(Half) DONE!

Well, no one said it would be easy. In fact, I'm quite sure everyone was saying it would be really hard. But we finished the operations exam (and by extention first year of our MBA program).

I think everyone generally agrees that Operations Management is the toughest course. And although I'm told engineers are supposed to have an advantage over our classmates when it comes to this course, I think my advantage may have left me when I wasn't looking.

Anyways, the class is heading to a variety of events tonight to celebrate, so I'll probably keep this short. Everyone's energy level has kicked up a notch as people are excited to move on. Some summer jobs are starting straight away on Monday May 3rd. A bunch of us are going on study tours (Latin America study tour flies out tonight and I'm told India study tour flies out this afternoon).

I'm excited to be going on the tour and will certainly keep a better blog post pace than recently.

Flirting with 0.5 MBA

We have entered exams week for Q4, the final quarter of our first year MBA program. We've started it off today with Managerial Accounting. Tomorrow, we have Global Managerial Perspective (GMP) and Friday will be Operations Management.

The other two courses, Business Ethics and Integrative Thinking Practicum (ITP) have major team assignments due, but most teams have finished this work well in advance of exams in order to focus their energies.

I've just moved to my new place closer to work downtown for the summer. I'm subletting from a friend who will be gone. I must say, it feels much more human to have moved out of my notorious "haunted house" in Chinatown near Spadina and College. In all fairness, a good friend of mine gave me some advice for first year: "You'll be at school most of the time until late anyways, so just get a place nearby so you can rest your head at night" and he was absolutely right. As much money as I would have saved staying at home, it was certainly worth the marginal cost to live close to school.

Allowance for Doubtful Collection

In continuing with the thoughts on revenue from last week, I thought it might be worthwhile to look to look at allowance for doubtful collection of funds. Generally, there are two methods which are used: % of receivables and the aging method.

The first method, % of receivables is quite simple and self explanatory. There is a predetermined percentage of receivables (calculated based on historic numbers) which is expected to default.

So assume that this is 1.85%. If the firm's gross revenue is $1M (and all credit sales), then the expected bad debt associated with those revenues is $18.5k. The net value of receivables is $1M - $18.5k or $981.5k.

The aging method is more sophisticated and provides a better picture, however, it requires a great deal more work.

For example: Assume the following definitions:
Normal - Receivables is between 0 and 60 days old (99% chance of collection)
Distressed – Receivables is between 60 to 90 days old (95% chance of collection)
In Default – Receivables over 90 days old (50% chance of collection)

Now assume that of that $1M, there is:
$900k of Normal AR
$90k of Distressed AR
$10k of In Default AR

The expected value of those receivables would be:
Normal – $900k x 99% = $891k
Distressed – $90k x 95% = $85.5k
In Default – $10k x 50% = $5k
Total value = $981.5k

I’ve chosen very particular numbers to get the same result as above, but this also proves a point. If the structure of your debts is predictable enough (or with little variation), a percentage of receivables method is essentially a sort of weighted average of probable defaults.

Winding Down, Gearing Up

While the MBA program is a very packed two years, it does seem to go by very fast. Already, we are almost halfway done (will be as of the end of next week). Yesterday, the GBC class reps had our last meeting of the year. In the last week, positions for various clubs have been announced and people are finding out in which capacity they will be assisting clubs. People have also started volunteering to prepare for the Orientation Camp 2010 for the incoming class (I've applied to participate in that also).

Unlike undergrad which (in engineering) we used to describe as "the worst four or best seven" years of your life, the MBA program is only two years which poses significant challenges when it comes to clubs. There is a very strong "in and out" mentality which is purely a function of the nature of the program when it comes to clubs relative to our undergraduate experience. However, many of the students have strong experiences in extracurriculars and work having passed through the recruitment and admissions process, so they are ready to be thrown right in and get right to it.

Already, there is some talk about some of the new initatives that will be undertaken next year and it will be exciting to see what results they produce. For the incoming class, I suspect that their experience will be improved from ours (which was improved from previous).

More than Mechanics

Many people are still job hunting (with some positive results being announced recently) and I've been collecting their experiences with the recruitment process.

One thing that is common with the successful candidates seems to be that they all have some form of edge and advantage to distinguish themselves from others. While it might be ironic to try to find a common thread which runs between a group in which individuals try to distinguish themselves, I think one of the common themes is the idea that there is more to finance than mechanics.

I can also appreciate that it is VERY easy to focus on the science, mechanics, valuation techniques etc. After all, that is the focus of this blog (generally speaking). However, as some of my colleagues in industry have mentioned: "Understanding the mechanics is table stakes. You can't play the game if you don't know the rules. But you can't succeed if you don't know how to build relationships."

So while having the technical skill is sufficient to do the job at a junior level, if you can't build relationships (leading to driving deals) you can't become a senior manager in finance (or anything really). And if you don't at least exhibit the potential to become a senior manager, you probably won't be given the opportunity to be a junior (after all, what's the point of hiring someone who doesn't have potential to excel?). Even the best Equity Research Analysts (considered one of the most quant jobs) are great at selling ideas. After all, who cares if you're analysis is perfect if you can't convince someone to look at it?

Having said that, a question asked by JD is a common question by people looking to enter the industry. How does my background fit when transitioning to a job (particularly finance)? In JD's case, with a background in sales in marketing (and any job in general) I'd focus on your ability to sell an idea. Don't worry about demonstrating your technical prowless.

While you need to strike a balance beween showing interest and going overboard, you can't expect to be able to answer EVERY technical question that comes up. As keen and diligent as you are, the person interviewing you has already passed the vigorous recruitment filtering process and is now doing this as their livelihood and is guaranteed 100% to know this more than you and drill you until you get to a place where you simply don't have the answer. It's more important to show interest, that you've taken the steps to learn as much as is reasonably possible and that you have the potential to excel.

Valuing Commodities Companies - Looking at P/NAV

Recently, I've been trying to learn more about commodities companies building on what we've learned in class as well as discussions with colleagues. Especially as Canada is a strong resource based economy (with a currency heavily influenced by the price of oil, I'm told), it is important to understand how these companies are valued.

Shree was previously very kind to explain why commodities companies provide leveraged exposure to the underlying commodity. In fact, I'm told that this is the reason why companies trade a P/NAV multiples greater than 1.

When I inquired as to what exactly Net Asset Value (NAV) was composed of, I was told that it is essentially the Asset Value (value of the commodity "in the ground") netted by the cost it took to get that asset out of the ground. So if you had to take a snap shot of what that company was worth, you'd intuitively assume that the value of the company was it's NAV.

However, as Shree demonstrated, the markets are always moving and the price of the commodity which the company bases its value on will change. This produces option like behaviour in the price of the company. While not a perfect explaination, I was told to think of it this way:

The value of the company is related to it's NAV PLUS a premium associated with the volatility of the commodity and the probability that the price of that commodity will increase. This is analogous to Intrinsic Value (NAV) + Time Value of a call option.

Obviously, there are a host of complicated relationships related to volatility, future price expectations, supply and demand, hedging and speculation which make this basic generalization a little too simple. However, I think it serves as a good starting point for how to think about and model the price.

This is similar to what we learned in Finance II when our professor explained the example of land that contained 1M barrles of oil which could be extracted at a price of $70 per barrel when the market price of oil was $60 per barrel. While a naive NPV calculation at today's rates would imply a negative NPV, the potential for the price of oil to top $70 provides real value to the land.

Another Look at Synergies

In thinking about OWC and also M&A recently, I was thinking about other possible forms of synergies rather than the two most obvious ones: revenue growth and cost reduction.

While not exactly the same as cost reduction, there are potentially certain economies of scale which can be achieved through reducing OWC requirements. Firstly, when looking at PV of CFs related to synergies, recall that FCFF (UFCF) is defined as:

FCFF = NI + Dep - Δ WC - Capex + Int (1 - t)

Increasing sales and decreasing costs will certainly affect NI, but I also thought that there was the possibility of also being more operationally efficient (reducing size of distribution networks, inventory holding requirements and demand / capacity mismatches due to manufacturing variations resulting in either lost sales etc). Most of these topics are the same topics ones we discuss in our Strategy and Operations Management courses and would affect all the activity ratios.

While probably not the most significant category of possible synergies, when dealing in deals worth millions or billions, I'm sure such attention to detail would probably result in noteworthy potential value creation opportunities. Also, this could be another potential reason why Stragetic buyers will probably command a higher premium than Financial buyers.

Another potential example I was thinking about was the idea of writing up intangible assets (which was the cause of my deal being dilutive). The value creation in this case, however, would be more for the target companies current share holders rather than the acquirers (and also be reflected in the division of synergies between the two groups through the premium).

The idea is that the target companies share holders gain value throught the premium which is the excess over fair market value. This excess is divided into write up of intangible assets and good will. While the acquirer "loses" some of the value through good will, it can reclaim some of the value of the write up of intangible assets through the tax shield provided by amortizing this value.

Again, while not as large an effect as the original two primary methods, I'm sure the attention to this detail will yield some additional value creation (and at least value retention for the acquirer) associated with an M&A deal. At the very least, the target shareholders can gain and the acquirers can give up less of their synergies.