December 3, 2013
This blog is an extension of our blog on #Twitter Truths: Identifying & Modeling Revenue Drivers of a Blockbuster Internet Venture.
We have expressed all the costs as percentage of sales and forecasted them in the same manner. While projecting the costs we have built in options of capitalization of R & D Expenses and Operating Leases. While such capitalization doesn’t impact the overall equity valuation of a firm, we should ideally follow the process for the reasons stated below. In industries and across the globe, there are enough opinions for doing and not doing so. We are guided by the article “Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE): Measurement and Implications” authored by Professor Aswath Damodaran, Stern School of Business, July 2007 for our approach. The notes in this section have been produced from this article.
1.Capitalize Research & Development (R & D) expenses:
Consider a technology or a pharmaceutical company with significant growth potential. To convert this growth potential into value, these firms have to invest, but their investment is usually not in land, buildings or equipment but in research and development. Under the rationale that the products of research are too uncertain and difficult to quantify, accounting standards have generally required that R&D spending be expensed in the period in which they occur. This has several consequences, but one of the most profound is that the value of the assets created by research does not show up on the balance sheet as part of the total assets (or capital) of the firm. This, in turn, creates ripple effects for the measurement of capital and profitability ratios for the firm. Research expenses, notwithstanding the uncertainty about future benefits, should be capitalized. To capitalize and value research assets, we have to make an assumption about how long it takes for research and development to be converted, on average, in to commercial products. This is called the amortizable life of these assets. This life will vary across firms and reflect the barriers to converting research ideas into commercial products. To illustrate, research and development expenses at a pharmaceutical company should have fairly long amortizable lives, since the approval process for new drugs is long. In contrast, research and development expenses at a software firm, where products end to emerge from research much more quickly should be amortized over a shorter period.
For Twitter, we have assumed the amortizable life to be 3 years. The capitalization model has been reproduced below:
2.Capitalize the Operating Lease expenses
While accountants and the tax authorities may differentiate between capital and operating leases, we see no reason for the differentiation in corporate finance and valuation. Operating lease commitments look very much like debt commitments in so far as firms as contractually obligated to make them. It is true that they may offer more flexibility and escape clauses than conventional debt, since firms can sometimes selectively abandon leases on properties that are not financially viable without exposing themselves to default risk. In that sense, they may be closer to unsecured debt than secured debt, but they should still be treated as debt. With that rationale in mind, let us consider the mechanics of the conversion.
a. We start with the lease commitments that the firm has already entered into and treat them as the equivalent of debt payments (interest and principal).
b. We discount these future operating lease commitments back at the firm’s current pre-tax cost of debt to arrive at the debt value of these commitments.
c. The present value of the operating lease commitments is then added to the conventional debt of the firm to arrive at the total debt outstanding.
d. Note that we restrict our analysis only to those commitments that have already been made and do not consider expected future lease payments or commitments.
e. We do this for the same reason that we restrict our definition of conventional debt only to debt outstanding today rather than expected future debt issues.
Once operating leases are re-categorized as debt, the operating income can be adjusted in two steps:
a. First, the operating lease expense is added back to the operating income, since it is being treated as a financial expense.
b. Next, note that the conversion of leases into debt creates a counter asset on the balance sheet that is the leased asset.
c. The depreciation on the leased asset is subtracted out of operating income to arrive at adjusted operating income.
d. If you assume that the depreciation on the leased asset approximates the principal portion of the debt being repaid, the adjusted operating income can be computed by adding back the imputed interest expense on the debt value of the operating lease expense.
e. Since equity income is net of operating and financial expenses, treating operating leases as financial rather than operating expenses should have no effect on net income and the book value of equity should not be impacted by the conversion. Thus, the return on equity should be unaffected by the conversion of leases into debt.
We are producing below the output of capitalization of operating leases:
Please refer to our detailed model for assumptions and workings. In our model, there is a drop down menu to choose whether you want to capital R & D Expenses and Operating Leases or not. We suggest to keep the choices as “No” in case you are using our model to compare the projections with that from other analysts or as published in other reports.
Margins of the Company had been shown below. EBITDA is the adjusted EBITDA calculated as per EBIT + Depreciation & Amortization + Stock Based Compensation expenses.
We then proceeded to model the capital expenditure, depreciation & amortization, gross block & net block of fixed assets and the same for intangible assets. The Company has disclosed an estimate of its capital expenditure for FY13E on page no. 47 of its Amendment no. 2 to Form S – 1. We reproduce the same below:
“…We anticipate making capital expenditures in 2013 of approximately $215 million to $235 million, and we may use a portion of the net proceeds to fund our anticipated capital expenditures…”
In the absence of any other information about the Company’s capital expenditure plans in future, we have expressed capital expenditure as %age of sales and depreciation as %age of closing gross block. The Company has stated that they follow straight line method for depreciation.
Once through with asset modeling, we now move on to take up “Leases, debt and interest expenses” modeling. Sources of financial expenses are:
1. Interest expenses on account of:
a. Capital leases on the balance sheet of the company: Company has financed purchasing of capital assets in the past through Capital leases. The future payments of such leases have been made available in the filing. We have assumed no further purchase through capital leases and amortized the same over the specified period of time. We have first calculated the imputed interest rate in the capital lease and used the same for capitalization of Operating Leases.
b. Capitalized operating leases: The operating lease commitments had been broken in to interest and principle repayment parts. Interest portion had been included in this head. If you have chosen not to capitalize operating leases on the assumption sheet, this head will not contribute to interest expenses.
c. Revolving credit facility: In October 2013, Twitter entered into a revolving credit agreement with certain lenders which provides for a $1.0 billion revolving unsecured credit facility maturing on October 22, 2018. We have provisioned for this but due to enough liquidity from IPO fund raise and operations, we have not utilized any credit under this facility.
2. Bank Charges:
a. Unused facility commitment charges
b. Processing Fees, one time, upfront
Twitter is obligated to pay other customary fees for a credit facility of this size and type, including an upfront fee and an unused commitment fee. Its obligations under the credit facility are guaranteed by one of the wholly-owned subsidiaries. As of October 22, 2013, no amounts were drawn under the credit facility.
Interest expenses have been netted off against interest income from interest bearing funds. We have calculated interest bearing funds as sum of cash equivalents comprising of Money market funds, US Government& agency securities, T Bills, corporate notes and CPs and Short Term Investments comprising of US Government& agency securities, T Bills, corporate notes and CPs.
Remember that the closing balance of following three debt like items should feed into the balance sheet at the end of this exercise:
1. Capital Lease, short term (current portion) and Capital Lease, long term (non-current portion)
2. Revolving credit facility (long term debt)
3. Operating Lease capitalized, short term (current portion) and Operating Lease capitalized, long term (non-current portion) – it will be set to zero, in case you have chosen not to capitalize operating lease on the assumption sheet.
Please refer to an earlier blog by us on this link Financial Modeling and Tax Modeling
to understand the intricacies involved in tax modeling.
Tax modeling will be a significantly difficult exercise here as the Company operates through a number of subsidiaries I different locations, each facing a different level of profitability and state / federal tax rates. Only simplification available to us is the fact that the Company is yet not profitable on the consolidated level. We have expensed R & D expenses fully as and when they are incurred (as per US GAAP) whether you have chosen to capitalize them or not. We have given credit for the losses accumulated since 2010 in subsequent years while calculating the tax. Actual and exact tax modeling will be very difficult and we have simplified by modeling the tax at consolidated level.
Once all the assumptions have been made and subsequent modeling done, we take a pause, look back at our assumptions and normalize the things. Ratio analysis is a handy tool for this. We conduct a detailed ration analysis to identify any knee jerk assumptions and rectify the same before proceeding to valuation. We bring to your notice some not so commonly used ratios used in this case:
1. Lease commitments to equity ratio (Instead of Debt to Equity Ratio)
2. Interest coverage ratio (Interest is inclusive of the interest portion of the financial as well as operating lease capitalized)
3. Lease servicing capability ratio (Instead of debt servicing capability ratio)
Please share your thoughts with us. Feel free to start a discussion below to contribute!
To read the last and final blog of this series, just follow the link to Twitter Truths: Implementing Valuation Methodologies in the Case of Internet-based Ventures
You can download detailed S1 Filings for Twitter from: http://goo.gl/OWRNPL