Governments and Value III: Bribery, Corruption and other "Dark" Costs

In this last post on the effects of government on valuations, I want to return to the value destructive effects that corruption, bribery and other "illegal" side-payments to government officials can have on value. In many countries, business people know that to keep doing business, they have to grease palms and provide “gratuities” to the gatekeepers of officialdom. A spate of news stories in the last few weeks should alert us all to the reality that the problem is not only still prevalent but that companies everywhere are exposed to its costs.

1. In a reminder to natural resource companies that the countries where these resources are most abundantly found are often also the ones with the most corrupt government officials, Cobalt International Energy, an energy company backed by Goldman Sachs, saw $900 million of its value wiped out, after revelations that three powerful Angolan officials held concealed interests in the company.
2. India is the second-largest telecom market in the world, with hundreds of millions of subscribers. The regulatory uncertainty that has always bedeviled companies competing in the sector was augmented to by a tainted telecom auction in 2008, which resulted in the resignation and arrests of a cabinet minister. The saga played out in the Indian Supreme Court's recent ruling taking away licenses awarded to eight companies in that auction; the fact that six of these eight companies were foreign suggested a nativist spin to corruption. Put in blunter terms, the ruling seemed to suggest that bribery of Indians by other Indians was par for the course, but bribery by foreign nationals was an abomination.
3. Finally, from the other great growth story in Asia, China, came the story of Bo Xilai, a prominent member of the party elite, and his family: his wife, who is accused of murdering a British businessman, and a son, Bo Guagua, who goes to the Harvard's Kennedy School of Government, drives a Ferrari and has the lifestyle of a top notch capitalist. While the story is filled with the kinds of details that tabloid newspapers love, the real story that the Chinese government wants to keep a lid on is that Bo is not alone among government officials, in accumulating wealth out of proportion to his "income" as a government official.

I am not an expert on corruption but here is what I see as the ingredients that allow it to flourish. First, for official gatekeepers to have power, you need gates: the more licenses, permissions or other official approvals you need to operate, the greater the potential for corruption. Second, it is a lot less risky being corrupt if you have political hegemony (whether it be of the dictatorial variety or one party rule), an ineffective legal system (making it impossible to challenge biased official acts) and an apathetic or controlled media (that either cannot or will not view corruption as a good news story). Third, the odds of corruption increase if the system is designed on the premise that corruption is the rule rather than the exception. Thus, setting the salaries of public employees at well below what the market would pay them, given their qualifications, on the assumption that they will augment these salaries with "side payments", will ensure that you will attract the "most corrupt" people into government and a continuation of the system.

Rather than debate the basis of corruption and whether culture and history play a role, I want to first focus on “objective” measures of corruption . Transparency International, an organization that tracks corruption globally, releases an annual listing of corruption across the world. Just to provide a summary, the following is a list of the ten least corrupt and the ten most corrupt countries in the world, based on their ranking.

Least corrupt countries in the world	Most corrupt countries in the world
1. New Zealand	1. Somalia
2. Denmark	2. North Korea
3. Finland	3. Myanmar
4. Sweden	4. Afghanistan
5. Singapore	5. Uzbekistan
6. Norway	6. Turkmenistan
7. Netherlands	7. Sudan
8. Australia	8. Iraq
9. Switzerland	9. Haiti
10. Canada	10. Venezuela

Just for information, the United States came in as the 24th least corrupt country out of 182 countries, China was 75th and India was 95th on the list. While I am sure that there are countries where you and I may disagree with the rankings, there are clearly regions of the world where operating a business without "paying off" government officials is close to impossible.

If you are valuing a company that operates in these dens of iniquity, how do you incorporate the costs of corruption into your value? Here are a three alternatives:

1. Treat bribes as operating expenses: From a valuation perspective, it would be easiest to deal with bribes if they were out in the open and  treated as a separate line item in the expenses. So, in your operating expense breakdown, you could have a line item titled "Bribes and payments to corrupt officials" with the expense associated with it. Perhaps, we can then assess firms on the efficiency of their bribery and treat it as a competitive advantage for companies that are exceptionally good at getting results for their money. Unfortunately, even in countries where corruption is endemic, it remains "under the surface" and unreported.
2. Treat corruption as an implicit (and unreported) tax: In the more likely scenario, where corruption exists but is not explicitly reported, it may make sense to consider the expenses associated with it as an implicit tax levied by the government. The fact that this tax revenue goes to the government officials and not to the taxpayers is deplorable, but that makes little difference to the company paying it. While this idea may seem farfetched, PWC did exactly this in an "opacity index" that they computed for dozens of countries and converted into tax rates. In 2001, for instance, they estimated the added cost of operating in China was the equivalent of facing an effective tax rate of 46%. Unfortunately, this listing is almost a decade old and while the opacity index itself has been updated by others, the effective tax rates no longer seem to be computed by country.
3. Increase the cost of capital to cover "government" partners: When corruption occurs at the highest levels, you can argue that as a private business owner, you have "corrupt government officials" as partners who provide no capital but get a share of the income. Consequently, you have to generate a higher return on your capital invested to cover the cash outflows to your implicit partners. You can find interesting attempts to quantify this effect here and here.

There are two complicating factors. The first is that the United States (among other countries) has laws on the books that forbid companies from paying bribes not only to US officials but to officials in other countries . As a consequence, the costs of bribery may be far greater than the actual expenditures incurred and include the penalties that these companies will be face, if the bribery is exposed. The second is that the "right connections in high places" in countries with extensive corruption is a significant competitive advantage in itself. Odious though we may find this proposition, the firms that understand how the system works (or who to pay and how much to pay to make it work) will generate excess returns and higher value than their more virtuous counterparts. 

Governments and Value II: Subsidies and Value

In my last post, I looked at the negative effects on equity value of the threat of government expropriation (nationalization). In this one, I want to focus on the more benign (and perhaps positive) impact that governments can have the values of some companies, through subsidies in one of many forms: providing or facilitating below-market rate financing, special tax benefits, revenues or price supports and even forcing competitors to provide direct benefits to a subsidized entity. Note that my intent in this post is not to examine the wisdom of these subsidies and whether governments should be tilting the playing field. While I do have strong views on the topic (and you can guess what they are from the subtext), I want to focus on the mechanics of how best to value businesses that benefit from these subsidies. This post was, in part, triggered by the recent news story on First Solar, where the company announced its intent to both scale back its operations and return a $30 million subsidy it had received from the German government.

Subsidy Variants
Governments, through the ages, have played favorites with businesses, either providing help to their preferred companies or, in some cases, handicapping their competition. Broadly speaking, there are at least four ways in which governments can try to benefit a subset of companies:

1. "Low or no cost" financing:  The cost of borrowing (debt) for a company should reflect its default risk. In some cases, governments can step in the fray and either provide or facilitate "cheap" or "below market rate" financing, ranging from grants (effectively free financing) to low-interest rate loans (Airbus) to acting as a loan guarantor with banks (Tesla). The net effect is the same: the company is able to borrow more money at lower interest rates than it otherwise would have been able to, which, in turns, lowers its overall cost of financing its operations. You can argue that bailouts are a variant on this subsidy, insofar as it offers a financial lifeline to distressed (usually too-big-to-fail) firms that otherwise would have faced default.
2. Tax holidays, credits and deductions:  The tax code has long been a favored device for the government to bestow benefits on chosen sectors or companies. In some cases, this can take the form of a lower tax rate on income (than the tax rate paid by other businesses) or a tax holiday, and in others it can take the form of more generous expensing and depreciation rules. Fossil fuel companies in the US, for instance,  have been allowed to expense a portion of exploration costs, granted tax credits amounting to 15% of investment costs related to enhanced oil recovery and gas pipelines can be depreciated over 15 years instead of 20 years. These benefits translate into higher after-tax cash flows (from paying less in taxes)  or timing benefits on tax savings (with expensing and depreciation breaks).
A side note: One oft-used proxy of which businesses get subsidized the most is the difference between the effective tax rate paid by these businesses and the marginal tax rate. I report the average effective tax rates on my website, by sector. However, I think that the dominant factor driving effective tax rates now is not tax subsidization but foreign sales. The more revenues a company (or sector) generates from overseas (where corporate tax rates are lower), the lower the effective tax rate will be.
3. Revenue or price support (Higher and more predictable revenues): In some cases, governments step in to both stabilize and increase revenues of businesses by providing price support to companies. For instance, the US government, among others, has provided price supports for some agricultural products, such as sugar. In other cases, governments benefit firms by handicapping foreign competition and imposing tariffs on imported goods. Sometimes, government can indirectly support revenues by providing the subsidies to the customers of preferred companies; an example would be credits offered to homeowners for using solar panels on their houses.
4. Indirect subsidies: Rather than provide benefits directly to a company, the government can also force competitors to sustain the company by either paying a cash subsidy to the company or by buying its products at an arranged price. The Zero Emissions Vehicle Program, a California state mandate requiring that auto manufacturers failing to produce a certain number of zero emission vehicles buy credits from those who did, resulted in Tesla receiving millions of dollars in payments from other auto companies.

Ways of dealing with subsidies
There are two ways of dealing with subsidies. One is to build them into your discounted cash flow valuation inputs and let them flow into your estimated value. The other is to ignore subsidies in a DCF valuation and to value subsidies separately and add them on.

1. Build into valuation 
Each of the subsidies, described above, can be incorporated into a DCF valuation input:
a. "Low cost" financing: Enter the subsidized cost of debt and/or the subsidized debt ratio into the cost of capital, which will yield a lower cost of capital and higher value. Thus, if a firm like Tesla that normally would not have been able to borrow money, since it is a risky, money losing company. and would have been all equity financed (say with a cost of equity of 11%) may be able to borrow a portion of its capital at a "low" interest rate (because of implicit or explicit government subsidization) and end up with a cost of capital of 10.8%.
b. Tax holidays, credits and deductions: Subsidies that take the form of a tax holiday or special tax rate will lower the effective tax rate and increase after-tax cash flows. To the extent that the tax subsidized operations can be kept separate from non subsidized business, the company may be able to still get the full tax benefits of borrowing. More generous expensing and depreciation rules don't increase the nominal tax benefits across time but the value of the tax benefits will increase because they occur earlier in time.
c. Revenue or price supports: These subsidies can show up in two places. First, the price support increases revenue to producers who can sell at the support price, which is higher than the market price. Second, to the extent that these subsidies make revenues more stable, they may reduce the operating risk in the business and increase value.
d. Indirect subsidies: The transfer payments from competitors will boost revenues and cash flows and increase the value of the subsidy-receiving company.
The advantage of this approach is that the subsidies then get baked into the valuation, with no need for post-valuation garnishing or augmentation. The disadvantage of this approach is that it is easy to forget that subsidies don't last forever and that the firm will eventually lose them, either because governments cannot afford them anymore or because the company loses its preferred status.
If you do decide to go this route, keep in mind at least two issues. If you build subsidies into your DCF valuation, think through how long these subsidies will last. For instance, the "low cost" financing subsidy may cease to be one, if your company becomes a larger, more profitable entity. In addition, check to see what the value of the company would be, with no subsidies. In other words, break the company's value down into its operating value and its subsidy value.

A valuation of Tesla
To illustrate the process, let me try to value Tesla Motors, the electric car company founded by Elon Musk, one of the co-founders of Paypal. Tesla Motors got a subsidy from the US government, in the form of a Department of Energy loan facility that it utilized to borrow about $250 million in 2011, at an interest rate of 3%. (You can download my excel spreadsheets, with the valuations, if you want):
Step 1: I valued Tesla Motors, with the subsidized financing. The company's borrowing gives it a debt ratio of about 10%, which with its subsidized interest rate, results in a cost of capital of about 10.8%. The valuation, where I do assume that Tesla's revenues will climb to about $ 5 billion in 10 years and that the pre-tax operating margin will converge on 12% (much higher than the average margin of 7% across automobile companies in 2011), yields a value per share of $10.40/share.
Step 2: I valued Tesla Motors without the subsidized financing, by assuming that the firm would have to raise the debt at a market interest rate of 9% (instead of the 3% subsidized rate). The resulting value per share is $9.60.
Step 3: The interest rate subsidy can be valued at $0.80/share, the difference between the valuation with the subsidy and the valuation without.
This is the narrowest measure of the subsidy. If we expand the subsidization to include tax credits for future investments (reducing reinvestment needs for the future) and perhaps less risk (if the government supports revenues or requires competitors to pay Tesla), the value per share would increase (and so would the subsidy value). In this final valuation, I expand the Tesla valuation to include broader subsidies and generate a value per share of $18.17/share.

2. Separate valuation
In this approach, the discounted cash flow valuation is done with inputs that the firm would have had in a non-subsidized world, and the value of the subsidy is assessed separately. Thus, in the case of Tesla, you would value the company using the 12% cost of equity (or capital) that the firm would have had in a non-subsidized world, and then value the effect of the low cost financing separately. Thus, if Tesla is able to borrow money at a lower rate, as a result of the government support or backing, the savings each year from the subsidy amount to the difference between the market and the subsidized interest rates. Taking the present value of these savings over time should generate a value for the subsidy, which can then be added on to the value obtained using the non-subsidized cost of capital.
While this approach requires more detailed information on the nature of the subsidy and what the firm would have looked like in its absence, it has two benefits:
a. The analyst can value the subsidy for only the period that he or she thinks it will be offered and discount it at an appropriate rate. Thus, if Tesla has $250 million in debt at a 3% subsidized rate, when it should have been paying 9%, it is saving $15 million a year because of the subsidy (9% of 250 - 3% of 250). Assuming that the subsidy is likely to continue for only 10 years and that the only risk of not getting it is if Tesla defaults, the present value of $15 million a year for 10 years, discounted back at the unsubsidized cost  of debt of 9%, yields a value today of $96.26 million.
b. If the subsidy from the government requires the company to offer something in return (build a manufacturing plant with higher cost labor), separating the effects of the subsidy from the valuation allows you to assess the costs and benefits of taking the subsidy. If the net benefit is negative, the company may be better off rejecting or returning the subsidy to the government.

Implications for investing/valuation
A company that gets significant subsidies from the government will have a higher value, in most cases, than one that does not. In some sectors, say green energy, the subsidies can account for a significant portion of the overall value of the firm (and its equity). As an investor, I have always been uncomfortable investing in these companies at prices that require the continuation of subsidies to justify the investments. Governments, especially in these times of budget constraints and sovereign defaults, are both fickle in their choice of favorites and unreliable subsidizers. Thus, if I can buy Tesla at a price that is less than its unsubsidized value, I will do so, and view the subsidies as icing on my investment cake. If, on the other hand, making money on Tesla requires me to count on the government's continuing indulgence, you can count me out. In this case, I am spared the choice, since Tesla at the prevailing stock price of $ 30 looks overvalued, even relative to the most generous subsidized value.

Governments and Value: Part 1 - Nationalization Risk

I have been writing about valuation for a long time and for much of that time period, I chose to ignore the effects, positive or negative, that governments can have on the value of businesses. Implicitly, I was assuming that governments could affect the value of a business only through the tax code and perhaps through regulatory rule changes (if you were a regulated firm), but that  a firm's value ultimately rested on its capacity to find a market for its products and generate profits from these products. The last five years have been a wake-up call to me that governments can and often do affect value in significant ways and that these effects are not restricted to emerging markets.

The news story that brought this thought back to the forefront was from Argentina, where Cristina Fernandez, the president, announced that the Argentine government planned to nationalize YPF. The ripple effects were felt across the ocean in Spain, where Repsol, the majority owner of YPF, now stands to lose several billion dollars as a consequence. Not surpringly, the stock price of YPF, already down about 50% this year, plunged another 21% in New York trading. If you own YPF stock, my sympathies to you, but it is too late to reverse that mistake. However, there are general lessons that we can take away from this sorry episode about how best to incorporate the possibility of government capriciousness into what you pay for shares in a company.

1. Intrinsic value and nationalization risk
There are three components to intrinsic value: cash flows (reflecting the profitability of your business), growth (incorporating both the benefits of growth and the costs of delivering that growth) and risk. If you have to value a company in a country where nationalization risk is a clear and present danger, the obvious input that you may think of changing is the risk measure. After all, as investors, you face more risk to your investments in countries with capricious heads of state or governments, than in countries with governments that respect ownership rights (and have legal systems that back it up).
There are three options that you can use to incorporate the effect of this risk on your value:


Option 1- Use a "higher required return or discount rate": If you are using a discounted cash flow valuation, you could try to use a higher discount rate for companies that operate in Argentina, Venezuela or Russia, for instance, to reflect the higher risk that your ownership stake may be taken away from you for less-than-fair compensation. The problem that you will face is that discount rates are blunt instruments and that the risk and return models  are more attuned to capturing the risk that your earnings or cash flow estimates will be volatile than to reflecting discrete risk, i.e., risks like survival risk or nationalization risk that "truncate or end" your investment.


Option 2: Reduce your "expected cash flows for risk of nationalization: You can reduce the expected cash flows that you will get from a company incorporated in a "nationalization-prone" market to reflect the risk that those cash flows will be expropriated. While this may be straight forward for the near term cash flows (say the first year or two), they will be much more difficult to do for the cash flows beyond that time period.

Option 3: Deal with the nationalization risk separately from your valuation: Since it is so difficult to adjust discount rates and cash flows for nationalization risk (or any other discrete risk), here is my preferred option.
Step 1: Value the company using conventional discounted cash flow models, with no increment in the discount rate or haircutting of the cash flows. The value that you get from the model will be your "going concern" value.
Step 2: Bring in the concerns you have about nationalization into two numbers: a probability that the firm will be nationalized and the proceeds that you will get if you are nationalized.
Value of operating assets = Value of assets from DCF (1 - Probability of nationalization) + Value of assets if nationalized (Probability of nationalization)

To illustrate, consider Dominguez & Cia, a Venezuelan packaging company, which generated 117 million Venezuelan Bolivar (VEB) in operating income on revenues of 491 million VEB in 2010. A discounted cash flow valuation of the company generates a value of 483 million VEB for the operating assets. Assuming a 20% probability of nationalization and also assuming that the owners will be paid half of fair value, if nationalization occurs, here is what we obtain as the nationalization adjusted value:
Nationalization adjusted value = 483 (.8) + (483*.5) (.2) = 435 million VEB
Subtracting out the debt (291 million) and adding cash (68 million) yields a value for the equity of 212 million VEB. At its traded equity value of 211 million VEB, the stock looks fairly priced. If you download the valuation, you can see that I have incorporated the high operating risk (separate from nationalization risk) in Venezuela with a higher equity risk premium (12%) and the higher inflation/interest rates in Venezuela with a higher risk free rate of 20%. In particular, play with the nationalization probabilities and the consequences of nationalization to see how it plays out in your value per share.

Note, though, that my 20% estimate of the probability of nationalization is a complete guess, in this case. If I were interested in investing in Venezuelan (Russian, Argentine) companies,  I would spend more of my time assessing Hugo Chavez's (Vlad Putin's, Cristina Fernandez's) proclivities and persuasions than on generating cash flow estimates for companies. Since my skill set does not lie in psychoanalysis, I am going to steer away from companies in these countries.

2. Relative value and nationalization risk
How would you bring in the concerns about nationalization, if you value companies based upon multiples? One is to use multiples extracted from the country in question, on the assumption that the market would have incorporated (correctly) the risk and cost of nationalization into these multiples. To an extent, this is reasonable and it is true that companies in countries with high nationalization risk trade at lower multiples.

Note that while Russian and Venezuelan companies trade at a discount to their emerging market peers (and my guess is that Argentine companies will join them soon), you have no way of knowing whether the discount is a fair one.

The problem, though,  becomes more acute when you are not able to find enough companies in the sector within that country to make your valuation judgment. With Dominguez & Cia, for instance, you have the only publicly traded packaging company operating in Venezuela. If you decide to go out of the market, say look at US packaging companies in 2011, the average EV/Operating income multiple is about 10.51 in January 2012. Applying this multiple to Dominguez's operating income would generate a value of  1230 million VEB, well above the market value of 211 million VEB. However, you have not incorporated the higher operating risk in Venezuela (separate from the nationalization risk) and the risk of nationalization.

The bottom line with multiples is simple. If you do not control for nationalization risk, companies in countries which are exposed to this risk will often look absurdly cheap on a PE ratio or an EV/EBITDA basis. But looking cheap does not necessarily equate to being cheap..

Implications
While it is too late to incorporate the risk of nationalization in the value of YPF, you can adjust the estimated values of other Argentine companies. While the government of Argentina may argue that YPF was unique and that they would not extend the nationalization model to other companies, I would operate under the presumption of "fool me once, shame on you... fool me twice, shame on me" and incorporate a higher probability of bankruptcy into the valuation of every Argentine company. The net effect would be a drop in equity values across the board: that is the consequence of government action. There are other repercussions as well. A government that is cavalier about private ownership is likely to be just as cavalier about its financial obligations: no surprise then at the news that the default spreads for Argentina have surged after the YPF news.

In closing
While this post is about the "negative" effects of government intervention, it is possible that the potential for government intervention can push up the value of equity in other companies. In particular, the possibility that governments may "bail out" companies that are "too large or important to fail" may increase the value of equities in those companies as will the potential for government subsidies to "worthy" companies. I will come back to these questions in subsequent posts.

Returning again to the Argentina story, Ms. Fernandez was quoted as saying, "I am a head of state, and not a hoodlum". Someone should remind her that the two are not mutual exclusive, and the problem may be that she is both.