Monday, 30 July 2012

Facebook - why its still expensive

The use, and abuse of valuation ratios

Investors place great store on valuation ratios - P/E being the usual suspect, EV/EBITDA if you feel like completely ignoring the capital intensity of a business (particularly widely used - bizarrely - capital intensive businesses like telcos), EV/Sales if you're a growth junkie.

The most notorious offender is of course the PEG ratio (P/E-to-growth) which I call the Great Glass Elevator of valuation ratios. It basically tells you that the elevator is going up very fast, without giving you a clue as to when its going to smash very hard into the top of the lift shaft. Therefore it only works if, like Charlie's Great Glass Elevator, there is no top of the shaft and you can simply carry on going up.

Anyhow I digress.

The important think to remember is that financial valuation ratios are useless as standalone tools to valuation. The only measure of true value of an investment is the value of its cashflows to the holder, best assessed by a discounted cashflow or its more esoteric (but neglected cousin) the EVA model. And yes I am aware both of these are hostage to your cost of capital assumption. Hey, no-one's perfect.

However where valuation ratios are useful is as a convenient shortcut to assess valuation. A back-of-fag-packet calculation. An arrow on the treasure map which points towards the treasure lies. And so long as you don't mistake the arrow for the treasure, they can actually be quite useful.

Facebook is a case in point. With the shares having crashed a cool 19% in the past week there has been a huge debate over its growth prospects. Its worth using an EV/Sales ratio to unpack what growth the market is still pricing in.

The market still thinks Facebook can do $12bn of revenues

I presented a very quick-and-dirty version of this analysis in an earlier post. What I'm doing now is updating and refining it, based on Facebook's recent falls.

A quick recap. The Price/Sales ratio (or EV/Sales as I'm using here, which nets off Facebook's $2bn cash pile) presents the value of a company as a multiple of its sales. Actually as I said before, the fundamental value of the company is tied to the amount of cash profit it generates, so the EV/Sales multiple is really a shortcut which assesses how good a company is at turning sales into profits. A higher multiple if its better at this, a lower one if its worse.

This is, of course, a stock market practitioners's perspective. Any business school professors out there shout out if you disagree.

In essence there are two factors driving an EV/Sales multiple. 1) How fast those sales will grow. 2) What proportion of those sales will be converted to profits (primarily what margin will they come out, though I acknowledge tax and earnings quality are also potential factors).

As a rule of thumb each 10% of operating margin equates to a 1x EV/Sales multiple for equities. As I said in my earlier post, an IT Services company doing a 10% margin trades on around 1x EV/Sales across the cycle, a software company doing a 25% margin around 2.5x. Trust me, it just works (if you're a stickler you can mathematically derive this - just run a Gordons' Growth Model with g = 3%, r=10% and a 30% tax rate).

So what does this mean for Facebook? Facebook currently has a market capitalisation of $50bn (or an Enterprise Value of $48bn, net of cash). If we assume a 40% long-term operating margin (about the Microsoft/Oracle/Large-Monopoly-Company-Margin) this implies a theoretical EV/Sales of 4x (note I've knocked this down from the 50% I used in my previous post, to be conservative). To justify this Facebook would need to have annual revenues of a shade over $12bn on my calculations (4x EV/Sales = $48bn EV / $12bn Sales).

That's on helluva growth hurdle

The problem is that Facebook currently has an annualised run-rate of $4.7bn of sales (+32% YoY). If it going to grow to the $12bn of sales the market is expecting it needs to sustain its current growth rate for another four more years. The chart below lays out the YoY growth rate the market is currently implying for Facebook.

The problem is, of course, as every commentator reminds you is that growth rates have been sharply declining. As I have written before there are still plenty of users (albeit in poorer parts of the world that Facebook could win. And there is a lot that they could do to raise their ARPU and boost revenues.

But the point is that, even after recent falls, the market is still pricing in that they will do that.

There is no margin of safety for the investor here.

Friday, 27 July 2012

I gotta bad feeling about this - Facebook's maiden numbers

Why earnings momentum matters

Maiden results for a recently listed company are always fraught, particularly if you're the biggest tech IPO ever. What investors love in a tech IPO is a smooth magic carpet rise, a nice beat and raise which gives your stock that magical ingredients: earnings momentum.

When earnings estimates are going up investors feel good because a) the stock can appreciate without requiring additional expansion in the valuation rating (e.g. the P/E ratio) and b) it gives a nice little buffer against that most unpleasant of surprises, a profits warning and an earnings downgrade (which in a tech stock is inevitably compounded by rating compression).

Remember some basic psychology - investors hate looking stupid by getting a stock wrong. Much more, in fact, than missing out on a stock that goes up (which arguably is actually the greater sin).

Which all helps explain why Facebook stock was down 10%, despite hitting consensus expectations for revenues and EPS (for the record, $1.18bn/12c respectively vs. consensus $1.16/11c).

I've written before about how Facebook's valuation is still inking in pretty chunky revenue growth. The focus on the results conference call was all about how they are going to get there - in particular how they are going to raise their ARPU (average revenue per user) from a relatively measly $5 (and why it won't decline due to the impact of mobile.

Facebook needs Sponsored Stories to drive ARPU...

The chart below show's Facebook ARPU by region. As a whole the group saw a modest 5% sequential increase across the group. To frank though that's not enough. If the market is pricing in Facebook growing its revenues five-fold, a 5% pricing increase (even assuming it compounds to a 22% annual growth rate) won't cut it.

What's Facebook's answer to the problem? Sponsored Stories. These are ads inserted directly into the newsfeed, rather than languishing (like an unwanted crumpet) on the sidebar.

In fact it wasn't all doom and gloom on this front. The US actually saw a decent ARPU ramp of 10% (remember on an annualised basis that will compound to a mighty 48% growth) on the back on the introduction of sponsored stories (which drove a 20% ramp in price per ad). That's pretty impressive, especially given Facebook have been relatively cautious in rolling these out. If they can push this out globally (and users don't get to cheesed off by getting spammed with advertising in their newsfeed), then that could reignite ARPU growth.

At least that's the story. However the other cloud hanging over ARPUs is Mobile.

... before they get smashed by Mobile

The scariest number in Facebook's results was the admission that volumes of US ads were down 2% YoY, as users switched to mobile (where fewer ads are served). Though they didn't call them out, Facebook admitted to similar trends in other developed markets. The bottom line is that in Facebook's most developed (and profitable) markets its going ex-growth. There are two reasons - first penetration is topping out - see the chart below showing penetration of internet users flat-lining in the US & Canada:

The second is that the shift to mobile is further diluting ad volumes. That's a toxic combination because it leaves Facebook depending on ARPU growth to drive overall revenue growth in its profit centres. The problem is that pricing growth is great, but its much harder and less sustainable than growing your installed base.

Payments also getting hit by Mobile

There was also a second, less commented-on hit from Mobile on the Payments business. As I have written before, being early in Payments with Facebook Credits is a huge plus for them. A quick look at eBay's valuation (contrary to popular perception, investors see the company as a gigantic payments business (Paypal) with a bit of auction stuff bolted onto the back end) highlights why this is such a beautiful area to be in.

That is so long as you don't get cut off at the knees.

Payments revenues were roughly flat sequentially in Q2, a poor result for what should have been a growth area of the business - Facebook is way too reliant on the troubled Zygna here (which has been crushed by its mobile-related woes). It is interesting to note that while Facebook disclosed payments revenues by region in its IPO prospectus, it dropped this break-out in its Q2 results. Normally when a company changes its disclosure there's a reason here - I wonder if there's a Zygna-related clanger contained in that regional split (e.g. a significant fall in US payments revenue?).

The problem Facebook has is that its payments platform isn't used on mobile. Instead people go via Google Wallet, or their carrier's native billing, or directly to card payments. The fundamental architectural issue is that Facebook is only an app on top of the mobile OS (Android or iOS) which in turn sits on top of the mobile network. So there are at least two other players (the OS operating and the carrier) which have a billing relationship with the customer below Facebook. This is why there has been so much discussion about a Facebook phone (which Zuckerberg pooh-poohed on the call) or having Facebook more deeply integrated into the OS layer (seen, albeit on the desktop, in this week's OSX Mountain Lion launch).

I reiterate, payments is a beautiful business and its a damn sight better for Facebook to be in it than not in it. But they face a real structural challenge getting it on the mobile.

User growth slows

Less attention on the call was paid to user growth, which I think is a mistake. As I said above the surest way to drive sustainable revenue growth is by expanding your customer base, not just jacking. Increasing prices is like taking gold out of a mine you already own, but adding new users is like finding a new gold mine.

Facebook reported Monthly Average User growth of 6.0% sequentially, down from 6.6% last quarter and 8.7% a year ago. However note there's a funny in there - buried in the earnings slides is the admission that Facebook's previous assumption that user numbers were inflated by 5-6% (contained in page 36 of the IPO prospectus) was incorrect and the actual number is more like 3.9% (page 18 of last night's slide deck). If you adjust the historic comparables for the lower assumption (i.e. implying Q1 MAUs were 915m rather than 901m) this brings down the sequential growth rate from 6.0% to 4.4%.

You can see the adjusted growth rate on the table below:

Should quarterly results matter?

Before we get carried away let's have a reality check.

One of the greatest diseases afflicting US corporate life is the focus on near-term earnings. Running a business for quarter numbers is just plain stupid, something Zuckerberg tacitly alluded to in its IPO when he wrote

"we don’t build services to make money; we make money to build better services"

This was one quarter where they key metrics were pointing down. User growth and ARPU growth were sluggish. Costs were ramping up (a topic I don't have space to expand on here, but in short I don't think spending to grow is a mortal sin). The one highlight was US ARPU growth, but Sponsored Stories remain a work-in-progress. (and we haven't even talked about European macro yet).

Nonetheless I doubt these are capital offences. Real businesses don't provide a smooth magic-carpet ride on earnings. And arbitrating that volatility is one reason why tech is such a great space for the common stock investors.

Nonetheless for the next few months at least Facebook is lacking that magic ingredient I talked about at the beginning. Earnings momentum.

Thursday, 26 July 2012

Can Facebook really treble it's sales?

You know what's cooler than a billion...? $12 billion

Facebook is currently minting a cool $1bn a quarter or a touch over $4bn a year (and bear in mind that's high margin business with a good cash conversion). In reality though, that's pocket change.

Facebook's valuation implies it should be making much more than a mere $4bn. Let's say three times more in fact.

Even after its post-IPO crash Facebook's shares ares trading on a cool 15x annual revenues. Now two things determine a stock's Price/Sales rating - 1) how profitable (and predictable) those sales are and 2) how fast those sales will grow.

As a rule of thumb, each 10% of operating margin equates to around 1x sales of valuation (e.g. an IT Services company making a 10% margin trades at 1x sales across the cycle; a software company making a 25% margin 2.5x). Facebook makes a roughly 50% operating margin (still pretty damn good; near-monopolists Microsoft and Oracle only manage 40%) which would equate to 5x Price/Sales.

However that's way off the current 15x sales rating. In short the market is clearly assuming longer-term revenues much greater than $4bn. Crudely applying the ratio between operating margin and sales, if Facebook is worth $60bn and its operating margin is 50% the market is saying it should be able to do a cool $12bn of revenues.

The question is how does Facebook get there. There are two ways to grow revenues - get more customers or charge them more. In this post I'll look at the first question - with 901m monthly users (and counting), where does Facebook find more customers?

Why you should always read IPO prospectuses

The place to start is the IPO prospectus.

Now IPO prospectuses are surprisingly useful documents. On the one hard they are a sales brochure, with every number and nuance minutely plotted by lawyers and bankers to present the candidate in the best possible light to bolster its valuation (and the capital raised). Think estate agent brochures, but with numbers rather than fish-eye lenses.

On the other hand however they are legal documents where  every statement in it needs to be independently verified. This means play too fast and loose with the facts and you open yourself to a lawsuit. Revered UK fund manager (and slightly less revered Chinese fund manager) Anthony Bolton places specific weight on offer documents for precisely that reason. I am tempted to agree - often you find little nuggets of information not always disclosed in (unaudited) quarterly press releases.

I daresay Facebook is a case in point (most recently amended prospectus here, with the document as originally filed here). For example buried in the footnotes (TIP - always read these documents from back to front. The interesting stuff is always in the footnotes) it remarks the Mark Zuckerberg awarded an unknown family member $9m to compensate them for initial working capital. Next time remember that when a family member comes to you wanting to start a business.

Why Facebook will look East

But there's also a surprisingly juicy amount of data on Facebook's user base - specifically Monthly Average Users. For example the table below shows the rise in Facebook's user base by region, now up to 901m in total:

Like any stupendously large number, its always good to place this into context. I calculate that 901m is a measly 13% of the world's population or more interestingly about 40% of internet users. The chart below shows how Facebook's penetration of internet users has progressed over time:

That bad news is that in the US Facebook is up to 70% user penetration, which means its pretty close to saturation. The good news is that penetration lags significantly behind in emerging markets such as Asia so there is clearly room to grow there (and NB that this does not include China where Facebook remains blocked - it China were to open up that would mean another you-know-how-many-billion extra potential users).

Of course the flip side of that is that Facebook's average revenue per user (ARPU) is much lower in Asia and poorer countries. It currently mints an annualised $11.44 of revenue per users in the US & Canada, but a measly $2.14 in Asia. Or to put it another way in the chart below I plot Facebook ARPU versus GDP/head. Unsurprisingly Facebook makes less money per user in poorer regions:

Pulling this all together I've arrive at the two charts below. The chart on the left shows Facebook's user base (blue), internet users who do not user Facebook (red) and non-internet users in the population (gray). It is basically a treasure map showing where un-mined Facebook users are buried.

The chart on the right shows the same data, but multiplied by the ARPU. In essence the blue is now Facebook's current revenue per region, the red is the revenue it would make if it had 100% penetration of internet users, and the green if it had 100% penetration of the global population (unlikely, but lets just say this has never been a company with small ambitions). Again it paints a similar picture, but also factors in the lower spending power of Asian users.

So that's one answer. Go East. If Facebook is going to triple its revenues to meet market expectations, it cannot do that just with users in North America and Europe. It needs to access new markets, in particular China (now where have we heard that one before?).

But the other solution is to charge more for customers, to get that ARPU number up (and believe me getting ARPU numbers up will be a BIG focus on Facebook's Q2 results call this evening). But we'll leave that question for another day...

Monday, 23 July 2012

The darker side of Facebook

And some things Facebook is doing that aren't so great...

Lack of innovation: Having lauded Facebook for being early to the platform game, I have to say that in recent years they have dropped the ball on the innovation front. The sad fact is there is little that people do on Facebook ago (posting pictures, organising events, playing Farmville) that they weren't doing two or three years ago. Despite Facebook's attempt to roll out major innovations such as Timeline or its souped up Open Graph API, the company still seems to be waiting for its next killer app. That's a problem, because in fast moving world of tech if you can't see the guy that's standing still, its probably you.

A ruthless disregard for users privacy: Facebook's mission statement is to make the world "open and more connected". The flip side of this however is that this is in opposition to the demands of personal privacy. You cannot be both private and more open and connected. And generally when Facebook has had to choose between the two it chooses openness over privacy.

A simple experiment. Go to Facebook. Go to your Account Settings. Try to figure out what's going on with your privacy. Then go to your Privacy Settings cos some of the functions are shoehorned away there too. Facebook is a smart company full of smart guys who can build smart UIs. However in this case they've clearly built the most labyrinthine system of menus and settings possible (reminiscent of some of Nokia's worst UI crimes) to keep you as far away from your privacy settings as possible.

This cavalier attitude is a two-sided coin. On the one hand its a short-term win for Facebook. Most people have pretty lax privacy settings because they don't know how to change them for the better. However in the long-run its bad because it destroys trust between the user and Facebook. As an informed user I trust Facebook way less with my private data than, say, Google. I have no confidence that Czar Zuck won't run out and sell my personal data to the highest bidder. Just sayin...

Mobile: The world is doing mobile. Over half of American users are on smartphones, except for smartphone read "small general purpose compute device that fits conveniently into your pocket with a wireless connection". And guess what - Facebook users are following suit. This is a challenge for Facebook because a) until earlier this year it didn't do much to monitise (i.e. advertise) on mobiles and b) even when you do advertise on mobiles the revenue per user is generally less than on a desktop computer (think less display space = smaller billboard = less ad revenue). To a degree this will be balanced by higher growth in the number of smartphone users, but mobile is a risk for Facebooks ad-driven revenue line.

China: Facebook has 85% penetration in Chile. Facebook has 60% penetration in the US. Germany? 30-40%. China? Zero.

In a business environment where people ask "what's your plan for China" in the same way they used to demand "what's your plan for the internet" that's a big gap. So far the Great Firewall of China hasn't been kind to Facebook and many of its service remained blocked (nice Communist dictatorship disagreeing with site that wants everything to be open; imagine that). So far Facebook hasn't found a solution round it maybe it compromises like Yahoo (you want some dissidents email addresses Mr Hu? Sure thing!) or plays hardball like Google. The problem is as Google reaches saturation point in its core markets, it will have to either a) compromise to enter new markets like China or b) accept lower growth. Go fig.

Anyhow the last two posts have provided a whistlestop tour of Mr Zuckerberg's Once and Future Kingdom. In our next exciting episode we'll delve into the murky world of Facebooks financials, ahead of their maiden results Thursday.

Facebook: What's so great about the new Empire

Facebook is the newest and brightest empire in the tech world. Its Czar Mark Zuckerberg (voting share: 57% of total equity) sets out a clear vision "to make the world open & more connected". This glorious future is to be achieved by having people connect on its systems via its services. It is the platform company par excellence - unlike Apple's more brutal vision of iOS its not quite a walled garden, but Facebook definitely owns all the grass.

To start with, here's a brief recap of some of the jewels in the Facebook empire, and some of its darker secrets.

What Facebook is doing that's so great:

First to see to power of platform: Mark Zuckerberg had one big idea. And funnily it enough it wasn't to build  a website, it was to build a platform. He recognised very early on that one website can struggle to muster the resources to compete, and be flexible enough to change. By building a platform with APIs which other app developers can plug into he enlisted the support of innumerable developers and built an evolving eco-system. And about all he did this early - the Facebook platform launched in 2007 in an era where the social networking dinosaurs of MySpace, Friendster and (let's not forget) were roaming the world dragging ponderous websites in their wake. Farmville. End of story.

Getting people to pay to pay for what they already have: The other early win for Facebook was the Wall. Any normal website has one massive problem - generating enough content to keep users coming back for more. Facebook has reversed this by getting the users to provide the content for free (by sharing their lives, primarily on their wall) which draws other users back to check the site again and again. They then pay for this (indirectly) by clicking through on the ubiquitous on-screen advertising. You get users to give you the product for free and then sell it back to them. Genius.

Critical mass: Partly because Facebook was the first (and has been the best) the site has enormous critical mass - 900 million active users and growing, plus the billions of connections, photographs and piece of background about them. And the great thing is that because they were first, that's likely to be the richest 900 million people on the earth (60% internet user penetration in the US of A), not the poorest.

Payments... The next big thing: Facebook mainly monitises its users via advertising (over 80% of revenues). However a significant portion also comes through payments (mostly its 30% cut when someone buys virtual goods on Facebook games). While that may seem minor and ephemeral, the importance of being in the payments business is not. An established payments business is one of the most beautiful things in the business world - just as Visa and Paychex who run enormous, cash generative and recurring businesses on the back of their position as payment processing monsters. Facebook is being proactive here.

Thursday, 19 July 2012

What does a world of platforms look like?

So the tech world is one of Empires and City-States.

The City-States are the individual success stories. The ones who've built a better mousetrap, beaten the opposition to the punch, moved through the IPO and are now set fair on the public markets. They make up the ecosystems.

These ecosystems revolve around vast platforms - the Empires of the tech world. City-States pay them tribute. Citizens pay them taxes. They sit vast, plutocratic, a law unto themselves.

But the empires constantly battle each other. Often they fight themselves to a standstill. Sometimes they wage proxy battles via City-States. Sometimes they swallow City-States whole and grind them to dust.

The important thing to remember is this is not a world at peace.

It is a world at war.

Hopefully I'll be able to bring you some dispatches from the frontline...

Why platforms matter

A Platform is a beautiful thing

The most powerful man isn't the King, it's the gatekeeper who controls access to the king.

Be it the Rahmenator for Obama, Anji Hunter for Tony Blair or (most notoriously) Martin Bormann for Adolf Hitler, enormous power has always been invested in the gatekeeper. Well in business it's the same thing, and its a licence to print money.

The holy grail for any technology company is to become the de-factor standard on which everyone else depends. You want to know why Microsoft and Oracle mint a 40% margin and have dominant share in the core businesses? It's because they are the platform. Effectively it means you are "da man", and if anyone wants to do anything they have to pay you a toll (let's be polite and call it a "licence fee") to play.

And when everyone else starts playing around you they create an eco-system, which is an even more beautiful thing. It acts like an impenetrable defensive jacket which wraps around you platform and keeps rivals out. Millions of pieces of software have  been built on Microsoft's Windows platform. Further billions on dollars have been spent by businesses building and maintaining systems on this platform. Everyone's invested in the eco-system. No one wants to leave.

Or on a smaller scale Apple control's the iOS platform and collects easy tolls from buyers of iPhones and sellers of Apps. Meanwhile the eco-system it has built up, while slowly being hauled in by Android, remains a key reason for people to buy its products (particularly in the Tablet market, which Android hardware has been there for a while but the software struggles to keep up).

That was one reason Facebook killed the opposition. They have one great idea very early on. While their competitors were building a website, they built a platform which Farmville and the like could plug right into (shame they've failed to do much with that platform since - but that's another story).

Every baby tech company wants to be a platform when it grows up. Because, to be brutally honest, that's where the money is.

But platform's aren't forever

Now having said that platforms are big, bad and hard to compete with, it had to be said that nothing lasts forever. Platforms can and do fail. Sometimes slowly but occasionally very occasionally quickly.

When a platform fails its like an avalanche - a catastrophic event which wreaks havoc on the environment. And when it fails rapidly its like an earthquake.

Of the top of my head Nokia is the most recently example of a fail (-ing) platform (particularly its Symbian smartphones). Yahoo too. MySpace had a shot but lost it (although these are all companies which, while dominant, never quite perfected the platform game in the first place). Often when they fail its due to two things - rapacious, fast moving competition and blinkered, complacent management.

Of course from an investment point of view this is a beautiful opportunity - a chance to profit by shorting the failing company and buying into the leader. And the great thing is a failure like this takes months or years, leaving plenty of time to profit from a long trade.

But that's another story.

The business of technology (2)

Disruption dynamics

Pricing power? Growth markets? Asset light models? scalable businesses? Great!

So what's the catch?

The catch is that a week is a long time in tech. The market and the industry is so fast moving that we can see empires rise and fall (Yahoo, Nokia, RIM anyone?) in the blink of an eye. In a nutshell, technology companies grow so quickly because they have disruptive products which customers want to buy. However by the same token they themselves are vulnerable to disruption by the Next Big Thing.

Put another way, growth rates are high but barriers to entry are often low.

Consider MySpace and Friendster, once the darlings of the social networking world but since immolated by fast follower Facebook.

Consider Nokia, which built an empire on bringing Nordic cool to the world of handsets, which in the past five years been reduced to close to an irrelevance by the rise of iOS and Android.

Consider TomTom, which built a small but profitable niche selling $600 satnav devices. Well unfortunately Google does it for free, and its hard to compete with free.

So one last aspect which sets apart the business of technology. You have fast growth, beautiful business models and constant innovation. But you also have horrifically low barriers to entry and the constant threat of disruption.

2 people who love disruption

So if there's a ten horse race where one horse suddenly streaks ahead (whilst convenient machine-gunning all the other horses as it does so with a hidden gatling gun), who benefits? 2 guys.

The guy who's riding the horse, and the guy who can jump onto the horse.

The first guy is the management of the guys leading the pack. It's a great job for them (well until another horse comes along convenient stocked with nuclear-tipped missiles).

The second guy is the common stock investor, who can buy and sell whatever technology company he so chooses (so long as it's publically traded of course). In essence disruption dynamics creates massive opportunities for the smart investor. It can create huge moves in the prices of large, liquid assets.

Funnily enough, the hard part isn't spotting them. The hard part is being able to stand back far enough to see them. The market is frequently so obsessed with the niceties of quarterly numbers and earnings guidance (an equally bonkers metric to assess and to run a business, but that's another story) that they almost always fail to see the woods for the trees.

Part of my job with this blog is to take a look outside the wood, and chop down some trees.

The business of technology (1)

In my first post I talked about why technological change makes tech companies different. Now I look at what's so special about their business models.

Technology companies are often extraordinarily good at making money. As an analyst of Software, tech Hardware and IT Services companies over the last ten years I've noticed a number of features of their business models which set them apart from most other companies.

Four habits of highly successful companies

1) Structural pricing power. I've already discussed the structural pricing power for much of tech in the previous post. Faster silicon = newer products = people want to pay up. One qualifier - sometimes this enables price to stay constant rather than going up (e.g. the New iPad costs as much as last year's iPad 2). That's also not a bad thing, so long as a lot more people want to buy this year's model than last year's i.e. volumes are going up.

2) High volume growth markets. This leads us onto volume, the second driver of revenue growth. Again this comes back to the the product innovation point mentioned before - technology companies often operate in markets which see extremely high (>20% annual) volume growth. Now this isn't normal - for more mature markets like cars, microwaves or groceries you're lucky if you see volumes up low single digits. But for cutting edge products like smartphone, cloud computing services or tablet computers its an entirely different ball game.

3) Scalable. Conventional business models often find it hard to ramp up growth to meet demand - to produce twice as many widgets you need to build twice as many factories; this all takes time. For technology companies however models are often extraordinarily scalable. There are a number of reasons for this. Firstly technology companies are often selling intangible goods such as software or services. These are easy to duplicate - want to sell more software? Just print off another CD or email out another copy of the program - marginal cost = close to zero.

Secondly for those companies which do manufacture physical product, many have adapted to globalisation and outsourced manufacturing - again someone else (normally a far Eastern manufacturing giant such as Foxconn) has already built the factory - Apple just tells them how many iPhones they want to build this month. A similar analogy applies to cloud computing services - Microsoft or Amazon do the leg-work of building the data-centres and providing the cloud computing platform. Cloud services providers simply build their products on top of that and can add as much capacity as they need at the flick of a switch.

4) Asset light models. As an adjunct to this, it means technology companies often don't need many assets to get of the ground (equipment required to launch this blog - 1 computer and 1 internet connection). This is a beautiful scenario from a business point of view, because how a business makes money is paying out more cash than you put in (not always the same as turning a profit on your P&L account!). The heart of value creation is producing a positive return on invested capital. Guess what? The less assets you have the less invested capital you require.

That's not saying other companies don't have all or some of these attributes, but from my experience technology companies are often lucky enough to have a number of them at once which gives them a great platform for doing business.

Tuesday, 17 July 2012

What's so special about Tech?

This blog is about technology, finance, and the clash of eco-systems.


What's so great about technology? Why are technology companies different from ones which make lighting, rubber boots or typewriters?* How is it that Google (founded 1998) can have a market value three times that of Boeing (founded 1916).

The chips are down

The answer, in one word, is Silicon.

What modern technology companies have in common is they are driven by silicon chips. Software runs on silicon, smartphones are built around silicon, chip companies (obviously) build silicon. The products provided by a technology companies are overwhelming built around microprocessors.

What's so great about that? Ask Gordon Moore, the co-founder of Intel. He famously observed (please note that Moore's Law is strictly speaking an observation, not an empirical Law!) that the transistor count on a silicon chip doubles every 18 months.

This is revolutionary, because it means that every year and a half a technology company has twice as much horsepower to play with for their new products as they did before. Imagine if Boeing could make its planes half the size, or Starbucks could make its frappucino's twice the size (OK they sort of do that). We'd be commuting  in 747s and drowning in iced milk. Well that's what Apple does with the chips in its iPhones and Google does with the functionality of its software. Twice the horsepower = twice the fun.

Of course in the real world it isn't quite as tidy as this, but you get the point. Every two-odd years technology companies can bring an entirely new product to market that's way better than the previous model. Guess what? Because its new people are prepared to pay up for it. In essence technology companies have structural pricing power.

iPhone's versus microwaves

So compare microwaves to iPhones. Today's microwave does pretty much the same as one from ten years ago (heats food, melts chocolate, remains a VERY bad way to dry off a soggy cat). Microwave ovens are pretty much a commodity - one is much like the other. The only way to differentiate is to be cheaper than the next guy. Essentially the market becomes a race to the bottom.

Contrast it with an iPhone. Last year's smartphone could sing, this year's can sing and dance, next year's will do the macarena whilst cooking you Turkish Breakfast Eggs (try em, they're great). Guess what? People are willing to pay ridiculous amounts of money and walk away happy. Remember, Apple makes a c40% gross margin on its kit, i.e. it charges you more than 60% for an iPhone than it costs to manufacture. Contrast that to the microwave where the more you pay, the less happy you are.

That's the miracle of modern technology.

* Observant readers would, of course, have noticed that Indian IT Services company Wipro makes lighting, Nokia used to make rubber boots and IBM typewriters. Which just goes to show the great thing about tech it that its always changing.