Monday, October 12, 2015

On the Uber Rollercoaster: Narrative Tweaks, Twists and Turns!

A slightly abbreviated version of this post appeared in TechCrunch on October 9, 2015, and it is the first of series of three on the ride sharing business. In the second post, I value Lyft, the other ride sharing company, and also look at how ride sharing companies globally are being priced. In the third and final post, I look at ride sharing as a business and at four possible scenarios for its evolution. Those posts will also appear in TechCrunch over the next two weeks and will be reproduced here soon after.

It seems like ages ago, and perhaps even in a far-off galaxy, that I first valued Uber on my blog, but it was in June of 2014. One reason it seems like a lot of time has elapsed is that Uber has managed to be in the news, for good and bad reasons, almost all through this period. With each news story, the response is either rapturous or funereal, depending on the responder’s prior views on the company. Given how eventful this last year has been, I think it is time for me to revisit my estimates, eat some humble pie and redo my valuation.

A look back
I became interested in Uber after reading a news story in June 2014 that indicated that it had been valued at $17 billion in a venture capital round. I posted my first valuation of Uber in June 2014, viewing it as an urban car service company, with local (but not global) networking benefits. Assuming that it would increase the size of the urban car service market by about 40%, while preserving its low capital-investment business model, I valued Uber at just under $6 billion.

While some in the VC community were quick to dismiss the valuation, I will remain grateful to Bill Gurley for a post where he took me to task for having too narrow a vision of Uber’s business model. In his counter narrative, he argued that Uber was not just urban (it could create inroads in suburbia), not just a car service (it was in logistics & transportation) and that it was working with other businesses to create global networking benefits. Since Bill, as an early investor in Uber with access to its internal workings, clearly knew far more about the company than I did, I revalued Uber using his narrative and arrived at $54 billion as the value that reflected the narrative.

I was then taken to task by value investors who took issue with the value changing so dramatically from my assessment to his, and my response was that this was exactly what you should expect, early in the life of a company, where there is room for widely divergent narratives, and values that reflect these divergences. In December 2014, I tried to show this by creating a build-your-own-Uber valuation template, where I let readers choose Uber’s market (urban car service, all car service, logistics or mobility services), the effect it would have on that market’s size (from none to doubling it), the competitive advantages that would determine its cut of the ride receipts (from the existing 20% down to 5%), the networking benefits it would have (none, local, partial global, global) and business model (from its current no capital intensity to higher capital investments), and derived values for Uber, ranging from less than $1 billion to close to $100 billion.

The news keeps coming..
As I noted at the top of this post, it is an understatement to say that Uber has been in the news. Each week brings more Uber stories, with some containing good news for those who believe that the company is on a glide path to a $100 billion IPO, and some containing bad news, which evoke predictions of catastrophe from Uber doubters. For me, the test with each news story is to see how that story affects my narrative for Uber, and by extension, my estimate of its value. In keeping with this perspective, I broke the news stories down based upon narrative parts and valuation inputs.

The Total Market 
The news on the car service market has been mostly positive, indicating that the market is broader, bigger, growing faster and more global than I thought it was, even a year ago. 
  1. Not just urban and much bigger: While car service remains most popular in the urban areas, it is making inroads into exurbia and suburbia. The evidence for this lies not only in anecdotal evidence and the market capitalizations commanded by ride sharing companies, but also in the numbers that have been leaked by these companies. A presentation to potential investors in the company put Uber’s gross billings for 2015 at $10.84 billion. It is true that these are unofficial and may have some hype built into them, but even if that number over estimates revenues by 20% or 25%, that represents a jump of 400% from 2014 levels.
  2. Drawing in new customers: One reason for the increase in the car service market is that it is drawing in customers who would never have taken been in this market in the first place. While the evidence for this is still mostly anecdotal, another leaked report out of Uber indicates that ride sharing has created a market three to four times larger that the original taxi cab/ limo market in San Francisco, the city with the longest history with new ride sharing services. While San Francisco is unusual in terms of the high proportion of its population that is young, tech-savvy and single, the argument that ride sharing is increasing the size of the market elsewhere, though not to the same magnitude that it did in the Bay Area, seems to be a solid one.
  3. With more diverse offerings: The other reason for the jump in the size of the ride sharing market is that it is no longer just a cab service, but instead has expanded to include alternatives that expand choices, reduce costs (car pooling services) or increase flexibility.
  4. And going global: The biggest stories on ride sharing came out of Asia, as the ride sharing market has exploded in that part of the world, and especially so in India and China. That should really come as no surprise since these countries offers the trifecta for ride sharing opportunities: large urban populations, with limited car ownership and bad mass transit systems. 
The bad news on the car service market front has come mostly in the form of taxi driver strikers, regulatory bans and operating restrictions. Sao Paulo may be the latest city to restrict Uber, but it is part of a long list of cities or entire countries that have tried to ban or restrict ride sharing. Even that bad news, though, contains seeds of good news, since the status quo would not be trying so hard to stop the upstarts, if ride sharing was not working. In my view, the attempts by taxi operators, regulators and politicians to stop the ride sharing services reek of desperation, and the markets seem to reflect that. Not only have the revenues collected by taxi cabs in New York city dropped significantly in the last year, but so has the price of NYC cab medallions, dropping almost 40% in value (roughly $5 billion in the aggregate) in the last two years. While auto sales may not have been affected materially yet, there are worries that there will be a drop in sales in future years, as people replace a "second" car or even a "first" car with ride sharing services.

In my December post, I noted the possibility that Uber could move into other businesses. The good news is that it has delivered on this promise, offering logistics services in Hong Kong and New York, and food delivery service in Los Angeles. The bad news is that it has been slow going, partly because these are smaller businesses (than ride sharing) and partly because the competition is more organized. However, these new businesses have moved from just being possible to plausible, thus expanding the total market.

Bottom line: The total market for Uber is bigger than the urban car service market that I visualized in June 2014, and will attract new customers, and expand in new markets (with Asia becoming the focus), and perhaps even in new businesses.

Networking & Competitive Advantage (Market Share and revenue sharing)
The news on this front is more mixed. The good news is that the ride sharing companies have increased the cost of entry into the market, with tactics such as paying large amounts to drivers as sweeteners to sign up. In the US, Uber and Lyft have become the biggest players, and some of the competitors from last year have either faded away or been unable to keep up with these two. Outside the US, the good news for Uber is that it is not only in the mix almost everywhere in the world but that Lyft has, at least for the moment, decided to stay focused on the United States in its expansion choices. 

The bad news for Uber is that, especially in Asia, the competition has been intense, and that it is fighting against domestic ride sharing companies that dominate these markets, Ola in India, Didi Kuaidi in China and Grabtaxi in South East Asia. Some of the domestic company dominance can be attributed to these companies being first movers and understanding local markets better, but some of it also reflects that the market is tilted (by local investors, regulation and politics) towards local players. There is even talk, though it may be just that, that these competitors will band together to create a “not-Uber” network that can share resources and users, though the news story, two weeks ago, that Didi Kuaidi and Lyft were going to create a formal partnership adds heft to the thesis. To add to the mix, all of these ride sharing companies have been able to access capital at sky-high valuations, reducing the significant cash advantage that Uber had earlier in the process.

No matter how this process plays out, one of the key numbers that will be (and in some cases is already) under pressure, due to this more intense competition, is the sharing of the gross billing, currently set at 80% for the driver and 20% for the ride sharing business. In many US cities, where Lyft is challenging Uber most aggressively, Lyft is already offering drivers the opportunity to keep all of their earnings, if they drive more than 40 hours a week. While the threat of mutually assured destruction has kept both companies from directly challenging the 80/20 sharing rule, it is only a matter of time before that changes.

Bottom line: The ride sharing market is becoming competitive, but as costs of entry rise and the capital requirements become intense, it looks like this will be a market with fewer players with larger regional networking benefits and more capital.

Cost structure
This is the area where the most bad news has been delivered. Some of the pain has been from within the ride sharing business, as companies have taken to offering larger and larger up-front payments to drivers to get them to switch from competitors, pushing up this component of costs. Much of the cost pressure, though, has come from outside:
  1. Drivers as partial employees: Early in the summer, the California Labor Commission decided that Uber drivers were employees of the company, not independent contractors. That ruling was further affirmed by a court decision that Uber drivers could sue the company in a class action suit, and it is likely that there will be other jurisdictions where this fight will continue. While ride sharing companies may be able to delay the effect, it is almost inevitable that at the end of the process, drivers for ride sharing companies will be treated perhaps not as employees but as semi-employees, entitled to some (if not all) of the benefits of employees (leading to higher costs for ride sharing companies).
  2. The insurance blind spot will be filled: The other shoe that is poised to drop is the cost of car insurance. Ride sharing companies in their nascent years have been able to exploit the holes in auto insurance contracting, often just having to add supplemental insurance to the insurance that drivers already have. As both regulators/legislators and insurance companies try to fix this gap, it is very likely that drivers for ride sharing companies will soon have to buy more expensive insurance and that ride sharing companies will have to bear a portion of that cost.
  3. Fighting the empire is not cheap: Earlier in this post, I noted that the status quo (the taxi business and its regulators) was fighting back and that its cause was hopeless. However, the fight will still be expensive as the amount of money spent on lobbying and legal fees will increase, as new fronts open up. 
The evidence that costs are running far ahead of revenues again comes from leaked documents from the ride sharing companies. This one, for instance, shows that Uber was a money loser last year and in this one, the contribution margins (the profits after covering just variable costs) by city not only reveal big differences across cities, but are uniformly low (ranging from a high of 11.1% in Stockholm and Johannesburg to 3.5% in Seattle).

Bottom line: The costs of running a ride sharing business are high, and while some of these costs will drop, as business scales up, the operating margins are likely to be smaller than I anticipated just over a year ago.

Capital Intensity and Risk
The business model that I assumed when I first valued Uber was minimalist in its capital investment requirements, since Uber not only does not own the cars driven by its drivers but invests little in corporate offices or infrastructure. That translated into a high capital turnover ratio, with a dollar in capital generating five dollars in additional revenues. While that basic business model has not changed, ride sharing companies are recognizing one of the downsides of this low capital intensity model is that it has increased competition on other fronts. Thus, the high costs that Uber and Lyft are paying to sign up drivers can be viewed as a consequence of the business models that they have adopted, where drivers are free agents who are not bound to either company. 

For the moment, there is no sign that any of the ride sharing companies is interested in altering the dynamics of this model, by either upping its investment in infrastructure or in the cars themselves, but this news story about Uber hiring away the robotics faculty at Carnegie Mellon may be suggestive of change to come.

Bottom line: Ride sharing companies will continue with the low capital intensity model, for the moment, but the search for a competitive edge may result in a more capital intense model, requiring more investment to deliver sustainable growth.

Management culture
Though not a direct input into valuation, it is unquestionable that when investing in a young business, you should be aware of the management culture in that business. With Uber, your responses to the news stories about its management team will reflect your priors on the company. If you are predisposed to like the company, you will view it as confident in its attacks on new markets, aggressive in defending its turf, and creative in its counter-attacks. If you don’t like the company, the very same actions will be viewed as indicative of the arrogance of the company, its challenging a status quo will signal its unwillingness to play by the rules and its counter attacks will be viewed as overkill.

In New York, I saw this come into play when the mayor and city council decided to restrict the ride sharing companies (and Uber in particular) from expanding in the city, using the argument that it was worsening traffic conditions in the city. In response, Uber struck back with a counter publicity blitz which included not only radio and TV ads, but also add-ons to the Uber app that left no doubt in Uber users’ minds about how these restrictions would affect their choices. I thought that the DeBlasio option on the Uber app was clever, and while Uber won this battle with New York city, I wonder whether the scorched earth policies that it used will come back to hurt the company down the road.

Bottom line: While there are a few indications that Uber might be trying to soften its image, there seems no reason to believe that the company will become less aggressive in the future. The question of whether this will hurt them as they scale up remains unresolved.

Uber: An Updated Valuation
In summary, a great deal has changed since June 2014, partly because of real changes that have happened to the ride sharing market since then and partly because I had to fill in gaps in my ignorance about the market. I think that the best way to capture the shifts in my valuation is to compare my inputs on key numbers in June 2014 with my estimates in September 2015.
Uber valuation (6/14), Uber valuation (9/15)

I was wrong about Uber’s value in June 2014, when my estimate of $6 billion was below the $17 billion assessment by venture capitalists then. Correcting for both my cramped vision and the changes that have occurred since June 2014, my estimated value today is $23.4 billion.
Über valuation Spreadsheet (Ignore the umlaut, spell check did it..)

I know my estimated value lags the $51 billion value that VCs are attaching to the company today. This may very well be a reflection that my vision is still too cramped to capture Uber’s possible businesses, but it is what it is.

Fire away
When teaching and writing, my objective is to evoke interest and excite my audience, and failing that, to provoke dissent and incite argument, but the reaction that I dread the most is boredom. The very fact that you are reading this post still is good news, but if you are in complete agreement with my valuation of Uber, I have failed. I would rather that you fall into one of three groups: that you think my value is too high, that you feel it is too low or that you believe that I have no business even valuing Uber.
  • If you think I have over estimated the value of Uber, it should not be because it is losing money (given its growth trajectory, you should be suspicious if it did not), is trading at a high multiple of revenues (it should) or because your stable growth dividend discount model gives you too low a number (it is the wrong tool for a growth company). It should because you think the regulatory roadblocks will make the ride sharing market smaller than I have forecast it to be, and that competition will be much more intense (reducing market share and operating margins). 
  • If you think that I have under estimated the value of Uber (again), don’t blame DCF models for being biased against growth companies. The fault lies with me, and it has to be somewhere in my inputs, i.e., that I am not foreseeing other markets that Uber could enter, that its networking benefits are far stronger globally than I predict them to be (giving it a higher market share) or that the operating margins will bounce back to much healthier levels once they navigate their way through the growth phase. 
  • If your view is that I have no business valuing Uber because I am not a tech person, that I am not an expert in the ride sharing business and/or that I have not made money as a VC, my responses are guilty as charged, you are right and without a doubt. I don’t have a tech background, don’t work on the right coast and know technology only as a user, but I don’t think any of those are prerequisites for investing in technology companies. I have tried to incorporate what I have learned from technology companies in the market into the valuation, in the form of easier scaling up, larger networking benefits and bigger market effects, but I might not have done it well enough. There are many who know a great deal more about ride sharing than I do, and while I have tried to learn about the inner workings of this business from Harry Campbell and about the Chinese growth potential from Drake Ballew, my ride sharing know-how is limited. Finally, if we did restrict writing about the valuation of young companies only to venture capitalists who have been consistently successful over long periods, the list of potential writers would be very short, and most of the people on the list would be too busy investing in these startups to write about them. 
Whatever group you belong to, rather than complain about my mistakes (which are too many to count) or bemoan my limitations (which are legion), please take my Uber valuation and make it yours, putting your superior knowledge and experience into the numbers. In fact, let’s give this a crowd valuation twist and get a shared Google spreadsheet going, where you can post your results.

To be continued..
Notwithstanding the dressing down that I got from some in the technology/VC space for my first valuation of Uber, or perhaps because of it, there is no company that I have enjoyed valuing and talking about more during the last year, than Uber. Thecompany illustrates all the broad themes in valuation that I have returned in my blog posts and teaching: that uncertainty is part and parcel of valuation, that narratives drive numbers and that the pricing and valuation processes can yield different numbers. As a teacher, I am constantly on the look out for learning and teaching moments, and few companies have offered me more than Uber. 

To show you how much Uber has found its way into my every day thinking, I will end with a personal story. Towards the end of last summer, my youngest son, who is fifteen had a friend over for the afternoon, and when it was time for the friend to leave, I looked out at the driveway, expecting the “Mom car", the typical mode of transportation for a 15-year old in the middle of suburbia (where I live). When I saw a strange sedan with a bearded man in the driver’s seat, I was taken aback, until I was told that it was an Uber car. Since this happened only two months after my valuation of Uber in June 2014, where I labeled it an urban car service company, my first reaction after I got over my surprise was that I needed to revalue Uber afresh. Of such small actions are obsessions born!

YouTube Version

Ride Sharing Series

  1. On the Uber Rollercoaster
  2. Dream Big or Stay Focused? Lyft's Answer to the Big Story Question!
  3. The Future of Ride Sharing: Playing Pundit!

Previous Blog posts

Thursday, October 1, 2015

Putting a Price Tag on Scandal: Sturm und Drang at Volkswagen!

My Vale missteps illuminated for me some of the risks of going where it is darkest, but I will not let them stop me from trying again. This time, my focus is Volkswagen, a company that has, over the course of a month, gone from being just another mature company in a bad business (automobiles) to one beset on all sides by governments, lawyers and investors. In this case, though, unlike Vale and Lukoil, much of the uncertainty comes from self-inflicted wounds and as its stock price drops, it is worth looking at whether the market reaction has been overdone.

The setting
For the last decade, Volkswagen has worked hard to make itself a global automobile giant. Last year, the company was the leading auto company in the world, in terms of revenues, and second only to Toyota in units sold. In the US, it has a much lower profile, with a market share in the low single digits.

The company has been able to weather the 2008 crisis well, and has seen revenues and earnings climb, albeit at the moderate levels that befit a mature automobile company.
Source: S&P Capital IQ, Data
The company's operating margin of 6.07% in the last twelve months (ending June 30, 2015) was higher than its historical average margin of 4.21%. During the period, the Volkswagen auto offerings have expanded to include not only Audi and Skoda but also luxury brands including Bentley, Lamborghini, Porsche and Bugatti.

The Scandal, The Stock Price and Knee Jerk Contrarianism
In the last few weeks, the wheels have come off the Volkswagen bus. The trigger was a revelation that VW had designed the computer software on its diesel automobiles to fool the EPA, when it was testing for emissions; this BBC story explains it well. Once the story became public, Volkswagen admitted that it had screwed up big time, its CEO resigned, a whole host of top managers lost their jobs and Volkswagen's stock price collapsed, losing almost 40% of its value in the last month.

While both the ordinary and preferred shares have collapsed, the preferred shares seem to have taken more of a beating; the ordinary shares that used to trade at par with the preferred now trade at a premium of about 8% (and I will take more about this later in this post)

There is no doubt that this is more than a tempest in a  teapot, and that that there will be consequences, but are the consequences dire enough to cause a loss of more than 30 billion Euros in market capitalization? That remains the key question, as investors who are attracted to beaten up stocks look at Volkswagen. A knee jerk contrarian strategy may argue that history and empirical evidence is on your side and push for investment in Volkswagen now, but I am wary of using average returns from past studies, often based upon large samples of companies, to justify investing in one company that meets the criteria. 

The Costs
In the aftermath of Volkwagen's revelations, the news media have turned their full attention to the company's foibles, real and made up, with a skew towards putting the worst possible spin on the company's actions. Thus, the fact that the company has close ties to German lawmakers is viewed as a sign of the company's moral turpitude, as if other auto makers do not have their own stables of legislators pushing for preferential treatment.  Thus, the first step in assessing the impact of this scandal on Volkswagen is separating the wheat from the chaff, or in Nate Silver's words, the signal from the noise. It is quite clear that this scandal is going to cost Volkswagen, in many different arenas, starting with penalties being imposed by governments and regulators for the deception, continuing with the costs of recalling and fixing the cars and expanding to cover lost sales, as potential customers switch to competing car companies.
  1. The Legal Penalties: There is no question that there are legal penalties coming, with Volkswagen already setting aside $7.3 billion (6.5 billion Euros) to cover the costs (fines/penalties, recall costs and other legal costs) that it will face, and the EPA's potential fines could expand to $18 billion. There is talk in Europe of similar penalties being meted out by European governments, which will add to the cost. (Update: A reader sent me the link to this article that provides some perspective on the potential fine size being closer to $11 billion, rather than $18 billion.)
  2. Auto Recall Costs/ Legal Costs: It is estimated that Volkswagen has about 11 million vehicles that it might have to recall and refit, and that will be costly. Not surprisingly, talk of lawsuits fill the air, with both European and American shareholders considering suing the company for damages; even if the company wins all of these suits, it will be paying hefty legal fees along the way.
  3. Lost Sales/Operating Income: There is also talk of lost trust and tarnished brand names, but these remain PR buzzwords until they start showing up in lost sales/profits. Unlike the BP or GM scandals, where lives were lost, the impact of this scandal is more diffuse, though the New York Times segued into this argument (a little far fetched) that the cheating could have cost lives. 
At the moment, the magnitude of these costs is still murky, but waiting for them to be clearer, as some investors seem to be doing, is an investment cop out. The market is already imputing a cost , and investors who want to invest in Volkswagen have no choice but to make their own judgments on whether the market imputed cost is too high (in which case Volkswagen becomes a buy), just right or too low (Volkswagen will be over valued).

I know that the cases are dissimilar, but to get a measure of what a scandal can cost an auto company, I looked at Toyota's experiences in 2010 with faulty gas pedals, the press coverage and controversy and the subsequent costs to the company.

The ScandalGas pedals stuck, causing acceleration & accidents.Computer software fooled EPA on emissions tests, reporting emissions at lower than actual level.
Deaths/Fatalities37* (NHSTA)None
Number of cars affected9 million11 million
EPA fines/ Government Penalties$1.2 billionVW set aside $7.3 billion
EPA maximum fine $18 billion
Auto Recall Costs & Car Owner lawsuits$1.1 billionIf proportional to number of cars, $1.34 billion.
Shareholder lawsuits$25.5 millionLawsuits being considering in both US and Europe.
Effect on Revenues/OperationsRevenues dropped from $19.1 billion in 2009 to $17.8 billion in 2010 and stayed about that level through 2011 and 2012, before rebounding to $21 billion in 2013.Not known yet
Effect on stock priceMarket Cap dropped 20% between 2009 and 2012, but rebounded in 2013.Market capitalization down 40% in month since story broke

The Valuation
To evaluate how this scandal affects Volkswagen's value as a company, I will adopt a two-step process. In the first, I will go back a month and value Volkswagen before the revelations, but to isolate the effect of the scandal, I will assume that the market capitalization a month ago (on August 31) was right and back out the operating income that the market was imputing in the stock price. In the second, I will make judgments on the extent of the costs, with a bias towards over estimating, rather than under estimating them, and revalue Volkswagen.

The Pre-Scandal Volkswagen
To value the company prior to the scandal, I drew on Volkwagen's financial history, which is summarized here. If you truly want to numb yourself, try reading Volkswagen's annual report, a model of opacity and bulk. Once I had those numbers and examined the landscape of the auto business, my initial narrative for Volkswagen was a boring one: it is a mature firm that I expect to grow barely (at the same rate as the economy), earn no excess returns and an established capital structure and regional exposure. Rather than try to value the company, I took the market capitalization of 82 billion Euros that the company was trading at then, and solved for the operating income that the firm would need to generate to be trading at the prevailing market value, arriving at 7,683 million Euros in operating income, well below the 12,886 million Euros that the company earned in the trailing 12 months, and about 25% below the average operating income generated over the last five years.
Update: I added a worksheet to the spreadsheet to explain how I came up with the net asset value for the financial services company. Put simply, rather than let its numbers drown out and distract me from valuing Volkswagen, I separate all of the assets and liabilities that VW reported for its financial services business and estimated a net book value. My estimate is significantly lower than VW's own book value of equity estimate for its financial service firm, reflecting what I chose to include in the financial service firm's assets and liabilities. I also fixed the post-scandal spreadsheet to let you change the operating income to any of the pre-specified choices and fixed an error in the total debt number.

The Post-Scandal Valuation
There have been no major financial reports from the company over the last month and the macro environment has changed little, with the German 10-year Euro bond rate stuck at 0.60%. In effect,  the only thing that has changed is that the company has revealed its deception and the costs are starting to be tallied. Using the structure that I described in the last section, I  brought in the effects of the scandal in three layers.
  1. Government and Regulatory Fines/Penalties: In this layer, I look at the fines and penalties that Volkwagen has to pay, and it seems reasonable that the lower bound on this number would be the $7.3 billion that VW has already set aside, but the upper bound may be much higher, ranging to include the $18 billion (16.07 billion Euros) that would be the maximum fine (for the EPA) and other fines that may come from European governments that have also been deceived. In my assessment, I added 10 billion Euros, reflecting the tendency of governments to pile on, to the 16.07 billion Euros to arrive at a total penalty of 26.07 billion Euros.
  2. Auto recalls & Lawsuits: To estimate the costs that Volkswagen might face, as a result of this scandal, note that 11 million vehicles may need to be recalled and "fixed" and the costs will be high. Scaling up the $1.1 billion that Toyota spent recalling 9 million cars to fix gas pedals, adjusting for inflation and adding a buffer, I estimate a recall cost of $1.6 billion. In addition, a big company in the midst of a self-inflicted scandal is a ripe target for lawsuits, from both shareholders and affected customers, and while the end judgment may not be huge, the legal costs will accumulate along the way. With Toyota, these lawsuits created more noise than consequences, with the final settlement being only $25.5 million, but I am sure that the legal costs to the company were a multiple of this number. With Volkswagen, I will take the conservative tack and estimate a cost of $2.4 billion, matching the largest judgment ever in a shareholder suit,
  3. Reputation Loss: Will customers stop buying Volkswagen cars as a result of this fiasco? Again, using the Toyota gas-pedal problem as an illustrative example, the company saw its revenues drop by about 7% in 2010 and stay low until 2012, though other factors may have contributed to the decline as well. Volkswagen will lose sales, especially in its diesel car segment, because of this scandal, but the effect will fade over time, just as it has for Toyota, GM and Ford, each of whom has had a scandal (or two) in the past. In fact, the car business is full of fallen sinners and soon-to-be sinners, and it seems unlikely that any company will be tarred for life.  Again, in the interests of being conservative, I will assume that Volkswagen will lose 20% of its (imputed) operating income each year for the next 5 years; the present value of these lost profts amounts to $5.17 billion.
Note that some of these costs will create tax savings, insofar as they are tax deductible. (Update: A reader notes that US tax law generally does not allow government fines to be tax deductible, but there is some give in the provision.)  In my assessment, in keeping with the conservative estimation, I will assume that only half of the costs on the first two items (fines and legal costs) are tax deductible. Finally, note that if Volkswagen pays the fines and incurs recall/legal costs, they will show up as expenses in the near years, and that you should expect to see reported losses in the mega-billions.

There is one more potential cost, which is that the management of Volkswagen will be focused on managing the scandal so much that they will not be able to direct their attention towards managing the company. If this were a creative company in a good business, I would be calculating the cost of lost investments and foregone growth and reducing my value. With Volkswagen, a not-that-imaginative company in a bad business (at least based on my narrative), I am less concerned, since an auto management's effort to grow faster (by acquiring other companies, expanding market share, entering new markets) is just as likely to destroy value, as it is to add value. In a perverse way, Volkswagen's stockholders may be better served by managers doing too little rather than trying to do too much.
With these conservative (almost worst-case numbers), I revalued Volkswagen's equity at 52.5 billion Euros, about 10% higher than the market capitalization of 48 billion Euros at the time of this assessment.  While that may not seem impressive, that is with an extremely conservative assessment of costs. Incorporating  the full tax benefit from the government penalties and auto recall increases the value to 56.7 billion Euros, and assuming a smaller penalty or less in legal costs will push the value up even further. (Negative numbers in the last column indicate under valued.)

AssumptionsValue of Equity (billions of Euros)% under or over valued
Worst CaseMaximum EPA Penalty + 10 billon in Other Government Fines, 4 bilion Euros in recall/legal costs, 20% loss in operating income forever, Fines and Legal costs not deductible.32.04 €59.47%
Base CaseMaximum EPA Penalty + 10 billon in Other Government Fines, 4 billion Euros in recall/legal costs, 20% loss in operating income for 5 years, Fines and Legal costs only 50% deductible52.50 €-8.05%
Better CaseMaximum EPA Penalty + 10 billon in Other Government Fines, 4 bilion Euros in recall/legal costs, 20% loss in operating income for 3 years, Fines and Legal costs 100% deductible58.75 €-17.95%
Likely CaseHalf of maximum EPA Penalty + 5 billon in Other Government Fines, 2 bilion Euros in recall/legal costs, 20% loss in operating income for 3 years, Fines and Legal costs 50% deductible65.91 €-30.54%
Best CasePenalties proportionate to Toyota, 20% loss in operating income for 3 years, Fines and Legal costs 100% deductible73.60 €-34.78%

Updated the likely case to make the costs only 50% deductible since readers who are much better versed than I on the tax law indicate that it is unlikely that VW will be able to deduce a large portion of their government fines. 
For the final question of whether to buy the ordinary or preferred shares, here is the trade off. The preferred shares have dropped by more than the ordinary shares and have historically been more liquid, but in times when you want a say in who runs the company and how it is run, it is better to own the ordinary shares. In fact, I would argue that the reason the common shares are trading at an 8% premium over the preferred shares now, as opposed to trading at par just a month ago, can be traced to the reawakening of interest in control and corporate governance that comes out of every scandal.

The End Game
This may be a reflection on my moral compass, but I find it difficult to muster the outrage that some people seem to feel about Volkswagen's deception. I think that the company's acts were stupid, short-sighted and greed-driven, but there have been far more appalling acts in corporate history, that are more deserving of my outrage. Volkswagen should be punished and the market has already meted out a hefty penalty, but looking at the possible costs of this scandal, I think that the market has over reacted. My market order for ordinary shares in Volkswagen went through yesterday, as my desire to have a say in management (with the ordinary shares) overwhelmed the bargain hunter in me (which was attracted to the preferred shares). I am investing in Volkswagen, but this will be a bumpy ride, for quite a while. This is the scandal du jour, of the moment, but there will be other news stories that draw the rubber necking crowd away. I have neither the desire, nor the inclination, to talk you into buying the stock. If you work through the numbers and come to the same conclusion that I did, I will be glad to have your company, but if your judgment leads you to a different assessment, I have no quarrels with you. To each, his (or her) own!


  1. Volkswagen: Financial Data (History)
  2. Volkswagen: Annual Report

  1. Volkswagen: Pre-scandal valuation (to get imputed operating income)
  2. Volkswagen: Post-scandal valuation

Friday, September 25, 2015

No Mas, No Mas! The Vale Chronicles (Continued)!

Some of my Brazilian readers seem to be upset that I used "No Mas", Spanish words, rather than Portuguese ones, in the title. To be honest I was not thinking about language, but instead about a boxing match from decades ago, where Roberto Duran used these words to give up in his bout with Sugar Ray Leonard

I have used Vale as an illustrative example in my applied corporate finance book, and as a global mining company, with Brazilian roots, it allows me to talk about how financial decisions (on where to invest, how much to borrow and how dividend payout) are affected by the ups and downs of the commodity business and the government’s presence as the governance table. In November 2014, I used it as one of two companies (Lukoil was the other one) that were trapped in a risk trifecta, with commodity, currency and country risk all spiraling out of control. In that post, I made a judgment that Vale looked significantly under valued and followed through on that judgment by buying its shares at $8.53/share. I revisited the company in April 2015, with the stock down to $6.15, revalued it, and concluded that while the value had dropped, it looked under valued at its prevailing price. The months since that post have not been good ones for the investment, either, and with the stock down to about $5.05, I think it is time to reassess the company again.

Vale: A Valuation Retrospective
In November 2014, in a post titled “Go where it is darkest”, I repeated a theme that has become a mantra in my valuation classes. While it easiest to value mature, money-making companies in stable markets, I argue that the payoff to doing valuation is greatest when uncertainty is most intense, whether that uncertainty comes from the company being a young, start-up without a business model or from macroeconomic forces. The argument is based on the simple premise that your payoff is determined not by how precisely you value a company but how precisely you value it, relative to other people valuing the same company. When faced with boatloads of uncertainty, investors shrink from even trying to do valuation, and even an imprecise valuation is better than none at all.

It is to illustrate this point that I chose Vale and Lukoil as my candidates of doom, assaulted by dropping commodity prices (oil for Lukoil and iron ore prices for Vale), surging country risk (Russia for Lukoil and Brazil for Vale) and plummeting currencies (Rubles for Lukoil and Reais for Vale). I valued both companies, but it is the valuation of Vale that is the focus of this post and it yielded a value of $19.40/share for a stock, that was trading at $8.53 on that day. The narrative that drovemy valuation was a simple one, i.e., that iron ore prices and country risk would stabilize at November 2014 levels, that the earnings over the last twelve months (leading into November 2014), which were down 40% from the previous year’s numbers, incorporated the drop in iron ore prices that had happened and that eventually Vale would be able to continue generating the mild excess returns it had as a mature mining company.
I did buy Vale shares after this analysis, arguing that there was a buffer built into earnings for further commodity price decline.

In April 2015, I revisited my valuations, as the stock prices of both companies dropped from the November 2014 levels, and I labeled the post “In search of Investment Serenity”. The post reflected the turmoil that I felt watching the market deliver a negative judgment on my initial thesis, and I wanted to check to see if the substantial changes on the ground (in commodity prices, country risk and currency levels) had not changed unalterably changed my thesis. Updating my Vale valuation, the big shifts were two fold. First, the trailing 12-month earnings that formed the basis for my expected value dropped a third from their already depressed levels six months earlier. Second, the implosion in Petrobras, the other large Brazilian commodity company, caused by a toxic combination of poor investments, large debt load and unsustainable dividends, raised my concern that Vale, a company that shares some of the same characteristics, might be Petrobrased. Again, I made the assumption that the trailing 12-month numbers reflected updated iron ore prices and revalued the company, this time removing the excess returns that I assumed in perpetuity in my earlier valuation, to arrive at a value per share of $10.71. 
I concluded, with a nod towards the possibility that my conclusions were driven by my desire for confirmation bias (confirming my earlier judgment on Vale being under valued), that while I might not have been inclined to buy Vale in April 2015, I would continue to hold the stock.

Vale: The September 2015 Version
The months since my last valuation (in April 2015) have not been good for Vale, on any of the macro dimensions. The price of iron ore has continued to decline, albeit at a slower rate, over the last few months. That commodity price decline has been partially driven by the turmoil in China, a country whose massive infrastructure investments have been responsible for elevating iron ore prices over the last decade.  The political risk in Brazil not only shows no signs of abating, but is feeding into concerns about economic growth and the capacity of the country to repay its debt. The run-up that we saw in Brazilian sovereign CDS prices in April 2015 has continued, with the sovereign CDS spread rising above 4.50% this week. 

Source: Bloomberg
The ratings agencies, as always late to the party, have woken up (finally) to reassess the sovereign ratings for Brazil and have downgraded the country, Moody’s from Baa2 to Baa3 and S&P from BBB to BB+, on both a foreign and local currency basis. While both ratings changes represent only a notch in the ratings scale, the significance is that Brazil has been downgraded from investment grade status by both agencies.

Finally, Vale has updated its earnings yet again, and there seems to be no bottom in sight, with operating income dropping to $2.9 billion, a drop of more than 50% from the prior estimates.  While it is true that some of the write offs that have lowered earnings are reflections of iron ore prices in the past, it is undeniable that the earnings effect of the iron ore price effect has been much larger than I estimated to be in November 2014 or April 2015. Updating my numbers, and using the sovereign CDS spread as my measure of the country default spread (since the ratings are not only in flux but don’t seem to reflect the assessment of the country today), the value per share that I get is $4.29.
I was taken aback at the changes in value over the three valuations, separated by less than a year, and attempted to look at the drivers of these changes in the chart below:

The biggest reason for the shift in value from November 2014 to April 2015 was the reassessment of earnings (accounting for 81% of my value drop), but looking at the difference between my April 2015 and September 2015 valuations, the primary culprit is the uptick in country risk, accounting for almost 61% of my loss in value.

Vale: Time to Move on?
If I stay true to my investment philosophy of investing in an asset, only if its price is less than its value, the line of no return has been passed with Vale. I am selling the stock, but I do have to tell you that it was not a decision that I made easily or without fighting through my biases. In particular, I was sorely tempted by two games:
  1. The “if only” game: My first instinct is to play the blame game and look for excuses for my losses. If only the Brazilian government had behaved more rationally, if only China had not collapsed, if only Vale’s earnings had been more resilient to iron ore prices, my thesis would have been right. Not only is this game completely pointless, but it eliminates any lessons that I might be extract from this fiasco.
  2. The “what if” game: As I worked through my valuation, I had to constantly fight the urge to pick numbers that would let me stay with my original thesis and continue to hold the stock. For instance, if I continue to use the rating to assess default spreads for Brazil, as I did in my first two valuations, the value that I get for the company is $6.65. I could have then covered up this choice with the argument that CDS markets are notorious for over reacting and that using a normalized value (either a rating-based approach or an average CDS spread over time) gives me a better estimate.
After wrestling with my own biases for an extended period, I concluded that the assumptions that I would need to make to justify continuing to hold Vale would have to be assumptions about the macro environment: that iron ore prices would stop falling and/or that the market has over reacted to Brazil’s risk woes and will correct itself. If there is anything that I have learned already from my experiences with commodity companies and country risk, it is that my macro forecasting skills are woeful and making a bet on them magically improving is wishful thinking. In fact, if I truly want to make a bet on these macro movements, there are far simpler, more direct and more lucrative ways for me to exploit these views that buying Vale; I could buy iron ore future or sell the Brazil sovereign CDS. I like Vale's management but I think that they have been dealt a bad hand at this stage, and I am not sure that they can do much about the crosswinds that are pummeling them. If you have more faith in your macro forecasting skills than I do, it is entirely possible that Vale could be the play you want to make, if you believe that iron ore prices will recover and that the Brazil's risk will revert back to historic norms. In fact, given my abject failure to get these right over the last few months, you may want to view me as a contrary indicator and buy Vale now.

Investing Lessons
It is said that you can learn more from your losses than from your wins, but the people who like to dish out this advice have either never lost or don’t usually follow their own advice. Learning from my mistakes is hard to do, but let looking back at my Vale valuations, here is what I see:
  1. The dangers of implicit normalization: While I was careful to avoid explicit normalization, where I assumed that earnings would return to the average level over the last five or ten years or that iron ore prices would rebound, I implicitly built in an expectation of normalization by taking the last twelve-month earnings as indicative of iron ore prices during that period. At least with Vale, there seems to be a lag between the drop in iron ore prices and the earnings effect, perhaps reflecting pre-contracted prices or accounting lethargy. By the same token, using the default spread based on the sovereign rating provided a false sense of stability, especially when the market's reaction to events on the ground in Brazil has been much more negative.
  2. The Stickiness of Political Risk: Political problems need political solutions, and politics does not lend itself easily to either rational solutions or speed in resolution. In fact, the Vale lesson for me should be that when political risk is a big component, it is likely to be persistent and can easily multiply, if politicians are left to their own devices. 
  3. The Debt Effect: All of the problems besetting Vale are magnified by its debt load, bloated because of its ambitious growth in the last decade and its large dividend payout (Vale has to pay dividends to its non-voting preferred shareholders). While the threat of default is not looming, Vale's buffer for debt payments has dropped significantly in the last year, with its interest coverage ratio dropping from 10.39 in 2013 to 4.18 in 2015.
There are two lessons that I had already learned (and that I followed) that helped me get through this experienced, relatively unscathed. 
  1. Spread your bets: The consequences of the Vale misstep for my portfolio were limited because I followed my rule of never investing more than 5% of my money in any new stock, no matter how alluring and attractive it looks, a rule that I adopted  because of the uncertainty that I feel in my valuation judgments and that the market price moving towards my value. In fact, it is the basis for my post on how much diversification is the right amount.
  2. Never take investment risks that are life-style altering (if you fail): Much as I would like to make that life-altering investment, the one whose payoff will release me from ever having to think about investing again, I know it is that search that will lead me to take "bad" risks. Notwithstanding the punishment meted out to me by my Vale investment, I am happy to say that it has not altered my life choices and that I have passed the sleep test with flying colors. (I have not lost any sleep over Vale's travails).
Closing Thoughts
If I had known in November 2014 what I know now, I would obviously have not bought Vale, but since I don’t have that type of hindsight , that is an empty statement. I don’t like losing money any more than any one else, but I have no regrets about my Vale losses. I made the best judgments that I could, with the data that I had available in my earlier valuations. If you disagreed with me at the time of my initial valuation of Vale, you have earned the right to say "I told you so", and if you went along with my assessment, we will have to commiserate with each other.

This is not the first time that I have lost money on an investment, and it will not be the last, and I will continue to go where it is darkest, value companies where uncertainty abounds and hope that my next excursion into that space delivers better results than this one.


Previous Blog Posts

  1. Go where it is darkest (November 2014)
  2. In search of Investment Serenity (September 2015)
Vale Valuations

  1. Valuation of Vale (November 2014)
  2. Valuation of Vale (April 2015)
  3. Valuation of Vale (September 2015)