Thursday, June 28, 2018

Twists and Turns in the Tesla Story : A Boring, Boneheaded Update!

There are lots of complaints that you can have about Tesla, but being boring is not one of them. It helps to have a CEO who seems to find new ways to make himself newsworthy, in good and bad ways. In fact, if Tesla were a reality show, the twists and turns in its fate would give it sky-high ratings and put the Kardashians to shame. Consequently, it should comes as no surprise that there is no other company where investors disagree more about the future than Tesla, with bulls finding new reasons for pushing it price up and short sellers picking the stock as their favorite, albeit elusive, target

Tracing my Tesla Past
I am often tabbed as a Tesla bear, and while I have never found it to be an attractive investment, I have admired the company, and by extension, Elon Musk, for shaking up the auto business. In my first valuation of Tesla in September 2013, I valued it as a luxury car company that would require large cash infusions to get to steady state. Factoring in the resulting negative cash flows and failure risk, the value per share that I obtained was well below the market price then. In the years since, I have revisited the company many times, and what I have learned about the stock has led me to to call it the ultimate story stock, which is how I described it in a post in 2016, explaining both its price volatility and its capacity to weather bad news. I also argued in that post that investors in Tesla were investing in Elon Musk, not the company, with the company reflecting his strengths, a surplus of vision and out-of-the-box thinking, and his weaknesses, which include an unwillingness to pay attention to operating details and financial first principles in running the company.

While Tesla's consistent failure to deliver on production targets over its lifetime is well documented, its failure to heed financial first principles may be even more damaging to it in the long term, as evidenced in at least two major decisions that the company has made in the last two years.
1. The acquisition of Solar City: In acquiring Solar City, a company where Musk was a lead stockholder and his cousin was CEO, Tesla had to not only overcome the perception of conflicts of interest, but it acquired a company with negative cash flows in a rapidly commoditizing business, not a great fit for a company that had its own cash flow problems.
2. The turn to debt: Tesla's decision to borrow more than $5 billion in September 2017 to fund its capital needs, was almost incomprehensible, given Tesla's standing at the time. As I noted in a post at that time, there was no good reason that could be offered for that borrowing, since none of the usual arguments for debt applied.
  • Tesla gets no tax benefits from debt: When a company is losing money, as Tesla was in 2017, there are no tax benefits to borrowing money, and to the argument that they might make money in the future, the response is that it then best to wait until then to borrow money. Borrowing money in anticipation of future profits is not just stupid, but it is dangerous.
  • Tesla has easy access to equity capital: It is true that Tesla needed capital to build up its production capacity, especially given its promise to deliver hundreds of thousands of Tesla 3s in 2018, but it is also true that the best way to raise this capital for a company with negative earnings and cash flows and significant growth potential is to use equity, not debt. To the counter that this will cause dilution, it is better to have a diluted share in a much valuable company than a concentrated share of a defaulted entity.
  • Musk's control of Tesla is absolute: There is the possibility that the debt issue was motivated by Elon Musk's desire to keep control of Tesla, but given his exalted status with shareholders and a rubber stamp board of directors, I see very little threat to his absolute control from issuing more shares in the company.
In sum, the Solar City acquisition was ill-advised in 2016, and there were no good reasons for the Tesla debt issue in September 2017, suggesting either that the company does not have a functioning CFO in Deepak Ahuja or that Elon Musk is taking on that role as well.

Tesla: News and Data Updates
As I said at the start of this post, the Tesla story is never a dull one and the last few months has brought that lesson home. Not only have their been multiple news stories about the company, but Elon Musk has outdone himself as a newsmaker:
  1. Financial filings: There have been three quarterly filings since my last valuation of Tesla and the company has only made the hole it is in, as a result of its operating losses, worse by adding debt to the mix. The chart below captures the trend lines in revenues, operating income and net income for the company on a quarter-by-quarter basis:
    Looking at the last three quarterly reports delivered since my last valuation of Tesla, there is little that would lead me to radically reassess what I think about the company. The good news is that revenues continue to grow but the bad news is that losses are growing proportionately, since there is no improvement in margins. Backing up the point made in the last section about the debt issue, Tesla's borrowing has made the hole that the company is in much deeper.
  2. Earnings Call: Earnings calls are normally staid affairs, where top managers stick to the script and analysts dance with them, asking questions about operations and seeking guidance on future growth. The Tesla earnings call after the most recent earnings report certainly did not fit this script, since Elon Musk, a few minutes into the call, blew up at at Toni Sacconaghi, a Sanford Bernstein analyst, calling his question about future capital needs "boring and boneheaded". He then proceeded to stop taking questions from analysts entirely and answered only questions posed by investors gathered by a recent YouTube start-up. While the market reaction to the bizarre earnings call was negative, with the stock dropping 5.5%, the stock, as it has so many times before, recovered in the weeks after and climbed to close to all-time highs.
  3. Other News: In the weeks after the earnings call, Musk has added to the news stories with more announcements, many of them taking the form of tweets. First, he announced that given Tesla's financial constraints, the company would focus. at least for the next few months, on turning out the higher priced version of the Tesla 3, priced at $75,000 rather than the $35,000 base price that he had announced as part of the original rollout. His reasons for doing so, i.e., that shipping the lower cost model would cause Tesla to "lose money and die" suggest that the lower priced version may not be viable in the long term. Second, he also announced that Tesla would lay off 9% of its employees, mostly from the Solar City portion of the company, explaining that the company needed to move towards sustained profitability. 
The need to become "profitable" is one of two constraints that Musk has added to the company's objective, with the other being that the company will be "cash flow positive" by the third quarter. In fact, Musk has been categorical that Tesla will not need to raise capital to cover its investment needs in the near future, in response to stories in the press that Tesla would need to raise between billions to cover its growth plans. In fact, much of Tesla's focus seems to be on delivering one part of a long-standing promise, which is manufacturing 5000 cars from its assembly lines each week, a meager number for most auto makers but driving decision making at Tesla. It is in pursuit of this goal that Tesla has augmented its Fremont plant with additional tented assembly lines, Musk has been "sleeping on the factory floor" and at least partly pulled back on its plan to replace workers with robots.

Tesla's Value Drivers
No matter what your story is for Tesla, the value of Tesla is determined by four big drivers and to help in construction your story, it is worth looking at background:
  1. Revenue Growth: In the trailing twelve months, ending March 2018, Tesla had revenues of about $12.5 billion and to justify the market capitalization at which the company trades at currently, these revenues have to grow significantly. To get perspective on how large revenues can become, I looked at the twenty largest auto companies in the world, ranked based upon trailing revenues:
    Note that most of the companies on this list are mass market auto companies, with Daimler (arguably) and BMW being the only exceptions. Put differently, the question of whether Tesla will be able to deliver on a $35,000 Tesla 3, now or in the future, becomes central to estimating revenue growth.
  2. Operating Margin: No matter how you slice it, Tesla is losing money, and it happens to operate in a sector where profit margins have been under pressure for a while, driven partly by competition and partly by changes in the business itself. In the chart below, I have a distribution of operating margins for global auto companies in June 2018:
    Global Auto Data
    Note that the median pre-tax operating  margin for auto companies is only 4.81%, with double digit operating margins putting you at the 80th percentile of all auto companies. It is also worth noting that among the ten largest auto companies, there is not a single one that generates an operating margin higher than 10%; BMW has the highest margin, at 9.89%.
  3. Reinvestment: Scaling up revenues will require significant reinvestment, especially in the auto business. One simple measure of this reinvestment is the sales to invested capital ratio, measuring how much revenue a dollar in invested capital generates. Looking at this measure across the global auto business, here is what I see:
    Note that the global auto business is capital intensive, with a dollar in capital invested generating only $1.29 in revenue at the median firm, and that Tesla, over its history, has been even more capital intensive, generating less revenue per dollar invested than the typical auto firm, with capital intensity increasing after the Solar City acquisition. Tesla's counter to this has  been that by bringing in technology into assembly lines, they will become more efficient than other auto companies, but that argument has lost some of its luster after the last few months, with Musk openly admitting that the robots that Tesla had hoped to put on the factory floor were not doing their jobs. 
  4. Risk: There are two dimensions through which risk affects Tesla's value. The first is the cost of capital, which reflects the operating risk at the company. As an auto company, Tesla is exposed to economic cycles and its cost of capital will reflect that risk:
    Global Auto Data
    The second is the risk of failure and distress, and while being a small, money-losing company is one reason for exposure, Tesla has magnified its risk by borrowing billions of dollars. 
Possible, Plausible and Probable Tesla Stories
I have long argued that every valuation tells a story and that one way to check your valuation is to check to pass your story through the 3P test: Is it possible? Is it plausible? Is it probable? If this sounds like a play on words, note that each test sets a higher standard than the previous one. There are lots of possible stories, a subset of plausible stories and an even smaller set of probable stories. 

Tesla is a stock where there are widely divergent stories, with bullish investors telling big stories with happy endings, that deliver large values for the company, and bearish investors pushing much smaller stories, some with bad endings. In this section, I will start by offering some solace for Tesla bulls by looking at a plausible story that delivers a value greater than the current stock price, then argue that Elon Musk's story for the company, or at least the version that he is telling right now,  is an impossible story and close with my (still upbeat) story for the stock and resulting value.

Getting to $400/share: A Plausible Story?
Is it plausible that Tesla, notwithstanding all of the troubles weighing it down, is under valued, at its current stock price of $340/share? Yes, but only it can put together the following results:
  1. Increase revenues ten-fold over the next decade: Tesla's current revenues of $12.5 billion will have to increase to $120 billion or more in the next ten years, giving it revenues close to those of BMW today. Assuming an average car price of $60,000, that would translate into 2 million cars sold in year 10, illustrating why the focus on whether Tesla can hit its target of 5,000 cars a week is missing the big picture.
  2. Improve operating margins to match the most profitable auto companies: While Tesla scales up its revenues, it will not only have to become profitable (a minimal requirement) but much more so than the typical auto company. In fact, its pre-tax operating margin will climb to 12%, well above the median auto margin of 4.81% or BMW's 9.89%, powered by brand name and pricing power.
  3. Invest more efficiently than the sector: To accomplish its objectives of increasing revenues and ramping up profitability, Tesla will have to reinvest and reinvest efficiently, delivering about $2.25 in revenues for every dollar of capital invested, much higher than than the typical auto firm. To provide perspective, Tesla in year 10 will have to deliver BMW-like revenues ($120 billion) with about a third of BMW's invested capital; with the estimated sales to capital ratio, Tesla's invested capital in year 10 will be $64 billion, whereas BMW's invested capital in 2018 was $185 billion).
  4. Navigate its way through debt to safety: Finally, as it moves towards becoming a much larger, more profitable firm, Tesla will also have to meet its commitments on current debt and not add to the mix, at least for the near term. In terms of operating risk, Tesla will have to face a cost of capital of 8.29%, in line with the typical auto firm.
Download spreadsheet
With these assumptions in place, the value that I get per share is $412, but as you can see from the assumptions, it would be the equivalent of a Royal Flush in poker. Note also that in this optimistic story, Tesla will have to have to raise $14 billion in fresh capital over the next few years and will not become operating cash flow positive until 2025. I am sure that there are people who will be unfazed by this story, especially if they are true believers in Elon Musk, but I am not one of them.

The Musk Story for Tesla: A Fairy Tale?
With a story stock, it is imperative that you have a CEO who not only is able to get the market to buy into a big story, but one who stays focused and disciplined. To me, there is no better example of how to do this well than Amazon, where Jeff Bezos has been consistent in telling the same story for the company, since its inception in 1997, and delivering on that story. Elon Musk is a gifted story teller, but as the last few months have shown, focus and discipline are not his strong points.

If you are a Tesla investor, your primary concern should be that Musk, with his numerous and often conflicting claims about the company, has muddled the Tesla story and perhaps put the company at risk. If Musk is to be believed, and the company will turn the corner on profitability soon and will not need to go back to capital markets in the near future, while also scaling up production and revenues. While that would be wonderful, from a value perspective, it is fantasy. Put bluntly, there is no chance that Tesla can deliver what it needs to, in terms of scaling up revenues and improving profitability, to justify its market capitalization, without raising new equity along the way. Either Musk knows this, and really does not mean what he says, in which case he is being deceptive, or he does not, in which case he is delusional. Neither is a good character quality in a CEO, especially one at a young company that needs investors on its side.

The fact that Tesla's stock price has remained at elevated levels, and even risen, may lead some to conclude that Musk's behavior has no consequences, but I believe it not only will, but it already has  hurt the company. For instance, I think that Tesla has got a bum's rap for some of the accidents that its cars have been in, either from malfunctioning auto-pilots or combustible cars. However, Tesla's hand is weakened by Elon Musk not only acting as the spokesperson for the company but by his responses, which are a mix of arrogance and victimhood (blaming the media, short sellers and analysts) that sap whatever sympathy bystanders may have for the company.

My Tesla Story in June 2018
My story for Tesla is still an optimistic one, but it is much less so than the Royal Flush story that delivered a value in excess of $400. I do think that Tesla will be able to grow revenues substantially over the next decade and improve margins to rank among the more profitable auto companies. I also think that Elon Musk will back track on his promise of not having to raise fresh capital and that Tesla will invest billions into new plant and equipment, and do so more efficiently than other auto companies, partly because it is not saddled with legacy investments. On the risk front, I am comfortable with assuming that operating risk will stabilize over time, but I do think that the debt burden will pose a danger to survival, at least for the next year or two. Pulling these assumptions together, I revalued the firm at about $186/share.
Download spreadsheet
In this story, Tesla's capital needs will be even higher than under the Royal Flush story, with negative cash flows for the next eight years, and $22 billion in new capital over that period. That may strike some as pessimistic, but notwithstanding all the talk about robots and technology, this remains a capital intensive business. It is entirely possible that over the next few weeks, Tesla might be able to get its production up to 5000 cars a week, using tents and spare parts, but that is not a long term solution. There is no tent big enough to produce 30,000 cars a week, which would be Tesla's target in my story, in year 10. 

Bottom Line
There is no denying the fact that Elon Musk has been central to the Tesla story and that his vision and charisma have been largely responsible for pushing the stock price to its current levels. That said, we are at a point in Tesla's history where I think that the question can be raised as to whether the negatives that Musk brings to the job are starting to catch up with, and perhaps overwhelm the positives. Picking fights with equity research analysts and short sellers may get the blood flowing for Tesla bulls, but they are distractions from what Tesla has to do right now. Promising the market that the company will turn the corner on profitability and be cash flow positive soon may signal Musk's faith in his own story, but they do more harm than good for the company's long term value. I know that it is inconceivable for many investors to think of Tesla without Elon Musk at its helm, but this is a company in clear need of checks and balances, either from a strong management team or a powerful board of directors. Unfortunately, neither exists at the company now, and if you are bullish on Tesla, that should scare you.

YouTube Video

  1. Auto companies data
  2. Tesla - Royal Flush Valuation (June 2018)
  3. Tesla - My Valuation (June 2018)
Past posts on Tesla
  1. Keystone Kop Valuations: Lazard, Evercore and the TSLA/SCTY deal
  2. Tesla: It's a story stock, but what's the story?
  3. A Tesla  2017 Update: A Disruptive Force and a Debt Puzzle

Tuesday, May 29, 2018

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

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

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

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

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

I applied closure by consider all corporate costs that are not directly related to users or subscribers in a corporate cost drag, a drag because it reduces the value of the business:
Cumulating the value of existing and new users, and netting out the corporate cost drag yields the value of operating assets, i.e., the same value that you would derive by discounting the free cash flows to the entire business by its overall cost of capital. You would still need to clean up, by adding in cash, netting out debt and dealing with outstanding options, but that process is the same in both models.

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

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

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

a. Cost Structure: Most young, user-based companies lose money but at the risk of sounding unbalanced, there are good ways to lose money and bad ones, from a value perspective. 
  1. Servicing Existing Users versus New User Acquisition: From a value perspective, it is far better for a company to be losing money, because it is spending money trying to acquire new users, than it is to be losing money, because it costs so much to service existing users. The latter signals a bad business model, at least for the moment, whereas the former offers a semblance of hope.
  2. Fixed versus Variable Costs: For mature companies with established business models, it is better to have a more flexible cost structure (with more variable costs and less fixed costs). With money-losing, high-growth companies, the reverse is true, since it is the fixed cost portion that yields economies of scale, as the company grows.
b. Growth: Repeating a value nostrum, growth is not always value-creating and not all growth is created equal.
  1. Existing versus New Users: A user-based model, where you can grow cash flows from existing users is more valuable, other things remaining equal, than a user-based model that is dependent on adding new users for growth. The reason is simple. Since a company already has expended resources to get existing users, any added revenue it derives from them is more likely to flow directly to the bottom line. Adding new users is more expensive, partly because it costs money to acquire them, but also because new users may not be as active or lucrative as existing ones.
  2. Cost of New User Acquisition: This is a corollary of the first proposition, since the value of a new user is net of user acquisition costs. Consequently, user-based companies that are more cost-efficient in adding new users will be worth more than user-based companies that spend considerable amounts on promotion on marketing, to the same end.  
This contrast is best illustrated by looking at Netflix and Spotify, both subscriber-based companies, but with very different models for paying for content. Netflix pays for content as a fixed cost, and derives economies of scale, when it adds fresh subscribers, whereas Spotify pays for content, based upon how much subscribers listen to songs, making it a variable and existing user based cost. As a result, Netflix derives much higher value from both existing and new subscribers:
Number of Subscribers117.671
Annual Revenue/Subscriber $         113.16  $         77.63 
Subscriber Service Expenses (as %)18.90%79.24%
CAGR in subscriber count223.93%369.86%

Value per Existing Subscriber $         508.89  $       108.65 
Cost of acquiring New Subscriber $         111.01  $         27.30 
Value per New Subscriber $         397.88  $         81.35 
Value of all Existing Subscribers $    59,845.86  $    7,714.28 
 + Value of all New Subscribers $  137,276.49  $  20,764.56 
 - Corporate Cost Drag $  111,251.70  $  13,139.75 
 =Value of Operating Assets $    85,870.65  $  15,339.10 

c. Revenue Models: There are three user-based models, the first is the subscription-based model (that Netflix uses), the second is the advertising-based model (that Yelp uses) and the third is a transaction-based model (that Uber uses). There are companies that use hybrid versions, with Amazon Prime (membership fees and incremental sales) and Spotify (Subscription plus Advertising) being good examples. Each model comes with its pluses and minuses. 
  1. Subscription models tend to be stickier (making revenues more predictable) but they offer less upside potential (it is difficult to grow subscription fees at high rates).
  2. Advertising models scale up faster, since they require little in capital investment and adding new users is easier (since they free), but revenues are heavily driven by user intensity (how much time you can get users to stay in your ecosystem) and exclusive data (collected in the course of usage).
  3. Transaction models are the riskiest, since they require users to use your product or service, but they also offer the most upside, since your upside is less constrained. Amazon Prime's value, in my view, does not stem primarily from the subscription revenues of $99/year but from Amazon's capacity to sell Prime members more products and services.
While no model dominates, picking the wrong revenue model can quickly handicap a business. For instance, using a subscription-based model for a transaction business, where usage varies widely across users, can result in self-selection, where the most intense users choose the subscription-based model to save money, and less intense users stay with a transaction-based model.

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

While the combination of high user value with low user acquisition costs may sound like a pipe dream, it is what network benefits and big data, if they exist, promise to deliver. 
  • Network benefits refer to the possibility that as you grow bigger, it becomes easier for you to get even bigger, making it less costly to acquire new users. That is the promise of ride sharing, for instance, where as a company gets a larger share of a ride sharing market, both drivers and customers are more likely to switch to it, the former, because they get more customers and the latter, because they find rides more quickly.
  • Big data, in a value framework, offers user-based companies an advantage, since what you learn about your users can be used to either sell them more products or services (if you are a transaction-based company), charge them higher premiums (if you are subscription-based) or direct advertising more effectively (if advertising-based). 
Many user-based companies aspire to have network benefits and to use data well, but only a few succeed.

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

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

MoviePass: Too Good to be True? 
If you subscribe to MoviePass, for a monthly subscription of $10, you get to watch one theatrical movie, every day, for the entire month. Given that the average price of a theater ticket in the US is $9, this sounds like an insanely good deal, and for an avid movie goer, it is, and the service had two million subscribers in May 2018. MoviePass, though, pays the theaters for the tickets, creating a model that is more designed to drive it into bankruptcy than to deliver profits.
MoviePass Economics
When confronted by the insanity of the business model, Mitch Lowe, the CEO of MoviePass, argued that after an initial burst, where subscribers would see four or five movies a month, they would settle into watching a movie a month, allowing the service to break even. Since Mr. Lowe is a co-founder of Netflix and a former CEO of Redbox, I will concede that he knows a lot more about the movie business than I do, but this is an absurd rationale. If the only way that your service can become viable is if people don't use it very much, it  is not much of a service to begin with.  

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

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

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

YouTube Video

Paper on User Based Value
  1. Going to Pieces: Valuing Users, Subscribers and Customers
Blog Posts on User-based Value
  1. Valuing Uber Riders
  2. Valuing Amazon Prime Members
  3. Valuing Spotify Subscribers
  4. Valuing Netflix Subscribers

Tuesday, May 22, 2018

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

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

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

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

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

That operating history includes two decades of stellar growth towards the end of the twentieth century, where Walmart reshaped the retail business in the United States, and the years since, where growth has slowed down and margins have come under pressure. As Walmart stands now, here is what we see:
  1. Growth has slowed to a trickle: Walmart’s growth engine started sputtering more than a decade ago, partly because its revenue base is so overwhelmingly large ($500 billion in 2017) and partly because of saturation in its primary market, which is the United States. 
  2. And more of it is being acquired: As same store sales growth has leveled off, Walmart has been trying to acquire other companies, with Flipkart just being the most recent (and most expensive) example. 
  3. But its base business remains big box retailing: While acquiring online retailers like and upscale labels like Bonobos represent a change from its original mission, the company still is built around its original models of low price/ high volume and box stores. The margins in that business have been shrinking, albeit gradually, over time.
  4. And its global footprint is modest: For much of the last few years, Walmart has seen more than 20% of its revenues come from outside the United States, but that number has not increased over the last few years and a significant portion of the foreign sales come from Mexico and Canada. 
Looking at the data, it is difficult to see how you can come to any conclusion other than the one that Walmart is not just a mature company, but one that is perhaps on the verge of decline.

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

The Common Enemy
Looking at Flipkart and Walmart, it is clear that they are very different companies, at opposite ends of the life cycle. Flipkart is a young company, still struggling with its basic business model, that has proven successful at delivering revenue growth but not profits. Walmart is an aging giant, still profitable but with little growth and margins under pressure. There is one element that they share in common and that is that they are both facing off against perhaps the most feared company in the world, Amazon. 
a. Amazon versus Flipkart: Over the last few years, Amazon has aggressively pursued growth in India, conceding little to Flipkart, and shown a willingness to prioritize revenues (and market share) over profits:
Source: Forrester (through Bloomberg Quint)
While Flipkart remains the larger firm, Amazon India has continued to gain market share, almost catching up by April 2018, and more critically, it has contributed to Flipkart’s losses, by being willing to lose money itself. In a prior post, I called Amazon a Field of Dreams company, and argued that patience was built into its DNA and the end game, if Flipkart and Amazon India go head to head is foretold. Flipkart will fold, having run out of cash and capital.
b. Amazon versus Walmart: If there is one company in the world that should know how Amazon operates, it has to be Walmart. Over the last twenty years, it has seen Amazon lay waste to the brick and mortar retail business in the United States and while the initial victims may have been department stores and specialty retailers, it is quite clear that Amazon is setting its sights on Walmart and Target, especially after its acquisition of Whole Foods. 

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

The Pricing of Flipkart
Walmart is just the latest in a series of high profile investors that Flipkart has attracted over the years. Tiger Global has made multiple investments in the company, starting in 2013, and other international investors have been part of subsequent rounds. The chart below captures the history:
Barring a period between July 2015 and late 2016, where the company was priced down by existing investors, the pricing has risen, with each new capital raise. In April 2017, the company raised $1.4 billion from Microsoft, Tencent and EBay, in an investment round that priced the company at $11 billion, and in August 2017, Softbank invested $2.5 billion in the company, pricing it at closer to $12.5 billion. Walmart’s investment, though, represents a significant jump in the pricing over the last year. 

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

The Why?
So, why did Walmart pay $16 billion for a 70% stake in Flipkart? And will it pay off for the company? There are four possible explanations for the Walmart move and each comes with troubling after thoughts. 
1. The Pricing Game: No matter what one thinks of Flipkart’s business model and its valuation, it is true, at least after the Walmart offer, that the game has paid off for earlier entrants. By paying what it did, Walmart has made every investor who entered the pricing chain at Flipkart before it a “success”, vindicating the pricing game, at least for them. If the essence of that game is that you buy at a low price and sell at a higher price, the payoff to playing the pricing game is easiest seen by looking at the Softbank investment made just nine months ago, which has almost doubled in pricing, largely as a consequence of the Walmart deal. In fact, many of the private equity and venture capital firms that became investors in earlier years will be selling their stakes to Walmart, ringing up huge capital gains and moving right along. Is it possible that Walmart is playing the pricing game as well, intending to sell Flipkart to someone else down the road at a higher price?
My assessment: Since the company’s stake is overwhelming and it has operating motives, it is difficult to see how Walmart plays the pricing game, or at least plays it to win. There is some talk of investors forcing Walmart to take Flipkart public in a few years, and it is possible that if Walmart is able to bolster Flipkart and make it successful, this exit ramp could open up, but it seems like wishful thinking to me.

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

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

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

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

What next?
In the long term, this deal may slow the decline at Walmart, but at a price so high, that I don’t see how Walmart’s shareholders benefit from it. I have attached my valuation of Walmart and with my story of continued slow growth and stagnant margins for the company, the value that I obtain for the company is about $63, about 25% below its stock price of $83.64 on May 18, 2018.
Download spreadsheet
In the short term, I expect this acquisition to a accelerate the already frenetic competition in the Indian retail market, with Flipkart, now backed by Walmart cash, and Amazon India continuing to cut prices and offering supplementary services. That will mean even bigger losses at both firms, and smaller online retailers will fall to the wayside. The winners, though, will be Indian retail customers who, in the words of the Godfather, will be made offers that they cannot refuse! 

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

YouTube Video

Data Links
  1. Walmart Valuation - May 2018

Thursday, April 26, 2018

Amazon: Glimpses of Shoeless Joe?

It was just over two weeks ago that I started my posts on the FANG stocks, starting with Facebook, which I decided to buy, because I felt that notwithstanding its current pariah status, its user base was too valuable to pass by, at the prevailing market price. I then looked at Netflix, a company that has shown a remarkable ability to adapt to the challenges thrown at it, while changing the entertainment business, but is, at least in my view, in a content cost/user cycle that will be difficult to break out of. With Alphabet, the cash cow that is its advertising business is allowing it to invest in the big new markets of tomorrow, and even with low odds and very little substance today, these bets can make or break the investment. That leaves me with the longest listed and perhaps the most intriguing of the four stocks, Amazon, a company whose reach seems to expand into new markets each year. 

Revisiting my Amazon past
I valued Amazon for the first time in 1998, as an online book retailer, and much of what I know about valuing young companies today came from the struggles I went through, modifying what I knew in conventional valuation, for the special challenges of valuing a company with no history, no financials and no peer group. Out of that experience was born a paper on valuing young companies, which is still on my website and the first edition of the Dark Side of Valuation, and if you want to see some horrendously wrong forecasts, at least in hindsight, you can check out my valuation of Amazon in that edition. 

While I had a tough time justifying Amazon’s valuation, in its dot-com days, I always admired the company and the way it was managed. When I was put off balance by an Amazon product, service or corporate announcement, I re-read Jeff Bezos’ letter to Amazon shareholders from 1997, because it helped me understand (though not always agree with) how Amazon views the business world. In that letter, Bezos laid out what I called the Field of Dreams story, telling his stockholders that if Amazon built it (revenues), they (the profits and cash flows) would come. In all my years looking at companies, I have never seen a CEO stay so true to a narrative and act as consistently as Amazon has, and it is, in my view, the biggest reason for its market success.

I have valued Amazon about once a year every year over its existence, and I have bought Amazon four times and sold it four times in that period. That said, there are two confessions that I have to make. The first is that I have not owned Amazon since 2012, and have thus missed out on its bull run since then. Second, through all of this time, I have consistently under estimated not only the innovative genius of this company, but also its (and its investors') patience. In fact, there have been occasions when I have wondered, staying true to my Field of Dreams theme, whether Shoeless Joe would ever make his appearance

Amazon’s Market Cap Rise
Amazon’s rise in market capitalization has had more ups and downs than either Google or Facebook, but it has been just as impressive, partly because the company came back from a near death experience after the dot-com bust in 2001.

The more remarkable feature of Amazon’s rise has been the debris it has left in its wake, first with brick and mortar retail in the United States, but more recently in almost every business it has entered, from grocery retail to logistics. These graphs, excerpted from a New York Times article earlier this year, tells the story:

I know that this picture is probably is too compressed for you to read, but suffice to say that no company, no matter how large or established it is is safe, when Amazon enters it's market. Thus, while you can explain away the implosion of Blue Apron, when Amazon entered the meal delivery business, by pointing to its small size and lack of capital, note that the decline in market value at Kroger, Walmart and Target on the date of the Whole Foods acquisition was vastly greater in dollar value terms, and these firms are large and well capitalized. It is also worth noting that the decline in market cap is not permanent and that firms in some of the sectors see a bounce back in the subsequent time periods but generally not to pre-Amazon entry levels.  If Amazon represents the light side of disruption, the destruction of the status quo and everything associated with it, in the businesses that it enters, is the dark side.

Amazon: Operating History and Model
Rather than provide an involved explanation for why I call Amazon a Field of Dreams company, I will begin with a chart of Amazon's revenues and operating income that will explain it far more succinctly and better:
Amazon has clearly delivered on revenue growth, as its revenues have gone from $1.6 billion in 1999 to $177 billion in 2017, but its margins, after an initial improvement, went through an extended period of decline. In most companies, this would be viewed as a sign of a weak business model, but in the case of Amazon, it is a feature of how they do business, not a bug. In effect, Amazon has extended its revenue growth by expanding into new businesses, often selling its products (Kindle, Fire, Prime) at or below cost.  That, by itself, is not unique to Amazon, but what makes it different is that it has been able to get the market to go along with its "if we build it, they will come" strategy.

The mild uptick in profitability in the last three years has been fueled by Amazon's web services (AWS) business, offering cloud and other internet related services to other businesses, and that can be seen in the graph below, showing revenues and operating profits broken down by segment:
Amazon 10K
Over the last five years. AWS has accounted for an increasing slice of revenues for Amazon, but it is still small, accounting for 10% of all revenues in 2017. On operating income, though, it has had a much bigger impact, accounting for all of Amazon's profitability in 2017, with AWS generating $4,331 million in operating profits and the rest of Amazon, reporting an operating loss of $225 million.

To back up my earlier claim that Amazon's low profits are by design, and not an accident, let's look at two expenses that Amazon has incurred over this period that are treated as operating expenses, and are reducing operating profit for the company, but are clearly designed as investments for the future. The first is in technology and content, which include the investments in technology that are driving the growth in the AWS business and content, for the media business. The second is in net shipping costs, the difference between what Amazon collects in shipping fees from its customers and what it pays out, which can be viewed as the investment is making in building up Amazon Prime.
Amazon 10K
Not only are the technology/content and net shipping costs a large portion of overall expenses, amounting to 18.32% of revenues in 2017, but they have increased over time. The operating margin for Amazon would have been over 20%, if it had not incurred these expenditures, but with those higher, the company would have had far less revenues, no AWS business and no Amazon Prime today. To value Amazon today, I think it makes sense to break it up into at least three parts, with the first being its retail/media business globally, the second its AWS business and finally, Amazon Prime. In the table below, I attempt to deconstruct Amazon's numbers to estimate how much each of these arms is generated as revenues and created in operating expenses in 2017, as a prelude to valuing them.
Note that I had to make some estimates and judgment calls in allocating revenues to Amazon Prime, where I have counted only the incremental revenues from Amazon Prime members, and in allocating content costs. For Amazon Prime, for instance, I have used an assumption that Prime members spend $600 more than non-Prime members, to estimate incremental revenues, and added the $9.7 billion in subscription premiums that Amazon reported in 2017. The net shipping costs have been fully allocated to Amazon Prime and all of the operating expenses that Amazon reported for AWS are assumed to be technology and content. The remaining expenses are allocated across AWS and Amazon Retail/Media, in proportion to their revenues. In my judgment, both Amazon Retail/Media and AWS generated operating profits in 2017, but the latter was much more profitable, with a pre-tax operating margin of 24.81%. Amazon Prime was a money loser in 2017, but its margins are less negative than they used to be, and at 100 million members, it may be poised to turn the corner.

Amazon Business Model
If there are any secrets in Amazon's business model, they are dispensed when you read Amazon's 10K, which is remarkably forthcoming about how the company approaches business. In particular, the company emphasizes three key elements in its business model:
  1. Focus on Free Cash Flow: I tend to be cynical when companies talk about free cash flows, since most use self serving definitions, where they add "stuff" to earnings to make their cash flows look more positive. Amazon does not seem to take the same tack. In fact, it not only nets out capital expenditures and working capital needs, as it should, but it even nets out acquisitions (such as the $13.2 billion it spent on Whole Foods) to get to free cash flow.
  2. Manage working capital investment: Perhaps remembering times as a start-up when mismanaging inventory brought it to its knees, the company is focused on keeping its investment in working capital as low as possible, though that does sometimes involve strong arming suppliers.
  3. Use Operating leverage: Amazon is clearly conscious about its cost structure, recognizing that its revenue growth can give it significant advantages of economies of scale, when it comes to fixed costs.
There are two additional features to the company that I would add, from my years observing the company.
  1. Patience: I have never seen a company show as much patience with its investments as Amazon has, and while there are some who would argue that this is because of it's large size and access to capital, Amazon was willing to wait for long periods, even when it was a small company, facing a capital crunch. I believe that patience is embedded in the company's DNA and that the Bezos letter in 1997 explains why.
  2. Experimentation: In almost every business that Amazon enters, it has been willing to try new things to shake up the status quo, and to abandon experiments that do not work in favor of experiments that do.
There is no scarier vision for a company than news that Amazon has entered its business. If you are in that besieged company, how do you survive the Amazon onslaught? We know what does not work:
  1. Imitation: You cannot out-Amazon Amazon, by trying to sell below cost and wait patiently. Even if you are a company with deep pockets, Amazon can out-wait you, since it is not only how they do business and they have investors who have accepted them on their terms.
  2. Cost Cutting: There are companies, especially in the US brick and mortar retail space, that thought they could cut costs, sell products at Amazon-level prices and survive. By doing so, they speeded their decline, since the poorer service and limited inventory that followed alienated their core customers, who left them for Amazon.
  3. Whining: Companies under the Amazon threat often resort to whining not only about fairness (and how Amazon breaks the rules) but also about how society overall will pay a price for Amazon domination. There are seeds of truth in both argument, but they will neither slow nor stop Amazon from continuing to put them out of business.
While there is no one template for what works, here are some strategies, drawn from looking at companies that have survived Amazon, that improve your odds:
  1. Tilt the game: You can try to get governments and regulators to buy into your warnings of monopoly power and societal demise and to regulate or restrict Amazon in ways that allow you to continue in business. 
  2. Play to your strengths: If you have succeeded as a company before Amazon came into your business, you had competitive advantages and core customers who generated that success. Nourishing your competitive advantages and bringing your core customers even closer to you is key to survival, but that will require that you live through some financial pain (in the form of higher costs).
  3. And to Amazon's weaknesses: Amazon's favored markets have high growth and low capital intensity, and when they get drawn into markets that demand more capital investment, like logistics, it is because they were forced into them. If you can move the terrain to lower growth, higher capital intensity businesses, you can improve your odds of surviving Amazon.
None of these choices will guarantee success or even survival, and there are times where you may have to seek partnerships and joint ventures to make it through, and if all else fails, you can try some witchcraft.

Valuing Amazon
In my prior iterations, I tried to value Amazon as a consolidated company, arguing that it was predominantly a retail company with some media businesses. The growth of AWS and the substantial spending on Amazon Prime has led me to conclude that a more prudent path is to value Amazon in pieces, with Amazon Retail/Media, AWS and Amazon Prime, each considered separately.

1. Amazon Retail/Media
To value the heart of Amazon, which still remains its retail and media business, I used the revenues and operating margin that I estimated based upon my allocation at the end of the last section as my starting point, and assumed that Amazon will be able to continue growing revenues at 15% a year for the next five years, while also improving its operating margin (currently 9.09%, with technology and content costs capitalized) to 12%. The revenue growth assumption is built on Amazon's track record of being able to grow and the improved margin reflect expected economies of scale. The resulting value is shown below:
Download spreadsheet
Based upon my assumptions, the value that I attach to the retail/media business is about $289 billion. The key driver of value is the operating margin improvement, built into the story.

2. AWS
If Amazon's reported numbers are right, this division is the profit machine for the company, generating an operating margin of close to 25%, while revenues grew 42.88% in 2017. While I believe that this business will stay high growth and profitable, it is also one where Amazon faces strong competitors in Microsoft and Google, just to name two, and both revenue growth rates and margins will come under pressure. I assume revenue growth of 25% a year for the next 5 years, with operating margin declining to 20% over that period. The value is shown below:
Download spreadsheet
The value that I estimate for AWS is about $139 billion. The key for value creation is finding a mix of revenue growth and operating margin that keeps value up, since going for higher growth with much lower margins will cause value to dissipate.

3. Amazon Prime
To value Amazon Prime, I use the same technique that I used last year to value it, starting with a value of a Prime member, and building up to the value of Prime, by forecasting growth in Prime membership and corporate costs (mostly content). I updated the Prime membership number to 100 million (from the 85 million that I used last August) and used the 2017 financial statements to get more specific on both content costs and on the cost of capital. The value is shown below:
Download spreadsheet
Based upon the layers of assumptions that I have made, especially on shipping costs growing at a rate lower than membership rolls, the value that I estimate for Amazon Prime is about $73 billion. The key input here is shipping costs, since failing to keep it in control will cause the value to very quickly spiral down to zero.

Amazon, the Company
With all three pieces completed, I bring them together in my valuation of the company, incorporating the total debt outstanding in the company of $42,730 (including capitalized operating leases) and cash of $30.986 million, to arrive at a value per share of $1019.

At $1,460/share, on April 25, the stock is clearly out of my reach right now. Given that I have not been able to justify buying the stock at any time in the last five years, as it rose from $250/share to $1500, my suggestion is that you do you don't take my word, and that you make your own judgment. You can download the spreadsheets that I have for Amazon Retail/Media, AWS and Amazon Prime at the end of this post, and change those assumptions of mine that you think are wrong.

Investment Judgment
The FANG stocks represent great companies, but of the four, I think that Amazon has the most fearsome business model, simply because its platform of disruption and patience can be extended to almost any other business, one reason why every company should view Amazon as a potential competitor. I know that the old value adage is that if you buy quality companies and hold them forever, they will pay for themselves, but I don't believe that! There are good companies that can be bad investments and bad companies that can be terrific investments, as I noted in this post. Amazon has fallen into the first category for much of the last five years and continues to do so, at today's market price. But good things come to those who wait, and I know that there be a time and a price at which it will be back in my portfolio.

Post-post Update: I deliberately posted this before the earnings report, and the report that came out about two hours after the post was a blockbuster, with higher revenue growth than expect, a doubling of net income and an increase in the stock price of close to $100/share in the after market. Incorporating the effects into the valuations will have to wait until the full quarterly report is available, but the biggest part of the report,  for me, was the increase in Prime Membership fees to $119/year. You can modify the Amazon Prime valuation spreadsheet to reflect the increase in membership feels to $119/year (from $99/year). Doing so increases the value of Prime to almost $116 billion, increasing value per share by almost $100/share.

YouTube Video

Data Links

  1. Amazon 10K
  2. Valuation of Amazon Retail/Media
  3. Valuation of AWS
  4. Valuation of Amazon Prime
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