Thursday, 30 August 2012

Telly Addicts Part 3 - Kicking Ass, Taking Names

The runners and riders

In the last week or so I've been thinking about the coming TV war. In my first post I laid out why the dull world of TV is actually one of the most exciting frontiers in consumer tech. In my second post I thought about what is the "Right Stuff" it would take to win, which to reiterate is:

  • Broadcast content
  • An app ecosystem
  • A physical presence in the home
  • A direct line to the consumer (and their credit card number)
  • A great user experience
  • Being able to sell at the right price point (preferably zero up-front)

So now it comes down to kicking ass and taking names, with some thoughts on the individual players and their chances of success:

The eco-system monsters

The first bucket at the super-charged challengers, the eco-system monsters who rule software land and who would like to invade TV-land. They generally have great brands, great user experience and strong app eco-systems, but little track record of executing in the mucky world of broadcast services and a critical lack of TV content.

  • Strengths: Google gives good App and (surprisingly for an avowedly engineering-led firm) good UX.  One last hidden strength which people never seem to talk about is that when they bought Motorola Mobility they also picked up its set-top box business which has a lot of nous about dealing with broadcasters (something sorely lacking in the initial Google TV launch). Recent press reports suggest they are trying to sell this unit off, but if they're smart they make sure they keep some of the key knowledge and DNA within Google.
  • Weaknesses: Google TV has been a bust (so far) and its hostage to its hardware partners (maybe this will change - interesting to see Google testing the waters with the Nexus Q). The big problem - and something which has really hurt Google TV so far - is that they do not own the broadcast content. 
  • Strengths: Apple's obvious strengths are its app ecosystem and its UX chops. No one understands what consumers (really) want better than they do. They also have a great consumer brand, and are the one company which has a real experience of coming in and disrupting existing markets - crucial during a period where many incumbents will be held back by the Innovator's Dilemma.
  • Weaknesses: However its glaring weakness is its lack of broadcast content. What's worse is having seen how the marmalised the record labels, the broadcasters who own the content are incredibly suspicious of sharing anything with Cupertino. Also Apple has historically made money from hardware sales, so it will be a challenge adopting to a low cost/subsidised model (although they have been willing to pitch Apple TV cheap, and have telcos play the subsidy game on iPhone).
  • Strengths: XBox is Microsoft's hidden weapon which gives them an internet-connected trojan horse into millions of households. It gives them a vast content catalogue of games to sit alongside MSFT's existing PC and (nascent) Windows Mobile app ecosystems.
  • Weaknesses: XBox Live aside, Microsoft have not traditionally had a strong end-user relationship on the consumer side (unlike enterprise software, packaged software is very much a "fire and forget" business). Also they have very little broadcast content (although studios may be more willing to play ball with them than with Apple).

The wannabes

Like the eco-system monsters, these vendors are coming at the problem as new entrants from the tech world, although less explicitly from a software/OS bent. 


  • Strengths: Playstation gives Sony many of the same advantages as XBox in terms of physical presence and content. They also unusual strength in content, thanks to their previous (and previously unsuccessful I might add) efforts to build an end-to-end conglomerate. 
  • Weaknesses: Their end-user relationships are weak as so much of what they sell goes through dealers and distributors, and while they have a presence in many areas they lack overwhelming strength in any of them.
  • Strengths: Amazon understand how to subsidise and sell content, and have the strongest customer relationship of any of the prospects. Also, although I don't explicitly list infrastructure as one of the essential criteria, their experience as a cloud vendor with Amazon Cloud Services and EC2 should help them on the delivery/execution side.
  • Weaknesses: Aside from their nascent Appstore (piggybacking on Android) they lack broadcast or software content. They also have very little physical presence in the front-room, although Kindle has shown they are not afraid of moving that way (think "Kindle TV"...).

The incumbents

These are the guys who should rule the world in internet TV, but have failed to deliver over the last ten years leaving them vulnerable to faster moving new entrants. Nonetheless they still have significant incumbency advantages and critically retain control of the all-important TV content.


  • Strengths: Under any rational scenario telcos should rule the world. They control the networks, have long-standing billing relationships with the customers and have a hardware presence in every home. 
  • Weaknesses: Unfortunately telcos suck at execution and have the UX abilities of a five year old. This is why, despite sending me mailshots advertising their IPTV services almost every month, telcos appear to be the dinosaurs forever condemned to roam the world and have their eggs stolen and devoured by nimbler faster moving creatures.
  • Strengths: There's a lot of overlap with these guys (the main difference is that broadcasters own the customer relationship whereas studios do not). Their trump card however is creating and owning content. This is their one big gambling chip because everyone will need to come to them before they can play the TV game.
  • Weaknesses: These guys have little experience on the "Internet" side of internet TV - understanding software, UX and apps. Note that broadcasters are highly fragmented between different regions which makes it hard for them to work together to build a common platform - the opposite of the global software eco-system monsters. Finally as they reap enormous cashflows from their current business models so are very likely to be held back by an "innovator's dilemma".
TV manufacturers:
  • Strengths: Much like telcos, TV manufacturers should be in a prime spot to dictate forthcoming TV standards. They have the best physical presence of all internet-TV challanges - after all they make the TVs!
  • Weaknesses: Unfortunately they spend so much time cutting each others throats in the ditches of the consumer hardware market, they never think about sitting back and working together. Instead of a unified internet TV standard each hardware vendor pursues its own equally cruddy attempt to "differentiate" (think handset manufacturer skins on Android). Ironically this just accelerates the commoditisation, as one crappy TV interface looks just like another from where I'm sitting...

Let battle commence!

The scorecard below sums up the competitive landscape. Note "balance scorecards" like this are not prescriptive - they are at best a rough and ready view. At the moment I think the ball is firmly in the court of the new challengers, primarily the eco-system monsters. They have a much clearer view of where the market will be going, a better arsenal to address that and are not held back by an incumbent's "Innovator's Dilemma".

However the one big (and I mean big) challenge they face is that TV Content remains concentrated in the hands of the broadcasters and the studios. Effectively whoever has control of this content retains a veto on the progress of anybody else. At best this gives Broadcasters/Studios the right to extract a rent on the success of any new entrant. At worst they can stymie the development of the market altogether and mean everyone loses out.

Address this stumbling block is the biggest strategic dilemma facing Apple, Google et al in their push towards connected TV. It is clear from the modest success so far of Apple TV and Google TV that they have failed to do this, partly because content-owners are so distrustful of them after seeing what iTunes did to the music labels.

I see a number of potential ways this could play out.
  • Both sides could reach an agreement, with the content providers receiving a suitable rent (unlikely at the moment but possible).
  • The new entrants could pursue Sony's strategy of trying to secure control of their own content.
  • Or new entrants could try to change the game and change the nature of TV content entirely. After all your children will never buy an LP, CD-ROM or DVD in their lives. Who's to say their children will ever watch an "episode" of a TV program ever again? But that is /definitely/ playing the long game.
Let battle commence!

Wednesday, 29 August 2012

Telly Addicts Part 2 - What is the "Right Stuff"?

The most important tech company in the world

The TV is the next great technology background. And as I wrote last week, whoever triumphs in the battle will become the most important tech company (and probably the most important company) in the world.

So what does it take to win? What is the "Right Stuff"?

The company which wins the TV war needs the following arsenal:
  • Broadcast content: Its King, let's face it. The biggest reason Apple won the iPod war is that it cajoled the record labels to fall into line - like a pack of lemmings as it turned out. 
  • An app ecosystem: Sort of a riff on content - but rather than broadcast content you need additional apps games that people want to a) use and b) pay for on your TV platform.
  • A physical presence: Whether its a set-top box, a smart-TV or a Playstation, you need a physical presence in the living room. Partly because of the added security it gives for rights management (that's why every broadcaster has a unique set-top box), partly because if you just rely on pumping it down the web browser you lost control of the viewer experience.
  • A direct relationship with the consumer (and with their credit card number): If you control the customer relationship everyone else in the ecosystem has to go through you. This is an enormous competitive advantage - the customer is paying you for the content, and everyone else is paying you to get to the customer.
  • A great user experience: Wanna know what a bad user experience is? Hit the Menu button on your remote and try to navigate the system. Both the controller and the menu system need to be elegant and usable (think of clunky thumb-boards supplied with some internet TVs and shudder). Steve Jobs thought he'd cracked it before he died. Maybe Siri still has something to say about the matter...
  • The right price point: Logitech is the only company I've seen to ever report negative sales for a product, in this case the Google TV. The reason why? Largely because they were charging $249 for the box, which was simply the wrong price for a beta product (something Apple picked up with when they priced Apple TV at $99). To succeed you will need an impulse-purchase price point. Ideally zero, subsidised with content sales (a la Kindle Fire model).
Tomorrow in my last post on this topic I'll give some thoughts on how the vendors stack up. But here's the initial scorecard (disclaimer - all very big picture, of course):

Saturday, 25 August 2012

Apple wins a battle, but is losing the war

Apple wins in the courts...

The clash of empires, which is at the heart of this blog, has been vividly brought to live over the last few weeks by the Apple vs. Samsung trial that has been waging in the California Courts.

Last night the jury delivered a crushing victory to Apple, awarding a cool $1,049m of damages against Samsung for violating Apple's patents and trade dress with its Android handsets.

In reality of course Samsung is just a proxy for the bigger war between Google's Android eco-system and Apple.

... But is losing in the field

But this is why the verdict doesn't matter:

The chart above show's the installed base for the Apple and Android eco-systems. Note I include both iPad and iPod Touch (the trial threw up some very interesting internal data on iPod Touch sales which allows us to quantify this part of the ecosystem for the first time). And I don't bother to include Android tablet sales. I assume a two year replacement cycle for older devices.

Even on that basis Android is spanking iOS hands down in terms of growth and installed base. And remember in any clash of Empires, it is the size of installed base which determines who comes out as the eventual victor. The chart below, showing quarterly new smartphone sales by OS, makes the trend very clear:

Apple's patent victories may be too little too late. A likely injunction against sales of last year's Android handsets is hardly going to stop the onward charge of the might Galaxy S III et al. In the meantime Samsung and its Android cohorts have managed to steal a lead against Apple in the smartphone race. In that context an extra $1,049m really isn't that much to pay...

Thursday, 23 August 2012

Telly Addicts

The final frontier

The television remains the final frontier for the internet. We browse the web on the bus. We browse it on the loo. Thanks to the wonders of satellite broadband we can browse the web at 20,000 feet.

We do not, however, browse the web on our TV.

This is bizarre, because the TV is the biggest by far of Ray Ozzie's Three Screens but the web barely touches it. Sure you could connect your laptop to your TV, or your iPad. But have you? Have you ever checked email on TV? Surfed Facebook?

For a supposedly wired culture, that's nuts. Quoth the American Time Use Survey:

Watching TV was the leisure activity that occupied the most time (2.8 hours per day), accounting for about half of leisure time, on average, for those age 15 and over. Socializing, such as visiting with friends or attending or hosting social events, was the next most common leisure activity, accounting for nearly three-quarters of an hour per day.

Put another way, the TV is the biggest billboard in people's lives, the supposed advertising revolutionaries like Google bare touch it. Instead it runs (give or take a TiVo), pretty much like it did twenty years ago. Turn it on, watch a program. Get force-fed some generic untargeted ads while you do so. Turn it off.

Which is a shame, because whoever controls that billboard controls the biggest pot of advertising revenue in the world.

The last days of the TV Appliance

This links to what I wrote about yesterday. The TV at the moment functions like an Appliance. It is a box that delivers a single service (pre-prepared, uninteractive video content). Sure manufacturers try to dress up their "Smart TVs" with YouTube, Twitter, Skype, 3D, HD, 3DHD, Wifi, TV Guides and one-click pizza delivery*. The reality is though, that people just use them as TVs (I ask you again, when did you last check Twitter on your TV).

This is going to change, and there are several reasons why.

1) The pipes are in place. Fiber broadband is finally getting to the point where HD video down IP is becoming a reality. You need roughly 5Mb of bandwidth to stream 1080p content. Multiply that a few times for different TVs in different rooms and the odd bit of background PVR and I figure you need a 30-50Mb service to deliver a reliable service. You can just about get that in the UK with Virgin cable and BT Infinity. And that's not mentioning Google's 1 Gigabit tech demo they're putting on in Kansas at the moment.

2) The punters are ready. Consumers are getting used to on-demand TV. Particularly in the UK with a plethora of free-to-air content online via BBC iPlayer, 4-On-Demand, ITV Player (soon to be aggregated into YouView), the idea of consuming TV down an IP line is a reality. I never look at TV schedules anymore - who cares when a TV program is being shown? All that matters is when the playback is going to expire.

3) The vendors are raring to go. Arguably they have for a while - the XBox360 and the PS3 have been obviously stealth plays to become the TV General Compute device for a while (TV was one Microsoft's third screen after all). However Apple and Google are also seriously gearing up.

It's a matter of record in Walter Isaacson's biography how much Steve Jobs wanted to revolutionise TV. What's less commented on is how much Apple are already willing to give it away. Consider the Apple TV - effectively its an iPhone 4 in a box minus the 3G radio and the screen. Those parts cost about $75. Yet the Apple TV sells for $99, a whole $450 less than the iPhone 4 costs. You think Apple are all about high gross margins and premium prices? Not when the future of TV's at stake they aren't:

Now you may argue that Apple TV is priced so low because its an irrelevance, it isn't going to sell but it doesn't matter how much they sell it for. This is a mistake - Apple have clearly put the flag in the ground at the $99 price point (the sort of impulse-price point which Logitech have long called the "don't have to ask your spouse point"), and one thing we know about consumer devices is that prices never go up. They willing to take the dogfight down into the weeds to make TV work.

The missing piece...

Of course there's one thing they still haven't figured out.

What to put on the sodding box.

For any TV content is king, and this is the one part of the TV puzzle the hardware and software vendors have never managed to crack. Sony tried the hardest with its ill-starred move to into movies and music. Microsoft dipped its toe in the water with MSNBC. But since Sony's failure, the device manufacturers have been very wary about piling into content.

And on the other side the broadcasters have been equally paranoid about jumping into bed with device manufacturers. They realise that so long as they control the must-watch content they have the upper hand, and they have seen how the music labels were immolated once they signed these over to the iTunes Music Store. So they are taking things as slowly as they can.

So we have the calm before the storm. On all sides the battalions are drawn up, ready to go to war. And what I want to do in the next few posts is run down the order of battle (and think through some of the implications for their share prices).

The prize

However it plays out though the prize is clear.

What is the first name you see when you turn on your TV?

In ten years time, that name will be the most important technology company in the world.

* Joking about the last one... but that's one helluva idea. Why don't Domino's give away subsidised TV's with an ORDER PIZZA NOW button integrated into the remote. And a beer cooler fitted to the side.

Wednesday, 22 August 2012

Dead appliances and disruptive devices

The Gadget Graveyard

Here's a list of gadgets you're never going to buy again:

Do you get the connection? All of these are Appliances, devices which are designed to perform a single function. A satnav is a Navigation Appliance, an iPod player is a Music Appliance, and a digital camcorder is a Video Appliance.

Similarly an old school candybar is a voicecall appliance and a Nintendo is a Gaming Appliance (or a get-kids-out-of-hair appliance, depending on your situation).

These things tend to be damn good at doing one thing, but pretty useless at something else.

And in the long-run they are all dead.

Why computers will take over the world

Appliances tend to be associated with the cutting edge. When a new consumer technology, be it GPS or MP3 playing comes along, it is relatively expensive. In order to bring it to mass market you need to make it as cheap as possible. This is where an appliance comes in - by making a completely dedicated device its the cheapest way to package a new technology up at a consumer price point (for an example of a current cutting-edge appliance, check out the Lytro Light Field Camera).

So an appliance tends to offer two advantages. 1) it is generally cheaper. 2) it is very good at performing its role because it is built as a dedicated device.

However as a technology matures it tends to get cheaper. This means it becomes cost-effective to fit it onto a General-Purpose Compute Device. A smartphone is a great example of this. It's a camera, satnav, Gameboy, camcorder all in one! Oh and it also makes phone calls!

Similarly a laptop fits the bill (It plays games! And runs spreadsheets! And browses the web!). As the name suggests these tend to be programmable (and usually have a less specialist device) which means they can be used for a number of different functions. Most have some sort of open platform so new programs can be built to run on top of them.

Now these general compute devices aren't quite as good as a dedicated appliance at performing the job in hand (advantage 2), however you get to a point where the 80/20 rule kicks in. Sure a professional minicab driver needs a satnav and a pro photographer needs a digital camera. But for 80% of us its more than good enough.

And its at this point that the market for the particular appliance crashes:

The charts above show the declines in revenue and volumes for TomTom satnavs and Apple iPods. Both were single-function appliances that were monstered by the rise of versitile touchscreen smartphones with GPS and NAND flash storage (TomTom's were monstered so much that the company actually stopped disclosing volumes and standalone revenues from the start of 2010, so embarassing was the decline!).

Managing disruption

This situation is the nightmare for any incumbent appliance manufacturer. On the one hand they generally have good products, for their function and a significant brand presence.

However their expertise, by definition, is very narrow which leaves them ill-equipped to produce more generalist devices. Typically they will not have much of a platform or eco-system built around their device. And finally the companies which make general compute devices tend to be larger and already have significant brand muscle.

In short you face a bunch of new competitors which are better than you and bigger than you.

In general I have seen two responses

  1. Bury your head in the sand and pretend the threat doesn't exist. (TomTom, Nokia, Flip)
  2. Try to build your own general compute device. (Garmin, Playstation/XBox, Apple)

The first response inevitably ends in disaster. Once generalist devices get good enough the market is moving inexorably against you, and you simply do not have the time (or the capital) to catch up.

The second response often ends in disaster. Garmin tried to build their own Garmin Phone, a laughable ambition given they were up against Apple, Motorola, LG, Sony Ericsson, Every Man + Dog.

However sometimes, if you're smart enough, it succeeds:

Profiting from disruption

Of course this creates great opportunities for the investor - both by shorting the roadkill, and by being long the winners. And as I have written about before, the beauty of this is that once a company start to move into a structural decline there are often ample opportunities to short because these are multi-year events (normally ending in some sort of real or potential balance sheet distress).

And where to find the next appliance story? Well simply go down to your local Currys or Best Buy and look around you. Off the top of my head here are some that spring to mind:

  • Televisions: The biggest appliance out there, in every way. With the rise of internet-connected devices this is the obvious compute platform for the modern home. Everyone, from Apple to Google to Sony is frantically trying to work out how to do this. Because whoever owns the TV-computer will own the biggest advertising billboard in your life.
  • Games Consoles: It is interesting to see how XBox and Playstation has been repositioned over the last few years as connected appliances / stealth set-top boxes. Of all the Appliances currently out there these have the best shot at evolving to general compute appliances. On the other hand Nintendo seem to remain focused on just doing games - a grievous mistake IMHO.
  • Radios: The venerable Audio Broadcast Appliance has had a long run, but at the point internet coverage becomes truly ubiquitous (believe it or not we're not quite there yet!), the radio is dead. Although I will miss having the shipping forecast interrupting Test Match Special - the iPlayer version doesn't include it. 

Friday, 10 August 2012

The best business model in the world

But if Carlsberg did make business models...

As I wrote yesterday, IMHO running a restaurant is probably the worst business model in the world. Which begs the question, what is the best?

Enterprise software.

Oracle, SAP and the boring bits of Microsoft rarely set the pulses racing. While Apple make's sexy phones and Intel whiz-bang chips, these guys basically make accounting software for big companies. But for an investor this is a thing of beauty.

Like the cigarette business, except it doesn't kill its customers

Here's an ideal enterprise software business model in a nutshell. You sell a licence to use your software for a million bucks (cash up front), you then go in and install it and charge another million bucks for the service. Them every year you charge the customer a $200,000 "maintenance fee" in exchange for regulatory updates and bug fixes. On that you make an 80-90% gross margin, and the rest of the opex base (split roughly evenly between R&D, sales & marketing and admin cost) lets you mint an operating margin of 20-30%.

And here's why its so great:
  • Asset light:  Upfront capex requirements are close to zero. Unlike a manufacturer which needs to build a new factory before they can even contemplate doing business, software companies require little more than an office, some computers and a phone line. 
  • Cash generative: Software companies are scarily good at converting accounting profits directly to cash in the bank, because there is very little cash tied up in working capital. In fact if you collect maintenance fees upfront, you can even have negative working capital - your customers are paying you to sell them stuff!
  • Scalable: Software has virtually zero marginal cost of production. Want to create twice as many copies of your software? Simply generate twice as many licence keys and point your customers to the download site.
  • No exposure to input costs: If you don't manufacture physical goods you have no suppliers and no exposure to fluctuating input pricing.
  • Flexible cost base: Normally the downside of high gross margin (i.e. low cost of production) businesses is a high fixed cost base which means small a small sales decline can wreck your margins. Software companies have this covered too. Sales and marketing staff (who's costs amount to about a quarter of revenues) are paid on a minimal salary+bonus basis. This means when times are hard you can almost instantly by slashing discretionary bonuses. Sure the sales guys aren't pleased but for them its better than a P45, and you can have a big cost buffer to protect your margins.
  • Customers never leave: Enterprise software is like the Hotel California - You can never leave. Once a large company has gotten stuck into a complex accounting system like SAP or Oracle the sheer institutional inertia and hassle to involved in ripping it out, junking the historical investment, and retraining everyone makes it virtually impossible to switch suppliers. Which makes the price negotiations very relaxing - for the software vendor.
  • Recurring maintenance revenues: Remember that $200k maintenance fee I mentioned earlier? That's money for old rope. In reality the company gets very little for the cash apart from the right to use something they've already paid for. And remember even if a software company isn't growing its licence revenues, if they are selling any licences at all the installed base of recurring high-margin maintenance revenues will carry on growing.
  • Eco-system: All good bullies have their sidekicks. In this case an eco-system of professional services companies like Accenture and IBM who's job is to sell even more services around your enterprise software installation. This means a) they make money, b) they do a lot of the sales & marketing legwork for the software company and c) customers become even more entangled in a spaghetti of legacy IT systems which makes it even harder to leave.

Warren Buffet loves the cigarette business because "It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty."

In short, software has all of that, plus the added advantage that it doesn't kill its customers.

And if you don't believe me, here is SAP's revenue and profit growth over the last decade or so. OK there's been a couple of acquisitions (Business Objects and Sybase), but the overall trend is clear. Note also how resilient profits are even when licence revenues are falling - that's due to that huge blue-shaded block of cash-rich maintenance revenues which grows at a steady pace, rain or shine.

As I said, probably the best business model in the world.

PS - So where's the catch?

I'm aware this post is a bit of a love letter to the enterprise software business. But where's the catch? Well nobody's perfect, so here's a few:

  • Lack of visibility: Unlike manufacturing industries there is little supply chain or end-market data to analyse, so forecasting software licences on a period-by-period basis can be quite difficult (although forecasting recurring maintenance is very easy). Not an issue for a true long-term investor but this means software companies can be volatile on a quarter-by-quarter basis.
  • Competitive market: Precisely because the software model is so good (and generates such high ROIC), the industry tends to attract competition and new entrants. For the industry behemoths like Oracle or SAP this isn't a huge issue, but for smaller companies it means competition can be brutal.
  • Piracy: Because software is easy to make its easy to pirate. Again for complex large-scale enterprise software this is not a big issue given the complexity means you can't just boot up and run pirate code, but this can be a challenge for simpler packages.
  • Maturity risk: Software companies tend to de-rate as they get larger (base effect - harder to sustain growth) and maintenance grows to a larger proportion of revenues. Actually from the point of a fundamental investor this is completely nuts - if companies are deriving a larger proportion of their revenues from high margin recurring maintenance streams their stocks should up-rate, not de-rate. However tech investors tend to be obsessed by growth-at-all-costs (even at the expense of profits) so mark down software companies which have substituted licence growth for maintenance growth. Go fig.
  • Platform risk: You could be the best damn company at making widgets which run on desktop PCs, but if all your customers switch to iPhones then you have platform risk. This rarely happens but when customers shift the device on which they consume their IT, AND you haven't kept up with them you run the risk of having your legs cut out from under you. (a good example of this is WordPerfect which had the dominant word processing software running on MS-DOS but completely missed the shift to Windows. In short they were late, and Microsoft Word won).

Thursday, 9 August 2012

The worst business model in the world

"Because I'm not as stupid as I look"

I consider myself to be quite a good cook. In fact I would say I'm the third best cook I know (behind a lady who worked at Alain Ducasse in Paris and a chap who was a semi-finalist in Masterchef). So inevitably people sometimes ask me "why don't you go and start a fancy restaurant". And my response invariably is:

"Because I'm not as stupid as I look."

A fine-dining restaurant is probably the most suicidally insane business model devised by mankind. It is the business school equivalent of trying to deep-fry ice-cream inside a chocolate teapot in the middle of the Sahara. As the old saying goes, the best way to create a small fortune is to start with a large fortune and open a restaurant.

Probably the worst business model in the world...

Putting my analyst's hat on there are a number of reasons why a posh restaurant restaurant counts as the World's Worst Business Model.

  • High upfront capex requirement: Villeroy & Boch china? Check. Reidel glasses? Check. Linen tablecloths (and associated recurring laundry bill)? Check. Three million bucks out the door before day one? Check. Put frankly, although it has little or nothing to do with the food the fixtures and fittings for a contemporary fine diner mean you need to stump up a seven figure sum before you've even fired up the oven.
  • High ongoing fixed costs: As a rule of thumb, ingredient costs make up about a third of the menu price in a good restaurant. That's your variable cost. Unfortunately much of the rest is fixed (largely rent). So even after you've fitted out the place and fired up the oven you then have a ridiculously large fixed cost base to cover before you start making a penny of profit.
  • Low volumes: Fixed costs aren't always bad -  McDonalds thrives with a high fixed cost, but that's because they pump tremendous volumes through that cost base (similar to the business model for data-processing companies like ADP or Amadeus). Unfortunately a high-end restaurant doesn't have that scalability - while McDs might turn tables twenty times an hour, you're lucky if you can turn them twice in an evening.
  • Cyclical demand pool: Oh and did I also mention that low volume demand pool is completely hostage to economic circumstance? (there's a reason why cheaper entz like McDonalds or Cinemas flourish in a recession) So which you volume upside is capped by limited capacity, your volume downside is completely hostage to the macro environment. Worst of both worlds.
  • Low leverage: You want to double the size of your restaurant? You need to find twice as much space, source twice as many fittings and hire twice as many staff. Hassle factor - high. Scalability factor - nil.
  • Vast competition, lower margins: You would think such criminally low returns would deter new competition. Unfortunately not - restaurants are one of those eternal "oh I reckon I could do that" propositions which attracts fresh new mugs at every turn (I blame Masterchef). Result - high competition, limited pricing power, low margins.
  • Exogenous risk: One bad review from Frank Bruni at the NY Times or Fay Machler in the London Evening Standard? You may as well pack up now.

Which is a very long-winded way of bringing me to my main topic of discussion, which is the counter-factual - if a restaurant is the world's worth business model then what is the world's best?

Step forward the dullards of enterprise software...

Tuesday, 7 August 2012

Roman candles and breached moats

Getting paid for failure

People don't like to dwell on failure.

However for an investor (particularly one with the ability to sell stocks short) being able to identify companies which fail can be just as rewarding as picking the ones which succeed. And the bigger they are, the harder they fall.

A particularly rewarding category are companies which Warren Buffet calls "Roman Candles", which burn brightly for a while but then explode in a shower of sparks. As he wrote in wrote in 2007:

Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed."

Because they are perceived as having strong moats such companies often earn very rich valuations for a time (and are overwhelmingly acclaim from market analysts), until their weaknesses become apparent. This obviously creates ample opportunity to sell the stock short, and even after an initial fall there is often much more downside to come as investors' anchoring means they are slow to cut their losses.

As the saying goes - what is the definition of a stock that's fallen 90%? A stock that's fallen 80% and then halved again...

How can the light that burned so brightly... 

Here are some of the Roman Candle's I've come across in recent years. One thing I have noticed is that belief in a false moat is often compounded by management arrogance. Often management are caught flat-footed by a new competitor, precisely because they believe their moat is unbreachable.

Nokia: Nokia's moats were design chops and scale. Certainly for low-end feature phones their usability and interface were far superior to their competition. However their business model also had real scale advantages - because of their scale and manufacturing reach they could work at a 20%+ operating margin while most of the competition was at half that (for example spreading fixed costs like R&D across a larger number of devices means a lower cost per device). They also had enough scale to offer direct distribution in emerging markets such as India or China while competitors had to go through local intermediaries.

However for all the strengths of these moats (and they were strong - after five years of turmoil Nokia is still the second largest vendor of mobile phones by volume) they were breached by Apple and android handset vendors. Quite simply Nokia at first dismissed Apple's chances of success. Then they retreated behind their supposed moats and failed comprehensively to bring out competitive products not only for one but two, and then three generations of device (warning, these reviews are painful to read!). When they finally got it brilliantly right at the fourth time of asking it was far too late (and they immediately junked that platform in favour of Windows Phone).

MySpace: Being the world's biggest and baddest social network (and having a user base replete with trendy Generation Ys) should have given MySpace a big network effect and created a massive moat for its business. That's what Rupert Murdoch thought when he splashed out $580m for it in 2005. However in reality that moat was illusionary - users proved fickle and by pursuing short-term page views and ad revenue rather than playing the long game as Facebook did to build an API and a platform, that moat simply melted away.

TomTom: For a brief moment in the late-noughties "TomTom" was as synonymous for SatNav device as "Hoover" was for vacuum cleaners or "Zamboni" was for, well, Zamboni's. By being first to the market, producing great, easy to use devices and creating a strong brand they seemed to have created a cosy duopoly between them and Garmin, fighting off low-end Far Eastern competition such as Mio/Mitac who only competed on price.

However once Google dropped the bombshell of free navigation on android smartphones that supposed brand loyalty was cruelly exposed. Compared to Google's brand, and the magical price point of "free" (plus an unwise debt-fuelled acquisition at the height of the credit bubble) TomTom went into a tailspin from which it still hasn't recovered.

RIM: RIM is a business which had two supposed moats. The first was its ubiquity within enterprise IT systems, and the way its high security Network Operating Centres (NOCs) could sit within a customer's firewall and offer notoriously fickle business customers enterprise-class security. The second was its Blackberry Messaging (BBM) instant messaging service which captivated a generation of consumers.

Actually despite some high profile outages the competitive advantage offered by the NOC model still remains in place (and would offer an enticing strategic asset to a potential acquiror, IMHO). However while BBM retains its loyalists, instant messaging services such as iMessage and Google Talk are two-a-penny nowdays and this has proved no moat at all against competition from low-cost android smartphones.

Where are the next Roman Candles?

"In retrospect" are the easiest words for an analyst to write. In retrospect everything looks inevitable. In retrospect everything is obvious. But "in retrospect" is never going to put bread on the table (unless you are a famous TV historian, perhaps). So where are some future Roman Candles.

I do not know, and if I did I would of course be on my way to becoming a millionaire. But here are a few which cross my mind.

Sage: Sage is a leading provider of accounting software for small businesses. Sound unglamorous? That's what's so great about it. Over decades it has assiduously built up an enormous customer base of small businesses who pay it annual support revenues (which now make up the majority of its business) which are high margin and largely recurring. This is a beautiful moat and while the company has displayed unspectacular growth set against racier tech companies, it has been a reliable defensive cash generator for many many years. The sort of company which Warren Buffet might like.

However the company has been excruciatingly slow to move towards a cloud computing model, partly because its fabulous customer reach is built on being as local as possible. Each country has its range of products (largely incompatible with those from the next country) which lets cosset its customers far more closely than its competitors. But as I have said this product spaghetti means it has been very slow to develop on-demand software which simply works through a browser. (Imagine if Google had to develop a completely different version of GMail for every country it operated in)

So the risk is, what if a new generation of customers grows up unused to the idea of buying and installing software locally and just uses on-demand software? And what if, growing up with the global homogenisation of Google and Facebook they don't give a fig about having your countries software being developed round the corner? Suddenly that moat won't be much of a moat after all.

Telecity: Sticking with the UK theme for a while, Telecity is one of Europe's largest providers of data-centre services. They operate a deliberately dumb model - they give you a room in a data-centre and then charge you by how much power you draw from the socket in the wall. You could fill the room with pinball machines if you like they don't care.

As I said, dumb, but brutally successful in a rising market. The shares have been a stock market darling and now trade on 30x forward earnings which would appear to price in a significant competitive advantage. CEO Mike Tobin is, along with Bill McDermott at SAP, the most impressive salesman I have ever met. The guy could sell oil to Arabs, and then get them to drive round again for a refill.

The competitive advantage Telecity enjoys is simply that in the short-term (say the next five years) it will be extremely difficult to add new capacity to the market due to the complexities of planning restrictions and the need to secure upfront investment. Telecity, which has access to more capital than it can use at the moment, is in a sweet spot. It earns ROIC in the mid-20% on a cost of capital which is more like 10%.

However in the long-term (and the shares now price in longer-term success) the prognosis is less bright. As I said the beauty of the model is that it is dumb. But that is also the weakness - there is no patent protection, no recurring revenues (customers renegotiate contracts on an annual basis), and although there are near-term constraints the outsized returns Telecity earns will one day attract competition. At that point they become eroded away and the bottom falls out of the model. One day.

Facebook? This is the biggie. As I wrote in the last post, Facebook has a big moat at the moment - over 900m active users and all their data and connections. It was also very early into the platform game, building precisely the API and app ecosystem which competitors like MySpace lacked.

However a little like Nokia I am continually bewildered by how much the platform seems to have stood still. Put simply in theory the app ecosystem should provide a huge moat, but since Farmville I have seen little or no innovation on it. And developers are now starting to make ominous rumblings about Facebook selling them short as it chases near term ad revenues.

True the installed base is another huge moat, but Google Plus has ramped from a standing start to 150m active users pretty damn fast. And remember every Android phone user has to have a Google account, making them a de facto part of Google's social network.

One thing's for sure - as MySpace showed when a social network loses its mojo it loses it big.

Monday, 6 August 2012

Why moats matter for tech investors

Think different

Microsoft is a company which arouses awe and anger in equal measure.

For the financial analyst awe at its 40% margins. At the unending cashflows which gush from its Windows and Office monopolies. At its $51bn net cash pile (plus the $80bn-odd in buybacks its made over the years).

For the tech lover anger at how it has repeatedly dropped the ball over the last few years. How they had a monopoly on browsers and blew it. How they were doing smartphones while the iPhone was still in sketchup. How they could have bought Google and blew it.

Warren Buffet thought about MSFT differently. For him it was a company which had a royalty on communication. Back in 1997 he wrote

"In effect the company has a royalty on a communication stream that can do nothing but grow.It's as if you were betting paid for every gallon of water starting in a small stream but wiht added amounts received as tributaries turning the stream into an Amazon. The toughest question is how hard to push prices.... Coke is now getting a royalty on swallows; probably 7.2 billion a day if these average gulp is one ounce. I feel 100% sure (perhaps mistakenly) that I know the odds of this continuing-again 100% as long as cola doesn't cause cancer. Bill has an even better royalty"

Put bluntly Microsoft had (and still has, fifteen years later) an enduring position which enables it to charge a tax (let's call it, the Windows/Office licence fee) every time a business wants to use a computing device.

The reason why this royalty has endured so long is because Microsoft has a very big moat.

Why Moats are a feather in your CAP

Moat's are an obsession for Warren Buffet. It's one of the key characteristics he looks for in a business - an enduring competitive advantage which keeps competitors out and allows you to therefore retain pricing power, margins and high returns. As he wrote in his 2007 Letter to Shareholders:

"A truly great business must have an enduring “moat” that protects excellent returns on invested capital.  The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns.  Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success.  Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed."

Restating this in more coldly financial terms, a business creates value if it generates returns above its cost of capital (the heart of the EVA valuation approach). Over time you would expect returns to be eroded down to the cost of capital, a period known as the competitive advantage period (CAP). A moat is simply a set of circumstances (be it patent protection, an ecosystem or a lower cost structure) which is hard for competitors to replicate and therefore extends your competitive advantage period.

Moats and technology

For technology companies owning a platform and the associated eco-system is the surest way to built a moat around your business. For all of Microsoft's failings over the last fifteen years (and they are many) it has retained an iron grip on the Windows computing platform, particularly in the world of enterprise computing where a combination of complexity, vested interests and sheer institutional inertia makes it very hard to displace.

True with the advent of cloud computing, remote systems and bring your own device, the days of a Microsoft free office may one day come, but that is still a very very long way off (and in the meantime MSFT has enjoyed a spectacular run, as least in terms of cash generation).

Moats are particularly important in technology for reasons which I highlighted in a previous post. Firstly technology companies often generate unusually high returns on their capital because they are asset light, and high growth. This means only a few years extra competitive advantage period can yield significant cash returns. Secondly the competitive landscape in technology can change much more rapidly in other industries as Moore's Law drives faster silicon and new product categories - therefore anything which can give you a material competitive advantage is worth its weight in gold.

A few technology moats

To round this post off, here's an entirely non-comprehensive list of moats in the technology world. Simply ones that occur to me as I write:

  • Oracle & SAP: Massive installed bases for their enterprise applications, where customers pay an annual royalty (let's call it tribute) on their initial licence, and will only ever switch in the direst of circumstances.
  • ASML: The biggest tech company you've never heard of. Near-monopoly position in next-generation EUV manufacturing processes. Bottom line - if you want to build a chip on a next generation process these are the ONLY people who produce the machines you need.
  • Apple: App ecosystem around iOS, particularly on the iPad (warning - it will be interesting to see though how quickly Android catches up. They are already getting there for smartphone apps :-x).
  • Facebook: Network effect of having everybody and their mum (or "and unfortunately their mum"!!) signed up on their platform (along with a vast amount of personal data, pictures and social connections). Also the eco-system of third party apps building on the Facebook platform.
  • ARM: Ecosystem of chip providers (Qualcomm, Samsung, Mediatek, Apple, TI &tc) who go to them for low-power chip designs because a) they are the de-facto standard and b) they are happy to sell neutrally to all comers.
  • eBay: Network effect of being the biggest online auction site - sellers and buyers will both go to where they can find liquidity.

However what's even more interesting (for an investor) than technology moats is when the markets thinks a company has a moat, but it doesn't at all. But that's a story for another day...

Thursday, 2 August 2012

Why successful shares are like the Czech football team

It's not how good you are that counts, its about how much better you are

A quick digression, and apologies to the wildly informed who know this already. Like much about equity markets, it isn't rocket science.

Often people are confused why shares can report good results and go down. Facebook grew revenues a cool 29% this quarter, but the shares then tanked 15%. What gives?

The most important thing to remember is that what determines how a share price reacts to results is not how good its numbers are, but how good they are relative to what the market was previously expecting.

(as I said, apologies to those who know this all already, but if there's any consolation there's some quite fun stuff to follow).

Why Spain weren't the best team at Euro 2012

I've always found a good way to explain this to the generalist is by showing a neat little piece of sporting analysis which I do every time there is a major football (soccer) tournament on (World Cup, European Championship):

This chart shows how well teams did in the recent European Championship on the vertical axis, and how well they were expected to do before the tournament on the horizontal axis.

I determine the rankings on the vertical axis based on (in descending order of importance) 1) How far they got in the tournament, 2) How many points they scored (Win = 1, Draw = 1, Loss = 0), 3) Goal difference, 4) Goals scored.

I determine the rankings on the horizontal axis by placing the countries in the order they appeared on the FIFA World Rankings issued directly before the tournament started (6th June 2012).

Now on one measure Spain were the best team at Euro 2012. They won the tournament after all, and had a stonking goal difference of +11 (next best team Germany at +4).

However on another measure the Czech Republic performed the best. As you can see from the chart they were the further above their expected position. They finished 5th in the tournament, but before the tournament they were only the 14th-based ranked team in Europe. (by the same logic the worst team weren't Ireland, with their mighty -8 goal difference, but actually the Netherlands who were ranked 3rd but came 15th).

The same logic applies to shares on the day they report results (or the day after for overnight reporters). Whether they move up or down depends on whether they have beaten or missed prior expectations.

More specifically a share generally moves up and down in proportion to the average full year earnings upgrade/downgrade from brokers the day after results. The correlation isn't perfect, but in my experience that's a good rule of thumb.

And why you should never go to Michelin Three Star Restaurants

Amusingly the same logic applies to restaurants. Now I'm a pretty massive foodie, but one thing I've noticed is how much you enjoy a restaurant is not actually tied to how good it is, its tied to how much better/worse it is than you were expecting.

You can have meal cooked to very high standards in a three-star restaurant, but if it isn't perfect you will leave disappointed because you were expecting the world (and paying accordingly). In contrast you can have a plain but well cooked piece of grilled lamb at a Turkish mangal (grill), but it can taste like the world if all you were expecting was burnt rubber.

So there you have it. Don't go to the Fat Duck. Go to the FM Mangal and save a bucketload of cash at the same time....

Wednesday, 1 August 2012

More nuggets from Facebook's 10-Q

Always read the small print!

When a US-listed company releases their earnings they often do it via a non-statutory press release (translation: most likely written by their financial PRs). The actual normal filings (a form 10-Q for quarterly results) normally becomes available a couple of days later. Facebook's 10-Q is now available to view here.

As I've said earlier, its best to read filings from back to front as all the interesting stuff is always in the footnotes. Similarly here - nothing earth-shattering (the headline numbers are already out) but just some detail which the company didn't mention on the press release.

Mobile users up, Zynga split down

Two nuggets - mobile-only MAU's were up 23% sequentially to 102m, versus an increase of only 6% for overall MAUs. Remember one of Facebook's big revenue problems is that revenue per user is much lower on mobile than desktop so the more mobile-only users, the less ad revenue Facebook gets. Not a direct comparison, but for reference Zynga said on its Q2 call that its ARPU for mobile users is roughly half that for desktop users.

Secondly Facebook disclosed that Zynga accounts for 10% of group revenues (down slightly from 11% in Q1). Ads from pages generated by Zynga accounted for an additional 4% of revenues (similar to Q1 but down from 7% of group last year). Interestingly if you strip out Zynga revenues from Facebook's Payments split, it shows that ex-Zynga payment revenues (a segment which should be growing fast and is potentially a high-margin revenue stream for Facebook) only grew 6% sequentially to $74m. Facebook has been early to the payments game but still looks lamentably under-scale in this space.