Company Valuations Implied by my Valuations Bible: Are Snap, Netflix, Square and Twitter Grossly Overvalued?

Applying the Gross Margin Multiple Method to Public Company Valuation

In my last two posts I’ve laid out a method to value companies not yet at their mature business models. The method provides a way to value unprofitable growth companies and those that are profitable but not yet at what could be their mature business model. This often occurs when a company is heavily investing in growth at the expense of near-term profits. In the last post, I showed how I would estimate what I believed the long-term model would be for Tesla, calling the result “Potential Earnings” or “PE”. Since this method requires multiple assumptions, some of which might not find agreement among investors, I provided a second, simplified method that only involved gross margin and revenue growth.

The first step was taking about 20 public companies and calculating how they were valued as a multiple of gross margin (GM) dollars. The second step was to determine a “least square line” and formula based on revenue growth and the gross margin multiple for these companies. The coefficient of 0.62 shows that there is a good correlation between Gross Margin and Revenue Growth, and one significantly better than the one between Revenue Growth and a company’s Revenue Multiple (that had a coefficient of 0.36 which is considered very modest).

Where’s the Beef?

The least square formula derived in my post for relating revenue growth to an implied multiple of Gross Margin dollars is:

GM Multiple = (24.773 x Revenue growth percent) + 4.1083

Implied Company Market Value = GM Multiple x GM Dollars

Now comes the controversial part. I am going to apply this formula to 10 companies using their data (with small adjustments) and compare the Implied Market Value (Implied MKT Cap) to their existing market Cap as of several days ago. I’ll than calculate the Implied Over (under) Valuation based on the comparison. If the two values are within 20% I view it as normal statistical variation.

Table 1: Valuation Analysis of 10 Tech Companies

  • * Includes net cash included in expected market cap
  • ** Uses adjusted GM%
  • *** Uses 1/31/18 year end
  • **** Growth rate used in the model is q4 2017 vs q4 2016.  See text

This method suggests that 5 companies are over-valued by 100% or more and a fifth, Workday, by 25%. Since Workday is close to a normal variation, I won’t discuss it further. I have added net cash for Facebook, Snap, Workday and Twitter to the implied market cap as it was material in each case but did not do so for the six others as the impact was not as material.

I decided to include the four companies I recommended, in this year’s top ten list, Amazon, Facebook, Tesla and Stitchfix, in the analysis. To my relief, they all show as under-valued with Stitchfix, (the only one below the Jan 2 price) having an implied valuation more than 100% above where it currently trades. The other three are up year to date, and while trading below what is suggested by this method, are within a normal range. For additional discussion of these four see our 2018 top Ten List.

 

Digging into the “Overvalued” Five

Why is there such a large discrepancy between actual market cap and that implied by this method for 5 companies? There are three possibilities:

  1. The method is inaccurate
  2. The method is a valid screen but I’m missing some adjustment for these companies
  3. The companies are over-valued and at some point, will adjust, making them risky investments

While the method is a good screen on valuation, it can be off for any given company for three reasons:  the revenue growth rate I’m using will radically change; a particular company has an ability to dramatically increase gross margins, and/or a particular company can generate much higher profit margins than their gross margin suggests. Each of these may be reflected in the company’s actual valuation but isn’t captured by this method.

To help understand what might make the stock attractive to an advocate, I’ll go into a lot of detail in analyzing Snap. Since similar arguments apply to the other 4, I’ll go into less detail for each but still point out what is implicit in their valuations.

Snap

Snap’s gross margin (GM) is well below its peers and hurts its potential profitability and implied valuation. Last year, GM was about 15%, excluding depreciation and amortization, but it was much higher in the seasonally strong Q4. It’s most direct competitor, Facebook, has a gross margin of 87%.  The difference is that Facebook monetizes its users at a much higher level and has invested billions of dollars and executed quite well in creating its own low-cost infrastructure, while Snap has outsourced its backend to cloud providers Google and Amazon. Snap has recently signed 5-year contracts with each of them to extend the relationships. Committing to lengthy contracts will likely lower the cost of goods sold.  Additionally, increasing revenue per user should also improve GM.  But, continuing to outsource puts a cap on how high margins can reach. Using our model, Snap would need 79% gross margin to justify its current valuation. If I assume that scale and the longer-term contracts will enable Snap to double its gross margins to 30%, the model still shows it as being over-valued by 128% (as opposed to the 276% shown in our table). The other reason bulls on Snap may justify its high valuation is that they expect it to continue to grow revenue at 100% or more in 2018 and beyond. What is built into most forecasts is an assumed decline in revenue growth rates over time… as that is what typically occurs. The model shows that growing revenue 100% a year for two more years without burning cash would leave it only 32% over-valued in 2 years. But as a company scales, keeping revenue growth at that high a level is a daunting task. In fact, Snap already saw revenue growth decline to 75% in Q4 of 2017.

Twitter

Twitter is not profitable.  Revenue declined in 2017 after growing a modest 15% in 2016, and yet it trades at a valuation that implies that it is a growth company of about 50%. While it has achieved such levels in the past, it may be difficult to even get back to 15% growth in the future given increased competition for advertising.

Netflix

I recommended Netflix in January 2015 as one of my stock picks for the year, and it proved a strong recommendation as the stock went up about 140% that year. However, between January 2015 and January 2018, the stock was up over 550% while trailing revenue only increased 112%.  I continue to like the fundamentals of Netflix, but my GM model indicates that the stock may have gotten ahead of itself by a fair amount, and it is unlikely to dramatically increase revenue growth rates from last year’s 32%.

Square

Square has followed what I believe to be the average pattern of revenue growth rate decline as it went from 49% growth in 2015, down to 35% growth in 2016, to under 30% growth in 2017. There is no reason to think this will radically change, but the stock is trading as if its revenue is expected to grow at a nearly 90% rate. On the GM side, Square has been improving GM each year and advocates will point out that it could go higher than the 38% it was in 2017. But, even if I use 45% for GM, assuming it can reach that, the model still implies it is 90% over-valued.

Blue Apron

I don’t want to beat up on a struggling Blue Apron and thought it might have reached its nadir, but the model still implies it is considerably over-valued. One problem that the company is facing is that investors are negative when a company has slow growth and keeps losing money. Such companies find it difficult to raise additional capital. So, before running out of cash, Blue Apron began cutting expenses to try to reach profitability. Unfortunately, given their customer churn, cutting marketing spend resulted in shrinking revenue in each sequential quarter of 2017. In Q4 the burn was down to $30 million but the company was now at a 13% decline in revenue versus Q4 of 2016 (which is what we used in our model). I assume the solution probably needs to be a sale of the company. There could be buyers who would like to acquire the customer base, supplier relationships and Blue Apron’s understanding of process. But given that it has very thin technology, considerable churn and strong competition, I’m not sure if a buyer would be willing to pay a substantial premium to its market cap.

 

An Alternative Theory on the Over Valued Five

I have to emphasize that I am no longer a Wall Street analyst and don’t have detailed knowledge of the companies discussed in this post, so I easily could be missing some important factors that drive their valuation.  However, if the GM multiple model is an accurate way of determining valuation, then why are they trading at such lofty premiums to implied value? One very noticeable common characteristic of all 5 companies in question is that they are well known brands used by millions (or even tens of millions) of people. Years ago, one of the most successful fund managers ever wrote a book where he told readers to rely on their judgement of what products they thought were great in deciding what stocks to own. I believe there is some large subset of personal and professional investors who do exactly that. So, the stories go:

  • “The younger generation is using Snap instead of Facebook and my son or daughter loves it”
  • “I use Twitter every day and really depend on it”
  • “Netflix is my go-to provider for video content and I’m even thinking of getting rid of my cable subscription”

Once investors substitute such inclinations for hard analysis, valuations can vary widely from those suggested by analytics. I’m not saying that such thoughts can’t prove correct, but I believe that investors need to be very wary of relying on such intuition in the face of evidence that contradicts it.

Ten Predictions for 2018

In my recap of 2017 predictions I pointed out how boring my stock predictions have been with Tesla and Facebook on my list every year since 2013 and Amazon on for two of the past three years. But what I learned on Wall Street is that sticking with companies that have strong competitive advantages in a potentially mega-sized market can create great performance over time (assuming one is correct)! So here we go again, because as stated in my January 5 post, I am again including Tesla, Facebook and Amazon in my Top ten list for 2018. I believe they each continue to offer strong upside, as explained below. I’m also adding a younger company, with a modest market cap, thus more potential upside coupled with more risk. The company is Stitch Fix, an early leader in providing women with the ability to shop for fashion-forward clothes at home. My belief in the four companies is backed up by my having an equity position in each of them.

I’m expecting the four stocks to outperform the market. So, in a steeply declining market, out-performance might occur with the stock itself being down (but less than the market). Having mentioned the possibility of a down market, I’m predicting the market will rise this year. This is a bit scary for me, as predicting the market as a whole is not my specialty.

We’ll start with the stock picks (with January 2 opening prices of stocks shown in parenthesis) and then move on to the remainder of my 10 predictions.

1. Tesla stock appreciation will continue to outpace the market (it opened the year at $312/share).

The good news and bad news on Tesla is the delays in production of the Model 3. The good part is that we can still look forward to massive increases in the number of cars the company sells once Tesla gets production ramping (I estimate the Model 3 backlog is well in excess of 500,000 units going into 2018 and demand appears to be growing). In 2017, Tesla shipped between 80,000 and 100,000 vehicles with revenue up 30% in Q3 without help from the model 3. If the company is successful at ramping capacity (and acquiring needed parts), it expects to reach a production rate of 5,000 cars per week by the end of Q1 and 10,000 by the end of the year. That could mean that the number of units produced in Q4 2018 will be more than four times that sold in Q4 2017 (with revenue about 2.0-2.5x due to the Model 3 being a lower priced car). Additionally, while it is modest compared to revenue from selling autos, the company appears to be the leader in battery production. It recently announced the largest battery deal ever, a $50 million contract (now completed on time) to supply what is essentially a massive backup battery complex for energy to Southern Australia. While this type of project is unlikely to be a major portion of revenue in the near term, it can add to Tesla’s growth rate and profitability.

2. Facebook stock appreciation will continue to outpace the market (it opened the year at $182/share).

The core Facebook user base growth has slowed considerably but Facebook has a product portfolio that includes Instagram, WhatsApp and Oculus. This gives Facebook multiple opportunities for revenue growth: Improve the revenue per DAU (daily active user) on Facebook itself; increase efforts to monetize Instagram and WhatsApp in more meaningful ways; and build the install base of Oculus. Facebook advertising rates have been increasing steadily as more mainstream companies shift budget from traditional advertising to Facebook, especially in view of declining TV viewership coupled with increased use of DVRs (allowing viewers to skip ads). Higher advertising rates, combined with modest growth in DAUs, should lead to continued strong revenue growth. And while the Oculus product did not get out of the gate as fast as expected, it began picking up steam in Q3 2017 after Facebook reduced prices. At 210,000 units for the quarter it may have contributed up to 5% of Q3 revenue. The wild card here is if a “killer app” (a software application that becomes a must have) launches that is only available on the Oculus, sales of Oculus could jump substantially in a short time.

3. Amazon stock appreciation will outpace the market (it opened the year at $1188/share).

Amazon, remarkably, increased its revenue growth rate in 2017 as compared to 2016. This is unusual for companies of this size. In 2018, we expect online to continue to pick up share in retail and Amazon to gain more share of online. The acquisition of Whole Foods will add approximately $4B per quarter in revenue, boosting year/year revenue growth of Amazon an additional 9%-11% per quarter, if Whole Foods revenue remains flattish. If Amazon achieves organic growth of 25% (in Q3 it was 29% so that would be a drop) in 2018, this would put the 3 quarters starting in Q4 2017 at about 35% growth. While we do expect Amazon to boost Whole Foods revenue, that is not required to reach those levels. In Q4 2018, reported revenue will return to organic growth levels. The Amazon story also features two other important growth drivers. First, I expect the Echo to have another substantial growth year and continue to emerge as a new platform in the home. Additionally, Amazon appears poised to benefit from continued business migration to the cloud coupled with increased market share and higher average revenue per cloud customer. This will be driven by modest price increases and introduction of more services as part of its cloud offering. The success of the Amazon Echo with industry leading voice technology should continue to provide another boost to Amazon’s revenue. Additionally, having a large footprint of physical stores will allow Amazon to increase distribution of many products.

4. Stitch Fix stock appreciation will outpace the market (it opened the year at $25/share and is at the same level as I write this post).

Stitch Fix is my riskiest stock forecast. As a new public company, it has yet to establish a track record of performance that one can depend upon. On the other hand, it’s the early leader in a massive market that will increasingly move online, at-home shopping for fashion forward clothes. The number of people who prefer shopping at home to going to a physical store is on the increase. The type of goods they wish to buy expands every year. Now, clothing is becoming a new category on the rapid rise (it grew from 11% of overall clothing retail sales in 2011 to 19% in 2016). It is important for women buying this way to feel that the provider understands what they want and facilitates making it easy to obtain clothes they prefer. Stitch Fix uses substantial data analysis to personalize each box it sends a customer. The woman can try them on, keep (and pay for) those they like, and return the rest very easily.

5. The stock market will rise in 2018 (the S&P opened the year at 2,696 on January 2).

While I have been accurate on recommending individual stocks over a long period, I rarely believe that I understand what will happen to the overall market. Two prior exceptions were after 9/11 and after the 2008 mortgage crisis generated meltdown. I was correct both times but those seemed like easy calls. So, it is with great trepidation that I’m including this prediction as it is based on logic and I know the market does not always follow logic! To put it simply, the new tax bill is quite favorable to corporations and therefore should boost after-tax earnings. What larger corporations pay is often a blend of taxes on U.S. earnings and those on earnings in various countries outside the U.S. There can be numerous other factors as well. Companies like Microsoft have lower blended tax rates because much of R&D and corporate overhead is in the United States and several of its key products are sold out of a subsidiary in a low tax location, thereby lowering the portion of pre-tax earnings here. This and other factors (like tax benefits in fiscal 2017 from previous phone business losses) led to blended tax rates in fiscal 2015, 2016 and 2017 of 34%, 15% and 8%, respectively. Walmart, on the other hand, generated over 75% of its pre-tax earnings in the United States over the past three fiscal years, so their blended rate was over 30% in each of those years

Table 1: Walmart Blended Tax Rates 2015-2017

The degree to which any specific company’s pre-tax earnings mix changes between the United States and other countries is unpredictable to me, so I’m providing a table showing the impact on after-tax earnings growth for theoretical companies instead. Table 2 shows the impact of lowering the U.S. corporate from 35% to 21% on four example companies. To provide context, I show two companies growing pre-tax earnings by 10% and two companies by 30%. If blended tax rates didn’t change, EPS would grow by the same amount as pre-tax earnings. For Companies 1 and 3, Table 2 shows what the increase in earnings would be if their blended 2017 tax rate was 35% and 2018 shifts to 21%. For companies 2 and 4, Table 2 shows what the increase in earnings would be if the 2017 rate was 30% (Walmart’s blended rate the past three years) and the 2018 blended rate is 20%.

Table 2: Impact on After-Tax Earnings Growth

As you can see, companies that have the majority of 2018 pre-tax earnings subject to the full U.S. tax rate could experience EPS growth 15%-30% above their pre-tax earnings growth. On the other hand, if a company has a minimal amount of earnings in the U.S. (like the 5% of earnings Microsoft had in fiscal 2017), the benefit will be minimal. Whatever benefits do accrue will also boost cash, leading to potential investments that could help future earnings.  If companies that have maximum benefits from this have no decline in their P/E ratio, this would mean a substantial increase in their share price, thus the forecast of an up market. But as I learned on Wall Street, it’s important to sight risk. The biggest risks to this forecast are the expected rise in interest rates this year (which usually is negative for the market) and the fact that the market is already at all-time highs.

6. Battles between the federal government and states will continue over marijuana use but the cannabis industry will emerge as one to invest in.

The battle over legalization of Marijuana reached a turning point in 2017 as polls showed that over 60% of Americans now favor full legalization (as compared to 12% in 1969). Prior to 2000, only three states (California, Oregon and Maine) had made medical cannabis legal. Now 29 states have made it legal for medical use and six have legalized sale for recreational use. Given the swing in voter sentiment (and a need for additional sources of tax revenue), more states are moving towards legalization for recreational and medical purposes. This has put the “legal” marijuana industry on a torrid growth curve. In Colorado, one of the first states to broadly legalize use, revenue is over $1 billion per year and overall 2017 industry revenue is estimated at nearly $8 billion, up 20% year/year. Given expected legalization by more states and the ability to market product openly once it is legal, New Frontier Data predicts that industry revenue will more than triple by 2025. The industry is making a strong case that medical use has compelling results for a wide variety of illnesses and high margin, medical use is forecast to generate over 50% of the 2025 revenue. Given this backdrop, public cannabis companies have had very strong performance. Despite this, in 2016, VCs only invested about $49 million in the sector. We expect that number to escalate dramatically in 2017 through 2019. While public cannabis stocks are trading at nosebleed valuations, they could have continued strong performance as market share consolidates and more states (and Canada) head towards legalization. One caveat to this is that Federal law still makes marijuana use illegal and the Trump administration is adopting a more aggressive policy towards pursuing producers, even in states that have made use legal. The states that have legalized marijuana use are gearing up to battle the federal government.

7. At least one city will announce a new approach to Urban transport

Traffic congestion in cities continues to worsen. Our post on December 14, 2017 discussed a new approach to urban transportation, utilizing small footprint automated cars (one to two passengers, no trunk, no driver) in a dedicated corridor. This appears much more cost effective than a Rapid Bus Transit solution and far more affordable than new subway lines. As discussed in that post, Uber and other ride services increase traffic and don’t appear to be a solution. The thought that automating these vehicles will relieve pressure is overly optimistic. I expect at least one city to commit to testing the method discussed in the December post before the end of this year – it is unlikely to be a U.S. city. The approach outlined in that post is one of several that is likely to be tried over the coming years as new thinking is clearly needed to prevent the traffic congestion that makes cities less livable.

8. Offline retailers will increase the velocity of moving towards omnichannel.

Retailers will adopt more of a multi-pronged approach to increasing their participation in e-commerce. I expect this to include:

  • An increased pace of acquisition of e-commerce companies, technologies and brands with Walmart leading the way. Walmart and others need to participate more heavily in online as their core offline business continues to lose share to online. In 2017, Walmart made several large acquisitions and has emerged as the leader among large retailers in moving online. This, in turn, has helped its stock performance. After a stellar 12 months in which the stock was up over 40%, it finally exceeded its January 2015 high of $89 per share (it reached $101/share as we are finalizing the post). I expect Walmart and others in physical retail to make acquisitions that are meaningful in 2018 so as to speed up the transformation of their businesses to an omnichannel approach.
  • Collaborating to introduce more online/technology into their physical stores (which Amazon is likely to do in Whole Foods stores). This can take the form of screens in the stores to order online (a la William Sonoma), having online purchases shipped to your local store (already done by Nordstrom) and adding substantial ability to use technology to create personalized items right at the store, which would subsequently be produced and shipped by a partner.

9. Social commerce will begin to emerge as a new category.

Many e-commerce sites have added elements of social, and many social sites have begun trying to sell various products. But few of these have a fully integrated social approach to e-commerce. The elements of a social approach to e-commerce include:

  • A feed-based user experience
  • Friends’ actions impact your feed
  • Following trend setters to see what they are buying, wearing, and favoring
  • Notifications based on your likes and tastes
  • One click to buy
  • Following particular stores and/or friends

I expect to see existing e-commerce players adding more elements of social, existing social players improving their approach to commerce and a rising trend of emerging companies focused on fully integrated social commerce.

10. “The Empire Strikes Back”: automobile manufacturers will begin to take steps to reclaim use of its GPS.

It is almost shameful that automobile manufacturers, other than Tesla, have lost substantial usage of their onboard GPS systems as many people use their cell phones or a small device to run Google, Waze (owned by Google) or Garmin instead of the larger screen in their car. In the hundreds of times I’ve taken an Uber or Lyft, I’ve never seen the driver use their car’s system. To modernize their existing systems, manufacturers may need to license software from a third party. Several companies are offering next generation products that claim to replicate the optimization offered by Waze but also add new features that go beyond it like offering to order coffee and other items to enable the driver to stop at a nearby location and have the product prepaid and waiting for them. In addition to adding value to the user, this also leads to a lead-gen revenue opportunity. In 2018, I expect one or more auto manufacturers to commit to including a third-party product in one or more of their models.

Soundbytes

Tesla model 3 sample car generates huge buzz at Stanford Mall in Menlo Park California. This past weekend my wife and I experienced something we had not seen before – a substantial line of people waiting to check out a car, one of the first Model 3 cars seen live. We were walking through the Stanford Mall where Tesla has a “Guide Store” and came upon a line of about 60 people willing to wait a few hours to get to check out one of the two Model 3’s available for perusal in California (the other was in L.A.). An hour later we came back, and the line had grown to 80 people. To be clear, the car was not available for a test drive, only for seeing it, sitting in it, finding out more info, etc. Given the buzz involved, it seems to me that as other locations are given Model 3 cars to look at, the number of people ordering a Model 3 each week might increase faster than Tesla’s capacity to fulfill.

Re-cap of 2017 Top Ten Predictions

I started 2017 by saying:

When I was on Wall Street I became very boring by having the same three strong buy recommendations for many years…  until I downgraded Compaq in 1998 (it was about 30X the original price at that point). The other two, Microsoft and Dell, remained strong recommendations until I left Wall Street in 2000. At the time, they were each well over 100X the price of my original recommendation. I mention this because my favorite stocks for this blog include Facebook and Tesla for the 4th year in a row. They are both over 5X what I paid for them in 2013 ($23 and $45, respectively) and I continue to own both. Will they get to 100X or more? This is not likely, as companies like them have had much higher valuations when going public compared with Microsoft or Dell, but I believe they continue to offer strong upside, as explained below.

Be advised that my top ten for 2018 will continue to include all three picks from 2017. I’m quite pleased that I continue to be fortunate, as the three were up an average of 53% in 2017. Furthermore, each of my top ten forecasts proved pretty accurate, as well!

I’ve listed in bold the 2017 stock picks and trend forecasts below, and give a personal evaluation of how I fared on each. For context, the S&P was up 19% and the Nasdaq 28% in 2017.

  1. Tesla stock appreciation will continue to outpace the market. Tesla, once again, posted very strong performance.  While the Model 3 experienced considerable delays, backorders for it continued to climb as ratings were very strong. As of mid-August, Tesla was adding a net of 1,800 orders per day and I believe it probably closed the year at over a 500,000-unit backlog. So, while the stock tailed off a bit from its high ($385 in September), it was up 45% from January 3, 2017 to January 2, 2018 and ended the year at 7 times the original price I paid in 2013 when I started recommending it. Its competitors are working hard to catch up, but they are still trailing by quite a bit.
  2. Facebook stock appreciation will continue to outpace the market. Facebook stock appreciated 57% year/year and opened on January 2, 2018 at $182 (nearly 8 times my original price paid in 2013 when I started recommending it). This was on the heels of 47% revenue growth (through 3 quarters) and even higher earnings growth.
  3. Amazon stock appreciation will outpace the market. Amazon stock appreciated 57% in 2017 and opened on January 2, 2018 at $1,188 per share. It had been on my recommended list in 2015 when it appreciated 137%. Taking it off in 2016 was based on Amazon’s stock price getting a bit ahead of itself (and revenue did catch up that year growing 25% while the stock was only up about 12%). In 2017, the company increased its growth rate (even before the acquisition of Whole Foods) and appeared to consolidate its ability to dominate online retail.
  4. Both online and offline retailers will increasingly use an omnichannel approach. Traditional retailers started accelerating the pace at which they attempted to blend online and offline in 2017. Walmart led, finally realizing it had to step up its game to compete with Amazon. While its biggest acquisition was Jet.com for over $3 billion, it also acquired Bonobos, Modcloth.com, Moosejaw, Shoebuy.com and Hayneedle.com, creating a portfolio of online brands that could also be sold offline. Target focused on becoming a leader in one-day delivery by acquiring Shipt and Grand Junction, two leaders in home delivery. While I had not predicted anything as large as a Whole Foods acquisition for Amazon, I did forecast that they would increase their footprint of physical locations (see October 2016 Soundbytes). The strategy for online brands to open “Guide” brick and mortar stores ( e.g. Tesla, Warby Parker, Everlane, etc.) continued at a rapid pace.
  5. A giant piloted robot will be demo’d as the next form of entertainment. As expected, Azure portfolio company, Megabots, delivered on this forecast by staging an international fight with a giant robot from Japan. The fight was not live as the robots are still “temperamental” (meaning they occasionally stop working during combat). However, interest in this new form of entertainment was incredible as the video of the fight garnered over 5 million views (which is in the range of an average prime-time TV show). There is still a large amount of work to be done to convert this to an ongoing form of entertainment, but all the ingredients are there.
  6. Virtual and Augmented reality products will escalate. Sales of VR/AR headsets appear to have well exceeded 10 million units for the year with some market gain for higher-end products. The types of applications have expanded from gaming to room design (and viewing), travel, inventory management, education, healthcare, entertainment and more. While the actual growth in unit sales fell short of what many expected, it still was substantial. With Apple’s acquisition of Vrvana (augmented reality headset maker) it seems clear that Apple plans to launch multiple products in the category over the next 2-3 years, and with Facebook’s launch of ArKIT, it’s social AR development platform, there is clearly a lot of focus and growth ahead.
  7. Magic Leap will disappoint in 2017. Magic Leap, after 5 years of development and $1.5 billion of investment, did not launch a product in 2017. But, in late December they announced that their first product will launch in 2018. Once again, the company has made strong claims for what its product will do, and some have said early adopters (at a very hefty price likely to be in the $1,500 range) are said to be like those who bought the first iPod. So, while it disappointed in 2017, it is difficult to tell whether or not this will eventually be a winning company as it’s hard to separate hype from reality.
  8. Cable companies will see a slide in adoption. According to eMarketer, “cord cutting”, i.e. getting rid of cable, reached record proportions in 2017, well exceeding their prior forecast. Just as worrisome to providers, the average time watching TV dropped as well, implying decreased dependence on traditional consumption. Given the increase now evident in cord cutting, UBS (as I did a year ago) is now forecasting substantial acceleration of the decline in subscribers. While the number of subscribers bounced around a bit between 2011 and 2015, when all was said and done, the aggregate drop in that four-year period was less than 0.02%. UBS now forecasts that between the end of 2016 and the end of 2018 the drop will be 7.3%. The more the industry tries to offset the drop by price increases, the more they will accelerate the pace of cord cutting.
  9. Spotify will either postpone its IPO or have a disappointing one. When we made this forecast, Spotify was expected to go public in Q2 2017. Spotify postponed its IPO into 2018 while working on new contracts with the major music labels to try to improve its business model. It was successful in these negotiations in that the labels all agreed to new terms. Since the terms were not announced, we’ll need to see financials for Q1 2018 to better understand the magnitude of improvement. In the first half of the year, Spotify reported that gross margins improved from 16% to 22%, but this merely cut its loss level rather than move the company to profitability. It has stated that it expects to do a non-traditional IPO (a direct listing without using an investment bank) in the first half of 2018. If the valuation approaches its last private round, I would caution investors to stay away, as that valuation, coupled with 22% gross margins (and over 12% of revenue in sales and marketing cost to acquire customers), implies net margin in the mid-single digits at best (assuming they can reduce R&D and G&A as a percent of revenue). This becomes much more challenging in the face of a $1.6 billion lawsuit filed against it for illegally offering songs without compensating the music publisher. Even if they managed to successfully fight the lawsuit and improve margin, Spotify would be valued at close to 100 times “potential earnings” and these earnings may not even materialize.
  10. Amazon’s Echo will gain considerable traction in 2017. Sales of the Echo exploded in 2017 with Amazon announcing that it “sold 10s of millions of Alexa-enabled devices” exceeding our aggressive forecast of 2-3x the 4.4 million units sold in 2016. The Alexa app was also the top app for both Android and iOS phones. It clearly has carved out a niche as a new major platform.

Stay tuned for my top 10 predictions of 2018!

 

SoundBytes

  • In our December 20, 2017 post, I discussed just how much Steph Curry improves teammate performance and how effective a shooter he is. I also mentioned that Russell Westbrook leading the league in scoring in the prior season might have been detrimental to his team as his shooting percentage falls well below the league average. Now, in his first game returning to the lineup, Curry had an effective shooting percentage that exceeded 100% while scoring 38 points (this means scoring more than 2 points for every shot taken). It would be interesting to know if Curry is the first player ever to score over 35 points with an effective shooting percentage above 100%! Also, as of now, the Warriors are scoring over 15 points more per game this season with Curry in the lineup than they did for the 11 games he was out (which directly ties to the 7.4% improvement in field goal percentage that his teammates achieve when playing with Curry as discussed in the post).

Top 10 Predictions for 2017

Conceptualization of giant robot fight.
Conceptualization of giant robot fight.

When I was on Wall Street I became very boring by having the same three strong buy recommendations for many years until I downgraded Compaq in 1998 (it was about 30X the original price at that point). The other two, Microsoft and Dell, remained strong recommendations until I left in 2000. At the time, they were each well over 100X the price of my original recommendation. I mention this because my favorite stocks for this blog include Facebook and Tesla for the 4th year in a row. They are both over 5X what I paid for them in 2013 (23 and 45, respectively) and I continue to own both. Will they get to 100X or more? This is not likely, as companies like them have had much higher valuations when going public compared with Microsoft or Dell, but I believe they continue to offer strong upside, as explained below.

In each of my stock picks, I’m expecting the stocks to outperform the market. I don’t have a forecast of how the market will perform, so in a steeply declining market, out-performance might occur with the stock itself being down (but less than the market). Given the recent rise in the market subsequent to the election of Donald Trump, on top of several years of a substantial bull market, this risk is real. While I have had solid success at predicting certain individual stocks’ performance, I do not pride myself in being able to predict the market itself. So, consider yourself forewarned regarding potential market volatility.

This top ten is unusual in having three picks that are negative forecasts as last year there were no negatives and in 2015 only one.

We’ll start with the stock picks (with prices of stocks valid as of writing this post, January 10, all higher than the beginning of the year) and then move on to the remainder of my 10 predictions.

  1. Tesla stock appreciation will continue to outpace the market (it is currently at $229/share). Tesla expected to ship 50,000 vehicles in the second half of 2016 and Q3 revenue came in at $2.3 billion. This equates to 100,000 vehicles and a $9.2 billion annualized run rate. The model 3 has over 400,000 units on back order and Tesla is ramping capacity to produce 500,000 vehicles in total in 2018. If the company stays on track, from a production point of view, this amounts to 5X the vehicle unit sales rate and about 3X the revenue run rate. While the model 3 is unlikely to have the same gross margins as the current products, tripling revenue should still lead to substantially more than tripling profits. Tesla remains the clear leader in electric vehicles and fully integrated automated features in an automobile. While others are looking towards 2020/2021 to deliver automated cars, Tesla is already delivering most of the functionality required. Between now and 2020 Tesla is likely to install numerous improvements and should remain the leader. Tesla also continues to have the strongest business model as it sells directly to the consumer, eliminating dealers. I also believe that the Solar City acquisition will prove more favorable than anticipated. Given these factors, I expect Tesla stock to have solid outperformance in 2017. The biggest risk is product delay and/or delivering a faulty product, but competitors are trailing by quite a bit so there is some headroom if this happens.

2. Facebook stock appreciation will continue to outpace the market (it is currently at $123/share). While the core Facebook user base growth has slowed considerably, Facebook has a product portfolio that also includes Instagram, WhatsApp and Oculus. This gives Facebook multiple opportunities for revenue growth: Improve the revenue per DAU (daily active user) on Facebook itself; begin to monetize Instagram and WhatsApp in more meaningful ways; and build the install base of Oculus. We have seen Facebook advertising rates increase steadily as more and more mainstream companies shift budget from traditional advertising to Facebook. This, combined with modest growth in DAUs, should lead to continued strong revenue growth from the Facebook platform itself. The opportunity to increase monetization on its other platforms should become more real during 2017, providing Facebook with additional revenue streams. And while the Oculus did not get out of the gate as fast as expected, it is still viewed as the premier product in VR. We believe the company will need to produce a lower priced version to drive sales into the millions of units annually. The wild card here is the “killer app”; if a product becomes a must have and is only available on the Oculus, sales would jump substantially in a short time.

3. Amazon stock appreciation will outpace the market (it is currently at $795/share). I had Amazon as a recommended stock in 2015 but omitted it in 2016 after the stock appreciated 137% in 2015 while revenue grew less than 20%. That meant my 2015 recommendation worked extremely well. But while I still believed in Amazon fundamentals at the beginning of 2016, I felt the stock might have reached a level that needed to be absorbed for a year or so. In fact, 2016 Amazon fundamentals continued to be quite strong with revenue growth accelerating to 26% (to get to this number, I assumed it would have its usual seasonally strong Q4). At the same time, the stock was only up 10% for the year. While it has already appreciated a bit since year end, it seems to be more fairly valued than a year ago, and I am putting it back on our recommended list as we expect it to continue to gain share in retail, have continued success with its cloud offering (strong growth and increased margin), leverage their best in class AI and voice recognition with Echo (see pick 10), and add more physical outlets that drive increased adoption.

4. Both Online and Offline Retailers will increasingly use an Omnichannel Approach. The line between online and offline retailers will become blurred over the next five years. But despite the continued increase in online’s share of the total, physical stores will be the majority of sales for many years. This means that many online retailers will decide to have some form of physical outlets. The most common will be “guide stores” like those from Warby Parker, Bonobos and Tesla where samples of product are in the store but the order is still placed online for subsequent delivery. We believe Amazon may begin to create several such physical locations over the next year or two. I expect brick and mortar retailers to up their game online as they struggle to maintain share. But currently, they continue to struggle to optimize their online presence, so much so that Walmart paid what I believe to be an extremely overpriced valuation for Jet to access better technology and skills. Others may follow suit. One retailer that appears to have done a reasonable job online is William Sonoma.

5. A giant piloted robot will be demo’d as the next form of Entertainment. Since the company producing it, MegaBots, is an Azure portfolio company, this is one of my easier predictions, assuming good execution. The robot will be 16 feet high, weigh 20,000 pounds and be able to lift a car in one hand (a link to the proto-type was in my last post). It will be able to shoot a paint ball at a speed that pierces armor. If all goes well, we will also be able to experience the first combat between two such robots in 2017. Actual giant robots as a new form of entertainment will emerge as a new category over the next few years.

6. Virtual and Augmented reality products will escalate. If 2016 was the big launch year for VR (with every major platform launching), 2017 will be the year where these platforms are more broadly evaluated by millions of consumers. The race to supplement them with a plethora of software applications, follow on devices, VR enabled laptops and 360 degree cameras will escalate the number of VR enabled products on the market. For every high-tech, expensive VR technology platform release, there will be a handful of apps that will expand VR’s reach outside of gaming (and into viewing homes, room design, travel, education etc.), allowing anyone with simple VR glasses connected to a smartphone to experience VR in a variety of settings.  For AR, we see 2017 as the year where AR applicability to retail, healthcare, agriculture and manufacturing will start to be tested, and initial use cases will emerge.

7. Magic Leap will disappoint in 2017. Magic Leap has been one of the “aha” stories in technology for the past few years as it promised to build its technology into a pair of glasses that will create virtual objects and blend them with the real world. At the Fortune Brainstorm conference in 2016, I heard CEO Rony Abovitz speak about the technology. I was struck by the fact that there was no demo shown despite the fact that the company had raised about $1.4 billion starting in early 2014 (with a last post-money at $4.5 billion). The problem for this company is that while it may have been conceptually ahead in 2014, others, like Microsoft, now appear further along and it remains unclear when Magic Leap will actually deliver a marketable product.

8. Cable companies will see slide in adoption. Despite many thinking to the contrary, the number of US cable subscribers has barely changed over the past two years, going down from 49.9 million in Q2 2014 to 48.9 million in Q2 2016 (a 2% loss). During the same period, Broadband services subscribers (video on demand for Netflix, Hulu and others) increased about 12% to 57.0 million. Given the extremely high price of cable, more people (especially millennials) are shifting to paying for what they want at considerably less cost so that the rate of erosion of the subscriber base should continue and may even accelerate over the next few years. I expect to see further erosion of traditional TV usage as well, despite the fact that overall media usage per day is rising. The reason for lower TV usage is the shift people are making to consuming media on their smart phones. This shift is much broader than millennials as every age group is increasing their media consumption through their phones.

9. Spotify will either postpone its IPO or have a disappointing one. In theory, valuation of a company should be calculated based on future earnings flows. The problem for evaluating companies that are losing money is that we can only use proxies for such flows and often wind up using them to determine a multiple of revenue that appears appropriate. To do this I first consider gross margin, cost of customer acquisition and operating cost to determine a “theoretic potential operating profit percentage” that a company can reach when it matures. I believe the higher this is, the higher the multiple and similarly the higher the revenue growth rate, the higher the multiple. When I look at Spotify numbers for 2015 (2016 financials won’t be released for several months) it strikes me (and many others) that this is a difficult business to make profitable as gross margins were a thin 16% based on hosting and royalty cost. Sales and marketing (both of which are variable costs that ramp with revenue) was an additional 12.6% leaving only 3.4% before G&A and R&D (which in 2015 were over 13% of revenue). This combination has meant that scaling revenue has not improved earnings. In fact, the 80% increase in revenue over the prior year still led to higher dollars in operating loss (about 9.5% of revenue). Unless the record labels agree to lower royalties substantially (which seems unlikely) its appears that even strong growth would not result in positive operating margins. If I give them the benefit of the doubt and assume they somehow get to 2% positive operating margin, the company’s value ($8 billion post) would still be over 175X this percent of 2015 revenue. If Spotify grew another 50% in 2016, the same calculation would bring the multiple of theoretical 2016 operating margin to about 120X. I believe it will be tough for them to get an IPO valuation as high as their last post if they went public in Q2 of this year as has been rumored.

10. Amazon’s Echo will gain considerable traction in 2017. The Echo is Amazon’s voice-enabled device that has built-in artificial intelligence and voice recognition. It has a variety of functions like controlling smart devices, answering questions, telling jokes, playing music through Sonos and other smart devices and more. Essentially an app for it is called a “skill”. There are now over 3,000 of these apps and this is growing at a rapid rate. In the first 12 months of sales, a consulting firm, Activate, estimated that about 4.4 million were sold. If we assume an average price of about $150, this would amount to over $650 million to Amazon. The chart below shows the adoption curve for five popular devices launched in the past. Year 1 unit sales for each is set at 1.0 and subsequent years show the multiple of year 1 volume that occurred in that year. As can be seen from the chart, the second year ranged from 2x to over 8X the first year’s volume and in the third year every one of them was at least 5 times the first year’s volume. Should the Echo continue to ramp in a similar way to these devices, its unit sales could increase by 2-3X in 2017 placing the device sales at $1.5-2.0 billion. But the device itself is only one part of the equation for Amazon as the Echo also facilitates ordering products, and while skills are free today, some future skills could entail payments with Amazon taking a cut.

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Re-cap of 2016 Predictions

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Samsung FamilyHub Fridge: manage groceries, family scheduling, display photos and play music through a wifi enabled touchscreen

In my post for top 10 predictions for 2016 I noted how lucky I had been for 3 years running as all my picks seemed to work. I pointed out that all winning streaks eventually come to an end. I’m not sure if this constitutes an end to my streak but in my forecasts for 2016 I was wrong with one of the three stock picks (GoPro) and also missed on one of my seven forecasts of industry trends (that the 2016 political spend would reach record levels). My other 2 stock picks and other 6 trend forecasts did prove accurate.

I’ve listed in bold the 2016 stock picks and trend forecasts below and give a personal evaluation of how I fared on each. For context, the S&P was up 7.5% and the Nasdaq 10.0% in 2016.

1. Facebook stock appreciation will continue to outpace the market (it is currently at $97/share). One year later (January 3) Facebook opened at $117.50, a year over year gain of 21.1% from the time of my blog post. While this was short of the 40% gain in 2015, it still easily outpaced the market.

2. Tesla stock appreciation will continue to outpace the market (it is currently at $193/share). One year later, Tesla shares opened at $219.25 (January 3), a 13.5% gain from the time of my blog post. It might have been higher but the acquisition of Solar City created headwinds for the stock as revenue grew well over 100%, gross profit improved and in Q3 (last reported quarter) EBITDA was positive. Still, it outperformed the market.

3. GoPro stock appreciation should outpace the market in 2016 (shares are currently at $10.86). This pick was a clear miss as the stock declined 17.1% from the time of the blog post to January 3. In my defense, I had it partly right as the stock peaked at $17/share at the time of the drone and new camera announcements. In retrospect, given GoPro’s history of poor execution, I would have been smarter to recommend selling at the time these were announced. Instead, I mistakenly viewed execution as pretty easy and failed to suggest this. Since the company, once again, had an execution misstep, I was proven wrong and the stock subsequently declined.

The remaining predictions were about industry trends rather than stocks.

4. UAV/Drones will continue to increase in popularity. Drones continued to increase in popularity at the end of 2015 and into the first half of 2016. According to Market Watch, drone sales were up over 200% in April of 2016 as compared with April of 2015. Starting in December of 2015, the government began requiring drone operators to register on a federal database and by December 2016 had registered over 600,000 drones and users.

5. Political spend will reach record levels in 2016 and have a positive impact on advertising revenue. This forecast proved incorrect. Donald Trump won the presidency despite raising less money than any major party presidential candidate since 2008. Hillary Clinton, raised nearly twice as much as Trump, but still fell short of what President Obama raised in 2012. In the case of President-Elect Trump, more than half of his small raise consisted of $66 million he personally donated to his campaign and $280 million from donors giving $200 or less. Mrs. Clinton, despite depicting Trump as the candidate of the rich, received a substantial portion of her donations from wealthy individuals. The two candidates raising less money meant that the size of the boost in advertising from political ads fell short of my prediction.

6. Virtual/Augmented Reality will have a big year in 2016. As expected, 2016 was the big launch year for VR and AR. Highly anticipated VR product launches (the Facebook Oculus Rift in March, the HTC Vive in April and the PlayStation VR in October) showed strong consumer interest with sales of over 1.5M units. Pokemon Go’s 500M + downloads and the initial release of Microsoft’s Hololense generated intense interest in AR, creating a flurry of application development across a variety of industries including healthcare, agriculture, manufacturing and retail. Unsurprisingly, this excitement is mirrored in VC investment dollars, with a 140% growth in funding over 2015, bringing the total amount invested this past year to $1.8 Bn. This shows a strong trajectory for more development across gaming and commercial applications in AR / VR as we move into 2017.

7. Robotic market will expand to new areas in 2016. From chatbots being introduced by many companies for interacting with customers, to a giant fighting robot (16 foot tall, 20,000 pounds) that can lift and throw a car, to robots for making pizzas, to robots that help educate kids, 2016 was a year of enormous expansion in the robotics market.

8. A new generation of automated functionality will begin to be added to cars. In 2016 autonomous cars moved from concept to closer to reality. To date, the technology leaders appeared to be Tesla and Google, the former building a fully integrated product, the latter a set of components that can be integrated into many different vehicles. Tesla, who appears to be furthest along in putting a fully autonomous car on the road in volume, added more components (software and sensors) to its autonomous technology but suffered a setback when a driver ignored Tesla requirements to “supervise” the autonomous driving and suffered a fatal accident. Autonomous cars took many steps forward in 2016 as additional companies entered the fray. Uber, a company that has much to gain from driverless cars (like eliminating the need for its over 1 million drivers), began an experiment in Pittsburg to offer driverless cars (supervised by an actual person in the driver’s seat) as part of its service. These cars are being manufactured in a partnership with Volvo using technology created by Carnegie Robotics (who’s founder was one of the creators of the Google technology). Uber also acquired Otto, a startup focused on driverless trucks, to gain further technology. In August, Ford announced its intent to bring an autonomous car to market by 2021. Audi just announced a partnership with Nvidia to bring an autonomous car to the road by 2020-21. Toyota, Chrysler and others have also announced intent to create such a vehicle. While I believe that the actual mass usage of driverless cars will be further out then 2021, we seem to be close to a breakout of “supervised automated vehicles”.

9. The Internet of Things will expand further into kitchen appliances and will start being adopted by the average consumer. In the past 12 months Samsung, LG, GE and others have launched numerous smart refrigerators. These can now be thought of as devices that can connect to a smart phone through an app. The user can receive alerts like ‘a water filter needs replacing’ or ‘the door was left open’. Some have digital bulletin boards on the fridges, other features can let you know when various items stored in the fridge are running low, and still more features can be deployed to control functionality (change temperature, etc). The adoption of these devices has reached sufficient levels for them to be carried in mainstream stores like Best Buy.

10. Amazon will move to profitability on their book subscription service and improve cloud capex. Amazon did indeed make three major shifts in its book subscription strategy. First, it significantly reduced payouts to publishers for their books that were downloaded; second, it reduced the proportion of third party published books offered to subscribers to the service and third it reduced the amount it pays their own authors. While Amazon does not report these numbers, I believe this combination has reduced the cost to Amazon by over 50% and has made the service profitable. The gross margin before stock based compensation for Amazon’s cloud service increased year over year in Q3 (last reported quarter) from 27.1% in 2015 to 31.6% in 2016.

 

While it wasn’t in my Top 10 post for 2016, I did predict that Kevin Durant would sign with the Warriors as he would fit right in and improve his chances of winning championships. He has signed, seems to fit in well, but we’ll have to wait to see if the championships follow.

I’ll be making my 2017 picks within the next week.

Top 10 Predictions for 2016

In my forecast of 2015 trends I wrote:

 “I’ve been very lucky to have a history of correctly predicting trends, especially in identifying stocks that would outperform. I say lucky because even assuming one gets the analysis right, the prediction can still be wrong due to poor management execution and/or unforeseen events. Last year I highlighted 10 trends that would occur in 2014 and I’m pleased that each proved accurate (see 2014 Predictions). Rather than pat myself on the back for past performance, my high-risk, A-type personality makes me go back into the fray for 2015. Last year’s highlighted stocks, Tesla and Facebook, were up 48% and 43%, respectively, from January 3 to December 31, 2014 vs. 15% for the Nasdaq and under 13% for the S&P 500. This year, I’ll identify more than two stocks to watch as I am probably over-confident due to past success. But because I’m not doing the level of work that I did on Wall Street, there is significant risk in assuming I’m correct.”

As I discussed in the last post I got even luckier in 2015 as my highlighted four stocks had average appreciation of 86% while the broader market was nearly flat. As we saw with the Golden State Warriors on December 12th, all winning streaks have to come to an end so bearing that in mind, I wanted to start with a more general discussion of 5 stocks and why I chose to highlight three and back off of two others (despite still liking their stories). The two stocks that I recommended last year that I’m not putting on the list again are Netflix and Amazon. The rationale is quite simple: neither is at the same compelling price that it was a year ago. Netflix stock, as of today, is up over 100% year/year while its revenue increase is under 25% and profit margins shrank. This means that the price-to-revenue and price-to-earnings multiple of its stock is about twice what it was a year ago. So, while I continue to like the long term fundamentals, the value that was there a year ago is not there today. Amazon is a similar story. Its stock is currently up over 100% year-over-year but revenue and profit growth for 2015 was likely around 20%. Again, I continue to believe in the long term story, but at this share price, it will need to grow 20% per year for three more years for the stock value to be what it was a year ago.

My two other highlighted stocks from last year are Facebook and Tesla. At today’s prices they are each at a lower price-to-revenue multiple than a year ago (that is, their stocks appreciated at a slower pace than revenue growth). But, in both cases, the fundamentals remain strong for another solid growth year (more below on these) and I would expect each to outpace the market. I’ll discuss my final (riskiest) stock pick below.

In each of my stock picks, I’m expecting the stocks to outperform the market. I don’t have a forecast of how the market will perform so in a steeply declining market, out performance might occur with the stock itself being down (but less than the market). So consider yourself forewarned on a number of accounts.

We’ll start with the three stock picks and then move on to the remainder of my 10 predictions.

  1. Facebook stock appreciation will continue to outpace the market (it is currently at $97/share). Most of the commerce companies in the Azure portfolio continue to find Facebook the most compelling place to advertise. Now many of the very large brands are moving more budget to Facebook as well. This shift to online and mobile marketing still has a long way to go and we expect Facebook revenue growth to remain very strong. In addition, Facebook has begun to ramp the monetization of other properties, particularly Instagram. If we start to see real momentum in monetization of Instagram, the market will likely react very positively as it exposes another growth engine. Finally, with the Oculus release early this year, we may see evidence that Facebook will become the early leader in the emerging virtual reality space (which was one of the hits at CES this year).
  1. Tesla stock appreciation will continue to outpace the market (it is currently at $193/share). Last year Tesla grew revenues an estimated 30%+ but order growth far exceeded that as the company remains supply constrained. The good news is that revenue growth in 2016 should continue at a very high level (perhaps higher than 30% year-over-year) and the stock’s price-to-revenue multiple is lower than a year ago. The new Model X has a very significant backlog (I’ve seen estimates as high as 25,000-30,000 vehicles). Since this would be incremental to Model S sales, growth could accelerate once capacity ramps. Additionally, both service revenue and sales of used Teslas are increasing as well. When this is added to distribution expansion, Tesla appears to have 2-3 years of solid revenue growth locked in. I’m not sure when the low priced vehicle will be announced (it is supposed to be in 2017) but a more modest price point for one of its models could increase demand exponentially.
  1. GoPro stock appreciation should outpace the market in 2016 (shares are currently at $10.86). On the surface this may appear my riskiest prediction but there are solid reasons for my thoughts here. I believe investors are mistakenly comparing GoPro to a number of tech high fliers that collapsed due to valuations based on “air”. GoPro is far from that. In fact, I believe it is now a “value” play. To begin, unlike many tech high fliers, GoPro is profitable and generates positive cash flow. Its current book value is over $6 per share (of which $3.73 is cash with no debt). It is trading at less than 1x revenue and about 15x 2016 earnings estimates. Despite the announced shortfall expected in q4 and a number of downward revisions, revenue should still be up about 15% in 2015. While the current version of its camera has failed to meet expectations (and competition is increasing), the brand is still the leader in its space (action video). If new camera offerings advance the technology, this could help GoPro resume growth in the video arena. The brand can also be used to create leverage in new arenas. The three that the company has targeted are: content, drones and virtual reality. Of the three, I would significantly discount their ability to create a large content revenue stream and believe virtual reality products may prove difficult (and even if successful, will take multiple years to be meaningful). However, the company is very well positioned to earn a reasonable share in the UAV/drone market (which was about $1.5B last year and could grow 50-100% in 2016). The primary use of drones today is for photography and video and the majority of the ones we saw at CES were outfitted with a GoPro camera. Given the GoPro brand and distribution around action video, I believe that, if they are able to launch a credible product by mid-year, the company will be well positioned to experience reasonable growth in H2 2016 and the shares should react well.

The remaining predictions revolve around industry trends rather than stocks:

  1. UAV/Drones will continue to increase in popularity. In 2015, the worldwide drone market reached about $1.5B and there is no sign of slowing growth. When I think about whether trends will continue, I base my analysis on whether there are valuable use cases. In the case of drones there are innumerable ones. We’ll save the detailed explanation for a full post but I’ll list several here:
    1. Photography: this is a major use case for both consumers and professionals, namely being able to get overhead views of terrain either in photos or in video.
    2. Security: as an offshoot of photography, drones offer the potential of having continuous monitoring of terrain from an aerial view. This enables intrusion detection, monitoring, and tracking.
    3. Delivery: although current drones are not yet able to carry significant payloads, they are close to having the ability to follow a flight path, drop off a small package and then return. As innovations in UAV hardware and battery technology continue, delivery will become more of a reality in the future (which companies like Amazon, Google and others are counting on). This will also require some type of monitoring of airspace for drones to prevent crashes.
    4. Consumer: consumers will purchase drones in droves not only for the simple pleasure of flying them but also for various types of competitions including racing, battling and obstacles.
  1. Political spend will reach record levels in 2016 and have a positive impact on advertising revenue. Political advertising is expected to reach a record $11.4 billion in 2016, up 20% from the previous presidential election year. While the bulk of spending is forecast to go to TV, 2016 will be the first election year in which digital ad spending will exceed $1 billion (and if the candidates are savvy may be even higher). Adding 2015 spending, total political advertising in this election cycle could total $16.5 billion or more. About 50% of the total spending typically goes for the national election and the other half to backing candidates and issues in local races. During the 2015-16 election cycle, $8.5 billion is expected to be spent on broadcast TV, with $5.5 billion coming from national races and $3.1 billion spent on state and local contests. Cable TV is forecast to see $1.5 billion in spending, with $738 million coming from the national contest and $729 million from local races. Online and digital spending is forecast to total $1.1 billion, with $665 million going for national races and $424 million spent on local contests.[1]
  1. Virtual/Augmented Reality will have a big year in 2016: With the general release of Oculus expected in 2016, we will see an emergence of companies developing content and use cases in virtual reality. Expect to see the early beginnings of mainstream adoption of virtual reality applications. In addition, augmented reality products were heavily on display at CES and we think they will begin to ramp as an alternative to virtual reality. Both virtual reality and augmented reality are similar in that they both immerse the user but with AR, users continue to be in touch with the real world while interacting with virtual objects. With VR, the user is isolated from the real world. For now, expect VR to remain focused on entertainment and gaming while AR has broader applications in commercial use (i.e., real estate, architecture, training, education) as well as personal use.
  1. Robotic market will expand to new areas in 2016: Outside of science fiction, robots have made only minimal progress to date in generating interesting products that begin to drive commercial acceptance (outside of carpet cleaning, i.e. the Rumba). This year could mark a change in that. First, carpet cleaning robots will expand to window cleaning, bathtub cleaning and more. Second, robots will be deployed much more generally for commercial applications (like they already are in the Tesla factory). And we will also see much more progress in the consumer entertainment applications highlighted by the emergence of actual giant robots that stage a monumental battle akin to ones previously only created visually in movies.
  2. A new generation of automated functionality will begin to be added to cars. Tesla has led the way for this and already has a fully automated car on the market. Others are now attempting to follow and perhaps even surpass Tesla in functionality. In addition to the automation of driving, the computerization of the automobile has led to the ability to improve other capabilities. One demonstration I saw at CES was from a company called Telenav. They gave a proof of concept demonstration of a next gen GPS. Their demonstration (of a product expected to launch in Q2 or Q3) showed a far more functional GPS with features like giving the driver alternate routes when there are traffic problems regardless of whether route guidance is on as it determined where the driver was going based on tracking driving habits by day of the week. Their system will also help you buy a cup of coffee in route, incorporate messaging with an iPhone (with the drivers voice converted to text on the phone and vice versa) for communicating with someone you’re picking up, helping you find a garage with available spots, etc. all through the normal interface. Telenav is working as an OEM to various auto manufacturers and others like Bosch are doing the same. And, of course, several of the car manufacturers are trying to do this themselves (which we believe will lead to inferior systems).
  3. The Internet of Things will further expand into kitchen appliances and will start being adopted by the average consumer. We’re going to see the launches of smart refrigerators, smart washing machines, ovens, etc. Earlier this month, Samsung released its new Family Hub refrigerator which uses three high quality cameras inside the fridge to manage groceries, identify foods you have or need, and track product expiration dates to cut down on waste. It also has a screen on its door that can interface with other devices (like an iphone) to find and display the current days schedule for each member of the household, keep a shopping list and more.
  4. Amazon will move to profitability on their book subscription service and also improve cloud capex. Amazon launched its book subscription service with rapid customer acquisition in mind. Publishers were incentivized to include their titles as the company would pay the full price for each book downloaded once a portion of it was read. This meant that Amazon was paying out far more money than it was taking in. We believe Amazon has gone back to publishers with a new offering that has a much more Amazon-favored revenue share which results in the service moving from highly unprofitable to profitable overnight. The Amazon cloud has reached a level of maturity where we believe the cash needed for Capex is now a much smaller portion of revenue which in turn should improve Amazon cash flow and profitability.

 

 

 

 

[1] http://www.broadcastingcable.com/news/currency/political-ad-spending-hit-114b-2016/143445

Top 10 Predictions for 2015

I’ve been very lucky to have a history of correctly predicting trends, especially in identifying stocks that would outperform. I say lucky because even assuming one gets the analysis right, the prediction can still be wrong due to poor management execution and/or unforeseen events. Last year I highlighted 10 trends that would occur in 2014 and I’m pleased that each proved accurate (see 2014 Predictions). Rather than pat myself on the back for past performance, my high-risk, A-type personality makes me go back into the fray for 2015. Last year’s highlighted stocks, Tesla and Facebook, were up 48% and 43%, respectively, from January 3 to December 31, 2014 vs. 15% for the Nasdaq and under 13% for the S&P 500. This year, I’ll identify more than two stocks to watch as I am probably over-confident due to past success. But because I’m not doing the level of work that I did on Wall Street, there is significant risk in assuming I’m correct.

So consider yourself forewarned.

  1. Facebook will have a strong 2015. I have not sold my Facebook shares (I’m up over 3x since acquiring them in mid-2013). Momentum appears just as solid as it did a year ago and revenue and earnings multiples have contracted. In 2014, revenue grew over 60% and earnings per share nearly 100% (using analyst estimates for Q4) vs the share price increase of 43%. Beware that high growth stocks can go through periods of multiple contraction, but Facebook ($75/share) seems well positioned to continue to see revenue surge and EPS increase even faster.
  1. Tesla should have another good year in 2015. I continue to hold my stock and think it will perform well despite expecting numerous wild gyrations ($192/share). Because the SUV launch has been delayed to 2016, revenue growth could taper off from the approximately 75% in 2014 (using analyst Q4 estimates). Investors could fear that lower gas prices will impact people’s desire for an all-electric car. But, do you believe customers paying $90,000 for a Tesla are doing so to save on fuel? I don’t. Tesla sales will be helped by: increasing distribution, more locations to charge one’s car (reducing one of the biggest buying inhibitors), more knowledge of the car, increasing awareness of its relative price attractiveness given the new $136,000 BMW I8 high-end sports hybrid and continued governmental incentives to buy an electric vehicle.
  1. Amazon should rebound in 2015. Last year the stock was down over 22% for a variety of short-term reasons. Amazon 2014 revenue is expected to be about 20% over 2013 revenue. Its competitive advantages in retail, if anything, improved as its local delivery capabilities continued to dominate competition (we expect Amazon to leverage this further by opening showrooms/ordering centers in several cities in 2015) and Amazon Prime service saw further and further adoption. But, 2014 was a year of substantial investment and this hurt the stock ($288/share). Such investment stimulating increased market share has occurred before and the stock typically bounces back subsequently. While it doesn’t have the growth dynamics of Facebook or Tesla and I don’t own the stock yet, I believe it is worth considering for any portfolio.
  1. Netflix power in the industry should increase in 2015. Like HBO before it, Netflix’ superior economics provides the opportunity to create more of its own proprietary content. It also may see more opportunity to launch movies online simultaneous to their launch in theaters – the success of The Interview could help drive this trend and no one is better positioned than Netflix to exploit it. After peaking mid-year at $480/share, the stock closed 2014 slightly down from a year earlier and is now at $332.
  1. Azure portfolio company, Yik Yak, will continue to emerge as the next important social network. This will cause a number of entrenched competitors to modify their products to try to slow Yik Yak growth. The most vulnerable public entity is Twitter as Yik Yak is the next, more modern version of Twitter. Given Twitter’s large user base, this will not likely affect its stock in 2015, but it is something to monitor.
  1. Curated Commerce will continue to emerge. This trend was one we forecast in last year’s blog and appears to have solid resonance. A number of startups in the category saw valuations rise to $300M – $1B including Honest Company, Birchbox, Stitchfix, and Dollar Shave Club. There is more to come as many shoppers want a better shopping experience from etailers. To date, most web shopping starts with knowing what item one wants to buy rather than “browsing”. The best brick and mortar retailers create a shopping experience by stocking items that are pleasing to those that visit their store. Most of us know people that prefer shopping in a particular store due to this experience. This trend is emerging on the web and will continue in 2015. At Azure, we continue to believe in this model and made investments into Julep, Le Tote, The Bouqs and Filter Easy in 2014.
  1. Wearable activity will slow. With the exception of the iWatch which is expected to release in early 2015, the hype around wearable devices will be more muted. Fitness trackers, wearable cameras, smart watches, heart rate monitors, and GPS tracking devices will largely be replaced by phone or watch-based apps. An early indication of this trend was an October 2014 report that claimed Apple had plans to remove Fitbit products from its physical retail stores. 
  1. Robotics will continue to make further inroads with products that provide value. Specifically, the commercial use of UAVs and drones will continue to accelerate. The recent FAA issuance of permits to use drones to monitor crops and photograph properties for sale is an initial first step in a broader application of UAVs. Companies involved in infrastructure and software related to UAVs will continue to attract more interest. 
  1. Part-time employees and replacing people with technology will continue to be a larger part of the work force. The Affordable care Act and increasing minimum wages will each be a force in driving this trend.
  1. 3D printers will be increasingly used in smaller batch and custom manufacturing.

Soundbytes.

  • Switched to an iPhone from Blackberry and while this may sound prehistoric, I will miss many of the efficiencies of a Blackberry that the iPhone lacks; but I had to change because the iPhone is so much better for online, graphics and had apps I felt were mandatory and it made more sense to switch than to buy the newest Blackberry.
  • Wanted to put a stake in the ground predicting the Cavaliers will have a much better second half of the season assuming LeBron is healthy.