a short reprise of the Zynga (ZNGA) IPO

King Digital Entertainment, PLC  is the maker of the fabulously successful mobile-centered game Candy Crush Saga.  The firm has filed a form F-1 in preparation for an IPO.  King (proposed ticker: KING) intends to raise around $500 million.

Not surprisingly, the KING offering has reawakened bad memories of the 2011 IPO of ZNGA, which was led by Morgan Stanley and Goldman (no shock, either, that neither of those firms has a role in the KING IPO).

I haven’t yet read the KING offering document.  It’s possible that I won’t.  But I still thought it might be useful to look back at the characteristics of ZNGA that, in my view, made that stock an unattractive investment from the start.

1.  Virtually all the traffic coming to ZGA’s games was generated by Facebook.  This made it difficult to tell whether ZNGA’s games were successful because they were great games, or because they were being featured on FB.  If the latter–which subsequently proved to be the case–FB held the economic power in their partnership.  Any lessening of FB’s marketing efforts would quickly translate into a reduction in ZNGA’s profits.  A big weakness of ZNGA, not a plus.

2.  A reasonable way of assessing social games is to measure:

–the time needed to reach the peak number of players,

–the number of peak users, and

–the rate at which the number of users fades from the peak.

Even prior to the IPO, ZNGA offerings launched after its signature game, Farmville, were peaking faster than Farmville, and at lower numbers of users than Farmville.  In addition, they were as fading from the peak more quickly.  In other words, none of them had anything near the oomph of Farmville. This was all bad news.

3.  The actions of  the lead underwriters, both before and after the ZNGA IPO were quite odd, in my view.

For one thing, according to the New York TimesMorgan Stanley mutual funds bought  $75 million worth of pre-IPO shares of ZNGA in February 2011 at $14 a share.  Some have suggested that this was done to help persuade ZNGA to choose Morgan Stanley as a lead underwriter.

For another, the underwriters released the top management of ZNGA, as well as some venture capital investors, from IPO share “lockup” agreements that prevented their sale of stock prior to May 29, 2012.   Instead, a sale of 49,4 million shares at $12 each raised close to $600 million in early April for these high-profile holders.  By the original lockup expiration, the stock was trading at little more than half that level.

My overall impression is that the underwriters (incorrectly) thought that the heyday of tech investing was over.  This would imply that they and the companies they were moving to initial public offerings had only a short time to cash in before the rest of the world figured this out.  As a corollary, the traditional rules of trust and fair play between underwriter and professional portfolio manager/wealth management client no longer held–because there would be no follow-on business that once-burned clients would shy away from.

relevance for KING?

Again, I should mention that I haven’t yet analyzed KING.  Candy Crush Saga may well prove a fleeting fad and KING a one-trick pony.  On the other hand, the underwriters are different this time.   And I don’t sense the same IPO-before-it’s-too-late urgency that was in the air in 2011.

Apple (AAPL) today

the stock vs. the company

the company

As a company, Apple has in most respects followed the typical pattern for businesses of high-flying growth stocks.

The company stabilized itself as a computer maker, after a brief flirtation with bankruptcy, with the return of Steve Jobs as CEO.  It took a chance on making the iPod, which a geeky DJ apparently brought to it.  That produced a series of big profit increases that lasted several years and doubled this size of the company.  Just as the iPod wave was cresting, Apple reinvented itself again, as the iPhone company.  Another huge profit surge followed, which crested as the global market for expensive smartphones matured.

Yes, Apple has reinvented itself again as the iPad company, but each blockbuster must be progressively larger to move the profit needle for a firm whose income has grown exponentially over the past decade.  The iPad doesn’t have enough oomph to do so.  Heartless as it may seem, Apple has gone ex-growth.

Look at IBM, or Oracle, or Cisco, or Wal-Mart  …or, on a smaller scale, the Cheesecake Factory or Chicos or PF Chang.  Same pattern.

the stock

What has been strange about Apple has been the behavior of its stock.  Typically, as a company’s earnings begin to accelerate, the price-earnings multiple begins to expand as well.  So the positive effect of the earnings growth is magnified.  When (or just before) earnings growth beings to disappoint, as it sooner or later will the PE begins to contract.–and the stock plunges.  Timing this shift is the key issue for growth investors.

Not so much with AAPL.  Its PE peaked in 2008, four years prior to the peak in earnings (which were, by the way, almost 8x the 2008 level).  The multiple contraction has been pretty continuous, moving from 30x ( and 1.8x the market multiple) in 2008 to 12.3x (and a .7x relative multiple) for 2013.

an investment thesis

Growth investors, who are searching for the next AAPL, have abandoned ship andgone elsewhere, leaving the field to their value counterparts.

For value investors, I think the key question revolves around the PE.  When growth stocks fall from grace, the multiple typically contracts severely–and over a long period of time.  The decline ends in an overreaction on the downside.

Looking at AAPL,nine months of stock price pain (late 2012 – mid-2013) would be unusually short period of time.  But, then, the AAPL multiple has already been contracting for five years.

Although I’m not a value investor (read: although I’m no good at making these judgments), my sense is that the AAPL PE is too low.  I don’t feel an overpowering urge to buy the stock.  But 10% earnings growth + one point of multiple expansion this year doesn’t sound so bad, either.

 

 

 

Verizon Wireless: who’s getting the better of the deal, Verizon (VZ) or Vodafone (VOD)?

I think it’s VZ.  The company says that even at a cost of $130 billion the buy-in of VOD’s 45% minority interest will add 10% to VZ’s earnings.  But VZ is also adding a significant amount of risk in leveraging itself financially.

a simplified history

In 1982 the federal government forced the breakup of the monopoly telephone service provider, ATT.  It separated the parts into a national long-distance provider, which retained the ATT name, and a bunch of regional local service providers, nicknamed the “Baby Bells.”  Each Baby Bell contained its area’s nascent mobile services.

Soon enough, the Baby Bells began to merge with one another, ultimately forming into a Western US group (which subsequently acquired “new” ATT and took on the ATT name) and an Eastern group, which subsequently renamed itself Verizon.  Proto-VZ wanted to keep its mobile assets.  Proto-ATT didn’t.  To keep the mobile assets out of the clutches of prot0-VZ, Airtouch, the proto-ATT mobile operation, sold itself to VOD in 2000.

VOD promptly struck a deal with VZ in which it merged Airtouch with the VZ mobile operations to form Verizon Wireless.  VZ had operating control and a 55% interest.  VOD had veto power over some decisions and held the other 45% of Verizon Wireless.

Got all that?

culture clash

VOD is a British company.  It apparently believed in the old-style colonial European way of doing business, according to which a firm with global pretensions could get more bang for a buck (or quid, in this case) of capital by taking large minority interests in important foreign  firms.  Through superior intellect/management technique, or force of will, or sheer European-ness, it would dominate the board of directors.  It would thereby get the benefits of 100% ownership without the capital outlay.   The resulting network of companies would move in lockstep with its European leader, buying the capital equipment suggested (getting discounts for all) and perhaps paying management fees to the European company for its advice.

VZ, an American firm, would have thought that no one in his right mind would accept a minority stake.  If would have figured that VOD would soon see the light and be persuaded to sell.

Or maybe that’s just how the two parties rationalized the unhappy partnership that they entered into.

what each party gets from the deal

Verizon

–when the deal closes early next year, VZ will have access to the cash flow from Verizon Wireless for the first time.  US tax law   requires that a parent have an 80% interest in a subsidiary before cash can flow tax-free from it to the parent

–VOD will no longer have an operational say in Verizon Wireless

–the very mature fixed-line telephone business will be a significantly smaller proportion of the whole

–the deal is accretive to earnings by 10%

Vodafone

–VOD extracts itself from its awkward minority position

–ir gets a big payday, even after distributing the bulk of the proceeds to shareholders, which it will presumably use for EU acquisitions

–VOD believes it can use a provision in UK tax law regarding transactions between conglomerates to pay only about $8 billion it taxes on this deal

Verizon (VZ), Vodafone (VOD) and flowback

VZ is buying the 45% of Verizon Wireless that VOD owns.

VZ, which owns 55$ of Verizon Wireless, recently agreed  to buy the other 45% from VOD for around $130 billion.

From what I can tell so far, the deal will be good for VZ.  And, at the very least, VOD gets a boatload of cash and stock.  In hindsight, VZ would have been a lot better off striking the same deal in March, before the Fed began hinting that it was thinking of ending the current post-recession period of extra-super-accommodative money policy in the US.  The interest rate VZ would have paid on newly issued bonds would have been lower.

More on this topic in future posts.

There may not be a great need to load up on VZ ( which I own) immediately, however–even if you think the deal is a spectacular coup for VZ (too enthusiastic for me).  The reason is flowback.

what flowback is

VZ is going to issue over a billion shares of new stock to VOD as part of the purchase price.  VOD has already announced it will distribute to its shareholders all of the VZ stock it receives.  That’s something like one VZ share for every 40 VOD shares held (the exact ratio isn’t important).

What is important is that VOD is a UK corporation whose stock is traded in London.  The bulk of its shares are held either by UK or Continental European institutions.  US institutions hold only about 15%.

Put another way, early next year almost everyone who owns VOD will receive shares in a foreign stock, VZ.

What will they do with it?

For index funds, the answer is clear.  If it’s not in the index, it has to be sold.

For institutional managers in the EU, the answer depends, in the first instance, on what their contracts with customers say.  They’ve presumably been hired for their expertise in EU equities.  Management agreements probably stipulate that they’re not allowed to hold non-European securities.

Even if they are permitted to hold VZ, why do it?  Why take the risk of holding a stock that’s outside your area of competence–and which will require considerable research effort to get a firm grasp on.  Selling is a much safer option.

For individuals, if form runs true, the first they’ll hear of the deal will be when their broker calls to tell them that shares of VZ have plopped into their accounts–and to urge them to get rid of this weird thing.

That’s flowback.

It happens in all cross-border deals that involve stock.  When shares of the issuing company leave the home country, some portion will be sold immediately by investors who are unable or unwilling to hold what is for them a foreign stock.

Where do these sales take place?   …ultimately in the home market of the issuer.

the VZ case

For VZ, average daily trading volume is around 10 million – 12 million shares.   Occasionally, volume can get as high as 30 million- 40 million shares without moving the stock too much.

Let’s make up a number and say that flowback will be 300 million shares.  That’s easily an entire month’s trading volume.  So this could be a serious issue for VZ’s price.

mitigating factors

There are three that I see:

–Verizon Wireless is the largest and most important asset for both VZ and for VOD.  Non-index investors in the EU must have wanted exposure to Verizon Wireless to be holding VOD shares.  Arguably, they will want to continue to have that exposure and will therefore be less inclined than normal to want to sell.  So maybe some will be able to wangle exceptions from their clients.

–trading volume in VZ over the past seven trading days (not including today) has averaged about 25 million, or–let’s say–12 million shares above normal.  If this is all merger-related short-selling, which it probably is, then this trading has already created demand for 80+ million shares of VZ when the shorts are covered.

–the stock has a current dividend yield of 4.6%.  At some point, this and other VZ fundamentals should provide price support.

my take

Worries about flowback are one reason large cross-world acquisitions involving stock aren’t that common.  This one was clearly too big for VZ to do any other way.

My guess is that anticipatory selling in advance of the acquisition will make it hard for VZ to go up for a while.  I also think, however, that downward pressure from potential flowback will abate long before the deal actually occurs.

At some point, an excellent buying opportunity for VZ will emerge from acquisition-related stock activity.  The trick is deciding exactly when.  The most prudent strategy, I think, is to establish a small position and await further developments.

 

 

Microsoft (MSFT) and Nokia (NOK)

A few days ago, MSFT announced a $7.2 billion deal to buy Nokia’s cellphone business.  That breaks out into $5 billion for the cellphone division + $2.2 billion to license Nokia’s relevant telecom patents.

Rather joining in the chorus of MSFT-bashing that’s accompanied the deal’s announcement, I want to make a single point.  This deal has been a long time in the making–at least two years–even if MSFT may not have realized this.

In late 2010, Stephen Elop, a consultant/general manager with a tech background who had worked for almost three years at MSFT, became CEO of NOK.  He promptly issued his “Burning Platform” memo, in which he likened working in NOK’s cellphone business to being stuck on an offshore oil platform that was being consumed by fire.  Two choices:  jump into the ocean or burn to death.

He followed that up in early 2011 by declaring that NOK was opting for the briny deep by abandoning its proprietary Symbian cellphone operating system in favor of Windows.  Why not Android, which would have been the safer choice?  Differentiation, Elop’s familiarity with MSFT, the potential for support from MSFT in the form of access to its smartphone intellectual property and possibly to its enormous pile of unused cash.

Sounds a little like Ron Johnson at J C Penney, doesn’t it?   … drama, and a bet-the-farm moment.

The announcement that Symbian’s goose was cooked had the predictable result.  People around the world stopped buying Symbian phones.  Cash flow from cellphones turned from strongly positive to significantly negative.  The situation didn’t improve when the first Windows-based Lumia phones debuted later that year.

By early 2012, it seems to me, the NOK board had to begin contingency planning.  What if the Lumia phones were slow in taking off?  How much of NOK’s cash flow from its other businesses would it be willing to plow into smartphones?  How much financial support would MSFT kick in?  When would continuing to prop up a failing Lumia line threaten to pull the parent company itself under?

We now know the answers.

NOK began to negotiate the sale of its smartphone business to MSFT in February, telling us that by that point NOK had determined it couldn’t continue its aggressive Windows phone bet without putting the entire company at risk.

Why did MSFT agree to buy the NOK cellphone business?

Without a Windows smartphone, MSFT’s grand vision of creating a Windows ecosystem like Android or Apple is DOA.  Also, MSFT probably regards itself as playing with $.65 dollars.  It gets to use a (small) portion of its foreign cash without repatriating it to the US and paying corporate income tax.

Anyway, NOK’s bungling the transition from flipphone to smartphone set a chain of events into motion that resulted in its willingness to sell.  MSFT’s bungling of its decade-long mobile phone initiative made it an eager buyer.  Whether the cobmination of the two will have a happier outcome is a completely different question.