Traditional analyses of capital budgeting have long pronounced DCF as the optimal way to assess whether or not capital projects -- such as the opening of a new plant, adoption of new raw materials or JV with a partner -- create or destroy wealth. Discounted cash flow, founded on the projection of cash flows discounted back to the present at a required rate of return (typically obtained via the CAPM or WACC approach), is one way to gauge capital budgeting. However, it is just that – one way, and often not the best way to look at how firms deploy capital, assess risk, and enter into projects in which the future is nebulous. When capital projects are driven by discounted cash flow models, which are static in nature, managers treat capital projects as “now or never” exercises. Typically, if the project is “positive NPV” (meaning the discounted cash inflows are > the initial capital outlay), the project is accepted. When the project is “negative NPV,” it is usually rejected – fast. So why do CEOs and investors sometime embrace and follow through on negative NPV projects? Good question – and one academics are trying to answer everyday.
Through four brief cases, we hope to shed light on the topic of real options. The two underlying threads of all four cases are: 1) the managers of the entities in question were all facing uncertainty of cash flow and 2) managers essentially bought options on something bigger down in order to take hold of opportunities to continue/defer all future investment and extract information from the marketplace. As we will see, through real options, managers can play off the embedded optionality of the capital budgeting process to test new markets, weigh risk, and take a wait-and-see approach. For investors, real options may provide a more realistic way in which to view the risks and payoffs managers juggle everyday.
Microsoft (MSFT) Got Game
Key Takeaway: Microsoft breaks into the lucrative gaming market by introducing a console that will allow it to understand the psychology of video gamers as well as compliment its core PC offerings.
Most people know Microsoft for their ubiquitous operating system and office-ready software. What some people forget is that as of 2001, Microsoft has also been manna for video game enthusiasts globally. That’s because in 2001, Microsoft officially launched the Xbox gaming console, which it was “forced to do” according to interviews with founder Bill Gates. Gates, apparently, was increasingly worried about Sony’s Playstation popularity and the idea that video games would one day shatter his PC empire. So Gates launched the Xbox with a small, tight knit group of designers. Although MSFT is STILL losing money on the XBOX business, Microsoft’s decision to enter the video game market should be embraced rather than castigated. $8 billion in gaming titles (for consoles and PCs combined) were sold in 2006 and that number is expected to increase as first time gamers – in their 30s – with higher incomes try this new “social experience,” as some experts have called it (CNET).
Since its 2001 launch, the Xbox has sold over 25M units, accounting for less than 5% of the ~$180 billion in sales MSFT has mustered over the same time period. Nevertheless, it has helped MSFT understand what goes on inside a gamer’s head as well as build the Microsoft product line and perpetuate the Microsoft brand among “all things electronic”. Indeed, the Halo franchise has become one of the most successful games of all time (In 2004, Halo 2 did $100 M in sales its first day). It has also helped MSFT “jump to the next option” by gathering a loyal gaming base to whom Microsoft offered a Live gaming service in 2005 (enables players around the globe to play games like Halo against each other for just $50/month).
We should not rule out the fact that Microsoft, if it wanted to, could cultivate the Xbox franchise even further and ultimately exercise the option of selling it to another consumer electronics giant, who would presumably pay a massive premium for the Xbox brand. The Xbox may be a money losing thorn to those on the outside, but for Microsoft executives, it’s probably seen as a cheap option on a better understanding of customer mindsets and the mushrooming gaming industry, which breeds the cult follower and online enthusiast the younger Gates probably resembled during his college years.
Google’s (GOOG) Most Expensive Acquisition to Date
Key Takeaway: Google acquires unprofitable YouTube, the giant of do-it-yourself video, as a bet on the nascent online video market and the possibility of generating more ad dollars.
20 million regular users, the Top 10 site on the net, and 100 million video views a day. Who else but You Tube, paragon of the digital age on which user-generated is king. On October 9th, 2006, GOOG announced it was gobbling up the revenue-less online site for $1.6B in stock. Quite expensive for some, a move of genius by my standards. The acquisition was a fraction of GOOG’s market cap at the time and put Google in the cat bird’s seat of online-driven media. Buying YouTube enabled Google management to move in on the fast growing online advertising market and build a media platform that goes above and beyond its core search business, which stockholders at the time were growing increasingly nervous about (since search was 95% of GOOG’s sales). Combining YouTube’s penchant for entertaining with Google’s drive to organize global information should be a “2 +2 = 5” scenario once Google begins to see the 2 inflows that matter: 1) future cash flow from its advertising customers and 2) the value of information: with You Tube, Google better understands its global user base and can thus serve them with better targeted ads. With the You Tube platform under its belt, Google now has the option to learn about online users, pour more money into expanding You Tube’s reach/vast library, and pursuing similar acquisitions that can help Google capture infinite eyeball share. As the adage goes, you can’t make an omelet without breaking an egg.
Delta (DAL) Plays a New Song
Key Takeaway: Delta Airlines experiments with the low cost model pioneered by Southwest “one plane at a time,” thus challenging Southwest Airlines (LUV) without having to flush billions down the corporate toilet
In 1971, Southwest Airlines pioneered the high frequency, point to point airline carrier model. 36 years later, Southwest does over $9 billion in annual revenues and possesses one of the most formidable brands across the world. In 2003, rival Delta Airlines decided to enter the market one plane at a time to test out the short haul model that flyers all over the US were embracing. Delta benefitted from deferring full investment in a business whose full potential was far from clear and whose fixed costs, if unsuccessful, could bludgeon Delta’s operating performance, which at the time was anything but stellar. In short, Delta was able to play on Southwest’s playground at just a fraction of the cost it would have to bear if it wanted to go out and become “the next Southwest.” In this case, the value for Delta came from the deferment of full investment. It accomplished this by committing “just” a small fleet of 47 Boeing 757 planes and offers a select number of routes, the NYC to Florida trip being the most popular. Rather than haphazardly expand expensive capacity, Delta used the opportunity to simultaneously research one of it major competitor’s platform and incrementally meet the growing social needs of its customers, who were opting for stylized, all economy flights. The action Delta took should e seen as a call option on the increasingly popular no-frills carrier market and the payoff being: immediate cash flows, brand building, and the wait and seeing that would help Delta visualize if Southwest’s model was worth attacking with full fury. In October 2005, with Delta doing everything in its power to emerge from bankruptcy, all 47 Song planes were converted to Delta planes; the last Song flight was a midnight trip out of Vegas on April 30, 2006.
Seeking Answers at Seeking Alpha
Key Takeaway: Independent equity research startup SeekingAlpha.com hooks up with Yahoo (YHOO) to test its ideas in an interactive environment and learn how big (and profitable) its readership can get if syndicated on a global portal like Yahoo!
Exactly one year ago today, on September 12 2006, blogging soon-to-be-giant Seeking Alpha, a NY based independent equity research outfit founded by former Morgan Stanley tech analyst David Jackson, announced that it had inked a “no money exchanges hands” deal with media titan Yahoo! The deal, Jackson said, would instantly give Yahoo’s global readership access to research on stocks “Wall Street didn’t cover or care to cover.” More importantly, by having its content distributed on a mass financial portal like Yahoo! Finance, the creators of Seeking Alpha were “testing” out the mass media market, something they had until then shied away from. It let Seeking Alpha, which covers over 4,000 stocks through 200 contributors, “nibble” on the traditional media pie and see what sort of profits/sales it could extract from it. In a word, the move helped Seeking Alpha’s young management answer the following question: can micro-publishing survive in a Wall Street Journal-run world? If streaming out blogged research could help independent investors make sense out of their portfolios, as well as offer the Street well-thought out research on stocks the sell side was ignoring, perchance Seeking Alpha could start charging for their material. Or better, maybe it could start licensing out research to other financial powerhouses, like Market Watch and TheStreet.com (TSCM). Whatever the case would turn out to be, the Seeking Alpha/Yahoo! deal was a layup – it cost the former virtually nothing and gave the startup an option to expand its platform and potentially change the “face of financial publishing.”
Real options are heavily studied in academia, but regrettably not as much on the trading desks and journalistic nests of Wall Street. We have purposely omitted any mathematical rigor or option modeling from this exercise in order to drive home one conceptual point: real options can be a valuable tool for investors and managers alike and that real options are as much a way of thinking about the world as they are modeling out strategies an firm may take (firms that use real options in their strategic actions will typically use binomial and Black Scholes models). Managers need not subscribe to traditional, static DCF models every time they take risks. Similarly, investors armed with even a rudimentary understanding of real options can be better equipped to deal with the vague nature of capital budgeting within the firm. Though the process has been slow, real option literature is bleeding its way into Wall Street practice and should become an increasingly valuable tool kit with which investors can make sense of firm’s use of capital and the market noise it may engender. In a world with higher and higher risk appetites, real options will become all the more critical to creating and understanding value creation.
Disclosures: At the time of publication, the author did not hold a position in any of the companies mentioned in this article. He drew on a number of publicly available resources, some more than others, to investigate this topic. Readers may email him anytime for a complete bibliography. Case examples come from the author’s own understanding of real options and he did not confer with the management teams of the companies under scrutiny at any time during the process. The author is a regular contributor to SeekingAlpha.com