March 2012 Early Indications I: Financial oddities of tech companies
Three data points start this exploration:
1) According to Thomson Reuters, Apple is moving the entire S&P 500: "the fourth-quarter earnings growth rate for the S&P 500 is running at 8.4%, or 5.3% if Apple’s results are excluded.” Apple, one stock among 500, accounts for 4% of the entire index by market cap and 35% of all earnings growth.
2) Apple alone is larger, by market cap, than the entire materials, telecoms, and utilities sectors of the S&P 500; that single company would be the eighth largest sector of a broad market index. The Dow Jones Industrial Average, a price-weighted basket of 30 stocks that is widely used shorthand for large-cap stock health, can't include Apple (or Google, for that matter) because their over-$500 share prices would skew the DJIA, whose components have an average share price of only $57. That means a 10% slide in one of the Godzillas would be equivalent to a 3M or Alcoa falling off the map. (See Jeff Reeves, "What Would Life Be Like Without Apple?" InvestorPlace, February 28, 2012)
3) Apple, at $542 as I write, has a price/earnings ratio of only 15.5, relatively low for a tech stock with strong growth prospects (the company does, however, have an astonishing $100 billion in cash). For comparison, Salesforce.com has a P/E ratio of 6,431 according to Wolfram Alpha -- it earned 2 cents a share with a stock price greater than $140. More relevantly, Amazon's P/E ratio is a stunning 130, or about 9 times greater than Apple's even though Amazon's prospects intuitively feel riskier, less global, and more limited by physical inventory channels. In contrast, I'm told the Big 3 U.S. automakers all used to trade in a very tight window between 5 and 10 times earnings.
These connected facts raise a number of questions. Among these are some obvious ones: First, how can the DJIA reflect -- in popular discourse, if not among professional money managers -- the U.S. equities market without including such powerful outliers? Second, how long can Apple's run last? Third, what will Apple do with that cash? These are such good questions, I will leave all of them for others to address.
Instead, our concern here will be with the apparently distinctive characteristic of tech companies to be "sectors of one": why is it that IBM and Microsoft (in the past), Google, Apple, and Amazon (in the present), and Facebook (sometime soon) each built a business that for some period had no direct peers?
This isn't a scientific methodology, but in no other sector could I find consistent behavior like that noted above: pharmaceuticals is downright crowded. Airlines are problematic in terms of profitability, but there are still four major domestic carriers plus Southwest. Automaking has the semi-American Big Three, plus major market-share winners from Germany, France, Japan, and Korea. Boeing competes intensely with Airbus, Walmart is counterbalanced by Target, and AT&T has Verizon. NBC, CBS, and ABC were joined by Fox and a plethora of specialty channels. Even after all the mega-mergers, Bank of America is hardly a sector of one. The same goes for ExxonMobil in energy. As a diversified conglomerate, GE encounters Rolls Royce in power generation, Siemens in medical electronics, and a Caterpillar subsidiary in locomotives -- each competitor a heavyweight -- not to mention all manner of financial services companies that duel with GE Capital.
Looking at the present day (Amazon, Apple, Facebook, and Google) plus Microsoft in its period of dominance, it turns out that the companies that are so big and so minimally overlapping have a variety of explanations. There are also some fascinating tidbits that can't be causal but are surely more than coincidence.
1) I'll start with the tidbit, which may not be insignificant. Apple, Microsoft, Amazon, Google, and Facebook all share a common trait: they were led by their founders as CEO or the equivalent for the decisive period in their march to dominance. I think it's also significant that what the companies eventually became known for (with the exception of Facebook, possibly) is not what they set out to do initially. Thus the founders built great companies that successfully navigated paths of sometimes substantial change in both market scale and type.
2) Tech dominance is not synonymous with monopoly: Microsoft was sufficiently monopolistic to attract antitrust litigation; Amazon and Apple are anything but. Google might be an ad monopoly but not a smartphone one; Facebook appears to be headed for monopoly status for some period.
3) Each company navigated the open/closed platform decision successfully. Microsoft gained enormous market share but never built "delightful" devices; Apple locked most everything down but presents a coherent user experience. Google is sort of open with Android but the core search-business moneymaker is a black box. Amazon's inner workings are tightly closed but the cloud operations and retail businesses (including Zappos) exhibit creative innovations in openness. Facebook is a garden with walls even higher than AOL built in its glory years. This point of reference raises a significant question: leaders in one generation rarely lead the next. Sports Illustrated did not found ESPN. Microsoft didn't win search or social networking. Sony succeeded in neither MP3 players nor online music distribution. EA did not build Farmville. AOL was well positioned to build something like Facebook, it would seem.
4) Network effects are key in many tech businesses, and here Facebook and Microsoft are the big winners. Amazon, Apple, and Google benefit somewhat less: if my sister is on Facebook and I'm not, that matters. If she's on Word and I'm not and we want to share documents, it matters. If we have differences with regard to search engines, or Amazon Prime, or iPhones versus Androids, it's not a big deal. Thus the emergence of a dominant company in a sector does not mean that strong network dynamics are necessarily an intrinsic property of the market.
5) User experience is no predictor of dominance. Apple is obviously a star here; Facebook is widely disliked by its users and the mobile experience, in particular, is frustrating. Google's search bar could not be much more straightforward, but its other ventures have not been characterized by the same clean, direct simplicity. Microsoft has never been known to delight its many users: looking for the "start" button to shut the system down is but one example of its counter-intuitive execution.
6) Perhaps related to the fact that founders kept these companies at least somewhat agile (think of Bill Gates' "Pearl Harbor" speech in response to Netscape), few seem to have been driven by the increasingly problematic* pursuit of "shareholder value." Each founder, instead, worked to instantiate a vision of great, breakthrough products rather than to meet quarterly earnings targets. Amazon's Jeff Bezos' actions speak loudly here, frustrating shareholders who want the stock to behave predictably (as a recent Economist article illustrates). In fact, Bezos set expectations in his first annual shareholder letter, which he reprints annually: he openly declared a long-term rather than quarterly focus, so sharebuyer beware. Steve Jobs focused relentlessly on great products, not quarterly numbers. Google's pre-IPO document explicitly told potential shareholders not to expect traditional quarterly guidance on revenue targets, or other shareholder accommodations.
*This may sound heretical, so let me explain. The average share of stock on the New York Stock Exchange used to be held as long as a decade (in the 1930s), but that time is now less than a year. That's an average, and averages are deceiving in information-rich environments. Given the incredible volumes generated by algorithmic trading (in which some firms hold a share for a reported average of 11 seconds), that 1-year figure is essentially meaningless, offset as it is with grandmothers holding stock for decades.
Thus the holding period for a share of stock is getting extremely short, though exactly how short nobody really knows. In addition, shareholding is increasingly indirect: hedge funds, mutual funds, professional money managers, and an individual share-owner all have different expectations of a given equity. As a result, for corporate managers to tie the fate of a company to the buying behaviors of today's markets, measured as they are in seconds or months, not years, makes little sense: few shareholders are betting on the long-term prospects of the company, the way its management, employees, and possibly customers must. The CEOs we're discussing here have that long-term view in mind, and in the process generate substantial stakeholder value for a broader range of people than only the stock-holding entities, whoever they may be at this moment.
What are the preferred ways to create shareholder value? Pay dividends and downsize, in the manner of many private equity investments, now so much in the news. What has made the tech giants great? Retaining earnings and reinvesting profits. Thus the current debate over Apple's cash position serves as a skirmish in this long-running debate. (For some academic context, see William Lazonick and Mary O'Sullivan, "Maximizing shareholder value: a new ideology for corporate governance," Economy and Society, v 29 (2000) pp. 13-35 )
In summary, what are the financial oddities of tech companies?
-Hypergrowth, with hockey sticks seen in no other markets
-The possibility of sectors of one, with no direct competitors
-Resistance to the tenets of the shareholder value school of management
Where might we look for such behavior next? I'll have some suggestions in another newsletter.