January 2019 Data Update 6: Profitability and Value Creation!

In my last post, I looked at hurdle rates for companies, across industries and across regions, and argued that these hurdle rates represent benchmarks that companies have to beat, to create value. That said, many companies measure success using lower thresholds, with some arguing that making money (having positive profits) is good enough and others positing that being more profitable than competitors in the same business makes you a good company. In this post, I will look at all three measures of success, starting with the minimal (making money), moving on to relative judgments (and how best to compare profitability across companies of different scales) and ending with the most rigorous one of whether the profits are sufficient to create value.

Measuring Financial Success

You may start a business with the intent of meeting a customer need or a societal shortfall but your financial success will ultimately determine your longevity. Put bluntly, a socially responsible company with an incredible product may reap good press and have case studies written about it, but if it cannot establish a pathway to profitability, it will not survive. But how do you measure financial success? In this portion of the post, I will start with the simplest measure of financial viability, which is whether the company is making money, usually from an accounting perspective, then move the goal posts to see if the company is more or less profitable than its competitors, and end with the toughest test, which is whether it is generating enough profits on the capital invested in it, to be a value creator.

Profit Measures

Before I present multiple measures of profitability, it is useful to step back and think about how profits should be measured. I will use the financial balance sheet construct that I used in my last post to explain how you can choose the measure of profitability that is right for your analysis:

Just as hurdle rates can vary, depending on whether you take the perspective of equity investors (cost of equity) or the entire business (cost of capital), the profit measures that you use will also be different, depending on perspective. If looked at through the eyes of equity investors, profits should be measured after all other claim holders (like debt) and have been paid their dues (interest expenses), whereas using the perspective of the entire firm, profits should be estimated prior to debt payments. In the table below, I have highlighted the various measures of profits and cash flows, depending on claim holder perspective:

The key, no matter which claim holder perspective you adopt, is to stay internally consistent. Thus, you can discount cash flows to equity (firm) at the cost of equity (capital) or compare the return on equity (capital) to the cost of equity (capital), but you cannot mix and match.

The Minimal Test: Making money?

The lowest threshold for success in business is to generate positive profits, perhaps the reason why accountants create measures like breakeven, to determine when that will happen. In my post on measuring risk, I looked at the percentages of firms that meet this threshold on net income (for equity claim holders), an operating income (for all claim holders) and EBITDA (a very rough measure of operating cash flow for all claim holders). Using that statistic for the income over the last twelve month, a significant percentage of publicly traded firms are profitable:

Data, by country

The push back, even on this simplistic measure, is that just as one swallow does not a summer make, one year of profitability is not a measure of continuing profitability. Thus, you could expand this measure to not just look at average income over a longer period (say 5 to 10 years) and even add criteria to measure sustained profitability (number of consecutive profitable years). No matter which approach you use, you still will have two problems. The first is that because this measure is either on (profitable) or off (money losing), it cannot be used to rank or grade firms, once they have become profitable. The other is that making money is only the first step towards establishing viability, since the capital invested in the firm could have been invested elsewhere and made more money. It is absurd to argue that a company with $10 billion in capital invested in it is successful if it generates $100 in profits, since that capital invested even in treasury bills could have generated vastly more money.

The Relative Test: Scaled Profitability

Once a company starts making money, it is obvious that higher profits are better than  lower ones, but unless these profits are scaled to the size of the firm, comparing dollar profits will bias you towards larger firms. The simplest scaling measure is revenues, a data item available for all but financial service firms, and one that is least likely to be affected by accounting choices, and profits scaled to revenues yields profit margins. In a data update post from a year ago, I provided a picture of different margin measures and why they might provide different information about business profitability:

As I noted in my section on claimholders above, you would use net margins to measure profitability to equity investors and operating margins (before or after taxes) to measure profitability to the entire firm. Gross and EBITDA margins are intermediate stops that can be used to assess other aspects of profitability, with gross margins measuring profitability after production costs (but before selling and G&A costs) and EBITDA margins providing a crude measure of operating cash flows.

In the graph below, I look at the distribution of pre-tax operating margins and net margins globally, and provide regional medians for the margin measures:

The regional comparisons of margins are difficult to analyze because they reflect the fact that different industries dominate different regions, and margins vary across industries. You can get the different margin measures broken down by industry, in January 2019, for US firms by clicking here. You can download the regional averages using the links at the end of this post.

The Value Test: Beating the Hurdle Rate

As a business, making money is easier than creating value, since to create value, you have to not just make money, but more money than you could have if you had invested your capital elsewhere. This innocuous statement lies at the heart of value, and it is in fleshing out the details that we run into practical problems on the three components that go into it:

1. Profits: The profit measures we have for companies reflect their past, not the future, and even the past measures vary over time, and for different proxies for profitability. You could look at net income in the most recent twelve months or average net income over the last ten years, and you  could do the same with operating income. Since value is driven by expectations of future profits, it remains an open question whether any of these past measures are good predictors.
2. Invested Capital: You would think that a company would keep a running tab of all the money that is invested in its projects/assets, and in a sense, that is what the book value is supposed to do. However, since this capital gets invested over time, the question of how to adjust capital invested for inflation has remained a thorny one. If you add to that the reality that the invested capital will change as companies take restructuring charges or buy back stock, and that not all capital expenses finds their way on to the balance sheet, the book value of capital may no longer be a good measure of capital invested in existing investments.
3. Opportunity Cost: Since I spent my last post entirely on this question, I will not belabor the estimation challenges that you face in estimating a hurdle rate for a company that is reflective of the risk of its investments.

In a perfect world, you would scale your expected cashflows in future years, adjusted for time value of money, to the correct amount of capital invested in the business and compare it to a hurdle rate that reflects both your claim holder choice (equity or the business) but also the risk of the business. In fact, that is exactly what you are trying to do in a good intrinsic or DCF valuation. 

Since it is impossible to do this for 42000 plus companies, on a company-by-company basis, I used blunt instrument measures of each component, measuring profits with last year's operating income after taxes, using book value of capital (book value of debt + book value of equity - cash) as invested capital:

Similarly, to estimate cost of capital, I used short cuts I would not use, if I were called up to analyze a single company: 

Comparing the return on capital to the cost of capital allows me to estimate excess returns for each of my firms, as the difference between the return on invested capital and the cost of capital. The distribution of this excess return measure globally is in the graph below:

I am aware of the limitations of this comparison. First, I am using the trailing twelve month operating income as profits, and it is possible that some of the firms that measure up well and badly just had a really good (bad) year. It is also biased against young and growing firms, where future income will be much higher than the trailing 12-month value. Second, operating income is an accounting measure, and are affected not just by accounting choices, but are also affected by the accounting mis-categorization of lease and R&D expenses. Third, using book value of capital as a proxy for invested capital can be undercut by not only whether accounting capitalizes expenses correctly but also by well motivated attempts by accountants to write off past mistakes (which create charges that lower invested capital and make return on capital look better than it should). In fact, the litany of corrections that have to be made to return on capital to make it usable and listed in this long and very boring paper of mine. Notwithstanding these critiques, the numbers in this graph tell a depressing story, and one that investors should keep in mind, before they fall for the siren song of growth and still more growth that so many corporate management teams sing. Globally, approximately 60% of all firms globally earn less than their cost of capital, about 12% earn roughly their cost of capital and only 28% earn more than their cost of capital. There is no region of the world that is immune from this problem, with value destroyers outnumbering value creators in every region.

Implications

From a corporate finance perspective, there are lessons to be learned from the cross section of excess returns, and here are two immediate ones:

1. Growth is a mixed blessing: In 60% of companies, it looks like it destroys value, does not add to it. While that proportion may be inflated by the presence of bad years or companies that are early in the life cycle, I am sure that the proportion of companies where value is being destroyed, when new investments are made, is higher than those where value is created.
2. Value destruction is more the rule than the exception: There are lots of bad companies, if bad is defined as not making your hurdle rate. In some companies, it can be attributed to bad managed that is entrenched and set in its ways. In others, it is because the businesses these companies are in have become bad business, where no matter what management tries, it will be impossible to eke out excess returns.

You can see the variations in excess returns across industries, for US companies, by clicking on this link, but there are clearly lots of bad businesses to be in. The same data is available for other regions in the datasets that are linked at the end of this post.

If there is a consolation prize for investors in this graph, it is that the returns you make on your investment in a company are driven by a different dynamic. If stocks are value driven, the stock price for a company will reflect its investment choices, and companies that invest their money badly will be priced lower than companies that invest their money well. The returns you will make on these companies, though, will depend upon whether the excess returns that they deliver in the future are greater or lower than expectations. Thus, a company that earns a return on capital of 5%, much lower than its cost of capital of 10%, which is priced to continue earning the same return will see if its stock price increase, if it can improve its return on capital to 7%, still lower than the cost of capital, but higher than expected. By the same token, a company that earns a return on capital of 25%, well above its cost of capital of 10%, and priced on the assumption that it can continue on its value generating path, will see its stock price drop, if the returns it generates on capital drop to 20%, well above the cost of capital, but still below expectations. That may explain a graph like the following, where researchers found that investing in bad (unexcellent) companies generated far better returns than investing in good (excellent) companies:

Original Paper: Excellence Revisited, by Michelle Klayman

The paper is dated, but its results are not, and they have been reproduced using other categorizations for good and bad firms. Thus, investing in the most admired firms generates worse returns for investors than investing in the least admired and investing in popular (with investors) firms under performs investing in unpopular ones. While these results may seem perverse, at first sight, that bad (good) companies can be good (bad) investments, it makes sense, once you factor in the expectations game. 

Finally, on the corporate governance front, I feel that we have lost our way. Corporate governance laws and measures have focused on check boxes on director independence and corporate rules, rather than furthering the end game of better managed companies. From my perspective, corporate governance should give stockholders a chance to change the way companies are run, and if corporate governance works well, you should see more management turnover at companies that don't earn what they need to on capital. The fact that six in ten companies across the globe earned well below their cost of capital in 2018, added to the reality that many of these companies have not only been under performing for years, but are still run by the same management, makes me wonder whether the push towards better corporate governance is more talk than action.

YouTube Video


Data Links

1. Profit Margins: US, Global, Emerging Markets, Europe, Japan, India, China, Aus & Canada
2. Excess Returns to Equity and Capital: US, Global, Emerging Markets, Europe, Japan, India, China, Aus & Canada

Papers

1. Return on Capital, Return on Invested Capital and Return on Equity: Measurement and Implications (Warning: It is long and boring!) 

Related Posts

1. Explaining a Paradox: Why good companies can be bad investments and vice versa

January 2019 Data Updates

1. Data Update 1: A Reminder that equities are risky, in case you forgot!
2. Data Update 2: The Message from Bond Markets
3. Data Update 3: Playing the Numbers Game
4. Data Update 4: The Many Faces of Risk
5. Data Update 5: Of Hurdle Rates and Funding Costs!
6. Data Update 6: Profitability and Value Creation!
7. Data Update 7: Debt, neither poison nor nectar!
8. Data Update 8: Dividends and Buybacks - Fact and Fiction!
9. Data Update 9: Playing the Pricing Game!

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Family Feuds: The Promise and Peril of Family Group Companies!

I teach a corporate finance class, a class that I describe as big-picture (since it covers every aspect of business), applied and universal in its focus. I use six firms, ranging the spectrum from large to small, developed (Disney & Deutsche Bank) to emerging (Vale & Baidu) and public to private (a privately owned bookstore in New York), as lab experiments to illustrate both corporate finance first principles and financial models/theory. One of my illustrative companies is Tata Motors, an India-based auto company, to illustrate the special challenges associated with managing and investing family group companies, where the conflict between what’s good for the family group and for the company can play out in every aspect of corporate finance. I picked a Tata group company for a simple reason; among Indian family groups, it is among the most highly regarded, and my intent was to show that even in the best run family group companies the potential for conflict lies just under the surface and events over the last few weeks has added weight to that argument.

The Tata Group, the Enlightened Family Group?

It is not hyperbole to say that the Tata family and Indian business have been intertwined for much of the last two centuries. The first Tata company came into being in 1868 and it was built up incrementally and often through difficult times to become the behemoth that it is today. Along the way, it spread itself across many businesses, creating what would have been a classic conglomerate, if it had stayed as one company. In typical family group style, though, it chose to pursue each business with a separate entity and by 2016, the group included more than 100 companies, with 29 of these being publicly traded, stand-alone entities. The picture below captures the company's holdings and control structure in 2016:

Note how the companies are all bound together by Tata Sons, which, in turn, is controlled by the Tata trusts, holding close to 66%, with power lying with the Tata family. As a side note, the largest non-Tata stockholder is the Shapoorji Pallonji Group, which control 18.4% of Tata Sons. While each publicly traded company in the group is an independent entity, with a CEO and a board of directors (with a fiduciary responsibility to protect the shareholders of that company), the independence is illusory. Not only does Tata Sons own a significant piece of each company, the companies all own shares in each other (cross holdings effectively controlled by the family group) and directors representing family group interests serve on each board. Note that though much is made of the conglomerate nature of the Tata Group, the group derives the bulk of its value (>70%) from TCS, a technology company that derives most of its revenues from outside India. It is a testimonial to the stability and continuity in the Tata Group that it has had only six men at its helm over its 150-year history:

Chairman	Tenure	Highlights
Jamsetji Tata	1868-1904	Founded the Tata Group as a trading company in 1868.
Dorab Tata	1904-1932	Instrumental in creating the Tata Trust, the family philanthropy
Nowroji Saklatvala	1932-1938	Related to the Tatas and started profit-sharing scheme.
JRD Tata	1939-1991	Legendary and longest-serving CEO and a pioneer in civil aviation.
Ratan Tata	1991-2012	Presided over global expansion of the group, acquiring global companies to do so.
Cyrus Mistry	2012-2016	Related to Tatas and son of one of the Tata group's largest stockholders.

JRD Tata who presided over the company for a large portion of the last century was legendary, not just for his business acumen but his social consciousness and was viewed as India’s most upstanding corporate citizen. In fact, Cyrus Mistry who became chairman of Tata Sons in 2012, was more insider than outsider, backed by Shapoorji Pallonji Group, as a scion of the family (behind that group) and also related by marriage to the Tata family. 

This history of stability is perhaps why investors and onlookers were shocked by the events of the last few weeks. On October 24, 2016, the board of directors of Tata Sons fired Cyrus Mistry as the Chairman of Tata Sons for non-performance, a failure to deliver on promises. Mr. Mistry did not go quietly into the night and fought back, arguing that not only was the removal not in keeping with Tata traditions of decorum and fairness, but that his removal was effectively a coup by old-time Tata hands who were threatened by his attempt to clean up mistakes made by the prior regime (headed by Ratan Tata). In particular, he argued that many of the high-profile acquisitions/investments that Mr. Tata had made, including those of Corus Steel (by Tata Steel) and forays into the airline business (Vistara and AirAsia) were weighing the company down and that it was his attempts to extract Tata companies from these messes that had provoked the backlash. Defenders of the removal argued that Mr. Mistry had been removed for just cause and that his numbers-driven (and presumably short-term) decisions were not in keeping with the Tata culture of building businesses for the long term.

The opacity that surrounds the Tata companies with their incestuous corporate governance structures (with directors sitting on multiple Tata companies) and complex holding structures makes it difficult to decipher the truth, but the two sides seems to be in surprising agreement on one point, that the bulk of the value of the Tata Group derives from two investments, TCS and Jaguar Land Rover. In fact, the area of disagreement is about why the rest of the group was in in trouble and what should have been done about them. The Mistry camp argues that the troubles at the rest of the group can be traced back to ill-advised and expensive acquisitions (Corus, Tetley) and investments (Nano) made during the Tata tenure and the Tata camp suggests that Mr. Mistry knew about those problems when he was hired and that he did little to fix them during the  four years of his tenure. Whatever the truth, the company has a mess on its hands. While Mr. Mistry has been forced out at Tata Sons, he remains on the boards of the other publicly-traded Tata companies and was chairman of the board at TCS until a couple of days ago. That sets the stage for a war of attrition, which cannot be good news for any Tata company stockholder or for either side in this dispute, since they both have substantial stakes in the group.

The more general question raised by this episode is a troubling one. If a corporate governance dispute of this magnitude can occur at a family group that many (at least on the outside) viewed as one of the least conflicted in India, and you and I, as stockholders in Tata companies, can do nothing but watch helplessly from the outside, what shred of hope can we have of being protected at other family groups that are much more open about putting their interests over that of stockholders? I remember being asked after I had completed a valuation of Tata Motors a few years ago whether I would buy its stock and shocking my audience by saying that I would never buy a Tata company for my portfolio. When pushed for my rationale, I said that buying a family group company is like getting married and having your entire set of in-laws move into the bedroom with you; in investment terms, if I invest in Tata Motors, I will (unwillingly) also be investing in many other Tata Group companies, because about 30-40% of the value of Tata Motors comes from its holdings in other Tata companies.

The 4Cs of Family Businesses: The Trade off

As an investor, I may not be inclined to invest in a family group company but it is undeniable that in much of Asia and Latin America, family group companies not only dominate the business landscape but have played a key role in economic development in the countries in which they operate. Consequently, there must be advantages they bring to the game that explain their growth and continued existence and here are a few:

1. Connections: In many countries, including populous ones like India, influence is wielded and decisions are made by a surprisingly small group of people who know each other not just through their business networks but also through their social and family connections. These “people of influence” include bankers, rule makers and regulators that determine which businesses get capital, what rules get written (and who gets the exceptions) and the regulations that govern them. Family group companies have historically used these connections as a competitive advantage against upstart competition (both from within and without the country), especially in an environment where you have to pass through a legal, bureaucratic and political thicket to start and run a business. 
2. Capital: Extended family group companies create internal capital markets, where profitable and mature companies in the group can invest their excess cash in growth companies within the same group that need the capital to grow. This works to their advantage, especially when external capital markets (stock and bond) are illiquid and poorly developed and in countries that are susceptible to shocks (political or economic) that can cause markets to shut down.
3. Control (Good): I have always taken issue with analysts who blithely add control premiums to the estimated values of target companies in acquisitions, not because I don’t think control has value but because I believe that to value control, you have to be specific about what you would change in the acquired company. Control is absolute in family group companies, sometimes because the families own controlling stakes in each of the companies in the group and sometimes because they have skewed the rules of the game in their favor (through opaque holding structures and shares with disproportional voting rights). In the benign version of this story, family groups use this control to make decisions that are good for the long term value of the company but that may be viewed negatively by “short term” investors in markets. Not having to pay attention to what equity research analysts write about their companies or look over their shoulders for hostile acquirers and activist investors may give family group companies advantages over their competitors who may be more vulnerable to these pressures.
4. Culture (Good): A successful business is usually driven not just by quantitative objectives but also by a corporate culture that is unique and binds those who work at that business. In a non-family group company, that culture may come from the ethos of the top management of the company but is more susceptible to change than at a family-group company, where the family culture not only is much more pervasive but more long term. To the extent that the culture that is embedded is a good one, that can be a benefit to the company both in terms of retaining employees and customer trust.

The research on family group companies is still in its nascency but the studies that I have seen seem to find strengths in these businesses, relative to conventional companies. That said, each of these advantages can very quickly be flipped to become disadvantages and here is that list:

1. Connections -> Cronyism: I have no moral objections to building connections-based businesses, but if your primary competitive advantage becomes the connections that you possess, it is possible that you will rest on that advantage and not work on developing other core competencies. That will put you at a disadvantage when you go into foreign markets, where you don't have the connections advantage or when global competitors enter domestic markets. It is also true that as the connections shift from family and social ones to the political arena you are on more dangerous ground, since a change of regime (democratic or otherwise) can be devastating to your  business interests.
2. Internal Capital -> Cross-subsidization and Cross-holdings: While there are advantages to letting the cash surplus companies in a family group fund those with cash deficits (and growth potential), there are two potential costs. The first is that without the discipline of an external lender or equity market, investments in companies may not meet bare minimum corporate finance criteria, with intracompany loans made at below-market rates and intracompany equity investments generating returns on capital that are less than the cost of capital. That cross subsidization not only transfers wealth from your best companies to your worst but can collectively make the group worse off. The other is that these investments and how they are recorded in accounting statements make them more complex and difficult for investors to understand. Valuing a company with twenty cross holdings effectively requires you to value twenty one companies.
3. Control (Good) -> Control (Bad): If the complete control that families have over family groups gives them the capacity to make long term decisions that are good for the company, in the face of market disapproval, that same complete control also can lock in the status quo, with inertia determining much of how it makes investment, financing and dividend decisions. Put differently, if a family is mismanaging a business, it can be very difficult to get it to change its ways.
4. Culture (Good) -> Culture (Bad): The culture of the family can pervade the family group, but that culture can sometimes become an excuse for not acting or even acting badly for two reasons. First, a family culture can go from benign to malignant, more Gambino than Von Trapp, and having that culture pervade an organization can be deadly. Second, the implicit assumption that family members share a common culture may be an artifact of times gone by, as families splinter and go their own ways. In fact, it is not uncommon to see two siblings or even a parent and a child with very different perspectives on corporate culture battle for the future a family group.

As you weigh the pluses and minuses of family groups, you can see why they developed as the dominant business form in Asia and Latin America over the last century. Many of the countries where family groups dominate have historically had rule and license driven economies with under developed capital markets (illiquid stock markets and state-controlled bankers). Protected in their domestic markets, family group companies have not only been able to grow but keep upstart competitors constrained. As these markets are exposed to globalization, though, and capital markets open up in these countries, the family group's advantages are declining but they are still entrenched in  many businesses.

Back to the Tata Group

If forced to invest in a family group company, I would take a Tata company over many other family group companies. The problem that I see in this latest tussle is less one of venality and more of a failure to adjust to the times and a clash of egos. Ratan Tata's global ambitions, manifested in a spate of acquisitions during his tenure, put the group into businesses and markets where their historical advantages no longer provide an edge. It is ironic that the two most successful pieces of the Tata group are Tata Consultancy Services, the company that is at odds with much of the rest of the Tata group in terms of focus and characteristics, and Jaguar Land Rover, a global luxury auto maker with a brand name that has little to do with the Tata family. I am sure that there is no shortage of advice being offered to the group at this time, but these would be my suggestions on what the group needs to do now.

1. Settle (soon): The dispute between Cyrus Mistry and Ratan Tata has to be settled and soon. Nothing good can come from continuing to fight this out in public and both sides have too much to lose.
2. This is personal: It seems to me that the fight has become a personal one, with managers and directors taking sides (voluntarily or otherwise) between Ratan Tata and Cyrus Mistry. That tells me that any rational solution will be tough to reach, unless both personalities withdraw from the fray. It seems to me that, for this crisis to abate, Ratan Tata has to step down as chairman and let a third party that both sides find acceptable step in, at least for the interim
3. Separate the public companies from the private: If this episode shows the danger of tying together all of the Tata companies to Tata Sons and the family group, the first step in untangling them is to separate the 29 public companies from the private companies in the group. The dangers of self dealing and conflicts of interest are greatest when the private businesses interact with the public companies.
4. Unit Independence: The next step in this process is to make each public company truly independent and that will require (a) selling cross holdings in other Tata companies and (b) removing family group directors who serve on the boards of the stand alone companies.
5. Restrict intra group activities: It would be impractical and perhaps even imprudent to bar Tata companies from interacting with each other, but those interactions should follow first principles in finance. Hence, while intra-group loans may sometimes make sense, the interest rates on these loans should reflect the risk of the borrowing entity and intra-group equity investments should be value adding, i.e., earn a return on capital that exceeds the cost.
6. Transparency: Disentangling cross holdings and restricting nitric will be a big step towards making the financial statements of the Tata companies more informative.

Some of these changes can (and should) happen soon, but some may take a while to unfold but they have to be set in motion, with the recognition that the end game may be that some Tata companies, some with storied histories, may have to shrink or even disappear and that others will be elevated.

Lessons for India Inc.

For most of the last two decades, the lament in India is that China has beaten it handily in the global growth game. While it would be unfair to blame this on family group businesses, it is worth noting that the one sector where India seems to have move forward the most is technology and where it has fallen behind the most in in infrastructure and manufacturing. It may be coincidence that technology is the sector where, TCS notwithstanding, you have seen the most entrepreneurial activity and that traditional manufacturing is dominated by family group businesses. As India moves towards being a global player, opening up hitherto unopened sectors (like retail and financial services) to global players, the family group structures in these sectors may operate as handicaps.  While I don’t believe that it is the government’s place to insert itself within family groups, it should stop tilting the playing field in their favor by doing the following:

1. Reduce the need for connections to do business: At the core of connection-driven business success is the existence of licenses and bureaucratic rules governing businesses. Reducing the licensing needs and the rules that govern how you run businesses will create a fairer business environment, though that may sometimes require governments to accept the result that a foreign company will win at the expense of a domestic competition
2. Government-based or influenced investors (LIC) should be more activist: The largest stockholder in the Tata Group is the Life Insurance Corporation (LIC), a state-owned company, that has holdings in almost every large Indian company. For decades, LIC has chosen to back incumbent managers against activist investors and has allowed the woeful corporate governance at many family group companies to continue without a push back. 
3. Banking/Family Group Nexus: Bankers, many government picked and influenced, have historically had cozy relationships with family group companies, lending money on projects with little oversight and often with implicit backing from the family group (rather than the company that is getting the loan). Those relationships not only give family group companies an advantage but are bad for banking health and need to be examined.

Conclusion

The turmoil at the Tata Group has all the makings of a soap opera and can be great entertainment if you are an armchair observer with no money in Tata company shares. It would be a mistake, though, to view this as an aberration because the palace intrigue and the infighting that you observe can not only happen in other family groups but take an even darker tone. To the extent that family group companies pushed their companies into public markets because they wanted to raise fresh capital and monetize their ownership stakes, they have to play by the rules of  the game

YouTube Video


Links

1. My Corporate Finance Class (Spring 2016)

References

1. Unfinished Business (India Today)
2. Cyrus Mistry vs Ratan Tata: FIIs worried (The Economic Times of India)
3. Turmoil and Tatas (The Economist)

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Tesla: It's a story stock, but what's the story?

The last few weeks have tested Tesla’s shareholders and frustrated short sellers in the stock. Shareholders have had to weather a series of bad news stories, ranging from a failure to meet its shipment targets in the last few months to a fatality with a driver using its autopilot function to a surprise acquisition of Solar City. While each of those stories has created pressure on the stock, the price has held up surprisingly well, frustrating long-time short sellers who have been waiting for a correction in what they see as an overhyped stock.

Tesla Stock Price: Google Finance

So, what gives here? Why has Tesla’s stock price not collapsed facing this adversity? I think that Tesla's price action illustrates the power of the “big story” and the sometimes difficult-to-understand market dynamics of story stocks.

Story Stocks

In earlier posts, I have made a case for valuation being a bridge between story and numbers, with every number telling a story and every story being captured in a number. Thus, while your final valuation may be composed of forecasts of revenue growth, profit margins and reinvestment, it is the story that binds together these numbers that represent the soul of the valuation.

That said, the balance between stories and numbers can vary across companies and for the same company, can change across time. For most companies, it is the story that comes first, with numbers following, and for others, it is the numbers that tell the story. 

There are some companies that I would classify as story stocks, where the story is so dominant in both how people price the stock and what determines its value that the numbers either fade into the background or have only a secondary effect. There are three characteristics that story stocks share:

Amazon remains one of my longest-standing examples of a story stock, a company, with a CEO (Jeff Bezos) who was and continues to be clear about his ambitions to conquer big markets, told that story well and acted consistently with it. You can see why Tesla also has the makings of a story stock, going after a big market (automobiles and perhaps even clean energy), with an unconventional strategy for that market and a larger-than-life CEO in Elon Musk. With story stocks, it is the story that dominates how the market perceives the stock, and that has consequences:

1. Story changes and information: it is shifts in the story that cause price and value changes. An earnings report that beats expectations (in either direction) or a news story of significance (good or bad) may not have any effect on either (value or price) if it does not change the story. Conversely, a shift in perceptions about the business story, triggered by minor news or even no news at all, can trigger major price changes. 
2. Wider disagreements: When a company’s value is driven primarily by numbers, there is less room for disagreement among investors. Thus, when valuing a company in a market with steady revenue growth and sustainable profit margins, there will be less divergence in what investors think the stock is worth. In contrast, with a story stock, investor stories can span a much wider spectrum, leading to a much bigger range in values, as illustrated with Uber in this post. 

The key to understanding story stocks is deciphering the story behind the company, then checking that story for reasonability and making it your own.

The Tesla Story

So, what is Tesla’s story? To structure the process, let me lay out the dimensions where investors can differ on the story and how these differences play out valuation. The first is Tesla's business, i.e., whether you see Tesla primarily as an automobile company that incorporates technology into its cars, a technology company that uses automobiles to deliver superior electronics (battery and software) or even a clean energy company with its focus on electric cars. The second is focus,  i.e., whether you believe that Tesla will cater more to the high end of whichever business you see it in or have mass market appeal. The third is the competitive edge that you see it bringing to the market, with the choices ranging from being first to the market, superior styling & brand name and superior (proprietary) technology. The fourth is the investment intensity needed to deliver your expected growth, with much higher reinvestment needed if you consider Tesla a conventional manufacturing company (like autos) than if you see it as a tech company. Finally, there is the risk in the company, with the auto story bringing with it the risks of cyclicality and high fixed costs and the tech story the risks of being rendered obsolete by new technologies and shorter life cycles.

The value that you attach to Tesla will be very different if you consider it to be an automobile company, catering to a high-end clientele than if you view it as an electronics company with a superior technology (in electric batteries) and a mass market audience.

My thinking on Tesla has changed over time. In my first valuation of the company in September 2013, I valued it as a high-end automobile company, which would use its competitive edges in branding and technology to generate high margins, with investment and risk characteristics more reflective of being an auto than a tech company. The resulting inputs into my valuation and valuation are summarized below:

Download spreadsheet

The value that I obtained for Tesla’s equity was $12.15 billion (with a value per share of $70) well below the market capitalization of $28 billion (and a stock price of $168.76) at the time.

In July 2015 I took another look at Tesla, keeping in mind the developments since September 2013. The company had not only sent signals that it was moving towards offering vehicles with lower price tags (expanding towards the mass market) but also made waves with its plans for a $5 billion gigafactory to manufacture batteries. The focus on batteries suggested to me that I had understated the role that technology played in Tesla’s appeal and I incorporated it more strongly into my story. Tesla remained an automobile company, but with a much stronger technology component and wider market aspirations, which in turn led the following inputs into value:

Download spreadsheet

The value of equity based on these inputs was 19.5 billion (share price of $123), much higher than my September 2013 estimate, but still below the value of $33 billion (share price of $220) at the time.

I took my third shot at valuing Tesla about two weeks ago,  just prior to its Solar City acquisition announcement, and I incorporated the news since my last valuation. The announcement of the Tesla 3 clearly reinforced my story line that it was moving towards being more of a mass market company. The unprecedented demand for the car, with close to 400,000 people putting down deposits for a vehicle that will not be delivered until 2018, indicates the hold that it has on its customer base. I have tweaked the inputs to reflect these changes:

Download spreadsheet

The value of equity that I obtained was $25.8 billion (with a share price of $151/share), climbing from my July 2015 valuation but the market capitalization stayed at $33 billion. Before I embark on looking at how the Solar City acquisition and Musk's master plan have on the narrative, it is worth looking at how the value changes as a function of revenues, reinvestment and profit margin:

Download spreadsheet

Note that there are pathways that lead to the value at or above the current stock price but they all require navigating a narrow path of building up sales, earning healthy profit margins and reinvesting more like a technology company than an automobile company.

So, what effect does acquiring Solar City have on the story? If nothing else, it muddies up the waters substantially, a dangerous development for a story stock and that is perhaps even why even long-term Tesla bulls and nonplussed. The most optimistic read is that  Tesla is now a clean energy company, with a potentially much larger market, but the catch is that Solar City's products don't have the cache that Tesla cars have as well as the competitive nature of the solar power market will push margins down. If you add the debt burden and reinvestment needs that Solar City brings into the equation, Tesla, already stretched in terms of cash flows, may be over extending itself. The most pessimistic read is that talk of synergy notwithstanding, this acquisition is more about Musk using Tesla stockholder money to preserve his legacy and perhaps get back at short sellers in Solar City.

The X Factor: Elon Musk

The Solar City acquisition spotlighted how difficult it is to separate Tesla, the company, from Elon Musk. Musk's strengths, and there are many, are at the core of Tesla's success but his weaknesses may hamstring the company.

• On the plus side, Musk clearly fits the visionary mode, dreaming big, convincing customers, employees and investor to buy into his dreams and, for the most part, working on making the dreams a reality. Like Bezos at Amazon and Steve Jobs at Apple, Musk had the audacity to challenge the status quo. 
• On the minus side, Musk is less disciplined and focused than Bezos, whose story about Amazon has remained largely unchanged for almost 20 years, even as the company has expanded into new businesses and markets. In fact, as someone who has followed Apple for more than three decades, it seems to me that Musk shares more characteristics with Steve Jobs in his first iteration at Apple (which ended with him being fired) than he does with Steve Jobs in his second stint at the company. Musk is a large social media presence, but he does strike me as thin skinned, as his recent exchange with Fortune magazine about the autopilot fatality showed. 

Your views on  what you think Tesla is worth will be a function of what you think about Elon Musk. If you believe, as some of his most fervent defenders do, that he is that rarest of combinations, a visionary genius who will deliver on this vision, you will find Tesla to be a good buy. At the other extreme, you consider him a modern version of P.T. Barnum, a showman who promises more than he can deliver, you will view Tesla as over valued. Wherever you fall in the Musk continuum, Tesla is approaching a key transition point in its life, a bar mitzvah moment so to speak, where the focus will shift from the story to execution, from master plans to supply chains, and we will find out whether Musk is as good at the latter as he is in the former.

Can Musk the visionary become Musk the builder? He certainly has the capacity. After all, if you can get spaceships into outer space and back to earth safely, you should be able to build and deliver a few hundred thousand cars, right? Given Tesla's missteps on delivery and execution, though, Musk may not have the interest in the nitty gritty of operations, and if he does not, he may need someone who can take care of those details, replicating the role that Tim Cook played at Apple during Steve Job's last few years at the company.  

Investment Direction

Tesla is a company where there seems to be no middle ground. You are either for the company or against it, believe that it is on a pathway to being the next Apple or that it is worth nothing, a cheerleader or a doomsdayer. I think that both sides of this debate are over reaching. I don't buy the talk that Tesla is on its way to being the next trillion dollar company, especially since I have a tough time justifying its current valuation of $33 billion. Unlike some of the high-profile short sellers who seem to view Tesla as an over-hyped electric car company that is only a step away from tipping into default, I do believe that Tesla has a connection to its customers (and investors) that other auto companies would kill to possess, brings a technological edge to the game and has viable, albeit narrow, pathways to fair value.  I will choose to sit this investment out, letting others who are more nimble than I am or have more conviction than I do to take stronger positions in Tesla.

YouTube Video

Blog Posts on Tesla

1. Valuation of the week I: A Tesla Test (September 2013)
2. Tesla: A Follow up (September 2013)
3. Many a slip between the cup and the lip (September 2013)
4. Return to the firing line: Revisiting Tesla and hopefully living to tell the tale (March 2014)

Spreadsheets

1. Tesla (September 2013) valuation
2. Tesla (July 2015) valuation
3. Tesla (July 2016) valuation

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