Alphabet Soup: Google is Alpha, but where are the Bets?

In my last two posts, I looked first at the turn in the market against the FANG stocks, largely precipitated by the Facebook user data fiasco and then at the effect of the blowback on Facebook's value. I concluded that notwithstanding the likely negative consequences for the company, which include more muted revenue growth, higher costs (lower margins) and potential fines, Facebook looks like a good investment, with a value about 10% higher than its prevailing price. I argued that changes are coming from both outside (regulators and legislation) and inside (to protect data better), and these changes are unlikely to be just directed at Facebook. It is this perception that has probably led the market to mark down other companies that have built business models around user/subscriber data and in these next posts, I would like to look at the rest of the stocks in the FANG bundle and the consequences for their valuations, starting with Google in this one.

The One Number

The value of a company is driven by a myriad of variables that encompass growth, risk and cash flows, which are the drivers of value. In a typical intrinsic valuation, there are dozens of inputs that drive value but there is one variable, that more than any other, drives value and it is critical to identify that variable early in the valuation process for three reasons:

1. Information Focus: We live in a world where we drown in data and opinion about companies and unfocused data collection can often leave you more confused about the value of a company, rather than less. Knowing the key value driver allows you to focus your information collection around that variable, rather than get distracted by the other inputs into value.
2. Management Questions: If you have the opportunity to question management, your questions can then also be directed at the key variable and what management is doing to deliver on that variable. 
3. Disclosure Tracking: If you are invested in a company and are tracking how it is performing, relative to your expectations, it is again easy in today's markets to get lost in the earnings report frenzy and the voluminous disclosures from companies. Having a focus allows you to zero in on the parts of the earnings report that are most relevant to value.

In short, knowing what you are looking for makes it much more likely that you will find it. But how do you identify the key driver variable? In my template, I look for two characteristics:

1. Big Value Effects: Changing your key driver variable should have large effects on the value that you estimate for a business. One of the benefits of asking what-if questions about the inputs into a valuation is that it can allow you to gauge this effect. 
2. Uncertainty about Input: If an input has large effects on value, but you feel confident about it, it is not a driver variable. Conversely, if you have made an estimate of input and are uncertain about that number, because it can change either due to management decisions or because of external forces, it is more likely to be a driver input.

If you accept this characterization, there are two implications that emerge. The first is that the key value driver can and will be different for different companies; a mechanistic focus on the same input variable with every company that you value will lead you astray. The second is that there is a subjective component to your choice, and the key value driver that I identify for a company can be different from the one you choose for the same company, reflecting perhaps the different stories that we may be telling in our valuations. In my just-posted Facebook valuation, I believe that the key variable is the cost that Facebook will face to fix its data privacy problems and it manifests itself in my forecasted operating margin, which I project to fall from almost 58% down to 42%, in the next five years. Note that revenue growth may have a bigger impact on value, but in my judgement, it is the operating margin that I am most uncertain about. I will use this post to value Google and highlight what I believe is the driver variable for the company.

The Alphabet Story

If Facebook is the wunderkind that has shaken up the online advertising business, Google is the original disruptor of this business and is by far the biggest player in that game today. It is ironic that the disruptor has become the status quo, but until there is another disruption, it is Google's targeted advertising model, in world, and its search engine and ad words that dominate this business. Google has had fewer brushes with controversy, with its data, than Facebook, partly because its data collection occurs across multiple platforms and is less visible and partly because it does have a tighter rein on its data. 

1. A Short History

Google has been a rule breaker, right from its beginnings as a publicly traded company. It used a Dutch auction process for its initial public offering, rather than the more conventional bank-backed offer pricing model, and while it has had a few stumbles, its ascent has been steep:

The secrets to its success are neither hard to find, nor unusual. The company has been able to scale up revenues, while preserving its operating margins:

The most impressive feature of Google's operations has been its ability to maintain consistent revenue growth rates and operating margins since 2008, even as the firm more than quadrupled its revenues.

2. The State of the Game

To value Google, we start with the numbers, but in order to build a story we have to assess the landscape that Google faces.

1. A Duopoly: The advertising business, in general, and the digital advertising business, in particular, are becoming a duopoly. In 2017, the total spent on advertising globally was $584 billion, with digital advertising accounting for $228.4 billion. Google's market share in 2017 was 42.2%, and Facebook's market share was 20.9%. Even more ominously for the rest of their competitors, they got bigger during the year, accounting for almost 84% of the increase in digital advertising during the course of the year.
2. Google is everywhere: Google's hold on the game starts with its search engine, but has been enriched by its other products, Gmail, with more than a billion users, YouTube, which dominates the online video space and Android, the dominant smart phone operating system. If you add to this Google Maps, Google shared documents and Google Home products, the company is everywhere that you are, and is harvesting information about you at each step. During the last week, a New York Times reporter downloaded the data that Facebook had on him and while what he found disturbed him, both in terms of magnitude and type, he found that Google had far more data on him than Facebook did.
3. Alphabet is still mostly alpha, very little bet: While Google's decision to rename itself Alphabet was motivated by a desire to let it's non-advertising businesses grow, the numbers, at least so far, indicate limited progress. In fact, if there is growth it has so far come from the apps, cloud and hardware portion of Google, rather than the bets themselves, but Nest (home automation), Waymo (driverless cars), Verily (life sciences) and Google Fiber (broadband internet) are options that may (or may) not pay off big time.

Google 2017 10K

The bottom line is that Google has changed the advertising business  and dominates it, with Facebook representing its only serious competition. It's large market share should act as a check on its growth, but Google has been able to sustain double digit growth by growing the digital portion of the advertising business and claiming the lion's share of that growth, again with Facebook. The wild  card is whether the data privacy restrictions and regulations that are coming will crimp one or both companies in their pursuit of ad revenues. As digital advertising starts to level off, Google will have to look to its other businesses to provide it a boost.

3. The Valuation

As with Facebook, I was a doubter on the scalability of the Google story, but it has proved me wrong, over and over again. In valuing Google, I will assume that it will continue to grow, but I set the revenue growth rate at 12% for the next five years, below the 15% growth rate registered in the last five, for two reasons. The first is that digital advertising's rise has started to slow, simply because it is now such a large part of the overall advertising market. The second is that data privacy restrictions, if restrictive, will take away one of Google's network benefits. I do think that the profitability of Google's businesses will stay intact over time, with operating margins staying at the 27.87% recorded in 2017. With those key assumptions, I value Google at $970, close to the price of $1030 that it was trading at on April 13.

Download spreadsheet

As with my Facebook valuation, each of my key inputs is estimated with error, and capturing that uncertainty in distributions yields the following outcomes:

Crystal Ball used in simulation

No surprises here. The median value is about $957 and at a stock price of $1.030, there is a 65% chance that the stock is over valued. As with Facebook, there is a positive skew in the outcomes, and that skew will get only more positive, if you build in a bigger payoff from one of the bets. 

4. The Value Driver

Google's value is driven by revenue growth and operating margins, and changing one or both inputs has a significant effect on value. 

The shaded cells represent the combinations that deliver values higher than the prevailing stock price of $1,030/share. In my judgment, Alphabet's bigger value driver is revenue growth, not margins, and it is on that input, this valuation will rise of fall. It is my view that while data privacy restrictions will translate into much higher costs for Facebook, partly because it has so little structure currently, it will result in lower growth for Alphabet. If the data privacy restrictions handicap Google so badly that it loses a big part of what has allowed it to dominate digital advertising for the next five years, Google's revenue growth and value will drop dramatically. However, Google is just starting to tap the potential in YouTube, and if it is able to position it as a competitor to Spotify, in music streaming, and Netflix, in video streaming, it could discover a new source of revenue growth, with strong operating margins.

5. The Google Bets
The least substantive part of Alphabet, at least in the numbers, is also its most intriguing from a value standpoint, and that is its investment in the other businesses, comprising the "bet" in Alphabet. Google has spent billions on Waymo, Verily and Nest, three of its higher profile other businesses, and while Waymo and Nest have received considerable public attention, they don't have much in revenues, and lots of losses to show for it. There are three views that one can bring to the Google bets, and which one you adopt will determine in large part, whether you will be tilted towards buy-ing Google:

1. Founder Playthings: The most cynical view is that the billions invested in these businesses are not meant to make money, but instead were directed by founder interests in electric cars, health care technology and home automation. Those who take this view will likely point to Google Glasses, an expensive and ill-fated experiment that ended badly and to the effusive support from Brin and Page for these businesses. If you buy into this this view, not only will these businesses not add value to Alphabet, they will continue to drain value from the company, because of the spending that goes with them.
2. Early Life, Big Market Businesses: The second and more optimistic view is that the Google bets should be viewed more as start-ups in potentially big markets, with industry-leading innovation. This is especially the case with Waymo, which if not at the cutting edge of the driverless car business is very close to it, and if successful, could be an entree into not just the driverless car market but also into ride sharing and car service. You could build business models for Waymo, Verily, Nest and Google Fiber that would resemble the models used to value young start-ups, with a bonus of access to Alphabet capital to survive for long periods, and add this value to the advertising business that remains Google's cash cow.
3. Real Options: The third view, which splits the difference, is that while the bet businesses represent potential, that potential is not only far in the future, but may never materialize, either because of the evolution of technology, regulation or market demand. Thus, driverless cars may never quite make it into the mainstream, either because customers don't trust them or they turn out to be too risky. With this view, you can argue that the Google bets are out-of-the-money options, and since the value of an option is determined by potential revenues and uncertainty about those revenues, they are valuable, even though only one of the bets may pay off and the others will have to be written off.

In my valuation of Alphabet, I have implicitly assumed that the company will continue to spend billions in its bets, by leaving the margin at existing levels; remember that the operating margin of 27.87% is after the company's spending on its bet businesses. By not explicitly giving credit for the revenues that the bet businesses will create, it may seem like I am taking the cynical view of these businesses as playthings, but I am not. Much as I dislike the corporate governance ethos that Brin and Page have brought to Google, and helped to proliferate across the new tech sector with their dicing and slicing of voting rights, I don't see them as individuals who would spend billions on expensive toys. That said, I do think that trying to build business models from scratch, to value Waymo, Verily and Nest is difficult to do right now, given that the markets that they are going after all still in flux. I believe that these investments are options and valuable ones at that, but I will make that claim based upon their underlying characteristics (high variance, big markets) rather than with explicit option pricing models. As an investor, looking at Alphabet, here is how it plays out in my investment decision. My intrinsic valuation for Alphabet is $968, within shouting distance of the company's stock price, and I believe that there is enough option value in the bets, that if the stock is fairly or even under valued at its current price. While I am not yet inclined to buy, I have a limit buy order on the stock, that I had initially set at $950, but have moved up to $1000 after my bet assessment, and I, like many of you, will be watching the market reaction to the Alphabet earnings report on Monday. Perverse though it may sound, I am hoping that there are enough negative surprises in it to cause a price drop that would make my limit buy execute, but if not, it will stay it in place. 

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Data Links

1. Google Valuation - April 2018

Blog Posts on Tech Takedown

1. Come easy, go easy: The Tech Takedown!
2. Facebook: Friendless, But Still Formidable!
3. Netflix: The Future of Entertainment or House of Cards?
4. Alphabet Soup: Google is Alpha, but where are the Bets?
5. Amazon: Glimpses of Shoeless Joe!

The Facebook Feeding Frenzy: Time for a Pause!

In my last post, I noted that the FANG stocks have been in the spotlight, as tech has taken a beating in the market, but it is Facebook that is at the center of the storm. It was the news story on Cambridge Analytica's misuse of Facebook user data,  in mid-March of 2018, that started the ball rolling and in the days since, not only have more unpleasant details emerged about Facebook's culpability, but the rest of the world seems to have decided to unfriend Facebook. More ominously, regulators and politicians have also turned their attention to the company and that attention will be heightened, with Zuckerberg testifying in front of Congress. That is a precipitous fall from grace for a company that only a short while ago epitomized the new economy.

A Personal Odyssey

My interest in Facebook dates back to the year before it went public, when it was already getting attention because of its giant user base and its high private company valuation. In the weeks leading up to its IPO, I valued Facebook at about $29/share, with a story built around it becoming a Google wannabe. If that sounded insulting, it was not meant to be, since having a revenue path and operating margins that mimicked the most successful tech companies in the decade prior is quite a feat.

That initial public offering was among the most mismanaged in recent years and a combination of hubris and poor timing led to an offering day fiasco, where the investment bankers had to step in to support the priced. The first few months after the offering were tough ones for Facebook, with the stock dropping to $19 by September 2012, when I argued that it was time to befriend the company and buy its stock, one of the few times in my life when I have bought a stock at its absolute low.

Much as I would like to tell you that I had the foresight to see Facebook's rise from 2012 through 2017 and that I held on to the stock, I did not, and I sold the stock just as it got to $50, concerned that the advertising business was not big enough to accommodate the players (Google, the social media companies and traditional advertising companies), elbowing for market share. I under estimated how much Google and Facebook would both expand the market and dominate it, but I have no regrets about selling too early. I did what I felt was right, given my assessment and investment philosophy, at the time.

A Numbers Update

To undersand how Facebook became the company that it is today, let's start with its most impressive numbers, which are related to its user base. At the start of 2018, Facebook had more than 2.1 billion users, about 30% of the world's population:

While the user numbers have leveled off in North America, where Facebook already counts 72.5% of the population in its user base, the company continues to grow its user base in the rest of the world, with an added impetus coming from the scaling up of Instagram, Facebook's video arm. These user numbers, while staggering, are made even more so when you consider how much time Facebook users spend on its platforms:

Collectively, users spent more than an hour a day on Facebook platforms, and that usage does not reflect the time spent on WhatsApp, also owned by Facebook, by its 1.5 billion users.

If you are a value investor, it would easy to dismiss Facebook as another user-chasing tech company and deliver a cutting remark that you cannot pay dividends with users, but Facebook is an exception. It has managed to to convert its user base into revenues and more critically, operating profits.

With its operating margin approaching 58%, if you capitalize its technology and content costs, Facebook outshines most of the other companies in the S&P 500, in both growth and profitability:

What makes Facebook's rise even more impressive is that it has been able to deliver these results in a market, where it faces an equally voracious competitor in Google.

In summary, Facebook has had perhaps the most productive opening act in history of any publicly listed company, if you define production in operating results. It promised the moon at the time of its IPO, and has delivered the sun. In my book on connecting stories to value, I pointed to Facebook as a company that seemed to find new ways, with each acquisition, announcement and earning report, to expand and broaden its story, first by conquering mobile and then going global. By the start of 2016, I had changed my story for Facebook from a Google Wannabe to one that would eclipse Google, with added potential from its user base. While the Facebook story has been one of business success, the company, its users and investors have been in denial about central elements in the story. Facebook's users have been trading information on themselves to the company in return for a social media site where they can interact with friends, family and acquaintances, and their complaints about lost privacy ring hollow. Facebook's strengths are built upon using the information that users provide about themselves to better target advertising and generate revenues, but Facebook and its investors have been unwilling to face up to the reality that the company's high margins reflect its use of third parties and outsiders to collect and manage data, a business practice that is profitable but that also creates the potential for data leakages. (Some of you seem to be reading into my words an implication that Facebook sells user data to third parties to generate revenues. It does not. It processes the data to make it information (its first competitive advantage), uses that information to better target advertising and generates revenues, as a consequence.)

A Story Break, Twist or Change?

If the Facebook story so far sounds like a fairy tale, there has to be a dark twist, and while Facebook's troubles are often traced back to the stories in mid-March 2018, when the current user scandal news cycle began, its problems have been simmering for much longer. Put on the defensive, after the 2016 US presidential elections, for being a purveyor of fake news, Facebook announced in January 2018, that it had changed its news feed to emphasize user interaction over passive consumption of public news feeds. That change, which led to a leveling off in user numbers and a loss of advertising revenues was not well received on Wall Street, with the stock price dropping almost 5%.

If Facebook was trying to preempt its critics with this announcement, the Cambridge Analytica story has knocked them off stride. Specifically, a whistle blower at Cambridge Analytica claimed that the company has not only accessed detailed user data on 50 million Facebook users but had used that data to target voters in political campaigns. In the three weeks since, the story has worsened for Facebook both in terms of numbers (with accessed users increasing to 87 million) and culpability (with Facebook's sloppiness in protecting user data highlighted). As politicians, commentators and competitors have jumped in to exploit the breach, financial markets knocked off $81 billion from Facebook's market capitalization. It is unquestionable that Facebook is mired in a mess and that it deserves market punishment, but from an investing perspective, the question becomes whether the loss in value is merited or not. 

The worst case scenario, and some have bought into this, is that the company will lose users, both in numbers and intensity, and that advertisers will pull out. If you add large fines and regulatory restrictions on data usage that may cripple Facebook's capacity to use that data in targeted advertising, you have the makings of a perfect storm, playing out as flat or declining revenues, big increases in operating costs and imploding value. In my view, and I may very well be wrong, I think the effects will be more benign:

1. User loss, in numbers and intensity, will be muted: It is still early in this news cycle, and there may be more damaging revelations to come, but I don't believe that anything that has come out so far is  egregious enough to cause large numbers of users to flee. We live in cynical times and many users will probably agree with Mark Snyder, a Facebook user whose data had been accessed by Cambridge Analytica, who is quoted as saying in this New York Times article, "If you sign up for anything and it isn’t immediately obvious how they’re making money, they’re making money off of you.” There is some preliminary evidence that can be gleaned from surveys taken right after the stories broke, which indicate that only about 8% of Facebook users are considering leaving and 19% plan significant cutbacks in usage. If this represents the high water mark, the actual damage will be smaller. I will assume that Facebook's push towards more data protections and its larger base will slow growth in revenues down to about 20% a year, for the next 5 years, from the 51.53% growth rate over the last five years.

   

   Source: Raymond James, reported by Variety

2. Advertisers will mostly stay on: While a few companies, like Mozilla, Pep Boys and Commerzbank, announced that they were pulling their ads from Facebook, there is little evidence that advertisers are abandoning Facebook in droves, since much of what attracted them to Facebook (its large and intense user base and targeting) still remains in place. Facebook, in an attempt to clean up the platform, may impose restrictions on advertisers that may drive some of them away. For instance, last week, Facebook announced that it would stop accepting political advertisements from anonymous entities and I would not be surprised to see more self-imposed restrictions on advertising. I will assume that there will be more defections in the weeks ahead, mostly from companies that don't feel that their Facebook advertising is effective right now, leading to a loss in revenues of $1.5 billion next year.
3. Data restrictions are coming, and will be costly: There is no doubt that data restrictions are coming, with the question being about how restrictive they will be and what it will cost Facebook to implement them. Data privacy laws, modeled on the EU's format, will require the company to hire more people to oversee data collection and protection. I will assume that these actions will push up costs and reduce the pre-tax operating margin from 57%, after capitalizing technology and content costs, to 42% over the next 5 years. Pre-capitalization of technology and content, I am expecting the operating margin to drop from 49.7% (current) to about 37-38%,
4. There will be fines: This is a wild card in this process, with the possibility that the Federal Trade Commission  may impose a fines on the company for violating an agreement reached in 2011, where Facebook agreed to protect user data from unauthorized access. While no one seems to have a clear idea of how much these fines will be, other than that they will be large, there are some who believe that the fines could be as high as a billion dollars. I will assume that the FTC will use Facebook to send a signal to other companies that collect data, by fining it $1 billion.

As I see it, the scandal will lead to lost sales in the near term, slow revenue growth in the coming years and increase costs at the company, making the Facebook story a less attractive one. My estimates of how the story changes will play out in the numbers is shown below:

In summary, the story that I have for Facebook is still an upbeat one, albeit one with lower growth and operating margins. The resulting value is shown below:

Download spreadsheet

The value per share that I obtain, with my story, is abut $181, and on April 3, the date of the valuation, the stock was trading at $155 a share. As always, I am sure that there are inputs where you will disagree with me, and if you do, you can download the spreadsheet and change the numbers that you disagree with. Some of you may be wondering why I have no margin of safety, but as I noted in this post on the topic from a while back, I believe that there are more effective ways of dealing with uncertainty that adopting an arbitrary margin of safety and sitting on the sidelines. In fact, my favored device is to face up to uncertainty frontally in a simulation, shown below:

Simulation run with Crystal Ball, in Excel

This graph reinforces my decision to invest in Facebook. While it is true that there is a 30% chance that the stock is still over valued, there is more upside than downside potential, given my inputs. The median value of $179 is close to my point estimate value, but that should be no surprise since my distributions were centered on my base case assumptions.

Time to Buy?

Every corporate scandal becomes a morality play, and the current one that revolves around Facebook is no exception. Facebook has been sloppy with user data, driven partly by greed (to keep costs down and profits up) and partly by arrogance (that its data protections were sufficient), and is and should be held accountable for its mistakes. That said, I don't see Facebook as a villain, and I don't think that the company should be used as a punching bag for our concerns about politics and society.  I am sure that when Mark Zuckerberg delivers his prepared testimony in a couple of hours, senators from both parties will lecture him on Facebook's sins, blissfully blind to their hypocrisy, since I am sure that many of them have had no qualms about using social media data to target their voters. I hear friends and acquaintances wax eloquent about invasion of privacy and how data is sacred, all too often on their favorite social media platforms, while revealing details about their personal lives that would make Kim Kardashian blush. I am an inactive Facebook user, having posted only once on its platform, but to those who would tar and feather the company for its perceived sins, I will paraphrase Shakespeare, and argue that the fault for our loss of privacy is not in our social media, but in how much we share online. I will invest in Facebook, with neither shame nor apology, because I think it remains a good business that I can buy at a reasonable price.

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Data Links

1. Valuation of Facebook - April 2018

Blog Posts on Tech Takedown

1. Come easy, go easy: The Tech Takedown!
2. Facebook: Friendless, But Still Formidable!
3. Netflix: The Future of Entertainment or House of Cards?
4. Alphabet Soup: Google is Alpha, but where are the Bets?
5. Amazon: Glimpses of Shoeless Joe!

Come easy, go easy: The Tech Takedown!

If there is one thing that I have learned about markets over the years, it is that they have a way of leveling egos and cutting companies and investors down to size. The last three weeks have been humbling ones for tech companies, especially the big four (Facebook, Amazon, Netflix and Alphabet or FANG) which seemed unstoppable in their pursuit of revenues and ever-rising market capitalizations, and for tech investors, many of whom seem to have mistaken luck for skill. Not surprisingly, some of the cheerleaders who were just a short while ago telling us that nothing could go wrong with these companies are in the midst of a mood shift, where they are convinced that nothing can go right with them. As Mark Zuckerberg gets ready to testify to Congress, amidst calls for both regulating and perhaps even breaking up tech companies, it is time to take a sober look at where we stand with these companies, what the last three weeks have changed and the consequences for investment decisions.

The Rise of Facebook, Amazon, Netflix and Google (FANG)

The outsized attention paid to the FANG (Facebook, Amazon, Netflix and Google) stocks sometimes obscures how young these companies are in the public market place. Amazon, a company that I valued as an online, book retailer in 1998, a year after its listing, is the granddaddy of the group. The Google IPO , remembered primarily because of its use of a Dutch auction, instead of a banker, to set its offering price was in 2004, but you probably completely missed the Netflix IPO two years earlier in 2002, and Facebook, the youngest of the four, went public in 2012. The growth in market capitalization at these companies is the stuff of investing legend and the table below shows how they have almost tripled their contribution to the overall market capitalization of the S&P 500 between 2012 and 2017 (with all numbers in billions of US $):

At the end of the 2017, Amazon, Google and Facebook were three of the ten largest market capitalization companies in the world.

The role that the FANG companies have played in driving US equities can be best seen with a different lens, by looking at the total change in the market capitalization of the S&P 500 and how much of that change can be attributed to the rising values of just these four companies:

To add weight to these numbers, consider these facts. The four companies that comprise FANG added almost $1.7 trillion in market capitalization over these five years and accounted for one-sixth of the increase in value for the entire index. Put simply, if you were a large-cap US portfolio manager and you held none of these stocks between 2013-2017, it would have been very, very difficult, if not impossible, to beat the S&P 500 over this period.

A Reversal in Fortunes for the FANG stocks

It is the sustained success of these companies that has made the last few weeks so trying for investors in them and so unsettling for market watchers. While these stocks went through the same ups and downs that the rest of the market was going through in February, it was in the middle of March that they became the central story, with the revelations from Cambridge Analytica, a data analytics and consulting firm, that they had harvested data on about 50 million Facebook users (a number that has since been increased to 87 million) for use in political and commercial campaigns. The political firestorm that followed has not only hurt Facebook, but the other three companies as well, and the graph below chronicles the damage in the days since the news story was released:

The numbers are staggering, at least in absolute terms. Collectively, the FANG stocks  lost $282 billion in market capitalization between March 15 and April 2 and contributed significantly to the drop in US equity markets over that period. To put that in perspective, the market capitalization lost in just these four companies in about two weeks was greater than the total value all crypto currencies (Bitcoin and all its relatives) as of the start of April of 2018, perhaps suggesting that we have been letting ourselves get distracted by penny change, when dollars are at stake. It is also interesting that while much of the attention has been directed at Facebook, which lost 15% of its value in just over two weeks, the three other stocks each lost about 12% of their value.

Speaking of perspective, though, investors in these four stocks should consider another fact before they complain too much about being punished by the market. Even with the losses through April 2 incorporated, the collective market value of these companies remains about $400 billion higher than it was a year ago, on April 3, 2017. 

The bottom line is that two weeks of market pull backs cannot take away from the longer term success at these companies. If this is what failure looks like, I would love to see more of it in my portfolio.

The Fang Story Line

To understand both the rise and recent pullback, let's look at what these four companies have in common. As I see it, here are the salient features:

1. Scaling Success: Each of these companies has been able to keep revenue growing rapidly, even as they scale up and acquire larger market share. In effect, they have been able to deliver small company growth rates, while becoming monoliths.
   
   This success of these companies at delivering high growth, as they have become bigger, have some led some to rethink long-held beliefs about the limits of growth.
2. Bigger Slice of a Bigger Pie: All four of these companies have also been able to change the businesses that they have entered, increasing the size of the total market by attracting new customers, while also changing the way business is run to their benefit. With Google and Facebook, that business is advertising, with Netflix, it is entertainment, and with Amazon, it is just about any business it enters, from retailing to entertainment to cloud services. In each of these businesses, they have not only made the pie bigger but also increased their slice of it, quite a feat!
3. Promise of Profitability: Alphabet and Facebook are money-making machines, with very high profit margins; Facebook's margins are among the highest among large market capitalization companies and Google's are in the top decile.
   
   Amazon has lagged on profitability historically, but it seems to be showing progress in the last few years, and Netflix still struggles to generate decent profit margins. The low margins that these companies show are deceptively low because they are low, after expensing what would be business building or capital expenditures in most other companies - $22.6 billion in technology and content at Amazon and almost $8 billion in content costs at Netflix. 

If, in 2008, you had described the trajectories that these companies would go through, to get to where they are today, I would have given you long odds on it happening. To the question of how they pulled it off, I would point to three factors;

1. Centralized Power: These companies are more corporate dictatorships, than corporate democracies. All four of these companies continue to be run by founder/CEOs, whose visions and narratives have focused these companies; Brin and Page, at Alphabet, Zuckerberg, at Facebook, Bezos at Amazon and Hastings at Netflix, have unchallenged power at these companies, and the only option that shareholders who disagree with them have is to sell and move on. 
2. Big Data: While big data is often a buzz word thrown into conversations where it does not belong, these four companies epitomize how data can be used to create value. In fact, you can argue that what Google learns from our search behavior, Facebook from our social media interactions, Netflix from our video watching choices and Amazon from our shopping carts (and Alexa) is central to these companies being able to scale up successfully and change the businesses they are in. Google and Facebook use what they learn about us to allow companies to target their advertising, Netflix develops content that reflects our watching preferences and Amazon uses our shopping history and Prime membership to run circles around its competitors.
3. Intimidation Factor: There is one final intangible in the mix and that is the perception that these companies have created in regulators, customers and competitors that they are unstoppable. Advertisers facing off against Google and Facebook increasingly settle for crumbs off the table,  convinced that they cannot take on either company frontally, the entertainment business which once viewed Netflix as a nuisance has learned not only to live with the company but has adapted itself to the streaming world and Amazon's entry into almost any business seems to lead to a negative reassessment of the status quo in that business.

In short, if you were an investor in any of these companies until three weeks ago, the story that you would have used to justify holding them would have been that they were juggernauts headed for global domination, and valued accordingly.

Story Break, Recalibration or Tweak?

If you have read my prior posts on valuation, you know that I am a great believer that stories hold together valuations, and that it is changes to stories that change valuation. It is still early, but the question that investors face is whether what has happened in the last three weeks has changed the story dynamics fundamentally at these companies.  At the very minimum, we have at least noticed that the strengths that we noted in the last section come with accompanying weaknesses

1. CEO heads cannot roll: Unlike traditional companies facing crises, where CEOs can be offered by a board of director as a sacrificial offering to calm investors, regulators or politicians, the FANG companies and their CEOs are so intertwined, with power entrenched in the current CEOs, this option is off the table. Even if Mark Zuckerberg performs like Valeant's Michael Pearson did in front of a congressional committee next week, he will still be CEO for the foreseeable future, an advantage that having voting shares and controlling more than 50% of the voting rights gives him.
2. The Dark Side of Sharing: I don't know what we, collectively as users of these companies' products and services, thought they were doing with all of the information that we were sharing so willingly with them, but until the last few weeks, we were able to look the other way and assume that it would be used benevolently. The Facebook fiasco with Cambridge Analytica has pushed some of us out of denial and perhaps into a reassessment of how we share data and how that data is used. It has also created a firestorm about data sharing and privacy that may result in restrictions in how the data gets used.
3. No Friends: When other companies feel threatened by your success and growth, it should come as no surprise that many of them are cheering, as you stumble. From Elon Musk shutting down Tesla's Facebook presence] to Tim Cook castigating Google and Facebook for misusing data, there seems to be a desire to pile on. Musk has far bigger problems at Tesla than it's Facebook page, and Cook should be careful about throwing stones from a glass house, but watching the FANG companies squirm is evoking joy in the boardrooms of its competitors.

So, what now? As I see it, there are three ways to read the tea leaves, with the effects on value ranging from very negative to non-existent.

1. Second Thoughts on Sharing: It is possible that the news stories about how exposed we have left ourselves, as a consequence of our sharing, will lead us to all to reassess how much and how we interact online. That would have significant consequences for all of the FANG stocks, since their scaling success and business models depend upon continued user engagement. 
2. Tempest in a teapot: At the other end of the spectrum, there are some who argue that after the Zuckerberg testimony, the story will blow over and that not only will the companies revert back to their old ways, but that they will continue to accumulate users and grow revenues, while doing so.
3. Data Protections: The third possibility lies somewhere between the first two. While the news stories may have little effect on how people use these companies' products and services, there may be new restrictions on how the data that is collected from their usage is utilized by the companies. That would include not only privacy restrictions, similar to those already in place in the EU, but also regulations on how the data is collected, stored and shared. In addition, the companies themselves may feel pressure to change current business practices, which while profitable, have left data vulnerabilities. 

I don't buy into either of the first two scenarios. I think that we are too far gone down the sharing road to reverse field, and that while we will have a few high profile individuals signal their displeasure by abandoning (or claiming to abandon) a platform, most of us are too attached to Google search, our Facebook friends, watching Black Mirror on Netflix and the convenience of Prime to throw them overboard, because our privacy has been breached. In fact, I would not be surprised if Facebook usage has gone up in the days since the crisis, rather than down. 

I also think that assuming that these stories will pass with no effect is a mistake, since there are changes coming to these firms, from within and without, that will have value consequences. To illustrate, Facebook has already announced that it will stop using data from third party aggregators to supplement its own data in customer targeting, because of data concerns, and I am sure that there are more changes  coming, many of which will increase Facebook's costs and crimp revenue growth, and through those changes, the value that we attach to Facebook. I also believe that you will see more restrictions on the use of data and that these rules will also have an effect on costs, growth and value. Rather than extend this post further, by looking at the impact of these changes, I will be using my next post to update my stories and valuations of Facebook, Amazon, Netflix and Google. If you want a preview, suffice to say that I am back to being a Facebook shareholder, that I am close to becoming a Google shareholder for the first time and that Amazon and Netflix remain out of my reach. 

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Blog Posts on Tech Takedown

1. Come easy, go easy: The Tech Takedown!
2. Facebook: Friendless, But Still Formidable!
3. Netflix: The Future of Entertainment or House of Cards?
4. Alphabet Soup: Google is Alpha, but where are the Bets?
5. Amazon: Glimpses of Shoeless Joe!

The Yahoo! Chronicles! Is this the End Game?

The big news of the day from the tech world comes from Yahoo (I am going to skip the exclamation point through the entire story, but don't read significance into that exclusion), where stories suggest that the board of directors may soon decide whether to sell its operating business, leaving it as a shell company with holdings in two other public companies, Yahoo Japan and Alibaba. The story has resonance for many reasons. One is the presence, as is required in any good story, of a villain, a role that is usually assigned to an activist investor and in this case ably filled by Starboard Value, a fund that has been pushing for this divestiture. The second is the existence of a heroine, albeit a tarnished one, in the form of Marissa Mayer, who was supposed to save the company by boldly moving where Yahoo had not gone before. The third seems to be an almost existential question of whether the  potential end game for Yahoo, a company that many journalists grew up with as part of the technology landscape, is an indication of their own aging.

Stepping back in time

Let's start with a reality check. By the time Marissa Mayer became CEO of Yahoo in 2012, its glory days were well in its past, as you can see in this graph that traces its history from young, start-up to mature (and beyond) in the life cycle:

Not only had Yahoo decisively and permanently lost the search engine fight to Google, but it was a company in search of a mission, with no clear sense of where its future lay. 

Ironically, the two best investments that Yahoo made during the recent past were not in its own operations, but in the other companies, an early one in Yahoo Japan, which prospered even as its US counterpart stumbled, and the other in Alibaba in 2005, a prescient bet on a then-private company. Alibaba's online sites, Taobao and TMall, through which almost 75% of all online retail traffic in China flows, makes it a legitimate and valuable symbol of the China story and it went public late last year to fanfare and a record-breaking market capitalization (for an IPO). I valued Alibaba at the time of its IPO filing and I extended my analysis to include Yahoo, which at the time held 21% of Alibaba. While my valuations need to be updated to reflect what has happened in the last year, the picture that I drew in September 2014, breaking down Yahoo's intrinsic value into its component parts remains largely intact:

Valuation in September 2014

Note that of my estimated value of my total estimated value of $46 billion for the company, less than 10% (about $3.6 billion) comes from Yahoo's operating assets.

The challenge that Ms. Mayer took on was to not only turn around a company that had lost its way in terms of its core business but one that derived most of its value from holdings in two companies that she had no control over. Her history of success at Google and the fact that she was young, attractive and female all played a role in some  choosing her as the anointed one, the savior of Yahoo.

Why Marissa Mayer's quest was always long shot

The odds of Ms. Mayer succeeding at Yahoo, at least in the ways that many of her strongest supporters defined success, were low right from the beginning, for two reasons:

1. It is hard enough to turn around a company but it becomes even harder when you are given control of only the rump of the company. The reality is that, on any given day, the value of Yahoo as a company was more influenced by what Jack Ma did that day at Alibaba, than what Ms. Mayer did at Yahoo.
2. In a post a few months ago, I noted that the tech business is an aging one, and that it is time for us to retire the notion that tech equals growth. I also argued that tech companies age in dog years, relative to companies in other sectors, and that a 20-year old tech company is closer to being geriatric than middle aged. It is for that reason that I give long odds to any aging technology company that tries to rediscover its youth. (I will be doing a follow-up post in a couple of days on my reasoning for why the tech business life cycle is compressed in time.)

Lest I sound fatalistic, it is true that there are counter-examples, aging tech companies that have rediscovered their youth, as evidenced by IBM's rebirth in 1992 and Apple's new start under Steve Jobs. Much as we would like to give Lou Gerstner and Steve Jobs credit for pulling off these miraculous feats, I believe that it was a confluence of events (many of out of the control of either man) that allowed both miracles to happen. The Lou Gerstner turnaround at IBM was aided and abetted by the the tech boom in the 1990s and as for Steve Jobs, the myth of the visionary CEO who could do no wrong has long since overtaken the reality. By promoting both turnarounds as purely CEO triumphs, we set ourselves up for the Yahoo scenario, where a new CEO (Marissa Meyer) is assumed to have the power to turn a company around but we are then disappointed in her failure to do so.  I am less disappointed in Ms. Mayer than many others, since my expectations on what she could do at Yahoo! were much lower, right from the start.

Betting the farm! 

In a recent article in the New York Times, Farhad Manjoo, a writer that I enjoy reading and respect for his tech savvy, made a case that Ms. Mayer's failures can be traced to her lack of boldness at Yahoo, or as he put it, her unwillingness to bet the farm, an ill-suited choice of expressions in many ways, at least for this CEO, and this company. First, as the CEO of a publicly traded company, she would not have been betting her farm, but that of her stockholders. Second, if you buy into the notion of Yahoo the company, as a farm, it is  difficult to bet the farm, when you are given control of only the farmhouse (Yahoo operating assets), as Ms. Mayer was with Yahoo, and the rest of the farm (Yahoo's holdings in Alibaba and Yahoo Japan) is off-limits to you.. Third, betting the farm also connotes seeking out of long odds, in the hope of a big payoff, entirely okay if you are a young start-up, with little to lose, but not so in the case of Yahoo.

Mr. Manjoo is not alone in believing that Marissa Mayer's fault was that she did not make a bigger acquisition or larger investment in some new business (for the most part, unspecified). In fact, it is part of what I termed the Steve Jobs syndrome, where CEOs aspire to be the next Steve Jobs. While some go so far as to don black turtlenecks and strut on the stage like he did, most settle for wanting to be heroic enough during their tenure to have books written about them, and Ashton Kutcher play them on the screen. More dangerous is what follows, since to be like Steve Jobs, you have to make a small company into a really big one, and the way to do that is to take dangerous risks or to "bet the farm". The end results reflect the laws of probability, and the stockholders in these firms end up paying for a CEO's play for celebrity status.

If you accept my thesis that many aging tech companies resemble the Walking Dead, you should also accept the follow-up proposition that what these companies need are not "visionary" CEOs but pragmatic ones, less Steve the visionary, and more Larry the Liquidator, a person with limited ambitions and a readiness to preside over the dismantling of an enterprise. Unfortunately, if you are such a CEO, and your life were made into a movie (odds of which are low), you will be played by  Danny DeVito and not Ashton Kutcher, but there is always a price for doing the right thing. The debate about what Ms. Mayer should or could have done at Yahoo is a subtext to the other great debate  about buybacks at US companies, and especially those at tech titans like IBM and Microsoft. Rather than wringing our hands at how these buybacks are leading to less investment at these companies, we should be relieved that these companies have moved past the denial phase and are dealing with the reality of aging.

What now?

If I were to offer advice to the board, in keeping with the gambling theme created by betting the farm, I would suggest that they listen to this Kenny Rogers tune. It is time get past the denial and sell Yahoo's operating business, while there still is a business to sell, and to get the best possible price on the deal, I would suggest the following:

1. Rather than talk about Yahoo's businesses (their search engine, advertising), which will draw the attention of potential buyers to the operating statistics (which are a downer), talk about the number of Yahoo users (the billion that you have overall and the 250 million who use Yahoo Mail). 
2. Look for a buyer with an ambitious CEO (i.e., with Steve Jobs syndrome) who wants to bet the farm and pay a premium price (using shareholder money) for stardom. Taking a cue from the gambling business, it is much better to be the taker of big bets than the maker of these bets

The cash from that sale and perhaps even the rest of the cash balance should be returned to stockholders, leaving Yahoo as a holding company, with Yahoo! Japan and Alibaba as its holdings. The tax consequences of selling these holdings will be substantial and the board should remove the resulting market discount by announcing its intent to continue to run Yahoo as a holding company, a closed-end fund with two holdings. As a stockholder in Yahoo, I can live with that, since I am getting Alibaba and Yahoo! Japan at a significant discount on their traded value, as can be seen below (even assuming that Yahoo gives away its operating assets for nothing):

	Market Cap	Yahoo's share	Value of holding
Yahoo! Japan (12/4/15)	$23,900	35.00%	$8,365
Alibaba (12/4/15)	$207,500	15.40%	$31,955
			$40,320
+ Yahoo Cash (Sept 2015)			$5,882
- Yahoo Debt (Sept 2015)			$2,161
+ Yahoo Operating Assets			$-
Value of Yahoo Equity			$44,041
Yahoo Market Cap (12/4/15)			$32,390
Discount on holdings			28.90%

Towards the end of my post on Yahoo from last year, I suggested that my returns on Yahoo would be inversely proportional to Ms. Mayer's ambitions and argued that my best case scenario would be one where she scaled the number of employees in the firm down to one (herself) and acquired two computer displays, one of which would deliver real time price quotes on Alibaba and the other the latest price of Yahoo Japan. If the board acts to sell Yahoo's operating assets, we may be closer to that vision than I ever thought I would get.

If this is the end game, I am thankful that, while Ms. Mayer did show flashes of ambition, as revealed in her acquisitions (with the Tumblr deal being the largest)  over the last three years, she did not "bet the farm" on an outlandishly large acquisition or investment. Perhaps, I am giving her more credit than I should, and the only reason she showed restraint is because she could not find a tax advantaged way to get rid of Yahoo's investments in Yahoo Japan and Alibaba. If so, this may be one of the few times that I am thankful to the IRS for not allowing the transaction to go through, since on its completion, Yahoo would have ended up with $20 billion in cash, and I shudder to think of how much damage a "bet the farm" CEO could have done with that money.

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Lead-in Blog Posts

1. The Aging of the Tech Sector
2. Living within our limits: Thoughts on RIM
3. Yahoo! A puzzle, a mystery and an enigma
4. The Walking Dead: Yahoo, Blackberry and the Zombie Apocalypse
5. Rebirth and Reincarnation: Escaping the Corporate Death Spiral

Tech Life Cycle Series

1. The Yahoo Chronicles! is this the end game?
2. Aging in Dog Years? Tech Company Life Cycles (Coming soon)
3. The Compressed Tech Life Cycle: The Manager's Challenge
4. The Compressed Tech Life Cycle: The Investor's Challenge