BHARTI AIRTEL COMPANY OVERVIEW Founded in1995 inNewDelhi, India,BhartiAirtel isa leadingprovideroftelecommunicationsservices,operatingthelargestmobilenetworkinIndiaandthirdlargestworldwide.ItcurrentlytradesonboththeBombayStockExchange(BSE)andtheNationalStockExchangeofIndia(NSE).Positionedsquarelyinthetelecommunicationsservicesindustry,itsbusinesslinesaresplitamongmobileservices, offeringGSMmobile services directly to customers nationwide; telemedia services, providingInternetconnectivityservicestohouseholds;businessservices,offeringvoice,data,networkintegration,anddatacenterservicestolarge-,medium-andsmall-enterprisesaswellasgovernmentstakeholders;anddirect-to-homedirectTVservices.ThiswiderangeofservicesisnaturallyunderpinnedbytherapidgainsinInternetandcommunicationtechnologiesthathaveswepttheworldoverthecompany’slifetime;yet,Bhartihassucceededinchiselinganicheinthemarketdrivenbyitsoutsourcingstrategy.Whileitmaintainsrobustinfrastructuredomesticallyintheformofopticalfibersandpointsofpresence(POPs),facilitatingmultiprotocollabelswitching(MPLS)andsynchronousdigitalhierarchy(SDH)toensurerapidandreliabledelivery.ThoughitscorebusinesshasthrivedinIndia,seeingroughly71%ofrevenuesasofQ32016,thegrouphasdiversified its geographic reach to operate in 17 other countries in Africa1 and the Asia-Pacific region,amongthemSriLankaandBangladesh.Assuch,itsmosttechnologically-developedoperationshavetakenroot in India,offering2G,3G,and4Gwireless services,mobilecommerce, fixed lineservices,andhighspeedDSLbroadband.Initsotherregions,itoffers2-and3Gwirelessservicesandmobilecommerce.DCF VALUATION: NUMBERS AND NARRATIVES
Cost of CapitalCumu. Discount FactorSales to Capital RatioInvested Capital
Cost of Capital 10.13% 10.13% 10.13% 10.13% 10.13% 9.44% 8.76% 8.07% 7.39% 6.70%Cumu. Discount Factor 0.9081 0.8246 0.7488 0.6799 0.6174 0.5641 0.5187 0.4800 0.4470 0.4189Sales to Capital Ratio 0.95 0.95 0.95 0.95 0.95 0.95 0.95 0.95 0.95 0.95Invested Capital 1,929,343₹₹ 2,007,952₹₹ 2,092,127₹₹ 2,182,261₹₹ 2,278,776₹₹ 2,374,383₹₹ 2,468,001₹₹ 2,558,509₹₹ 2,644,759₹₹ 2,725,602₹₹
Takes into account a composite Equity Risk Premium of based upon business operating regions: Africa, India, Bangladesh and Sri Lanka.
+ xBased upon an industry unlevered beta of 0.62.
Scenario Analysis
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Intoday'sever-digitizingworld,telecommunicationsoftenservesthecrucialsocialglueacrosspeoplegroups.Foundedin1995inNewDelhi,India,BhartiAirtelhasbeenpositionedwithoneofthelargestdemographicbasesintheworldfromitsinception,allowingittocapitalizeonthedigitalrevolutionthathasoccurredoverthepasttwodecadestomakeIndiathesecond-largesttelecommunicationsmarketintheworldtoday.Withsuchamixofproductsthatmayserveruralandurbanregionsalike,Airtel'sgeographicreachandtechnicalexpertisearelastingcompetitiveadvantagesthathaveallowedittodiversifybothitsbusinessandlocation-basedrisksandrealizesuccess. Itscustomerbaseisnowwellover360millionindividuals,roughlyatenpercentyear-over-yeargrowthincustomeracquisition.Assuch,itscurrentrevenuegrowthratehasbeenmodeledat7.08%,reflectiveofthehistoricalfive-yearaverageofitsrevenuegrowthrate.Coupledwithconsistentandacceleratinggrowthin‘TotalMinutesSpentonNetwork’—whatweidentifiedtobeakeyrevenuedrivergiventhestrengthofthemobileservicesbusinessanditspay-per-minuterevenuemodel—thisbodeswellforthesustainabilityofsuchrevenuegrowthinthenear-term.WhileteledensityinIndiaiscurrentlyaround84%,havinggrownexponentiallyoverthepastdecade,thiscanbeexpectedtoreachnearly100%withinthemedium-term,leadingtoanaturalupperlimitonthegainsthatcanberealizedfromsuchatrendandattendantslowdownin revenuegrowth.Asaconservativeestimate,weexpect thisnumber toscaledownwards tosettleat4.43%,therisk-freerateutilizedinthevaluation. Though theglobal industryaverageoperatingmargin is15.2%, the teamagrees thatBharti'soperatingmarginisoneofitskeycompetitiveadvantagesthatitwillcontinuetomaintainoverthenear-term,duetoits costmodel utilizing the low-cost, high-volume ‘minutes factory’ approach. Even so, for the sake ofconservatism,weassumedthattheoperatingmarginwillneitherimprovenorworsenoverthehorizon.Airtel’s current Africanmarkets in a high effective tax rate of nearly 50%, however,we recognize thatAirtel’s intention to consolidate its African markets will lessen the significance of high-tax businessenvironmentsandcause its tax rate toapproach India’smarginal tax rate.Additionally,Airtel’s currentinefficiencyinutilizingitscapital(itssales-to-capitalratio)canbeattributedtoitslargeandpoorcapitalprojectchoices.However,itsimpendingconsolidationwillservetoincreaseitssales-to-capitalratio—hereto0.95—particularlyinfocusingbackuponmarketsinwhichtheappropriatetechnologicalinfrastructurealready exists without needing significant capital investments. Ultimately, it is assumed that thetelecommunicationssectorwillhavelowerriskthanothers,givenitsgovernmentalpreferenceaswellaslower-riskoperations,thusleadingtoalowercostofcapitalinthelongrunthanthefirmcurrentlyfacesRELATIVE VALUATION Inordertoderivearelativevaluation,theteamturnedtoS&PCapitalIQtocollectthedataofasampleof30 comparable companies which serve to provide an accurate industry regression—the “directcomparison” approach. These companies share various ‘fundamentals’ with Airtel, such as marketcapitalization (greater than $15B, compared to Airtel’s $21.4B) and, of course, primary industry(telecommunications),whilespanningawidegeographicrangetopaintamoreholistic‘global’pictureandcontrol for geographic risk factors through diversification. Given the large infrastructural investmentsrequiredtosupportatelecommunicationscompanyaswellasthephilosophicalimportanceofsalesinacustomer-centric industry, the team felt it appropriate to utilize a firm-wide EV-Salesmultiple for theregression.Asseenbelow,theR-squaredcorrelationmetricis49.87%,suggestingthattheregressioncanbeconsideredrelativelyrepresentativeoftheobservations.Moreimportantly,however,theT-valuesforeachoftheindependentvariableschosen—3-yearrevenueCAGRasanindicatorofgrowth,operatingmarginasanindicatorofprofitability,andreinvestmentrateas
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a proxy for growth efficiency—were observed to be statistically significant and therefore telling in thecontextofourregression.Usingourregressedequation,wederivedapredictedmultipleof2.46x,belowitsactual2.68xbasedontoday’smarketpricing.Backingoutenterpriseandequityvalues,weobtainedapredictedvaluepershareof₹293.57,ofwhichAirtel’scurrenttradingpriceis117.35%.
Thesimpler,traditional‘average-comps’approachyieldsanaverageEV/Salesmultipleof2.63xandimpliedshare price of ₹333.80, still 103% of the current trading price. Though this value reveals only slightovervaluation—surely not enough ceteris paribus to sway our position—we believe that the level ofovervaluationindicatedbytheregressionequationshouldgiveuspausewhenconsideringourportfolio.MARKET REGRESSION VALUATION ThemarketregressionequationforEV/Sales forGlobalcompanies (Damodaran, January2017)shownbelowprovesinsufficientwhenusedtopricethiscompany.Itsyieldedpredictedmultiplevalueis1.18x,resultinginanegativeequityvalueandimpliedsharepriceof-₹4.37.Clearly,thisvaluecannotbetrustednorutilizedwhenanalyzingthecompanyathand.Giventhisregression’slowR-squaredvalueof8.80%,however,theteamhadnotexpectedatellingresult.
Adoptingaslightlydifferentperspective,wedecidedtoexaminethemarketregressionequationforEV/Sales for Emerging Markets Companies (Damodaran, January 2017) seen below. Though its yieldedpredictedmultiple valuewas slightlymore optimistic at 1.24x, resulting in a positive equity value, theimpliedsharepriceremainedmerepeanuts,at₹9.52,3621%ofitscurrenttradingprice.WithanR-squared
EV / Sales = 2.137 - 2.83 Total Revenues, 3 Yr CAGR % [LTM] + 4.85 Operating Margin + 0.253 Reinvestment Rate
EV / Sales = 2.53 + 0.32 g + 4.91 Op. Margin + 2.50 DFR - 2.30 Tax Rate
CONCLUSION Bothourintrinsic(DCF)valuationandrelativevaluationapproachessuggestthatBhartiAirtelisovervalued,leadingustoanaturalconclusiontosell.Thoughamature,stablecompanywhodoesnotquitefacethesame volatilities or risks of failure as other younger companies may, its recent track record of poorinvestmentprojectchoices—particularlyinitsAfricanmarkets—giveuspausetoreconsidertheintrinsicsoundnessofthecompany’sgrowthtrajectory.ItshouldalsobenotedthattheDCFisbuiltuponeventhemost generous of reinvestment assumptions. Thoughoperatingmargin can reasonably be expected to(conservatively)remainthesameor(optimistically)improveasoperatinglossesintheAfricanmarketsareconsolidated,itremainstobeseenwhetherAirtelwillbeabletocaptureandintegratetheadvancesintechnologicalefficiencywithoutattendantinvestmentsintechnologicalinfrastructures:thekeytrade-offinthisscenario.RECOMMENDATION SELL.Asourestimatedvaluepershareisamere₹220.74relativetothecurrenttradingpriceof₹344.50,webelieve this isanexcellentopportunity to recognize someupside.Particularly inviewof the recentdownwardtrendinitsstockprice,wewouldadvisethischangeinpositionoccurassoonaspossible.
EV / Sales = 3.13 + 0.62 g + 3.60 Operating Margin - 1.70 DFR - 3.70 Tax rate
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JET AIRWAYS COMPANY OVERVIEW JetAirwaysisthesecondlargestairlineinIndiaafterIndigowith21.2%passengermarketshare.Itoperatesover300flightsdailyto68destinationsworldwideincluding45domesticand20internationaldestinationsin15countriesacrossAsia,EuropeandNorthAmericafromitsmainhubssituatedinMumbai,Chennai,BangaloreandKolkata.MostofitsflightsaredomesticconnectingacrossthemetropolitancitiesinIndia.Thisisamoneylosingcompanyasitreportedsignificantlossesfor8consecutiveyearsfrom2007to2015.JetAirwaysisoperatinginanextremelycompetitiveandcyclicalmarketwithrisingcapitalexpenditures,extremelyhighdebt levels, anddecliningmarginsasmostaviationcompanies inSouthAsiahavebeenincurringsignificantlosses.Thecompanyreviveditselfwitha24%stakesaletoEtihadin2013whichapartfromgivingitanecessarycashinfusionalsobroughtaboutsynergiesintermsofjointfueluplift,marketingandsales.JetAirwayswasfinallyabletoearnaprofitof3971.6millionRsin2016-2017,thusindicatingsomepositivesignsinthefuture.However,itisimportanttonotethattheprofitwasprimarilyaresultofareductioninfuelpriceswhichreducedtheairline’sfuelcostsby27%.DCF VALUATION : NARRATIVES AND NUMBERS
tomaintain this growth of 11.28% over the next 5 years as well going forward.While estimating theOperatingMarginforJetAirways inyear10,weassumedthatJetAirwayswouldbeableto improveitsoperations and achieve the global industry average of 11.05%, which is an optimistic assumptionconsideringthefinancialsituationitisincurrently.Finally,webelievethatJetAirwayswouldn’tincreaseitsreinvestmentratesignificantlyconsideringitsbudgetaryconstraintsofhigh-levelsofdebtandthushaveestimatedthesalestocapitalratiotobe1.15,whichwastheaverageratiointheprevious5years.Usingabottomupleveredbetaof1.22,thecostofequitycomesupto15.17%.Withanafter-taxcostofdebtof6.83%andadebtcapitalratioof69%,thecostofcapitalforJetAirwaysis9.45%.Finally,tocalculateterminalvalue,wehaveruledouttheassumptionthatthecompanywillhaveacostofcapitallikematurecompaniesafter10years.JetAirwaysisalreadyamaturecompanywithacostofcapitalof9.45%andthatisthecostofcapitalweareassumingafteryear10.Wehavehoweverassumedthatthecompanywillbeearningareturnoncapitalequaltothecostofcapital,becausewedon’tbelievethatJetAirwayshasanylong-lastingcompetitiveadvantagesgoingforwardthatitwouldallowittoearnahigherreturnoncapital.Usingalltheseestimations,theDCFmodeltellsusthattheestimatedvaluepershareforJetAirways is175.37Rs.Thecurrentsharepriceis529Rsandthuswebelievethattheequityisovervaluedby302%.Thereareamultiplenumberofreasonswefeelthatthesharepriceisovervaluedbythemarket.Tobeginwith,JetAirwayswasfinallyabletomakeprofitsin2016after8yearsandalsoreleasedpositiveearningsinthethirdquarterwhichhasledtoinvestorsbeingbullishaboutthestockduetoashorttermismapproachwhichignorestheoperationalproblemsofJetAirways,itspreviousyearsoflossesanditshighdebtlevels.AnotherreasonforthespikeinthestockpricehavebeenspeculationsthatEtihadAirwaysisplanningtoraiseitsstakeinJetAirwaysfrom24%to49%.JetAirways’abilitytoearnprofitsin2016wasnotduetosignificantimprovementinoperationalefficiencyorturnaroundbymanagementbutduetothereductioninfuelpricesby27%thusloweringJetAirways’operationalexpenses.WeclearlybelievethatJetAirwayshasthusbenefittedfrommarketconditionsintherecenttimesandwelookforwardtoseeiftheaviationcompanyisabletoimproveitsfuturecashflowsgoingforward.Going forward, themanagement isplanning touse its cash flowsand raise300-million-dollarequity tofinanceexpansionabroad.However,thecompanyhashighlevelsofdebtwithadebtcapitalratioof0.69anditsreturnoncapitalis5.89%whichisfarlowerthanitscostofcapitalof9.45%.Thus,webelieveJetAirwayscould increaseshareholdervaluebyusing itscashflowstopayback itsdebtandpaydividendsratherthanusingitforexpansionpurposes.RELATIVE VALUATION The team collected data from S&P Capital IQ and used 31 companies as comparable to construct theindustryregression.Allcomparablecompanieswerepubliccompaniesthatfellunderthe‘airlineservices’sectorwithintheAsianemergingmarketsector.SinceJetAirwayshasanegativebookvalueofequity,wedecidedtouseafirmmultipleforourvaluation.Tochoosethebestmultiple,weranregressionsacrossmultiples likeEV/Sales,EV/EBITDAandEV/FCFFusingdifferentproxies for revenuegrowth, riskandre-investmentratefoundoutthatEV/SaleshadthehighestR-Squareof51.08%asshownbelow:
UsingJetAirways’numbers,thepredictedEV/Saleswas0.86whiletheactualEV/Salesis0.56.Moreover,theestimatedvaluepershareforJetAirwayswouldbe641.57Rsasopposedtothecurrentmarketsharepriceof529Rs.WebelievethatthemajorreasonwhyrelativevaluationgivesusanundervaluedresultforJetAirwaysisbecausemostofthecomparableaviationcompaniesusedintheanalysisareintheemergingAsianmarkethavebeenincurringhugelosses,whichmakesJetAirwaysrelativelybetter. Increasingthesamplesizetoincludeaviationcompaniesinmoredevelopeddevelopedmarketsmaytellusadifferentstory.OPTION VALUATION SinceJetAirwaysisamoney-losingfirmwithhighlevelsofdebt(50%),wefeltthatitwouldbeinsightfultovaluethecompanyasacalloption.Weinputtedthevalueofoperatingassetsastheunderlyingassetoftheoption andestimated the variance as the global air-transport industry varianceof 46.40%. Furtherinputtingthecumulativefacevalueofdebt,averagematurityof5yearsandrisklessIndianrateof6.94%,thevaluepershareamountedto1009.16Rs.Thiswouldbethevalueofthecalloptionifliquidatedinthefutureandthusexplainswhatthepotentialsharepricecouldbeconsideringthevarianceof46.40%andthetimevalueofmoney.TheoptionvaluationalsorevealedthatJetAirways’probabilityofdefaultis48%,whichisfairconsideringthatauditorshadraisedaredflagregardingthecompany’s‘goingconcern’statusrecentlyin2013RECOMMENDATION:TheDCFValuation ismostsuitedtovalueJetAirwaysbecause it takesa long-termapproachandfindsanintrinsicvalueofthecompanybyincorporatingthekeyvaluedriversofthecompany.Itdoesn’tgetaffectedbytheshort-termpositiveswingsofthemarketandtunnel-visionapproachofthe
EV/Sales = 0.416 + 0.525 5 Year Beta [Latest] + 4.69 Operating Margin-1.102 Total Revenues, 10 Yr CAGR %
Regression Analysis: EV/Sales versus 2 Year Beta , 5 Year Beta , 1 Year Beta , ... Analysis of Variance Coefficients Term Coef SE Coef T-Value P-Value VIF Constant 0.597 0.241 2.48 0.022 2 Year Beta [Latest] -0.018 0.403 -0.04 0.965 2.74 5 Year Beta [Latest] 0.457 0.314 1.46 0.160 2.23 1 Year Beta [Latest] -0.249 0.243 -1.02 0.318 2.10 Operating Margin 4.25 1.55 2.74 0.012 1.28 Total Revenues, 10 Yr CAGR % [L -1.13 1.11 -1.02 0.321 1.84 Total Revenues, 5 Yr CAGR % [LT -1.14 2.90 -0.39 0.699 4.13 Total Revenues, 3 Yr CAGR % [LT 0.75 3.24 0.23 0.819 6.79 Total Revenues, 1 Yr Growth % [ 0.65 1.46 0.45 0.660 3.60 Reinvestment Rate -0.0153 0.0226 -0.68 0.506 1.14 Model Summary S R-sq R-sq(adj) R-sq(pred) 0.457992 51.08% 30.11% 0.00%
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investorsandratherestimatesthecompany’sabilitytoearnfuturecashflowsbasedonitscurrentfinancialhealth. Although theRelativeValuation indicated the company is under-valued,webelieve it could besubjecttobiasesasincreasingthesamplesizetoinvolveglobalaviationcompaniesmaygiveusadifferentanswer.Finally,optionvaluationisagoodwaytoestimatethepotentialvalueoftheshareifliquidatedinthefuture,howeverthevaluepershareishighaccordingtotheOptionValuationmostlybecauseofthelargeestimatedvarianceof46.4%,whichverywellcouldworkagainstthecompany.RECOMMENDATION Sell:thecurrentsharepriceisRs529whiletheDCFValuepershareisRs175.37.
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PAYPAL HOLDINGS COMPANY OVERVIEW OnJuly17,2015,PayPalHoldingsbecameanindependentpubliclytradedcompanybyspinningofffromeBay.Itisaleadingtechnologyplatformanddigitalpaymentscompanywhosevisionistodemocratizethefinancial services. PayPal offers a two-sided proprietary global technology platform to facilitate theprocessingofpaymenttransactionsaroundtheglobe.Thisbusinessismatureastheyalreadyhaveover197 million users and process over 6.1 billion transactions. PayPal is also available in more than 200countriesandsupport25currencies.Theywillseektoexpandtheirglobalcapabilitiesinthisbusinessbyincreasingtheircustomerbaseandscaleandexpandtheirvaluepropositiontocustomers.Thegrowthoftheirnewbusiness,digitalpayments,willdependontheexpansionofmultiplecommercechannels,thegrowthofmobiledevicesandmerchantapplications,thegrowthofconsumersgloballywithInternetandmobileaccess,andthepaceoftransitionfromcashandcheckstodigitalformsofpayment.Theirstrategywill be to build new strategic partnerships to acquire new customers, recreate its role in the digitalecosystem,andfocusoninnovationinthedigitalworld.PayPalfaceshighcompetitionastheycompetewith a wide range of businesses including banks, credit card providers, technology and ecommercecompanies,and traditional retailers.Theyhavealsocompleted fouracquisitions in2015,which includeXoom,Paydiant,andCyActive.DCF VALUATION: NUMBERS AND NARRATIVES
PayPalisnotonlyaprocessingcompanybutisbecomingadigitalpaymentscompanybyenteringmobilepaymentsonbehalfofconsumersandmerchantsworldwide.CEODanSchulman’svisionalignswithmovingtobeingmoremobile-bankingfriendly.Itsmaturebusiness(paymentprocessing)willwitnessdecreasingrevenues and operating margins due to increased competition and concessions granted in several
Stable Growth
NOL: -
EBIT: $1721.69
Current Revenue:$11,273
Current Margin: 15.27%
Revenue Growth: 20%
Sales Turnover Ratio: 1.86
Competitive Advantages
Expected Margin: 14.9%
Value of Op Assets $48,339.30 + Cash $8,928.00= Firm Value $57,267.30- Debt $481.65= Equity $56,785.65 - Equity Options $105.45 Value per share $ 47.18
All existing options valued as options, using current stock price of $49.05.
Stable Revenue Growth: 2.33%
Stable Operating Margin: 14.9%
Stable ROC = 6.83% Reinvest 34% of EBIT(1-t)
Terminal Value: $68,326.50 * 0.5370 = $36,689.37
Riskfree Rate:10 year t-bond rate = 2.33%
Beta: 0.63
InternetMerchantServices
Unlevered Industry Beta corrected for cash
Current D/E : 0.82%
Risk Premium: 6.20%
Single Business Operating Countries ERP
Country Risk Premium: 6.20%
1 2 3 4 5 6 7 8 9 10
Cost of Equity: 6.26%
Cost of Debt:2.33% + 1.6% = 3.93%Tax Rate = 30%
Used S&P credit rating (BBB/Baa2) to determine appropriate default spread (1.6%).
∞Terminal Year:
Rev: $44743.04603 COC: 6.83%
Tax Rate: 30%EBIT (1 – t):
$4,666.70 Reinvestment: $1,592.01
FCFF: $ 3,074.69
PayPal as of May 2, 2017In Millions USD
Sanchit Kumar
Cost of Capital: 6.24%Debt to Capital = 0.81%
Sales to Capital ratio is internet merchant services industry average.
Expected margin is weighted average of comparables (Global Payment for Mobile Payments & Total System Services for Transaction Processing)
New business of mobile payments = high growth
Sensitivity Analysis:
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partnershipswithcompetitors(Visa,Mastercard,andDiscover)tohaveseveralretailpointofsalesolutionsforitsnewmobilepaymentsbusiness.Yet,itsvisiontoenterthemassivepaymentsindustrycoupledwithmonetizingrecentpaymentandsocialmediaacquisitionslikeVenmoandBraintreewillfuelhighrevenuegrowthat20%andahighreturnoncapitalat18.35%atyear10.Inthefuture,competitionfromAmazonandAppleinmobilepaymentswillcapitsrevenues(inthe10thyear)muchbelowthesegiants.IntheFCFFmodel,theteamassumesthatexpectedmarginswilldecreaseovertimeduetoincreasingcompetitionindigitalpaymentsandpaymentsprocessing.A30%TaxratewasusedasweexpectchangesintheUSTaxCodeinthenearfuture.Additionally,weassumetheinternetmerchantservicesindustryreinvestmentrate(orsalestocapitalratio)asPayPalis likelytoreinvestintoitsnewbusinesslikeotheronlinetechnologycompanies.Wealsoassumethatitwillfunctionasamaturecompanyafteryear10sinceitalreadyhasamaturebusiness,and therefore its costof capitalwill likelyparallel thatofamaturecompany (6.83%).AlthoughtheteamseesPayPalearningaROChigherthanitsCOCforthenext10years, itscompetitiveadvantagesithastodaywilllikelyfadeovertimesinceitwillfacehighcompetitioninbothindustries.Theseassumptionsprovidedavaluepershareof$47.18.Itisovervaluedsinceitscurrentstockpriceis$49.05.After carrying out a sensitivity analysis in which the key variables for the valuation are its expectedoperatingmarginanditsgrowthrate,theteamisconfidenttosuggestthatPayPalisovervaluedsinceagrowthrateof20%isfairlyoptimistic.RELATIVE VALUATION Byremovingnegativeandextrememultiples,theteamcollecteddatafromS&PCapital IQandused18companiesascomparabletoconstructtheindustryregression.Allcomparablecompaniesfellunderthe‘internetmerchantservices’ sectorandhadmarketcapsofgreater than$1billion.Further,onlypubliccompanieswerechosenandglobalcompanieswereusedsincePayPaloperatesinover200countriesandhasadiversifiedrevenuestream.Sincecompaniesinthissectorhaveverydifferentgrowthrates,theteamdecidedtochoosethePEGratiotoeliminatedifferencesingrowth.TheykeyintrinsicvaluefactorsinPEGincludepayout,growth,andrisk.However,sinceoursamplesizewasrelativelysmall,weonlyusedtwovariables(growthandrisk)toconducttheregression.TheteamassuredthatthePEGratiowasconsistent--growthmustbematcheduptotheEPSonwhichitisbased.Sincemostexpectedgrowthratesareofftrailingearnings, theteamdecidedtousea trailingPEG.Aftercreatingacorrelationmatrixofdifferingmetrics for growth and risk, the highest correlations with the multiple and least correlation betweenindependentvariableshelpedchoosetherespectiveindependentvariablesforgrowthandrisk(2yearbetaandexpectedgrowth2year).AfterrunningscatterplotsofPEGagainsteachvariable,itwasimperativetotakeanLNofgrowthsincethiswouldincreasetheR-squaredastherelationshipbetweenexpectedgrowthandPEGwasnotlinear.Asaresult,theR-squaredincreasedasshowninthisfittedlineplot:
OCCIDENTAL PETROLEUM CORPORATION COMPANY OVERVIEW OccidentalPetroleumCorporation (OXY), founded in1920,engages in theacquisition,exploration, anddevelopmentofoilandgaspropertiesintheUnitedStatesandinternationally.Thecompanyoperatesinthreesegments:OilandGas,Chemical,andMidstreamandMarketing.TheOilandGassegmentexploresfor,develops,andproducesoilandcondensate,naturalgasliquids(NGLs),andnaturalgas.TheChemicalsegmentmanufacturesandmarketsbasicchemicals,includingchlorine,causticsoda,chlorinatedorganics,potassium chemicals, ethylene dichloride, chlorinated isocyanurates, sodium silicates, and calciumchloride;vinylscomprisingvinylchloridemonomerandpolyvinylchloride;andotherchemicals,suchasresorcinol.TheMidstreamandMarketingsegmentgathers,processes,transports,stores,purchases,andmarketsoil,condensate,NGLs,naturalgas,carbondioxide,andpower.Thissegmentalsotradesarounditsassetsconsistingoftransportationandstoragecapacity,aswellasoil,NGLs,gas,andothercommodities.Over the last2.5years, theoil industryexperienced itsdeepestdownturn since the1990s.AfterOPECagreed to cutproduction late last year,oilprices strengthened for severalmonths.However, as springrolledaround,USinventoriesbegantobuild,andprospectsofstrongeroilpriceshavefadedsomewhat.While OXY has certainly seen consecutive years of negative earnings/growth, the company is heavilydiversifiedwithintheOilandGassector.Asan‘IntegratedOilandGas’company,OXYseemstobehedgedagainstoveralloilpricevolatility.Inrecentyears,OXY’sChemical&MidstreamandMarketingarmshavedoneextraordinarilywell. Furthermore,OXYhasdivestedofunprofitableplants inCaliforniaandNorthDakota, while developing new partnerships in lucrative areas outside of the oil sector. In early 2011,OccidentalpartneredwithAbuDhabi’sstateoilcompanyindevelopingtheShahField,oneofthelargestnaturalgasfieldsintheMiddleEast,throughajointventureknownasAlHosnGas.AlHosnGasbecameoperational in2015.WhileOccidentalwill certainly see short-termsetbacksasoilpricesbecomemorevolatileand thecompanydiversifies further, strategicmanagementdecisionscouldgenerate long-termreturns.DCF VALUATION: NUMBERS AND NARRATIVES
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AsOXYisanintegratedoilandgascompany,itsearningsarenotfullydependentuponoilpricevolatility.Therefore,inthevaluationprocess,theteamchosetoapplyaFCFFapproachinconjunctionwithanoptionsvaluationapproach (toaccount for theundevelopedreservesofoil,gas,andLNGs). Indeterminingthemarginalcostofextraction,theteamanalyzedthevolumesofeachnaturalresourceineachcountry,thenusedthecountryaveragetodeterminethefinalnumber.Growthnumbers(25%)areprimarilybaseduponOXY’stimelineofproduction/plantdevelopment,andhistoricgrowthfiguresafterplantdevelopment.Asplantsbecomefullyoperational,OXYwillnaturallyreaphigherrevenuesBoththesalestocapitalratio(2.5)andtargetoperatingmargin(15%)arecertainlyabovetheindustryaveragesanddrawnfromassumptionsof high growth within the mid-market and chemicals sector – as previously mentioned, OXY is highlydiversified (and more diversified than many of its competitors). This works as an advantage for OXY,especiallyasitdevelopsitschemicalandmid-marketsegmentsfurther.Still,however,relativelyaggressivegrowthestimatesyieldedavaluepershareof$53.29,approximately$7lessthanOXY’searlyMaytradingprice.Aspunditsandeconomistspostulate,marketsareinefficient:OXY’sstatus as ‘overvalued’ could indicate the market expectation that oil prices will go up. However, aspreviouslymentioned,OXYishighlydiversifiedandmaynotfollowthesamepatternasthatofoilprices.OXY’sstructuralissues(hugepilesofdebt)haveonlybeenamelioratedrecently,andthecompanywillonlystarttoseegrowthasnewventuresbecomefullyoperational.Further,theteamassumedthattheROCwouldexceedtheCOC(8.6%)intheyearsaftertheterminalyear.Theteambelievesthatthefirmhaslong-lasting competitive advantages in its level of diversification–OXY’s presence in the chemical andmid-marketsegments(andrelativesuccessinthese)willpropelitforwardascompetitorssufferthroughcyclicalpricepatterns.RELATIVE VALUATION
The team collected data from S&P Capital IQ and used 36 companies as comparable to construct theindustryregression.Allcomparablecompaniesfellunderthe‘integratedoil&gas’sectorandhadmarketcapsofgreaterthan$1billion.Sincecompanies inthissectorsee largeamountsof thedebt, theteamchosetostickwithafirmmultiple(EV/EBITDA)fortheregression.TheR-sqcorrelationmetricisrelativelylow,butaspreviouslymentioned,eachcompany’slevelofdiversificationvaries,sotheindustrymaynothaveconsistentmetrics/levelsofcorrelation.Further,theenergysectorhasseensignificantvolatility inlightofpolicydecisions(OPEC)andenvironmentalconcerns.
Model Summary S R-sq R-sq(adj) PRESS R-sq(pred) 4.80207 20.43% 12.73% 1058.37 0.00% Coefficients Term Coef SE Coef 95% CI T-Value P-Value VIF Constant 6.85 1.58 ( 3.63, 10.06) 4.34 0.000 Total Revenues, 1 Yr Growth % [ 0.0636 0.0327 (-0.0032, 0.1303) 1.94 0.061 1.03 1 Year Beta [Latest] 4.22 2.21 ( -0.29, 8.73) 1.91 0.066 1.03 Effective Tax Rate -1.55 1.62 ( -4.85, 1.75) -0.96 0.345 1.01 Regression Equation EV/EBITDA = 6.85 + 0.0636 Total Revenues, 1 Yr Growth % [ + 4.22 1 Year Beta [Latest] - 1.55 Effective Tax Rate
Withthesevalues,OXYyieldsaEV/EBITDAof31.22andacorrespondingsharepriceof$122.70.Clearly,the market regression equation does not account for industry-specific factors and may be generallyunreliableforacompanyinvolvedinmultiplebusinessesanddrivenbycommodityprices.Further,thelowR-sq(6%)fortheregressionindicateslowpredictiveability.CONCLUSION TheteamultimatelyplacesmoreweightontheDCFvaluation.WhileboththeDCFvaluationandrelativevaluationpointtowardsthesamedecision(SELL),thelackofcorrelationamongstoil/gascompaniesandthe market in general makes relative valuation a weak method. Even though a company could becategorizedas ‘integratedoilandgas,’thismaynot indicatethesamelevelofdiversificationacrosstheboard. As OXY is highly diversified, the relative valuation yielded generally unreliable numbers. DCFvaluationsaremorerobust,especiallyfornegativeearningsenergycompanies,whichrequireadditionalanalysisintoundevelopedreserves,extensiveleasecommitments,andR&Dcosts.Relativevaluationsdon’tnecessarilytakethesefactorsintoaccount.RECOMMENDATION Sell.BasedonourDCFvaluationof$53.29,werecommendsellingOccidentalstockatthecurrentpriceof$60.19.
EV / EBITDA = 35.83 + 7.60 g - 19.10 DFR - 24.40 Tax Rate - 147.60 WACC
16
TESLA COMPANY OVERVIEW Tesla designs, develops, manufactures and sells high-performance fully electric vehicles, and energystoragesystems,aswellasinstalls,operatesandmaintainssolarandenergystorageproducts,includinggeneration, storage and consumption. Tesla has established a global networkof vehicle stores, servicecenters and Supercharger stations to accelerate the widespread adoption of Tesla products. Tesla’svehicles, engineering expertise across multiple products and systems, intense focus to accelerate theworld’s transition to sustainable transport, and business model differentiates them from othermanufacturers.DCF VALUATION: NUMBERS AND NARRATIVES
Teslaisarelativelyyoung,highgrowthcompanywithnegativeearnings.Theteam’sassumptionforthekeyvalue drivers—5-year compounded annual growth rate, target pre-tax operating margin and sales-to-capitalratio—dependedsignificantlyonthestorythattheteambelievedforTesla.Indeterminingthetypeof company that Tesla has evolved into, we looked to the company’s competitive advantages. Tesla’sprimary competitive advantages are the loyalty that the Tesla brand commands and its significanttechnologicaledgeoveritscompetitors.Brand Loyalty & Technological Edge Elon Musk contributes heavily to consumers’ perceptions of the company. Mr. Musk’s effect on thecompanycanbecomparedtoSteveJobs’effectonAppleduringhistimeasChairmanandCEOoftheSiliconValleytechgiant.Mr.Musk,muchlikeMr.Jobs,isanextremelyeffectiveshowmanandsalesmanprimarilyduetotworeasons:theconsistencyofhisvisionforasustainablefuturewhichisreflectedinallofTesla’s
Weights:Debt = 11.52%Equity = 88.48%Cost of Capital = 8.04%
Used S&P credit rating to determine appropriate default spread.
Terminal Year:
$ 169,790.83 Revenues7.50% COC
30% Tax rate$ 11,647.65 EBIT (1-t)
$ 3,015.45 Reinvestment$ 8,632.20 FCFF
Tesla in May 2017In Millions USD
Sahaj Sood
17
products, and his ability to sell that vision from a superior, almost ideological standpoint. Tesla’stechnological edge also distinguishes it from other automakers. One of the company’s significantbreakthroughs is its lithium ionbattery technology,whoseenergystoragecapabilitieshavecontributedgreatlytotheadvancementoftherangeoffully-electriccars.Therefore,initsvaluation,theteamdecidedthatTeslashouldbeviewedasmuchasatechcompanyasitisviewedanautomotivecompany.DespiteitsacquisitionofSolarCitylatelastyear,theteambelievedthatoverthenextdecade,itsmarginswouldbedrivenmainlybyitsautomotivebusinesssegment.Thesecompetitiveadvantagesledustoselectatargetpre-taxoperatingmarginof9.80%,thesamemarginearnedbyhigh-endautomakerBMWlastyear.ThisisdespiteTesla’sshifttowardsbecomingamass-marketproducerofcarswhotypicallyearnalowermarginthanourassumedtarget.WechoseBMWasapointofreferenceasitprimarilyproduceshighendvehiclesandalsohasafullyelectriccarinitsfleetofofferingsintheformofits‘i’Series.Value Drivers: Bridging the story-telling and number-crunching OurviewofTeslaasatechandautomotivecompanydroveourassumptionsofthevaluedrivers.Forthesales-to-capital ratio, the team computed a weighted average measure. The weights used were theestimatedvalueofthe“Auto&Truck,”“Electronics(General)”and“Power”businesssegmentsrelativetothe estimated value of the whole business. To calculate the value of Tesla’s “Electronics (General)”business,theteamsplittherevenuesearnedbythecompanyoverthelasttwelvemonthsequallybetweenthatsegmentandthe“Auto&Truck”segment.Wethencomputedeachsegment’sestimatedvaluesbymultiplyingtherespectiverevenuesbytheindustryaverageEV/Salesratios.Wecametoasales-to-capitalratioof1.40.Tesla’santicipatedreleaseofthemass-marketModel3isthemainreasonfortheteam’s50%five-yearcompoundedannualgrowthrateestimate.EarlyindicationsofconsumerexcitementfortheModel3isevidencedbythe180,000reservationsthatweremadeduringthefirstdayoforderingforthemass-marketcar,asreportedbytheWallStreetJournal.IfTeslacanmatchsupplywithdemand,webelievethatour50%growthrateismore-than-justifiable.The team also elected to override four key assumptions of the FCFFmodel.We believe that in stablegrowth,Teslawillhaveacostofcapitalof7.5%,higherthanthetypical‘risk-freerate+4.5%’estimateforstablegrowthfirmsinmaturity.Thisisdrivenbythecompany’spurchaseofSolarCity,whichoperatesinanascent industry,andMr.Musk’strackrecordofbeingabullish,risk-takingCEO.WealsooverrodetheassumptionthatTeslawillearnareturnoncapitalequaltoitscostofcapitalinmaturitybyassuminga9%ROC.WequalifythisbyassumingthatTesla’scompetitiveadvantagesintechnologyandbrandloyaltywillnot necessarily fade over the next decade and beyond. However, the team, recognizing Mr. Musk’spenchantforrisk-takingandinvolvementinavarietyofdifferentprojectswhichcouldindicatealackofclear focus, coupledwith the reality thatmanyyounggrowth firms fail,hasdecided toconsidera10%probabilityoffailureforTeslainthefuture.Wechose10%sinceMr.Musk’svisionforhismanycompaniesappearstobeunfoldingonscheduleandaccordingtoplan,yethisinvolvementinmanyotherprojectssuchasSpacex,NeuralinkandTheBoringCompanycouldmeanthatheisspreadinghimselftoothin.Finally,weoverrode the assumption that the company has no losses carried forward from prior years into thisvaluation.TeslaiscurrentlyanegativeearningscompanywithanNOLcarriedforwardof$341.17millionthatwillshielditsincomefromtaxes.Afterincorporatingtheseassumptionsintothevaluationmodel,theteamarrivedatavaluepershareof$177.13.ThedayclosepriceasofMay7,2017was$308.35, indicatingthat thestock isovervaluedby74.08%.Belowisascenarioanalysistheteamconducted:
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Valuepersharein2027assumingEBIT(Operating)margin=
8.5%
SalestoCapital
1.28(Auto) $56.41
1.40(WeightedAverage) $95.27
1.66(Tech) $160.19
Valuepersharein2027assumingEBIT(Operating)margin=
9.8%
SalestoCapital
1.28(Auto) $138.271.40(WeightedAverage) $177.13
1.66(Tech) $242.05
Valuepersharein2027assumingEBIT(Operating)margin=
11.5%
SalestoCapital
1.28(Auto) $245.33
1.40(WeightedAverage) $284.191.66(Tech) $349.11
Theanalysisindicatesthatat50%growth,Teslawouldneedan11.5%growthandaslightlyhighersales-to-capitalratiothanthe1.40weightedaveragetoachieveavaluepersharesimilartothemarketprice.Assumingthesamesales-to-capitalratioandpre-taxoperatingmargin,thecompanywouldneedtodisplaygrowthof61%toachieve$308.80valuepershare.Theteamfeelsthatthisisunlikely,andthatthemarketwilleventuallycorrectitself.Therefore,werecommend:SELL.RELATIVE VALUATION The team used S&P Capital IQ to screen for comparable companies in the ‘Storage Batteries’ and‘AutomobileManufacturers’ sectorswithmarketcapitalizationsgreater than$1billion toconstruct theindustryregression.Ourfinalscreeningcontained42companies:40automobilemanufacturersand2inthestoragebatteriessector.Wechosetoscreenonlyforpubliclytradedcompaniesacrosstheworld.SinceTeslaisanegativeearnings,high-growthcompany,theteamoptedtousetheEV/Salesmultiple.Thekeydriversof theEV/Salesmultiple includeoperatingmargin, re-investment rate, revenuegrowth,andtheweightedaveragecostofcapital.Aftercreatingacorrelationmatrixofthevariousproxiesforgrowth,risk,and cash flow potential, the team considered proxies with high correlations to the multiple and lowcorrelationsbetweenindependentvariablesthemselvestocontainmulti-collinearity.TheteamransomeinitialregressionstoobtainaclearerpictureofwhichindependentvariablesbestpredictedtheEV/SalesbyexaminingdifferentR-Squaredandt-valueresults.Thefollowingshowsourfinalregressionresults:Model Summary S R-Sq R-Sq(Adj.)0.794554 65.71% 62.00%
InputtingtheindependentvariablesintotheregressionequationyieldedapredictedEV/Salesof5.37.ThepricepersharepredictedforTeslausingthismultipleis$265.76,16%overvalued.Theteamchosetouse5-yearbetaastheriskmeasurebecauseofitssignificantlyhighersignificancecomparedtoDFR.Wealsoexcluded re-investment to stay consistentwith our belief that automakers’ reinvestment rates are notproperlyrepresentativeofTesla’s,whichreinvestsmoreinlinewithtechcompanies.Market Regression Equation
