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.

 

what the utility “death spiral” is

I’ve been hearing and reading a lot lately about a potential electric utility “death spiral.”  So I thought I’d write, in simplified terms, what this is all about (by the way, the Economist magazine has an excellent recent survey of the electricity generating industry worldwide).

utility 101

Governments have generally decided that capital-intensive public service businesses, like provision of water, electric power, natural gas shouldn’t be open to all potential entrants.  Instead, the government chooses a single provider.  In return for being awarded a monopoly in a given service area, the company in question agrees to government regulation of its charges.

For every utility I know of (cable tv being, arguably, an exception), regulation takes the form of limiting the utility to a maximum allowed return on its net investment in plant and equipment.  Net here means after subtracting accumulated depreciation charges.  In most countries, the return is set annually.

setting rates

The rate fixing process boils down to this:

–the government utility regulator specifies an allowed return on plant for a given year, say 5%.  If the utility has net plant and equipment of $40 million, the  total allowed profit is 5% of that, or $2 million.

–the utility submits an estimate of the number of units it will sell in the coming year and what the cost per unit will be.  Let’s say it figures it will provide 20 million units to customers and that it will cost $.20 a unit to do so.  The utility is allowed to add a profit element (i.e., $2 million/20 million units = $.10 a unit) to its costs to arrive at the total per unit charged to customers.  In our case, this is $.30/unit.  [The reality is a little more complex:  bulk customers or industrial users who agree their service can be interrupted in periods of peak usage may get discounts; peak period users may be charged a premium.  That doesn’t make a difference for the “death spiral,” though.]

electricity

Let’s say the service in question is electricity.  Let’s also say the population is stable (there’s a life cycle aspect to utility profits, but that’s another wrinkle we won’t worry about yet).

the spiral begins

Over time, people buy appliances that conserve power.  New construction is better insulated, so air conditioning doesn’t have to run so much.  New light bulbs run cheaper.  Home power monitoring systems optimize and reduce electricity consumption even more.  On top of this, responding to government subsidies, some people put solar panels on their roofs.

Suppose all of that cuts electricity usage in the service area by 20% (very high, but just to make the point), to 16 million yearly units.

The new calculation of the electricity company per unit profit becomes:  $2 million/16 million units = $.125/unit.  The per unit charge becomes $.325, or 8% higher than before.

The 8% increase causes more people cut their power consumption, either by investing in new, less power-hungry devices, finding substitutes (those solar panels no longer look quite so ugly) or simply by heating/cooling the house less.  Let’s say the price response reduces annual demand in the service area to 14 million units.

What happens at the next annual price setting?  The new per unit allowed profit is:  $2 million/ 14 million units = $.143/unit.  So the cost of electricity rises by another 5.5% to $.343.

That causes another round of conservation/substitution   …which drives the per unit charge even higher   …and prompts another round of conservation.

That’s the death spiral.

Is it real?  Maybe in some places in the EU.  In the US it seems to me there’s a tipping point out there someplace that we haven’t yet reached.  I don’t spend time dreaming about my next utility stock purchase, however.

other stuff

If the service area is growing, with new customers arriving every day, the potential problem is a worry for the distant future.  If the service area is shrinking, on the other hand–like if retirees are departing for warmer/cheaper climes–the issue is on the table today.

From an investor point of view, two further non-death spiral complications:

–when the service area matures, the regulator typically sees no further need to maintain a high allowable return on plant to make raising new capital easier, so the return percentage is pared back

–without new capital spending, net plant shrinks as accumulated depreciation …well, accumulates.  This is another minus for mature service areas, since smaller net plant = smaller allowable profit.

Both of these factors mitigate the spiral effects.  Neither makes the utility in question prettier to Wall Street eyes.

dividend-paying stocks

Robert Rhodes of Rhodes Holdings LLC made one of his usual astute comments about my post last Thursday on utility stocks.  In this post, I’m going to elaborate on my view of buying stocks for their income.

Financial planning guides often mention that when selecting a stock because of its dividend, one should consider not only its current yield but also the potential for the payout to grow.  My impression is that the authors don’t just want to steer us away from too-good-to-be-true extremely high current yields, which are most often a sign that the market thinks the dividend is likely to be cut sharply or even eliminated.  I think they also believe it’s better for investors to pick a stock with, say a 3% current yield and the possibility of 8% annual growth in the payout vs. a stock with a relatively secure 6% yield and no dividend growth potential.

For a Millennial, who arguably has no business getting involved with income stocks, the expert advice is probably correct.  In contrast, for a senior citizen looking for income-generating investments to support retirement, the 3% yield + the promise of growth is certainly better than Treasuries.  But for a seventy-something a good argument can be made that the 6% current yield is the better choice.   At least, that’s what I’ve thought until very recently.

my reasoning?

The handy-dandy rule of 72 tells us that a 3% yield growing at 8% per year doubles in nine years (72/8).  It takes that long for the payout to equal the 6% dividend of the non-grower.  This also means someone who buys $100 worth of the 3% yielder collects $40.50 over the nine-year period, assuming the payout increases at a uniform rate.  The person who chooses the 6% yielder collects $54.  It takes the former another two years+ to draw even in terms of total income received.

Put a different way, the superiority of the 3% yielder with growth doesn’t come into bloom until over a decade after purchase.  That’s a long time.  It hasn’t been clear to me that financial planners fully appreciate how large/long the shift in income is away from the period a senior citizen may be young and healthy enough to enjoy the money.

Capital gains?  In theory, the steady-state 6% yielder has significantly less capital gains potential than the 3%er.  But who knows?  Arguably the senior citizen is more concerned with preservation of income than in making capital gains.  It’s also possible that the sprier utility won’t be able to sustain profit expansion for such a long time.

my change of heart

As I wrote last week, the negative effects of years of downward regulatory pressure on utility rates in mature areas, and the consequent corporate response of cutting maintenance/replacement are starting to become apparent.  It’s no longer clear to me that the dividend payments of no-growth utilities are as rock solid as I’ve been assuming.  So, yes, there’s a chance that the fast grower will slow down in short order.  But I now think there’s also a good chance that mature utilities will be forced to divert large amounts of cash flow away from shareholders in order to shore up creaky infrastructure.  So the mature utilities may be much riskier than they appear.

 

yesterday’s gas explosion in Harlem and the economic structure of utilities

Yesterday morning a leaking 125-year old cast iron gas main in East Harlem, just east of Park Avenue in Manhattan, exploded.  The blast killed six (an equal number are still missing) and injured 60.  The two five-story buildings the main served were pulverized.  Debris even covered the nearby elevated train tracks, disrupting commuter train service to Connecticut and upstate New York.

I have a generator in my backyard because the electric power outages in my neighborhood ars so frequent.

After Superstorm Sandy, it was a month before the first Comcast trucks appeared on our street to restore internet and cable (Verizon was on the scene a day or two after the storm, causing virtually everyone to switch).

Why do things like this happen?    .

..welcome to the world of mature utility operation, one where, in the Northeast US at least,  “business as usual” is facing increasing citizen discontent.

background

Governments grant monopolies to electric, gas and water companies in a given service area.  They do so to avoid expensive and disruptive duplication in the buildout of infrastructure.  In return for their exclusive status, utility companies are subject to rate regulation by the local utility commission.  No matter what formula is officially used, the rate-setting ultimately comes down to the utility receiving a specified return on its net (that is, after subtracting accumulated depreciation) plant.

When the service area population is growing, the utility has smooth sailing.  Its net plant is continually increasing as it hooks up new customers.  The utility commission also grants a generous return on that plant, in order that the utility has no trouble getting money, by issuing stock or bonds or borrowing from banks, to pay for the new plant and equipment it needs.

When the service are matures, however, this favorable dynamic changes.  Because there are no/few new customers, the utility’s net plant growth slows to a halt.  Net plant may even begin to shrink, meaning so too does operating income.  In addition, the utility commission no longer sees any reason to keep the allowable return as high as it did in the past.  More than that, the utility is now “trapped” like any other highly capital-intensive business with a lot of sunk costs (think: a cement plant, or a supertanker).  It can’t rip up the lines and leave.  So it’s a price taker, meaning the utility commission can easily bow to pressure to keep utility rates low by reducing the return it allows.

So high returns on a rising base morphs into falling returns on a shrinking base.

How does the utility respond to reduction in its cash flow?  Shareholders want higher profits and higher dividends.  Management wants a higher stock price.  The only way to get higher net income  is to pare expenses.  This means replacing meter readers with machines.  It means cutting maintenance staffs and maintenance itself.  And it means trying to make aging plant last longer before replacement.

Personally, think we may be reaching a tipping point, where utilities have pushed cost-cutting too far and where business as usual becomes socially unacceptable.  Probably not good for utilities in ares that aren’t growing.

Investment significance?

There’s a long-standing dynamic in utility investing:  choosing between high dividends that are not growing and more modest payouts that have the potential to rise steadily.  To the limited degree that I buy utilities, my instinct has been to pick the higher current yield.  Why?  I’ve found the point where the growing dividend bridges the gap with the static one occurs too far in the future.  As utility service breakdowns continue to occur with come regularity in areas like the Northeast, that thinking is probably much less sound than I’ve realized.

when the dust clears, I’m buying a generator

no power–again!

I live in a detached house in the northeast US.  Hurricane Sandy is the third occasion in a little over a year for my neighborhood to lose electric power for an extended period–a phenomenon I associate more with emerging nations than developed ones.  This means no lights, no heat, no hot water for 5-10 days.  No TV, no refrigerator, no internet, either.  It’s back to checks instead of the bank website to pay bills.  For many people (not us, though) it also means no water at all, so, among other negatives, the toilets don’t work.

bad luck?   …no

I think that our recent experience isn’t simply horrible bad luck.  The more I think about it, the more I’m convinced that long power outages are going to occur routinely where we live from now on (hopefully less frequently than once every few months).

My conclusion has in principle little to do with global warming, although global warming makes the problem potentially much worse.

utilities are a little like banks

For decades, economists have pointed to the potentially disastrous consequences of the dual nature of banks in the developed world.    On the one hand, they have an important social function–they’re the main vehicle for transmitting national monetary policy from the central bank to the economy at large.  On the other, they’re publicly traded companies whose managements aim at making steadily increasing profits to please shareholders.

Sometimes, these two roles are incompatible.

If the banks take too much risk in seeking net income rises, they’ll lick their wounds and refuse to lend, no matter what signals the central bank sends them.  Less often–the only example I can think of is the decade leading up to the US housing collapse–the banks can listen to crazy signals from the government (thanks, Mr. Greenspan), make a pile of unbelievably stupid loans, and bankrupt themselves.

I’m coming to realize that electric utilities are a poor man’s version of the phenomenon of having two conflicting social roles.  Actually, I’ve known this in theory for a long while.  But we appear to have hit a tipping point here in the Northeast, so that the negative effects of the arrangement are becoming apparent.

my reasoning

rate-setting

Typically, because of the immense expense involved in establishing and expanding an electricity generation and transmission network, governments grant a single company a monopoly over service provision in a given area.  In return, that company accepts government regulation of the rates it charges.  The economic sense used in the rate-setting process is that the company is entitled to a certain rate of return on its net plant and equipment investment.  The big question is what that rate will be.

a growing service area

When a community is growing, the regulators are content to allow generous rates of return.  This makes it easier for the utility to raise the capital needed to expand its network.  The prospect of high returns on a growing capital base makes banks willing to lend.  The promise of rising dividends makes equity investors willing to bid up the company’s stock and to subscribe for new shares in public offerings.  Everyone is happy.

a mature area

When the area matures, however, and expansion slows/stops, the dynamic changes in two ways:

–since there’s no necessity to attract new capital, the government sees no need to continue to grant rate increases.  More than that, it sees there’s a political advantage to lowering the rate of return.  What can the utility do–rip out its lines and leave?

–for a company, the operating profit it gets from providing its services is based on net plant–that is, its initial investment minus yearly depreciation charges.  So if it can’t add new plant, the money it receive doesn’t remain constant.  It begins to decline as yearly depreciation whittles down the net plant figure.

Voters are happy because utility charges aren’t rising.  The utility company, however, undergoes an enormous squeeze.

the utility response

Every capital-intensive company becomes a price taker (meaning it has little or no influence over the price it receives for its goods/services) once its capital investment has been made.  It’s true for a cruise ship, a hotel, a cement plant–and a public utility.  All it can control is its costs.  All it can do to increase profits is to cut costs (the firm can also become a holding company and invest part of its cash flow in non-utility areas, but in this post let’s keep focused on the utility) .

It can merge with other utilities to eliminate administrative overhead.  It can also shift from gold-plated repair and maintenance to some less expansive variety.  It does so by reducing the number of local employees, planning instead to borrow from neighboring states in case of emergency.  It cuts back on inventories of replacement parts. It tries to nurse senescent plant and equipment into working for “just one more year.”   Aging infrastructure makes the whole system more fragile.  As a result, the utility may be more vulnerable to shocks and less able to respond quickly to emergencies.

My diagnosis is that this is what’s happening in the Northeast US now.  Hence my belief that the lengthy power outages of the past year or so aren’t just unfortunate coincidences but indications of what life will be like in the future.  Ergo, my upcoming generator purchase.

investment implications?

My main conclusion is that the situation I describe is a negative for utilities in mature areas of the US.  One caveat is the possibility that regulators might boost allowed returns in order to get utilities to invest more in their plant and staff.  But recent legislation allowing third parties to sell cheap electric power through the existing utility distribution networks cuts against this idea.

I don’t want to point the finger at any one party as having caused the current state of affairs.  The bottom line is that we have the utility system we’re willing to pay for.

I can imagine that continuing power outages will accelerate population drift away from the affected areas toward the growing regions of the country in the South and West.

On a more (useful and) micro level, outages should shift internet usage more quickly to mobile.  In our area, VZ coverage seems to be proving far superior to that of T, so outages may encourage customer switching to the former.

If we’re still looking for anyone whose “fault” the situation I’m describing may be, try blaming Adam Smith.  His “invisible hand,” is, after all, the basis for the idea that leaving everyone to pursue his own self-interest somehow produces the best social outcome.

600 million (!!!) without power in India–the negative investment case in a nutshell

Indian power outages

Media reports tell us that 620 million in India have no power, due to widespread failure of the country’s electricity grid.  That’s half the population of that country–and almost 10% of the world!  And we on the East Coast of the US think we have power problems!

For the twenty years or so that I’ve been following India, the south Asian giant has been touted as being the next big thing for emerging market investors.  But the dream has never become reality.

investment plusses…

The attractions are obvious:

–a mammoth domestic market,

–a significant number of entrepreneurs,

–a large pool of hard-working, well-educated workers, and

–the fabulous success of the IT outsourcing industry in Bangalore.

…and minuses

Three negatives, however, are just as prominent:

–the immense power wielded by a small number of industrial conglomerates that control much of Indian commerce, and which are not particularly interested in foreign competition,

–highly bureaucratic government at the national and regional levels, which tends to be highly inwardly focused and which is subject to religious, ethnic and class tensions, and

–the resulting lack of infrastructure, particularly roads and electric power.

the post-WWII development model

The classic post-WWII development pattern for emerging countries is to encourage technology transfer from highly skilled foreign firms.  These are typically induced to set up operations in the emerging nation through government incentives (tax breaks and red tape slashing) and by the availability of cheap labor, good roads and ports and sufficient electric power/clean water.  Underlying all this is a national consensus to make the sacrifices needed to foster economic development.

India doesn’t fit

India doesn’t fit this model.   In fact, according to the World Bank, India has recently been losing ground in important areas of infrastructure.  In its 2012 Logistics Performance Index, the Bank rates the second-largest country in the world by population as #46 in the quality of its logistics.  That’s just below Brazil, and slightly higher than Mexico and Argentina.  It’s also an improvement of one position since the 2010 report.

If we look a little deeper, however, India has fallen to #65 from #47 in the quality of its infrastructure, to #54 from #46 in international shipping and to #56 from #52 in its ability to track and trace shipments.

Its boost in the ratings comes from the timeliness of the shipments it does make (#44, up from #56) and its skill in using the logistics apparatus it has (#38, up from #40).  In other words, the ratings improvement comes from more efficient use of what little there is, rather than having an expanding logistics infrastructure.

The country hasn’t helped its reputation either with the Vodafone cellphone network affair, where it decided to retroactively change its tax laws to subject the UK firm to a multi-billion dollar levy on profits from a sale.  True, Vodafone may have exploited a loophole in the existing laws.  That’s irksome.  But changing the rules after the fact, rather than just closing the loophole, must give potential foreign investors pause.

By the way, India does have a program that allows private companies to build their own power plants.  In theory, they could use the electricity to drive their own operations and sell the remainder to the public grid.  But the latter prices are controlled by law, and set at a level that forces private power companies to lose money.  …oh, well.

 

Verizon (VZ) outperforming Apple (AAPL)? …what’s going on?

VZ vs. AAPL

Yes, it’s true.  Over the past three months, VZ is up 10.7% while AAPL is flat and the S&P 500 is down 4.2%.  We should toss in another 50bp to VZ’s outperformance because it has a high dividend.

Maybe there’s nothing to this.  After all, the stock market is, even at its best, a two-steps-forward, one-step-back affair.  So VZ could be having one of its forward steps while AAPL is temporarily in reverse.  The period in question is very short.  The overall market is also down over the past quarter, the kind of environment that favors more defensive stocks.  And, of course, VZ and AAPL were neck and neck through the first half of last year before AAPL rocketed ahead and left VZ in the dust.

Still, there may be something a little more substantial going on.  I don;t mean to argue that AAPL will be an underperformer.  The surprise may be that VZ continues to be an outperformer.  I may be biased here, too.  I haven’t finished my research yet, but I have recently bought some VZ.

the argument for VZ

the US cellphone market is maturing

According to Nielson, 69% of current cellphone purchasers in the US are buying smartphones.  If we break that out by age, close to 80% of new phone purchases by Americans under 55 years of age are smartphones.  About half of those 55 or older are choosing smartphones, too.

Given that there will be some–mostly 65+–users who will never adopt new technology, can it get much better than this?  I don’t think so.

strategy shift in maturing markets

In a recurring subscription business, the winning tactic in any new market is usually to stake out as much territory for yourself as possible, without much regard for profitability.   You don’t care what anyone else is doing.  You just want to get as many clients in the door as you can.

As the market matures, however, two changes occur:

–growth comes from taking customers away from competitors, not from finding people who have never used the service before.  This is typically harder work and more expensive, so firms with scale end to have an advantage.

–profitability becomes more important.  Firms try to raise prices and to cut operating costs.

I think this is where we are in the US cellphone market.

sources of profit growth for VZ

1.  lowering phone subsidies.  To use round numbers, let’s say VZ pays AAPL $600 for an iPhone 4s.  It resells the phone, linked to a two-year contract, to a customer for $200.  VZ loses $400 on the transaction.

If the company can persuade that customer to choose an Android phone that it pays, say, $450 for, it loses $250 instead.  So it’s $150 better off.  That’s all incremental profit.

Better (for VZ) still, if the customer chooses a Nokia Lumia phone, the loss may be only  $200.

In Europe, phone companies are experimenting with using INTC reference designs to make house-branded phones.  Why bother?  INTC is only interested in selling chips, so it is ceding the entire wholesale markup to the carrier.  So it may cost the carrier $350 for a phone it can resell for $200–meaning a loss of $150.

Make this sort of marketing shift for enough customers and the savings become significant, even for a company of VZ’s large isze.

2.  raising prices.  In a sign that VZ thinks its market is maturing, it is fundamentally reworking its pricing.  Starting late this month, customers will get voice for free but begin to pay for data.  No more all-the-data-you-can-use plans, either.  Interestingly, VZ is going to eliminate a $20 per month charge for the ability to make your phone a mobile “hot spot” for internet access.  So you can tether your laptop or tablet to your phone for free, just by asking VZ politely.  Why?  Videos look a lot better on a tablet.  And they’re very data intensive.

all good things end, someday

At some point, possible profit-enhancing measures will run their course.  But that’s probably several years down the road.  In the meantime, VZ’s profit performance vs.Wall Street expectations may be surprisingly good.

In a perfect world (for the holder of VZ shares), the company would be able to spin off or otherwise shed its fixed line and FIOS money pits.  For stockholders, that would be like hitting the lottery.  It’s very highly unlikely to happen, in my opinion.  But, on the other hand, there’s nothing in the stock price for the possibility.