Thoughts on Tech, Deals, and Markets

Apple announced their Q4 earnings today, and the stock is up 9% after hours.   Their iPod sales (iPod Touch sales aren’t separately broken out, but clearly are a large component) were 22.7m units, up 3% y-o-y, which was almost 20% above consensus.  iPhone sales were 4.4m, below consensus of 5m.

Some think the iPod Touch is cannabilizing iPhone sales.   While there’s inevitably some of that in the short run, in the long run it’s the other way around.  The iPod Touch’s success will continue to attract more developers who will make to better apps for the App Store.  Those improved apps will be available on the iPhone.  That will enhance the user experience of the iPhone’s most important differentiator, widening its lead over competitors as the most functional smartphone on the market.

The word ‘arbitrage’ is commonly misused in online marketing circles.  Arbitrage, as Wikipedia defines it, is “a risk-free profit.”

Many refer to buying traffic from one place and then running it through another with a simple monetization engine as arbitrage.  It’s not.  For a number of reasons.  Here are three.  First, there’s the risk that paid traffic won’t convert.  For example, many in the mortgage space made traffic buys that became disastrous when the market began to implode.  Second, there’s the negative cash flow.   Few traffic buyers are paid before they have to pay their traffic sources.  Third, there are all the overhead costs associated with the infrastructure necessary to make the traffic buy work.   True, when a company is at scale those costs can be relatively small.  But for the average Joe who wants to get into ‘arbitrage,’ that cost is a significant barrier to entry.

In many markets, arbitrage connotes an elegant execution of a market imperfection.  But in the context of online marketing, it’s usually a negative.  It trivializes the risks and challenges to execution of the business.  It’s used by many who believe online marketing businesses lack differentiation and barriers to entry.  Surely some categories have fewer barriers than others, but the dominating fact is that many in the space consistently make tons of money.  It it were simply arbitrage, those profits would have been competed out of the industry long ago.

In the next few days, I’ll be putting out a number of posts on the keys to establishing competitive advantage in the space.

I’ve been scouring press releases covering the recent NPD data on December video game sales to confirm this, but it appears that this data doesn’t include video game sales related to the iPhone or iPod Touch.  If you did include iPhone/iPod game revenue, then the video game market actually looks even stronger.  Ironically, the success of the iPhone/iPod is actually a major threat to the rest of the industry.  It’s the most important trend in video games today:  the disruptive innovation represented by the iPhone and iPod Touch as a gaming platform.

Here is a good primer on disruptive innovation, an idea first articulated by Clayton Christensen:

Sustaining vs. Disruptive Innovation

The central theory of Christensen’s work is the dichotomy of sustaining and disruptive innovation. A sustaining innovation hardly results in the downfall of established companies because it improves the performance of existing products along the dimensions that mainstream customers value.

Disruptive innovation, on the other hand, will often have characteristics that traditional customer segments may not want, at least initially. Such innovations will appear as cheaper, simpler and even with inferior quality if compared to existing products, but some marginal or new segment will value it.

Games on the iPhone and iPod Touch, all bought via the App Store, are dramatically cheaper and much simpler than console and PC-based games.

For this platform to be truly disruptive, it will have to cannabalize console and/or PC-based games.  Will that happen? Based on the recent data, it’s clearly not happening now.  The sophistication and performance of legacy systems are so impressive that it’s hard to imagine the iPhone/iPod Touch platform as a replacement.  But I think this will  happen in coming years because:

• The iPhone/iPod Touch will rapidly improve their computing power, enabling better game play.
• The growth of the gaming market for the iPhone/iPod will attract more development resources, producing better games.
• The increasingly social nature of games.  As the iPhone and iPod sell tens of millions of units, the number of potential game players on the iPhone/iPod will dwarf that of other platforms, creating a richer social experience.
• While PC and console-based games will also continue to improve, the marginal value of that improvement will pale in comparison to the improvement of iPhone/iPod as a gaming platform.

I’m not predicting the end of PC or console-based games and I do think the video game market will continue to grow.  But I also think the iPhone/iPod will rapidly gain video game market share in coming years, eventually becoming the dominant gaming platform.

Even as retail has fallen off a cliff–down 10.2% in December–video game sales (the combination of software, hardware, and accessories) were reported up 9% in December.   Software was up 15%.  That is astonishing.

Ben Edelman, the young HBS prof who has build a reputation for revealing unscrupulous online advertising practices, has a new article fingering Yahoo’s Right Media for featuring “widespread ads exactly designed to deceive.”  He mentions deceptive ads that tell viewers that someone has a crush on them, that they have won something, that their computer has systems problem, etc.–yet all are bogus and intended to attract a click that inevitably leads to another page, laced in subterfuge, that attempts to monetize the unwitting visitor.

These practices are in clear violation of FTC regulations.  However, those regulations are enforced with the consistency of speed limits.  Not surprisingly, companies continue to transgress with few, if any, consequences.  Not surprisingly, these practices are extremely profitable.  Not surprisingly, they give the online performance-based marketing sector a bad name.

Good news on credit market conditions from the WSJ last Monday:

Best Week for Debt Sales in a Year Raises Hopes

Everyone knows about the real estate industry’s crash by now.  But few know about the crash in the online real estate industry–that is, the marekt for domain names.  It’s a story worth telling, though the space is so opaque it’s unlikely anyone ever will do it.  It’s dripping with irony.  For example, a major selling point of domain industry advocates  was that domains are like real estate.  I don’t think they meant it in this way, but they were smarter than they realized–like offline real estate, domains experienced a huge bubble.  Now, both markets have crashed.

The list of domain companies that took private investment is ugly:  Geosign, Oversee.net, and Dotster, to name a few, have not been able to hide their massive problems.  Internet REIT raised a ton of money and has also had huge layoffs.  NameMedia pulled its S-1, leaving its investors tied up in a troubled asset.  The public companies with large domain portfolios have been crushed.  Marchex (MCHX) is off about 60% from its 52-week high, and about 80% from its high back in mid-2006.  Dark Blue Sea (DBS, listed on the ASX) is down over 60% since last May.  Not counting Demand Media (which has large domain assets, has attracted over $200m in capital, will likely lose investor money, but has signifiant non-domain assets as well) the space has attracted over $600m of institutional capital in recent years.  Equity investors will be lucky to get half of their money back, particularly given they sit behind large levels of debt.

What happened?  I don’t have the space or the knowledge to give  a comprehensive list, but a key driver was the success of early speculators.  They earned growing domain parking revenue then plowed that revenue back into buying more domains.  Just like flippers bidding up the prices of housing of all price levels, domainers bid up the prices of domains of all quality levels.  Likewise, the housing run up attracted hot money that drove prices even higher.  Same in domains where, as referenced by the companies above, hot money entered the market and accelerated price increases.

What truly staggers me is the magnitude of ignorance displayed by industry players in both industries.  In real estate, investors such as the buyers of RMBS were utterly disconnected from the value of the assets underlying their securites.  In domains, investors were similarly in the dark.  They would buy hundreds of thousands of domains while only visually inspecting a fraction of them.  As a result, they had little understanding of which domains were actually producing revenue.  Not only were the most brandable generic names not producing as much revenue as often assumed, but often the lion’s share of revenue in domain portfolios was generated from typos and trademark-infringing domains.   If investors in either industry had dug just a bit into what they were buying, much of the boom and bust would have been avoided.

Actually, this qualifies as very good news.

Hat tip to Calculated Risk:

The TED spread is at 0.99, sharply lower. (improved)The TED spread was stuck above 2.0 for some time. The peak was 4.63 on Oct 10th. The TED spread has finally moved below 1.0, although a normal spread is around 0.5.

The TED spread measures the difference between the interest rates on interbank lending (as measured by LIBOR) and  the three-month US Treasury.

And:

The three month LIBOR has decreased to 1.109%. The three-month LIBOR rate peaked (for this cycle) at 4.81875% on Oct. 10. (improved) Imagine all those adjusted rate mortgage loans tied to treasuries or even the 3 month LIBOR? The rates are looking pretty good!

The sudden, huge spikes in the LIBOR and the TED spread were at the center of the financial panic last September and October.  Every participant in the market was scared stiff that every market entity not backed by a developed government was on the brink of worthlessness.  The great irony of that moment was that, due to the panic, everything was, indeed, teetering on the edge.

The frenzied, ‘animal spirits’ of last fall are finally calming.  The credit markets are beginning to thaw.  Gradually, market participants are rebuilding their tolerance for risk.  If this continues, it will shorten the path to economic stabilization and, eventually, recovery.

It’s easy to focus on backwards-facing economic news such as unemployment or earnings reports, particularly when they are as heinous as they have been of late.  But these are lagging indicators, not forward-looking.  On the other hand, real-time measures of risk tolerance in the credit market are causal, and therefore highly predictive.  While we aren’t there yet, when it returns a healthy credit market will spur lending that will drive  future economic activity.

In the M&A and private equity world, improved credit markets will reduce the fear that has gripped many buyers and investors since the last September, catalyzing deal flow.  Frozen credit markets translated into a sky-high cost of capital.  Little leverage was available to goose investor returns.  Combine that with the lack of visibility into ’09 earnings and it’s understandable that the deal sidelines have been crowded of late.  However, as credit conditions improve, there will be opportunities for value for buyers and investors who are willing to move before the crowd.

Yahoo just announced the hiring of a new CEO, Carol Bartz.   Bartz earned a strong reputation as CEO of Autodesk for 14 years, and generally has received favorable reviews in recent media coverage.  Most importantly, unlike the last outsider hired to be CEO at Yahoo, Terry Semel, she is not allergic to technology.   Semel didn’t use email.   Could you imagine an airline company hiring a new CEO who didn’t fly?  Apparently that analogy didn’t occur to Yahoo’s board, which ironically has more execs with experience in airlines (2, Roy Bostock and Gary Wilson) than Internet (1, Jerry Yang).

Having run Autodesk as an independent software company for 14 years, Bartz seems unlikely to lead Yahoo to a quick sale.

My favorite magazine is the New Yorker.  I’m used to receiving emails from them regarding my subscription.  But today was a first–I received an email that was a pure third-party advertisement, in this case for a new Blackberry.   I don’t remember ever signing up to receive third-party advertisements on their behalf, so it’s surprising to get that type of email.  Particularly from a media company that has such high-end demographic.  On the other hand, given their financial difficulties, it’s understandable.

At the same time, this is a sign that email quality will suffer.  As media companies become more aggressive in emailing their lists, it will crowd inboxes and diminish the marginal value of extra email.