UnitedHealth Group- A Company Valuation

(Disclaimer: Excel file attached below the post) 

UnitedHealth group is due to report its FYE '23 financial results in the near future, and I wanted to take a day or two and analyze the company and its financials and prognosticate as to what its true intrinsic value might be. I would be lying if I said that UNH is one of the companies I keep tabs on, I don't; what truly prompted this valuation was the latest opioid related lawsuit and the billions that major players in the healthcare industry have had to pony up. My typical approach to valuations is to look at the bigger picture and then work my way down to the company's operations, but I will refrain from doing that for this post because as mentioned before, this is not an industry I track and so I don't believe that my two cents about the future of the industry as a whole would be accretive to the overall valuation. So, I will talk briefly about UnitedHealth's business operations, the various segments that it reports, its past historical performance, and finally what I think the company is worth based on what I think could be its future. 

UnitedHealth- Operations and Historic Performance

Before we delve deeper into the company and its operations, I think that the historic stock price of any publicly traded company is a decent barometer of not only the company's performance but also how the markets have perceived it throughout its nascent and maturity years. So I went back 10 years and I gathered UNH's historic stock price and trading volume.

UNH's performance in the last ten years alone is enough to solidify its spot in every portfolio, but what drove the stock price from $72.39 in Dec '13 to $524.05 in Dec '23? Has it been outperforming its competitors in top line growth? Or is the astronomical share price growth because of beyond standard operating margins? Is it its diversification and the myriad tentacles spreading across the health space? Before we can venture in to the reasons, lets look at UNH's family tree and the various sections of the industry that it serves. Instead of writing them down, I figured a good avenue might be to concoct a family tree of sorts, to make things more amenable to our conversation here.

As is evident, UNH is well diversified, but not diversified in the normal sense of the word where a portfolio manager might have holdings spread out across different industries and sub categories, but rather in the sense that the company doesn't only provide health insurance, but also conducts business in every other aspect of the field; it provides analytics, software, consulting, and administrative support through its Optum Insight branch, it not only provides comprehensive patient care through Optum Health, but also has an Optum bank with $20 billion in assets under management, and as expected, it provides pharmacy services through Optum Rx, and health insurance coverage through its UnitedHealthcare branch. Diversification is without a doubt a pro for the company, but how has this diversification played out in numbers over the past ten years? Lets look at its revenue growth, operating income and margins over the last decade.

looking at the numbers over the last ten years, at the risk of being reproach by others, I fail to see the extraordinary factor that has contributed to its monumental growth. Operating margins have stayed relatively flat over the observed period- from 7.9% in FY '13 to 8.8% in FY '22- and its operating income has increased at a moderate pace from $9.6B in FY '13 (on revenues of $122B) to $28B in FY '22 (on revenues of $324B). One thing that does stand out is its top line growth. Revenues have grown from $122B in FY '13 to $324B in FY '22; so, the next question that I instantly have is why hasn't the operating income grown substantially- in line with the revenues? Why have the margins remain flat? I think the answer lies in the very industry that it operates in. Upon inspection of its income statement, it is abundantly clear where all the revenues vanish to: Its the cost of doing business. For instance, the total operating costs for fiscal years '22, '21, '20 were $296B, $264B, and $235B, on revenues of $324B, $288B, and $257B, respectively. 

Lets further peel the onion and understand what revenues are comprised of, and what other metrics look like. UNH breaks down its revenues in the following categories: Premiums, Products, Services, and Investment and other income. Premiums, without any surprise, constitute the bulk of revenues for UNH; Premiums were 79% of the overall revenues for FY '22, followed by 12% for Products, 9% for Services, and 0.6% for Investment and other income. Moving onto other metrics, the company reported NI of $6B with net margins of 4.6%, ROE of 18% and ROIC of 30% for FY '13. Fast forward to FY '22, UNH reported NI of  $20B (16% growth YOY) with profit margins of 6%, ROE of 26% and ROIC of 33%. Below is a visual representation of UNH's NI, ROE and ROIC along with its operating income for the last decade.

When valuing a company, any company, I believe there are some questions that the inquisitor ought to ask; Does the company in question have a competitive advantage? Has the company been generating a decent return on its invested capital? Is there vivid growth in both the top and bottom lines? Looking at the historic numbers, I believe that UNH does have a competitive advantage, even if its operating margins have hovered around 7-8%, again, I believe that low margins are because of the industry that it is in and the cost of doing business in it. The company has also been generating a steady amount of ROIC and ROE over the last decade. Looking at one company in the sector does not really help our case, so I decided to look at the market caps of UNH and other major players in the industry over the course of the last five years. 

Comparing UNH to some of its close competitors, it has by far and large, outperformed other companies in the industry. Its market cap has almost doubled from around $250B in FY '18 to $535B by the end of FY '23. Looking at the trend, UNH seems to be the favorite and the poster child within the managed healthcare industry, but why is that? Why has its market cap almost doubled when the rest of the companies have remained comparatively flat? I think a major cause or reason is its long history, its brand name, its lucrative relations with federal and municipal governments, as well diversification of revenues, and strong relationships with employers. These are all intangible assets, and at the risk of stating the obvious, this post is not about valuing intangible assets. I will only go as far as to say that its brand name- along with other assets- is well represented in its revenue growth, and so I reckon, it'd be moot for me to value its brand name, governmental relations, etc.

I also went a step ahead and compared UNH to S&P, a mutual fund managed by Fidelity, and an ETF controlled by iShares. Prior to '21, UNH underperformed when compared to S&P and its share price was in line with the mutual fund and ETF managed by Fidelity and iShares, but after 2021, as shown below, the company outperformed S&P as well as both the ETF and the mutual fund.  

Valuation

Before I proceed with the valuation, I think it is prudent for us to understand what stage of the life cycle UnitedHealth Group is in, and for us to fully comprehend that, lets look at the various stages that a business typically goes through.

        Source: Aswath D. 

Having gone through UNH's financial statements, its history, and performance over the last decade, I believe that the company is in its mature stable stage. Its high growth, or even mature growth, days are in rearview mirror, and so I think that going forward, UNH will struggle to put up the revenue growth that it has enjoyed over the course of its aged history. In its present stage, I believe that its top line growth will slowly converge with the general economy- from 12.7% YOY in '22 to 3.4% in '32. For a detailed breakdown of growth in its reported segments, please refer to the file attached below. 

I further believe that its operating income will slowly move from 9% in '22 to 8% in '32- driven mainly by its brand name, its long and historic relations, innovation and diversification, and lastly, because everyone needs health insurance. Furthermore, I believe that Capex and D&A will converge over the long run (I know, not a safe assumption given that I have assumed a long term growth rate of 3%), as well as NWC margin working its way down to 10% in '32 from 14% in '22. I have assumed a long term growth rate of 3% which I believe fully encapsulates what the future holds for the company: a company that is at the long tail of its existence, and will only be reinvesting enough for moderate growth in perpetuity. After converting my assumptions into numbers, and running the model, I got a price per share of $562.89; other related numbers can be seen in the image below. 

At the time of this valuation, UNH was trading at $526.55. Do I think that the stock is undervalued? Yes, but it is also simply the share price I got based on what I think about the company. It is entirely possible that the market is right and is pricing in what the management has done or expects to do in the future, or maybe the analysts are privy to information that I simply do not possess or have a better understanding of the industry, but nevertheless, I sternly stand by my numbers and narrative. For analytical purposes, I also ran a few sensitivity tests with data tables as well as the Monte Carlo simulation. 

Sensitivity:

        Image 1        

        Image 2

        Image 3

Sensitivity analysis allows us to look at the impact of various factors on price per share, equity value, or really any other item you are trying to sensitize. As such, image 1 shows what the equity value might be given different long-term growth rates and WACC. In my base case assumption of 3% long-term growth rate and a WACC of 9.4%, I got an implied equity value of $528B, but we can see what effect changes in growth rate and WACC might have on UNH's implied equity value. For instance, If I were to assume that the long-term growth rate will be 4% instead of 3%, and WACC will be slightly lower at 8.9%, then we get an equity value of $644B, giving us a higher price per share. 

Similarly, image 2 above shows the impact of long-term growth rate and WACC on the implied price per share. My base case assumption of 3% and a WACC of 9.43%, gives me an implied per share of $562.89, but what happens if we slightly change those assumptions? If I assume a growth rate of 4%, given a WACC of 9.14%, I get a price per share of $658.44. Image 3 paints a similar picture; it sensitizes the share price given different revenues and operating margins in FY '32.

To further understand and illustrate how different assumptions could impact the implied value per share, I decided to also run a Monte Carlo simulation and assess how far the values are from the mean assuming a normal distribution. 

The usual suspects when valuing a company are the growth rate, operating margins, and the cost of capital. I assumed a 2.5% standard deviation in my growth rate, why 2.5%? Because it is entirely possible that I might be wrong about what stage of the business cycle the company is in, rendering my assumptions about revenue growth rate futile, or that the management ends up generating revenue through other means. I also assumed a 0.50% standard deviation in the cost of capital, because WACC is driven off of macro trends and could deviate from one year to the next. Finally, for my operating margins, I gave myself a standard deviation of 2%, assuming that the margins could be different from what I hypothesized. I ran 10K simulations with my assumptions, and the distributions are as shown above. As you can clearly see, most of the values lie between $540- $580 price per share. 

Conclusion:

Based on my narrative and understanding of the company, at $526 a share, UNH is undervalued. My one year price target for the stock is $615.16. With all this being said, this is not meant as an investment advice, because as is clear from my profile, I am not an industry professional. I do this for educational purposes and also to quench my curiosity. I recommend you download the attached file, and change the numbers with what you think about the company and its future. 

Links:

UnitedHealth Group- Valuation

Macy's- Renaissance Through LBO?

(Disclaimer: Excel file attached below the post) 

I recently came across an article about a takeover offer for Macy's- a brand synonymous with retail and a pivotal piece of the American cultural fabric. On Dec 01, Arkhouse Management and Brigade Capital submitted an offer of $21/ share- a premium of 33% over Friday's closing price- to purchase all of the outstanding shares that they do not possess. Proposed per share price, given Macy's roughly 274MM diluted shares outstanding as of the latest 10Q, translates to an offer or equity value of approximately $5.9B. I am a native New Yorker and so I have always been enamored by Macy's corporate headquarter in Herald Square, by its behemoth presence in the consumer staples and retail industry, and lastly, by its 150+ years of history; and so given my fondness, I decided to inspect the possible outcomes of the proposed transaction. I sternly believe that putting things in historic perspective can be of huge help when valuing a company's operations, basic fundamentals, position in the industry and society, and most important of all, its possible future cash flows; so, as a result, I have taken the top down approach where I will look at the retail industry, Macy's historic performance, and finally, whether or not the company has the operational wherewithal to weather an LBO transaction, especially in this environment.     

Retail Industry: Past, Present, and the Future

Past

I am no historian, by any stretch of the imagination, but I believe that retail is as archaic and crucial in human history as all of the ancient civilizations. Bartering and haggling for goods and services can be traced back centuries, albeit in slightly different formats. It wasn't until the late 1800s and the early 1900s that contemporary form of shopping abridged the gap between culture and retail. It is during this time that department stores began to appear in neighborhoods and changed the retail business in its entirety. Many of those retailers offered so much more than just goods and services, they offered an experience, luxury, and entertainment; in some sense, this was also the dawn of shopping malls: mega-centers with all of the time's major retailers. Retailers like Le Bon Marche, Bloomingdales, Saks, Nordstrom, Macy's, JC Penny, and Sears took advantage of ever changing consumer demands and along with offering goods, they also initiated offering services such as reading rooms, art galleries, and in some cases, even concerts; whatever they needed to do to get consumers through the doors.

The industry, as a whole, has gone through ups and downs but, for the most part, maintained its elegance and need in society. Retailers, to remain profitable and relevant, have embraced other channels of revenues along with their prime brick and mortar locations, online shopping, metaverse, same day delivery, and curbside pick ups to name a few. It should come as no surprise that any industry reliant on end consumer has to invest heavily in analytical tools and software to remain ahead of the curve and the changing consumer trends and behaviors. In order to understand the ever changing hierarchy and tumult in this industry, I looked at the share prices of some of the major retailers, going as far back as possible, and the anarchy could not be more vivid.

As shown, retailers have always persevered through rough micro and macro environments, but this is not an industry for faint of hearts. I can not think of another industry that is as reliant on the macro environment and the general health of the economy as the retail industry. Retailers are easily impacted, good or in adverse ways, by general consumer sentiment and the economy. If you look at the share prices you can almost immediately see that the ups are directly corelated with positive sentiment around economy and less competition, and conversely, the downs are directly related to downturns and recessions. Despite their decades of existence, nowhere else in their history have the retailers had to endure what they went through after the emergence of the world wide web, as shown by the decrease in the share prices after 2000s. Internet did to retailers what they did to prior forms of shopping: it made them less relevant. It is come human fallacy to think that the deeper you are rooted in society, the harder it becomes to dismantle you; major retailers suffered from a similar ailment. They thought that they will remain forever green and no disruption of any kind could unwind or alter their existence. 

Turn of the century became the beginning of the end for traditional retail shopping. The emergence and mass adaptation of internet gave customers what they always deeply desired: the convenience and capability to shop from the comfort of their homes, and companies like Google, Yahoo (a major player back then), and Amazon were more than happy to oblige. I believe that traditional retailers could not fathom a society without their trademark store fronts and locations, and so they lagged in terms of keeping track of their competition, namely Amazon, or even invest in similar technologies and advancements so that they could at the very least retain their customer base and market share. Driven by their hubris and egotistical ways of doing business, they became more and more irrelevant with every passing year.   

Present

Even before the COVID-19 pandemic, many of the major retailers were on the brink of collapse given the heavy load of debt and liabilities and higher costs of doing business compared to their dwindling revenues and operating incomes. To make matters worse, health related closures during the pandemic wreaked havoc across the spectrum and retail industry was pummeled the most. With zero foot traffic and heavy load of lease and debt liabilities, many of the major retailers have had to file for either chapter 11 or 7 bankruptcy. J.C. Penny, Neiman Marcus, Sears, GNC, J. Crew Group are some of the notable names in the long and ever expanding list of bankruptcies in the retail world. 

Some of the bankruptcies were driven by lack of innovation or just flawed business models for the modern days, while others were pushed into oblivion due to a number of industry trends being accelerated by the pandemic. Digital commerce is not a new norm, as mentioned before, it has been around for nearly two decades now, but pandemic made shopping online a necessity and so the retailers had to adapt, those who could, lived for another day, and those who couldn't, became part of the bankruptcy statistics. Another trend that skyrocketed during the pandemic was working from home and little to no social life; which essentially meant that consumers had less incentive to go out and shop for work or social soirees. I am a 'cup half full' kind of a guy and so I try to see the silver lining in everything; the good thing about pandemic is that it has given us an emphatic understanding of the symbiotic relationship between consumers and the retail industry. 

Future

It is not all doom and gloom in the retail world. Retailers are convalescing and will emerge from the dust with a far better understanding and resiliency. Fluctuations, pre and post pandemic, have compelled retail executives and managers to think out of the box, to conjure creative solutions to their modern problems, and most important of all, how to survive given the current competitive climate. Going into the future, retailers will have to assess what matters to their consumers the most, and how to best deliver that at the lowest possible cost. To that end, retailers- both major and regional- will need to take initiatives to invest in their supply chains, digital commerce, and omnichannel capabilities. Executives and managers will need to understand that customers are tethered to a seamless and convenient experience. Digital presence will also play an integral role in determining who survives and who essentially will lose their business. Retailers will have to invest ever more in software development, online platforms, and better analytical tools. The cost of acquiring a customer has skyrocketed compared to a few years ago and the cost of retention is even higher, and so investing in modernized ways of shopping could serve as an anchor that reinforces customer loyalty. 

Given retail world's dependence on the macro/micro environment, there are some economic trends that I believe retailers will have to keep an eye on and possibly even endeavor to mitigate. A slowing economy could push sales further down and rising rates and inflation could inflate the cost of doing business, and so managers will have to keep their COGS, SG&A and R&D in check for the next couple of years. However, the stunted growth due to a slowing economy could partially be offset by a relatively strong and resilient labor market. With the soft landing narrative winning the democratic race, I believe that consumers will continue to spend. Additionally, with things returning to normalcy- social events and soirees- consumers will be tempted to again experience the traditional ways of shopping by physically going into the brick and mortar stores and malls rather than shop entirely online, think Hudson Yards in NY or Newport Mall in Jersey City. 

Secondly, inflation could play a huge role in this space for the next couple of years. Flashy rate hikes over the last year and half has given rise to inflation which has reduced consumers' purchasing power. Retailers will see their nominal earnings grow due to inflation, but it is the real sales that they will have to keep an eye on. Finally, consumer spending on services is likely to continue into the near future. Pandemic was all bad, but people spending essentially a year and a half indoors could prove to be the oasis that retailers needed. Most people are agitated and are desperate to make up for the time that they have lost, and so they have come back- events, concerts, and parties- with a thudding bang. This increase in spending in the services industry could also trickle into the retail industry. 

Macy's

History

In 1858, R.H. Macy opened a dry goods store in New York City and called it R.H. Macy & Co. It eventually grew into a phenomenon and rapidly began expanding and taking over adjacent buildings. Macy's is credited for having created the modern department store along with other major breakthroughs in the retail industry, namely to include buying and selling of products using cash, introducing products such as the teabag and Idaho baked potato, and also creating a made-to-measure clothing operation that tailored suits and clothes onsite. Macy's is also highly tooted for their elaborate and festive window dressings that the department store started way back in 1864 along with concocting the retail Santa concept. After R.H. Macy's demise in 1877, the Strauss family took ownership and in 1902 moved the department store to its now iconic location in Herald Square. Macy's held it inaugural Thanksgiving Day Parade in 1924, a tradition that has not only survived to the present day but has also increased the brand's value exponentially. As of the FYE 2022, company owned 722 locations and 783 boxes. 

Macy's, for years, has been analogous with retail shopping and department store model. Consumers have been visiting Macy's stores to purchase everything from clothes and cosmetics to perfumes and furnishings for years, but its elongated history also means that it has suffered from every minor and major event in the economy along with the corresponding ailments of the retail industry. So, as an effort to offset some of the downsides of the business, Macy's sought to grow through partnerships and acquisitions; and has acquired brands such as Bloomingdales, and Bluemercury along with having inhouse innovations, i.e., FDS Bank, Market by Macy's, and Macy's Backstage along with many others. To understand how Macy's has prevailed over the years, I looked at its share price and trading volume since its IPO, that is a long way back but I believe the image below provides a better view of the past and the future to come for Arkhouse and Brigade.

One thing that is immediately evident is that the stock has not seen stability ever since it went public. It witnessed gradual growth from 1992 to 2000, and around the emergence of internet, it became volatile with periods of highs and lows through time. Another thing that might be noticeable is the fact that the lows are directly correlated with economic recessions. The first slump came in the 1999-2000 period and if you are as old as I am, you'd know that that was the dot-com bubble. For years after 2000, it showed growth and prospects but then plummeted during the great recession from almost $50 a share in 2007 to $10/share by early 2009. Final thoughts on Macy's performance throughout the years is that it is nearly impossible to predict what the future holds for this particular industry; I wouldn't even care to venture a guess as to its long term growth let alone the potential possibilities that could change its trajectory in the future. Macy's is not alone in this arena of instability and volatility though, from what I have gathered, it comes with the territory. Below, I look at some of the major players in this sector and their market capitalizations over the course of the last five years. 

As I said before, equities in this particular industry are not for your IRAs or 401Ks, but they do seem like the ideal candidates for options and derivatives players in the marketplace. I am utilizing the six stocks in the graph as proxy for the sector as a whole, but the above image only traces the market caps for the last 5 years, imagine what it would look like if we went back 10 years, 15 years, or maybe even 20 years. The unpredictability is resounding, and I think that going into the future, we have to keep the past in our rearview mirror before we make any prophetic projections. 

Business

Macy's divides its net sales into four categories: Women's accessories, shoes, cosmetics and fragrances, Women's apparel, Men's and kid's, and Home/other. Company's also gets a decent portion of its total revenues from its credit card business. According to the latest 10K filed in Feb 2023, Net sales for women's accessories, shoes, cosmetics, and fragrances were $9.5B; $5.3B for the women's apparel; $5.2B for the men's and kid's, and lastly, 4.2B for the home/other category. Net sales for all of the categories combined was $24.4B in FYE 2023, a slight decline of (1%) YOY. Company also reported $863MM in credit card revenues, and given their COGS and SG&A of $15.3B and $8.3B respectively, yielded an operating income of $1.7B and margins of 7%; you can immediately see the flaws in the retail business model. To put things in historic perspective, I also looked at Macy's net sales, excluding credit card revenues, for the last 20 years along with its operating income and margins.

Macy's operating margins have never seen a pretty day. Cost of doing business and SG&A have weighed on billions of revenues throughout its observed operational history. Knowing how the PE industry and LBOs generally work, this could potentially be one of the drivers for future improvement of cash flows and therefore payment of future leverage to boost IRR and MOIC for investors at exit. 

LBO 

Macy's has historically been slow to adapt to new technologies- one of the slew of reasons of fluctuations in its stock- such as online shopping or modernizing its store fronts. Macy's has made herculean efforts- new brands, smaller stores, and improving its online presence- over the years to revitalize its brand and improve its long term trajectory. Macy's stock has dropped more than 70% from its once peak of $73/share in 2015 to $15.76/ share as of the writing of this post; making it a prime target for a consortium of PE firms. Macy's generates plenty of operating cash flows, enough to even finance this proposed transaction under my personal hypothetical assumptions pertaining to debt and interest rates; the question that I asked myself at the end of this analysis is "why hasn't anyone taken Macy's private over the course of last 10 years?" The company has the potential to trade at $73/ share, and given that it has been trading in the teens for a good while now, with healthy revenues and decent operating income, where have the PE firms been? As I run through the numbers, I don't think that this LBO would be difficult, even in this environment. In the long run, the investors could greatly benefit from the company's intangible assets, as well as from potentially liquidating its prime real estate locations- Herald and Union Square- to even selling off the credit card business and other subsidiaries such as Bluemercury and Bloomingdales. As of the writing of this post, the terms of the deals were not disclosed other than just the offer price, and so I have made some high level assumptions in terms of what the enterprise value could be and what amount and kind of debt the company could think of undertaking. 

As disclosed, the investors made an offer of $21/ share, a 32% premium over the last Friday's closing price, for Macy's roughly 274MM (according to 3rd quarter 10Q) diluted shares outstanding. The proposed share price gives us an offer value of $5.9B, and with Macy's net debt of $5.8B, an enterprise value of roughly $11.7B. I have also assumed that the group decides to keep a minimum cash balance of 200MM through the holding period, as well as assuming that the exit multiple will be the same as the entry multiple: 5.8x. Some other assumptions that I have made are about the kind of debt the investors could take on and the potential interest expense on that debt. I have assumed that the consortium will take out a revolver, but the revolver will have a balance of zero at the beginning (for simplicity, I have not tethered revolver's drawdown to inventory or other assets), along with term loans. I have also assumed that the transaction and financing fees will be $118MM (2% of offer value) and $741MM, respectively. Additionally, I have made the following assumptions for the sources and uses of funds for this transaction.

Cash Flows

Macy's has plenty of adjustments that we need to make to make sure that we arrive at an appropriate adjusted EBITDA and operating cash flows. For FYE '22 and '23, starting from net income, after adding back interest expense, taxes, stock based compensation, depreciation and amortization, and other non-recurring charges, the company's operating cash flows were $1.6B and $2.7B, respectively; we also get $3.3B and $2.1B in adjusted EBITDA (for both the years) after making the necessary adjustments- I decided to arrive at normalized EBITDA through NI as opposed to the conventional way of working down from EBIT because that is how the company goes from GAAP to Non-GAAP in its financial statements and I wanted to stay consistent with that.  

At the time of this analysis, SOFR was at 5.32% and so I decided on a 2% spread over SOFR for the revolver and term loans A and B, as well as assuming 7% for both the senior and subordinated notes, and given the total amounts shown above, the interest expense would be $841MM in the first year, $783MM in the second, and $685MM, $552MM, and $391MM for the last three years. I have also made the implicit assumption that the terms of the loans also require 6% annual amortization for both the term loans, giving us annual required loan payments of 507MM for the holding period. Additionally I have assumed 100% cash sweeps (unconventional, I know, but I wanted to test the limits) for both the loans. After having put all those numbers in, and letting excel do the work for me, even my base case generates enough healthy cash flows to pay the annual interest expense along with the required paydowns. My base case assumptions also show me that any drawn revolver in the first year, along with $5.3B of term loan A and a significant portion of term loan B could all be paid off by the end of the fifth year, leaving senior note of  $3.3B and $1.4B of term loan B at exit. I have intentionally left preferred stock and management rollover blank, but they are all tethered so any curious Joe could give those tiers of the capital structure a shot and see what the model spits out. 

Returns Analysis

In my base case, the acquired company could have $5.3B in adjusted EBITDA on total revenues of $27.7B in the exit year. Given the same entry and exit multiple of 5.3x, we get an enterprise value of $29.8B, and with a net debt of  $4.6B, we get an equity value of $25.3B at exit, a mind-boggling 90% IRR and 25x MOIC. If we assume that the investors could sell at a higher EBITDA multiple, say 6.6, they would have $30.6B in equity, an IRR of 98% and MOIC of 30.3x. So, I ask again, why hasn't this happened before? I am unaware of the investors required rate of return so I wanted to see what the maximum amount of offer value could be at various hurdle rates, and the results are as follows:

As is evident by the matrix above, if there hurdle rate, rate of return, was 20%, the maximum offer they could make is $15B to reach that hurdle rate. And if there required rate of return is 30% or 35%, the maximum they could offer is $11.7B and $10.5B, respectively. If the investors can get away with an offer value of $5.8B, it would be an early Christmas gift for them. I do not see, under any scenario, $5.8B being a fair value for Macy's and its operations. The company has real estate holdings that could very well be worth anywhere north of $4B, and highly lucrative intangible assets and other businesses that could be used to either finance the transaction or liquidated to pay the debt down the road. 

Conclusion

The purpose of this analysis was twofold, one to satisfy my own curiosity, and second for educational purposes. But some parting advice for Macy's BOD, ask for more, way more!

Links:

Macy's LBO Valuation 

Visa- Is Cash Really the King?

(Disclaimer: Excel file attached below the post) 

I think it is difficult to think of a company, or a business model, that has the capability to endure macro, micro and market turbulences and tribulations. The closest that a company comes to the above description is Visa (V). I understand that there are risks and exposures that Visa is prone to, but I still believe that Visa is fully equipped to swim through any curve balls that the markets might throw at it, albeit with slightly lower profits. Before I move on to the valuation and numbers, I would like to go over the industry and its outlook as well as Visa's history- since its IPO in 2008- and business and try to defend my claims with evidentiary documentation.

Global Payments Industry

The adage, "Cash is king" sounds more futile now than it ever did throughout the history of mankind. I am a huge movies and TV shows aficionado, and I remember witnessing cash thrown around in almost everything I watched. But, in the last decade or so, I have seen less and less cash transactions and more and more digital and electronic payments. It used to be that certain sectors of the economy, think small businesses such as food carts and your local corner delicatessens, only accepted cash as a viable payment for goods and services; but the transition has been so monumental that even the most remote operators in our economies have succumbed to the trends and have started accepting digital and electronic forms of payments. For instance, I got my car fixed two days ago, and believe it or not, I zelled the amount due; when was the last time a vendor, of any sort or size, asked you to transfer money into his/her bank account for services rendered?

The industry has changed dramatically and the advances are easily noticeable to any keen eye. Consumers and businesses have embraced electronic payments with full throttle, and it doesn't seem like it will change anytime soon, at least not in the near future. A simple transaction has transformed from just paying for goods into an entire journey embedded with value-added services and various solutions. The technological and proprietary advancements have propelled revenue growth, operating margins, and profits. According to BCG's report on global payments, high revenue growth and strong future potential has attracted and generated more than 5,000 fintechs into the payments atmosphere, and account for approximately $100 billion of the total industry revenues. According to the same report, total payment revenues grew at an annual rate of 8.3% to $1.6 trillion by the end of 2022, and is expected to grow to $2.2 trillion by the end of 2027. The industry as a whole has maintained decent shareholder gains, with the exception of fintechs/disruptors that have posted significantly higher shareholder gains over the last two years but have receded down to the industry norms as shown in the image below.

 

                    Source: Mckinsey's Report

The industry is poised to maintain growth throughout the future, and with companies reinvesting more capital into the business, technological modernization such as the implementation of AI and AI driven software is only imminent. Where does Visa stand in all of this? Visa holds one of the most prominent, if not the most, positions in the industry. The company has posted solid revenues, operating income and margins since its IPO. 

Visa: Trip Down the Memory Lane

Visa was founded in 1958 by Bank of America as the BankAmericancard credit card program. BofA then proceeded to licensing the program to other financial institutions in 1966. By 1970, BofA gave up control of the program, and as a result, formed a cooperative with various other banks. It was renamed Visa in 1976. If you are familiar with the company's history and how effectively the management, before and after the IPO, finessed its way through various hurdles such as the Durbin Amendment and plummeting of the stock as a result of the subprime mortgage crises to linking up JP Morgan and officially entering DJIA in 2013 as one of the 30 companies, then you'd know that throughout the years, Visa has never been cheap; it has always traded at a premium than the market and its competitors. Surprisingly, even after decades of existence, if one thinks about the corporate lifecycle, Visa is still posting double digits growth- from 74.5% in 2008 to 11.4% in 2023, with just as impressive operating margins, consistently hovering around 50-60% throughout its public history. Visa's growth, as stated above, is solely because of its business model; with every passing year, cash is loosing share to digital and electronic payments, consumers are leaning towards mobile and tap payments, and inflation is increasing the amount of money in circulation pushing more and more transaction volume to Visa's network. 

IPO: 

In February 2008, Visa announced its plan to go public, and consequently, the IPO took place in March of 2008. Some might have had thoughts about the IPO during the heat of the financial crises, Bear Stearns had just collapsed and S&P 500 index was down 9% for the year, but Visa still went ahead and decided to raise capital in the trepidatious market of '08. Visa's IPO was slightly different than the average IPO, in the sense that Visa was a cooperative going public as compared to a privately owned company issuing shares to the public. At the time of of its offering, many a analysts thought that the banks were trying dump Visa at a time when markets were in turmoil and banks were looking to preserve capital for the cobblestone road ahead. But, against all odds, the IPO ended up being extremely lucrative for investors; Visa's market cap at the time of IPO was around $39 billion, and 17 years later, the value is north of $400 billion. Company issued 406 million class A shares at a price of $44 (higher than the forecasted range of $37-$42), raising $17.9 billion through the offering, etching its name in the history books. To really understand its growth and journey since its IPO, I looked at Visa's share price for each month since its IPO:

Visa's growth and profitability could largely be attributed to its business model- Visa is not a bank, it does not issue cards or take deposit and make loans- but also partially to the management's capability to curb competition and regulation. Payments industry has seen plenty of new entrants (upstarts and fintechs) but they, at best, have only been able to smell the pie, not eat it. Visa and Mastercard have kept their dominance intact throughout the years. There was a time, not long in the past, when companies and groups of merchants endeavored to create their own network to rival Visa's VisaNet , but ultimately came to their senses and realized that it would be much better for their top and bottom lines to pay for a service rather than spending an exorbitant amount of money to create a network and then incentivize its usage and implementation. Big telecommunications companies also took a shot but then ended up partnering with Visa instead. The company, it seems, is very well acquainted with its market and any and all rising or existing threats- a welcoming treat that a lot of managers and companies simply do not possess. 

Visa's competition does not only stem from fintechs and start-ups, but also from companies with long standing histories such as Mastercard (MA), American Express (AXP), Discover Financial Services (DFS) and PayPal (PYPL),with AXP tracing its history back to1977. If we assess all of the companies by their share price (listed below), they have all witnessed ginormous growth in their price (with the exception of PayPal which has giveth and taketh), so what sets Visa apart? What sets the company apart is its global presence, its brand name, experienced management, and the company's laser focus on innovation and technology.

All of Visa's traits that I have mentioned are what experts refer to as intangible assets, so how do they play out in Visa's operations? Well, lets look at Visa's operational history since it went public. Before doing that, I would like to take a quick detour into Visa's business and various segments of revenues.

Visa's Business

Visa is one of the largest, if not the largest, leaders in the digital and electronic payments environment. Visa's primary business is to facilitate payments between consumers and businesses. Visa, since its inception and subsequent IPO, has been wholly vested in extending, enhancing, and investing in its proprietary transaction network: VisaNet. VisaNet offers a single connection point for facilitating transactions between multiple end points. The company offers and facilitates secure and efficient money movement among consumers; it also offers wide range of Visa branded payment products. As of 2023, Visa's revenues comprised the following items:

• Service revenues: These are earned for services provided in support of client usage of Visa payment service.
• Data processing revenues: These are revenues earned for authorization, clearing, settlement; value added services related to issuing, acceptance, and risk and identify solutions; network access; and other maintenance and support services that facilitate transaction and information processing among clients. 
• International transactional revenues: These are revenues earned for cross-border transaction processing and currency conversion activities.
• Other revenues: These revenues consist mainly of value added services related to advisory, marketing, and certain card benefits; license fees for use of the Visa brand or technology; and fees for account holder services, certification and licensing.
• Client incentives: These are not cash inflows but rather what Visa pays financial institution clients, merchants, and other business partners to grow payments volume.

Going back to why Visa stands out, Visa posted revenues of $3.6 billion in 2007 and operating income of ($1.5) billion with operating margins of negative 40.4%. Just a year into its IPO, in 2008, it almost doubled those revenues to $6.2B- YOY growth rate of 74.5%- and clocked an operating income of $1.2 billion- that is a whopping 185% YOY growth and margins of 19.7%. Fast forward to FYE 2023, Visa reported revenues of $32.6 billion with operating income of $21 billion- that is an operating margin of 64.3% and a CAGR of 18.9% over the last 17 years. For those of you that are visual learners, here is a visual depiction of the historic numbers and why I believe Visa has, and most likely, will stand the test of times. 

Valuation: Back to the Future

If you have stuck with me this far, I hope that I have set the stage right for my you. I wanted to make sure that there were no doubts about Visa's business and its operational, managerial, and growth story. Diving into my numbers, I would like to tackle Visa's various segments of revenues individually and try to dictate what my base case scenario entails. 

Base (Conservative) Case:

• Services revenues: I believe that the company is very well situated and will continue to increase its market share and as a result I expect services revenues to grow from 11% in 2023 to 15% in 2033. 
• Date processing revenues: I expect revenues for this segment to gradually increase from 10.9% in 2023 to 12.8% by 2022.
•  International transaction revenues: Given the incremental need of various countries to develop their own local payment processing systems and networks in the future, I expect the revenues from this segment to decrease from 18% in 2023 to 12.6% in the next 10 years.
• Other revenues: Other revenues consist mainly of value-added services coupled with other revenue streams that don't really fall into any of the other categories. I expect this segment to witness a modest decline from 24.5% to about 20% in 2033.
• Client incentives: Given the growing competition, both domestic and abroad, I expect that the company will have to keep investing to incentivize its platform over its competitors and so as a result, I expect client incentives to remain modestly flat- 19.4% in 2023 to 18% in 2033.

Given the growth assumptions above, I believe that Visa will grow its revenues at a CAGR of 11.7%, from $32.6 billion in 2023 to $98.6 billion in 2033. I believe that my assumptions adeptly reflect what I believe about the company; and with net debt of ($1,134) billion, long term growth of 3% and a WACC of 10.12%, I get the following price per share, in case you can't read, my base case gave me a share price of $257.25.

At the time of my valuation, Visa was trading at $256.31. I firmly believe that the company possesses the business fundamentals- brand name, competent management, viable products, and secured network- to justify its trading price per share and my DCF derived value. If we move onto my best case, which I must confess could very well be the base case, I get a price per share of $351.42. My weak case scenario, in which I assume there will be a recession down the lane and Visa might moderately suffer from its impacts, gives me a share price of $165.98. 

Forest for the Trees

I would like to end this post by saying that don't be completely engulfed by Visa's individual performance. It is imperative, in investing and the real world, to never loose sight of the bigger picture. It is important to understand the risks Visa faces and their downside. Visa has immense competition to overcome, and constantly being on the watch might cause the management to spasm. As stated in my assumptions above, Visa could lose market share to international rivals as countries are focusing more and more on developing home grown payment services and platforms. Competition isn't only global, domestically speaking, as of this post, I believe the Federal Reserve is planning to launch its own instant payment service referred to as FedNow. Finally, Visa is also prone to regulations similar to the Durbin Amendment in 2010 where the Federal Reserve put out a proposal to cap interchange fees. 

I think I have gone on for far too long. I can spend all day trying to amplify my assumptions and beliefs about the company and its future, but I think everyone is capable of thinking for themselves; and so I have attached my valuation to this post. Feel free to play around with numbers and make your own assumptions. 

Links:

Visa Valuation