The Great Debate
The Great Debate I refer to in today’s letter has nothing to do with the two candidates for America’s highest office. Instead, I am talking about the debate between digital and analog. Analog or Digital? Which are we? Could we be both? And the future…is it completely digital? Or purely analog?
“Like many people,” writes Jim Davidson, moved by the spirit of democracy, “I have a cell phone which mainly operated on digital signals. But it also serves as an analog device when a digital signal is not available. In that sense, I feel that our thinking should be both “digital” and “analog.” We should pick up the strongest and most useful signal that comes available.”
On one hand, some people say that the Internet changes everything. On the other, there are people who say it changes nothing. I’m going to go out on a limb here…but I firmly believe both are right.
Let, me try to tidy up around the edges of the discussion to see if I can reconcile this paradox.
Many people, fascinated and impressed by the Internet, routers, optic fiber, chips and the other paraphernalia of the New Era, are quite sure that these advances must lead to good new businesses…and must also undermine old ones.
In this, they are certainly right. We already have a great number of very good businesses of the New Economy persuasion. Intel, Microsoft, Cisco – these are all fairly new companies, and very profitable. (For whom they are profitable – the workers or investors – is another story.)
These companies – and many others – benefit from the tremendous economies of scale in the new information economy.
Rick Ackerman sent me this explanation: “The technological leap forward made possible by our brand-new computer and communications technologies creates a large host of winner-take-all markets. If you are producing an information good-a computer program, a piece of online entertainment, or a source of information-the work only needs to be done once and then it can be distributed to a potentially unlimited number of consumers for pennies: producing at twice the scale gains you nearly a 50% cost advantage.”
Specialization produces better goods and services at lower costs. The Internet makes it easier to select the best deal – giving the best company a huge advantage. Plus, in all markets where Metcalfe’s Law applies – that is, where the more widely used a particular product is, the more useful it is to each user (like the telephone) – economies of scale give the largest-scale producer an added advantage. Who wants to own a computer that is not compatible with the most common software?
So, the companies – such as Microsoft, Cisco and Intel – that enjoy these huge economies of scale, can be expected to become very good businesses. You only have to make it once – and you can sell it everywhere at very low extra production cost. In that sense, these products are like the Daily Reckoning. It costs no more to send it to 100,000 people than it does to send it to 10 people.
By contrast, there are a lot of companies that operate on the Internet but fail to benefit from specialization and/or economies of scale.
The most familiar example is our old favorite river-of- no-returns, Amazon.com. Ackerman continues: “Here the logic of reduced frictions takes over: for without a large scale economy-driven cost advantage, the effect of the new economy is not to increase but to reduce margins…”
Selling books is not a high margin business, anyway. In a world where the customer can click on a search engine (www.isbn.nu) to find the best price, margins nearly disappear. Amazon sees the problem too. Its solution is to try to be something else – a place where you come to shop…like the parking lot of a suburban mall. Amazon hopes to make its money by getting a little piece of a great number of transactions. Will it work? Who knows.
VitaminShoppe.com, an example cited by James Cramer in today’s column, is a similar case. It was described as a ‘category killer’ and was backed by a parent with 60 stores and $132 million in sales. It came out in October at $11 and promptly fell to $9.75. But then, it was named the #1 Top (a little redundancy helps get the point across) E-commerce site. And its daily unique visitor traffic increased by 337% according to Media Metrix.
The stock roared up to $16.
But was it a good business? Well, no. The company could bring in a lot of visitors, but it had no way of taking advantage of the Internet’s economies of scale. Vitamins are not an information product. Like books, and unlike software, they’re tangibles that cannot be replicated at negligible marginal cost. The only way VitaminShoppe could bring in and retain customers was by competing on price…which meant squeezing the margins.
Soon, no one cared what Media Metrix said. Investors realized that the whole B2C – business to consumer – e- tail industry was a loser. Amazon continues to struggle to hold its stock above $30…as investors hope the company will figure out how to realize some economies out of its enormous scale. VitaminShoppe.com has fallen down to just $1.16 – with negative $2.60 of earnings for each share.
Microsoft, Cisco and Intel, however, are recognized as good businesses. Not only are the recognized as such, they are practically canonized.
But a good business is not necessarily a good investment. It depends on what price you have to pay to acquire it. No matter what kind of business you buy, you’re paying for a stream of income. In the end, that’s all there is. A digitally-oriented man could do the arithmetic. Simply make reasonable assumptions and discount the expected stream of income from any of the Big Techs to present value and see what you get. You will get a number much lower than the current selling price.
The typical man may think digitally when he writes software code, or builds a computer switch. But when he calls his broker, he reverts to more analog behavior. He is gripped by fear, greed, confidence or anxiety – depending up the temper of the times and his own mood. A stock may shout BARGAIN to him one day and whisper “sell” to him the next. Going along with the great mass of other investors, he responds to these suggestions with the enthusiasm of a Republican with a defense contract.
Cisco is a good business now. It will probably be a good business 5 years from now. But it will only be a good investment when most investors no longer think so.
Ouzilly, France August 29, 2000
*** Remember Michael Saylor, CEO of MicroStrategy? He was back in the news yesterday, announcing a layoff of 234 employees – 10% of his workforce. Not only that, the company cancelled its annual Caribbean cruise for employees and their families. Things must be tough in the New Economy.
*** But even in adversity, Saylor took care of the workers (at capitalists’ expense, of course). Each laid- off employee will get accelerated options and $10,000 worth of Saylor’s own stock.
*** Saylor’s business has been unprofitable from the get- go. The stock traded as high as $333, but in March, he was forced to restate earnings. Then, down it came – reaching its latest resting point at $27 yesterday.
*** There are a lot of no-account New Economy companies, but Saylor attracted attention by the evangelical way in which he shilled for the New Era. “Information should be as cheap and free-flowing as water,” he remarked. He maintained at an on-line university would revolutionize education, and that free information would move economic growth ahead at warp speed.
*** But the rocket fuel of the New Era is not information. It’s cash and credit – both of which are still rising. MZM (cash) is going up at about a 6.3% annual rate. And personal spending for July rose at about a 7% annual rate. Both of these numbers are about twice as big as the number for personal income growth.
*** Meanwhile, in Japan, the personal spending numbers came out and showed that the average Japanese person is, true to recent stereotype, not spending more, but spending less. Personal spending on the island of perpetual darkness fell by 3.6% in July.
*** What the numbers tell us is not, I believe, something fundamental about the difference between the Japanese character and the American one. Spending is not, at least I don’t think, directly correlated with, say, height…or inversely correlated to the desire to eat uncooked seafood.
*** Instead, the numbers reflect an episodic shift in confidence. Reuters reports that U.S. investors are enjoying a “growing confidence” – which is in itself remarkable, inasmuch as confidence and self-esteem were already at the highest levels ever recorded. Americans seem to have cornered the market on self-esteem…and maybe there is some subterranean Smoot-Hawley Act prohibiting the exportation of it – particularly to Japan, where confidence hasn’t been seen in more than a decade.
*** Yahoo fell almost 10% yesterday after an alert analyst noticed that Internet advertising revenue, which is Yahoo’s income source, may be softening.
*** But it was a good day for most stocks. The Dow rose 60 points. The Nasdaq stumbled upwards by 27 points – putting the index in barely-positive territory for the year.
*** The dollar fell against the yen…and rose against the euro. Nothing important.
*** Oil rose 77 cents.
*** The German economy rose at a rate of 3.1%. This is a slower pace than the U.S. figure – but the number is more reliable. German number crunchers are not (at least yet) teasing up their calculations with ‘hedonic’ measures.
*** And here in France, things are looking up too. Laurent Fabius, the finance minister, said he would soon announce the biggest tax cuts since WWII. He said he recognized that high taxes in France were a structural impediment to growth and aimed to do something about it.
*** Gold fell 10 cents…but platinum rose $5.90. “The world is running out of gold reserves, and faster than you think.” This is a quote from Chris Thompson, CEO of the world’s second largest gold producer, recorded by Harry Schultz in a recent newsletter (www.Hschultz.com) “Central banks will soon realize it’s not smart to either sell gold or lend gold they may have trouble getting back in a gold-scarce market.”
*** There are still a lot of IPOs in the pipeline. A NY Times piece says that about 280 companies are waiting to go public this year – hoping to raise about $36 billion. That’s about as much as for the whole of 1998.
*** In addition to the IPOs there is also a huge supply of insider stock that is coming out of ‘lock-up’ restrictions. Typically, insiders can’t sell their shares until at least 6 mo. after an IPO. Millions of shares from IPOs of last year and early this year are now coming on the market. The sale of these shares, as well as new supply from IPOs, seems directly related to the Nasdaq. The NY Times piece: “In May, according to IPOlockup.com., insiders at 63 companies were free to sell 2.7 billion shares. Nasdaq fell 12 percent that month. In June, the shares available for sale dwindled to 1.3 billion shares, and the Nasdaq rose 17 percent.”
*** “Now, however,” the Times piece continues, “the lull is over. By the end of the month, some 1.7 billion shares issued by 53 companies will have been unlocked. And in September, 1.8 billion shares in 45 companies will be free to trade for the first time.”
*** Henry and Edward head back to school in Paris today. Poor things. The summer went by so quickly. And we were all so busy. I don’t remember spending any time with them. Could I rerun the tape, please, in slow motion? Ah…but that’s the problem. The Internet may have destroyed many of the limitations of space. But time has become even more precious.
*** I’m still down here in the country – with Jules, Maria and Sophia. The older kids don’t start school until next week, so we’re enjoying one last week of vacation. Jules is fishing. Maria is swimming. And Sophia is on the Internet trying to figure out where to go to college next year. (I’ve been discouraging her…but more about that another time.)