Aging in Dog Years? The Short, Glorious Life of a Successful Tech Company!

The corporate aging theme is one that I have returned to repeatedly in my posts, and I have looked at how the aging process creates dysfunctional responses on the parts of managers, who want to find ways to reverse it, and investors, who make bets on such reversals. It was the under pinning for my last post on Yahoo, and in that post, I argued that technology companies have compressed life cycles, i.e., age in dog years, relative to non-tech companies. In this post, I would like to provide a rationale for why this may be the case and set the stage for my next post on what the implications are for managers and investors.

The Corporate Life Cycle

The corporate life cycle follows a familiar pattern. It begins with an idea, that develops into a product, which evolves into an operating business, that matures, and eventually dies. 

I have also highlighted the transitions that determine whether a company moves to the next stage and the mortality rate especially early in the life cycle is high. There are wide differences across companies in how long they take to climb the life cycle, how much time they spend as mature companies and how quickly they decline. As legal entities, corporations do have a little more give in the process, i.e., the capacity to slow or even reverse the process for periods, than individuals do, but not as much as they (and their strategic advisors) think that they do.  The one reality that I think is incontestable is that even the most exceptional companies will age and that whether they deal with that aging gracefully is what determines how their stockholders will do during the process. 

Determinants of the Life Cycle

To get a sense of what drives differences across companies and how the life cycle evolves, I tried to take a look at the determinants of each phase of the cycle in the graph below:

• When you start up, your focus is survival, and that will depend on (a) how much access you have to capital, (b) how much you need to invest to enter the market and (c) the time lag before you have a product or a service. Your chances of survival improve, if you have access to more capital and don't have to wait very long before you have a functioning product. 
• The speed of your growth will depend on (a) how quickly the overall market is growing, (b) the ease of scaling up your operating and (c) how much inertia there is on the customers side. You will be able to grow faster, if the overall market is growing exponentially, scaling up is easy and you are dealing with customers who are willing to switch from incumbent products/services.
• The length of the mature phase will depend upon the nature of your competitive advantages, how big they are and how long they last. If your competitive advantages are strong and sustainable, your mature phase can last for a long time. Consumer product companies with strong brand names, one of the strongest and most sustainable competitive advantages, have longer mature phases than companies that have a cost advantage, a more transient and short term competitive advantage.
• In decline, the speed with which your business will deplete will depend upon (a) how quickly new companies can enter the market  (b) how quickly they can scale up and how willing customers are to try new products. In other words, you see that a mirror image of the qualities  that allow for speedy growth also contribute to a quick decline.
• In the end game, your choices depend on what your remaining assets look like and whether they can be liquidated, without substantial losses. If they can, your end will be speedy and perhaps even painless. If not, your death throes can be long and painful.

Tech versus Non-tech

Before we start on a discussion of how tech companies are different from non-tech companies, we have to think about what separates the two groups, and that separation becomes hazier by the day. In the 1980s, at the start of the tech revolution, the distinction was a simple one. If a company�s products or services were computer-related (either personal or business computers), it was classified as a technology firm. That distinction allowed us to identify Microsoft, Apple and Atari as technology firms, and bring in HP, IBM and Digital Equipment as the old guard. That definition no longer works, as almost every product we buy (from appliances to automobiles) has a computerized component to it, and it has meant that deciding whether a company is a tech company is a judgment call. Given that reality, I would propose that rather than draw hard lines of distinction between tech and non-tech, we consider technology on a continuum, where at one end you have companies whose products and services are entirely technology driven (Google, Facebook) and at the other, you have companies that almost no technology component to them (consumer products and cosmetics companies, for instance). With this continuum, you can argue that Tesla and Ford are both auto companies, but that Tesla has a larger technology component than Ford. 

Why do we care about these distinctions? First, they have practical implications for analysts and portfolio managers. Sell-side equity research analysts are usually put into sector silos and asked to keep their focus on the companies that they are assigned. With companies like Amazon, Netflix and Tesla, high profile names to follow, I have noticed that there are big differences across banks. Some assign these companies to the technology analysts, some to the businesses that these companies operate in (Tesla in autos, Netflix in entertainment and Amazon in retail) and some create new sector groupings just for these gray area companies. Second, for better or worse, the categorization of a company can affect its pricing. Tesla, classified as an auto company, will look expensive, compared to other auto companies, but classified as a young tech company, it may look cheap. That is perhaps why companies seek out the tech label for themselves, even if technology is only a small component of their offerings.

The Tech Life Cycle

If you accept my argument that technology is a continuum, then you can perhaps live with my definition of �tech� companies as those that get the predominant portion of their value from technology. With that definition, I can revisit the corporate life cycle and its determinants and make the following generalizations (and I am sure that you can think of exceptions with each one):

• Scaling up is easy: Tech companies often operate in businesses where entry is not restricted, the up front investment is minimal and scaling up in easy. If market conditions are favorable, they are aided and abetted by access to  capital and by less sticky customer preferences in their markets. Not surprisingly, tech companies can grow quickly.
• Holding on is tough: Once tech companies reach the mature phase, they don't get to have long harvest periods. Their competitive advantages are fleeting and quickly deplete.
• Decline is rapid: The same forces that allow technology companies to grow, i.e., unrestricted entry, ease of scaling up and customer switching, also make them vulnerable to new entrants seeking to take their business away from them.
• And there is little left in the end game: Unlike other businesses, which accumulate physical assets as they grow and thus have a liquidation potential, with technology companies, there is little of substance to fall back, once earnings power is exhausted.

Here, for instance, is my contrast between the life cycle of the typical tech company, contrasted with a typical tech company.

Is there evidence that this is what happens in the market? I could use Blackberry as an example, but I would then be guilty of using anecdotal evidence to advance my theory. Instead, I will argue that the evidence exists, albeit in scattered form. First, there is evidence that the small tech firms (that survive the first tests) are able to scale up faster in terms of revenue growth (at least) than small non-tech firms. The fact that they often lose money while doing so is as much a function of the accounting inconsistency of treating research and product development costs as operating expenses, as it a function of operating weakness. The second is that these tech firms, once established, have a more difficult time maintaining growth. The third is that decline, once it starts at tech firms, is more difficult to reverse and quicker to accelerate. All of these points are made in this  McKinsey article on growth at tech companies. 

A Life Cycle Perspective on Disruption

Disruption is the new buzz word in corporate strategy, a reason that I listed it as on my list of words that operate as weapons of mass distraction, and is often used to cut off debate or not talk specifics. From my perspective, the essence of disruption is a that it is a new way of doing business that radically changes the fundamentals of on established business. In the context of technology-driven disruption, it a company, with a tech model, coming into a non-tech business, characterized by long growth periods, extended mature phases and elongated declines.

Consider car service, i.e., the taxi cab and limo business. The old non-tech model for this business required regulatory approval (making entry difficult) and substantial investment (in cars) in a market governed by customer inertia. Uber and the other ride sharing companies have upended the model by bypassing regulatory approval, not investing in cars and breaking through inertia by reaching out to customers through their smart phones. The results speak for themselves. Not only have Uber, Lyft and Didi Kuaidi grown at rates unlike any seen by traditional car service companies, but each has a market reach that is beyond the old model. No traditional cab company can afford to operate in 300 cities, like Uber does.

The effect of disruption is that it upends the fortunes of mature companies from the old business model, coasting in their mature phase, convinced that change is slow. Unprepared for the speed of change emanating from the tech entrants, these old players wait too long to respond, looking to regulators and rule makers for protection, and not surprisingly, face an implosion. That, in a nutshell, is what has happened to the taxi cab and limo business in many cities. The new entrants, though, should not celebrate too quickly, since their tech model disruption comes with its dangers. Their models are difficult to mine for cash flows and are themselves susceptible to competition. As I noted in my post on the future of the ride sharing business, disruption is easy, but making money on disruption is hard.

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Tech Life Cycle Series

1. The Yahoo Chronicles! is this the end game?
2. Aging in Dog Years? Tech Company Life Cycles (Coming soon)
3. The Compressed Tech Life Cycle: Investing and Management Implications

The Yahoo! Chronicles! Is this the End Game?

The big news of the day from the tech world comes from Yahoo (I am going to skip the exclamation point through the entire story, but don't read significance into that exclusion), where stories suggest that the board of directors may soon decide whether to sell its operating business, leaving it as a shell company with holdings in two other public companies, Yahoo Japan and Alibaba. The story has resonance for many reasons. One is the presence, as is required in any good story, of a villain, a role that is usually assigned to an activist investor and in this case ably filled by Starboard Value, a fund that has been pushing for this divestiture. The second is the existence of a heroine, albeit a tarnished one, in the form of Marissa Mayer, who was supposed to save the company by boldly moving where Yahoo had not gone before. The third seems to be an almost existential question of whether the  potential end game for Yahoo, a company that many journalists grew up with as part of the technology landscape, is an indication of their own aging.

Stepping back in time

Let's start with a reality check. By the time Marissa Mayer became CEO of Yahoo in 2012, its glory days were well in its past, as you can see in this graph that traces its history from young, start-up to mature (and beyond) in the life cycle:

Not only had Yahoo decisively and permanently lost the search engine fight to Google, but it was a company in search of a mission, with no clear sense of where its future lay. 

Ironically, the two best investments that Yahoo made during the recent past were not in its own operations, but in the other companies, an early one in Yahoo Japan, which prospered even as its US counterpart stumbled, and the other in Alibaba in 2005, a prescient bet on a then-private company. Alibaba's online sites, Taobao and TMall, through which almost 75% of all online retail traffic in China flows, makes it a legitimate and valuable symbol of the China story and it went public late last year to fanfare and a record-breaking market capitalization (for an IPO). I valued Alibaba at the time of its IPO filing and I extended my analysis to include Yahoo, which at the time held 21% of Alibaba. While my valuations need to be updated to reflect what has happened in the last year, the picture that I drew in September 2014, breaking down Yahoo's intrinsic value into its component parts remains largely intact:

Valuation in September 2014

Note that of my estimated value of my total estimated value of $46 billion for the company, less than 10% (about $3.6 billion) comes from Yahoo's operating assets.

The challenge that Ms. Mayer took on was to not only turn around a company that had lost its way in terms of its core business but one that derived most of its value from holdings in two companies that she had no control over. Her history of success at Google and the fact that she was young, attractive and female all played a role in some  choosing her as the anointed one, the savior of Yahoo.

Why Marissa Mayer's quest was always long shot

The odds of Ms. Mayer succeeding at Yahoo, at least in the ways that many of her strongest supporters defined success, were low right from the beginning, for two reasons:

1. It is hard enough to turn around a company but it becomes even harder when you are given control of only the rump of the company. The reality is that, on any given day, the value of Yahoo as a company was more influenced by what Jack Ma did that day at Alibaba, than what Ms. Mayer did at Yahoo.
2. In a post a few months ago, I noted that the tech business is an aging one, and that it is time for us to retire the notion that tech equals growth. I also argued that tech companies age in dog years, relative to companies in other sectors, and that a 20-year old tech company is closer to being geriatric than middle aged. It is for that reason that I give long odds to any aging technology company that tries to rediscover its youth. (I will be doing a follow-up post in a couple of days on my reasoning for why the tech business life cycle is compressed in time.)

Lest I sound fatalistic, it is true that there are counter-examples, aging tech companies that have rediscovered their youth, as evidenced by IBM's rebirth in 1992 and Apple's new start under Steve Jobs. Much as we would like to give Lou Gerstner and Steve Jobs credit for pulling off these miraculous feats, I believe that it was a confluence of events (many of out of the control of either man) that allowed both miracles to happen. The Lou Gerstner turnaround at IBM was aided and abetted by the the tech boom in the 1990s and as for Steve Jobs, the myth of the visionary CEO who could do no wrong has long since overtaken the reality. By promoting both turnarounds as purely CEO triumphs, we set ourselves up for the Yahoo scenario, where a new CEO (Marissa Meyer) is assumed to have the power to turn a company around but we are then disappointed in her failure to do so.  I am less disappointed in Ms. Mayer than many others, since my expectations on what she could do at Yahoo! were much lower, right from the start.

Betting the farm! 

In a recent article in the New York Times, Farhad Manjoo, a writer that I enjoy reading and respect for his tech savvy, made a case that Ms. Mayer's failures can be traced to her lack of boldness at Yahoo, or as he put it, her unwillingness to bet the farm, an ill-suited choice of expressions in many ways, at least for this CEO, and this company. First, as the CEO of a publicly traded company, she would not have been betting her farm, but that of her stockholders. Second, if you buy into the notion of Yahoo the company, as a farm, it is  difficult to bet the farm, when you are given control of only the farmhouse (Yahoo operating assets), as Ms. Mayer was with Yahoo, and the rest of the farm (Yahoo's holdings in Alibaba and Yahoo Japan) is off-limits to you.. Third, betting the farm also connotes seeking out of long odds, in the hope of a big payoff, entirely okay if you are a young start-up, with little to lose, but not so in the case of Yahoo.

Mr. Manjoo is not alone in believing that Marissa Mayer's fault was that she did not make a bigger acquisition or larger investment in some new business (for the most part, unspecified). In fact, it is part of what I termed the Steve Jobs syndrome, where CEOs aspire to be the next Steve Jobs. While some go so far as to don black turtlenecks and strut on the stage like he did, most settle for wanting to be heroic enough during their tenure to have books written about them, and Ashton Kutcher play them on the screen. More dangerous is what follows, since to be like Steve Jobs, you have to make a small company into a really big one, and the way to do that is to take dangerous risks or to "bet the farm". The end results reflect the laws of probability, and the stockholders in these firms end up paying for a CEO's play for celebrity status.

If you accept my thesis that many aging tech companies resemble the Walking Dead, you should also accept the follow-up proposition that what these companies need are not "visionary" CEOs but pragmatic ones, less Steve the visionary, and more Larry the Liquidator, a person with limited ambitions and a readiness to preside over the dismantling of an enterprise. Unfortunately, if you are such a CEO, and your life were made into a movie (odds of which are low), you will be played by  Danny DeVito and not Ashton Kutcher, but there is always a price for doing the right thing. The debate about what Ms. Mayer should or could have done at Yahoo is a subtext to the other great debate  about buybacks at US companies, and especially those at tech titans like IBM and Microsoft. Rather than wringing our hands at how these buybacks are leading to less investment at these companies, we should be relieved that these companies have moved past the denial phase and are dealing with the reality of aging.

What now?

If I were to offer advice to the board, in keeping with the gambling theme created by betting the farm, I would suggest that they listen to this Kenny Rogers tune. It is time get past the denial and sell Yahoo's operating business, while there still is a business to sell, and to get the best possible price on the deal, I would suggest the following:

1. Rather than talk about Yahoo's businesses (their search engine, advertising), which will draw the attention of potential buyers to the operating statistics (which are a downer), talk about the number of Yahoo users (the billion that you have overall and the 250 million who use Yahoo Mail). 
2. Look for a buyer with an ambitious CEO (i.e., with Steve Jobs syndrome) who wants to bet the farm and pay a premium price (using shareholder money) for stardom. Taking a cue from the gambling business, it is much better to be the taker of big bets than the maker of these bets

The cash from that sale and perhaps even the rest of the cash balance should be returned to stockholders, leaving Yahoo as a holding company, with Yahoo! Japan and Alibaba as its holdings. The tax consequences of selling these holdings will be substantial and the board should remove the resulting market discount by announcing its intent to continue to run Yahoo as a holding company, a closed-end fund with two holdings. As a stockholder in Yahoo, I can live with that, since I am getting Alibaba and Yahoo! Japan at a significant discount on their traded value, as can be seen below (even assuming that Yahoo gives away its operating assets for nothing):

	Market Cap	Yahoo's share	Value of holding
Yahoo! Japan (12/4/15)	$23,900	35.00%	$8,365
Alibaba (12/4/15)	$207,500	15.40%	$31,955
			$40,320
+ Yahoo Cash (Sept 2015)			$5,882
- Yahoo Debt (Sept 2015)			$2,161
+ Yahoo Operating Assets			$-
Value of Yahoo Equity			$44,041
Yahoo Market Cap (12/4/15)			$32,390
Discount on holdings			28.90%

Towards the end of my post on Yahoo from last year, I suggested that my returns on Yahoo would be inversely proportional to Ms. Mayer's ambitions and argued that my best case scenario would be one where she scaled the number of employees in the firm down to one (herself) and acquired two computer displays, one of which would deliver real time price quotes on Alibaba and the other the latest price of Yahoo Japan. If the board acts to sell Yahoo's operating assets, we may be closer to that vision than I ever thought I would get.

If this is the end game, I am thankful that, while Ms. Mayer did show flashes of ambition, as revealed in her acquisitions (with the Tumblr deal being the largest)  over the last three years, she did not "bet the farm" on an outlandishly large acquisition or investment. Perhaps, I am giving her more credit than I should, and the only reason she showed restraint is because she could not find a tax advantaged way to get rid of Yahoo's investments in Yahoo Japan and Alibaba. If so, this may be one of the few times that I am thankful to the IRS for not allowing the transaction to go through, since on its completion, Yahoo would have ended up with $20 billion in cash, and I shudder to think of how much damage a "bet the farm" CEO could have done with that money.

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Lead-in Blog Posts

1. The Aging of the Tech Sector
2. Living within our limits: Thoughts on RIM
3. Yahoo! A puzzle, a mystery and an enigma
4. The Walking Dead: Yahoo, Blackberry and the Zombie Apocalypse
5. Rebirth and Reincarnation: Escaping the Corporate Death Spiral

Follow-up Blog Posts

1. The Yahoo Chronicles! is this the end game?
2. Aging in Dog Years? Tech Company Life Cycles (Coming soon)

System Helps Novices Design 3-D-Printable Robotic Creatures

 

                                Disney, CMU Develop Tool That Ensures Legged Robots Move as Intended

Digital designs for robotic creatures are shown on the left and the physical prototypes produced via 3-D printing are on the right.

Even a novice can design and build a customized walking robot using a 3-D printer and off-the-shelf servo motors with the help of a new design tool developed by Disney Research and Carnegie Mellon University.

The user can specify the shape, size and number of legs for the robotic creature, using intuitive editing tools to interactively explore design alternatives. The system also ensures that the resulting design is capable of moving as desired and not falling down; it even enables the user to alter the creature�s gait as desired.

�Progress in rapid manufacturing technology is making it easier and easier to build customized robots, but designing a functioning robot remains a difficult challenge that requires an experienced engineer,� said Markus Gross, vice president of research for Disney Research. �Our new design system can bridge this gap and should be of great interest to technology enthusiasts and the maker community at large.�

�We aim to reinvent the way in which personal robotic devices are designed, fabricated, and customized according to the individual needs and preferences of their users,� said Stelian Coros, a former Disney research scientist who is now an assistant professor of robotics at Carnegie Mellon.

The research team presented the system at SIGGRAPH Asia 2015, the ACM Conference on Computer Graphics and Interactive Techniques, in Kobe, Japan.

�We aim to reinvent the way in which personal robotic devices are designed, fabricated, and customized according to the individual needs and preferences of their users.� � Stelian Coros

�Our ambition is to make the design of compelling robotic creatures as accessible and intuitive as possible,� said Bernhard Thomaszewski, a research scientist at Disney Research. �Our tool allows the user to design the structure and motion of a robot while receiving immediate feedback on its expected real-world behavior.�

The design interface features two viewports: one that enables editing of the robot�s structure and motion and a second that displays how those changes would likely alter the robot�s behavior.

The user can load an initial, skeletal description of the robot and the system creates an initial geometry and places a motor at each joint position. The user can then edit the robot�s structure, adding or removing motors, or adjusting their position and orientation.

The system takes over much of the non-intuitive and tedious task of planning the motion of the robot. The user nonetheless is able to adjust the robot�s footfall pattern and stylistic elements of its motion.

The researchers have developed an efficient optimization method that uses an approximate dynamics model to generate stable walking motions for robots with varying numbers of legs. In contrast to conventional methods that can require several minutes of computation time to generate motions, the process takes just a few seconds, enhancing the interactive nature of the design tool.
Once the design process is complete, the system automatically generates 3-D geometry for all body parts, including connectors for the motors, which can then be sent to a 3-D printer for fabrication.

The researchers designed and built two four-legged robots using the design system and found that the overall motions of the prototypes were consistent with the behaviors predicted by their simulation.

�It took us minutes to design these creatures, but hours to assemble them and days to produce parts on 3-D printers,� Thomaszewski said. �The fact is that it is both expensive and time-consuming to build a prototype � which underscores the importance of a design system such as ours, which produces a final design without the need for building multiple physical iterations.�

In addition to Gross, Thomaszewski and Coros, the research team included Vittorio Megaro and Otmar Hilliges of ETH Zurich and Maurizio Nitti of Disney Research.

Source: edu

Texas project privately raising $4 billion

A JR Tokai N700 series shinkansen

NAGOYA -- A project to develop a high-speed railway in the U.S. state of Texas, building upon the technological assets of Central Japan Railway, is tapping local businesses to raise about $4 billion, according to people familiar with the matter.

     Through the fundraising campaign, the project will secure about a third of the $12 billion in assumed total construction costs. Central Japan Railway, known as JR Tokai, could invest a few million more.

     The envisaged high-speed railway is to run a revamped version of JR Tokai's mainstay N700 series shinkansen on some 400km between Dallas and Houston. Unlike most other high-speed railway projects, which are funded with state money, the Texas venture is being bankrolled entirely by the private sector. Locally financed Texas Central Partners is responsible for setting routes and acquiring the necessary land.

     Texas Central Partners plans to set up a new company by 2017 to start construction. It hopes to open the route by 2021. The rest of the construction costs are expected to be covered by debt. Texas Central Partners has already raised about $73 million from local companies and other parties.

     The Japan Overseas Infrastructure Investment Corporation for Transport & Urban Development on Saturday said it will help to speed up the project by investing $40 million in Texas Central Partners, with an eye to increasing the amount to about $146 million.

Value and Taxes: Breaking down the Pfizer- Allergan Deal

A week ago, I began my series of posts on the drug business, starting with my perspective on how the business is changing and then moving on to posts on Valeant's business model and the runaway story of Theranos. I am finishing this series with a post on Pfizer's plan to merge with Allergan and the economics of the merger. This deal, which will make one of the largest pharmaceutical companies in the world even larger has drawn attention not just because of its magnitude, but also for its motives. While there is some desultory chatter about synergy (as is the case with every merger), this deal seems focused on two specific motivations: the first is that this is a bid by Pfizer to buy Allergan's higher growth and the second is that this is a deal designed to save taxes. Not surprisingly, the latter is attracting attention not just from investors and financial journalists, but also from politicians. 

Growth but at what cost?

One of the most dangerous maxims in both corporate finance and investing is that it is better to grow than to not grow, and that a company that faces stagnant or declining revenues (and income) should seek out higher growth (at any price). In a post from a long time ago, I looked at the value of growth and noted that the net effect of growth depends on how much you pay to get it, and that overpaying for growth will give you higher growth and a lower value. In the graph below, you can see the effect of growth on value for three companies, all of which grow, the first by making investments that generate returns that exceed the cost of capital, the second by making investments that earn the cost of capital and the third by making investments that earn less than the cost of capital.

It is this perspective on growth that makes me skeptical about companies that grow through acquisitions, especially when those acquisitions are big and are of public companies. Since you have to pay market price plus (a premium of 20-30%) to acquire a public company, for a growth-motivated acquisition to create value, you have to be able to find a growth company that is under valued by more than 20% or 30%, given its growth rate, at the time that you initiate the deal to be able to walk away with value added. Note that, much as I am tempted to do a riff about the wondrous benefits of bringing both Botox and Viagra under one corporate entity,  I am deliberately keeping synergy out of the equation since it can justify a premium.

Let's consider then the proposition that the Pfizer deal for Allergan is driven by the motivation of buying growth. The basis for the story is visible in this comparison of Pfizer and Allergan's operating numbers over the last five years:

Over these five years, Pfizer's revenues shrank about 6% a year whereas Allergan's revenues grew at 40.62% a year. That makes the case for the acquisition, right? Not quite, because it depends on whether the market is already pricing in Allergan's growth. If it is, buying Allergan will allow Pfizer to grow faster, but not create value and may in fact destroy value if the premium paid is large enough.  To examine whether Allergan offers growth at a bargain, I considered valuing Allergan, but very quickly abandoned the idea, because it reminded me of Valeant, insofar as it has grown rapidly through acquisitions, funded with significant amounts of debt and its financial statements are a mess. Thus, while it clear that Allergan has grown fast, the question of whether it has grown sensibly is a question that remains to be answered. Looking at the multiples at which Allergan was trading, prior to the Pfizer bid, there is almost no multiple on which it looks like a bargain.

	Pharmaceuticals	Allergan	Allergan Premium
PE Ratio	31.24	NA	NA
Price/Book Equity	4.11	4.37	6.33%
EV/EBIT	20.12	53.15	164.17%
EV/EBITDA	13.97	19.32	38.30%
EV/EBITDAR	9.71	16.58	70.75%
EV/Sales	4.71	7.85	66.67%

What is the bottom line? If I were a Pfizer stockholder, I would be concerned if buying growth were the primary reason for this acquisition, since the growth at Allergan is not only at a premium price but also untested (insofar as it is acquired growth rather than organic growth). I would be terrified, especially after recent scares, that the acquisition accounting at the company may be hiding bad surprises.

The Insanity of the US Tax Code

One of the most surprising aspects of this deal is how open the Pfizer management has been about the tax motivations for the deal, with Ian Read, the CEO of Pfizer, saying that "the company is at a tremendous disadvantage under the U.S. corporate tax code and that Pfizer is competing against foreign companies with one hand tied behind our back.� This planned "inversion", of course, has triggered a heated response, understandable (at least politically), though some of the critics don't quite understand the US tax law and what exactly Pfizer will gain by leaving behind its US incorporation. 

I have vented extensively about the absurdity of US tax law and how it encourages perverse behavior from businesses (and individuals). Rather than repeat myself, let me focus in on the three aspects of the law that makes it so damaging: 

1. The level of rates: There was a time four decades ago when the US federal corporate tax rate, at 40%, was in the middle of the global tax rate distribution, with many countries adopting a policy of punitive corporate taxation. The corporate tax rate in the US was last lowered in 1986 to 34%, then raised to 35% in 1993 and has remained unchanged since. With state and local taxes, it amounts to close to 40% in 2015. The rest of the world has moved away from the US and lowered corporate tax rates, leaving it with one of the highest marginal tax rates in the world in 2015. (See this KPMG site for tax rates around the world) 

   

   Source: KPMG

2. Global versus Territorial taxation: Adding to the US tax code's woes is the requirement that US companies pay the US tax rate not just on US income but on income generated elsewhere in the world. In 2015, it remains one of six countries that follow this practice, whereas the rest of the world has moved to a territorial tax model, where companies get taxed based on where they generate income (and are done). The Global tax model, which was born in an age when the US economy was the driver of the global economy and US companies were domestically focused, results in US multinationals facing much higher tax rates on world income than multinationals incorporated elsewhere.  (Interestingly, Ireland is one of the six countries with a global tax model but with its low tax rate, the effect is muted.)
3. The Repatriation Trigger: To cap off this trifecta, US tax law adds a clause that specifies that the �additional US tax� due on foreign income has to be paid only when that income is repatriated to the United States. In response, US companies have had the logical reaction and not repatriated foreign income, leaving that income �trapped� in foreign locales. In 2015, it was estimated that the trapped cash amounted to more than $2 trillion, money that cannot be used to pay dividends, buy back stock or make investments in the US, but can be used to make investments anywhere else in the world. 

The benefit to a company of removing itself from US tax incorporation, i.e., inversion, is therefore two fold:

1. No US taxes on foreign income: While the company will continue to pay the US tax rate on its US income, its foreign income will be taxed only at the foreign domicile's tax rate. 
2. Untrap cash: To the extent that the company has built up trapped earnings (in foreign locales) that it is restricted from using, it can release the cash without any tax penalties.

Given US tax law, the question is not why some companies seek to leave its tax jurisdiction, but why more of them do not, and the answer lies in an uneasy middle ground, a wait-it-out scenario that many US companies have adopted, where they let income accumulate in foreign markets and wait for one of two developments. One is a change in US tax law, which people on both sides of the aisle seem to agree is needed, but don't seem to want to bring to fruition. The other is that Congress will blink yet again and pass another one of its "tax holidays", a "once in a lifetime" chance (that shows up once every decade)  that will be given to companies to bring their cash home with no penalties. The net effect is that the US ends up with the worst of all worlds: a tax code that is ineffective at collecting taxes (as evidenced by the drop in corporate tax collections over the last three decades) while encouraging companies to borrow more and more money (and save on taxes at the marginal rate).

Pfizer: The Numbers 

To understand how exposed Pfizer is to the vagaries of US tax law, I started by looking at the geographical distribution of Pfizer revenues over time:

Note that Pfizer generated only 43.08% of its revenues in the first nine months of 2015. If Pfizer were to be taxed, at the marginal rate in each region, based on where it generated its revenues (regional tax), its tax rate in those nine months would have been 30.68%. As a US company, though, Pfizer would have to pay almost 40% of this income as taxes, translating into significantly higher taxes each period.  Pfizer, of course, chose not to take this course, as manifested in two numbers. The effective tax rate that Pfizer has paid over the last five years has averaged to 23.45%, well below 40%, and a significant portion (my rough estimate is $12 billion) of Pfizer�s cash balance of $20.66 billion is trapped. Binging it back will result in a tax bill of $1.99 billion (using a differential tax rate of 16.55%, the difference between the US marginal tax rate of 40% and the effective tax rate of 23.45%). 

Valuing Pfizer 

To illustrate the impact that changing the tax code that governs Pfizer has on its value, I considered three scenarios. 

1. Patriot Games: In this scenario, I assume that Pfizer does its patriotic duty (as some critics would label it) and not only decide to bring all of its trapped cash home today (and pay the differential taxes) but repatriate all of its foreign income each year back to the US and pay a 40% marginal tax rate on that income. 
2. Wait-it-out (Tax Limbo): In this scenario, Pfizer will leave its trapped cash overseas, continue to pay taxes to foreign governments on foreign income but not repatriate the cash. That will leave their effective tax rate well below the US marginal tax rate and Pfizer will have to hope that US tax law gets fixed or that Congress does another one of its �once in a lifetime� tax holidays. 
3. Go Irish: In this scenario, Pfizer buys Allergan and meets the requirements for shifting its incorporation to Ireland. Note that doing so does not affect their taxes on US income but it will not only un-trap their cash but also remove the constraint they face today on foreign income. 

The different assumptions that I make about taxes under the three scenarios are summarized:

Tax Model	Marginal tax rate (for cost of debt)	Effective tax rate (next 10 years)	Effective tax rate (in stable growth)	Trapped Cash
Patriot Games	40%	40%	40%	Return immediately & pay taxes now.
Wait-it-out (Tax Limbo)	40%	23.45%, with taxes on deferred taxes paid in year 10.	40%	Return in ten years & pay taxes then.
Go Irish (Invert)	40%	23.45%	30.68%	No taxes due

In the table below, I value Pfizer under each scenario (see spreadsheet), first using the conventional accounting numbers (which treat R&D as an operating expenses) and next using adjusted numbers (where I capitalize R&D):

		Patriot Games	Wait-it-out	Go Irish	Effect of Inversion
R&D Expensed	Equity Value	$154,806.00	$176,047.00	$209,637.00	$33,590.00
	Per share	$25.09	$28.53	$34.39	$5.86
R&D capitalized	Equity Value	$121,074.00	$135,156.00	$162,309.00	$27,153.00
	Per share	$19.62	$21.91	$26.60	$4.69

The rationale for an inversion is that it will increase Pfizer�s equity value by $27.2 billion and its share price by $4.69 per share. This calculation, though, is based on the assumption that US tax law will never change, and that its dysfunctional components will continue in perpetuity. If you assume that the current bipartisan talk of fixing the law will result in changes (in either the corporate tax rate or in the global tax feature), the value increase will drop off substantially.

Deal or No Deal?
I applaud Ian Read's focus on shareholder value but will this deal create that value? I am skeptical and here is why. Even if you accept the upper limit of the value of inversion ($27.2 billion), that increase in value does not incorporate two potential costs associated with inversion.

1. The new rules covering inversions will require that Pfizer go through contortions to qualify and some of these contortions will add to the cost of the deal.
2. There is the possibility of a backlash, not so much from customers, but from politicians. There are senators who are already threatening the company with consequences, though I am not sure that any of them would actually go as far as to ban or restrict Pfizer product sales in the US (since that would hurt those who need the drugs the most). Even if they do, given that the US Senate is disproportionately composed of older men, I am confident that they will carve out a "Viagra exception" for themselves.

There is a second and even bigger concern that I would have as a Pfizer stockholder. If the rumors that Pfizer is planning to pay a 30% premium are right, that would translate into a premium of more than $30 billion over Allergan's market capitalization to buy the company. Since the growth is already priced in (at least in my view), the only way you can create value is to draw on synergy and nothing that either company has said suggests any concrete benefits from the combination.

The bottom line is that this looks like a bad deal for the wrong company, at the wrong time and at the wrong price, the wrong company because Allergan's accounting statements are a mine field due to acquisition accounting, the wrong time because we may actually be on the verge of a major change in US corporate tax code and at the wrong price because of the premium on an already large market capitalization.

The Morality Play? 

As I was writing this post last week, I had a conversation with a friend about Pfizer. After I explained why I thought the Pfizer plan to acquire Allergan made sense, given the tax code and Pfizer's global exposure, her response was that Pfizer should not do this because �it is immoral". While I was floored initially by her assertion, it would be have been both futile and hubristic for me to try to prove her wrong. She is entitled to her moral judgments, just as I am entitled to mine, but it is moral, rather than economic, differences that usually lie at the heart of tax debates and that is perhaps why it is so difficult to get a consensus.

If you own a business that would benefit from shifting away from the US for tax reasons, and you have patriotic or moral reasons for not doing so, you are well within your rights in staying US-bound and I support you in your choice. If you are the manager of a publicly traded company and you face the same choice, I am afraid that you cannot impose your patriotic or moral judgments on your stockholders. Not only are many of them foreign investors (with a very different sense of what comprises patriotism), but quite a few of them will part ways with you on your judgment that maximizing taxes paid  to the government is a moral calling.

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Blog Posts in this series

1. Divergence in the Drug Business: Pharmaceuticals and Biotechnology
2. Checkmate or Stalemate? Valeant's Fall from Grace
3. Runaway Stories and Fairy Tale Endings: The Theranos Lesson
4. Value and Taxes: Breaking down the Pfizer- Allergan Deal

Datasets

1. Tax Rates by Country

Spreadsheets

1. Valuing the effects of a tax inversion: Pfizer