Friday, October 24, 2014

Corporate Breakups: Value and Pricing Effects

As HP and EBay announce break-ups and longstanding market players like GE and IBM make moves to narrow their business focus, it seems like corporate strategy has come full circle. In fact, as I watch strategists, consultants and analysts tell me how breaking up companies will make them more valuable, I cannot but be cynical, because it was not so long ago that these same strategists, consultants and analysts were selling me on the wondrous benefits of building “all-in-one” companies, where synergies and economies of scales were the mantra. The best cure for that cynicism is for me to take a deep breath and look at the possibility that this time these experts mean what they say and to give the story a fair hearing. In keeping with a theme that I have pushing on my blog, I will first look at how and why a break up can affect value and then examine whether there may be a pricing rationale for break ups.

The value effect of a break up
I may sound like a broken record but the value of a business is determined by the level of its cash flows from existing investments, the value that can be created (or destroyed) by future growth and the risk in both these components. To make an argument that break ups enhance value, we have to meet two tests. The first is to show how a break up can affect cash flows, the value of growth and risk and that is relatively straightforward. The second, and this is the tougher test, is to make the argument that the consolidated company could not have made the changes without breaking up and to back up that argument.

When a consolidated company is broken up, the value of the pieces created by the breakup have to show up in the numbers, in general, and in the cash flows, growth value or risk of the business, in specific, for there to any value effects.
  1. Cash flows: A break up can increase the cash flows, if the broken up units will have lower costs than the consolidated company (efficiency rationale), is expected to pay less in taxes than the consolidated unit (a tax payoff) or can reduce the amount it invests in maintenance capital expenditures & working capital to maintain its existing operations (a working capital story). 
  2. Value of growth: A break up can increase the value from growth if the broken up units invest more than the consolidated unit (if you are in good businesses), redirect investment from one business to another (if one business is good and the other is not) or invest less than the consolidated unit (if both businesses are bad).
  3. Risk: A break-up can reduce the cost of funding the businesses (cost of capital) if the broken up units are able to choose debt mixes that lower their cost of capital or are able to alter the type of debt they use to better reflect their asset characteristics. In some cases, a break up can also reduce the overall risk of failure, if one of the units of a consolidated company faces a potentially catastrophic risk (from a legal or regulatory event), by separating the rest of the company from it.
The picture below brings all of these possibilities into perspective.


Looking at the picture, it is easy to portray break ups as value creating, but there are two caveats to keep in mind. First, note that with a little tweaking this same picture can be used to show the value of synergy in a merger, with the only difference being that the consolidated unit is the one that has the advantage in that case, with lower costs, higher value to growth and less risk. Second, the tougher test to meet with both break ups and mergers is showing that you could not have created these value-enhancing changes, without breaking up or merging. Thus, if your argument is that breaking up can create cost savings, it also behooves you to follow up and explain why the consolidated company could not have cut these costs on its own. In general, the following table summarizes reasons why breaking up may be necessary for the changes to occur, with examples (and feel free to add your own):


Constraint
Explanation
Example (s)
Regulatory restrictions
If you are a regulated company, with an unregulated (& growing) business, regulatory restrictions may prevent you from investing as much as you would like to in that business.
In the early (and growth) days of the cell phone business, some established phone companies (which faced regulatory constraints) separated their cell phone businesses. (AT&T spinning off its wireless holdings in 2001)
Legal constraints
If one part of a consolidated company faces legal jeopardy (from a class action lawsuit or government action), its other businesses may be viewed as contaminated, and thus constrained in their operations.
At the height of the tobacco lawsuit wars, tobacco companies separated themselves from their non-tobacco holdings. (RJR Nabisco split up in 1999)
Debt/Bond Covenants
If the consolidated company is bound by covenants in past bond issues/bank debt from changing its financing mix or type, it may benefit from breaking up and relieving itself of those covenants.
These break ups, when they are announced, are almost always contested by bondholders and banks, who have lent to the consolidated company. They still do occur.
Tax Code
If a consolidated company faces a higher tax rate than its broken-up parts will face, breaking up will make sense.
While this is undoubtedly a motive in some break-ups, no sensible management will ever mention it, since it is sure to draw fire.
Corporate culture/history
A company with a long history and an entrenched culture may be unable to change its business practices, but its broken up parts (or at least some of them) may not feel as constrained.
The older and more set in its way a company is, the more likely it is that a break up will be needed to shake up practices. (Kraft's break up and rebranding)
Dividend clientele
A company accumulates investors who like its dividend policy. To the extent that this dividend policy is no longer sustainable, the company may need to be broken up to institute change.
Most likely to be the case when a business that used to be stable/mature changes characteristics to becomes higher growth/riskier. (AT&T IPO of  Bell Labs (as Lucent))

There is one final possible explanation for why a break up may sometimes be needed for value creation and it relates to the well-discussed and much over-used notion of disruption. If you buy into Clayton Christensen's thesis that disruption is more likely to come from upstarts that have nothing to lose than from the establishment entities that have to weigh in the lost profits from existing products, a company that has a disruptive business unit, with the disruption aimed at one of its existing (and perhaps more profitable) businesses may find its value enhanced by separating the disruptive unit from the company (and giving it the resources to continue on its disruptive path).

The Price Effect of a Break up
I believe that much of what companies do is directed at increasing price rather than value. Thus, the simpler explanation for break ups is that they are actions designed to either correct what companies perceive to be market mistakes in how they are being price or in some insidious cases, to create market mistakes in their favor. The pricing effect rests on the presumption that investors may price a consolidated company differently than they price its pieces. At the risk of repeating myself, the pricing process is based upon three choices that investors make:
  1. Pricing metric: You can price based upon revenues, earnings, book value or a revenue driver, and you either look at just equity value or the value of the business. That is the essence of a multiple, whether PE, EV/EBITDA or EV/Revenues. 
  2. Comparable firms; All pricing is based on a comparison to a set of firms that you believe are comparable to the one that you are trying to analyze. 
  3. Control factors: Since the multiples will vary across the firms because of differences in fundamentals (growth, cash flows and risk), you have to control for those differences, either subjectives (story telling) or objectively (by bringing them into the multiple or statistically).
To capture the effect and lay the foundations for why it may exist, consider the following picture:

Note that the pricing metric used, the comparable companies that are chosen and the control variables/processes are all subjective and that breaking up the company may change all of these choices. Thus, an IBM or GE may be valued relative to other large market cap, mature companies by analysts tracking them, but if broken up into parts, they may be compared to individual businesses that are priced differently (on different metrics and with different values, for the same metrics). Not surprisingly, the kinds of companies that gain the most in pricing from breaking up are firms that have one or more of the following characteristics:
  1. Opaque financials: In theory, you should be able to price a consolidated company as the sum of its pieces but to do so, you will need operating details at the unit level. While many consolidated companies report operating metrics for each unit, those values can be difficult to read for many reasons. The first is if there are significant intra-company transactions, transfer pricing may affect reported revenues. The second is that many corporate expenses have to be allocated across businesses and those allocations reflect accounting judgments and may not fairly capture costs at the unit level. Finally, if there are significant corporate costs that are unallocated, they become a wild card in valuation, since ignoring them will lead you to over value consolidated companies. (Much of the  academic work done on the conglomerate discount, in my view, reflects not only pricing but very sloppy pricing, at that.)
  2. Diverse businesses: The possibility of mis-pricing also increases as the diversity (on both operating and financial dimensions) of businesses within the corporate umbrella increases, making it more difficult to find a metric and comparable firms for the consolidated company.  After all, who really can come up with the right metric or comparable firms, if you are pricing a GE, Siemens or United Technologies?
  3. Hot "sector": The potential pricing effect of breaking up is much greater if there is a part of the consolidated business that is in a hot sector (where the market is attaching high market value to potential) but that part is being obscured by the details of the rest of the company. Thus, if Microsoft has a booming social media presence (I am not saying it does), would you even notice that presence?
It is worth noting, though, that the nature of pricing is that the price effect of a break up may reflect game playing and cosmetics more than reality. In other words, it is just as likely  that the market was pricing the consolidated company correctly and that it is the broken up pieces that are being over priced as it is that the market was under pricing the consolidated unit and that the break up leads to a correct pricing.

Bottom line
Breaking up a company, by itself, cannot increase value. It is what you do (not say that you will do) with the broken up units to change the fundamentals (cash flows, growth or risk) that determine whether a break up is value creating, value neutral or value destroying. However, breaking up a company can have a price effect, for good reasons and bad ones. As an example of the former, a company that is sorely misunderstood and misclassified by investors and analysts can see its market value go up after breaking up. At the same time, though, some break ups can be motivated by the desire to fool some investors some of the time, with most of the price increase coming from either a n accounting sleight of hand (a reshuffling of expenses and earnings across business units) or from a sector being over priced. I will be looking at the HP and EBay breakups in my next post to see where they fall on both value and pricing dimensions.

Posts on corporate break ups

  1. Corporate Breakups: Value and Pricing Effects
  2. The HP and EBay Breakups: More or Less than meets the eye?

Thursday, October 16, 2014

Go Pro: Camera or Smartphone? Social Media or Electronics? Price or Value?

My sixteen-year old, a sophomore in high school, joined the investment club at school a couple of weeks ago, and entered a stock-picking competition. Club members invest in a stock or stocks of their choice, with the winner chosen in about five weeks, based upon price appreciation. Thinking I would have some sage advice on where to invest his money, he asked me for some stock picks and I almost suggested that he put all his money in GoPro, a choice that is clearly at odds with the prudent investing practices of diversification and perhaps with conventional value investing precepts. While GoPro is not the investment I would recommend for my son as his Roth IRA investment (with real long money and a long time horizon), in a game with a five-week window, where the winner takes all, momentum will beat out intrinsic value and diversification will be more hindrance than help. (Note that momentum fairy was in GoPro's corner at the time, and has taken a break in recent days.)  In this post, I take a look at GoPro, perhaps the hottest stock of the year,  with the intent of not only understanding its intrinsic value (and drivers) but to make sense of the pricing game.

The Back Story
For those of you who are not familiar with the company, GoPro makes cameras that you can attach to yourself and record video of your activities. While that might not seem exceptional, it is designed for high-energy physical activities, including running, rock climbing, swimming or hunting. You can get a measure of the company’s current offerings on its website. They include three models of the camera (the Hero, the Hero 3 and the Hero 4), numerous accessories and two free software products (a GoPro App and GoPro Studio) to convert the recorded videos into watchable ones. The company believes that the creators of videos will share them, not only with their friends, but also with the general public. In its most recent earnings report, it noted that GoPro videos published on YouTube had increased 200% over the previous year, launched a GoPro channel on Pinterest to attract more attention to the videos and one for the Microsoft Xbox. 

The company’s cameras have found a ready market, with revenues hitting $986 million in 2013 and increasing to $1,033 million in the twelve months ending in June 2014. In spite of large investments in R&D ($108 million in the trailing twelve months), the company still managed to be profitable, with operating income of $70 million in that period. Capitalizing R&D increases their pre-tax operating margin to 13.43%, impressive for a young company. The figure below looks at the evolution of revenues and units sold  over the history of the company. (You can download the company's prospectus and its only 10Q.)

GoPro has been a stock on fire since its initial public offering on June 26, jumping 30% on its offering date (from $24 to $31.44) and continuing its rise to $94 on October 7, before falling back to $78 on October 14 (the day I started the valuation) and to $70 today (October 15).


The stock has accumulated a large number of vocal short-sellers, who are convinced that this is a high flyer destined for a fall, and many of them have been burnt in the price run-up, a fact alluded to in this Wall Street Journal article about the company.

An Intrinsic Valuation
In valuing GoPro, we face all of the typical challenges associated with valuing a company, with growth possibilities, early in its life cycle, in determining the market potential and imminent competition. 

1. Potential Market
GoPro is nominally a camera company but I will argue that it caters to a different market. To get a measure of the potential market for GoPro's products, I will make my argument in three steps:
  1. The conventional camera market is under threat from smart phones, and its share of the camera market has been shrinking over the last few years and there is little hope that it will stop doing so in the future.
    Source: CIPA
  2. The camera market is changing and expanding. The entry of smart phone cameras has not only taken away market share from conventional camera companies but has changed the market by attracting new users into the market. These new customers, who are mostly uninterested in conventional cameras (and recording images and videos for family albums), are being drawn into this market, by their desire to record and post photos/videos on social media sites. That trend will continue into the future and I believe that the camera market will become a subset of the smart phone market. The good news is that the smartphone market is huge, estimated to be $355 billion in 2014, larger than the entire electronics market ($340 billion) in 2014. The bad news is that most of the consumers in this market will be satisfied with the cameras on their cell phones and will be unwilling to spend money on an expensive accessory, unless it serves a very specific need. 

    Source: IC Insights
  3. The action camera market will be a subset of the smartphone market and its customers will be those who are physically active people who also happen to be active on social media (over active, over sharers). To make an estimate of how many consumers are in this market, I used the CDC's statistic that about 22% of Americans are physically active. Generalizing (and globalizing) this statistic to the smartphone market yields a potential market that is about $80 billion in 2014 (22% of $355 billion). That is likely to be an over estimate, since not all physically active people are "sharers" on social media. According to this survey, about 31% of adults post videos on their social media site and it has both increased over time and is higher among younger adults (ages 18 through 29), 40% of whom post videos. Using the latter statistic, the overall market for action cameras is $31 billion (in 2013), estimated as 40% of $80 billion. Applying a 5% growth rate on this market yields a potential market of $51 billion in 2023. The picture below captures the sequence of assumptions that yields this number:

2. Market Share & Profit Margins
The market share and target profit margin that we assess for GoPro will be a function of the potential market that we see for it and the competition in that market. If we define it as the camera market, the competition is already intense and dominated by Japanese manufacturers:

If we define it, as I think we should, as the subset of the smartphone accessory market that wants active cameras (the $51 billion market in 2023 identified in the last section), GoPro is the first mover in the market and has more growth potential (both because the market is growing and it has relatively few competitors, for the moment).

To gauge the expected market share that GoPro can get of this market, it is worth noting that while it initially had the action-camera market to itself, the competition is starting to take form from upstarts, established camera makers and from some smartphone manufacturers. Even if GoPro can establish a brand name advantage (by being the first one on the market), I don’t see any potential networking advantages that GoPro can bring to this process that will allow it, even if successful, to control a dominant share of this market, as the market gets bigger. Drawing from the established camera business market shares, I will assign a market share of 20% (resulting in revenues of about $10 billion for GoPro in 2023, i.e., 20% of $51 billion) , roughly similar to the 20% market share for Nikon, the leading camera maker, of the camera market in 2013. (I am not drawing a direct parallel between Nikon and GoPro, but I am arguing the market share breakdown of the action camera market is going to resemble the market share breakdown of the conventional camera market).

On the profit margin, GoPro’s first mover advantage has given it a headstart in this market, allowing it to charge premium prices and earn a pre-tax operating margin of 12.5%. This is slightly lower than the margin (13.43%) posted by the company in the most recent 12 months, but the trend lines in margins for the company are decidedly negative:

This estimate (12.5%) of the pre-tax operating margin is significantly higher than the 6%-7.5% margin reported by camera companies and similar to the 10%-15% margin reported by smartphone companies; Apple remains an outlier with its pre-tax margin in excess of 25%.  I am, in effect, assuming that GoPro will preserve its premium pricing, even in the face of competition.

3. Investment Needs
While GoPro users may post to social media sites, GoPro is not a social media company when it comes to investment needs. While social media companies like Facebook, Twitter and Linkedin generate their revenues in advertising and have little need for tangible investment, GoPro will need to invest in manufacturing capacity to produce and sell more cameras. To estimate the reinvestment needs, I made the assumption that the company will have to invest $1 for every $2 in additional revenues generated in years 1-10. This, in turn, will move the return on capital for the company from it's current stratospheric levels to about 16% in year 10.

4. Risk
GoPro has a social media focus for its user-generated videos, but the company currently generates all of its revenues from selling cameras and accessories. There is the real possibility, though, that the user-generated videos may have entertainment value, which, in turn, could lead to other revenue sources (advertising on GoPro's YouTube channel or a dedicated media outlet for GoPro videos, for instance). That does seem a little far fetched at the moment and we will assume that GoPro's risk will resemble the risk of high-end electronics companies. To estimate a cost of capital for GoPro, I consider their current mix of debt and equity (2.2% debt, 97.8% equity) as my starting point, and estimate a cost of capital of 8.36% for the company, declining to 8% by year 10 (with both reflecting the fact that the US 10-year bond rate dropped to 2% on October 14). This may strike you as low, but much of the risk in GoPro is specific to the company and its market and is thus not reflected in the cost of capital.

5. Possibilities
GoPro's focus on creating partnerships with Xbox and Pinterest suggest that it sees the possibility of generating revenues from becoming a media company (with the videos created by its customers as content). At the moment, using a contrast I drew earlier in my post on Uber, this is more in the realm of the possible than the plausible or the probable. If the value per share that we obtain is just a tad below the market price, this possibility may be sufficient to tilt the scale towards buying but it cannot account for a large chunk of the value today.

6. Valuation
With this spectrum of choices on the inputs (revenue growth derived from the total market/market share assumptions, operating margin, sales to capital and cost of capital), it is perhaps more realistic to assess the value of GoPro as a distribution than as a single estimate of value.

Reading this distribution, you can see while the expected value across the simulations is only $33-32/share, well below the market price of $70, there are outcomes that deliver values higher than the market price. Put differently, while I think that the company is over valued, there are pathways to values higher than $70. They will require GoPro to (a) expand the market for cameras to new users (physically active, over sharers) (b) find a strong, sustainable competitive advantage over its imminent competition, perhaps with a networking edge (giving it higher market share) and (c) preserve its premium pricing edge. 
(You can download the base case valuation by clicking here)

A Pricing of GoPro
In keeping with my argument that much of what passes for valuation in practice is really pricing, let me make the pricing case for GoPro. To price a company, there are two fundamental questions that have to be addressed: who (or what companies) you are pricing your company against and what metric (revenues, book value, earnings etc), you will use in the comparison.

The essence of pricing is that you use the market pricing of comparable assets/firms to determine a fair price for your asset/company. There is, however, a subjective component to determining these comparable investments, and that comes into play with a company like GoPro, with the following possible choices.
  1. Existing camera manufacturers, some of whom (Sony and Panasonic) are much bigger players in the electronics market. (Sample of ten companies, all of them Japanese)
  2. Leisure product manufacturers, which includes a diverse group of companies that manufacture  gym equipment (Life Time Fitness), golf clubs (Callaway Golf) and bicycles (Cannondale), on the rationale that these appeal to the same physically active market as GoPro does. (138 global companies)
  3. Electronics companies, which includes all consumer electronics companies listed globally. (103 global companies)
  4. Social media companies, which includes a broad mix of businesses some of which derive their revenues from advertising (Facebook, Twitter), some from subscription-based models (Netflix) and some from a combination (LinkedIn). (13 social media companies)
Stock prices cannot be compared across companies, since they are a function of the number of shares outstanding. Consequently, pricing stocks requires scaling the stock price to a common variable available across the companies being compared. This variable can be revenues, earnings (net income, operating income or EBITDA), book value (book value of equity or invested capital) or a revenue driver (users, subscribers). 

Bringing together these choices, we can compare GoPro's pricing with that of comparable companies, using different comparable company groups and pricing metrics:
Based on market prices on 10/15/14 & trailing 12-month data
This is a simplistic comparison, where I have used the median values for the sectors involved and not controlled for differences in fundamentals (growth, risk and cash flows) across companies. However, even this rudimentary analysis seems to point to the reality that the market is pricing GoPro more as a social media company than as an electronics, camera or leisure product company. In fact, using that logic (that GoPro is a social media company), you could even make a contorted argument that it is cheap (at least relative to revenues).

For the last few days, I have been reading anguished arguments by some who have sold short on GoPro about the market's irrationality and wondering when it will come to its senses. Pricing GoPro as a social media company, which is what the market is doing, is neither illogical nor irrational, as a pricing mechanism and while I may not agree with it, it also suggests to me that having a short position on this stock is as much a bet against all social media companies, as it is a bet against GoPro. 

Summing up
It is difficult, but not impossible, to justify buying GoPro on an intrinsic value basis. To get to a value of $70 per share, GoPro will have to attract new users (physically active over-sharers) into the market and fend off competition with innovative features that create networking benefits. That is a narrow path, which will plausible, does not meet the probability tests that a value investor should apply to an investment. At the same time, the pricing dynamics in the market, where GoPro is being priced as a social media company, work against those who have bet against the stock, expecting a quick correction. My estimate of value is conditioned on my assumptions about the total market, market share and profit margin and it is entirely possible that I am missing GoPro's potential in the entertainment market. Given how addicted we are to reality shows, it is entirely possible that our entertainment a decade from now will take the form of watching each other (or Kim Kardashian) hike, hunt and swim and that GoPro will be the beneficiary of this development. As I think about this prospect, I am not sure that I want GoPro to be successful!

Attachments:
  1. GoPro Prospectus
  2. GoPro 10Q (June 31, 2014)
  3. GoPro Intrinsic Valuation (Base Case)
  4. GoPro Simulation Assumptions and Valuation Output
  5. GoPro Comparables (Peer Pricing)

Tuesday, September 30, 2014

The Walking Dead: Blackberry, Yahoo and the Zombie Apocalypse!

I will start with a confession. I have distinctly lowbrow tastes when it comes to literature, movies and entertainment. I would much rather read a novel about a unhinged serial killer than one written by the latest Nobel Literature Prizewinner, watch The Avengers than an art film and be at Yankee stadium than the Museum of Modern Art. That may reflect the limits of my intellect and the shortcomings of my cultural education, but I know what I like, am set in my ways and no cultural gatekeeper is going to tell me otherwise. Given my plebeian tastes, it should come as no surprise that last summer, I joined my fifteen-year old son in binge-watching the first three seasons of The Walking Dead, a television show with not much of a stray line, lots of gore and few redeeming social qualities.  For those of you who have never watched the show, here is a taste:


You may be wondering why I am talking about television shows on a blog dedicated to markets, but the Walking Dead was what came to my mind in the last couple of weeks, as I watched Blackberry and Yahoo, two companies that I have posted about before, make the news. 

Blackberry announced that they were introducing a new phone, priced at $599, and aimed at getting them back into the smartphone market. Yahoo was initially not in the news, but Alibaba, a company that Yahoo owns 22.1% of, was definitely the center of attention at its initial public offering on September 19. While Alibaba opened to rapturous response, its stock price jumping 38% on the offering date, Yahoo’s stock price strangely dropped by 5%, the day after. By the end of last week,  Yahoo had been targeted by an activist investor, taken to task for not managing its Alibaba tax liability and pushed to merge with AOL. Since I have owned Yahoo for the last few months, I have a personal financial interest in trying to make sense of the dissonant behavior and I am afraid that  the Walking Dead is the best I can come up with as an explanation.

The Life Cycle and beyond
A few months ago, I posted on the life cycle that businesses go through and argued that companies are born, grow, mature and decline and that it is often both expensive and pointless to fight the cycle.


The life cycle view of the corporate world may be simplistic, but it is surprisingly powerful in analyzing the evolution of corporate governance and different investment philosophies. Thus, there are some who argue that while an autocratic CEO can be a hindrance in a mature or declining company, he or she can be an asset early in the life cycle, and that success goes to those who are strong on narrative, early in the life cycle, but that the numbers people dominate later.

In a series of posts, I looked at the challenges of managing and investing in companies across the life cycle, including a few in the most depressing phase, which is during decline.  I also conceded that there are examples of rebirth and reincarnation, where companies find a way back from decline (IBM in 1992 and Apple in 1999). In most cases, though, companies in decline that try to spend their way back to maturity have little to show in terms of earnings and growth for the billions of dollars spent on investments, acquisitions and R&D.

The Walking Dead Company
In drawing a parallel between human beings and corporations on the life cycle, I think I missed a key difference. Human beings die, no matter how heroic the medical attempts to keep them alive may be. Corporations on the other hand can survive well after their business models have expired, the Walking Dead of the business world, and can create damage to those vested in and closest to them. Here are the characteristics of these zombie companies:
  1. Broken Business Model: The company's business model is dead, with the causes varying from  company to company: management ineptitude, superb competition, macroeconomic shocks or just plain bad luck. Whatever the reasons, there is little hope of a turnaround and even less of a comeback. The manifestations are there for all to see: sharply shrinking revenues, declining margins and repeated failures at new business ventures/products/investments.
  2. Management in Denial: The managers of the company, though, act as if they can turn the ship around, throwing good money after bad, introducing new products and services and claiming to have found the fountain of youth. In some cases, the company may change managers at frequent intervals during the death spiral, but they all share in the denial.
  3. Enabling Ecosystem: The managers are aided and enabled by consultants (who collect fees from selling their rejuvenating tonics), bankers (who make money off desperation ploys) and journalists (either out of ignorance or because there is nothing better to write about than a company thrashing around for a solution). 
  4. Resources to waste: While almost all declining companies share the three characteristics listed above, the walking dead companies are set apart by the fact that they have access to the resources to continue on their path to nowhere and have to be kept alive for legal, regulatory or tax reasons. Those resources can take the form of cash on hand, lifelines from governments and/or capital markets that have taken leave of their senses.
The challenges that you face as an investor in a walking dead company is that you cannot assess its value, based upon the assumption that the managers in the company will take rational actions: make good investments, finance them with the right mix of debt and equity and return unneeded cash to stockholders. To get realistic assessments of value, you have to assume that managers will sometimes take perverse actions, investing in low-probability, high-possible-payoff investments (think lottery tickets), financing them with odd mixes of debt and equity (if you are on the road to nowhere, you don't particularly care about who you take down with you) and holding back cash from stockholders. Incorporating these actions into your valuation will yield lower values for these companies, with the extent of the discount depending upon the separation of management from ownership (it is easier to be destructive with other people's money),  the capacity of managers to destroy value (which will depend on the cash/capital that they have access to and will increase with the size of the company) and the checks put on managers (by covenants, restrictions and activist investors). At the limit, managers without any checks, given enough time, on their destructive impulses can destroy all of a company's value, if not immediately, at least over time. For value investors, these companies are often value traps, looking cheap on almost every value investing measure but never delivering the promised returns, as managers undercut their plans at every step. 

Blackberry’s future: Staring into the Abyss
In fact, I argued in a post in December 2011 that Blackberry (then called Research in Motion) needed to act its age, accept that it would never be a serious mass-market competitor in the smart phone market and settle for being a niche player. That post, which occurred when Blackberry had a market capitalization of $7.3 billion, argued that Blackberry should give up on introducing new tablets or phones and revert to a single model (which I termed the Blackberry Boring) catering to paranoid corporates (who do not want their employees accessing Facebook or playing games on smart phones). I also suggested that Blackberry settle on a five-year liquidation plan to return cash to stockholders.

I was accused of being morbid and overly pessimistic, but here we are three years later, with Blackberry’s market cap at $5.3 billion. In the three years since my last post, the company has spent $4.3 billion in R&D,  while its annual revenues have dropped from $18.4 billion in 2011-12 to $4.1 billion in the last twelve months and its operating income of $1.85 billion in 2011-12 has become an operating loss of -2.7 billion in the trailing twelve months. Blackberry’s new model may be a technological marvel, but the smart phone market has moved on, where a phone is only as powerful as the ecosystem of apps and other accessories available for it is. If it was true three years ago that Blackberry could not compete against Apple and Google in the operating system world, it is even truer today, when either of these mammoth companies can use petty cash to buy Blackberry. (Apple’s cash balance is $163 billion, Google’s cash balance is $63 billion and Blackberry’s enterprise value is $4.1 billion). Perhaps, I am missing something here, but I really don't see any light in the smartphone tunnel for Blackberry and even if I do, it is the headlight of an oncoming locomotive.

The options for Blackberry, in my view, are even fewer than they were three years ago. At this stage, I am not sure that even the niche market option is viable any more. I see only two ways to encash whatever value is left in the company. The first is to hope that a strategic buyer (which to me is a synonym for someone who will pay far more than justified by the cash flows) with deep pockets will see some value in the Blackberry technology and buy the company.  The second is a more radical idea. In a world where social media companies like Facebook, Twitter and Linkedin command immense value, with each user generating about $100 in incremental market cap, Blackberry should consider relabeling itself as a social media company, create a Blackberry Club, where those with Blackberry thumbs can stay connected. Outlandish, I know, but why not?

Do you Yahoo? 
On May 10, 2014, I posted on Yahoo! and valued itscomponent parts: its operations in the US (Yahoo US), its 35% holding of Yahoo Japan and its 22.1% holding of Alibaba. I first valued it on an intrinsic basis at $41.19:
Note that these numbers reflect my estimates of intrinsic value, which generated $146 billion for Alibaba's equity.  I then revalued it on a relative basis at $39.19, but this valuation reflected a pricing of Alibaba at $118 billion.
I closed by arguing that the stock seemed under priced at $ 34 and that I would use it as my proxy bet on Alibaba.  The stock initially stalled but as the Alibaba IPO became imminent, Yahoo’s stock price rose to $42.09 at close of trading on Thursday, the day before the IPO:


Alibaba went public on Friday, September 19, and its market capitalization jumped to $230 billion.  I updated my valuations and prices of Yahoo, Yahoo Japan and Alibaba in the table below:
Updated using trailing 12-month values
Note that both the intrinsic and relative values of Yahoo have increased over the period, almost entirely due to an increase in Alibaba's intrinsic value.  It is true that Yahoo did have to sell 124 million shares (actually good news, since that amounted to only 5.1% of Alibaba shares, when initial estimates suggested that the would have to sell about 9%)  worth of Alibaba stock on the IPO date at the IPO price of $68, giving it a net cash balance of about $ 8 billion on Monday, after allowing for a tax liability of $3.3 billion on the Alibaba stock sale. Updating the intrinsic value picture to reflect this, here is what I get:


Allowing for both the higher cash balance and the re-estimated intrinsic values for the three businesses, my estimate of intrinsic value of $46.44 per share for Yahoo is higher than the current price of $40.66. If you don't trust my intrinsic value estimates, here is a simpler and far more powerful picture of where Yahoo stands today. Using today's market prices for Yahoo's holdings in Alibaba and Yahoo! Japan and adding the net cash balance that Yahoo has, net of taxes due on the shares sold on the IPO date, the value per share is $52.14.  At its current price, the market is attaching a value of -$12.22 billion (-$11.48/share) for the operating assets in Yahoo US.


It is tough to imagine that this is a market oversight, since the market values of Yahoo Japan and Alibaba are easily checked and the cash balance is not really subject to debate. I am more inclined to view this as a Walking Dead discount, reflecting investor concerns, merited on not, that  Yahoo's management might do something senseless with the cash, and incorporating the reality that liquidation is not a viable or a sensible option today. Why? Liquidating Yahoo's holdings today will require cashing out of the Yahoo Japan and Alibaba holdings today, resulting in a total tax bill of $16.3 billion and a value for the equity per share of $34.18.

What now? 
As an investor in Yahoo, the question I face is whether the discount that the market is applying to Yahoo is reasonable. While I believe that Marissa Mayer can do serious damage to me as investor, by embarking on ambitious expansion plans with the cash, I also believe that she will be checked by activist investors along the way.  I will continue to hold Yahoo, at least at its current price, and hope for the best. That, to me, would require that Ms. Mayer recognize that Yahoo is really a shell company with two very valuable holdings and very little in actual or potential operating value. Perhaps, she would consider returning all cash to stockholders, reducing the workforce in the company to one person and giving that person a dual-display terminal and let him/her just watch the market value of Alibaba on one and Yahoo Japan on the other. That is my best case scenario and it is unfortunate, but true, that my value per share will move inversely with Ms. Mayer's ambitions.

Attachments
Master Spreadsheet for Yahoo (with holdings)
Intrinsic value of Yahoo US
Intrinsic value of Yahoo Japan
Intrinsic value of Alibaba