Industry Analysis of Fintech Startups

January 19, 2015 by Larry Sukernik in Technology, Industry Analysis

Financial technology (fintech) startups are trending topic in recent years. The financial industry can be a sloth-like creature, with banks just recently adding support for decent mobile apps and more advanced capabilities such as spending trackers and remote deposit support. There are still many gaps left between what consumers want and what banks provide. This gap is currently being filled by fintech startups.

As I see it, there are currently three major categories of fintech: Payments & Money Transfer, Spending Trackers, and Investments. The order in which these categories are listed is not random: each category becomes easier to enter, in terms of the capital (human and financial) and barriers to entry. To be abundantly clear, let me further define the first category. The Payments & Money Transfer encompasses companies that allow you to pay for goods and services through them, or transfer money to anyone you wish. I lumped payments and money transfer together because the distinction between the two is not always clear (are you transferring money to pay someone?). This category includes companies like Venmo, Square, TransferWise, Stripe, and PayPal. It also includes Apple Pay and Google Wallet, but these services are provided by established companies and do not fit the bill for this analysis, which focuses on smaller companies. To be comprehensive, however, I have added them to the graphics below. You may even argue that Square and PayPal are too large to include here, but I feel they are not large enough to eschew.

1) Payments & Money Transfer

As I briefly mentioned earlier, the Payments & Money Transfer category is most difficult to enter. It is extremely expensive to process payments due to the risks involved for each transaction, fraud, required security measures, governmental requirements, and a slew of other difficult problems that need solving. It’s not impossible, and we’ve seen some startups attempt to solve these problems, but on the whole, these startups are much larger in size and rarer in quantity. While I think a few may thrive on their own and even become public (Square, Stripe), the most likely scenario is for them to be purchased by the tech giants (Apple, Google, or Microsoft). For this scenario to be avoided, this category of services must find new ways and markets to monetize - an extremely hard proposition (Square is currently paying users $1 - $5 to use their Square Cash app!).

2) Spending Trackers

The Spending Tracker category is exactly what it sounds like. It is a service provided by startups that allows you to monitor your income, expenses, bills, and everything else that measures your cash flows. This category includes startups like Mint, Mint Bills (formerly Check and Pageonce before that), Level Money (as if to prove my point, acquired by Capital One at the time of this writing), and a few others. Unlike Payments & Money Transfer, the barriers to entry here are lower. However, it is costly to partner with banks to allow for a historical list of your transactions. The very same risks are present here as for Payments & Money Transfer, but they aren’t as demanding. The reason we see relatively few companies compete in this category is because there is very little money to be made. Spending tracking apps and services provide a value-add, but most consumers are not willing to pay additionally for it. Consequently, these types of apps are best when used as gateways to other products, or when they are bundled with an existing product.

To illustrate, let’s look at Mint, which is the largest and most popular Spending Tracker. The company began as a startup, and was soon purchased by Inuit, which sells personal finance and small business software. Although Intuit could have certainly charged users to use Mint, they smartly did not, because Mint is a gateway product to other Intuit software, most of which is not free.

Just this week, Capital One purchased Level Money, a spending and budget tracking app. The reasoning behind this purchase is likely to acquire Level’s infrastructure, team, and technology. I expect to see Capital One’s apps to improve in the next year as a result of this acquisition, either by incorporating Level into its existing apps or keeping it standalone and adding features.

It’s becoming increasingly difficult for banks to compete solely on savings and checking accounts, so they began to compete in mobile and online services. If Capital One’s mobile app are superior, for example, to Chase’s mobile app, it is more likely that a consumer will open an account with Capital One. Spending Tracking startups, of which not many remain private, will not survive on their own. They will either close shop or be acquired by larger financial companies.

3) Investments

Investment startups (aka Robo Advisors) are the final major category of fintech companies which I have identified. They are also the most common. This includes huge startups like Wealthfront and Betterment, in addition to smaller companies like Acorns and Robinhood. They are all companies which aim to help you invest (long or short term). These startups compete with the established financial advisory and investment firms (Vangaurd, Schwab, TD Ameritrade). I listed this category last because I believe the barriers to entry are lower than for the above two categories, but I’m not against rearranging this category with Spending Trackers either. They have very different barriers to entry, and it is difficult to say which is harder to break into. Do not get too preoccupied with the order of the categories, as the order is more for academic than hierarchical purposes.

This category of startups may actually succeed on its own, because they take a percentage fee or a flat cut of your investment. As I have written previously, these Robo Advisors face the majority of their challenges from huge traditional institutions, which have a lot more capital and consumer trust. The startups, however, have vastly better apps and sometimes provide more features than the traditional firms.

I see this category playing out in one of three ways. First, the less disruptive startups will simply flounder, since they won’t be able to get consumers to invest with then.

The second scenario concerns the innovative, but smaller startups like Acorns and Robinhood. They do not have the resources to compete effectively on their own, since investing is a capital intensive business. Consequently, most of these startups will go the way of Spending Trackers, and will be acquired by larger financial institutions for the same reasons: infrastructure, team, and technology.

The last scenario involves the larger Investing startups, such as Wealthfront and Betterment. They have much more capital to work with, and can hire the best people. Additionally, the more assets under management (AUM) they have, the more consumer confidence they will get, which will result in even more signups. It will become a virtuous cycle, to the point where these companies become large enough to stand on their own or otherwise go public. Not all of the larger firms will succeed, however, since there is a limited market for such services. The unsuccessful ones (success is measured by profitability) will either close shop or also be purchased, at a bargain, by the larger institutions.

In summary, due to the current unprofitability of fintech startups and the psychological aversion to risk that most consumers hold, most fintech startups will not succeed on their own. I see two emerging trends that effect the three fintech categories.

The first is for larger, established and traditional financial institutions to purchase fintech startups (i.e. Simple was acquired by BBVA, Mint by Intuit, Level Money by Capital One). This is a win for both parties; the startup gets the capital to create disrupting technologies, and the banks get the best technology, infrastructure, and human capital. Finally, consumers trust their money to the banks, and are more likely to make use of new technologies.

Second, fintech companies can go public to raise capital. We’ve seen this most recently with LendingClub, but this will become a trend in the future. For example, Square and Stripe seem ripe for an IPO (unless they get acquired). If Wealthfront continues to grow and steal market share from Vanguard, it too can look into an IPO. Again, this will provide them with the additional capital needed to succeed in the financial industry, and it will reinforce consumer beliefs in the long-term health of the company.

Not a trend but a reality of business, the unsuccessful startups will fail. This is a sad, but true reality of any business. Most businesses fail, and startups are businesses. Not all fintech startups will be able to become profitable businesses, and some will inevitably lose funding and exit the market.

Postface: This analysis did not include every startup in the fintech industry - there are simply too many to include. For this reason, I have chose to include only the largest and most well-known fintech startups.

Spotify's Temporary Growth Spurt

January 13, 2015 by Larry Sukernik in Technology

Spotify released their latest subscriber numbers yesterday, announcing they have 15 million paying subscribers (up from 12.5 million in November), and 60 million total users (up from 50 million).

I have updated all of my Spotify models, and below is my latest chart showing user growth.

While month over month growth rates seem to have increased (temporarily), the new subscriber data is likely an outlier. By outlier, I mean these rates shouldn't be used to make stable projections of future Spotify growth. Let me explain why.

In December, the company held a promotion that let users sign up for a three-month Spotify Premium subscription for $0.99, instead of paying $9.99 per month. Great deal, right?

Right. But how many of those users who signed up for this promotion will actually stay with the service after the three months are up? My guess is 15-25% (25% is the current paying-to-free user ratio, and 15% is the more realistic rate, since users who signed up for this promotion are less likely to keep the subscription active).

In addition, December is the holiday month, so it's very likely Spotify gift cards and subscriptions were gifted by friends and family. This further inflated the latest Spotify figures.

It's never a good sign when companies inflate their numbers to proclaim better than expected results, but you will be hard-pressed to find companies that abstain from this practice. Especially in the world of startups. Fortunately for us, Spotify's number-inflation was easy to spot (sorry, I had to). Unfortunately for Spotify, it was caught.

Apple Watch: The Good, the Bad, and the Ugly

January 07, 2015 by Larry Sukernik in Strategy, Technology

Apple has become one of the largest companies in the world, which means every move the company makes gets thoroughly analyzed. Since I began following Apple in 2007, I recall analysts predicting that the iPhone, the iPad, and every update to those products will be a failure. In order to call a product a failure, one must compare it to a similar product. Analysts called the iPad a failure because they expected it to sell as well as the iPhone, which would never be the case. I am sure that while designing the iPad, Apple knew this too. iPhone sales are so great because they are practically a necessity, they're subsidized by carriers in the U.S., and provide unbelievable value for the price.

The iPad never had a chance to enter a market as large as the iPhone. In the past few quarters, iPad unit sales have been slowing. They have slowed so much, in fact, that Apple sold more iPads in every quarter of 2013 than 2014. My explanation the declination of the iPad is that it was never backed by the full faith and credit of Apple. The iPhone was always their number-one product, and everyone the iPad got just piggybacked off the iPhone. A smaller market for tablets, and a lack of effort from Apple is what significantly slowed iPad growth.

This post, however, is not about the iPhone nor the iPad. It's about Apple's new product - the Apple Watch. I began with a brief background of the iPhone and the iPad just to explain the basic reasons for why the iPhone is so popular, and why the iPad is not.

There is no shortage of Apple Watch predictions on the web. I do not aim to regurgitate any of them. I will simply list some thoughts, and you can do the thinking on your own.

There are many people still working for Apple that have been there since the original iPhone. Many of them stayed on the same product. That is, they've been working on some element of the iPhone (hardware, camera, Safari, Mail, etc) for the last few years. Sometimes they join a different team, such as switching from working on the Mail app to the Core OS, but they're still working on the same product, the iPhone. Sometimes they get transferred to work on the iPad, but this is just a side project for them. Unlike the iPad, which was a half-hearted effort, many original iPhone engineers and designers are now working full-time on the Apple Watch. That does not mean it will be a successful product, but it does mean it's getting Apple's effort.
Related to Apple's effort in the watch are the people hired to work on it. There are many. I will name some of the more well-known hires. Kevin Lynch (previously CTO at Adobe), Angela Ahrendts (she's in charge of Apple retail, but her fashion background undeniably helps), Marc Newson (albeit working part-time), Patrick Pruniaux (previously VP of Sales at Tag Heuer), Jay Blahnik (fitness consultant), Michael O-Reilly (previously VP at Masimo), and many others involved with medical sensors. I don't recall as many experienced hires coming aboard to work on the iPad.
There are one of three paths the Apple Watch can follow. First, it can flop, and Apple will abandon efforts. For the watch to flop, there it must either be a bad product, the competition must be better, or there is simply no market demand for it. Historically speaking, Apple is not known to design bad products. One can argue that Apple has lost its way and will design a bad product, but not much evidence supports this theory. As I've written previously, designing a smartwatch is extremely difficult and expensive, and not many companies can undertake such a herculean effort. The major players in the smartwatch space so far are Fitbit, Jawbone, Pebble, Motorola, Samsung, Garmin, Microsoft, and a handful of others. I don't see any of the smaller players competing effectively against Apple, but a better smartwatch from Samsung or Microsoft is something Apple should be thinking about. The smaller players can, however, compete on price by offering cheaper options. This can be a disruptive technology in the future, but not in the short term. Finally, there may simply be no demand for smartwatches. I do not have billions of dollars to spend on consultants and market research, so I do not know how the market will react to a smartwatch. But I do know that Apple has billions of dollars to spend on consultants and market research, and I can only assume they did some sort of research before beginning work on such a large project. Market research can be wrong, and Apple may have found a market where none actually exists (or is too small to matter), but I wouldn't bet on it.
It can be a semi-successful product like the iPad. Being the risk-avoidant person that I am, if I had to take a bet to predict the outcome of the Apple Watch, this is the option I would choose. But I'm not a gambling man, so I wouldn't even be playing this game. In the business, this option is what we call a hedge, since it covers the bases if the Apple Watch is a flop or a success. Billion dollar companies are not usually huge risk-takers, and Apple is the epitome of a company that avoids or reduces risks. For the Apple Watch to be a semi-successful product, multiple things can happen, either concurrently or alone. The Apple Watch may not be a bad product, but it may not be amazing either. It may end up being just a decent smartwatch. Technology and smartwatch aficionados may be the only ones to purchase it, which will stimulate reasonable sales volume. Not enough to call it a success, but enough to cover the expenses of designing, manufacturing, and distributing the product. Additionally, the market for smartwatches may actually be smaller than predicted. This would obviously decrease the potential of the watch significantly. Again, there are nuances to this point as well. The market can be tiny, and Apple will experience losses. The market can be medium-sized, and Apple will breakeven. Or the smartwatch market can be slightly smaller than predicted, leading to satisfactory but not ideal sales. Of course, nobody knows for sure. At the moment, the smartwatch market is tiny, but that's because the value proposition for current smartwatches is equally small. Nobody expected the smartphone market to be as large as it is today, and the same can be true for the smartwatch market.
It can be extremely successful like the iPhone. This is, of course, the ideal scenario for Apple. It implies that the Apple Watch is a great product and there is a large market for smartwatches. Once again, there is nuance to the point. A great product doesn't imply a perfect product, rather, it's one that meets consumer needs and slightly surpasses them. I will again make reference to the iPhone because it is most relevant to this discussion. The original iPhone was by no means a perfect phone; it had terrible battery life (compared to flip-phones), everything was slow as if covered in molasses, and it didn't even have an App Store. But it allowed consumers so many things that they couldn't have done previously. After a few updates and revisions, the iPhone became a hit and remains one to this day. In short, the iPhone started by meeting and slightly exceeding expectations, through updates it became even better, and now it is Apple's most successful product (perhaps even the most successful product of all time). The iPad did not follow this trajectory. It did not meet expectations when it came out. Nor did the updates bring it in-line with consumer expectations. Hence, it was a good product in a medium-sized market, and sales reflected that reality. I do not know how the Apple Watch will turn out: will it be a bad, good, or great product? I can also assuredly say that no analyst worth his salt knows which of the echelons the watch will become. Apple might think it knows, but even for them it is impossible to know for sure.

I started this piece with a brief history of the iPhone and the iPad, and heavily relied on their trajectories to predict the possible paths the Apple Watch can take. What I explicitly did not do is tell you how many units the watch will sell, what the average selling price would be, and how much revenue the product will contribute. I left this out because I do not know, and my best guess is as good as any analysts out there. Surely you can measure the size of the smartwatch market as it is now, and you can even add the traditional watch market to this pool. Perhaps you also take into account the fitness wearable one. You then multiply this aggregate market pool by a percentage share that Apple will take from it, and now you have Apple's share of smartwatch revenues and volumes. If you are especially ambitious, you added a growth rate to the market, since presumably it will expand in the future. Will that be an accurate figure of Apple's market share?

I would be lying if I said I did not already attempt to do this. My spreadsheets are filled with Apple Watch estimates (guesstimates). It is impossible to run a successful business without them, and I am not saying it is foolish to calculate projections, but this is not a concern you should be worried about. This is a problem for Apple and its consultants. For you, dear consumer, care only about the finished product.

Twitter: Introspective

January 02, 2015 by Larry Sukernik in Technology, Strategy

Preface: This is the first of a new series of articles I will be writing, which are called Introspectives. For these types of articles, I will be doing some number-crunching and analysis, so that they are more in-depth and introspective (thus the name). They will include graphs/charts, followed by my thoughts on what the data shows. My hope with these introspectives is threefold. First, and with selfish intentions, I want to get better at data visualization and manipulation, and the best way for me to learn is through working with real data. Second, my hope is to share my opinions on what the data exposes, which the mainstream tech media did not pick up on. Finally, my goal for these introspectives is to create a narrative based on facts. In short, I want them to be strong enough to stand on their own.

The first introspective will be on Twitter, partly because it's the social network I use most, and partly because it's not doing so well. For me, it's exponentially more interesting to dig into unsuccessful companies than successful ones.

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Income Statement Exploration

If you peaked into my spreadsheet, you would find a lot of work done on Twitter's balance sheet. While it's true that the balance sheet is fundamental to a company's analysis, it doesn't tell us much about the future potential, since balance sheets are snapshots in time. On the contrary, income statements represent data over a period of time (3, 6, 9, or 12 months), and provide us with more interesting information. Let's start with the basics: Revenues and Cost of Revenues.

- This is a fairly simple chart, showing us the revenues and the expenses required to create those revenues. It's a healthy sign when a company has higher revenues than cost of revenues (from hereon abbreviated CoR), which is indeed the case for Twitter.

- Notice how revenues and CoR began to divulge heavily starting with Q3' 13, which is when Twitter's revenue hit a growth spurt. Since social media is a young business, is it difficult to benchmark if Twitter's CoR is within industry standards, considering the industry is so young. You could compare Twitter to Facebook, or LinkedIn, but any differences wouldn't be an immediate cause for concern.

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This next chart includes revenues and CoR, but it also incorporates other elements of the income statement, notably Research and Development, Sales and Marketing, and General and Administrative expenses.

- This chart is what Twitter should be concerned about. Total costs and expenses, which includes all of the above items, exceeds revenues by a significant amount.

- R&D is almost half as large as revenues. Twitter started spending a huge amount on R&D in Q1' 14, probably to search for products and services that could be incorporated into Twitter. We've seen Twitter Music (which failed), the ability to tweet multiple photos, and detailed tweet activity, among many other small additions to the service this year. All of these features are great, but they don't fundamentally add new use-cases to Twitter the service. This leads me to think that the immense amounts that Twitter spends on R&D could be toned down, which to their credit, they seem to have done in Q3' 14. We will see what happens to R&D spending in Q4' 14, but my advice is to slow it down, since results are unsatisfactory.

- The next highest expense on Twitter's income statement is Sales and Marketing, which is almost as high as R&D in Q3' 14 ($164 vs. $183 million). Here, I am not so confident that Twitter should reduce spending. It seems like S&M and revenues go hand-in-hand, since the company must advertise the service to advertisers (ironic, but that's how the online advertising business works).

- General and Administrative expenses make up the lowest costs, but they too have been steadily increasing. Again, it's hard to say if this item is too high or too low, but it's worth noting that executive salaries are placed in here. Given Twitter's gross management turnover, I would expect G&A expenses to increase in future periods.

- As I'm sure you noticed, expenses ballooned in Q4' 13. Without getting too technical, the explanation for this is Twitter's stock-based compensation expense, which accounted for $406 million in restricted stock units (RSU's). They expensed these in Q4' 13 in no doubt to gain some favorable tax treatment in future years, where losses could be used to offset any profits.

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As a summary of the income statement breakdown, I've included a revenue and net loss chart that encompasses everything we've talked about previously. Some observations follow.

- Since Q3' 13, it looks like Twitter has been attempting to contain its net loss to half of its revenues. Management can spin it any way they like, but these consecutive net losses are worrying and don't seem to be stopping in the future. Twitter is either too costly to run, or it can't find enough revenue streams to offset the high costs. Or perhaps both.

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Balance Sheets, Income Statements, and Narratives

As an accounting major, I can tell you it's very easy to get lost in the numbers, and forget about the big picture. While the details certainly matter (MACRS or straight-line depreciation), they don't tell us the true condition of a company. Think about the time you got a nice big juicy pimple on your forehead, which is extremely noticeable to everybody. Does this mean you have a life threatening disease? Of course not. But it may be a sign that you should cut back on that General Tso's Chicken you've been ordering every Wednesday night. At the very least, you know to skip the fortune cookie.

Similarly, the expenses we looked into previously (CoR, R&D, S&M, G&A) are extremely obvious to everybody, and lend themselves to be preoccupied with. However, they don't tell us the true condition of the company - they only explain half the story. The other half of the story, which in the pimple example would be the functioning of your immune system, is the company narrative.

Let's ease into the Twitter narrative slowly, starting with revenues, costs, and monthly active users (MAU's).

- Only one new piece of evidence has been introduced into this chart, and that is MAU's. Revenues and total costs are both dollar-sign items, while MAU's are an intangible, but equally fundamental statistic to the salubriousness of Twitter. What becomes immediately clear from this chart is that user growth is not in as rapid as revenue or expense growth. In fact, user growth is downright sluggish, especially compared to the growth of Facebook and Instagram (found later in this analysis).

- What Twitter has been able to do was to increase revenues much quicker than users. The goal of this analysis isn't to figure out how they've done it (although that is certainly interesting as well), but instead, the focus is on the future. At a certain point, there is a limit to what Twitter can charge an advertiser to place an ad on the service. That limit is monthly active users. Given the lazy growth of MAU's, revenues growth will eventually plateau to be in line with user growth. This is assuming that Twitter-the-service continues to be the main product for Twitter-the-company. Twitter doesn't have diversified income streams like WhatsApp and Instagram, which Facebook smartly purchased, so revenue growth is bound to hit a roadblock if nothing changes. One can only assume Twitter knows this, and is working on new products and services down the road.

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Sometimes it helps to visualize the same data in a different light. Below is a chart showing MAU's and revenues, as well as a logarithmic trendline of the MAU's. Note the y-axes, which correspond to different data points.

- The MAU trendline tells the whole story. User growth started up rapidly, growing from Q1' 12 through Q1' 13, and then slowing down thereafter. I wasn't able to find revenues for that period of time, since Twitter was still a private company, but if Q3' 13 is any indication, revenues were measly - there were no public shareholders to please yet.

- It looks like there is some fanciful accounting going on in Q3' 13. As mentioned earlier, Twitter had a large stock-based compensation expense in Q4' 13, and I'm guessing they accelerated revenue recognition in that same quarter to make the loss look better. As a result, the next quarter (Q1' 14) had very little revenue growth. This is conjecture, of course, but accountants are known to manipulate revenue recognition like so.

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Normally, I don't like comparing social media companies to each other. Social media is it's own industry, but it's too adolescent to benchmark companies against each other. Facebook serves needs that are different from Instagram, and the latter serves different needs than Twitter. That said, they are all social companies, so some sort of comparison is allowable. Comparing Twitter to Facebook/Instagram serves to further explain its narrative. It's also a great tool for getting a feel for the size of Twitter. With that, let's look at the MAU's of Facebook, Instagram, and Twitter.

- Facebook is king. Zuckerberg's company simply engulfs Twitter and Instagram (reminder: it's owned by Facebook), and it's so large that comparing Twitter to Facebook would be futile. It does tell us one thing though - Twitter is not Facebook, and it will not be the next Facebook.

- The story of this chart is actually lies with Instagram. Just recently, Instagram announced it has 300 million MAU's, which makes it larger than Twitter. To be fair, Instagram is primarily a photo sharing service, while Twitter focuses on 140-character text messages, but you can bet Twitter would love to have Instagram under its portfolio. If you recall, Twitter wanted to purchase Instagram, but likely got outbid by Facebook for it. Regrets, I've had a few.

- Analysts like to dig extremely deep into the details, but all we need to see about how Twitter is doing is right in this chart. Twitter's MAU growth was not able to match that of Facebook, and eventually, people realized Twitter is not Facebook and will never be as large as Facebook. Stock markets adjusted, and everyone moved on. Now Instagram, another product in Facebook's portfolio, outpaced Twitter's growth. The trajectory of Instagram shows it's going up, while Twitter's is slowing down and might even level-off. This doesn't make Twitter a bad company, it just signals that it will no longer be a growth company, which led investors to invest in Twitter in the first place.

- You're probably now thinking Twitter should be worried about Instagram's success. They should be worried insofar as to why Twitter can't match Instagram's growth rate. But I wouldn't worry about Instagram in the competitive sense, since they are two entirely different social networks. I haven't looked into the data, but I would venture to say that many people use both Twitter and Instagram (in addition to Facebook), and use of one service doesn't take away users from the other. I also don't see Instagram adding any functionality similar to Twitter, since the beauty of Instagram is its elementary simplicity. In short, Twitter shouldn't be actively preoccupied about Instagram's success, and instead focus on their own issues (of which there are many).

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This final chart displays the same data as above, in a slightly different view. Note that there is no Instagram MAU's for Q1' 14 and Q2' 14, because Instagram didn't release this data to the public.

MAU's: Twitter + Facebook + Instagram #2

- It's easier to see by how much Facebook trumps both Instagram and Twitter in this chart. Facebook is huge.

- Q3' 2014 is when Instagram overtook Twitter. It's worth reiterating that this doesn't mean much in itself, it only tells us how successful Instagram was in growing.

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Coda

As I was writing this introspective, I was faced with a conundrum. On one hand, I wanted to present my findings about Twitter. On the other, I wanted to give my advice on what Twitter should do to grow as a company. Since I have no higher body to report to, I chose to do both. Sprinkled within this analysis are my opinions, which I believe are good strategic decisions for Twitter. That said, the focus of this analysis was not recommendations, of which I have many. If you are interested in my recommendations, or just have a comment to add, feel free to contact me via email, or fittingly, by Twitter.

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Download the PDF of this report: Twitter Introspective

How Apple is Not Spending its Cash

December 23, 2014 by Larry Sukernik in Technology

The debate about what Apple should do with its pile of cash continues. This week, Eric Jackson attempted to explain the reasoning behind why he thinks Apple should purchase Pinterest, Twitter, and Tesla. His major point is Apple's $100 billion stock buyback program is a waste of return, and should instead be used to make more "beach front" acquisitions like the ones mentioned above. As I've written before, stock buybacks are a controversial topic, so you shouldn't be surprised to see everyone sharing their opinions on the subject. That said, most of Jackson's advice is not realistic for the following reasons.

Apple does not get social

Purchasing Twitter, Pinterest, or even Path could be a profitable move for Apple, long term. But the chance of that is slim-to-none. Everything a company does regresses to the mean, which means the company's strategies will likely play out like they have in the past. Apple has tried social before, with the notorious iTunes Ping music sharing network. To say it was a colossal failure would be wholly appropriate. Without a doubt, Apple would love to have a successful social network in its portfolio, but its strengths are not in social. In fact, I would argue social is Apple's competitive weakness, because the company almost always places privacy over sharing. A social network made by a company that is fundamentally private is a magnificent act in futility. Apple could surely purchase Twitter or Pinterest, but I would expect that to destroy value, not create it. There is no historical evidence that says otherwise.

Apple isn't a portfolio company

Some companies have huge portfolios of products that range from refrigerators to televisions. They diversify, spreading risk over multiple industries, so if one operating segment flounders, the others could keep the company afloat. Apple is not such a company - it's actually the direct opposite. Apple's competitive advantage has always been differentiation, which allows it to focus on a few products that dominate the market. This intense focus only works when there are few products to focus on. Inevitably, purchasing a large company like Tesla will result in a loss of focus. Some companies are conglomerates that are able to spread their focus, but Apple is not such a company. Perfection runs deep in the culture, and spreading it over too many products will be a risk they shouldn't assume.

Historically...

Wall Street professionals, most of which have a classical business education, have never understood Apple. The company continually engaged in strategies that would make a business professor squeal with disbelief. Steve Jobs famously blocked Adobe Flash from all iOS products, despite a huge demand for it. Today we know this was a good idea. Apple has also been opinionated to the point of aggression, engaging in unprofessional marketing feuds with Microsoft and Samsung. Moreover, the company has cannibalized its own products voraciously: the iPod was replaced by the iPhone, the iPad initially stole from Mac sales, and now the opposite has been true with Mac sales eating into those of the iPad. As long as people are buying some Apple product, Apple remains content. All of these actions by Apple are not traditional, and they have flustered analysts since the beginning. Sometimes these actions actually hurt the company. But overall, Apple has always remained an enigma, which probably doesn't fully understand itself. Advice by those classically trained in business should be taken with a grain of salt by Apple, since its success has come from being different.

I should mention I myself have this classical business education, so my biases are evident. But I would also highly encourage everyone else with this same education to appreciate its shortcomings. Business strategy has a huge element of luck, timing, and other uncontrollable factors which cannot be reasonably predicted. Let's not forget that.