Monday, September 22, 2014

Stock Buybacks: They are big, they are back and they scare some people!

This has been a big year for stock buybacks, continuing a return to a trend that started more than two decades ago and was broken only briefly by the crisis in 2008. Focusing just on the S&P 500 companies, buybacks in the 2013 amounted to $475.6 billion, not quite as substantial as the best buyback year in history (2007, with $589.1 billion), but still significantly up since 2009. As stock prices rise and anxiety about bubbles and real economic growth also come to the surface, it is not surprising that some of those looking at rising prices are trying to make a connection, rightly or wrongly, to the buyout numbers. As a general rule, even insightful stories about buybacks tend to focus on one cause or effect of the buyback phenomenon but miss the big picture. In particular, there have two news stories about buybacks, one in the Economist and one in the Wall Street Journal. Since I talked to both journalists as they wrote these stories, and I am quoted in one of them, I should disclose that I like both writers and think they did their research, but their particular perspectives (that stock buybacks can be value destructive in the Economist and that they affect liquidity in the WSJ) may be blurring the big picture of buybacks. In fact, I think that the Economist overplayed their hand by calling buybacks “corporate cocaine”, a loaded header that treats buybacks as a destructive addiction (for which the cure, as with any other addiction, is abstinence). This post is not aimed at the vast majority of investors who sensibly view buybacks as good or bad on a company-by-company basis but at the shameless boosters of buybacks, who treat it as a magic bullet, at one extreme, and the equally clueless Cassandra chorus, who view it as the market equivalent of the Ebola virus, signaling the end of Western civilization as we know it, at the other.

Laying the Groundwork: Trends and History
For much of the last century, companies were not allowed to buy back stock, except in exceptional circumstances. In the United States, companies have been allowed to buy back stock for most of their existence, but the pace of buybacks did not really start picking up until the early 1980s, which some attribute to a SEC rule (10b-18) passed in 1982, providing safe harbor (protection from certain lawsuits) for companies doing repurchases. The legal rules governing buybacks in the US today are captured nicely in this Harvard Law School summary. In the graph below, I show aggregate stock buybacks and dividends at US companies going back to 1980.
Dividends & Buybacks at all US firms (Source: Compustat)
This graph backs up the oft-told story of the shift to buybacks occurring at US companies. While dividends represented the preponderance of cash returned to investors in the early 1980s, the move towards buybacks is clear in the 1990s, and the aggregate amount in buybacks has exceeded the aggregate dividends paid over the last ten years. In 2007, the aggregate amount in buybacks was 32% higher than the dividends paid in that year. The market crisis of 2008 did result in a sharp pullback in buybacks in 2009, and while dividends also fell, they did not fall by as much. While some analysts considered this the end of the buyback era, companies clearly are showing them otherwise, as they return with a vengeance to buy backs.

As some of those who have commented on my use of the total cash yield (where I add buybacks to dividends) in my equity risk premium posts have noted (with a special thank you to Michael Green of Ice Farm Capital, who has been gently persistent on this issue), the jump in cash returned may be exaggerated in this graph, because we are not netting out stock issues made by US companies in each year. This is a reasonable point, and I have brought in the stock issuances each year, to compute a net cash return each year (dividends + buybacks - stock issues) to contrast with the gross cash return (dividends + buybacks).
Gross cash (Dividends+Buybacks) and Net Cash (Dividends+Buybacks-Stock Issues) as % of Market Cap
Note that I have converted all these numbers into yields, by dividing them by the aggregate market capitalization at the end of each year. Both the gross cash yield (5.53%) and net cash yield (3.89%) peaked in 2007, and the lowest values for these numbers were in 1999 and 2000, when the gross cash yield was 2.17% (1999) and the net cash yield was 0.67% (2000). At the end of 2013, the gross cash yield stood at 4.49% and the net cash yield at 3.16%, both slightly higher than the aggregate values of  4.24% for the gross yield and 2.46% for the net yield over the 1980-2013 time periods; the simple averages yield 4.65% for the gross yield and 2.60% for the net yield over the entire time period.

Since the aggregate values gloss over details, it is also worth noting who does the buybacks. It goes without saying that the largest buybacks (in dollar terms) are at the largest market cap companies, and the following is a list of the top fifteen companies buying back stock in 2013:
Companies buying back the most stock in 2013 (in millions)
Not only is more money being returned in the form of buybacks, but the practice of buybacks has also now spread far and wide across the corporate spectrum, with small and large companies, as well as across different sectors, partaking in the phenomenon:
Dividends and Buybacks in 2013: Data from S&P Capital IQ
Other than utilities, the shift to dividends is clear in every other sector, with technology companies leading with almost 76% of cash returned taking the form of buybacks. 

Keep it simple: Buybacks are a return of cash to stockholders
To understand buybacks, it is best to start simple. Publicly traded companies that generate excess cash often want to return that cash to stockholders and stockholders want them to do that. There are only two ways you can return cash to stockholders. One is to pay dividends, either regularly every period (quarter, semiannual or year) or as special dividends. The other is to buy back stock. From the company’s perspective, the aggregate effect is exactly the same, as cash leaves the company and goes to stockholders. There are four differences, though, between the two modes of returning cash. 
  1. Dividends are sticky, buybacks are not: With regular dividends, there is a tradition of maintaining or increasing dividends, a phenomenon referred to as sticky dividends. Thus, if you initiate or increase dividends, you are expected to continue to pay those dividends over time or face a market backlash. Stock buybacks don’t carry this legacy and companies can go from buying back billions of dollars worth of stock in one year to not buying back stock the next, without facing the same market reaction.
  2. Buybacks affect share count, dividends do not: When a company pays dividends, the share count is unaffected, but when it buys back shares, the share count decreases by the number of shares bought back. Consequently, share buybacks do alter the ownership structure of the firm, leaving those who do not sell their shares back with a larger share in a smaller company.
  3. Dividends return cash to all stockholders, buybacks only to the self-selected: When companies pay dividends, all stockholders get paid those dividends, whether they need or want the cash. Thus, it is a return of cash that all stockholders partake in, in proportion to their stockholding. In a stock buyback, only those stockholders who tender their shares back to the company get cash and the remaining stockholders get a larger proportional stake in the remaining firm. As we will see in the next section, this creates the possibility of wealth transfers from one group to the other, depending on the price paid on the buyback.
  4. Dividends and buybacks create different tax consequences: The tax laws may treat dividends and capital gains differently at the investor level. Since dividends are paid out to all stockholders, it will be treated as income in the year in which it is paid out and taxed accordingly; for instance, the US tax code treated it as ordinary income for much of the last century and it has been taxed at a dividend tax rate since 2003. A stock buyback has more subtle tax effects, since investors who tender their shares back in the buyback generally have to pay capital gains taxes on the transaction, but only if the buyback price exceeds the price they paid to acquire the shares. If the remaining shares go up in price, stockholders who do not tender their shares can defer their capital gains taxes until they do sell the shares.
Buybacks: The Value Effect
Buybacks can have no effect, a positive effect or negative effect on equity value per share, depending on where the cash from the buyback is coming from and how it affects the firm’s investment decisions. To illustrate the effects, let’s start with a simple financial balance sheet (not an accounting one), where we estimate the intrinsic values of operating assets and equity and illustrate the effects of a stock buyback on the balance sheet.

Note that the buyback can be funded entirely with cash, partly with cash and partly with new debt or even entirely with debt. (I am going to leave out the perverse but not uncommon scenario of a company that funds a buyback with a new stock issue, since the only party that is enriched by that transaction is the investment banker who manages both the issuance and the buyback). The value of the operating assets can change, if the net debt ratio of the company changes after the buyback (thus affecting the cost of capital) or if the buyback reduces the amount that the company was planning to invest in its operating assets (thus changing the cash flows, growth and risk in these assets).  This framework is a useful vehicle to look at the conditions under which buybacks have no effect on value, a positive one and a negative one.

The indifferent: For buybacks to have no effect on value, they should have no effect on the value of the operating assets. That must effectively mean that the buyback is entirely funded with cash off the balance sheet or that even if funded with debt, there is no net value effect (tax benefits cancel out with default cost) and that the buyback has no effect on how much the company invests back into its operating assets. As an example, consider the $13.2 billion in stock buybacks at Exxon Mobil in 2013. The company funded the buybacks entirely with cash surpluses and it not only had more than enough cash to cover reinvestment needs but continues to generate billions of dollars in excess cash (over and above its reinvestment needs).

The good: There are three pathways through with which a buyback can have a positive effect on value:
  1. Discounted cash holdings: There are some companies with significant cash balances, where investors do not trust the management of the company with their cash (given the track record of the company). Consequently, they discount the cash in the hands of the company, on the assumption that they will do something stupid, and this stupidity discount can be substantial. This is one of the few scenarios where a stock buyback, funded with cash, is an unalloyed plus for stockholders, since it eliminates the cash discount on the cash paid out to stockholders.  
  2. Financial leverage effect: A firm that finances a buyback with debt, increasing its debt ratio, may end up with a lower cost of capital, if the tax benefits of debt are larger than the expected bankruptcy costs of that debt. That will occur only if the firm has debt capacity to begin with, but that lower cost of capital adds to the value of the operating assets, though it can be argued that it is less value enhancement and more of a value transfer (from taxpayers to stockholders). 
  3. Poor investment choices: There is also the scenario where a firm that has been actively investing in a bad business or businesses (earning less than the cost of capital) redirects the cash towards buybacks. Here, less investment is value increasing and I will let you be the judge on how many firms on the top fifteen list in 2013 fall into that scenario. (I can think of quite a few...)
The bad: There are two ways in which a buyback can have a negative effect on value. The first is if the firm is correctly or over levered and chooses to finance the buyback with even more debt, since that would push the cost of capital higher after the buyback (as the expected bankruptcy costs overwhelm the tax benefits of debt). The second is if the firm takes cash that would have been directed to superior investment opportunities (where the return on capital > cost of capital) and uses it to buy back stock; this requires that the company also face a capital constraint, imposed either internally (because the company does not like to raise new financing) or externally (because the company is prevented from raising new financing). 

Buybacks: The Pricing Effect
If buybacks have no effect on value, can they still affect stock prices? Sure, and there are three possible factors that may cause the effect. The first is if there is a market mistake at play, where the stock is priced above or below its intrinsic value and the buyback occurs at a price that is not equal to the value. The second is that markets extrapolate from corporate actions and may view the buyback as a signal about what managers of the company think about its fair value. The third is that a buyback, especially if large and/or on a lightly traded stock, can have liquidity effects, tilting the demand side of the pricing equation. All of the effects are captured in the picture below:


  1. Market mispricing: If the stock is mispriced before the buyback, the buyback can create a value transfer between those who tender their shares back in the buyback and those who remain as stockholders, with the direction of the transfer depending on whether the shares were over or under valued to begin with. If the price is less than the value, i.e., the stock is under priced, a buyback at the prevailing price will benefit the remaining shareholders, by letting them capture the difference but at the expense of the stockholders who chose to sell their shares back at the “low price”. In fact, it is likely that the market will view the announcement of the buyback as a signal that the stock is under valued and push the price impact in what is commonly categorized as a signaling effect. If the price is greater than the value, i.e., the stock is over priced, a buyback will benefit those who sell their shares back, again at the expense of those who hold on to their shares. In either case, there is no value creation but only a value transfer, from one group of stockholders in the company to another. Lest you feel qualms of sympathy for the losing group in either scenario, remember that most stockholders get a choice (to tender or hold on to the shares) and if they make the wrong choice, they have to live with the consequences. 
  2. Signaling: For better or worse, markets read messages into actions and then translate them into price effects. Thus, when companies buy back stock, investors may consider this to be a signal that these companies view their stock to be under valued. If there is a signaling effect, you should expect to see the stock price jump on the announcement of the buyback and not the actual execution. The problem with this signaling story is that it attributes information and valuation skills to the management of the company that is buying back stock, that they do not possess. The evidence on whether companies time stock buybacks well, i.e., buy back their stock when it is cheap, is weak. While there is some evidence that companies that buy back their own stock outperform the market in the months after the buyback, there is also evidence that buybacks peak when markets are booming and lag in bear markets. 
  3. Liquidity effects: A stock buyback, especially if it is of a large percentage of the outstanding shares, does create a liquidity effect, with the buy orders from the company pushing up the stock price. For this to occur, though, the shares bought back have to be a high percentage of the shares traded (not the shares outstanding). If there is a liquidity effect, you should expect to see the stock price rise around the actual buyback (and not the announcement) but that price effect should fade in the weeks after. While the Wall Street Journal makes legitimate points about how buybacks can sometimes tilt the liquidity playing field, looking across companies that buy back stock and scaling the buyback to the daily trading volume on the stock, the median value of buybacks as a percent of annual trading volume was 0.79% and the 75th percentile across all firms is 2.17%. It is true that there are firms like IBM and Pfizer that rank among the biggest buyback firms, where buybacks are a significant percentage of annual trading volume and there will be a liquidity effect at these companies, albeit short lived:

The Sum of the Effects
In summary, buybacks can increase value, if they lower the cost of capital and create a tax benefit that exceeds expected bankruptcy costs, and can increase stock prices for non-tendering stockholders, if the stock is under valued. Buybacks can destroy value if they put a company’s survival at risk, by either eliminating a cash buffer or pushing debt to dangerously high levels. They can also result in wealth transfer to the stockholders who sell back over those who remain in the firm, if the buyback price exceeds the value per share. 

What about the share count effect? This is the red herring of buyback analysis, a number that looks profoundly meaningful at first sight but is useless in assessing the effect of a buyback, on deeper analysis. Let’s start with the obvious. A stock buyback will always reduce share count. For those lazy enough to believe that dilution is the bogeyman, and that less shares is always better than more, buybacks are always good news. However, lower share count often does not signify higher value per share and it may not even signify higher earnings per share (or whatever per share metric you use). For those slightly less lazy, focused on earnings per share, the assessment of whether a buyback is good news boils down to estimating how much earnings per share goes up after it happens. In a world where PE ratios stay constant, come out of sector averages, or are just made up, this will translate into higher price per share. The problem is that a buyback alters the risk profile of a firm and should also change its PE ratio (usually to a lower number).

To assess the effect of a buyback, you have to consider the full picture. You have to look at how it is financed (and the effect it has on debt ratio and cost of capital) and how the stock price relates to its fair value (under priced, correctly priced or over priced) to make a judgment on whether stockholders will benefit or be hurt by the stock buyback. I have a simple spreadsheet that tries to do this assessment that you are welcome to take for a spin.

Back to the Market
Now that we have the tools to assess how and why stock buybacks affect stockholders in the companies involved, let’s use them to look at whether the buyback “binge” in the market is good news, neutral news or bad news, at least in the aggregate.  The article in the Economist provides the perspective of those who believe that stock buybacks are the most destructive trend in corporate America. Looking at the value destruction pathways described in the last section, this group believes that the stock buybacks at US companies are increasing leverage to dangerously high levels and/or reducing investment in good projects. But are these contentions true? Let’s check the facts:

1. The leverage story: The notion that US companies are dangerously over levered seems to be built on two arguments: the aggregate debt levels of businesses as reported in the US national accounts and on anecdotal evidence (Apple borrowed money to do buybacks, so every one must...). To examine this argument,  I have estimated debt levels at US companies from 1980 to 2013 in the graph below, both as a percentage of capital (book and market) and as a multiple of EBITDA.
Debt as % of capital & multiple of EBITDA: All US companies (Source: Compustat)
It is true that overall financial leverage, at least as measured relative to book value and EBITDA has increased over time (though it has remained relatively stable, as a percent of market value). While this increase can be partially explained by decreasing interest rates over the period, it is worth asking whether buybacks were the driving force in the increased leverage. To answer this question, I compared the debt ratios of companies that bought back stock in 2013 to those that did not and there is nothing in the data that suggests that companies that do buybacks are funding them disproportionately with debt or becoming dangerously over levered.
Data from 2013: Debt burdens at buyback versus no-buyback companies
Companies that buy back stock had debt ratios that were roughly similar to those that don't buy back stock and much less debt, scaled to cash flows (EBITDA), and these debt ratios/multiples were computed after the buybacks.

2. The under investment story: The belief that US companies in sectors other than technology have been reinvesting less back into their businesses is widespread, but let’s check the facts again. In the table below, I look at capital expenditures at US firms collectively, as a percent of revenues and invested capital, from 1980 to 2013: 
Capital Expenditures, Revenues and Invested Capital: US companies (Source - Compustat)
The trend line (on everything other than cap ex as a percent of sales) does back the conventional wisdom, and since buybacks went up over the same period, the bad news bears seem to win this round, right? Well, not so fast! What if investment opportunities in the US, in sectors other than technology, are drying up, either because of global competition or due to industry maturation? If this is the case, not only should you expect exactly what you observe in the data (less reinvestment, more cash returned) but it is a good thing, not a bad one. Before you get too heated under the collar, there are three things to remember in this debate.
  1. The first is that there is little evidence that companies that buy back stock reduce their capital expenditures as a consequence. The table reports on the capital expenditures and net capital expenditures, as a percent of enterprise value and invested capital, at companies that buy back stock and contrasts them with those that do not, and finds that at least in 2013, companies that bought back stock had more capital expenditures, as a percent of invested capital and enterprise value. When you net depreciation from capital expenditures (net cap ex), the two groups reinvested similar amounts, as a percent of enterprise value), but the buyback group reinvested more as a percent of invested capital.
    Capital Expenditures & Net Capital Expenditures = Capital Expenditures - Depreciation; US firms in 2013
  2. The second is that the cash that is paid out in buybacks does not disappear from the economy. It is true that some of it is used on conspicuous consumption, but that is good for the for the economy in the short term, and a great deal of it is redirected elsewhere in the market. In other words, much of the cash paid out by Exxon Mobil, Cisco and 3M was reinvested back into Tesla, Facebook and Netflix, a testimonial to the creative destruction that characterizes a healthy, capitalist economy. 
  3. The third is the notion that more reinvestment by a company is always better than less is absurd (unless you are a politician), especially if that reinvestment is in bad businesses. In the table below, I have listed the ten companies that were the biggest buyers of their own stock over the last decade (using the Economist's ill advised heading for those who buy back stocks):

As a stockholder in any of these companies, can you honestly tell me that you would rather have had these companies reinvest back in their own businesses? Put differently, how many of you wish that Microsoft had not bought back $100 billion worth of shares over the last decade and instead pumped that money into more Zunes and Surfaces? Or that Hewlett Packard instead of paying out $60 billion to stockholders had bought three more companies like Autonomy (and written them off soon after)? Or that Cisco had spent the $70 billion in buyback money on a hundred small acquisitions? If, as the Economist labels them, these companies are cannibals for buying back their own stock, investors in these companies wish they had more voracious appetites and eaten themselves faster.

There are two other issues brought up by critics of stock buybacks. One is that there is firms may buy back stock ahead of positive information announcements, and those investors who tender their shares in the buy back will lose out to those who do not. The other is that there is a tie to management compensation, where managers who are compensated with options may find it in their best interests to buy back stock rather than pay dividends; the former pushes up stock prices while the latter lowers them. Note that doing a buyback ahead of material information releases is already illegal, and any firm that does it is already breaking the law. As for management compensation, I agree that there is a problem, but buybacks are again a symptom, not a cause of the problem. In my view, it is poor corporate governance practice on the part of boards of directors to grant huge option packages to managers and then vote for buybacks designed to make managers even better off. Again, fixing buybacks does nothing to solve the underlying problem.

Wrapping up
I think that both ends of the spectrum on buybacks are making too much of a simple cash-return phenomenon. To the boosters of buybacks as value creators, it is time for a reality check. Barring the one scenario where companies that buy back stock stop making value-destructive investments, almost every other positive story about buybacks is one about value transfers: from taxpayers to equity investors (when debt is used by an under levered firm to finance buybacks) and from one set of stockholders to another (when a company buys back under valued stock).

To those who argue that buybacks are destroying the US economy, I would suggest that you are using them as a vehicle for real concerns you have about the evolution of the US economy. Thus, if you are worried about insider trading, executive compensation, tax-motivated transactions and or under investment by the manufacturing sector, your fears may be well placed, but buybacks did not cause of these problems, and banning or regulating buybacks fall squarely in the feel-good but do-bad economic policy realm.

Is it possible that some companies that should not be buying back stock are doing so and potentially hurting investors? Of course! As someone who believes that corporate finance at many companies is governed by inertia (we buy back stock because that is what we have always done...) and me-too-ism (we buy back stock because every one else is doing it...), I agree that there are value destroying buybacks, but I also believe that collectively, buybacks make far more sense than dividends as a way of returning cash to equities. In the Economist article, I am quoted as saying that dividends are a throwback to the nineteenth century (not the twentieth), when stocks were offered as investment choices to investors who were more used to bonds and that fixed, regular dividends were designed to imitate coupons. Since equity is a residual claim, it is not only inconsistent to offer a fixed cash flow claim to its owners, but can lead (and has led) to unhealthy consequences for firms. In fact, I think firms are far more likely to become over levered and cut back on reinvestment, with regular dividends that they cannot afford to pay out, than with stock buybacks.

Attachments:
  1. Stock buybacks, dividends, stock issuances - Aggregate for US companies (1980-2013)
  2. Debt ratios/multiples - Aggregate for US companies (1980-2013)
  3. Buyback effect calculator

Tuesday, September 16, 2014

Alibaba's Governance by Politburo: Corporate Governance and Value

In my last post on Alibaba, I valued the company at about $162 billion but also argued that investors considering investing in the company might hold back because of corporate governance concerns. I will start by making the case (and it is an easy one) that Alibaba is more corporate dictatorship than corporate democracy, but I would then like to use the company as a vehicle to talk about what constitutes good corporate governance and how best to incorporate its presence or absence into value. 

The Alibaba Corporate Governance Model
In theory, the stockholders in a publicly traded company are its owners and get to determine who runs the company and how it is run. In practice, we know that this is more myth than reality and that a variety of constraints, both internally  and externally imposed, exist on stockholder power. Even in  the most idyllic corporate democracies, incumbent managers start off with an advantage over stockholders in the power game, though activists can sometimes even the playing field. With a company like Alibaba, stockholder don't even have the fig leaves of choice that they do with most other publicly traded companies and there are three reasons why:
  1. Legal Structure: The corporate governance problem with Alibaba starts with its legal structure. As I have noted in my prior posts, if you buy shares in Alibaba, you are not getting a piece of Alibaba, the Chinese online merchandising profit-machine, but a portion of Alibaba, the Cayman-Islands shell entity that has a contractual arrangement to operate its Chinese counterpart. While the Chinese government has granted legal standing to that contractual agreement, at least for the moment, it reserves the right to change it's mind and if it does, Alibaba's  shareholders will be left with just the shell.
    Operating Structure for Alibaba
  2. Management Powers: While the board of directors in publicly traded companies often fail in their obligation to protect the interests of stockholders, stockholders at least get to elect board members and have a say (nominal thought it may be) in the management of the company. With its partnership set-up, Alibaba has stripped even this minimal power away from stockholders, and the board will be named by a group of partners, which includes Jack Ma and his hand-picked partners. This is decision by corporate politburo, not through corporate democracy, but to give the Hong Kong Stock Exchange credit, they refused to allow Alibaba a listing with this set-up, but the NASDAQ NYSE seemed to have no qualms. In fact, given the NASDAQ’s NYSE's track record of going after large market cap listings at any cost, is there is any entity (Atilla the Hun? The Evil Empire?), with sufficient market capitalization, that the NASDAQ NYSE would refuse to list? (In my initial version of this post, I had wrongly accused the NASDAQ for this listing sin and I apologize, since I am sure that the NASDAQ would never have been this craven).
  3. Country setting: China has been the growth story of the decade and there is much to admire in the country’s single minded focus at making itself a first world economy. However, it is not a market economy in any sense of the word and I do not believe that the management at a Chinese company, let alone one as large and high-profile as Alibaba, can survive, if it upsets the Beijing power structure. Thus, it not only does not surprise me to read stories like this one about ties with politics but it brings home the realization that what stockholders want for this company is irrelevant, if their wants are not consistent with what the Chinese government would like to see happen. 
In effect, you have a corporate non-governance trifecta, a publicly traded entity with questionable legal standing, run by a strong willed CEO who can write his own rules, in a country that does not put much weight on ownership rights. To give Alibaba credit, they do not hide the fact that this is a company where stockholders are powerless, as evidenced by this section from the prospectus (Pages 57-60), where they are clear that they are not required to maintain the illusion of board independence and accountability that most public corporations are required to.

What is corporate governance?
Now that we have established that stockholders in Alibaba have no power, it is time to ask a broader question about what exactly constitutes good corporate governance. In the last three decades, academic research and shareholder services have followed a standard path to measuring corporate governance by looking at the corporate charter and the composition of the board of directors. Institutional Shareholder Services (ISS), which provides perhaps the most widely used measure of corporate governance, builds its quick score around four pillars: an audit pillar (looking at whether the company makes its financial filings in time), a board pillar (director composition, compensation and shareholder approval rates), a shareholder rights pillar (hostile takeover restrictions, ease of dilution) and a compensation pillar (whether it is aligned with performance, how much say stockholders have in setting it and how well it is disclosed). Through no fault of ISS, companies have learned the system and play it well, meeting the checklist criteria for good corporate governance while rendering the concept toothless.

While I understand the need to use objective measures to arrive at corporate governance scores, my definition of corporate governance is both broader and more difficult to measure. It reflects the power of stockholders to change the management of a company, if they feel the urge to do so. In that sense, it is very similar to the power that voters have in a democracy, to change their government. Note that the right to change management (or a government) may not always be exercised, because stockholders (voters) are lazy and abstain, or be exercised wisely, insofar as stockholders (voters) may leave bad managers (governments) in place or replace good managers (governments). The key is that with they have the power to create change, if they choose to.

Corporate governance and corporate performance

Proponents of stronger corporate governance argue that it critical to corporate performance, but the evidence of the link between the two is not very strong. There are badly run companies with impeccable corporate governance in place and superbly performing businesses where there is absolutely no restraint on corporate managers. Google and Facebook are corporate fiefdoms, where founder/CEOs have unchallenged power to do almost anything that they want, but they are also companies that have delivered immense profits and value to their stockholders. 

It is true that generalizing on the basis of anecdotal evidence is dangerous, but studies that look at the overall relationship between measures of strong corporate governance and value deliver the same fuzzy message that good corporate governance does not always translate into higher value or better performance. One of the most widely quoted studies in support of strong corporate governance is this one, which finds that companies with stronger stockholder rights have higher profits and trade at higher multiples than companies with weak governance. Other studies, though, note that the the correlation between corporate governance measures and stock performance is weak and that there is some evidence that subsets of firms with weak corporate governance deliver superior performance.

As in the previous section, you can use an analogy from political governance to examine the link of governance with performance. Is a country better off run by a benevolent (and intelligent) ruler-for-life or by a sometimes chaotic, often messy democracy? As someone whose instincts tend towards the latter, I would love to tell you that the answer is obvious, but I have had my moments of frustration with self-serving, short-term legislation and populist politicians, when I have dreamed about the former.

The Value of Corporate Governance
At the start of each of my valuation classes/sessions, I start with what I call the It Proposition and here is how it goes, “If it does not affect the cash flows or the risk in an investment, it cannot affect value”. If you are wondering what “it” is, “it” can be any of those words that are used to justify adjusting value with premiums (control, synergy, brand name) or discounts (illiquidity). Since it would be hypocritical of me to abandon this proposition in the context of corporate governance, I would argue that any corporate governance effect on value has to show up in either the cash flows or the risk.

Valuing Corporate Governance: The Static Framework

To consider how best to incorporate good or bad corporate governance into the value of a company, consider the determinants of value. We make judgments about how well a company is managing its existing assets, how much value there will be in future growth and the risk in the business to arrive at an estimate in value. 


These judgments, though, are based upon assumptions about who is running the company (the management) and what these incumbent managers do well or badly. Thus, if you are valuing a company where managers have had a history of delivering high growth efficiently but are conservative when it comes to the use of debt, you may assume continued high quality growth accompanied by predominantly equity funding in valuing the company. In contrast, if you are valuing a company that borrows too much and consistently over pays on acquisitions, you may assume that those destructive tendencies will continue in valuing the company. Let’s term these the status quo values. Now, consider revaluing these companies with a new management in place without the blind spots of the status quo managers and reassess investment, financing and dividend policies. This will require you to take a fresh look at the key inputs into value, and with the changes that you make in how the company is run, you can revalue the company. Let’s term this value the optimal value

By definition, the optimal value cannot be lower than the status quo value, but it can be equal to it (in the unlikely event that your company is perfectly run by the existing management) and will generally be greater.  Now that you have the status quo value and the optimal value of a publicly traded company, you can write the expected value of the company as a probability weighted average of the two numbers:
Expected value of company = Status Quo Value (Probability of Existing Management staying in place) + Optimal Value (1 – Probability of Existing Management staying in place)
Note that the probability attached to the optimal value can be construed as the probability of management change and it gives us a platform for assessing the value of corporate governance. If corporate governance is weak or non-existent, the probability of changing management decreases and the expected value of a company will converge on the status quo value. That may not result in significant value loss, if you have a well managed company, but the discount for bad corporate governance can be significant for a poorly managed company. 

Valuing Corporate Governance: The Dynamic Framework

The static approach to valuing corporate governance tends to work better for mature companies that are set in their ways. It does not work as well for younger companies that are run by strong willed CEOs, but are also perceived as being run well (at least for the moment). In these companies, the status quo and the optimal values may converge, leading to the conclusion that corporate governance does not have an impact on value. Thus, if you were valuing Google or Facebook, companies with excellent track records and imperial CEOs, you may conclude that there is little consequence to having poor corporate governance.

Taking a longer-term perspective, and borrowing again from the political governance framework, the advocates for strong corporate governance would argue that there is a cost to bad corporate governance even at companies that are well managed today, since you are buying a share of these companies in perpetuity. That cost will show up in the future, when managers make wrong choices (and even the best ones do) or take value destructive paths. Since they are not accountable to stockholders and boards tend to be rubber stamps, there is no mechanism for bringing them back on track and the costs in the long term can be immense to stockholders. Even with the longer term perspective, though, there are others who argue that the restraints put on top management in a strong corporate governance system will result in slower and sub-optimal decisions, perhaps costing investors value in future periods.

In valuation, the question of how best to capture this long term risk is a difficult one to answer. It is almost impossible to do in conventional valuation, where you make you base your value on your expected values for growth, risk and cash flows. It is possible, however, to get a sense of how much  corporate governance matters, if you are willing to estimate a distribution for value, allowing for both good and bad decisions/outcomes. Returning to my Alibaba valuation, I reframed the inputs on revenue growth, operating margin, reinvestment and risk (cost of capital) as distributions (rather than point estimates) and estimated a distribution of value for the equity per share in the company:


Notice that while the expected value ($66.45/share & $162.9 billion in equity) and median value ($65.15/share & $159.7 billion in equity) are close to my base case valuation ($65.98/share & $161.7 billion in equity), there are outcomes that diverge widely from these numbers. Based on my assumptions, Alibaba could be worth as little as $38.11/share ($93.7 billion), if revenue growth drops, margins sag and risk rises, or as much as $153.10/share ($ 374.4 billion ). While this is going to be true for any firm with uncertainty about the future, the distribution of value allows us to get perspective on the contrasting points of view about strong management. 
  1. The Benevolent Ruler school: Investors in this school see an upside to unrestrained managers, arguing that there will be opportunities that will open up for the company to increase its value that require the quick, decisive and consistent actions that a strong, informed CEO can make without having to worry about or being slowed down by stockholder reactions or board approval. In effect, investors in this school may actually add a premium to discounted cash flow value to reflect the CEO's power, because they believe that a stronger CEO makes it more likely that Alibaba's value will converge on a higher number.
  2. The Corporate Democracy school: Investors in this school believe that CEOs with absolute power will inevitably make mistakes, and lacking accountability to shareholders and an active board of directors, will continue down value-destructive paths. Not surprisingly, these investors will reduce their DCF value to reflect this probability.
The determinants of the premium attached by the first school and the discount tacked on by the second school are surprisingly similar. They will both increase as the uncertainty in the value of the business increases, since they have the characteristics of an option: a call option that adds value for the benevolent ruler school and a put option that reduces value with the corporate democracy school. They will also increase with your time horizon as an investor, with longer time horizons associated with higher values for both the premium and discount. Thus, if you are investor with a ten-year time horizon, you care a lot more about the good and bad qualities of top management than if have a six-month time horizon. That, in turn, may explain why so few portfolio managers and investors seem to be even looking at the corporate governance question with Alibaba with any concern.

The Bottom Line
As a long term investor, I am torn. While I think that Alibaba's current management team has done an superb job in building up the company, my instincts as an investor and my memories of well-managed companies that have mutated into badly run ones (with the same CEO in place) make me hold back. To be honest, I don't like being asked for my money (as an investor) and then being told that I have no say in how its run. With Alibaba, the decision is easier for me, at least for the moment, because the company is, at best, fairly priced at its offering price. It will be a decision, though, that I will have to revisit, if the price drops and the value does not. In effect, I will have to decide the discount on value at which I am okay with being in Jack Ma's outhouse.

Attachments
  1. Alibaba: A China Story with a Profitable Ending (My May 8th post on Alibaba)
  2. Alibaba's Coming out Party: Fairly Valued but is it fairly priced? (My September 8th post on Alibaba)
  3. The value of control (My paper on status quo and optimal values)
  4. My valuation of Alibaba 
  5. My simulation assumptions for Alibaba (You will need Crystal Ball or some variant to be able to run the simulation yourself)

Monday, September 8, 2014

Alibaba's coming out party: Valued right, but is it priced right?

As Alibaba's IPO approaches and the road show kicks into high gear, questions about its accounting, value and corporate governance that came up at the time of the filing of its initial prospectus on May 6, 2014, are resurfacing. Alibaba's banking team announced on Friday that their initial pricing for the stock would between $60 and $66 a share, giving the company an estimated an equity value of about $155 billion at the pricing midpoint. That would make it the most valuable IPO in history, much higher than the $80 billion at which Facebook's equity was priced at the time of its IPO in 2011 or the $25 billion at which Google priced itself in 2004.

Valuing Alibaba
I valued Alibaba in May 2014, right after their initial prospectus was filed in this post which I titled "Alibaba: A China Story with a profitable ending?". In that post, I argued that Alibaba's dominance of the Chinese online retail market provided a foundation for immense value, driven by the size of and the growth in that market and sky-high operating margins. While I will not repeat the specifics of the valuation here, the combination of high revenue growth, sustained margins and relatively low reinvestment, I argued, yielded a value of $145.6 billion for the company and a value per share of approximately $61/share.

Much has happened in the five months since: Alibaba has navigated its way through some accounting quicksand, rumors surfaced of an investment in Snapchat that valued the company at $10 billion though the deal fell apart, and Alibaba updated its prospectus to reflect an additional quarter of information. Since a few months can shift both the numbers and the narrative for a young company, I revalued the company on September 2, 2014 (it was the first valuation of the week in my Fall valuation class) using Alibaba's filing from August 27, 2014. While there a few tweaks to the valuation, my assessment of the company has changed little. The value of equity that I get, allowing for an initial offering proceeds of $20 billion, is $161 billion, with about half of the increase in value   coming from a larger initial offering, and the value per share that I get for the company is about $66. The picture below captures my assumptions and you can contrast it with my earlier valuation from May, if you are so inclined:

You can download this valuation in spreadsheet form, by clicking here.

In keeping with my posts on narrative and numbers, the key question is whether there is anything that has happened in the last few months that has changed my narrative of Alibaba as a dominant, profitable Chinese online merchandiser and the answer is 'not yet'. The reason that it is not an emphatic no is that some of the actions taken by Alibaba in the last few months, including a rumored investment in Snapchat, suggest that it has ambitions to become a global retail giant, competing with Amazon, Google and even Facebook. In the quarters to come, if these actions become more concrete and costly, I will revisit this valuation to see the effects, positive and negative, of this narrative shift.

I have a few emails in the last few days asking whether I feel vindicated by the fact that Alibaba's bankers seem to have arrived at a number very similar to mine and my reaction is mixed. First, given what I think about the valuations that emerge from investment banks in general, I am queasy that I am in agreement with their assessments of Alibaba's value. In fact, it is entirely possible and perhaps likely that both the bankers and I are hopelessly off track on our assumptions and that the true value is a number very different from our assessment. Second, and repeating a point I have made on prior posts about IPOs, bankers don't value companies in IPOs; they price them and the fact that they are thinking of pricing the company close to my estimate of value is, in my view, more coincidence than a reflection of consensus.

Pricing Alibaba
When asked to attach a number to an asset, I believe that you have to start with a fundamental question: Is your mission to attach a value to the asset or is to price the asset?  If your job is to facilitate a transaction or get a deal done, as is the case with bankers in an IPO, you have a pricing mission and we would all save ourselves significant disappointment and disillusionment, if we remembered that. In effect, Alibaba's bankers have to price the stock for the IPO, not value it. To get to the right price for a company in an IPO, there are five key steps involved, though one of them is purely for external consumption.
  1. Use pricing metrics and comparable firms to arrive at an estimate of what investors will pay for the shares: Those pricing metrics take the form of multiples of earnings, book value and revenues and the comparable firms are other publicly traded companies that you believe investors will compare your firm to. The process clearly has subjective judgments in it, in your choice of multiple, in what firms you include in your comparable list and how you control for differences. The table below provides the range of estimates of equity value that I obtain for Alibaba, depending on which multiple I use (PE, Price to Book Equity, EV/EBITDA, EV/Sales or EV/Invested Capital), what I choose as my comparable firms (Just Baidu, Online Advertising, Online Retail, Online Services or all Online companies) and how I compute my sector average (Simple average, Median, Aggregate values). I can get values ranging from $11.9 billion (using the EV/Sales of online advertising companies) to $944 billion (using the simple average PE ratio of Online service companies), and while this may strike you as absurd, it also points to why how easily relative valuations can be used to justify almost any point of view or sales pitch. With Alibaba, at least, it seems clear to me that if multiples are used in the road show, they will almost always be earnings-based (since you get much higher values with those than with revenues or book value) and that the comparable firms will be pruned to create a sample that makes Alibaba look cheap. You can download a spreadsheet that lets you alter the choices and one that contains the raw data on individual companies.
    Alibaba Equity Value: Based on Trailing 12-month numbers. With EV multiples, I add cash and subtract out debt to get to equity value
  2. Gauge demand: If pricing yields such a wide range of numbers for Alibaba, how do you arrive at a price for the initial offering? The answer is surprisingly simple. The bankers setting the price start by getting a measure of how much potential investors (especially larger ones) are willing to pay for the stock and gauging demand. If investors seem too enthusiastic at a specified price, they will move the price up, whereas a muted response will lead to a lowering of the price. 
  3. Build in the "pop": For better or worse, bankers are not feted for getting the price right but for getting it wrong, albeit in one direction and not by too much. A well-priced IPO is one where the stock jumps on the offering date by about 10-15%, relieving bankers of their underwriting responsibility, rewarding key clients (who were able to subscribe at the offering price) with a  quick profit and providing press buzz and price momentum for the issuer to make subsequent offerings. I may be reading more than I should into Alibaba's initial pricing numbers, but the fact that the offering price is set at $63 ($155 billion) suggests to me that the bankers believe that a fair price for the stock is about $180-$200 billion.  
  4. Reverse engineer a "valuation" to back up your price: For some reason, bankers seem to believe that they have to cloak their pricing in a value framework, i.e., make it look like the price that they have arrived at is really the result of an intrinsic valuation. Thus, a DCF valuation is created, inputs are tweaked and first principles are often mangled to arrive at the desired number (from the first three steps). To be fair to bankers, this step in the process may be designed to prevent legal jeopardy, since courts seem to also think that due diligence in this process requires a DCF valuation. 
  5. Reassess demand: While we think of roadshows as designed to help the issuing company and its bankers make their sales pitch to investors, the information flows both ways, as investors' views and reactions can help bankers reassess their offering price range. The final offering price does not have to be set until the day before the offering date, leaving plenty of time for adjustments and readjustments. 
After all of this effort on pricing, you would think that the bankers/issuing company would get it right, but as Facebook and Twitter illustrated in divergent ways, it is easy to get it wrong, with the offering price set too high for Facebook and too low for Twitter. As to how Alibaba will fare on opening day, your guess is as good as mine, but if the stock does jump about 15% on the opening day, the company and its bankers will celebrate a Goldilocks pricing moment. 

Investing or Trading
Should you invest in Alibaba? At its estimated offering price of $150-160 billion, I think that it is a fairly-valued investment, if you can overcome two fears. The first is that, as a shareholder, you are not becoming part owner of Alibaba, the Chinese online merchandiser,  but instead get a share of a shell entity (the Cayman Islands based variable interest entity) that controls the operating company through a legal agreement (that exists because the Chinese government treats it as such, for the moment). The second is that you are buying a corporate governance nightmare, where this will remain Jack Ma's company for the foreseeable future and you will have no say in what the company does, how it is overseen or its management decisions. I will return to the issue of corporate governance, why it matters and how best to incorporate it into value in another post. I, for one, will stick with my indirect investment in Alibaba, through Yahoo!, and hope that I get the spillover benefits.

Should you trade Alibaba? That will depend on whether you are good at playing the pricing game and I drew the distinction in this earlier post. Since I am not particularly good at this game, my advice on this count is worthless, but if you do play the pricing game, recognize that your capacity to make money will come from assessing investor mood and stock price momentum.

Attachments
My last post on Alibaba (May 2014)
Valuation of Alibaba (DCF spreadsheet) on September 2, 2014
Pricing/Relative Valuation of Alibaba Spreadsheet
Raw Data on Comparable firms

Tuesday, September 2, 2014

The Education Business: A Road Map for Disruption

My first post of every school year is about my upcoming classes, in specific, and about the future of education, at least as I see it, in general, and this year will be no exception. As I get ready to teach the first session of the 52nd iteration of my valuation class (more about that latter), I am reminded again of both how lucky I am to be a teacher and how dysfunctional education is, as a business. 

The Education Business
Nothing raises hackles among the education establishment (which includes most university administrators, many academics and some teachers) than to call education a business. Their response is that it is not a business and cannot be run like one, and that the encroachment of for-profit entities into their hallowed space is sacrilege that will spoil their knowledge-seeking paradise. I am sorry, but I think that this is nonsense and an excuse for the complete lack of accountability that characterizes education today. At the risk of killing a few sacred cows, here is what I think:
  1. Education is a business: The essence of a business to me is simple. If you have a mission to accomplish (and it does not have to be profit maximization), a product or service that you offer in pursuit of this mission and consumers that buy that product or service from you, you are a business. If the sales pitch of universities is to be believed, their primary mission is to educate, the product they offer is a university degree and they not only charge a hefty price for the education, but get the federal government to provide backing for that cost. Thus, it seems to me incontestable that education is a business and students are the customers. It follows then that like all businesses, universities and schools should be held accountable for the quality of the products that they provide. Listening to some defenders of the education establishment fulminate against business practices being used in education, I am inclined to believe that what they fear is being held accountable for their failures.
  2. Education is not not-profit: Even those educators who accept that education is a business and needs to be judged like one are wary of the for-profit model, arguing that this leads to the dilution of the education mission. That argument, though, is based on the delusion that the existing education system is a non-profit model, when it is clearly not. Using the language that I learned in my Economics 101 class, and defining profits as the surplus claimed by the owners of a business, I would argue that “non profit” education, as practiced today, generates plenty of surpluses, but that these surpluses are repackaged and claimed by the stakeholders in the existing system. At the university level, administrators take some of the surplus to expand their fiefdoms, professors claim another chunk to reduce teaching loads, fund research and guarantee their jobs (tenure) and some graduate students use the surplus to extend their education well into middle age. I prefer the unvarnished focus on profits of the for-profit university/school to the double talk that I hear at non-profit educational institutions. 
The Disruption Model
If you accept the premise that education is a business and that the key difference between for-profit and non-profit education is the who gets to keep the surplus, the discussion then can be opened up to the question of whether this is a business that is ripe for disruption, the moats that defend the existing structure and the weakest links in this defensive system.

The Castle: The Education Status Quo
Disruption is the hottest concept in strategy today and while I think it is used more casually than it should be, there can be no denying that many businesses have been disrupted and changed over the last two decades. Thus, Amazon’s inexorable expansion in retailing has not only put dozens of department stores and conventional storeowners out of business but has changed the business models for the remaining retailers in the business. Google’s surge in online advertising has sapped the profitability of newspapers and magazines, putting some of them out of business and changing the way the others operate. A few months ago, I valued Uber on this blog and argued that its value would come from the disruption of the taxi and car service business. But what is it that makes a business ripe for disruption? I am not a strategist, but these seem to be some common features:
  1. Market Size: Clearly, the bigger the business is, in terms of dollars spent on it, the more attention disruptors will pay to that business. Retailing collectively generates trillions of dollar in revenues and global advertising in all its forms reported aggregated revenues of $600 billion last year. I estimated that just the taxicab business, summed up across the globe, was worth more than $100 billion last year. The education business, defined to include not only the tuition collected at educational institutions but also the subsidies that some of them receive from governments, is huge. In fact, student loans alone in the United States amounted to more than a trillion dollars last year.
  2. Inefficient: If you are a disruptor, you are not only looking for a large business but one that is inefficiently run, in terms of the costs incurred in delivering the product or service. That inefficiency may come from a lack of accountability (cost plus pricing) or from inertia (where the world has changed but the business has not). Anyone who has had dealings with the education business, whether it be as a business that is negotiating with a university or public school system or as a parent/student trying to fix a tuition payment mistake or to graduate early, will attest to the fact that they system is layered with inefficiencies.
  3. Protection from competition: Another common feature that disrupted businesses seem to share is that they are protected from competition, either implicitly or explicitly, thus allowing them to continue to be inefficient, with impunity. With taxicabs, that protection comes from a state-sanctioned system that prevents competitors from providing cab service without a license; the price of a yellow cab medallion in New York city hit $1 million last year. It is true that neither retailing nor advertising had explicit barriers to entry but the large costs of entering these businesses (real estate in retailing, the cost of buying a newspaper/magazine in print media) made it possible for inefficient practices to continue in both businesses. The education business has been protected from competition both explicitly (accreditation boards, state laws) and implicitly (professional degree requirements).
  4. Lack of customer focus: Most businesses that get disrupted make it easy for disruptors by losing their customer focus, either by accident or by design. Thus, some retailers made Amazon’s job easier by having poor inventory, a sullen and unresponsive sales staff and terrible customer service, just as print media paved the pathways for its own destruction by exalting its noble mission (news makers, societal watchdogs) often at the expense of their advertising clients. If you have a child who is a student in high school or an under graduate at a college, is he or she being treated like a customer? If you are the one paying for the education, do you get the respect that any paying customer should get? And if you don’t like a class, do you get to ask for your money back? Suffice to say that universities have not treated students as their customers for a long time and thus deserve what is coming to them.
The Moat
If education is ripe for the take down, you may wonder why it has not happened yet, and I would suggest that it is a combination of factors, some psychological, some economic and some structural.  At the start of this year, I posted on the specific barriers to entry that have insulated universities from competition for decades (and perhaps centuries).  I would consolidate those barriers into four broad ones:
  1. Bundled Product: As I noted in the above-linked post, you get more than a collection of classes for the tuition that you pay at a university or college. You (arguably) get a structure for your classes, a social network, entertainment (college football, anyone?) and career placement. Until competitors can come up with their own bundled product to compete, universities are going to be at an advantage.
  2. Inertia: It is difficult to get people to change the way they think, even if the rationale for that thinking has long since dissipated. As long as people (parents and their children) assume that an education requires four years in an (ivy-covered) campus, it will be difficult for alter that system. The sheer cost of a university degree is forcing some people to reexamine this assumption but it will take time and perhaps a generation to pass on for change to truly occur.
  3. Laziness: For decades, employers, would be spouses and other outsiders have taken the lazy way out, when judging the intelligence, training and aptitude of a person. Rather than devise good ways of measuring potential value as employees or observing work output, they have looked at resumes and made judgments based on where you went to college and the degree or degrees you collected along the way. Thus, the fact that you got an undergraduate degree at Yale and a Harvard MBA predisposes potential employers to think of you as top-pedigree employee.  
  4. The System: There are also structural constraints, some of which are imposed by the state (accreditation committees), some by trade groups and unions (example: you have to get an degree in education to be a teacher) and some that are completely arbitrary, which protect the system from assault.
The Barbarians
The education business has been lucky so far. Most of the entrepreneurs who have tried to disrupt the system have either been technology people, who don't quite understand what the education business. At the risk of offering advice that may put my comfortable existence at risk, here are some suggestions:
  1. It's not just about the classes: The buzz about massive open online classes (MOOCs) has been replaced with disillusionment with their poor completion rates, since 90-95% of those who start these classes don't seem to complete them.  The problem, in my view, is that while MOOCs may deliver class room content (sometimes very effectively), they fail at providing the rest of the bundle that makes for education. If you truly want to disrupt education, you have to consider things you can add on (either technologically or with hybrid classes) to replicate the social networking, career counseling and other benefits you get in a university education.
  2. Screening does matter: The other mistake that MOOCs made was in their attempt to reach large numbers, they ignored screening as a tool. I think that the most effective challenge to the university system will come from an online education venture that is selective about who it allows into the system and then proceeds to measure how much and how well a student has learned, relative to others in the class.
  3. Exploit the weakest links: Education disruptors should use the weakest links in the university system to breach the walls. In particular, universities want to keep costs under control but don't like to or are unable to cut costs that hurt their strongest constituencies (administrators, tenured faculty) and have no compunction about cutting costs related to their weakest groups. It is not surprising to me that the biggest inroads  made by online players in the university system have been in core classes, that are taught by graduate students, adjunct faculty or reluctant tenured faculty.  
  4. Good teachers and content: If you do want to provide education in a disruptive way, you have to get the content to deliver. That requires that you find good teachers who are comfortable in an online environment and the technological support to make the online classes stand out. As a teacher, my one advice to education entrepreneurs is to recognize that what motivates a good teacher is not the money but the impact that he or she can have with an online class.
My Benedict Arnold Moment!
If you are a disruptor looking at education as your business to disrupt, I should view you as the enemy, right? Not really, and for two reasons. The first is that I am also a consumer, with one child who has finished his college education, two others in the midst of theirs and one working his way towards college, and I share in the economic pain. The second is that I am a teacher first, and I am truly appalled at how little education truly matters in the current educational system. So, as I have done for the last few years, I will do my small part to undermine the status quo and put my valuation class online, this fall, for anyone who is interested to partake in one of three venues:
  1. Online (on my website): This is the entry point on my website to the class, with webcasts for the class and material for it.
  2. Lore: This is an online site as well, with the webcasts for the class and material. You will need a code to enroll as an auditor of the class and it is PK9N3T.  
  3. iTunes U: This is an easy and relatively painless way to take the class, if you have an Apple device (iPad is great and an iPhone will suffice). If you have an Android device, you will need an app that lets you work with iTunes U and I have been told that TuneSpace works sell.
The first session will be tomorrow (September 3, 2014) and the webcasts will be posted on these sites by the end of the day, and I will continue with that practice every Monday and Wednesday until December 12, 2014, the date of the final exam.
I also know that watching 80-minute lectures online is painful, the equivalent of poking needles in your eyes, and that very few of you will have the time and the inclination to do this. If you prefer your classes in bite-size pieces, I have an entirely online version of this class (with twenty five, 15-minute lectures replacing the 80-minute ones), which you can also get in one of three places:
  1. Online (on my website): My online entry point for the class, with links to webcasts and material.
  2. iTunes U: The iTunes U version of the class.
  3. YouTube:A playlist of all 25 webcasts. The advantage of YouTube is that it is supremely flexible, you can watch it from any computer or device and it adjusts to your bandwidth.
These sessions are all ready to go. So, you can start this class and be done with all 25 sessions by tonight.
In terms of sequencing, though, the valuation class is the second in a sequence that I teach in the MBA program, with the first being a corporate finance class. I describe corporate finance as the ultimate big picture class, where everything you talk about in any business discipline has a place.  This summer, I invested some time and resources in creating an online corporate finance class, composed of thirty six sessions of roughly 15 minutes length each, which you can access in the same three places: 
  1. Online (on my website): My online page, where I have gathered together the resources for the class, including webcasts, slides and post-class tests.
  2. iTunes U: The iTunes U version of the class
  3. YouTube: A playlist of all 36 webcasts, with short descriptions of each.
These classes are also are all accessible and ready to go now.
To complete the sequence, you can also try my class on investment philosophies, where I provide my perspective on growth investing, value investing, charting and market timing. The videos in this class are not as polished, but they deliver the message:
  1. Online (on my website):  My online starting point for the class.
  2. iTunes U: The iTunes U version of the class.
  3. YouTube: A playlist of all 38 webcasts (and I apologize for the lack of polish in these videos, which I recorded in front of my computer).
In the larger scheme of things, I am sure that my actions will not change the status quo by much, but every revolution needs to start somewhere. There has to be a point where we say enough is enough, pick up our pitchforks and go after the establishment. I wish you the best!

Monday, September 1, 2014

The Tax Dance: To Pass Through or Not to Pass Through Income?

I started last month by looking at US tax law and how it induces bad corporate behavior  and in this one, I want to expand the discussion to look at how the tax structuring of a business can affect its value. In particular, I would like to look at the differences between taxable entities (public corporations, private C-Corps) and pass-through entities (MLPs, REITs and private S-Corps), both on taxes and other aspects of doing business, and the trade off that determines why companies in one group may try to move to the other. I use the framework to look at Kinder Morgan’s decision to bring its master limited partnerships under the corporate umbrella and the value effects of that decision.

The Evolution of Different Tax Entities
For most of the last century, publicly listed firms in the United States followed the corporate model, where the earnings made by a company were first taxed at the corporate level, and investors in the company were then taxed again, often at different rates depending on whether the income was paid out as dividend or allowed to accumulate in the firm to generate capital gains. In its spasmodic attempts to use the tax code to encourage the "right kind" of investments, Congressional legislation created two entities that were allowed to escape entity-level taxes: real estate investment trusts (REITs) in 1960 and master limited partnerships (MLPS) in 1987, the former obviously for investments in real estate and the latter directed towards energy investments.

Across the privately owned business spectrum, the vast majority of businesses are structured as sole proprietorships, but among private businesses that choose to incorporate (to get the benefits of limited liability), the choice is between C-Corps, which resemble publicly traded companies in tax treatment and S-Corps, which are pass-through entities. While the original rationale for these pass-through structures may have been long forgotten, a CBO report in 2012 noted an undeniable trend towards pass-through entities in the last three decades:
Source: Congressional Budget Office
Not only has the percentage of income reported by taxable corporations dropped from almost 90% in 1981 to less than 60% in 2007, but the proportion of firms organized a pass-through entities has climbed from 83% to 94%. While the CBO report stopped in 2007, there are signs that the movement towards pass-through entities has continued in the years since. In particular, not only have we seen dozens of MLPs go public in the last few years, driven by the energy boom in the United States, but we have also seen increasingly creative REIT issuances, such as the one by Windstream, a telecom company, which classified its phone lines as real estate. In the private business space, the S-Corp form, which was generally used by smaller firms, has been embraced by some larger entities as well; Bechtel is one example of a large private business structured as an S-Corp.

The Trade Off
As pass-through entities grow in popularity, we are not only faced with the question of why this shift is occurring but also pragmatic questions about how best to value or price these entities. In this section, I will start with a discussion of the tax differences that are not unexpectedly at the center of the story and then look at the rest of the story (which does muddle the trade off somewhat), with the intent of answering these questions.

The Tax Story
Not surprisingly, most of the news stories that I have read about the growth in pass-through entities emphasize the tax angle. They argue that replacing the double taxation that is inherent in a conventional corporation (C-Corp), where the entity first pays taxes and equity investors are then taxed again, with a pass-through model, where income is taxed only at the investor level only, saves taxes. That may be true, in a general sense, but the story is a little more complicated. To understand the difference, I have outlined how taxes work at taxable corporations versus a pass-through entity (S-Corp or MLP) in the figure below:

Pre and Post tax Income: The Tax Effect of Pass Through Entities
Using a company with $100 in pre-tax operating earnings, in conjunction with the top statutory tax rates on corporate income (35%), personal income (40%), dividends (20%) and capital gains (20%) today, and assuming that 40% of corporate earnings get paid out as dividends, the pass through entity delivers higher post-tax income to the investor.
Statutory tax rates and income
In particular, starting with pre-tax income of $100, the pass-through entity delivers after-tax income of $60, $8 higher than $52 you receive as an investor in the corporate entity, translating into an earnings and value premium of about 15.38%:
Earnings/Value Premium for pass-through = ($60/$52) -1 = .1538 or 15.38%
The story gets complicated when you consider two additional factors. The first is that corporations get more wiggle room that individuals do when it comes to taxes, both in terms of tax deductions/deferral and how foreign income is taxed, allowing them to lower the effective tax rate that they pay. The second is that the tax due on the capital gains portion of corporate income can be deferred by investors to future periods, since it is not collected until the stock is sold. In the example above, for instance, replacing the corporate statutory tax rate of 35% with the average effective tax rate of 27% (the weighted average tax rate across money-making US corporations in 2013) and allowing for the fact that about 25% of investors are tax exempt (thus reducing the tax rate that investors pay on dividends/capital gains to 15%), we get the result that  the collective taxes paid by a corporate entity is lower than that paid by a pass-through.
Actual taxes and Earnings
The pass through entity will trade at a discount of 3.30% on the taxable entity in this case and this example, though simplistic, illustrates the trade off between taxable and pass through entities depends on the following factors:
  1. The differential between corporate and personal taxes: The greater the the tax rate on pass-through investor income, relative to the corporate tax rate, the less incentive there should be to shift to a pass-through entity form. This may explain why more companies have shifted to the pass-through structure since 1986, when the individual tax rate was brought down to match the corporate tax rate.
  2. The proportion of earnings that gets paid out as dividends: The returns to investors from holding stock in a corporate entity can take the form of dividends or price appreciation. Until 2003, dividends were taxed at a much higher rate than capital gains, and the effective tax paid by investors on corporate income was therefore greater in high dividend paying stocks. While the tax rates have converged since, capital gains retain a tax-timing advantage, since investors don't have to pay until they sell the stock. 
  3. The make up of investors in the entity: As noted in the section above, investors in publicly traded companies can have very different tax profiles, from wealthy individuals who pay taxes on dividends/capital gains to corporations that are allowed to exempt 70-80% of their dividend income from taxes to tax-exempt investors (pension funds) that pay no taxes on any corporate income. Furthermore, the taxes paid by taxable investors on capital gains can vary depending on how long they hold the stock, with short term investors paying much higher taxes than investors who hold for longer than a year. In summary, companies with primarily wealthy, short-term, individual investors holding their shares have a greater benefit from shifting to pass-through status than companies with primarily tax-exempt or long term investors, holding their shares.
The Rest of the Story
If the only difference between pass-through entities and taxable entities were on taxes, the assessment that mattered for value would be whether you paid more or less in taxes with one form over the other. However, the laws that created the pass-through entities also created restrictions on other aspects of business behavior including where and how these businesses invest, how much they have to pay out in dividends and how they finance their operations. In the picture below, I have categorized business decisions into investing, financing and dividend pieces, to illustrate the restrictions that you face with the pass-through entities.

Investment Policy
Financing Policy
Dividend Policy
Taxable
Pass Through
Taxable
Pass Through
Taxable
Pass Through
There are generally no investment constraints.REITs and MLPs are restricted in the businesses that they can invest in, the former in real estate and the latter in energy.
S-Corps face    no explicit investment constraints.
Can claim interest tax deduction on debt, giving it tax benefits from borrowing.No direct benefit from debt.
MLPs and REITs can issue new shares, but S-Corps cannot have more than 100 shareholders.

Managers have the discretion to set dividends, reinvest earnings in projects or just hold on to cash.
REITs are required to pay out 90% of their income as dividends, on which investors have to pay the ordinary income tax rate (rather than the dividend tax rate). MLPs and
S-Corps do not have explicit dividend payout requirements but MLPs generally return large portions of cash flows to investors.

(For those of you who commented on my MLP dividend policy restrictions, I updated the dividend policy description. I hope that I have got it right now).
In summary, choosing a pass-through tax-status for your business will narrow your investment choices (to real estate if you are a REIT, and to energy, if you are an MLP), require you to return much or all of your earnings as dividends and reduce your financing options (by restricting your capacity to attract new stockholders if you are a sub-chapter S corporation and by making the tax benefits of debt indirect). 

Will these restrictions make you a less valuable business? If you are a mature business with few growth opportunities and no desire to stray from your investment focus, the costs imposed by the pass through entity are minimal. In fact, the discipline of having to pay the cash out to investors may reduce the chances of hubris-driven growth and wasteful investment. If you are a business with good growth opportunities, the restrictions can reduce your value, either because you are unable or unwilling to issue new shares to cover your investment needs, or because you cannot take direct advantage of the tax subsidies offered by debt (to traditional corporations).

The valuation of pass through entities
Most of valuation practice and theory has been built around valuing publicly traded companies. In a typical public company valuation, we generally estimate cash flows after corporate but before personal taxes and discount it back at a cost of capital that is post-corporate taxes (with a tax benefit for debt) and pre-personal taxes. While the principles of valuation don't change when you value pass-through entities, it is easy for inconsistencies to enter valuations, especially if some of the inputs (margins, betas, costs of equity) come from looking at publicly traded, taxable entities. The process enters the danger zone, when appraisers create arbitrary rules of thumb (and legal systems enforce them), and attach premiums or discounts are attached to public company values (obtained either in intrinsic valuations or from multiples/comparable). To value pass through entities consistently, I would suggest the following steps:

Step 1: Take a post-personal tax view on cash flows
Broadly speaking, you can value a passthrough entity either on a pre-tax basis or on the basis of post-tax cash flows. If you decide to do your valuation on a  pre-tax basis, you estimate the cash flows generated by the entity, whereas on a post-tax basis, you will have to net out the taxes that investors have to pay on these cash flows. The rest of the inputs into cash flows, including growth and reinvestment, then have to be tailored appropriately. This choice, though, has value consequences and I would argue that, if valuing a pass through entity, you will get a fairer estimate of value using post-personal tax numbers for two reasons:

  1. If the rationale for shifting from one tax form to another is to save on taxes, it seems incongruous to be using pre-tax numbers. After all, it is the fact that you get to have higher cash flows, after personal taxes, that causes the shift in tax status in the first place.
  2. Some practitioners use the argument that if you are consistent, it should not matter whether you look at pre-tax or post-tax numbers, but that holds only if there is no growth in perpetuity in your entity earnings. If you introduce growth into your valuation, you do start to see a benefit that shows up only in the post-tax numbers and there is an intuitive explanation for that. The expected growth rate in an intrinsic valuation model is a measure of the value appreciation in the business, i.e., the capital gains component of return. Even though the income in a pass through entity is taxed in the year in which it is earned at the personal tax rate, the increase in value of a pass through entity (MLP, Subchapter S, REIT) is not taxed until the business is sold and qualifies for capital gains taxes, thus creating the premium in the post-tax value. It is precisely to counter this tax benefit that pass through structures are required to pay almost of their earnings out as dividends. As a result, the growth in earnings in a pass through entity has to be funded either with new equity issues (whose prices will reflect the value of growth) or new debt (without the direct tax benefit from interest expenses) and that growth has much smaller or no price appreciation effect.
Step 2: Estimate a tax-consistent discount rate
This is a key step, where the discount rate has to be estimated consistently with the cash flows, with pre-tax discount rates for pre-tax cash flows, and post-personal tax discount rates for post-tax cash flows. It is at this stage that inconsistencies can enter easily, since most of the public data that we have and use in estimating discount rates comes from taxable entities (publicly traded companies) and is post-corporate, but pre-personal taxes. Consider, for instance, the estimation of the cost of equity for a publicly traded real estate development company, where we use a risk free rate, a beta (say for real estate as a business) and an equity risk premium (either historical or implied). Using a 10-year T.Bond rate of 2.5% as the risk free rate in US dollars, a beta of 0.99 for real estate development and an equity risk premium of 5.5%, the cost of equity we obtain for this company is 7.95%:
Cost of equity of publicly traded real estate development firm = 2.5% + 0.99 (5.5%) = 7.95%
Using the average debt to capital ratio of 19.94% and an after-tax cost of debt of 3.30%, we estimate a cost of capital of 7.02% for the company:
Cost of debt = 5.50% (1-.40) = 3.30%
Cost of capital = 7.95% (.8006) + 3.30% (.1994) = 7.02%
Note, though, that this is a cost of equity and capital for a public company, post-corporate taxes and pre-personal tax.

To convert these numbers into pass through discount rates, you first have to take the tax benefit of debt out of the equation. Consequently, it is safest to work with an unleveled beta/cost of equity, on the assumption that the pass through does not use or at least does not benefit from the use of debt and then bring in the effect of personal taxes. The steps involved are as follows:
1. We start with the unlevered beta of 0.85 for a real estate development company and compute a cost of equity based not that beta.
Unlevered cost of equity = 2.5% + 0.85 (5.5%) = 7.18%
2. To convert this number into a pre-tax cost of equity that you can use to discount pre-tax cash flows on a pass-through real estate development company, you will need two additional inputs. The first is the tax rate that investors in the publicly traded entity pay on corporate returns (dividends & capital gains) and the second is the tax rate that investors in the passthrough entity pay on their income. If you assume that the investor tax rate on corporate income is 15% and the investor tax rate on pass-through income is 40%, the pre-tax cost of equity for a real estate development company is 10.17%.


The after-tax cost of equity will then be 6.10%, computed as follows:
Pass through aftertax cost of equity = 10.17% (1-.4) = 6.10%
Implicitly, we are assuming that investors demand the same return after personal taxes of 6.10% on an investment in real estate development, no matter how the entity is structured for tax purposes.

At the start of every year, I estimate costs of equity for publicly traded companies, classified by sector, on my website. I have updated that table to yield pre-tax and post-personal-tax costs of equity for pass through entities in each sector, using a tax rate of 15% for investors on corporate income and 40% for investors on passthrough income, but I give you the option of changing those numbers, if you feel that they are unrealistic for the sector that you are working with.

Step 3: Build in the constraints that come with pass-through form
As a final step in the valuation, you should bring in the effects of the constraints that come with pass-through entities. One reason that I scaled the cost of equity of publicly traded companies for the tax effects, rather than the cost of capital, is because taxable companies get a direct tax benefit from borrowing money (thus lowering cost of capital) and pass through entities do not get this debt benefit.  To capture the investment constraints, coupled with and perhaps caused by the forced dividend payout requirements, you have to either assume a lower growth in income (if the company chooses not to issue or cannot issue new equity) or equity dilution in future periods.

Step 4: Do the valuation
With pretax (post tax) cash flows matched up to pretax (post tax) discount rates, you can now complete the valuation of the pass through entity with that of an equivalent corporate entity. If you are consistent about following this process, the value of a business can go up, down or remain unchanged, when it shifts from a taxable form to a pass through entity, depending in large part on the tax characteristics of the investors involved and the growth potential of the company. In particular, you will be trading off any tax savings that may accrue from the shift to a pass through status against the lost value from the investment and financing constraints that accompany a pass through structure. Thus, the notions that a S-Corp is always worth more than a C-Corp or that converting to a MLP is always beneficial to investors are both fanciful and untrue.

To illustrate this with a simple example, assume that you have a real estate development business that generated pretax operating income of $100 million last year, on invested capital of $400 million, and expects this income to grow at 2.5% a year, in perpetuity. Assume that you are considering whether to  incorporate as a taxable corporation or as a pass through entity and that you are provided the corporate and investor tax rates on both corporate and pass through earnings. In the picture below, I value the effect for a given set of inputs.


In this case, the pass through entity has a slightly higher value than the taxable form, but reducing the corporate effective tax rate to 25% tips the scale and makes the taxable entity more valuable. In fact, using the average effective tax rate of 19.34% that was paid by companies in the real estate development sector last year gives the taxable form a decided benefit. You can use the spreadsheet yourself and change the inputs, to see the effects on value.

The Kinder Morgan Conversion
With the framework from the last two sections in place, let us look at the recent news out of Kinder Morgan. The company (KMI), one of the lead players in the MLP game, with its pipelines constructed as MLPs, announced recently that it planned to consolidate three of these MLPs (KMP, KMR and EPB) into its corporate structure, thus shifting them back from pass through entities to more traditional taxable form. 

The market reaction to the consolidation has been positive for all of these stocks, but is the market right? And if yes, where is the additional value coming from? Like other MLPs, the Kinder entities were trapped in a vicious payout cycle, where investors expected them to pay out ever increasing amounts of cash, which they funded with debt, on which they get no direct tax benefit (though their investors indirectly benefit). Thus, converting back to corporate form will release them from the vice grip of dividends, partly because they will not be obligated by law to pay out their earnings in dividends and partly because their investor base will shift. That release presumably will allow them to both pursue more growth and perhaps fund it more sensibly with equity (retained earnings) and tax-subsidized debt. This value creation story rests on the company being able to find value-enhancing growth investments and on good corporate stewardship.  

There is one final aspect of the Kinder Morgan deal that suggests that the net effect of this deal will be much more negative for partnership unit holders than it is for parent company stockholders. The partnership has deferred taxes on its income that will come due on the consolidation, estimated at $12 to $18 per partnership unit, depending on the investor's tax rate and how long he or she has held the unit, which is higher than the $10.77/unit that will be paid out as a distribution on the conversion. 

Conclusion
Since the prevailing wisdom seems to be that corporations and wealthy investors evade or avoid taxes, it is not surprising that any story on conversions to or from a pass through tax status becomes one about tax avoidance. Thus, we are told by journalists and analysts that the broad shift of businesses to pass through status (MLPs) is all about saving taxes and we are also then told that Kinder Morgan's conversion back from an MLP set up to a corporate entity is also about saving taxes. This borders dangerously close to  journalistic and analyst malpractice for two reasons. The first is that both pass through and taxable entities pay taxes and the tax savings are never as large as either critics or promoters of pass through entities make them out to be. The second is that if you compare the tax structures of traditional corporations and pass through entities, it strikes me that it is the former with its multiple layers of taxes (corporate, dividend, capital gains) that is convoluted, complex, and ripe for manipulation, and not the latter. In fact, if you wanted to make one tax system your standard one, it is the pass through version that seems to offer more promise.

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