Bear On Business

Over this past week, the Zayo Group executive team thoroughly reviewed our operational plan.  When we started this review in the beginning of the week, the financial markets were in their worse shape in decades.  As each day elapsed, the financial markets worsened.  By the end of the week, dire warnings were being offered up by anyone with an opinion.

As I mentioned in my post last Friday, the entire Zayo team needs to fully accept the macro-environment we are in.  It is what it is.  We can’t control it.  It would be a mistake to take it lightly.

There is a silver lining for Zayo.  We are in good shape financially.  We are generating healthy and growing EBITDA.  We have cash to fund all of our committed capital projects.  We can fund a healthy amount of discretionary capital–and hence have an extremely valuable and scarce resource.  We can get to FCF break-even by 2Q09/3Q09.

Another silver lining for Zayo is that we are a roll-up of fiber based telecom companies.  Our goal is to remain active as a consolidator.  If we play our cards well, we have a tremendous opportunity to create value through M&A during this economic implosion.  It won’t be easy–but our entire thinking is geared toward how we best position ourselves to exploit buying opportunities.

I don’t want to leave anyone with a false sense of security though.  We will play defense first; offense second.

What do I mean by defense?  We will be taking steps to ensure (as best we can) we can withstand a prolonged downturn.  We will scrutinize our spending.  We will be raising our thresholds for success based capital.   We will prioritize near term profitability and free cash flow over long term growth.

It is time for leaders to emerge from all levels of our organization.   Where are we spending money on things that we can do without?  How do we lower costs of network augmentations, construction, and expansion?  Do we have opportunities to generate additional revenue from what we are already doing?  How do we work with our customers such that we can help them navigate through this environment while at the same time helping ourselves?  How do we complete our big projects–like FTT (Fiber to the Tower) and integration–without delays, so that we can enjoy the benefits of them?

My advice to our team members is this:  highlight to your management how you help us generate value in this environment.  Be creative.  Be proactive.  Tell your management what you are going to do to help the cause–and then do it.  You cannot control the financial markets.   You can control how you personally respond to the adversity we all will face.

The herd mentality is in full gear.  It is feeding off of itself.  The constant chatter about gloom and doom leads to spending cuts by companies and consumers.  It becomes self fulfilling.   As we keep talking about how bad it is going to get, the likelihood of economic disaster increases.

So does that mean we should stop talking about it?  Should we resist the temptation to act as everyone else and forgo cost cutting and hunker-down tactics?  Should we go on the offensive instead of the defensive?  Isn’t it the contrarians who make the money when the herd is trampling?

A while back, I wrote a post titled The Problems with Contrarian Investing. Now is an awful good time to read this post.  I will reprint a couple quotes from the post:

The overwhelming percentage of contrarian ideas are not just wrong, they’re downright horrible.

Your ideas have to be right, even if they sound wrong. You have to raise money, even though most money sources think the idea is flawed. You have to trust your convictions, even as others chip away at your confidence.

I ended the post with “Do you still want to be a contrarian investor?”  My answer for most people is “don’t go there“.  My answer for me–”hell yes!!!“.  I just hope I dont get trampled by the herd.

[Follow-on to What the heck is Intrinsic Value?]

If you know what free cash flows will really be, you will be able to ascertain Intrinsic Value.  In fact, “really” allows an investor to use a lower discount rate–very low in fact if you know with certainty.

Capital Asset Pricing Model (CAPM) is used to determine a theoretically appropriate required rate of return of an investment.  In layman’s term, the appropriate rate of return is equal to the risk free rate of capital + a premium that is based on the riskiness of the particular investment.  The premium is broken down by multiplying riskiness (which is called “beta”) by the amount of premium that an investor should expect for each unit of risk.

The term beta is a very popular term in the world of finance.  “What’s the beta?” translates to “How risky is the investment?”.  The more risky, the higher the return an investor will expect to make on the investment.  As the expected rate of return goes up, the value of the investment today is pushed down.

Tomorrow I will bridge this discussion into why really is an important term in my definition of Intrinsic Value.

I know what you are thinking: “If that’s the layman’s version of CAPM, how weird is the non-layman’s version?”  For those few who might be interested, try this on for size:

Where:

• is the expected return on the capital asset
• is the risk free rate of interest 
• is the beta coefficient returns,
• is the expected return of the market
• is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return).

If Brad Feld wrote this post, the title would be “What the F*@! is Intrinsic Value?”.   Except he wouldn’t have used the *@!.

The past week’s worth of posts, which ended with Maximize Intrinsic Value, not Stock Price, used the expression Intrinsic Value many times.  Warren Buffett uses it frequently as well.  In fact, it is so important of an expression that the Omaha Oracle insists that among the key responsibilities of a CEO is Maximizing Intrinsic Value.  For reasons I discussed in the prior posts, Maximizing Intrinsic Value replaces the more commonly held notion that a CEO should view her job as maximizing stock price.

In these entire discussions, I never bothered to explain what Intrinsic Value is.  All employees of Zayo and Envysion–please take the time to appreciate what Intrinsic Value means.  It matters in everything we do.  If we know what it is–and if we know our job is to maximize it–we will be on the same page on how we approach our business.

An enterprise is worth what its free cash flows, appropriately discounted, are really going to be; this is my definition of Intrinsic Value.

Simple enough.  But powerful too.  What will our free cash flows be? If we know this, we will be only one step away from knowing our Intrinsic Value.  We will have to treat future cash flows as less valuable than today’s cash flow–as a dollar today is worth more than a dollar tomorrow.  But if we know free cash flows with a high degree of certainty, the discount rate will be modest and, within a small margin of error, knowable.

How do we maximize what our free cash flows really will be? This should be the basis for all business decision making.  It should guide the dialogues we have with one another.  It should be the focal point of all analysis.

Note that I use the word really in my definition.   I will elaborate on this tomorrow.

Several posts from last week centered around Warren Buffett’s belief that a CEO should view their goal is to have stock price equal Intrinsic Value.  The Oracle differentiates this goal from the commonly held belief that the CEO should be looking to maximize stock price.

The story doesn’t end here though.  Buffett shares another important principle regarding the job of the CEO.  A CEO’s goal is to Maximize Intrinsic Value.   Keep stock price in line with Intrinsic Value while at the same time do your damnest to maximize Intrinsic Value.

If a company does a good job at maximizing Intrinsic Value, then it will produce a growing stock price.  But this principle (beyond just its merits from a fairness perspective) emphasizes that the focus needs to be on Intrinsic Value, not stock price.

Last week, I must have used the expression Intrinsic Value a dozen or more times.  Many readers might not know what I mean by this expression.  I will discuss this in a follow-on post.

Cogent has warned of challenges it is facing in its business.  In parallel, it has been buying back its stock and debt–both of which are priced at a sharp discount to 2007 values.  The past few posts have discussed the context around the situation.   Yesterday’s post “Both Overvalued and Undervalued is Bad” explained Warren Buffett’s principle that the job of a CEO is to ensure stock price reflects intrinsic value.  I ended with the point that Cogent’s actions might be appropriate despite the apparent contradiction of the Oracle’s point.

Let’s assume Cogent has very real concerns about the challenges its business is facing.  If so, it is their responsibility to share these concerns with shareholders.   More important now than ever is not to hide such challenges from shareholders.  The CEO owes its shareholders this information.  It should be disclosed.

Let’s also assume that Cogent has been very clear that it is purchasing equity and debt on the open market.  I’ll use stakeholders to refer to both equity and debt holders.  Stakeholders have this information, along with Cogent’s warnings, and can factor it into their decisions to buy or sell.  Presumably the fact that Cogent is buying props up the value of the debt and equity.  Stakeholders who disagree with Cogent’s assessment of its value are thus able to sell at a higher price.  They likely appreciate that this option is available and they likely know their exit price would be lower if Cogent wasn’t buying.

Key to this discussion is that no one knows what the true value of Cogent really is.  Management has an opinion.  Certain investors of Cogent might disagree with management and therefore choose to sell even knowing that the company and its CEO are buying. After all, it is differences in opinion about the value of a company that determines stock price.

Here is the core issue though that troubles me a bit.  Cogent is putting itself in a difficult-to-navigate position.  Let’s assume Cogent believes in Warren Buffett’s principle that Cogent’s goal should be that Stock Price = Intrinsic Value.  By being a buyer while warning of business challenges creates the appearances of conflict of interest.  One could argue that the appearances is reason enough to not be buying securities while warning of bad results.

I stress again though that those who want to sell might fevorishly disagree.

[Continuation of Ethics of Stock Price Management].

Warren Buffett promises to his shareholders that his goal is for Berkshire Hathaway’s stock price to reflect the Intrinsic Value of the company.  Buffett playfully cautions shareholders that this means his goal is not for stock price to be as high as possible–instead, he wants it to be a fair price.

Buffett explains he wants to give all his shareholders a fair shake–both existing shareholders as well as future ones.  He does not want one class of shareholders (those who own the stock today, for example) to make money at the expense of another class of shareholders (that is, those who buy the stock tomorrow).

The Oracle calls this Berkshire’s its-as-bad-to-be-overvalued-as-undervalued approach.

So let’s apply this to Rob Powell’s recent post on Cogent.  Cogent is warning of challenges it is facing while buying up stock and debt.  Many other companies paint an optimist view of their future while selling securities.  “Aren’t these the mirror image of each other?”, Rob asks.

Well, for reasons perhaps different than what Rob was implying, the answer according to Mr. Warren Buffett might be yes.  Both might be possible violations of Buffett’s “It is as bad to be overvalued as undervalued” principle.  Both could result in the shifting of value between classes of shareholders.

Cogent certainly believes it is worth more than its public enterprise value; else it wouldn’t be buying back its equity and debt.   If Cogent is right, value is shifting from old stakeholders to remaining ones.

However, please do not interpret this post as a suggestion that Cogent is doing something inappropriate.   In fact, many might conclude their actions are highly appropriate given the circumstances.  I will discuss this more in tomorrow’s post.

Yesterday’s post was titled “Buying Back your Stock on the Cheap“.  The post covered a situation where a company is warning the public markets that business is bad.  The stock price and debt have fallen dramatically.  In the meantime, the company and its CEO are buying equity and debt.

Rob Powell of Telecom Ramblings posed the question of how should we view this relative to the mirror image–when companies talk-up their companies and then raise money at higher prices (or personally sell their shares).   What is the ethics of each scenario?

This is a question that Warren Buffett answers oh-so-well.  Many months back, I wrote a post on the topic called “High Stock Price = Bad (sometimes)“.  This is a hugely important topic and I encourage my co-workers (particularly executives) to read it carefully.

The gist of Buffett’s point is this:  executives should aim to have their stock price reflect the intrinsic value of the company, not more and not less. The Oracle of Omaha cautions his shareholders that this means he does not view his mandate to get the stock price to be as high as possible; instead, his promise centers around the goal of having the stock price reflect intrinsic value.

This is in contrast to how many executives view their job: they believe the goal is to get their stock price as high as possible.   On one level, they are right.  On another level, they are wrong and the mistaken notion could lead to dire consequences.  The executive must understand the subtle but all-important nuance in the principle that Warren Buffett holds so dear to his heart.  My answer to Rob Powell’s question lies in the Oracle’s wisdom.

I will pick this up Thursday.

A week or so ago, Rob Powell posted Cogent, Self Promotion, and the Mirror Image.  In the post, Rob asks (me paraphrasing):

What happens when executives talk their company down, and then buy the stock or debt at a substantial discount on the open market?

The situation that led to Rob asking this question is Cogent.  Since May, Cogent has been communicating that business is not so good.  Growth in traffic has slowed.  Price competition is fierce.  And Cogent has no choice but to aggressively lower their price.  Not surprisingly, their stock fell sharply–it is 75% lower than its 2007 price–and their convertible debt has been trading at an enormous 50% discount.

In the meantime, Cogent has been using its excess cash to buy stock and debt.  Evidently, they believe their company is worth a lot more than the public markets. In addition,  Cogent’s CEO is personally purchasing debt at this steep discount.

Rob Powell contrasts this situation to its mirror image.  He opines that CEOs often pump up their stock price, thereby enabling them to raise money at higher prices or sell their shares at inflated prices.  Rob asks “are the ethics different when we look at a mirror image?”.

I will provide my perspective to this question tomorrow.

Rob Powell of Telecom Rambling’s fame led me to a thorough article on “How the Internet works“.  The article was written by Rudolph van der Berg in ars technica.  Rudolph–thank you for making this available.

At the end of the article is a link to another white paper “The Art of Peering“.

Zayo Team:  I encourage you to print these out and read them.   It is hard to find thorough material that helps people connect the dots on the inner-workings of the Internet.