Innovators of the World, Unite!

Dan Denning discusses Google, GM’s future, piracy in the South China Sea, and Airbus, among other things.

Innovators of the World, Unite!

***Pirates of the Sulu Sea, Oil Chokepoints
***Dreamliner Takes off, and so Does the A380
*** What Is Google Worth, or a Berkshire Hathaway for the 21st Century

“Many critics believe that GM’s real problem is the inferior nature of its products. They aren’t just saddled with humongous legacy costs…they have been outdesigned, out-engineered and outclassed by their competitors at every turn. For decades. Even if the U.S. government decided to give GM a shot in the arm by taking on the majority of its legacy costs, putting it on a level playing field with Toyota and Nissan, it would still likely be crushed in the long run. GM has simply been lapped, numerous times, by the top competitors in the global automotive industry.”

— Justice Litle, editor, Outstanding Investments

Dear Reader,

Some bonus Whiskey action for you this week, courtesy of a heated debate about the value of Google, the future of General Motors, the battle between Boeing and Airbus, and piracy of the good old-fashioned kind. Enjoy!

By the way, you may already have read Justice’s ideas about the energy situation in China. But if you haven’t, take a look at the latest scenario he and Addison Wiggin have conjured up called, “When the Lights go Out in Shanghai.”

Pirates of the Sulu Sea, Oil Choke Points

Austin Bay ( always has interesting things to say about geopolitical and military affairs. Today, he covered a theme I’ve written about here before: world oil choke points. If you think of oil as the blood of the world’s economy, the choke points are like giant transit hearts scattered over the globe. A little constriction at these points — for any reason — can cause an economic heart attack.

China — which is hugely dependent on imported oil — is particularly vulnerable to its oil supply being choked off at the Strait of Malacca. I mentioned it last week in Strategic Investment. And it’s something I’ve covered in The Bull Hunter as well.

Yesterday, Austin Bay wrote about the possibility that piracy and terrorism could combine to cause very real problems at these choke points, especially in China’s part of the world:

“In late 2002, I was in Singapore and received a short briefing in on counterpiracy operations. (That trip led to a Weekly Standard article entitled “Dire Straits.”) The Singaporean police officer who briefed us stressed the need for international cooperation by police and naval forces — not too earthshaking a statement, but then he started discussing some of his concerns with port security. In Southeast Asia, the interests of pirates and political terrorists can and do intersect. It’s another example of organized crime and political terror intersecting in what an earlier post on this page called the ‘Venn diagram of violence.’

“U.S. and U.S.-ally naval officers have told me the big fear in Southeast Asia is terrorists hijacking an oil tanker. The terrorists blow up the tanker and create an ecological disaster. Of course, this attack could be executed anywhere. Straits (choke points) channel sea traffic. Pirates in small, fast boats can launch a quick attack from the coast. A terror attack will always generate huge headlines, but the headlines will be bigger if international shipping is stalled because a key strait is closed. (Recall that a French tanker was attacked in a channel off Yemen’s coast, though I think it had already cleared the strait leading to the Red Sea.) The other fear police, coastguardsmen, and security planners share: a nuclear or chemical bomb hidden in a shipping container. I’ve a quote below from a Web site discussing pirate attacks. It mentions the Sulu Sea in the Philippines as a pirate ‘hot spot.’ The Sulu Sea cropped up in a discussion I had with a U.S. Navy officer in 2001 — along with eastern Borneo and the Thai coast. Abu Sayyaf (the Filipino Islamist terror organization) operates in the southern Philippines and scoots from island to island in small powerboats — operating like local pirates.”

Our Pittsburgh correspondent and Navy man Byron King is on the high seas as we speak. But I’m sure we’ll be hearing more on this story in the future.

Dreamliner Takes off, and so Does the A380

The A380 finally made it off the ground today. I had my doubts that the behemoth would actually be airworthy. In fact, I didn’t think it would make it off the ground. But there it was, up in the French sky, all 421 metric tons of it.

The A380 is designed to carry 555 passengers. But it can be expanded to carry as many as 800. Who would want to share the same air with 799 other passengers for nine or 10 hours on one of the long-haul routes the A380 is designed to fly?

Airbus has already taken 154 orders for the freighter version of the plane. And the airline Emirates, based in Dubai, has already ordered 43 of the Big Berthas. No orders yet from American carriers.

Don’t weep for Boeing, though. Airbus’ biggest competitor has had a great 2005, despite the disappointing results it announced this morning. Boeing said first-quarter earnings fell 14%. Deliveries of airplanes fell by six planes from the same time last year, mainly due to competition from Airbus.

The whole Boeing-Airbus feud is fertile ground for examining economic issues like government subsidies, the impact of oil prices on transportation, and the use of composite materials in fuselage construction (more on that below). But it’s also a textbook case for studying business strategy.

The A380 is impressive in the way an enormously fat baby is impressive. We are slightly in awe of it while being delighted with the unnatural size. Still, the whole thing smacks of grandiosity ahead of practicality.

Not that modesty should be required in aircraft design. But the Boeing strategy of building smaller planes with less passenger capacity — but ones that can go point to point and get people exactly where they want to go — seems to be vindicated by the number of orders rolling in for 787, the Dreamliner.

Boeing has sold out its entire annual production capacity for the 787 for 2008, 2009, and almost all of 2010. The 787 carries a maximum of 257 passengers — or less than half what the A380 can carry. But this week, Air Canada ordered 14 787s, in addition to 18 other Boeing planes. And yesterday, Air-India ordered 27 787s, each of which is priced at about $120 million. The list price of an A380 is about $220 million.

Twice as much plane is worth an extra $100 million, right? Or is it? How do the economics of the planes work? Like any business, there are metrics unique to the airline industry that determine what kind of revenue you can expect to produce and how much it costs you to produce it.

In the airline business, for example, the number of seats, fuel efficiency, and maintenance costs are the big factors. That’s why using composite materials to make a plane lighter improves both speed and fuel efficiency while reducing maintenance costs. Time will tell which company has read the market right. And strictly speaking, the 787 doesn’t compete directly with the A380. Airbus has smaller plane, the A330, which is more useful for the sake of comparisons.

Still, it is hard to resist the imagery of the A380 versus the Dreamliner. It is not a perfect metaphor for differences between Europe and America. After all, both firms are subsidized — directly or indirectly — by governments that want them to succeed. In the end, it will come down to what people prefer to fly in.

Or think of it in public transportation terms. In London, you can take a black cab or a double-decker Routemaster bus. The bus system is good, but you have to put up with the pervasive dour faces and multiple stops. A black cab, while slightly more expensive, will get you door to door. Which do you think the world’s business travellers are going to prefer?

Public perception may end, depending on the safety of new composite fuselages — the element so critical to the cost advantages and improved fuel efficiency of the 787. As Boeing has pointed out, several new technologies make their debut in the 787, the most important of which is composite wing and fuselage construction.

Composite technology allows Boeing to build the fuselage in several large pieces, rather than many smaller metal ones. A normal metal fuselage can require as many as 1,200 aluminium pieces held together by as many as 50,000 rivets. And proponents say the composite planes will last longer, wear better, and require less maintenance.

We’ll see. That is, we’ll only find out after the composite planes have a longer operating history. And it seems obvious that the use of composite materials in the construction of airframes is one way to cut costs, especially with prices for base metals rising over the horizon.

But how well does a composite airframe handle turbulence at 35,000 feet after, say, 10 years in service and thousands of hours in the air? I’m not trying to an alarmist, but the temptation to use lighter, stronger materials is obviously driving the development of new planes. And it certainly makes sense. For more on how composite airframes are built, see:

And if you’re an engineer with some special knowledge of this kind of thing, hit us up with an e-mail. And by the way, I included a chart of Boeing below going back to 1971, in log scale. What does it show us? Well…it could be a giant head-and-shoulders pattern for industrial companies faced with increased global competition and rising energy prices…or something else entirely…or nothing at all.


And one final note on composite construction materials from a Web site about mountain bikes. Why mountain bikes? Mountain bike makers have been using composite materials for years because it makes the bikes lighter (which riders like me, who are not getting lighter, like) and cheaper to produce. Increased sales. Declining production costs. Not a bad formula.

But as the anonymous poster below points out, there are some structural dangers. I should disclaim this by saying I’m not implying the same things could or will happen in the airline industry. After all, the cost of structural failure at 39,000 feet is probably going to be higher than at 3 feet, with a lot more lives at stake. But it’s worth thinking about. The post is about the propensity of carbon-based frames to shatter when confronted with irregular kinds of stress.

You can find the whole post at By the way, I don’t agree with the poster’s conclusion about the nature of capitalism, but as I am quoting a lot of his work, I thought it wouldn’t be fair to edit out his point of view on the whole matter:

“Carbon frames aren’t carbon. They’re a composite of many different materials and a plastic or resin (like plastic, anyway) filler. The outer layer on a good composite frame or component will usually be spectra or rouging or Kevlar or SGlass or something to protect the structural carbon below. This is because carbon is indeed brittle, but not like you’d expect. It doesn’t shatter, really. It’s fibrous, and when it breaks, it’s sort of like breaking a stick of celery, but flakier.

“Anyway, the stresses concentrate at weak areas, much like a weak link in a chain will break first. The stress piles up there, usually causing some damage, making it even weaker, and causing more damage, till you have a failure point. Grooves, sharp corners, angles, seams, scratches, anywhere there’s an interruption in the surface becomes the weak link and is called a stress riser (the amount of stress rises on these features).

“There’s an entire science behind notch sensitivity. It’s a big deal. A notch will alligator out till your frame rips open or your cranks crack or your bars snap, etc. There are ways for this notch sensitivity to become a problem. A big one is galvanic corrosion. Companies who do a quickie job of bonding aluminium fittings and inserts into carbon amaze and delight on the showroom floor. A full-carbon Trek for $700! Yippee! Yes, well, aluminium reacts rather poorly, I’m afraid, when in direct contact with carbon. So this is where frames get more expensive.

“A carbon seatpost goes into your frame and gets pinched by the cheap slotted-seat tube method everyone’s been using forever. Tighten that skewer or bolt too much and you’ll cause the edges of your slot to indent into the post. That poor little length of seatpost has to support all the load and impact loading your entire frame has to. Putting a notch in such a critical place is like taking the express train to tire-induced friction burn on a** town. Still, everybody does it. Yep, and everybody breaks ’em, too. You just accept it.

“Seatposts break. Carbon ones doubly so…Same goes for cranks. And frames. The less expensive your carbon frame, the higher the failure rates will be. Doing carbon right takes time, and there’s no way around it. Also, typically, the bigger the company (like the one I work for. Anonymity is grand), the cheaper their carbon will be, regardless of the sticker price. This is due to a few things, but one very big one is that when you get very big, there are exponentially more hands in the pie, and keeping your retail price competitive means the cost has to come out of somewhere, and it certainly can’t come out of payroll. So you find the cheapest possible way to get the job done and charge as much as you possibly can for it in the end, hoping that there’s a penny left in it for you after the dealers have taken their 40% margins, the reps have taken their 20% cuts, the distributors have taken their 30% margins…welcome to capitalism. We’ve become a nation of suck-eyed jackals skimming off the top. But who suffers? The not-I’s go all the way around till they find you sitting in the middle of the trail on a broken pile of carbon slivers and aluminium shards…Price-driven markets kill innovation. But in a dangerous sport like this, they kill people. But you people keep buying what we’re selling, so as far as we’re concerned, money talks, and it’s your own damned fault.”

What Is Google Worth, or a Berkshire Hathaway for the 21st Century

After the MoneyWeek roundtable last night, I walked down past the Southwark tube station to have dinner with my fellow roundtablers at Baltic, a crowded and loud restaurant featuring…food from the Baltic. Or something like that.

“Did you realize that Google’s market cap is now larger than GM’s and Ford’s…combined?” one of my colleagues asked me.

It’s true. Google sports a $60 billion market cap, trades at 85 times trailing earnings and 15 times last years sales.

“Which would you rather buy,” my colleague asked me, “Newscorp, Rupert Murdoch’s baby, or Google?”

“Well, why would you pay that much for Google now?”

“Because its future earnings are going to be even higher.”

“What are its assets?”

“I don’t know. But even Murdoch admitted that the old media need to become more digital, or they’ll get passed by.”

I’m not going to Google bash. Google is no The company nearly quadrupled its profits in the first quarter on a double in revenue growth. The $369 million in profits on $1.25 billion in sales came out to a net income per share of about $1.29 — enough to send the stock up nearly 10% since it reported the good news last Thursday.

But if I’ve got my math right, based on Google’s SEC filings, 57% of the growth in Google’s balance sheet assets in the last quarter came from a $319 million increase in the value of its marketable securities. Hmm.

What marketable securities? The recent quarterly report does not break them out by line item. But the last annual report did. What it shows — again, if I’ve got my math right — is that in 2004, the value of Google’s marketable securities increased by 818%…and within that set, its municipal securities (bonds?) showed an 818% increase.

Google appears to own $1.6 billion in muni bonds, unless I’m missing something.

I bring it up because during the post-roundtable dinner (and drinks), Merryn Somerset Webb, the editor of MoneyWeek, asked us to suggest questions for her interview of Warren Buffett next week in Omaha.

My question: If you were starting Berkshire Hathaway over today and you had to choose between starting with Google or GM, which would it be?

I’m sure Buffett wouldn’t accept the premise of the question. But for me, the intriguing part of the question is the difference in assets. Granted, GM’s liabilities complicate the matter. But even in liquidation, you have to wonder if GM’s tangible assets — whether they pay off bondholders or pensioners in a liquidation is an entirely different question — are more or less valuable than Google’s municipal securities.

Google admits that other than its cash, its chief asset is its proprietary technology and its business model. Among risk factors in its report, it cites two that caught my eye:

  1. New technologies could block our ads, which would harm our business.
  2. Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services, and brand.

GM is paying the price for competing in a globalized manufacturing world and trying to turn itself into a finance company. Yet it still does have real assets and capital.

What does Google have that can’t be stolen, pirated, or regulated into submission?

I asked this question internally and got a flurry of responses, one of which I quoted at the beginning of today’s letter. Not too many investors would want to be in the position of HAVING to own either Google or GM.

But in some ways, the stocks of these companies already tell you a lot about the American economy. Will GM foist off its pension obligations on the government? Will the government accept them, preferring to create another liability for taxpayers, rather than putting a lot of voters out of work if GM fails? Will GM fail? And if it goes, would the financial fallout on jilted GM bondholders be, in economic terms, worse than a mass layoff?

Depends on who you ask, I suppose. We may find out the answer soon enough.

Until then,

Dan Denning
April 27, 2005

P.S. GM does have real assets, and plenty of them. But it also has tremendous liabilities, not least is it’s long-term debt. A GM debt default would send ripples through the entire economy.

It’s also impossible to separate what’s happening with GM with what’s happened in China. Industries are being wholly dismantled, buckling under the weight of the labor advantage of the East.

How can American manufacturing firms remain competitive in this environment? James Dyson, the British engineer and vacuum magnate, says you do it by going back to your roots…superior engineering.

It may be easy to rip off intellectual property these days, as Google candidly acknowledges in its annual report. But constant innovation is the key to retaining a competitive advantage. Some firms in China may make a very good living reverse-engineering Western-manufactured goods.

But if you stick with quality and constantly add value, you’ll find your niche. And in any event, Dyson makes the excellent point that making something in China is not a complete loss — IF the intellectual property value added is contributed from the United Kingdom, and the profits go to UK shareholders and the taxes get paid to a UK government.

Is Dyson right? Who knows? It’s unlikely that the UK and American economies will suddenly rediscover the value of mechanical engineering. We favor “retail therapy” over taking our medicine. And when it comes to our institutions of higher learning, it’s a lot more fun to study the past under a charlatan like Ward Churchill than do something about the fact that your economic birthright and future is being consumed by your peers in the East.

Don’t expect Dyson’s solution — going back to our saving and investing roots — to become a public policy goal, either. Most national governments are concerned with saving jobs because workers are also voters. And in any event, national policy will do little to reverse economic trends if the incentives for business don’t change too. Change will come at the firm-by-firm level.

Some firms will be better at using Dyson’s innovation model than others. Some will combine low labor costs with high value add and quality and make out like bandits. And frankly, as an investor, who cares where those firms are based? How Western economies succeed or fail at adapting to the new realities of the Money Migration makes for an interesting theoretical discussion.

But the more practical discussion is figuring out how to identify and invest in the firms that can compete in the coming years. What are their characteristics? More on this in the coming weeks…