Elon's Twitter Play: Valuation and Corporate Governance Consequences

I am not a prolific user of social media platforms, completely inactive on Facebook and a casual lurker on LinkedIn, but I do use Twitter occasionally, and have done so for a long time, with my first tweet in April 2009, making me ancient by Twitter standards. That said, I tweet less than ten times a month and follow only three people (three of my four children) on the platform. I am also fascinated by Elon Musk, and even more so by his most prominent creation, Tesla, and I have valued and written about him and the company multiple times. When Musk made news a little over two weeks ago, with his announcement that he owned a major stake in Twitter, I could not stay away from the story, and what's happened since has only made it more interesting, as it casts light on just Musk and Twitter, but on broader issues of the social and economic value of social media platforms, corporate governance, investing and how politics has become part of almost every discussion.

The Twitter Story

To get a measure of Musk's bid for Twitter, you have to also understand the company's path to its current status. In this section, I will focus on the milestones in the company's history that shape it today, with an eye on how it may affect how this acquisition bid plays out.

Inception to IPO

Twitter was founded in 2006 by Jack Dorsey, Noah Glass, Biz Stone and Evan Williams, and its platform was launched later that year. It succeeded spectacularly in attracting people to its platform, hitting a 100 million users in 2012, and then doubling those numbers again by 2013, when it went public ,with an initial public offering. In a post on this blog on October 5, 2013, I valued Twitter, based on the numbers in its prospectus:

Spreadsheet with valuation

In keeping with my belief that every valuation tells a story, my IPO valuation of Twitter in October 2013 reflected my story for the company, as a platform with lots of users, that had not yet figured out how to monetize them, but would do so over time. My forecasted revenues for 2023 of $11.2 billion and predicted operating margin of 25% in that year reflected my optimistic take for the company, with substantial reinvestment (in acquisitions and technology) needed along the way (as seen in my reinvestment). A few weeks later, the offering price for Twitter's shares was set at $26, by its bankers, and the stock debuted on November 7, 2013, at $45. In the weeks after, that momentum continued to carry the stock upwards, with the price reaching  $73.31 by December 26, 2013. 

If the story had ended then, the Twitter story would have been hailed as a success, and Jack Dorsey as a visionary. But the story continues...

The Rise and Fall of Jack Dorsey

In the years since its IPO, the Twitter story has developed in ways that none of its founders and very few of its investors would have predicted. On some measures of user engagement and influence, it has performed better than expected, but in the operating numbers measuring its success as a business, it has lagged, and the market has responded accordingly

Users: Numbers and Engagement

In terms of user numbers, Twitter came into the markets as a success, with 240 million people on its platform in November 2013, at the time of its public offering. In the years since, those user numbers have grown, as can be seen in the chart below:

In keeping with disclosure practices at other user-based companies, in 2017, Twitter also started tracking and reporting the users who were most active on its platform, by looking at daily usage, and counting daily active users (DAU). While total user numbers have leveled off in recent years, albeit with a jump in 2021, the daily active user count has continued to climb. 

Over the last decade, the company's platform, and the tweets that show up on it, became a ubiquitous part of news, culture and politics, as politicians used the platform to expand their reach and spread their ideas and celebrities built their personal brands around their followers. Looking at the list of the Twitter persona with the most followers provides some measure of its reach, with a mix of politicians (Barack Obama, Narendra Modi), musicians (Justin Bieber, Katy Perry, Taylor Swift, Ariana Grande), celebrities (Kim Kardashian) and sporting figures (Cristiano Ronaldo). Sprinkled in the list are brands/businesses (YouTube, CNN Breaking News), with millions of followers, though relatively few business people make the list, with Elon Musk being the exception.  It is worth noting that many of the people on top follower list tweet rarely, and that behavior is mimicked by many of the users on the platform, many of whom never tweet. The bulk of the tweets on the platform are delivered by a subset of users, with the top 10% of users delivering 80% of the tweets. 

While there are multiple reasons that Twitter users come to the platform, the demographics of its platform provides some clues, especially when contrasted with other social media platforms:

Pew Research

Twitter's user base skews younger, more male, more educated and more liberal than the US population, and especially so, when compared with Facebook, which has the biggest user base.

Revenues, Profits and Stock Prices

As Twitter user base and influence have grown, there has been one area where it has conspicuously failed, and that is on business metrics. The company's revenues have come primarily from advertising (90%) and while these revenues have grown, they have not kept up with user engagement, as can be seen in the chart below:

In the last few years, revenue growth has flattened, again with the exception of 2021, and while operating margins have finally turned positive in the last five years, there has been no sustained upward movement. To give a measure of Twitter's disappointing performance, note that the company's actual revenues in 2021 amounted to $5.1 billion, well below the $9.6 billion I estimated in 2021 (year 8 in my IPO valuation) as revenues in my IPO valuation of the company in November 2013, and its operating margin, even with generous assumptions on R&D, was 19.02% in 2021, still below my estimate of 19.76% in that year. 

The disappointments on the operating metric front has played out in markets, where Twitter's stock price dropped to below IPO levels in 2016 and its performance has lagged its social media counterparts:

Source: Bloomberg

In fact, Twitter's stock prices did not breach their December 2013 high of $73.31 until February 26, 2021, when the stock peaked at $77.06, before dropping back to 2013 levels again by the end of the year. The company that provides the best contrast to Twitter is Snapchat, another company that I valued at the time of its IPO in February 2017 at $14.4 billion, with a value per share of $10.91. Like Twitter, Snapchat had a rousing debut in the market, rising 40% to hit $24.48 on its first trading day, before falling on hard times, as Instagram undercut its appeal. The stock dropped below $6 in 2019, before mounting a comeback in 2021. While Snap is a younger company than Twitter, a comparison of the operating metrics and user numbers yields interesting results:

Looking at the 2021 numbers, Snap now has more daily active users than Twitter, but delivers less in revenues and is still losing money. That said, the market clearly either sees more value in Snap's story or has more confidence in Snap's management, since there is a wide gap in market capitalizations, with Snap trading at a premium of 60% over Twitter.

Corporate governance

While Twitter can be faulted on many of its actions leading into and after its IPO, there is one area where credit is due to the company. In a period when companies, especially in the tech sector, fixed the corporate governance game in favor of insiders and incumbents, by issuing shares with different voting classes, Twitter stuck to the more traditional model, with equal voting right shares.  It is also worth noting that Twitter came into its IPO, with a history of bloodletting at the top, with Jack Dorsey, who led the company at the start, getting pushed aside by Evan Williams, his co-founder, before reclaiming his place at the top. In fact, at the time of its IPO, Twitter's CEO was Dick Costolo, but he was replaced by Dorsey again, a couple of years later. Dorsey's founder status gave him cover, but his ownership stake of the company was not overwhelming enough to stop opposition. As disappointment mounted at the company, the murmuring of discontent became louder among Twitter shareholders, especially since Jack divided his top executive duties across two companies, Twitter and Square, both of which demanded his undivided attention.  

The corporate governance issues at Twitter came to a head in 2020, when Elliott Management, an activist hedge fund, purchased a billion dollars of Twitter stock, and demanded changes. While Dorsey was successful in fighting off their demands that he step down, he surprised investors and may company employees when he stepped down in November 2021, claiming that he was leaving of his own volition. That may be true, but it seemed clear that the relationship between Dorsey and his board of directors had ruptured, and that the departure might not have been completely voluntary. As a replacement, the board did stay within the firm in picking a successor, Parag Agrawal, who joined Twitter as a software engineer in 2011 and rose to become Chief Technology Officer in 2017.

The Musk Entree!

It is ironic that the threat to Twitter has come from Elon Musk, who has arguably used its platform to greater effect than perhaps anyone else on it. There are some Twitter personalities who have more followers than Musk, but most of them are either inactive or tweet pablum, but Musk has made Twitter his vehicle for selling both his corporate vision and his products, while engaging in distractions that sometimes frustrate his shareholders. While he has made veiled promises of alternative platforms for expression, it was a surprise to most when he announced on April 4, 2022, that he had acquired a 9.2% stake in the company. Stock prices initially soared on the announcement, but what has followed since has been one of the strangest corporate chronicles that I have ever witnessed, as you can see in the time line below:

This post is being written on April 19, and the only thing that is predictable is that everything is unpredictable, at the moment, and that should come as no surprise, when Musk is involved.

The Value Arguments: Status Quo and Potential

While Musk's acquisition bid is anything but conventional, the gaming that it initiated on the part of Twitter, the target company, and Musk, the potential acquirer, was completely predictable. The company's initial response was that it was worth great deal more than Musk's offering price, and that Twitter shareholders would be receiving too little for their shares if they sold. Musk's response was that the market clearly did not believe that current management could deliver that higher value, and that he would be able to do much better with the platform.

Twitter's argument that Musk was lowballing value, by offering $54.20 per share for the company,  and that the company was worth a lot more is not a novel one, and it is heard in almost every hostile acquisition, from target company management. That argument can sometimes be true, since markets can undervalue companies, but is it the case with Twitter? To answer that question, I valued Twitter on April 4, at about the time that Musk announced his 9.2% stake, updating my story to reflect a solid performance from the company in 2021, and with Parag Agrawal, its newly anointed CEO:

Spreadsheet with Twitter Status Quo Value

In my story, which I view as upbeat, given Twitter's inability to deliver on operating metrics in the last decade, I see continued growth in revenues, with revenues reaching almost $13 billion in 2033, and a continued increase in operating margins to 25%, not quite the levels you see at the dominant online advertising players (Facebook and Google), but about what you would expect for a successful, albeit secondary, online advertising platform. (Note that I am capitalizing R&D expenses to give the company healthier margins right now, to begin my valuation). The value per share that I obtained was about $46, $ 4 higher than the prevailing stock price, but below Musk's acquisition offer of $54.20.

To the critique that revenue growth could surprise and that margins could be higher, my answer is of course, and to incorporate the uncertainty in my inputs, I fell back on one of my favored devices for dealing with uncertainty, a Monte Carlo simulation. I picked three variables, the revenue growth over the next five years, the target operating margin and the initial cost of capital, to build distributions around, and the results of the simulation are below:

The median value in the simulation is $45.17, close to the base case valuation, but at least based on my estimates, Musk's offering price is at the 75th percentile of value. It is possible that the value could be higher but making that is not a particularly strong argument to make, if you are Twitter's board.

Competing Views: The Fight for Twitter

As a company that has lived its entire life on the promise of potential, it should come as no surprise if that is where the next phase of this argument heads. In particular, Twitter's management will claim that the company's platform has the potential to deliver significantly more value, either by changing the business model (and including subscriptions and other revenue sources) or fine tuning the advertising model. On this count, Musk will agree with the argument that Twitter has untapped potential, but counter that he (and only he) can make the changes to Twitter's business model to deliver this potential. In short, investors will get to choose not only between competing visions for Twitter's future, but also who they trust to deliver those visions.

The problem that Twitter's management will face in mounting a case that Twitter is worth more, if it is run differently, is that they have been the custodians of the company for the last decade, and have been unable or unwilling to deliver these changes. Shareholders in Twitter will welcome management's willingness to consider alternative business models, but the timing makes it feel more like a deathbed conversion rather than a well thought through plan. Elon Musk's problem, on the Twitter deal, is a different one. If you think Jack Dorsey was stretching the limits of his time by running two companies, I am not sure how to characterize what Musk will be doing, if he acquires Twitter, since he does have a trillion dollar company to run, in Tesla, not to mention SpaceX, the Boring company and a host of other ventures. In addition, Musk's unpredictability makes it difficult to judge what his end game is, at least with Twitter, since he could do anything from selling his position tomorrow to bulldozing his way through a poison pill, taking Twitter down with him. I know that there are question of how Musk  finance the deal and whether he can secure funding, but of all of the impediments to this takeover, those might be the easiest to overcome. The fact that Twitter's stock price has stayed stubbornly below Musk's offering price suggests that investors have their doubts about Musk's true intentions, and whether this deal will go through.

Alternate Endings

No matter what you think about Elon Musk and how his acquisition bid will play out, it is undeniable that he has put Twitter in play here, and that it is likely that the company that emerges from this episode will look different from the company that went into it. In particular, I see four possible outcomes for Twitter:

1. Status Quo: It is possible that Twitter wins this round with Musk, and that the poison pill adopted by the board is sufficient to get him to walk away from the deal, perhaps selling his holdings along the way. The existing management go back to their plans for incremental change that they have already put in motion, and hope that the payoffs of higher revenue growth and profitability will unlock share value. 
2. Musk takes Twitter private: Having spent more than a decade seeing Musk pull off what most market observers would view as impossible, I have learned not to underestimate the man. For Musk to succeed at this point, he has to be able to buy enough shares in a tender offer and/or convince other shareholders to put pressure on the board to remove the poison pill, and allow him to move forward with his plans. The odds are against success, but then again, this is Elon Musk.
3. Independent, but with corporate governance changes: Even if Twitter is able to fend off Musk, the way that the company's management and board have handled the deal does not inspire confidence in their ability to run the company. In fact, having gone through five CEOs over Twitter's life, it is worth asking the question whether the dysfunction at the company lies with the board, and not just with the CEO. In this scenario, institutional investors will follow through by pushing for change in the company, translating into new board members and perhaps even a new CEO.
4. Someone else acquires Twitter: There may be something to Musk's claim that the changes that are needed to make Twitter a functional business can only be made, if it is taken private. If so, it is  the board may be willing to sell the company to someone other than Musk, albeit at a slightly higher price (if for no other reason than to save face). The fact that the buyer may be Silver Lake, a firm that Musk has connections with, or another private equity investor, whose plans for change are similar to Musk's, will mean that Elon Musk will have accomplished much of what he set out to do, without spending $43 billion dollars along the way or having to deal with the distractions that owning Twitter will bring to his other, more valuable, ventures.

If I were to put these possibilities in terms of likelihood, I would put "staying independent with significant corporate governance changes" as most likely, followed by someone else acquiring Twitter, with the status quo and Musk succeeding getting the lowest odds.

Political Markets?

In this discussion, I have deliberately stayed away from the elephant in the room, which is that this is , at its core, a political story, not a financial one. To see why, consider a simple test. If you tell me which side of the political divide you fall on, I am fairly certain that I will be able to guess whether you favor or oppose Musk's takeover bid. As with most things political, you will provide an alternate, more reasoned, argument for why you are for or opposed, but you are deluding yourself, and hypocrisy is rampant on both sides.  

• If you are opposed to the deal, and your argument is that billionaires should not control social media platforms, that outrage cannot be selective, and you should be just as upset about Jeff Bezos owning the Washington Post or a George Soros bid for Fox News. If it is Musk's personality that you feel is what makes him an unsuitable owner, I wonder whether we should be requiring full personality tests of the owners of other media companies.
• If you are for the deal, and it is because you want Twitter to be a bastion of free speech, it is worth remembering that every social media platform is involved in some degree of censoring, for legal reasons and self preservation. It should also be noted that while those disaffected with Twitter have attempted to build their own social media platforms, they still get far more mileage from their presence on Twitter than from their posts on alternate platforms, and the complaints about Twitter not being balanced seem to end up being on Twitter.

The hand wringing from pundits about changes that may or may not be coming to Twitter, and the impact it will have on our collective consciousness, to be over wrought. In fact, some critics of Musk seem to have decided that Twitter, in its current form, is a national treasure that needs to be preserved or at least protected from money grubbing barbarians. I beg to differ. The brevity (of having to compress your thoughts into 280 characters) and timeliness of Twitter's platform has made it the place to go to get breaking news, but the notion that it is an educational platform shortchanges the meaning of learning, and the impulsiveness that it encourages from users is a recipe for tweeting remorse, or worse. I believe that while there are some who come to Twitter for news and witty repartee, many come to the platform for the same reasons that they slow down on highways to look at car crashes, i.e., to witness, and sometimes partake in, deranged arguments about trivial issues. Much as we like to complain about the ugliness and anger that we see on social media, it is exactly those forces that draw users to it, and arguing that Elon Musk will make it worse, misses the point that he symbolizes the strengths and weaknesses of the Twitter platform better than any other person walking the face of the earth. 

YouTube Video

Spreadsheets

1. Valuation of Twitter on October 5, 2013 (for IPO)
2. Valuation of Twitter on April 4, 2022 (after Elon takes stake)

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 Jet.com 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 Entrée (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.

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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

Fairness Opinions: Fix them or Flush them!

My post on the Tesla/SCTY deal about the ineptitude and laziness that Lazard and Evercore brought to the valuation process did not win me any friends in the banking M&A world. Not surprisingly, it drew some pushback, not so much from bankers, but from journalists and lawyers, taking me to task for not understanding the context for these valuations. As Matt Levine notes in his Bloomberg column, where he cites my post, "a fairness opinion is not a real valuation, not a pure effort to estimate the value of a company from first principles and independent research" (Trust me. No one is setting the bar that high. I was looking for biased efforts using flawed principles and haphazard research and these valuation could not even pass that standard)  and that "they (Lazard and Evercore) are just bankers; their expertise is in pitching and sourcing and negotiating and executing deals -- and in plugging in discount rates into preset spreadsheets -- not in knowing the future". (Bingo! So why are they doing these fairness opinions and charging millions of dollars for doing something that they are not good at doing? And there is a difference between knowing the future, which no one does, and estimating the future, which is the essence of valuation.) If Matt is right, the problems run deeper than the bankers in this deal, raising questions about what the purpose of a   "fairness opinion" is and whether it has outlived its usefulness (assuming that it was useful at some point).

Fairness Opinions: The Rationale

What is a fairness opinion? I am not a lawyer and I don't play intend to play one here, but it is perhaps best to revert back to the legal definition of the term. In an excellent article on the topic, Steven Davidoff defines a fairness opinion as an "opinion provided by an outsider that a transaction meets a threshold level of fairness from a financial perspective". Implicit in this definition are the assumptions that the outsider is qualified to pass this judgment and that there is some reasonable standard for fairness.  In corporate control transactions (acquisition, leveraged buyout etc.), as practiced today, the fairness opinion is delivered (orally) to the board at the time of the transaction, and that presentation is usually followed by a written letter that summarizes the transaction terms and the appraiser's assumptions and attests that the price paid is "fair from a financial point of view". That certainly sounds like something we should all favor, especially in deals that have obvious conflicts of interest, such as management-led leveraged buyouts or transactions like the Tesla/Solar City deal, where the interests of Elon Musk and the rest of Tesla 's stockholders may diverge.

Note that while fairness opinions have become part and parcel of most corporate control transactions, they are not required either by regulation or law. As with so much of business law, especially relating to acquisitions, the basis for fairness opinions and their surge in usage can be traced back to Delaware Court judgments. In Smith vs Van Gorkom, a 1985 case, the court ruled against the board of directors of Trans Union Corporation, who voted for a leveraged buyout, and specifically took them to task for the absence of a fairness opinion from an independent appraiser. In effect, the case carved out a safe harbor for the companies by noting that “the liability could have been avoided had the directors elicited a fairness opinion from anyone in a position to know the firm’s value”.  I am sure that the judges who wrote these words did so with the best of intentions, expecting fairness opinions to become the bulwark against self-dealing in mergers and acquisitions. In the decades since, through a combination of bad banking practices, the nature of the legal process and confusion about the word "fairness", fairness opinions, in my view, have not just lost their power to protect those that they were intended to but have become a shield used by managers and boards of directors against serious questions being raised about deals. 

Fairness Opinions: Current Practice?

There are appraisers who take their mission seriously and evaluate the fairness of transactions in their opinions, but the Tesla/Solar City valuations reflect not only how far we have strayed from the original idea of fairness but also how much bankers have lowered the bar on what constitutes acceptable practice.  Consider the process that Lazard and Evercore used by  to arrive at their fairness opinions in the Tesla/Solar City deal, and if Matt is right, they are not alone:

What about this process is fair, if bankers are allowed to concoct discount rates, and how is it an opinion, if the numbers are supplied by management? And who exactly is protected if the end result is a range of values so large that any price that is paid can be justified?  And finally, if the contention is that the bankers were just using professional judgment, in what way is it professional to argue that Tesla will become the global economy (as Evercore is doing in its valuation)? 

To the extent that what you see in the Tesla/Solar City deal is more the rule than the exception, I would argue that fairness opinions are doing more harm than good. By checking off a legally required box, they have become a way in which a board of directors buy immunization against legal consequences. By providing the illusion of oversight and an independent assessment, they are making shareholders too sanguine that their rights are being protected. Finally, this is a process where the worst (and least) scrupulous appraisers, over time, will drive out the best (and most principled) ones, because managers (and boards that do their bidding) will shop around until they find someone who will attest to the fairness of their deal, no matter how unfair it is. My interest in the process is therefore as much professional, as it is personal. I believe the valuation practices that we see in many fairness opinions are horrendous and are spilling over into the other valuation practices.

It is true that there are cases, where courts have been willing to challenge the "fairness" of fairness opinions, but they have been infrequent and  reserved for situations where there is an egregious conflict of interest. In an unusual twist, in a recent case involving the management buyout of Dell at $13.75 by Michael Dell and Silver Lake, Delaware Vice Chancellor Travis Lester ruled that the company should have been priced at $17.62, effectively throwing out the fairness opinion backing the deal. While the good news in Chancellor Lester's ruling is that he was willing to take on fairness opinions, the bad news is that he might have picked the wrong case to make his stand and the wrong basis (that markets are short term and under price companies after they have made big investments) for challenging fairness opinions.

Fish or Cut Bait?

Given that the fairness opinion, as practiced now, is more travesty than protection and an expensive one at that, the first option is to remove it from the acquisition valuation process. That will put the onus back on judges to decide whether shareholder interests are being protected in transactions. Given how difficult it is to change established legal practice, I don't think that this will happen. The second is to keep the fairness opinion and give it teeth. This will require two ingredients to work, judges that are willing to put fairness opinions to the test and punishment for those who consistently violate those fairness principles.

A Judicial Check

Many judges have allowed bankers to browbeat them into accepting the unacceptable in valuation, using the argument that what they are doing is standard practice and somehow professional valuation.  As someone who wanders across multiple valuation terrain, I am convinced that the valuation practices in fairness opinions are not just beyond the pale, they are unprofessional. To those judges, who would argue that they don't have the training or the tools to detect bad practices, I will make my pro bono contribution in the form of a questionnaire with flags (ranging from red for danger to green for acceptable) that may help them separate the good valuations from the bad ones.

Question	Green	Red
Who is paying you to do this valuation and how much? Is any of the payment contingent on the deal happening? (FINRA rule 2290 mandates disclosure on these)	Payment reflects reasonable payment for valuation services rendered and none of the payment is contingent on outcome	Payment is disproportionately large, relative to valuation services provided, and/or a large portion of it is contingent on deal occurring.
Where are you getting the cash flows that you are using in this valuation?	Appraiser estimates revenues, operating margins and cash flows, with input from management on investment and growth plans.	Cash flows supplied by management/ board of company.
Are the cash flows internally consistent?	1.     Currency: Cash flows & discount rate are in same currency, with same inflation assumptions. 2.     Claim holders: Cash flows are to equity (firm) and discount rate is cost of equity (capital). 3.     Operations: Reinvestment, growth and risk assumptions matched up.	No internal consistency tests run and/or DCF littered with inconsistencies, in currency and/or assumptions. -       High growth + Low reinvestment -       Low growth + High reinvestment -       High inflation in cash flows + Low inflation in discount rate
What discount rate are you using in your valuation?	A cost of equity (capital) that starts with a sector average and is within the bounds of what is reasonable for the sector and the market.	A cost of equity (capital) that falls outside the normal range for a sector, with no credible explanation for difference.
How are you applying closure in your valuation?	A terminal value that is estimated with a perpetual growth rate < growth rate of the economy and reinvestment & risk to match.	A terminal value based upon a perpetual growth rate > economy or a multiple (of earnings or revenues) that is not consistent with a healthy, mature firm.
What valuation garnishes have you applied?	None.	A large dose of premiums (control, synergy etc.) pushing up value or a mess of discounts (illiquidity, small size etc.) pushing down value.
What does your final judgment in value look like?	A distribution of values, with a base case value and distributional statistics.	A range of values so large that any price can be justified.

If this sounds like too much work, there are four changes that courts can incorporate into the practice of fairness opinions that will make an immediate difference:

1. Deal makers should not be deal analysts: It should go without saying that a deal making banker cannot be trusted to opine on the fairness of the deal, but the reason that I am saying it is that it does happen. I would go further and argue that deal makers should get entirely out of the fairness opinion business, since the banker who is asked to opine on the fairness of someone else's deal today will have to worry about his or her future deals being opined on by others.
2. No deal-contingent fees: If bias is the biggest enemy of good valuation, there is no simpler way to introduce bias into fairness opinions than to tie appraisal fees to whether the deal goes through. I cannot think of a single good reason for this practice and lots of bad consequences. It should be banished.
3. Valuing and Pricing: I think that appraisers should spend more time on pricing and less on valuation, since their focus is on whether the "price is fair" rather than on whether the transaction makes sense. That will require that appraisers be forced to justify their use of multiples (both in terms of the specific multiple used, as well as the value for that multiple) and their choice of comparable firms. If appraisers decide to go the valuation route, they should take ownership of the cash flows, use reasonable discount rates and not muddy up the waters with arbitrary premiums and discounts. And please, no more terminal values estimated from EBITDA multiples!
4. Distributions, not ranges: In my experience, using a range of value for a publicly traded stock to determine whether a price is fair is useless. It is analogous to asking, "Is it possible that this price is fair?", a question not worth asking, since the answer is almost always "yes". Instead, the question that should be asked and answered is "Is it plausible that this price is a fair one?"  To answer this question, the appraiser has to replace the range of values with a distribution, where rather than treat all possible prices as equally likely, the appraiser specifies a probability distribution. To illustrate, I valued Apple in May 2016 and derived a distribution of its values:

Let's assume that I had been asked to opine on whether a $160 stock price is a fair one for Apple. If I had presented this valuation as a range for Apple's value from $80.81 to $415.63, my answer would have to be yes, since it falls within the range. With a distribution, though, you can see that a $160 price falls at the 92nd percentile, possible, but neither plausible, nor probable.  To those who argue that this is too complex and requires more work, I would assume that this is at the minimum what you should be delivering, if you are being paid millions of dollars for an appraisal.

Punishment
The most disquieting aspect of the acquisition business is the absence of consequences for bad behavior, for any of the parties involved, as I noted in the aftermath of the disastrous HP/Autonomy merger. Thus, managers who overpay for a target are allowed to use the excuse of "we could not have seen that coming" and the deal makers who aided and abetted them in the process certainly don't return the advisory fees, for even the most abysmal advice. I think while mistakes are certainly part of business, bias and tilting the scales of fairness are not and there have to be consequences:

1. For the appraisers: If the fairness opinion is to have any heft, the courts should reject fairness opinions that don't meet the fairness test and remove the bankers involved  from the transaction, forcing them to return all fees paid. I would go further and create a Hall of Shame for those who are repeat offenders, with perhaps even a public listing of their most extreme offenses. 
2. For directors and managers: The boards of directors and the top management of the firms involved should also face sanctions, with any resulting fines or fees coming out of the pockets of directors and managers, rather than the shareholders involved.

I know that your reaction to these punitive suggestions is that they will have a chilling effect on deal making. Good! I believe that much as strategists, managers and bankers like to tell us otherwise, there are more bad deals than good ones and that shareholders in companies collectively will only gain from crimping the process.

YouTube Video


Attachments

1. The Fairness Questionnaire (as a word file, which you are free to add to or adapt)

Keystone Kop Valuations: Lazard, Evercore and the TSLA/SCTY Deal

It is get easy to get outraged by events around you, but I have learned, through hard experience, that writing when outraged is dangerous. After all, once you have climbed onto your high horse, it is easy to find fault with others and wallow in self-righteousness. It is for that reason that I have deliberately avoided taking issue with investment banking valuations of specific companies, much as I may disagree with the practices used in many of them. I understand that bankers make money on transactions and that their valuations are more sales tools than assessments of fair value and that asking them to pay attention to valuation first principles may be asking too much. Once in a while, though, I do come across a valuation so egregiously bad that I cannot restrain myself and reading through the prospectus filed by Tesla for their Solar City acquisition/merger was such an occasion. My first reaction as I read through the descriptions of how the bankers in this deal (Evercore for Tesla and Lazard for Solar City) valued the two companies was "You must be kidding me!".

The Tesla/Solar City Deal

In June 2016, Tesla announced that it intended to acquire Solar City in a stock swap, a surprise to almost everyone involved, except for Elon Musk. By August 1, the specifics of the deal had been ironed out and the broad contours of the deal are captured in the picture below:

At the time of the deal, Mr. Musk contended that the deal made sense for stockholders in both companies, arguing that it was a "no-brainer" that would allow Tesla to expand its reach and become a clean energy company. While Mr. Musk has a history of big claims and perhaps the smarts and charisma to deliver on them, this deal attracted attention because of its optics. Mr. Musk was the lead stockholder in both companies and CEO of Tesla and his cousin, Lyndon Rive, was the CEO of Solar City. Even Mr. Musk's strongest supporters could not contest the notion that he was in effective control at both companies, creating, at the very least. the potential for conflicts of interests. Those questions have not gone away in the months since and the market concerns have been reflected in the trend lines in the stock prices of the two companies, with Solar City down about 24% and Tesla's stock price dropping about 8%.

The board of directors at Tesla has recognized the potential for a legal backlash and as this New York Times article suggests, they have been careful to create at least the appearance of an open process, with Tesla's board hiring Evercore Partners, an investment bank, to review the deal and Solar City's board calling in Lazard as their deal assessor. Conspicuously missing is Goldman Sachs, the investment banker on Tesla's recent stock offering, but more about that later.

The Banking Challenge in a Friendly Merger

In any friendly merger, the bankers on the two sides of the deal face, what at first sight, looks like an impossible challenge. The banker for the acquiring company has to convince the stockholders of the acquiring company that they are getting a good deal, i.e., that they are acquiring the target company at a price, which while higher that the prevailing market price, is lower than the fair value for the company. At the same time, the banker for the target company has to convince the stockholders of the target company that they too are getting a good deal, i.e., that they are being acquired at is higher than their fair value. If you are a reasonably clever banking team, you discover very quickly that the only way you can straddle this divide is by bringing in what I call the two magic merger words, synergy and control. Synergy in particular is magical because it allows both sides to declare victory and control adds to the allure because it comes with the promise of unspecified changes that will be made at the target company and a 20% premium:

In the Tesla/Solar City deal, the bankers faced a particularly difficult challenge. Finding synergy in this merger of an electric car company and a solar cell company, one of which (Tesla) has brand name draw and potentially high margins and the other of which is a commodity business (Solar City) with pencil thin margins) is tough to do. Arguing that the companies will be better managed as one company is tricky when both companies have effectively been controlled by the same person(Musk) before the merger. In fact, it is far easier to make the case for reverse synergy here, since adding a debt-laden company with a questionable operating business (Solar City) to one that has promise but will need cash to deliver seems to be asking for trouble. The bankers could of course have come back and told the management of both companies (or just Elon Musk) that the deal does not make sense and especially so for the stockholders of Tesla but who can blame them for not doing so? After all, they are paid based upon whether the deal gets done and if asked to justify themselves, they would argue that Musk would have found other bankers who would have gone along. Consequently, I am not surprised that both banks found value in the deal and managed to justify it.

The Valuations

It is with this perspective in mind that I opened up the prospectus, expecting to see two bankers doing what I call Kabuki valuations, elaborately constructed DCFs where the final result is never in doubt, but you play with the numbers to make it look like you were valuing the company. Put differently, I was willing to cut a lot of slack on specifics, but what I found failed even the minimal tests of adequacy in valuation. Summarizing what the banks did, at least based upon the prospectus (lest I am accused of making up stuff):

Tesla Prospectus

Conveniently, these number provide backing for the Musk acquisition story, with Evercore reassuring Tesla stockholders that they are getting a good deal and Lazard doing the same with Solar City stockholders, while shamelessly setting value ranges so wide that they get legal cover, in case they get sued.  Note also not only how much money paid to these bankers for their skills at plugging in discount rates into spreadsheets but that both bankers get an additional payoff, if the merger goes through, with Evercore pocketing an extra $5.25 million and Lazard getting 0.4% of the equity value of Solar City.  There are many parts of these valuations that I can take issue with, but in the interests of fairness, I will start with what I term run-of-the-mill banking malpractice, i.e., bad practices that many bankers are guilty of.

1. No internal checks for consistency: There is almost a cavalier disregard for the connection between growth, risk and reinvestment. Thus, when both banks use ranges of growth for their perpetual value estimates, it looks like neither adjusts the cash flows as growth rates change. (Thus, when Lazard moves its perpetual growth rate for Solar City from 1.5% to 3%, it looks like the cash flow stays unchanged, a version of magical growth that can happen only on a spreadsheet).
2. Discount Rates: Both companies pay lip service to standard estimation technology (with talk of the CAPM and cost of capital), and I will give both bankers the benefit of the doubt and attribute the differences in their costs of capital to estimation differences, rather than to bias.  The bigger question, though, is why the discount rates don't change as you move through time to 2021, where both Tesla and Solar City are described as slower growth, money making companies.
3. Pricing and Valuation: I have posted extensively on the difference between pricing an asset/business and valuing it and how mixing the two can yield a incoherent mishmash. Both investment banks move back and forth between intrinsic valuation (in their use of cash flows from 2016-2020) and pricing, with Lazard estimating the terminal value of Tesla using a multiple of EBITDA. (See my post on dysfunctional DCFS, in general, and Trojan Horse DCFs, in particular).

There are two aspects of these valuations that are the over-the-top, even by banking valuation standards:

1. Outsourcing of cash flows: It looks like both bankers used cash flow forecasts provided to them by the management. In the case of Tesla, the expected cash flows for 2016-2020 were generated by Goldman Sachs Equity Research (GSER, See Page 99 of prospectus) and for Solar City, the cash flows for that same period were provided by Solar City, conveniently under two scenarios, one with a liquidity crunch and one without. Perhaps, Lazard and Evercore need reminders that if the CF in a DCF is supplied to you by someone else,  you are not valuing the company, and charging millions for plugging in discount rates into preset spreadsheets is outlandish. 
2. Terminal Value Hijinks: The terminal value is, by far, the biggest single number in a DCF and it is also the number where the most mischief is done in valuation. While some evade these mistakes by using pricing, there is only one consistent way to get terminal value in a DCF and that is to assume perpetual growth. While there are a multitude of estimation issues that plague perpetual growth based terminal value, from not adjusting the cost of capital to reflect mature company status to not modifying the reinvestment to reflect stable growth, there is one mistake that is deadly, and that is assuming a growth rate that is higher than that of the economy forever. With that context, consider these clippings from the prospectus on the assumptions about growth forever made by Evercore in their terminal value calculations:
   

   

   Tesla Prospectus

   I follow a rule of keeping the growth rate at or below the risk free rate but I am willing to accept the Lazard growth range of 1.5-3% as within the realm of possibility, but my reaction to the Evercore assumption of 6-8% growth forever in the Tesla valuation or even the 3-5% growth forever with the Solar City valuation cannot be repeated in polite company. 

Not content with creating one set of questionable valuations, both banks doubled down with a number of  of other pricing/valuations, including sum-of-the-parts valuations, pricing and transaction premiums, using a "throw everything at the fan and hope something sticks" strategy.

Now what? 

I don't think that Tesla's Solar City acquisition passes neither the smell test (for conflict of interest) nor the common sense test (of creating value), but I am not a shareholder in either Tesla or Solar City and I don't get a vote. When Tesla shareholders vote, given that owning the stock is by itself an admission that they buy into the Musk vision, I would not be surprised if they go along with his recommendations. Tesla shareholders and Elon Musk are a match made in market heaven and I wish them the best of luck in their life together.

As for the bankers involved in this deal, Lazard's primary sin is laziness, accepting an assignment where they are reduced to plugging in discount rates into someone else's cash flow forecasts and getting paid $2 million plus for that service. In fact, that laziness may also explain the $400 million debt double counting error made by Lazard on this valuation,. Evercore's problems go deeper. The Evercore valuation section of the prospectus is a horror story of bad assumptions piled on impossible ones, painting a picture of ignorance and incompetence. Finally, there is a third investment bank (Goldman Sachs), mentioned only in passing (in the cash flow forecasts provided by their equity research team), whose absence on this deal is a story by itself. Goldman's behavior all through this year, relating to Tesla, has been rife with conflicts of interest, highlighted perhaps by the Goldman equity research report touting Tesla as a buy, just before the Tesla stock offering. It is possible that they decided that their involvement on this deal would be the kiss of death for it, but I am curious about (a) whether Goldman had any input into the choice of Evercore and Lazard as deal bankers, (b) whether Goldman had any role in the estimation of Solar City cash flows, with and without liquidity constraints, and (c) how the Goldman Sachs Equity Research forecast became the basis for the Tesla valuations. Suspicious minds want to know! As investors, the good news is that you have a choice of investment bankers but the bad news is that you are choosing between the lazy, the incompetent and the ethically challenged.

If there were any justice in the world, you would like to see retribution against these banks in the form of legal sanctions and loss of business, but I will not hold my breath waiting for that to happen. The courts have tended to give too much respect for precedence and expert witnesses, even when the precedent or expert testimony fails common sense tests and it is possible that these valuations, while abysmal, will pass the legally defensible test. As for loss of business, my experience in valuation is that rather than being punished for doing bad valuations, bankers are rewarded for their deal-making prowess. So, for the many companies that do bad deals and need an investment banking sign-off on that deal (in the form of a fairness opinion), you will have no trouble finding a banker who will accommodate you.

If this post comes across as a diatribe against investment banking, I am sorry and I am not part of the "Blame the Banks for all our problems" school. In fact, I have long argued that bankers are the lubricants of a market economy, working through kinks in the system and filling in capital market needs and defended banking against its most virulent critics. That said, the banking work done on deals like the this one vindicate everyone's worst perceptions of bankers as a hired guns who cannot shoot straight, more Keystone Kops than Wyatt Earps!

YouTube Video


Attachments

1. Tesla Prospectus for Solar City Deal