Stuff I thought about last week 2-3-19
Greetings - we posted a new short paper this week on the broadening definition of fiduciary duty in the Information Age - let us know what you think, and as always reply back with any comments or questions.
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Stuff about Innovation and Technology
The value in Apple’s stock has been slowly transitioning from hardware to software and services as the fees it earns from 3rd party apps and its own services grow as a percentage of their total revenue and profits. This is in part due to the slowdown in demand for smartphones, tablets, and computers, but also in part because this services business is tied to the user base which continues to grow for Apple thanks to the 2nd hand phone market (up 9% over last year to 900M active iPhone users). I think this is a positive and important shift for Apple, but I’ve also written in the past about several sources of potential future pressure on Apple’s services business and wondered aloud whether the app store is a real network effect “platform” or a simply a distributor? If it’s a platform with strong internal network effects whereby each user of an iPhone benefits as other people use their iPhones more (virtuous circle), then investors would be smart to put a healthy future multiple on the services business. If, however, Apple is just a distributor of software and services, that business will be a less valuable component of Apple’s future. While we won’t know the answer with certainty for some time, I’ve come to believe app stores in general have characteristics more typical of simple distribution businesses and therefore may be over-earning today at the expense of the apps they distribute by charging too high of a fee. Recall Netflix’s high profile decision to no longer sell subscriptions through iOS as one example of this.
This week Apple appeared to bite off the head of a couple of those very apps that feed its services ambitions when it shut down internal access to critical enterprise apps at Google and Facebook. Both Google and Facebook were in error by using what’s known as internal apps (apps developed for a company’s employees that are not to be distributed to consumers including beta and test apps as well as apps used to run your business) with consumers to collect data on mobile phone usage behavior. These research apps were in violation of Apple’s terms and resulted in the suspension of developer licenses which thus shut down all the other internal corporate iOS apps. Reportedly this caused a bit of chaos at both Google and Facebook, and Apple did ultimately restore those internal apps after their period of punishment was over. To be clear it seems Google and Facebook were in violation and Apple was within their rights to shut down their developer licenses - this is pretty straightforward. It also seems a safe guess that Apple might have been punishing Facebook and Google intentionally knowing that this shutdown would cause their internal development and potentially operations to be heavily disrupted. Christopher Mims in the WSJ described it this way: “By bringing a gun to a knife fight, Apple reminded the world what power it has over not only other major companies, but anyone using a phone, tablet or computer bearing its famous logo.”
Last week when I talked about Facebook and Zynga I mentioned the important concept of borrowed network effects - do you control your platform or are you heavily reliant on some other platform’s network effect for survival - I wrote then:
“Regardless of what turns out to be true or causal here, there is a very important takeaway when running a business or investing in one: who owns the network effect? For example, if you sell your app on iOS, would your business survive an Apple policy change? If you sell your mutual funds through advisors, would you survive those platforms deciding to shut down active management options or in source various choices for their investors? In the Information Age, a direct connection to customers is easier and more vital than ever as distributors of all types of goods and services either shrivel or change their own business models.”
This seems particularly relevant with the Apple-Facebook-Google war this week - just how heavily reliant are these companies on iOS for distribution? Tim Cook has made it clear Apple will express its own judgment against apps and content that pass through the app store - that’s certainly their right as a business. Tim Cook has also made it clear he does not think social networking is good for people, and nothing internal stops him from a permanent ban of Facebook apps on iOS devices. Unless Tim also wanted to control all web browser traffic, users would likely be able to visit Instagram’s website but not have the functionality of something like Facebook messenger or the full apps. Consumers could then decide to switch from Apple devices to something else if they disagree with Tim - likely with some cost of a new device. However, other switching costs are now effectively zero as you can simply log into your apps on a new Android device with very little hassle these days. So, obviously Apple knows they risk a great deal in over regulating the app store.
Herein lies the core hypocrisy of Tim Cook - Apple claims to be a great defender of user privacy and declares with great arrogance that the user is not the product for Apple - pointing the finger at Facebook, Google (which will likely pay Apple around $10B this year in search revenue sharing!), and other tech giants that make their money on user data. And yet, Apple is begging investors to focus on the profit growth in their services business as their years of lagging innovation is causing slowing hardware sales - and, what is driving this services business? A mass of apps that make money off of user data. If Tim is serious about defining morality for Apple users, he’d have to shut down a lot of apps and risk losing much of Apple’s vital iPhone base. Making a few assumptions (which I want to be very clear could be wrong since I don’t have complete information), if Google’s TAC (traffic acquisition costs, or search revenue share payments) made to Apple are around the number that analysts estimate, then it could be 20-25% of Apple’s total services revenues. Further, this should be at near 100% margin - i.e., no cost to Apple. When you back that out, you see that the remaining 75-80% of Apple’s service revenues could be at a gross margin of closer to 50%, down from the segment’s reported 63% in the Dec 2018 quarter. One more bit of analysis for fun - if investors put a 20x multiple on the after tax profits from services, you see that roughly half of the market cap (and more of the enterprise value) is attributed to the durability of services (rough math: 16% of FY19 revenues as services at a 63% gross margin and a 25% tax rate at a 20x multiple is about $400B). And of this $400B, Google payments would theoretically represent $150B (over $10B at a 70%+ after tax margin) which is over 18% of the market cap and over 22% of the current enterprise value. One last point here, some investors argue for a multiple higher than 20x for Apple’s services (Microsoft trades at 23x this fiscal year’s consensus earnings and is a software and services business), so it’s possible I understate the impact here - is greater than a quarter of Apple’s current enterprise value driven by direct payments from Google, which Tim Cook places squarely in the “data-industrial complex”? It sort of seems that way! I want to emphasize that this is all speculative, and Apple continues to build a high value and growing annuity base of iPhone users creating an impressive free cash flow machine that appears durable today.
This week Google and Facebook got a taste of what it would be like if and when Apple decides to police the world even more, and it no doubt rang through as a warning to the other big apps out there reliant on Apple’s app store to reach their 900M users globally. What if Netflix broadcasts a show that Apple doesn’t like? What if Microsoft sells an app to a customer Apple doesn’t like? What if Amazon...well, you get the picture. I can’t help but wonder if there will be increased cooperation to make sure Android or some other open source mobile OS continues to take share from Apple. As I mentioned in the past, the big tech giants are no longer competing heavily with each other like they were 3-5 years ago (with the exception of Google and Amazon who are still waging a war of AI assistants). Microsoft has settled into a deep integration with Android. Amazon allows you to to purchase media like books in their Android apps, something they do not allow in the iOS versions due to Apple’s fees. Facebook does not compete with Google directly on anything material anymore (though they share the same advertiser customer base for their revenues). These 4 giants can do a lot to incent consumers to shift away from Apple, including launching apps first on Android or apps on Android with more functionality (like Office 365 exists today). These giants can also go directly to carriers and provide marketing dollars and rebates to support sales of one operating system over another. I doubt any of this comes to pass, but it again brings up two important topics I talk a lot about: are you a platform or a distributor, and who owns your network effect and relationship with the customers? This week Facebook got Zynga’d by Apple and got a little taste of what it feels like to lose control of your business to someone else without warning.
Changing the topic, but continuing with the theme of borrowed network effects, here’s some brief comments on the rising layoffs in the digital news industry so far this year: I am not sure what all the factors are impacting the slowdown in online journalism - clearly it’s not related to demand since we are in the hype-iest hype cycle of news the species has seen that I am aware of. So, there seems to be a lot of other negative factors at play. One is likely a saturation of sources - too much of the same. Another is the reliance on advertising, as we are seeing it become harder and harder to track users across devices, an increase in ad blockers, and other crack downs that favor the big data collectors like Google and Facebook over the small ad networks that generally support news websites. And, perhaps one of the biggest factors is that many of these sites were built off the network effects of Facebook and to a lesser extent YouTube. Because those platforms control user behavior in different ways through their algorithms, many media companies may find themselves without their user base and no way to get it back cost effectively. Another example of this is the shuttering of Machinima, a near 20 year old video gaming media business that at one point had hundreds of employees and hundreds of millions in revenue - possibly a victim of saturation and loss of audience (Machinima may be much more complicated as it’s part of the messy rationalization happening at WarnerMedia under AT&T).
Accenture developed software that facilitated the automation of 40,000 jobs internally over the last 5 years; the company then re-trained those 40,000 displaced employees to do things humans are (at least for now!) still better at. Now Accenture is making this software available to their clients. It appears the automation largely affected legacy BPO (business process outsourcing) jobs in low cost regions, but, by the nature of the AI, it will iterate, learn, and move up the decision chain. This will only accelerate as other companies in other industries adopt the platform. Currently, this is a part of Accenture’s business that was largely headcount based - charging a markup on cost of the employee to do the job; however, if Accenture can evolve to sell based on value created for customers by implementing automation, there could be a significant upside for their business as it continues to transition to digital. There also seems to be a looming downside here, felt by millions of emerging market BPO employees, that will likely spread to white collar jobs in the West.
Tens of millions of people logged on to Fortnite (and millions more watched on YouTube and Twitch) for a live concert on Saturday. I’ve talked a lot about gaming evolving into a full blown social network phenomenon, and platforms like Fortnite (which is multi platform itself and owns its customers and its network effect!) represent the biggest threat to legacy social platforms like Facebook, Snapchat, and Instagram. Communication tools like Facebook are the most fickle beasts for Internet companies to create, endure, and monetize - they tend to come and go unlike utility services such as Google Search and Amazon shopping, but there is something about game based communication that seems more like a simulation of real world interaction as opposed to the artificial “hey, look at me!” nature of something like Instagram. Communication tools like email, messaging, and social posts have a more difficult balance of monetization and user experience - it’s odd to have a conversation interrupted by an ad. However, games like Fortnite are (so far) monetized through totally different mechanisms than ads.
I am always interested in arguments for why a large company should be broken up, and when such arguments reference the amazing book “Scale” by SFI scientist Geoffrey West they are going to catch my attention even more. In this article the author argues that the big Internet platforms today are holding back the next wave of innovators - that might be true. And the author suggests that China is likely to create the next wave of innovators instead (though I would argue that China also faces the problem that Alibaba and Tencent are even more dominant than Amazon and Facebook). One counter argument I’d make is that the mathematics of the Information Age is power laws, and if we break up one power law market share player today, like Google for example, we are highly likely to only have a new power law dominant substitute in short order. So, a better proposal might not be to break up the Internet giants, but incent innovation and new ideas leveraging their data - assuring that no single company has a monopoly on data collection and data hoarding. Putting all these hypothetical guesses aside, I’d point to the Fortnite example above as a clear case that major platform innovation is happening and the mega platforms enabled it but don’t control it in anyway - so perhaps it’s a little pessimistic to say Google, Amazon, Facebook, and Microsoft are failing to innovate or disallowing innovation in the West.
I’ve been writing about the pending investment and upgrade to 5G cellular networks for a couple of weeks, and this week Nokia gave us a reason to be bearish short term as they see slower sales in the 1st half of 2019 followed by a pickup later this year and into 2020. Despite the likely decline of competitors Huawei and ZTE in the West, there is quite a bit of uncertainty at Western telco customers. In the US we have the potential consolidation of T-Mobile and Sprint which are unlikely to spend ahead of any decision. AT&T is contending with its DirecTV business and the debt from the recently acquired WarnerMedia. In Europe perhaps Brexit uncertainty and lack of customer demand is causing a pushout as Nokia suggests. So as a good Bayesian analyst, we have to take this week’s data as a small negative and be a little cautious as to when the 5G cycle will start and when incumbent equipment providers will benefit from pressure on Chinese suppliers. It remains hard to reconcile this with the bullish comments from Xilinx’s CEO I highlighted last week, but it’s possible Xilinx is benefiting from 5G growth in other areas - perhaps China is more rapidly deploying 5G to support its vast AI control network as well as prop up Huawei in a time of need.
This is a nice recap of how time flies as we get older because we aren’t learning and experiencing as many new things: “There’s an inversely proportional relationship between stimuli processing and the sense of time speeding by, Bejan says. So, when you are young and experiencing lots of new stimuli—everything is new—time actually seems to be passing more slowly. As you get older, the production of mental images slows, giving the sense that time passes more rapidly.”
The Criterion Collection is coming back to streaming! As you might remember I lamented the loss of this source for classic movies when it was shuttered by AT&T after the WarnerMedia acquisition. The theory is that AT&T is working to create a mega bundle of Turner, WB, HBO etc. content to rival Netflix, Hulu, and the pending Disney+ service. But, prior to any new Warner streaming launch they abruptly shut down their FilmStruck app, which combined Criterion movies with Turner Classics. The new Criterion selection will lack the TCM library, but maybe they can add on if the service is successful when it launches.
Stuff about Geopolitics, Economics, and the Finance Industry
In a New Yorker article this week by Evan Osmos, Baupost CEO Seth Klarman indicated “shortsighted business practices are imperilling public confidence in capitalism itself.” Klarman went further to lament he is part of a breed of investors that have a bad reputation: “Klarman believes that he and his peers need to prevent their field from being defined by some of its worst actors. “People will say the words ‘Wall Street’ with a derogatory tone. They’re talking about an immoral place, where there’s just disgusting amounts of greed and nothing good happens—which isn’t fair and isn’t true.” He said, “I’m not on Wall Street, I’m in Boston, but you’re tarred with that brush.” On balance, he said, “We’re complicated individuals. Each of us is good in this way; we’re not good in that way.” While it’s too easy and unfair for me to throw stones here, I have a bit of a hard time reconciling Klarman’s statements with Baupost’s large PG&E position - recall that PG&E is the utility I’ve written about a couple of times recently that has filed for bankruptcy because of years of prioritizing shareholder dividends over the safety of its customers and employees. I was a bit outraged in that same SITALWeek by the unforgivable comments made by another PG&E investor, BlueMountain Capital, indicating that PG&E’s only duty was to its equity holders - customers and employees be damned. I would have liked to see Klarman extend his views publicly to condemn the comments of BlueMountain if he in fact believes in his very important message delivered in his annual letter and New Yorker interview. But, to be clear, I don’t know if Baupost is still a PG&E investor, though they were recently buying PG&E’s insurance liabilities. My takeaway is that we are all facing some serious cognitive dissonance as we want to push forward positive outcomes, and need to be thoughtful about how and where we invest.
The PDF available at this link from the US China Economic and Security Review Commission is an interesting and important read on the US pulling out of the INF nuclear missile pact that Reagan and Gorbachev signed as it relates to China’s escalating arming. The crux of any potential escalating conflict, I believe, will be whether Taiwan can remain independent or not, which all comes down to the importance of semiconductors to the future of China’s ability to maintain communist control:
“China plans to threaten or use its conventional missile arsenal against both regional countries and U.S. military assets and bases in Asia in the event of a future regional conflict, including one over Taiwan or islands in the East or South China seas. If such a conflict were to occur, experts assess China would use its conventional missiles to destroy its opponent’s key military targets, starting with reconnaissance and early warning, command and control, and air defenses before moving on to missile sites, aircraft, and ships. The sheer number of Chinese missiles and the speed with which they could be fired constitutes a critical Chinese military advantage that would prove difficult for a regional ally or partner to manage absent intervention by the United States (see Figure 2). China has also already demonstrated a willingness to use its missile capabilities to intimidate and coerce an opponent in scenarios short of war, such as in the 1995–1996 Taiwan Strait Crisis, when Beijing fired missiles into the waters off of Taiwan. The missiles China fired during the crisis were DF-15 short-range ballistic missiles that would be banned by the INF Treaty.”
I am a broken record on this topic, but TAXES MATTER when you are managing a mutual fund!
If you are largely selling your product through middlemen distributors and they are potentially not earning their keep or even blatantly overcharging, do you have an obligation to make sure your customers aren’t being ripped off and their returns mooched away? This is a complicated mess of a problem for most mutual fund companies that don’t control their distribution, as advisors often overcharge.
How do major tax changes to the ultra wealthy impact charitable donations? I wondered about this last week when I mentioned the proposed wealth taxes. This week Sanders proposed a 77% estate tax for billionaires which I think would cause billionaires to sign up for Gates and Buffett’s Giving Pledge more so than they already have. Why pay 77% when you can give most of it away (for a tax break!) and still leave a lot to heirs? What you give away will likely have a much bigger impact and possible multiplier effect to counter inequality than simply paying more taxes.
Nothing in this newsletter should be construed as investment advice. I may own long or short positions in stocks discussed in this newsletter. This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I may change my opinions without updating them in the newsletter. Lastly, often I try to make jokes, and they aren’t very funny - sorry.
I was the portfolio manager of the Janus Henderson Global Technology products (ticker: JAGTX) from May 2011 to November 2018. Prior to that I held various roles as an analyst and portfolio manager at Janus Henderson Investors for most of the period starting as a summer intern in 1998 up until the end of 2018. I graduated from Williams College in 2000 with BAs in Economics and Astrophysics. A complete resume can be found at www.linkedin.com/in/bradsling
Investment framework co-authored with Brinton Johns “Complexity Investing” can be found here: http://www.evolusophy.com/complexityinvesting/
If you have any articles of interest, comments or questions please send them by responding to this email. I will generally try to read and respond to your comments or questions, but may not always be able to in a timely manner, for which I apologize in advance.