The Knowledge Economy Cash Anomaly, Part 3: The exciting conclusion

This is part 3 in a series.  Here are Part 1 and Part 2.

Tax Shields 

The organization of the knowledge economy is inclined towards creating great tax advantages.  Both start-ups and mature companies enjoy huge advantages that the resource economy does not enjoy.  Most investments can be expensed.  The companies grow fast enough that they create huge tax losses, even as they create extraordinary value for the owners.  Once they become mature global companies, their assets can be transferred almost costlessly to whatever jurisdiction offers the most favorable treatment.  Transfer pricing makes it almost impossible for authorities to tell where value was added.  Money generated off-shore can stay off-shore tax free indefinitely.  In contrast, resource economy companies have easily traceable assets, some of which require particular locations and may be quite literally fixed to that location.  Their assets are comparatively easy to tax, whatever form their assets take.

If this is the case, it follows that knowledge economy companies have huge tax shields from their operations.  To have these tax shields add value to the business, the CFO of a company needs a business that is low risk, earns the cost of capital after tax, and does not consume much management attention.  Investing in marketable securities seems like just the ticket.  The gain on securities allows the owners of the company to take advantage of the tax shields that would otherwise go unused.

Here is what we’ve been looking for all along.  A reason why cash is better off in the pocket of the company than in the pocket of the owner.  In addition, all the other reasons why a firm might hold so much cash are still active and valid.  Full use of tax shields would be a driving factor for keeping cash on the balance sheet.  The discount rate for tax shields is low and even if only gets used every few years, it adds to the wealth of the shareholders.  For a founder, cash on the balance sheet capitalizes an otherwise unused tax shield, provides diversification, defends the core business, and enhances the value of R&D investments by its mere presence.

The question for further study would be when we would expect to see these benefits diminish?  Can we empirically test which of these hypotheses are most important in guiding payout policy?

The Knowledge Economy Cash Anomaly, Part 2

This is a continuation of Part 1.

Option Value of Cash on the Balance Sheet

This theory of the cash anomaly posits that the returns from R&D are high, but also highly uncertain.  Every once and awhile, the R&D of a company will produce a really high value project that requires massive investment and possibly acquisitions to use in combination with the asset.  The problem with R&D as an economic asset is that it is very difficult to sell or even be exploited by organizations other than the organization that developed it.  Unlike discovering oil, it is not clear even after discovery of a project that another firm could develop the project to create economic returns.

Because exploitation relies on unique capabilities inside the firm that are only poorly understood outside the firm, their economic value is harder to forecast.  This violates the costless symmetric  information condition of efficient markets is violated, unlike the projects of old economy companies, where the market has a reasonable expectation that it will understand the value of the project.  This uncertainty introduces huge frictions if projects need to raise new capital. Therefore, if a company has R&D projects, the value of that project stream is greatly enhanced if the company also has a means of financing the projects that does not require subjecting those projects to the friction of market financing.  These frictions are both directly financial in the form of more returns to new investors and intermediaries, and also temporal.  In winner takes all markets, which many technology markets are, temporal costs are huge.

The option value of cash on the balance sheet could be huge, however, we would expect more tech companies to at least on occasion, expend all their cash and perhaps even borrowing capacity when they exercised options if this were the case.  This is common in growing technology companies.  Mature tech companies, rarely, if ever come close to expending their investment capacity.

I’m skeptical of this explanation.  Why does Google need to hold enough cash to buy Yahoo or Facebook in cash, if they are never exercise the option to do so?  When was the last time you heard that a company was undertaking a project with more than a billion dollars of expenditures in year one of the project?  These kinds of companies can make acquisitions with stock, invest over time out of future cash flows, and they even have relatively low cost borrowing capacity should it be required.

Cash Poor at Home

Recently, much has been made of the U.S. companies that are parking cash overseas to avoid the tax when they repatriate it.  Many companies are cash poor in their U.S. entity, but their consolidated balance sheet shows a lot of cash.  This cash can’t be repatriated for distribution without a large tax bill.  This is the worst of all possible worlds from a policy perspective, but it doesn’t seem to afflict tech companies as much as industrial conglomerates.

(BTW, Congress doesn’t need to capitulate to corporate demands for no tax on foreign earnings.  All it has to do charge the companies income tax on their cost of capital for any overseas investments, then true up when the companies bring cash home.  Particularly if the law slightly over estimated the cost of capital, or ignored the cost of capital on financial assets in the WACC calculation, so that repatriating funds usually triggered a small refund rather than a small bill, you could just sit back and relax and watch them all bring their cash home while still paying tax.)

Distress Costs

The final explanation I’ve heard offered is the idea that since most of the investments of a technology company are in workforce and R&D, the costs of financial distress are huge.  Not only that, but the costs of financial distress can manifest themselves long before bankruptcy is close.  If managers are cutting benefits or tightening R&D activites, and the costs are not properly captured by accounting frameworks.  New talent goes elsewhere, the best old talent leaves, R&D becomes less creative, less real economic capital employed stealthily decreases without the accountants noticing.  However, CFOs are smart, they know this–even if the accountants don’t.  They keep cash on the balance sheet, employee benefits generous, and 10% time meaningful.  This prevents the stealthy erosion of the real assets of the company, by the prospect of distress, which the intelligent and savvy workforce is acutely aware of even if they don’t conduct formal analysis.

But there is one more reason…

In part 3, I will outline how holding cash creates economic value, regardless of and in addition to, all these explanations.  Go to Part 3.

Cognex [NASDAQ:CGNX]: Economic Valuation of A Robotics Company

I prepared this valuation for Prof. Joel Stern.

If you would like to see a chart or table with a white background, click through it twice.  Use the back button to return to the article.

Executive of Summary

Cognex is correctly valued in the market.

A aiagram from a machine vision patent assigned to Cognex

A diagram from a machine vision patent assigned to Cognex

Overview of Cognex

Cognex is a machine vision systems corporation—they focus on computers which can see—particularly in industrial automation applications.  Originally an MIT spin-out, whose name stood for Cognition Experts, they are headquartered in Natick, Massachusetts—though one of their two main divisions is in the Bay Area like a respectable technology company should be.  They have been public since 1989 and have been paying an extremely modest dividend since 2003.

CGNX Share Price Chart

Figure 1 – Source:  Google Finance

As of close on December 7th, Cognex stock was trading at $36.62 a share with 42,961,000 shares outstanding and a market capitalization of $1.573 billion.   Their revenues are well diversified with 66% coming from outside the United States and the top five customers only account for 7% of revenue.  Like most robotics companies, Cognex has no debt and exhibits the cash anomaly of the knowledge economy.  For tax reasons, Cognex is planning to pay a large 4th quarter dividend, but before paying the dividend, Cognex will have over $400 million in cash and securities on its balance sheet.  Cognex’s non-financial, GAAP capital, net of operating liabilities was only about $200 million and of that $80 million was goodwill.  Contrary to popular wisdom, it does not take a lot capital to build robots.

Cognex is a classic, mid-sized, public robotics company if there if ever was one.  Financially, it looks very similar to other successful robotics companies like Brooks Automation (BRKS), iRobot (IRBT), Aerovironment (AVAV), and to a lesser extent Intuitive Surgical (ISRG)—although none of these companies are direct competitors.

Cognex has unique technologies, a portfolio of successful and related products, and a habit of expanding its business with both organic growth and prudent, related acquisitions.  The macroeconomic trends of the coming decades probably favor Cognex.  The growth of on-shoring, higher labor and environmental standards, rising third-world wages, continued growth of the global middle class, and the increased pace and automation of supply chains all favor the growth of Cognex’s business.  There is some threat of emerging competition or economic disruption from start-up companies like ReThink Robotics, but Cognex’s cash and industry relationships make it equally likely that they are the distribution and exit strategy for such start-ups.

Valuation Process

The valuation process relies on data gathered from market reporting and the SEC’s EDGAR database.  Historical returns allowed me to compute the cost of capital.  Following this, I made adjustments to discover Cognex’s historical assets and economic returns to assets.  I assumed that the 7 year historical return, approximately one economic cycle, would be a good guide to future returns as this is not Cognex’s first economic cycle.  This means that we are assuming that Cognex returns 21.3% on its economic assets every year.

I used a somewhat roundabout way to get investment.  First, I assumed that the GAAP assets required to produce these sales would remain unchanged and so depreciation would exactly equal GAAP investment.  Compared to other robotics and tech companies Cognex has too many GAAP assets, see Figure 2.  To estimate future R&D spending, I observed Cognex has been remarkably consistent in spending 14% of gross revenue on R&D, so I backed into gross revenue from the economic return on assets by assuming a fixed ratio from historical data.  From there, I took 14% of gross revenue and added it to capitalized R&D.  From this capitalized R&D figure, I removed 1/12 annually for obsolescence, to arrive at a capitalized R&D figure.  This figure was added to GAAP non-financial assets to get the economic assets of the firm.

Reader, my apology for overuse of this chart

Reader, my apology for overuse of this chart

Figure 2 – Source: 2011/2012 10-Ks on EDGAR as of July 2012

From this forecast of the company growth, I used three valuation methods.  First, I estimated a free cash flow, which is the economic return of the assets of the company less the addition to capitalized R&D.  Because they have no debt and no GAAP investment beyond depreciation, this is equal to Cognex’s operating profit.  Next, I calculated the economic value added, this is the spread on the total economic assets employed by the company in any given year.  I calculated both of these methods for the next 20 years, with a perpetuity value beyond the forecast period.  Finally, I calculated a long form economic value driver model of the firm.  For this, I ran the calculation two ways.  One way, the forecast period is 20 years, the other has an investment period of 10 years.  The ten year period brought the value in line with the other methods.  This may be a consequence of the way that I dealt with the changing investment amounts.  However, the long form is mostly intended to talk about the sources of value in the stock price, not accurately predict what the price should be.

Cost of Capital

To estimate the cost of capital for Cognex, I regressed the monthly returns to Cognex over the ten year treasury return for the last five years against the equity premium of the Russell 3000.  The result is below in table 1.  The alpha is not significant—and even if it was, this alpha could not be expected to be permanent—however forcing it to zero does not yield a significantly different beta, so I used a beta of ~1.38.

Cost of Capital Regression

Table 1 – Regression of Cognex Premium Returns to Russel 3000 Premium Returns

This beta times a future equity risk premium of 6% and on top of a ten year risk free rate of 1.626% results in cost of capital 9.89%.  Since Cognex has no debt, this is the weighted average cost of capital as well.  The ten year bond may not be a perfectly appropriate choice given our forecast period of twenty years, but it should be an adequate estimator for our purposes.  Using the 30-year yield would raise the cost of capital by about 1% to be almost 11% instead of just under 10%.  Given the economic spread that Cognex returns, this would change the valuation by about 10-15%, but it probably wouldn’t change many of the company’s investment decisions.

Free Cash Flow Valuation

Using the method above, I prepared a forecast of the free cash flows Cognex can be expected to produce.   The table below shows the forecast with the intervening years truncated.  Of course this forecast does not adequately capture the cyclicality of Cognex’s business selling industrial equipment.  However, it gets very close to the share price in the market.

FCF Valuation

Table 2 – Free Cash Flow Valuation of Cognex [Entries 2018-2031 Omitted for Clarity]

Discounted Economic Value Added Valuation

R&D should be capitalized in the firm.  This is the key asset which Cognex derives its revenues from.  Robotics factories tend to be singularly unimpressive and largely undifferentiated affairs.  The basis of the 21.3% return the Cognex has historically earned on its economic assets is largely the R&D.  As pointed out above, Cognex is probably not very efficient at managing its real GAAP assets.  My R&D capitalization schedule relies on assumptions, but I think reasonable ones based on my experience in the robotics industry.  These assumptions, along with the spread on employed economic capital, drive the value in the discounted economic value added method.  The spread that I used has to be pretty close to a fair estimate given the R&D depreciation method that I used, which assumes that R&D useful life is a random exponentially distributed variable with a mean of 12 years.

Discounted EVA Valuation

Table 3 – Discounted EVA Valuation of Cognex [Entries 2018-2031 Omitted for Clarity]

Long Form Economic Valuation

The long form model of the firm show in table 3 looks at the drivers of value.  As investment is variable over the period, I used the starting value of economic investment to .  This will likely understate the long form value of the firm slightly.  However, the long form appears to overstate the value of the firm compared to the other methods.  If an investment period of 10 years is used, the long form comes much more into harmony with current prices and the other methods.

Long Form Economic Value Drivers Model Table 4 – Long Form Valuation of Cognex

Conclusion

I’m not very enamored of public equity investing so I’m a little foggy on what the analyst terms mean.  In recent periods it has seemed like analyst terms like, “strong buy” and “buy,” mean things quite contrary to their common meaning—perhaps closer to “Be careful” and “Call your broker with a sell order ASAP.”  Going by conservative assumptions derived from historical data of the last economic cycle, I got prices that were very close to, and bracketed, the market price of the stock.  Cognex would be reasonable to hold in a portfolio if you expect earn the market cost of capital on your portfolio.  There is upside potential, but there are also risks the current price.  All in all, it looks set to return the cost of capital for the foreseeable future.

There is power in being able to say what amount of economic capital you are employing—regardless of where the accountants hid it.  It also allows you to look at any company like it is a bank.  The firm takes in capital from whatever sources, and using it for purposes that earn a spread over the cost of capital, then returning the capital and pocketing the spread for the owners.  This uniformity of treatment, really gets at the heart of what is creating value in the firm.

However, I’m not sure that any of the methods of valuation adequately speak to what the real risk of this company is—which is that it needs its research to match the needs of its customers.  The dogs might not eat the dog food, or they might unexpectedly ask for seconds.  These changes in customer demand are going drive immense fluctuations in all the assumptions that financial forecasts make.  It is a messy and localized business, but fundamentally, this is what really creates the value.  Just doing R&D is not going to necessarily create value, true of any asset, but the matching problems are much more severe in R&D and the rate of economic return incorporates a lot implicit assumptions about how management will make the assets perform.

Appendix

Data and Estimates

Data and Estimates

Table 5–Data and Estimates

Full Calculation

Table 6 — Printable Full Discount Calculations

The Knowledge Economy Cash Anomaly: Part 1

This is part 1 in a three part series about why technology companies hold so much cash on their balance sheets.  Here are Part 2 and Part 3.

The academics disclaim knowledge of a definitive answer as to why companies in the knowledge economy hoard a such a disproportionate amount of cash.   The problem is that the chart below has two branches where our classical understanding would only expect one.

Robotics (Blue) is firmly in the knowledge economy, using very few real assets, but a disproportionate amount of financial assets, to finance the company.

Robotics (Blue) is firmly in the knowledge economy, using very few real assets, but a disproportionate amount of financial assets on the company’s balance sheet–just like software companies.

The Expectation

The companies that form a cluster heading up close to the Y-axis are the traditional economy companies.  They are everything from utilities to content companies to retailers–some of them quite high-tech.  Basically, they have the real assets that they need to their business and a little bit of cash and securities to get them through the shocks of the next couple of months.

This is what financial economists expect companies to look like:  orderly, well managed institutions that collect cash from operations and distribute the operating profits out to shareholders and debt holders.  Since these companies have access to relatively liquid and efficient capital markets, they have no need to hold onto cash.  Good investment projects can simply be financed through issuing new securities or retaining more future earnings.

Tech Companies

Robotics companies and tech companies on the other hand horde massive amounts of cash–spreading out along the X-axis in the chart above.  Many of these companies, already profitable, could forego revenues for over a year.  And, oddly enough, the most profitable and most successful of these companies hold the most financial assets.  Nobody quite understands why companies do this.  The previous discussion, Is a Dollar Worth a Dollar on a Tech Company’s Balance Sheet?, reviewed some of the arguments for and against the value of cash on a company’s balance sheet.

Holding Cash Is Usually Bad

Most investors feel that excess cash in the company is a temptation to value destroying misadventures by management.  Particularly if management has incentives to grow gross profit, management can grow gross profit by deploying the company’s cash in less than profitable ways.  The classic example of this overpriced acquisitions.  Say you were the CEO of HP and you wanted to grow profits.  You might have heard about this company called Autonomy.   So you decide to buy it at market price plus a huge control premium.  Your profits go up, because you have HP + Autonomy’s profits together.  You get a bonus.  But your shareholders get hosed.

If the shareholders wanted to buy Autonomy, they could have owned it without paying the control premium.  Unless these so-called synergies show-up (and synergies are what go up the banker’s chimney after Santa Claus comes down–see I learned something in business school),  there is no reason to pay the control premium.   The control premium just gets pocketed by the previous owners and the bankers with all that value lost to the shareholders of the acquirer–those are your shareholders.

Conversely, if the company disgorges the cash, and you and your management team go to the market to raise new debt or equity to finance the purchase of Autonomy, Instagram, or any of another thousand bad acquisitions–the financial market has a chance to tell you that this is a really bad idea.  But if it is a good acquisition, the market will easily provide you with the money.  So all in all, investors tend to discount cash on the balance sheet and reward paying it out where they can reinvest it.  So why would companies hold all this cash?

Concentrated Ownership

Many tech companies are owned or controlled largely by single individuals or small groups.  The company represents a substantial portion–if not substantially all–of the wealth of the these founders.  Since they control the company, they are willing to take steps to decrease the risk to the company that are not economically maximal to diversified shareholders.

Consider this hypothetical:  Google and Apple are locked in winner take all product war for a small market that is worth $2Bn in market capitalization to Google now, but will go entirely to Apple in year unless Google spends $3Bn.  If all of your wealth is in Google and you couldn’t easilty get it out, you might be willing to have Google spend $3Bn to save $2Bn in wealth.  Your loss is now $1Bn instead of $2Bn.  However, if you are a diversified investor and own both Google and Apple, you want Google to let the business go and refund you the $3Bn.  You still have your share of the $2Bn in your portfolio and the chance to invest your share of the $3Bn somewhere else to earn a return.

Founder Payout Diversified Common Shareholder Payout
Spend money to protect Failing Business -1 -1
Do Not Spend Money to Protect Failing Business and Payout Cash -2 +3Bn

Less sinister, the company may just be conducting tax free diversification on behalf of the founder.  The effective corporate tax rate is below the individual tax rate, especially on capital gains.  While this is tax efficient for a founder, it may not be tax efficient for other investors.  The harm is probably not as stark as the example above, but it does raise the question about who the firm is being run for and rubs our Anglo-Saxon sensibilities about the primacy of the shareholders the wrong way.

Defense

The story here is that only Apple or Microsoft would ever even think about entering search knowing that Google has the largest market share, the best technology, and is sitting on $45Bn in cash.  If you want to take search from Google, you are playing a long game and an extremely expensive game.  It will fight hard and it has the resources to do this.  Potential competition is scared off, increasing the ability of the company to earn rents in on its primary operations.   While closely related to concentrated ownership story, this is actually favorable to the common shareholder if this is true.   Services like Siri, Wolfram Alpha, and IBM’s Watson cast some doubt on this story, but perhaps at least in the example of general consumer search it is mostly true.

The defensive effect need not be 100% effective to be worthwhile.  This effect is an extra return on the cash that shows up in operations, not financing, because of accounting rules.   Additionally, the company always has the cash, so there is option value.  In our example, if Bing every really started to rule search, Google could decide not to fight, and either sell or wind down search operations.  They still  have $45Bn to distribute even if the value of operations falls to zero, but the option to fight is inherently valuable.  With the cash to execute this option, it becomes more valuable, or credible.

to be continued…   Next up, option value of IP and distress costs

Jump to Part 2