Feb 22, 2011

When Elephants Dance

In the tech sector, there's an old saying, "When elephants dance, the mice get trampled." Lately, however, it seems the elephants may be doing more damage to each other-- and their stock prices -- than anything else.

Two weeks ago, Cisco announced weak results and disappointed the market with an uninspiring forecast for the coming quarter.

Perhaps most notably, Cisco's gross margins compressed by 4.3 percentage points from the prior year, suggesting increased competitive pressure in its core networking business plus the impact of lower-margins from some of its acquisitions in set-top boxes (Scientific-Atlanta) and consumer electronics (Flip Video).  The market responded by taking Cisco down 15%

Tonight, after the market close, Hewlett-Packard reported earnings that beat expectations but on weaker-than-expected sales.  In addition, the company's guidance for the coming quarter and full year was clearly below expectations, and the stock promptly sold off by 10-12% in after-market trading.

HP's problems were largely related to soft sales of consumer PCs (as opposed to enterprise sales, which propelled Dell to better than expected results last week) and its services business.  In servers, networking and storage, where it increasingly competes with Cisco, HP enjoyed a boost in both sales and operating profit.

Despite optimistic forecasts for IT spending in 2011, the latest results are highly idiosyncratic, suggesting that a robust and widespread recovery in tech spending may remain elusive for awhile.

Feb 9, 2011

Nokia's Burning Man

In an unusually vivid and candid internal memo, recently installed Nokia CEO, Stephen Elop scolded his colleagues for Nokia's rapid descent from the world's leading supplier to mobile phones to also-ran status in high-end smartphones.

In what may prove to be an unfortunate metaphor*, he compares Nokia's plight to the choice faced by workers on BP's Deepwater Horizon drilling rig who jumped 100 feet into the pitch black Gulf of Mexico rather than burn to death.

"The State of our Company"
Photo credit, US Coast Guard

Summarizing the situation, Elop writes:

For example, there is intense heat coming from our competitors, more rapidly than we ever expected. Apple disrupted the market by redefining the smartphone and attracting developers to a closed, but very powerful ecosystem.
In 2008, Apple’s market share in the $300+ price range was 25 percent; by 2010 it escalated to 61 percent. They are enjoying a tremendous growth trajectory with a 78 percent earnings growth year over year in Q4 2010. Apple demonstrated that if designed well, consumers would buy a high-priced phone with a great experience and developers would build applications. They changed the game, and today, Apple owns the high-end range.
And then, there is Android. In about two years, Android created a platform that attracts application developers, service providers and hardware manufacturers. Android came in at the high-end, they are now winning the mid-range, and quickly they are going downstream to phones under €100. Google has become a gravitational force, drawing much of the industry’s innovation to its core.
Let’s not forget about the low-end price range. In 2008, MediaTek supplied complete reference designs for phone chipsets, which enabled manufacturers in the Shenzhen region of China to produce phones at an unbelievable pace. By some accounts, this ecosystem now produces more than one third of the phones sold globally - taking share from us in emerging markets.
While competitors poured flames on our market share, what happened at Nokia? We fell behind, we missed big trends, and we lost time. At that time, we thought we were making the right decisions; but, with the benefit of hindsight, we now find ourselves years behind.
Many observers expect Nokia to announce on Friday a partnership with Microsoft to use the Windows Mobile 7 operating system on Nokia smartphones.  By my count, this will leave Nokia supporting three different operating systems: MeeGo, Symbian and WM7, which will hardly streamline their product development pipeline.

And doesn't that passage above -- "We fell behind, we missed big trends, and we lost time" --  pretty well describe the recent history of Windows Mobile?

* No doubt Mr. Elop's goal was to set the stage for some radical change at Nokia and I suspect the memo was leaked intentionally to create a "point of no return" to squelch continued internal debate or back-sliding on the issue.  The memo clearly states that Nokia's executives must make decisions they would never consider under less dire circumstances.  At a deeper level, however, if Nokia announces its intent to develop Windows-based phones, Mr. Elop's metaphor suggests that's a plunge a rational company would take only when the alternative is imminent death by immolation... hardly a resounding vote of confidence in one's new partner.

The engineering team might print up some "I'd rather develop a Windows phone... than burn to death." tee shirts.

Update February 11, 2001
As expected, Nokia announced a "broad strategic partnership" with Microsoft. under which Nokia would adopt Windows Phone as its smartphone platform.  Curiously, the following disclaimer appears on the Nokia press release:
DISCLAIMER Nokia and Microsoft have entered into a non-binding term sheet. The planned partnership remains subject to negotiations and execution of the definitive agreements by the parties and there can be no assurances that the definitive agreements would be entered into.
In my experience, it is unusual for Microsoft to participate in an announcement based on a non-binding term sheet.  This has the feel of a hurried deal, which may explain why Nokia's stock traded down nearly 15% today.

Feb 8, 2011

AOL Acquires Leading Media Company
(2011 Version)

This post was updated February 14, 2011 with a different version of the graph below.  The scaling on the graph has been changed as well as the value for Twitter as explained below.  The original version of this post is available at Seeking Alpha.

Last Sunday, AOL announced the acquisition of the Huffington Post for $315 million. The acquisition is right in line with the strategy Armstrong has articulated for AOL, and the management team deserves credit for its focus and decisiveness. Time will tell if they overpaid; it's notable that the HuffPo's shareholders took 95% of the purchase consideration in cash even as AOL's stock price is bumping around its all-time lows.

The ensuing press coverage is way out of line with the importance of the deal, probably because $315 million seems like such a big number for a five-year old, controversial and unconventional news site.

But most remarkable about this deal is how "conventional" it really is. AOL is simply amassing a stable of media titles under one umbrella, with the hope that it can figure out some scale economies before the cash flow from its dying ISP business runs dry. Michael Wolff has a pithy column on this topic here.

AOL is unabashedly becoming a content farm, much like the recently IPO'ed Demand Media. But with HuffPo and some of its other brands, AOL seems to think it can slap a brand name on its product (think "Chiquita" or "Sunkist") and get a small premium compared to generic produce. This may be a survival strategy, but it lacks the scalability to make it a big winner online.

After all, there are other brand name content providers on the internet, and this strategy hasn't really worked for them either. The websites of most metro newspapers in the US offer some pretty high caliber content, but revenue and a profitable business model remain elusive. The problem is not solved by replacing so-called "high priced" talent -- go ask a journalist how well she gets paid -- with low-cost freelancers generating search-engine optimized ad bait, because that's not the problem.

The problem is that, on the internet, there's a lot less value to the curation and aggregation of content (and ads) than there was in the pre-internet days when your local newspaper had a quasi-monopoly on the process. (See related post here).  The value created by "organizing the internet" is captured by search sites like Google and social media sites like Facebook and Twitter that direct users to relevant content.

Take a look at the following graph, which plots "enterprise value" (the value of all of a company's stock, plus its net debt) against revenue for various companies.

(Click on chart to enlarge)
At the top, there are three highly scalable businesses: Google (GOOG), Facebook (FB) and Twitter, whose business models are based (currently and mostly) on the sale of advertising against content supplied by others. For Facebook I have assumed $1.8 billion in revenue and based on recent report, $50 billion of enterprise value. For Twitter, $45 million in revenue, $6 billion in enterprise value, halfway between the $4 billion value in its last financing and the $8 billion being rumored in a possible sale to Google or Facebook.

Then there are some traditional newspaper companies, the New York Times (NYT) and McClatchy (MNI). These two publicly listed companies are mostly "pure play" newsgathering companies working through the transition to the online world. Clustered among them are Demand Media (DMD), AOL and HuffPo, online media companies pursuing a distinctly conventional approach to curating and aggregating content.

Finally, I have added Yahoo! (YHOO), which is a bit of a tweener and the company AOL probably aspires to be... or to be acquired by. (see Note 1.)

Note that the axes are logarithmic scales. Adjusted for company size (since valuation is highly dependent on expected growth and hyper-growth gets harder as a company gets larger) market valuations are roughly 10x greater for the scalable businesses than for the content aggregation businesses. This is not surprising, since the scale economies in these businesses provide meaningful growth opportunities at enviable profit margins, something that investors used to say about newspapers.

I expect AOL will continue to acquire as its bank account and stock price permit and a merger with Demand Media would be a way to add acreage to the content farm, while eliminating the temptation for both companies to over-produce and drive down the value of their ad inventory. One can even imagine AOL merging with a traditional media company so long as the merger partner could suffer the inevitable comparisons with the ill-fated AOL-Time Warner merger a decade ago.

(Note 1. I have reduced YHOO"s enterprise value by approximately $7.5 billion, my estimate of the after-tax value of YHOO's passive investments in Alibaba and Yahoo! Japan in order to show a "pure play" value for the company.)

Feb 4, 2011

AOL Gives Itself a Swirly

Business Insider has posted an internal AOL document, The AOL Way, on its website. It's a detailed 58-page slide show (ugh!) that provides a fascinating look at AOL's content strategy.

But I couldn't help noticing the image on the cover page.  Is that the AOL logo circling the drain?