Thread by @borrowed_ideas

1/ Thread: The role of intangibles in valuation

I feel like a broken record, but @mjmauboussin and Dan Callahan recently published another intriguing piece titled "One Job".

What is "One Job"?

To take advantage of gaps between expectations and fundamentals.

But first a quiz.

2/ Which of the following stocks you want to own?

Stock A: it's profitable for last 15 years. Both sales and net profit CAGR 40%. Dividend initiated in year 3 and grew at 50% CAGR.

Stock B: Negative FCF for last 15 years. Debt grew at 34% CAGR. Cash was 2.5% of sales in yr 0...

3/ ...and it came down to 2.0% in yr 15.

Of course, it's a trick question. Stock A and B are actually the same company. It's $WMT.

If you hated stock B, well, here's a shocker. The stock had 29% CAGR return during this 15-yr period vs 11% for $SPY.

4/ Instead of looking at just mere multiples/accounting numbers, you are probably better off trying to understand the company's value creation process.

This value creation has transformed from tangibles to intangibles in last few decades.

5/ Three sections in this report.

First, how we can measure intangibles
Second, the characteristics of intangibles, and
Third, the implications for investors

6/ Before we discuss how we can measure intangibles, it's always helpful to start from the very basic.

What really are some examples of intangible assets? See the table here.

7/ Let's get back to measurement now.

Start with SG&A (defined as all expenses except COGS). Then subtract R&D and advertising expense which are generally known as intangibles.

What you have now is "Main SG&A". Then figure out how much of "Main SG&A" is necessary to...

8/...maintain the business. The rest is "Investment Main SG&A" which is an intangible investment.

Just see how the "Investment Main SG&A" has eclipsed other cost components in the Income Statement.

9/ But how do we incorporate these for individual companies we analyze?

We need some adjustments. Based on some research, here are some rules of thumb.

100% R&D is intangibles
70% S&M is intangibles
20% G&A is intangibles

10/ If you convert those Income Statement items as investments, you also have to amortize. Here are the rules of thumb for amortization schedule:

6 years for R&D
2 years for S&M
2 years for G&A

11/ Now it's time for a real example: $MSFT

See the standard FCF calculations first here and then we'll do the adjustments later.

12/ Based on our rules of thumb, $MSFT had $34 Bn expenses in fiscal 2020 that can be considered as investments in intangibles.

13/ So we now make three adjustments.

I. Add the intangible investment net of amortization back to NOPAT

II. Add the same figure to investment which increases invested capital

III. Capitalize the intangible in balance sheet and amortize in the Income Statement

14/ Here's how it looks like after all these adjustments

Note even though there are lots of changes in different numbers, the FCF doesn't change at all.

So why do we care?

15/ The ROIC profile changes dramatically after these adjustments. Prior to any adjustment, $MSFT ROIC was 52% in 2020 and post-adjustments, it came down to 33% which is, of course, still incredible.

16/ There are some caveats to this approach, especially how it treats all R&D as "investments".

Also, can we all just agree to take out SBC from our FCF calculation?

Mauboussin also mentioned how mistreatment of leasing expenses can also distort FCF calculations.

17/ So what are the characteristics of these intangibles?

Four characteristics. The four S.

I. Scalability
II. Sunkenness
III. Spillovers
IV. Synergies

18/ I. Scalability

Intangibles generally require significant upfront costs but very low incremental costs. Example: drug development, Unreal engine etc.

Network effects can also come into play here. Because of this, more value can be created with greater scale.

19/ So something interesting happens when you have scale with network effects.

Supply-side economics is at work with higher scale as incremental unit cost goes down.

Demand-side economics is at work as willingness to pay increases with greater network effects.

Win-Win.

20/ II. Sunkenness

If you invest in a tangible and it doesn't turn out well, you can see it and re-capture some of your investments. With intangibles, that's not the case.

If it doesn't work, it's zero.

21/ III. Spillovers

Since intangibles are non-rival and non-excludable goods, it can be imitated rapidly.

I always find it mildly funny how $FB is vilified for copying others when so many others unabashedly copy them as well.

22/ IV. Synergies

Brian Arthur said "innovation arises from combining technologies that already exist"

Paul Romer also argued for endogenous, not exogenous growth theory when it comes to technology.

Development of jet engine is a relevant example.

23/ Implications for Investors

Pay attention to intangibles, especially since relevance of earnings has declined over time.

24/ One study found after adjusting for intangibles, 40-60% "value" or "glamor" stocks switched categories.

In any case, these are "marketing" terms, probably not much relevant if you are an individual investor in my opinion.

End/ Have a great weekend, everyone!

Link to the full report: morganstanley.com/im/publication…

All my twitter threads: mbi-deepdives.com/twitter-thread…