Investors Focus on Tech Disruption Risks…

On my latest roadshow around Asia, the macro implications of new technologies were a key presentation theme and topic for debate as much as China’s leverage unwind, and indeed tech has been a sustained overweight and the subject of several notes over the past year, including the ‘Rise of the Machines’ looking at the next wave of automation published last April. On that topic, I suggest that every investor reads “The Second Machine Age” by Erik Brynjolfsson and Andrew McAfee of MIT, which I finished on my travels (and “The Zero Marginal Cost Society” by Jeremy Rifkin covers the same ground, albeit with a more utopian bias). They posit that advances in computer technology, robotics and artificial intelligence mean that an algorithm driven automation wave will erase many job functions over the next decade. It will also slash the profitability of many consumer facing sectors, as we’ve seen already from music to mobile operators, by crashing entry costs and margins. In Shibuya in Tokyo, I visited a café with 3D printing machines for hire for instant prototyping (mostly for Kawaii trinkets, from what I saw, but this technology is now going mainstream for niches like biomedical implants), an early sign of a very different future for mass manufacturing and the associated global supply chain. I met a hedge fund manager who is so paranoid about being eavesdropped that he uses the highly secure Telegram app for his instant messaging, and a proxy web server that hops around a dozen countries for everything else – I didn’t ask if he’s taking his fees in Bitcoins. Meantime, Alibaba bought a controlling stake in ChinaVision to launch a Netflix style content streaming business and a stake in a US messaging app to combat Tencent’s mobile threat ahead of its landmark US listing (which will likely ring the bell on the increasingly frothy wider social media/mobile web subsector near-term – note the selloff in equally heated US biotech).

The integration of neuroscience and software to give say a factory robot the intelligence to ‘learn by doing’ i.e. rewriting its own software code by simply repeating a task, would have profound implications. Indeed the topic of machine learning and its macro consequences are critical for investors to understand – one point I’ve made repeatedly is that the ‘cognitive threshold’ for a job in terms of its automation vulnerability is rising very rapidly now, and given the immutable IQ bell curve a substantial proportion of the population will simply become surplus to requirements. There are of course plenty of signs of this already, including high levels of graduate unemployment globally – about 3m Korean graduates are ‘economically inactive’ in an academically obsessed country, while US graduate underemployment is becoming entrenched. This looks quite different from the industrial revolution that began 150 years ago and which saw a huge migration in Europe and then the US from farms and country to factories and cities, driving a virtuous urbanisation/productivity cycle as repeated in recent decades in China. A trend I’ve highlighted is the growing concentration of household and corporate wealth and cash flows, the latter focused on the tech sector which is leading the overall economy toward a growing ‘dematerialization’ i.e. we need less capital and labour input for every increment of GDP and corporate revenue (and China will belatedly make that same shift, as its own tech giants begin devouring SOE margins). Think for instance of the implications of all those taxi booking apps proliferating from the US to China – by matching supply and demand more precisely and adding private limo supply (and in Uber’s case removing fixed pricing), they reduce redundancy and the overall fleet of vehicles required to serve any given population – Airbnb is doing the same to hotels by adding private spare bedrooms as a competitor.

Sophisticated data analysis reduces capacity slack in the system (as airlines have known for many years) but huge chunks of the global economy are now becoming subject to similar optimising ‘yield management’ software. If Amazon can generate a million USD of incremental turnover with a tenth of the labour and even less real estate overhead of a WalMart, the only rational response of the latter (and Tesco etc.) is to restructure their business model as margins get compressed. Having a large legacy workforce and real estate assets to restructure and downsize as new online entrants cherry pick your client base is a looming threat – there will however be a first-mover advantage for those adapting business models early.

Social Media Giants Battle for Mobile Dominance…

“The competition in mobile and the social space intensified. It is imperative that we increase our market space in mobile in order to stay competitive.” Sina Weibo’s CEO this week, echoing Facebook’s dilemma

“Party like it’s 1999…” Prince, who unwittingly wrote the anthem to the last tech bubble

I’ve been consistently overweight tech over the past year as a beneficiary of relatively scarce revenue growth momentum and global excess liquidity, as well as several new innovation driven growth cycles. Back in a note covering the ongoing upside for China’s social media giants last September, I highlighted that ‘…there is no question that we are now seeing similar global investor excitement over the potential of the mobile internet as the original PC based model back in 1999.’ The social media sector is essentially a smartphone screen ‘land grab’ at this stage with relatively low barriers to entry, and in investment terms a global momentum trade until clear winners emerge and/or overall customer acquisition growth rates peak – it’s dangerously late to chase the theme. Many fundamental investors understandably recoil from social media/mobile web valuations, but these companies will eventually be value destructive across huge swathes of a blue chip equity portfolio, as consumers shift their media and retail consumption as well as financial management to the mobile device, and revenues follow them. For the moment, investors in this exponential growth sector think less about fundamentals to focus primarily on numbers of users, their growth rate and engagement with the service as indicators of potential future revenues, as detailed below. In other words, ignore them at your peril as a force for classic technological ‘creative destruction’.

It is very likely that the market is over estimating the value of users at social media companies in aggregate, as many brands will fall by the wayside like fallen web giants (and early movers) MySpace or AOL over the past decade. As social media companies move up the life cycle, the variables to price companies will change from number of users/user intensity to revenues, earnings and cash flows. When that happens, there will be a repricing of social media companies, with those that were most successful in turning users into revenues/earnings being priced higher. The problem for companies (and investors) is that these transitions happen unpredictably and that markets can shift abruptly from focusing on one variable to another. For Facebook, the path to success with this deal is therefore simple, albeit not easy. Start by trying to attract Whatsapp users to the Facebook ecosystem, and hope and pray that the market’s focus stays on the number of users for the near term until you can monetize them in some sustainable way, and the user churn rate in these services is likely to be very high.

Facebook paid 11% of its market value, or approximately 35% of cash on hand and nearly 10x the company’s 2013 free cash flow for WhatsApp, which is worth more to Facebook than it is on it own because the competitive threat from mobile messaging services could cause a significant decline in Facebook’s valuation if the company didn’t act – they’re pretty good at game theory in Silicon Valley. If say WhatsApp gets to a billion users and it continues to charge them only $1 per year, that implies well over $600m in operating income, given that the only material costs are likely to be the 30% app payout to Google and Apple. That incremental EPS largely offsets the deal dilution. If Facebook has significant competition, and its acquisitions of Instagram and WhatsApp and the attempted acquisition of Snapchat signify that it believes it does, it’s hard to justify Facebook’s current valuation on a standalone basis, and using that high priced stock currency to pre-empt competitive threats, even in their start-up infancy, makes sense for the US tech giants (as Google has done recently with the UK’s DeepMind), although it will ultimately strangle innovation and deliver some form of cartelization of the internet.