Hizook 2012 VC in Robotics is out!

Friends, take a look and see what needs to be added.  The definitive list of private funding in robotics for 2012 is out, help make it complete by adding a comment if you know of private funding for a robotics company that isn’t included.


Intuitive Surgical, a manufacturer with almost no tangible assets?

Intuitive Surgical (NASDAQ:ISRG) is a prime example of how robotics is similar to other IP intensive industries like software, biotech, and entertainment.

In December my colleagues and I produced a valuation of Intuitive Surgical.  Below is a representation of our model of the asset structure of Intuitive Surgical in our forecast.  Whether you agree with our estimate of a 31% return on economic assets or not (though the stock market roughly seems to), this chart is very instructive to look at what the economic assets of a successful robotics firm are.

And hey, guess what?!  Intuitive looks more like a software company than a traditional manufacturer.  Strike another blow for the case that robotics companies–at least successful ones–are capital efficient!

Moreover, if I was critiquing the model in the valuation I would say that we hadn’t adequately valued the intangible assets of Intuitive Surgical.  The intangible assets of the firm probably have a market value of 2-8 times what we estimate.  Even with our conservatism, look at what you’re buying into when you buy a share of Intuitive:  A $2Bn stack of cash, a multi-billion dollar IP portfolio, and a smallish medical device manufacturing company.

Assumptions of FCF forecast through an economic view
[How to read this chart:  Black is our estimate of “R&D assets” in $K so starting balance is just shy of $2Bn.  Red is GAAP non-financial assets, otherwise know as real stuff, like buildings, inventory, and accounts receivable.  Grey is our estimate of financial assets with the current dividend policy–this model posits that Intuitive will be sitting on $4Bn in cash or the like in 2016 and an IP portfolio equally as large and valuable.
Return on economic assets was estimated using our income forecast over capitalized R&D spending in the R&D account plus assets less cash and securities.  The model has a depreciation factor for R&D each year to account for obsolescence and expiration.  We went back several years to estimate an appropriate R&D account starting balance for the projection.]

The stock market assigns a $20Bn valuation to Intuitive.  It recognizes that Intuitive’s control of  intangible assets is very valuable. The graph of the model here only scratches the surface of intangible assets.  We assumed that the only off balance sheet economic asset was an R&D account.  Clearly, this is not the case as Intuitive Surgical also has unique and valuable organizational processes, sales relationships, and employment relationships with talented employees but those are much harder to find information about in SEC disclosures.    Similarly, we also marked R&D at cost–with a portfolio as valuable as Intuitive’s the market is probably going to value the R&D output at more than Intuitive paid to develop the R&D assets.

Even with all this, Intuitive Surgical looks like lean, mean, capital efficient, IP intensive, knowledge economy company.  Can anyone tell me why we let people talk about robotics like it is capital intensive?

I’d like to gratefully acknowledge my co-authors of this report who have given me permission to publish it: Avinash Belur, Naohiro Furuta, Masayuki Minato, Kohei Mutoh, & Dashampreet Sidhu.  Analysis available by request.


ExOne IPO Successful: Shareholders Contribute Random Passers-by

Before I start bashing bankers, I’d like to congratulate the ExOne Company on a successful initial public offering (IPO).  I haven’t seen much about ExOne [NASDAQ:XONE] on the robotics sites, but if we’re calling Stratasys [NASDAQ:SSYS] a robotics company, we should call ExOne a robotics company as well.  It is really good to see another public company in our sector.  Hopefully, this will encourage more investment of both capital and entrepreneurial energy in our industry.

Last time I checked 26 is a lot more than 18.

Last time I checked 26 is a lot more than 18.

By the criteria of the market commentators, the ExOne IPO was a huge success.  You can Google things like “3D printing red hot.”  The IPO was priced at the top of the range $16-18, it opened around $26 before shooting up over $33.  Almost a week later it is trading roughly at its opening price.

Now this is all fine and dandy as far as it goes, unless you were an ExOne shareholder.  Who, by the way were the ones selling in the IPO.  One shareholder sold 300,000 shares in the IPO.  This means that this one shareholder transferred a gain of $2.4M to some connections of the underwriters.  This shareholder is taking $5.4M, less fees and discounts, call it $5M from of the IPO, so $2.4 is not exactly a rounding error.  Presumably, this shareholder is also more inclined to build companies with the capital than whatever speculators are hovering over the IPO.  Similarly, the company lost out on $40M of capital that could be invested in projects.  Think about that.  The company is worth less than $350M and the IPO mis-pricing cost it $40M of cash.  Cash!  Cash that could be sitting on the balance sheet scaring off competition and waiting for the next expansion opportunity.

It is hard to explain an IPO price that is so far below the fair market value of the company.  I know that there are a lot reasons why bankers try to justify under pricing an IPO, but giving-up over 10% of the firm’s market value in a single transaction seems really hard to justify no matter what.  I’m not sure what part of the economic gains from listing publicly should be given to financial intermediaries and incoming investors to get a deal done, but over 10% of the company seems quite excessive.  These new shareholders have no restrictions on ownership and quite likely to flip their shares instead of taking an active roll in growing the company, which seems to further erode any claim they might have to extraordinary gains.

I’m not familiar with the track records of FBR, BB&T, and Stephens, the underwriters for the ExOne IPO, but I’d think twice or three times about hiring them if I was going to do an IPO.  They seem to have not only underpriced the IPO, but also floated too much of the company, almost 40%.  Underpricing the IPO might be tolerable if the bankers had only floated 5-10% of the company.  The company could have done a secondary offering later once the offering had an established market price, instead of getting ripped off during the IPO.  The large offering certainly did do one good thing for the bankers: it increased the underwriting fee.

If my company ever goes public, I hope I’ll have the good sense to hire Morgan Stanley–unless an underwriter is involved in litigation for overpricing an IPO, how can you be sure they’re any good?  Heck, they even give discounts–what’s not to like!

Robohub: What funding scheme is most conducive to creating a robotics industry?

money robotRobohub just posted a great series on optimal funding schemes for robotics start-ups.  I highly recommend reading it.  I believe that it probably represents the best collective wisdom in our industry.  Frank Tobe probably has the most informative response for someone actually looking to raise money: robotics is still at the point where you need to appeal to individual personalities who see it and get it, or find a government customer.  However, I thought that all the authors raised thought provoking points.  Here are the follow-up questions that I posed:

Rafello D’Andrea:  What structural and cultural changes need to be made to robotics departments so that they become as entrepreneurial as computer science or biochemistry departments?

My own observation is that here at CMU–one of the most prolific robotics start-up hot beds–that robotics is pretty theoretical and academic compared with other engineer disciplines, particularly other disciplines in the computer science school.  The revolving door between industry and academia just doesn’t happen in robotics the way it does in other disciplines.  How do we get industry thinking into robotics departments?  After staying close to the university for 40 years, it is going to be hard to change the culture of the robotics departments, however I think that universities that succeed have a chance to maintain or overtake the currently established leaders in the field.

Henrik Christensen:  If much of the benefits from robotics R&D accrues to parties who didn’t do the research—whether competitors or society at large, economics tells us that subsidies are not only appropriate, but necessary, to get to the socially optimal level of investment. What portion of the gains from commercial robotics R&D is controlled by the company that does the research?  How does this compare with other industries?

I know the Georgia political climate is such that private industry is always the answer.  We all agree on the need for more private investment, but if robotics companies have trouble capturing the value that they create, we need to do one of two things:  1) Either subsidize their research in some rational way that creates the most social gain or 2) adjust intellectual property laws so that more of the benefit of robotics R&D accrues to companies making the investment.  Some econometric research is probably in order here… any econ Ph.D. candidates reading?

Mark Tilden:  Doesn’t your suggestion of investing in crowd funded start-ups point at the opposite of needing more innovative roboticists?  If crowd funding is the shining star in our industry, wouldn’t that suggest that our roboticists are plenty innovative—as high end research is not required to make marketable stuff—but rather our entrepreneurs and business managers are behind the power curve?

Obviously, market traction is the key.  Financing is for companies is in some way just a loan to future consumers–even if the consumers don’t know it.  This question of what’s the real roadblock to creating more successful robotics start-ups is a key one.  I’ve made my belief that the robotics “parts bin” has plenty of technology in it pretty clear on this blog as well as my belief that robotics has a shortage of qualified entrepreneurs and managers.  The problem is not on the engineering side, it is with those giving directions to engineering.

Frank Tobe:  If the individual / angels / VC route is more of the direction that we want robotics to go in, what do the special people that you point to in your response see that other investors don’t see?  Or are they doing something different?   What is the barrier to other investors who might want to do the same?

If robotics is at the point where it is being funded by visionaries, how does one go about finding, cultivating, or creating more?  Are the visionaries right or is their compass off?  I don’t have good answers to this, but I do think that robotics seems to require a more comprehensive understanding of engineering, current business practices, and what the future should be than most other industries do.  That said, one would expect that there are extraordinary rewards for solving these hard problems, unless some of the basic economic problems that I want to suggest in my question to Henrik Christensen exist.

Nicola Tomatis:  Software and biotech companies aren’t cheap to build in absolute sense either, but they are called capital efficient by investors.  Financially, robotics is probably more like software and biotech than it is like retail or [green] energy businesses—which really require a lot of money.   Is there data that supports the position that robotics is expensive compared to other capital efficient industries?

The part of this blog I’m most proud of is gathering the evidence to show, to a practitioner’s standard, that robotics companies are as  capital efficient as software companies, conditional on success for both.   While plenty of robotics companies waste investors money, I’m not sure that this that different from any other IP intensive industry.  However, whenever a software company fails we blame management or the market–but when a robotics company fails we blame the underlying technology.  We need to stop that.  It makes it harder for the next guy to start a robotics company–the underlying technology is there–we just haven’t made many companies with it yet.

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


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.


Data and Estimates

Data and Estimates

Table 5–Data and Estimates

Full Calculation

Table 6 — Printable Full Discount Calculations