The Twitter IPO: Thoughts on the IPO End Game

The Twitter IPO moved into its final phase, with the announcement last week of the preliminary pricing estimates per share and details of the offering. The company surprised many investors by setting an offering price of $17 to $20 per share, at the low end of market expectations, and pairing it with a plan to sell 70 million shares. Having posted on my estimate of Twitter’s price when the IPO was first announced and following up with my estimate of value, when the company filed its prospectus (S-1) with Twitter, I thought it would make sense to both update my valuation, with the new information that has emerged since, and to try to make sense of the pricing game that Twitter and its bankers are playing.

Updated valuation

In my original valuation of Twitter, just over a month ago, I used the Twitter's initial S-1 filing which contained information through the first two quarters of 2013 (ending June 30, 2013) and the rough details of what investors expected the IPO proceeds to be. Since then, Twitter has released three amended filings with the most recent one containing third quarter operating details and share numbers that reflect changes since June 30. Incorporating the information in this filing as well as the offering details contained in the report leads me to a (mostly minor) reassessment of my estimate of Twitter’s value.

Operating Results: Twitter’s third quarter report contained both good news and bad news. The good news was that revenue growth continued to accelerate, with revenues more than doubling relative to revenues in the same quarter in 2012, but it was accompanied by losses, which also surged. The table below compares the trailing 12-month values of key operating metrics from June 2013 (that I used in my prior valuation) with the updated values using the September 2013 reports:

As with prior periods, the R&D expense was a major reason for the reported losses and capitalizing that value does make the company very mildly profitable. Note that while the numbers have shifted significantly, there is little in the report that would lead me to reassess my narrative for the company: it remains a young company with significant growth potential in a competitive market. Consequently, my targeted revenues in 2023 ($11.2 billion) and the operating margin estimates (25%) for the company remain close to my initial estimates (October 5).

IPO proceeds: In the most recent filing, the company announced its intent to issue 70 million shares, with the option to increase that number by 10.5 million shares. In conjunction with the price range of $17-$20 that is also specified, that implies that the proceeds from the offering will range anywhere from $1.19 billion (70 million shares at $17/share) at the low end to $1.61 billion (80.5 million shares at $20/share) at the high end. In my valuation, I will assume that the offering will happen at the mid-range price ($18.50) and that the option to expand the offering will not be utilized, leading to an expected proceeds of $1.295 billion.

Share number: As with most young companies, the share number is a moving target as options get exercised and new shares are issued to employees and to fund acquisitions. In the table below, I compare the share numbers (actual, RSU and options) from the first S-1 filing with those in the most recent filing:

The share count has increased by about 8.02 million shares, since the last filing, while there has been a slight drop off in options outstanding. (Note: The most recent filing also references 80.3 million shares for future issuance to cover equity incentive & ESOP plans that I have not counted.)

The final valuation is contained in this spreadsheet, but it has changed little from my original estimate, with the value per share increasing to $17.84/share from my original estimate of $17.36/share. The picture is below:

Reading the pricing tea leaves

Now that the company (and its bankers) have announced a price range ($17-$20) that is close to my estimate of value, my ego, of course, wants me to believe that this is a testimonial to my valuation skills but I know better. There is a fairy tale scenario, where my value is right, Goldman Sachs has come up with a value very close to mine and the market price happens to reflect that value. It is a fantasy for a simple reason. As I noted in my price versus value post, the IPO process has little to do with value and everything to do with price, and given how the market is pricing other social media companies, I find it difficult to believe that price and value have magically converged, with Twitter.

Accepting that the closeness of Goldman’s pricing of Twitter to my estimate of value is pure coincidence frees me to think about what it does tell me about the bankers' (and the company’s) view of what they see as a “fair price” for Twitter. If Goldman and the banking syndicate are pricing Twitter at $17-$20, I am inclined to believe that they think that the “fair price” today is higher for the following reasons:

1. The underwriting skew: The Twitter IPO, like most public offerings, is backed by an underwriting guarantee from bankers that they will deliver the agreed upon offering price. If the offering price is set too high, relative to the fair price, that creates a substantial cost to the bankers, whereas if it is set too low, the cost is much smaller. Not surprisingly, IPOs tend to be underpriced, on average, by about 10-15% as I noted in this prior post.
2. The PR twist: There is a public relations and marketing component to what happens on the offering date that cannot be under estimated. To provide a contrast, look at the reactions to the Facebook and Linkedin offerings in both the immediate aftermath of and in the weeks after the offering. While both IPOs were mispriced by the same lead banker (Morgan Stanley), with Facebook being over priced and Linkedin being under priced, Morgan Stanley was bashed for doing the former and emerged relatively unscathed from the latter. In the months after the offering, Facebook saw its shares lose more ground, as institutional investors abandoned it, while LinkedIn shares were carried higher, at least partly because of the opening day momentum. 
3. The feedback loop: I know that the bankers have been testing out the level of enthusiasm among investors for the Twitter offering and I find it difficult to believe that they are not incorporating that into their pricing. In other words, if they want excitement at the road show, it will come from investors thinking that they are getting a bargain and not from being offered a fair deal.

My completely uninformed guess is that the bankers think that Twitter’s fair price is closer to $25/share and that they have set the range at roughly 20% below those estimates. If the offering goes as choreographed, here is how it should unfold.

1. The road show will be well received and the bankers will announce (reluctantly) that the high enthusiasm shown by investors has pushed them to set the offering price at $20/share. 
2. Institutional investors will start lining up for their preferred allotments at that offering price and the enthusiasm bubble will grow.
3. On the offering date, the stock will jump about 20%-25%, leading to headlines the next day about the riches endowed on those who were lucky or privileged enough to get the shares in the offering.
4. Some of the rest of us, who were not lucky or privileged enough to be part of the offering, will be drawn by these news stories into the stock, pushing the price higher, and keeping the momentum game going. 
5. In a few months or perhaps a year, some of the owners of Twitter (big investors and venture capitalists) will be able to sell their shares and cash out. 

So, what can go wrong with this script? The biggest actor in this play is Mr. Market, a notoriously moody, unpredictable and perhaps bipolar (though that may require a clinical judgment) character. As was the case in Facebook, a last minute tantrum by Mr. Market can lay waste the best laid plans of banks and analysts. 

Winners and Losers

Some of you may take issue with my cynical view of the IPO process, arguing that this is not a play or a game and that there are real winners and losers in the process. While this is generally true for any investing process, who are the losers in this process? By under pricing IPOs, the existing owners of the company going public are leaving money on the table. In the aftermath of the Linkedin offering, where the offering price doubled on the opening day, there were stories that the company had been scammed by bankers. Before you feel too sorry for Evan Williams and the venture capitalists, who are the primary owners of Twitter, you should take into account two facts:

1. Only a small fraction of the equity is being offered to the public on the offering date: If all of Twitter being offered for sale on the offering date, an underpricing of 20% (selling the shares at $20, when the fair price is $25) would cost investors almost $3 billion in value (since the company would be priced at $12 billion instead of $15 billion). However, as noted earlier, only $1.2 to $1.6 billion will be offered to investors in the IPP. Even if you take the upper end of this amount ($1.6 billion), a 20% under pricing would translate into a loss of $400 million to the owners. While that may be a lot of money to most of us, it would work out to about 3% of overall value for the existing owners.
2. The existing investors in Twitter are neither babes in the wood nor naïve fools: The current owners in Twitter are a who's who of venture capital investing, entirely capable of watching out for their own interests and just as likely to use bankers as they are to be used by them. Rather than being victims here of the under pricing, they are willing accomplices in this pricing process, who view the loss on the opening day as a small cost to pay for a more lucrative later exit.

There are some winners, though none of them emerge unscathed from the process. The first are the bankers, who by under pricing the offering enough, render the underwriting guarantee moot and get paid for it anyway. Here again, though, issuers are not entirely helpless and Twitter managed to get a discount on the underwriting fees. The second are those investors who are allotted shares at the offering price, many of whom are preferred clientele for the banks. They generally tend to be wealthier investors (institutions and individuals) who bring in revenues in other ways to the banks (as private banking clients or through trading). Since banks are not altruistic, I am not sure that these preferred clients end up with a bargain if you count the other fees they fork out to banks. The third is the financial media (and that includes bloggers) that can use the IPO as grist for the mill, churning out endless stories (and blog posts) about the IPO.

Cut out the bankers?

If you buy into my cynical view of the Twitter IPO, it does make the whole process seem like a charade and raises questions about whether it is needed. What if we could skip the bankers, the offering price, the road shows and the endless debate about what will happen on the offering date and just go directly to the offering?  It is true that bankers play other roles in the process that may be difficult to replace in some IPOs, but I am not sure that can be said about their role in Twitter.

	Banker's role	The Twitter IPO
Credibility	If investors have never heard off or know little about a company, the banker may provide credibility to the company with investors.	Not only is Twitter as recognized a name as Goldman Sachs, it may have more credibility with investors.
Pricing	Bankers can price the stock, not only by looking at what the market is paying for similar stocks, but also by testing the price with investors.	Since the stock has had VC transactions as well as acquisitions where the stock has been effectively priced, the banker has less work to do.
Selling	Use their sales forces and road shows to get investors interested in the stock and excited about the offering.	The sector is already "buzzed" and if you set the price at 25% below the “fair” price, you don’t really have to sell it very much.
Post-offering price support	In the months after the offering, the bankers may step in and provide  price support in the face of selling.	With a $12 billion company, banks don’t have the capital or deep pockets to provide more than surface support.
Corporate Finance advice	Guide the company in financing & dividend policy and in interactions with markets.	Bankers know little about running social media businesses, which don't use much debt and have no cash to pay dividends/ buy back stock.

Looking at the facts, I think that Twitter could have saved itself some money and time if it had followed Google and chosen an auction process for its public offering. After all, if your job is pricing, who does it better than the market? On the other hand, the ceremony and ritual of the IPO process, useless and predictable though it might be in most cases, may play a role in easing the transition of the company to the public market place and setting a narrative for the momentum game.

What now?

So, now that we have a sense of where Twitter will be priced and what will happen on the offering date, what next? Here are the four options:

1. Try to get an allotment of shares at the offering price:  While the odds may be in your favor, it is definitely not a risk free or costless strategy and please do pay heed to some of the suggestions in this post. 
2. Wait until the offering date and play the momentum game: The trading game begins on opening day and stocks like Twitter are a momentum investors' dream (and nightmare) as prices are moved up and brought down by wisps of information and mood changes. If you are good at this game, you can play it for profit, as long as you do not let delusions of being an investor get in the way.
3. Buy the stock as a long term investor: I do not have a  deep rooted aversion to buying young or money losing companies, if the price is right. Given my estimate of value ($18/share), the stock would be, at best, a fair value at the offering price and I can think of far less ulcer-inducing investments that earn their fair value. That does not mean that Twitter will never be on my radar. If the momentum game turns against the stock and the price drops to $10/share, I will be ready to buy.
4. Entertainment/ educational value: I am enjoying and will continue to enjoy every moment of this IPO for sheer entertainment value, as I listen to analysts make hilariously ill conceived arguments for or against the stock and portfolio managers act as if they are making reasoned judgments about value while desperately checking out momentum indicators. This is the ultimate reality show and I am just waiting for Ashton Kutcher, Kanye West and Lady Gaga to show up as Twitter IPO experts on CNBC.

Valuing Athlete Earning Potential? Tracking Arian Foster!

In a week during which both Google and Netflix hit all-time highs, you would think I would pick one of these high fliers for special valuation attention. While I still plan to look at these companies, I am going to spend this week on a quirky valuation challenge: valuing tracking stock on a star athlete’s future income. Last week, a company called Fantex filed an S-1 (prospectus for a forthcoming security issue) with the Securities Exchange Commission, making public its intention to issue tracking stock on Arian Foster, a star running back for the Houston Texans in the National Football League (NFL). In the filing, Fantex reported that it had paid $10 million in early October to Mr. Foster in return for 20% of all contract and endorsement income that he will earn after February 28, 2013. The S-1 also specifies that Fantex plans to raise approximately $10 million (thus covering its outlay) from the issuance of 1.055 million Arian Foster tracking shares to the public, and use its share of Mr. Foster’s income to pay dividends to these shareholders. The picture below captures the initial set up: 

Fantex intends to use its platform to attract more athletes and celebrities into the mix, thus creating a portfolio of tracking shares that can be traded by investors. 

Arian Foster: Background 

Arian Foster was born on August 24, 1986, and is a running back for the Houston Texans. He played college football at the University of Tennessee and was signed as an undrafted free agent by the Texans in 2009. In 2010, he had a monster year, leading the NFL in rushing, yards from scrimmage and touchdowns. He continued with impressive performances in 2011 and 2012, as can be seen in his career statistics page. 

Arian is also clearly a self-promoter (in the best sense of the word) and has aspirations beyond the gridiron. He has his own website, where he characterizes himself as an all-pro running back, entrepreneur, philosopher and father. 

On March 5, 2012, Arian signed a five-year contract with the Texans worth $43.5 million. The contract had a guaranteed payment of $20.75 million, including a signing bonus of $12.5 million, his first year salary (2013) and $3.25 million of his second year salary (2014).  He is also entitled to bonus payments, based on performance in games, of up to $5.25 million in 2013, $5.75 million in 2014, $6 million in 2015 and $6.5 million in 2016. He is a free agent in 2017. 

Claim and Contract details 

To value the claim on Arian Foster’s income, you need to break down the cash flow claims that you have on the income. Note that while Fantex has a contractual claim on 20% of Foster’s future income, investors in the tracking stock don’t have that direct claim. Instead, they are dependent on the dividends that Fantex chooses to pay out from that income. 

As noted in the figure, there are at least two expenses that Fantex will incur that will make the dividends paid less than the income that they get from Foster. The first is that a portion will be set aside to cover the expenses associated with managing and maintaining the Fantex platform. The second is that Fantex views its role as not just a contractual intermediary but also as a brand building organization. Effectively, that implies that Fantex can and will use some of the Foster income to market him better (and hopefully increase endorsement income). 

To value the Foster tracking stock, we will go through three steps. In the first, we will lay out broadly the risks faced by investors in the tracking stock. In the second, we will value the cash flow claim that Fantex has on Foster’s contract and endorsement income. In the third, we will evaluate the claim that investors in the Foster tracking stock have on the dividends they receive from Fantex.

The Risks 

The S-1 goes to great lengths to emphasize the point that this is a speculative investment, but since that should have been obvious to anyone thinking about the investment, it is important that we break down the risks at each stage of the process: 

Working the risks through the pipeline, here at the layers of risks that we see, starting with risks to the earning stream and then moving on to risks in the intermediary and ending with risks at the investment level.

Earnings Risks

1. Player Risks

The most immediate impact on player earnings comes from the athlete with two big risks to earnings: injuries that are career ending or a drop off in performance skills, either as a result of age or earlier injuries.

1.1. Player Skills/Longevity

A. Player Injuries: If you are laying claim on a professional athlete’s future earnings, you are exposed to any injury/event risk that impedes his or her capacity to perform on the field. Part of this risk can be mitigated at the contract level, if you have guaranteed income (that will be paid even if the athlete is injured) but it will still affect the athlete's earnings power in terms of getting contract renewals & bonus income.

Arian Foster shares: Foster's guaranteed income on his contract has dwindled down to $3.25 million and almost all of his remaining income will be at risk if he is injured. While Foster has been durable through his early years, there are two reasons to worry. The first is that he just hurt his hamstring this season, an injury that may keep him out for a portion of the season and may be a harbinger of things to come. The second is that injuries tend to climb as athletes age, and especially so for running backs whose bodies take significant punishment on the field. 

1.2. Player performance

While a player’s current contract may be unaffected by declining performance, there are two reasons why it will feed through into the earnings claims. First, if there are bonus payments, as is the case with Arian Foster, they will clearly be put at risk, if performance deteriorates. Second, to the extent that you are counting on a continuation of earnings from a contract renewal (from the current team or another team), future earnings will be lower, if the player’s performance deteriorates. 

Arian Foster shares: Age has to be factored into the equation since he is 27 in a sport where running backs seem to age faster than everyone else in the field. One assessment of running back output based on age yielded the following graph on production for running backs (and quarterbacks): 

Note that output for running backs peaks early (24-25), levels off until about 27 and starts deteriorating after that age. Foster may very well be the exception to this rule, but it is dangerous to bet against history. 

2. Macro Factors

There are two macro level risk factors that can affect a player’s earnings. 

2.1. Collective Bargaining Constraints

In most sports, there is a players’ union that negotiates with team owners on both contract rules and constraints. While individual players may negotiate on their own behalf with teams, the constraints imposed by collective bargaining agreements may affect earnings potential for individual players. For instance, the hard caps on team payrolls imposed in the NBA and NHL and even the soft caps in the MLB (soft, because they can go over the cap as long as they pay the penalty tax) have affected player negotiations and contracts. 

Arian Foster Tracking stock: The NFL’s current salary cap is $123 million per team and each team is required to spent more than 95% of that cap. Both teams and players, though, have become adept at evading the cap constraints by loading more of the payment into future years. With Arian Foster, I am going to assume that this will be a minor factor. 

2.2. Economic factors

The magnitude of a player’s earnings may be affected by the overall economy, especially if a large proportion comes from endorsement income and that income is expected to grow over time. The growth in the aggregate economy can also affect revenues to a sport in the aggregate and thus indirectly affect how much can be paid out in contracts to players. 

Arian Foster Tracking stock: Since only a small portion of Foster’s current earnings (less than one million) came from endorsements in 2013, the impact of the overall economy on his earnings is likely to be small. 

3. Player Default 

Even if the athlete in question generates high earnings, the earnings stream to investors is dependent upon that athlete carrying through his side of the contractual agreement and delivering the promised portion of earnings to investors. If the athlete defaults on that obligation, your earnings down stream are at risk. You could, of course, seek legal recourse but given that an athlete who defaults is also likely to have other financial problems, it is unlikely that you will get much of your promised payback. 

Arian Foster shares: We have little evidence on Arian Foster’s default history. The strongest case that can be made for him is that he is ambitious and hopes to parlay his pro career into entrepreneurial ventures. Presumably, that will mean that he will not be cavalier in defaulting on contract obligations. That does not mean that there is no default risk but we will assume low default risk. 

4. Intermediation Risks

Investors don’t have a direct claim on Arian Foster’s earnings, since those earnings will be first collected by Fantex, which will then decide how to much of these earnings will be returned to investors as dividends. Consequently, there are three additional risks to factor into the assessment: 

4.1. Poor brand building investments

Fantex views itself as a brand builder for the athletes who decide to use it. That would imply that some of the earnings collected from the athlete will be spent in trying to increase earnings in the future, primarily from endorsements. There are no guarantees, though, that this trade off will be a positive one. Thus, it is possible that Fantex will expend 20%, 30% or even 50% of Foster’s earnings, trying to increase his marketability, with no discernible effect on endorsement earnings. 

4.2. Spillover risks

 One of the stranger features of the Arian Foster stock is that investors in the stock may be called upon to bear losses incurred by Fantex on other athletes that it may have in its portfolio. Thus, if Fantex makes a big up front investment in a potential superstar (Andrew Luck) and that star suffers a career ending injury, investors in the Foster stock may take a hit. 

4.3. Corporate governance risk

The nature of tracking stock is that holders of the stock are onlookers when it comes to corporate governance, since they have no power to change or even influence managers. This is going to be a factor on two levels. The first is that Fantex will take a portion of the collective revenues it gets from player earnings to cover management expenses & fees; if it keeps “too large a portion” of the earnings for these expenses, there is little recourse for you as an investor. The second is that Fantex is not required to pay the residual earnings (after brand building expenses, management expenses and other portfolio charges) to investors) as dividends. While this is always a problem with publicly traded company stock, investors in conventional shares get a claim on the cash balance which may compensate (at least partially) for the unpaid dividends. There is no such compensating claim with tracking stock. 

5. Investment Risk

If you are an investor who decides to buy Arian Foster tracking stock, there is one final risk that has to come into the picture. Since there is no ready market (yet) for these shares, it may be difficult and expensive to liquidate these investments. In valuation, that is generally a reason for either charging a “illiquidity premium” in your discount rate (increasing the discount rate) or attaching an “illiquidity discount” to the value. The extent of the effect will depend upon how much you value liquidity as an investor and how easy/difficult it is to trade these shares. 

Arian Foster tracking stock: Since this is the first set of tracking stock, I will assume that there is substantial illiquidity risk. That risk may decline over time as more athletes get listed and the Fantex trading market becomes more liquid, but neither is a reality yet. 

Valuing the Fantex Claim 

To value the claim on Arian Foster's earnings, I began by forecasting aggregate earnings to Arian Foster. In making these forecasts, I assumed that:

1. Expected playing time: I will assume that Foster will play for nine more years, until the age of 36, at which point both his contract income and his endorsement income will end.
2. Current contract: The current contract would deliver on the remaining $23.5 million due between 2013 and 2016. On average, that works out to $5.875 million a year. During the current contract period, I will also assume that he will earn approximately $2 million in bonuses each year, approximately a third of his overall potential bonus payments.
3. Contract renewal: At the end of the current contract period, I am assuming that Arian Foster will get resigned to a new contract for the rest of his, worth $4 million a year, assuming that his age (31) and the production decline that comes with age with affect his earning power. I will also assume a step down in bonus income to $1 million a year for the rest of his career.
4. Player fines/penalties: Given Foster's clean history and the position he plays, I will assume no dollar penalties will be imposed on his during his lifetime.
5. Endorsement Income: Arian Foster's endorsement income in 2013 was $687,750 (though some of it is contingent on performance). I will assume that there is substantial growth potential (10% annual growth rate) in this income.

To value the cash flows, I have to make assumptions about player and default risk. For player risk, I will assume that there is a 5% probability of a career ending injury each year, resulting in cumulative probabilities that will increase over time (to 37% by the last year). For default risk, I will assume that Arian Foster's history & desire for commercial success will keep default risk low (a default spread of 1.50% and a discount rate of 4.1%). will be added to the risk free rate. For endorsement earnings, I will assume that there is low exposure to macroeconomic risk, resulting in an equity risk premium of 3% (and a discount rate of 5.60%). The table below captures the cash flows, discounted value and the value today (with the link to the spreadsheet).

The value of the claim on Foster's earnings to Fantex, based on these assumptions, is $10.06 million (before accounting for expenses and injury probabilities).  Fantex paid $10 million to get these claims, this looks like a break even deal for both sides of the transaction, with Arian Foster having the slight edge.

Valuing the Tracking Stock

To value the tracking stock, I have to factor in the drains on the cash flows from management expenses and branding investment, as well as the additional risks from not getting a direct claim on the earnings. For the first, I will assume that management expenses will consume 5% of the flow through earnings (as specified in the S-1) and branding investments will account for 15%, leaving 80% of the earnings as residual earnings. While I will assume that all of the residual earnings will be paid out as dividends, Fantex has no history (good or bad) in this respect and I will add an extra 3% to my discount rates to capture my absence of any corporate governance power (over either expenses or dividends). Finally, I will incorporate an additional premium of 3% in my discount rate for illiquidity, since it is unclear to me how I would exit this investment, without bearing significant costs. The value of my claim is illustrated below (with the link to the spreadsheet):

Specifically, I will be willing to pay $6.11/share for the Adrian Foster tracking shares, with my assumptions. There is a conversion feature on these shares, but it can be exercised only by the company to convert these tracking shares into Fantex platform shares; that option will make my claim less valuable, not more so. Consequently, I would not be a buyer at the $10 share price that Fantex has tentatively tagged the shares as worth in the S-1 filing.

Update: In both the Fantex and tracking stock claim valuations above, I did not incorporate the injury probabilities. Since I have an estimated probability that Foster will be playing in future years, I decided to incorporate that probability into the value and not surprisingly, it brings both numbers down:

Note that there is only a 63% chance that Foster will be playing in year 9 and the value of the Fantex claim drops to $8.2 million, giving Foster the clear edge on the deal, and the value per claim drops to $5.07. 

Arian Foster Tracking Shares S-1 filing

My valuation of Fantex claim/ Tracking Stock

Chill, dude (Part II): Debt Default Drama Queens

When I took my first finance class, I was taught that the government bond rate in the currency in question is the risk free rate. Implicit in that teaching was the assumption, misplaced even then, that governments do not default on their local currency borrowings, since they control the printing presses. When confronted with evidence of government defaults in the local currency in prior decades, the defense offered was that these defaults occurred in tumultuous emerging markets but would never happen in developed markets. I took that teaching to heart and for almost three decades used the US Treasury bond unquestioningly as the risk free rate in US dollars. With the government default looming tomorrow, you would think that this would be a moment of reckoning for me, but my faith in governments being default free was lost a while back, in September 2008. For those who do remember that crisis (and it is amazing how quickly we forget), there were two events that month that changed my perceptions of government default. The first occurred on September 17, 2008, where money market funds (supposedly the last haven for truly risk averse investors) broke the buck, essentially reporting that they had lost principal even though they had invested in supposedly risk free, liquid securities. The second happened a week later, when the nominal interest rate on a US treasury bill dropped below zero, an almost unexplainable phenomenon, if you believe that the US government has no default risk. After all, why would investors pay more than a thousand dollars today for a T.Bill for the right to receive a thousand dollars in the future, unless they perceive a chance that they will not be paid?

That last question is the key to understanding default risk. It is not a zero-one proposition, where it shows up only after you have defaulted. If an entity is truly default free, the question of whether there is default risk will never come up, and if it does come up, that entity is not default free. Put in specific terms, I believe that markets have perceived and built in some default risk in the US Treasury since 2008, though it is perhaps small enough to ignore. The issue was crystallized two summers ago, when S&P announced its ratings downgrade for the US, to screams of protest from politicians in DC. At the time, I posted my reaction to the downgrade and advised investors to take it down a notch and that while the downgrade was definitely not good news for any one, it was not the end of the world that it was made out to be. 

Market Assessments of US default risk

To back up my point about how default risk is not a zero one proposition to markets and investors, I will start with a graph of credit default swap spreads for the US on a monthly basis from January 2008 through today. While I have posted about the limitations of the CDS market, it provides a barometer of market views on sovereign default risk that are much more timely than sovereign ratings.

Looking at the chart, it is clear that the crisis is 2008 changed market perceptions of default risk in the United States. The US CDS spread increased from 0.105% in January 2008 to 0.73% in January 2009. While that number dropped back for a while, it started climbing again in late 2010 and the S&P downgrade in August 2011 had little impact on the spread, suggesting that as always, ratings agencies follow markets, rather than lead them. Updating the numbers through this year, the US CDS spread has dropped over the course of the year and the debt default drama has had little impact on that number, suggesting again that while the recent events in Washington may have increased investor concern about default risk, the effect is not as large or as dramatic as it has been made out to be.

If you are concerned that the month to month graph might not be indicating day to day volatility in the market, this graph should set that fear to rest:

Some analysts have pointed at the increase in the T.Bill rate as evidence of market concern about default and there is some basis for that.

The one-month T. Bill rate has climbed from zero in mid-September to 0.35% yesterday. However, note that the US T.Bond rate actually declined over the same period, again indicative that if there is a heightened sense of worry about default with the US Treasury, it is accompanied by a sense that the default will not last for long and will affect short term obligations by more.

Valuation Implications

What are the implications of heightened default risk in government bonds for risky assets? In the immediate aftermath of the 2008 crisis, I worked on a series of what I call my "nightmare" papers, where I took fundamental assumptions we make about markets and examined how corporate finance and valuation practice would have to change, if those assumptions were not true. The very first of those articles was titled, "Into the Abyss: What if nothing is risk free?" and it looked at the feedback effects of  government default into valuation inputs. You can download the paper by clicking here, but I can summarize the effects on equity value into key macro inputs that affect the value of every company:

1. Risk free rate: How will a default or a heightened expectation of default by the US government affect the risk free rate in US dollars? It is tough to tell, but my guess is that the risk free rate in US dollars will decline. That may surprise you, but that may be because you are still equating the US treasury bond rate with the risk free rate in US dollars. Once government default become a clear and present danger, that equivalence no longer holds and the risk free rate in US dollars will have to be computed by subtracting out the default spread for the US from the US treasury bond rate. Thus, just as a what if, assume that there is default and the US T.Bond rate jumps from 2.60% today to 2.75% tomorrow and that your assessment of the default spread for the US (either from a newly assigned lower sovereign rating or the CDS market tomorrow) is 0.25%.

Risk free rate in US dollars = 2.75% - 0.25% = 2.50%

Why do I expect the risk free rate in US dollars to drop? A pure risk free rate is a composite of expected inflation and expected real interest rate, and as I have argued before, reflects expectations of nominal growth in the economy. A default by the US treasury will affect both numbers negatively, since it may tip the economy back into a recession and bring lower inflation with it. In fact, looking back at the daily T.Bond rates and CDS rates over the last month, I tried to break down the T.Bond rate each day into a risk free US $ rate and an estimated default spread. To estimate the latter, I compared the CDS spread each day to the CDS spread of 0.20% on August 31, 2008.

If you go along with my estimates, the US $ risk free rate has dropped from 2.67% to 2.42% over the last 30 days, while the default spread has widened from 0.19% to 0.28%.

2. Equity Risk Premiums and Corporate Default Spreads: Lest you start celebrating the lower risk free rate as good for value, let me bring the other piece of the required return into play. If the default risk in the US is reevaluated upwards, it is also very likely that investors will start demanding higher risk premiums for investing in risky assets (stocks, corporate bonds, real estate). In fact, I think that the absence of a truly risk free alternative makes all risky investments even riskier to investors and that will show up as higher equity risk premiums. The same argument can be applied to the corporate bond market, where default spreads will increase for corporate bonds in every ratings class, as sovereign default risk climbs. To get a measure of how equity risk premiums have behaved over the last month, I can provide my daily estimates of the implied ERP from September 16 to October 16 for the S&P 500.

Note that I have computed the implied ERP over my estimated US$ risk free rate (and not over the US T. Bond rate). You can download the spreadsheet and make the estimates yourself. The net effect on equity will therefore depend upon whether equity risk premiums (ERP will increase by more or less than the risk free rate decreases. If default occurs, the ERP will increase by more than the risk free rate drops, which will have a negative effect on the value of equity. However, that effect will not be uniform, with the negative impact being greater for riskier companies than for safer ones.

The End Game

By the time you read this post, I would not be surprised if Congress has stitched together a last minute compromise to postpone technical default to another day. In a sense, though, it is too late to put the genie back in the bottle and while it is easy to blame political dysfunction for this debt default drama, I think that it is reflective of a much larger macro economic shift. With globalization of both companies and markets, even the largest economies are no longer insulated from big crises and in conjunction with the loss of trust in institutions (governments, central banks) over the last few years, I think we have to face up to the reality that nothing is truly risk free any more. That is the bad news. The good news is that the mechanism for incorporating that shift into valuation and corporate finance exists, is already in use in many emerging market currencies and just has to be extended to developed markets.

When the pieces add up to too much: Micro Dreams and Macro Delusions

A few years ago, my family and I spent two weeks on a summer vacation in San Clemente in Southern California and acquired a new vice. Every afternoon, we would stop at a frozen yogurt (FroYo) store in town and eat astonishingly large portions, secure in our misguided delusion that the “ healthy yogurt” would overcome the sugar and calories in the mix. When we got home to New Jersey, we scoured the neighborhood for FroYo stores and found none close by and only one within five miles. My kids suggested that I quit my day job (since they cannot believe that anyone would pay to hear me talk) and start a new store nearby, pointing to the untapped market potential. I am glad that I did not take them up on the suggestion, because that market gap must have been observed by others as well, some of whom took the next step and opened up stores. Today, my search on Yelp provides a listing of twenty five frozen yogurt stores within five miles of my house, a number far too large for the number of frozen yogurt fans in the neighborhood. As we drive by the sparsely filled stores, it is quite clear that a large number of these stores will not make it through the winter. 

This phenomenon of individual decision makers behaving rationally, given the information they have at the time of their decisions, but creating a collective irrationality is not restricted to frozen yogurt business. In fact, you often see it play out in the valuations of young companies in a market with significant growth potential. In the late 1990s, it was the promise of online retailing riches that drove the market values of dot-com companies to unsustainable heights. In today's market, we see this process repeated at social media companies, where as each new company enters the public market,  the vast potential of online advertising is used to justify a lofty valuation. While each company’s valuation, standing alone, may be defensible, given the market potential, the question that is worth examining is whether the collective valuation of these companies is consistent with the size of the overall market. 

The Online Advertising Market

Before embarking on an assessment of the collective revenues that the market is imputing to online advertising companies, let's start by looking out the market as it exists today. In the figure below, I look at the total advertising market globally, broken down by type in 2011, 2012 and 2013:

Source: Zenith Optimedia

Broken down by geography, I can add to that story:

Source: Zenith Optimedia

The basis for the macro story being told about social media companies is visible in this graph. Advertising is growing as a business, driven by growth in emerging markets, and an increasing proportion of the revenues comes online. The biggest losers are newspapers and magazines, but television and other conventional outlets (radio, cinema & outdoor) have held up surprisingly well under the online assault.  The prediction is that this shift to online advertising will continue into the future, though the rate of growth will slow down as online advertising becomes a larger and larger slice of total advertising. In the table below, I look at expected online advertising revenues (in billions of US dollars) in 2023, with different assumptions about annual growth in the market and the online share of that market.

Thus, in the optimistic scenario for online ad spending, I assume that it continues to gain market share at the same rate as it did between 2011 and 2013 (to get from 19.83% today to 40% in 2023) and that ad spending grows at 4% a year for the next decade and arrive at a value of $303.04 billion in spending on online advertising in 2023.

Imputed Future Revenues in Market Values

To assess what investors are anticipating as expected revenue growth in online advertising companies, I started with the current financials of the company and its revenues and operating income in particular. I then looked at the enterprise values of these companies, computed based upon current market capitalization (market value of equity), debt outstanding and current cash/investment balances.

Enterprise value = Market Capitalization + Debt – Cash and ST investments 

If you are willing to make assumptions about the target operating margin of the company (whether it will be higher, lower or equal to the current margin) a cost of capital for the firm and how much you will need to reinvest to grow (sales to capital ratio, in my model), you can then solve for the imputed revenues that you will need in year 11 (2023) to justify today’s market capitalization. 

To illustrate, consider Google, the biggest player in the online advertising market. Its enterprise value on October 14, 2013 was $240,579 million:

Enterprise value = $291,586 m (Mkt Cap) + $4,989 m (Debt) - $55,996 m (Cash) = $240,579 m

In the most recent twelve months, the company generated a pre-tax operating margin of 22.49% on revenues of $56,594 million. If I attach a cost of capital of 10% to the company’s cash flows, assume that the current operating margin does not change and that the sales to capital ratio will be the industry average of 1.50, I can use the current enterprise value of the company to back into the imputed revenues in year 10:

Thus, with my assumptions, the imputed revenues in 2023 for Google will have to be $168,336 million to justify today's market value. Clearly, if you change my assumptions about operating margin, cost of capital and sales to capital ratio, you will get a different imputed value; decreasing margin & sales to capital ratio and increasing the cost of capital will all push up the imputed revenues in 2023. If you are interested, you can download the spreadsheet which contains Google’s numbers and change the inputs.

I used this spreadsheet, with standardized numbers (cost of capital of 10%, sales to capital ratio of 1.50 and a target operating margin of 25% for most of the companies, to get imputed revenues for all of the publicly traded companies in my social medley list. The table below summarizes the imputed revenues for an incomplete list of companies that derive their revenues from online advertising, with four large non-US companies thrown into the mix.

All of the break even DCFs area available in this folder. It is true that not all of the revenues at each of these companies is from online advertising. Using the most recent annual reports, I estimated the percentage of overall revenues from advertising and backed out the portion of the imputed online advertising revenues keeping that percentage unchanged. If you add up the imputed revenues across companies, the total online advertising revenue across just these companies of $319.2 billion, higher than my estimate of the overall online advertising market in 2023. Note that I erred on the  conservative side in my assumptions to generate lower imputed revenues; shifting to a 12% cost of capital for all companies increases imputed revenues in 2023 to over $400 billion, as does using a target operating margin of 20%. Given that there are other online advertisers that have not been counted in this list, that there are a whole host of private companies like Pinterest and Snapchat waiting in the wings, ready to go public, and still more brewing in the fertile imaginations of creative people somewhere, it is safe to say that the market collectively has a macro problem that is difficult to explain away.

Implications

1. Social media companies are collectively over valued: As in other young sector booms - PC companies in the 1980s, dot-com companies in the 1990s - the market seems to be getting the macro story right but the micro valuations wrong. Diversification as a strategy may be a good one in sectors where the law of large numbers work in your favor, but not in sectors like social media, where you have "bias upwards" in the valuations. A social media ETF may be a good momentum play but it is unlikely to be a good investment.
2. One or two of them will be the winners over the next decade: If you are an investor with a social media company in your portfolio, is that investment doomed? Not necessarily, because while these companies may be collectively over valued, there will be winners among these companies that will emerge as the sector matures. Using the dot-com sector as the template again, an investor in Amazon even at the peak of the boom in January 2000 would have little to complain about today. The key to investment success in this sector then becomes tagging the winners early in the process. While Google and Facebook are the early leaders in this race, those standings will change as technology and customer behavior change over time.
3. The valuations may be put at risk if entry into this business is “easy”: The PC business from the 1980s should offer a cautionary note for investors who assume that a market that is growing fast will also deliver high value to investors in companies in that  market. If the barriers to entry are low, you can have high revenue growth in conjunction with low margins and little value creation.  

What can investors do?

1. Less macro story telling: As investors, we should be wary of story tellers, who use the same macro argument (the online ad market is getting bigger, there are a billion people in China) to justify one company valuation after another. Stories are a useful starting point but they have to be linked to specifics.
2. Longer time horizons: While I understand the desire of analysts to frame their assessment of companies around the near term (next quarter’s earnings, next year’s revenues), you have to attempt to look at where the firm will end up over the long term. (I use ten years, but it does not have to be that long). It is tough to introduce any macro discipline in your thinking with short time horizons. 
3. Winner and Losers: If we start off with the presumption that the pie, defined broadly (as advertising and not online advertising), is limited, high revenue growth for one company often has to come from competitors and it behooves us to be explicit about winners and losers. For instance, in my Twitter valuation, where I estimate revenues will grow from $448 million right now to $11 billion in 2023, I should have tried to explain how much of this additional revenue will come from old-world media (newspapers, magazines, cinema), how much from other online advertisers (Google, Facebook) and how much from growth in the market. 
4. Transparency: While revenue growth and operating margins are both critical inputs into valuation, they are interconnected and often require that you look at trade offs. Thus, going for higher revenue growth will generally mean lower operating margins and the net effect can be positive or negative.

It is easy to develop tunnel vision when valuing companies and forget that the rest of the world does not remain static, while the company being valued plots its path to success. Unless we consciously step back and look at the big picture, we will continue to create micro valuations that don't up aggregate to create viable macro environments.