Thursday 28 November 2019

Is Kylie Jenner a Billionaire, or Even Close? Part II

A little over a year ago, I wrote a short blog post taking issue with a Forbes magazine article that had concluded that Kylie Jenner’s company, Kylie Cosmetics was worth over $1B. In light of last week’s news that Coty Inc., a publicly traded cosmetics firm, is purchasing a 51% share in Kylie Cosmetics for $600M, this would seem to confirm that Forbes was right and I was wrong. Or does it?

I’ll begin by making a few technical observations. The Forbes article had stated that Kylie’s revenue for 2017 was $400M, and pre-tax profit margins (it seemed to imply) were in the range of 40%, for pre-tax profit of around $160M.

The public disclosures so far surrounding the Coty transaction appear to indicate that in fact:
  • Revenue for the last twelve months has been only $177M, which represents growth of 40% over calendar 2018. This would seem to imply that revenue in calendar 2018 was around $125M.
  • EBITDA margins are “>25%”
These numbers are far different from those presented in the Forbes piece, so different in fact that the company described by Forbes bears little resemblance to the company that Coty has actually purchased. So throw the whole Forbes analysis out the window, and let’s ask the question again: Is Kylie Jenner a billionaire, or even close?

Now, Ms. Jenner stands to receive $600M in cash for the 51% of her company. $600M is worth $600M; not even I can argue otherwise. But what is her remaining 49% interest in her company worth? Ostensibly, if 51% of her company is worth $600M (which is what Coty is paying for it), then the other 49% should be worth a little bit less than $600M, which would put Ms. Jenner at around $1.2B. Or does it?
There are a few points worth considering:
  • Coty is a beauty-care company with a market cap that has hovered in the range of $9B, with annual revenues of around $9B. Its business has been performing poorly and it was looking for a way to reconnect with a younger demographic. Ms. Jenner fits that bill. So a large portion of the $600M Coty paid for Ms. Jenner’s shares is likely represented in the synergistic or knock-on effects it feels that Ms. Jenner’s small company will have on Coty’s results. These are benefits that, as a shareholder of a 49% stake in Kylie Cosmetics, Ms. Jenner does not necessarily get to participate in.
  • Second, the stock market’s reaction to the deal has not been particularly enthusiastic. Coty’s market capitalization has fallen by around $300M (from $9.0B to $8.7M) in the week or so since the deal was announced. So while Coty may have paid $600M for Kylie Cosmetics, it is less than clear that Coty’s investors feel that this was fair market value for the company.
  • Finally, Ms. Jenner is now a minority shareholder in her company, and her ownership interest may be valued at less than her pro-rata interest in her company. The details of the deal have not been disclosed, so it is unclear how much representation Ms. Jenner will retain on the board of her own firm. But this is something that could potentially have an impact on  the value of the remaining 49% of the business.
What do I think Kylie Cosmetics is worth now? It is very difficult to say. Here is one possible model that shows a value for the entire company at $600M. This model makes some very aggressive assumptions about growth and the staying power of her brand; as I have argued previously, neither of these assumptions may prove realistic. It also ignores things such as capital investments (e.g. working capital) to accommodate the high rate of growth.


 

Thursday 25 July 2019

Calculating Damages in Representations and Warranties Cases

Introduction

Mergers and acquisitions (“M&A”) can be a double-edged sword. When done right, M&A can allow acquirers to scale their businesses and create value through synergies. When done poorly, M&A can result in drastic overpayments for assets that are not nearly as valuable as believed and for economies of scale that are very difficult to achieve. 

One of the main risks in M&A is information asymmetry: simply put, the vendor knows much more about its business than the acquirer. While the acquirer is able to perform due diligence, time pressures to close the deal mean that this process can sometimes be imperfect; issues are sometimes missed.  This is where Representations and Warranties (R&W) insurance can come into play. This brief article provides a brief overview of R&W insurance, and discusses some of the issues we have encountered as forensic accountants and business valuators in quantifying losses under this type of insurance coverage.

What is R&W Insurance?
R&W insurance provides indemnity for “losses” related to overpayment by the acquirer resulting from breaches of representations and warranties as set out in the purchase agreement for the acquisition.

These types of policies are becoming increasingly popular. One global broker recently reported a 30% increase in deals written in 2018 compared with the prior year. The average policy limit was equal to 15% of the total enterprise value of the deal (e.g. a deal for $100M would have a policy limit of $15M); while deductibles were generally set at 1% of enterprise value. The same publication also reported that premiums have been declining over the past two years, as more insurers enter this market. Another publication by a leading insurer in the space mentions that the frequency of claims has been roughly one claim for every five transactions.

Two types of mistakes
Based on our experience quantifying losses under R&W coverage, there are two main types of misrepresentations: one-time misrepresentations and long-term misrepresentations.

One-time misrepresentations
These types of misrepresentations generally relate to the balance sheet. M&A transactions typically will set a target level of “net working capital”, based on an overall understanding of the subject company. If issues with this calculation are discovered following the closing, the economic loss to the purchaser is generally equal to the amount of the misstatement. 

Quantifying these types of issues involves first obtaining a detailed understanding of the components of the purchase price and ensuring that the alleged misrepresentations are not already factored into the price. For example, if the claim is that a large amount of inventory had to be written off following closing, one would need to make sure that the inventory balance included in the closing statements did not already consider a provision for obsolete inventory.
Long-term misrepresentations 

Long-term misrepresentations will tend to involve the income statement. For instance, in one case we were recently involved in, the seller had represented to the purchaser that it was not subject to a particular type of property tax. This turned out to be incorrect, and as a result the purchaser was liable to pay this additional, unexpected amount every year for the foreseeable future. In that case, the loss to the purchaser is equal to the present value of the ongoing annual tax liabilities.

How does one value these sorts of long-term misrepresentations? One shorthand approach might be to simply apply the acquisition multiplier to the value of the annual misstatement. For instance, if the deal multiplier was 10 times the seller’s trailing EBITDA, and the value of a misrepresentation (such as the unreported property tax issue) is $1M per year, then one might reasonably conclude that the value of the misstatement is $10M.

This approach can be appropriate in some cases, but sometimes it can lead to incorrect results, when the cash flows associated with the misrepresentation in question have different characteristics (term, riskiness or growth forecast) than the acquired business as a whole. Consider the following example:

·         The business being sold has two divisions, Rapid Robotics and Flat Pancakes. After-tax cash flows last year were $10M ($5M for each division), and the business recently sold for $200M, or 20 times after-tax cash flows.

·         It was discovered that due to regulatory changes in the pancake market (which were known to the seller prior to the deal), Flat Pancakes will need to eliminate a particular product line that accounted for $1M in after-tax cash flows. The purchaser advances a claim for $20M, equal to the annual value of the misrepresentation of $1M times the acquisition multiplier of 20 times.

·         The problem with this approach is the 20x multiplier may actually consist of a multiple of 30 times cash flows for the Rapid Robotics division, and only 10 times cash flows for the Flat Pancakes division. The higher multiplier for Rapid Robotics would represent the value attributed by the purchaser to the anticipated growth in that division.

·         This means that the value of the $1M misrepresentation in the slow-growth Flat Pancakes division is only $10M, not $20M.
In order to perform a proper analysis of these longer-term misrepresentations, it is therefore generally very beneficial to obtain a copy of the valuation model used by the acquirer in the transaction in order to understand how the transaction multiplier was arrived at and to reverse engineer the impact of the particular misrepresentation on business value.

Closing
This article has only scratched the surface of the types of issues that, in our experience, can arise from post-acquisition M&A disputes. As M&A insurance becomes, in the words of one insurer, “the new normal”, we will no doubt have the opportunity to revisit this topic in future articles.

This article first appeared in the July 25, 2019 edition of Lawyer's Daily, published by LexisNexis Canada

Wednesday 26 June 2019

Award

It was an honour to receive the CBV Institute's "Communicator of the Year" award last week at its annual conference in Montreal.
 
My wife still doesn't believe me, but here is the proof: