P&G - Leveraging Web 2.0 to Sell Pre-Web Products

Note: this post was carried today on Wallstrip

Overview

Beauty is in the eye of the beholder, and P&G’s stock price performance has been something to behold. And this from a “boring” consumer goods conglomerate that counts diapers, shampoo, and recently acquired disposable batteries and men’s grooming products among the assets in its portfolio. It’s not difficult to imagine why first year Investment Banking analysts dread being placed in the consumer products vertical. Who could possibly want to cover a company whose biggest revenue generator is laundry soap? But hey, they make a ton of cash, and are a virtual Harvard case study on the value of intangible assets. IBM might have the largest patent portfolio, but who has the largest intangible asset portfolio? Without running a number I would hazard a guess that P&G is near the top of the pack. And not wanting to be complacent, Management has been working overtime to extend its brands and to deepen its products’ appeal to the massive and massively profitable 15-34 demographic. How? By becoming a Web 2.0 company. And it is this adaptive behavior which gives P&G a decidedly growth stock luster.

Bringing Active Management to the Brand

P&G, throughout its long history, has changed the model of consumer decision- making. And Neil McElroy, former President of P&G, was the individual who changed the face of marketing forever.

The shift to brand management began on May 13, 1931, with an internal memorandum from Neil McElroy (1904-1972), an athletic young man who had come to P&G in 1925 right after his graduation from Harvard College. While working on the advertising campaign for Camay soap, McElroy became frustrated with having to compete not only with soaps from Lever and Palmolive, but also with Ivory, P&G’s own flagship product. In a now-famous memo, he argued that more concentrated attention should be paid to Camay, and by extension to other P&G brands as well. In addition to having a person in charge of each brand, there should be a substantial team of people devoted to thinking about every aspect of marketing it. This dedicated group should attend to one brand and it alone. The new unit should include a brand assistant, several “check-up people,” and others with very specific tasks.

The concern of these managers would be the brand, which would be marketed as if it were a separate business. In this way the qualities of every brand would be distinguished from those of every other. In ad campaigns, Camay and Ivory would be targeted to different consumer markets, and therefore would become less competitive with each other. Over the years, “product differentiation,” as businesspeople came to call it, would develop into a key element of marketing.

Brand Management. That’s P&G’s entire business model. Create the perception of value through brand management and a fundamental understanding of consumer behavior. Flip through P&G’s 10-K, and it’s no surprise that the number one risk factor is “material change in demand for products.” Trivial, but important since the consumer pays a massive premium for the label. P&G needs its consumers to associate brand names with goods, and that means establishing the connection at the optimal time.

Bringing Web 2.0 Techniques to Brand Management

As you know, I am a big buyer of methods by which investors can leverage the internet (Web 2.0 tools and content) to make better investment decisions, but this article I came across was yet another reminder of how corporations can leverage social media to boost their profits.

Procter & Gamble’s Crest Whitestrips is giving college students something to really smile about this year with Smile State — its new sponsored group on Facebook.com. The group is giving undergrads at 20 select campuses across the nation VIP access to concerts, other exclusive events, promotions, contests, behind-the-scenes web content and more, all for free. All they have to do to join in on the fun and collect prizes is become a member of Smile State.

The benefits of joining are many, culminating with the chance for four campuses to win a stop on the Smile State Tour. At the end of the first semester, the four schools with the largest Smile State membership will score an exclusive concert on their campus featuring the latest acts from Island Def Jam all happening at the close of the fall semester. In addition to the tour, each of the 20 chosen schools is guaranteed to receive two free VIP pre-release movie screenings right at their school and Smile State is also tapping into the latest competitive craze and hosting rock, paper, scissors contests on select campuses, all of which will be open only to Smile State members.

Facebook Groups are mini-communities within the social networks. They allow users to post on discussion boards, send out mass emails, and general promote their interests. Facebook recently allowed corporations and organizations to build their own groups for a nominal fee, with some Groups (like Apple) surpassing half a million users. With such an addictive tool on every college student’s monitor, you can be sure they’re getting the most bang out of their buck.

A study conducted at CalTech explains how brand loyalty has little to do with quality of the product and more with emotions.

Subjects of the experiment were shown images of different brands while undergoing a brain scan. The images cause a reaction in an area of the brain tied to social image and identity.

Michelle Nelson, who is a University of Wisconsin assistant professor of journalism and mass communication, said the use of brain scans in the field of market research, or neuro-marketing, confirms how important brand images are to consumer behavior.

“This work actually shows the power of brand perceptions,” Nelson said.

It goes on to say that college-age kids (who are nearing the point of financial independence) are a particularly important target.

Conclusion

I realize that this Facebook group of less then 10,000 users (even if they ALL purchased massive amounts of Crest Whitestrips) will have nothing more than an infinitesimal effect on the stock price. The point is that with this relatively inexpensive advertising technique, P&G has potentially created a portfolio of perpetuities, solidifying revenue streams for years to come – that’s what their business is all about. Multiply this a couple million times and your position in P&G will pay enormous dividends for years to come. It is Management’s willingness and ability to meet its rapidly changing markets head-on that is most impressive. Bringing Web 2.0 techniques to a pre-Web company - this is a good story that is only getting better.

Thanks to Rick Calmon for his assistance with this post.
The author does not have a position in the securities of Proctor & Gamble.

HD - Leveraging Mystique into a Global Powerhouse?

Note: this post was carried today on Wallstrip

Overview

What is Harley-Davidson (”HD”) without its mystique? It is, in short, a lifestyle product. It’s not just a bucket of chrome, bolts and fancy paint - it represents youth, vitality, freedom and free expression. This is a company so aware of its user base, so in tune with its brand image that it has its own user group - H.O.G. An extract from the Company’s website describing H.O.G. - “It’s one million people around the world united by a common passion: making the Harley-Davidson dream a way of life.” This is a salesman’s fantasy. The brand practically sells itself. This is demonstrated by their recent financial performance, which is nothing short of stellar. Harley has made many on Wall Street and across the investment community smile this year. The stock is above both its 50-day and 200-day moving average, and recently hit a new high on news of a stellar quarter. Margins are higher than ever, and sales continue to grow both in the US and abroad. The question du jour: can they keep this up?

The Core Asset - the Brand

HD is a community-fueled juggernaut. One only has to Google “Harley-Davidson” to see the breadth and depth of this community. Hundreds of websites, forums, blogs, online magazines, and alternative news sources have sprung up which cover every conceivable praise and criticism. Not bad for a Company grappling with a mid-life crisis (see Demographics below). A list of a mere subset of the HD community’s web presence is provided here:

The Hog Blog
Gaijin Bikers in Japan
In High Cotton
knucklebuster
Biker Chick Motorcycle Diaries
Planet Harley Blog
Total Motorcycle
Harley Davidson Forum
Cruisers, Custom Motorcycles & Choppers
V-TwinFORUM
California Harley Davidson Forums
Harley Chat Group

This amount of coverage is a marketer’s dream. Remember focus groups, surveys, and point-to-point interviews as inputs to the market research process in order to get some sense of what’s happening in the real world? Well, one need look no further than the internet to get a pretty good handle on sentiment, key issues, concerns, areas of strength and trends among customers and prospects alike. It is almost as if, given the right web tools and analytical frameworks, one could replace an entire grass roots research function at a fraction of the cost and with lightning speed. Pretty darn cool. Few companies have as much fodder for this type of analysis as HD does, but given that they do, they’re blessed.

Spending a few hours browsing this plethora of enthusiasts, there is one unifying message – We like Harley just the way it is. Do not change. Well, my friends, that may work for you but it probably doesn’t work for HD stockholders over the long term. So, given the power of the brand and the organic growth the Company has experienced to date, what are some of the challenges and opportunities that lie ahead?

The Challenge and the Opportunity - the Demographics

I think a few facts about the composition of the HD customer base might be instructive: the average age of a Harley purchaser is mid-to-upper 40s, with 43% of all new sales purchased by pervious Harley owners. Only 11% of buyers are women. As noted in the Sydney Morning Herald, this older age group was responsible for the this year’s surge: 

THEY’RE often regarded as symbols of youthful rebellion.

But cashed-up buyers in their 40s and 50s are believed to be behind a huge surge in Harley-Davidson motorcycle sales in the past year.

Figures released on the eve of the Sydney Motorcycle Show next month show Harley sales grew about 35 per cent in the 12 months to September.

In the past 12 months, Harley-Davidson sales have risen from 2864 to 3862. The average age of a Harley buyer was 43. Overall bikes sales were also up more than 20 per cent, in part due to the cost of fuel.

Compare this with the profile of the Japanese-dominated sports biker market (mid 30’s, higher percentage of women, and 30% first-timers), and one wonders how much time HD has to continue milking this valuable cash cow.

While this level of devotion and support from a specific demographic is great, with it comes a portfolio of risks. A post in the motorcycle enthusiast site Kneeslider raises several very important and relevant questions. I apologize for showing most of the post here but it is chock-full of good observations and interesting issues:

Harley Davidson, like any other company, has a customer base with certain similarities, in their similar taste in bikes if nothing else. But the story now being promoted is the male baby boomers are aging enough, the first wave moving into their sixties, that buying a new Harley may not on their list of things to do. News stories suggest hip and knee replacements are pervasive and make you think once you hit sixty, the whole world falls apart. (I think a few of those writers haven’t been paying attention to the advances in health recently)

Obviously, most sixty plus riders aren’t going to be putting their knees down unless they’re changing their oil, but is that a problem for HD? That sounds like the huge baby boom generation won’t be buying sportbikes as often but you can ride a big Harley just as well as a Gold Wing and I don’t see any suggestions of Honda losing touring bike sales in an aging market. Some older riders will eventually stop riding and younger riders will pick it up. But, still, is this aging market a problem?

It could be if you focus on serving only the male, primarily white, baby boomer market but recently Harley has been trying to attract more women riders, just like all of the other companies and motorcycle accessory manufacturers, too. Everyone seems to be coming out with riding gear aimed specifically at women, which is a good thing as comments we’ve received indicate, and they’ve also been looking to ethnic markets where HD has been a bit weak. Blacks and Hispanics are not seen as often in the Harley crowd and HD wants to change that. This is exactly like the auto manufacturers who are more recently targeting cars and trucks to those groups.

Harley has promoted a “Harley Davidson lifestyle” for a long time, a semi fictional series of images that play in the minds of potential customers to get them to walk into the local HD dealer so they can join in. Does this lifestyle fit the needs or desires of the groups they want to attract? Probably not without a little tweak here and there or even some major revisions and maybe that’s what they need to do. Maybe there isn’t one story or image that will appeal to enough customers to keep things going and they may have to diversify that image to fit smaller groups. Someone interested in the urban biker scene is unlikely to find a Harley to his liking which is where some Buell derivation might fit. The Vrod family is more likely to attract the drag racing or horsepower and performance crowd. The big Harley Touring rigs always have a market for long range riders and the softail or FXR models appeal more to the chopper or custom type of customer.

Although Honda used to have their “You meet the nicest people on a Honda” campaign many years ago, no one tries to fit everyone into a Honda lifestyle because there isn’t one. Honda covers all the bases and as a result sells a lot of bikes. Harley can appeal to most of those same riders, too, as long as they don’t try to force a “one size fits all” strategy on those riders.

Harley may have to adapt in the future but not simply because their primary market is aging but because there are fewer homogenous markets for anything anymore and if you think about it that way, all companies have the same worry, not just Harley. I expect to see Harley around for a long time, not quite the same Harley we’ve seen over the years maybe, but they’ll be around, nevertheless.

A few more thoughts: Harley’s recent decisions to push into China may be an example of the “one size fits all” strategy instead of targeting groups with focused products. The Harley lifestyle in China? The market is changing for everyone and trying to do more of what you did before because it worked here so it will have to work there, too, isn’t thinking long term and ignores your potential customers. Hard as it may be for Harley to admit, not everyone wants to be an American Harley rider, China has no movie history like “The Wild One” and “Easy Rider” and no Sturgis or Bike Week. Dropping big chrome V twins on their market may just result in a dull thud when they hit. Looking at the huge number of Chinese people doesn’t mean they’re going to be HD customers. The HD appeal here in the US has to change and developing those other target markets in this country may make it easier to sell Harleys worldwide.

So, not good answers here, only the point that the very thing driving HD’s awesome results over the recent past may not have legs. What to do about an aging cash cow? This is a risk the Company must - and will - aggressively address.

The Engines of Growth - the Global Expansion and High Performance Plans

Management has demonstrated time and time again the ability to overcome significant obstacles. They orchestrated a brilliant recovery in the face of near collapse, catalyzed by a radical restructuring of HD’s supply chain along with a shift in its and relationship with its 3rd party vendors. Given this record of necessary adaption and crisis execution, there’s no reason to believe that they don’t fully understand the need and have the tools to appeal to new markets.

In 1998 HD acquired Buell Motorcycle, America’s only significant manufacturer of sporting motorcycles. This move shrewdly allowed the Company to participate in the growing market for performance bikes without the risk of tarnishing the HD image. According to the Company’s latest 10-K, while commanding less than a 1% share of the US market, Buell has been making solid progress in Europe. Almost 2/3 of HD’s 359 European dealerships are actively promoting and selling Buell models. This is smart.

The same strategy is being applied to new performance models such as the XR 1200, which premiered not in the States but in Europe. The XR1200 prototype is being billed as a way for HD to work its way into the hearts of the European motorcycle enthusiast. That’s right. Our proud American motorcycle company comes up with one of the most bad-ass looking Sporty’s ever created and offer it up our neighbors across the pond first. Now you know Management is looking to maximize profits and grow the business the right way - why else would they give this to the Euros first? Smart, smart, smart.

Conclusion

Since its brush with near death, HD has become a master at both risk management and brand management. They know the audience that has been paying the bills and funding growth - the US boomer cyclist. They listen to what they say very, very carefully. They will efficiently milk this cow for a long, long time. In light of an inevitable demographic shift, HD is prudently moving more aggressively into Europe and China, but in a risk-controlled manner. Leverage existing distribution where possible, attempt to cater to the local markets without losing sight of its global image. Management has done a terrific job thus far. Many companies have made the grand error of ignoring their base, with disastrous results. HD looks to be doing this right, and with consumer sentiment only a few clicks away, there’s no reason they shouldn’t be able to deftly navigate this shift from an American icon into a global powerhouse.

Thanks to Rick Calmon for the great research
The author does not hold a position in the securities of Harley-Davidson

Thoughts on the Sunday NYT

Again, a few nice things to write about and think about in today's Sunday NYT Business Section.

1. Ben Stein on Regulation - a little off the rails

I always enjoy reading Ben and find his passion and intellect inspiring (even giving him the props in a post I had written about Management Buy-Outs), but his piece today on Hank Paulson and the Committee on Capital Markets Regulation (the "Committee") was some preachy, tiresome stuff. Read below - see what I mean?

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Don’t get me wrong. Powerful people have studies that prove their points, and then they lobby Congress, federal regulators and state legislatures to get what they want. This is how the world works. This is called working the system, dealing with the world as it really is. But is it really right for prominent American executives, amid a host of scandals involving other executives looting their shareholders blind, to have the best and the brightest of academe and the Street lobbying for less accountability to shareholders?

Is there any higher goal at all for management than serving the stockholders openly and honestly? Is “competitiveness” even a meaningful word, compared with honesty and integrity in serving the owners of the company? What can “competitive” mean in this context? Would a hospital be more “competitive” if it didn’t have to take care not to kill its patients when it operated on them?

TOO many of our corporate chiefs are already paid too much. They already have too many layers insulating them from accountability to the law and to their stockholders. Our businesses are plenty competitive if you measure by profits — and how else would we do it? (Long ago, we gave up doing it by how we treat workers, a scale on which we would be in a lot of trouble.)

It’s fine for corporate bosses to be lobbying to keep themselves at the trough. That’s what we expect of them. But Mr. Paulson is sworn to represent all of the people, not just the powers that be on Wall Street. He is way, way too high up the pay scale to be their lackey.

Maybe it’s time for him to back off this committee and start thinking of a legacy that includes law, integrity and responsibility to more than just the chosen few of Wall Street and the corporate boardroom.

I don't know what was in your Wheaties this morning, Ben, but the whole premise of your missive is both insulting to Secretary Paulson and insulting to our intelligence. I, like you, have seen many fascinating and thrilling movies over the past 20 years, including: Portfolio Insurance - The Horror Flick (circa 1987), Private Equity and Junk Bonds - The Beach Party (circa 1985-89), Leveraged Derivatives - They're Not Just for Speculators Any More (1990-95),  Enron, WorldCom, Cendant and Other Space Age-sounding Companies - What's in a Financial Statement? (1999-2001). None of these movies were particularly fun and/or exciting, but we (the financial markets and its denizens) survived. Sh*t happened and people paid. So the whole self-righteous tone really doesn't do you or the issues justice.

The issue to me isn't whether or not regulation is appropriate, but what regulations are appropriate and how these regulations should be administered. I can tell you that a patchwork system - Federal agencies, State and local authorities, private citizens - won't work. Have you run a company of scale, Ben, or spent years operating in the bowels of a regulated institution? It's hard. It's costly. It's bureaucratic. So to ask Hank (and/or the Committee) not to ask the question about the impact of regulations on competitiveness is ludicrous. They're not saying abolish regulation. I think they are trying to determine the right amount of regulation and the right model for adminstering the regulations. Seems pretty sensible to me.

It is clear you have an axe to grind about executive compensation and that is ok. Don't own those companies whose compensation policies you believe are flawed and vote with your feet. But don't tell me that what the Committee is considering or the people they have asked to participate are part of some grand conspiracy to maintain the status quo or to roll back our fantastic regulatory regime. The current system is confusing and it sucks. What we don't want is a phenomenon similar to what we've seen in health care, where litigation overhang and the costs of insuring these risks has crippled the system. We need clear, sensible rules, with equally clear accountability and enforcement mechanisms. And this is not something achievable through a diffuse, patchwork regulatory model. I am happy Secretary Paulson has chosen to get involved in the Committee's mission and to raise its profile - the implications of its findings are potentially far-reaching and could materially benefit both managements and shareholders alike.

2. Paul Lim on Indexing - Hard to Beat

Paul had another sensible and insightful article, this time the value of indexing and how so few active managers have successfully beaten the indexes this year and, in fact, over the previous five years.

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This year through September, only 28.5 percent of actively managed large-capitalization funds — which try to beat the market through stock selection — were able to outpace the S.& P. 500 index of large-cap stocks, according to a new study by S.& P. In the third quarter alone, it was even worse, with only one in five actively managed large-capitalization funds beating the index.

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Over the five years through the end of the third quarter — a span that included both bull and bear markets — only 29.1 percent of large-cap funds managed to beat the S.& P. 500. What’s more, only 16.4 percent of mid-cap funds beat the S.& P. 400 index of mid-cap stocks, and 19.5 percent of small-cap funds outpaced the S.& P. 600 index of small-company shares. “The long term does seem to favor the indexes,” Ms. Pane said.

So does the near term. That’s because corporate earnings are finally expected to decelerate meaningfully over the next several quarters, said Richard Bernstein, chief investment strategist at Merrill Lynch. And in a period of slowing profit growth, stock market leadership typically narrows.

You would think that active fund managers would thrive during such periods — because, in theory, they could select the winning stocks from the market’s losers. But choosing the winners actually becomes that much harder, Mr. Bernstein said.

“In the past few years, when we saw unprecedented breadth in the stock market, it was a stock picker’s paradise,” he said. “Even if you were a poor stock picker, your chances of outperforming the broad market were quite high.”

But as it becomes more difficult to find stocks generating sizable gains, “we’ll begin to uncover who truly has the stock-picking ability out there,” he said.

Wow. I knew the numbers were compelling but not this compelling. I have long believed in creating a portion of my long equity portfolio in an "index-plus" manner, seeking managers and strategies that are specifically geared toward a narrow index base (e.g., a more concentrated portfolio than a broad-based index) with alpha generation via successful model-based algorithms. In fact, I actually seeded a company called Clear Asset Management that does exactly this. And they've done pretty well. Investing for alpha generation is a tough game - and the statistics are hard to escape.

How to Get Ahead

A frequent commenter on my blog is a young man named Yaser Anwar. Yaser is a college student. He is getting out of undergraduate school in 2008. Yaser has, in a fairly short period of time, become quite a well-recognized investment blogger through his site, Investment Ideas Blog. Yaser has been quoted several times in The Wall Steet Journal as well as in TheStreet.com. He has figured out the blogging scene and worked it incredibly well.

He identified me as someone with whom he wanted to establish a relationship several months back, and began to email me. He sent me some of his investment write-ups. I told him thanks, but I really wasn't that interested in this stuff. Undeterred, he forwarded me several interesting studies and scholarly reports he thought I might find interesting based upon my writings. His tone was respectful yet persistent, and he was able to strike a tone that was neither annoying nor burdensome. I ended up blogging about one of them when I wrote a post on the future of sell-side research.

Yaser continued to stay in touch and, about two weeks ago, asked me if I'd be willing to be part of an interview with him that he would post on his blog. I said send over the questions and I'd think about it. The questions were interesting and intelligent, and I said, ok, but I am really busy and can't get to it now. No problem, he said. Get to it when you can. Which I did. The results of which are now posted on his blog. Oh, and his post was picked up in NYT DealBook as well as DealBreaker. Why? Because he told them about this interesting interview he had done which he thought might be of interest. Good idea, Yaser. Get it out there, pal. Help people find you.

Anyway, the reason for this post is as follows: for those readers who are young, smart, hungry and ambitious, take a page out of Yaser's playbook. He is providing you with a great roadmap of how to network, how to build relationships, how to get recognized for your intelligence and how to build a brand. I'll confess, I was nowhere near as evolved and as heads-up as my new pal Yaser at a like age. I was doing the undergrad thing and doing fine, but certainly not pursuing my dream with the intensity and focus as Yaser. Keep it up, Y Man. You are great example for people everywhere in this competitive and fast-moving 2.0 world.

More Mistaken Thoughts about Hedge Funds - A European Perspective

After taking a little break from the single stock write-ups for Wallstrip, I am once again reading the editorial pages and getting somewhat nauseous. My latest case of indigestion is from some friends over in Europe who seem to think that, well, we are all taking too relaxed a view about those big, bad, cataclysm-inducing hedge funds. This little missive is straight out of today's Financial Times. They've given me so many softballs here that I don't know where to start, but please, review the text below (PS. the highlighting is my own):

LETTERS TO THE EDITOR: Even the professionals don't know all hedge fund risks

By: By leke van den Burg and Poul Nyrup Rasmussen, Financial Times
Published: Oct 26, 2006

From Ieke van den Burg MEP and Poul Nyrup Rasmussen MEP.

Sir, Although the public debate about the economic impact of hedge funds has barely started, you seem to have already drawn your conclusion in your editorial of October 17: don't hedge them in! Charlie McCreevy, the European commissioner for internal markets, seems to be of the same opinion.

We would be inclined, though, to ally ourselves more with the serious concerns expressed by several leading regulators of the financial markets.

First of all, you tend to play down the Amaranth case as a minor incident. How can you be so sure that the well-regulated banking and securities sector is able to compensate for all the risks?

If competent authorities such as Jean-Claude Trichet, president of the European Central Bank, tell us that they neither fully understand the new complex products nor have full oversight about the possible domino effects of collapses of a larger size, how can we then be sure that bigger and more complex collapses can be carried by the regulated part of the market?

Second, it is questionable that professional and institutional investors know all these risks. Since they do not play with the money only of rich people, but also with the hard-earned money of pensioners and workers, we would be inclined to regulate and monitor these so-called professionals somewhat more closely, to prevent them from running after hype and the super-profits conjured up to them.

Third, the short-term interests of hedge funds have in too many cases ruined the long-term strategies of strong and sustainable companies, leaving them saddled with heavy debts and either split or merged for short-term gain. This is not what we would call better corporate governance and a more competitive European economy.

So, we see at least three reasons that much more research and analysis is needed. This makes your anti-regulation conclusion, "don't hedge funds in", irresponsibly premature!

Ieke van den Burg,

Socialist Group in the European Parliament (The Netherlands)

Poul Nyrup Rasmussen,

President, Party of European Socialists (Denmark)

Messrs. van den Burg and Rasmussen, I have no idea how many people you represent, but if it is more than 10 I am deeply concerned. Your comments - or should I say rhetoric - show a phenomenal lack of understanding of both the issues and any semblance of equanimity. There are pros and cons to everything, gentlemen, something which is sorely lacking in your analysis. Let's take your comments one by one:

1. Amaranth. Nobody that I've read has said that Amaranth was a "minor incident." I'd say that most of what's been written has been highly critical of the fund's management, poor oversight, weak risk management culture, as well as the incredible latitude provided multi-strategy hedge fund managers. These criticisms were appropriate, justified and necessarily sober. Further, it has brought intense scrutiny on multi-strategy hedge funds in general, and the due diligence performed by hedge fund consultants in particular. Again, the situation has given rise to much healthy criticism and debate.

What has NOT been written is that Amaranth has posed a systemic risk that has rippled through the financial (or even the energy) markets. Why? Because it hasn't. The fund made a lousy, mis-sized bet. Word got out. They got crushed. Those better able to take on the risks of the positions stepped into Amaranth's shoes. They did well. The markets barely hiccuped. So, my Dutch and Danish friends, chill out. You know not of what you speak.

Intermission: Using Jean-Claude Trichet as the barometer by which you judge the risks and appropriateness of oversight of the hedge fund marketplace? You've got to be kidding me. Only in Europe. Come on, boys. Get serious.

2. Professional money managers. Gentlemen, why have we so little faith? It's not very nice to speak of an entire class of people, even money managers, with so little respect. Be that as it may, if you have so litle regard for these people, what makes you think that regulators can do any better? In fact, given the wording of your criticism, it seems that if professional and institutional investors don't know all the risks they should be regulated - by regulators, who presumably, know all the risks? If these regulators are so smart, then why aren't they managing money, smart guys? Because they want to do a service for society and give up all that money? Ha - give me a break! At least money managers have some training and experience in, er, money management. Also, please don't bring the "women and children" argument out - why is it that 98% of the time I hear that is when I'm either speaking to or reading a tract from a Contentinal European?

We have a concept over here in the US that governs situations where people in the position of responsibility for others' (yes, women, children, elderly, etc.) monies need to comport themselves in a certain way: as a fiduciary. If someone is found to be in breach of their fiduciary duty, they are in big, big trouble. So, these people in positions of power are, in fact, regulated by a very powerful statute and held to a very high standard of conduct. Instead, you two would rather have a bunch of ill-equipped regulators looking over the shoulders of money managers and telling them what they can and can't do? Right. This should lead to fabulous performance and attract only the best people into the field - not.

3. The evil hedge funds destroying Corporate Europe. This is the best of all! If only European shareholders were lucky enough to have hedge funds forcing managements to act in economically rational ways. Your argument on this point is so weak and pathetic as to completely undermine everything you've said before. I really thought we'd moved beyond this creaky old protectionist thinking, but clearly I'm wrong. You are living in a global economy, boys, whether you like it or not. Good luck selling all that high priced stuff for export with artificially high wages, bloated management structures and restrictive work rules. And don't even purport to know what creating a "competitive Europe" means - I guarantee your protectionist plan would be shot down by almost every credible economist on the planet.

If a company's strategy was so great and so sustainable, it couldn't possibly be "ruined" by a hedge fund. The only way a hedge fund succeeds in restructuring a business is if the other shareholders go along - nobody is holding a gun to their head. Again, to repeat, existing shareholders (not to mention management, with the support of shareholders) would tell the hedge fund to go away if it was believed their recommendations would impair the value of the company's prospects and, therefore, its stock price. The reasons why hedge funds are sometimes successful is when they target a company that can do better, so much so that other investors join them in executing their plan. So get you facts straight, guys. You are so off-base on this one it is mind-boggling.

Sorry about the rant, but if I read one more piece of editorial puffery (it seems to be like a virus that is going around) about big, bad hedge funds I may lose my mind. 

SNY - Is Big Really Beautiful?

Note: this post was carried today on Wallstrip

Overview

Times they are a changin’, and not just for SNY but for all of Big Pharma. The issues being faced by the largest pharmaceutical companies are as vast and as complex as ever: In-house R&D versus purchased R&D? Benefits of scale versus benefits of focus? How to beat back the constant onslaught of generics and illegal copies? How does the increasingly stringent regulatory landscape for new drug approvals impact the drug development cycle and, therefore, valuation? None of these questions are easy. But the internet gives us a window into some of these issues and their potential ramifications for SNY. In a nutshell, they will have to walk a very fine line to be successful, not exactly the “margin of safety” I generally am looking for when making investments. But before drawing any conclusions…

Big Pharma – Not as Diversified as You’d Think

An extremely interesting and insightful post from the online industry journal Pharmaceutical Executive gives us some historical perspective on this issue:

For decades, blockbuster product development has driven the pharmaceutical industry. Under that model, a handful of products-and, in some cases, a single product-produce the lion’s share of revenue and dictate a company’s strategic direction. As companies get larger, they rely more and more on blockbusters to sustain their growth. The high cost of developing major, successful drugs only reinforces the need to focus on blockbusters. It’s a vicious cycle that remains firmly in place for most Big Pharma.

In 2000, for instance, Claritin (loratadine) accounted for 45 percent of Schering-Plough’s total revenue. Similarly, Prilosec (omeprazole) represented 44 percent of AstraZeneca’s 2000 pharmaceutical revenues. At Aventis, two blockbuster therapies-Allegra (fexofenadine) and Lovenox (enoxaparin)- accounted for 22 percent and 20 percent of reven-ues, respectively. (See “Big Pharma’s Product Pie,”)

Although the blockbuster approach has served well for many years, it is now under pressure on several fronts:

Uncertainty over pipeline sufficiency. There may not be enough blockbusters in the pipeline to sustain the industry’s double-digit growth .

Genomics and the promise of personalized medicine. These powerful trends raise the possibility of fragmented, smaller markets, unsuited to the blockbuster model.

Increased speed of “fast follower.” The time between product innovation and second-generation has dropped from years to months, limiting pharma’s ability to maintain a premium price for innovative therapies.

Reimbursement and cost pressures. Payers are trying to reign in healthcare costs, and pharmaceuticals are a prime target. Some states have refused to pay the high price of innovative drugs and threatened such actions as limiting reimbursement levels.

Tightening of regulatory pressures. FDA and other regulatory agencies are raising the bar for both getting new drugs approved and keeping existing ones on the market.

As those pressure points converge on Big Pharma, it becomes clear that the existing blockbuster model will not survive unchanged in this decade. This article offers lessons from medium-size pharma companies that have pursued alternative approaches with comparable success and from other industries that have had to reinvent their blockbuster strategy in the face of changing economic and competitive imperatives.

Oh, and FYI, that post was from four years ago. Talk about prescient. These are exactly the issues being faced by Big Pharma today and have profound implications for the restructuring of this massive industry. Remember what happened to Merck when Vioxx was pulled? Even without the financial overhang of pending lawsuits, the loss of a key revenue stream was absolutely crushing. Because of the high cost of bringing a drug from “whiteboard to Walgreens,” Big Pharma has grown up around the blockbuster model to generate the cash necessary for R&D. This model has to change.

Big Pharma - a Broken Business Model

The key issues surrounding this business model/R&D problem were illustrated in a very interesting piece by in-Pharma Technologist.com:

New data gathered by the Financial Times Research Centre shows that on average, the top 30 pharma firms spent almost 17 per cent of sales on research last year, not so surprising considering that bringing a new drug to market can now cost anything between $900m (€715m) and $1.2b.

As expected, the big spender is Pfizer, with over 14 per cent of its £27bn sales invested in R&D in 2005, followed by GlaxoSmithKline with over £3bn spent on research during the same year, and French giant Sanofi-Aventis with £2.7bn.

Meanwhile, it seems that Big Pharma is changing its approach on how to spend it.

The report suggests that relying on in-house research and development only has become increasingly complex in terms of budget and resources and it is now almost unviable for companies to have control over all the aspects of drug development.

As a result, companies are staying away from big mergers with other giant companies and are instead buying smaller biotech companies, entering joint ventures or in-licensing drugs, according to the report.

“Shifting away from over-reliance on in-house R&D makes sense, but brings new risks too,” the report said.

This is due to the failure of the majority of biotech start-ups and to the fact that academic researchers now try to commercialise their work at a much earlier stage.

According to the report, this leads to companies rushing to buy overpriced acquisitions of academic ventures with no real product in sight.

Meanwhile, the report also shows that the biggest players are not necessarily the most profitable.

The most profitable companies last year were either young biotech firms with successful drugs or reputable pharma companies with off shored operations taking advantage of the lower costs and high-skill base of developing countries.

So this raises the issue - is the skill set necessary to succeed in 21st century Big Pharma really more akin to venture capital than hard science? Given the troubling ROI of in-house R&D, are successful Big Pharma execs simply better asset allocators than their peers, doling out monies across in-house researchers, licensed research from leading academics, licensed R&D from small-and mid-size biotechnology firms and selective fill-in acquisitions, with each trying to find that optimal point on the efficient frontier (that balances risk and return - akin to striving for the highest Sharpe ratio)? Wow, I can’t believe how much the industry has changed since my perception of the benevolent scientists in their lab coats in the 1970s. Today we’re talking expensive suits, complex asset allocation algorithms and probability matrices of drug efficacy and success in getting through clinical trials. It makes my head hurt.

Big Pharma - But Wait, There’s More

Looking towards the future, the risks to Big Pharma are only getting bigger. Staring down the barrels of (1) an increasingly litigous and costly landscape together with (2) ever-more stringent FDA rules means more and more drugs will never actually make it market. These two factors alone should cost Big Pharma billions and billions of dollars a year. Further, states are pushing the use of generics: see Massachusetts’s mandatory healthcare bill which means a greater emphasis on generic drugs. Oh, yes, and then there are the issues of knock-offs. China and India continue to flood both their home and foreign markets with counterfeit versions of blockbuster drugs, costing Big Pharma additional billions each year. And, last but not least, let’s not forget the number of patents set to expire. What has been a windfall for Big Pharma will turn into a competitive nightmare, compressing margins, depressing revenues and thinning out IP portfolios. Taken together, this is not a pretty picture.

So, in short, it seems that Big Pharma just sucks right now. It’s all about risk/reward, and it is not hard to see how the scale is tipped in today’s environment.

Investing in Pharma - The Internet as a Source of Value

Taking a look at small- and mid-cap biotech companies out on the internet is a hoot. Stocks skyrocketing and crashing based upon little tidbits of news, be it related to a drug in Phase III trials, pending FDA approvals, mergers and acquisitions, whatever. We have noticed significant timing asymmetry between information that is specifically released by companies, and that which is available from various credible sources out on the internet. For example:

Accentia, a company that specializes in cancer vaccines. For months it had little trading volume, with its share price in slow but steady decline. Once word came out that its vaccine demonstrated promising results, millions of shares traded hands and the stock price surged over 40%. Not too shabby.

Interestingly enough, Wall Street never caught on that the trial results were posted on both the Journal of the National Cancer Institute and the University of Navarre websites, several weeks before the Company issued a press release.  People were even blogging about it. This is the kind of cool stuff that can be gleaned through tools that help users extract and filter information from the internet.

Conclusion

SNY and Big Pharma is a rough place to be at the moment. Sorry. But that doesn’t mean that money can’t be made investing in pharma - as long as you have the tools. You see, there is always a silver lining!

Hat tip to Rick Calmon for the Accentia find.

The author does not have a position in the securities of Sanofi-Aventis.

Nike - Swooshing or Sinking?

Note: this post was carried today on Wallstrip

Overview

As always, I’ll let’s the internet dialogue do the talking, but what emerges from the data is one of the more complex and confusing pictures I’ve seen yet. The challenges and opportunities facing Nike are both daunting and exciting to the investor, and some of the major themes include:

The Good - a possibility

1. Can Nike broaden its brand appeal from identification with a single individual into THE sports and fitness company? 

2. Can Nike become the principal sports and fitness-goods beneficiary of the health wave across its big-spending demographic?

3. Can China serve as an engine for turbo-charging sales in what is shaping up to be a key battleground?

4. Can partnerships with truly cool companies like Apple propel Nike into the vanguard of hip?

5. Can line extensions into an increasingly broad array of sporting and fitness products leverage Nike’s brand and distribution network into rising profits?

The Bad and the Ugly - let’s hope not

1. Can Nike maintain its hip image in a post-Jordan world?

2. Has its brand become too prostituted through its sponsorship of everything sports from high school and college football teams to Tiger Woods?

3. Will increased scrutiny on poor offshore labor working conditions cause a PR nightmare?

4. Will its use of “informants” and other paid influencers in its target market precipitate a backlash against its “contrived cool” image?

5. Will the costs of competing in China against a fierce rival like Adidas make a “win” a pyrrhic victory?

I guess when it comes right down to it there are two principal themes that get right to the core of Nike’s prospects - success in positioning the brand to be “cool” yet sustainable and success in growing its franchise and making money in China. Answer these two questions and you’ve got the answer of the stock’s near- and medium-term prospects.

Nike - the Brand

The boys from Beaverton are working hard to create Nike 2.0. All you need to do is to live on their website a little to get a sense of the image they are trying to create:

1. We’ve got a clear mission (tag line: “To bring inspiration and innovation to every athlete in the World” and, oh by the way, our definition of athlete is: “If you have a body, you are an athlete.” Sure, guys, whatever)
2. We’re all about innovation and inspiration (and we happen to have a picture of the uber-hip iPod Nano to prove it)
3. We’ve got a rich and proud heritage - this stuff isn’t contrived man. We’ve been around a long time (that old black-and-white picture you’ve got up there really makes me teary…sniff, sniff)
4. We’ve got cutting edge product technology (and it’s not just shoes, man. What are those hardware gadgets? I really think these guys DO want to be Apple)

Stuck in the past?

Ok, ok, maybe they are trying too hard, but you get the point. There is no doubt from both the internet conversation and their website and corporate messaging that they are trying to bridge the gap from an image built around an icon (Sir Air himself) to one built around technology and cool. And the effect of Michael is still being felt today, even in the key venues of hip like NoHo’s Flight Club:

The entire back wall of the store is devoted to Air Jordans, the sneakers that revolutionized footwear. But, I asked one of the clerks, why Michael Jordan? “Because before Michael Jordan there was none of this,” he said, sweeping his hand along the wall of shrink-wrapped individual Jordans as if showing off his new Picasso mural. “Back in the day it used to be all about the Adidas. Then Nike came along, and Michael Jordan came along, and that was that. Everything changed.”

Now, being tethered to an icon of the past is not necessarily a good thing:

I’m sorry that there has to be a negative comment but I think that all the products are very ‘Nike’ in their styling and I dont really like Nike because I think that the products in general are a bit kitch (apart from the classic Nikes with the big tick and the concept of the air max 95). Are Nike shoe designers mainly product designers or fashion designers? I understand that Nike design shoes with a big emphasis on function for sport etc but I get the impression that they dont research into true fashion trends outside of the US. I’m not sure if Nike realise this but in the UK Nike are seen as uncool in a lot of social groups (unless you’re wearing an oldskool design). If Nike want their shoes to fit in with the fashion of youth groups then they should really study these groups in Europe and maybe do research based on music groups… because often thats where these trends develop from. Not everyone is into Hip Hop and sport if you know what I mean.

If Nike had a design studio based in the UK (or Scandinavia, or Australia) that really understood the trends of young people they really would double their sales. Someone should definitely make good use of that tick.

Now, Nike is working hard to broaden their appeal and perception as a sports and fitness, company, not just a shoe company, which is illustrated by several acquisitions they have made to extend their reach, for instance:

1. Cole Haan
2. Bauer
3. Hurley
4. Converse

Running towards the Future

Ok, ok, that’s cool. But none of this is really moving the meter in terms of enhancing brand value. Likely the biggest (and hippest) branding initiative going on right now relates to their budding relationship with Apple around the Nike+ project. Apple’s press release is here.

Nike+iPod is a partnership between two iconic, global brands with a shared passion for creating meaningful consumer product experiences through design and innovation, Parker said. This is the first result, and Nike+iPod will change the way people run. Nike+iPod creates a better running experience. We see many more such Nike+ innovations in the future.

Now, hitching your star to Apple + Steve Jobs can never be a bad thing. Right? Well, let’s hear what the blogosphere has to say:

For $29, you too can be a runner by Brent Ozar

One of our recently hired Windows engineers sold me on it when he walked me through the Nike Plus web site. It showed his progress, showed challenges he’d entered with other runners, and showed various Nike challenges, showed Lance Armstrong’s running pace, yadda yadda yadda. The graphs made my eyes pop - I could envision myself looking at a graph of my progress, seeing a metric of my improvement. That was it. I was sold.

Running Works. by Closet Therapy

Seriously, who woulda thunk? I’ve been running (actually, it’s more of a combination of a jog-walk) more regularly since I got my Nike+iPod set. True, the set is a bit excessive: I can just as easily run without it. But something about the satisfaction I get while syncing the iPod to my computer after each run and reviewing it online gives a sense of accountability, the iPod doesn’t lie.

Nike+ iPod running appliance: this is Web 2.0 by Sean Teirney

Possibly the coolest feature is the seamless integration via iTunes with the NikePlus.com site- every time you sync your Nano, it will send the stats from your latest workouts to your account on Nike+ so you have one place where you can login and track your progress. You can also challenge up to fifty friends anywhere in the world and compare their progress with your own (smack-talking is always the best motivator for improvement). The Nike / Apple partnership is genius on so many levels- Apple has a new product, Nike sells more of their shoes and sports apparel that integrates, Apple sells entire workout playlists of celebrity athlete’s favorite workout songs complete with voiceovers to inspire the runner, both get access to a valuable community.

Analysts: Apple deal a boost for Nike by Mathew Honan (Playlist)

Despite Nike’s strong association with sports, Apple has owned the market for portable players, with the iPod shuffle and iPod nano dominating the flash-based music player market traditionally favored by athletes due to the devices smaller sizes and durability. At the 2006 Winter Olympic Games in Turin, for example, a pair of white earbuds were seemingly de rigueur for athletes from all over the world, be they figure skaters or snowboarders.

Ok, so we all get the joke. This looks pretty good. I guess the question we all need to be asking ourselves is who is getting the better end of the stick here - Nike or Apple? This from Business Week:

Nike dreamed up the idea for the product and contacted Apple to develop the technology behind it, Nike CEO Mark Parker said at the news conference: “A while back we asked a big question: Could we harness the power of digital technology to improve a runner’s experience?” It turns out the answer is a smart running shoe, equipped with a small sensor that can track motion and distance and other metrics that runners find important, but the information would only be available after their run is complete, not while running. “We quickly realized that making a smart shoe wasn’t smart enough.”

So Parker called a friend: Apple CEO Steve Jobs. The result was the kit, which both called simply a “great start.” The two companies will develop more products as part of an ongoing partnership.

Boarding for Hip?

Nike is taking steps well beyond Apple to cement their image as a hip, responsive, edgy comapany. For example, look at their approach towards Skateboarders:

And the surveillance paid off. Within two years, Nike reissued the Dunk, a 1985 basketball shoe that executives discovered had been co-opted by skaters. And it kept on reissuing it ­ the same basic design ­ but with different color schemes and motifs designed in collaboration with celebrities, graffiti artists, skaters and storeowners. Playing on skate’s secret language of images and icons, the different editions soon became cult fetish objects with “personalities” and nicknames like Shanghais, which
contain a Chinese character, and Heinekens whose color scheme resembled that of the Dutch beer. But they kept the numbers strictly limited ­ stores were only able to order 24 pairs and most lines were produced in hundreds rather than thousands. According to Niketalk, just 777 of the Dunk Lucky 7 were ever made and a collaboration with artist Futura resulted in just two dozen
pairs of shoes.

Nike did it smart. By keeping numbers down they were able to manage demand, and the potential profit margins of being able to sell Dunks for as much as 5x the suggested $65 retail price eroded the resistance of many independent storeowners, by, as Bodecker put it, allowing them to “keep the lights on.” So you won’t find Nike skate shoes in chain stores, or the huge barn-like retail outlets. Nike only sells to small independent skate stores, but where there used to be only two or three in a city, now there are two or three in a mall.

Nike knows how to build markets and brand. If history provides any guidance, management will make the right moves and take their time.

Nike and China - Fun for Profit or a Competitive Quagmire?

The Opportunity: a $3 billion sport shoes and apparel market poised for explosive growth (by comparison, American’s spend $30 billion on sport shoes and apparel). Nike has done well in China thus far, but the challenge has been positioning a premium product in an emerging market where cheap knock-offs are yours for the asking. Even with these challenges, Nike is letting it all hang out; with the 2008 Beijing Olympics coming, Nike is sponsoring 21 out of 28 of China’s Olympic squads. To say this shows commitment is the understatement of the century. That all said, nobody is ceding this risky but unbearably attractive market to the Beaverton boys. At present, there are three major players in the Chinese market: Nike, Adidas, and Li-Ning (the local challenger).

The current name of the game in China: major land grab in advance of the 2008 Beijing Olympics. Let’s take a quick look at the competitive landscape.

1. Li-Ning

China : Sports brand Li-Ning plans for Beijing Olympics (fiber2fashion)

Leading Chinese sports giant Li-Ning plans to add 700 stores this year for a total of 4,000 in preparation for the 2008 Beijing Olympics. In 2005, store number rose from 2,887 to 3,300.

The company said about 80 percent of the new stores, which will be located mainly in shopping malls, will be franchised.

Same-store sales, which increased 12.8 percent in the first half of 2005, will also see double-digit growth for the full year.

Ahead of the Olympics, the firm is also boosting promotional and NPD spending. Promotional investment will account for 14-16 percent of total turnover in 2007, compared to the current 13-15 percent, and NPD will rise to 5 percent of costs in 2008 from 3.8 percent currently.

2. Adidas

Adidas aims to overtake Nike sales in China by 2008 Olympics (FinanzNachrichten.de)

Adidas AG (Nachrichten/Aktienkurs) aims to overtake Nike Inc. (Nachrichten) in the China market by the 2008 Beijing Olympics, with a program of accelerated store openings, sponsorship deals and its acquisition of Reebok International Ltd., Adidas’s top executive told the Wall Street Journal.

It plans to open an average of 1.5 new outlets a day in China over the next two years as part of a plan to double its current 2,500 Adidas-brand stores in the country by 2010, chief executive Herbert Hainer was quoted as saying in the report.

‘In two years, I believe we will be market leader in China,’ said Hainer, in Beijing to meet with China’s Olympic Games organizing committee as an official sponsor for the games, where it has committed to spend an estimated 80 mln usd.

Nike, Adidas and Li Ning in three-way race by Normandy Madden (AdAgeChina)

Nike’s global dominance and marketing firepower helped it secure the No. 1 position in China several years ago. Exact market share figures are difficult to come by in China, but industry experts believe Nike controls about 30% of the market today, followed by Adidas with 25% and Li Ning in third place with 18%.

Although Nike has less fashion credibility among Chinese teens than brands like Adidas, its brand is aspirational, according to P.T. Black, a partner at Jigsaw International, a youth trend consultancy in Shanghai. “It encourages kids to be strong in character and have the courage to be an individual,” not entirely Confucian ideals.

So, in short, Nike is fighting the good fight but any battleground that requires major capital commitment, gobs of management time and entails large execution/counterfeiting risks worries me.

Bottom line - Nike has good products. Problem is, they are subject to fads, are still overcoming the legacy of an icon that cannot be replaced, facing increasing competition abroad and trying to extend their brand into other areas. This is not a backdrop where the risk/reward looks favorable. Based upon the data. But the data is just people, right?

Thanks to Rob Passarella and RIck Calmon for their copious research and assistance with this post.

The author does not have a position in the securities of Nike.

Google - A Ben Graham-type Value Play?

Note: this post was carried today on Wallstrip

Overview

I know, I know. I am going to catch a ton of crap from “true believers” in value investing for using such a comparison. I may even be labeled a heretic. But just wait a minute - before the deep value guys burn me at the stake, please read the thought process below. In short, the way it looks to me is that Google has created a platform for my most favorite word - arbitrage. Buy customers cheap, use the platform to catalyze a revenue transformation, and get rewarded for it (effectively, “selling” them) in the public market. I might even make the argument that there is a built-in “Margin of Safety” to the model Google has created and the strategy it is pursuing, further blurring the distinction between its classification as a rapid growth company and one of the principal tenets of value investing (are you hearing this, Warren?). This is a beautiful thing, made massively scalable by Google’s unsurpassed back-end architecture and massively profitable by its advertising revenue-generating machine. After looking at the numbers, doing a little thoughtful analysis and gauging the data across the blogosphere, it appears that our friends in Mountain Valley might, in fact, be a true value play. Let the arguments begin.

Getting a Grip on Google

1. YouTube - Boon or Bane?

In the late 1990s we heard a lot of talk about business model and revenue - but not a whole lot about profits. The philosophy was land grab, plain and simple. There are several looking at YouTube the same way, thinking that Google got taken (or, perhaps, suffering from a little “Irrational Exuberance” in Schiller-speak). I’m not so sure. For a moment let’s take a step back and think of a metaphor to help us understand Google’s thought process. These are clearly not stupid people and must have some logical basis for laying out $1.65 billion for this nice little company. Using the Jeet Kun Do model, clearing our mind and thinking outside the box, I’d like to offer one possibility: Think Advertising. Using this model, a company’s valuation is based solely on audience, and getting other people to pay money for access to this audience. Market capitalization should, therefore, be directly related to the population of people you can attract to whom you can display ads (for which you can get paid). So, the thinking goes that a useful, yet simple-headed metric for customer valuation could be market capitalization divided by unique users. Let’s try this out and see where we get.

For those of you who have been living under a rock for the past eight years, Google makes a LOT of money from advertising and keywords. Real money. Big, big money. Monetization is not Google’s problem. Eyeballs targeted => Ads => MONEY. People pay to advertise and get priority access to keywords on the Internet, and Google is all about directing traffic and making money. They are like the ultimate traffic cop on the take (sorry, Ray Kelly).

2. YouTube - By the Numbers

“The Tube” spends most of its dollars on technology to route, upload, access and search videos, based on user requests. Google paid $1.6 billion for 72 million unique monthly viewers. That equates to an acquistion cost per customer of $22. You can argue over the 72 million users, so if we cut that in half (to forestall any arguments) to 36 million, that’s a cost per customer of $44. So to Google, a YouTube customer cost somewhere in the $22-$44 range.

3. Other Media Outlets - By the Numbers

TV

Fox’s American Idol has 21.1 million viewers. At $660,000 for a 30 second spot, a 1-hour show would have close to 15 minutes of commercials yielding a revenue of $950 million a year (30 spots a show X 4 shows a month X 12 months), or an implied value of $45 per user.

NY Times

The New York Times Company, has seen better days. In the last 2 years the stock has gone from the low 40s to the low 20s. Imagine that - 50% of its market cap erased in 2 years - a direct result of online media taking its toll on MSM. NYT currently has a market cap of $3.3 billion, Net Income of $259 Million, and a 5% profit margin. They have 1.7 million print subscribers and 37.7 million unique web viewers per month, which includes About.com. For arguments sake we’ll put them together for a total of about 40 million viewers. Using our admittedly rough methodology a NYT customer appears to be worth approximately $82.

The Googleplex

With a market cap of a stunning $144 billion, Net Income of $1.4 billion and 25% Profit Margin, what is a customer worth to The Beast? In the strictest sense Google is all about advertising, and it has rapproximately 380 million unique monthly users according to Neilsen/NetRatings - spending an average of 22 minutes on the site. The market cap divided by the number of unique users per month nets a per customer value of $380. Zowie.

4. YouTube - the Verdict

With YouTube valued at $22-$44 dollars a user, Google must see this and be licking its chops. Or, to me, “This is a grand arbitrage opporunity.” Google knows what it can squeeze from a user, how it can scale users and how much it should pay to acquire users. I’d say that $380 in vs. $22-$44 out represents the kind of margin of safety value investors can get their arms around. Even if the ad market gets increasingly competitive (say, if Yahoo! can ever post a credible challenge), and they can monetize even at the levels of the NYTimes, that’s a YouTube valuation of $2.8 billion ($82 X low-end 34 million customers). In short, this represents a pretty nice IRR given the likely monetization time horizon. Even a little exposure to the Googleplex can go a long, long way.

Getting a Grip on the Risks

With a margin of safety like that where are the risks? Well…

YouTube - This Isn’t a Game

YouTube isn’t simply a place to go to upload/download video content. Why did YouTube prevail over Google Video despite the significantly faster bandwidth and fewer restrictions? It has created an expansive yet tightly-knit user base – in short, a culture and a community all its own. With these entanglements comes risk. A user-base sensitive to changes, especially one that could fundamentally impact the user experience, will not hestitate to speak out - and do so with great force. Mark Zuckerberg of Facebook found this out the hard way.

Generation Facebook is taking action — against Facebook. On Tuesday morning the popular social networking site unveiled a new feature dubbed the “News Feed,” that allows users to track their friends’ Facebook movements by the minute. For many of Facebook’s 8 million-plus student users, it was too much. Within 24 hours, hundreds of thousands of students nationwide organized themselves to protest the new feature. Ironically, they’re using Facebook to do it.

Since Tuesday, a handful of anti-News Feed groups have sprung up on Facebook. The largest has 284,000 members and is called “Students Against Facebook News Feed (Official Petition to Facebook).”

This is a user base that is all about open discourse, free exchange (copyrighted material), pushing boundaries.  Check out my post on the Michelle Malkin controversy, in addition to the latest controversy over a restricted political ad which drew a firestorm in the blogosphere. In short, the integration of YouTube is not simply A+B=C^2 (with the exponent due to Google’s ability to turbocharge per-user revenue). In fact, the equation could end up being A+(B-D)x2=C, where the D is disruption and conflict arising from integration, and the x2 reflects the drain on management time required to deal with a troubled acquisition.

Being Big and Successful - It can Really Suck

Google is quickly becoming and established, BIG Corporation – with all the restraints and controls that come with it. The Boston Herald carried a great piece on the backlash of some users. It was just one of many visceral reactions YouTube members had to the news. Many comments and videos posted on the site were congratulatory. But many people expressed concern that Google’s acquisition could tame the Wild West culture YouTube has fostered.

“Anytime a huge corporation takes over another one, the fact of the matter is, things change,” a YouTube user, who goes by Mykal100, said in a video post. “Google, hands off. Don’t change a thing.” One only has to look at the responses to the now- famous “Kings” video, featuring founders Chad and Steve to feel the hesitation and fear amongst their loyal fans:

fuck this place seriously its just going to go to hell. once google gets their hands on it its just going to have a bunch of restrictions. all you stupidasses can congratulate them for selling out but i think they sold us off to the slaughter.

nothing good lasts. youtube is gonna go down hill from now since its in googles hands, get ready for comercials or having to pay to put a video on. i would of sold out too but i wouldnt of made a stupid video about it…

Well, they have now taken the you out of youtube. The whole point of youtube was to allow a bunch of nobodys, teens, adults, elderly people, and let them broadcast themselves. From what I’ve heard you will now have to pay to watch. Who in their right mind will pay to watch Mr. Pregnant?

The biggest risk in the YouTube deal is something so old economy - Integration Risk. Google needs to leverage YouTube without destroying the ultimate value of YouTube, the community. Google will need to balance open, edgy world of YouTube and the emerging corporate safeness and conformity of Google. Already we can see chinks in the armor. A few months ago I had written a post on creative destruction, and specifically referenced Google. I think it is some of the things I mentioned in that post which pose the greatest risks to the Company as it continues to grow and evolve:

So, what about Google, the glamour gal of the moment? Still pulling in great people, losing few top performers, innovating like crazy, focused on organic growth. So where are the chinks in the armor? As noted in a previous post, Google is really great at general search but pretty crappy at targeted, vertical search. Domain expertise is not their forte, and a massive industry has been born and is being nurtured around this idea of domain-specific vertical search. Depending upon how robust and specialized these search engines get, one can imagine that advertisers would be willing to pay more for eyeballs that have essentially self-selected by living on a particular vertical search tool versus surfing a generalized search tool. This could suck ad dollars away from Google and render their general search model a highly profitable but less rapidly growing enterprise.

This would not be good and would readily translate into a manifestation of creative destruction. While they have clearly created an innovation culture around Google Labs and fostered big-thinking by their employees, they need to turn some of this potential energy into kinetic energy if they are to maintain their growth trajectory, drive stock price and keep employees pumped and excited.

While it is hard to get to the top, time (and our friend J. Schumpeter) has shown that it is even harder to stay there.

Conclusion

Bottom line: an investment in Google entails risks, and serious risks to be sure. That said, the margin of safety for investing in the Company - given its dominance in online advertising, an unparalleled infrastructure and some of the brightest minds on the planet -means a lot of bad things can happen before its model begins to weaken. And as it becomes more acquisitive, its opportunity for turbocharging its value creation just grows. I see Google as a legitimate value play. May Ben Graham’s ghost not strike me dead for uttering these words. But we’re talking Google, baby. I’m not sure I see the analogy in the Ben Graham era.

Thank you, Rob Passarella and Rick Calmon.  Excellent job researching this post.

The author does not have a position in the securities of Google.

3 Thoughts on Today's NYT Business Section

These could be three epic-length posts by yours truly, but given my lack of time and your lack of interest I have decided to consolidate my thoughts into this one post on three interesting pieces in today's NYT Business Section.

1. Randall Stross in Digital Domain on VC in the Silicon Valley

First things first. I live in New York. I run a venture-backed company. Before I ran a venture-backed company I knew lots of NY-based VCs and many successful Tri-state area start-ups. Yet somehow, the Silicon Valley PR machine just keeps on cranking out favorable pieces in the popular press. Don't get me wrong; I love the Valley. Super smart people. Super forward-thinking investors. Incredible sources of intellectual capital. Amazing linkages among the entrepreneurial community, the VC community and the university R&D community. They've been at it a long time and really have a finely-tuned machine for incubating and developing ideas. They rock.

But Randall and friends, I've got something to tell you. New York is a great place to do a start-up. Why do I seldom hear more textured analysis about the kind of start-ups that might be better suited to the Valley versus NYC? Say, more consumer-oriented, enterprise-software-type start-ups out West and more B2B, advertising and media-related start-ups out East? The Valley may have all those legendary VCs, a base of successful entrepreneurs, world-class angels and Stanford, but NYC has some pretty awesome VCs, a smaller but growing base of successful entrepreneurs, very well-formed and effective angel groups, Columbia, NYU (MIT not too far away), Wall Street, Big Media, Big Advertising, and pretty much Big Everything Else.  Somehow this all gets lost in the wash - why this is I don't know.

So my message is short and sweet. For all those looking to start a company, please, go to the Valley. That will just leave more for us out here. NYC simply rocks. But it's PR really sucks.

2. Mark Hulbert on the Meaning of Large Corporate Cash Balances

I apologize in advance for taking such large snippets of this article and re-posting it below, but Mark Hulbert has hit on a very important topic that was at the core of some work I did with a colleague in the late 1990s. Here are key extracts from Hulbert's piece and I'll tell you why I believe they are so meaningful below.

PUBLICLY traded American companies hold so much cash that, as a group, they could pay off all their debt and still have money left over. According to a new study, this cash-heavy status reflects a major shift over the last two decades, and it isn’t necessarily a good sign for stocks.

The study has been circulating since September as a National Bureau of Economic Research working paper. It is titled “Why Do U.S. Firms Hold So Much More Cash Than They Used To?,” and its authors are Thomas W. Bates and Kathleen M. Kahle, finance professors at the University of Arizona, and René M. Stulz, a professor of banking and monetary economics at Ohio State. A version is at nber.org/papers/w12534.

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So what is the main cause of the climb in corporate cash? Upon analyzing a dozen factors that economic theory suggests could play a role, the professors found that the biggest was an increase in risk — as evidenced by factors like unpredictable cash flow. Corporations have become less able to count on steady cash flow from year to year, according to the professors, and despite the growth of a complex derivatives market, companies can’t adequately hedge this risk without holding more cash.

This helps to explain why so few companies are paying out their bigger cash hoards as dividends. Because companies are loath to cut or eliminate a dividend once they start paying it, they won’t establish or increase a dividend unless they are highly confident that they can stick with it through thick and thin. But that confidence is precisely what is missing at a growing number of companies.

The professors’ analysis casts an entirely new light on valuation measures that rely on cash levels — gauges like cash-to-assets or cash-to-sales ratios. An investor who relies on such measures often assumes that companies with more cash are less risky, because they have more of a buffer against rainy days.

But this assumption may well be wrong, Professor Stulz asserted in an interview, if the companies holding more cash have more rainy days than companies holding less cash.

To properly compare two companies on the basis of cash holdings, Professor Stulz says, you should first compare their risk, as measured by factors like the volatility of their cash flows. Only if a company is holding more cash than is justified by its risk can we conclude that it is genuinely more conservative.

Professor Stulz says he is not aware of any investment firms that now conduct the econometric calculations needed to make these assessments. And he concedes that those calculations would be complex. But without them, contrasts of companies’ cash levels amount to little more than comparisons of apples and oranges.

This analysis and their reasoning for why corporate cash balances have risen is absolutely spot-on. In the 1999-2000 period, when I ran a team in equity derivatives at Deutsche Bank, I worked with a fellow named Tim Opler (now of CSFB) on a framework for analyzing the "cost of financial distress" for a given company and, therefore, the optimal amount of cash to be held as a hedge. Tim, a former finance professor at Ohio State and SMU and a total brainiac, worked in the Liability Strategies Group at Deutsche and shared my passion for helping companies address this thorny issue. 

We essentially ran models that looked at precisely the things mentioned in the study above - namely, the volatility of a company's cash flows, its relationship to economic cycles, potential changes in business mix and its impact on the characteristics of future cash flows, quantifying what constituted "financial distress" and arriving at a recommendation for a base level of cash or near-cash that should be held to cover this risk. We specifically looked at companies that generated large amounts of cash - technology companies, telecommunications companies, regulated utilities, etc. - and advised managements on corporate finance policies like stock buybacks, dividends, and long-term debt issuance strategies. I will tell you that this type of analytical framework resonated with Treasurers and CFOs alike, and had a real impact on how many companies managed their cash - in some cases, gaining the comfort to increase their dividends/share buyback programs, while others chose to issue long-term debt to build the necessary cushion to most efficiently take the tail risk of financial distress off the table.

In any event, thanks to Mark for raising this issue and citing this study. It will become a core piece of corporate finance literature that should have a material impact on company policy now and in the future.

3. Alex Tarquinio on Bank of America's Retail Brokerage Strategy

Alex writes a nice piece on the nuts and bolts of B of A's new offer. But one story line I seemed to have missed (and, quite honestly, the story line that I want to read about) is how this was a massively disruptive move to the online brokers and how billions in market cap disappeared overnight in the wake of B of A's prescient move. TD Ameritrade, E*TRADE, Charles Schwab - not fun to be them right about now. B of A has, overnight, changed the playing field.

They are a multi-product retail powerhouse. They could, should they so choose, scoop up on of the major online brokers to gain access to retail accounts that they could cross-sell mortgages, credit cards, and a panoply of bank-related products with attractive profit margins. Or, they could pursue an organic growth strategy that just chips away at the big online brokers' client base. B of A did this in the corporate credit market, then derivatives, then debt and equity issuance, then advisory services. Don't get me wrong - Goldman Sachs they are not. But they've got pockets of product excellence, strong management, a deep bench and an unparalleled balance sheet. It will be fascinating to see how this retail brokerage strategy plays out but of one thing you can be sure - they are not messing around. And with a strong stock, 250 billion in market cap and the staying power for a marathon, the world is their oyster.

Thanks, NYT, for raising so many interesting topics this Sunday. I'm looking forward to next week's performance.

More on Derivatives - Necessity vs. Novelty

First of all, I'd like to thank the folks over at the FT for taking my somewhat tough post concerning MSM's depiction of Wall Street trading risk so seriously. They put up a post in their blog, Alphaville, about my emotional (passionate?) missive in Information Arbitrage yesterday. I had to crack up when their lead-in was as follows:

In the blogosphere, the mainstream media, the FT included, has got Information Arbitrage’s Roger Ehrenberg, the former head of Deutsche Bank’s fund of hedge funds and president of Monitor110, all hot under the collar.

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“A $120 million loss on a trading desk, unless the loss was the result of poor controls or a rogue trader, is neither a show stopper nor something that warrants intense eyebrow-raising and upset stomachs.”

Message received loud and clear, Roger.

Bottom line: they heard me. That's pretty cool - thanks, Alphaville. I don't know whether or not it was coincidence, but the FT had two very interesting stories yesterday on the issue of derivatives that I believe warrant discussion. But before that, let me tell you my view of the evolution of the derivatives marketplace since the early 1990's.

My 2 Cent Perspective on Derivatives History

I think the early-mid 1990's could be characterized as the wild, wild west period of the derivatives markets. A bit of a gold rush mentality prevailed across most asset classes. Interest rates were low, companies frequently viewed their Treasury operations as profit centers and people sold crazy, crazy instruments to banks. Sales of naked options - principally variations on interest rate puts. Leveraged derivatives (does anyone remember the LIBOR-cubed swaps?). Pure punts via "index amortizing swaps" calibrated to a particular rate view. Risky and massive mortgage books that served to underlie MBS pools. At the same time, banks built huge portfolios of complex correlation risks while the risk management systems themselves weren't yet sufficiently evolved to deal with these mounting exposures. You can think of the risks inherent in this market environment as something akin to a Ferrari attempting to traverse the cobblestone streets of Rome at 140 mph. Someone is going to hit the wall. It was inevitable.

Then came the Fed's 300 bps increase in rates starting in early 1994. The party was over, and the derivatives speculators (note that I use this word and not the word "hedgers"), in general, were caught off-guard. This includes both corporate sellers of volatility who were simply trying to collect premium they thought (and hoped) they wouldn't give back (which they did, in spades) and trading desks that were also poorly positioned for the flattening yield curve environment. MBS buyers also got clobbered as duration was extended in a rising rate environment. And all of this happened in the face of one of the steepest yield curves in history, with short rates pegged at 3% and the long bond trading at 8%. Remember why a yield curve slopes upward? The interest rate market's expection of higher future rates. Did this scare people? No way - sell forward optionality! Harness that steepness to collect premium today which hopefully won't have to be paid back later. And this is why things got really ugly when the Fed took the punch bowl away.

First came the P&G/Bankers Trust debacle. A corporation taking a $200 million trading loss on a "hedge?" Sure, a "hedge" that had a duration of 125 years (which offsets precisely what exposure in the business?). Then Air Products. Then Gibson Greetings. And countless other corporations of scale who lost hundreds of millions of dollars when they had to mark these derivatives to market but who suffered in silence when the losses hit. And, of course, the corporations blamed the banks for fleecing them (which is a bunch of crap, to be sure, but hey, you gotta blame somebody other than yourself). Bottom line - a little bit of the luster came off of the derivatives market, but even if corporate use of these tools slowed during the 1994-1996 period, institutions and governments continued to use these tools in quantity.

As the late 1990s/early 2000s rolled around, there was a key theme that precipitated the exponential growth of the derivatives marketplace: the blurring of the lines between debt and equity. First the equity derivatives marketplace really exploded, with an amazing amount of innovation benefiting investors and issuers alike. Structured convertible bonds that lowered issuance costs for corporations, equity hedging strategies that created extremely flexible, cash-efficient share buyback programs, private convertible instruments to monetize appreciated stock positions, portable alpha strategies for pension funds, and on and on and on. At the same time, the concept of "capital structure arbitrage" was born, emerging from either the convertible trading desks or the credit trading operations of the large Wall Street firms. This strategy of trading the different strips of the capital structure was facilitated by an innovative but very straight-forward tool - the credit default swap (CDS). CDS allowed credit buyers and sellers to use derivatives in lieu of the actual instruments to create a position. It was this emergence that, to me, accelerated the blurring of distinction between debt and equity. Artificial barriers would no longer be tolerated. How can you optimize the trading of equity without taking advantage of the information and liquidity inherent in the debt? And this, in turn, set in motion the innovation we have continued to witness over the past five years.

CDS, LCDS, CBOs, CDOs, CLOs - these tools have emerged to help buyers and sellers get what they want, either in terms of risk transfer or portfolio return objectives. As these markets have grown they have become more standardized, and issues of weak documentation are being dealt with aggressively by Wall Street trading desks and their counterparties alike. I am sure, by now, you are completely nauseated by my little missive on derivatives history, but I have done this to prove a point - when instruments are created that generate real value, the markets explode. When they are mere gimmicks that fail to materially enhance one's ability to either make money or manage risk, they falter. And it is here that I'd like to turn to the two stories in the FT.

When Derivatives are Necessary - A Market Emerges

Richard Beales' article drives home the point that innovation has been rapid and has created real benefits, but not without some concerning arising from fears over how the markets will handle stress and unacceptable levels of undocumented trades:

The pace of financial innovation is quickening. Products that barely existed a few years ago are already multi-billion-dollar markets.

Derivatives and structured instruments have evolved particularly quickly across the capital markets, especially in the worlds of credit, equities and commodities.

Many of these innovations benefit the financial system because they help disperse risk more widely, analysts and regulators say. But there are concerns as they have come at a time of economic growth, low interest rates and low volatility.

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Other novel instruments are also designed to serve a practical purpose. Loan-only credit default swaps (LCDSs) allow lenders to hedge exposure by buying a type of insurance or protection against the borrower's default – though they also allow hedge funds and others to take positions without owning the underlying debt.

The LCDS market is an offshoot of the still rapidly growing market for basic credit default swaps, the most common credit derivatives. While CDSs enable market participants to buy and sell protection against default on unsecured bonds, LCDSs are designed to track the credit of secured loans.

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Innovation brings challenges for regulators. In the credit derivatives world, US and European regulators have also had a hand in encouraging the finance industry to put its house in order. Last month was the anniversary of an initiative to clean up paperwork problems and increase automation in the industry.

The Federal Reserve Bank of New York, which hosted a meeting of 16 dealer banks and their regulators, welcomed progress in cleaning up the backlog, which a year earlier had been seen as a potential threat to the stability of the financial system.

But in a sign of the pace of innovation, the regulators' attention is shifting to other parts of the derivatives world, such as equity derivatives.

"We look forward to seeing the industry improve the automation and standardisation of over-the-counter equity derivatives trading and reduce the current levels of unconfirmed trades," said the New York Fed.

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Sure, when you are building a trillion dollar market there will be bumps in the road. But when you look at the ability for issuers and investors alike to:

1. Benefit from enhanced liquidity;
2. Transfer risk to those best able to absorb it; and
3. Access a vehicle for taking a holistic view of the capital structure and to express a view in a variety of different manners and market

It is hard to underestimate the value of this innovation.

When Derivatives are a Novelty - The Market Flounders

Saskia Scholtes also had an interesting piece on the equity default swap (EDS) market, which has has languished since its development in 2003:

Of the many ideas thrown at the wall by investment banks eager to develop the latest must-do derivative, not all stick that well.

One product that appears to have been consigned to the derivatives larder for now is the equity default swap.

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Launched in 2003, when memories of the bursting stock market bubble were still painfully fresh, the concept was logical, say investors.

But equity market volatility has subsided and the attraction has waned. Protection against a fall in share prices is also easily achieved with a simple put option. The promised growth in EDS trading volumes may be on hold, at least until the next bear market.

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The idea was to allow banks and investors to fine-tune their positions further. But one credit hedge fund manager suggests that this added level of complexity may have been "one step too far" for broad-based market adoption.

The key take-away here is that innovation for innovation's sake simply doesn't work, even in the "arcane and esoteric" world (needless to say, I am being extremely sarcastic) of derivatives. The market knows what it needs, and when smart people come up with smart ideas there is rapid adoption followed by exponential growth. It is good to know that there is a self-policing mechanism in place called Mr. Market which makes sure necessary ideas are rewarded while others fall by the wayside. This is the way it should work, right?