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.

 

"Quantifying the Rescission Remedy under the Arthur Wishart Act" - 2019 Version

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

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:

 

 

 

Canada's Fall Economic Update and Its Impact on Valuations

A couple of days ago, the federal government of Canada came out with its Fall Economic Update. One aspect of the update that impacts businesses (and business valuations) is the changes to the Capital Cost Allowance (“CCA”) system by which businesses get to write-off their capital assets for tax purposes. This brief article discusses some aspects of this change.

CCA and the Half-Year Rule

For non-manufacturing equipment, we used to have the “half-year rule”, whereby a purchaser of a new asset only got to apply half of the normal CCA rate in the first year; for example, if you bought an asset for $100,000 and the normal CCA rate is 20%, you’d only get to write off 10% (or $10,000) in the first year for tax purposes.

The half-year rule has now been replaced with a new first year rule which allows purchasers to apply 1.5 times the normal CCA rate in the first year; to continue the example from the previous paragraph, the CCA in year 1 would now by $30,000.

For valuators, this means that the tax shield formula on new capital expenditures will change from:

UCC x Tax Rate x CCA Rate / (Discount Rate + CCA Rate) x (1- (Discount Rate / (2 x (1 + Discount Rate))))

to

UCC x Tax Rate x CCA Rate / (Discount Rate + CCA Rate) x (1+ (Discount Rate / (2 x (1 + Discount Rate))))

Does this matter?

So, will this change impact a) actual capital expenditures and b) valuations in Canada going forward? The short answer is: in many cases, "not really".

The amount of CCA that businesses can take over the life of the asset in question does not change based on the new rules; all that is affected is the timing of CCA. By accelerating the CCA in the first year of the asset’s life, businesses will get to reduce their taxes in the first year, but their taxes will be slightly higher in subsequent years. The value of this timing difference depends on the discount rate one uses.

A common practice in valuations is to use a firm’s pre-tax cost of debt as the discount rate to calculate the present value of CCA. The reason for this is that the odds that a firm will have at least some taxable income against which to apply the CCA are fairly good, certainly less risky than the overall returns to equity holder as a whole.

Using a discount rate of 8%, I calculate that the impact of the new tax changes to the cost of asset purchases will be less than 1%, regardless of the CCA asset class. 

This is not to say that these changes will not spur a sudden rash of equipment purchases – they may have some psychological effect. But the actual savings, at least in most cases I can envision, are pretty marginal.
  

Springboard Profits/Damages in Canadian Intellectual Property Litigation

A few weeks ago, I co-presented at the Intellectual Property Institute of Canada’s annual conference in Vancouver on the topic of financial remedies in patent litigation. My portion of the talk focused on springboard profits as part of the accounting of profits remedy. In this post, I’ll share some of my thoughts from the presentation, as well as some other ideas that were suggested to me by my co-panelists and audience members.

The Concept

The concept behind springboard profits is that, by virtue of having infringed a patent, the infringer has achieved a financial advantage that continues beyond the expiry of the patent. This can occur for several reasons:

• A valid patent prohibits not only the sale, but also the manufacture and offering for sale of an invention covered by the patent. This means that had the infringer not infringed during the life of the patent, it would have taken some time to develop its product, to build up inventory, to market the product and build distribution channels. In short, it would have taken months, if not years, to build up their sales to a steady plateau. By infringing, the infringer is able to “hit the ground running” following the expiry of the patent.
• If the patented product is a durable good, then the benefits to the infringer in selling that good may include not only the initial sale, but also the sale of replacement parts, maintenance services, or other associated revenue streams. While the initial sale of the good may have taken place during the life of the patent, there will be additional benefits accruing to the infringer well beyond the life of the patent.
• In some instances, there may be an even longer-lasting benefit to the infringer. The existence of multiple firms already selling the patented product by the time of the patent’s expiry may dissuade additional firms from joining the market following the patent’s expiry, firms who may otherwise have entered the market if there had been only a single incumbent with whom to compete. In situations like this, the infringer’s benefit will continue into the indefinite future.

Are such post expiry springboard profits recoverable in an accounting of profits? In Dow Chemical Company v. Nova Chemicals Corporation, 2017 FC 350 (CanLII), Justice Fothergill found that they were. He was persuaded by Dow’s argument that if the incremental profits earned by the infringer following the expiry of the patent are not also disgorged, then the infringer will be left in a better financial position than if it had not infringed, a result that is antithetical to the very concept of the accounting of profits remedy.

Nova’s Argument

While they were ultimately rejected, the arguments raised by Nova also deserve some comment. Nova advanced several arguments. Conceptually, the most interesting arguments was the following:

• An infringer who disgorges its profits from infringement is implicitly acting as the agent of the patentee, and such payments implicitly serve to effectively condone the infringing activities themselves.
• The difficulty with this argument is that the profits remedy is not necessarily equal to the amount that, in the real world, the plaintiff would have agreed to in exchange for use of its patented technology. In many cases (such as the Dow case) the plaintiff would clearly never have agreed to license the technology under those terms, as its Minimum Willingness to Accept would be based on the damages it would suffer by reason of losing its monopoly over the invention in question.

The same argument would hold if the remedy awarded was lost profits (i.e. damages). The damages award compensates the patentee for its losses during the patent period only; any losses beyond that period would also need to be considered insofar as they are causally connected to the infringement.

Could Nova’s argument work in a damages context?

Is there a situation in which Nova’s argument would have carried more weight? Perhaps.

Suppose a plaintiff elects a damages remedy, which it measures based on a reasonable royalty since it is unable to prove it suffered any loss of sales as a result of the infringement.  In that scenario, the plaintiff’s MWTA is less than the defendant’s MWTP; that is, the benefit to the defendant from licensing is greater than the value to the plaintiff of its monopoly. This arises most commonly where the plaintiff is a smaller firm, while the defendant is much larger and able to scale to market.

In that case, a hypothetical royalty rate (and a fortiori an empirically based royalty rate, measured based on comparable transactions) should incorporate the fact that the defendant will thereby gain a springboard advantage. If so, then there should be no award of springboard damages.

This conclusion is implicit in the words of Justice Fothergill at paragraph 123 of the Dow decision:

[123]      Dow is entitled to awards under both ss 55(1) and 55(2) of the Patent Act. Even if the royalty rates calculated by Dr. Heeb and Dr. Leonard can be said to include the period following the expiration of the ’705 Patent, the royalty compensates Dow only for Nova’s infringement during the period December 9, 2004 to August 21, 2006. The accounting of profits extends over a much longer period.

Happy Belated Bobby Bonilla Day! Some Valuation-Related Thoughts on MLB Contracts

With the World Series upon us, I thought I’d do a post or two on valuation and investment principles involved in baseball player contracts. In this post I'll talk about fixed income valuation and interest rates, through the vehicle of the infamous Bobby Bonilla contract.

Bobby Bonilla was a fine player for the Pittsburgh Pirates in the early 1990s, and he and fellow "Killer B", Barry Bonds (who was a lot skinnier back then) went to three straight National League Divisional Series, losing all three.

Bonilla eventually arrived with the New York Mets (after stops in Baltimore, Florida, and the Mets themselves (in a previous go-round)), and by the year 2000 his skills were in severe decline. The Mets owed Bonilla $5.9M on the last year of his contract. Instead of paying Bonilla the $5.9M that year, however, the Mets and Bonilla agreed to a series of payments whereby the Mets would pay Bonilla $1.193M per year every year for a 25-year period, beginning on July 1, 2011 and ending in the year 2035, when Bonilla is 72 years old. The nominal value of the total payments will be just shy of $30M.

July 1 is now sadly observed by Mets fans every year as “Bobby Bonilla Day”. The sadness is due to three main reasons:

• It seems ridiculous that the team is still paying a former player, now in his early 50s, over $1M a year.
• Bonilla was somewhat of a disappointment even while he played for the Mets. While he made a couple of All Star teams in his first stint with the team, by 1999 he was producing a negative WAR value.
• It is commonly known that then-Mets owner Fred Wilpon was a major investor of disgraced Ponzi-schemer Bernie Madoff, and it is believed that the outsized “returns” Madoff was generating led to what was, objectively speaking, a foolish financial decision.

I’m not here to dispute the first two points, but I do want to talk a little about the financial principles of the third point. 
Discounting and Interest Rates in the Year 2000

It is often pointed out that the interest rate, or discount rate, on the Bonilla deal is 8%.  This is true, as I show in the table below. Thus, from the Mets’ perspective if they could invest the $5.9M at a rate of 8% per year for the next 35 years, they would earn exactly enough money to pay off the annual payments to Bonilla, leaving them with no balance owing at the end of the 35 years. 

Is it crazy for the Mets to have made that assumption? It would appear that the answer may be “no”. While it may be hard to remember based on the current low-yield environment, the US T-bond rate back in 2000 was in the range of 6.5% to 7% in the first part of 2000, while the 30-year “High Quality Market Corporate Bond Rate” at the time was around 8%. While that is a pre-tax rate, it nonetheless appears true that the Mets could have taken their money and invested it in a fairly safe investment and been none the worse for wear. So the deferral seems to make some sense from the Mets' point of view.

Another way to look at the deal is from Bonilla’s perspective. Effectively, Bonilla was agreeing to lend the Mets $5.9M for a long period of time, eventually getting paid back at an annual interest rate of 8%. Given the overall steadiness of Major League Baseball – no teams have folded for over 100 years - this would be similar to lending money to a high quality corporation. The one difference is that for Bonilla, there has been a significant tax advantage to a) spreading more of his earnings across lower tax brackets, and b) being taxed now as a resident of Florida (which has no state taxes) rather than New York (which does). So at the time, this was a win-win deal.

 

Interest Rates in 2018

There is a belief that bonds (lower case, the financial instruments, not the allegedly HGH-infused home run king) are a safe investment. After all, unlike the stock market they provide a fixed, knowable series of payments over time.

This is, in many ways, a mistake. While it is true that the payments on a bond are prescribed, the value of those payments will vary based on changes in rates of return on other investments. Bonds will fluctuate very significantly in value based on changes in nominal interest rates. Thus, if a ten-year bond with face value of $1,000 is issued with a coupon of 5% and the market interest rate at the time is 5%, the bond will sell for $1,000. If interest rates drop the next day to 3%, the same bond (paying a 5% coupon) will become much more valuable, and investors will be willing to pay almost $1,200 for the same bond.

If you think of Bobby Bonilla's contract as a bond with a coupon of 8%, it is clear that the cost of honouring that bond has gone up, with long-term interest rates in the 4% range now. Because the Mets did not (it would appear) secure the future Bonilla payments by matching them to a long-term fixed income investment back in 2000, the value of their liability has not been declining by nearly as much as it should have over time. The present value of the Mets' remaining payments to Bonilla is currently several million dollars higher than it should have been had interest rates remained high.

Conclusion

Trying to predict interest rates is a bit of a mug's game., and in any event the financial landscape in Major League Baseball has shifted so dramatically in the past 18 years that the money remaining on the Bonilla deal is really small change at this point, remarkable more for its strangeness and symbolism than its monetary significance. 

Bobby Bonilla has done well with his contract (assuming he did not sell or assign it!), but if interest rates had risen he would have been singing a different tune. The real advantage to this sort of a long term deal exemplified by Bonilla's is a) the tax savings, and b) the enforced savings and the knowledge that he will have over $1M coming to him for the next 17 years.