Showing posts with label Corporate Crisis. Show all posts
Showing posts with label Corporate Crisis. Show all posts

Thursday, July 2, 2020

A Viral Market Update XI: The Flexibility Premium

I must confess that when I started these updates in February, I did not expect to be doing them in July, but a crisis is as good a time as any, to learn new lessons and relearn old ones. As the virus makes a comeback, particularly in the United States, it is not surprising that markets reflect the uncertainty that we all feel about how the rest of the year will play out in both our personal and business lives, with  mood rising and falling on positive and negative news stories. In this post, I will begin by updating the numbers for markets overall, and within the equity market, across regions, sectors and industries. I will then use the differences I see across companies to highlight flexibility in investing, operating, financing and cash return policies as the one quality that seems to be separating the winners from the losers in these last few months, and argue that this represents an acceleration of a longer term shift towards more nimble and adaptable business models.

Market Update
If you have been reading all of my viral market updates during this crisis, I admire your fortitude, and I know that you will get a sense of deja vu, as you read this section, since I follow the same road map on each of them. I start, as always, by looking at US dollar returns on selected equity indices around the world:

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Looking at the entire time period (2/14-6/26), US equity indices have done better than European equity indices, with a strong rebound from the lows of March 20 allowing for a complete recoupment of losses in the NASDAQ and an almost complete retracing for the S&P 500. Asian equities have diverged, with Japan and China performing better than India. As equities have seesawed, US treasury bonds have stabilized, after a steep drop in yields in the first four weeks of the crisis:
The treasury rates have settled in, at least for the moment, at close to zero at the short end of the maturity spectrum and at about 0.65-0.75% for the 10-year bonds and 1.2-1.4% for 30-year bonds. I know that there is a widely held view that it is the Fed that has engineered the rate drop, but note that much of the decline occurred before the Fed made its quantitative easing announcements in mid-march.  I think that the Fed’s real impact has been on private lending, with its March 23rd announcement that it would operate as a backstop in corporate bond and lending markets. You can see the effects of that announcement on default spreads for corporate bonds, across ratings classes:
Note the climb in default spreads between February 14 and March 23, with investment grade (BBB) rated bonds almost tripling during that period, and the pull back in spreads since, to end at levels higher than on February 14, but well below the March 23rd levels. Mirroring the changes in the price of risk in the corporate bond markets, the price of risk in equity markets (measured with an implied equity risk premium) has been on a wild ride, rising dramatically between February 14 and March 23, before sliding down towards pre-crisis levels:
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At one level, the fact that equity risk premiums are above 5% and well above historic norms (4.86% between 2000-2019 and 4.20% between 1960-2019) may seem comforting, but there is a disconcerting component to these expected values. The equity risk premium of 4.83% on February 14 was earned on top of a ten-year bond rate of 1.59%, yielding an expected return of 6.42% on equities, already low by historic standards. The equity risk premium of 5.23% on June 30 was earned over and above a ten-year bond rate of 0.66%, yielding an annual expected return of 5.89% on equities for the long term, a number well below the 7-8% that investors were pricing stocks to earn during much of the last decade. Paraphrasing Winston Churchill, equities don't look good as an investment class, until you compare them to the alternatives.

Looking at oil and copper, the two economically-sensitive commodities that I have tracked through this crisis, the divergence between the two remains, with oil prices down almost 30% since February 14 and copper prices up 4.31% since that date:

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Finally, I keep tabs on gold, a crisis investment of long standing, and bitcoin, a more recent entrant into the game. 

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If this were a contest for a crisis asset, gold wins by a knock out, since bitcoin, at least during this crisis has moved with stocks, dropping more than 50% between February 14 and March 20 and rising more than 70% from its lows after March 20. It is possible that bitcoin can still live up to the promise of being a good currency, but it has not even come close to being one yet, snd if you are a Bitcoin advocate, you have your work cut out for you.

Equities: An Overview
I stick with my practice of downloading the market capitalizations of all publicly traded companies in the world, and then computing aggregated changes in value by groupings. In my first grouping, I look at how equities have performed across the regions of the world:

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Looking at percentage change in aggregate market capitalization between February 14 and June 26, global equities have lost 9.30% of their value ($8.4 trillion), but that is quite a comeback from the 29% loss ($26.3 trillion) recorded on March 20. Emerging markets in Africa, Latin America and Eastern Europe show far more damage than developed markets over the entire period (February 14-June26), though the UK is an exception, down almost 20%. Breaking down the market action by sector:

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If you were primarily invested in technology and health care, your reaction to the crisis might be "What crisis?", since those sectors are now ahead of where they were on February 14, and consumer product companies (both discretionary and staple) are not far behind. Energy and real estate have lagged the market, as have utilities, but financials remain the worst performing sector remains. If you look at the last four columns, you can see that even in sectors that have held their own during this period, the recovery has been uneven, with more stocks down than up in every sector. Finally, I break down sectors into industries, and list the ten worst and best performing, in terms of market cap change from February 14 to June 26:
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As in my prior week updates, there is a preponderance of infrastructure and financial services in the worst performing industry list, and a dominance of health care and technology on the best perfuming list. Education is a new entrant into the best performing list, perhaps reflecting the promise and potential of online education.

The Flexibility Story
As the market makes its way back from its lows, it remains an uneven one, with wide divergences between winners and losers, and in my earlier posts, I have looked for clues in the data. In my fourth post from March 23, I noted that heavily indebted companies have under performed companies with lighter debt loads, and in my eighth post from May 13, I highlighted the fact that growth stocks are outperforming value stocks. In my last post from June 19, I used the concept of a corporate life cycle, and noted that younger companies seems to be doing much better than older companies. Others have noted that capital intensive businesses seem to have been worse affected during this crisis than capital-light businesses, and early in the crisis, buybacks were highlighted as a reason why some companies and sectors were doing worse than others. In fact, the new buzzword that business consultants are pushing is "resilience", arguing that the resilient companies have weathered this crisis better than the rest of the market. While there is some truth in all of these contentions, I would argue that if there is one quality that ties together all of these seemingly disparate factors, it is flexibility, and this crisis has reaffirmed the value of flexibility.

Flexibility across the Business Model
Simply put, the flexibility of an organization measures the speed and cost with which it responds to changed circumstances, with more flexible firms adjusting faster and at lower cost than less flexible firms. That definition, though, encompasses a range of actions that stretch across every aspect of business, covering everything from how investments are made, to how the business is operated, to how it is funded, and finally to how much cash is returned to owners (in the form of dividends and buybacks).

a. Investment Flexibility
To grow, businesses have to reinvest and investment flexibility measures how much they have to reinvest to deliver a given growth rate, and how long it will take for the investment to pay off. 


While it is true that companies that are in businesses that require heavy infrastructure investment (toll roads, telecommunications, automobiles) have low investment flexibility, and service and software firms generally have high investment flexibility, the divide is not necessarily on whether the investments are in tangible or intangible assets. Pharmaceutical companies, for instance, have low investment flexibility because they have to spend large amounts in R&D, with significant leakage (as some R&D will not pay off) and have to wait long periods before commercial success. Over the last decade, disruption in many businesses with a history of low investment flexibility has come from new entrants with business models that allow them to scale up quickly, with relatively low investment. Uber and Airbnb are examples of sharing economy companies that have had a decisive advantage this dimension over their established competitors. To see how this crisis has played out on the financial flexibility dimension, I classified all non-financial service companies listed globally, based upon the ratio of sales to invested capital, on the (questionable) assumption that invested capital (computed from the accounting balance sheet values of debt, equity and cash) measures reinvestment, into ten deciles:

Note that companies that can generate the most revenues per dollar of invested capital are signaling the highest investment flexibility and they have done far better during this crisis than firms that are in lowest decile of this measure. Some of this may be spurious correlation, but it is an interesting first take on how investment flexibility has been treated by the COVID market.

b. Operating Flexibility
During the course of operations, businesses will be hit by shock that cause their revenues to unexpectedly increase or drop, and operating flexibility measures how those revenue changes flow through into operating profitability. The key to decoding this effect is to break down the operating expenses of a company into fixed and variable, with the latter moving up and down with revenues, while the former stays fixed:

Companies with high fixed costs, as a percent of revenues, will see much more dramatic swings in operating income, as revenues change, than companies that have more flexible cost structures. It is not surprising, therefore, that airlines have wild swings in profitability from good years to bad ones, whereas online retailers and service businesses have more muted effects. To see how operating flexibility has played out in this market, I would have liked to have broken costs down into fixed and variable for all companies, but lacking clean accounting measures of either, I settled for gross profit margins, on the assumption that companies with high gross margins have far more flexibility in dealing with revenue shocks than companies with low margins. Breaking down companies based upon gross margin into deciles, here is what I find:

With a full admission that gross margin is a flawed measure of operating flexibility, companies with higher gross margins have done better than companies with lower gross margins, as this crisis has unfolded.

c. Financing Flexibility
As revenues go up and down, and operating income tracks those changes, financial flexibility measures how much net income (to equity investors) is altered, with firms with low financial flexibility showing much bigger swings in net income for a given change in operating income. The key drivers of financial flexibility are debt obligations and cash holdings, with the interest expenses on the former pushing up net income volatility, and the interest income from the latter dampening that volatility:

If net debt, as a percent of cash flows or value, is the driver of financial flexibility, we can see how financial flexibility has played out in this crisis by breaking companies down into deciles based upon Net Debt as a multiple of EBITDA:

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Companies with high net debt ratios have low financial flexibility and they have been damaged far more than companies with low net debt ratios. Note that the lowest decile of net debt ratios includes firms that have negative net debt, i.e., cash balances that exceed the debt, and they show an increase in market capitalizations between February 14 and June 26.

d. Cash Return Flexibility
The end game, when investing in publicly traded company stocks, is to collect cash flows from that investment, and companies have two choices when it comes to returning cash. The conventional approach has been to pay dividends, but over the last three decades, US companies in particular have turned to returning cash in the form of buybacks. Both dividends and buybacks have to be funded by cashflows to equity investors, and cash return flexibility measures how quickly companies can adjust their cash returns to reflect changes in cash flows to equity:

Obviously, companies that return little or no cash, relative to their free cash flows to equity, are not only accumulating cash, but have far more cash return flexibility than companies that return a large proportion of their cash flows. Since dividends still remain the primary mechanism for returning cash across the world, I start by looking at dividend yield, classified into deciles, and looking at the market action in each decile for global companies:
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Clearly non-dividend paying stocks and stocks with low dividend yields have done much better than companies with high dividend yields. Among companies that do return large portions of cash, those that return the bulk of their cash flows in the form of dividends have far less flexibility than those that buy back stock, mostly because dividends are sticky, since once they are initiated and set, companies are reluctant to change them. To examine whether the mode of cash return has been a factor in the market action, I break companies into four groups based upon whether they pay dividends and/or buy back stock:

While companies that pay both dividends and buybacks have been worst affected and companies that use neither have performed the best over the period, isolating only companies that pay only dividends or buy back stock, companies that pay only dividends have under performed companies that buy back only stock. While the results are only indicative, they do suggest that making buybacks the bogeyman in this crisis is not backed up by the evidence.

Implications and Conclusion
During this crisis, markets have rewarded flexible companies, a continuation of a trend that predate the crisis to the last one. If the last decade has been a disruptive one, that disruption has been largely driven  by companies that have not only built flexible structures, but also used that flexibility to gain competitive advantages over their status quo competitors. As companies get pushed to increase flexibility, it is worth noting that this quest comes with costs, and these trade offs have to be acknowledged:
  1. Compressed Corporate Life Cycle: Earlier in this post, I argued that one of the benefits of having high investment flexibility is that companies can scale up faster; Uber and Airbnb have been able to go from start ups to large companies (at least in terms of operations and value) in very short time periods. However, the same forces that allow these companies to scale up faster also create business models which are more difficult to defend against new competitors, leading to shorter periods of maturity and more speedy decline, with important consequences.
  2. Losses on the upside: With operating and financial flexibility, the trade off is much simpler, since companies with greater operating and financial flexibility will be more protected on the downside, but at the expense of giving up some of the upside. Having large fixed costs and/or high net debt will result in bigger losses when times are bad, but it will also create larger profits on the upside.
  3. Social costs: As new business models are built to have motor flexibility, some of the actions that increase flexibility come with costs that are borne by society, rather than the company. For instance, Uber's business model of treating drivers as independent contractors rather than employees gives the company a more flexible cost structure, but it does pass on the costs of providing a safety net (health care and pensions) to society. As a society, we need to debate whether the benefits we gain by having a more nimble economy outweigh the social costs. 
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Tuesday, April 10, 2018

The Facebook Feeding Frenzy: Time for a Pause!

In my last post, I noted that the FANG stocks have been in the spotlight, as tech has taken a beating in the market, but it is Facebook that is at the center of the storm. It was the news story on Cambridge Analytica's misuse of Facebook user data,  in mid-March of 2018, that started the ball rolling and in the days since, not only have more unpleasant details emerged about Facebook's culpability, but the rest of the world seems to have decided to unfriend Facebook. More ominously, regulators and politicians have also turned their attention to the company and that attention will be heightened, with Zuckerberg testifying in front of Congress. That is a precipitous fall from grace for a company that only a short while ago epitomized the new economy.

A Personal Odyssey
My interest in Facebook dates back to the year before it went public, when it was already getting attention because of its giant user base and its high private company valuation. In the weeks leading up to its IPO, I valued Facebook at about $29/share, with a story built around it becoming a Google wannabe. If that sounded insulting, it was not meant to be, since having a revenue path and operating margins that mimicked the most successful tech companies in the decade prior is quite a feat.

That initial public offering was among the most mismanaged in recent years and a combination of hubris and poor timing led to an offering day fiasco, where the investment bankers had to step in to support the priced. The first few months after the offering were tough ones for Facebook, with the stock dropping to $19 by September 2012, when I argued that it was time to befriend the company and buy its stock, one of the few times in my life when I have bought a stock at its absolute low.

Much as I would like to tell you that I had the foresight to see Facebook's rise from 2012 through 2017 and that I held on to the stock, I did not, and I sold the stock just as it got to $50, concerned that the advertising business was not big enough to accommodate the players (Google, the social media companies and traditional advertising companies), elbowing for market share. I under estimated how much Google and Facebook would both expand the market and dominate it, but I have no regrets about selling too early. I did what I felt was right, given my assessment and investment philosophy, at the time.

A Numbers Update
To undersand how Facebook became the company that it is today, let's start with its most impressive numbers, which are related to its user base. At the start of 2018, Facebook had more than 2.1 billion users, about 30% of the world's population:

While the user numbers have leveled off in North America, where Facebook already counts 72.5% of the population in its user base, the company continues to grow its user base in the rest of the world, with an added impetus coming from the scaling up of Instagram, Facebook's video arm. These user numbers, while staggering, are made even more so when you consider how much time Facebook users spend on its platforms:
Collectively, users spent more than an hour a day on Facebook platforms, and that usage does not reflect the time spent on WhatsApp, also owned by Facebook, by its 1.5 billion users.

If you are a value investor, it would easy to dismiss Facebook as another user-chasing tech company and deliver a cutting remark that you cannot pay dividends with users, but Facebook is an exception. It has managed to to convert its user base into revenues and more critically, operating profits.

With its operating margin approaching 58%, if you capitalize its technology and content costs, Facebook outshines most of the other companies in the S&P 500, in both growth and profitability:

What makes Facebook's rise even more impressive is that it has been able to deliver these results in a market, where it faces an equally voracious competitor in Google.

In summary, Facebook has had perhaps the most productive opening act in history of any publicly listed company, if you define production in operating results. It promised the moon at the time of its IPO, and has delivered the sun. In my book on connecting stories to value, I pointed to Facebook as a company that seemed to find new ways, with each acquisition, announcement and earning report, to expand and broaden its story, first by conquering mobile and then going global. By the start of 2016, I had changed my story for Facebook from a Google Wannabe to one that would eclipse Google, with added potential from its user base. While the Facebook story has been one of business success, the company, its users and investors have been in denial about central elements in the story. Facebook's users have been trading information on themselves to the company in return for a social media site where they can interact with friends, family and acquaintances, and their complaints about lost privacy ring hollow. Facebook's strengths are built upon using the information that users provide about themselves to better target advertising and generate revenues, but Facebook and its investors have been unwilling to face up to the reality that the company's high margins reflect its use of third parties and outsiders to collect and manage data, a business practice that is profitable but that also creates the potential for data leakages. (Some of you seem to be reading into my words an implication that Facebook sells user data to third parties to generate revenues. It does not. It processes the data to make it information (its first competitive advantage), uses that information to better target advertising and generates revenues, as a consequence.)

A Story Break, Twist or Change?
If the Facebook story so far sounds like a fairy tale, there has to be a dark twist, and while Facebook's troubles are often traced back to the stories in mid-March 2018, when the current user scandal news cycle began, its problems have been simmering for much longer. Put on the defensive, after the 2016 US presidential elections, for being a purveyor of fake news, Facebook announced in January 2018, that it had changed its news feed to emphasize user interaction over passive consumption of public news feeds. That change, which led to a leveling off in user numbers and a loss of advertising revenues was not well received on Wall Street, with the stock price dropping almost 5%.

If Facebook was trying to preempt its critics with this announcement, the Cambridge Analytica story has knocked them off stride. Specifically, a whistle blower at Cambridge Analytica claimed that the company has not only accessed detailed user data on 50 million Facebook users but had used that data to target voters in political campaigns. In the three weeks since, the story has worsened for Facebook both in terms of numbers (with accessed users increasing to 87 million) and culpability (with Facebook's sloppiness in protecting user data highlighted). As politicians, commentators and competitors have jumped in to exploit the breach, financial markets knocked off $81 billion from Facebook's market capitalization. It is unquestionable that Facebook is mired in a mess and that it deserves market punishment, but from an investing perspective, the question becomes whether the loss in value is merited or not. 

The worst case scenario, and some have bought into this, is that the company will lose users, both in numbers and intensity, and that advertisers will pull out. If you add large fines and regulatory restrictions on data usage that may cripple Facebook's capacity to use that data in targeted advertising, you have the makings of a perfect storm, playing out as flat or declining revenues, big increases in operating costs and imploding value. In my view, and I may very well be wrong, I think the effects will be more benign:
  1. User loss, in numbers and intensity, will be muted: It is still early in this news cycle, and there may be more damaging revelations to come, but I don't believe that anything that has come out so far is  egregious enough to cause large numbers of users to flee. We live in cynical times and many users will probably agree with Mark Snyder, a Facebook user whose data had been accessed by Cambridge Analytica, who is quoted as saying in this New York Times article, "If you sign up for anything and it isn’t immediately obvious how they’re making money, they’re making money off of you.” There is some preliminary evidence that can be gleaned from surveys taken right after the stories broke, which indicate that only about 8% of Facebook users are considering leaving and 19% plan significant cutbacks in usage. If this represents the high water mark, the actual damage will be smaller. I will assume that Facebook's push towards more data protections and its larger base will slow growth in revenues down to about 20% a year, for the next 5 years, from the 51.53% growth rate over the last five years.
    Source: Raymond James, reported by Variety
  2. Advertisers will mostly stay on: While a few companies, like Mozilla, Pep Boys and Commerzbank, announced that they were pulling their ads from Facebook, there is little evidence that advertisers are abandoning Facebook in droves, since much of what attracted them to Facebook (its large and intense user base and targeting) still remains in place. Facebook, in an attempt to clean up the platform, may impose restrictions on advertisers that may drive some of them away. For instance, last week, Facebook announced that it would stop accepting political advertisements from anonymous entities and I would not be surprised to see more self-imposed restrictions on advertising. I will assume that there will be more defections in the weeks ahead, mostly from companies that don't feel that their Facebook advertising is effective right now, leading to a loss in revenues of $1.5 billion next year.
  3. Data restrictions are coming, and will be costly: There is no doubt that data restrictions are coming, with the question being about how restrictive they will be and what it will cost Facebook to implement them. Data privacy laws, modeled on the EU's format, will require the company to hire more people to oversee data collection and protection. I will assume that these actions will push up costs and reduce the pre-tax operating margin from 57%, after capitalizing technology and content costs, to 42% over the next 5 years. Pre-capitalization of technology and content, I am expecting the operating margin to drop from 49.7% (current) to about 37-38%,
  4. There will be fines: This is a wild card in this process, with the possibility that the Federal Trade Commission  may impose a fines on the company for violating an agreement reached in 2011, where Facebook agreed to protect user data from unauthorized access. While no one seems to have a clear idea of how much these fines will be, other than that they will be large, there are some who believe that the fines could be as high as a billion dollars. I will assume that the FTC will use Facebook to send a signal to other companies that collect data, by fining it $1 billion.
As I see it, the scandal will lead to lost sales in the near term, slow revenue growth in the coming years and increase costs at the company, making the Facebook story a less attractive one. My estimates of how the story changes will play out in the numbers is shown below:
In summary, the story that I have for Facebook is still an upbeat one, albeit one with lower growth and operating margins. The resulting value is shown below:
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The value per share that I obtain, with my story, is abut $181, and on April 3, the date of the valuation, the stock was trading at $155 a share. As always, I am sure that there are inputs where you will disagree with me, and if you do, you can download the spreadsheet and change the numbers that you disagree with. Some of you may be wondering why I have no margin of safety, but as I noted in this post on the topic from a while back, I believe that there are more effective ways of dealing with uncertainty that adopting an arbitrary margin of safety and sitting on the sidelines. In fact, my favored device is to face up to uncertainty frontally in a simulation, shown below:
Simulation run with Crystal Ball, in Excel
This graph reinforces my decision to invest in Facebook. While it is true that there is a 30% chance that the stock is still over valued, there is more upside than downside potential, given my inputs. The median value of $179 is close to my point estimate value, but that should be no surprise since my distributions were centered on my base case assumptions.

Time to Buy?
Every corporate scandal becomes a morality play, and the current one that revolves around Facebook is no exception. Facebook has been sloppy with user data, driven partly by greed (to keep costs down and profits up) and partly by arrogance (that its data protections were sufficient), and is and should be held accountable for its mistakes. That said, I don't see Facebook as a villain, and I don't think that the company should be used as a punching bag for our concerns about politics and society.  I am sure that when Mark Zuckerberg delivers his prepared testimony in a couple of hours, senators from both parties will lecture him on Facebook's sins, blissfully blind to their hypocrisy, since I am sure that many of them have had no qualms about using social media data to target their voters. I hear friends and acquaintances wax eloquent about invasion of privacy and how data is sacred, all too often on their favorite social media platforms, while revealing details about their personal lives that would make Kim Kardashian blush. I am an inactive Facebook user, having posted only once on its platform, but to those who would tar and feather the company for its perceived sins, I will paraphrase Shakespeare, and argue that the fault for our loss of privacy is not in our social media, but in how much we share online. I will invest in Facebook, with neither shame nor apology, because I think it remains a good business that I can buy at a reasonable price.

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Data Links

  1. Valuation of Facebook - April 2018
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