From Shareholder wealth to Stakeholder interests: CEO Capitulation or Empty Doublespeak?

Last week. the Business Roundtable, composed of the CEOs of some of America’s largest companies, put out a press release that hinted at a fundamental, perhaps revolutionary, shift in corporate focus. In the statement, the CEOs seemed to be saying that corporations should be run to protect all corporate stakeholders, defined to include customers, society and employees, rather than hew to its conventional objective of maximizing shareholder wealth. The reason that I say “seemed to” is because the document was written in CEO-speak, full of platitudes and open to interpretation. I will confess that I have a personal interest in this debate since I teach and write about corporate finance, a discipline built around shareholder wealth maximization, and valuation, which is about measuring it.

The Business Roundtable Speaks: A flawed message from a flawed messenger

The Business Roundtable, tracing it history back to 1972, and restricting its membership to CEOs of major corporations, lobbies for business-friendly legislation and has a history of making statements about corporate purpose that are usually completely predictable and not very newsworthy. This year’s statement, at least on the surface, breaks with this past with its talk of stakeholder interests and rather than give you my interpretation of the statement, I will quote directly from it:
While each of our individual companies serves its own corporate purpose, we share a fundamental commitment to all of our stakeholders. We commit to:

• Delivering value to our customers. We will further the tradition of American companies leading the way in meeting or exceeding customer expectations.
• Investing in our employees. This starts with compensating them fairly and providing important benefits. It also includes supporting them through training and education that help develop new skills for a rapidly changing world. We foster diversity and inclusion, dignity and respect.
• Dealing fairly and ethically with our suppliers. We are dedicated to serving as good partners to the other companies, large and small, that help us meet our missions.
• Supporting the communities in which we work. We respect the people in our communities and protect the environment by embracing sustainable practices across our businesses.
• Generating long-term value for shareholders, who provide the capital that allows companies to invest, grow and innovate. We are committed to transparency and effective engagement with shareholders.

The use of the word “stakeholders: and an explicit listing of how corporations should act in each of their interests has drawn extensive attention from a diverse group of individuals, each drawing its own conclusions and making its own criticisms. Critics of shareholder wealth maximization viewed this statement as vindication, an acceptance of their long-term tenet that focusing on shareholder wealth has given rise to income inequality, loss of good manufacturing jobs and societal costs. Supporters of shareholder wealth maximization considered the statement to be not only ill-advised but also a craven concession to populist forces. Cynics argued that it was more political document than restatement of purpose, smoke and noise that signified nothing. Journalists have concluded that this statement is, in fact, a fundamental restatement of corporate purpose, driven by political pressures. 

While the statement was signed by 181 CEOs, including Bezos (Amazon), Tim Cook (Apple), Brian Moynihan (B of A) and Mary Barra (GM), I found it odd that Jamie Dimon, the CEO of JP Morgan Chase, was the person who was chosen to deliver the message. To give Mr. Dimon his due, he is a very good banker and has excellent political skills, a plus at the top of a money center bank, but he is definitely not someone that I would view as putting shareholder interests first. Over the last decade, Jamie Dimon has repeatedly clashed with his own stockholders, first over his decision to chair the board of directors that is supposed to oversee him and multiple times about his compensation. He has technically won these fights at annual meetings, but with some of the highest opposition among large, widely held public companies, and he has been well protected by his ineffectual and mostly rubber stamp board of directors. Jamie Dimon talking about shareholder wealth is about as believable as Madonna singing “like a virgin” or Kim Kardashian speaking about the importance of privacy.

The Stakeholders in a Corporation

To most laymen, the debate about whether to focus on shareholders or stakeholders may seem like an obscure one that has few consequences for their lives, but it is of huge import and the best way to get perspective is to see who these stakeholders in the modern corporation are and what their relationship is with public companies:

Stakeholders therefore have different legal relationships with the company and divergent interests, implying that actions that make one stakeholder group better off may make other stakeholder groups worse. It is this conflict that makes the discussion of which group has primacy in decision making so heated and political. 

Versions of Corporatism

In the section below, I will present five different perspectives on how corporations are run, and I will let you draw your own conclusions on which one best describes current corporate behavior and argue that your that choice will determine, in large part, what you think should be the norm.

1. Cutthroat Corporatism
The most extreme view of corporations is what describe as cutthroat capitalism, where the strong companies drive out the weak and the end game is stockholder wealth maximization (often with a founder/family being the prime beneficiary) at almost any cost:

In the late nineteenth century, the robber barons of the age (Andrew Carnegie, John D. Rockefeller and others) hewed to this template to build some of the greatest companies of the time, some of which survive to this day. They were ruthless in their march towards domination, crushing competitors through fair means or foul, bending society to their will and exploiting customers and employees. Their overreach led to Teddy Roosevelt’s election and the subsequent passage of antitrust laws, but much as we tend to view these corporate chieftains as villains, they played a major role in making the US a global economic power. In the century since, there are other companies that have aspired for dominance, using what many critics have viewed as ruthless and perhaps even illegal ways to exercise market dominance. Lest you view this model of corporate behavior as a historical artifact, many of today's companies have, at least in some aspects of their behavior, have been accused of following this model.

2. Crony Corporatism

A variant of this win-at-all-costs corporatism is crony corporatism, where the end game is still market dominance but the base is built less on economies of scale, efficient operations and product differentiation, and more on connections to government and rule writers, with the objective being tilting the scales of competition in the company’s favor:

While the end result of cutthroat and crony capitalism is the same, i.e., large market-dominating companies that give short shrift to employees and customers, it can be argued that since the winners are the most connected, not the most efficient, crony capitalism offers all of the costs of cutthroat capitalism, with none of the benefits. While family group companies in some emerging markets obviously fit this mould, I think that an argument can be made that there is an element of cronyism in many developed markets.

3. Managerial Corporatism

There is a third version of corporatism that comes to the forefront, especially as public companies age, founders/families are replaced with professional managers and shareholdings get dispersed among lots of shareholders with small (percent) stakes. In this version, it is the professional managers whose interests drive decision making in the company, with other stakeholders viewed as side players.

Note that the managers who make corporate decisions often own little equity in the company, or if they do, get it as part of compensation packages, often determined by boards of directors that operate less as checks and more as rubber stamps. The question of how well other stakeholders do in this version depends in large part on whether their interests converge on those of managers; if there is convergence, their interests will be advanced, but only because it happens to advance managerial interests as well, and if not, they will find themselves paying the price to make managers better off. This was the default for US companies in the decades after the second world war, with long tenures for CEOs and little or no shareholder activism, and overall economic prosperity allowing for a coopting of other stakeholder: solid wage gains for employees, corporate charity and restrained competition.

4. Constrained Corporatism

I suspect that there are very few people, even among true believers in free markets and capitalism, who will defend cutthroat or crony capitalism. There are some who are nostalgic for managerial corporatism, pointing to the solid stock returns, well-paying jobs and societal side benefits that came with it, not seeing that these stakeholder benefits were made possible by US economic dominance during the period, and the ease with US companies could make money. It is no coincidence that shareholder activism rose to the surface in the 1980s, as US economic power slipped and managerial interests were served at the expense of not just shareholders, but other stakeholders. While this activism resulted in leveraged buyouts in some companies, it also gave rise to a version of shareholder wealth maximization that I center my corporate finance decision making, that I call constrained corporatism, where companies preserve the primacy of shareholders, while constraining how they interact with other stakeholder groups:

The efficacy of this version of corporatism depends largely on how well the constraints protect other stakeholders and what drives companies to adopt the constraints in the first place, with three possible drivers for the latter:

• Government-imposed constraints: Governments can write laws or draw up rules that constrain how corporations treat stakeholders, with labor laws determining not only how much workers get paid but also conditions under which they can be hired or fired, product laws capping prices on some products and protecting customer interests in others and anti-trust laws determining whether product markets stay competitive. European governments have been far more aggressive with this approach than the US, but the globalization of businesses has not only weakened the protections offered by these laws, but also put companies covered by them at a competitive disadvantage, relative to companies that operate in countries without these laws and restrictions.
• Self-imposed constraints: In this variant, companies voluntarily adopt constraints on their interactions with other stakeholder groups, often choosing to pay higher wages (than they could get away paying) to their employees, charging customers less for products/services than they could have, given their pricing power, and turning away investments that they could pursue legally, for profits, because of the costs that it will create for society. In effect, the essence of these constraints is that the profit settles for less profit than it could have made if it have as an unconstrained player. The problem with self-imposed constraints is that your capacity to adopt them will be correlated with how profitable you are to begin with, with companies with more slack built into their business models being in a better position than companies facing profit pressures in an intensely competitive market. 
• Market-driven constraints: In this final variation, companies adopt constraints on how they treat stakeholders because it makes them more valuable companies, even as they settle for less profits, at least in the near term. That seeming contradiction can be explained by two factors. The first is that whatever costs the company faces in the short term from imposing the constraints may be overwhelmed by benefits in the long term; paying employees more may yield more loyal and better employees, offering customers better deals may lead to more repeat business and being a good corporate citizen may operate as advertising, attracting more customers to the company. To top it all off, investors who care about any or all of these behaviors may be more inclined to invest in your shares, pushing up stock prices. The second is that companies that exploit customers and employees or acquire a reputation for being bad corporate citizens will have few defenders when it does make a mistake or have a problem, inevitable in the long term, leading to potentially catastrophic costs.

As an advocate for shareholder wealth maximization, I would love to live in a world where the market rewarded companies that try to do the right thing, since it would make good behavior entirely consistent with value maximization. That said, I am a realist and accept that some constraints have to be imposed by governments, regulators and rule writers, and that some companies, especially ones with strong profitability and substantial slack in their business models, may accept self constraints.

5. Confused Corporatism
In some sectors and in some markets and during some time periods, markets will not do the job, leaving us as the mercy of bad behavior by some or many corporate players. It is therefore not surprising that stakeholder wealth maximization is seen as an alternative corporate model:

It is quite clear that the corporate mission in this version of corporatism has been enlarged to cover all stakeholders, often with very different interests at heart. On the surface, it may look like constrained capitalism, but unlike it, in this version, you have multiple objectives, with no clear sense of which one dominates. Your job as a top manager or CEO is to pay not just a fair, but a living wage, even if you cannot afford it as a company, but also deliver maximum value to your customer, preserve society’s best interests and ensure that your business stays competitive, while also making sure that you deliver the returns your stockholders and lenders desire. In my view, it is destined to fail for three reasons:

• Conflicting interests: By treating the interests of all stakeholders as equivalent, it ignores the reality that decisions in companies, almost by definition, will make stakeholders better off and others worse off. Since some of these costs and benefits will be not easily translated into numbers, it is not clear how managers will be able to decide what investments to take, what businesses to enter and exit, how to finance these businesses and when and how much cash to return to shareholders. 
• No accountability: The fact that there are multiple stakeholders with conflicting interests also leaves CEOs and top managers accountable to none of them, with the excuse with any group that was ill-served during a period being that other group’s interests had to be met. 
• Decision paralysis: If one of the problems at large companies has been the time it takes to make decisions, I will predict that expanding decision making to take into account the interests of all stakeholders will create decision paralysis, as the “on the one hand, and on the other” arguments will multiply, often with no way to resolve them, since some stakeholder interests will remain fuzzy and non-measurable.

To those who believe that stakeholder wealth maximization will usher in a period of common good, with society, customers and employees benefiting from more compassionate corporatism, I offer you two cautionary counter examples. First, you may want to take a look at government-owned and run companies not just in the socialist economies but in many capitalist ones. The managers of these companies were given a laundry list of objectives, resembling in large part the listing of stakeholder objectives, and told to deliver on them all. The end results were some of the most inefficient companies on the face of the earth, with every stakeholder group feeling ill-served in the process. Second, let me use a second illustration not from the corporate sector, but s setting that I am intimately familiar with, because I have spent almost four decades of my life in it. Research universities in the United States are entities built without a central focus, where the stakeholder group being served and the objective is different, depending on who in the university administration you talk to, and when. The end result is not just economically inefficient operations, capable of running a deficit no matter how much tuition is collection, but one where every stakeholder group feels aggrieved; students feel that they pay too much in tuition and have too little say in their education, faculty believe that their rights are being chipped away by no-nothing administrators and the communities feel disrespected and cheated. If you want publicly traded companies to look like research universities in terms of economic efficiency or taking care of stakeholder group interests, confused capitalism is your answer.

Revisiting the Message

To be fair to the CEOs, there is enough ambiguity in the Business Roundtable statement for readers to read into it whatever they want it to mean, but there are three possible interpretations:

1. A Public Relations Move: It is undeniable that the public perception of corporations has become more negative over the last few decades, and politicians have noticed. Populists on both sides of the political divide have found that the public buys into their framing as corporations as self-interested entities that don’t care about employees, customers or society, with their focus on shareholders being the reason. CEOs have noticed, and the Business Roundtable’s statement may be just a restatement of constrained corporatism.
2. A Return to the Past: Since the business roundtable is composed of CEOs, many of whom have felt the heat of activist investors and pushy shareholders, the cynic in you may lead you to conclude that what the CEOs in the Roundtable would like to see is a return to the good old days of managerial corporatism, where they could rule their companies with little push back, and that this push for stakeholder interests is a diversionary tactic.
3. The Conspiratorial Twist: There is a third twist, and it does require a conspiratorial mindset. Note that the CEOs who are in the Roundtable represent the status quo, large and established companies, many of which find their business models being disrupted by young, start-ups. One way to preempt disruption is to increase the costs of doing business and having to take care of all stakeholders does that, but it is a cost that established companies may be able to bear better right now than their disruptive competitors. ( If you are skeptical, remember I said that you need a conspiratorial mindset.

Conclusion

I know that this is a trying time to be a corporate CEO, with people demanding that you cure society’s ills and the economy’s problems, with the threat of punitive actions, if you don’t change. That said, I don’t believe that you can win this battle or even recoup some of your lost standing by giving up on the focus on shareholder wealth and replacing it with an ill-thought through and potentially destructive objective of advancing stakeholder interests. In my view, a much healthier discussion would be centered on creating more transparency about how corporations treat different stakeholder groups and linking that information with how they get valued in the market. I think that we are making strides on the first, with better information disclosure from companies and CSR measures, and I hope to help on the second front by connecting these disclosures to intrinsic value. As I noted earlier, if we want companies to behave better in their interactions with society, customers and employees, we have to make it in their financial best interests to do so, buying products and services from companies that treat other stakeholders better and paying higher prices for their shares.

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Country Risk: A Mid-year 2019 Update

One of the consequences of globalization is that investors, analysts and companies can no longer stay focused on just their domestic markets, but have to also understand the risks and opportunities elsewhere in the world. When developed market companies first embarked on the journey of expanding into emerging market growth economies, investors pushed up their stock prices, primarily because of the potential that they saw in these markets for expansion. Over time, though, we have learned that, as with much else in business, this strategy comes with additional risk, not just from changing exchange rates, but from unstable economic and political forces. This growth/risk trade off explains why some companies have gained from value from globalizing and others have lost. In this post, I look at country risk through many lens, but with the end game of being able to incorporate it into decision making both for investors and businesses.

The Sources of Country Risk
When companies invest outside their domestic markets, the most immediate risk that they are exposed to is exchange rate risk, since revenues, profits and cash flows are affected by changing exchange rates. That risk, though, is but a piece of the puzzle, a symptom of economic fundamentals and affected by political crises. Digging deeper, the factors that make some countries riskier than others can be broadly classified into the following groups:

1. Life Cycle: I have used the construct of a corporate life cycle to talk about companies at different stages in the life cycle, and how they differ on cash flow generation and growth potential. It is also generally true that younger companies, deriving more or most of their value from future growth, are riskier than more mature companies, where the bulk of their value coming from investments already made. The same construct can be applied to countries, with emerging economies that are growing rapidly being more exposed to global shocks than mature countries. It should come as no surprise, therefore, that in almost every market crisis over the last decade, emerging markets have paid a much large price in terms of lost economic growth and lower market value than developed markets.

2. Political Risk: If the last few years have taught us a lesson, it is that politics can affect economic and market risk, not just in emerging markets, but also in developed ones. While there are many forms of political risk, ranging from abrupt changes in fiscal and monetary policy to regime change, there are at least two measurable manifestations of this risk in the form of corruption risk and exposure to violence.

• Corruption Risk: There are parts of the world where the costs of doing business include greasing palms and paying off intermediaries, and the roots lie deep, resisting feel-good quick fixes. While anecdotal stories of corruption and its consequences are plentiful, there are services to try to measure corruption levels across countries. Transparency International, for instance, derives a corruption score, by country, and in its 2019 report, provides a listing of the ten least and most corrupt countries in the world in the figure below, with higher scores indicating less corruption) for 2018.

  

  Source: Transparency International

  The effect of corruption upon business is insidious, making winners of those most willing to play the bribery game and losers of those who resist. In an earlier post, I argued that corruption creates the equivalent of an informal tax, pushing down after-tax income to companies.
• Physical Violence: When talking about risk in investing or business, we tend to focus on financial risk, but it is undeniable that adding the threat of physical violence, from war, terrorism or crime, makes it more difficult to operate a business. There are services again that measure exposure to violence in different countries, and while each brings its own biases, the Institute of Economics and Peace has created and reports on a Global Peace Index, measuring exposure to violence, by country.

  

  Source: Institute of Economics and Peace

  The map summarizes their findings from the most recent year. I must confess that I am surprised to see Botswana at the top of the list, but having never been there, that may be a reflection of my regional biases.

3. Legal Risk: A business derives its value from the assets it owns, physical ord intangible, and to continue to derive value, it has to not only preserve its ownership but have a legal system that enforces it’s rights. The quality of this protection varies across countries, either because property rights have fewer protections in some countries or because those rights are not enforced in a timely manner in others. A group of non-government organizations has created an international property rights index, measuring the protection provided for property rights in different countries. The results in 2018, by region, are provided in the table below:

4. Economic Structure: Just as diversification helps investors spread their bets and reduce risk exposure, countries with more diversified economies are less exposed to global macroeconomic shocks than countries that derive their value from one or two industries, or as is often the case from one or two commodities. In a comprehensive study of commodity dependent countries, the United National Conference on Trade and Development (UNCTAD) measures the degree of dependence upon commodities across emerging markets and the figure reports the results.  

Source: UNCTAD

Note the disproportional dependence on commodity exports that countries in Africa and Latin America have, making their economies and markets very sensitive to changes in commodity prices.

Measures of Country Risk
To the extent that country risk comes from different sources, you need composite measures of risk to help in decision making. This section begins with a look at country risk scores, where services, using proprietary factors, measure country risk with a number, followed with financial measures of country risk, primarily designed to measure default risk.

Country Risk Scores

There are services, ranging from the World Bank to the Economist that measure country risk with scores, though each one uses different criteria and scalars. The PRS Group provides numerical measures of country risk for more than a hundred countries, using twenty variables on three dimensions: political, financial and economic. The scores range from zero to one hundred, with high scores (80-100) indicating low risk and low scores indicating high risk. The figure below captures the June 2019 update, as well as the 10 countries that emerged as safest and riskiest in that update.

Source: Political Risk Services (PRS)

Default Risk Measures

Country risk scores have the benefit of being comprehensive, but they are also difficult to translate into business-friendly metrics. There are country risk measures in markets, albeit focused primarily on default risk, and the most public of these are sovereign ratings, there are now also market based measures, sovereign CDS spreads.

Sovereign Ratings
Moody’s, S&P and Fitch all estimate and publish ratings for countries, ranging from Aaa (AAA) for countries they view has having no default risk to D for countries already in default. The figure below provides a map of sovereign ratings across the world in July 2019, using Moody’s ratings where available and S&P to fill in some gaps. While the sovereign ratings themselves are alphabetical (and thus are difficult to incorporate into financial analysis), they can be converted to default spreads by looking at traded bonds in the market.

Source: Moody's Sovereign Ratings

Note that while the Aaa rated countries (in dark green) are predominantly in North America and Northern Europe, there are shades of green in Asia, reflecting the region's improvement on risk and that much of Africa remains unrated.

Sovereign CDS Spreads

Ratings agencies have come under fire, especially since the 2008 crisis, with one of the primary critiques being their perceived bias. I am not being dismissive of that critique, but I believe that their bigger sin is that they are slow to respond to changing fundamentals, causing rating changes to lag real changes on the ground. In the last two decades, a market has risen to fill in the gap, where investors can buy protection against default risk by buying sovereign credit default swaps (CDS). If the insurance against default is complete, the price of a sovereign CDS can be viewed as a default spread for the country. On July 23, 2019, the map below summarizes the sovereign CDS spreads for the 81 countries that they were available for. 

Source: Bloomberg (10-year $ Sovereign Spreads)

While these market-set default spreads provide more timely readings of sovereign default risk than the sovereign ratings, they suffer from the standard problems that all market-set numbers are exposed to. They are volatile, affected by momentum and mood and can give misguiding signals on risk.

Equity Risk
While default spreads may represent adequate measures of country risk if you intend to lend to a sovereign or buy bonds issued by it, you are exposed to more and sometimes different risks, if you plan to expand your business into a country, or invest in equities in that country, and you need equity risk premiums that capture that risk. It is true that many practitioners use default spreads as proxies of additional country equity risk and add it to a mature market premium (often a historical US premium) to arrive at country-specific equity risk premiums. As readers of this blog know, I use a mild variation on this approach, replacing the historical equity risk premium with an implied premium for the US and augmenting the default spread by a scaling factor, to reflect the higher risk of equity:

The equity risk premiums that result from this process in July 2019 are reported in the picture below, with the implied equity risk premium of 5.67% for the S&P 500 on July 1, 2019, representing the base number. 

Source: Damodaran Online (Current Data)

The picture continues a story that has been building over the last decade. While Africa and Latin America remain hotbeds of country risk, Asia has become safer over time and parts of Southern Europe have regressed. 

If you are a developed market company or investor, and believe that risk in Africa, Latin America or parts of Asia don’t apply to you, you may want to think again. The risk exposure of a company does not come from where it is incorporated but from where it does business. Thus, Coca Cola and Royal Dutch may be US and UK-listed companies respectively, but their business models expose them to risk around the world. With Coca Cola, that risk comes primarily from where it sells its products. With Royal Dutch, the risk is derived from where it extracts its oil and gas, making it more exposed to emerging markets than many emerging market companies. By the same token, Vale and Infosys may be Brazil and India-based companies, but there are both global companies that are exposed to risk in the rest of the globe. In addition, when multinationals try to estimate hurdle rates for projects, it should reflect not just the currency you do the analysis in but also the country in which the project will be located. A Royal Dutch refinery investment in Nigeria will have a higher hurdle rate than an otherwise similar refinery investment in the United States. If you find these concepts intriguing, I have my annual update on country risk available for download at this link. Be warned! It may operate as a narcoleptic to those who are sleep deprived.

Conclusion
There was a time a few decades ago when the line between developed and emerging markets was a clear one. On one side were developed markets, with independent central banks, rule-following governments and stable fiscal policies, and on the other side were emerging markets, with unstable and unpredictable political leadership and central banks that did their bidding. The last decade has seen a blurring of lines, as some “developed markets” mimic emerging market behavior and some emerging markets mature. There are some (companies and investors) who have decided that this convergence is a reason to ignore country risk, but I think that they do so at their own peril. Notwithstanding globalization and convergence on some dimensions of risk, we face wide variations in risk across the world, and prudence and good sense demand that we incorporate these differences into our decisions.

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Paper on Country Risk
Country Risk: Determinants, Measures and Implications - The 2019 Edition

Data Links

1. Measures of Corruption, by Country (Transparency International)
2. Measures of Violence, by Country (Institute for Peace and Economics)
3. International Property Rights Index 
4. Commodity Dependence, by country (UNCTAD)
5. Country Risk Scores (PRS Group)
6. Sovereign Ratings, by Country (Moody's, S&P)
7. Sovereign CDS Spreads (10-year) on 7/21/2019
8. Equity Risk Premium, by country (Damodaran Online)

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Meatless Future or Vegan Delusions? The Beyond Meat Valuation

In a big year for initial public offerings (IPOs), with Uber, Lyft, Pinterest and Zoom, to name just a few, already having gone public and more companies waiting in the wings, it is ironic that it is not a tech company, but a food company, Beyond Meat, that has managed to deliver the most dazzling post-IPO performance of any of the listings. As the stock increased seven-fold, investors who were able to get into the stock at the offering price have been enriched, but those who jumped on the bandwagon later have also reaped extraordinary returns. The speed and magnitude of the stock price rise has left many wondering whether investors have over reached and whether a correction is around the corner. 

The Meatless Meat Company!

The Company: Let's take a look at what Beyond Meat's products are and the market opening it is exploiting, before diving into a story and valuation for the company. The company, headquartered in Southern California, and founded in 2009, makes makes plant-based (pea protein) products that mimic burgers and ground meat  in taste, texture and aroma. In the prospectus that it filed leading up to its IPO, the company argues that its production process is revolutionary and new, and is responsible for its capacity to replicate animal-based meats. 

The Competitors: While Beyond Meat is a leader right now in the specialized sub-category of meatless meats, it faces a formidable competitor in Impossible Foods, another young start-up producing its own plant-based versions of meat-like products. Since it is very likely, especially after Beyond Meat's explosive market debut, that Impossible Foods will be going public soon, it is inevitable that there will be comparisons between the two companies. While I have done my own taste test, taste is in the mouth of the beholder, and this article perhaps has the most even-handed comparison of the two companies' products. Both companies have also adopted similar strategies of enlisting fast-food companies as product adopters, with Impossible Foods showing up on Burger King (Impossible Whopper) and White Castle menus, and Beyond Meat countering with TGI Friday's, Carl's Jr. and Red Robin. Other companies are taking note, including companies like Amy's Kitchen, a long standing producer of organic and vegan offerings, and companies like Tyson Foods and Perdue that derive the bulk of their revenues from meat, but see opportunity in this new market.

The Drivers: Both Beyond Meat and Impossible Foods have been helped by a shift away from meat to meatless alternatives, and that trend has been driven by three factors:

1. Health: While the research on the health consequences of eating meat continues, it has become part of conventional wisdom that meat-based diets (and red meat in particular) are associated with a greater risk of cardiovascular disease and cancer. This link provides a fairly balanced account of whether this belief is true, but for better or worse, it has led some meat eaters to cut back and sometimes stop consuming meat. 
2. Environment: As climate change and environmental concerns rise to the top of concerns for some, they are feeling the pressure to shift away from meat, in general, and beef, in particular, because of its environmental footprint. I am not  an environmental scold, but I don't think that there is any debate that meat-based diets puts a greater pressure on the environment 
3. Taste: Until recently, shifting away from a meat-based diet also meant giving up the taste and texture of meat, since most meat substitutes did not come close. As companies like Beyond Meat and Impossible Foods are showing, plant-based alternatives are getting better at mimicking real meat, and for those who are attached to the texture and taste of meat, that is making a difference in their diet decisions.

None of these three factors are likely to fade away. In fact, I think that we can safely assume that they will only get stronger over time, accelerating the shift from meat to meatless alternatives. 

Market Sizing

All of the talk about the shift to vegan and vegetarian diets can sometimes obscure two basic facts about this market and its underlying trends:

1. The meatless meat market is still small, relative to the overall meat market: In 2018, the meatless meat market had sales of $1-$5 billion, depending on how broadly you define meatless markets and the geographies that you look at. Defined as meatless meats, i.e., the products that Beyond Meat and Impossible Foods offer, it is closer to the lower end of the range, but inclusive of other meat alternatives (tofu, tempeh etc.) is at the upper end. No matter which end of the range you go with, it is small relative to the overall meat market that is in excess of $250 billion, just in the US, and closer to a trillion, if you expand it globally, in 2018. In fact, while the meat market has seen slow growth in the US and Europe, with a shift from beef to chicken, the global meat market has been growing, as increasing affluence in Asia, in general, and China, in particular, has increased meat consumption,  Depending on your perspective on Beyond Meats, that can be bad news or good news, since it can be taken by detractors as a sign that the overall market for meatless meats is not very big and by optimists that there is plenty of room to grow.
2. It is still a niche market: Meatless meat products have made their deepest inroads in urban and affluent populations and its allure is greatest with former meat-eaters rather than lifelong vegetarians, who don't crave either the taste or texture of meat. The plus is that this market has significant buying power, but the minus is that urban, well-to-do millennials can eat only so much. 

The big question that we face is in estimating how much the shift towards vegan and vegetarian diets will continue, driven by health reasons or environmental concern (or guilt). There is also a question of whether some governments may accelerate the shift away from meat-based diets, with policies and subsidies. Given this uncertainty, it is not surprising that the forecasts for the size of the meatless meat market vary widely across forecasters. While they all agree that the market will grow, they disagree about the end number, with forecasts for 2023 ranging from $5 billion at the low end to $8 billion at the other extreme. Beyond Meat, in its prospectus, uses the expansion of non-dairy milk(soy, flax, almond mild) in the milk market as its basis, to estimate the market for meatless meat to be $35 billion in the long term. 

Beyond Meat: Story and Valuation

History: At the time of its public offering, Beyond Meat had all of the characteristics of a young company, not much separated from its start up days, with revenues of $87.9 million, operating losses of $26.5 million and a common equity of -$121.8 million. Its first earnings report, delivered to a rapturous market response, reported a tripling of revenues and a narrowing of operating losses, but even with it incorporated, the company remains a small, money losing company.

The Story: To value young companies, I first have to put my optimist hat on, and with it firmly in place, my story for Beyond Meat is that it is catching the front end of a significant shift towards vegan and vegetarian-based diets. The key parts of my story are below:

1. Total market for meatless meats will grow significantly: I see the total market for meatless meats growing from just over $1 billion in 2018 to $12 billion by 2028. While that is less than the $35 billion that Beyond Meat's back-of-the-envelope estimate delivers, it is closer to the upper end of the range of forecasts that you have for this market.
2. With Beyond Meat capturing a significant market share: As the market grows, the number of players will increase, but I see Beyond Meats capturing a 25% market share of this market, building on its early entry into the market and brand name recognition, partly from its fast food connections.
3. While delivering operating profits similar to the large US food processing companies: Over the next five years, I see pre-tax operating margins improving towards the 13.22% that US food processing business delivered in 2018, built largely on economies of scale and pricing power. 
4. And reinvesting a lot less, in delivering that growth: While Beyond Meat generates about a dollar in revenue per dollar in invested capital right now, I will assume that it will be able to use technology as its ally to invest more efficiently in the future. Specifically, I will assume that the company will generate $3 in revenue for every dollar in invested capital, about double what the typical US food processing company is able to generate.

Is there risk in this investment? Absolutely, and you may be surprised that my cost of capital is only 7.46%, but that reflects my assessment of risk in this investment, as a going concern and as part of a diversified portfolio. As a money-losing company that will require about $500 million in capital over the next four years to deliver on its potential, there remains a significant chance of failure, and I estimate the probability of failure to be 15%.

The Valuation: With the story in place, the valuation follows and the picture below captures the ingredients of value:

Download spreadsheet

With my story, which I believe reflects an upbeat story for the company, the value that I obtain for its equity is $3.3 billion, yielding a value per share of about $47. At the end of June 10, when I completed my valuation, the stock price was close to $170, well above my estimated  value. What the stock dropped almost $41 on June 11 to $127/share, it still remained over valued.

What if? As with any young company, the value of Beyond Meat is driven almost entirely by the story you tell about the company, and in this case, that story revolves around two key inputs. The first is the revenue that you believe the company can generate, once mature, and that reflects how big you think the market for meatless meats will get and Beyond Meat's market share of the market. The second   is its profitability at that point, which is a function of how much pricing power you believe the company will have. While I have assumed that Beyond Meat will deliver about $3 billion in revenues in 2028, with an operating  margin of 13.22%, your story for the company can lead you to very different estimates for one or both numbers:

The shaded cells represent break even points, where you could justify buying Beyond Meat at the price ($127) it was trading at on June 11, 2019. Put differently, if your story for the meatless meat market and Beyond Meat's place in it leads you to revenues of $5 billion or higher with an operating margin of 20%, you should be a value investor in the company. 

Macro Bets and Micro Value

As you can see from the what-if analysis on Beyond Meat's value, the value that you obtain for Beyond Meat is determined mostly by how large you believe that market for meatless meats will end up being. In fact, there are some investors whose primary reason for investing in Beyond Meat is as a bet on a macro trend towards vegan and vegetarian diets. That said, it is worth remembering that investors don't get pay offs from making the right macro bets, but from the micro vehicles (individual investments) that they use as proxies for those bets. To get the pay off from a correct macro call, there are two additional assessments that investors have to make:

1. Industry structure: A growing market may not translate into high value businesses, if it is crowded and intensely competitive. That market will deliver high revenue growth, but with low or no profitability, and no pathway to sustainable profits and value added. In contrast, a growing market where there are significant barriers to entry and a few big winners can result in high-value companies with large market share and unscalable moats. 
2. Winners and Losers: Assuming that there is potential for value creation in a market, investors have to pick the companies that are most likely to win in that market. That is difficult to do, when you are looking at young companies in a young market, but there is no way around making that judgment. In a post from 2015, I argued that in big (or potentially big) markets, you can expect companies to be collectively over valued early in the game. 

In my Beyond Meat valuation, I have implicitly made assumptions about both these components, by first allowing operating margins to converge on those of large food processing companies and then making Beyond Meat one of the winners in the meatless meat market, by giving it a 25% market share. My defense of these assumptions is simple. I believe that the meatless meat market will evolve like the broader food business, with a few big players dominating, with similar competitive advantages including brand name, economies of scale and access to distribution systems. I also believe that Beyond Meat and Impossible Foods, as front runners in this market, will use their access to capital to scale up quickly. Their use of fast food chains feeds into this strategy, with bulk sales increasing revenues quickly, allowing for economies of scale, and name-brand offerings (Impossible Whopper at Burger Kind, Beyond Famous Star burger at Carl's Jr.) helping improve brand name recognition. I will undoubtedly have to revisit these assumptions as the market evolves and some of you may disagree with me strongly on one or both assumptions. If so, please do download the spreadsheet and make your best judgments to derive your value for the company.

A Trading Play

Early in a company's life, it is the pricing game that dominates and it is futile to use fundamentals to try to explain a stock price or day-to-day changes. This table, from one of my presentations on corporate life cycles, illustrates how investors and trades view companies as they move through the life cycle.

For a young company like Beyond Meat, making the transition from start-up to young growth, it is all pricing all the time, with stories about market size driving the pricing,. This trading phenomenon is exacerbated by the fact that it is one of the few pure plays on a macro trend, i.e., a shift in diets away from meat to plant-based options. That leads me to two conclusions. The first is an unexceptional one and it is that you will see wide swings in the stock price on a day to day basis, for little or no reason. That is a feature of priced stocks, not a bug, as mood and momentum shift for no perceptible reasons. The second is that selling short on a stock like this one (small, with a small float) is a dangerous game, since you are unlikely to have time as your ally, and while you may be right in the long term, you may bankrupt yourself before you are vindicated. 

YouTube Video

Links

1. Beyond Meat: Prospectus for IPO
2. Valuation of Beyond Meat (June 2019)

Past Posts

1. Big Markets, Over Confidence and the Big Market Delusion (August 2015)

Tesla's Travails: Curfew for a Corporate Teenager?

It should come as no surprise to anyone that Tesla is back in the news, though it seems to be for all of the wrong reasons. From Musk's Twitter escapades with the SEC, to talk about electric lawn blowers to concerns about a debt death spiral, the company has managed, yet again, to get in its own way, and this time, it has paid a price in the market, as its stock price tests lows not seen in a couple of years. I would be lying if I said that I do not find the company fascinating, and as has been my pattern for the last six years, it is time for a Tesla valuation update.

Looking Back: My Tesla Posts in 2018

In my last valuation of Tesla, set in June 2018, I considered possible, plausible and probable valuations for the company. In my story, which I admitted was an optimistic one, I mapped out a pathway for the company to deliver $100 billion in revenues in 2028, while pushing pre-tax operating margins to 10% by 2023.  The value that I obtained for the stock was $170-$180 per share, depending on how the very generous option package (20.2 million options) granted to Musk were treated, and is in the picture below:

Download spreadsheet

In that post, I also listed possible, perhaps even plausible, scenarios where Tesla's value per share could be higher than $400/share, but argued that it would require the equivalent of a royal flush for the company to get there, a combination of a ten-fold increase in revenues, an operating margin of 12% and reinvesting more like a technology than an automotive company. Since the stock was trading at close $360 at the time of the valuation, I concluded that it was significantly over valued. True to form, Elon Musk roiled the waters in August 2018 with his now infamous tweet about funding being secured for a $420 buyout of the stock, causing a surge in the stock price, before questions arose about both how secured the funding actually was and whether the $420 price itself was fiction. In my post on the topic, I argued that if you were a private equity investor interested in taking a company private, Tesla would be a poor target, given its need for capital to keep growing, its heavy debt burden and the presence of Elon Musk as CEO. In the months after, both Musk and Tesla paid hefty prices for the indiscreet tweet, with the former in the SEC crosshairs for alleged stock price manipulation and the latter having to fight through the fog to get its story heard.

Catching up with the news

If you are wondering how much can happen in a year, you obviously don't follow Tesla, since the company is a magnet for newsworthy events. Borrowing a movie title to categorize what's happened to the company in the last year, I would break the news down into the good, the bad and what I can only term as gobsmacking, where you whack your head and say "what the heck was that?"

1. The Good

The market momentum has clearly shifted against Tesla, and all the news about the company seems to skew "bad", it is worth noting that there are good things that have happened at the company over the last year:

1. Revenue Surge: In the drama around production targets and logistical misses, it is easy to lose sight of the fact that the Tesla 3 has caused the company to almost double revenues over the course of the last year, while easily winning the race for best selling electric car in the world. 
2. Improving Profitability: While Musk's tweets about Tesla turning earnings positive may have been premature, the company has moved down the pathway to profitability, reducing operating losses and with R&D capitalized, perhaps even turning the corner on operating profitability. 

In short, the operating base on which I will be building my Tesla valuation in June 2019 will be a more solid one than the one that I was using in 2018.

2. The Bad

With Tesla, good news is always bundled with bad, some of it caused by macro events but much of it the consequence of self inflicted wounds:

1. Debt load and Distress: When Tesla chose to add to its debt burden by borrowing $5 billion in 2017, I argued that there was no good reason for Tesla to borrow money, since money losing companies gain no tax benefits and debt put growth potential at risk. Tesla has since added to that debt, using the false logic that it needed to borrow money to fund its growth; a much better option would have been to raise equity, the dilution bogeyman notwithstanding. In June 2019, that debt, now close to  $14 billion, is revealing its dark side, as a bond price plunge and ratings downgrades threaten to put Tesla's growth story at risk.
2. Reinvestment Lags: Growth requires reinvestment, and especially so for automobile companies, where assembly lines and logistical infrastructure need to be put in place for cars to be delivered to customers. It is both frustrating and puzzling that Tesla, a company with a loyal customer base that is willing to wait, has been unwilling to make the investments that it needs to meet the demand. Instead, the company seems to lurch from one production crisis to another one (remember the tents that had to be put up to reach the 5,000 cars/week target) while its CEO muddies the water further by arguing that the company is not just earnings positive but cash flow positive. At the moment, the Fremont plant remains Tesla's major production facility, and while a plant in China is supposedly set for production late in 2019, the US/China trade war and Tesla's own tangled history on operating delays leads to skepticism.

It is also worth noting that a significant part of Tesla's time has been spent extracting itself from another unforced error, its acquisition of Solar City in 2016, with cost cuts and employee layoffs that are incongruent with a company claiming to tell a great growth story.

3. The Gobsmacking

An investor in Tesla should earn a special premium for having to endure news stories about the company that are so unusual that they would be considered fiction at other companies. Just to give a sampling, here are the other items that added to the smoke around the stock:

1. SEC Oversight: If there has been a recurring story over the past year, it has to do with the aftermath of Elon Musk's "funding secured" tweet, which led to a SEC investigation and a threat of sanctions on the company. While the company came to a settlement wit the SEC, that settlement requires restraint on the part of Musk on future disclosures to the market (especially in the form on tweets), and restrain is not a Musk strong point.
2. Autonomous Cars: In April 2019, Musk unveiled a plan to roll out autonomous taxis, with Tesla owners being allowed to add to the network, in the near future, with the promise that Tesla's technology on auto driving was well ahead of the competition. There is a debate worth having about autonomous cars and how they will change the ride sharing business, but it is almost certain that this will not happen smoothly or soon.
3. The Rest: This being Tesla, there were the weekly distractions as Musk muddied the waters with talk of electric leaf blowers and insurance products. 

An Updated Tesla Valuation

For the bulk of its existence, Tesla has been a story stock. That remains true, but as the company ages and acquires substance, you can argue that the story is getting more bounded. In this section, I will update my Tesla story and valuation first, then look at the uncertainty around the valuation and close with a comment on a "valuation" by ARK Invest, one of Tesla's biggest institutional cheerleaders.

1. The Story: Tesla, Corporate Teenager?

Bringing together everything that has happened at Tesla over the last year, I find myself telling the same story that I told about Tesla a year ago, of a company that would find a pathway to revenues of $100 billion in 2028, with strong operating margins, remains intact, with one notable change. The company's debt overhang, already a concern a year ago, has become a clear and present danger to the company. In effect, on an operating basis, the company is in better shape than it was a year ago but on a financial leverage basis, it faces more truncation risk (a chance of failure of 20%). The value per share that I get with both effects built in is about $190/share:

Download spreadsheet

If there is a modification to my story, it would be this. As I watched Musk repeatedly put Tesla's story and value at risk with his distractions, I was reminded of teenagers around the world, with immense potential and intelligence, who risk it all for momentary and often meaningless rushes. In fact, I am tempted to add a corporate teenage phase in my corporate life cycle framework and put Tesla in it, a corporate teenager with immense potential, who repeated puts it all at risk for distractions. 

To provide perspective on why the value per share today is higher, even with a much greater chance of failure, I compared the numbers that I used in my valuation in June 2018 to June 2019:

Note that while my end game on revenues ($100 billion by 2028) and operating margins (10% in 5 years) has not changed, the base numbers make both easier reaches. The rise in failure risk (from 5% in 2018 to 20% in 2019) is at least partially offset by a lower risk free rate and a cost of capital. In truth, the value per share is close enough that I would argue that there really has been little change, but the price per share has dropped by almost 50%, making the stock go from being significantly over valued to close to fairly valued now.

2.  Facing up to Uncertainty

As with every Tesla valuation that I have done over the last six years, this one comes with caveats and uncertainties, and the contrasting views that bulls and bears have about the company are captured in the table below:

As you can see, I borrow from both sides of this debate, and I am sure that Tesla bulls will be disappointed that I don't have higher revenues for the company and Tesla bears will take issue with my reinvestment assumptions and expectations that the company will eventually deliver solid margins. Using a technique that I find useful, when confronted with divergent views, to deal with uncertainties, I computed Tesla's values in a simulation, with the results below:

in summary, the median value across the 100,000 simulations is $180/share, the 10th percentile delivering a $52 value/share and the 90th yielding $380/share. In this simulation, I have assumed that Tesla will remain a stand alone, going concern, and that the equity value could drop to zero, if there is a shock to the value of operating assets, given the debt load. There is talk, however, that Tesla could become an acquisition target, to an automobile company or a tech company (see this rumor about Apple being interested in 2014). While there are some entanglements (such as the one with Panasonic in the battery factories) that will have to be worked out, there have generally been two impediments on this path. One is that Tesla has been an expensive target, especially when its market capitalization exceeded $50 billion. That will become less of a barrier, as the stock price drops, and at a market cap of less than $15 billion, it could be much more affordable. The other is a bigger and more intractable problem. With Elon Musk as part of the package, Tesla has a poison pill that few companies will want to imbibe, and it is likely that the relationship will have to be severed or at least significantly weakened for an acquisition to occur. I remain skeptical on the odds of an acquisition, precisely because I don't see Musk going quietly into the night, but adding an acquisition floor at a $15 billion value for equity (about $60/share) increases the simulated value for the stock by about $10/share.

3. The ARK Tesla Pricing

It is not my role to be an arbiter of other people's valuations, and I generally avoid commenting on them unless they are in the public domain, as was the case with the Tesla/Solar City fairness opinions, or seek public comment. I will make an exception with the ARK "valuation" of Tesla, partly because they are among the stock's strongest boosters and partly because they put their model up for public comments, for which I commend them. In summary, here are the ARK numbers:

Download ARK pricing from Github

1. This is a pricing, not a valuation: I know that this will strike some as nitpicking but what ARK has produced is a forward pricing for Tesla, not a valuation. An intrinsic valuation requires forecasting cash flows over time, after taxes and reinvestment, and then discounting those cash flows back at a rate that reflects the risk in the investment. A pricing usually involves picking a metric (revenues, earnings, EBITDA), picking a forecast year for the metric and applying a multiple based upon what other companies in the peer group trade at. ARK's basic model forecasts revenues, earnings and other metrics in 2023, and applies a multiple to estimated EBITDAR&D in 2023, making it a forward pricing.
2. The ARK bear is bullish:  The ARK bear case requires that Tesla will sell 1.7 million cars in 2023, at an average price of $50,000/car and generate an operating margin of 6.1% on those revenues. Each of these assumptions is plausible, and the combination is possible, though to call a seven fold increase in revenues over five years, with a concurrent improvement to industry average profitability, a bear case seems to be stretching the definition of bear.
3. The weakest link: The model's weakest link is on cash flows, since to sell 1.7 million cars, you have to make them first, and Tesla's production capacity, even if you count the China plant as functional and about the same capacity as the Fremont plant, brings you only about half way to the goal. It will be magical, if adding another $3.7 billion to net PP&E (as ARK seems to be assuming) and $1.2 billion to working capital will allow you to increase revenues by $63.5 billion, but it gets even more stretched, when you assume that Tesla also pays off $14 billion in debt (as ARK seems to) over the five years. In sum, the bear case will require at the very least $25 to $30 billion in cash flows, even with ARK's own assumptions, over the next five years, and since the operating cash flows at the company are still a trickle, this will require equity issuances in massive proportions fairly soon. ARK does allow for an equity capital raise of $10.6 billion which strikes me as too little to fill the gap, but in the absence of a balance sheet or statements of cash flows, I may be missing something (and it has to be very big).
4. Share count issue: Even for the equity capital raise of $10.6 billion, ARK reduces the impact on share count by assuming a stock price of $360/share (market cap will be $70 billion) at the time of the raise. Since this capital will have to be raised soon, there is an element of wishful thinking here, i.e., that stock prices will double in short order and the capital raise will follow. In addition, if stock prices do climb, as ARK assumes, there will there is an overhang of 20 million options that have been granted to Musk by the board of directors that will become actual shares. In short, for the ARK bear case to unfold, the share count will have to double over the next five years.
5. There is a time value question: Applying a multiple to EBITDAR&D in 2023 gives you a value in 2023, and to make it comparable to today's stock price, you will have to discount it back to today, at a risk adjusted rate. In fact, if you bring in the probability of failure embedded in Tesla bonds, there will an additional discounting on value.

Even if you take the ARK bear case as realistic, with Tesla projected to sell 1.7 million cars in 2023 and earn operating margins close to the auto sector, the pricing per share that you get will be closer to $250/share, with a more realistic share count and time value adjustments, not the $560 that you see on the ARK spreadsheet. As for the bull case, I will leave it untouched, since it strikes me as more fairy tale than valuation, a world where there will be 7.2 autonomous cars on the road in 2023, with Tesla controlling a 70% market share, and generating $52 billion in annual cash flows. I am willing to accept the argument that Tesla is closer to mastering the autonomous car technology than its competitors, but I see a business that is further in the future than 2023, less dominated by Tesla and much less profitable than ARK is assuming it to be. In short, right now, it is more option than conventional going concern value, and even if I believed it, I would make more money selling short on Uber and Lyft, than buying Tesla.

Bottom Line

I did my first valuation of Tesla in 2013, and undershot the mark, partly because I saw its potential market as luxury cars (smaller), and partly because I under estimated how much it would be able to extract in production from the Fremont plant. Over time, I have compensated for both mistakes, giving Tesla access to a bigger (albeit, still upscale) market and more growth, while reinvesting less than the typical auto company. In spite of these adjustments, I have consistently come up with valuations well below the price, finding the stock to be valued at about half its price only a year ago. This year marks a turning point, as I find Tesla to be under valued, albeit by only a small fraction. Even in the midst of my most negative posts on Tesla, I confessed that I like the company (though not  Elon Musk's antics as CEO and financial choices) and that I would one day own the stock. That day may be here, as I put in a limit buy order at $180/share, knowing fully well that, if I do end up as a shareholder, this company will test my patience and sanity. (Update: My limit buy just executed. As a shareholder my risks would be much lower, if Musk was banned from tweeting...) 

YouTube Video

Spreadsheet links

1. Tesla Valuation in June 2018
2. Tesla Valuation in June 2019
3. ARK's Tesla Pricing - May 2019

Blog Post Links

1. Twists and Turns in the Tesla Story: A Boring, Boneheaded Update
2. The Privatization of Tesla: Stray Tweet or Game Changing News