Saturday, April 5, 2014

FB buying WhatsApp: By The Numbers


There was a storm of news coverage regarding FaceBook’s stunning announcement a few weeks ago regarding their acquisition of social media startup WhatsApp. Unfortunately, none of the stories made any serious attempt to analyze the financials or business logic behind the purchase. When one does take a moment to explore the available information in depth, however, the results are both paradoxical and illuminating.

Typical of the recent spate of internet startups in the San Francisco Bay area over the last half decade, WhatsApp is a tiny company with only 55 people on staff. The “value” of each employee from the purchase price works out to approximately $865M. This detail alone gives reasonable cause to doubt the sanity of FB’s executive team and directorial board.

Some have tried to explain away this exhorbitant price tag by focusing on the fact that “only” $4B of this is actual cash, while the remaining $15B is in the form of stock. Nonetheless, the stock portion has a cash value that could have been used either to acquire other assets or applied to other strategic initiatives such as new product R&D.

As an example: for $19B, FB could have bought Broadcom and had $1.5B in cash left over, or purchased both NVidia and Marvell Semiconductor together. These firms are well established, powerhouse technology companies with well developed customer bases and channels, as well as healthy financials.  Their technology-leading product portfolios consist of SoC (System on Chip) hardware and software for 3C (computing, communications & consumer) and mobile computing systems. From this simple comparison, one can immediately conclude that the widespread criticism and ridicule FB received for spending $19B to buy a 55-person social media startup remains exceedingly valid.

To be fair, a first order analysis suggests the acquisition may not appear to be completely stupid. WhatsApp claims to have about 450M users presently, with the user base growing by perhaps 1M/day. These users exchange 10B-20B text messages daily and have the ability to share video, audio and images, as well as conduct group chats.

The cost for these services varies widely. Downloading the app is generally free with annual costs ranging between $0 and $2, depending on where the user resides.
Though this suggests the possibility of an instant and potentially large revenue stream from the acquisition, a closer examination casts immediate doubt on such a possibility. WhatsApp does not currently support ads. Perhaps it could be recoded to do so, but the smartphone format has proven to be problematic for all advertisers – an issue with which not only the social media sector but the entire internet advertising industry is struggling.

Perhaps FB could expand the offering and drive up revenue potential by the provision of streaming media or some other attractive service with an increased (or at least reinforced) fee structure. The possibility of success in such an effort, on the other hand, becomes a dubious proposition once the composition of the user base is scrutinized more assiduously.
The proximally zero cost of WhatsApp has proven to be a nearly irresistible attraction to the third world. Apparently the overwhelming majority of current and new users are in underdeveloped countries. The appeal of the service stems from the ability to send texts in unlimited quantities for free.

From the viewpoint of these customers, WhatsApp is an incredibly cost effective way of staying in touch with family and friends worldwide. It becomes unnecessary for these customers to get on the internet, have a FB account or rely on any sophisticated access device such as a smartphone, tablet, laptop or desktop computer – items which are, in any event, mostly beyond the reach of such a user base.

These markets are served by bottom level cellphones that are offered with a very low cost yearly subscription plan – normally on the order of $25/yr. It is not uncommon to find WhatsApp already bundled with the offering.

This leads us to a financial analysis of the transaction. Keeping in mind that the overwhelming majority of the demographic does not have significant disposable income, let’s assume that FB finds a way to extract a steady $2/yr from every single individual in the customer base – both the existing users as well as the new ones added every day.
The first table shows the growth in WhatApp’s customer base, in millions of users:
2014
2015
2016
2017
2018
2019
450
450
450
450
450
450
365
365
365
365
365
365

365
365
365
365
365


365
365
365
365



365
365
365




365
365





365
815
1180
1545
1910
2275
2640

The bottom number indicates the total number of users at the end of that calendar year. Assuming that none of the 450M current users or any of the future new users ever quits the application and the growth rate continues unabated, WhatApps’ customer base at the end of 2019 will, in theory, amount to 75% of the entire population of the third/underdeveloped world. 
Just for fun, let’s assume that this ridiculous number is achievable and that absolutely every single user – now and in the future – signs up for an enhanced bundle of services that costs $2/yr. The new users accumulated during a given year would deliver their full revenue potential only in the subsequent calendar year; therefore, the year in which they are signing up as fresh users naturally records an attenuated revenue collection. The resulting revenue stream would look something like this:
2014
2015
2016
2017
2018
2019
$900
$900
$900
$900
$900
$900
$365
$730
$730
$730
$730
$730

$365
$730
$730
$730
$730


$365
$730
$730
$730



$365
$730
$730




$365
$730





$365
$1,265
$1,995
$2,725
$3,455
$4,185
$4,915

Summing the cumulative revenues from 2014 thru 2019 results in a total of $18.54B. Thus, given all of the above decidedly optimistic assumptions, FB will have to wait for a bit more than six years before they can expect to simply break even on the acquisition.

There is an additional wrinkle to this analysis which bears consideration. All these new users sending and receiving huge quantities of data thru text, video and audio - as well as whatever additional services FB bolts in so as to ensure that they can collect $2/yr from every WhatsApp user - will need bandwidth to support their activity. This will place enormous pressure on the regional cellphone service providers to expand their PPE (Property, Plant and Equipment.) Who is going to pay for this? Will the providers revolt and demand that Facebook share its WhatsApp revenues with them?

All of these factors cannot but help to give Facebook shareholders and market observers pause. At the moment, the only clear winner in this transaction is, most likely, the NSA. Despite heated denials and obfuscation, the cooperative relationship between Facebook and the US signals intelligence agency is at this point widely known. One could imagine NSA executive directors being keenly interested in monitoring the text and multimedia exchanges occurring in the underdeveloped world. Perhaps the NSA is providing financial compensation to FB for its cooperation in such matters, which would go a long way towards explaining the seeming ease with which FB parted with $19B in cash and stock.

Does FB know something that we don’t know? Perhaps. Do they have a method of collecting significantly more subscription revenue from users? Maybe. But until FB becomes much more expansive about its motivations, cost justifications, overall strategy and plans regarding WhatsApp, the wisdom of the acquisition will remain questionable with much of the public, as well as the internet and financial communities.


The author would like to thank the following people for their insights, contributions and critiques on this topic:
Abhijit Athavale – Markonix

Chris Demetrakos – Manzanita LLP

Tuesday, April 1, 2014

Diversity and High Tech



A rather bizarre phenomenon has developed of late in the High Tech world. There are today a number of newly formed investment banking groups making waves in Silicon Valley with an agenda that relegates the pursuit of financial gain or the creation of new technology to a relatively secondary status. The primary motivation of these firms is to employ their financial reserves as leverage to “improve the diversity” of Silicon Valley companies at every level of the organizational hierarchy.

These investment funds champion a particular group based on race, ethnicity or gender under the premise that the particular special interest group is willfully under-represented in High Tech and that the industry needs to begin favoring the group in question. Those companies which do so can expect to receive support for their stock price if the shares are publicly traded, or are offered venture capital if the enterprise is not a public entity.

Such funds believe that High Tech companies will unquestionably benefit from the infusion of the group’s viewpoints and values into the company workforce. The underlying premise is that the ideas, mores and values of the group are currently outside of the company’s prevailing operational framework and that the group's culture and principles are at least as valid as or better than the company's existing functional mindset. In the fund's view, this is not only an unrecognized weakness in the company's culture, but is also intrinsically unfair and unjust.

Investment funds of this sort also believe they serve a greater social purpose and capture this in a mission statement generally along the lines of "passion and principles before profit." It is their firm conviction that society would improve thru social re-engineering to reflect the firms' standards of greater fairness and equitability in economic and social status between groups. Such investment banking firms believe that the High Tech sector is non-compliant to these principles and, as corporate members within that society, need to be part of any such transformation.

In a rather interesting paradox, these "socially conscious" investment banks are right - but for the wrong reasons. Diversity is an extremely beneficial and even vital component of any viable High Tech organization. The definition of diversity employed by these funds is, however, fatally flawed, and its forceful application to the High Tech sector would be counterproductive.

Silicon Valley is,in fact, the most diverse working environment in the history of civilization. There is simply no race, creed, color, gender, sexual orientation, ethnicity or tribe that the author has not worked for as an employee or alongside as a colleague. Compared to Silicon Valley, the UN Plaza in Manhattan looks shamefully insular and parochial.

Supplementing Silicon Valley’s intrinsic diversity has been the absence of any one dominant ethnic group. Though Silicon Valley began as an American phenomenon, the original Fairchild Camera semiconductor team split to form their own companies in the late 60’s and early 70’s, quickly attracting people from across the globe who wanted to be a part of building a better tomorrow. Today, it is a completely routine matter to find an entire organization, from the executive suite all the way to the most junior members of the rank and file, composed of people from just about every continent, country and culture on the face of the earth.

This has been a major causative factor in why Silicon Valley has displayed an instinctive gift for developing novel solutions to extraordinarily complex and multivariate problems. It also explains much of why Japanese chip firms started falling permanently behind in the late 90’s. We will explore these propositions in greater detail below.


The surest defense against Evil is extreme individualism, originality of thinking, whimsicality, even — if you will — eccentricity.  – Joseph Brodsky

Engineers are highly individualistic by nature - it's a profession that holds unique appeal to such types of people.The inate superiority of the individual over any group dynamic can be illustrated by a simple example. Say a newly minted electrical engineer steps off a flight that just arrived at San Francisco International Airport. This engineer could be Sandeep from Bangalore, Chen from Taipei or Elisabetta from Livorno. A socially conscious investment banking firm would only see them from the perspective of their gender and nationalities – in their eyes, Elisabetta is an Italian woman while Sandeep and Chen are Indian and Taiwanese men. This simplistic characterization is insulting, degrading and extraordinarily shallow.

First off: Elisabetta, Sandeep and Chen have all picked up roots from the land of their birth, leaving friends, family and all that which was familiar behind them to start a professional life in Northern California. That takes nerve, folks. It also indicates a strong independent streak in their character. Furthermore, they are all intrinsically a terror to any bureaucratic organization, as they all share the trait, to one extent or another, of being “mavericks.”

Starting from their first day at work, they will find themselves in an environment where no one group – including their own – constitutes a majority in the company. There is no common pool of experiences, behaviors, surroundings, language or cultural norms such as what they had back home in which they can immediately and subconciously submerge themselves. The only source of commonality they have with their coworkers is the engineering, operational and business challenges faced by the company, which they have to deal with together.

Since all three are engineers and mavericks removed from their accustomed cultural environment, their individuality by necessity immediately comes to the fore. Granted, their characters are influenced by their backgrounds. Yet without the familiarity of the surroundings they left behind, any tendencies towards the groupthink of their paternal/maternal culture is not supported by environmental stimuli and is consequently left dormant or stripped away by the exigencies of High Tech business pressures, leaving a core of beliefs, desires, preferences, ambitions , goals and dreams that is unique to that person. Under these circumstances, everything they say, think and do at their Silicon Valley workplace primarily represents all that they are as individuals.

The common characteristics of "groupthink" include: an illusion of invulnerability; an unquestioned belief in the group's inherent morality; collective efforts to discount warnings; stereotyped views of the enemy as evil; self-censorship of deviations from group beliefs; a shared illusion of unanimity; suppression of dissent; and the emergence of self-appointed mind-guards who screen the group from dissidents. - Connie Peck

There is a downside to such individuality, as experienced time and again by Valley veterans who have been part of many memorable debates in staff or program meetings. Nonetheless, it has produced an engine of creativity and innovation the likes of which the world has never before seen.

Notice, by contrast, the experience of the Japanese semiconductor industry that rose to prominence in the early and mid 80’s thru manufacturing excellence stemming from an exquisitely refined attention to detail. Despite this cultural competitive advantage, however, the suffocating conformity of Japan’s corporate framework - reflective of paternalistic Japanese society as a whole - began to tell in the early 90’s, as native microelectronics firms found themselves reduced to “fast followers” of Silicon Valley technological innovation, with the gap widening thru the mid 90’s and becoming chronic over time. Today, there’s hardly anything left of a once globally dominant chip sector in Japan. They’ve almost all disappeared in a wave of mergers and acquisitions.

The lesson is clear. Groupthink is anathema to a healthy High Tech industry. The uniquely fragmented social, ethnic and cultural landscape of High Tech in Silicon Valley has been key to ensuring that it remained fungible and adaptable.The success of the Technology sector in Silicon Valley and its ultimate failure in Japan has hinged on diversity and individual expression.

Some would insist that corporations cannot be trusted to promote “diversity” within their ranks and thus must be forced by social & economic pressure along with government decree to meet hiring quotas and impose organizational hierarchies that reflect “fair, just and equitable” standards defined by some sort of social engineering formula. Though appealing to ivory tower academics, utopian idealists and fervently ideological government bureaucracy apparatchiks, the approach again focuses on groups. As clearly demonstrated from the above discussion, group thinking kills the goose that lays the golden egg in High Tech. Initiative, creativity, original thinking and unique perspective are qualities of individuals – not groups. 

Nonetheless, this does not mean that the socially conscious investment banking firms that are trying to establish their presence in Silicon Valley are superfluous. They can indeed fulfill a valuable purpose - but only if they redirect and focus their efforts on a more specific mission.

Though ethnic, racial and cultural diversity is intrinsic to Silicon Valley, there does remain something of a gender gap. More specifically - though women have established a presence for themselves in Silicon Valley with roles in finance, accounting, operations, sales and marketing, there has always been a noticeable lack of women in engineering, both for hardware and software. Though somewhat less so for women from the Far East and southern Asia, the shortage has been particularly acute for women of African, Middle Eastern, European or Latin American ancestry.

Trying to correct this by calling for hiring quotas would be, in a word, stupid. Silicon Valley respects talent in whatever form it takes - its history demonstrates that quite clearly. High Tech is also the most mercilessly competitive industry on the planet. Japan's technology sector did not take sufficient steps to reap the advantages that a highly diversified workforce provides and suffered disastrously as a consequence.

The real problem is that women so infrequently choose electrical engineering or computer science as a profession. Some would say that certain cultures pressure women to select other disciplines of study; others would say that the gender gap in High Tech engineering is self-imposed. Whatever the reason may be, the inescapable fact is that it is a rare sight to see women in a university degree program for electrical engineering or computer science.

Here is where socially conscious investment banking enterprises can redefine themselves and make a tangible difference. As investment bankers, these companies have a responsibility to their investors and shareholders to invest their funds wisely and effectively. Nevertheless, a social-engineering-minded investment fund could take its profits and redirect them towards creating or supporting foundations that provide scholarships to aspiring woman engineers. There are many universities and privately run institutions who would welcome such active support.

In short: the hunger for talent in High Tech is insatiable, and Technology firms don't care about gender, race, ethnicity or any other labels, provided an applicant has the talent they need. The best and most effective initiative that socially conscious investment firms can support with their resources is to help make that talent available.





Sunday, March 30, 2014

TSMC , Smartphones and the Internet of Things: Behind the Numbers

              

On March 27, TSMC’s venerable chairman Morris Chang spoke at the annual Taiwan Semiconductor Industry Association meeting in Hsinchu. In his speech, Chang delivered a number of interesting announcements and prognostications, including:

1      - Cellphone sales would grow 4.9% year to year from 1.8B in 2013 to approximately 1.9B in 2014;
2     - Worldwide smartphone shipments would grow 25% from 2013’s 968M to 1.25B in 2014;
3     -  Smartphones would continue to be the leading semiconductor growth market for the next two years;
4     -  The 28nm and 20nm nodes would be the primary beneficiaries of that growth;
5     -  Moore’s law has another 5-6 years of life left in it;
6     - The Internet of Things (specifically, mobile computing devices other than tablets and smartphones) would be the driver of semiconductor unit and revenue growth after Smartphones, lasting for 5-10 years
7     - The most important semiconductor technologies and skillsets for the IoT era would be advanced chip packaging services, MEMs sensors and low power technologies & design methodologies that could reduce power consumption by at least an order of magnitude.

Concurrently, communiqu├ęs were issued by AT&T, Cisco, GE, IBM and Intel regarding their partnership in the newly formed Industrial Internet Consortium. The group has tasked itself with developing specifications and standards for interoperability, testing, modularization and security of IoT products targeting applications across a broad swath of industrial markets.
One can infer a certain synergy and theme of optimism in these back to back announcements. Yet before acting on these news items, a sober analysis of the facts and assessment of risks is in order. This editorial will constitute that critique, separated into two parts.
Part 1: The Mobile Phone Market
A critical analysis of Chang’s predictions can be performed by taking a closer look at the numbers. Below is a table of mobile phone unit shipments over the last six years. The source is Gartner, the same provider of general market data that TSMC uses.


2008
2009
2010
2011
2012
2013
smartphone units (MM)
128
172
297
477
680
968
Growth (y/y)

34.4%
72.7%
60.6%
42.6%
42.4%
Feature phone units (MM)
1094
1039
1300
1299
1066
839
Growth (y/y)

-5.0%
25.1%
-0.1%
-17.9%
-21.3%






mobile phones (MM)
1222
1211
1597
1776
1746
1807
feature phones (MM)
1094
1039
1300
1299
1066
839
smartphone units (MM)
128
172
297
477
680
968

One can readily discern the healthy growth of smartphones and the concurrent decline of feature phones. Yet the overall mobile phone market has been essentially flat for the last three years. The growth of smartphones is clearly stemming from the direct cannibalization of feature phone accounts. This effort went into high gear during 2013, as smartphone unit prices declined in what many observers deemed a price war and service plan costs shrank in parallel to entice cash-strapped consumers to switch to a higher functionality mobile phone.
The TSMC forecast for 2014, however, raises some eyebrows. Chang predicts growth of the entire market by 100M units for a total of 1.9B mobile phones and a further 25% growth for smartphones to 1.25B. Simple subtraction tells us that Chang is expecting roughly 675M feature phones to be bought in 2014. Doing a little math, that means the feature phone market would decline by 19.5%.
Now we can see contradictions emerging within the detail of Chang’s forecast. Smartphone growth is plainly rolling over, as the historical numbers suggest. Even the 42.4% growth rate of 2013 belies a growing weakness in the sector, as the second half of the year saw smartphone unit and service plan pricing promotions reach a panic pitch in an effort to maintain flagging momentum. Market observers are seeing parallels to the PC market as it matured in the 90’s, with features and enhancements losing the ability to command value, forcing manufacturers more and more to compete on the simple basis of price.
Since smartphone sales are evidently growing thru cannibalization of feature phones and feature phone sales are historically declining at an INCREASING rate, one would expect smartphone sales growth to correspondingly weaken and the overall market to either stay flat or decline. Yet Chang’s prediction calls for feature phone momentum to REVERSE and the overall market to GROW.
Why? There’s no apparent logic to it if one looks at market conditions. The world economy in 2014 is not strengthening over 2013, but manifestly declining. China’s economy has reversed momentum and is rather clearly headed for a recession – possibly a strong one. Exports shrank by 18% last year – a first for China in many years. All the BRICS nations are suffering as well - their exports have declined precipitously and growth rates have tapered, stalled or even reversed. Copper and iron prices worldwide are deteriorating to multi-year lows – highly indicative of a major slowdown in worldwide manufacturing. The western economies continue to stink to high heaven as they wallow in a financial cesspool of consumer, financial sector and sovereign debt, and the previous illusion of immunity projected by the NYSE’s record year belie the fundamental weakness of the US economy – a fact which the deteriorating housing market and deeply depressed workforce participation rate (stuck in a 35 year low) are revealing for all to see. America is evidently following Europe and Japan into economic stagnation and fiscal deterioration.
All of the above indicate that consumer discretionary income is not going to grow in 2014, but more than likely shrink even further. This suggests that TSMC’s expectations are unrealistically optimistic both in terms of smartphone growth and feature phone decline. A more realistic forecast would be one in which the mobile phone market would be lucky to stay flat against 2013’s numbers and more likely than not to experience a small decline.
Part 2: The Internet of Things (IoT)
Morris Chang expressed high optimism that the latest industry efforts to create portable computing devices beyond tablets and smartphones would lead to a wave of highly attractive consumer products that would continue the revolution in how people across the world live, work and interact. It would be rather stupid to discount Chang’s views out of hand, as he has proven to be one of the two or three most prescient and insightful leaders in High Technology over the last thirty years.
Nevertheless, the formation of the Industrial Internet Consortium (IIC) should not lead one to conclude that the industrial markets targeted by IoT device developers will shortly burgeon into an electronic renaissance with stellar growth and precipitously ramping volume. That the formation of broad industry partnerships to standardize electronics markets is often beneficial cannot be rationally disputed – just look at the long term effects of the IEEE’s 802.3 and 802.11 specifications on wired and wireless connectivity. Yet the IIC’s area of interest is so fragmented in terms of covered markets, technology and applications that it cannot help but give one pause.
Consider the markets which the IIC has chosen to encompass with a set of unified standards, specifications, testing guidelines, modularity and security protocols: energy, medical, manufacturing, transportation and the public sector. Each of those markets has multiple subsegments with their own application requirements and end user markets. The overwhelming majority of opportunities are low volume sells that require high levels of software and hardware customization. There are also a great many trade secrets wrapped up in medical equipment design, manufacturing processes and energy exploration – secrets which sector participants often think are integral to their value proposition. Such companies will be inherently resistant to revealing even a hint of what their ‘secret sauce’ might be like, further hobbling the efforts of standards definers.
IIC members seem to be distinctly aware of the obstacles they face in making their organization effective. When queried as to what specific initiatives there were on which the group would begin work and when the first set of standards could be anticipated to be released, the general response was “Ummmm……..errrrrr…….yeah, uuuuh, we’ll get back to you on that.”
Does this mean that we won’t be seeing some sort of revolutionary IoT device or set of products hit the market two years from now, as Morris Chang implied? Well, anything is possible. Genius is not a regularly occurring and predictable phenomenon. Nevertheless, it’s abundantly clear that no such products exist today. With this in mind, it might be a safer course of action to assume that Morris Chang was more than anything simply expressing his hopes rather than issuing a forecast on the IoT and its influence on the medium and long term prospects of the electronics sector.