The ‘Sharing Economy’ Shock…

The bedrock of economic exchange is trust, and technology now allows a reliable degree of ‘crowd sourced’ trust to be established between total strangers in order to share resources, which has profound implications for investors. As I’ve highlighted many times, a range of new online services are reducing slack and redundancy in the economic system – the internet from its inception has been about reducing search costs and price asymmetries between producers and consumers i.e a fundamentally deflationary force. These ‘sharing economy’ business models are typically zero marginal cost in terms of adding inventory, simply acting as a marketplace brokering transactions between individuals and thus have a potentially exponential growth path, explaining heady venture capital valuations.

Opportunities for these business models to tap into idle or underutilized inventory abound – the average car in a large Western city sits unused 90% of the time, and the opportunity to tap into that unused transportation capacity is the target of numerous start-ups. One of the most interesting I’ve seen recently is a grocery shopping service, that for a small fee sends a freelance ‘personal shopper’ and their car to the supermarket of your choice, to be delivered to your home. No new depots or delivery vans as captured by conventional capital spending measures and yet incremental productive capacity unleashed – this trend will make the US and other advanced economies inherently ‘lighter’ over the next decade.

We are seeing hundreds of similar ‘sharing economy’ apps from parking space rental in unused urban front drives to appliance sharing (does every garden shed really need a lawnmower?). Aside from the incremental impact of underutilized capacity being monetized over the next few years (implying fewer new hotel rooms/cars etc.), we are seeing an interesting cultural shift among the under 30s in the desirability or need for ownership, whether of a property or consumer durable.

Meantime, drivers of London’s iconic black taxi cabs (the ones that spew out noxious diesel fumes and often equally noxious political opinions if you’re unwise enough to engage in conversation with the driver) are planning to paralyse the city next month in protest against Uber’s expansion to London with its smartphone app based private car hire service. With average earnings of £40-60k depending on hours and whether they own or rent their cabs, taxi drivers pull in up to twice national average earnings for a skill which was rendered obsolete by technology a decade ago i.e. memorizing a map of London. They are likely to go apoplectic when US service Lyft (which is more of a pure sharing economy model allowing private individuals to become ad hoc taxi drivers) inevitably arrives in the UK. It’s a bit like dockside stevedores fighting the advent of containerization back in the 1960s, the hopeless battle of a closed shop against technological innovation and another bastion of premium semi-skilled incomes being demolished by Silicon Valley invaders – the overachieving geeks love nothing more than blowing up barriers to entry with some clever code.

The original sharing economy shock hit the music and media industries a decade ago, as consumers dis-intermediated the industry giants to become producers of their own content, creating huge value for platforms that rode the trend like YouTube. As covered in previous posts, the financial world is now in the cross hairs of the tech giants monetizing messaging apps as well as innumerable well-funded start-ups; we’re seeing a surge in innovation from peer-to-peer lenders such as Lending Tree to angel VC funding. Fund managers won’t be immune – for instance, online brokerage start-up Motif Investing offers professionally weighted stock baskets based on crowd sourced top-down thematic asset allocation ideas.

I’m in Silicon Valley next month visiting VC and hedge funds and looking at the next wave of these disruptive business models, which bear close watching for their impact on established industries and the confusion they are already creating in interpreting increasingly outmoded economic statistics (e.g. the freelancing/self-employment trend distorting employment data). We’re entering a world where anyone in a major city can use these platforms to freelance as an amateur landlord, taxi driver, tutor etc. and derive multiple income streams but also in the early stages of a technology driven economic shift which will have major implications for trend inflation, capex and profit margins over the next decade and should be a key investor (and indeed policymaker) focus.

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.

‘Internet of Things’ Set to Drive a Connectivity and Industrial Capex Boom…

5th December 2013

A key structural theme this year (see April monthly ‘The Rise of the Intelligent Machines’) has been to overweight global industrial capex/automation plays, in anticipation of a belated cyclical rebound in global factory investment, China’s growing automation trend but also a new wave of connectivity which is adding previously ‘dumb’ standalone hardware to the Internet and will drive an upgrade cycle. The jargon and acronyms in this emerging tech cycle can be confusing, but the bottom line is that makers of sensors, smartphone components such as radio chips and batteries, electric motors and automation equipment are all in an investment sweet spot over the next few years as technologies from the consumer mobile and gaming sectors are embedded within the industrial and urban infrastructure There are a number of new technology cycles gaining momentum, but this one will probably have the widest economic and market impact.  The so-called ‘Internet of Things’ (IoT) isn’t just about household appliances that can be remotely controlled, but a new generation of sensors and actuators embedded in physical objects from pipeline valves to factory machine tools that are for the first time networked.

These networks (of which Machine to Machine communication or M2M is an industrial/infrastructure subset of the IoT) then generate huge volumes of data for analysis and far more precise control of energy use, supply chain optimization etc. While investor/analyst focus has been excessively on smartphone sales to consumers, it’s crucial to understand that the wireless ‘ecosystem’ is rapidly expanding to encompass physical objects, whether household durable goods or parts of the industrial infrastructure, and this new market will be a key driver of incremental revenue growth for mobile component manufacturers (and indeed network operators). The combination of advanced gyroscope/visual/temperature etc. sensors plus wireless technology to create an intelligent network with real time feedback will gradually have huge economic impact, ranging from productivity growth to corporate margins and trend unemployment rates as more functions are automated.

More than 9bn devices around the world are currently connected to the Internet, including PCs and smartphones but that number will explode, with over 12bn M2M devices alone connected by end decade and upwards of 180-200bn devices in total from gaming consoles to fridges, cars and personal healthcare monitoring devices will have some form of internet connection on IDC estimates. Only a small fraction of those will use existing 3/4G wireless rather than wide area fixed WiFi networks and various short-range communication technologies. They will all need RF chips, MEMS based sensors etc. to function. Forecasts vary widely as to the market opportunity given a variety of regulatory and technology issues that need to be resolved (e.g. we will need far more IP addresses on the web) but with the cost of adding communications functionality to a device having tumbled sub $10, the classic tech ‘J Curve’ volume tipping point is in sight.

Can Chinese Smartphones Bundled With Local Apps Challenge Silicon Valley?

Is Apple really worth 45x Lenovo’s market value or Samsung 21x, given the shift in incremental smartphone penetration growth to emerging markets? Is Facebook worth more than 10 times Sina and Qihoo combined? I very much doubt it and although the valuations of US web stocks are touching euphoric levels, there is no question that we are now seeing similar investor excitement over the potential of the mobile internet as the original PC based model back in 1999 (reflected in China’s buoyant Shenzhen market). The winners from the current land grab in China’s mobile search and social networking markets will likely become leading emerging market technology brands over the next 5-10 years by bundling localized versions of their services in the new wave of cheap Chinese smartphones. Local pure internet plays are highly valued; the cheapest, Sina, trades at 4.3x book and 8x EV/sales,  Baidu on 9.5x book and 11x sales while star performer Qihoo, is on 21x EV/sales and 17x book. The hottest web stocks in the US like LinkedIn and Yelp are valued at about 20x EV/sales range, but all are further along with monetizing their audiences. However there are several credible Chinese stocks offering pure play exposure on low double digit earnings multiples, from Giant Interactive to NetEase and in a global tech portfolio, I’d be switching Chinese for US mobile internet exposure.

China is the only country in the world with a domestic technology sector of sufficient scale to compete against the US web giants, and the breadth of software innovation combined with an indigenous hardware sector makes it unique among emerging markets. As the PC cycle ebbs (although reports of its death are exaggerated) we are already beginning to see Chinese brands expand beyond their home market – Tencent’s WeChat for instance now has 100m subscribers outside China while Baidu has launched a range of its services in Indonesia. The symbiotic relationship between Chinese smartphone makers and local internet brands monetizing web services via gaming and advertising revenues is crucial. Back in the 29th January note on the potential for a breakthrough by Chinese smartphone manufacturers, I noted that: The rise of the ultra-cheap smartphones from upstart vendors which run on Google’s Android OS and use off the shelf chip designs is going to transform the industry over the next couple of years, which will see the sort of price and margin pressure experienced in LCD/LED TVs, where sustaining a brand premium has proved impossible amid endless discounting.’ Samsung and Apple wouldn’t disagree with that analysis. The recipe is to take MediaTek chipsets, Korean touch screens, add say 8GB of flash memory, and load the phone with the Android OS stripped of all traces of Google but pre-loaded with about 30-40 Chinese apps, which are increasingly being localized for Asian export markets.

The internet sector is unique within the Chinese economy in that it is dominated by a handful of forceful self-made entrepreneurs, and yet has benefitted from de facto protectionist government policies shutting out global competitors. The local media market is already highly sophisticated and focused on mobile. Compared to the US, where Americans spend 42% of time watching TV and a combined 38% on internet (mobile plus PC), the Chinese spend a much larger percentage of their media consumption on the web. This in part reflects the dismal quality of local TV and the need to go online for American TV steaming downloads (under 25s in China watch foreign TV series on tablets rather than TV sets), but it should still enable and encourage Chinese innovation in the mobile space.

China Gatecrashes Smartphone Market With Cheap Clones…

The smartphone market has had five years of turbocharged growth, but success will increasingly be determined on selling price rather than device branding as the key hardware technologies become commoditised. Last week, Apple’s share price decline from its September peak reached over 35% on underwhelming revenue and margin guidance, while Samsung also expressed caution on average selling prices for its smartphones.  As developed markets reach 50% plus penetration rates (over 60% in the UK and Spain), the incremental buyer will come from an emerging economy and be inherently more price sensitive. A key technology trend which will pressure margins is the launch of cheap ‘system on a chip’ processor designs from vendors including Qualcomm and MediaTek, which level the playing field for aggressive Chinese entrants like Huawei and ZTE. Meantime, the 4G networks being rolled out globally have been designed primarily for data rather than voice and use the same TCP/IP protocols that underpin the internet, so that the new generation of 4G/LTE (long term evolution) phones are optimized for streaming video and even multiplayer online games.

Value investing in technology can be dangerous, given ever faster product cycles and tumbling barriers to entry. When RIM’s share price hit over $60 in early 2011, it had PER, P/B price/sales ratios very similar to Apple recently, just as margins and revenue dropped as it followed Nokia in missing a rapid market shift and the stock slumped 90% over the subsequent 18mth period. The fast accelerating growth in Android focused mobile apps reduces Apple’s ‘user experience’ competitive advantage, but will benefit Chinese handset manufacturers as much as Samsung, as they are device agnostic.

The rise of the ultra-cheap smartphones from upstart vendors like China Wireless which run on Google’s Android OS and use off the shelf chip designs is going to transform the industry over the next couple of years, which will see the sort of price and margin pressure experienced in LCD/LED TVs, where sustaining a sustained brand premium has proved impossible amid endless discounting. Apple faces a tricky decision in how far it risks diluting its brand premium by introducing a lower cost ‘iPhone Lite’. Samsung’s overall growth in Q4 was driven by the handset business, which accounted for well over half the group’s operating profit for the year. Sales in the division rose 58% in the final quarter y/y and profits 89%, driven partly by strong uptake of the Galaxy series devices. The total smartphone market reached about $240bn in 2012, up 34% y/y, and smartphones now comprise of 83% of the global market by revenue (or 40% by unit volume). Apple’s share of global handset revenue is 29%, but only 7% of global handset units as Apple charges $618 per phone vs. the industry average of $149, given most basic mobile phones are priced below $50.

However, the company highlighted an uncertain outlook by breaking from its usual practice of giving a target figure for capital expenditure this year, but indicated that it would be similar to last year’s $21.5bn. The key line from the statement was that: “In the first quarter, demand for smartphones in developed countries is expected to decelerate.” That slowdown was inevitable given the typical pattern of penetration rates for new technology. Most independent analysts estimate that LTE smartphones with wholesale ASPs under $200 will account for the bulk of smartphone shipments within four years.

The market has plenty of unit sales growth potential as feature phones get upgraded; smartphone shipments will account for 50% of all handset shipments by 2014 and become the largest handset segment in the world, according to the latest market forecasts by market intelligence firm ABI. By 2018, smartphones will account for 69% of all handset shipments, and LTE handsets half of that smartphone total. It’s feasible that at the premium end of the market, Apple will be chasing Samsung’s technology leadership in 2013 through the foreseeable future. Since 2010 Samsung has grown its smartphone market share from 8% to over 30% in 2012; meanwhile Apple’s market share is expected to peak in 2013 at 22%; remaining flat through 2018. However, both companies face growing pressure from new entrants competing on price, as well as Nokia and RIM’s efforts to restore their lost market share (with a combination of the latter with Lenova an intriguing possibility).