Sunday, March 29, 2015

What's driving the trend towards intangible value?

The trend for the market values of firms to increasingly diverge from book value, and particularly from tangible book value, is really striking. As I wrote in my previous post on inflation, this is a trend that merits more attention.

So I was happy when I saw Justin Fox's piece for Bloomberg bringing more attention to this pattern. He presents an updated chart using data from Ocean Tomo (which I reproduce here from the original source)



Here's an older chart which also breaks out tangibles (gray) as well as the subset of intangibles that are on the books (brown, mostly goodwill):




It is important to understand exactly what the charts are showing. "Intangible assets" on the first chart is just a residual, the part of aggregate market capitalization that is in excess of aggregate tangible book value. (This is the red plus the brown on the second chart). It seems investors are increasingly willing to pay a lot more for a firm than would seem justified just by looking at the tangible "stuff" on the firm's balance sheet (including property-plant-equipment, inventories, and net financial assets including cash.)

I liked Fox's piece, but I wish his focus had been a little broader. "Most of their value," he writes, "comes from brands, patents, ideas and other intangibles....the modern corporation really is a different, much less bricky-and-mortary creature than its predecessors." Reading this, one thinks of firms like Google and Facebook, that have a lot of valuable software but only a relative handful of highly-skilled employees.

But it's too narrow to think about this just in terms of R&D and intellectual property and "ideas". Other important intangibles are scale, existing relationships with customers and suppliers, and "organizational capital," i.e. the value of having in place a large organization of skilled and trained employees with established procedures.

 In fact, by the measure shown in the figures, Google and Facebook are far from the most "intangible" corporations in the S&P500. Both have positive tangible book value. This would still be true even if you removed their cash.

By contrast, there are over 100 firms in the S&P 500 that have negative tangible book value. In other words, by the measure presented here, more than 100% of their market value is "intangible." The most strongly negative firms tend to be communications companies like Verizon or Time Warner Cable. But there are all sorts of firms on the list. A big part of this is that some firms have a lot of debt, but there is more going on here as well. (Interestingly, financial firms tend to be the most "tangible" by this measure.)

The case of United Rentals

Lets look at one of these negative book value firms: United Rentals (URI). With a market cap of around $9 billion, it is one of the smaller firms in the S&P500, having been added to the index in 2014.

United Rental's business is to rent out heavy equipment and other tools. Customers  include "construction and industrial companies, manufacturers, utilities, municipalities, homeowners, government entities." As of 2014, URI had 881 rental locations in the US and Canada, all filled with big expensive machines available for rent. The firm owns over $6 billion of property-plant-and equipment (about $60 per share). It has over 12,000 employees, more than Facebook. It would seem this firm is very, very brick-and-mortary indeed.

URI stock currently sells for about $90 per share. They are profitable, with a reasonable P/E of 17.5. But they also have over $80 per share of debt, and a tangible book value of equity of approximately negative $25 per share.

All in all, the tangible assets on their balance sheet are worth $2.6 billion less than their liabilities. Why is their stock worth 9 billion dollars? Why is anyone willing to lend them money (which they then use to repurchase their seemingly overpriced shares)? Where does the extra firm value come from?

The 2014 annual report gives an answer in the form of a list of "competitive advantages":

  • Large and diverse rental fleet
  • Significant purchasing power
  • National account program (i.e. relationships with large customers)
  • Operating Efficiencies. (i.e. "Equipment Sharing Among Branches," "Customer Care Center," and "Consolidation of Common Functions.")
  • Strong Brand Recognition. 
  • Geographic and Customer Diversity. 
  • Strong and Motivated Branch Management. 
  • Employee Training Programs. 
  • Risk Management and Safety Programs. 

You could summarize these advantages as "scale" and "organizational capital." (There is some notion of "brand" there as well, although I doubt that a large customer really cares about "brand" in the same way a 13-year old cares about Under Armour, so maybe "reputation" would be a better word.)

Of course scale and organizational capital are not new. But the evidence suggests they may be more important than ever. Why? Perhaps information technology and increased regulation are factors that favor scale. Perhaps the relative decline in the price of manufactured goods relative to wages has inevitably made tangible goods a smaller portion of firm value. Perhaps the workforce (or a portion thereof) is more skilled, but effectively using these skills requires building complex organizations, with a large element of learning by doing.

I don't know the answer, but it's certainly an interesting question.

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