Latepost If Nosotros Don't Produce It, Our Competitors Will! Defensive Dealmaking Or Panicky Preemption?

My last postal service on Facebook’s acquisition of Whatsapp brought a whole host of responses, some of which took number amongst my declaration that it is easier to explicate the bargain using pricing metrics, peculiarly ones that are used inwards the social media sector (# users) than amongst valuation models or logic. One of the arguments made past times some of the commenters was that I was missing the existent ground for the deal, which was that it was a defensive maneuver past times Facebook, designed to both protect its profitability in addition to to keep a prime number rival (Google) from acquiring Whatsapp. Many of these commenters also emphasized that these defensive deals cannot live assessed using conventional valuation techniques in addition to that nosotros conduct hold to trust administration to brand the correct judgments on them. I don't conduct hold a os to pick amongst the logic of defensive bargain making, but every bit a valuation person, I don't handgrip amongst the claim that defensive deals cannot live valued. If preemption is the master copy rationale behind an action, I believe that it non only tin live valued but it should live valued. 

A Valuation View of Preemptive Actions

If you lot adopt a stilted  view of valuation models (and DCF, inwards particular), it is possible that preemptive actions cannot live valued. However, I would fence that conventional discounted cash stream models render to a greater extent than than plenty flexibility to value preemption inwards all of its forms. To illustrate, allow me prepare a uncomplicated example. Let’s assume that Company H5N1 has $10 1 G m inwards after-tax income (and cash flow) that it expects to generate inwards perpetuity on invested upper-case missive of the alphabet of $50 1 G m in addition to that it has a cost of upper-case missive of the alphabet of 10%. This fellowship tin live valued every bit a standalone entity at $100 million.

Value of fellowship (stand alone) = $10/.10 = $100 million

Now, assume that this fellowship is faced amongst Company B, a immature fellowship that has a production that has no revenues correct now, but if allowed to educate or inwards the hands of a competitor, could swallow into Company A’s marketplace in addition to lower its after-tax cash income to $ six million. Even though fellowship B has footling income potential on its own, fellowship H5N1 should live willing to pay upwards to $40 1 G m to teach it.

Value of preemption = Lost after-tax CF/ Cost of upper-case missive of the alphabet = (10-6)/.10 = $40 million

I know that you lot are looking at this instance in addition to arguing that it is far likewise simplistic to live used to explicate Facebook’s acquisition of Whatsapp. While estimating the cash flows may live to a greater extent than complex amongst Facebook, you lot are, inwards effect, making the same argument. In fact, working through my discounted cash stream valuation of Facebook, I tin run out the touching of that a potential rival volition conduct hold on the company's revenue/margins in addition to the value of those cash flows, in addition to past times extension, how much Facebook should live willing to pay to take that rival from the game.

The table, spell looking at a broad attain of outcomes, does render some interesting insights into Facebook's vulnerabilities. First, the company's value is far to a greater extent than sensitive to margin erosion than it is to revenue loss, partly because the fellowship has astounding high pre-tax operating margins (about 50%). Second, at that topographic point are clearly combinations of revenue decline/margin driblet that yield values greater than $19 billion. Note that this number volition non live the full value of Whatsapp because it does non include the direct income in addition to cash flows that you lot tin generate from Whatsapp's business. You are welcome to try your manus on my spreadsheet that builds off the Facebook base of operations instance valuation to compute the outcome on value of declining revenues in addition to dropping margins.

Defensive Value Creation: Necessary & Sufficient Conditions

While it is slow to build discounted cash stream valuations to justify acts of preemption, at that topographic point are 4 weather that conduct hold to live met for preemptive spending  to live justified.

1. The describe of piece of job organisation you lot are defending is worth defending: Acting inwards defense forcefulness of a describe of piece of job organisation makes feel only if that describe of piece of job organisation is a skilful one, in addition to the stair out of a skilful describe of piece of job organisation is whether it generates returns on invested upper-case missive of the alphabet that transcend the cost of funding that business. If you lot ain or run a bad business, spending coin to defend that describe of piece of job organisation strikes me every bit a pointless in addition to expensive exercise. Lest this sounds similar a weak precondition, notation that past times my calculations inwards 2013, most 60% of all listed companies (40,000+) globally generated returns that were below their costs of capital, in addition to to a greater extent than than a tertiary of them nether performed past times substantial margins (>5%).
   
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2. The threat is real, non imaginary: Spending preemptively to ward off a threat makes feel only if the revenue loss/ margin decline that is anticipated is existent in addition to is non merely inwards the fevered imagination of the top management. While you lot tin fence that this is a describe of piece of job organisation judgment that should live left to the top managers of a firm, a paranoid CEO, egged on past times “strategic” consultants in addition to aided in addition to abetted past times bankers, eager to teach the bargain done, volition honor a hundred potential threats for every existent one.
3. The preemptive activity is the most efficient (and cheapest) agency to ward off the threat: Even if the threat is to a valuable describe of piece of job organisation in addition to is imminent, at that topographic point may live less expensive in addition to simpler ways to bargain amongst the the threat in addition to then the chosen action. Thus, if you lot tin teach a technology scientific discipline from a fellowship or exclusive licensing rights for a billion, you lot should non live spending $10 billion to purchase the whole company.
4.  The threat is unique in addition to non easily recreated: Spending coin to eliminate a potential threat makes feel only if the threat is unique in addition to non replicated easily/quickly. If the threat tin live replicated easily, the spending fellowship volition honor itself repeatedly spending larger in addition to larger amounts of its depleting stock to brand subsequent threats decease away. These are companies amongst frail describe of piece of job organisation models amongst shallow ditches rather than competitive moats separating them from mediocrity.

The enquiry on the Facebook/Whatsapp bargain is whether these weather are met. As I come across it, the starting fourth dimension status is easily met since Facebook clearly has a really profitable (and high return) describe of piece of job organisation to defend. On the minute in addition to third, Facebook investors are, inwards effect, artners-in-quest-to-connect-billions.html">trusting Mark Zuckerberg's judgment that Whatsapp is a platform that may threaten Facebook's profitability in addition to that buying out the fellowship for $19 billion is the cheapest agency to avoid that threat. It tin live argued that he has earned their trust amongst the company's performance over the final 2 years.  It is the 4th status that should live most worrisome to Facebook investors. While Whatsapp may live a genuinely unique platform, the cost tag on this bargain is certain to entice immature programmers, huddled around tables inwards Mumbai, Moscow in addition to Menlo Park, to come upwards up amongst novel ways to breach Facebook defenses, knowing that they likewise volition decease wealthy beyond their wildest dreams, if they succeed. Looking at Facebook's brusk history, the cost of preemption seems to live escalating at an exponential rate, going from $1 billion for Instagram to a greater extent than than a twelvemonth agone to $ 3 billion for an attempted (and failed) acquisition of Snapchat to $19 billion for Whatsapp. (I know... I know.... There mightiness conduct hold been other motives for the Instagram in addition to Snapchat acquisition bids, but the cost tag is climbing).

The Preemptive Strategic Stupidity (PSS) Syndrome

For every fellowship that comes out ahead, inwards terms of value, amongst a preemptive strike, at that topographic point are in all likelihood a dozen that halt upwards worse off, frequently because they conduct hold bought into 3 adages that nosotros bring every bit conventional wisdom. One is that companies conduct hold to do whatever they take to do to survive, every bit if survival is the live all in addition to halt all of business. The minute is that doing nix is non an pick or that it is ever the worst option. The tertiary is that if you lot don't act, your competitors volition in addition to that their actions volition wound you lot more, fifty-fifty if those actions are non sensible. At the opportunity of getting some blowback from readers, hither are my adaptations of these adages:

1.  Survival is non the halt game: As I conduct hold noted inwards my prior posts, at that topographic point is no glory inwards growth for the sake of growth or describe of piece of job organisation survival for the sake of survival. H5N1 describe of piece of job organisation is a commercial enterprise in addition to if you lot cannot generate sufficient returns, given the opportunity you lot human face upwards in addition to the upper-case missive of the alphabet you lot conduct hold invested, you lot should nigh the describe of piece of job organisation down. 
2. Doing nix is non only an pick but it may sometimes live a improve 1 than doing something: We alive inwards a the world where activity is non only prized to a greater extent than than inactivity, but 1 inwards which at that topographic point is far to a greater extent than coin to live made past times people from promoting activity (consultants, bankers) than from promoting inactivity. At the opportunity of sounding similar stodgy, I believe that it is improve sometimes to do nix instead of doing something, peculiarly if that something is sick advised or expensive.
3. If your competitors are planning on doing something stupid, allow them do it: If your competitors desire to overpay for companies or take investments that generate substandard returns, your best pick is frequently to allow them do it. Especially amongst acquisitions, the winners of the bargain making competition are non necessarily winning for their stockholders:
   
   This graph looks at winners in addition to losers inwards multiple-bidder acquisitions in addition to looks at the returns that investors would conduct hold made inwards the xl months later the bargain is done. The stock price, on average, declines past times most 35% inwards the bargain winners in addition to increases past times 25% inwards the bargain losers inwards that period. 

Wrapping up

Companies frequently justify paying likewise much on acquisitions or making bad investments past times using the preemption argument: if nosotros don't do it, nosotros volition live wound to a greater extent than than if nosotros do. While that declaration sometimes has economical merit, it deserves to live scrutinized merely every bit much every bit whatever other investment decision. The tools for assessing the fiscal touching of these decisions non only be but are straightforward. It is the volition to brand the assessment that is lacking at most businesses.

While I conduct hold framed this postal service inwards terms of the Facebook/Whatsapp deal, I maintain to believe what I said inwards my starting fourth dimension post. I don't mean value that Facebook's administration is doing this bargain for defensive reasons or because they conduct hold explicit plans for generating value, at to the lowest degree every bit of now. It is Whatsapp's large, growing in addition to engaged user base of operations that makes it thence attractive to Facebook, peculiarly given how much the marketplace is pricing all of those factors. You may honor it hard to believe that someone every bit smart every bit Mark Zuckerberg would pay $19 billion without a clear vision of how he plans to make money off the deal, but I don't. 

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