Wednesday, February 26, 2014

If we don't do it, our competitors will! Defensive Dealmaking or Panicky Preemption?

My last post on Facebook’s acquisition of Whatsapp brought a whole host of responses, some of which took issue with my argument that it is easier to explain the deal using pricing metrics, especially ones that are used in the social media sector (# users) than with valuation models or logic. One of the arguments made by some of the commenters was that I was missing the real reason for the deal, which was that it was a defensive maneuver by Facebook, designed to both protect its profitability and to keep a prime competitor (Google) from acquiring Whatsapp. Many of these commenters also emphasized that these defensive deals cannot be assessed using conventional valuation techniques and that we have to trust management to make the right judgments on them. I don't have a bone to pick with the logic of defensive deal making, but as a valuation person, I don't agree with the claim that defensive deals cannot be valued. If preemption is the primary rationale behind an action, I believe that it not only can be valued but it should be valued. 

A Valuation View of Preemptive Actions
If you adopt a stilted  view of valuation models (and DCF, in particular), it is possible that preemptive actions cannot be valued. However, I would argue that conventional discounted cash flow models provide more than enough flexibility to value preemption in all of its forms. To illustrate, let me set up a simple example. Let’s assume that Company A has $10 million in after-tax income (and cash flow) that it expects to generate in perpetuity on invested capital of $50 million and that it has a cost of capital of 10%. This company can be valued as a standalone entity at $100 million.
Value of company (stand alone) = $10/.10 = $100 million
Now, assume that this company is faced with Company B, a young company that has a product that has no revenues right now, but if allowed to develop or in the hands of a competitor, could eat into Company A’s market and lower its after-tax cash income to $ 6 million. Even though company B has little income potential on its own, company A should be willing to pay up to $40 million to acquire it.
Value of preemption = Lost after-tax CF/ Cost of capital = (10-6)/.10 = $40 million

I know that you are looking at this example and arguing that it is far too simplistic to be used to explain Facebook’s acquisition of Whatsapp. While estimating the cash flows may be more complex with Facebook, you are, in effect, making the same argument. In fact, working through my discounted cash flow valuation of Facebook, I can work out the impact of that a potential competitor will have on the company's revenue/margins and the value of those cash flows, and by extension, how much Facebook should be willing to pay to remove that competitor from the game.

The table, while looking at a wide range of outcomes, does provide some interesting insights into Facebook's vulnerabilities. First, the company's value is far more sensitive to margin erosion than it is to revenue loss, partly because the company has astounding high pre-tax operating margins (about 50%). Second, there are clearly combinations of revenue decline/margin drop that yield values greater than $19 billion. Note that this number will not be the total value of Whatsapp because it does not include the direct income and cash flows that you can generate from Whatsapp's business. You are welcome to try your hand on my spreadsheet that builds off the Facebook base case valuation to compute the effect on value of declining revenues and dropping margins.

Defensive Value Creation: Necessary & Sufficient Conditions
While it is easy to construct discounted cash flow valuations to justify acts of preemption, there are four conditions that have to be met for preemptive spending  to be justified.
  1. The business you are defending is worth defending: Acting in defense of a business makes sense only if that business is a good one, and the measure of a good business is whether it generates returns on invested capital that exceed the cost of funding that business. If you own or run a bad business, spending money to defend that business strikes me as a pointless and expensive exercise. Lest this sounds like a weak precondition, note that by my calculations in 2013, about 60% of all listed companies (40,000+) globally generated returns that were below their costs of capital, and more than a third of them under performed by substantial margins (>5%).

  2. The threat is real, not imaginary: Spending preemptively to ward off a threat makes sense only if the revenue loss/ margin decline that is anticipated is real and is not just in the fevered imagination of the top management. While you can argue that this is a business judgment that should be left to the top managers of a firm, a paranoid CEO, egged on by “strategic” consultants and aided and abetted by bankers, eager to get the deal done, will find a hundred potential threats for every real one.
  3. The preemptive action is the most efficient (and cheapest) way to ward off the threat: Even if the threat is to a valuable business and is imminent, there may be less expensive and simpler ways to deal with the the threat then the chosen action. Thus, if you can acquire a technology from a company or exclusive licensing rights for a billion, you should not be spending $10 billion to buy the whole company.
  4.  The threat is unique and not easily recreated: Spending money to eliminate a potential threat makes sense only if the threat is unique and not replicated easily/quickly. If the threat can be replicated easily, the spending company will find itself repeatedly spending larger and larger amounts of its depleting stock to make subsequent threats go away. These are companies with fragile business models with shallow ditches rather than competitive moats separating them from mediocrity.
The question on the Facebook/Whatsapp deal is whether these conditions are met. As I see it, the first condition is easily met since Facebook clearly has a very profitable (and high return) business to defend. On the second and third, Facebook investors are, in effect, trusting Mark Zuckerberg's judgment that Whatsapp is a platform that may threaten Facebook's profitability and that buying out the company for $19 billion is the cheapest way to avoid that threat. It can be argued that he has earned their trust with the company's performance over the last two years.  It is the fourth condition that should be most worrisome to Facebook investors. While Whatsapp may be a truly unique platform, the price tag on this deal is sure to entice young programmers, huddled around tables in Mumbai, Moscow and Menlo Park, to come up with new ways to breach Facebook defenses, knowing that they too will become wealthy beyond their wildest dreams, if they succeed. Looking at Facebook's short history, the price of preemption seems to be escalating at an exponential rate, going from $1 billion for Instagram more than a year ago to $ 3 billion for an attempted (and failed) acquisition of Snapchat to $19 billion for Whatsapp. (I know... I know.... There might have been other motives for the Instagram and Snapchat acquisition bids, but the price tag is climbing).

The Preemptive Strategic Stupidity (PSS) Syndrome
For every company that comes out ahead, in terms of value, with a preemptive strike, there are probably a dozen that end up worse off, often because they have bought into three adages that we accept as conventional wisdom. One is that companies have to do whatever they need to do to survive, as if survival is the be all and end all of business. The second is that doing nothing is not an option or that it is always the worst option. The third is that if you don't act, your competitors will and that their actions will hurt you more, even if those actions are not sensible. At the risk of getting some blowback from readers, here are my adaptations of these adages:
  1.  Survival is not the end game: As I have noted in my prior posts, there is no glory in growth for the sake of growth or business survival for the sake of survival. A business is a commercial enterprise and if you cannot generate sufficient returns, given the risk you face and the capital you have invested, you should shut the business down. 
  2. Doing nothing is not only an option but it may sometimes be a better one than doing something: We live in a world where activity is not only prized more than inactivity, but one in which there is far more money to be made by people from promoting activity (consultants, bankers) than from promoting inactivity. At the risk of sounding like stodgy, I believe that it is better sometimes to do nothing instead of doing something, especially if that something is ill advised or expensive.
  3. If your competitors are planning on doing something stupid, let them do it: If your competitors want to overpay for companies or take investments that generate substandard returns, your best option is often to let them do it. Especially with acquisitions, the winners of the deal making contest are not necessarily winning for their stockholders:
    This graph looks at winners and losers in multiple-bidder acquisitions and looks at the returns that investors would have made in the 40 months after the deal is done. The stock price, on average, declines by about 35% in the deal winners and increases by 25% in the deal losers in that period. 
Wrapping up
Companies often justify paying too much on acquisitions or making bad investments by using the preemption argument: if we don't do it, we will be hurt more than if we do. While that argument sometimes has economic merit, it deserves to be scrutinized just as much as any other investment decision. The tools for assessing the financial impact of these decisions not only exist but are straightforward. It is the will to make the assessment that is lacking at most businesses.

While I have framed this post in terms of the Facebook/Whatsapp deal, I continue to believe what I said in my first post. I don't think that Facebook's management is doing this deal for defensive reasons or because they have explicit plans for generating value, at least as of now. It is Whatsapp's large, growing and engaged user base that makes it so attractive to Facebook, especially given how much the market is pricing all of those factors. You may find it difficult to believe that someone as smart as Mark Zuckerberg would pay $19 billion without a clear vision of how he plans to make money off the deal, but I don't. 


UniverseofRisks said...

My limited intuition is telling me that this deal is all about expanding Facebook's moat. Facebook is a colossal social index and was not designed with monetization in mind. Adding 400 million (and growing) phone numbers and contact lists can only expand the moat. Facebook might also be going for the network effect trying to make it difficult for people to abandon it. Monetization of watsapp users can come later.

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Arjun Narayan said...

Dear Professor Damodaran,

Excellent post on why the defensive moat theory doesn't hold up. I share your skepticism about point 4 (uniqueness of threat). It does not seem to be the case in the mobile sector due to the fact that the social network moat can be rapidly built up from phone contacts. This shows that in the mobile sector, the moat that is the social network is easier to breach than on desktops.
Witness how fast Snapchat, and now Telegram, have grown through using phone contacts.

I think one non-valuation point that you haven't addressed is the fact that Facebook's dual-class ownership structure biases it towards empire building. Matt Yglesias has a good article on this topic:

I know that thesis falls outside the scope of valuation, but if we're trying to generate an explanatory model for why Facebook splurged on this purchase, and cannot find a solid one on valuation grounds (both defensive and offensive), then that one makes the most sense.

Anonymous said...

Hi, professor!

I’m a huge fan. I watched your MBA valuation classes and read your blog regularly. I understand you teach that stable growth should be equal to or smaller than GDP growth.

Smaller would make sense because young companies have high growth and, thus, stable companies would have a smaller growth to compensate for that.

The young companies that prosper have a lot of growth, but most young companies fail, and so the growth for those failures is negative.

I wonder if the collective effect of young companies on growth (including the failures) is truly above GDP growth. Is there an explanation or hard data that could make me better understand this relationship? (maybe this make for a future post)

Congratulations on your awesome work!

Unknown said...

Growth for the sake of growth is called cancer. Maybe Zuckerberg should watch your youtube videos.

Thanks for another post, I am a huge fan.

Yoav Saffar said...

Professor, what about the possibility that Facebook believes that its shares are overvalued, yet on a proportional basis, Whatsapp worth about tenth or more of Facebook?

That's probably the reason the deal was done 80% equity 20% cash?

I didn't see someone tackling this transaction from this angle yet

Would love to have your thoughts on that, since in prior work you've done, you also claim Facebook is way overvalued at current levels.


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Unknown said...

good article with multiple number of ideas.good to read

Anonymous said...

@Yoav Saffar: The prof addressed that on his previous post - check it out

Arinjay said...

Excellent analysis Professor

Unknown said...

Excellent analysis Professor !

Anonymous said...

what about current value of Facebook, if we believe that 19B (or less) properly values the threat to Facebook; I mean, the threat is already in place - is it in the price or not ?

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Anonymous said...

Prof, in the facebookWhatsapp spreadsheet, on Input Sheet, the numbers you used for the options represent the balance as of Dec 30 2012, instead of 2013. Is there a reason for this?

Should it be 22.1m options outstanding at an average strike price of $3.56? Or am I missing something?


Anonymous said...

I dont think this preemptive acquisition is a sound valuation argument, especially for listed companies. The reason is simple - investors can swap your stock with any of your competitor's. The board must've been sleeping.

Anonymous said...

The board is borderline useless since Zuckerberg has complete voting power. I think he may replace the entire board whenever he pleases, so what they think it's pretty much irrelevant for the most part.

It's hard to imagining a board member at FB voicing dissent over anything

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One would expect that at a minimum very basic arbitrage opportunities do not exist in integrated financial markets.


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