Wednesday, April 20, 2016

Valeant: Information Vacuums, Management Credibility and Investment Value

As an investor, would you buy shares in a company that is at the center of a political and legal firestorm? What if this company has a CEO who has lost the faith of his board and an ex-CFO who is being accused of shady financial practices? And would you pull  the buy trigger if the company has delayed its scheduled annual filing by more than two months, and by doing so is running the risk of violating debt covenants and being pushed into default? And to top it all off, would you be a little worried  if the largest investor in the stock, a well known activist with his reputation and wealth on the line, is now calling the shots? No way, you say! At the right price, I would, and that is the reason that I decided to revisit my Valeant valuation last week, six months after I valued it for the first time, in the aftermath of a crisis born of hubris and happenstance. In structuring this post, I will draw on an old-time consulting matrix, where companies were classified into stars, cash cows, dogs and question marks, to illustrate the transience of these classifications, since Valeant has cycled through the entire matrix in a year.

Valeant, the Star
Valeant's rise from an obscure Canadian drug company to pharmaceutical star has been well chronicled and rather than drown you in prose, I think it is best captured in this picture, which shows the increase in market value (market cap and enterprise value) and operating numbers (revenues and operating income), especially between 2009 and 2015:
Source: S&P Capital IQ
During a period when other pharmaceutical companies were struggling with revenue growth and profit margins, Valeant outstripped them on both counts, growing revenues at almost 43% a year while posting higher operating profit margins than the rest of the sector. At least on the surface, the company seemed to be delivering the best of all combinations: high growth with high profitability.

So, how did Valeant pull of this feat? In an earlier post on the company, in November 2015, I argued that the Valeant business model was a stool with three legs: growth from acquisitions, with the acquisitions funded primarily with debt, followed by a strategy of increasing prices on "under priced" drugs.

The unique combination of growth and profitability made the company a target for value investors, making it a favored stop for investors as diverse as Bill Ackman, the activist investor, and the Sequoia Fund, a storied mutual fund, and a dominant part of their portfolios. In their defense, not only were these investors transparent about their big bets on Valeant, but at least until September 2015, their concentration was viewed as a strength rather than a weakness. In fact, when I posted on why diversification is a necessary component of even a value investing strategy, it was these two investors that were held up as a counters to my argument.

To see the allure of Valeant to value investors, let me go back to mid-year last year, when the company's business model was going strong, its stock price was higher than $200/share and its enterprise value exceeded $100 billion. If the intrinsic value of a company is driven by cash flows from existing assets, value-creating growth and low risk, Valeant looked attractive on almost every dimension:

Valeant was not only delivering the value trifecta, high revenue growth in conjunction with high operating profit margins and generous excess returns, but was doing so on steroids (taking the form of low taxes and high debt). One note of caution even then, though, was that the business model was built on an architecture of acquisitions, with acquisition accounting playing a large role in pushing up operating profitability and lowering taxes.  If you were unfazed by the acquisition accounting effect and assumed that the company could continue to deliver this combination going forward, the value per share that you would have obtained for the company would have been more than $200/share. 
Download spreadsheet
In estimating the value, I did lower the compounded revenue growth for Valeant to 12% for the next ten years, but that translates into revenues more than tripling over the decade. 

From Star to Cash Cow
While many trace Valeant's fall to September and October of 2015, when short sellers launched an assault on its links to Philidor, an online pharmacy, the business model was already under pressure in the months prior, a victim of its own financial success. The model was designed, in my view, to operate under the radar, since key parts of it (the drug pricing and acquisition accounting) would wither under exposure. While much of what Valeant did in 2010 and 2011, when the company was not a household name, went unnoticed, its actions in 2015, when it was a higher profile company, drew attention from unwelcome sources. The company's acquisition of Salix increased the scrutiny, both because of it's size and partly because the Salix drugs that Valeant acquired (and repriced) affected more people (and drew more complaints). The Philidor revelations pushed these concerns into hyperdrive and the stock lost almost 55% of its value in September and October, dropping from $180/share to $80/share.

In my November post, I rehashed much of this story and argued that even if Valeant were able to survive legal and regulatory scrutiny, the company would never be able to return to its old business model. In effect, even in the absence of more bad news, Valeant would have to be run like other pharmaceutical companies, reliant on R&D, rather than acquisitions, for (more anemic) growth. Removing the debt-funded acquisitions and the drug repricing  from the business model yielded a company with lower revenue growth (3% a year, rather than 12%), lower margins (a pre-tax operating margin of 43.66%, instead of 49.82%) and higher taxes (with an effective tax rate of 20% replacing 16.51%).

Download spreadsheet

Note that these numbers were reflective of more conventional drug companies and reflect a profitable, albeit slow-growth business. With these numbers, though, the value per share that I obtained for Valeant was about $77, down substantially from its star status, but the market price, at $82, was higher. 

From Cash Cow to Dog?
If there were dark clouds on the horizon for Valeant in November 2015, the months since have only made them darker for four reasons:
  1. Information blackout: In November 2015, when I valued Valeant, I used the most recent financial filings of the company, from October 2015,  to update my numbers. Almost six months later, there have been no financial filings since, and the 10K that was expected to be filing in February 2016 was delayed, ostensibly because the company was still gathering information, and that delay has extended into April. 
  2. Managerial Double talk: In the intervening months, Valeant’s managers have been in the news, almost as often giving testimony to Congress, as holding press conferences. Arguing, as they did, that they grew through R&D like any other pharmaceutical company and that their revenue increases came mostly from volume growth (rather than price increases) was so much at odds with the facts that they became less credible with each iteration. Michael Pearson’s hospitalization for an undisclosed illness, just before Christmas, was something that was out of the company’s control but its handling added to the air of opacity around the company. 
  3. Legal Jeopardy: The Philidor entanglement, the original source of the crisis, did not go away. In fact, the company, after claiming that separation from Philidor would be low-cost and easy backtracked in January and February with disclosures that suggested deeper links, with the potential for legal problems down the road. 
  4. Debt load: Debt is a double edged sword, increasing earnings per share and providing tax benefits in good times but potentially making bad times worse. That argument got backing from what happened at Valeant, a company that accumulated more than $30 billion in debt during its acquisition binges, with about half of that debt being added on during 2015. That debt came with the added covenant that if financial disclosures were not filed by March 30, 2015, the firm could technically be in default, a possibility that spooked markets. 
Without financial disclosures from the company, a management that seemed to be making up stuff as it went along and the possibility of a debt covenant being triggered, it is not surprising that the market marked down Valeant’s stock price further:

This price collapse, following last year’s swoon, has reduced the market capitalization of the company to $11 billion, almost 85% lower than its value a year prior. In late March 2016, the company announced that Michael Pearson would be stepping down as CEO, the clearest sign yet that there will no return to the old business model, and Bill Ackman increased his involvement of the company in a bid to preserve what was left of his investment in the company and more importantly, his reputation as a savvy activist investor.

With the stock trading at $32, the question of whether the stock is a good buy now looms large. Compared to my November 2015 estimate, the answer is an emphatic yes, but the caveat is that a great deal has happened to the company’s fundamentals during the last six months that could have shifted the value down significantly. The problem that I face, like any other investor in Valeant, is that in the absence of financial filings, there are no numbers to update. The solution seems simple. Wait for the delayed filing to come out in late April, early May or later, and use that updated information in my valuation. That is the low-risk option, but I think that it is also a low return option, since if the filing contains good news (that revenues have held up and profit margins remain healthy), the stock price will adjust before my valuation does. The alternative is scary, but it has a bigger payoff. I could try to make a judgment on Valeant’s value now, before the information comes out, and follow through by buying or selling the stock. In arriving at this value, here are some of the adjustments that I chose to make:
  1. The Dark Side of Debt: The debt at Valeant has become more burden than a help, as it has not only triggered worries about covenants being violated but has opened up the possibility that that the company will have trouble making its payments. In fact, Moody's lowered the bond rating for Valeant to B1, well below investment grade, in March 2016, causing an increase in the cost of capital used in the valuation from 7.52% (in my November 2016 valuation) to 8.29%. The secondary impact is that there is a chance now that Valeant's going concern status may be jeopardized by its debt commitments; I assume a 5% chance of this occurrence in conjunction with the assumption that a forced liquidation of its assets will come at a discount of 25% on fair value. 
  2. The Bad News in Delay: Delayed news is almost never good news and there are two key operating numbers where the delayed report can contain bad news. The first is that the company may restate revenues, reflecting its separation from Philidor and perhaps for other undisclosed reasons. The second is that the company may reveal that some or all its acquisition-related expensing from prior years may have been overdone, resulting in some or a big chunk of these expenses being moved back into the operating expense column. In my valuation, I will assume (and cheerfully admit that this is based on no news) that the revenue reduction will be small (about 2%) and that half of all acquisition expenses will be shifted to operating expenses, reducing the pre-tax operating margin to 40.39% (from the 43.66% that I used in November 2015). 
Since I had already assumed that the existing business model was dead in my November 2015 valuation, I don't see any need to lower revenue growth further or to raise the effective tax rate. The value that I obtain with these updated numbers is below:
Download spreadsheet
The value per share that I obtain for Valeant is $43.66, higher than the stock price ($32) at the time of this analysis. That value, though, is clearly a bet on what the delayed financials will deliver as a surprise. One way to measure the exposure that you have to this risk is to measure value as a function of how much of a revenue and earnings surprise you get from the report:

Is there a chance that the earnings report could contain news that make Valeant a bad investment at $32? Of course, and you will have to make your own judgment on that possibility, but based upon my priors (uninformed though they might be), it looked like a good investment at $32, late last week, and I own it now. 

I am sure that Valeant will be used to draw many lessons and I will extract my share in future posts about acquisition accounting, activist investing and corporate finance. The first is that acquisition accounting is rife with inconsistencies and plays into investor biases and preconceptions about companies. The second is that cookbook corporate finance, with its dependence on metrics and magic bullets, can have disastrous consequences when it overwhelms the narrative. The third is that activist investing, notwithstanding its successes, has two weak links: concentrated portfolios and investors who can become too wedded to their investment thesis.   I will continue to draw on Valeant as an illustrative example of how quickly views on a company and its business model can change in markets and why absolutism in investing (where you know with certainty that a business model is great or awful, that a stock is cheap or expensive) is an invitation for a market takedown. 

YouTube Video

  1. Value of Valeant as Star (September 2015)
  2. Value of Valeant as Cash Cow (November 2015)
  3. Value of Valeant as Dog (April 2016)

Friday, March 11, 2016

Negative Interest Rates: Impossible, Unnatural or Just Unusual?

In the years since the 2008 crisis, there is no question in finance that has caused more angst among investors, analysts and even onlookers than what to do about "abnormally low" interest rates. In 2009 and 2010, the response was that rates would revert back quickly to normal levels, once the crisis had passed. In 2011 and 2012, the conviction was that it was central banking policy that was keeping rates low, and that once banks stopped or slowed down quantitative easing, rates would rise quickly. In 2013 and 2014, it was easy to blame one crisis or the other (Greece, Ukraine) for depressed rates. In 2015, there was talk of commodity price driven deflation and China being responsible for rates being low. With each passing year, though, the conviction that rates will rise back to what people perceive as normal recedes and the floor below which analysts thought rates would never go has become lower. Last year, we saw short term interest rates in at least two currencies (Danish Krone, Swiss Franc) become negative and this year, the Japanese Yen joined the group, with rumors that the Euro may be the next currency to breach zero. While it has been difficult to explain the low interest rates of the last few years, it becomes doubly so, when they turn negative. I would be lying if I said that negative interest rates don't make me uncomfortable, but I have had to learn to not only make sense of them but also to live with them, in valuation and corporate finance. This post is a step in that direction.

Setting the table
There are a handful of currencies that have made the negative interest rate newswire, but it is worth noting that the rates that are being referenced in many of these stories are rates controlled by central banks, usually overnight rates for banks borrowing from the central bank. In March 2016, there were two central banks that had set their controlled rates below zero (Switzerland and Sweden) and two more (ECB and Bank of Japan) that had set the rate at zero. (Update: The ECB announced that it would lower its rates below zero on March 10.)
February 2016
Note that these are central bank set rates and that short and long term market interest rates in these currencies can take their own path. To provide a contrast, consider the Japanese Yen and Euro, two currencies where the central banks have pushed the rates they control to zero. In both currencies, short term market interest rates have in fact turned negative but only the Yen has negative long term interest rates:

In a post from earlier this year, I looked at long term (ten-year) risk free rates in different currencies, starting with government bond rates in each currency and then netting out sovereign default spreads for governments with default risk. Updating that picture, the government bond rates across currencies on March 9, 2016, are shown below:
Ten-year Government Bond Rates - March 9, 2016
Joining the Japanese Yen is the Swiss Franc in the negative long term interest rate column. Why make this distinction between central bank set rates, short term market interest rates and long term interest rates? It is easier to explain away negative central bank set rates than it is to explain negative short term interest rates and far simpler to provide a rationale for negative rates in the short term than negative rates in the long term. Thus, there have been episodes, usually during crises, where short term interest rates have turned negative, but this is the first instance that I can remember where we have faced negative long term rates on two currencies, the Swiss Franc and the Japanese yen, with the very real possibility that they will be joined by the Euro, the Danish Krone, the Swedish Krona and even the Czech Koruna in the near future.

Interest Rates 101
I am not a macroeconomist, have very little training in monetary economics and I don't spent much time examining central banking policies. Keep that in mind as you read my perspective on interest rates, and if you are an expert and find my views to be juvenile, I am sorry. That said, I have to process negative interest rates, using my limited knowledge  of what determines interest rates.

Intrinsic and Market-set Interest Rates
When I lend money to another individual (or buy bonds issued by an entity), there are three components that go into the interest rate that I should demand  on that bond. The first is my preference for current consumption over future consumption, with rates rising as I value current consumption more. The second is expected inflation in the currency that I am lending out, with higher inflation resulting in higher rates. The third is an added premium for any uncertainty that I feel about not getting paid, coming from the default risk that I see in the borrower. When the borrower is a default-free entity, there are only two components that go into a nominal interest rate: a real interest rate capturing the current versus future consumption trade off and an expected inflation rate.
Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate
This is, of course, the vaunted Fisher equation.  There is an alternate view of interest rates, where the interest rate on long term bonds is determined by the demand and supply of bonds, and it is shifts in the demand and supply that drive interest rates:

How do you reconcile these two worlds? To the extent that those demanding bonds are motivated by the need to earn interest that covers the expected inflation and generate a real interest rate, you could argue that in the long term, the intrinsic rate should converge on the market set rate.

In the short term, though, as with any financial asset, there is a real chance that the market-set rate can be lower or higher than the intrinsic rate. What can cause this divergence? It could be investor irrationality, where bond buyers overlook their need to cover inflation and earn a real rate of return. It could be a temporary shock to the supply or demand side of bonds that can cause the market-set rate to deviate; this is perhaps the best way to think about the "flight to safety" that occurs during every crisis, resulting in lower market interest rates. There is one more reason and one that many investors seem to view as the dominant one and I will address it next.

The Central Bank and Interest Rates
In all of this discussion, notice that I have studiously avoided bringing the central bank into the process, which may surprise you, given the conventional wisdom that central banks set interest rates. That said, a central bank can affect interest rates in one of two ways:

  • The first and more conventional path is for the central bank to signal, through its actions on the rates that it controls what it thinks about inflation and real growth in the future, and with that signal, it may alter long term rates. Thus, the Fed lowering the Fed funds rate (a central bank set rate that banks can borrow from the Fed Window) will be viewed as a signal that the Fed sees the economy as weaken and expects inflation to stay subdued or even non-existent, and this signal will then push expected inflation and real interest rates down. This will work only if central banks are credible in their actions, i.e., they are viewed as acting in good faith and with good information and are not gaming the market. 
  • The second channel is for the central bank to actively enter the bond market and buy or sell bonds, thus affecting the demand for bonds, and interest rates. This is unusual but it is what central banks in the United States and the EU have done since 2008 under the rubric of quantitive easing. For this to have a material effect on interest rates, the central bank has to be a big enough buyer of bonds to make a difference. 
Thus, as you read the news stories about the Japanese central bank and the ECB considering negative interest rates, recognize that they cannot impose these rates by edict and that all they can do is change the rates that they control and let the signaling impact carry the message into bond markets.

Measuring the Fed Effect
Just ahead of the Federal Open Market Committee meetings last year, as debate about whether the Fed would ease up on quantitative easing, I argued that we were over estimating the effect that the Fed had on market set rates and that while it has contributed to keeping rates low for the last six years, an anemic economy was the real reason for low interest rates. To compute the Fed effect, I chose to track two numbers:
  • An intrinsic interest rate, computed by adding together the actual inflation each year and the real growth rate each year, two imperfect proxies for expected inflation and the real interest rate.
  • The ten-year US treasury bond rate at the start of each year, set by the bond market, but affected by expectation setting and bond buying by the Fed.
The graph below captures both numbers, updated through 2015:

Note how closely the US treasury bond has tracked my imperfect estimate of the intrinsic interest rate, and how low the intrinsic rate has become, post-crisis. At the risk of repeating myself, the Fed has, at best, had only a marginal impact on interest rates during the last six years and it is my guess that rates would have stayed low with or without the Fed during this period.

Negative Interest Rates
Turning to the question at hand, is it possible for nominal interest rates to be negative, based upon fundamentals? The answer is yes, but with a caveat. If the preference for current consumption over future consumption dissipates or gets close to zero and you expect deflation in a currency, you could end up with a negative interest rate. In fact, that is the common thread that runs through the economies (Japan, the Euro Zone, Switzerland) where rates have become negative.

Now, comes the caveat. If you have nominal negative interest rates, why would you ever lend money out, since you have the option of just holding on to the money as cash. Historically, that has led many to believe that the floor on nominal rates should be zero. As rates go below zero, it is time to reexamine that belief. One way to reconcile negative interest rates with rational behavior is to introduce costs to holding cash and there are clearly some to factor in, especially in today's economies. The first is that while the proverbial stuffing cash under your mattress option is thrown around as a choice, you will increase your exposure to theft and may have to invest in security measures that are costly. The second is that there are some transactions that are extraordinarily cumbersome to get done with cash; imagine buying a million dollar house and counting out the cash for the payment. The Danish, Swiss and Japanese governments are embarking on a grand experiment, perhaps, of how much savers will be willing to pay for the convenience of staying cashless. In effect, the lower bound has shifted below zero but there is still one. To those who are convinced that negative interest rates have nothing to do with fundamentals and that they are entirely by central bank design, I would argue that the only reason that these central banks have been able to push rates below zero, is because real growth and inflation have become so low in their economies that the intrinsic rate was close enough to zero to begin with. There is no chance that the Brazilian and Indian central banks will follow suit.

Interest Rates, Financial Assets and the Real Economy
When central banks in these currencies strongly signal their intent to drive interest rates to zero and below, what could be the motivation? Put simply, it is the belief that lower interest rates lead to higher prices for financial assets and more real investment in the economy, either through the mechanism of "lower" hurdle rates for investments or a weaker currency making businesses more competitive globally. In this central banking heaven, where central banks set rates and the world meekly follows, this is what unfolds:

So, why has it not worked? As interest rates in the US, Europe and Japan have tested new lows each year for the last few, we have not seen an explosion in real investment in these countries, and while stock prices have risen, the rise has had as much to do with higher earnings and cash flows, as it has to do with lower interest rates. In my view, the fundamental miscalculation that central banks have made is in assuming that their actions not only affect other pieces of this puzzle but are also read as signals of the future.  In particular, central bankers have failed to incorporate three problems: that interest rates do not always follow the central bank lead, that risk premiums on equity and debt may increase as rates go down and that exchange rate effects are muted by other central banks acting at the same time. In this reality-based central banking universe, the lowering of rates by central banks can have unpredictable and often perverse consequences, lowering financial asset prices, reducing real investment and making a currency stronger rather than weaker.

This is all hypothetical, you may say, but there is evidence that markets have become much less trusting of central banking and more willing to go their own ways. For instance, as the risk free rate has dropped over the last few years, note that the expected return for stocks has stayed around 8% during that period, leading to higher and higher equity risk premiums.

While bond markets initially did not see this phenomenon, last year default spreads on bonds in every ratings class widened, even as rates dropped. Interestingly, the most recent ECB announcement that they would push the rates they control lower was accompanied by news that they would enter the bond market as buyers, hoping to keep default spreads down. That is an interesting experiment and I have a feeling that it will not end well.

Dealing with Negative Interest Rates
My interests in negative interest rates are primarily in the context of valuation and corporate finance. In both arenas, the hurdle rates we use to pick investments and value businesses build off a long term risk free rate as a base and having that base become a negative value is disconcerting to some. There are two choices that you have:
  1. Switch currencies: You can value Danish companies in Euros or US dollars, where long term rates are still positive (albeit very low). This evades the problem, but you can run but you cannot hide. At some point in time, you will have to work in the negative interest rate currency.
  2. Normalize risk free rates: This is a practice that has become more prevalent in both the US and Europe, where risk free rates have dropped to historic lows. To compensate, analysts are using the average rate across long periods as a normalized risk free rate. I have problems with this approach at three levels. The first is that normal is in the eye of the beholder and what you call a normal 10-year T.Bond rate is more a function of your age than scientific judgment. The second is that given that the risk free rate is where you plan to put your money if you don't make your real investment, it seems singularly dangerous for this to be a made-up number. The third is that using a normalized risk free rate with the high equity risk premiums that are prevalent today will lead to too high a hurdle rate, since the latter are primarily the result of low risk free rates.
  3. Leave the risk free rate negative: So, what if the risk free rate is negative? In valuation, you almost never use the risk free rate standing alone, but only in conjunction with a risk premium. If you can update those risk premiums, they may very well offset the effect of having a negative risk free rate and yield a cost of equity and/or debt that does not look different from what it did prior to the negative interest rate setting. There is one other adjustment that I would make. In stable growth, I have been a proponent of using the risk free rate as your cap on the stable growth rate. With negative risk free rates, I would stick with this principle, since, as I noted earlier in this post, negative interest rates signify economies with low or no real growth combined with deflation and the growth rate in perpetuity for stable companies in these economies should be negative for those same reasons.
What Real Negative Interest Rates Signify
When interest rates of from being really small positive numbers (0.25% or 0.50%) to really small negative numbers (-0.25% to -0.50%), the mathematical consequences are small but I do think that breaching zero has consequences and almost all of them are negative.
  1. The economic end game: For those who ultimately care about real economic growth and prosperity, negative interest rates are bad news, since they are incompatible with a healthy, growing economy. 
  2. Central banks insanity, impotence and desperation: As I watch central bankers preen for the cameras and hog the limelight, I am reminded of the old definition of insanity as trying the same thing over and over, expecting a different outcome. After six years of continually trying to lower rates, with the expectation of economic growth just around the corner, it is time for central banks to perhaps recognize that this lever is not working. By the same token, the very fact that central banks revert back to the interest rate lever, when the evidence suggests that it has not worked, is a sign of desperation, an admission by central banks that they have run out of ideas. That is truly scary and perhaps explains the rise in risk premiums in financial markets and the unwillingness of companies to make real investments. 
  3. Unintended consequences: As interest rates hit zero and go lower, there will be some investors, in need of fixed income, who will look in dangerous places for that income. A modern-day Bernie Madoff would need to offer only 4% in this market to attract investors to his fund and as I watch investors chase after yieldcos, MLPs and other high dividend paying entities, I am inclined to believe that is a painful reckoning ahead of us. 
  4. An opening for digital currencies: In a post a few years ago, I looked at bitcoin and argued that there will be a digital currency, sooner rather than later, that meets the requirements of trust needed for a currency in wide use. The more central bankers in conventional currencies play games with interest rates, the greater is the opening for a well-designed digital currency with a dependable issuing authority to back it up.
In the next few weeks, I am sure that we will read more news stories about central banks professing to be shocked that markets have not done their bidding and that economies have not revived. I am not sure whether I should attribute these rantings to the hubris of central bankers or to their blindness to market realities. Either way, I feel less comfortable with the notion that central bankers know what they are doing and that we should trust them with our economic fates.

YouTube Video


Tuesday, February 23, 2016

Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!

As I watch GoPro and LinkedIn, two high flying stocks of not that long ago, come back to earth my mind is drawn to two much told stories. The first is the Greek myth about Icarus, a man who had wings of feathers and wax, but then soared so high that the sun melted his wings and he fell to earth. The other is that of Lazarus, who in the biblical story, is raised from the dead, four days after his burial. As investors, the decision that we face with GoPro and LinkedIn is whether like Icarus, they soared too high and have been scorched (perhaps permanently) or like Lazarus, they will come back to life.

GoPro: Camera, Smart Phone Accessory or Social Media Company?
GoPro went public in June 2014 at $24/share and quickly climbed in the months following to hit $93.85 in October of that year. When I first valued the company in this post, the stock was still trading at more than $70/share. Led by Nick Woodman, a CEO who had a knack for keeping himself in the public eye (not necessarily a bad thing for publicity seeking start up), and selling an action camera that was taking the world by storm, the company’s spanning of the camera, smartphone accessory and social media businesses seemed to position it to conquer the world. Even at its peak, though, it was clear the competitive storm clouds were gathering as other players in the market, noting GoPro’s success, readied their own products.

In the last year, GoPro lost much of its luster as its product offerings have aged and sales growth has lagged expectations. It is a testimonial to these lowered expectations that investors were expecting revenues to drop, relative to the same quarter in the prior year, in the most recent quarterly earnings report from the company.

The company reported that it not only grew slower and shipped fewer units than expected in the most recent quarter, but also suggested that future revenues would be lower than expected. While the company’s defense was that consumers were waiting for the new GoPro 5, expected in 2016, investors were not assuaged. The stock dropped almost 20% on the news, hitting an all-time low of $9.78, right after the announcement.

To evaluate how the disappointments of the last year have impacted value, I went back to October 2014, when I valued the stock at $30.57. Viewing it as part camera, part smart phone and part social media company (whose primary market is composed of hyper active, over sharers), I estimated that it would be able to grow its revenues 36% a year, to reach about $10 billion in steady state, while earning a pre-tax operating margin of 12.5%. Revisiting that story, with the results in the earnings reports since, it looks like competition has arrived sooner and stronger than anticipated, and that the company’s revenue growth and operating margins will both be more muted.

In my updated valuation, I reduced my targeted revenues to $4.7 billion in steady state, my target operating margin to 9.84% (the average for electronics companies) and increased the likelihood that the company will fail to 20%. The value per share that I get with my updated estimates is $17.66, 35% higher than the price per share of $12.81, at the start of trading on February 22, 2016.  Looking at the simulation of values, here is what I get:
Spreadsheet with valuation
At its price of $12.81, there is a 68% chance that the stock is under valued, at least based on my assumptions.

I am fully aware of the risks embedded in this valuation. The first is that as an electronics hardware company that derives the bulk of its sales from one item, GoPro is exposed to a new product that is viewed as better by consumers, and especially so if that new product comes from a company with deep pockets and a big marketing budget; a Sony, Apple or Google would all fit the bill. The second is that the management of GoPro has been pushing a narrative that is unfocused and inconsistent, a potentially fatal error for a young company. I think that the company not only has to decide whether its future lies in action cameras or in social media and act accordingly, but it also has to stop sending mixed messages on growth; the stock buyback last year was clearly not what you would expect from a company with growth options.

Linkedin: The Online Networking Alternative?
LinkedIn went public in May 2011, about a year ahead of Facebook and can thus be viewed as one of the more seasoned social media companies in the market. Like GoPro, its stock price soared after the initial public offering:

LinkedIn Stock Price: IPO to Current
While it often lumped up with other social media companies, Linkedin is different at two levels. The first is that it is less dependent on advertising revenues than other social media companies, deriving almost 80% of its revenues from premium subscriptions that it sells its customers and from matching people up to jobs. The second is that its pathway to profitability has been both less steep and speedier than the other social media companies, with the company reporting profits (GAAP) in both 2013 and 2014, though they did lose money in 2015.

Unlike GoPro, where expectations and stock prices had been on their way down in the year before the most recent earnings report, the most recent earnings report was a surprise, though, at least at first sight, it did not include information that would have led to this abrupt a reassessment:
Linkedin delivered earnings and revenue numbers that were higher then expectations and much of the negative reaction seems to have been to the guidance in the report.

While I have not valued Linkedin explicitly on this blog for the last few years, it has been a company that has impressed me for a simple reason. Unlike many other social media companies that seemed to be focused on just collecting users, Linkedin has always seemed more aware of the need to work on two channels, delivering more users to keep markets happy and working, at the same time, on monetizing these users in the other, for the eventuality that markets will start wanting more at some point in time. Its presence in the manpower market also means that it does not have to become one more player in the crowded online advertising market, where the two biggest players (Facebook and Google) are threatening to run up their scores. Nothing in the latest earnings report would lead me to reassess this story, with the only caveat being that the drop in earnings in the most recent year suggests that profit margins in the manpower business are likely to be smaller and more volatile than in the advertising business.

Allowing for Linkedin’s presence in two markets, I revalued the company with revenue growth of 25% a year for the next five years, leading to $15.3 billion in revenues in steady state (ten years from now), and a target pre-tax operating margin of 18%, lower than my target margins for Twitter or Facebook, reflecting the lower margins in the manpower business. The value per share that I get for the company is $103.49, about 10% below where the market is pricing the stock right now. The results of the simulation are presented below:

Spreadsheet with valuation
At its current stock price, there is about a 40% chance that the company is under valued.  If you have wanted to hold LinkedIn stock, and have been put off by the pricing, the price is tantalizingly close to making it happen. As with other social media companies, LinkedIn’s user base of 410 million and their activity on the platform are the drivers of its revenues and value.

The Acquisition Option
If you are already invested in GoPro or LinkedIn, one reason that you may have is that there will be someone out there, with deep pockets, who will acquire the firm, if the price stays where it is or drops further, thus putting a floor on the value. That is not an unreasonable assumption but to me, this has always been fool's gold, where the hope of an acquisition sustains value and the price goes up and down with each rumor. I have seen it play out on my Twitter investment and I do think it gets in the way of thinking seriously about whether your investment is backed by value.

That said, I do think that having an asset or assets that could be more valuable to another company or entity does increase the value of a company. It is akin to a floor, but it is a shifting floor, and here is why. Consider LinkedIn, a company with 410 million users. Even with the drop in market prices of social media companies in the last few months, the market is paying roughly $80/user (down from about $100/user a couple of years ago). You could argue that an acquirer would be a bargain, if they could acquire LinkedIn at $8 billion, roughly $20 a user. However, the price that an acquirer will be willing to pay for LinkedIn users will increase if revenues are growing at a healthy rate and the company is monetizing its users. 

To evaluate the impact that introducing the possibility of an acquisition does to LinkedIn's value, I started by assuming that the acquisition price for LinkedIn would be $8 billion, but that the value would range from $4 billion (if revenue growth is flat and margins are low) to $12 billion (if revenue growth is robust). I then reran the simulation of LinkedIn's valuation, with the assumption that the company would be bought out, if the market capitalization dropped below the acquisition price. In the picture below, I compare the values across the two simulations, one without an acquisition floor and one with:

You may be surprised by how small the effect of introducing an acquisition floor has on value but it reflects two realities. One is my assumption that the expected acquisition price is $8 billion; raising that number towards the current market capitalization of $15.4 billion will increase the effect. The other is my assumption that the acquisition price will slide lower, if LinkedIn's revenue growth and operating profitability lag. 

Fighting my Preconceptions
I must start with a confession. After watching the price drop on these two stocks, and prior to my valuations, I really, really wanted LinkedIn to be my investment choice. I like the company for many reasons:
  1. As noted earlier, unlike many other social media companies, it is not just an online advertising company.
  2. The other business (networking and manpower) that the company operates in is appealing both because of its size, and the nature of the competition.
  3. The top management of LinkedIn has struck me as more competent and less publicity-conscious that those at some other high profile social media companies. I think it is good news that I had to think a few minutes about who LinkedIn's CEO was (Jeff Weiner) and check my answer.
I have a sneaking suspicion that my biases did affect my inputs for both companies, making me more pessimistic in my GoPro inputs and more optimistic on my LinkedIn values. That said, the values that I obtained were not in keeping with my preconceptions. In spite of my inputs, GoPro is significantly under valued and in spite of my implicit attempts to pump it up, LinkedIn does not make my value cut. Put differently, the market reaction to the most recent earnings report at LinkedIn was clearly an over reaction, but it just moved the stock from extremely over valued, on my scale, to close to fair value. 

YouTube Video

  1. GoPro - Bloomberg Summary (including 2015 numbers)
  2. LinkedIn - Bloomberg Summary (including 2015 numbers)
  1. GoPro - Valuation in February 2016
  2. Twitter - Valuation in February 2016
Blog posts in this series
  1. A Violent Earnings Season: The Pricing and Value Games
  2. Race to the top: The Duel between Alphabet and Apple!
  3. The Disruptive Duo: Amazon and Netflix 
  4. Management Matters: Facebook and Twitter
  5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
  6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
  7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
  8. Taming the Market? Rules, Regulations and Restrictions (Later this year)