Competing for Customers and Capital

Creating Intangible Value

Two-thirds of the market value of US companies is based on intangibles. Yet, the source of all this intangible market value is considered to be “a mere detail” in some stock pricing models. For example, intangible market value is not given even a passing mention in McKinsey & Co.’s widely read Valuation (4th ed.) by Tim Koller, Marc Goedhart and David Vessels. And the internal costs of developing intangible assets are summarily dismissed by the rules of financial accounting:

Development costs for intangible assets can be capitalized only under the most stringent conditions (page 580).

Roughly speaking, this means that “intangibles” can enter a company’s balance sheet as an asset only when the market price paid for an asset is greater than its book value. To understand this dilemma one needs to recognize the fundamental difference between market value and book value. The former is based on the price of the company’s stock – to which investors’ credit management for the creation of intangible market value. The latter is determined by the rules of financial accounting – which are unable to recognize the creation of intangible assets as a function of managerial decisions, unless they are acquired.

The purpose of this post is to take a first step in tracing the theoretical linkage between the decisions of management and the creation of intangible market value.

THE MISSING FACTORS MODEL
In my post on Air Express Carriers: Mr. Smith Goes to Holland I compared actual market shares with optimal shares as if a merger had been consummated between FedEx (NYSE: FDX) and TNT [AEX: TNT] in 2007. Theoretical maximum earnings market share occurs when the operating expense of one carrier are optimized relative to those in its peer group.  The peer group in that analysis consisted of the Swiss carrier Kuhne+Nagel [SWX: KNIN]; United Parcel Service (NYSE: UPS); and DHL [XET: DPW].

I followed that post with one on Air Express Carriers and the Missing Factors Model. It takes a lot from my book Competing for Customers and Capital where I build the three “missing factors” into the stock valuation process. These factors are:

1. Peer performance
2. Intangible value creation
3. Expense optimization

The following sections illustrate how to capture the effects of the three missing factors in a single metric. I call it Relative Earnings Productivity -- REP for short. While the methodology is generically applicable, here I reveal its specific use with air express carriers.

MARKET SHARE IS THE FULCRUM
Market share is the hook on which I hang the three missing factors listed above. One of the first questions you might ask about this approach is: Why use market share? The answer is commonsensical -- if unexpected. Market share is the fulcrum of a business strategy. It is the pivot point on which to leverage intangible value from operating expenses. In short, if you optimize operating expenses and you maximize earnings. It turns out a widely accepted market share model can be found the marketing literature.

Thirty-five years ago John D. C. Little and David E. Bell wrote a working paper on the Assumptions of a Market Share Theorem. That paper was published by MIT’s Operations Research Center in May 1973.  Ralph Keaney joined Little and Bell to write a revision titled A Market Share Theorem that was published two years later in the Journal of Marketing Research. In the ensuing years hundreds of papers were inspired by this work. Among the most recent and relevant to this post is Why is Five a Crowd in the Market Share Attraction Model: The Dynamic Stability of Competition by Professor Paul Farris of the Darden School at the University of Virginia and his co-authors. In order to explain why they selected the Market Share Attraction [MSA] model to study competitive market dynamics the authors point out several of its important features:

• The MSA model is logically consistent
• Market shares are bounded by zero and one
• Shares sum to one across all the firms
• Other models do not have this property
• The model derives from four simple axioms
• Its parameters can be estimated easily
• It's a better predictor than alternative models.

MSA often is expressed in words as an us/(us+them) model. Mathematically stated m = y/(y+f) where m is market share, y is our company’s operating expenses and f is the sum of their (peer companies) expenses. Operating expenses include the costs of everyone and everything that might affect how customers and investors value the business. In the case of express air carriers these range from the costs of operating aircraft and delivery vehicles to research & development, advertising & promotion expenses as well as the salaries and benefits of all employees. The basic premise is this: Every line item in an air carrier’s operating expenses has some impact – however small or large it may be -- on its intangible market value.

MAXIMUM EARNINGS MARKET SHARE
Maximum earnings occur when marginal operating costs just equal the marginal operating income of the next share point. This means earnings after operating expenses are maximized at some unknown market share. To find this unknown value you begin by expressing company earnings and operating expenses as a function of market share, take the first derivative of this function with respect to m, set this expression equal to zero and solve (Appendix A, page 251). The result is the following maximum earnings market share equation.

The numerator under the radical in this expression is the marginal cost and the denominator is marginal profit of the unknown market share where earnings are maximized. That’s the sweet spot in a business strategy. If a company’s market share is greater than that sweet spot it throws money down the drain. If its share is less that the sweet spot it leaves money on the table. Note this assumes there is no change in the underlying capital structure of the firm.

Now plug the data from the combined 2007 income statements of FDX and TNT into this expression along with their three competitors. The result is the theoretical maximum earnings market share: 23.6% of the peer group’s total revenues, or $216.8 billion USD. This translates into FDX+TNT sales revenues of $51.1.

The two entries represented by the green balloons need some explanation. First, an express carrier’s gross margin is assumed to be 100% because the marginal operating cost per “package” is virtually zero. One cannot even assign the marginal cost of fuel to a single package.

Second, the operating efficiency ratio [OER] of the combined companies is better than average. The expected value of OER is exactly one. An OER of 0.95 means that FDX+TNT would have to spend just $0.95 on operating resources that cost an average competitor $1.00. Five cents doesn’t seem like a heck of a lot until you multiply it by $132.7 billion and realize this represents a $6.6 billion in operating efficiencies. This accounts for over half the EBITD of $12.1 billion produced by maximizing earnings of the combined companies. See Mr. Smith Goes to Holland.

The maximum earnings market share equation for a merged FDX + TNT in 2007 is more easily visualized as marginal cost and earnings schedules it produces.  The schedules in the following chart were produced by simulating the equation over a range from 15% to 30% share of peer group revenues. Marginal earnings and costs are charted on the vertical axis.

Maximum earnings of the merged companies occur in this chart where the (red) marginal cost schedule intersects the (green) marginal earnings schedules. This happens at $2.2 billion USD. The difference between actual and maximum earnings market where the schedules intersect is just 18 basis points. What does this have to do with the creation of intangible market value?

COMPETITIVE ADVANTAGE AND SHAREHOLDER VALUE
Alfred Rappaport understands the relationship between shareholder value and competitive strategy perhaps better than anyone. Here’s what he said about this relationship in his classic book Creating Shareholder Value: A Guide for Managers and Investors:

It is … productivity that the stock market reacts to when pricing a company’s shares.  Embedded in all shares is an implied long-term forecast about a company’s productivity – that is, its ability to create value in excess of the cost of producing it.  When the stock market prices a company’s shares according to a belief that the company will be able to create value over the long term, it is attributing [this belief] to the company’s long-term productivity or, equivalently, a sustainable competitive advantage.  In this way, productivity is the hinge on which both competitive advantage and shareholder value hang (Rappaport 1998, 69).

When management wrings the last drop of earnings out of each sales dollar they can do no better unless they change their business model -- or merge, which amounts to the same thing. The degree to which they achieve this goal is measured by relative earnings productivity. This is the ratio of actual earnings to maximum earnings scaled to zero when the two are equal.

The following chart shows what the relative earnings productivity of the leading air express carriers would have been in 2007 if FDX had merged with TNT in that year.

The vertical axis is relative earnings productivity. The combined FDX+TNT and its three peers appear on the horizontal axis. Since the merged carrier’s actual and maximum earnings are virtually equal at $12.1 billion its REP is zero. Close behind is UPS with a relative earnings productivity of -4%. Trailing these leaders at some distance are DPW and KNIN with relative earnings productivity of -21% and -34% respectively.

WILL INVESTORS READ THE TEA LEAVES?
DPW’s actual earnings in 2007 were $19.3 billon USD. The company’s theoretical maximum earnings were $24.4 billion. That is, the company fell 21% short of its maximum potential earnings in 2007. KNIN’s actual earnings in that same year were $5.3 billion compared with maximum potential earnings of $8.0 billion. This represented a 34% short fall. Will investors read my tea leaves and factor these earnings short-falls into each company’s stock price? Look to the future for an answer to this question.

Thanks for visiting. As always your comments are welcome.

~V

The Missing Factors Model

McKinsey & Co.’s Valuation (4th ed.) by Tim Koller, Marc Goedhart and David Wessels is one of the most widely read management books on stock pricing. In fact, at the moment it's # 3 among the corporate finance books sold on Amazon. If you’ve read their book it’s easy to understand the reason for its popularity. It conveniently gathers together decades of scholarly research and financial practice in a highly readable volume with carefully worked examples.

THE MISSING FACTORS
Despite the fact that so much scholarly research has been dedicated to refining the financial valuation model I contend there remain three critical missing factors:

1. Peer firms are ignored even though their revenues and stock prices have a direct influence on the company's performance.

2. Financial valuation models depend on tangible assets despite the fact that two-thrids of the value of US firms is based on intangibles.

3. Financial valuation models are driven by expected performance even though optimum performance is the gold standard.

These are strong assertions. But they also are well founded, as the following discussion will show.

THE FINANCE MODEL
This key financial formula for free cash flow is given in McKinsey & Co.’s Valuation (page 62):

Is it surprising that the three factors listed above are missing from this key financial formula.? Not really. After all this formula is grounded in finanical theory. But there a compelling reasons to reach beyond its disciplinary boundries. Let’s examine each of them in turn.

PEER PRESSURE
Every variable in the financial model of free cash flow is based on a stand-alone company. One might think this was a monopoly model. True, a company’s free cash flow discounted by its weighted average cost of capital [WACC] can meaningfully be compared with the company’s peers. But the model lacks interdependence between company and peer performance.

Companies in the same GICS sub-industry compete for many of the same customers as well as investors. Peer pressure in the intense competition for customers and capital has a direct effect on a company’s free cash flow, but the model is not adjusted for these effects. It’s interesting to note that neither the words “competitors” nor “peers” are indexed in McKinsey’s Valuation.

THE TAILWIND FACTOR
This bottom-up approach also ignores what happens to the peer group as a whole, in say the case where the revenues of all competitors change. In other words, it fails to account for either “tailwind” or “headwind” effects on company revenues. Which can be substantial since top-line growth is a key to success. Three other McKinsey consultants assert in their 2005 paper on The Do-Or-Die Struggle for Growth that: 

The experience of the large companies that we followed across the 1984-93 and 1994-2003 business cycles shows how difficult it is to grow without a tailwind. Although almost half of these companies maintained their status as growth giants through the two cycles, all except Wal-Mart had or built new businesses in health care or financial services – sectors that were hot in both cycles (bold type inserted, page 42). 

One might wonder: If peer pressure and the tailwind factors are so important why are they missing from the financial valuation model? Part of the answer lies is the well known “silo” effect. Scholars in finance and marketing have built virtually impenetrable walls around their disciplines. What isn’t so well known is the impact of the silo effect on business education in general and equity valuation in particular.

MEASURING THE SILO EFFECT
One tell tale measure of the silo effect can be found in the failure of scholars to provide interdisciplinary references in their research. Professors Rik Pieters and Hans Baumgartner studied cross-citations in their paper Who Talks to Whom? Intra- and Interdisciplinary Communication of Economics Journals. The following table reports citation counts by authors publishing papers in the top five marketing and top five finance journals in the three years 1995-1997 (pages 492 & 506).

Authors in the top five marketing journals cited their own discipline 5,278 times. They cited finance journals exactly 31 times. The marketing to finance journal cite ratio was 170 to 1. The complimentary numbers show the finance to marketing journal citation ratio was much worse: 569 to 1.

One can only conclude from these data that marketing and finance scholars believe they have nothing to learn from each other. Considering these papers were written largely by faculty from the top business schools – the same faculty who write the textbooks that students in all business schools study -- it’s should not be surprising to find that the tail wags the dog in financial valuation models.

A NARROW PERSPECTIVE ON VALUE
Free cash flow in the Key Financial Formula above is calculated by reorganizing the information reported in the income statement and balance sheet.  For example, NOPLAT is net operating profits less adjusted taxes (from the income statement). Invested capital is inventory, accounts payable, property, plant and equipment (from the balance sheet). Return on these investments is NOPLAT divided by invested capital. The symbol “g” stands for the rate of growth in NOPLAT. Divide the free cash flow formula above by WACC-g and you have what Koller, Goedhart and Wessels call the “Zen of Corporate Finance.”

We call the key value driver formula the Zen of Corporate Finance because it relates a company‘s value to the fundamental drivers of economic value: growth, ROIC, and the cost of capital. You might go so far as to say that this formula represents all there is to valuation. Everything else is mere detail (page 63).

Everything else is mere detail? Even though two-thirds of the market value of US companies is based on intangibles, the sources of this intangible value are not given even a passing mention in the Zen of Corporate Finance.

THE TAIL WAGS THE DOG
As you might expect there’s a lot of variation in the percent of intangible value from one industry to another. The following bar chart shows the value of intangibles as a percent of total market value in 30 industries in 2003, right between the 2001 and 2008 market downturns.

Total shareholder value in the sample of 479 companies on which this chart is based was $4.41 trillion.  The total value of intangibles was $2.95 trillion, or 67%.  The only place the financial model seems to fit comfortably is in gas pipelines, passenger air transportation and proprietary computers. But even in passenger air transportation nearly a quarter of the value is driven by intangibles.

Clearly in most of these industries the tail (tangible assets) wags the dog (market value) in the financial model of free cash flow. Of course it’s true that FASB rules do not allow R&D, advertising and promotion [A&P] expenses or the costs of people to be treated as investments, because they are not assets in the financial accounting sense of the term. And I don’t argue they should be treated as assets in that sense of the word.

What I do argue is these expenditures, though not assets in their own right, are the primary sources of a company’s intangible market value and can be built into a new equity pricing formula. The expenditures on R&D, A&P and salaried employees appear in COMPUSTAT data as Selling, General & Administrative expenses when this item is reported separtely. For an overview of these sources of intangible value see my 12 minute audio slide show on Enterprise Marketing Expenses.

OPTIMIZE CASH FLOW
Perhaps equally mysterious is this last missing factor: Why does the financial model not calculate maximum free cash flow (or earnings) by optimizing operating expenses? Even in the finest detail presented in the appendices to Valuation there is no mention of optimizing operating expenses. I know this is a handbook and therefore cannot be expected to address issues at the state of the art. But expenses/cash flow optimization in equity pricing also is missing from the current academic literature as well.

A search of the JSTOR finance journals for combinations of (1) cash flow/earnings, (2) optimal/optimization and (3) value/price turns up only 7 papers. And none of these address valuation per se. Fifteen additional papers were netted in this search, mostly in management science and accounting journals. But these addressed issues in pricing components of a portfolio or optimizing investments in specific balance sheet variables like inventories or receivables.

THE MISSING FACTORS MODEL
I wrote Competing for Customers and Capital to build these three missing factors into the valuation process:

• The impact of peers
• Intangible value creation
• Expense optimization

In my next post I’ll show how a merged DFX and TNT could come within 18 basis points of maximum earnings market share by optimizing enterprise marketing expenses. At the same time I’ll introduce two of three missing factors: Enterprise Marketing Efficiency and Relative Earnings Productivity.

Thanks for visiting. As always your comments are welcome.

~V

Mr. Smith Goes to Holland

COULD IT BE?
The previous post in this series was Air Carrier Wars: Managing Market Share for Optimal Earnings. In it I compared actual market shares with optimal ones for each of the five leading air express carriers: Kuhne+Nagel (SWX: KNIN); TNT (AEX: TNT); FedEx (NYSE: FDX); United Parcel Service (NYSE: UPS); and DHL (XET: DPW).

• DPW turned in the worst performance of the group. Its maximum earnings market share (31.8%) was a full 13 points less than its actual share (44.8%) of revenues.

• UPS turned in a much better relative performance with a maximum earnings share of 18.6% compared with actual share of 22.9%.

• FDX, TNT and KNIN all posted actual shares of revenue that were significantly less than their maximum earnings shares.

These findings begged two questions:

1. Would you dare tell Dr. Frank Appel, Chairman of DHL that he should harvest sales for earnings?
2. Could you convince Frederick W. Smith, CEO of FDX to increase sales by as much as 27% through organic growth or acquisition?

My answers were “No” and “Maybe,” in that order. The purpose of this post is to explore alternative answers to these two questions.

LATE BREAKING NEWS
Almost a week later a New York Times article published on May 29, 2008 reported that DHL planned to partner with UPS to restructure its loss-making US business.

The American unit would record an underlying operating loss of $1.3 billion this year, reducing to $300 million in 2011, Deutsche Post told a news conference at its headquarters on Wednesday.

DHL Express also planned to cut its network capacity by 30 percent and lower overhead and administration costs. Up to 10 percent of Express employees would be affected, Post said.

“We have promised to relentlessly focus on improving financial performance,” the chief executive Frank Appel said. “I am confident we have found a sustainable way forward for U.S. Express.”

I guess Dr. Appel didn’t need my analysis to know his company was throwing money down the drain.

SHOULD FDX ACQUIRE TNT?
Digging through TNT Facts I discovered that FDX and the Dutch express company have had a long standing partnership:

In the early 1990's GD Express Worldwide further expanded with key milestones being the introduction of a daily transatlantic freighter service, the development of an Asian Air Network and the delivery contract for all Federal Express shipments in Europe (bold added).

I also discovered talk of a FDX merger with TNT has been around for some time. The following comments surfaced in an article on the possibility:

As shares of the world's fourth-largest package carrier fizzled Thursday, Wall Street matchmakers couldn't resist thinking FedEx Corp. would be the perfect suitor.

Dutch transportation company TNT NV, a composite of three entities - the Dutch postal service, express delivery and logistics - lost more than 5 percent of its stockholder value Thursday, a day after a private German investor said he was putting together a group, including an unnamed strategic investor in the logistics field, to buy it.

"It would give FedEx a strong presence within Europe and the ability to offer comprehensive logistics and supply chain solutions," said Jon Langenfeld, analyst at Robert W. Baird & Co.

These discoveries turned on a light bulb in my mind: What would be the optimal vs. actual earnings of this combination?

FDX+TNT OPTIMAL EARNINGS
In a nutshell, more market share is a good thing only up to a point. After a company reaches that point, earnings begin to decline -- because the cost of the next share point suddenly exceeds its value. Where “that point” occurs depends on a host of things. And it may occur at a very low or a very high market share. But sooner or later that point will be reached. You can get a quick overview of this principle in my audio slide show: The Role of Maximum Earnings.

The following chart compares actual with optimal earnings of a merged FDX-TNT based on 2007 financial statements. It’s a surprising story.

 

The combined share of actual revenues would be 23.77% [FDX=16.25%; TNT= 7.52%]. The combined company’s optimal share of revenues would be 23.59% -- just 18 basis points lower than actual shares. Combined actual compared with optimal revenues would be $51.55 vs. $51.14 billion USD. Actual vs. optimal earnings [EBITD] of a merged FDX-TNT are virtually the same: $12.06 billion.

MR. SMITH GOES TO HOLLAND
If Fred Smith needs additional motivation to visit TNT in Holland to pursue a merger this earnings forecast should be it. The next question he might like to have answered is this: What would be the market value of the combined companies? The following posts in this series will explore this question using the principles of competitive stock valuation from my book Competing for Customers and Capital.

Thanks for visiting. As always your comments are welcome.

~V