I came, I saw, I botched – How MySpace was given away for a song

On Wednesday June 29 2011 Reuters reported that News Corporation had sold MySpace for $35 million to Justin Timberlake and Specific Media Inc. - an Irvine, CA based advertising company. Justin Timberlake?! I’ll get to that in a minute. This sale represents a return on investment to News Corp of –94%. 

This deal comes on the heels of a long auction process originally expected to raise hundreds of millions of dollars for News Corp’s exit strategy. In the end, Justin Timberlake emerged as the only white knight. Well, him and Specific Media. In an era where internet companies are commanding ridiculously high valuations in the billions of dollars, it’s hard to imagine the lackluster appetite investors have shown in MySpace's bidding process. Not to downplay Timberlake, but in 2011 where we’ve seen Groupon and Zynga file to go public; and LinkedIn, Pandora and Yandex already go public (all of which are expected to have valuations in the billions) if Timberlake was the best MySpace could do then something must have seriously gone wrong.

News Corporation acquired MySpace for $580 million by outbidding Viacom Inc. in 2005 at a time when MySpace had tremendous potential and was poised for triple digit returns. Or so they thought. However, what actually happened has been a totally different story. News Corp’s management of MySpace has been characterized by one execution flaw after another. I’d like to address one of those – how MySpace handled (or mishandled) its 2009 acquisition of San Francisco, CA based social media company Imeem.

Imeem started in 2003 as a social media website where users could legally share, upload  and stream music and music videos. Imeem was a pioneer of a revolutionary business model – free, advertising supported online music. Imeem generated revenue through online advertising, MP3 downloads, sale of tickets and ring tones, and subscription fees from premium account users. Unlike Pandora where free accounts get only 40 hours of internet radio and are also unable to create their own playlists; Imeem users had unlimited access to stream content online and customize  playlists from different users. It was a daring model and Imeem would have been an explosive success if they had achieved their break-even number of users before the credit crunch hit. They hoped to generate enough critical mass from the free online model in order to raise advertising revenue to pay for music royalties. In 2007, Imeem became the first online music site to acquire licenses from all four major US record labels - Universal Music Group, Sony Music Entertainment, Warner Music Group and EMI Group. However by December 2009, the credit crunch had forced Imeem into solvency problems as it was hard to generate sufficient ad revenue to pay for royalties. MySpace acquired it in a fire-sale for an undisclosed amount.

MySpace's integration of the newly acquired firm was executed horrendously. They botched the migration of Imeem’s data onto their servers in a monumental manner. Within days of the acquisition, MySpace decided to import everything from Imeem onto MySpace servers and shutdown the Imeem website. As an Imeem user, I remember receiving an email from MySpace telling me to create a MySpace account and import my playlists within seven days. With MySpace's convoluted website architecture and its own restrictions on music offerings, many users either ignored the email and lost their playlists as a result; or those that created MySpace profiles, couldn’t find their playlists.

Within a few weeks, MySpace had managed to single handedly alienate millions of Imeem users; effectively making the acquisition worthless. The strategic rationale for the acquisition was to attract more users onto the MySpace site in order to increase web traffic, bolster ad revenue and rival Facebook. MySpace had failed to achieve all three.

Instead of trying to migrate Imeem “overnight”, MySpace should have proceeded with the integration on a phased time table. Just like Google did with YouTube when they acquired it in 2006, MySpace should have maintained Imeem as a subsidiary (while maintaining the Imeem site) and then figure out a way to address royalty payments -  perhaps by making the subscription service more attractive and limiting free users to say X hours of streaming, like Pandora does.

They could have figured out creative ways of generating additional revenue such as bundling the free streaming with other services to attract more traffic to the site. The free streaming would serve as a “loss leader” to attract more profitable complementary services. The idea is once you bundle the free service with other attractive services, you tie your users and increase their switching costs. Over time you limit the complementary services to only premium accounts by which time users’ switching costs would be so high it would make sense for them to buy a premium subscription. It’s been proven empirically that products with high switching costs tend to be inelastic (i.e. less price sensitive). At this point the premium accounts could be tied with “free” file conversion software, online games, messaging service and so on and so forth. These would make premium very attractive, thereby having a consistent fee service plus ad revenue to pay for royalties.

They could also have opened up the Imeem platform to open-source developers to design additional services to complement Imeem’s core offerings. Such a penetration pricing strategy would probably have succeeded in making Imeem a dominant platform. In the technology space, free and open source platforms tend to dominate through network effects. Think of how Google’s Android OS is rapidly gaining market share from Apple’s iPhone iOS.

Once Imeem became the dominant platform thereby increasing the switching costs of users, MySpace could then gradually migrate users on a pilot basis until all Imeem users had MySpace accounts. Once their playlists remained intact, it would almost be guaranteed that Imeem users would visit MySpace in a phased migration. However MySpace lacked the vision, strategy, creativity and execution to stay committed to a working plan that would probably have taken many months (perhaps a few years) but could have been successful.

One can point anecdotally to Former IBM CEO Lou Gerstner who noted that a corporate strategy is only as good as its execution. Think of how GE integrates its subsidiaries – on a gradual basis. Or how Oracle integrated Sun Micro Systems after its acquisition. Or how Google allowed Google voice users to send free international text messages for months before introducing a billing service. It’s all about tying and bundling packages for users.

Instead, MySpace destroyed any potential of accreting value from the Imeem deal and eventually had to cut its losses and exit. Such is the difference between success and failure – having the vision and commitment to work out a gradual plan. In the end MySpace has become a poster child of how NOT to integrate an acquired company.

Remembering Chernobyl and what it means for the energy challenges of the future.

On April 26 1986, a series of explosions at a nuclear power plant in Chernobyl, Ukraine led to the emission of huge amounts of radioactive contaminants over a wide geographical area. Much of Europe was contaminated with catastrophic levels of ionizing gamma radiation and nuclear fission particles including radioactive iodine, cesium and strontium.  As of 2008, the WHO estimates the deaths resulting from the long term effects of the radioactive fallout from the accident at 4,000. Other estimates range from 200,000 to 985,000. On the 25th anniversary of what has become the worst nuclear accident in history, it’s important to reflect on the role of nuclear energy and engage in a broader discussion on global energy consumption patterns.

The US Department of Energy estimates that nuclear energy currently accounts for 20% of US electricity and 70% of its “carbon free” electricity. Fossil fuels account for close to 70%  of US electricity generation with coal accounting for 46%, natural gas 23% and petroleum 1%. Coal accounts for the bulk because it is a relatively cheap source and it occurs naturally in abundant proportions in the United States.

Unfortunately, burning fossil fuels to generate electricity leads to significant environmental pollution. Combustion of coal for instance produces unfathomable amounts of green-house gases such as carbon dioxide, carbon monoxide, sulfur dioxide and heavy metals like mercury, uranium, thorium and arsenic. Plumes of thick poisonous smoke billowing from coal-fired plants produce significant amounts of fly and bottom ash that permanently stay in the earth’s atmosphere and become smog. Aside from the green-house gases and their well known effects on global warming and climate change, the ash predisposes residents in close proximity to fossil-fuel combustion plants to lung cancer. Coal mining can also affect the water table and contaminate underground water. Arsenic and mercury poisoning of underground water resources has led to many deaths in Bangladesh and neighboring countries. In addition to the green-house effects of sulfur dioxide, it also contributes significantly to acid rain.

With such a devastating environmental impact, it’s important to focus attention on carbon free sources of energy. The Obama administration has been making a strong push for clean energy with emphasis on renewable sources such as wind, solar and hydroelectric power. In December 2010, however, Energy Secretary Steven Chu said that the administration’s push for a clean energy standard could include non-renewable sources such as nuclear energy and clean coal. While nuclear energy is carbon free it comes with a separate set of costs. In the wake of the Fukushima I nuclear crisis following the March 11 tsunami in Japan, nuclear energy as a source of generating electricity has come under serious scrutiny.

Nuclear power is produced by the splitting of the nucleus of dense fissile material (such as uranium or plutonium) which generates an incredible amount of energy. This reaction is referred to as nuclear fission. Nuclear fission is exothermic (meaning heat is released) and it is that heat energy that powers a nuclear reactor to generate electricity. The problem with nuclear fission however is that the nuclear chain reaction produces particles that are different from the original element, a process called nuclear transmutation. Therefore the fission products – iodine, cesium, krypton, cadmium, strontium, xenon, lanthanides, etc tend to be highly radioactive. They have unstable nuclei and decay spontaneously by emitting ionizing radiation. They become even more dangerous when radioisotopes of iodine and cesium get absorbed in the human food chain. These ultimately become silent killers because they are absorbed into the leucocytes predisposing people with prolonged exposure to leukemia and other forms of cancer. Cesium-137 is even more dangerous this way because it has a half life of 30 years. This poses a serious problem for nuclear waste disposal and storage.

Normal waste can be easily disposed – hydrocarbons can be recycled, organic waste decays naturally because it’s biodegradable and the rest can be incinerated. The problem with nuclear waste is infinitely more complicated. Uranium 235, the uranium isotope used as a fuel rod in nuclear plants has a half-life of 700 million years. Half-life is the time it takes for an element undergoing radioactive decay to decrease by half. With a half life that long it becomes a major headache to safely dispose of spent nuclear fuel. It’s also worth noting that while spent uranium undergoes its natural decay in storage it emits particles/fission products that are also radioactive.

The largest environmental cleanup exercise in the world is currently underway at the Hanford nuclear site in Hanford, WA.  Hanford was the first full scale plutonium production reactor in the world. The plutonium bomb dropped on the city of Nagasaki during Word War II was manufactured at Hanford. The facility was decommissioned in the 1970s but disposal of the radioactive waste has been a problem since then. Much of the spent nuclear waste on the site is stored underground in double shell tanks. These tanks have corroded from rain over the decades and it is feared that liquid radioactive waste could seep into the ground and contaminate the area’s underground water and possibly the Columbia River further downstream. A major groundwater remediation project costing the government billions of dollars is currently underway there. Furthermore, the Hanford Waste Vitrification Plant (after construction is complete) will process nuclear waste into canistered glass logs for long term disposal at an underground national repository yet to be determined. The purpose of vitrification is to make radioactive waste stable (neither decay nor react with other elements) by heating the radioactive waste in a furnace with fragmented glass. The resulting glass is a new substance in which the waste is bonded into the glass matrix when it solidifies. This new glass is very stable and suited for long term underground storage for up to thousands of years. This project has been ongoing for close to a decade and it’s expected to cost the federal government up to $200 billion in 50 years.

Obviously, nuclear energy is not necessarily “better” than fossil fuels as the costs of disposing spent nuclear fuel is enormous. In addition, nuclear reprocessing technology can be used to sequester and harvest fissionable (weapons grade) plutonium from spent nuclear fuel to manufacture nuclear weapons. Over 90% of spent nuclear fuel is made up of several isotopes of uranium. Reprocessed uranium can also be re-enriched to recover Uranium-235 which is weapons grade. The by product of uranium enrichment, depleted uranium is commonly used in mortar shells of army tanks. Given it’s potential to lead to the proliferation of nuclear weapons, spent nuclear fuel (or their lack of proper disposal) poses significant challenges. Despite this grim picture, there is some hope. There are significant technologies out there that can considerably facilitate the disposal of heavy metal and nuclear waste.

Two such technologies were developed by ChemNano Materials Limited, a startup based in Akron, OH. The company owns patents to two technologies that remove heavy metals and radionuclides (including uranium and plutonium) from liquid or gas. NanoDM is the sequestering agent for heavy metals and NanoUREX for radionuclides. NanoDM can remove heavy metals such as lead, mercury, zinc, arsenic, copper, chrome, and cadmium from liquid or gaseous industrial waste in two simple steps. Waste streams from coal fired plants, ore refineries or chemical processing plants that contain such heavy metals pass through NanoDM which then captures the target metals after a few hours of contact. NanoDM sequesters the metal waste onto solid NanoDM polymer matrix. The efficiency of this technology can significantly save millions of dollars by eliminating several stages in the current treatment of the waste. This technology can significantly complement current clean coal technology to make coal more appealing as a source of energy.

NanoUREX sequesters liquid radioactive waste nuclides onto a solid nanotube matrix. By passing the liquid radioactive waste over the matrix, NanoUREX concentrates the liquid waste which makes it coalesce into solid around the nanotube matrix. This can considerably reduce the volume of radioactive waste for storage. A 2005 Congressional report states that as of the end of 2004, total inventory of discharged spent fuel from nuclear power plants across the country was 54,000 metric tons. NanoUREX can help reduce the volume of this radioactive waste considerably. The technology can also complement the vitrification plant at Hanford, WA by reducing the volume of nuclear waste that has to be vitrified for storage.

Furthermore, significant investment should be made into Carbon Dioxide Capture and Storage (CCS) technologies. CCS is a broad term that encompasses a number of technologies that can be used to capture CO2 from point sources, such as power plants and other industrial facilities; compress it; transport it mainly by pipeline to suitable locations; and inject it into deep subsurface geological formations for indefinite isolation from the atmosphere. As world energy demand increases, propelled by China’s exponential growth, much of the supply has come from fossil fuels. This has had adverse effects on climate change and global warming. Therefore clean coal will remain a critical tool for the future management of energy policy.

Finally and most important, renewable sources of energy should become an integral part of global energy needs. Wind energy, hydroelectric power, geothermal energy, tidal energy, biofuel, ethanol, and solar energy must be encouraged to help reduce the carbon footprint from fossil fuels. An August 2010 BusinessWeek article titled “Obama: Clean Energy's Venture Capitalist-in-Chief” commented on the administration’s aggressive policies towards promoting renewable energy. I think the President is making the right bets by promoting sustainable energy. The costs of inaction could be much worse.

KALEVOR: Accounting treatment of Convertible Debt and Bonds with detachable stock warrants – a conceptual evaluation

                                           Source of image: Investopedia.com

Behavior of the Price of the conversion option of a Convertible Bond

When I was at Simon, my Corporate finance professor, Cliff Smith had a fascinating way of using humor to engage us in an otherwise technical, often boring subject. During one of his classes on capital structure, he once joked that “on Wall Street, when debt is not straight, we don’t call it gay - we call it convertible.” I was like, what? I couldn’t stop laughing but neither could I stop paying attention. With that said, let’s get a little technical.

The accounting treatment for convertible debt has always attracted a great deal of controversy. The bearer of a convertible bond has the option to convert the bond to equity within some specified time after issuance. The hybrid nature of convertible debt affords the investor the security of holding a bond (guaranteed interest income plus principal at maturity) as well as the flexibility of the added option of conversion if the value of the issuer’s stock appreciates considerably. For the issuer it offers two main advantages – to raise quasi-equity (or mezzanine capital) without necessarily diluting EPS and secondly to raise debt at a cheaper rate. If Google needed to raise $2 billion for instance and the current stock price was $500, it would have to issue 4 million new shares which would have a major dilutive effect. On the other hand it could issue 2 million convertible bonds at $1,000 par each convertible into 1 share of common stock. This way Google is able to raise the $2 billion it needs but only commits 2 million shares instead of 4 million. In addition, issuers are able to raise convertible debt at rates much lower than current market yield to maturity on similar rated straight debt. For instance, Google could issue its convertible debt at a yield to maturity of say 4.5% when the effective yield on similar rated straight debt would be say 6.5%. By foregoing this 2% spread, investors acquire the right to convert their bonds to common stock at a specified time period after issuance.

The conceptual dilemma lies in the accounting treatment of convertible debt at the time of issuance. At the date of issue the method for recording convertible debt follows that of straight debt – all proceeds are recorded as debt, none as equity. The reasons are that at the time of issuance, it is difficult to predict when, if at all, conversion will kick in. At the time of conversion, the debt ceases to exist and is converted to equity. So for instance in the Google example, at issuance the following journal entries would occur:

Cash	$2 billion
Bonds payable		$2 billion

If all the investors converted their debt into equity and Google common stock had a par value of $10:

Bonds payable	$2 billion
Common Stock (2 million * $10)		$0.02 billion
Paid in Capital in excess of Par		$1.98 billion

While this current treatment is logical as the debt ceases to exist after conversion, merely ignoring the equity component of a hybrid security misrepresents its economic reality. The reason is that at issuance investors receive a lower yield on convertible debt compared to similar straight debt. This lower yield represents the opportunity cost of acquiring the conversion option. Secondly, by converting to equity, investors actually lose future interest income till maturity and the principal itself. So why then are we not separately accounting for the equity component at issuance, if the opportunity costs (which are real and quantifiable economic costs) of the conversion option and the equity itself are so significant?

To better understand this argument, let’s compare convertible bonds to a straight bond issued with a detachable stock warrant. As the name suggests a detachable stock warrant can be separated and traded as a separate security from the underlying security (in our example a plain vanilla bond). The warrant is essentially a long term option to buy common stock at a fixed price. The FASB treatment for such securities is to separately account for the debt and the equity component.

For instance, let’s assume that Amazon issues 10,000 bonds with 5-year detachable warrants to buy one share of common stock (par value $10) at $28. These warrants would enable Amazon to price its bond offering below market yield of similar debt that didn’t have such warrants. So for example Amazon’s bonds would normally sell for say 95 cents on the dollar without the warrants based on Amazon’s bond rating. However, because the bonds were issued with detachable warrants they would sell for say par (100 cents on the dollar). Assume further that Amazon’s investment bank estimates the market value of each of the 10,000 warrants to be $30 and that the price for the 10,000, $1,000 par value bonds (with the warrants) was $10,000,000. With these facts, the allocation between debt and equity would be as follows:

Fair market value of bonds without warrants ($10,000,000*0.95)	$9,500,000
Fair market value of warrants ($30*10,000)	300,000
Aggregate fair market value	$9,800,000

So the allocation would be as follows:

Allocated to bonds: (9,500,000/9,800,000)*10,000,000

$9,693,878

Allocated to stock warrants: (300,000/9,800,000)*10,000,000
       306,122

$10,000,000

So here, the investor is buying both a bond and a possible future claim on equity (detachable stock warrant) for which he pays $306,122. The bonds (without the warrants) would have cost $9,693,878 but investors pay $10,000,000. The difference of $306,122 is the price of the stock warrant.

If all 10,000 warrants were exercised the following journal entries would be recorded:

Cash (10,000*$28)	$280,000
Paid-in-Capital – Stock warrants	$306,122
Common Stock (10,000*$10)		$100,000
Paid-in-capital in excess of par		$486,122

So the difference between this and a convertible bond is that the underlying bond continues to exist after the warrants are exercised but a convertible bond no longer exists after conversion. Arguably, the conversion feature of a convertible bond is not significantly different in nature from the call represented by a warrant. The litmus test is whether sufficient similarities exist to require the same accounting treatment regardless of the different legal forms.

In its current exposure draft on this issue, the Financial Accounting Standards Board (FASB) suggests that companies should separate the debt and equity components of securities such as convertible bonds. This seems like a reasonable assertion and I’m personally leaning towards it. The fact of the matter is, in either case (a convertible bond and a bond with a detachable stock warrant) the investor makes a payment to the issuer for an equity feature – the option to acquire common stock at some future date. In both cases the payment for the equity option is in the form of a lower yield to maturity compared to the market yield on similar traded straight debt.

The only real distinction between them is the additional payment made when the equity is actually acquired – for a stock warrant, the holder pays additional cash to the company ($28 * 10,000 = $280,000 in the Amazon example); and for a convertible bond, the holder forfeits the present value of future interest income till maturity plus the principal. Clearly, the only real difference between these two hybrid securities lies in the method of paying for the equity component if/when it is exercised; but the economic substance remains the same, regardless of legal form. Based on this, I think it’s fair to expect these two to receive the same accounting treatment at issuance. However, until the accounting rules are amended to reflect this similarity, convertible bonds will continue to remain a controversial issue.

The Godfather–The Pursuit of the American Dream by an Immigrant Family

Michael Corleone

Statue of Liberty

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Kicking with my big brother, watching the Godfather II and blazing a cohiba while at it. It was a perfect way to decompress on a rainy weekend in the Pacific Northwest. I make it a point to watch the Godfather trilogy at least once a year as it was pivotal in shaping my passage to adulthood. I haven’t seen the movie in the last two years as the pressures of life have prevented me from doing the things I enjoy. Watching it again this weekend gave me an opportunity to reflect and contextualize the movie to contemporary challenges.

The Godfather II is my favorite among the three. Michael Corleone was ruthless, cunning and nefarious. He called everything right except for killing his own brother Fredo. After finding out Fredo had betrayed him to Hyman Roth, I would have shipped him (Fredo) some place faraway to keep him out of the loop but not kill him. I understand why he did but that wouldn’t be my choice – I’d never kill a brother under any circumstances. Nonetheless, Al Pacino played the role masterfully. Tom Hagen was ever so smart, eloquent and witty as Consiglieri of the Corleone family. How he got Frank Pentangeli not to testify at the Senate hearing is still a mystery to me. It’s a testament to his resourcefulness - Robert Duvall gracefully played this key character. And last but not least, my personal favorite; Robert De Niro as Vito Corleone. It was just a delight to watch De Niro speak Italian. Vito’s meteoric rise to become the boss of all paisans in the Bronx was catalyzed by a single action – his assassination of Don Fanucci. He knew how to pick his battles and he hit it hardest when it counted the most. He cleverly outmaneuvered Pete Clemenza and Sal Tessio (who both introduced him to crime) to become their Don. Brilliant!

Vito Corleone arrived on Ellis Island in 1901 when he was 9 years old from Corleone, Sicily. His whole family had been murdered by Don Ciccio, a rival mafia chieftain who was locked in a turf war with Vito’s late father, Antonio Andolini. He came to America at a time when the US had opened its doors to immigrants from Europe. It is widely believed that the derogatory term “wop” (meaning without papers) referred to Italians because unlike the other Europeans, they were required to carry their immigration papers. I’m not sure how true this is but this didn’t deter young Vito from getting on a ship to America at age 9. It is a testament to the bravery, courage, determination, hard work and resourcefulness of many immigrants in pursuit of the American dream.

Let’s contextualize the Corleone family’s story to the struggles of modern day immigrants in particular international students looking for work in the US. From time immemorial, the US has attracted the best and brightest from around the world because it has always opened its doors to talent. According to Simon School – University of Rochester Dean Mark Zupan, the US has always benefited from this open door policy and tends to lose in the long run when its policies become inward looking and protectionist.

Dean Zupan’s comments come at an important time for this country especially as the economy starts to recover from the deepest recession since the Great Depression. Typically the international students that come to the United States are people that are very smart, highly motivated, hardworking, entrepreneurial and willing to take calculated risks. These are traits that are overwhelmingly synonymous with American values. It was these same traits that drove the pilgrims, the Irish, the Jewish, the Italians, etc to come here. The biggest innovations of the past two decades have come from foreigners working in PhD labs in American universities. Protectionism especially of high caliber talent stifles these traits, kills innovation and in the long run America loses. I have never seen the Godfather through these lenses before but there’s no limit to the kind of things this movie opens your eyes to. That’s what makes it an all time classic.

Unless an international student gets extremely lucky, the challenges he has to face to navigate these issues are unimaginable. Under the shadow of student loans from American banks that are almost impossible to defer, the odds are dire. Yet, I’m sure many international students wouldn’t do anything differently in hindsight. After all, it is the ultimate pursuit - the pursuit of the American dream.