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
Pass Through
Pass Through
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.
Both REITs and MLPs 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).
S-Corps do not have explicit dividend payout requirements.

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. 

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.


Friday, August 8, 2014

Reacting to Earnings Reports: Let's get real!

In my last two posts, I considered how earnings reports can generate narrative shifts or changes, thus affecting value, and pricing effects, when companies trail or beat investors’ estimates on metrics (earnings per share, revenues, user numbers etc.). In this one, I intend to apply the lessons in those posts to three companies that I have been working with over the last couple of years: Apple, Facebook and Twitter. In particular, I would like to look at the most recent earnings report for each company, the news each report contained, the distractions in each one and the effect on stock prices. I would also like to look at the information in past earnings reports for each company, over the entire (limited) histories for Facebook and Twitter’s, and the last two years of reports for Apple, with the intent of incorporating what I have learned into updating my narrative for each company.

Apple Earnings Reports: The Meh Chronicles

I looked at Apple in detail a few months ago, chronicling my estimates of value for the company and stock price movements starting in 2011 and going through April 2014. The graph below reproduces my findings (with prices and values per share adjusted for the recent seven to one stock split), with an update through August 2014:
Apple: Price versus Value (My Estimates)
Note that while stock prices have ranged from $45 to close to $100 over this period, my value estimates have had a much tighter range, reflecting my largely unchanged story line for the company, over the period. Starting in 2011, my narrative for Apple has been that it is a mature company, with limited growth potential (revenue growth rates< 5%) and sustained profitability, albeit with downward pressure on margins, as its core businesses becomes more competitive. I allowed for only a small probability that the company would introduce another disruptive product to follow up its trifecta from the prior decade (the iPod, the iPhone and the iPad), partly because of its large market cap and partly because I thought it had used up its disruption karma over recent years. 

Looking at the earnings reports from the company over the last nine quarters, it is remarkable how little that narrative has changed. In the first two sets of columns, I report on Apple’s revenues and earnings per share and contrast the actual numbers with the consensus estimate for these numbers in each quarter. For much of the time period, Apple has matched or beaten revenue and earnings estimates, albeit by small amounts, but the market has been unimpressed, with stock prices down on six of the nine post-report days and seven of the nine post-report weeks. 
Apple: Earnings Reports from July 2012 to July 2014
Note that after controlling for the quarterly variations, revenues have been flat or have had only mild growth and operating margins have been on a mild downward trend.  With Apple, the other focus in the earnings reports has been on how iPhone and iPad sales are doing and the table below reports on the unit sales that Apple reported each quarter, with the growth rates over the same quarter’s sales in the prior year. In the last two columns, I report Apple’s global market share in the smartphone and tablet markets, by quarter. 

Apple: Unit Sales for iPhone & iPad, with global market share
While the market fixation with Apple’s iPhone and iPad sales may be disconcerting to some, it makes sense for two reasons. First, it reflects the fact that Apple derives most of its revenues from smartphones/tablets and that the growth in unit sales and change in market share therefore becomes a proxy for future revenue growth. Second, Apple’s earnings are being sustained by its impressive profit margins in the smartphone and table businesses and looking at how well it is doing in these markets becomes a stand-in for how sustainable the company’s margins (and earnings) will be in the future. Each quarter, there are rumors of another Apple disruption in the works, but each time the promises of an iWatch or an iTV don’t pan out, investor expectations that Apple will pull another rabbit out of its hat have eased. 

The most recent earnings report seems to reflect this period of stability, temporary though it may be, for Apple, where investor expectations have moderated and the company is being measured for what it really is: an extraordinarily profitable company, with the most valuable franchise in the world. It seems to have stabilized its position in the smart phone world, is seeing its tablet market shrink and its personal computer business is being treated as a rump business. In effect, analysts are treating it as a mature company that is being powered by the iPhone money machine, where margins are declining only gradually. Since that is the narrative that I have using all along in my valuations, I see little change in my assessment of intrinsic value for Apple. Allowing for the stock split, the value per share that I assess for the company, with the information in the new earnings report incorporated into my estimates, is $96.55, almost unchanged from my estimate of $96.43 in April 2014. With the new iPhone 6 launch just a few months away, I am sure that the distractions will start anew, and I think it is prudent for me as an investor to map out an exit plan, if the stock price rises to $100 or higher. If it does not, I will happily continue to hold Apple, collect my dividends, and hope for a disruption down the road.

Facebook: Bigger than Google?
I valued Facebook just before its IPO in this post, and argued that the stock was being over priced at $38 for the offering. The tepid response to the offering price made me look right, but for all the wrong reasons. The botched IPO was not because the stock was over priced or because the market attached a lower value to the stock but largely due to the hubris of Facebook’s investment bankers who seemed to not only think that the stock would sell itself but actively worked against setting a narrative for the company. My initial valuation, though it will look conservative in hindsight, was based upon the belief that Facebook would be as successful as Google in its growth in the online advertising business, while maintaining its sky-high profit margins. 

Looking at Facebook’s earnings reports since its IPO, there have been nine reports and the market reaction has shifted significantly over the period.
Facebook: Earnings Reports & Price Reaction
I think that the botched public offering colored the market response to the very first earnings report, with the stock down almost 25%. In fact, I revalued Facebook after this report, when the stock price plunged below $20, and wrote this post, arguing that there was nothing in the report that changed the narrative and that the company looked under valued to me. I was lucky enough to catch it at its low point, since the company turned the corner with the market by the next quarter and the stock price more than doubled over the following year. I revisited the valuation after the August 2013 earnings report, and chose not to change my narrative, leaving me with the conclusion that the stock was fully priced at $45 and that it was prudent to sell.  Looking at the earnings numbers over the nine quarters, it is clear that has Facebook has mastered the analyst expectations game, delivering better-than-expected numbers for both revenues and earnings per share for each of the last seven quarters. 

With Facebook, the market has also paid attention to the size and growth of its user base as well as the company’s success at growing its mobile revenues. In the table below, I list these numbers as well as Facebook’s invested capital each quarter (computed by adding the book values of debt and equity and netting out cash) and a measure of capital efficiency (sales as a proportion of invested capital):
Facebook: User Numbers, Revenue Breakdown & Invested Capital
This table captures the heart of the Facebook success story: a continued growth rate in a user base that is already immense, a dramatic surge in both online users and advertising and improving capital efficiency (note the increasing sales to capital ratio).  The most recent earnings report provided more of the same: continued user growth, increased revenues from mobile advertising and improved profitability, both relative to revenues and invested capital. Looking at the last report, I have to conclude that I was wrong about Facebook’s narrative remaining unchanged, for the following reasons: 
  1. While my initial reaction to Facebook’s success on the mobile front was that it was what it needed to do to sustain its narrative as a successful online advertising company, the rate at which it has grown in the mobile market has been staggering. In fact, I think that there is now a very real possibility that Facebook will supplant Google as the online advertising king and continue to maintain its profitability. That is a narrative shift, which will translate into a larger market share of the online advertising market, higher revenue growth and perhaps more sustainable operating margins (than I had forecast). 
  2. The inexorable growth in the user base, astonishing given how large the base already is, has also been surprising. That remains Facebook’s biggest asset and a platform that they can try to use to enter new markets and sell new products/services. Facebook has also shown a willingness to spend large amounts of money on acquiring the pieces that it needs to keep increasing its user base and build on it. The downside of this strategy is that growth has been costly (though the costs are hidden for the moment in the financials), but the upside is that is putting in place the pieces it needs to monetize its user base. While the revenue breakdown does not reflect this business expansion yet, I think that Facebook is better positioned for a narrative change now than it was a year or two ago. 
My updated valuation for Facebook reflects these adjustments. Incorporating a higher revenue target ($90 billion, rather than $60 billion) and more sustained margins (40% instead of 35%) , I estimate a value per share of $63 today. For those of you who have been taking me to task for selling at $45 in September 2013, I commend you for your foresight in holding on to the stock, but I am at peace with decision for two reasons. First, given what I knew in September 2013, I did what I had to do, given my investment philosophy, and second guessing it now is an exercise in futility. Second, if the biggest regret I have in my investing life is that I sold a stock to make a 150% return rather than holding on to it to make a 300% return, I would consider myself to be truly blessed. I may be compounding my mistake here, but at $72, I don't see it as a bargain, and I am in no hurry to buy the stock now. For those of you who are Facebook stockholders, though, this may be one of those companies where the value could chase the price for years, as the company finds way to turn the possible into the plausible and the plausible into the possible, and I wish you only positive returns.

Twitter:  The Early Returns
In the weeks leading up to the Twitter IPO, I wrestled with valuing the company. In the valuation that I did in the week before the IPO, the narrative I offered was of a company that would become a significant but not a dominant player in the online advertising business. I argued Twitter’s strength (the 140 character limit on messages) would also be its weakness, and that businesses would be loath to make Twitter their primary advertising platform. My targeted revenues in ten years were still substantial, and in conjunction with a healthy profit margin of 25%, yielded a value per share of $18, well below the offering price of $26 and even further below the opening day price of $46. 

In the months since, Twitter has had three earnings reports, and the accounting results are summarized below, with analyst expectations and the stock price reaction to each report. 
Twitter: Earnings Reports and Price Reactions
Twitter’s first two earnings reports were received badly by the market, though the company beat revenue forecasts on both, partly because the company continues to lose money. The most recent earnings report received a rapturous response immediately after it came out, though some of the rapture seems to have eased in the days after.  Even more so than Facebook, the market has focused on secondary numbers at Twitter, with particular attention being paid to the growth in the user base. In the table below, I list these other numbers: 
Twitter: The Other Numbers
The negative reaction to the second earnings report was partly due to the low growth (relative to expectations) that Twitter reported in the number of users and the positive reaction to the last report seems to be traceable to Twitter beating analyst expectations for user growth in the most recent quarter.  Looking at both the accounting and user numbers, what is striking about Twitter is how little the company has changed over the period that it has been in the market. The proportion of revenues it receives from advertising has remained around 90%, its revenues from international sales have increased only marginally and its mobile advertising has stayed at a high percentage of revenues (which is not surprising given that its compact format travels well to mobile devices). Its use of invested capital has not become more efficient and while you may argue that this is early in the game, contrast Twitter's evolution with Facebook's over the first few quarters.

There is nothing that I see (and I may be missing some key component) in these reports that would lead me to reassess my initial narrative, i.e., that Twitter will be a successful, but not dominant online advertising company, and the last earnings report only reinforced that view. There was some good news in the report, especially on the revenue front, but there was some game playing that was needless, in my view. First, as this article points out, the user numbers includes those who are not Twitter users in the conventional sense but are exposed to tweets in the context of news stories. Since these indirect users will not get to see (and therefor click on) the sponsored tweets that are the company’s advertising mainstay, I think that including them with total users is a little misleading, though the company may not have intended to be deceptive. Second, and this is not a problem specific to only Twitter, is the claim that the company actually made money, if you do not count stock-based compensation as an expense. As I argued in this post, this is nonsense, but I blame the analysts and investors who buy into this fiction just as much as I do the companies that feed them the fiction. In fact, as I listened in on the Twitter earnings call, I was left with the uneasy feeling that this was an earnings report produced for equity research analysts, by an equity research analyst, in terms of the numbers it emphasized. It may be pure coincidence that Twitter acquired a new CFO between its last report and this one, and that in addition to being a banker who led their public offering, he was an equity research analyst in a prior incarnation, but I don't think so. 

Incorporating everything that I have learned from these reports into my valuation, I see little movement in my intrinsic value. Even allowing for a much more efficient use of capital in the future, my estimate of value per share is $22.53. It is still early in Twitter’s corporate life and like Facebook, and I did see this news story about Twitter perhaps entering the online retailing world, and while it may be just as much a sign of desperation as hope, it is true that young company narratives can change quickly. There is a lot more about Twitter (and its business model) that I do not know than I do, and I would like to see Twitter come through on their promise of better metrics of user engagement with their business model. 
  • I am curious about how many users actually click on the sponsored tweets. I don't like to extrapolate from personal experience but I not only have never clicked on one (or even been tempted to do so) but I find myself irritated to see tweets in my timeline from businesses trying to sell me their products and services. For Twitter's sake, I hope that I am an outlier.  
  • I am also curious about how much it is costing Twitter to get new business (how much does it cost to add an advertiser) and what their pricing system for ads is. After all, surging revenues don't have much value, if your costs to deliver those revenues surge even more.
As someone who uses Twitter a lot more than Facebook, I would like to see the company succeed, but as an investor, I remain a skeptic.

The Bottom Line 
I could go on with other companies but I think I will outlive my welcome. With just these three companies, I hope that I have been able to bring home two salient points about earnings reports. The first is that while it is always the most recent earnings report that people tend to focus on, there is value in looking at a time series of reports, since there are patterns that may emerge from that series. The second is that the patterns you observe should feed back into your narrative and valuations, reinforcing your existing views in some cases, changing them in small ways in other cases and shifting them dramatically in still others. The earnings report trail is leading me to different destinations: with Apple, to an exit point, with Facebook, to a shifting of perception on what the company is worth (though not to the point of being a buyer at its current price) and with Twitter, to no real change in my perception that while the company has promise but is over priced.