Go Pro: Camera or Smartphone? Social Media or Electronics? Price or Value?

My sixteen-year old, a sophomore in high school, joined the investment club at school a couple of weeks ago, and entered a stock-picking competition. Club members invest in a stock or stocks of their choice, with the winner chosen in about five weeks, based upon price appreciation. Thinking I would have some sage advice on where to invest his money, he asked me for some stock picks and I almost suggested that he put all his money in GoPro, a choice that is clearly at odds with the prudent investing practices of diversification and perhaps with conventional value investing precepts. While GoPro is not the investment I would recommend for my son as his Roth IRA investment (with real long money and a long time horizon), in a game with a five-week window, where the winner takes all, momentum will beat out intrinsic value and diversification will be more hindrance than help. (Note that momentum fairy was in GoPro's corner at the time, and has taken a break in recent days.)  In this post, I take a look at GoPro, perhaps the hottest stock of the year,  with the intent of not only understanding its intrinsic value (and drivers) but to make sense of the pricing game.

The Back Story

For those of you who are not familiar with the company, GoPro makes cameras that you can attach to yourself and record video of your activities. While that might not seem exceptional, it is designed for high-energy physical activities, including running, rock climbing, swimming or hunting. You can get a measure of the company’s current offerings on its website. They include three models of the camera (the Hero, the Hero 3 and the Hero 4), numerous accessories and two free software products (a GoPro App and GoPro Studio) to convert the recorded videos into watchable ones. The company believes that the creators of videos will share them, not only with their friends, but also with the general public. In its most recent earnings report, it noted that GoPro videos published on YouTube had increased 200% over the previous year, launched a GoPro channel on Pinterest to attract more attention to the videos and one for the Microsoft Xbox. 

The company’s cameras have found a ready market, with revenues hitting $986 million in 2013 and increasing to $1,033 million in the twelve months ending in June 2014. In spite of large investments in R&D ($108 million in the trailing twelve months), the company still managed to be profitable, with operating income of $70 million in that period. Capitalizing R&D increases their pre-tax operating margin to 13.43%, impressive for a young company. The figure below looks at the evolution of revenues and units sold  over the history of the company. (You can download the company's prospectus and its only 10Q.)

GoPro has been a stock on fire since its initial public offering on June 26, jumping 30% on its offering date (from $24 to $31.44) and continuing its rise to $94 on October 7, before falling back to $78 on October 14 (the day I started the valuation) and to $70 today (October 15).

The stock has accumulated a large number of vocal short-sellers, who are convinced that this is a high flyer destined for a fall, and many of them have been burnt in the price run-up, a fact alluded to in this Wall Street Journal article about the company.

An Intrinsic Valuation

In valuing GoPro, we face all of the typical challenges associated with valuing a company, with growth possibilities, early in its life cycle, in determining the market potential and imminent competition. 

1. Potential Market

GoPro is nominally a camera company but I will argue that it caters to a different market. To get a measure of the potential market for GoPro's products, I will make my argument in three steps:

1. The conventional camera market is under threat from smart phones, and its share of the camera market has been shrinking over the last few years and there is little hope that it will stop doing so in the future.

   

   Source: CIPA

2. The camera market is changing and expanding. The entry of smart phone cameras has not only taken away market share from conventional camera companies but has changed the market by attracting new users into the market. These new customers, who are mostly uninterested in conventional cameras (and recording images and videos for family albums), are being drawn into this market, by their desire to record and post photos/videos on social media sites. That trend will continue into the future and I believe that the camera market will become a subset of the smart phone market. The good news is that the smartphone market is huge, estimated to be $355 billion in 2014, larger than the entire electronics market ($340 billion) in 2014. The bad news is that most of the consumers in this market will be satisfied with the cameras on their cell phones and will be unwilling to spend money on an expensive accessory, unless it serves a very specific need. 
   
   

   

   Source: IC Insights

3. The action camera market will be a subset of the smartphone market and its customers will be those who are physically active people who also happen to be active on social media (over active, over sharers). To make an estimate of how many consumers are in this market, I used the CDC's statistic that about 22% of Americans are physically active. Generalizing (and globalizing) this statistic to the smartphone market yields a potential market that is about $80 billion in 2014 (22% of $355 billion). That is likely to be an over estimate, since not all physically active people are "sharers" on social media. According to this survey, about 31% of adults post videos on their social media site and it has both increased over time and is higher among younger adults (ages 18 through 29), 40% of whom post videos. Using the latter statistic, the overall market for action cameras is $31 billion (in 2013), estimated as 40% of $80 billion. Applying a 5% growth rate on this market yields a potential market of $51 billion in 2023. The picture below captures the sequence of assumptions that yields this number:

2. Market Share & Profit Margins

The market share and target profit margin that we assess for GoPro will be a function of the potential market that we see for it and the competition in that market. If we define it as the camera market, the competition is already intense and dominated by Japanese manufacturers:

If we define it, as I think we should, as the subset of the smartphone accessory market that wants active cameras (the $51 billion market in 2023 identified in the last section), GoPro is the first mover in the market and has more growth potential (both because the market is growing and it has relatively few competitors, for the moment).

To gauge the expected market share that GoPro can get of this market, it is worth noting that while it initially had the action-camera market to itself, the competition is starting to take form from upstarts, established camera makers and from some smartphone manufacturers. Even if GoPro can establish a brand name advantage (by being the first one on the market), I don’t see any potential networking advantages that GoPro can bring to this process that will allow it, even if successful, to control a dominant share of this market, as the market gets bigger. Drawing from the established camera business market shares, I will assign a market share of 20% (resulting in revenues of about $10 billion for GoPro in 2023, i.e., 20% of $51 billion) , roughly similar to the 20% market share for Nikon, the leading camera maker, of the camera market in 2013. (I am not drawing a direct parallel between Nikon and GoPro, but I am arguing the market share breakdown of the action camera market is going to resemble the market share breakdown of the conventional camera market).

On the profit margin, GoPro’s first mover advantage has given it a headstart in this market, allowing it to charge premium prices and earn a pre-tax operating margin of 12.5%. This is slightly lower than the margin (13.43%) posted by the company in the most recent 12 months, but the trend lines in margins for the company are decidedly negative:

This estimate (12.5%) of the pre-tax operating margin is significantly higher than the 6%-7.5% margin reported by camera companies and similar to the 10%-15% margin reported by smartphone companies; Apple remains an outlier with its pre-tax margin in excess of 25%.  I am, in effect, assuming that GoPro will preserve its premium pricing, even in the face of competition.

3. Investment Needs

While GoPro users may post to social media sites, GoPro is not a social media company when it comes to investment needs. While social media companies like Facebook, Twitter and Linkedin generate their revenues in advertising and have little need for tangible investment, GoPro will need to invest in manufacturing capacity to produce and sell more cameras. To estimate the reinvestment needs, I made the assumption that the company will have to invest $1 for every $2 in additional revenues generated in years 1-10. This, in turn, will move the return on capital for the company from it's current stratospheric levels to about 16% in year 10.

4. Risk

GoPro has a social media focus for its user-generated videos, but the company currently generates all of its revenues from selling cameras and accessories. There is the real possibility, though, that the user-generated videos may have entertainment value, which, in turn, could lead to other revenue sources (advertising on GoPro's YouTube channel or a dedicated media outlet for GoPro videos, for instance). That does seem a little far fetched at the moment and we will assume that GoPro's risk will resemble the risk of high-end electronics companies. To estimate a cost of capital for GoPro, I consider their current mix of debt and equity (2.2% debt, 97.8% equity) as my starting point, and estimate a cost of capital of 8.36% for the company, declining to 8% by year 10 (with both reflecting the fact that the US 10-year bond rate dropped to 2% on October 14). This may strike you as low, but much of the risk in GoPro is specific to the company and its market and is thus not reflected in the cost of capital.

5. Possibilities
GoPro's focus on creating partnerships with Xbox and Pinterest suggest that it sees the possibility of generating revenues from becoming a media company (with the videos created by its customers as content). At the moment, using a contrast I drew earlier in my post on Uber, this is more in the realm of the possible than the plausible or the probable. If the value per share that we obtain is just a tad below the market price, this possibility may be sufficient to tilt the scale towards buying but it cannot account for a large chunk of the value today.

6. Valuation

With this spectrum of choices on the inputs (revenue growth derived from the total market/market share assumptions, operating margin, sales to capital and cost of capital), it is perhaps more realistic to assess the value of GoPro as a distribution than as a single estimate of value.

Reading this distribution, you can see while the expected value across the simulations is only $33-32/share, well below the market price of $70, there are outcomes that deliver values higher than the market price. Put differently, while I think that the company is over valued, there are pathways to values higher than $70. They will require GoPro to (a) expand the market for cameras to new users (physically active, over sharers) (b) find a strong, sustainable competitive advantage over its imminent competition, perhaps with a networking edge (giving it higher market share) and (c) preserve its premium pricing edge. 
(You can download the base case valuation by clicking here)

A Pricing of GoPro

In keeping with my argument that much of what passes for valuation in practice is really pricing, let me make the pricing case for GoPro. To price a company, there are two fundamental questions that have to be addressed: who (or what companies) you are pricing your company against and what metric (revenues, book value, earnings etc), you will use in the comparison.

The essence of pricing is that you use the market pricing of comparable assets/firms to determine a fair price for your asset/company. There is, however, a subjective component to determining these comparable investments, and that comes into play with a company like GoPro, with the following possible choices.

1. Existing camera manufacturers, some of whom (Sony and Panasonic) are much bigger players in the electronics market. (Sample of ten companies, all of them Japanese)
2. Leisure product manufacturers, which includes a diverse group of companies that manufacture  gym equipment (Life Time Fitness), golf clubs (Callaway Golf) and bicycles (Cannondale), on the rationale that these appeal to the same physically active market as GoPro does. (138 global companies)
3. Electronics companies, which includes all consumer electronics companies listed globally. (103 global companies)
4. Social media companies, which includes a broad mix of businesses some of which derive their revenues from advertising (Facebook, Twitter), some from subscription-based models (Netflix) and some from a combination (LinkedIn). (13 social media companies)

Stock prices cannot be compared across companies, since they are a function of the number of shares outstanding. Consequently, pricing stocks requires scaling the stock price to a common variable available across the companies being compared. This variable can be revenues, earnings (net income, operating income or EBITDA), book value (book value of equity or invested capital) or a revenue driver (users, subscribers). 

Bringing together these choices, we can compare GoPro's pricing with that of comparable companies, using different comparable company groups and pricing metrics:

Based on market prices on 10/15/14 & trailing 12-month data

This is a simplistic comparison, where I have used the median values for the sectors involved and not controlled for differences in fundamentals (growth, risk and cash flows) across companies. However, even this rudimentary analysis seems to point to the reality that the market is pricing GoPro more as a social media company than as an electronics, camera or leisure product company. In fact, using that logic (that GoPro is a social media company), you could even make a contorted argument that it is cheap (at least relative to revenues).

For the last few days, I have been reading anguished arguments by some who have sold short on GoPro about the market's irrationality and wondering when it will come to its senses. Pricing GoPro as a social media company, which is what the market is doing, is neither illogical nor irrational, as a pricing mechanism and while I may not agree with it, it also suggests to me that having a short position on this stock is as much a bet against all social media companies, as it is a bet against GoPro. 

Summing up

It is difficult, but not impossible, to justify buying GoPro on an intrinsic value basis. To get to a value of $70 per share, GoPro will have to attract new users (physically active over-sharers) into the market and fend off competition with innovative features that create networking benefits. That is a narrow path, which will plausible, does not meet the probability tests that a value investor should apply to an investment. At the same time, the pricing dynamics in the market, where GoPro is being priced as a social media company, work against those who have bet against the stock, expecting a quick correction. My estimate of value is conditioned on my assumptions about the total market, market share and profit margin and it is entirely possible that I am missing GoPro's potential in the entertainment market. Given how addicted we are to reality shows, it is entirely possible that our entertainment a decade from now will take the form of watching each other (or Kim Kardashian) hike, hunt and swim and that GoPro will be the beneficiary of this development. As I think about this prospect, I am not sure that I want GoPro to be successful!

Attachments:

1. GoPro Prospectus
2. GoPro 10Q (June 31, 2014)
3. GoPro Intrinsic Valuation (Base Case)
4. GoPro Simulation Assumptions and Valuation Output
5. GoPro Comparables (Peer Pricing)