Valuation of Technology Companies for IFRS Accounting Purposes J.P. Morgan and McKinsey Technology M&A Workshop February 7, 2018 ValueTrust Financial Advisors SE www.value-trust.com Agenda Agenda Contact information 1. Start-up vs high growth companies: Still the dark side of valuation? 3 Prof. Dr. Christian Aders Chairman of the Executive Board 2. The Drillisch and 1&1 merger as case study 5 P: +49 (0)89 388 790 100 M: +49 (0)172 850 4839 3. Convergence period and consistent terminal value calculation 10 [email protected] 4. Valuation for IFRS impairment testing 16 i. Value in use 19 ii. Fair value less costs of disposal 24 5. Empirical analysis of tech and high growth companies 28 6. Practical implications and conclusion 34 Appendix 36 ValueTrust Financial Advisors SE Office Munich Theresienstrasse 1 80333 Munich Germany Office Frankfurt Bockenheimer Landstrasse 2-4 60306 Frankfurt am Main Germany www.value-trust.com February 7, 2018 2 1. Start-up versus high growth companies Start-up versus high growth companies Still the dark side of valuation? Start-up High growth Characteristics Characteristics § Innovative business model § Technology, IP and brand mostly key value drivers & § High uncertainty differentiators § High growth rates and negative cash flows § Often in the group of market leaders § Tax losses § High investments in intangible assets § Equity financed and liquidation preferences § Partial debt financed (but often still liquidation § Often no benchmarks preferences before IPO or sale) § In some cases a real option exists § Decreasing insolvency risk and changing capital structure over time § Declining growth rates and ROIC excess returns mid and long term Valuation issues Valuation issues § Discount rate for negative cash flows § Adjustment of cost of equity to decreasing § Scenario analysis operational risk profile § Changing risk profile over time § Cost of debt and tax shields are unsecure § Incorporation of insolvency risk in cost of equity or § Convergence rate for revenue growth and ROIC decision tree valuation approach § Appropriate planning horizon § Modeling of convergence from start up to high § Determination of long term growth rate and cost of growth company equity February 7, 2018 4 2. The Drillisch and 1&1 merger as case study Drillisch and 1&1 Telecommunication merger Background Valuation Opinion § In May 2017, Drillisch and United Internet entered into a Business Combination Agreement Valuation expert to the governing the acquisition of 1&1 Telecommunication by Drillisch under United Internet. management board of § With the acquisition, the two companies merge Drillisch's and United Internet's business to create a strong fourth player in the German mobile market. on the acquisition of § United Internet transferred 1&1 Telecommunication shares to Drillisch in a capital increase by way of contribution-in-kind under the exclusion of subscription rights. In return, United Internet received new Drillisch shares. Provided a valuation opinion in connection with the contribution in kind and assessed the appropriateness of the proposed exchange ratio § The valuation of 1&1 Telecommunication is agreed at EUR 5.85 billion, while Drillisch is valued at EUR 2.99 billion. Assignment ValueTrust has been retained to perform the following tasks to support the management: § Assess the appropriateness of the proposed exchange ratio for shares in Drillisch and 1&1 Telecommunication in the context of the contribution in kind § Analysis of the business plans including benchmarking and KPI analyses for both companies § Value Drillisch and 1&1 Telecommunication in accordance with the valuation standard of the Institute of Public Auditors in Germany (IDW S 1) as well as DVFA § Thereby using different valuation methods especially Discounted Cash Flow (DCF) after personal taxes according to IDW S 1, DCF before personal taxes according to DVFA and different industry multiples in the market multiple approach February 7, 2018 6 Transaction structure Corporate structure prior to transaction: 100% United Internet United Internet AG Investments Holding GmbH 100% 20,08% 1&1 Telecommunication SE Drillisch AG 100% 85% 1&1 Telecom Other companies GmbH Corporate structure after successful transaction: 100% United Internet United Internet AG Investments Holding GmbH >731) 1&1 100% Telecommunication SE Drillisch AG 100% 100% 1&1 Telecom Other companies GmbH 1) Status as of Q3 2017. February 7, 2018 7 Drillisch valuation is based on a two-phase model for reporting purposes Planning period TV External view in EUR m 2017 2018 2019 2020 2021 § Five years planning period + Terminal Value Gross Performance 699 823 953 1,045 1,125 1,286 Growth (in %) 23.4% 17.7% 15.7% 9.7% 7.6% n.a. (TV) § Traditional auditors approach Gross Profit 326 391 436 477 516 522 Margin (in %) 46.6% 47.5% 45.7% 45.6% 45.9% 40.6% EBITDA 174 235 278 313 348 300 Margin (in %) 24.8% 28.5% 29.2% 29.9% 31.0% 23.4% Internal view EBIT 125 201 247 286 325 243 § 14 years convergence + TV Margin (in %) 17.9% 24.4% 25.9% 27.3% 28.9% 18.9% § Convergence required to model beneficial Net Income 89 139 173 198 224 168 contract expiring in 2030 Margin (in %) 12.7% 16.8% 18.1% 18.9% 19.9% 13.1% § No disclosure of confidential company g = 0.5% information beyond planning period Timing of terminal value application should not affect equity value. Source: ValueTrust report. February 7, 2018 8 Implementation of a convergence phase (three-phase-model) and estimation of the appropriate Terminal Value growth rate Detailed Business Plan Convergence period Terminal Value Nominal growth rate in % g = 0.5% t 2017 - 2021 2022 - 2035 § Expected market decline of approx. § Revenue growth above market § Stagnating revenues as well as high 2% p.a. projections competitive pressure in the telecommunications market § Revenue growth due to price § Continuation of EBIT margin due to advantage from purchase agreement contractually guaranteed purchasing § Strong focus on price-sensitive with Telefónica conditions until 2030 customers § The purchase agreement with Telefónica § After expiration of purchase agreement § Increasing EBIT margin through is about to expire in 2030 with Telefónica probably partial loss of economies of scale in procurement price-sensitive customers Convergence period is required in order to model long-term strategy. February 7, 2018 9 3. Convergence period and consistent terminal value calculation Traditional two-phase DCF-model uses Gordon-Growth-Model for TV calculation Gordon- Business Plan Growth-Model FCF t 1 t 2 t 3 t 4 t 5 Terminal T+1 + + + + + Value = 110 100 130 200 100 WACC – g Enterprise = Value Present value of free cash flows (FCF) The future cash flows are discounted with the „cost of capital (WACC)“; discounting converts the value of future cash flows into the value of the cash flows at the valuation date. The enterprise value corresponds to the total amount of all discounted cash flows. February 7, 2018 11 Calculation of terminal value within the WACC approach (Gordon Growth Model) FCF: Free Cash Flow NOPLAT: Net Operating Profit IC × (ROIC - g) Less Adjusted Taxes TV = IC: Invested Capital WACC g - ∆IC: Change of Invested Capital mit: FCF = IC · (ROIC – g) ROIC: Return on Invested Capital (NOPLAT / IC) g: Growth rate of IC / FCF Implicit assumptions in the Gordon-Growth-Model for the WACC approach: - Constant leverage ! ³ - ROIC WACC Key: When are all variables constant? -gWACC = ROIC x Ie ΔIC - (Expansion-) Investment ratio: I = > 0 e NOPLAT February 7, 2018 12 Competitive advantage period determines the planning horizon The competitive advantage period (CAP) is the period during which the company achieves a return above the cost of capital. It can be seen separately from the length of the detailed planning horizon. ? ROIC > Economic reality: ROIC = WACC Competitive pressure reduces WACC profitability over time t Competitive Advantage Period Implementation of a convergence period for modelling purposes using the DCF method: Detailed planning phase Terminal Value ü Detailed planning phase Convergence phase Terminal Value February 7, 2018 13 Implementation of convergence phase and estimation of the TV growth rate Detailed Business Plan Convergence Phase Terminal Value Consistency of Assumptions 30% § The growth rate is usually determi- 25% ned exogenously based on market 19% analyses 20% 17% 14% • It has to be checked if the 10% NominalWachstum growth in % rate in % implicit ROIC resulting from this 10% 6% determination is higher than 2% 1% 1% the cost of capital (WACC): 0% 1 2 3 4 5 6 7 8 9 ROIC ³ WACC § § In the Detailed Planning Phase the § The Convergence Phase is mainly § The Terminal Value constitutes The growth rate can be determined business plan usually contains determined by the assumption of the the explicit valuation directly as a product of the sustain- able ROIC and reinvestment rate: • detailed assumptions speed of convergence (in other words assumption regarding the regarding growth and the number of years for convergence) sustainable growth level of the profitability, and to a “steady state” cash flows g = ROIC x I • detailed planning of income • Transition to Terminal Value § Precondition for the formula of statement, balance sheet • Derivation of long term growth the Terminal Value: State of and cashflow statement rate and transition to Terminal equilibrium and steadiness (so- The ROIC of the Terminal Value should be higher than the WACC § Typically, business plans show Value growth rate called “steady state”) still a very high growth rate and • Derivation of long term § Definition of the “steady state” margins above “market” level at profitability level and transition to requires Only when ROIC ³ WACC, a going the end of the detailed planning “market” margin • Constant growth/ profita- concern with retention makes phase • Derivation of dilution factor based bility/rentability sense on strategic analysis • Constant competition ratio/market share ratio The Convergence Phase has to be Immediate transition into etc.