“The analog folks believe that booms inevitably lead to busts.”
Ed YardeniYesterday’s email brought this promotional message from Motley Fool:
“Predictions are that by 2003, there will be more Internet-ready handsets than personal computers connected to the Web. When it comes to future trends, they don’t get much closer to ‘a sure thing’ than wireless does.”
The Fools proposed to sell me a report that would clarify the near ‘sure thing’ opportunities presented by wireless.
But I am no stranger to wireless technology investments. Years ago I traded advertising space in one of our publications for a chance to win a cellular phone license. Winner that I am, I was notified not long after that my ship had come in. A motley crew of investors and publishers, myself included, won a cellular franchise for an area of western Nebraska.
But this ship proved to be a ship of fools. If we had been able to persuade cattle to use cellular phones, it might have been different. But as it turned out, there were too few people out on the high plains to make a cellular system profitable. And most of them, as I recall, were analog humans, not digital. They were still tied to land lines. Though perhaps it is different now.
The cellular license carried the obligation of building a system – which proved more expensive than the actual business would justify. We sold it off – at a loss. In one of the great paradoxes of investing – ‘sure things’ almost always end in losses.
Yesterday’s letter recalled how the sure thing of the late 19th and early 20th century – railroads – proved a disappointment to investors, too. Almost every technological innovation – from air-conditioning to airlines to the internal combustion engine – has gone through the same boom-bust cycle.
Warren Buffett says, for example, that the airline industry has failed to make investors a single penny – net – since Orville and Wilbur Wright flew their first plane at Kitty Hawk. I don’t know if that is true of automobiles, but nearly 500 auto manufacturers went broke, got bought out or merged since the industry began. Your odds of choosing the winners were less than 1 in 100.
But all of these innovations were developed by the soon- to-be-extinct Analog Men. Maybe the Digital Man of Ed Yardeni’s imagination will do better.
So far, the results are not encouraging. Internet companies – run by people who ‘got it’ long before Yardeni – are going bust. Nothing wrong with the business models, of course – the fault, again, lies in the lack of vision of analog investors. Living.com, for example, which went belly up on Tuesday, did not run out of vision. It ran out of cash.
“Everyone thought that subsequent financing would not be a problem, and were shocked to find that the stock market would not support a secondary offering and that private investors had become skeptical,” said Ken Cassar, analyst at Jupiter Communications, a research firm in New York.
But maybe wireless will be the big breakthrough for Digital Man. Barely a discouraging word has been heard about wireless. Investors are still behind it.
“In the next few years,” Grant’s quotes the chairman of Deutsche Telekom, “growth of mobile phones in the U.S. will be larger than the growth in Germany, Italy, France and the U.K. put together.”
But it is not as if there weren’t some things that could go wrong. Building out cellular systems is expensive. And governments are using the license fees as a major source of finance. “Thus, one point of significance of the wireless phenomenon,” Grant’s reports, “is that, at the margin, leveraged telecom debt is replacing sovereign debt in the world’s bond portfolios.”
The questions for the giant telecoms turn out to be the same ones we face in our pathetic Nebraska franchise… and the same ones that every business must ask: What is the likely stream of income? How much is the investment really worth? How much debt can the enterprise support?
So far, Mr. Market has been sympathetic and supportive. Like the railroads at the end of the last century, the wireless industry is drawing in huge amounts of capital – both debt and equity – and losing vast amounts of money. Nextel, to use the example described in Grant’s, saw its stock price rise 337% in 1999, and was able to raise an additional $7 billion in “additional outside capital commitments” during the second half of 1999, a year in which it’s net profits are listed as minus $1.462 billion. Nextel’s capitalization, meanwhile, surpassed that of Boeing, Merrill Lynch, Texaco and Dow Chemical.
As a group, the wireless companies in Grant’s sample carried about $26 billion in debt by the end of 1999 and lost $4 billion on $27 billion in revenues.
Will they be able to make a profit in the future? “The fact is,” continues Grants, “that prices for monthly services have been declining as a result of competition…”
Ah…competition. What kind of profit margin might a cellular phone company expect in a fiercely competitive market? And how does the industry manage to turn around a $4 billion loss…plus pay the interest on $26 billion in debt…with only $27 billion in revenues?
Revenue growth? Already, 53% of the eligible subscribers are signed up. Cows, as far as I know, have still not learned to use the equipment. The math doesn’t look good.
Nor does the math look good for the entire technology sector. Tech’s contribution to GDP is only 8%. But it represents more than 30% of S&P 500 market capitalization.
Since 1993, the value of the tech portion of the S&P 500 has jumped from $271 billion to more than $3.5 trillion.
“Naturally,” as Grant’s puts it, ” Mr. Market can change his mind…” Which is exactly what Mr. Market is likely to do. Each technological innovation seems to be accompanied by a psychological wave that lifts investors up…and then dashes them to the ground. Extraordinary amounts of money are pumped in – based on extraordinary expectations of profit. The money – both debt and equity – reaches levels that the business model cannot possibly support. Eventually, Mr. Market discovers his mistake. But by then, it is too late.
Each boom in technology leads to a bust, just as the analog folks say.
Your still-analog correspondent, unable to kick the habit,
Ouzilly, France August 17, 2000
P.S. Today is Francois’s last day of work on the farm. After more than 50 years – he came a small boy and began work when he was 14 – Francois is retiring and moving to a nearby hamlet. The place won’t be the same without him.
*** Yesterday’s Consumer Price Index report showed inflation rising at twice the expected level – that is at 0.2% rather than 0.1%. Small numbers. Who cares?
*** But this measure only applies to the ‘core’ rate of inflation – a sweet confection of the Bureau of Labored Statistics which excludes the bitter, but essential to life, ingredients: energy and food.
*** Naïve readers might ask – how can you have a cost of living index that doesn’t include the cost of calories – the fuel that runs man’s body, heats (and cools his buildings) and powers his machines? What kind of hocus- pocus is this?
*** Stephen S. Roach, now with Morgan Stanley Dean Witter, but formerly with Federal Reserve Board, recalled recently how the core rate came to be (Grant’s 7/21/2000…[http://www.grantspub.com]). Jim Grant sets the stage: “After the quadrupling of oil prices in 1973, the redoubtable Arthur Burns, Fed chairman and renowned business-cycle scholar, called his staff together and demanded that they present him with a CPI stripped of energy costs. After all, if there ever was an exogenous event – one over which the Fed had no control – the Yom Kippur War was it.”
*** “Little did we know at the time,” confessed Roach, “that we were creating the first gauge of core inflation… A few months later, Burns called us back together and noted an alarming pick-up in the rate of food inflation… So he instructed us to take food out of the CPI as well.”
*** Readers old enough to remember the mid-’70s may recall that this ‘core’ measure of inflation had a serious flaw – it completely failed to detect the huge wave of inflation that was about to wash over the U.S. economy.
*** Likewise undetected by July’s core inflation figure, oil rose yesterday to $31.80 a barrel. It is at a 10-year high. And shipping rates are at a 30-year high. There is, of course, plenty of oil in the ground. But there are not as many oil tankers as there are stars in the sky. Both oil and shipping rates may increase further.
*** The Dow shrugged off the CPI report, closing down only 58 points for the day. Most seriously damaged were the retailers. A Financial Times headline announces that “Nordstrom profits fall as expected.” Walmart – the nation’s most important retailer – closed below $50. Home Depot is not far behind. And Heilig Meyers, a furnishings wholesaler, went bankrupt.
*** Also on the consumer front, housing starts dropped 3.3% in July.
*** Why is retail slipping? Because the ‘wealth effect’ has lost its mojo. People look at their portfolio statements and figure they should wait for a pick up before spending money. This trend – away from spending towards saving – threatens to throw the ‘good times’ economy into reverse, Japanese style.
*** 1,594 stocks rose yesterday. 1,243 fell. There were 103 new highs on the NYSE; 41 new lows. Most likely, there will be little movement in the Dow until after the Fed meeting on the 22nd.
*** The Nasdaq managed a very modest increase – up 9 points. Amazon is doing well – it rose to more than $38.
*** Gold – perhaps spotting a weakness in the dollar – rose $2.70.
*** The battle between the euro and the dollar raged overnight. But neither side gained much ground.
*** Speaking of raging…Bill King tells us that the band “Rage Against the Machine” is entertaining protest groups gathered in Los Angeles. Reporters have begun referring to Al Gore “the machine.” Could it be that Mr. Gore is one of the Digital People – heartless, soulless, with a brain like a Pentium chip? He IS the father of the Internet, isn’t he? It’s all starting to make sense.
*** The news was unusually rich in absurdities this morning:
…in Argentina a top surgeon killed himself…and a government employee threatened to jump off a radio tower unless he got paid (no mention as to whether anyone intervened) – because of an economic slowdown.
…A Wisconsin man, who raped and murdered a 9 year old girl was just awarded a settlement from a trash collection company after the firm refused to hire him. Discrimination, he charged. He should have been treated differently. Much differently.
…In New Jersey, a 6-year-old and his two accomplices were kicked out of school after they “used their fingers as pretend guns and said they wanted to shoot each other.”
… From Access to Energy comes the story that at Stockport College in Greater Manchester, England, such phrases as “normal couple,” “history” (sexist), “lady” and “gentlemen,” “slaving over a hot stove” (minimizes horrors of slavery) – have been declared offensive and banned…
*** And a friend reports from Boulder, Colorado: “I’m not making this up…the city’s ordinances have been rewritten and all references to animal or pet “ownership” have been changed to “caregiver” so as to strengthen the bond between the “caregiver” and the pet.”