Can Turtles Fly?

Online Social Networks and the Ascent of Facebook

2012-02-19T02:01:00.000-05:00

As bizarre as this sounds, one of the most valuable innovations in technology over the last several decades is Facebook's "Like" button. That's what has propelled the company to a galaxy-orbit valuation for its forthcoming initial public offering, filed Wednesday.

This is not only because the word "like" is, like, the identifying word of an entire generation. It's because computing has evolved beyond just taking directions from humans—and instead is cozying up to us and sniffing out our emotions and intent.

— Andy Kessler, Wall Street Journal

Three decades ago, if someone had told you that a company that didn't make any physical products, had existed for less than a decade, and had less than 3,000 employees would be worth $100 billion, would you have believed it?

But here we are, three decades later, and stock market participants appear ready to award a $100 billion valuation to Facebook (FB). Are they crazy? Is this irrational exuberence taken to another level?

Mark Zuckerberg and his team have done an amazing job creating something out of, literally, nothing. Facebook's valuation does appear bubbly and contrarians like me would never buy it at these valuations. However, the company's fundamentals are far more solid than many skeptics claim.

Facebook is not what it seems; the more I read about it, the more impressive it gets.

What is Social Networking?

Here is a quick recap of social networking through the ages ;):

(source: The History of Social Networking, An Odd Todd Cartoon. Time, 2010)

I never read Time magazine but it was once famous for its Person of the Year award it gives out. I think the significance of that award has been lost, now that politicians and others accomplishing little in the world continuously keep receiving the citation, but, nevertheless, sometimes, it signals major social changes. Time may have been onto something when it named Mark Zuckerberg as Person of the Year in 2010 (Julian Assange of WikiLeaks was more deserving but Zuckerberg was a worthy pick as well). In justifying its choice for the 2010 Person of the Year, Time wrote a fitting description of why social networking has risen to such heights and why there is so much hype around it:

"On or about December 1910, human character changed."
— Virginia Woolf, 1924

She was exaggerating — but only a little. Woolf saw a fundamental shift in human relations taking place at the beginning of the 20th century "between masters and servants, husbands and wives, parents and children." Those changes, she predicted, would bring about transformations in every sphere of life, from religion to politics to human behavior. Few would say she got it wrong.

A century later, we are living through another transition. The way we connect with one another and with the institutions in our lives is evolving. There is an erosion of trust in authority, a decentralizing of power and at the same time, perhaps, a greater faith in one another. Our sense of identity is more variable, while our sense of privacy is expanding. What was once considered intimate is now shared among millions with a keystroke.

***

Evolutionary biologists suggest there is a correlation between the size of the cerebral neocortex and the number of social relationships a primate species can have. Humans have the largest neocortex and the widest social circle — about 150, according to the scientist Robin Dunbar. Dunbar's number — 150 — also happens to mirror the average number of friends people have on Facebook. Because of airplanes and telephones and now social media, human beings touch the lives of vastly more people than did our ancestors, who might have encountered only 150 people in their lifetime. Now the possibility of connection is accelerating at an extraordinary pace. As the great biologist E.O. Wilson says, "We're in uncharted territory."

Online social networks are radically changing the nature of life. One hundread and fifty "friends" may be the optimal number but I think people have many more social contacts when it comes to online social networks. I wonder if humans have permanently expanded our capacity to surpass the Dunbar number. I am having problems with information overload—can't even follow anything on Twitter due to too many tweets; and I don't follow too many tweeters either—but the younger generations seem to be adept at handling it, and keeping in touch with many more people.

I was planning to go into greater length on the importance of online social networks, as well as criticism of them, but this post is very long and I'll save it for another day. As one author once remarked, social networks are a reflection of human elements of nacissicism and voyeurism. Let's save the underpinnings on why they are popular for another day.

It's suffice to say that there are many different types of social networks that are forming. My feeling is that the Internet has magnified some activities that happened in the real world onto the virtual world. These range from mass broadcasting (Twitter), to professional networks (LinkedIn), to photo-scrapbooking (Pinterest), to you-name-it.

Some of the key benefits of online social networks are as follows (some of these are really benefits of the Internet revolution which are being magnified by online social networks):

Easily connect with friends, family and relatives: Once upon a time, it was difficult to keep track of friends you haven't seen in a while or who have gone in a different direction in life. Not anymore.
Socialize with strangers if you want: Depending on the social network and your nature, you can have a somewhat deep discussion with strangers as easily as with friends. In contrast, in real life, it is rare that you can start a discussion with some stranger, even if they work in your office building or live in an adajcent neighbourhood, without some difficulties.
You can observe or participate: Related to the prior bullet, it is more easier to observe things in online social networks and not participate if you don't want to. For instance, I forget the exact number but something like 40% Twitter users don't actively tweet. Similarly, I think around 20% of Facebook users are responsible for more than 50% of the updates, photo uploads, news feeds, and other actions carried out on a regular basis.
Easier collaboration: We haven't seen the power of this yet but once online social networks are established, it's easier to collaborate. Right now, most networks seem primitive with only limited video chats and text communications, but imagine watching movies together with distant friends, or listening to a music mix that is being mixed live by one of your friends. Possibilities are endless.
Share interests and hobbies: In the past, people often formed hobby groups or social gatherings for particular interests. If you were in a town with few others who shared your hobby, you were all alone. This has dissipated with online networks.
Cheaply save information, photos, favourite lists, etc: Capitalizing on the low-cost, widely-accessible, Internet, mobile telecommunications, and data storage revolutions, online social networks have made it easy—even for people who aren't tech-savvy—to upload pictures, videos, and the like. In fact, in many cases, it is easier to upload photos to a social network than to your home desktop PC or laptop—this would have been unthinkable even 10 years ago!
Innovation at the speed of the Internet: Online social networks are mostly driven by software innovations (and less dependence on hardware), and they are able to innovate at the speed of the Internet; whereas the desktop PC and laptop, not to mention corporate computing, are hampered by slow hardware updates and software development cycles.
Lower search and transaction costs: Online social networks make it easier to find goods and services that interest you more easily and cheaply than traditional sources. One of the reasons Google feels threatened by companies like Facebook is because, asking your social network to recommend a restaurant, for example, will bypass traditional Internet search.

This rest of this post will focus on Facebook, which is the strongest and, at least in my mind, the network that encapsulates the greatest benefits (and dangers) of online social networking. I'll primarily look at Facebook as an investor and will ignore issues pertaining to its social impact.

Thoughts on Facebook's Business Model

If rumours and speculations end up being correct, Facebook will end up being priced at ridiculously-high P/E and P/S multiples. I haven't checked the numbers but Anh Hoang at GuruFocus reports that if the market prices Facebook at a market cap of $100 billion, it will be "valued at 100x P/E, 106x free cash flow, 67x operating cash flow and 15.8x its book value."

These are extremely high multiples for a large-cap company but I believe the numbers are a bit misleading and not reflective of the potential, underlying, business characteristics. Facebook's sales and earnings are depressed right now in my eyes. Facebook's revenues is as follows (thanks to SplatF for the graph):

(source: "How Does Facebook Make Money?" SplatF. February 3, 2012 12:14 pm)

Facebook takes in almost $4 billion but, obviously, this isn't good enough to support a rumoured $100 billion valuation.

Facebook hasn't started monetizing its service and there is lots of room for revenue growth. Facebook has been focused on attracting customers for the last 5 years and now that it has a huge customer base—more than 800 million active users and several hundread in USA alone—it will likely focus on trying to earn money from them.

I see many similarities between Facebook and Youtube in terms of their revenue potential. Readers may be aware that I'm really bullish on Youtube's business prospects. Youtube has something like 500 million viewers but doesn't earn much from them; but it is the in process of trying to monetize their services. Facebook is kind of like that, with it having a huge userbase but very little revenue. (I haven't researched this but it wouldn't surprise me if radio was like this in the very early days: lots of listeners but little revenue and uncertain business model.)

The question for Facebook (and Youtube) is whether they can retain their customers and maintain strong customer relationship as they try to increase revenues. They may lose some customers along the way but I suspect most won't flee (more on this when I talk about its moat).

Tech writer Robert Scoble commented in a post on where future Facebook revenue may come from. The first item he identifies is the potential from mobile devices, such as smartphones. Facebook doesn't really earn anything from mobile right now, even though it is heavily used in mobile phones. This should be the easy fruit for Facebook. Scoble also provides some insightful thoughts on the potential from their partners who use the Facebook platform:

Open Graph is only one way. Companies like Foodspotting push information INTO Facebook, but they don’t get value out. Developers, like Foodspotting, tell me they are hearing rumblings that Facebook is developing a new kind of advertising. One that looks sort of like Ad Sense, but that push ads out to Open Graph partners. Spotify, for instance, has pushed five billion songs INTO Facebook. Imagine when Facebook pushes ads OUT to Spotify!

Not only does Facebook have huge advertising potential, it also will likely earn higher fees since it is more targetted than even what Google offers. As Nicholas Thompson of The New Yorker pointed out,

Precise targeting is the reason for one of the most impressive statistics in the much-ballyhooed I.P.O.: as Facebook sells more ads, it has made more money off of each one. In contrast, across much of the rest of the Web, ad prices keep dropping because inventory keeps soaring.

Unlike many other Internet businesses, Facebook also has great potential in new revenue streams. Many seem to think of Facebook as generating most of its revenues from advertising, and hence tend to compare it to Google. As the chart above shows, advertising has been most of its income over the years, but I suspect that mix could change significantly.

The chart already shows how Facebook is starting to earn revenue from payments and 3rd party activity. I think Facebook will become more of a platform—this seems to be Mark Zuckerberg's vision—and will end up earnining significant revenue from their partners. In article for Fast Company, E.B. Boyd commented on the strategy (as usual, bold highlights by me):

A year ago, at Web 2.0, Zuckerberg explained Facebook’s goals. “Over the next five years, most industries are going to get rethought to be social and designed around people,” he said. Media industries, in particular, he said, “are going to be completely re-thought.”

Facebook didn’t want to do the re-thinking for those companies, Zuckerberg explained. Instead, it wanted to be a platform that those industries could build their new social selves on top of.

“We should play a role in helping to re-form and re-think all those industries,” he said.

The new Timeline that Facebook launched today, and the new class of social apps, is the next phase of implementing that vision. Facebook becomes a platform that allows other applications to build more sharing directly into their own offerings.

And while this certainly conforms to Facebook’s mission to make the world a more open and connected place, it can also conceivably contribute mightily to Facebook’s bottom line.

***

The partners that have decided to join forces with Facebook, like Spotify, Hulu, and Nike, presumably hope that what Zuckerberg says is true--that adding a social dimension to their offerings will lead to more consumption.

Spotify CEO Daniel Ek told the audience at f8 that Facebook users who use Spotify today listen to more music on a weekly basis than non-Facebook users, listen to a wider variety of music, and are twice as likely to pay for music.

“In the old days, we used to go to each other’s houses and browse through each other’s record collections. Until now that hasn’t’ been possible online,” Ek said.

As mentioned in the example above, imagine someone who listens to a song on Internet radio through Facebook and then purchases a song. Facebook could easily earn a chunk of every such transaction. Facebook can essentially become a user's Internet home, fulfilling the dream of Internet architects from the late 90's to build portals and personalized sites:

“Think of Facebook City,” said analyst Tim Bajarin of Creative Strategies Inc. “Ultimately, while they would never create a walled garden, they could create a community where once you come in, you pretty much have all you need there.”

Facebook’s goal, he said, is have more users making purchases, do their banking or even making dinner reservations in the site.

It's not clear how successfully Facebook will execute on some of these ideas. Facebook only has around 3,000 employees—an amazingly low size for a company potentially valued at $100 billion—and it remains to be seen if it can grow without losing its edge.

Customer Base Likely Near Peak

Some in the investment, technology, and media communities seem to be paying a great deal of attention to Facebook's customer growth, but I think this is a flawed approach.

Facebook's customer base is likely near the peak. I don't think the number of Facebook users will grow much further. There will still be increases from population growth and entering new emerging markets but that is likely to be limited. For instance, untapped markets like China will still be out of reach due to privacy issues and the existence of a totalitarian government; similarly, many countries with draconian governments—Middle East, most of Africa, some South American countries, some South Asian countries—will be out of reach of a social network like Facebook where real life names, pictures, etc are shared. My understanding is that anonymous social networks are popular in some of these regions—Facebook clearly isn't based on an anonymous social network business model.

So, Facebook has probably captured most of the Internet users. They can try increasing activity frequency—a customer using Facebook once a week may be converted to someone using it once every couple of days—but that's about it.

Going forward, everything will come down to monetization of existing customers.

To use an online video streaming analogy, Facebook is like Youtube (GOOG) rather than something like Netflix (NFLX). Netflix can still increase its subscriber base because there are still a large number of users who don't use Internet streaming to view movies and television shows. In contrast, Youtube is already being used by almost everyone. Youtube needs to focus on monetizing their existing users and worry less about attracting new users. Similarly. Facebook really can't grow its userbase very much and will spend most of its effort on earning revenue off the existing customers, and ensuring that the customers are retained.

Does Facebook Have a Powerful Moat?

I think so.

But like all moats, they can deteriorate if not maintained.

Successful venture capitalist and blogger at AboveTheCrowd.com, Bill Gurley, rates Facebook on key criteria he has developed as follows:

Bill Gurley is a venture capitalist and is a growth investor, hence, I suspect he focuses on peak (exit) valuations and is short-term-oriented. He is extremely bullish and thinks the company has a strong moat.

You can see how the thought process of growth investors and venture capitalists differs from value investors, who are generally long-term-oriented, by looking at the last factor, growth, in the table above. Bill is concerned that sales growth may be topping out on a quarterly basis. This is important for short-term-oriented growth investors, especially those pricing in huge growth expectations and hence paying high valuations for Facebook.

In contrast, if you were a long-term investor, looking out 10 to 20 years, the sales growth decline in the near-term is not so important. After all, it is a certainty sales will slow down over time as the company grows, regardless of how good your company is—case in point is present day Google, and, I suspect, pretty soon, Apple. What you really care about is the growth rate over the next 10+ years. This rate is not going to average anywhere near the current 88% sales growth in 2011.

I think Bill is way too optimistic with his rating of Facebook on the factors he cited. Nevertheless, I largely agree with his views on the strength of Facebook's moat.

I say it has a moat because user activity and brand loyalty is very strong—so far! Take a look at the type of activities customers use Facebook for, in the following infographic slightly edited by me (go to the original source for the full infographic; data refers to early 2011 figures):

(source: From the article "Obsessed with Facebook," Mashable. January 12, 2011)

I don't know how accurate the sampling in this infographic is but I find it quite amazing. Think about the type of activities: News! Daily status updates from friends! Photos! These are critical elements of one's life. They are all habit-forming!

It's amazing to think how almost half of the youth and young adults rely on Facebook to inform them of news events. As these individuals get more used to the platform, develop a greater dependence, and grow up and age, Facebook's moat is likely to become very strong. Facebook will probably end up having a stronger reputation as a news source than a newspaper website.

How many would leave Facebook if they can't transfer their photos over? Right now, the photos are probably more "fun" and "experimental" than anything meaningful but people will likely cherish these photos as they age. Just check out the following promo video from Facebook showing how the current generation is building memories like the prior generations did with Kodak film and photobooks:

I forget where I read it but I think it was an insurance executive who said that the #1 thing people save from a burning house, apart from living things, is their photobooks. People would rather run into their burning home and grab their photos than their wallets or laptops or their fancy clothes. How many of those people who upload photos to Facebook are going to switch easily to another platform? As long as Facebook stays somewhat close to the latest technologies and makes improvements—for instance, the resolution of pictures on its site is lower than Google's—it will get harder and harder to dislodge.

Based on Bloomberg's compilation of Facebook data, the percentage of users that have visited the site daily versus a monthly basis has increased over the years:

"In last year’s fourth quarter [4Q 2011], 57 percent of users went to Facebook daily. The proportion climbed from a low of 44 percent in the second quarter of 2009."

What this tells me is that people are using Facebook more and more for daily needs, such as the ones cited in the infographic above.

Once you develop a habit at a youthful age, you are likely to stick by it for your entire life. A lot of demographic trends—fashion & style, car purchase preferences, television viewership—tend to depend on what individuals were influenced by when they were young.

The switching costs are going to be enormous pretty soon! As most investors may already know by now, switching costs are a huge barrier to entry. The only other company that comes anywhere near Facebook in terms of high switching costs is probably eBay (a different business). Facebook has a sizeable moat and it may end up being one of the biggest in the Internet space.

Just because you have a moat doesn't mean you can't be dislodged—ask Nokia or RIM about Apple—but as long as Facebook continues to build its moat, it does increase the probability of long-term survivability.

Is Facebook Overvalued?

Based on analysis presented in the following Business Insider chart, Google's revenue from each customer is around $24 per unique user versus Facebook's $4/user (note that these numbers are from early 2011 before Facebook disclosed detailed numbers so they are not the most recent, but this doesn't detract from my analysis).

Although Google and Facebook are not exactly the same business—I tend to think of Google as more of a search or content aggregation company whereas I treat Facebook like a media platform or portal-type company—Google's numbers do give a rough estimate of what Facebook is capable of earning.

An excellent article in Reuters points out the possibilities:

Internet advertising is expected to grow at an annual average rate of 15.9 percent to $113 billion in 2014, from an estimated $84.2 billion this year, according to Zenith Optimedia. That makes the Internet the second-largest ad market behind TV, which by 2014 will reach $215.7 billion.

Facebook currently commands only a sliver of agency ad dollars. In 2011, Sorrell said WPP spent $1.6 billion with Google and just $200 million with Facebook. This year Sorrell, who labeled Google a "frenemy" in 2006, expects to spend $2.3 billion with the search giant and $400 million with Facebook.

Sorrell said the disparity is because of the greater difficulty of monetizing social media. Not to mention that the increased competition with Google in recent years has made it a "friendlier frenemy," Sorrell added with a laugh.

"Facebook is a superb branding medium, but right now it is more about PR than advertising," he said.

The fact that WPP, a leading, global, advertising agency, is doubling its Facebook spend from $200 million to $400 million, shows the strong interest from advertisers. We are not talking about small increases here and there; we are seeing big commitments by serious players.

So, when I say that Facebook's present sales and earnings are depressed, they really are. I would be shocked if Facebook's long-term earnings are at the same level as now.

Aswath Damodaran, Finance Professor at NYU Stern School, has a done a detailed valuation estimate for Facebook so anyone interested in Facebook should check out his blog post. Using an approach that assumes Facebook's growth will mirror (actually slightly best) what Google has seen post-IPO over 8 years, he arrives at the following valuation for operating assets:

Discounting the cash flows back at the cost of capital (with changes over time) results in a value of $71,240 million. To get to equity value, I subtract out the outstanding debt ($1,174 million) and add the current cash balance ($1,512 million)...

Value of equity = $71,240 + $1,512 - $1,174 = $71,578 million

Google's growth trajectory for Facebook looks very aggressive but if you think, like me, that Facebook's sales are severely depressed then this isn't as risky as it seems. You are looking at a potential Golden Goose in, what I believe could be, a winner-takes-all-type market (common in Internet services with strong networking effects, like Ebay or Amazon).

Damodaran went on to produce a graph of valuation distribution based on various factors. As he remarks, "As with my Groupon valuation, I ran a simulation,making assumptions about distributions for my key assumptions (revenue growth, operating margin, cost of capital and reinvestment)":

(source: "The IPO of the decade? My valuation of Facebook," Aswath Damodaran, Musings on Markets. February 16 2012)

Based on the simulation above, it looks like Facebook should be worth between $42.6 billion and $116.7 billion, with the median around $70.9 billion. The highest probability seems to be around $62 billion. (All this based on very aggressive Google-like growth expectations. I haven't seen Damodaran do a business analysis so I'm not sure if he actually believes Facebook will grow like Google or if he is just doing a hypothetical scenario here.)

My Estimate of Facebook's Market Cap

I have pretty much come down to using a crude method to value stocks: the P/E multiple. No wonder my investment returns suck ;) In any case, I like using multiples to value companies because there can be huge errors in estimating detailed growth rates. It's better to just pick a rough long-term profit figure and think about whether the company can sustain that.

One should keep in mind that a lot of Facebook's users are foreign users and their revenue potential is far lower than in rich countries like USA (at least for the next decade or so). Regardless, Facebook should be able to increase their revenue to at least half of Google's per-unique-user figure to arrive at around $12/user. Given Facebook's current userbase is around 800 million, this means that Facebook can probably earn $9.6 billion in revenue eventually, or slightly more than double its current revenue. If the company maintains its competitive positioning, its revenue will surpass this figure eventually (say 20 years and beyond) but it won't grow beyond GDP or Internet adoption rate or something like that.

It's difficult to estimate earnings from the sales figure (since profit margins are more complicated with companies like these; they likely won't scale up linearly due to it being a low-asset service industry) but it wouldn't surprise me if that quardrupled from the current $1 billion or so, to around $4 billion.

Net income of $4 billion on sales of $9.6 billion means that Facebook will have an extremely high profit margin of around 42%. This is very high and usually unsustainable but it is possible in Internet services which tend to have low assets, few employees, and have low marginal cost for each additional customer (it's kind of like the software services industry). Although rare and every entrepreneur and competitor will want a piece of that profit pie, Facebook can probably sustain that as long as it maintains its moat (anyone investing in Facebook needs to make a judgement on whether it can maintain its moat).

If Facebook does maintain a profit margin close to 40% over the next two decades, it will probably have the highest for a large-cap company. For example, assuming Yahoo! Finance numbers are correct, Oracle (ORCL) has a profit margin around 26%, Apple (AAPL) is at 26%, Google (GOOG) is at 26%, and Microsoft (MSFT) is around 33%. If Facebook can execute successfuly on its plans to dominate its market, it'll be like a super-charged baby Microsoft—at least for the next decade.

If we apply a multiple of 15, that pegs Facebook's valuation at $60 billion. I'm using a P/E of 15 because that's the very-long-term market multiple and Facebook likely has a lifespan beyond 30 years. (I did my calculation long before I encountered Damodaran's results and the fact that it is in his ball-park figures gives me some confidence in my number.)

Since conservative investors should buy with a margin of safety, I think the company is attractive around $40 billion to $50 billion. That's not going to happen any time soon and conservative investors likely will be out of the market for a long time (but that's the price you pay for being conservative—the sexy stocks are out of reach until they falter).

Even with these figures, do note that there is a lot of speculation, particularly the growth trajectory, built into the figures above. Facebook needs to execute and it's dangerous to buy companies on the hope that they will—growth investors don't mind doing this but value investors should stay clear. This is why you need to buy the company at, say, $40 billion even if you think it's worth $60 billion.

Key Risks Facing Facebook

Facebook's biggest risk as a public company will involve maintaining strong privacy and customer relationship, while it strives to boost sales. As Reuters reported in a story,

The big question is whether Facebook can further evolve its advertising offerings, which are tempered by privacy laws and the changing parameters around how social networks can mine user data for targeted marketing.

"Their ad product opportunities aren't too robust right now, and the effectiveness is spotty at best," Hayes said.

Facebook has come under criticism for the way it has used member data in the past, including in 2008 when its Beacon advertising product was assailed for disclosing such things as what purchases people were making on Amazon.com to their friends without permission.

Companies have also removed ads from being displayed against offending user or group profiles, not unlike how brands pull commercials on television shows in protest.

Facebook listed the evolving nature of privacy and data protection laws as two risk factors that could impinge future growth in a regulatory filing.

Still, the key for Facebook, according to David Eastman, president of digital at JWT, which is part of the WPP group, is keeping Wall Street at bay while it figures out how to monetize its role as an identity broker.

"I'm worried about how the IPO will affect creative," said Eastman. "I'm worried that the demand for growth and making numbers will get in the way of really evolving the platform to figure out how to monetize influence."

Mark Zuckerberg is setting up Facebook—somewhat like Google and its dual-class shares—to ensure that Wall Street doesn't pressure the company to favour short-term profits at the expense of benefitial long-term strategy. These non-standard corporate governance structures are very anti-democratic and shareholder-unfriendly but if you believe in the key executives running the company, then it is actually a better way of running the company.

On top of numerous other problems, my opinion is that one reason MySpace fell off a cliff was because of the buyout by Rupert Murdoch's News Corporation (NWSA; NWS) completely altered the company and its culture. On top of not understanding the Internet, my guess is that News Corp didn't invest enough in MySpace. It seems unlikely that Facebook will face those problems any time soon but it remains to be seen.

The biggest difficulty for Facebook will come when governments start getting their hands into the business. There is no better way to manipulate the population, not to mention "track down the evil-doers," than to access data from companies like Facebook. I'm curious to see how Facebook, as well as companies like Google, handle these emerging issues. Companies like Amazon and Ebay rolled over dead and didn't challenge the US government (and other governments) when they were pressured by politicians (without court rulings) to cut off funding for WikiLeaks, and I'm curious to see if Facebook will stand up for its users or not. Microsoft, from my impression from some cases in China and Russia, also has a habit of not standing up for its consumers and business users when governments act outside "the law." Unlike all these other companies, Facebook contains way more private data, and if the public loses faith in it, it's all over for the company. In contrast, a company like Amazon can still continue operating as a less-trustworthy online retailer. Facebook won't have that option.

The Future of Facebook

I started off by quoting Andy Kessler's article in The Wall Street Journal, espousing on the innovation of the "Like" button. For those not familiar, the "Like" Facebook button, which you may have seen on many websites, allows Facebook members to indicate articles and products and brands and songs and movies and clothing items and websites and many other items that they support—or like. This enables Facebook to understand the preferences of customers, and build a narrower demographic profile. As Kessler continued in his article,

That's where the Like button comes in. The adage about advertising is that only half of ads are effective, but no one knows which half. So companies will drop $3.5 million to NBC for a 30-second Super Bowl ad. Or run Keystone Light ads on Comedy Central. They may work, but advertising—ask P&G—is an industry ripe for productive innovation. With the Like button, Facebook is like Bob Eubanks on "The Newlywed Game," who promised contestants "a prize chosen especially for you." Advertising's nirvana is an ad chosen especially for you. Of all the players, Facebook is the closest to delivering.

Facebook takes the revolution in advertising to the next level, from the peak reached by Google. As some of you may be aware, Google revolutionized advertising by reaching potential purchasers, just before they were about to make a purchase. I covered this in an earlier post where I quoted the excellent Charles Petersen essay in The New York Review of Books (bolds by me):

Google’s executives realized that ads on search engines reach users at a singularly receptive time: unlike readers browsing through articles on a news website, users of search engines are often looking for something very specific. A user who asks a search engine, for instance, “Where can I find the best car insurance?” would be a more promising potential customer than a visitor to a news website, because by searching for car insurance a user signals that he or she is, at that moment, in the market for car insurance. A car insurance ad programmed to appear next to the results of such a search would allow the advertiser to target its most desirable audience.

Facebook takes it to the next level by allowing advertisers to learn what individuals want before they even purchase something.

It'll be interesting to see if Facebook can successfully navigate the privacy issues that it will face, as advertisers start using its users to make a profit. Will there be a consumer backlash? Will the users feel as if their privacy is being used without any benefit to them?

Or will Facebook consumers actually be happy with advertising that is relevant to them? Instead of sifting through irrelevants ads, as their parents and grand-parents had to do, will they be happy with offers that seem tailored to their tastes?

The newspaper and television industries made a living by successfully selling their customers to advertisers, without incurring a big backlash. It remains to be seen if Facebook, and others like it, will accomplish something similar.

Regardless of how you look at it, Facebook is powerful and likely to stay. Its estimated valuation seems too high but I do think it has a big moat, that can potentially morph into a very big one.

Hope you enjoyed the writing. I'll be revisiting in 9 years when the valuation is much lower ;)

Oh, all this written by someone who isn't on Facebook—yet!—and has no "friends."

Useful References (starred are recommended):

* Facebook Inc. Form S-1 Registration Statement, SEC.

"How Facebook makes money could change" by Benjamin Pimentel, MarketWatch. February 2, 2012.

* "Facebook IPO $100 Billion Valuation Is Not So Overpriced" by Anh Hoang, GuruFocus. February 3, 2012.

"Why Facebook will be worth a half trillion by 2015: the mobile and open graph revenue it’s leaving on the table" by Robert Scoble, Scobleizer blog. February 1, 2012.

* "The IPO of the decade? My valuation of Facebook," Aswath Damodaran, Musings on Markets. February 16 2012.

"Why Facebook Clearly Belongs in the 10X Revenue Club" by Bill Gurley, AboveTheCrowd.com. February 1, 2012.

"As Facebook grows up, it courts Madison Avenue" by Peter Lauria, Reuters. February 5, 2012 8:18pm EST.

"Retailers Shut Facebook Storefonts Amid Apathy" by Ashley Lutz, Bloomberg. February 17, 2012.

"New Facebook Timeline Is All About Discovery And Explosive Revenue Growth" by E.B. Boyd, Fast Company. September 22, 2011.

"Person of the Year 2010 Essays: Only Connect" by Richard Stengel, Time. December 15, 2010.

* "Opinion: The Button That Made Facebook Billions" by Andy Kessler, Wall Street Journal. February 2, 2012.

"News Desk: What Facebook Can Sell" by Nicholas Thompson, The New Yorker. February 2, 2012.

* "In the World of Facebook" by Charles Petersen, New York Review of Books. February 25, 2010. (Book reviews of The Accidental Billionaires: The Founding of Facebook, A Tale of Sex, Money, Genius, and Betrayal by Ben Mezrich; Stealing MySpace: The Battle to Control the Most Popular Website in America by Julia Angwin)

* "Generation Why?" by Zadie Smith, New York Review of Books. November 25, 2010. (Reviews of "The Social Network," a film directed by David Fincher; You Are Not a Gadget: A Manifesto by Jaron Lanier)

"Mind Control & the Internet" by Sue Halpern, New York Review of Books. June 23, 2011. (Book reviews of World Wide Mind: The Coming Integration of Humanity, Machines, and the Internet by Michael Chorost; The Filter Bubble: What the Internet Is Hiding from You by Eli Pariser; You Are Not a Gadget: A Manifesto by Jaron Lanier)

"Small Change - Why the revolution will not be tweeted" by Malcolm Gladwell, The New Yorker. October 4, 2010.

"Ask the Author Live: Malcolm Gladwell on Twitter," The New Yorker. September 29, 2010.

"The Face of Facebook - Mark Zuckerberg opens up" by Jose Antonio Vargas, The New Yorker. September 20, 2010.

"A Woman’s Place - Can Sheryl Sandberg upend Silicon Valley’s male-dominated culture?" by Ken Auletta, The New Yorker. July 11, 2011.

"More Than Half of Facebook Users Need Their Dose Daily: Chart of the Day," Bloomberg

"Tweet Science" by Joe Hagan, New York. Published Oct 2, 2011.

"Influencing People - David Fincher and 'The Social Network.'" by David Denby, The New Yorker. October 4, 2010.

Sunday Spectacle CLXII

2012-02-19T00:11:00.000-05:00

History of Radio

(click on buttons at bottom left to activate larger infographic)

Original source: "The History of Radio," Sonos. Posted on February 6th, 2012.
Embedded infographic from Visualizing.org

Inside Look at Warren Buffett's Office and His Interests & Ideologies

2012-02-14T21:09:00.000-05:00

Thanks to CanadianValue for this great find: a video of Warren Buffett's office, as well as him sharing his hobbies and describing some of his ideological views.

Sunday Spectacle CLXI

2012-02-12T00:00:00.000-05:00

Public Transportation - Helsinki, Finland

Check it out fullscreen in 720p HD;
They should have used more colours but oh well

(h/t: "Helsinki Public Transportation Visualized," By Lauri Vanhala. Visualizing.org)

Financial Crisis Redux - Michael Lewis Talks About Wall Street

2012-02-11T19:59:00.000-05:00

I ran across a pretty good, old, video, posted on July 15, 2011, but possibly from an event in 2010(?), of a conversation between Vanity Fair's editor, Graydon Carter, and Michael Lewis. The talk mainly covers the financial crisis, Wall Street culture, and book authorship. It's a really good 8-part interview, lasting approximately 40 minutes, and I recommend it to anyone interested in the culture of Wall Street, the 2008 financial crisis, or is simply interested in writing non-fiction books.

Most of you probably know of Michael Lewis as a contributor to Vanity Fair and Bloomberg, and the author of popular books such as Moneyball, The Big Short, and Liar's Poker. Lewis is arguably the most-entertaining American writer covering business culture. He isn't everyone's cup of tea given how he paints with broad brushes and makes stories easy to digest, but I love his writing and his humour. I haven't read The Big Short yet but do plan to do it at some point. (If you are interested in the financial crisis, the best book is probably The Great Hangover, a collection of articles and essays by Vanity Fair, which also includes a couple of articles by Michael Lewis.)

(Thanks to @pkedrosky for originally bringing these videos to my attention.)

The following is the 1st part out of 8. I can't seem to embed all 8 into the same blog post for some reason so grab them at the original source from this link.)

Part 1 of 8

In hindsight it seems Lewis was too optimistic about financial reform. Given how little the Obama administration and others throughout the world have done, it almost seems like, at least to me, that little has changed and the problems still percolate underneath.

Sunday Spectacle CLX

2012-02-05T13:31:00.000-05:00

What is Facebook?

(source: "Facebook Revealed," The Globe and Mail. February 1, 2012. Last updated February 2, 2012.)

Baltic Dry Index Approaches Multi-decade Low

2012-01-29T03:00:00.000-05:00

One of the biggest bubbles over the last decade was the shipping bubble. Driven by the trade boom with China and other emerging markets, large investments were made in ships. Companies mortgaged their future and purchased a large number of ships, with the assumption of good times continuing forever. Long-time readers may recall when I wondered about the industry (from a contrarian point of view) back in 2009 in this post and this one. Time flies but even then, it seems like the shipping industry is still working through its overcapacity problem. It's interesting to note that they are still having problems—this, without China entering any slump, yet. Marketwatch reports,

The warning signs being flashed by the collapsing Baltic Dry Index (BDI), a leading global economic indicator, may reflect the folly of misguided expectations during the prior global economic boom, according to Hong Kong-based shipping analysts.

New super-sized ships ordered up during the era of cheap credit and surging global trade could explain the index’s 57% plunge in the last three weeks, according to Macquarie Research, which described this month’s BDI drop as “relentless” and “extreme.”

***
Shipping companies appear to have jinxed their own industry by ordering up too many grand ships when conditions looked very favorable before 2008.

Meanwhile, further new capacity, equivalent to 22.7% of the existing fleet, is due to be delivered this year, according to Macquarie calculations.

The Baltic Dry Index (BDI) hit a low back in late-2008/early-2009 and I didn't think it would decline back to that level again, but it appears to have happened. The following chart from stockcharts.com illustrates how the BDI has collapsed lately.

The index is very volatile but the move in the last month has been spectacular, with it down almost 70% within one month. From a long-term point of view, the index is approaching the multi-decade low set in 2009.

The following chart from InvestTools.com—yes, colours could be better—shows the long-term chart of BDI. The BDI line is blue one in the top chart while the others are moving averages.

I, as well as many others, place greater weight on BDI than many other measures because it is a commodity price index. That is, it is actually an index of shipping prices for dry goods (do note that there are other indexes that track the cost of shipping other items such as crude oil). If you are a free market guy like me, you tend to pay more attention to the price of goods or services set by the market than to security prices. It's kind of like comparing crude oil prices (commodity) to the share price of an oil company (security). The fact that shipping companies are seeing very low prices could mean one of two things.

There was a boom in shipbuilding and the price collapse may be due to severe overcapacity. As the Marketwatch article mentions, a large number of ships are to be delivered. This may account for the collapse in the BDI index. I'm sure this plays a big role but can it account for the entire collapse?

Another possibility, one that isn't covered much in the media, is the possibility of weakening global trade. There is the looming threat of a global economic slowdown due to problems in China and Europe. People always talk about that but I wonder if the BDI index may be detecting a real slowdown.

An Investment Worth Investigating?

Back in 2009, I wondered if the shipping companies were worth investigating from a contrarian point of view. I thought it was an area worth checking out but didn't feel they were attractive enough to invest. How about now?

The following is a chart of the Philadelphia Marine Shipping Index (SHX):

This index consists of leading shipping companies that trade on the US exchanges. It includes popular companies such as Frontline (FRO), Dryships (DRYS), Eagle Bulk Shipping (EGLE), and so on.

As you can see, the shares are off 50% in the last year. Interestingly, this index started falling in the middle of last year, whereas the BDI index started collapsing late last year. However, do keep in mind that the SHX index consists of shipping companies that are engaged in activities other than dry bulk shipping, and hence will be driven by other factors. The shipping companies also tend to pay out most of their income as dividends so there will be huge dividends that won't be captured properly on stock charts like the one above.

Back in 2009, I wrote how Mohnish Pabri, a value investor, successfully invested in a distressed shipping company, Frontline, but felt the situation at that time (2009) wasn't anywhere near what Pabri faced. Quoting my post from before,

There are some cases where value investors have invested in these companies. Mohnish Pabrai invested in Frontline 5 or so years ago. The shipping industry was, like now, struggling back then and Pabrai bet that Frontline will survive while others go bankrupt. I haven't read Pabrai's books so I'm not sure what gave him the confidence but I suspect it was the potential liquidation value. Right now, however, it would be extremely difficult to pull off the same tactic. Back then, the shipping companies weren't coming off a boom where thousands of ships entered the market.

I think the current situation, from a contrarian investment perspective, has improved since my comment from 3 years ago. I think the excess capacity is being worked off, and we are probably closer to a so-called "bottom" now. So, anyone interested in a contrarian bet on a distressed sector may want to look at these companies.

However, as I remarked in my post from a few years ago, the shipping companies are really more suited for macro investors or those making a largely contrarian bet, than value investors:

Sometimes people wonder how investments would differ between a macro investor and a value investor. Well, the shipping companies are a good example of investments that a macro investor would make but nearly all value investors would avoid (except in some special cases.) Shipping companies are good for macro investors because they are a pure-play bet on world trade, China, commodities, or whatever else one deems critical. The fact that they pay out most of their earnings right away means that you can realize profits easily. In contrast, if you bet on, say a copper mining company, it is possible that the company may waste profits (assuming your macro case is right) on buying out other companies, investing in dubious other schemes, and so on. In the latter case, the only way you can make money is if the market bids up the price of your stock.

A value investor would be hard pressed to buy these companies. Nearly all of them are commodity businesses that have zero pricing power. All it takes is for some dumb competitor to increase capacity (i.e. buy too many ships at the wrong time) and you can go bankrupt when the tide turns. These are also companies that likely have asset values that can decline precipitously right when you want to get rid of ships. When there is too much capacity, no one wants a ship--even at cheap prices (you literally have to scrap them.) In contrast, most other industries can recoup some value for their factories, equipment, or real estate even during recessions.

So, my feeling is that these aren't what a buy & hold, Buffett-Prime, investor would pursue. But, classic value investors, who are good at competitive industry analysis and determining liquidation value of companies, may contemplate them. Ultimately, though, these are contrarian investments.

Speaking as someone who still maintains his bearish stance on China and world trade in general—yes, a terrible call that has been wrong for years—I think the shipping situation could deteriorate further. There seems to be a cyclical bottom in the first quarter of every year, so the dry bulk prices may rise from here. But I don't have any confidence the situation is anywhere near being resolved. If you are interested in this industry, I would start tracking and study them but I wouldn't really plunge in without a good understanding of worst-case scenarios.

Sunday Spectacle CLIX

2012-01-29T00:03:00.000-05:00

Warren Buffett Speech

at the

University of Georgia

Terry College of Business

2001

(source: University of Georgia - Terry College of Business. 2001.

Thanks to Aniruddha "Andy" Kardile's League of Extraordinary Value Investors blog

for bringing this to my attention.)

Traders and Computer Trading

2012-01-28T17:30:00.000-05:00

The Globe & Mail's Report on Business magazine had a short blurb on the current state of computer trading in Canada. As many readers are likely aware, a huge chunk of the trading that occurs on stock exchanges presently comes from computer trading (such as high-frequency trading and computer-driven arbitrage).

I am not a trader and most readers of this blog likely aren't either, but you may be interested to see how the short-term traders act. Trading has always been tough—to make matters worse, many of the markets they operate in are zero-sum markets!—but now they are competing against computers following algorithms. I have never been a trader, and am not familiar with professional traders either, so it's not clear to me if the current environment is harder for the professionals. Instead of relationships, now it's down to the strength of the algorithms and computing power. As for amateur traders, I suspect the situation is probably the same as a decade ago (for small traders, whether you are competing against trading houses with massive capital and skill, or against powerful computers with a lot of money spent developing algorithms, it's probably the same difficulty).

The article profiled a few key players in Canada and had the following graphic on how some traders behave when trading against a computer.

(as usual, click on image for bigger picture)

Pre-Market

During & After Open

(source: "The people behind Bay Street's trading supercomputers" by Tim Kiladze. Report on Business, The Globe & Mail. Last Updated January 27, 2012)

Opinion: Do the Flaws With Private Equity Need Fixing?

2012-01-23T21:53:00.001-05:00

(Image by boston.com. Downloaded from jamieflinchbaugh.com)

In his latest for The New Yorker, James Surowiecki points out two major flaws with private equity as it currently operates. In particular, he raises the carried interest controversy and the notion that private equity uses debt to extract profits, while, at times, running the company into the ground. Should the government scrutinize how private equity is allowed to operate in America?

The Carried Interest Controversy

One criticism he raises is the 'carried interest' loophole, which allows private equity manager compensation to be taxed at the capital gains rate, rather than the higher, personal income rate. This has been debated to death but has been raised lately due to Mitt Romney's political campaign for presidency. In an opinion piece for The New York Times in 2007, Alan Blinder explained the problem with 'carried interest' and why it appears unfair:

They are normally compensated by the “2 and 20” formula, meaning that they earn 2 percent of assets plus 20 percent of the fund’s profits — the latter being called “carried interest,” or just “carry.” So, for example, a manager of a $2 billion fund that earns a 15 percent annual return collects a $40 million management fee, plus 20 percent of the fund’s $300 million profit, or another $60 million, in carry. The tax issue concerns the carry.

Suppose the whole $60 million consists of long-term capital gains. The tax bill is then 15 percent of $60 million, or $9 million. But if carry were considered earned income instead, the bill would be 35 percent in income taxes plus 2.9 percent in payroll taxes, for a total of $22.74 million. You can see why the industry loves its current tax treatment.

But is the low 15 percent tax rate justified? For better or, as I will argue shortly, worse, capital gains are taxed far more lightly than wages. Since carry stems mostly from capital gains, defenders of the status quo argue that it deserves the low tax rate. Critics, however, object that carry looks and feels like payments for managing money, that is, like earnings.

As you can see, the gap between paying capital gains taxes and personal income taxes is fairly large. The question is should a private equity manager pay capital gains tax or personal income tax:

Who’s right? It’s true that carry is mostly derived from gains on capital — but it’s mostly someone else’s capital. Which is presumably why former Treasury Secretary Robert E. Rubin said at a conference last month, “I think what they’re doing is getting paid a fee for running other people’s money.”

Sounds right to me. This judgment does not dispute the fact that fund managers’ compensation is risky. But so are the incomes of movie actors, the royalties of authors and the prize winnings of golfers — none of which is treated as capital gains.

The thing I never understand about the private equity carried interest defenders is how they can argue that a manager should be paying capital gains taxes when they are using capital that doesn't belong to them. Mutual fund managers' pay isn't taxed at the capital gains tax rate, and neither are, as Blinder alludes to, movie actors or book authors. So how can anyone possibly defend the low tax rate for private equity managers?

As far as I'm concerned, this is an issue that needs fixing and the sooner America and others do it, the better. Private equity investments aren't as popular in other countries so this problem isn't as prevalent in other countries.

Extracting "Profits" from Debt

James Surowiecki also points out to a seemingly flawed outcome whereby private equity extracts profit by overloading companies with debt (bolds by me):

Having already piled companies high with debt in order to buy them, many private-equity funds had their companies borrow even more, and then used that money to pay themselves huge “special dividends.” This allowed them to recoup their initial investment while keeping the same ownership stake. Before 2000, big special dividends were not that common. But between 2003 and 2007 private-equity funds took more than seventy billion dollars out of their companies. These dividends created no economic value—they just redistributed money from the company to the private-equity investors.

As a result, private-equity firms are increasingly able to profit even if the companies they run go under—an outcome made much likelier by all the extra borrowing—and many companies have been getting picked clean. In 2004, for instance, Wasserstein & Company bought the thriving mail-order fruit retailer Harry and David. The following year, Wasserstein and other investors took out more than a hundred million in dividends, paid for with borrowed money—covering their original investment plus a twenty-three per cent profit—and charged Harry and David millions in “management fees.” Last year, Harry and David defaulted on its debt and dumped its pension obligations. In other words, Wasserstein failed to improve the company’s performance, failed to meet its obligations to creditors, screwed its workers, and still made a profit. That’s not exactly how capitalism is supposed to work.

I think it's important to raise this issue, but I don't think there is anything wrong with the system here. Yes, this is an undesirable outcome and we definitely don't want private equity issuing debt and extracting that money for themselves, and then letting the companies suffer. However, I think this situation is unusual and possibly an outlier.

After all, in a free market, why are the creditors lending to the private-equity-owned company if the company can't handle the debtload? I think the onus is on the creditors to price debt and lend as it seems fit. If they are making a mistake, it will get corrected eventually. This is especially true if government doesn't come and bail out the creditors (this is not what happened with the creditors who lent to the banks that invested in toxic assets, but is not common in other industries—some still argue the bailout of bank creditors was a mistake).

I admit that workers and the taxpayers (via the pension failures) are being hurt when companies are overloaded with debt, but that is a debt load mistake and can happen even without private equity involvement. Instead, the flaw here is occuring with the creditors who are willing to loan money to the private-equity-owned companies. Such mistakes by creditors, in my opinion, are part and parcel of capitalism and isn't a concern in the long-run.

Summary Opinion

I think the carried interest issue, whereby private equity managers pay a lower tax rate, is something that should be fixed. It is a big flaw in the system and punishes workers in other professions, and consequently distorts the free market.

On the other hand, the fact that some private equity firms overload their companies with debt and take out the money as "profit" and "service fees" is not a problem in the system. Rather, it is a mistake by creditors and if the free market is working properly, the market should punish the bondholders for making the mistake.

Sunday Spectacle CLVIII

2012-01-22T00:00:00.000-05:00

Will China Ever be As Rich as USA?

China's total GDP will surpass USA within a few decades simply due to its larger population. But will each of its citizens be as rich as USA soon?

There is nothing to say China—or some other country—won't ever surpass the wealth of USA on a per capita basis, but it's not as likely as many assume. The Federal Reserve Bank of Dallas examined this question in their June 2011 Economic Letter (bolds by me):

So, is it likely that Chinese living standards will ever match those in the U.S.? To get a handle on this question, it is useful to look at other countries’ experiences over a long period. Many nations underwent development miracles in the latter half of the 20th century. Reviewing data on the evolution of global living standards over the period reveals two interesting facts. First, there are several countries where per capita GDP exceeds that of the U.S., often by significant amounts. Almost all of these nations are oil exporters. For them, per capita GDP may not accurately measure living standards because a significant component of economic activity involves depleting the country’s natural resources or wealth. Thus, we exclude those nations from the analysis.

Second, other countries with per capita GDP significantly exceeding the U.S. level are generally small, with large, offshore financial centers. Given the well-known difficulties associated with determining financial-sector output, per capita GDP in such nations may not accurately measure living standards. So we also exclude them.

The FedRed examined data of all the countries, excluding those filtered out as described above, over the last 50 years and produced the following scatterplots:

The chart above shows growth rate (y-axis) versus real GDP per capita (which is a proxy for income). It should be obvious how as we move to the right (income increases), growth rates slow down. According to this data, barely any country grows beyond 10% per year (real) once GDP per capita surpasses $10,000 or so (do note that some oil-rich and tiny, financials-oriented, countries are excluded).

The second chart is a bit more confusing and illustrates how countries perform as they get closer to the US GDP per capita level. Since the US GDP per capita has varied over time, this chart is way more confusing than it seems and it's hard to discern much from it.

The best chart of the bunch is the one above. It shows G7 members, which includes some super-star growth countries in the post-war period. Countries like Germany (dark-green square), Italy (grey), and Japan (aqua) had spectacular growth in the post-1950's period as they were rebuilt from a low, war-destroyed, level. Even with amazing growth, the fast-growing Germany, Japan, et al, have not been able to surpass USA's GDP per capita.

The country that is closest to USA, in terms of wealth, is Canada (purple). One can think of Canada as the slightly-poorer neighbour down the street. Canada hasn't seen as strong a growth as Europe but it has kept pace with USA. As USA became wealthier (move to the right on the chart), Canada has grown at a similar level (the vertical gap to the 100% line has generally stayed the same).

The author finishes his report by saying,

Why do countries fail to reach U.S. living standards? Therein lies something of a mystery. Economists speak of a middle-income transition, or middle-income trap, where previously rapidly growing economies slow down dramatically and never achieve the same standard of living as the technological leader. The reasons for this are unclear. It may be that policies appropriate for one stage of development are less effective at later stages and that the institutional structure lacks the agility to adjust as circumstances change.

In a recent paper, economists Barry Eichengreen, Donghyun Park and Kwanho Shin examined a large number of growth slowdowns over the past 50 years (declines in per capita GDP growth rates of at least 2 percentage points from rates of at least 3.5 percent per annum).

The economists looked for factors correlated with these declines.They found that the slowdowns tend to occur when per capita GDP reaches about $17,000 in 2005 PPP-adjusted dollars and when per capita GDP reaches about 58 percent of per capita GDP in the lead country. Maintenance of an undervalued exchange rate also appeared correlated with the slowdowns.

***

In 1820, China was responsible for about one-third of global GDP, while the U.S. accounted for just 1.8 percent. So, the likely shift in relative size in the next decade is in some ways simply a return to what we previously experienced. Even then, U.S. living standards were twice those of China. If China were to become the first country to completely close the gap with the U.S., it would mark a significant break with development patterns observed over the past half-century.

(source: "Will China Ever Become as Rich as the U.S.?" by Mark A. Wynne, Federal Reserve Bank of Dallas. Economic Letter—Insights from the Federal Reserve Bank of Dallas. Vol. 6, No. 6, June 2011)

Evaluation of Netflix's Financials

2012-01-18T21:03:00.000-05:00

Netflix Headquarters
(Image source: Getty Images, via Huffington Post)

I took a look at some of the qualitative aspects Netflix (NFLX) in prior posts (here and here) and it's time we look at the financials. I think any success or failure with Netflix's stock will still come down to its business model and competitive dynamics but, nevertheless, the financials provide a valuation guide for an entry point.

The stock has run up so much this month that its valuation isn't attractive right now. Most of the shareholders of Netflix—or at least those represent a big chunk of the volume—appear to be growth investors or momentum traders, so you will see more volatility in this stock than a typical company.

As I have mentioned before, Netflix is going through a major transformation, from a DVD-by-mail business to an online streaming business, so its financials prior to 2010 aren't reflective of its future. Furthermore, the company has grown so rapidly within an year that focusing on a few quarters is more insightful. I decided to look at quarterly numbers, which typically isn't a good idea with most companies.

(I had good feedback on my prior post so feel free to leave your comments, challenge my views, and point out any mistakes.)

Income & Expenses

I have been researching Netflix for a few months now, and was mostly using its 3Q 2011 financial statements. The company is to annouce fourth quarter results next week so one may want to use that for their analysis. The soon-to-be-released 4Q will likely provide better visibility into customer defections (from the price increase annouced several months ago) and the cost of the international expansion into Latin America, Britain, and Ireland.

I thought I would start off with a chart of revenue, net income, operating income and key expense categories. Do note that all the charts below show quarterly periods, and they are from the 3Q 2011 financial statements. As usual, click on the chart for a bigger figure.

The line that stands out from the chart is the teal line—revenue—which has risen significantly in two and a half years. In March 2009, Netflix's revenue was $394 million, whereas by September of 2011 it has risen to $822 million. No wonder growth investors drove this stock to some ridiculous valuation. (Note that these are quarterly figures.)

The revenue numbers include streaming plus DVD-by-mail subscribers, but as you will see later, most of Netflix's customers are streaming right now. Some skeptics believe online streaming is a failure but, so far, Netflix has done extremely well.

Interestingly, even with the big consumer backlash over the price increase in 2011, revenue has continuously gone up. However, net income and operating income (bar charts) have declined in the latest period. Some of the decline is due to international expansion costs, but most of it is likely due to customer defections.

It remains to be seen if those customer who leave Netflix ever come back. Netflix said something like 1/3 of customers who leave, come back, but it remains to be seen if that rate goes up. Netflix already has very high churn for a retailer (historically around 4%, with latest quarter around 6.3%) so it needs this number to go down in the very long-run to increase profit.

A key line on this chart is the content expenses (listed as subscription expenses). This has risen from $217M to $472m, and many bears argue is indicative of a flawed business model. It's too early to say for sure, but I don't think the content costs are as big of a concern as some believe. Yes, costs have gone up significantly (almost doubled within 3 years) but it is growing in line with revenue.

It is important to keep in mind that, more so than many other business types, Netflix's bottom line depends a lot on how costs are amortized. Since we are dealing with a new industry—online video streaming—the way management is amortizing content costs may or may not be reflective of reality. The contracts Netflix enters into with content providers is complex and generally not disclosed on the financial statements or in any public filings or presentations. For instance, how content costs can escalate, or if there is a limit to number of customers that can stream at any point in time, or if they are indexed to some other variable (DVD sales, awards received, etc), and so forth, is unclear to me. This appears to be the norm in the movie and television industry, and I don't really have a good understanding of what the content costs actually represent. In fact, even industry insiders have a hard time understanding these deals.

To see the complexity I am referring to, consider how, in mid-2011 or thereabouts, Netflix lost access to Sony content because its content licensor, Starz, hit some subscriber viewing threshold. I'm not sure how that is comprehended in the financial statements. Does the content get written down to zero when the threshold was hit? Or does it appear as Netflix continually paying for something that it doesn't have anymore? I'm not sure.

So, one should be careful with short-term income figures. Cash flow, as usual, is a better measure but even that is confusing, because Netflix tends to sign 2 or 3 year contracts and can make big lump-sum payments (on another note, these contract obligations are off-balance-sheet so one should pay attention to them as well.) In the long run, none of these issues matter since what the company pays in total is what will drive shareholder returns.

The rapidly-increasing subscription costs also indicates how Netflix has little economies of scale and isn't as leveraged to fixed assets as in the past. Yet, as I have suggested in the past—admittedly a controversial view probably not shared by anyone else—the rising content costs are actually a barrier to entry. It's weird to think of rising costs as being a barrier for competitors but it is in this case—particularly if valuable content is exclusive. Netflix will spend around $1.7 billion on content in 2012 and, as long as revenue is sufficient to cover that cost with decent margin, there are very few other competitors who will spend anything like that on content. The giant in online television with over 700 million customers, YouTube, has only announced deals totalling around $100 million(!) so far. I don't remember the figure for Hulu Plus but I believe it spends as much as Netflix does. In the long run, YouTube and Hulu Plus (and others like them) will likely spend way more on content since they are mass-market, advertising-supported, networks.

The fulfillment expense (related to DVD-by-mail business) and marketing expenses have risen quite a bit in percentage terms, but, they are not too important in dollar terms. I don't think it's worth paying attention to these figures but if one thinks Netflix is suffering, the marketing expenses line may be a proxy on how badly Netflix wants to attract customers. I suspect marketing expenses will also rise now that Netflix is entering new overseas markets. I'm also curious how Netflix intends to promote its original content (such as House of Cards and Arrested Development) with access to the first window — are we going to see heavy marketing spend for these original shows? Overall, like in most businesses, you want these expenses to remain constant as a percentage of sales.

Cash Flow, You Say?

The trend in the modern era with fundamental investors (such as value investors) is to rely more on cash flow than on net income. Everyone, including me, still looks at the income figures but cash flow is the cleanest measure. There are several reasons for this but the main one is that it represents reality—income statement has non-cash items like depreciation, which may or may not represent the truth—and is harder for management to (legally) manipulate the numbers (income statement is vulnerable to different revenue recognition techniques, subjective use of mark-to-market gains and losses, deferred taxes, etc).

The following quarterly chart plots net income, along with operating cash flow and free cash flow. I also threw in my guess of owner earnings. I'm computing FCF (which generally is operating cash flow minus capex) as operating cash flow minus content acquisition costs minus property & equipment.

As value investors would know, owner earnings is Warren Buffett's most important income measure and it is similar to FCF: operating cash flow minus sustaining capex (it excludes growth capex since that is not reflective of the long-term). For owner earnings, I'm taking 33% of property and equipment spending to represent maintenance capex. Admittedly, 33% is arbitrary and I decided to use that because I believe most of Netflix's plant & equipment spending is growth capex; Netflix will not spend as much if it doesn't grow. So, my owner earnings formula is operating cash flow minus content acquisition costs minus 33% of property & equipment.

Do note that these are quarterly periods and there may be seasonality in Netflix's business.

The negative impact of the customer defection due to the price increase, identified on the sales and expenses chart earlier, is more obvious here. All the income and cash flow metrics peaked in the March 2011 period and has been declining ever since. No wonder many think Reed Hastings is one of the worst CEOs in America. This is a disturbing trend for Netflix so it remains to be seen if they will start increasing soon.

My guess is that FCF probably won't increase materially until 3Q 2012. I think we will see the end of customer defections but the international expansion costs should start hitting the company soon. Netflix has said that it may take as long as 2 years for their expansion areas to turn a profit—this is consistent with most start-ups and new businesses—so the numbers may look weak for a while longer. If the stock market sells off Netflix on weak earnings (including the possibility of an annual loss), it may be an opportunity to buy shares (depending on the price, of course).

A Look at Margins

The following table summarizes some key figures I computed from the figures shown in the previous charts.

The top part of the table shows quarter-over-quarter change, while the bottom part shows margins (as a percent of sales). The quarterly change is almost useless since the time interval is too short and there are too many moving parts (customer defections, shift to streaming, seasonable effects, etc). The margins are more important.

The main thing to observe in the top section is how subscription expenses, which are key, moves relative to revenue. Netflix has historically kept content costs in check.

The bottom part re-emphasizes how Netflix has good management of content costs. The bears keep arguing that content costs are growing out of control, but they seem to be managed well. If you look at gross profit, it has remained between 34% and 39% over the last two and a half years. So, even though Netflix spends almost a billion on content now (estimated to be as much as $1.7B in 2012), its gross margin is fairly stable.

The question is what happens when revenue stops growing, or, indeed, falls due to some setbacks. Can Netflix rein in content spending growth if revenue doesn't grow as fast? That remains to be seen but so far, the company is manging its skyrocketing content costs quite well.

Net margin was hovering around 7% about two years ago and is around 8% now. So, this is another data point to indicate that, even in light of rising content costs, profitability is fairly stable. Over time, as the business matures, Netflix needs to raise its net margin. It would be good if the company can raise its net profit margin above 10%. If profit margin hits 10% and stays there, it may indicate that Netflix has a moat (I think the best check for a moat is persistently-high ROE but Netflix's ROE is difficult to interpret because its asset base is very low (i.e. Netflix has ROE around 55% but I'm not sure if that's high or not for a company like this)).

Overall, I don't see anything dangerous in the margins or quarterly changes in key metrics. The numbers will likely deteriorate over the next few quarters but the streaming-focused business is managed similarly to the past.

Customer Revenue and Acquisition Costs

This section needs a post on its own so I'm going to keep it somewhat short.

Since Netflix is a fast-growth business with a business model change, it is important to think about how the company may look in the future. As I have mentioned several times, the company is going to be nothing like its past self.

I think it's important to understand two elements of Netflix's business: subscriber count and cost of subscription. The following chart plots total number of subscribers (yellow bars), and the revenue per subscriber (teal) and subscriber acquisition cost (red).

I have also indicated Netflix's 3Q 2011 subscriber figures in the green box.

As indicated in the green box, Netflix had a total subscriber count of around 22.8 million. In terms of subscriptions, this amounted to 21.4 million streaming subscribers and 13.9 million of DVD-by-mail subscribers. It was difficult in the past to separate streaming from DVD-by-mail, but now that the two services have been unbundled, the figures are more clear. Do note that many subscribers have both streaming and DVD-by-mail subscriptions (that's why the subscription number is higher than the subscriber count).

You can see why Reed Hastings has bet big on streaming. Not only does it support his thesis for the future (read my prior posts), he is actually seeing more uptake for streaming subscriptions than DVD-by-mail subscriptions. So it was great strategic move!

By looking at the yellow bars, you can also see the negative impact of the price hike instituted by Netflix. Subscribers totalled 23,263 thousand in the June quarter, while they fell to 22,843 thousand in the latest, September, quarter. I think the separation of DVD and streaming business was necessary and the price hike was warranted. Although skeptics think it was a dumb move, I think it was actually a very good tactic. (On a side note, Netflix is already very cheap so if people leave for a small price hike, those may not be very profitable customers in any case.)

For long term investors, the most important lines are the teal and red ones.

The red line shows subscriber acquisition cost. This may surprise some but subscriber acquisition was more costly two years ago, in the DVD-by-mail business, than now! In March 2009, each subscriber cost around $25.79 whereas the cost is $15.25 in the latest quarter. The acquisition cost actually hit a low of $10.87 in the December 2010 quarter but it has risen over the last year. This is probably due to higher content costs.

Some investors, including one I pointed out in a post earlier in the year, forget that the subscriber acquisition cost is a lifetime cost! This is why acquisition cost is higher than revenue. Depending on the churn rate, the company can tolerate a fairly high acquisition cost.

The declining subscriber acquisition cost is bullish for Netflix; however, Netflix is earning less from each customer now than they were two years ago. In the March 2009 quarter, Netflix's average monthly revenue for paid subscribers was $13.63. In the September 2011 quarter, Netflix was earning $11.56 per month per paid subscriber. This is a bearish trend but not too surprising if you sit back and think about it.

Although it doesn't sound good, Netflix's revenue per customer will fall as streaming takes off. This is due to the fact that streaming only costs $7.99 per month whereas there were several DVD-by-mail subscriptions and many of them cost more.

Declining revenue per customer is often not a good thing but it does have some major positives in some scenarios. In particular, declining costs generally expands the market size! Most technology companies are built for deflationary environments and tend to get richer as prices fall! Most industries, however, suffer as prices fall—think about how few commodity businesses become richer as prices fall, or how few retailers increase profits as prices fall.

Declining subscription revenue is bad for the video industry—think how many cable or satellite companies will survive if cable bills fell—so it remains to be seen if Netflix is better off with a lowly-priced subscription offer or not. Content costs will not decline much so it remains to be seen if Netflix can maintain a successful business model with $7.99/month revenue.

If I get some time and feel like it—the higher this stock goes, the less incentivized I am :(—I will take a look at the market potential for Netflix and its performance under different scenarios. In particular, I hope to look at what the potential of Netflix is vis a vis household viewership of television; and how much content spending can be afforded by Netflix.

What Is Netflix Worth?

Most important question for investors: what's the valuation?

I am a fan of using P/E or P/FCF multiples so let's use that method.

From the cash flow chart above, the Trailing-12-month (TTM) figures for net income and owner earnings are $238M and $236M, respectively. Let's round this to $235M.

I think Netflix's earnings will be higher in real terms in the future than now. But, let's be conservative and assume it stays where it is right now. (I might do a future post with scenario analysis with a more realistic expectation.)

If we apply a P/E multiple of 15, we are looking at a company that is worth $3.53 billion.

(P/E of 15, as most of you probably know, is the long-term market multiple. Given how interest rates are low right now, the P/E ratio can be higher right now. Also, if you were a growth investor, you would attach a higher multiple, but I'm not one and have no confidence in high future growth.)

Netflix presently has a market cap of around $5 billion, at a share price around $95. This means that the company is near fair value at a share price around $66. (I'm not sure if the share count in my calculation is correct, since there was a roughly 10% dilution late last year, but assume these are rough numbers for now.)

If you want a margin of safety and use a P/E of around 12, the company is worth $2.8 billion and the shares should be bought around $53.

In late December, the shares dropped to $62.37 so it wouldn't surprise me if it hits $50ish sometime this year. If the stock market crashes and/or Netflix starts posting losses, it can reach an attractive valuation.

A stock price in the $50s is extremely attractive if you believe Netflix will continue to grow at above-market rates. You need to do a business analysis and make a judgement call.

Last Word For Now

To sum up, Netflix is going through major changes to its business model but management has successfully kept its eye on the financial metrics. Content costs have risen significantly over the last two and a half years, but they are in line with revenue.

There are more streaming customers than DVD-by-mail customers (although many have both) and the trend is unlikely to stop. Netflix's revenue per subscriber will likely fall, and approach its streaming offer of $7.99/month. It's not clear if falling costs in the media business increases wealth for shareholders.

Netflix has trailing owner earnings (and net income) of around $235 million. Based on my estimation, this means Netflix is worth around $3.53 billion, and I would buy it at around $2.8 billion (share price of approximately $53). Share price needs to fall around 50% to hit my figures so that probably isn't going to happen without some major calamity in the markets.

Sunday Spectacle CLVII

2012-01-15T01:09:00.000-05:00

The Technology Ecosystem Demystified

(source: "Startup Ecosystem: Predator vs. Prey" Downloaded from visualizing.org. Original source: udemy blog)

How Much of a Threat are Technology Companies to Netflix? How About UltraViolet?

2012-01-11T23:13:00.002-05:00

One the claims by some Netflix bears is that technology companies like Microsoft and Apple will be a huge threat. Although things can change, technology companies are unlikely to compete successfully in fixed price video streaming services (they can, however, do fine in pay-for-download or pay-per-view digital content businesses). You get a feel for this with the following Reuters story via The Globe & Mail on Microsoft:

Microsoft Corp has put its talks with media companies about an online subscription service for TV shows and movies on hold, according to people familiar with the discussions.

The technology giant had been in intense talks with potential programming partners for over a year and was hoping to roll out the service in the next few months. But it pulled back after deciding that the licensing costs were too high for the business model Microsoft envisaged, according to these people.

“They built Microsoft TV, they demoed it for us, they asked for rate cards but then said ‘ooh ah, that’s expensive,’ ” said one senior media executive who had been involved in the talks.

I suspect this story will play out numerous times with other technology companies.

The reality is that, it is very expensive to purchase film and television streaming rights. As Reed Hastings has repeated several times, until someone is willing to spend, say, $1 billion, they are not even in the game. Microsoft is actually cash-flow positive and has low cost of capital yet it can't get into the streaming (or some sort of subscription) business. Even YouTube, with at least 100 million unique American viewers, and as much as 500 million global viewers, and backed by cash-rich Google, is unable or unwilling to ink anything totalling $1 billion per year (in the long run, unlike Microsoft or Apple or Amazon, I think YouTube will become a viable, highly profitable, Internet TV service).

As long as Netflix can maintain its subscriber based and earn around $2 billion in revenue—say 20 million subscribers x $8/month x 12 months—and spend as much as $1.3 billion on content every year, its moat is getting stronger and stronger. As recently as two years ago, you could have been in the streaming game with a spending level around $200 million per year. Right now, you need around $1 billion to compete against Netflix.

The number of potential competitors will decline if Netflix is able to raise its subscribers and pay more for content. Short-term-oriented investors, who appear to be the main shareholders of Netflix right now—just look at the ridiculous run-up in the stock in the last few weeks—will be concerned with near-term rising content costs. Yet, from a long-term perspective, as long as the company isn't wasting money, it is building a moat that will get harder and harder to penetrate. It's kind of like how Amazon's costs were rising in the early 2000's as it was building warehouses and building out the Internet infrastructure, but by mid-2000's, very few companies could afford to spend money to keep up. Netflix isn't building any physical infrastructure, but by raising the cost of content (while hopefully attracting and increasing customer loyalty), it blocks potential competitors from entering the business.

How About UltraViolet?

Ultraviolet is a system being rolled by a consortium of content creators, distributors and consumer device manufacturers. According to wikipedia,

UltraViolet (UV) is a digital rights authentication and cloud-based licensing system that allows consumers of digital home entertainment content to stream and download purchased content to multiple platforms and devices. UltraViolet adheres to a 'buy once, play anywhere' approach that allows users to store digital proof-of-purchases under one account to enable playback of content that is platform- and point-of-sale-agnostic.

UltraViolet is developed and deployed by the 70-plus members of the Digital Entertainment Content Ecosystem consortium, which includes film studios, retailers, consumer electronics manufacturers, cable companies, ISPs, network hosting vendors, and other Internet systems and security vendors. Apple including both iTunes and the various popular devices such as the iPad and iPhone do not support any integration with the UltraViolet platform at this time and Disney is developing its own competing Keychest format.

From the official site, here is a diagram of how it works:

(source: UVVU Ultraviolet)

Basically, the UVVU (aka Ultraviolet) service allows you to purchase digital content and then share it with numerous supported devices. The interesting thing about Ultraviolet is that it lets you purchase from numerous retail locations while authenticating from one central source, and share it by either downloading it from the cloud or streaming it.

The streaming part is the area that might be an emerging threat to Netflix. It's too early to say how well the streaming aspect will work. There will be two issues.

First of all, everything will come down to price. Purchasing content is more expensive, and the studios would prefer that you do it. Streaming content via fixed-fee services like Netflix is cheap but the studios don't like it, which means Netflix will neither have as much content nor will it be new same-season releases. If Ultraviolet purchase remains somewhat expensive, it probably won't take off.

The second issue is the quality of streaming. Ultraviolet's cloud doesn't store the digital content and stream it to the customer. Instead, it appears that UVVU authenticates but the customer ultimately streams from the retail point of purchase (say, Amazon or Best Buy). So, the retailer has to provide the streaming infrastructure.

I suspect the fact that the streaming depends on the retailer probably gives an advantage to companies like Netflix. Although some customers complain about Netflix—mostly due to their connection by the ISP which has little to do with Netflix—it is generally thought by many that Netflix has superior streaming technology. It's doubtful that many online retailers, other than a select few like Amazon, will ever develop advanced streaming technology. For instance, from what little I know (I could be wrong), Netflix uses Amazon clould to a small degree, and, to a greater degree, uses content delivery networks (CDNs) from Akamai and Level 3 Networks. I'm not sure if an online retailer will be spending as much money as Netflix does on those CDNs.

So to sum up, Ultraviolet doesn't appear to be a big threat to Netflix (or similar competitors) at the present. However, if the price of content purchase declines materially—say $1 per film—then Netflix's business could be threatened.

A Look at Netflix's History and Its Business Transformation

2012-01-08T22:24:00.000-05:00

It's hard to imagine how I haven't purchased a stock in over two years — certainly not a good way to succeed in investing :( One of my New Year's resolutions is to focus more on investing and work much harder. In any case, I have been researching Netflix (NFLX) lately and it keeps getting more interesting by the minute. I remember an anonymous reader said in my prior post he/she thought Netflix was worth around $50 to $60 per share and he/she would buy it around $40. Well, the stock did decline to $62, before skyrocketing recently. There was also a roughly 10% dilutive capital raise in the last few months so the stock price is close to the range of the anonymous poster. It's still a high risk stock—it can easily go bankrupt within 10 years—but some of its qualities seem attractive.

I took a preliminary look at its business model and competitive environment in this post about two months ago, and thought I would write up its background and the transformation it is undergoing, or at least my understanding of it. I was actually writing a post analyzing its financials but the business change was important and I ended up writing quite a bit about it. I'll save my thoughts about its financials for a future post.

The Game Has Changed

Netflix is kind of complicated to analyze and I suspect value investors won't look at it for another 4 or 5 years. The reason isn't because Netflix is a complicated operation—it isn't and is easier to understand than something like Berkshire Hathaway or Disney—and neither is it due to the lack of multi-year historical data. Netflix has almost 10 years of financial statements and this should be enough of a record for most investors. Contrary to some people's view, I also don't think Netflix operates in a technology industry with rapidly changing products. If anything, the product Netflix deals with (video media) doesn't really change much and isn't based on hits, fads, or trends (note: I'm talking about video as a whole and not necessarily about individual content).

Instead, the complication with Netflix is that its historical financials are almost useless! Netflix has embarked on a radical change to its business—I support the change and think it is required since its DVD business may dissapear within 5 years—and, hence, its current performance and future outcome cannot be discerned from the past. Drawing the line is quite subjective but I would say its financial statements prior to 2010 are not reflective of its future business.

In particular, the business model of Netflix is changing and its financial performance will be quite different in the future. Anyone investing in Netflix right now is essentially investing in a restructuring. However, unlike classic restructuring carried out at the last minute when the company is failing, Netflix is profitable and is trying to create a new market.

Once Upon a Time in America

For those who are not familiar, Netflix had one line of business for the last 10 years or so: DVD rentals by mail. With a Netflix subscription, customers can choose movies or tv shows or other special video content on DVD and rent them by mail. According to some, the collapse of DVD rental powerhouses, Hollywood Video (later on owned by Movie Gallery) and Blockbuster Video, were due to the ascent of Netflix. Whereas Netflix offered rentals by mail only, the other three mostly owned physical locations.

(On a side note, Hollywood Video was founded in 1988, while Movie Gallery and Blockbuster started in 1985. Given how all of them went bankrupt in 2010, and how other rental stores probably started a little before that, it means that the video rental industry had a lifespan of around 30 years. Unless you are investing in megacaps, it's probably a good rule-of-thumb to assume that companies last 20 to 30 years.)

Netflix became dominant in DVD rentals by capitalizing on the Long Tail, as Amazon had done with books initially. For those not familiar with the notion of the Long Tail, it can be described as:

The term Long Tail has gained popularity in recent times as describing the retailing strategy of selling a large number of unique items with relatively small quantities sold of each – usually in addition to selling fewer popular items in large quantities. The Long Tail was popularized by Chris Anderson in an October 2004 Wired magazine article, in which he mentioned Amazon.com and Netflix as examples of businesses applying this strategy. Anderson elaborated the concept in his book The Long Tail: Why the Future of Business Is Selling Less of More.

The distribution and inventory costs of businesses successfully applying this strategy allow them to realize significant profit out of selling small volumes of hard-to-find items to many customers instead of only selling large volumes of a reduced number of popular items. The total sales of this large number of "non-hit items" is called the Long Tail.

Basically, the Long Tail strategy involves catering to a large audience of niche tastes, rather than to the volume-heavy popular audience. Chris Anderson characterized companies such as Amazon and Netflix as capitalizing on the Long Tail. The following images—horrible colour scheme :(—from his writing at Wired and the Long Tail blog illustrates the Long Tail:

(source: "The Long Tail," Chris Anderson, Wired. October 2004.)

(source: "The real meaning of 80/20," Chris Anderson, The Long Tail. March 16, 2005.)

Similar to what Amazon did with bookstores in the late 90's and early 2000's, Netflix offered a far larger library catalogue than bricks&mortars stores like Blockbuster Video. If you walked into a Blockbuster video store, you had access to around 3,000 DVDs, whereas Netflix subscribers could order from a colleciton of 25,000 DVDs. Customers who wanted instant videos and couldn't wait 2 or 3 days for a rental to be delivered through the mail, or wanted the popular hits, used Blockbuster. But those who wanted obscure movies or TV shows (these can be expensive since there are many episodes over many seasons) found Netflix to be more useful. Netflix basically ended up with a large number of customers, possibly with low volume per customer, for a big selection.

Netflix's strong customer focus also enabled it to provide superior customer service. It was often ranked near the top of customer service surveys for retailers or media distribution companies. I think the low-cost, cancel-anytime, subscription model helped with customer satisfaction. Netflix had lower marketing costs due to strong word-of-mouth.

A very important point to note is that the cost of the DVD-by-mail business didn't vary much as the business scaled up. If you purchased a DVD, you could rent it as many times as possible (this is how the legal framework is in America and somewhat similar in many other places). Furthermore, once you built out the distribution centers, customer support, and the like, your costs didn't rise very much with each new customer.

A Fork in the Road

As the video rental business evolved, and mainstays like Hollywood Video and Blockbuster collapsed, Netflix came to the conclusion that video viewership was going to shift to online streaming. Netflix had always been interested in online streaming but Reed Hastings probably felt they had to capitalize on first-mover advantage and decided to go big.

The big thesis of Reed Hastings is that online streaming cost is declining precipitously (or conversely, connection speed is increasing), following an almost-Moore's-Law-like curve. His feeling is that streaming will not only be accepted by the mainstream, but that it will be cheaper. There are quite a number of people, including many Netflix bears, who think this isn't true or that costs can't continuously fall. I side with Hastings, and although ISPs will try to charge more for Internet connections, I think the value proposition will still favour online streaming.

I feel that re-architecting the company in the direction of online video streaming is the proper strategy. Netflix's numbers do seem to support the shift-to-online-streaming thesis. For instance, as of 3Q 2011, Netflix had around 21.5 million streaming subscriptions versus 13.9 million DVD subscriptions (do note that these numbers overlap since many customers have both). As recently as 2 years ago, Netflix had almost zero streaming customers. So the strategic shift is the right move. If Netflix didn't capture these streaming customers now, competitors may lock them up and Netflix will be stuck with a perpetually-declining DVD-by-mail business.

However, by pursuing online streaming, Netflix radically altered its business. There are some advantages to streaming but there are some big negatives as well. In particular,

Netflix lost its Long Tail benefit,
Has significantly weaker negotiating power against content producers (movie and television studios),
Will face off against powerful MVPD (multi-video programming distribution i.e. cable/satellite/pay-TV) providers, and
Face new, financially-strong, media-technology competitors like YouTube (owned by Google) and Amazon.

The road taken was necessary but it is new terrain for Netflix.

Some of the threats are over-blown and dependent on many 'ifs' and 'buts.' For instance, services like YouTube don't really compete directly against Netflix since they are advertising-supported. It's kind of like comparing HBO, a specialty subscription channel, to ABC, a free, ad-supported, channel. Yes, they compete for viewership time but someone that wants free television is not going to subscribe to HBO.

The first two items listed above are quite significant and important for investors to understand. I thought I would present my opinion on them.

Loss of the Long Tail & Bargaining Power

One of the reasons investors drove Netflix to a high valuation—Netflix had a market cap of around $15 billion at its peak—was because they probably thought it was going to expand its Long Tail advantage to online video streaming. And, become totally and utterly dominant like Amazon.

Unfortunately for Netflix and its shareholders, the online streaming business is actually worse—so far—for distributors. In fact, Netflix will lose its Long Tail advantage it had in the physical DVD rental market. Netflix will never monopolize the video streaming content! Potential investors need to factor this into their valuations. When this became evident, investors headed for the exit and marked down the valuation back down to around $4 billion.

Netflix owned the Long Tail content in physical DVD rentals because it could acquire the content on its own. As long as a physical DVD (and later on, Blue-ray) was available, it could buy it and rent it to as many customers as possible. As the company became more and more successful, and could purchase more DVDs, it ended up owning more and more, eventually owning almost anything available on DVD.

With online streaming, Netflix can neither buy content (it's way too expensive), nor can it procure content on its own. Instead, it has to sign licensing deals with the content owners. This killed off the Long Tail immediately for several reasons:

First of all, owning most of the content was difficult since there are numerous content owners and you had to sign licensing deals with all of them. Just getting all the content owners to agree is an arduous task. In fact, there are some content that is almost impossible to license since there are so many content rights holders and you can't even track them down — think about trying to sign a licensing deal for an art film from the 1950's with some studio that may not even exist now and who knows where the rights ended up.

Secondly, as Reed Hastings has detailed clearly in shareholder letters, and quoted in a prior post, the normal structure of the video business is to sign exclusive deals. This is different from the norm in the music industry but that's how television and the movie business has operated for 50+ years. If you think about television, you'll notice this. For example, a television show or movie acquired by, say, ABC, is not shown on CBS. So, a company like Netflix or YouTube was never going to own all the streaming rights to all the content; you would have to be as big as all the cable, satellite, movie theater, and pay-TV companies combined in order to exclusively acquire all the content. (Having said that, do note that pay-per-view or digital purchase is generally not exclusive. What I am describing in this post, and what Netflix is involved in, is fixed-subscription services that are comparable to cable/satellite television.)

Related to the prior point, content owners—these are companies like Disney, Dreamworks, Time Warner—earn most of their income from cable, satellite, pay TV, and similar distributors. The content producers are concerned about devaluing their content so they won't offer streaming rights that hurt their existing business or devalues the future worth of their content. So, strategically, the content owners are unlikely to give away all their content to one company. They also are likely to, and indeed have been, force online streaming to occur well after the lucrative television/theater release windows.

So, as Netflix becomes more of a streaming provider, won't have much bargaining power. In the grand scheme of things, although Netflix has a sizeable 22 million subscribers, its revenue isn't very large and it is small compared to the content producers or the existing MVPD competitors. This isn't likely to change any time soon.

One of the big complaints against Netflix streaming, by current as well as potential customers, is that it doesn't generally have new content. Customers also complain that Netflix doesn't have all the content. I don't think this situation is going to change and other online streaming providers (so far, YouTube, Hulu Plus, Amazon Prime, HBO Go, TV Everywhere) will have the same problem.

Given the radical changes to the business and the limited online streaming content, it's possible that Netflix may experience big changes in the nature of its customers. Netflix customers used to DVDs and the Long Tail content may eventually leave Netflix since its streaming business will never have anywhere near the same content (note that Netflix will still continue its DVD-by-mail business but it won't focus on it). On the other hand, those used to traditional television may view streaming as better than what they were used to on television (streaming content limitation is no different than on television and the instant-ON nature of streaming is a strong value proposition for television viewers). In addition, Netflix (and its competitors) may pick up totally new customers who may consume content on portable devices like tablets or Internet-connected cars. These are customers who may never have used the Long Tail aspect of DVDs, and wouldn't even be aware of the limited content.

If my theory that the make-up of the customers may change is correct, it'll be critical for Netflix, which has depended on customer service and a low fixed price to differentiate itself, to satisfy the new breed of customers. The new customers will likely behave quite differently from the traditional DVD-by-mail customers. Since the content will be limited, Netflix will have to provide superior streaming quality, better software design, new social networking features, and so forth. It's not clear that Netflix can pull this off.

The Story Doesn't Sound Good

One might be wondering if there is anything that Netflix actually gains from the new streaming model. I think Netflix loses a lot of its strengths by moving into the online streaming business. It was necessary in my eyes so it didn't have much choice — if not now, it would have faced a similar situation in 2 or 3 years!

My philosophy in life is that there is a good to any bad situation, and, conversely, there is always a bad side to any good circumstance. Such is the case in business as well.

Netflix's bargaining power is weaker in online streaming and it is almost starting from scratch since it is a new market. Yet, that same scenario also gives it an opportunity to gain first-mover advantage and potentially develop and expand a new market. Netflix had almost saturated its DVD-by-mail business and destroyed all its competition so it had limited growth opportunities. But not so in online streaming.

If Netflix can expand the video market without destroying content value, it'll satisfy the content producers, and direct more money towards content creation. For instance, one reason high-value shows like Mad Men or Sopranos get produced is because the premium cable/satellite providers created value for content producers. Before the emergence of premium cable in the 90's, such shows would never have been made. Similarly, many sporting events, particularly NFL and NBA, have very high production values because the distibutors created value for the content producers. Netflix isn't in sports but it sort of shows how more money directed towards the content producers is good. It'll be good for the ecosystem if the market can be expanded.

An example of how the market may be expanded is through international expansion. This is very costly and who knows if Netflix (or companies like it) will be successful but it is a big opportunity. Not every country has the Internet infrastructure but I remember Reed Hastings commenting once how Costa Rica (or some country like that) was laying fiber optic cables for Internet than building out traditional phone lines or laying cable for television. It was actually cheaper to build out the Internet infrastructure. Even people who couldn't afford regular television may be streaming content within a decade—similar to how many developing countries skipped to mobile phones without spending money building out landlines.

If Netflix remained as a DVD-by-mail business, international expansion would have been difficult to almost impossible. For instance, many developing and even some middle-of-the-pack developed countries don't have good, affordable, mail delivery systems (not to mention theft and damage). If Netflix can attract international customers, it will be able to potentially sign world-wide content deals—not only paying more to content producers, but pushing content to customers who didn't have access to it.

As Netflix becomes more and more of an online streaming company, it also becomes asset-light. Netflix already has high ROE (since it has few assets) and it'll have even higher ROE as it morphs into a streaming company. High ROE means that very little shareholder capital is required to acquire more customers. The downside is that there is almost no physical assets for the shareholder to fall back on if things deteriorate.

I'll cover more of the underlying business characteristics of Netflix when I look at its financials in a future post.

Interview with Elon Musk

2012-01-08T05:34:00.002-05:00

Elon Musk is the co-founder of PayPal, SpaceX, Tesla, and SolarCity. He is through-and-through an entrepreneur with a technical mind and "scientific ambition" — by scientific ambition I mean those that dream of things that don't exist. People like Elon Musk are the ones that can have a big impact on society.

Those interested in science, particularly clean energy and space, or entrepreneurship will like the following video. The video is Elon Musk's answers to questions posed by reddit.

Sunday Spectacle CLVI

2012-01-08T00:01:00.000-05:00

Hate to Say It,
E-mail Spam Actually Works

(click on image for larger pic)

(source: "Spam Works," Bloomberg Businessweek. December 2011)

The Year That Was, 2011

2012-01-01T00:33:00.000-05:00

How Was 2011?

Here are some items from 2011... to keep you entertained in 2012.

(anything marked with stars are worth checking out)

Google Zeitgeist 2011

A Picture is Worth
a Thousand Words

* The Year in Pictures - Part I *

The Big Picture - Boston.com

* The Year in Pictures - Part II *

The Big Picture - Boston.com

* The Year in Pictures - Part III *

The Big Picture - Boston.com

Science in 2011: Triumphs, disasters and climaxes – in pictures
The Guardian

Must-see Science Videos of 2011
Cosmic Log on MSNBC.com

* Ten of the Top Science Videos of 2011 *
Txchnologist

* The Most Important Graphs of 2011 *
Derek Thompson for The Atlantic

* Top 10 Video Ads of 2011 *
The Globe & Mail

* Slide Show: The Top Ten Art Sales of 2011 *
Bloomberg

Best Google Doodles of 2011
WebProNews.com

Wallpaper* Graduate Directory - 2011
Wallpaper*

Business & Investing

* Top Business Scandals of 2011 *
The Globe & Mail

Stars and Dogs of 2011
The Globe & Mail

10 Worst Business Predictions of 2011
Fortune

Ten Most Unusual Interview Questions of 2011
Fortune

RIM’s year to forget: Where did it all go wrong?

Financial Post

* Slide Show: Top SEC Settlemens of 2011 *

Bloomberg

* RIM’s year to forget: Where did it all go wrong? *

Financial Post

A Big, Big, World

The Year that Was
The New Yorker

* The Top Science Stories of 2011 *
Scientific American

The Top Scientific Discoveries of 2011
Wired

Tech 2011: Biggest News Stories of the Year
Wired

* The Verge Year in Review *
The Verge

Major Cyber Security Events of 2011
Financial Post Tech Desk

* Canada's Top 10 Technology Stories of 2011 *
Financial Post Tech Desk

2011: A Huge Year for Social Media
TheNextWeb.com

For the Literate

* Best Business Books of 2011 *
Strategy+Business

* The Best Business Books of 2011 *
American Public Media Marketplace

* Best Books of 2011: The Complete List *
NPR

Six Graphic Novels That Will Draw You In
NPR

Five Good Books

The New Yorker

* The Verge Booklist 2011 *

The Verge

The New York Times Top 10 Books of 2011

The New York Times

The 11 Best History Books of 2011