Masayoshi Son and Donald Trump

Masayoshi Son is the visionary entrepreneur who controls Softbank, an innovative Japanese communications and internet giant.  Several years ago, Softbank gained control of the US wireless company Sprint.  Mr. Son’s intention was to buy T-Mobile and merge the two, creating a third large national wireless company able to compete with ATT and Verizon.

The Obama administration vetoed the combination on antitrust grounds.  On the surface, this made sense, since the number of competitors in the US market would be reduced from four to three.  On the other hand, the relative market shares of #3 and #4 ares small enough that they have not made much difference in how the two giants operate.  Also, Mr. Son entered the Japanese wireless market in the same fashion, piecing together a national network out of smaller firms. Then he disrupted the existing oligopoly through very aggressive, consumer-friendly, price competition.  He created competition–and much lower wireless bills–where there had been none before.

His intention is to do the same in the US market.  From where I sit, government disapproval of the proposed merger of Sprint and T-Mobile stifled competition rather than promoting it.

My guess is that Mr. Son will have better success explaining his motives to the Trump administration.  A Sprint/T-Mobile combination would likely be good for us as consumers of wireless services, but bad for the incumbents, ATT and Verizon.

the changing nature of competition

Happy Halloween!!

This is the continuation of my post from last Friday.

A generation ago, establishing a competitive edge in a business was about having plant and equipment, operating that physical capital efficiently and, for consumer-facing firms, advertising to create and maintain a brand image.

First mover advantage was often key, since it might allow the initial entrant to achieve economies of scale (lower unit costs) in manufacturing or marketing that would discourage potential rivals  by making their path to profits prohibitively long and expensive.

The Internet, and the rise of China as a low-cost contract manufacturing hub, changed all that.  Supply chain management software did allow vertically integrated companies to coordinate actions much more efficiently.  But it also gave smaller, more focused firms the power to create virtual integration using third-party supply chain partners.

 

Today’s competition, particularly in the consumer arena, is as much about services as physical products.  The development of internet-based social media has made it much easier for a fledgling niche product to find a voice without spending heavily on traditional advertising.

Knowledge and relationships have replaced plant and cumulative advertising expense as “moats” that protect a firm from competition.

 

These developments present two problems for stock market investors:

–the first one is straightforward.  Comparing a stock price with the per share value of tangible balance sheet assets (Benjamin Graham) may no longer provide relevant buy/sell signals.  Nor will supplementing this analysis by including intangibles (Warren Buffett), using, say, the sum of the past ten years’ advertising expense.

A very successful value investor friend of mine used to say that there are no bad businesses, there are only bad managements   …and bad managements will invariably be replaced.  In an overly simple form, he thought that so long as he could see large and growing revenue, everything else would take care of itself.  Broken companies were actually better investments, since their stock prices would leap as new managements created turnarounds.

As I see it, in today’s world this traditional approach to valuation is less and less effective–because assets no longer have the enduring worth they formerly did.

–first mover advantage is probably more important today than in the past.  But while network effects are readily apparent, a company’s development stage, where the network is growing but the source of eventual profits is unclear, can be very long.  And it may be difficult in the early days to separate a Fecebook from a Twitter.

 

So while we can all dream of finding a profit-spinning machine that has high turnover and negative working capital, today’s versions are inherently more vulnerable than those of a generation ago.  They may also come to market in their infancy, when what kind of adults they’ll tun into is harder to imagine or predict.

 

the Dollar Shave Club and Unilever

Unilever has made a $1 billion offer to buy the Dollar Shave Club, an online razor blade (and other grooming accessories) business started from scratch in 2011.

Media reaction to the deal is that this is a story about the power of the internet   …which it partly is.  The big traditional makers of razors and blades, Gillette and Schick, ignored the possibility of alternate distribution channels despite almost two decades of strong evidence of the “creative destruction” power of the internet.

But that’s not the whole story.  Two other, more traditional factors are involved:

–over the past ten years or more, razors and blades from Gillette and other manufacturers have become more complex and much more expensive.  “New and improved” (read: higher-priced) models have been introduced with greater frequency.  This has also been happening at a time when the overall market is stagnating as fewer men are shaving every day.  I can’t help believing that this behavior is at least in part as a way to justify the $54 billion Procter and Gamble paid to acquire Gillette in 2005.

No matter what the cause, however, the result has been to make the ground-level mistake of creating a pricing umbrella under which an online competitor–which, after all, will have higher unit production and distribution costs–could prosper.

–A fundamental rule of marketing is that self-cannibalization of a product market is always preferable to having an outsider grab market share from you.  Gillette et al. should have responded to the emergence of services like DSC by aggressively creating similar online products.  Yes, this may mean that total profits may end up being only 75% of what they once were.  And it means abandoning the illusion that the prior market structure will magically be restored.  But having the 75 for yourself is better than you having 50 and a new entrant having 25.

Pretended that this new competition doesn’t exist won’t make it go away.  Nevertheless, the sad fact is that the first strategy of the status quo is almost always denial.  In the short term, this protects bonuses and perks.  But allowing new competition to flourish is invariably a long-term disaster.

Amusingly, DSC investor David Pakman’s blog offers this strategy tidbit:

  • Choose categories where the CEOs of the incumbents are professional CEOs, not founders (thus are far less-likely to cannibalize existing businesses and adopt new business models).

That says it all.

UPS survey of online shopping

A week ago, UPS released its fifth annual survey of online shopping.  The main results:

–for the first time ever, more than half of the purchases made by survey respondents are made online

–over three quarters use smartphones for their buys

–a third use social media sites to gather information; a quarter have bought things through social media sites

–a third start their shopping either at Amazon or eBay

half of online shoppers take delivery at a physical store.  Almost half make additional purchases when they go to pick their items up

–60% of returns go through physical stores.  Again, consumers frequently buy additional items once they’re inside

–almost a third of purchases in a store are smartphone-guided, meaning buyers use their phones for product information, price comparison or download discount coupons

–35% of packages not sent to a store go to non-home locations, a trend that has been steadily rising recently

pure physical-store shopping, meaning no online involvement in either search or purchasing, is down to 20% of all buys in the US.

 

No wonder traditional retailers, especially mall-based ones, are taking such a beating.  No wonder Amazon is aggressively beefing up its own shipping operations, while starting to tiptoe into opening physical stores (as a better way of processing returns?).

Square, venture capital and the late-1990s Internet bubble

a bubble deflating

Internet payments company Square came to market yesterday.  It has a two-letter symbol, SQ, and trades on the NYSE, not NASDAQ.  But the most salient fact about the offering is that the IPO price was a lot below the private market value that venture capital investors had placed on SQas little as a year ago.

At the same time, the small number of mutual funds which have been aggressive venture capital buyers in Silicon Valley have been, more or less quietly, writing down the carrying value of their non-public company holdings.

What we’re seeing is, I think, a smaller and much more benign–both for the economy and for us as stock market investors–analogue of the deflation of the Internet mania of the late 1990s that started in early 2000.

the late 1990s and the internet

I remember noticing in 1998, that earlier- and earlier-stage companies were coming to market successfully.  Some were little more than concepts.  Take Amazon (AMZN), for example, which IPOed in mid-1997.  The pre-offering roadshow that I saw emphasized that investors had made gigantic fortunes on buying unknown companies like Microsoft during the personal computer era and that AMZN was a lottery ticket to a similar outcome in the Internet Age.  Of course, even a success like AMZN didn’t turn profit for its first eight years as a public company, surviving on the proceed from the IPO and follow-on debt offerings.

I thought at the time, and unfortunately committed my theory to writing, that we were seeing a fundamental change in the role of the stock market in capital formation.  Portfolio managers were gradually taking on the role previously played by venture capital.  So, I mused, managers of mutual funds like me might have to think about reserving a small place–no more than, say, 5%–of their portfolios for developing companies that they normally wouldn’t have touched with a ten-foot pole.

Not my finest intellectual hour.

today’s bubble deflation

The slow escape of air from the venture capital bubble that is now going on will not have much effect on publicly traded companies, I think, for several reasons:

–the amount of money involved in this speculation is much smaller

–investors of all stripes still wear the scars of 2000-2001, so they haven’t been anywhere near as crazy this time around

–the people who are losing money now are, or represent, wealthy, seasoned speculators, not retail investors

–maybe most important, much of the original internet froth surrounded highly capital-intensive efforts to build a global physical internet transport infrastructure.  Names like Global Crossing and Worldcom come to mind.

Yes, too much physical capacity did get built back then, and some builders were highly financially leveraged.  But also dense wave division multiplexing, a technological breakthrough in technique (basically, putting glorified prisms on each end of a cable), made it possible for each fiber optic strand to carry 2x, 4x, 8x, 16x ( in 2015 the number is 240x)…  more traffic than initially anticipated.  Thanks to DWDM, suddenly, despite the rapid growth of internet traffic, an acute shortage of signal transport capacity turned to mind-boggling glut.  The transport industry was facing collapse as customers played a ton of potential suppliers against each other for lower prices.  Naturally, new construction–and related orders for all sorts of high-and low-tech components, dried up completely.   So did investment, employment in civil engineering   …and the stocks.

In today’s software world, there’s no equivalent, other than perhaps the market for software engineers.  And there are no signs I can see of recession in this arena.  Quite the opposite.