Latepost Spend Upwards As Well As Denial: Thoughts On Blackberry Endgame As Well As Microsoft Equally Value Trap

The in conclusion few days receive got been filled alongside reminders for me of both the destructive too the redemptive powers of life. The weekend started alongside a identify unit of measurement outing to a Yankee game. As a fan, it was wrenching to run into Mariano Rivera too Andy Petite, 2 players who I receive got watched for almost 2 decades, pitch for the terminal fourth dimension inwards Yankee stadium, but it was redeemed at to the lowest degree partially yesteryear a immature Yankee pitcher, Ivan Nova, pitching a consummate game on Saturday. Yesterday was my birthday, a joyous 24-hour interval marred entirely yesteryear the realization that putting every bit many candles on the cake every bit my historic catamenia merited would probable laid off burn alarms. Before I could experience piteous for myself, though, my eighteen-year erstwhile daughter, a freshman inwards college, called, exhilarated nearly getting a hundred on her start college exam. Towards the terminate of the day, the Tesla too Facebook, it is the revenue growth too target operating margins that determine value too non how much debt they receive got inwards their uppercase construction or how much they pay inwards dividends. When valuing mature companies, the focus inwards valuation changes to valuing existing assets (and their earning power) too to the effects on value of ameliorate financing too dividend choices. Thus, for Apple, every bit much of the give-and-take of value is focused on whether the fellowship volition gain from its role of debt too buying dorsum stock every bit it is on the futurity growth of the company. When my Dec 2011 post on Blackberry, I estimated a value of nearly $ nine billion for the company, on the supposition that the best class for the describe of piece of work solid was to narrow its focus to a niche production (I called it the Blackberry Boring, a telephone for security-conscious corporates that would forestall games, apps or other distractions from getting inwards the means of employees checking their email) too liquidate itself over fourth dimension (five years) inwards an orderly fashion. I followed upwardly yesteryear looking at Blackberry (RIM) too Nokia every bit potential contrarian plays inwards June 2012, but luckily, I went alongside Nokia every bit my pick. That alternative play paid off partially because Nokia recovered from its lows but the large wages came, ironically, when Microsoft bought them early on this month.

Reactions to Decline: Anger, Denial too Acceptance

If aging is part of existence human, it is merely every bit human to teach by aging too businesses seem to follow the same script. Rather than receive got maturation too pass upwardly every bit inevitable parts of the describe of piece of work concern life cycle, businesses seem to cash inwards one's chips through their version of the stages of grief, starting alongside anger (at markets), denial (about existence mature or inwards decline) too terminal acceptance. 

Stage 1: Anger

When growth companies transition to becoming mature companies, the marketplace position responds yesteryear lowering the multiples that they are willing to pay for net turn a profit too some investors demand that the fellowship comport similar a mature company, borrowing to a greater extent than too returning to a greater extent than cash to its stockholders (in dividends too buybacks). In many of these companies, managers reply start yesteryear accusing markets (and yesteryear extension, their ain investors) of existence curt term too ignorant of the facts. While that characterization may check some (or fifty-fifty many) investors, it nevertheless remains truthful that markets are oft to a greater extent than perceptive than managers are. 

Stage 2: Denial
Managers, angry at investors for treating their companies every bit mature or declining, brand it their mission to bear witness the globe incorrect yesteryear going for to a greater extent than growth, too inwards the process, oft exercise farther harm to themselves too their investors. The impetus to teach by maturation too pass upwardly is fed yesteryear iv factors:

1. The emotional connection: In the midst of the Second World War, when it was clear that United Kingdom could no longer agree on to its far flung colonies, Winston Churchill was quoted every bit proverb that "I receive got non teach the King's First Minister inwards gild to preside over the liquidation of the British Empire." Many managers at iconic companies that receive got fallen into pass upwardly tend to cash inwards one's chips along alongside this sentiment, particularly if (like Churchill) they were involved inwards edifice upwardly the companies inwards the start place. That explains why a Michael Dell would exit a comfortable retirement inwards 2007 to provide to his namesake fellowship every bit CEO, inwards a futile endeavour to plow the fellowship around. 
2. Fountain of youth ecosystem: Just every bit at that spot is a lucrative ecosystem that makes coin of the wish to rest immature (cosmetic surgery, magic supplements, pilus transplants etc.), at that spot is an fifty-fifty to a greater extent than lucrative ecosystem of bankers, consultants too turnaround experts who hope mature too declining companies that they volition Pb them dorsum to everlasting growth. They play to administration egos too offering them hope, spell eating through billions of dollars of stockholder money, alongside piffling to demonstrate for it.
3. Analyst Growth Obsession: Many equity query analysts are obsessed alongside net turn a profit growth, judging companies on how much they grow rather than on how much value that growth adds. Thus, a declining fellowship that invests badly to grow at a depression charge per unit of measurement is viewed every bit ameliorate than a declining fellowship that shrinks, spell paying out large dividends. Not surprisingly, managers experience the demand to feed this obsession for growth.
4. The PR problem: If your describe of piece of work concern is declining too your growth prospects don't aspect good, the correct thing for you lot to exercise every bit a travel yesteryear administration is to receive got that reality, bring it to your employees too start shrinking the business. However, that is non painless too people volition lose jobs, employees volition run into their paychecks shrink too customers volition lose their favorite products. If you lot are inwards Blue Planet eye, you lot (as the CEO) volition live labeled a Scrooge or worse. It is no wonder, therefore, that companies that are serious nearly facing upwardly to pass upwardly prefer to exercise so every bit private businesses rather than every bit world companies.

While denial is understandable, it is also costly to investors. As I receive got noted inwards a prior post, growth tin live value destructive, if it is expensive. In fact, to illustrate the effects of “value destroying” growth, I receive got taken a base of operations instance of a mature company, alongside no growth prospects too $100 1000000 inwards after-tax net turn a profit that pays out its entire net turn a profit every bit cash flows. If you lot attach a cost of uppercase of 10% for this company, its value is $ 1 billion (=$100 million/.10). Now assume that the managers of this fellowship determine to force for growth, though that growth requires them to invest immense amounts of uppercase (in acquisitions, R&D too novel projects) alongside a provide on uppercase of 5%. In the figure below, I receive got the value of the fellowship at unlike growth rates. 

You tin consider the departure betwixt $1 billion too the estimated value of a fellowship at whatever given growth charge per unit of measurement to live the cost of denial to investors inwards the company. Thus, at a 5% expected growth rate, the value of the fellowship is $792.47 1000000 too the cost of denial yesteryear managers (and for stockholders) is $207.53 million. (You tin play alongside the spreadsheet yesteryear clicking here).

This analysis should opened upwardly investors eyes to a clear too an ever-present danger when investing inwards mature too declining companies that aspect inexpensive (on a value footing or fifty-fifty based on a PE or PBV ratio). Those companies are cheap, entirely if their managers don’t seek also hard. In fact, the to a greater extent than activity at that spot is on the part of administration to "fix" the growth problem, the less inexpensive the companies become. To me, this is the fundamental to agreement “value traps”, companies that aspect inexpensive on every metric but rest inexpensive forever. To offering you lot iii examples, consider Cisco, Microsoft too Merck’s stock prices over the in conclusion decade:

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These are companies that I receive got seen tagged every bit inexpensive companies repeatedly over the in conclusion x years, but none of them would receive got delivered much inwards terms of returns. These iii companies had administration teams that receive got tried  hard to provide them to growth status, spending billions of dollars inwards that venture: Merck inwards R&D, Cisco on acquisitions too Microsoft on “new” products. I know that I receive got the exercise goodness of hindsight here, but I would wager that investors inwards these companies would receive got been ameliorate served, if they had lowered their sights on growth too focused on delivering the most net turn a profit from existing investments too returning the cash dorsum to stockholders. 

I decided to select a shot at valuing Microsoft yesteryear breaking it downwards into the value of assets inwards identify (Microsoft Office too Windows, for the most part) too expected value of growth. In the financial twelvemonth ended June 30, 2013, Microsoft reported $26,764 1000000 inwards pre-tax operating income on revenues of $77,849 million; revenues increased yesteryear 5.60% over the previous twelvemonth but operating income was downwards 4.26%. Using the company's effective taxation charge per unit of measurement of 19.2% for the twelvemonth too attaching a cost of uppercase of 8% to the fellowship (in the 60th percentile of United States of America companies), you lot tin value Microsoft assuming no growth inwards the future:

Value of assets inwards identify (with no growth, no reinvestment) = $26,764 (1-.192)/ .08 = $270,316 million

Adding their cash residuum of $ $77,022 1000000 on June xxx to this value too subtracting out the debt outstanding of $15,600 1000000 yields an estimated value of equity of $331,738 million, nearly $61,198 1000000 higher than the marketplace position cap of $270,540 million. Put briefly, assuming no growth inwards earnings, Microsoft is worth nearly 22% to a greater extent than than its marketplace position capitalization. You tin select give the spreadsheet a try, if you lot are so inclined. (I know that I may live overstating the value of assets inwards identify yesteryear assuming that Office too Windows volition generate net turn a profit inwards perpetuity, but using a fifteen-year annuity yields a value unopen to the marketplace position price.)

It is no wonder too so that Microsoft keeps looking inexpensive using all the criterion metrics (PE, EV/EBITDA etc,) but at that spot may live a marrow employment that nosotros are ignoring. For most of the in conclusion 20 years, Microsoft has spent billions on novel technologies too products too has piffling to demonstrate for it. While it is hard to isolate the provide on uppercase on merely these novel investments, it is quite clear that it has been less than the cost of capital. I recollect I am existence generous to Microsoft inwards assuming that its'  new ventures receive got earned an average provide on uppercase of 6%, but alongside that assumption, it is quite clear that if Microsoft continues to maintain trying for growth, it volition live value destructive, every bit shown inwards the figure below:

The intrinsic value of Microsoft drops alongside every increment inwards growth too at a growth charge per unit of measurement of 7% for the side yesteryear side decade, the intrinsic value converges on the actual marketplace position price. This may explicate the horrific reaction that the marketplace position had to Microsoft's annunciation that it would teach Nokia for $7.2 billion, too Microsoft's marketplace position capitalization dropped yesteryear to a greater extent than than $15 billion. It may non receive got been the acquisition per se that triggered the driblet off but the signal that it sent to investors that Microsoft alongside its novel CEO (from Nokia) would maintain trying to grow. The best news, if you lot purchase int this analysis too you lot are a Microsoft investor, would live an annunciation yesteryear the describe of piece of work solid that they are disbanding their R&D department, stopping all novel production evolution too appointing Larry the Liquidator every bit their novel CEO.

Stage 3: Acceptance

Ultimately, no affair how hard you lot teach by aging, reality sets in. For individuals fighting middle age, the 2nd of awakening may live a torn musculus from trying to run a fast intermission on a basketball game court, but for businesses, it may select a longer time. In some cases, it may require pressure level from activist investors too inwards some, a novel travel yesteryear administration who has no emotional connectedness to the company's history. In some, though, it volition live forced upon the describe of piece of work concern yesteryear external factors, difficulty making a debt payment or an inability to retain employees. 

What shape volition credence take? If the describe of piece of work concern is mature, it volition start behaving similar a mature firm, tilting its uppercase construction towards to a greater extent than debt too increasing cash returned to investors. For many followers of Apple, that capitulation seemed to plow over off inwards their March net turn a profit report, where the fellowship ratcheted downwards its forecasted growth, announced its start debt number too increased its stock buybacks. 

If the describe of piece of work concern is inwards decline, it may live the credence that the futurity volition non entirely live less rosy than the yesteryear but also a innovation for gradual or partial liquidation. That, to me, seems to live the message inwards the proposed Blackberry deal. Fairfax Financial is the largest stockholder inwards Blackberry too its primary executive, Prem Watsa, has been labeled the “Canadian Buffett”. His plans seem to live to focus on Blackberry’s describe of piece of work concern services too to throw inwards the towel on the smartphone too tablet businesses. Will he succeed? I hope so but I recollect he has his function cutting out for him. The fellowship has done pregnant harm to its orderly liquidation prospects inwards the 2 years since my in conclusion valuation too it may live also belatedly to plow this shipping around.

It's actually non also bad

On a personal note, I am older today than I was yesterday but given the alternative, I am okay alongside that. I actually don't wish to live eighteen, 20 iii or 20 5 again, non because those were non cracking years, but so was my most recent year. I could tell you lot that I know to a greater extent than today than I did iii decades ago, but that is actually non true, but I exercise know to a greater extent than nearly what I don't know today than I did iii decades agone (if that makes whatever sense). Keeping alongside the subject of this post, I know that my Tesla/Facebook days are means inwards my yesteryear (I am non certain that I had them), that my Google days are inwards my rearview mirror, that I am in all probability inwards the Apple days of my existence (which is actually non also bad) too that I volition i 24-hour interval live inwards my Blackberry/Microsoft stage of life. I tin entirely pray that when that stage arrives,  I volition receive got the grace to exercise an orderly winding downwards of my activities too non maintain reaching dorsum inwards fourth dimension for the glory of bygone days. In the meantime, I volition teach my revenge on fourth dimension yesteryear using it every bit productively every bit I can.