Mike Kwatinetz is a Founding General Partner at Azure Capital Partners and a Venture Capitalist investing in application software (SaaS), ecommerce, consumer web and infrastructure technology companies. Successful exits include: Bill Me Later, VMware, TripIt and Top Tier.
Apple’s progress from a company in trouble
to becoming the first company to reach a trillion dollar market cap meant over
400X appreciation in Apple stock. The metamorphosis began when the company
hired Fred Anderson as an Executive VP and CFO in 1996. Tim Cook joined the
company as senior VP of worldwide operations in 1998. Fred and Tim improved the
company operationally, eliminating wasteful spending that preceded their
tenure. Of course, as most of you undoubtedly know, bringing back Steve Jobs by
acquiring his company, NeXT Computer in early 1997 added a strategic genius and
great marketer to an Apple that now had an improved business model. Virtually
every successful current Apple product was conceived while Steve was there.
After Fred retired in 2004, Tim Cook assumed even more of a leadership role
than before and eventually became CEO shortly before Jobs’ death in 2011.
Apple post Steve Jobs
Tim Cook is a great operator. In the years
following the death of Steve Jobs he squeezed every bit of profit that is possible
out of the iPad, iPod, iMacs, music content, app store sales and most of all
the iPhone. Because great products have a long life cycle they can increase in
sales for many years before flattening out and then declining.
Table 1: Illustrative Sales Lifecycle for Great Tech Product
Cook’s limit is that he cannot
conceptualize new products in the way Steve Jobs did. After all, who, besides
an Elon Musk, could? The problem for Apple is that if it is to return to double
digit growth, it needs a really large, successful new product as the iPhone is
flattening in sales and the Apple Watch and other new initiatives have not sufficiently
moved the needle to offset it. Assuming Q4 revenue growth in FY 2019 is
consistent with the first 9 months, then Apple’s compound growth over the 4
years from FY 15 to FY 19 will be 3.0% (see Table 2) including the benefit of
acquisitions like Beats.
iPhone sales have flattened
The problem for Apple is that the iPhone is
now in the mature part of its sales life cycle. In fact, unit sales appear to
be declining (Graph 1) but Apple’s near monopoly pricing power has allowed it
to defy the typical price cycle for technology products where average selling
prices decline over time. The iPhone has gone from a price range of $99 to $299
in June 2009 to $999 to $1449 for the iPhoneX, while the older iPhone 7 is
still available with minimal storage for $449. That’s a 4.5X price increase at
the bottom and nearly 5X at the high end! This defies gravity for technology
Graph 1: iPhone Unit Sales (2007-2018)
In the many years I followed the PC market,
it kept growing until reaching the following set of conditions (which the
iPhone now also faces):
Improvements in features were
no longer enough to drive rapid replacement cycles
Pricing was under pressure as
component costs declined and it became more difficult to convince buyers to add
capacity or capability sufficient to hold prices where they were
The number of first time users
available to buy product was no longer increasing each year
Competition from lower priced
suppliers created pricing pressure
Prior to that time PC pricing could be
maintained by convincing buyers that they needed one or more of:
The next generation of
A larger or thinner screen
Next generation storage
What is interesting when we contrast this
with iPhones is that PC manufacturers struggled to maintain average selling
prices (ASPs) until they finally began declining in the early 2000s. Similarly,
products like DVD players, VCRs, LCD TVs and almost every other technology
driven product had to drop dramatically in price to attract a mass market. In
contrast to that, Apple has been able to increase average prices at the same time that the iPhone became a mass
market product. This helped Apple postpone the inevitable revenue flattening
and subsequent decline due to lengthening replacement cycles and fewer first
time buyers. In the past few years, other then the bump in FY 2018 from the
launch of the high priced Model X early that fiscal year, iPhone revenue has
essentially been flat to down. Since it is well over 50% of Apple revenue, this
puts great pressure on overall revenue growth.
To get back to double digit growth Apple needs to enter a really large market
To be clear, Apple is likely to continue to
be a successful, highly profitable company for many years even if it does not
make any dramatic acquisitions. While its growth may be slow, its after tax
profits has been above 20% for each of the past 5 years. Strong cash flow has
enabled the company to buy back stock and to support increasing dividends every
year since August 2014.
Despite this, I think Apple would be well
served by using a portion of their cash to make an acquisition that enables
them to enter a very large market with a product that already has a great
brand, traction, and superior technology. This could protect them if the iPhone
enters the downside of its revenue generating cycle (and it is starting to feel
that will happen sometime in the next few years). Further, Apple would benefit
if the company they acquired had a visionary leader who could be the new “Steve
Jobs” for Apple.
There is no better opportunity than autos
If Apple laid out criteria for what sector
to target, they might want to:
Find a sector that is at least
hundreds of billions of dollars in size
Find a sector in the midst of major
Find a sector where market
share is widely spread
Find a sector ripe for
disruption where the vast majority of participants are “old school”
The Automobile industry matches every criterion:
Matching 1. It is well over $3 trillion in size
Matching 2. Cars are transitioning to
electric from gas and are becoming the next technology platform
Matching 3. Eight players have between 5%
and 11% market share and 7 more between 2% and 5%
Matching 4. The top ten manufacturers all
started well over 50 years ago
And no better fit for Apple than Tesla
Tesla reminds me of Apple in the late
1990s. Its advocates are passionate about the company and its products. It can
charge a premium versus others because it has the best battery technology
coupled with the smartest software technology. The company also designs its
cars from the ground up, rather than retrofitting older models, focusing on
what the modern buyer would most want. Like Jobs was at Apple, Musk cares about
every detail of the product and insists on ease of use wherever possible. The
business model includes owning distribution outlets much like Apple Stores have
done for Apple. By owning the outlets, Tesla can control its brand image much
better than any other auto manufacturer. While there has been much chatter
about Google and Uber in terms of self-driving cars, Tesla is the furthest
along at putting product into the market to test this technology.
Tesla may have many advantages over others,
but it takes time to build up market share and the company is still around 0.5%
of the market (in units). It takes several years to bring a new model to market
and Tesla has yet to enter several categories. It also takes time and
considerable capital to build out efficient manufacturing capability and Tesla
has struggled to keep up with demand. But, the two directions that the market
is moving towards are all electric cars and smart, autonomous vehicles. Tesla
appears to have a multi-year lead in both. What this means is that with enough
capital and strong operational direction Tesla seems poised to gain significant
Apple could accelerate Tesla’s growth
If Apple acquired Tesla it could:
Supply capital to accelerate
launch of new models
Supply capital for more
Increase distribution by
offering Tesla products in Apple Stores (this would be done virtually using
large computer screens). An extra benefit from this would be adding buzz to
Supply operational knowhow that
would increase Tesla efficiency
Add to the luster of the Tesla
brand by it being part of Apple
entertainment product (and add subscriptions) into Tesla cars
These steps would likely drive continued
high growth for Tesla. If, with this type of support, it could get to 5% share
in 3-5 years that would put it around $200 billion in revenue which would be
higher than the iPhone is currently. Additionally, Elon Musk is possibly the
greatest innovator since Steve Jobs. As a result, Tesla would bring to Apple the
best battery technology, the strongest power storage technology, and the
leading solar energy company. More importantly, Apple would also gain a great
The Cost of such an acquisition is well within Apple’s means
At the end of fiscal Q3, Apple had about
$95 billion in cash and equivalents plus another $116 billion in marketable
securities. It also has averaged over $50 billion in after tax profits annually
for the past 5 fiscal years (including the current one). Tesla market cap is
about $40 billion. I’m guessing Apple could potentially acquire it for less
than $60 billion (which would be a large premium over where it is trading).
This would be easy for Apple to afford and would create zero dilution for Apple
If the Fit is so strong and the means are there, why won’t it happen?
I can sum up the answer in one word – ego. I’m not sure Tim Cook is willing to admit that
Elon would be a far better strategist for Apple than him. I’m not sure he would
be willing to give Elon the role of guiding Apple on the product side. I’m not
sure Elon Musk is willing to admit he is not the operator that Tim Cook is
(remember Steve Jobs had to find out he needed the right operating/financial
partners by getting fired by Apple and essentially failing at NeXT). I’m not
sure Elon is willing to give up being the CEO and controlling decision-maker
for his companies.
So, this probably will never happen but if
it did, I believe it would be the greatest business powerhouse in history!
My long term readers know that every so
often the blog wanders into the sports arena. In doing so, I apply the same
type of analysis that I do for public stocks and for VC investments to sports,
and usually, basketball. Given all the turmoil that has occurred in the NBA
this off-season, including the Warriors losing Durant, Iguodala, Livingston,
Cousins and several other players, I thought it would be interesting to
evaluate the newly changed team. Both ESPN and CBS power rankings have them 7th
in the West and 11th in the NBA. I find that an overreaction as the
Warriors may have beaten the Raptors if Klay Thompson not been injured, they
swept Portland, and won the last 2 Rockets games without Durant. At the time
this drove a lot of chatter that the team might be better off without Durant (I
But rather then compare the revised roster to
last year’s, it seems more closely matched with the 2014-15 team, as that was a
championship team that did not include Kevin Durant. I will make 2 key
Klay Thompson will return by
the end of February and be as effective as he was before his injury
The Warriors will make the
playoffs despite missing Thompson for the majority of the season
It all starts with Curry
A third key assumption that has been proven over and over again is that players that come to the Warriors usually perform better as they benefit from the “Curry Effect”, namely, getting more shots without having someone closely guarding them, (The Curry Effect), resulting in an average improved shooting percentage of over 5%. In all fairness, it really is the “Curry plus Thompson Effect” as the extreme focus on preventing the two of them from taking 3 point shots is what frees up others. It helps that Curry is unselfish and readily passes the ball when he is double or triple teamed. Thompson’s passing has improved substantially but since he gets his shot off so quickly, he has less need to pass it. Last year both shot over 40% from 3 despite defensive efforts focused on preventing each of them from taking those shots.
Starting Teams: 2019-20 vs 2014-15
Curry, Thompson and Green, the heart and soul of the Warriors, all remain from the 2014-15 roster, and now are at their peaks. In the 2014-15 season when Green first became a starter, Curry was one year away from reaching his peak and Thompson was just coming into his own especially on defense. I believe each of them is better today then they were at that time. At his best, Bogut may have been better than Cauley-Stein, but by 2014 Bogut had been through a number of injuries. Last year Cauley-Stein averaged nearly double the points of 2014 Bogut (11.9 vs 6.3), took slightly more rebounds per game and was a better free throw shooter. Stein, much like Bogut, is also considered a solid pick setter and defender. Russell is someone who should benefit greatly from playing with Curry. Even without that, last season he averaged over twice as many points per game as 2014 Barnes (21.1 vs 10.1) which should take considerable pressure off Curry (and Klay when he returns). However, Barnes was a better defender in 2014 than Russell is today. I give the edge to all 5 starters on the 2019 starting team compared to the 5 that started in 2014-15.
Thompson may be the most underrated player in the league!
It’s unfortunate that Thompson was injured in game 6 of the 2019 finals as he was once again proving just how good he can be. Not only was he playing lockdown defense, but he also drove the offense in what has been referred to as a typical Klay game 6. In just 32 minutes, before getting injured, he scored 30 points on 83% effective shooting percentage (67% on 3s), went 10 for 10 on free throws, and had 5 rebounds and 2 steals. I believe Golden State, even without Durant, would have forced a game 7 if Thompson did not get injured.
It boggles my mind that one of the websites
could refer to Thompson as “an average player” who did not merit a max contract.
This is bordering on the ridiculous and has a lot to do with the fact that the
most important measure of shooting, effective shooting percentage (where each 3
made counts as 1½ 2 point shots made) does not normally get reported (or even
noticed). In Table 2, I list the top 31 scorers from last season (everyone who
averaged at least 20 points per game) and rank them by effective shooting.
Thompson is number 8 in effective shooting and number 3 in 3-point percentage
among this group. So, if effective shooting percentage was regularly published,
Thompson would show up consistently helping the perception of his value. When
this is coupled with his being a third team all-defensive player (i.e., one of
the top 15 defenders in the league) it appears clear that he should be
considered one of the top 15 players in the league.
2: Top Scorers 2018-2019 Season
6th Man 2019-20 vs 2014-15
Kevon Looney has emerged as a potential
star in the works. While he may not yet be the defensive presence of Iguodala,
he is getting close. His scoring per minute played was higher than Andre’s
2014-15 numbers and his rebounds per minute were more than twice as much. While
Iguodala had greater presence and could run the team as well as assist others
in scoring, Looney at least partly makes up for this in his ability to set
screens. Looney also has a much higher effective shooting percentage (62.7% vs
54.0%) than Andre had in 2014-15. While Kevon doesn’t shoot 3s he gets many
points by putting back offensive rebounds and dunking lob passes. Overall, I
give the edge to Iguodala based on the Looney of last season but given Looney’s
potential to improve this might be dead even in the coming one.
Rest of the Bench for the 2 teams
It is the bench that is hardest to
evaluate. Unlike last year’s bench, the 2014-15 bench was quite strong which
spawned the Warrior logo “Strength in Numbers”. It included quality veteran
players like Leandro Barbosa, David Lee, Mareese Sprouts and Shaun Livingston, who
was playing at a much higher level than last season. The four of these together
averaged over 26 points per game. This
coming year’s bench is much younger and more athletic. It includes Alec Burks,
Glenn Robinson, Alfonzo McKinnie and Omari Spellman, plus several rookies and
Jacob Evans III. The first four are all capable of scoring and are solid 3-point
shooters (they could increase to well above average once with the Warriors). I
expect that group, coupled with one or two of the others, to exceed the 2014-15
bench in defense…but may not have as much scoring fire power. The team is
likely to give one or two of the rookies as well as Evans opportunities to earn
minutes as well. The bench is an improvement over last year but may not be as
strong as the 2014-15 squads.
I believe the 2019-2020 squad is better
than the championship team of 2015. The starting lineup features the core 3
players who have improved since then, D’Angelo Russell who was an all-star last
year, and a solid center in Willie Cauley-Stein making the edge substantial.
Looney as 6th man is already giving evidence of future stardom.
While he was not quite the Andre Iguodala of 2014-15, the difference is modest,
and Looney continues to improve. The 2014-15 bench appears superior to that of
next season, but the edge is not great as the newer group should be stronger
defensively and is not far off the older group as scorers – the question will
be how well they gel and how much the Curry/Klay factor improves their scoring.
Finally, I think Kerr is a better coach today than he was given the last 5
years of experience.
They May Have Improved vs 2014-15, but so has the Competition
ESPN and CBS power rankings reflect the
fact that multiple teams have created new “super star” two-somes:
Lakers: Lebron and Anthony
Clippers: Kawhi Leonard and
Houston: Harden and Westbrook
(in place of Chris Paul)
Nets: Kyrie Irving and Durant
Contenders also include improving young teams
like Boston, Philadelphia, Denver, and Utah plus an improved Portland squad. This
makes the landscape much tougher than when the Warriors won their 2015
championship. Yet, none of these teams seem better than the Cleveland team (led
by a younger LeBron, Kyrie Irving and Kevin Love) the Warriors beat in 2015.
So, assuming Klay returns by late February and is back to par, I believe the
Warriors will remain strong contenders given the starting team with four all-stars
augmented by Willie Cauley-Stein and an improving Kevon Looney as 6th
man. However, it will be much tougher going in the early rounds in the playoffs,
making getting to the finals longer odds than in each of the past 5 years.
An examination of Table 2
reveals several interesting facts:
Curry, once again is the leader
among top scorers in effective shooting and the only one over 60%
Antetokounmpo is only slightly
behind despite being a very poor 3-point shooter. If he can improve his
distance shooting, he may become unstoppable
Russell Westbrook, once again,
had the worst effective shooting percent of anyone who averaged 20 points or
more. In fact, he was significantly below the league average. Part of the
reason is despite being a very poor 3-point shooter he continues to take too
many distance shots. Whereas most players find that taking 3s increases their
effective shooting percent, for Westbrook it lowers it. I haven’t been able to
check this, but one broadcaster stated that he has the lowest 3-point
percentage of any player in history that has taken over 2500 3-point shots!
I believe that Westbrook has a
diminished chance to accumulate as many triple doubles next season as he has in
the past. There is only one ball and both he and Harden tend to hold it most of
the time. When Chris Paul came to the Rockets his assists per game decreased by
about 15% compared to his prior 3 season average.
Applying Private Investment Analysis to the Rash of Mega-IPOs Occurring
first half of 2019 saw a steady stream of technology IPOs. First Lyft, then
Uber, then Zoom, all with different business models and revenue structures. As
an early investor in technology companies, I spend a lot of time evaluating
models for Venture Capital, but as a (recovering) investment analyst, I also
like to take a view around how to structure a probability weighted investment once
these companies have hit the public markets. The following post outlines a
recent approach that I took to manage the volatility and return in these growth
Question: Which of the Recent technology IPOs Stands out as a Winning
Investing in Lyft and Uber, post IPO, had
little interest for me. On the positive side, Lyft revenue growth was 95% in Q1,
2019, but it had a negative contribution margin in 2018 and Q1 2019. Uber’s growth was a much lower 20% in Q1, but it
appears to have slightly better contribution margin than Lyft, possibly even as
high as 5%. I expect Uber and Lyft to improve their contribution margin, but it
is difficult to see either of them delivering a reasonable level of
profitability in the near term as scaling revenue does not help profitability
until contribution margin improves. Zoom Video, on the other hand, had
contribution margin of roughly 25% coupled with over 100% revenue growth. It also
seems on the verge of moving to profitability, especially if the company is
willing to lower its growth target a bit.
Zoom has a Strong Combination of Winning Attributes
There is certainly risk in Zoom but based
on the momentum we’re seeing in its usage (including an increasing number of
startups who use Zoom for video pitches to Azure), the company looks to be in
the midst of a multi-year escalation of revenue. Users have said that it is the
easiest product to work with and I believe the quality of its video is best in
class. The reasons for Zoom’s high growth include:
Revenue retention of a cohort is currently 140% – meaning that the same set of customers (including those who churn) spend 40% more a year later. While this growth is probably not sustainable over the long term, its subscription model, based on plans that increase with usage, could keep the retention at over 100% for several years.
It is very efficient in acquiring customers – with a payback period of 7 months, which is highly unusual for a SaaS software company. This is partly because of the viral nature of the product – the host of the Zoom call invites various people to participate (who may not be previous Zoom users). When you participate, you download Zoom software and are now in their network at no cost to Zoom. They then offer you a free service while attempting to upgrade you to paid.
Gross Margins (GMs) are Software GMs – about 82% and increasing, making the long-term model likely to be quite profitable
Currently the product has the reputation of being best in class (see here) for a comparison to Webex.
Zoom’s compression technology is well ahead of any competitor according to my friend Mark Leslie (a superb technologist and former CEO of Veritas).
The Fly in the Ointment: My Valuation Technique shows it to be Over
My valuation technique, published in one of our blog posts, provides a method of valuing companies based on revenue growth and gross margin. It helps parse which sub-scale companies are likely to be good investments before they reach the revenue levels needed to achieve long term profitability. For Zoom Video, the method shows that it is currently ahead of itself on valuation, but if it grows close to 100% (in the January quarter it was up 108%) this year it will catch up to the valuation suggested by my method. What this means is that the revenue multiple of the company is likely to compress over time.
Forward Pricing: Constructing a Way of Winning Big on Appreciation of
So instead of just buying the stock, I constructed
a complex transaction on May 29. Using it, I only required the stock to
appreciate 10% in 20 months for me to earn 140% on my investment. I essentially
“pre-bought” the stock for January 2021 (or will have the stock called at a
large profit). Here is what I did:
Bought shares of stock at $76.92
Sold the same number of shares of call options at $85 strike price for $19.84/share
Sold the same number of shares of put options at $70 strike for $22.08/share
Both sets of options expire in Jan 2021 (20 months)
Net out of pocket was $35/share
Given the momentum I think there is a high
probability (75% or so) that the revenue run rate in January 2021 (when options
mature) will be over 2.5x where it was in Q1 2019. If that is the case, it seems
unlikely that the stock would be at a lower price per share than the day I made
the purchase despite a potential for substantial contraction of Price/Revenue.
In January 2021, when the options expire, I will either own the same shares, or double the number of shares or I will have had my shares “called” at $85/share.
The possibilities are:
If the stock is $85 or more at the call date, the stock would be called, and my profit would be roughly 140% of the net $35 invested
If the stock is between $70 and $85, I would net $42 from the options expiring worthless plus or minus the change in value from my purchase price of $76.92. The gain would exceed 100%
If the stock is below $70, I’ll own 2x shares at an average price of $52.50/share – which should be a reasonably good price to be at 20 months out.
Of course, the options can be repurchased, and new options sold during the time period resulting in different outcomes.
Break-Even Point for the Transaction Is a 32% Decline in Zoom Video Stock
Portfolio Managers that are “Value
Oriented” will undoubtedly have a problem with this, but I view this
transaction as the equivalent of a value stock purchase (of a high flyer) since
the break-even of $52/share should be a great buy in January 2021. Part of my
reasoning is the downside protection offered: where my being forced to honor
the put option would mean that in January 2021, I would own twice the number of
shares at an average price of $52.50/share. If I’m right about the likelihood
of 150% revenue growth during the period, it would mean price/revenue had
declined about 73% or more. Is there some flaw in my logic or are the premiums
on the options so high that the risk reward appears to favor this transaction?
I started writing this before Zoom reported
their April quarter earnings, which again showed over 100% revenue growth
year/year. As a result, the stock jumped and was about $100/share. I decided to
do a similar transaction where my upside is 130% of net dollars invested…but
that’s a story for another day.
Estimating the “Probabilistic” Return Using My Performance Estimates
Because I was uncomfortable with the
valuation, I created the transaction described above. I believe going almost 2
years out provides protection against volatility and lowers risk. This can
apply to other companies that are expected to grow at a high rate. As to my
guess at probabilities:
75% that revenue
run rate is 2.5x January 2019 (base) quarter in the quarter ending in January
2021. A 60% compound annual growth (CAG) for 2 years puts the revenue higher
(they grew over 100% in the January 2019 quarter to revenue of $105.8M)
95% that revenue
run rate is over 2.0X the base 2 years later (options expire in January of that
year). This requires revenue CAG of 42%. Given that the existing customer
revenue retention rate averaged 140% last year, this appears highly likely.
99% that revenue
is over 1.5X the base in the January 2021 quarter (requires slightly over 22% CAG)
1% that revenue is
less than 1.5X
Assuming the above is true, I believe that
when I did the initial transaction the probabilities for the stock were (they
are better today due to a strong April quarter):
50% that the stock
trades over 1.5X today by January 2021 (it is almost there today, but could hit
a speed bump)
80% that the stock
is over $85/share (up 10% from when I did the trade) in January 2021
10% that the stock
is between $70 and $85/share in January 2021
5% that the stock
is between $52 and $70 in January 2021
5% that the stock is
Obviously, probabilities are guesses since
they heavily depend on market sentiment, whereas my revenue estimates are more
solid as they are based upon analysis, I’m more comfortable with. Putting the
guesses on probability together this meant:
80% probability of
140% profit = 2.4X
10% probability of
100% profit = 2.0X
5% probability of
50% profit (this assumes the stock is in the middle at $61/share) = 1.5X
5% probability of
a loss assuming I don’t roll the options and don’t buy them back early. At
$35/share, loss would be 100% = (1.0X)
If I’m right on these estimates, then the
weighted probability is 120% profit. I’ve been doing something similar with Amazon
for almost 2 years and have had great results to date. I also did part of my DocuSign
buy this way in early January. Since then, the stock is up 27% and my trade is
ahead over 50%. Clearly if DocuSign (or Amazon or Zoom) stock runs I won’t make
the same money as a straight stock purchase would yield given that I’m capped
out on those DocuSign shares at slightly under 100% profit, but the trade also
provides substantial downside protection.
Conclusion: Investing in Newly Minted IPOs of High Growth Companies with
Solid Contribution Margins Can be Done in a “Value Oriented” Way
When deciding whether to invest in a
company that IPOs, first consider the business model:
Are they growing at a high rate
of at least 30%?
contribution margins already at 20% or more?
Is there visibility to profitability
without a landscape change?
Next, try to get the stock on the IPO if
possible. If you can’t, is there a way of pseudo buying it at a lower price? The
transaction I constructed may be to complex for you to try and carries the
additional risk that you might wind up owning twice the number of shares. If
you decide to do it make sure you are comfortable with the potential future
Why doesn’t Amazon produce more earnings given its dominance?
Amazon just reported earnings and, as was the case in 2017 and 2016, emphasized that 2019 will be an investment year, so the strong operating margin expansion of 2018 would be capped in 2019. This, of course, is great fodder for bears on the stock as Amazon gave sceptics renewed opportunity to point out that it is a company that has a flawed business model and would find it difficult to ever earn a reasonable return on revenue.
In contrast, I believe that Amazon continues to transform itself into a potential strong profit performer. For example, taking the longer perspective, Amazon’s gross margins are now over 40% up from 27.2% five years ago (2013). So why doesn’t Amazon deliver higher operating margin than the slightly over 6% it reported in 2018? Amazon’s dirty little secret is that it continues to invest heavily in creating future dominance through R&D. Had it spent a similar amount in R&D to its long time competitor, Walmart, EBITDA would have nearly tripled… to over 17% of revenue! I must confess that in the past I haven’t paid enough attention to how much Amazon spends on R&D. As a result, I was surprised that Apple and Microsoft trailed it in voice recognition technology and that Amazon could lead IBM and Microsoft in cloud technology. The reason this occurred is not a surprising one: Amazon outspends Apple, Microsoft and IBM in R&D.
In fact, Amazon now outspends every company in the world (see Table 1) and have been dedicating a larger portion of available dollars to R&D (as measured by the % of gross margin dollars spent on R&D) than any other large technology company, except Qualcomm, for more than 10 years. Even though Amazon had less than 50% of Apple’s revenue and less than 1/3 of its gross margin dollars 5 years ago (2013) Amazon spent nearly 50% more than Apple on R&D that year… by 2018 the gap had increased to close to 100% more.
Table 1: Top 10 (and a few more) U.S. R&D Spenders in 2018 ($Bn)
Note 1: Ford and GM may be in the top 10 but so far have not reported R&D in 2018. If they report it at year end the table could change. Walmart does not report R&D and their spend is generally unavailable, but I found a reference that said they expected to spend $1.1M in 2017.
Note 2: A 2018 global list would include auto makers VW and Toyota (with R&D of $15.8B and about 10.0B), drug company Roche (&10.8B) and tech company Samsung at $15.3B in place of the lowest 4 in Table 1.
The Innovators Financial Dilemma: Increasing Future Prospects can lower Current Earnings
When I was on Wall Street covering Microsoft (and others) Bill Gates would often point out that the company was going to make large investments the following year so they could stay ahead of competition. He said he was less concerned with what that meant for earnings. That investment helped drive Microsoft to dominance by the late 1990s. Companies are often confronted with the dilemma of whether to increase spending to drive future growth or to maximize current earnings. I believe that investment in R&D, when effective, is correlated to future success.
It is interesting to see how leaders in R&D spending have transitioned over the past 10 years. In 2008 the global leaders in R&D spending included 5 pharma companies, 3 auto makers and only 2 tech companies (Nokia and Microsoft which subsequently merged). In 2018, 6 of the top 7 spenders (Samsung plus the 5 shown in Table 1) were technology companies.
Table 2 – 2008 global R&D leaders ($Bn)
Note: *Facebook data from 2009, first available financials from S-1 filing
It’s hard to change without tanking one’s stock
When a company has a business model that allocates 1% of gross margin dollars to R&D, it is not easy to turn on the dime. If Walmart had decided to invest half as much as Amazon in R&D in 2018, its earnings would have decreased by 80% – 90% and its stock would have depreciated substantially. So, instead it began a buying binge several years ago to try to close the technology gap through acquisitions (which has a much smaller impact on operating margins). It remains to be seen if this strategy will succeed going forward but in the past 5 years Walmart revenue (including acquisitions) increased only 5% while Amazon’s was up 130% in the same period (also including acquisitions).
Whatever Happened to IBM?
When I was growing up, I thought of IBM as the king of tech. In the early 1990s it still seemed to rule the roost. The biggest fear for Microsoft was that IBM could overwhelm it, yet now it appears to be an also ran in technology. From 2014 to 2018, a heyday era for tech companies, its revenue shrank from $93 billion in 2014 to $80 billion in 2018. I can’t tell how much of the problem stems from under investing in R&D versus poor execution, but for the past 5 years it has spent an average of about 13% of GM on R&D, while the 6 tech companies in Table 1 have averaged about 24% of GM dollars with Apple the only one under 20%.
Soundbyte I: Tesla
I recently had a long dialogue with a very smart fund manager and was struck by what I believe to be misinformation he had read regarding Tesla. There were 3 major points that he had heard:
The quality of Tesla cars was shoddy
Tesla could not maintain reasonable margins as it began producing lower priced Model 3s
The upcoming influx of electric cars from companies like Porsche, Jaguar and Audi would take substantial market share away from Tesla
I decided to do a bit of research to determine how valid each of these issues might be.
Tesla Quality: I found it hard to believe that the majority of Tesla owners thought the car was of poor quality since every one of the 15 or so people I knew who had bought one had already bought another or were planning to for their next car. So, I found a report on customer satisfaction from Consumer Reports, and I was not surprised to find that Tesla was the number 1 ranked car by customer satisfaction.
Tesla margins: this is much harder to predict. Since Tesla is relatively young as a manufacturer it has had numerous issues with production. Yet it is probably ahead of many others when it comes to automating its facilities. This tends to cause gross margins to be lower while volume ramps and higher subsequently. The combination of that, plus moving up the learning curve, should mean that Tesla lowers the cost of producing its products. However, Tesla charges more for cars with higher capacity for distance, but as I understand it uses software to limit battery capacity for lower priced cars. This would mean that a portion of the difference between a lower priced Model 3 and a higher priced one (the battery capacity) would be minimal change in cost, putting pressure on margins. The question becomes whether Tesla’s improving cost efficiencies offset the average price decline of a Model 3 as Tesla begins fulfilling demand for lower priced versions.
March 1 Update: After this post was complete (Thursday February 28) the company announced it was closing many showrooms to reduce costs. Then late today (Friday) announced that the $35,000 version of the model 3 is now available. So, we shall soon see the impact. I believe that if Tesla has increased capacity there will be very strong sales. It also likely will experience lower gross margin percentages as it climbs the learning curve and ramps production.
Will the influx of electric cars from others impact Tesla market share?
Porsche is an electric sports car starting at $90K – at that price point it is competitive with model S not model 3. In competing with the S it comes down to whether one prefers a sports car to a sedan. I have owned a Porsche in the past and would only consider it if I wanted a sports car with limited seating capacity (but very cool). I loved my Porsche but decided to switch to sedans going forward. Since then I’ve owned only sedans for the past 10+ years. It also appears that early production is almost a year away, so it is unlikely to be competitive for 2019.
Audi is at price points that do compete with the Model 3 and expects to start delivering cars in March. However, I think that is mainly in Europe where Tesla is an emerging brand so it might not impact them at all. When I look at the Audi models I don’t think they will appeal to Tesla buyers as they are very old-line designs (I would call them ugly). The range of the cars on a charge is not yet official but seems likely to be much lower than Tesla which has a big lead in battery technology.
The Jaguar competes with the Tesla Model X but while cheaper, appears a weak competitor.
I don’t want to dismiss the fact that traditional players will be introducing a large number of electronic vehicles. The question really is whether the market size for electric cars is a fixed portion of all cars or whether it will become a much larger part of the entire market over time. I would compare this to fears that analysts had when Lotus and Wordperfect created Windows versions. They felt that Microsoft would lose share of windows spreadsheets and word processors. I agreed but pointed out that Windows was 10% of the entire market for spreadsheets, so having a 90% share gave Microsoft 9% of the overall spreadsheet market. I also predicted Microsoft would have over a 45% share when Windows was 100% of the market. So, while this would decrease Microsoft’s share of Windows spreadsheets, it would grow its total share of the market by 5X Of course we all were proven wrong as Microsoft eventually reached over 90% of the entire market.
For Tesla, the question becomes whether these rivals are helping accelerate the share electric cars will have of the overall market, rather than eroding Tesla volumes. I’m thinking that it’s the former, and that Tesla will have a great volume year in 2019 and that its biggest competitive issue will be whether the Model 3 is so strong that it will get people to buy it over the Model S. Of course, I could be wrong, but believe the odds favor Tesla in 2019, especially the first half of the year where the competitors are not that strong.
The 2018 December selloff provides buying opportunity
One person’s loss is another’s gain. The market contraction in the last quarter of the year means that most stocks are at much lower prices than they were in Q3 of 2018. The 5 stocks that I’m recommending (and already own) were down considerably from their Q3 2018 highs. While this may be wishful thinking, returning to those highs by the end of 2019 would provide an average gain of 78%. Each of the 5 had revenue growth of 25% or more last year (and 3 were over 35%) and each is poised for another strong year in 2019.
For the 4 continued recommendations (all of which I mentioned I would recommend again in my last post), I’ll compare closing price on December 31, 2019 to the close on December 31, 2018 for calculating performance. For the new add to my list, I’ll use the stock price as I write this post. I won’t attempt to predict the overall market again (I’m just not that good at it) but feel that the 14% drop in Q4 means there is a better chance that it won’t take a nosedive. However, since stock picks are always relative to the market, success is based on whether my picks, on average, outperform the market.
I’ll start the post with stock picks and then follow with the remaining 5 predictions.
Tesla stock will outpace the market (it closed last year at $333/share and is essentially the same as I write this)
In Q3, 2018 the Tesla model 3 was the bestselling car in the U.S. in terms of revenue and 5th highest by volume. This drove a 129% revenue increase versus a year earlier and $1.75 in earnings per share versus a loss of $4.22 in the prior quarter. I expect Q4 revenue to increase sequentially and growth year/year to exceed 100%. In Q3, Tesla reported that nearly half of vehicles traded in for the Model 3 were originally priced below $35,000. As Tesla begins offering sub-$40,000 versions of it, demand should include many buyers from this high-volume price range. Since the backlog for the Model 3 is about 300,000 units I expect 2019 sales to remain supply constrained if Tesla can offer lower price points (it already has announced a $2,000 price reduction). The important caveat to demand is that tax credits will be cut in H1 2019, from $7500 to $3750 and then cut again to $1875 in the second half of the year. Part of Tesla’s rationale for a $2000 price drop is to substantially offset the initial reduction of these tax credits.
Tesla began taking orders for its Q1 launch in Europe where demand over time could replicate that in the U.S. The average price of a Model 3 will initially be about $10,000 higher than in the U.S. Tesla is also building a major manufacturing facility in China (where Model 3 prices are currently over $20,000 higher than the U.S.). This Giga-Factory is expected to begin production in the latter half of 2019. While moving production to China for vehicles sold there should eliminate trade war issues, Tesla still expects to begin delivering Model 3s to Chinese customers in March.
The combination of a large backlog, reducing prices within the U.S. and launches in Europe and China should generate strong growth in 2019. Some investors fear price reductions might lead to lower gross margins. When I followed PC stocks on Wall Street, this was a constant question. My answer is the same as what proved true there: strong opportunity for continuous cost reduction should enable gross margins to remain in the 20-25% range in any location that is at volume production. So, perhaps the Chinese Giga-Factory and a future European factory will start at lower margins while volume ramps but expect margins in the U.S. (the bulk of revenue in 2019) to remain in the targeted range. Higher prices in Europe and China due to massive initial demand allows premium pricing which may keep margins close to 20%+ in each.
Facebook stock will outpace the market (it closed last year at $131/share).
Facebook underperformed in 2018, closing the year down 28% despite revenue growth that should be 35% to 40% and EPS tracking to about 36% growth (despite a massive increase in SG&A to spur future results). The stock reacted to the plethora of criticism regarding privacy of user information coupled with the continuing charges of Russian use of Facebook to impact the election. Before the wave of negative publicity, Facebook reached a high of $218/share in July. Facebook is likely to continue to increase its spending to address privacy issues and to burnish its image. However, scaling revenue could mean it keeps operating margins at a comparable level to 2018 rather than increasing them. Rumors of Facebook’s demise seem highly exaggerated! According to a December 2018 JP Morgan survey of U.S. Internet users, the three most used social media products were Facebook (88% of participants), Facebook Messenger (61%) and Instagram (47%). Also, 82% of those surveyed picked a Facebook-owned platform as being the most important to them. Finally, the average Facebook user reported checking Facebook roughly 5 times per day with 56% of users spending 15 minutes to an hour or more on the platform on an average day. While Facebook has experienced a minor decrease in overall usage, Instagram usage has increased dramatically. Facebook, Instagram, and WhatsApp together give the company a growing and dominant position.
At the beginning of 2018 Facebook stock was trading at 34 times trailing EPS. By the end of the year the multiple of trailing EPS was below 18. If I assume EPS can grow 20%+ in 2019 (which is below my expectation but higher than the consensus forecast) than a multiple of 20 would put the stock at about $180/share by December 31. If it grew EPS, more in line with revenue and/or returned to a multiple closer to 34 it could reach well over 200.
Two key factors:
A 20% increase in revenue (I expect the increase to be about 30%) adds over $11 billion in revenue. A comparable 20% increase in SG&A would provide over $4 billion in additional money to spend, affording the company ample dollars to devote to incremental marketing without impacting operating margins.
Given the “low” stock price, Facebook increased its buyback program by $9 billion to $15 billion. Since it generates $6B – $7B in cash per quarter from operations (before capex) and has roughly $40 billion in cash and equivalents it could easily increase this further if the stock remains weak. The $15 billion could reduce the share count by as much as 3% in turn increasing EPS by a similar amount.
Amazon stock will outpace the market (it closed last year at $1502/share).
While its stock dropped from its September high of $2050, Amazon remained one of the best market performers in 2018 closing the year at $1502/share. At its 2018 high of $2050, It may have gotten ahead of itself, but at year end it was up less than 2018 revenue growth. Leveraging increased scale meant net income grew faster than revenue and is likely to triple from 2017. Growth will be lower in Q4 then Q3 as Q4 2017 was the first quarter that included all revenue from Whole Foods. Still, I would not be surprised if Amazon beat expectations in Q4 since this is already factored into analyst forecasts. Amazon trades on revenue coupled with the prospect of increasingly mining the revenue into higher profits. But the company will always prioritize making long term investments over maximizing near term earnings. Growth in the core ecommerce business is likely to gradually slow, but Amazon has created numerous revenue streams like its cloud and echo/Alexa businesses that I expect to result in maintaining revenue growth in the 20% plus range in 2019. The prospect of competing with an efficient new brick and mortar offering (see prediction 6 in this post) could drive new excitement around the stock.
Profitability in 2019 could be reduced by: announced salary increases to low end workers; increasing the number of physical store locations; and greater marketing incentives for customers. Offsets to this include higher growth in stronger margin businesses like AWS and subscription services. The stock may gyrate a bit, but I expect it to continue to outperform.
Stitch Fix stock will outpace the market (it closed last year at $17/share).
In my 2018 forecast I called this my riskiest pick and it was the most volatile which is saying a lot given the turbulence experience by Facebook, Tesla, and Amazon. I was feeling pretty smug when the stock reached a high of $52/share in September! I’m not sure how much of the subsequent drop was due to VCs and other early investors reducing their positions but this can have an impact on newly minted public companies. Whatever the case, the stock dropped from September’s high to a low point of $17.09 by year’s end. The drop was despite the company doing a good job balancing growth and profitability with October quarter revenue up 24% and earnings at $10.7 million up from $1.3 million in the prior year. Both beat analyst expectations. The stock was impacted because the number of users grew 22% (1-2% less than expected) despite revenue exceeding expectations at 24% growth. I’m not sure why this was an issue.
Stitch Fix continues to add higher-end brands and to increase its reach into men, plus sizes and kids. Its algorithms to personalize each box of clothes it ships keeps improving. Therefore, the company can spend less on acquiring new customers as it has increased its ability to get existing customers to spend more and come back more often. I believe the company can grow by roughly 20% or more in 2019. If it does and achieves anything close to the revenue multiple that it started with in 2018 (before the multiple doubled in mid-year), there would be a sizeable stock gain this year. But it is a thinly traded stock and likely to be quite volatile.
Docusign Stock will outpace the market in 2019 (it is currently at $43/share).
Docusign is a new recommendation. Like Stitch Fix, it is a recent IPO and could be volatile. Docusign is the runaway leader in e-signatures, facilitating multiple parties signing documents in a secure, reliable way on board resolutions, mortgages, investment documents, etc. Strong positives include:
A high value for a reasonable price – I am increasingly annoyed when I need to deal with manual signatures for documents.
As of October 31, 2018, Docusign had over 450,000 customers up from 350,000 customers one year earlier. Of which 50,000 are Enterprise/Commercial accounts;
There are hundreds of millions of users whose e-signatures are stored by the company making the network effect quite large;
Roughly 95% of revenue is from its SaaS product which has 80% gross margin with the rest from services where margins have improved and are now positive;
As a SaaS company with a stable revenue base growth is more predictable. The company exceeded revenue guidance each quarter with the October 31, 2018 quarter revenue up 37%;
Most customers pay annually in advance. This means cash flow from operations is positive despite the company recording an operating loss;
Customers expand their use resulting in retained customers growing revenue faster than decreases from churned customers making net revenue retention over 100%;
International expansion remains a large opportunity as international is only 18% of revenue.
Picks 6 – 10: Major Trends that will surface in 2019
I developed my primary method of stock picking at my first Wall Street firm, Stanford Bernstein. The head of research there, Chuck Cahn, emphasized that you could get small wins by correctly determining that a stock would trade up on certain news like a new product, a big customer win, and beating consensus forecasts. But larger and more predictable wins of 5X or more were possible if one identified a long-term winner riding a major trend and stuck with it for multiple years. All 5 of my stock picks fall into the latter category. I’ve been recommending Facebook, Tesla, and Amazon for 4 years or more. All 3 are now over 5X from when I first targeted them as I bought Tesla at $46 and Facebook at $24 in 2013 (before this blog) and they have been in my top 10 since. Amazon was first included in 2015 when it was at $288/share. Stitch Fix and DocuSign are riskier but if successful have substantial upside since both are early in their run of leveraging their key trends.
The next 4 picks are in early stages of trends that could lead to current and next generation companies experiencing benefits for many years. The first two go hand in hand as each describes transformation of physical retail/restaurants, namely, replacing staff with technology in a way that improves the customer experience. This is possible because we are getting closer to the tipping point where the front-end investment in technology can have a solid ROI from subsequent cost savings.
Replacing Cashiers with technology will be proven out in 2019
In October 2015 I predicted that Amazon (and others like Warby Parker) would move into physical retail between then and 2020. This has occurred with Amazon first opening bookstores and then buying Whole Foods, and Warby Parker expanding its number of physical locations to about 100 by the end of 2018. My reasoning then was simple: over 92% of purchases in the U.S. were made offline. Since Amazon had substantial share of e-commerce it would begin to have its growth limited if it didn’t create an off-line presence.
Now, for Amazon to maintain a 20% or greater revenue growth rate it’s even more important for it to increase its attack on offline commerce (now about 90% of U.S. retail) I’m not saying it won’t continue to try to increase its 50% share of online but at its current size offline offers a greater opportunity for growth.
A key to Amazon’s success has been its ability to attack new markets in ways that give it a competitive advantage. Examples of this are numerous but three of the most striking are Amazon Cloud Services (where it is the industry leader), the Kindle (allowing it to own 70% share of eBook sales) and Prime (converting millions of customers to a subscription which in turn incentivized buying more from Amazon due to free shipping).
Now the company is testing an effort to transform brick and mortar retail by replacing staff with technology and in doing so improving the buying experience. The format is called Go stores and there are currently 5 test locations. Downloading the Amazon Go App enables the user to use it to open the automated doors. The store is stocked (I think by actual people) with many of the same categories of products as a 7-Eleven, in a more modern way. Food items include La Boulangerie pastries, sushi, salads, an assortment of sandwiches and even meal kits. Like a 7-Eleven, it also has convenience items like cold medicine, aspirins, etc. The store uses cameras and sensors to track your movements, items you remove from the shelves and even whether you put an item back. When you leave, the app provides you with a digital receipt. Not only does the removal of cashiers save Amazon money but the system improves customer service by eliminating any need to wait in line. I expect Amazon to open thousands of these stores over the next 3-5 years as it perfects the concept. In the future I believe it will have locations that offer different types of inventory. While Amazon may be an early experimenter here, there is opportunity for others to offer similar locations relying on third party technology.
Replacing Cooks, Baristas and Waitstaff with robots will begin to be proven in 2019
The second step in reducing physical location staff will accelerate in 2019. There are already:
Robotic coffee bars: CafeX opened in San Francisco last year, and in them one orders drip coffee, cappuccino, latte, or hot chocolate using an app on your phone or an iPad available at a kiosk. The coffee is made and served by a robot “barista” with the charge automatically put on your credit card. Ordering, billing, and preparation are automatic, but there is still one staff member in the shop to make sure things go smoothly.
The first robotic burger restaurant: Creator opened in San Francisco last June. It was in beta mode through September before opening to the general public. While a “robot” makes the burgers, Creator is not as automated as CafeX as humans prepare the sauces and prep the items that go into the machine. Creator also hasn’t automated ordering/payment. Startup Momentum Machines expects to open a robotic burger restaurant and has gotten substantial backing from well-known VCs.
Robots replacing waitstaff: For example, at Robo Sushi in Toronto, a “Butlertron” escorts you to your table, you order via an iPad and a second robot delivers your meal. Unlike the robots in the coffee bar and burger restaurant these are made into cute characters rather than a machine. Several Japanese companies are investing in robotic machines that make several of the items offered at a sushi restaurant.
Robotic Pizza restaurants: The furthest along in automation is the Pizza industry. Zume Pizza, a startup that uses robots to make pizzas, has recently received a $375 million investment from Softbank. Zume currently uses a mix of humans and robots to create and deliver their pizzas and is operational in the Bay Area. Pizza Hut and Dominos are working on drones and/or self-driving vehicles to deliver pizzas. And Little Caesars was just issued a patent for a robotic arm and other automated mechanisms used to create a pizza.
At CES, a robot that makes breads was announced. What all these have in common is replacing low end high turnover employees with technology for repetitive tasks. The cost of labor continues to rise while the cost of technology shrinks a la Moore’s Law. It is just a matter of time before these early experiments turn into a flood of change. I expect many of these experiments will turn into “proof points” in 2019. Successful experiments will generate substantial adoption in subsequent years. Opportunities exist to invest in both suppliers and users of many robotic technologies.
“Influencers” will be increasingly utilized to directly drive Commerce
Companies have long employed Influencers as spokespersons for products and in some cases even as brands (a la Michael Jordon and Stephan Curry basketball shoes or George Forman Grills). They appear on TV ads for products and sometimes used their social reach to tout them. Blogger, a prior Azure investment, understood how to use popular bloggers in advertising campaigns. But Blogger ads, like most TV ads did not directly offer the products to potential customers. Now we are on the verge of two major changes: tech players creating structured ways to enable fans of major influencers (with millions of followers) to use one-click to directly buy products; and technology companies that can economically harness the cumulative power of hundreds of micro-influencers (tens of thousands of fans) to replicate the reach of a major influencer. I expect to see strong growth in this method of Social Commerce this year.
The Cannabis Sector should show substantial gains in 2019
In my last post I said about the Cannabis Sector: “The industry remains at a very early stage, but numerous companies are now public, and the recent market correction has the shares of most of these at more reasonable levels. While I urge great care in stock selection, it appears that the industry has emerged as one to consider investing in.” Earlier in this post, I mentioned that riding a multi-year wave with a winning company in that segment is a way to have strong returns. I’m not knowledgeable enough regarding public Cannabis companies, so I haven’t included any among my stock recommendations. However, I expect industry wide revenue to grow exponentially. The 12 largest public Cannabis companies by descending market cap are: Canopy Growth Corp (the largest at over $11B), Tilray, Aurora Cannabis, GW Pharmaceuticals, Curealeaf Holdings, Aphria, Green Thumb Industries, Cronos Group, Medmen Enterprises, Acreage Holdings, Charlotte’s Web Holdings and Trulieve Cannabis.
I believe one or more of these will deliver major returns over the next 5 years. Last year I felt we would see good fundamentals from the industry but that stocks were inflated. Given that the North American Cannabis Index opened this year at 208 well down from its 2018 high of 386 investing now seems timely. I’ll use this index as the measure of performance of this pick.
2019 will be the Year of the Unicorn IPO
Many Unicorns went public in 2018, but this year is poised to be considerably larger and could drive the largest IPO market fund raising in at least 5 years. Disbelievers will say: “the market is way down so companies should wait longer.” The reality is the Nasdaq is off from its all-time high in August by about 15% but is higher than its highest level at any time before 2018. Investment funds are looking for new high growth companies to invest in. It appears very likely that as many as 5 mega-players will go public this year if the market doesn’t trade off from here. Each of them is a huge brand that should have very strong individual support. Institutional investors may not be as optimistic if they are priced too high due to the prices private investors have previously paid. They are: Uber, Lyft, Airbnb, Pinterest, and Slack. Each is one of the dominant participants in a major wave, foreshadowing substantial future revenue growth. Because information has been relatively private, I have less knowledge of their business models so can’t comment on whether I would be a buyer. Assuming several of these have successful IPOs many of the other 300 or so Unicorns may rush to follow.
Oh, what a difference a month or 3 makes! If only 2018 had ended earlier…
I’m sure I’m not the only one who would have liked 2018 results to have been as of November 30th (or even better, October 1st). My stock forecasts were looking a lot better on those dates (and if I were smarter, perhaps I would have taken some of the gains at that point). My average gain was over 34% on October 1st (versus the S&P being up 8.5%) and was still holding at +10% as of November 30th with the S&P ahead 2.4%. Unfortunately, the year includes a disastrous December and my 4 stock picks ended the year at a 6.6% average loss. Since stock picks are always relative to the market, I take some solace in minutely beating the performance of the S&P which was down 7.0% for the year, especially since I favor very high beta stocks.
Before reviewing each of my picks from last year, I would like to provide a longer term view of my performance as it has now been 5 years that I’ve published my blog’s stock picks. Even with a down year in 2018 my compound gain is 310% versus an S&P gain of 38% over the same period. This translates to an average annual gain of 25% per year which coincidently is the target I set in my book (published years ago and now out of print).
Table 1: Mike’s Annual Blog Stock Pick Performance (5 Years)
Unlike last year, I certainly cannot take a victory lap for my 10 forecasts as I missed on 3 of the 10 and barely beat the S&P for my average among my 4 stock picks (all of which will be included again in my 2019 top ten). I’ve listed in bold each of my 2018 stock picks and trend forecasts below and give a personal, and only modestly biased, evaluation of how I fared on each.
Tesla stock appreciation will continue to outpace the market (it opened the year at $312/share)
Tesla had an extraordinary Q3, 2018 as the model 3 launch showed how potent a player the company is becoming. In the quarter the Model 3 was the best selling car in the U.S. in terms of revenue and 5th highest by volume. This drove a greater than 100% revenue increase versus a year earlier and $1.75 in earnings per share versus a loss of $4.22 in the prior quarter. Given that the starting price for a model 3 was at $49,000, it is rather amazing that it could generate that volume of sales. Since the backlog for the Model 3 appears to remain at well over 300,000 cars and Tesla is closing in on a launch in Europe, Tesla seems assured of continued strong revenue through 2019 and likely beyond. However, much of the backlog is awaiting the lower priced (sub $40,000) version of the car which I believe will be available in Q2, 2019. As I had predicted, the Model 3 ramp up in production volume led to improved gross margins which exceeded 20% in the quarter. Despite the down market, Tesla stock was up about 7% in 2018. While we will continue recommending the stock, the phaseout of tax credits for buying an electric car has already begun. In its Q3 update Tesla stated that “better than expected Model 3 cost reductions is allowing us to bring more affordable options to the market sooner.” Yet, despite this forecast, the recently announced price decreases drove the stock down.
Facebook stock appreciation will continue to outpace the market (it opened the year at $182/share).
Facebook stock did not perform well in 2018, closing the year down 28%, making this pick a losing proposition last year. This comes despite revenue growth that should be between 35% and 40%, and net income that is tracking towards about 35% growth (despite a massive increase in SG&A to spur future results). What impacted the stock heavily was the plethora of criticism regarding privacy of user information coupled with the continuing charges of Russian usage to impact the election. Before the wave after wave of negative publicity the stock had reached a new high of $218/share in July. Because of the need to improve its reputation, Facebook is likely to continue to increase its spending to address privacy issues and to burnish its image. In summary, the fundamentals of the company remained quite sound in 2018 but the barrage of issues torpedoed the stock.
Amazon stock appreciation will outpace the market (it opened the year at $1188/share).
While its stock dropped considerably from its September high of $2050, Amazon remained one of the best market performers in 2018 closing the year at over $1500/share. The company continued to execute well, growing every part of its business. It also began to leverage its scale as net income grew considerably faster than revenue and is likely to be well over triple that of 2017. Growth should be lower in Q4 2018 than earlier in the year as Q4 2017 was the first quarter that included all revenue from the acquisition of Whole Foods. Since the analyst consensus forecast already reflects Whole Foods revenue being in Q4 last year, as well as concerns over Amazon maintaining strong performance in Q4, I would not be surprised if Amazon was able to beat expectations in Q4.
Stitch Fix stock appreciation will outpace the market (it opened the year at $25/share).
In my forecast I stated that this was my riskiest pick and it certainly proved the most volatile (which is saying a lot given the turbulence experience by Facebook, Tesla, and Amazon). I was feeling pretty smug when the stock reached a high of $52/share in September with a little over 3 months left in the year! Obviously, I was less sanguine as it dropped precipitously from September’s high to a low point of $17.09 by year’s end. I’m hoping that those of you who followed my advice trimmed back when the stock soared (I confess that I didn’t). The company continued to balance growth and profitability throughout the calendar year with October quarter revenue (up 24%) and earnings ($10.7 million up from $1.3 million in the prior year) both beating analyst expectations. Yet, concerns over user growth severely impacted the stock. I’m somewhat surprised by this as the users grew 22% and revenue 24% – since revenue beat expectations this means that analysts did not forecast an increase in average revenue per user. But the bottom line is, despite solid fundamentals the stock did not perform well.
The stock market will rise in 2018 (the S&P opened the year at 2,696 on January 2).
When I made this forecast, I pointed out that I’m not particularly good at forecasting the overall market. My belief was based on the fact that the tax cut for corporations would mean a rise in earnings that exceeded the norm. I felt stronger earnings growth would be enough to offset the risk of the longest bull market in history turning negative. I sited the likelihood of higher interest rates being an additional risk. The market almost made it through the year as it was still up heading into December, but the combination of 4 interest rate hikes in the year coupled with considerable criticism of President Trumps behavior was just too much for the market by December. I view this as a partial victory as I had all the fundamentals right and came within less than a month of being right for the year when many felt the bears would gain control in early 2018.
Battles between the federal government and states will continue over marijuana use but the cannabis industry will emerge as one to invest in.
During the year the legalization of marijuana for recreational use continued to increase on a state by state basis with the number increasing from 6 at the start of the year to 10 by years end. Use of medical marijuana is now legal in 33 states. Several other states, while not formally legalizing it have lowered restrictions on individual use. The industry remains at a very early stage, but numerous companies are now public, and the recent market correction has the shares of most of these at more reasonable levels. While I would urge great care in stock selection, it appears that the industry has emerged as one to consider investing in.
At least one city will announce a new approach to urban transport.
In this prediction I cited the likelihood that at least one city would commit to testing a system of small footprint automated cars on a dedicated route (as discussed in our post on December 14, 2017) as this appears to be a more cost effective solution than rail, bus, Uber, etc. Kyoto has now announced that it signed an agreement to test the system offered by Wayfarer and the company is now out of stealth mode. Wayfarer expects to provide substantial capacity at a fraction of the cost of other alternatives: both in the initial cost of the infrastructure/equipment and the annual cost of running the system. Of course, once there is a live installation in Kyoto or one of their other prospective customers, the validity of this system will be authenticated (or not).
Offline retailers will increase the velocity of moving towards omnichannel.
This forecast discussed both acquisitions of e-commerce companies by offline retailers (with Walmart leading the way) and introducing more online technology in physical stores. Walmart did continue its online buying spree in 2018 with major acquisitions of Art.com, Bare Necessities, Eloquii, Cornershop and Flipkart (the largest at $16 billion). In the case of the acquisitions that are online brands, Walmart intends to introduce these into their physical stores and continue to sell them online. Nordstrom has also moved further to integrate its online and offline business by taking valuable floor space in stores and repurposing it for online buyers to pick up and try on clothes they have purchased online. By placing the location in a very prominent spot, I’m sure Nordstrom is thinking it will help spur more customers to buy online. By having in store locations for picking up and trying on, Nordstrom should reduce returns, lower the cost of shipping, and bring additional customers into their stores (who otherwise might not visit them).
Social Commerce will begin to emerge as a new category
Recall that social commerce involves the integration of social media with commerce through tactics like:
A feed-based user experience
Having friends’ actions impact one’s feed
Following trend setters to see what they are buying, wearing, and/or favoring
One click to buy
Now, about 25% – 30% of shoppers say that social platforms like Pinterest, Instagram, Facebook and Snapchat have influence over their purchases. On June 28, 2018 Snapchat began a program for its influencers to use Social Commerce through a tool that allows users to view a video from the influencer and then to swipe up on a product shown in the video to buy it. In September, The Verge reported that Instagram is developing a new app for social commerce. Pinterest and Facebook have been in the social commerce fray longer and have increasing success. It appears that 2018 was the year the social commerce wars accelerated.
“The Empire Strikes Back”: automobile manufacturers will begin to take steps to reclaim use of its GPS.
Carmakers face a serious problem regarding their built-in navigation systems. Consumers are forced to pay hundreds of dollars for them and then use free apps on their phones like Waze or Google maps instead. This does not endear them to consumers. The problem is that carmakers are not great at software design but have been reluctant to use third party providers for their GPS and entertainment. Now, the Renault-Nissan-Mitsubishi Alliance has agreed to design Google’s Android OS, including Google navigation, into their next generation cars expected starting in 2021. This is a win for users as that will provide a competent GPS that utilizes the existing screen in cars as opposed to having to rely on your phone app for navigation.
In another win for consumers, Amazon and Telenav (a connected car and location based services provider) announced a significant partnership today, January 7, 2019. As part of it, Amazon’s voice assistant will now be part of Telenavs in-car navigation systems. With this included, Telenav’s next generation system will enable its customers, like General Motors, to provide a “smart assistant” thereby making the system included with cars the one to use rather than one’s phone apps.
Stay tuned for my top ten predictions for 2019…but remember that I have already said the 4 stocks recommended for 2018 will remain on the list.
My December 2016 post analyzed the Trump deal to retain Carrier workers in the United States and concluded it was positive for the country and for the state of Indiana. It saved 800 jobs and had a payback to the government of more than 14X their investment. I was clear in the post that I hadn’t voted for Trump and consider myself an independent. While I remain an independent, the opportunity to analyze the recently announced deal to get Amazon to commit 25,000 – 40,000 jobs for New York City is irresistible to me as my conclusions will be in support of politicians on the opposite side of the spectrum from Trump: New York Mayor Bill de Blasio and Governor Andrew Cuomo. I believe that:
Analysis of benefits and drawbacks of any major negotiation should be politically independent.
Unfortunately, this has become less and less the case given the divisive politics that we have in our country. What was shocking to me in this case was that some members of their own party (Democrats), heavily criticized de Blasio and Cuomo.
Major Assumption: Jobs are good for a City/State if the cost to government is reasonable
One of the major responsibilities of a political leader is improving the economy in their State/City. The crux of the discussion is really the question: ‘what is a reasonable cost’ for doing so? On one hand, it can be measured in pure cash flow of moneys paid to Amazon (or any other entity a government wants to attract) versus the cash the government will receive from additional tax dollars. On the other hand, there are other factors that benefit or degrade life in the community. Since the former is more measurable, I’ll start with that.
What are the Actual Out-of-Pocket dollars New York City (NYC) and New York State (NYS) will give to Amazon?
I can’t tell if its rhetoric or a lack of clear communication, but many detractors, like state Senator Michael Gianaris, are saying “We’ve got $3 billion dollars to spend, how would you spend it? Amazon would be very low on the list of where that money would go.” To be blunt, this is a ridiculous comment. NYC is spending zero dollars in cash and while the state is providing $505 million of actual cash as a capital grant, far more money will flow back to it. The Capital grant is based on $2.5 billion that Amazon has promised to invest in New York City (to build their HQ, a 600-seat public school, affordable space for manufacturers and to develop a 3.5-acre waterfront esplanade and park).
The rest of the $3 billion falls into 3 incentive programs that have existed for many years to help woo companies to NYS. They are:
The Excelsior Jobs Program was created in 2010 to replace the expiring Empire Zone Program. Like the prior program, it’s objectives are to provide job creation incentives to firms in targeted industries, like high-tech, for relocating in NYS. The credits are based on the wages added and several other factors. This program, which is available to all companies in the targeted sectors, will generate $1.2 billion in state business income tax credits for Amazon if it meets its commitments.
The Relocation and Employment Assistance Program (REAP), first established in 2003, targets creating jobs in parts of the city more in need of them, rather than adding to the heavy cluster in downtown and midtown Manhattan, namely the outer boroughs or north of 96th street in Manhattan. The tax credits generated from this program total $897 million and can be used towards reducing Amazon’s New York City corporate taxes over 12 years. This credit is based on the rules of the existing law.
The Industrial and Commercial Abatement Program (ICAP), which replaced a prior program, created in 2008, provides tax incentives for commercial and industrial buildings that are built, modernized, or expanded. The credits are based on the taxable value created if the city believes it is beneficial based on its location and other factors. This program is generally available and the $386 million in credits are directly tied to the rules of the law.
Table 1: Benefits to Amazon from NYS and NYC
It is important to note most of the benefits to Amazon are “as of right”, so any company can get them. Since these programs scale based on the number of employees or the amount of capital investment, the sheer size of the Amazon commitment creates a “sticker shock” given the associated benefits. The 3 programs were not created for Amazon but have been in existence for years to encourage job creation and industrial development in targeted areas. The credits under REAP and ICAP appear to be as mandated by those programs and not discretionary. It’s harder for me to tie the state tax abatement amount granted under the Excelsior program (by the state) to the law, but the calculation appears to follow it with some judgement in the cap of what is awarded. The capital grant seems to be the only discretionary part of the package and is the only portion that involves out of pocket dollars from the state (the city will not provide any cash incentives).
Could New York Have won the HQ with lesser incentives?
Given the large return on investment to NYC and NYS, the only question in my mind is whether they could have succeeded with even less incentives and generated an even greater return! A whitepaper by Reis, an analytic company for real estate evaluation, judged New York City as a top candidate without considering incentives offered to Amazon. It’s difficult to judge whether New York City would have been chosen with reduced incentives. On the one hand it has the best public transportation, strong cultural advantages, and several great Universities (as a source of employees), especially the new Cornell-Technion campus located directly next to Amazon’s HQ2 location. On the other hand, it is a very expensive place to do business which is why these incentive programs were created to begin with. As a basis of comparison, consider the bundle of incentives Wisconsin offered to get the Taiwanese technology company Foxconn to build a U.S. plant there. For the 13,000 jobs (at an average annual wage of $53,000) that Foxconn has committed to, Wisconsin plus the County and local village have provided about $3.8 billion in tax credits and breaks. The taxable wages in NY will be 6-9 times as much and the incentives are lower. Therefore, I suspect other locations offered Amazon incentives at the same or a greater level as those from New York.
How Does Revenue to the City and State Compare to the out of pocket cost?
I’m going to make the following assumptions:
New York State Corporate Tax is 6.5% and NYC is 8.85% but I’m assuming the business tax incentives from Excelsior and REAP will be sufficient to preclude Amazon paying any incremental taxes to NYC or NYS (above what they currently pay) for the 12 years they apply. Subsequently, there should be substantial incremental taxes for the additional 8 years of the time horizon I’m using. Since I’m not including this income flow to the city and state, there is considerable upside to my calculations.
The PILOT program payments, estimated by Deputy Mayor Alicia Glen, at $600 to $650 million are the only real estate taxes Amazon will pay. I’m not sure what it would have been without the ICAP credit but the range for the PILOT program amount appears to be known.
NYS and/or NYC will benefit from income, sales and property taxes on employees hired by Amazon and taxes on any additional jobs that get created because of Amazon. I’ll assume taxes are on full wages but that employees have no other income (like interest, capital gains, etc.) and all individuals are single. This puts my model for some who are married without a working spouse at higher taxes then they will pay, but my estimates will be too low for those with a working spouse or any with other sources of income. For this purpose, I’ll use the initial 25,000 jobs plus half of the additional 15,000 (32,500) as the average number over a 20 year period. Since the incremental employment should average longer, that seemed a conservative average to use. I’ll also use an average starting salary of $150,000 for the future Amazon employees as that has been in the announcement. As another assumption, to keep my calculations below what should occur, I haven’t assumed any increases in salary. Even a 4% increase per year would cause salaries to more than double by the end of the 20 years (and NYS and NYC income taxes grow by even more). Since those involved in the project would likely have wage increases over time their income and other taxes would be considerably higher than those based on my assumptions. This coupled with the fact that the negotiators for NYC and NYS used 25 years as the horizon, means their tax calculations will be considerably higher (and more accurate) than mine for the direct employees.
I used the website Smart Asset calculator to generate estimates of NYS and NYC Income tax, sales tax, and property tax per year for each income level. As stated before, the actual numbers will be higher because many of these individuals will have other sources of income, a working spouse and will have salaries escalating over time. Table 2 shows the totals for these estimated taxes to be nearly $15B.
Table 2: NYS & NYC Tax Impact from Amazon HQ
Scholars have found strong evidence of the presence of a local multiplier effect. These come from the direct employees hired, indirect jobs created from suppliers and partners and induced jobs that are a result of the spending of the direct and indirect jobs as well as each layer of induced jobs. For example, a noted scholar on the subject, Enrico Moretti, determined that when Apple Computer was employing 12,000 workers locally, an additional 60,000 jobs were created. These included 36,000 unskilled positions like restaurant or retail workers, and 24,000 skilled jobs like lawyers or doctors. If I assume this 5 to 1 ratio would hold for the highly paid Amazon workers, then 32,500 technology jobs would generate 162,500 more jobs in NYC! Based on the Apple example, 60% of these would be unskilled and 40% highly skilled. Assuming an average salary of $35,000 for the unskilled, an average of $100,00 for half of the skilled and $150,000 for the other half, taxes generated from the multiplier effect over the 20 years would be over $28 billion.
The $2.5 billion Amazon has committed to spend on capital projects would in turn generate further jobs in construction and an associated multiplier impact, but since this is a temporary benefit over 2-5 years, I have omitted it from the analysis.
The $43 billion estimated total of these income streams to the city and state assume the tax abatements cause no incremental corporate taxes from Amazon. While Amazon will be paying rent on the land leased from the city, I also left out this benefit as I couldn’t estimate the amount. While I believe the actual benefit could be higher, consider that even if I’m off by 75% on the multiplier effect, the total would still be over $22 billion and the payback about 44X the $505 million cash outlay!
Other Benefits and Negatives of Attracting Amazon
There are a variety of more difficult factors to analyze than the straight forward financial windfall the city and state will get from this agreement. Living in the San Francisco Bay Area has taught me that what I may view as obvious might not be so to others. Becoming the Florence of the Tech World has meant that the Bay Area is incredibly wealthy, in turn generating a huge tax base for government to use to fund helping the homeless, stem research and many other perceived public good initiatives. Attracting 25,000 – 40,000 technology jobs will vault New York City into a clear contender for tech community leadership. It will lead to others following and to the creation of more startups, one or two who could become the next Amazon, Apple, Google, Facebook, or Microsoft (generating more jobs and more tax income to NYC and NYS). This is not universally celebrated in the Bay Area as it also has led to traffic congestion, higher housing prices, and increased cost of entertainment. But It has meant increased employment opportunities across the full spectrum of jobs. However, an average worker, while making more than elsewhere, can find it a difficult place to afford. In New York City these issues are partly offset for those renting apartments due to rent control and rent stabilization as over 50% of all rental units are under some form of regulation.
New York City is large enough to be able to absorb 25,000 to 40,000 workers relatively easily, but it could add to the problems for the already strained subway system. I believe it’s no accident that Amazon chose a location near the water so that its employees could take advantage of the new, highly praised, NYC Ferry system. While many of the workers may choose to live near the Amazon facilities, some may decide to buy houses in locations that require utilizing mass transit. If I were to guess, I would say a portion of the increased cash flow, to the city will be used to improve the subway system, Long Island Railroad and to add more Ferries each of which will benefit all New Yorkers.
Conclusion: The Amazon Agreement for HQ2 to be in NYC is a Huge Positive for NYC and NYS
While detractors may nitpick at the deal, it has a great ROI for the City and State, will increase employment, provide revenue to improve mass transit and follows incentives mandated by existing laws. Clearly a coup for Mayor de Blasio and Governor Cuomo.
The SF Chronicle published an article on November 28, 2018 touting Stephan Curry’s strong credentials as a possible MVP this year. In it they used several of the statistics we discussed a year ago. Namely, how much better his teammates shoot when they play with Curry and his amazing plus/minus.
Sticking with sports, I can’t help ruminating on how the NFL keeps shooting itself in the foot. I won’t comment on the latest unsavory incidents among players towards women or the Kaepernick fiasco. Instead, I keep thinking about what to call the team about to leave Oakland:
Oakland Raiders, their current name
Oakland Traders, given their propensity to exchange top players for draft choices
Oakland Traitors, trading away their best current players, which has insured a terrible season – thus completing the betrayal of the City of Oakland and the most loyal and colorful fan base in the league