rent vs. buy: subscriptions/leasing/the cloud

renting services

I’ve been wanting to write about companies that rent products or services.  Some are very new, like (the highly speculative) Solarcity (SCTY).  Others are older and are switching to this earnings model, like Adobe (ADBE).

To do that, though, I thought it best to start with the profit model.  The business involves high up-front costs to set up and/or to find customers, with only gradual revenue generation.  So it means negative cash flow on each new customer st first, followed hopefully by a waterfall of incoming cash eventually.

Most analysts, me included, use some variation on Discounted Cash Flow (DCF),to value on this kind of activity.  But, unlike using DCF to calculate the value of a bond, this process is inherently risky when figuring the value of having a given customer base.  That’s because the future cash flows aren’t guaranteed.  The customer can often switch to another service provider, for example.  Or he may, for one reason or another, stop using the service altogether.

not new

The model itself isn’t new.  Companies using it include:

–insurance companies issuing policies

–load investment management companies selling mutual funds

–companies that rent or lease equipment or services.

the main variables

The main variables to consider are:

–general costs of subscriber acquisition, like necessary capital equipment, R&D…

–the specific costs of acquiring a customer, like providing free trial periods or paying sales commissions, and

–the length of time a customer typically keeps the service.

an example

For example, in a traditional mutual fund management company, a service provider:

–maintains a staff of analysts and portfolio managers and does brand advertising

–it pays a commission of, say, 5% of the principal invested to the salespeople who sign up the customer,

–it collects, in the simplest payment structure, an annual management fee of about 1% of the money under management, and

–it keeps a client in a given product (or at least it did when I was more intimately familiar with the numbers) for about eight years.

So it pays 5% of the beginning assets up front and collects 8% of the assets in fees before the client leaves.  …a reasonable, but not great, deal for the management company in a rising market, not such a hot one in a falling market.  Something also depends on how the client leaves–that is, whether he exits the fund group entirely or merely shifts to another product within the fund family.

That’s it for today.





Candy Crush–ed: an odd but encouraging result (except for shareholders)

King Digital Entertainment (KING), maker of the popular mobile game Candy Crush, went public yesterday, It sold 22.2 million shares at an offering price of $22.50 each, a price that was in the middle of the announced $21 – $24 range.  The offering was led by JP Morgan, Credit Suisse and Merrill Lynch–KING wanted no participation by Morgan Stanley or Goldman, powerful underwriters the company apparently felt were tainted by the Facebook IPO fiasco.

the odd part

The stock opened relatively quickly, before 10 am, but at $20.99 on 842,000 shares.  After some initial gyrations, it fell fairly steadily from there, closing the day down by 15% at $19, on volume of 41 million shares.

What’s peculiar is that I can see no effort by the underwriters to stabilize the price at the offering level.

Typically underwriters place about 15% more stock with clients than they purchase from the IPO firm.  This allows them to absorb any potential selling during the initial hours of the stock’s debut.  Yes, this is legal.  The underwriters declare when they are stabilizing the stock and when they have halted this activity.  Normally you don’t need to see an announcement, though.  The stock runs into a brick wall (for a while, anyway) that prevents it from falling below the offering price.

In this case, there was no trading at all at the offering price.  The underwriters trading books must have been hit by a wall of selling (presumably limit orders as well as market) that convinced them that resistance was futile.The odd part is that this all occurred less than a day after the offering price was set and the deal fully subscribed.

the good

It seems to me that KING must be regarded as a speculative stock.  Yes, the company earned $1.75 a share in 2013.  But the vast majority of that comes from a single game that competes in a notoriously fickle casual gaming arena.  One has to ask how long Candy Crush will remain popular and what other hits are in the pipeline.

There may well be good answers.  And the company may prove very successful.  However, predicting earnings for 2014, 2015…requires a substantial leap of faith.  This places it in the same camp as, say, WDAY, TWTR, TSLA and maybe AMZN and NFLX.

Anyway, everyone in the latter group has been selling off pretty heavily recently.  I don’t think the companies have changed much, if at all.  What’s occurring, I think, is that the stock market is taking a more sober attitude toward risk as the Fed lays out more concrete plans to end the emergency monetary stimulus that has characterized the past half-decade for it.

The more self-correction we see in the stock market now, the less likely it becomes that upcoming Fed action will cause the entire market to decline when it happens.





Intel (INTC) and next-generation semiconductor plants

We’re living in a time of immense structural change.  For investors, the internet-led waning of established brand names and bricks-and-mortar distribution networks and the loss in value of existing manufacturing plant and equipment as new factories spring up in developing countries are among the most important.

One exception to this trend has been in semiconductor production.  There the engineering knowhow required to run the factories is very high and the pace of change has been very swift.  In addition, the cost of building a new fab is prohibitive for most:  a current-generation plant costs about $3 billion.  If a firm wants to fill the plant exclusively with its own chips, that requires annual sales of $7 billion or so.  In other words, only INTC and Samsung are big enough and rich enough to afford their own plants and the technological edge that brings.  Everyone else has to use third-party contract foundries like TSMC.

INTC currently has maybe a two-year lead over other semiconductor manufacturers in process technology.  It can make smaller, faster, less power-hungry chips than anyone else.  To preserve this advantage, the company has been making preparations–including funding research by equipment manufacturer ASML–to be the first out of the blocks with plants running new “extreme ultraviolet” technology and processing much larger silicon wafers to boot.

What has come to light very recently, however, is that these new factories are going to be mega-expensive, at $10 billion apiece or more.  As things stand now, that makes building one of them a bet-the-company move for anybody, even an industry giant like INTC.

Where to from here?

It’s not 100% clear, to me anyway, but:

–extreme ultraviolet lithography is probably at least a half-decade away, not a 2017 event as previously thought.  This means R&D and capital spending will be spread over a much longer period of time.  All other things being equal, this will mean higher cash generation by INTC.

–absent a significant cost-reducing breakthrough in EUL, INTC will likely partner with at least one other party to fund a next-generation fab.  Partnering could either be with other chipmakers or with one or two large deep-pocketed users of chips.   …AAPL?  …MSFT?

–it’s conceivable that INTC will itself end up with a substantial foundry business manufacturing chips designed–at least in part–by third parties.  One might argue that this would be a come-down for the premiere manufacturer of proprietary microprocessors.  However, the best foundry, TSMC, trades at a substantial PE premium to INTC even though its technology is inferior.  So morphing into a foundry could easily add a quarter or a third to INTC’s stock price.

Seth Klarman, round two

Yesterday I wrote about the concerns voiced by veteran hedge fund manager Seth Klarman about the current state of global securities markets.  He appears to have three main worries:

1.  he can’t find ultra-cheap things to buy.  As far as the stock market goes, there are no more deeply undervalued, asset-rich companies.  In the way he operates, this means he goes to cash, awaiting the next big market decline before reinvesting.

2.  he sees rampant speculation, particularly in the bond market.  This will not end well when the Fed begins a long period of money policy tightening.

3.  Stocks won’t escape unscathed.  They went up by 30% least year;  issues like TSLA, NFLX, AMZN are at crazy-high prices.

My thoughts:

1.  Bonds are at much greater risk than stocks:

–the speculative stretch for yield in fixed income is much more widespread than the speculative stretch for growth in company earnings.  The latter is a relatively recent phenomenon, I think, and is centered on a relatively small number of issues.

–stocks have had two sharp and very painful declines over the past 15 years.  Bonds, in contrast, have had smooth sailing for a generation.  To me, this means that veteran bond managers have been trained by long experience that being very aggressive–even to the point of buying ostensibly overvalued securities–always pays off.  This is like the (loony) momentum players who ran Janus in the late 1990s, only on a larger scale.  Having been burned twice in recent memory, the stock portfolio managers who have survived both downturns will be more conservative.

–in past periods of Fed tightening, stocks have gone sideways while bonds declined.  That’s because rising corporate earnings resulting from an improving economy have offset for stocks the negative effect of higher rates.

2.  No one really knows what will happen as the Fed tightens this time.  The Fed freely admits this.  During past tightening periods, short rates have risen by ~200 basis points.  This time the Fed is officially saying that “normal” for the Fed Funds rate is ~400 basis points higher than the current zero (personally, I think this is too high).  Arguably, part of the associated adjustment in long rates has already occurred, when Mr. Bernanke raised the possibility of tapering last year.  Still, the road back to normal is much longer than anything I’ve seen before.

Also, it’s not clear to me how much the Fed is motivated by wanting to quash the speculation Mr. Klarman points to, rather than by seeing rude economic strength.  If it’s more the former than the latter, corporate earnings may not be strong enough to keep stocks from declining.

3.  How far could securities fall?

For bonds, I have no clue.  I suspect most of the damage will be in things like the recently issued TSLA convertibles and in similar low coupon, long-dated corporate bonds.  No-covenant junk bonds won’t win any prizes, either.

For stocks, we’re not talking about the destruction of the world financial system and the complete cessation of industrial activity.  We know that that scenario led to a 50% decline from a speculative high in 2007.  A garden-variety bear market, meaning down 20%-30%?  I don’t see that either, since I don’t think recession is imminent.  Down 10%?  It’s possible.

4.  What to do now?

Better said, what I’m doing now.

I’m becoming mildly more defensive, and then waiting to see how the stock market develops.  This means three things:

–I’ve already accelerated sale of the clunkers I’ve identified in my portfoiio.  I’m also eyeing smaller, more speculative ideas, like SPLK, to do the same

–I’m looking at my largest positions and deciding how far to cut them back

–I’m focusing on low current PE as a criterion for stocks to add.

To sum things up, I think we’re leaving a TSLA market and entering a MSFT one, where the here and now is much more important than possible earnings a half-decade away.


One more point:  price action over the past week or so may provide valuable clues about how the stock market is reorienting itself.

hedge fund manager Seth Klarman’s market warning

Seth Klarman’s shareholder letter

Seth Klarman is a value-oriented hedge fund manager who has remained in business for over thirty years and currently had $27 billion under management at the end of 2013.  I don’t know Mr. Klarman, nor am I familiar with his track record.  Nevertheless, it seems to me that thirty+ years of staying alive in a brutally competitive business and $27 billion under management earn you at least a hearing.

Mr. Klarman has made the news recently, as a result of his yearend 2013 letter to investors (I’ve only seen excerpts from the financial press and on other blogs).  In it he cites a long list of warning signals for stock and bond markets.  They include:

–least year’s 30%+ gain in the S&P without a commensurate increase in earnings

–a near-tripling in stock prices from the market low in 2009

–record amounts of margin debt, high IPO activity

–nosebleed valuations for stocks like AMZN, NFLX, TSLA, TWTR…

–all sorts of speculative activity in the bond market, particularly in lower quality securities like junk bonds.

All these worrisome developments are the unfortunate consequences of a “Truman Show” environment orchestrated by the Fed in the aftermath of the financial collapse in 2008.

Mr. Klarman underlines his concern about the current state of Wall Street by informing clients that he will be returning (this has apparently already happened) a total of $4 billion of their money to them–forgoing a large chunk of annual management fees.  If press reports are correct, Klarman has been running with 50% of his assets in cash and feels he can find nothing at today’s prices to buy.  (In addition, if he is charging a management fee of 2% of assets (+ some percentage of profits), the big cash holding is clipping 1% yearly off his net return.)

a little arithmetic

As of December 31st, Mr. Klarman’s hedge fund held 4.9% of the outstanding shares of Micron Technology (MU).  That’s after selling 20% of his holding during the December quarter.  MU made up 32% of his publicly traded equity exposure at yearend  …meaning his entire equity holding was about $3.8 billion on January 1st.  This implies his non-equity exposure must have been just under $10 billion.  So the stock market is the least of his professional worries.  The bond market is his biggest potential risk.

his big concern

It’s the same as everyone else’s–can the Fed withdraw the excessive monetary stimulus that he believes to be (me, too) the root cause of the high degree of speculative activity without causing a great deal of direct damage to global fixed income markets and a lot of further collateral damage to stocks?

It’s not surprising that a traditional value investor would be having difficulty finding stocks to buy in today’s market.  After all, stocks in general have almost tripled from the lows, with left-for-dead deep value names having done far better.  MU, for example, is up by 10x from its late-2008 low.

In addition, in every market cycle, value works best in the early years.  Than growth takes over.  On top of that, I think that in the post-Internet world traditional value investing will work progressively less well as time goes on.


It’s not what Mr. Klarman is saying.  It’s that I’m not ignoring it in the way I would have a year ago.

More tomorrow.





Comcast (CMCSA) and Time Warner Cable (TWC)

I laughed out loud when I heard the press report that the Roberts family, which controls Comcast, is concerned that customers are not giving them credit for their attempts to improve service.  On virtually any metric you’d care to choose, and for as long as I’ve been watching the company–both as an investor and as a customer–CMCSA has consistently ranked at or very near the worst in customer satisfaction.  It’s the only reason TWC isn’t in last place.

Hence the legislative and regulatory concern about consolidating the bottom of the pile into one low-service mega-company.   …and, I presume, the claim that customer service is now a priority for CMCSA.

I have only limited experience with TWC.  My impression is that no one is in charge.  This contrasts with CMCSA, where I don’t think incompetence is the issue.  Instead, I believe the profit-maximizing strategy of the firm is to:

–find the line where customer dissatisfaction turns into revolt and make the minimum investment necessary to stay just above it.  I’ve never discussed this with CMCSA management–in fact, I can’t recall ever having spoken with them.  But companies all have personalities.  And that’s the way CMCSA acts.

CMCSA wouldn’t be the first to do this.  Marriott (MAR) had  similar thinking at one time.  It built its hotel rooms with the ceilings an inch or two lower than other companies and the rooms, say, 10% smaller in total area.  The hot water was never really hot.  MAR managment argued to that these deviations from the norm all saved money and were too small for anyone to notice.  People would, at worst, only be vaguely uncomfortable.  And then they wondered why they were never able to attract (lucrative) business customers.

Eventually, the lightbulb came on for the Marriotts. The family ousted the management that thought up this approach.  (Those guys decamped to Disney, where then created the Eurodisney fiasco, and, after being pushed out the door again, went on to severely clip the wings of Northwest Air.)  MAR began to build more comfortable hotels and built a thriving corporate business (by the way, I own MAR shares).

The difference between MAR and CMCSA is that the latter is a semi-monopoly.  Customers have very few other choices.  That’s why a customer-unfriendly strategy continues to work.  It’s also why the question of whether regulators should encourage this behavior is coming up.

I’m not a CMCSA customer any more.  I use FIOS now.  Superstorm Sandy did me in.

The week after the storm, Verizon (VZ, another stock I own) trucks were all over our neighborhood, repairing their mobile and wired internet infrastructure.  CMCSA trucks didn’t arrive for a month!!  Nevertheless, CMCSA continued to charge for the service it was not delivering.  The customer service representatives I spoke with on more than one occasion explained that I could get a refund for the time the service was unavailable.  To do so, however, I would have to submit proof that my electric power had been restored.  And I would not get a refund for any time (a week, in my case) that the electric power was out.  Yes, CMCSA cable and internet weren’t available for a month after the storm.  But for CMCSA that was irrelevant.  Their argument was that without electricity I couldn’t receive the service CMCSA couldn’t provide.  So I had to pay for the non-service anyway.   Talk about through the looking glass.

Anyway, like most everyone else on our street, we switched to FIOS.

It will be interesting to see how the regulators treat the possible merger of CMCSA and TWC.