Sunday, 18 June 2017

Valuing Disruption, Tesla, and other stuff I will never understand

On the subject of never understanding stuff...

I watched game 6 of the Nashville/Pittsburgh series last Sunday night, and I will "NEVER" understand how the play was blown dead in the first few minutes of the second period on a goal that should have counted, by a referee who's view of the puck was obstructed (at least temporarily).

If you haven't seen this play, you can watch it below and judge for yourself:

Every single sport out there allows reviews of mission critical plays, and to say this play was not mission critical is the understatement of the century. This was the Stanley Cup Final! As far as ridiculous calls go, this has to rank up there in the top 10 of all time. If the goal had counted, the tone of game 6 would have been completely different. I'm not saying that Pittsburgh wouldn't have eventually won, but come on guys, call a fair game.

On the subject of disruption...

I believe that there is a noticeable dichotomy between participants strictly governed by a grounding in conventional (i.e., Graham-esque) valuation theory and participants latching onto the theme of disruption. This dichotomy has probably always existed, I've just never really thought about it until recently.

I also believe that there is a theoretical intersection between the two approaches somewhere, and I guess that as long as participants at both ends of the spectrum generate alpha for themselves and their clients, who really cares, right?

The main difference, in my mind anyway, is that strict adherents of conventional Graham-esque valuation principles probably scoff at the at the idea of paying lip service to the notion of valuing disruption, and yet here we are, collectively paying seemingly outrageous multiples for ownership stakes in disruptive businesses, while casting aside businesses which appear to be victims of disruption. Need proof? Look no further than juxtaposing the performance of anything supplanted by Amazon as the road to Amazon $1,000 has been littered with the corpses of all things bricks and mortar (at least up until recently anyway).

By my calculations, approximately 10% of the S&P500's current capitalization is attributable to Google/Alphabet, Apple, Amazon, Facebook, Tesla, and Netflix, the collective epitome of disruption, so indeed, someone out there loves paying for disruption and the broad indices reflects this fact almost daily. Passive do-it yourself indexers be wary, 10% of your future retirement fortunes are locked into the fortunes of these 6 companies.

And the weighting towards large cap tech doesn't stop at just the S&P500. Even Harvard educated, 30 years in the business, institutional fund managers are heavy on the tech disruption bus. Don't believe me? Here's Fidelity's Will Danoff's top holdings by weight, who, incidentally, was profiled earlier this year by the Globe in the following article...

"Star stock picker Will Danoff now accessible to Canadian investors"...

Fidelity has even run a tear jerking commercial spot tapping into a cascade of emotions surrounding entrusting your family's future with the legend himself, by touting units of the Fidelity Insights Class under Mr. Danoff's careful jurisprudence.

Here's a link to the full holdings, and here's a previous incarnation of said tear jerking commercial:

My question: why would a Harvard educated, 30 year tenured fund manager, introduced to Canada as "legendary" want to simply mirror the QQQ's? I will leave the question open and move on.

On the subject of Tesla...

Not a day goes by that Tesla isn't front page news, so I thought, why not try a simplistic DCF valuation. After all, I'm a simple muppet, so here goes (I'm going to preface my attempt with a deep take this with a grain of salt/caveat).

Before I get to my results, a conclusion up front: I must have approached the exercise incorrectly from the get go, why? Because I attempted to use linear logic to run my DCF.

In my first attempt, I used the historical financial results from 2012 through current in order to model out a number of assumptions, gathering info from various sources on Global Plug-in/EV forecasts out to 2025, which seem to peg 2025 EV units at between 25% and 35% of estimated deliveries globally. This translates into around $750B of total global EV sales (assuming global auto sales of $2.5T in 2025, and taking the mid range forecast of EV share at 30%).

I also had to make assumptions pertaining to Tesla's expected market share in 2025. Currently around 4% of global EV's, I'm going to optimistically assume a 10% market share as the company moves towards mass marketing and maturity in 2025 and beyond. My sources for global EV sales (in $'s) is a combination of reports from both the International Energy Agency, link here, and Statista, link here.

By my estimates, Tesla's market share in terms of dollars worked out to around 4% of total EV sales in 2016 (i.e., $7B in sales vs. $164B in sales globally). Assuming EV sales represent 30% of global auto sales in 2025, this works out to 30% x $2.5T x 10% Tesla market share = around $75B in sales, a staggering tenfold increase in sales vs. 2016.

Taking industry wide ratios for mature auto manufacturers (i.e., GM, Ford, Daimler AG BMW, etc.), I used average EBIT of 7.5% to model expected operating profit and an average reinvestment ratio of -1.14 in order to estimate reinvestment (net capx + working capital), courtesy of Professor Aswath Damodaran at NYU. I also estimated a future tax rate of around 25% (assuming the company uses up it's $4B and counting of loss carryforwards before 2025).

On this basis, I came up with expected sales of $75B in 2025, EBIT of $5.6B, and total units of 1.2M at an average sales price of $60K per unit (assuming average sales price per unit decrease incrementally each year commencing in 2018 post Model 3 mass production rollout).

Logical and linear, right?

Here's the problem. In my opinion, linear logic gets tossed out the window when considering the ongoing net reinvestment required to produce $75B in sales in 2025 (at least from a logical valuation perspective). At $75B in sales (up from my own estimates of $63B in sales in 2024), and assuming industry average net reinvestment of -1.14 x delta sales, this level of sales would seem to suggest net reinvestment of around $10B, see below:

Here's the historical net reinvestment between 2012 & 2016, using published financial statements (2017 is ttm):

So certainly not outside the realm of possible to accept that sales growth should be accompanied by ongoing material net reinvestment. The issue thus far is that the company has been spending more on capital in advance of the Model 3 rollout than would normally be required by a mature industry participant already mass producing. Therefore, in modelling future production, I have assumed that the sales/capital ratio will increase from .24 to .74 commencing in 2018, and as the company reaches economies of scale post Model 3 rollout, I have added 10 bps per year commencing in 2019 in order to reduce estimated net reinvestment, until I get to the industry average of 1.14.

This matters (from a DCF modelling perspective) because the growth in sales has to be supported by net reinvestment in capital. And as net reinvesment grows, free cash falls until net reinvestment levels off. And I'd hazard a guess that net reinvesment levels off or even declines in the case of non-capital intensive businesses (due to to scale-ability), which doesn't seem to be the case with Tesla.

Assuming EBIT is $5.6B in 2025 and tax is 25%, I get NOPAT of $4.2B, less net reinvestment of -$10B, which results in negative free cash flow of -$5.B. And this was my issue all the way through my first attempt. I never came up with positive free cash flow!

The argument therefore, is that I can't really use a DCF model here unless I make some very aggressive generalizations as to what EBIT and net reinvestment should be once the company becomes a mass producer operating efficiently near capacity. At some point net reinvestment should be small relative to what the company is spending now to build out, but I have no idea when this will be. My best guess is that when the company is mature, it will spend around what other manufacturers spend, or around sales / -1.14.

Maybe, the best approach here is to try to derive what cash flows the market is estimating in terms of current valuation, and work backwards from there in order to determine how reasonable these assumptions are. So here goes (and forgive me if this looks like an extreme case of curve fitting, but that's exactly what it is):

I started my second attempt with the following question:

What combination of sales, EBIT margin, reinvestment, and two-stage discount rates is the market pricing in today in order to arrive at a valuation of $65B, assuming 2025 as the terminal cash flow year?

Before I get to a "possible" answer, I want to make mention of Marketwatch running the following piece on Baron Capital regarding Tesla last week. Apparently, Mr. Baron believes that Tesla will get to $70B in sales and operating profits of $10B in 2020 (i.e., an EBIT margin of 14%, or double the industry average), a full five years before my estimated 2025 $75B in sales. This implies 1,000,000 in units sold in 2020 (vs. my originally estimated 497K units). And the source for this 1,000,000 unit target is the company itself.

So, rejigging my DCF model to incorporate Mr. Baron's estimates, in order to justify a valuation of close to $65B, the market must be expecting a terminal reinvestment rate of close to sales/-2x (vs. an industry average reinvestment rate of sales/-1.14x), a terminal EBIT margin of 20% (vs. an average industry EBIT margin of 7.5%), and imputed two stage discount rates of 4.9% in the near term and 6.9% terminally on 1M units in 2020, and $70B in sales, as follows:

The growth curve isn't linear at all: it's exponential in terms of the jump from current production to mass marketing the Model 3. For this model, I've assumed sales triple between 2018 & 2020, and then decrease incrementally at the rate of 90% x the previous year's growth rate between 2021 and 2025. Number of units sold is a function of the incremental decrease in avg unit price between 2020 & 2025. EBIT margins inch up from 7.5% in 2019 to 20% in 2020 (a possible function of economies of scale and lower lithium input costs over time).

Concluding Thoughts

So are these expectations reasonable? I honestly don't know. My gut tells me no, and yet what do I really know? Maybe the company growth curve is still in its infancy, and non Graham-esque participants dismissing the disruptive merits here are missing out on the potential for a 10 bagger. Maybe, just maybe, the cult of Tesla followers have vision, and I don't.

What I do know is this: There is a huge amount of uncertainty surrounding future cash flows. And when there is huge uncertainty combined with an admittedly outrageous starting valuation predicated on future production targets which may or may not transpire, everything, and I mean everything has to go right from now until 2025 in order to justify the current valuation. And this begs the following question: If the market is happy to pay $65B (fair value) for this story at 4.9% near term, and 6.9% terminally, what happens if we double the discount rates (for silly argument's sake):

Here's what happens:

Caveat emptor indeed.

Sunday, 21 May 2017

Aimia from a Muppet's Perspective

About a year ago, I found BBB rated Aimia strip coupon bonds offered at TD Direct. I already owned the Jan 2018 4.35% bonds in another account ($5,000 face), and the strips being offered were the principal portion of the May 2019 bonds, which at the time (July 2016), were offered to yield 4.9%. I bought $2,976 face at $.87315.

My logic surrounding the purchase was as follows:

  1. I had analyzed the company's historical financial statements going back 5 years. My observation at the time was that the company had sufficient liquidity to redeem its debt up until 2020. I was buying a 2019 obligation which shouldn't be affected if anything untoward resulted from its negotiations with Air Canada with respect to the 2020 Aeoroplan loyalty contract. There were only two series of bonds in the capital structure and an unused credit facility.
  2. I used management's adjusted EBITDA from their annual reports in order to determine interest coverage after deducting depreciation and amortization but not amortization of accumulation partner's contracts, customer relationships and technology (as a rough proxy for EBIT). My thoughts were that interest was covered approximately 5.5x in 2016. My rationale for not deducting amortization of accumulation partner's contracts, customer relationships and technology was due to my concluding that this line was a result of a restructuring of the overall business back in 2013 and wouldn't likely be repeated, therefore, this line was non-cash. Management's own interest coverage determination was 8.73x based on their MD&A (this should have been a warning sign to me).
  3. At the time, I couldn't foresee a major liquidity problem, given that cash on hand at the end of 2016 amounted to $293M, short term investments amounted to $80.4M, and long term investments (comprised of marketable securities) amounted to $342M, which in aggregate, were more than enough to redeem $448M of both series of secured bonds. If anything, the common and perpetual dividends would be cut before the company missed a coupon payment. 
  4. Shoring up my logic, the company reported free cash flow of $234M, $202M and $287M between 2016 & 2014 before dividends, and $96M, $61M and $144M after dividends. The bonds should have therefore been redeemed using a combination of liquidity on hand, available credit, and net free cash flow if needed.
Well, around two weeks ago, Air Canada announced that they were going it on their own post 2020, and Aimia common dropped almost 70%, as the market decided that Aimia was a dead duck without Air Canada. In order to salvage some modicum of confidence, Aimia announced that they would redeem the 2018 bonds early (which I owned), but the 2019 bonds got hit, trading down to near $.80 recently. 

Here's a chart:

So what happened? Why did the 2019 bonds get hit when the contract (and resulting impact on future cash flows) isn't set to expire until 2020?

I have an idea, and this is just an idea at this point.

This isn't just about the company having sufficient liquidity as presented on the balance sheet. This is about everything off-balance sheet. What I mean by this is, what happens if there's a crisis of confidence in Aimia's ability to meet an avalanche of loyalty reward redemption requests all within a short period of time (as a result of loyalty plan holders deciding that maybe now is a good time to redeem their un-redeemed loyalty rewards)?

Heck, if you were an Aeroplan loyalty reward plan member, and you got news that Air Canada has walked away from the Aeoroplan contract post 2020, would you wait until 2020 to redeem your rewards balance?

In this case, Aimia would need to tap into its cash, marketable securities and long term investments in order to meet any influx of redemption requests. Here's a description of how their Cost of Rewards works from their 2016 annual report:

Cost of Rewards, Direct Costs and Operating Expenses 

Cost of rewards consists of the cost to purchase airline seats or other products or services from Redemption Partners in order to deliver rewards chosen by members upon redemption of their Loyalty Units. At that time, the costs of the chosen rewards are incurred and recognized. The total cost of rewards varies with the number of Loyalty Units redeemed and the cost of the individual rewards purchased in connection with such redeemed Loyalty Units. 

The Average Cost of Rewards per Loyalty Unit redeemed is an important measurement metric since a small fluctuation may have a significant impact on overall costs due to the high volume of Loyalty Units redeemed.

In its 2016 annual report, the company discloses a redemption reserve amount of $410.2M included in both short and long term investments, "held to comply with a contractual covenant with a major Accumulation Partner...representing 18.5% of the consolidated Future Redemption Cost liability"(assuming the major Accumulation Partner is Air Canada here).

The company also discloses an unused general redemption reserve amount of $300M, and I can either assume that the $300M is already included in the $410.2M Accumulation Partner reserve above, or I can assume that $300M is in addition to the Accumulation Partner reserve.

Let's assume that $300M is already included in the the $410.2M Accumulation Partner reserve above.

In this case, the company seems to be hinting at a full Future Redemption Cost liability of $410.2M / .185 = $2.2B. This is pretty close to the disclosed purchase obligation under the CPSA commitment of $1,986B (off-balance sheet), and I suppose that the accepted conventional wisdom has always been that although this obligation exists, it would be fulfilled by virtue of future cash flows resulting from future gross billings under the existing (and to be extended) Air Canada contract. All of this depends on Aimia remaining a going concern.

In this case, if there were to be a run on unredeemed loyalty rewards all within a short period of time, the company would need to somehow find a way to make good on making its members whole.

My hypothesis, therefore, is that the market is somehow anticipating a rush of member redemptions in advance of 2020. Why else would the 2019 bonds have collapsed one full year before the contract is set to expire?

In any case, I exited the strips I paid $.87 for back in July 2016 for $.72 and took my lumps, predicated on my re-analysis of the situation per above.

Truth be told, this risk was always there, I just didn't see it (and by virtue of a 70% drop in the common neither did most other participants, i.e., Muppets).

Concluding Thoughts

I have a number of concluding thoughts on this situation, in no particular order:

  • What made me an authority on Aimia bonds in the first place? Why was I smug (or stupid) enough to have risked $7,976 (5% of consolidated capital at the time) on an issuer of which I really knew nothing about, and which had a gaping hole in its business model which I chose to ignore (i.e., 100% economic dependence on an unrelated 3rd party for its entire business model)? Although I got lucky on the 2018 bonds, I wasn't so lucky on the 2019 strips. 
  • The above point brings to question, just what am I an authority on when it comes to evaluation of credit? The answer: NOTHING. For the same capital at risk, I could have spent the same time researching who the best active bond fund manager is in Canada and bought $7,796 of units in his/her fund. Now, I know this comment ventures into the whole active vs. passive vs. do it yourself argument, and I know that do it your-selfers just abhor paying management fees, but I believe that there is a price to participate in excellent and consistent management, and when it comes to evaluation of credit, this is definitely not my playground, and I paid for it. 
  • Following this, I therefore believe that an honest evaluation of one's own capabilities is absolutely necessary in participating in a particular asset class, whether that class be fixed income or equities or whatever else we choose to invest in. There are professionals out there who's entire focus is to evaluate credit, daily. For the same effort it took me to develop initial expectations (which ultimately proved incorrect) surrounding purchasing Aimia credit in the first place, I could have made a short list of the best active bond fund managers and whittled that list down to one or two candidates. 
  • Ok, let's say you do consider yourself an expert in credit and you are a do it your-selfer at the same time. Minimum bond purchases at most dealers are $5K face. Achieving proper diversification across both ratings classes and durations must be a function of account size. On $150K in assets under management, I could really only buy 30 different bonds, which I don't believe is anywhere near enough in order to diversify issuer credit risk, not to mention geographic risk, duration/interest rate risk, etc. And even if I bought 30 different bonds, I'd be 100% fixed income! Not too intelligent.
PS, there is a silver lining to all of this. I just redeemed $1,000 of un-redeemed Aeroplan loyalty rewards for two $500 Best Western gift cards which I intend to use in a month during a family stay in Orlando Florida. My rationale? Why wait?

Friday, 19 May 2017

Welcome to the Diary of a Mad Retail Muppet (aka me)

Welcome to my first blog entry.

Unlike my previous blog, the title of which was something of a misnomer, I feel it's much more appropriate to refer to myself as a mad retail muppet, because, this is truly what I am. And when I say mad, I don't mean angry mad, I mean looney-bins mad.

So what do I hope to achieve here? Much more breadth of discussion and furtherance in my own personal financial journey while pulling no punches and calling things as I see them, with a view to hopefully assisting readers see through (and find humour in) the daily financial tomfoolery that seems to proliferate by the millisecond, whether from (supposed) reputable or non-reputable financial information sources.

The majority of my writings will be of observational in nature, and I hope to focus my efforts in an attempt to garner a better understanding of subjects such as valuation (whether stand alone or relative), behavioral finance, and portfolio management.

I will attempt to post all of my detailed work in arriving at my valuation observations, documenting my thought process and questions I have along the way.

Comments and criticisms are welcome.