules for banks and insurance companies require them to reveal the credit standing of their loan portfolios and their regulatory capital levels to investors and the public. These exceptions notwithstanding, disclosure laws written to cover concerns in one sector (such as the use of management options at technology firm or lease commitments at retail and restaurant companies) have been applied broadly to all companies. It is time to rethink this principle and allow for a more variegated disclosure policy, with some disclosures required only fir subsets of companies. Since the next big bout of disclosures that are coming down the pike will be related to ESG, this discussion will play out in a wide range of ESG data items. For instance, while it makes sense to require that fossil fuel and airline companies report on their carbon footprints and greenhouse gas emissions, it may just be a time consuming and wasteful exercise to require it of technology companies.

From earnings-based to value-based materiality

I do not think that you will find many who disagree with the premise that any information that has a material effect should be disclosed, but there is disagreement on what comprises materiality. I believe that the "materiality principle", as defined by accountants, is diluted by measuring it in terms of impact on net income and the fact that accountants tend to be naturally conservative in measuring that impact. Simply put, it is safer for an accounting or audit firm to assume that a disclosure is material, and include it in reports, even if it turns out to be immaterial, than it is to assume that it is immaterial, and be found wrong subsequently.  One solution to this problem is to redefine materiality in terms of effects on value, rather than earnings, thus accomplishing two objectives. First, it will reduce the number of noise disclosures, i.e., those that pass the materiality threshold for earnings, but don't have a significant impact on value. Second, since value is driven by expected cash flows in the future and not in the past, it will shift the focus on disclosures to items that will have an impact on future earnings and cash flows, rather than on past earnings or book value.

Triggered Disclosures

At first sight, the requirements to make disclosures slimmer and more informative may seem at war with each other, since disclosure bloat has largely come from well-intentioned attempts to make companies reveal more about themselves. Triggered disclosures, where disclosures are tailored to a company's make-up and stories, are one solution, where contentions made by a company trigger additional disclosures related to that contention. Thus, a company that claims that brand name is its supreme competitive advantage would then have to provide information to not only back up that claim, but also to allow others to value that brand name. 

Disclosure Illustration: Initial Public Offerings
    
It is difficult to grapple with disclosure questions in the abstract, and to illustrate how my proposed solutions will play out in practice, I will focus on initial public offerings, where there is a sense that the disclosure rules are not having their desired effect. In my last post, I noted that prospectuses, the primary disclosure documents for a companies going public, have bulked up, contrasting the Microsoft and Apple prospectuses that came in at less than a 100 pages in the 1980s to the 400+ page prospectuses that we have seen with Airbnb and Doordash in more recent years. At the same time, applying a disclosure template largely designed for mature public companies to young companies, often with big losses and unformed business models, has resulted in prospectuses that are focused in large parts on details that are of little consequence to value, while ignoring the details that matter.  Since companies going public often do so on the basis of stories that they tell about their futures, and these stories vary widely across companies, this segment lends itself well to the triggered disclosure approach. To do so, I will draw on a paper that I co-wrote with Dan McCarthy and Maxime Cohen, to provide details. In that paper, we argue that a going-public company that wants to build its story around certain dimensions (a large total addressable market or a large user base) will trigger disclosure of a more systematic, business type-specific, collection of “base disclosures” that are required to understand the economics of businesses of that type, whatever type that might be.

Total Addressable Market (TAM)
Companies going public have increasingly supported high valuations by pointing to market potential, using large TAMs as one of the justifications. These TAMs are often not only aspirational, but also come with very little justification and no timeline for how long it will take for the existing market sizes to grow into those TAMs. For instance, the graph below shows the TAMs that Uber and Airbnb claimed in their prospectuses at the time of their initial public offerings.
Uber and Airbnb Prospectuses
Is Uber’s total addressable market really $5.2 trillion? I don’t think so, but you can see why the company was tempted to go with that inflated number to push a “big market” narrative. To prevent the misuse of TAM as little more than a marketing ploy, companies that specify a TAM should also have to provide the following:
a. TAM, SAM and bridges: Companies that specify a TAM should also specify the existing market size (i.e., the serviceable addressable market or SAM), as well as additional “bridges” so that investors can understand the evolution from SAM to TAM (e.g., an estimate of how many individuals would be interested in the company’s product before considering price). Investors who may be skeptical of a lofty TAM could still look to SAM as a more achievable intermediate metric.
b. Market share estimates: As long as companies do not have to twin TAM with expectations of market share, there is little incentive for them to restrain themselves when estimating TAM. We would recommend requiring that companies that disclose TAM figures couple them with forecasts of their market share of those TAM figures. For companies that are tempted to significantly inflate their TAMs, the worry that they will be held accountable if their revenues do not measure up to their promises, will act as a check.
c. Ongoing metrics or measures: Companies usually provide TAM, SAM, and variants thereof on a one-shot basis, disclosing these figures in their pre-IPO prospectuses and then never again. We believe that investors should be given these measures on an ongoing basis. This will help on two levels. First, it will allow investors to see how well the company is adhering to its prior disclosures and forecasts and provide investors with updates if conditions have changed. Second, companies that know they will be held accountable to their IPO disclosures after they go public will be more incentivized to make those disclosures realistic and achievable. 

To the extent that investors will continue to assess premiums for companies that have bigger markets, the bias on the part of companies will still be to overestimate TAM. That said, these recommendations should help rein in some of those biases.

Subscription-Based Companies
A subscription-based company derives its value from a combination of its subscriber base (and additions to it) and the subscription fees its charges these subscribers.  Consequently, the value of an existing subscriber can be written as the present value of the expected marginal profit (subscription fee net of the costs of servicing that subscription) from the subscription each year, over the expected life of the subscriber (based upon renewal/churn rates in subscribers), and the value of a new subscriber will be driven all of the same factors, net of the cost of acquiring that subscriber. The overall value of the company can be written in terms of its existing and new subscribers:


Companies that sell a “subscriber” story have the obligation, then, to provide the information needed to derive this value:
  1. Existing subscriber count: Observing the total number of subscribers in each period (e.g., month or quarter) allows us to track overall growth trends in the number of subscribers, and to understand how revenue per subscriber evolves over time, because revenue is disclosed.
  2. Subscriber churn: To value a subscriber, a key input is the renewal rate or its converse, the churn rate. Holding all else constant, a subscription business with a higher renewal rate should have more valuable subscribers than one with a lower renewal rate. It would stand to reason that any subscription-based company should report this number, but it is striking just how many do not disclose these measures or disclose them opaquely. For example, while the telecom industry regularly discloses churn figures, Netflix has not disclosed its churn rate in recent years. 
  3. Contribution profitability: For subscribers to be valuable, they need to generate incremental profits, and to estimate these profits, you need to know not just the subscription fees that they pay, but also the cost of servicing a subscription; the net figure (subscription fee minus cost of service) is called the contribution margin. Many subscription companies explicitly disclose contribution profits (e.g., Blue Apron, HelloFresh, and Rent the Runway), but many others do not (e.g., StitchFix). In the absence of explicit contribution profit data, investors often resort to simple proxies for it, such as gross profit, but these proxies are imperfect and noisy.
  4. Subscriber acquisitions & drop offs: To move from the value of a single subscriber to the value of the entire subscriber base, we must also know how many subscribers are acquired over time, not just the net subscriber count. Put differently, if a company grew the overall size of its subscriber base from 10 million to 12 million subscribers in a year, it is quite different if that net growth came about because the company acquired 10 million customers that year but then lost 8 million of them, versus if the company acquired 2 million customers and lost none of them. Acquisition (or equivalently, churn) disclosures are what allow us to piece this apart.
  5. Cost of acquiring subscribers (CAC): Subscription-based companies attract new subscribers by offering special deals or discounts, or through paid advertising. While the cost of acquiring subscribers can sometimes be backed out of other disclosures at subscription-based companies (such as subscribers numbers, churn and marketing costs), it would make sense to require that it be explicitly estimated and reported by the company.
  6. Cohort data: While many subscriber companies are quick to report total numbers, only a provide a breakdown of subscribers, based upon subscription age. This breakdown, called a cohort table, can be informative to observe retention and/or monetization patterns across cohorts, as noted by Fader and McCarthy in their 2020 paper on the topic. Many subscription-based firms, including Slack, Dropbox, and Atlassian, now disclose cohort data, and the figure below shows one such chart for Slack Technologies:
    Source: Slack Technologies Form S1
By breaking down cohort-specific retention and monetization trends, a cohort chart offers investors visibility into retention and development patterns as a function of subscriber tenure (e.g., does the retention rate get better or worse as subscribers get older), and trends across time, as subscribers stay on the platform. 

Transaction-Based Companies
The guiding principles driving our disclosure recommendations for subscription-based businesses largely extend to transaction-based businesses, with the primary difference being that subscription revenues are replaced with transaction revenues, a number that is not only more difficult to estimate, but one that can vary more widely across customers. The value of the customer base at transaction-based businesses is driven off the activity of these customers, translating into transaction revenues and profits. 


As with subscriber-based businesses, this framework can only be used if the company provides sufficient data from which one can estimate the inputs. Deconstructing this picture, many of the key disclosures track those listed for subscription based companies, including contribution profitability, customer acquisition costs and cohort data. In addition, there are three key additional pieces of information that can be useful in valuing these companies:
  1. Active customer count: We replace the notion of a subscriber with that of an “active” customer, which is more suitable for transaction-based businesses. After all, a customer in your platform who never transacts is not affecting value, and one issue that transaction-based companies have struggled with is defining "activity". Wayfair, Amazon, and Airbnb, for example, define an active customer to be one who has placed at least one order over the past 12 months. In contrast, Lyft, Overstock, and many other companies define a customer as active if they placed an order in the past 3 months. 
  2. Total orders: In transaction-based companies, the average purchase frequency of active customers can change, often significantly, over time. We need to know the total orders because this further allows us to decompose changes in revenue per active customer into changes in order frequency per active customer and changes in average order value. While some transaction-based businesses disclose this information, including Wayfair, Overstock, Airbnb, and Lyft, this data is notably absent for many others, such as Amazon.
  3. Promotional activity: It can be easy to significantly increase purchase activity through enticing targeted promotions, creating the illusion of rapid growth that may not be sustainable over the long run, due to their substantial cost. Since these promotions are often reported as revenue reductions, rather than expenses, the cost of these campaigns are often opaque, to investors. For example, DoorDash did not disclose their total promotional expense during the most recent 6 months in their IPO prospectus, creating substantial uncertainty for investors as to how this may have influenced gross food sales). 
Fintech Companies
In the last decade, we have seen banks, insurance companies and investment firms face disruption from firms in the "fin-tech" space, covering a diverse array of companies in the space. With all of these companies, though, there is (or should be) a lingering concern that part of their value proposition comes from "regulatory arbitrage", i.e., that these disruptions can operate as financial service companies, without the regulatory overlay that constrains these companies, at least in their nascent years. Since this regulatory arbitrage is a mirage, that will be exposed and closed as these fin-tech companies scale up, investors in these companies need more information on:
  • Quality/Risk metrics on operating activity: In the aftermath of the 2008 crisis, banks, insurance companies and investment banks have all seen their disclosure requirements increase, but ironically, the young, technology-based companies that have entered this space seem to have escaped this scrutiny. In fact, the absence of a regulatory overlay at these companies makes this oversight even more dangerous, since an online lender that uses a growing loan base as its basis for a higher valuation, but does not report on the default risk in that loan base, is a problem waiting to blow up. It is highly informative for investors to observe the evolution of these measures in the years and quarters leading up to the IPO. Indeed, lenders can be tempted to strategically lower their credit standards to issue more loans (and hence significantly increase revenue through loan-related fees, which are often assessed upfront) to create the illusion of growth at the expense of long-term profitability and trust (since many of these risky loans are likely to default in the future).
  • Capital Buffer: It is worth remembering that banks existed prior to the Basel accords, and that the more prudent and long-standing ones learned early on that they needed to set aside a capital buffer to cover unexpected loan losses or other financial shortfalls. In the last century, regulators have replaced these voluntary capital set asides, at banks and insurance companies, with regulatory capital needs, tied (sometimes imperfectly) to the risk in their business portfolios. Many fintech companies have been able to avoid that regulatory burden, largely because they are too small for regulatory concern, but since they are not immune from shocks, they too should be building capital buffers and reporting on the magnitude of these buffers to investors. 
Conclusion
As data becomes easier to collect and access, the demands for data disclosure from different interest groups will only increase over time, as investors, regulators, environmentalists and others continue to add to the list of items that they want disclosed. That will make already bulky disclosures even bulkier, and in our view, less informative. There are three ways to have your cake and eat it too. The first is to allow for increasing customization of disclosure requirements to the firms in question, since requiring all firms to report everything not only results in disclosures becoming data dumps, but also in the obscuring of the disclosures that truly matter. The second is to shift the materiality definition from impact on earnings to impact on value, thus moving the focus from the past to the future. Finally, tying disclosures to a company's characteristics and value stories will limit those stories and create more accountability.

YouTube Video

Papers

Monday, October 4, 2021

The Indian Smartphone Revolution: Paytm's Coming of Age IPO!

A few weeks ago, I valued Zomato, the Indian online food delivery company, just prior to its IPO, and argued that the excitement about its potential was tied to the potential for growth in India and the shifting habits of Indian consumers. Since its public offering, Zomato's stock price has reflected that excitement, more than doubling from its offering price of 74 rupees per share. Waiting in the wings for its public debut, is Paytm, a company that in many ways is even more closely tied to India's macro story, drawing on the growth of online commerce in India and a willingness of Indian consumers to use mobile payment mechanisms. In this post, I will look at the levers that drive Paytm's value, and you can make your judgments on where you think this offering will lead in terms of valuation and pricing. 

Setting the Table

As the Paytm IPO speeds to offering date, it is worth looking back at its relatively short history as a company, and how much change has been packed into that period. Since so much of Paytm’s success has been driven by the rise if smart phone usage among Indian consumers, and the concurrent rise in mobile payments for goods and services, I will start with a review of that rise, before looking at how Paytm has put itself in position to take advantage of that market shift.

The Rise of the Indian Smartphone User

India was late to join the smart phone party, held back both by the relative expensiveness of these devices, as well as the absence of affordable and reliable cell service in much of the country. In 2010, fewer than 2% of Indians had smart phones, with most of them being well off and living in urban areas. In the decade since, that has changed, as the smart phone market has exploded to reach hundreds of millions of Indians in 2020. 

Source: World Bank Database

Entering 2021, more than 500 million Indians had smart phones, making it the second largest smartphone market in the world (after China), but its penetration rate of less than 50% of the market gave it more room to grow. There are multiple forces that have contributed to this shift, but two stand out. 

  • The first is that the costs of smartphones have decreased, and especially so in India, as technology and competition have worked their magic. In particular, the entry of Chinese brands, with Xiaomi and Vivo leading the charge, played a major role in making smartphones more affordable to Indians.
  • The second is that cell service costs have also dropped, and in India, the drop in costs has been precipitous, after Reliance Jio entered the game in 2016, and quickly acquired 100 million subscribers by offering free voice and data calls over its 4G network. Today, Jio has more than 400 million subscribers, and while it remains a lightning rod for criticism, it is undeniable that it has played a major role in the evolution of the market. 
As smart phones have become ubiquitous in India, their usage has soared, partly because they are the only digital devices that many Indians have available to them to get online, and thus use to access social media, entertainment and shopping. By 2020, Indians ranked third in the world in how much time they were spending per day on their phones, with COVID contributing to a surge in that year:

App Annie, State of Mobile 2021

Access to these smartphones, in conjunction with poor banking outreach in India, has created the perfect storm for a surge in mobile payments in India, and this graph bears out this trend:

S&P, 2020 India Mobile Payments Market Report

Within the mobile payment space, there was also an external development that added to its acceleration, and that was the advent, in 2016, of Unified Payments Interface (UPI), a real-time payment interface devised by the National Payments Corporation of India, and regulated by the Reserve Bank of India, facilitating and speeding up inter-bank, person to person and person to merchant transactions. 

Paytm: Operating History 

The rise of Paytm (Pay through Mobile) as a company parallels the rise of mobile phones in India. When it was founded in in 2010 by by Vijay Sharma, it operated as a pre-paid mobile platform, but its market then was small both in terms of numbers and services offered. As mobile access improved, Paytm has relentlessly added to its suite of products. In 2014, it introduced Paytm Wallet, a digital wallet that was accepted as a payment option by leading service providers and retailers. In 2016, it added ticket booking to movies, events and amusement parks, with flight bookings soon after, and started Paytm Mall, a consumer shopping app, based upon Alibaba's Taobao Mall model. In 2017 it added Paytm Gold, allowing users to buy gold in quantities as little as 1 rupee, and Paytm Payments Bank, a messaging platform with in-Chat payments. In 2018, it added a Paytm Money, for investment and wealth management, and in 2019, it launched a Paytm for Business app for merchants to track payments. In short, over time, it has used its platform of users to launch itself into almost every online activity. As Paytm's product suite has expanded, its numbers reflect both its strengths and weaknesses, with four key statistics tracking its expansion. 

  • The first is the number of users on its platform, using one or more of its many services. 
  • The transactions that these users make on the platform plays out  in the gross merchandise value of all the products and services bought.
  •  The third is the take rate, i.e., the percentage of this gross merchandise value that Paytm records as its revenues. 
  • The last is the operating margin, it operating income (or loss) as a percent of operating income each year.
The table below is my attempt to recreate how Paytm has performed on these key measures in recent years, with the caveat that some of the information (on users and GMV, especially prior to 2019) is cobbled together from claims by corporate executives, press reports and opaque disclosures from the firm.
Take Rate = Revenues/ GMV
Looking at the numbers, we start to get a picture of Paytm, warts and all, over its lifetime. First, it is a growth company, if you define growth as growth in user count and number of transactions done on its platform, and perhaps in gross merchandise value. However, its growth in revenues has not kept track with those larger statistics, leading to a cynical conclusion that the company is adding new services and giving them away for nothing (or close to it) to pad its user/transaction numbers. Second, this is a company that seems to run on hyperbolic forecasts from its founders and top management, that are not just consistently higher than what the company deliver, but often by a factor of three or four. For instance, just to pick on one of many examples, Vijay Sharma claimed in an interview in 2019 with Business Standard that the company's GMV would be $ 100 billion (7500 billion rupees) by the end of the year, more than double what the company reported as GMV for that year or the next. Third, access to capital from its deep pocketed investors, especially Alibaba, seems to have made this company casual about its business model and profitability, even by young, tech company standards. In fact, there is almost never even a mention of profitability (or aspirations towards profitability) in any of the corporate soundbites that I was able to read.  The picture that emerges of Paytm is that of a  management that is too focused on racking up user numbers, and too distracted to care about converting those into revenues and profits, while making grandiose statements about its future. Using the corporate life cycle framework to assess Paytm, it resembles an adolescent with attention deficit issues, in its scattershot approach to growth and absence of attention to business details, and if you are an investor, you have to hope that going public will cause it to grow up quickly.

Paytm: Funding and Ownership

Paytm's ambitious growth plans have made it one of India's premier cash burning machines, and it has been able to pull these plans off, because it has found ample sources of capital to feed them. In the table below, I list Paytm's big capital infusions over its lifetime:


Along the way, there have been others who have provided capital to the firm (Reliance, Ratan Tata) who have exited as foreign investors, led by Alibaba and SoftBank, have muscled their way into the firm. Those capital infusions have naturally led to a diminution of the share of the company held by its founder, and the pie chart below lists the owners of Paytm, ahead of its IPO:
Paytm Prospectus

Note that while the company's origins and business are in India, it is primarily a Chinese-owned company ahead of its IP0, with Ant Group, Alibaba and SAIF Partners (a Hong-Kong based private equity firm) collectively owning more than 50% of the shares, with the Softbank Vision fund as the next largest investor with 18%. Vijay Sharma's holdings in the company have dwindled to 15% of the company, and his tenure as CEO depends on whether he can keep his foreign shareholder base happy. 

Paytm: Story and Valuation

    With that lead in, the pieces are in place to value Paytm and I will start by laying out the value drivers for the company and follow with my valuation. In making this assessment, I will draw on the company's stated plans to raise money from the offering, though they may be altered as the company gets to its offering date.

The Story

    The company's history provides some insight into the Paytm's value drivers, starting with a large and growing mobile payment market in India, and working down to the company's operating metrics. 

The value story for Paytm starts with a large and growing digital payment market in India, one that has surged over the last four years, and is expected to increase five-fold over the next five years, as the smart phone penetration rate rises for India and more merchants accept mobile payments. While Paytm has the advantage of having been in the Indian mobile payment market the longest, and having the largest user base, PhonePe and Google Pay have outmaneuvered Paytm in the UPI app ecosystem, claiming the lion's share of that market, though the bulk of the transaction in that ecosystem are person-to-person. Paytm's large user base, close to 350 million, and the wide acceptance of its wallets allow it to dominate the person to merchant (P2M) market in India, giving it a market share of close to 50% in early 2021.

The growth in the Indian mobile payment market will provide enough of a tailwind for Paytm to continue to grow its user base and transactions, but the bigger challenges for Paytm will be on the business dimensions where it has lagged in the past. 

  • The first is in the take rate, where Paytm has seen its revenue share of GMV drop from 2.18% in 2016-17 to 0.79% in 2020-21, as the company has prioritized acquiring users and user transactions over actually generating revenues from these transactions. To get a measure of a reasonable take rate that the company can aspire to reach in the long term, I looked at larger, more established players in the payment processing space:

From company 10Ks. Removed net interest income from Amex revenues and subscription/bitcoin/hardware revenues from Square revenues
Visa and Mastercard, the status quo players, still retain considerable market share, though Mastercard has a higher take rate (1.83%) than Visa does (1.11%); American Express has a higher take rate than the two larger players, because it gets a higher percent of its revenue from annual card fees. Paypal Shopify and Square, all of which derive their revenues from merchandising value, have take rates between 2% and 3%, though Square gets substantial additional revenues from bitcoin transactions (not counted in GMV or revenues in this table). Ant Financials, perhaps the company that Paytm has most closely modeled itself around, has a low take rate (1.37%), but makes up for it with huge transaction volumes. In modeling Paytm's take rate over time, I will begin by assuming that the company will spend the next few years putting user growth first, at the expense of generating revenues, and that the take rate will stay low over the next five years, rising slowly to 1% in 2026. In the years following, though, I expect the take rate to double (to 2%), as the focus shifts from users to revenues, and its business model approaches that of a more conventional payment processing company.
  • The second big challenge that Paytm faces is generating profits, a feat the company has been unable to accomplish over its lifetime. While the operating margins posted by Visa and Mastercard may be unreachable, note that Paypal's operating margin has been trending up, as the company has become bigger. As Paytm increases its revenues, and user growth starts to level off, Paytm's marketing and personnel expenses should start to decrease, and I expect operating profits to turn positive and the operating margin to reach 5% in 2026, and for that improvement to accelerate in the following five years, as growth rates decrease, allowing for an operating margin of 30% in stable growth.
  • As a technology company, whose most valuable asset is the platform that it offers and products and services on, Paytm's reinvestments have been mostly in the form of acquisitions and technology investments, and we assume that it will continue to follow this path, generating 3  in revenues for every rupee of capital invested in the near term, but 2.45 per dollar invested in the long term, converging on an industry average (for business and consumer services). Within the online payment space, this number has wide variance, with Paypal, perhaps the most mature of the companies, having a sales to invested capital of 2.54 over the last five years and Square, a younger and faster growing player, reporting a sales to invested capital of 5.68.
  • On the risk front, there is little reason to reinvent the wheel. Paytm's cost of capital, in rupee terms, is 10.43%, reflecting its business risk, and puts the company just below the median Indian company, in risk terms. The company's capacity to burn cash will continue to expose it to risk, but with deep pocketed investors (Alibaba and Softbank), and a large cash balance (post IPO), the risk of failure is low (5%).
  • To get from these numbers to a value per share, I use the existing share count, in conjunction with the information in the prospectus that the company plans to raise 16,600 million at the offering, with half of these proceeds staying in the firm to cover future investment needs and the other half going to existing shareholders, cashing out.

There are other Paytm businesses that may augment revenues in future years, but each one comes with caveats. The money deposited in Paytm wallets by users can potentially earn interest for the company, but restrictions that this money be kept in escrow accounts at banks, not always paying close to market interest rates, can crimp that income stream. Paytm Bank could expand from its very limited presence now to more traditional banking (taking deposits, making loans), but that is a capital and regulation intensive business. I believe that Paytm's core value comes from being an intermediary, in the payments business, and the story reflects that belief.

The Valuation

If you buy into my story of Paytm continuing to maintain a dominant market share of the mobile payment market in India, while also increasing its take rate over time and improving operating margins to those of an intermediary business, you have the pieces in place for a valuation of Paytm, captured in the picture below:

Download spreadsheet; Price per share of ₹2950 is for unlisted shares.

I know that there are many on both sides of the value divide who will disagree with me on my story and valuation, and that is par for the course. On one side, there will be some  who view a value of close to $20 billion (1500 billion) for a company with a pittance in revenues, a history of operating losses and distracted management as insanity. On the other side, there will be some who feel that I am not giving the company credit for all of the new businesses it can enter, using its vast platform of users, and thus under valuing the company. To both sides, my defense is that this is my story and valuation, and it will drive my investment, but that you are welcome to download the spreadsheet, change the inputs that you disagree with and come up with your own valuations. 

In making my assessment, I fully understand that there is substantial operating and execution risk in this story, since this value presupposes that Paytm will remain a dominant player in the Indian mobile payment space, as it grows, and that Paytm's management will pivot from growing users to growing revenues and from growing revenues to growing profits, over time, with nothing in their history to back that up. Needless to say, if I invested in Paytm, it would not only have to be at the right price, i.e., trading at less than 1500 billion, but also with the acceptance that this cannot be a passive (buy and hold) investment, but one that will require active engagement and monitoring of the company's actions and performance. To assess how this uncertainty will play out in my estimates of overall equity value, I did a Monte Carlo simulation, with my point estimates on total GMV, take rate, operating margin and sales to invested capital replaced with distributions:

Crystal Ball used for simulation

There are lessons, albeit some obvious, that emerge from this simulation. First, given that almost all of the value of Paytm comes from expectations of the future, and there is significant uncertainty on every single dimension, it should come as no surprise that the range on estimated value is immense, with a 3%chance that the company's equity is worth nothing to more than ₹2000 billion at the 90th percentile. Second, with this range in value, the potential for your priors and biases to play out on your final valuation are strong. Put simply, if you like the company so much that you want to buy the stock, you can find a way to make the assumptions that get to that value. Third, even if you strongly favor the company and find it under valued, it would be hubris to concentrate your portfolio, around this stock. In other words, this is the type of stock that you would put 5% or perhaps 10% of your portfolio in, not 25% or 40%.

Closing Thoughts

As human beings, it is natural for us to categorize choices we face into broad groupings, because those groupings then allow us to generalize. In the 1980s, when technology companies first entered the market in big numbers, we classified them all as high growth, high risk investments. While that categorization would have worked at the time, it is quite clear that the technology sector today is not only a dominant segment of the market (accounting for the largest slice of the S&P 500 market capitalization pie), but is also home to a wide array of companies. In fact, at one end of the spectrum, there are many older tech companies that are now mature, and perhaps even in decline, and several are stable, cash earning machines, akin to the consumer product companies of the 1980. At the other end, you see new sub-segments of technology-based companies that have emerged to claim the "high growth, high risk" mantle, deriving more of their value from the number of users on their platforms, than from conventional financial metrics.  A few weeks ago, when I valued Zomato, I argued that it was a joint bet on the company's continued dominance of the food delivery market and the growth in the Indian restaurant/food delivery business. Paytm is also a joint bet on an early entrant into the Indian mobile payment market, continuing to maintain market share, in a growing digital payment market in India. That said, the companies have very different business models, with Zomato's 20% plus take of every dollar spent on its platform vastly exceeding Paytm's less than 1% take of every dollar spent on its platform. They are both big market bets, but the Paytm bet is much more dependent on management figuring out a way to grow, while improving take rates at the same time. 

YouTube Video

Spreadsheets to download

  1. Valuation of Paytm (for IPO)


Tuesday, September 14, 2021

The ESG Movement: The "Goodness" Gravy Train Rolls On!

Last year, I wrote a post on ESG and explained why I was skeptical about the claims made by advocates about the benefits it would bring to companies, investors and society. In the year since, I have heard from many on the topic, and while there are some who agreed with me on the internal inconsistencies in its arguments, there were quite a few who disagreed with me. In keeping with my belief that you learn more by engaging with those who disagree with you, than those who do, I have tried my best to see things through the eyes of ESG true believers, and I must confess that the more I look at ESG, the more convinced I become that "there is no there there". More than ever, I believe that ESG is not just a mistake that will cost companies and investors money, while making the world worse off, but that it create more harm than good for society.

ESG: Value and Pricing Implications

Rather than repeat in detail the points I made in last year's post, I will summarize my key conclusions, with addendums and modifications, based upon the feedback (positive and negative) that I have received. 

1. Goodness is difficult to measure, and the task will not get easier!

The starting point for the ESG argument is the premise that we can come up with measures of goodness that can then be targeted by corporate managers and used by investors. To meet this demand, services have popped up around the world, claiming to measure ESG with scores and ratings. As I noted in my last post, there seems to be little consensus across services on how to measure goodness, and the low correlation across service measures of ESG has been well chronicled. The counter from the ESG services and ESG advocates is that these differences reflect growing pains, and just as bond ratings agencies found convergence on measuring default risk, services will also find commonalities. I think that view misses a key difference between default risk and goodness, insofar as default is an observable event and services were able to learn from corporate defaults and fine tune their ratings. Goodness is in the eyes of the beholder, and what you perceive to be a grevious corporate sin may not even register on my list, as a problem. To illustrate how investors can differ on core values, consider the chart below, where investors were asked to assess which issues should rank highest, when considering corporate goodness:

Based on this survey, younger investors want the focus to be on global warming and plastics, whereas older investors seem to focus on data fraud and gun control. If you expand these factors to include other social and religious issues, I would wager that the differences will only widen. As ESG scores and ratings get more traction, researchers are also looking at the factors that allow companies to get high scores and good rankings, and improve them over time. Studies of ESG scores find that they were influenced by company size and location, with larger companies getting higher ESG scores/rankings than smaller companies, and developed market companies getting higher scores and rankings than emerging market companies:

LaBella, Sullivan, Russel and Novikov (2019)

It is entirely possible that big companies are better corporate citizens than smaller ones, but it is also just as plausible that big companies have the resources to play the ESG scoring game, and that more disclosure is a tactic used by these companies that want to bury skeletons in their current or past lives, rather than expose them. In fact, a JP Morgan study of ESG Ratings and disclosures also points to a larger danger from enhanced ESG disclosure requirements, which is that the ESG ratings seems to increase across companies, as disclosure increase. 

Chen et al, JP Morgan

While I am sure that there will be some in the ESG community who will view this as vindication that disclosure is inducing better corporate behavior, the cynic in me sees companies learning to play the ESG game, at least as designed by services, and using the disclosure process to check boxes and up their scores. To me, the parallels to the corporate governance movement from two decades ago are uncanny, where services rushed to estimate corporate governance scores for companies, accountants and rule writers added hundreds of pages of disclosure on corporate governance, and promises were made of a "golden age" for shareholder power. The fact that the corporate governance movement enriched services, consultants and bankers, and left shareholders more powerless than they were before the movement started, holding shares in companies with dual class shares or worse, should act as a warning for ESG disclosure/measurement advocates, but I have a feeling that it will not.

2. Being “good” will add to value some companies, hurt others, and leave the rest unaffected!

If the ESG sales pitch to companies, which is that if you are a "good" company, you will be worth more, is right, why do we need ESG? In fact, Milton Friedman, the bĂȘte noire of ESG advocates, would stand vindicated, and companies would do good, because it made them more profitable and valuable, and not because of lectures about morality and goodness. This may be cynical, on my party, but the very fact that ESG advocates keep insisting that being "good" increases value must be because they are themselves unsure why or whether this is true. The framework for tracing out the effect of ESG on value is a simple one, since ESG, if it affects value, has to affect one of four variables: revenue growth (by increasing or decreasing growth), operating profit margins, reinvestment efficiency (the payoff to investing in new capacity)  or risk (through the cost of funding/capital and failure risk). In last year's post, I noted that the empirical evidence that ESG has a positive payoff is weak, at best, and inconclusive, for the most part:
The strongest evidence that is supportive of ESG comes on the risk front, with evidence that it does not pay to be a "bad" company, with some  a higher cost of funding and greater risk of catastrophes, but much of that evidence comes from fossil fuel companies. The weakest evidence in ESG's favor is on profitability and cash flows, since almost every study that purports to find positive correlation between profitability and ESG scores trips up on the causality question, i.e., are "good" companies more profitable or are companies that are more profitable able to take the actions that make them look good? An objective look at the data would lead us to conclude that while one can make a reasonable case that companies should work at "not being bad", there is very little evidence that there is a payoff to  spending more money to be "good".

3. The ESG sales pitch to investors is internally inconsistent and fundamentally incoherent

If the argument that ESG translates into higher value is weak, the argument that incorporating ESG into your investing is going to increase your returns fails a very simple investment test. For any variable, no matter how intuitive and obvious its connection to value might be, to generate "excess" returns, you have to consider whether it has been priced in already. That is why investing in a well managed company or one that has high growth does not translate into excess returns, if the market already is pricing in the management and growth. Applying this principle to ESG investing, the question of whether ESG-based investing pays off or not depends on not only whether you think ESG increases or decreases firm value, but also on whether the market has already priced in the impact.

  • If the market has fully priced in the ESG effect on value, positive or negative, investing in 'good' companies or avoiding 'bad' companies will have no effect on excess returns. In fact, if being good makes companies less risky, investors in good companies will earn lower returns than investors in bad companies, before adjusting for risk, and equivalent returns after adjusting for risk.
  • If the market is over enthused with ESG and is overpricing how much being "good" will add to a company's profitability or reduce risk, investing in 'good' companies will generate lower risk-adjusted returns than investing in 'bad' companies.
  • If the market is underestimating the benefits of being good on growth, margins and risk, investing in 'good' companies will generate higher returns for investors, even after adjusting for risk.
In the latter two cases, the excess returns (negative in the "markets are over estimating" case and positive in the "markets are under estimating") will manifest only when the market corrects its mistakes.   Bringing in market pricing into the discussion is important for two reasons. 
  • The first is that it suggests that much of the research on the relationship between ESG and returns yields murky findings. Put simply, there is very little that we learn from these studies, whether they find positive or negative relationships between ESG and investor returns, since that relationship is compatible with a number of competing hypotheses about ESG, value and price. 
  • The second is that bringing in market pricing does shed some light on perhaps the only aspect of ESG investing that seems to deliver a payoff for investors, which is investing ahead or during market transitions. In my last post, I pointed to this study that find that activist investors who take stakes in "bad" companies and try to get them to change their ways generate significant excess returns from doing so. Another study contends that investing in companies that improve their ESG can generate excess returns of about 3% a year, but skepticism is in order because it is based upon a proprietary ESG improvement score (REIS), and was generated by an asset management firm that invests based upon that score. 
If you are interested in making market transitions on ESG work in your favor, you also have to be clear about the strengths you will need to get the payoffs, including skills in divining not only what social values are gaining and losing ground and which changes have staying power.

4. Outsourcing your conscience is a salve, not a solution!

    Even if being “good” does not increase value or make investors better off, could it still help, by making the world a better place? After all, what harm can there be in asking and putting pressure on companies to behave well, even if costs them? In the short term, the answer may be no, but in the long term, I believe that this will cost us all (as society). The ESG movement has given each of us an easy way out of having to make choices, by outsourcing these choices to corporate CEOs and investment fund managers, asking them to be “good” for us, while not charging us more for their products and services (as consumers) and delivering above-average returns (as investors). Implicit in the ESG push is the presumption that unless companies that are explicitly committed to ESG, they cannot contribute to society, but that is not true. Consider Bill Gates and Warren Buffett, two men who built extraordinarily valuable companies, with goodness a factor in decision making only if it was good for business. Both men have not only made giving pledges, promising to give away most of their wealth to their favorite causes in their lifetimes, and living up to that promise, but they have also made their shareholders wealthy, and many of them give money back to society. As I see it, the difference between this “old” model of business and the proposed “new ESG” version is in who does the giving to society, with corporate CEOs and management taking over that responsibility from shareholders. I am willing to listen to arguments for why this new model is better, but I am certainly not willing to concede, without challenge, that a corporate CEO knows my value system better than I do, as a shareholder, and is better positioned to make judgments on how much to give back to society, and to whom, than I am.

    For a perspective more informed and eloquent than mine, I would strongly recommend this piece by Tariq Fancy, whose stint at BlackRock, as chief investment officer for sustainable investing, put him at the heart of the ESG investing movement. He argues that trusting companies and investment fund managers to make the right judgments for society will fail, because their views (and actions) will be driven by profits, for companies, and investment returns, for fund managers. He also believes that governments and regulators have been derelict in writing rules and laws, allowing companies to step into the void. While I don’t share his faith that government actions are the solution, I share his view that entities whose prime reasons for existence are to generate profits for shareholders (companies) or returns for investors (investment funds) all ill suited to be custodians of public good.

Cui Bono? The ESG Gravy Train (or Circle)!

    If ESG is a flawed concept, perhaps fatally so, and if the flaws are visible for everyone to see, how do we explain the immense push in both corporate and investment settings? I think the answer always lies in asking the question "Cui Bono, or who benefits?". With ESG, the answer seems to be everyone, but those it is purported to help, i.e. corporate stakeholders, investors and society. The picture below captures the groups that have primarily benefited from the ESG boom, and how they feed off each other.

Given how much ESG disclosure advocates, measurement services, investment funds and consultants feed off each other, it is no wonder that they have an incentive to sell you on its unstoppable growth and inevitable success. Given that shareholders in companies and investors in funds are paying for this gravy, you may wonder why corporate CEOs not only go along with this charade, but also actively encourage it, and the answer lies in the power it gives them to bypass shareholders and to evade accountability. After all, these are the same CEOs who, in 2019, put forth the fanciful, but great sounding, argument that it is a company’s responsibility to maximize stakeholder wealth, rather than cater to shareholders, which I argued in a post then that being accountable to everyone effectively meant that CEOs were accountable to no one.  In some cases, flaunting goodness has become a way that founders and CEOs use to cover business model weaknesses and overreach. It is a point that I made in my posts on Theranos, at the time of its implosion in October 2015, and on WeWork, during its IPO debacle in 2019, noting that Elizabeth Holmes and Adam Neumann used their “noble purpose” credentials to cover up fraud and narcissism. 

I should add that, notwithstanding my negative views about ESG, I do not think that ESG consultants, fund managers and analysts are venal, but I do think that they, like everyone else, are driven by self interest. I also believe that many in the ESG ecosystem are driven by good motives, a desire to do good for society and make the world a better place, but that are being used by a few at the top of the ESG pyramid, whose commitment to the cause is skin deep. If you are someone working in the ESG space or a true believer, please do look to the highest profile spokespersons for your cause, mostly corporate CEOs and investment fund titans, and remember the adage about waking up with fleas, if you lie down with dogs.

A Roadmap for being and doing Good

    My skepticism about ESG notwithstanding, I understand its draw, especially on the young. As individuals, each of us has a moral code, sometimes coming from religion, sometimes from family and sometimes from culture, but whatever its source, our actions should be consistent with that code. Since those actions involve what we do at work, and in investing, it stands to reason that there are some investments you will and should not make, because it violates your sense of right and wrong, and other investments that you will make, because they advance your view of goodness. It is for this reason that I would suggest a more nuanced and personalized version of ESG, built around the following principles:

  1. Start with a personalized measure of goodness, and don’t overreach: The key with moral codes is that they are personal, and for goodness to be incorporated into your investment and business decisions, you have to bring in your value judgments, rather than leave it to ESG measurement services or to portfolio managers. I would also recommend that you focus on core values, rather than try to find a match on every one, not only because adding too restrictions will constrain you in your choices, perhaps to the point of paralysis, but also because you may find yourself accepting major compromises on your key values in order to meet secondary values. 
  2. As a business person, be clear on how being good will affect business models and value: If you own a business, you are absolutely within your rights to bring your personal views on morality into your business decisions, but if you do so, you should work through the effects on growth, margins and risk, and be at peace with the fact that staying true to your values may, and probably will, cost you money. If you are making decisions at a publicly traded company, as an employee, manager or even CEO, you are investing other people’s money and if you choose to make decisions based upon your personalized moral code, you cannot justify these decisions with hand waving and double talk. In fact, you have an obligation to be open about what your conscience will cost your shareholders, a twist on disclosure that ESG advocates will not like.
  3. As an investor, understand how much goodness has been priced in: If you are an investor, you don’t have to compromise on your values, as long as you start with the recognition that, at least in the long term, you will have to accept lower returns than you would have earned without that constraint. If you are tempted to have your cake and eat it too, and who isn’t, you may be able to do so by getting ahead of the market in detecting shifts in social mores and pushing for change in the companies you invest in, to change. 
  4. As a consumer and citizen, make choices that are consistent with your moral code: If you believe that owning a portfolio of “good” stocks or running a “good” business is all you have to do to fulfill your moral or societal obligations, you are wrong. Your consumption decisions (on which products and services you buy) and your citizenship decisions (on voting and community participation) have as big, if not greater, an effect. Put simply, if your key societal issue is climate change, your refusal to own fossil fuel stocks in your portfolio is of little consequence, if you still drive a gas guzzler, air condition your house to feel like an ice box all summer and take private corporate jets to Davos every year.
On a personal note, I have always found that the people that I've known who do good, spend very little time talking about being good or lecturing other people on goodness. I would extend that perspective to companies and investment funds as well, and I reserve my skepticism for those companies that spend hundreds of pages of their annual filings telling me how much "good" they do.

In conclusion
    The ESG movement’s biggest disservice is the message that it has given those who are torn between morality and money, that they can have it all. Telling companies that being good will always make them more valuable, investors that they can add morality constraints to their investments and earn higher returns at the same time, and young job seekers that they can be paid like bankers, while doing peace corps work, is delusional. In the long term, as the truth emerges, it will breed cynicism in everyone involved, and if you care about the social good, it will do more damage than good. The truth is that, most of the time, being good will cost you and/or inconvenience you (as businesses, investors or employees), and that you choose to be good, in spite of that concern. 

YouTube Video