Tonight I saw Adam Lashinksky speak about his book Inside Apple: How America’s Most Admired–and Secretive–Company Really Works. As he was describing how Apple would erect walls inside its offices to keep projects secret , I realized this extreme level of secrecy solves a core part of the The Innovator’s Dilemma. It becomes impossible for one part of the company to impede the disruptive innovations of another when the first part has no idea what the second part is doing. Other pieces of what Lashinksky described about how Apple operate,s including having being functionally organized rather than having multiple business units, helps keep Apple innovating rather than getting mired in protecting its current businesses. But I’m wondering if the secrecy that was designed to keep information from getting outside the company also prevents Apple from getting it in own way.
LinkedIn stock’s large price jump following it’s IPO last Thursday has caused many to comment that LinkedIn was “ripped off” by its underwriters by pricing the offering too low. LinkedIn used the standard offering process where the its underwriters, Morgan Stanley and Bank of America, offer the stock to their clients and set the offering price. Most of the commentary has missed the underlying economic fault in the traditional offering process which is having individuals price anything especially when they have competing incentives is asking for a poor outcome. The underwriters benefit by giving their best clients a big instant return on a hot IPO as they extract part of that gain through high fees on those clients. Pricing too high will lead to a failed offering which the underwriters will be blamed for.
There’s a better way as Google demonstrated in its 2004 IPO. A modified Dutch auction will set a market price for the IPO and maximize the value the company and the shareholders participating in the offering receive. For those not familiar with the procedure, a modified Dutch auction is pretty simple. Everyone interested in buying shares makes a bid saying they will buy X shares at a price of Y. The auction prices at highest price, called the clearing price, that will sell all the shares on offer with everyone biding the clearing price or higher getting their bid filled. The US Treasury uses the process to sell Treasury Bills and Bonds so it’s empirically proven in addition to being a theoretically sound.
To compare the two alternatives I normalized the offering prices of LinkedIn and Google to 100 and looked at the relative returns over the first 3 trading days. Google retuned 18% over its offering price versus 109% on the first day for LinkedIn. Much more money could have ended up in LinkedIn coffers if they had priced as close to the market price as Google did.
There are too few examples of high demand IPOs being Dutch auctioned to do a statistically significant comparison. However, the available evidence suggests it’s a much better pricing mechanism and economic theory is solidly behind that conclusion. I doubt Dutch auctions will become anymore common though. For non-hot IPOs, it’s not clear would be enough bidders. The underwriters will be opposed since it both marginalizes their role in the process and reduces the amount of value they can capture for their clients and ultimately themselves. Underwriters can not be eliminated from process since the securities laws require them. Corporate executives aren’t likely to clamor for it either. While a Dutch auction will benefit their shareholders, doing something unconventional always carries more risk of negative personal repercussions if it goes wrong. It’s lot easier to blame the underwriters for a unsuccessful IPO if their advice for traditional offering is followed rather than actively discarded.
Jack Welch had a famous rule that GE would only be in businesses where they can be number one or number two. In the industrial businesses GE was in, the scale that biggest players could achieve gave cost advantages that allowed for much higher profitability than the smaller players could achieve. Software is a world away from GE’s businesses but for platforms and operating systems, the number one or number two rule applies but for very different reasons. Operating systems with small share can not attract the third party developers needed to make the platform successful.
The personal computer era showed how minor platforms do not make it. Windows dominated the landscape for two decades with the Macintosh being the only viable competitor. Many others came and went like OS/2 and BeOS. NeXT which would later show itself to have the right attributes to be successful didn’t perform well in the market till Apple bought it and transformed it into OS X.
Android and iOS already have huge leads as application platforms. One of them could stumble but with the momentum both have, this looks unlikely. Even though the spoils are likely to be meager, there are several competitors for third place: Blackberry OS, WebOS (Palm/HP), and Windows Phone 7. Nokia had the good sense to take Symbian out of the race but made the peculiar choice of of Windows Phone 7. Both RIM (Blackberry) and Nokia would be be better off switching to Android as it would would put them on a platform where there’s already a wealth of third party apps. Neither RIM nor Nokia has ever proven themselves to be world class at mobile software. RIM’s entire success was based on email and they could salvage their market position by bringing their email system to Android.
These kind of strategic mistakes always puzzle me. I wonder if RIM, HP, Nokia and Microsoft have all convinced themselves they can become number two or if they believe there’s a profitable path as number 3 or 4.
I’m a bit surprised that Facebook is (rumored to be) entering the email market. Partially my surprise is that consumer email feels like a mature market and I expect Facebook to be concentrating on areas where more innovation and value creation is possible. The rest of my surprise is why Facebook book wants to enter a space that’s not a great business for any of the incumbents. EMail is essential to Yahoo and AOL for the recirculation opportunities it provides to better monetizing channels but in and of itself, email does not move the needle for anyone today.
Here’s my take on the pros and cons for Facebook entering the email market:
1) Free consumer email is a tough business
Being an email provider is expensive because you have store to an ever growing amount of old emails essentially forever even though they are rarely, if ever, viewed. Being rarely viewed means it’s impossible to monetize those petabytes of messages eating up storage space in the data center. In the old days before GMail changed consumer expectations forever, storage space for free accounts was sharply limited and additional space meant highly profitable premium revenue.
Compounding the problem, email page views monetize poorly compared to other types of content. Partially this is because the incumbent providers (Yahoo, AOL, Windows Live) with exception of GMail do not target using email content. My suspicion is even targeting off of email content does not help that much anyway. Advertising is valuable either when the purchase intent is high (where search is king) or there’s value in brand affiliation (full page New York Times ad). Email has neither of these characteristics and is likely getting worse on purchase intent. No one emails anymore to ask which camera, laptop, cell phone they should buy since it’s easier and hipper to ask in a Facebook status.
2) EMail does not fit well into the walled garden model of Facebook
Facebook messaging today is an unpolluted stream where messages are almost certain to have been sent by person. There’s no outside spam. EMail is the exact opposite both due to its history and the expectations around it. EMail started off with no way to verify sender identity and thus invites spam and scams. There have been some technical fixes (DKIM, SPF) but at the end of the day you really do not know who is sent a message. It’s also expected to be ubiquitous and completely interoperable thus removing the option of excluding bad actors from the system.
In contrast, Facebook can kick anyone out of their network. The Stuff White People Like article on Facebook is humor but its underlying point resonates with me. The nice, safe neighborhood feel of Facebook is a key part of its success. Most people over 30 were never going take to the generally messiness of My Space. Opening up your Facebook account to email, is almost like inviting the world to come by and litter on your front lawn. And there’s no way to “de-friend” someone sending you email. None of this is to say email is not an essential method of communication in the modern world. I just don’t see adding email fits with the positioning that’s made Facebook so successful.
Facebook does have several things going for it in the email market:
1) Capability to run large scale operations at low cost
Facebook has the operational know how to run a email operation at lower cost than most of the incumbents other Google. A cost advantage is always a huge competitive advantage in a low margin market. It’s harder to leverage though in email since pricing to the consumer is already zero. The price of an email account is really the amount of ads and Google has been able to effectively exploit their low costs through less intrusive advertising.
2) Good targeting data
Facebook already knows so much about their users they do not need to use email for targeting. How valuable this makes email to them is a function of how much excess ad inventory they already have. If Facebook ad inventory is already selling out at least for certain segments, adding email will be valuable simply by boosting ad inventory. If they are already swimming in inventory which is going for fire sale prices, there’s not a lot of money to be made.
3) Keep younger users away from Google and Yahoo
Although the kids of today do not have much use email, they will get older and need to start interacting with the grown-up world which still largely runs on email. At that point, they will need an email address. Providing them though Facebook keeps those users from deepening or even creating their relationship with Google or Yahoo which may benefit Facebook in the long run. However, that benefit is mitigated by the Google and Yahoo’s failure to be at all competitive in the social space.
4) Social Graph
Facebook’s biggest advantage in any area they enter into is their owership of all that social graph information. Maybe they have found a clever way to leverage it with email. I’m a bit skeptical because of the inherent identity problems with email.
I’m curious to see what Facebook has come up or if the rumors are even in the right ballpark. However, I doubt I’ll be creating myself a Facebook email address. GMail serves my needs really well today.
Meg Whitman’s has spent what seems to be an insane amount of her personal money in her campaign to be Governor of California. The Sacramento Bee reports that she’s already put in over $119 million:
Republican gubernatorial candidate Meg Whitman became the biggest ever U.S. campaign self-spender yesterday after putting another $15 million into her campaign, bringing her total contribution to $119,075,806.11.
Every governor proposes moving boxes around to reorganize government. I don’t want to move boxes around; I want to blow them up.
Now, here is what we need to accept. Our economy is 21st century and our tax system is 20th century. It is stuck in the wrong century.
My two and a half year old Blackberry Curve that I’d subjected to a hard life finally died a few weeks back when it’s USB connector came loose and won’t charge. While I waited for my new phone that I bought off of EBay to arrive, I’ve discovered that hoarding old electronics some times pays offs since I can use my old 8700c as a battery charger. The process of buying a new phone got me wondering why unsubsidized phones cost so much.
I can buy a 8GB iPod Touch retail for $199 which has every component that’s need to build a smart phone minus the cellular radio and mic. Seeing as how a basic cell can bought in the third world for less than $40, these components can not be that expensive. Apple has some of the highest margins in the electronics industry. The latest teardown I can find for the iTouch is for the 8GB touch introduced in in 2007. iSuppli put the cost at $155.04 and at introduction that 8GB iPod touch retailed for $299 which puts the gross margin at 48.1%. In an accounting sense, the gross margin is probably slightly lower to transport and distribution costs which will appear under Cost of Goods Sold on the income statement. But as benchmark for makes a for a very profitable electronics business, materials cost at 48% of retail is a good one.
The 48% hardware margin is steady for Apple as the 16GB wifi iPad has a teardown cost $259.60 according to iSuppi which at $499 retail puts the gross hardware margin at 48.1% By comparison, Nokia which sells many more feature phones rather smart phones had a gross margin of 34.3% in 2008. This is company wide and is probably boosted by non-phones but as a rough benchmark it’s not a bad place to start. Apple is also making money from iTunes store sales so and iPad and iTouch are even more profitable but nonetheless, but 48.1% hardware margins is still indicative of a very profitable business.
The question that puzzles me is why new entrants to the smart phone market do not sell unlocked phones cheaper. The Palm Pre costs $138 to build which at Apple margins would put the retail price at $265.9 but off contract the Palm Pre was $549 at introduction. A similar story for Google Nexus One which has a tear down cost of $174.15 which at Apple margins would have a retail price of $335.55 but instead is sold by Google for $529 unlocked.
I have no doubt the off contract pricing is set by the agreements the device manufactures have with handset manufactures. However, I have to wonder to the wisdom about late entrants (or in the case of Palm, re-entrants) following the established practice of very high unlocked contract pricing. Palm only sold 400,000
for it’s Dec-Feb quarter and Nexus One sales are even worse.
I find Google’s decision to stick to the standard distribution model even more puzzling as Google has a history of upending the pricing and margins of the business it enters. Gmail’s 1GB of storage ended Yahoo Mail’s practice of charging for storage space over 4GB and forced the the whole free email industry to go to essentially unlimited free email storage. Google Map’s free API undermined the pay for access model that incumbent providers like MapQuest had built sizable revenue streams off of. Perhaps since Google’s number one goal to sell as many Android units through multiple handset manufactures as possible to establish Android as major mobile platform, it makes sense not to poke the cell phone carriers in the eye. Palm had no such motivation. Granted Palm probably got great terms on it’s exclusive Spint deal but those terms didn’t stop the meltdown Palm experienced which only ended with their sale to HP.
If I had been able to buy an unlocked Nexus One cheaper, perhaps I would have done that rather than a Blackberry from EBay. I was not in the mood to take a new cell contract so I was in the minority of shoppers who didn’t want to trade low upfront pricing for a 2 year commitment. But perhaps there are more people in this situation than meets the eye. Anyone who loses or breaks their phone early in their contract is in the same situation. There’s really no good alternatives today for those who don’t want or are already in a contract since all smart phones follow the huge premium for an unlocked phone other than buying a used phone from EBay.
A professor of mine has a recent blog post where he wonders why executives take risks that academic finance has known for decades don’t add value:
Whenever I meet a senior executive from a company that got in trouble because of too much leverage, I ask (nicely, I hope) whether they know MM, which implies that investment decisions should not be made based on capital structure. Most say no, but they are very interested to hear about it.
This is stuff that has been known for a long time.
This got me thinking about the value of the knowing things. My visceral reaction is that learning through study and research has to be valuable, but sadly my post-MBA experience has largely shown otherwise. And when I say valuable, I mean in a career sense since to me knowledge has high intrinsic value.
There are several reasons while I think “knowing things” is not valuable as it should be outside of academia:
1) People prefer (over) confidence
Knowing something could be unwise or dangerous gets in the way of being supremely confident. Those who have no inkling that a particular action could be problematic can advocate for it without expressing any doubt. The persuasive ability of complete confidence has always seemed like a cognitive bias to me but I’ve seen it work over and over.
2) Tail risk pays off in the short run. Or maybe more bluntly put: The incentives reward stupidity
Let me start by explaining tail risk. Tail risk is the negative impact from a “rare” event in the probability distribution. The formal definition is a 3 standard deviation event. It’s easy to make money most of the time on tail risk. One can write a way out of the money call or put option and pocket the premium. Until the rare extreme swing to the stock happens, this strategy produces a steady stream of money. When the rare event happens, the loss can be enormous.
Overlevering a company has the same effect. Most of the time a company can service its debts. But a particularly bad downturn or other unexpected event can push the company to bankruptcy court. Since in most years we do not experience a bad downturn, the company’s returns look good.
In reality, that bankruptcy risk is reflected in needing higher returns on the stock. The Modigliani-Miller theorem says the “savings” on the “cheap” debt is exactly offset by higher required return on the equity to compensate for the increased risk in other words: on a risk adjusted basis, there is no extra return for loading up on debt. Like all finance theories, there are assumptions like frictionless markets and no taxes that aren’t met in the real world, so in reality it’s not exactly offset and tax treatment favors moderate debt.
But in the short run, the equity returns look higher and these managers are likely to be rewarded for that.
3) It’s downer
Knowing what I just explained is a downer since most of the time everything is going well and voicing concern about over leverage, is not going to be unpopular. After all the risks pay off now most of the time, and explaining there’s no real value being created and those extra returns are not actually better in the long run just annoys those who don’t understand this. All this worrying about disaster sounds like Chicken Little.
The stories I’ve heard about the mortgages security practices in the great real estate bubble are even worse than this. The loan issuers and resellers knew the loans were extremely risky and a bad long run bet, but were making so much money issuing or trading them that they didn’t care. The resulting disaster was so bad that many of the businesses in this mortgage backed security chain went bankrupt in the bust due to their exposure to these assets they knew were bad. But when everyone is making huge bonuses taking these risks, anyone who points out the risks is probably making a career limiting move.
4) Over emphasis on prior experience
Both in hiring and in the decision process, most people over emphasize their past experience. The problem with this approach is that the experiences of a career span is not a full picture or as we might say in more technical language, a representative distribution. Even 30 years experience in a field is a short sample of possible risks. Understanding the full range of possible outcomes and thus risk exposure requires study, often of the academic kind.
The problem is even worse for rare events that don’t show up in the historical data since history based quantitative methods do not account for those risks either. To understand those kinds of risks, one must take an approach based on theory rather than experience.