India e-commerce – Unicorns and Donkeys Pt. V.

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Flipkart likely to buy Snapdeal. 

  • The latest in a series of woes that has hit the Indian e-commerce market reinforces my view that in network based businesses, there really is only space for one player to do well.
  • This time around it is Snapdeal which is cutting costs by laying of 800 people, cutting the salaries of its founders to zero and exploring the sale of its mobile wallet FreeCharge at a big discount to what it paid for it in 2015 ($400m).
  • The founders of Snapdeal admit to spreading themselves too thin and not executing optimally, but I think that the real issue here is much more fundamental.
  • Snapdeal and Flipkart like Alibaba and to a lesser degree Amazon are market places which bring together merchants and buyers in one easy to use location and from which they can take a small cut.
  • In effect, they are network businesses just like Uber, Alibaba, AirBnB, Craigslist and so on and consequently, they are bound by the same rules.
  • 18 months ago I proposed a rule of thumb that states: A company that relies on the network must have at least 60% market share or be at least double the size of its nearest rivals to begin really making profit (see here).
  • This, in a nutshell, is the problem faced by both Flipkart and Snapdeal in India.
  • Flipkart is bigger than Snapdeal and so it is in a slightly better position but it is not double the size of its nearest rival.
  • Furthermore, both have to contend with Amazon which is determined not to make the same mess of India that it made in China when it went up against Alibaba and lost.
  • Amazon is not the largest in India, but it has the backing of the mothership meaning that it can lose money for far longer than either of the other two.
  • Flipkart has the best chance of reaching this hallowed status as it is the largest in India with around 35% of monthly active users but it will need to reach at least 50% before it is double the size of Amazon (7Park Data).
  • This is why I think it could end up acquiring Snapdeal, because adding Snapdeal’s users to its own would get it pretty close to achieving that milestone.
  • Without this combination, we are likely to be left with 2 unprofitable donkeys that are slowly ground out of existence by the vastly more powerful foreign player.
  • This uncertainty keeps me from recommending investments in either of the Indian e-commerce companies even at the discounts now being offered but if I had to go for one, it would be Flipkart.

Yahoo & Verizon – Final execution.

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Finally, Yahoo executes.

  • Yahoo may have badly failed to create any value for investors in mobile, but its execution on the sale of its core business is finally generating significant value for its long-suffering shareholders.
  • Verizon will now pay $4.48bn to acquire the core business of Yahoo a reduction of 7% of $350m and the two companies will share any legal and regulatory liabilities that arise from the two massive data breaches that Yahoo has suffered.
  • I think that this is a triumph for Yahoo which is capitalising on Verizon’s apparent desperation to build a digital ecosystem.
  • For the last 10 years Yahoo has neglected its Internet assets but it has still managed to enjoy high usage and engagement in the fixed Internet despite its failure in mobile.
  • It is this engagement that Verizon is paying $4.48bn for.
  • However, recent events have given users the perfect excuse to finally close their Yahoo email account and move to something else.
  • I have long believed that Yahoo Mail is the service that generates most of the usage and should users leave Yahoo, then the value that Verizon is attributing to Yahoo will have to be written off.
  • Top of the list of Yahoo’s many misfortunes are two massive hacks, one of which took Yahoo 4 years to detect.
  • Over the last 12 months, Yahoo has admitted that around 1.5bn user accounts have been compromised in two very large break ins.
  • This is more accounts than Yahoo actually has, implying that every account that Yahoo has been compromised with a good number of its users having suffered the indignity twice.
  • If this was not enough, Yahoo’s Q4 results showed improving margins solely due to cost cuts which deflected attention away from the fact that revenues are still falling, albeit more slowly than before.
  • On top of Yahoo, Verizon already owns AOL and is trying to rebuild its Go90 mobile video service using the team and assets acquired from Vessel in 2016.
  • The problem I have with Verizon’s strategy is that it is late to game meaning that it has ending up acquiring all of the assets that no one else wanted.
  • Furthermore, Yahoo and AOL have both badly failed to generate any traction on mobile but somehow Verizon seems to think that putting all of these together will create a thriving ecosystem.
  • This is of course possible, but if Yahoo was unable to hold onto the talent capable of executing this dream, I think that Verizon has very little chance.
  • Consequently, instead of a thriving ecosystem, I see a bunch of disparate assets from which users are likely to drift away from at the first opportunity.
  • The real winner here is Yahoo which is receiving far more value for this asset than I think that it is worth and has also managed to halve its exposure to liabilities that I think it should be fully on the hook for.
  • Combine this value with the continued strong performance of Alibaba and Yahoo Japan, and it is not difficult to still see upside in the Yahoo share price.
  • Marissa Mayer may have been terrible at executing on a digital ecosystem but she seems to be a great salesperson.

Alibaba – Five guns east

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Alibaba is going guns blazing for offline. 

  • Alibaba appears to be moving into offline retail much more quickly than I had anticipated as it is complimenting its $2.6bn bid for Intime Retail Group with a partnership with Shanghai Bailian Group which owns 4,700 stores in 200 cities in China.
  • This is a huge step forward from its bid to acquire Intime retail group which operates 29 department stores and 17 malls predominantly in the eastern province of Zhejiang where Alibaba’s home town of Hangzhou is to be found.
  • The idea of this partnership is to bring Alibaba much further into the physical world where $4.5tn of sales are still transacted every year as well as improve the offline experience that users have in Bailian stores.
  • Chinese retail is a fragmented and frustrating experience where decent service and information with regards to inventory, product lines and so on is routinely not available.
  • Consequently, when an online offering appears where this information is clear and one is able to easily purchase goods and know when they will be delivered, shoppers quickly adapt.
  • It is the terrible offline experience with regards to almost everything that has allowed so many other goods, services and activities in China to rapidly migrate from offline to mobile.
  • It these problems that Bailian hopes to fix via its partnership with Alibaba which will provide its technology, its understanding of logistics and its processing systems to modernise Bailian.
  • In return Alibaba will get a large physical presence, access to shopper data and the first big launch for Alipay into the physical world.
  • There are two large mobile payment systems in China.
  • One is Alipay which utterly dominates B2C e-commerce and the other is WeChat Pay which dominates peer to peer as well as payments to shops, restaurants and service providers.
  • This move will bring Alipay into direct competition with WeChat Pay for the first time.
  • I think this partnership will be similar to the potential deal with Intime but on a much larger scale.
  • I have previously viewed (see here) the potential deal with Intime as an experiment in retail which would then be rolled out more widely once it had been proven to work but it looks like Alibaba is going national regardless.
  • Fortunately, as this is a partnership, there will not be much downside risk if it goes wrong which leads me to believe that for Alibaba, this is really about data and pushing Alipay into a new domain.
  • If Alibaba can have a deeper understanding of, and relationship with Chinese shoppers then it will be able to more accurately predict their shopping patterns resulting in better purchasing rates and the ability to charge a higher percentage of GMV to its merchants.
  • This will translate into better revenue and profit growth as was the case in 2016 where increasing monetisation underpinned a large part of the company’s outperformance.
  • I think this expansion will be much slower in 2017, and so I remain cautious on Alibaba preferring Tencent or Baidu in China.

Huawei & Baidu – Bodies and time.

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I think Huawei would be better off doing a deal with Baidu.  

  • It looks like Huawei has decided to build its own Chinese language digital assistant to cement its recent gains at home but no matter how many bodies it throws at this task, its lack of the core raw materials (data and history) is going to cause problems.
  • The digital assistant is the first real Digital Life service that is entirely dependent on artificial intelligence for its functionality which creates a huge challenge.
  • Furthermore, in order to evolve, all digital assistants need to generate usage data which can then be used to improve the algorithms that power the user experience.
  • Even the best assistants out there today are hugely limited in terms of what they can understand and what they can achieve.
  • For example, to accurately answer questions around exchange rates, the assistant has to be taught what these are, how they work and in what form the questions are likely to be asked.
  • For example, asking Amazon Alexa how many US Dollars there are to the GB Pound provides the correct answer but ask for UAE Dirhams to the Pound or Dollar and Alexa falls silent.
  • Only Google Assistant was able to provide the right answer due to the combination of the best search system and the best AI available.
  • In effect RFM research has found that Alexa, Cortana and Siri have been programmed with a fairly narrow set of capabilities and the AI and data set is simply not there to support the service when something unexpected is requested.
  • Fortunately for Huawei, Google is not present in China but at home it will be facing an opponent that is almost as good: Baidu.
  • Baidu dominates the search market in China and has been working on its AI algorithms for nearly 20 years.
  • Furthermore, Baidu has already launched its own digital assistant called Duer which I suspect will be significantly better than anything that Huawei is likely to produce in the medium term.
  • However in China, none of the ecosystems are preinstalled devices meaning that Baidu will be unable to install Duer on the device and set it as default.
  • RFM research (see here) has found that this could confer a substantial advantage to any ecosystem as strategy is virtually absent in the Chinese market outside of the app stores.
  • Huawei as a handset maker will have this advantage and so I can see a scenario where users try its digital assistant but unless it is superb they will quickly switch to Duer.
  • This is where I think Huawei will have difficulties as even though it has 100 engineers working on this product, it is starting from scratch and building decent AI takes years and requires vast quantities of data.
  • Hence, I think it unlikely that Huawei will ever come up with a product as good as Baidu’s.
  • This is where I think Huawei and Baidu could help each other as Baidu has the product and Huawei a mechanism for distributing it.
  • A deal where Huawei installs Duer at the factory and sets it by default in return for being paid TAC (traffic acquisition cost) makes more sense to me than paying 100 engineers to come up with an inferior product.
  • This will not help Huawei’s ambitions to develop an ecosystem and generate better profitability, but TAC revenue from Baidu would certainly help improve margins.
  • Given its recent market share gains at home, the time to negotiate this deal is now rather than when its own assistant has tried and failed.
  • Although Baidu looks like it may be backing out of its ecosystem, the short-term improvement in its financials that cost cuts could generate could give the shares a lift (see here).
  • This is why it is still on my preferred list along with Tencent and Microsoft.

Facebook – Brainless video.

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Focusing on video first makes complete sense.

  • I think that Facebook is making the right choice in targeting video first as it already has traction and video-based services tend to have the lowest requirements for artificial intelligence to make them easy, fun and useful.
  • With the launch of a TV app being just the latest move Facebook has made in video, it is increasingly clear that Media Consumption is Facebook’s number 1 priority for 2017.
  • The TV app that is being launched is very simple in that it makes it easy for a user that does not have time to watch videos on Facebook during the day to easily to so at night on a larger screen.
  • This should enable a better video experience and begin to spread engagement across other devices but it will come with the added complication of multiple resolutions and bit rates.
  • On a mobile device the screen is small which means that lower resolution videos and bit rates are acceptable, but once these are played on a larger screen, their shortcomings quickly become obvious.
  • This move into TV comes hot on the heels of the addition of a tab at the bottom of the Facebook app which links to the top trending videos as well as videos that Facebook thinks that the user might like.
  • The TV app will initially be available on Amazon TV and Apple TV but I expect that it will quickly spread to Xbox, PlayStation and the other streaming TV devices that are available.
  • The one place I don’t expect to find it is Chromecast as Facebook’s video aspirations are clearly a challenge to YouTube.
  • Of the three new areas of Digital Life (Gaming, Media Consumption and Search) that I see Facebook targeting (see here), going for video first makes complete sense.
  • This is because Facebook already has a lot of traction in this space and also because it is the least demanding in terms of requiring intelligent automation.
  • The total number of video items that are present is very low compared to other things like music or searches and knowing who posted the video is a good indicator of its content and who will like it.
  • I continue to see Facebook as the laggard in AI (see here) and targeting video is sensible as it gives it more time to improve its AI before having to apply it to more difficult tasks.
  • Furthermore, the fact that video is a fast growing, but likely soon to mature, medium for digital advertising also means that the time to really address it is now.
  • I see the app on the TV as just the beginning and would not be surprised to see this being followed up with premium content taking it into the realm of Netflix, Hulu, YouTube and Amazon Prime.
  • That being said, I don’t think that Facebook’s offering in Media Consumption is anything like mature and so I think it will be some time yet before it becomes a real destination like YouTube.
  • Consequently, I still see a slow period of revenue expansion while its new strategies mature before revenues take off again.
  • As this reality sinks in, I think the valuation could unwind somewhat providing a better opportunity than now to invest for the long-term.

Baidu – One trick pony?

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Baidu may be giving up on its ecosystem.

  • There is little doubt that Baidu’s investments outside of its core search offering have proven expensive, but it appears that Baidu may be losing the stomach to endure the heavy losses required to build an ecosystem.
  • The three assets in particular are Nuomi, its e-commerce offering, iQiyi, its video streaming service and its on-demand food delivery service.
  • Nuomi and iQiyi have been the real areas of investment and in recent quarters have between them consumed over 50% of the operating profit generated by the core businesses.
  • This combined with its problems with low quality advertising and its higher tax rate, have put it under much greater pressure to deliver better profitability.
  • This has been further exacerbated by the fact that of the three BATmen, Baidu is by far the weakest both in terms of cash flow generated each quarter and cash reserves on the balance sheet.
  • This is why I suspect that Baidu has been forced to look at these investments to find ways of reducing their drain on the financial performance of the Baidu Group.
  • I understand that outside investment as well as trade sales have been considered but it looks like the most likely outcome will be heavy cost cuts.
  • This will limit both Nuomi and iQiyi’s ability to compete against Alibaba’s T-Mall, JD.com and Alibaba’s Youku Tudou leaving them as niche services rather than national leaders.
  • On the Chinese Digital Life pie (see here) Media Consumption and Shopping make up 29% of the total meaning that if Baidu was to abandon or sell these activities its coverage would drop to 24% (Search, Browsing and Mapping).
  • Consequently, I think that it would spell the end of Baidu’s ambitions to become a leading ecosystem in the Chinese market leaving it as a dominant player in just a few segments.
  • Search, Mapping and Artificial Intelligence are extremely important segments and I think that Baidu will be able to make a good living from them, but its real long-term upside will have been curtailed by this retrenchment.
  • The net result in the short-term will be a substantial improvement in its financials making the current valuation look cheap and so I suspect that news of this move will have a quite positive, but short-term, impact on the shares.
  • This is why I am happy to keep Baidu on my preferred list along with Tencent and Microsoft despite the possibility that its long-term upside may now evaporate.

Twitter Q4 16 – No Trump card

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Trump card fails to win the trick.

  • Despite becoming a major channel for the White House to communicate with voters, the realities of Twitter’s situation have continued to dominate its financial performance.
  • Q4 16A revenues / Adj-EPS was $717m / $0.12 badly missing consensus at $740 / $0.23.
  • Monthly active users (MaU) also remained stagnant coming in at 319m up 4% YoY which reflected the anaemic revenue growth which was just 1% YoY.
  • Daily active users did manage to grow 11% indicating some increase in engagement with the service, but it was not nearly enough to convince advertisers to spend more money on the platform.
  • This reality was reflected in Q1 17 guidance where Adj-EBITDA will be $75m – $85m well below consensus at $188m which I think reflects stagnant revenues as well as higher investments in media consumption.
  • I continue to believe that the lack of growth is caused by the fact that Twitter has already fully monetised its segment and in order to grow revenue further it has to address the other segments of the Digital Life pie.
  • In this regard, Twitter has opted to go for Media Consumption which would add another 10% points to its coverage, bringing it to 28%.
  • This is why its progress with its streaming of NFL games and partnership with Bloomberg, Buzzfeed News and PBS is so important.
  • If Twitter can develop this offering into a fully-fledged Media Consumption service with real engagement, then I could see Twitter increasing its revenues to over $1bn per quarter giving annualised revenues of $4-5bn.
  • However, it is still very far from challenging YouTube or Facebook Video which is why I need to see far more than just NFL streaming and a bit of news in order to become confident that Twitter has a media consumption offering that it can monetise.
  • With $196m in cash flow from operations in Q4 16 and $763m for FY2016, Twitter is very far from any existential danger but I see the fair value of the company with no growth being way below where it is today.
  • Consequently, I see nothing in 2017 that is going to drive Twitter back to growth which will put further pressure on the share price.
  • I continue to see Twitter as a potential acquisition target but would expect to see the shares touch $10 before real interest is triggered.
  • I see no reason whatsoever to go bargain hunting as there is no bargain to be had.

Facebook vs. Alphabet – Worlds apart

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Facebook and Alphabet are worlds apart when it comes to AI.

  • While Google is pushing the boundaries of artificial intelligence forward, Facebook is making excuses for its inability to control hate speech highlighting once again who is the leader and who the laggard in the field of AI.
  • Google has demonstrated a system that it has built that allows very poor digital photos to be enhanced to reveal details of the photograph that have been completely obliterated.
  • In a similar fashion to the way that Deep Mind built AlphaGo, Google has combined two neural networks to produce the algorithm capable of enhancing low resolution images.
  • One of these networks uses its knowledge of certain images to add details while the other effectively reverse engineers the process by which the image was compressed into its current form.
  • The result is quite startling but it is worth remembering that the machine knew what the original image was a face or a bedroom but no more than that.
  • Despite Google’s claim that this was an experiment only with no plans to put it to use, I think that the uses for this are endless.
  • This technology would be useful in upscaling video to high resolution screens as well as being highly applicable to law enforcement, security, military, medical and so and so forth.
  • Hence, I think that this technology or an off shoot of it is likely to find its way into Google’s products and services in the medium term.
  • To me this is another demonstration of how well Google leads the field of artificial intelligence and is the closest to using it to enhance the richness and quality of its Digital Life services.
  • This will be a huge benefit to Google as better services will drive more usage through its networks giving it a greater opportunity to monetise.
  • However, this is also the opportunity that Facebook is chasing but when it comes to making its Digital Life services deeper and richer with intelligence, I see it being miles behind.
  • The problems that it has had with fake news, idiotic bots and Facebook M, all support my view that when Facebook tries to automate its systems, things always go wrong.
  • The problem is not that Facebook does not have the right people but simply that it has not been working on artificial intelligence for nearly long enough.
  • RFM research has found that time is the single most important element when it comes to having a solid foundation of intelligent algorithms upon which to build intelligent services (see here).
  • In contrast, Google has been working on this for over 20 years and is still innovating as fast as it can.
  • Facebook’s most recent pronouncement by one of its lawyers that it is unable to control hate speech on its platform due to the scale of data that is posted every day, is just another data point highlighting the problem.
  • Facebook has to get this under control otherwise I fear that it will fail to really expand beyond social networking and instant messaging as the offerings from its rivals will be more useful and more fun.
  • Facebook has some time to get to grips with this problem but I still think it will have to resort to making a series of acquisitions in order to catch up with its rivals.
  • I remain uninterested in both Alphabet and Facebook at this time preferring Microsoft, Tencent and Baidu with Apple for income based investors.

Snap Inc. – Pain not gain

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I see only pain for investors paying $22.5 at the IPO.

  • $20bn – $25bn is at least 32% too much to pay for investors who will also have no say whatsoever in how the company is run despite having significant skin in the game.
  • Snap Inc. has published its S-1 document allowing for a fundamental-(ish) based valuation to be made for the first time.
  • Given that Snap Inc. has no profits and no cash flow, only an analysis based on revenues and users is possible at this point.
  • At the end of Q4 16 Snap Inc. had 158m daily active users (DaU) from which it generated $166m in Q4 16 and $405m for the full year.
  • I think that the most applicable peers for Snap Inc. are Facebook which owns Snap Inc’s two biggest rivals, LINE which is very similar company based in Japan and Twitter which operates in a niche just as Snap Inc. does.

DaU based valuation.

  • For DaU, the only reliable comparison is Facebook as the other peers do not reliably disclose this metric.
  • Facebook has 1.2bn DaU and an enterprise value (EV) of $339bn giving EV / DaU of $283.
  • By comparison Snap Inc. at the IPO EV of $21.5bn looks cheap with an EV / DaU of just $136.
  • However, Facebook generates 6.6x more revenue from each of its users than Snap Inc. and therefore I think each Snap Inc. user has much lower value.
  • Furthermore, I remain concerned that Snapchat’s core user base of 12-24 year olds is not as interesting to advertisers as the older demographic groups.
  • This is because this age group does not have a lot of money to spend on products and therefore is of less value to advertise to.
  • This combined with the fact that Snap Inc. has only 14% coverage of the Digital Life pie compared to Facebook at 36% means that its long-term potential in its current business is much lower.
  • If I adjust Facebook’s EV / DaU to account for these factors, I find myself willing to pay around $80 per user giving me an EV estimate for Snap Inc. of $12.6bn.

EV/Sales based valuation.

  • The peer group of Facebook, Twitter and LINE Corp is trading on a forward EV/Sales multiple of 6.0x for 2017E and 5.0x for 2018E.
  • Given, Snap Inc.’s current growth rate and its medium-term potential (see here), I think that the company could conceivably generate revenues of $800m in 2017E and $1.2bn in 2018E.
  • Being generous to Snap Inc. and because it is growing much faster than the peer group I can give it a 300% premium to its peers giving an EV valuation of $12.0bn based on 2017E and $21.6bn based on 2018E.
  • The average of these two is $16.8bn with which I can be comfortable assuming flawless execution, continued rapid growth and a move into generating profits.

Corporate governance.

  • Very much like Facebook, Alibaba, Baidu and Google, the founders will continue to control the company with the new investors being sold non-voting shares and having no say in how the company is run.
  • While, this is an acceptable structure in early stage, private companies, I think it has no business being present in large capitalisation, publicly listed companies.
  • This is because history has shown that while things are going well, this is not a problem but when things go wrong, the problems tend to be much worse and last for much longer than they would otherwise if minority shareholders had a say in management and strategy change.
  • This happens because founders tend to be emotionally attached to their companies to the strategies that they have created and as a result they hold onto them for far longer than they should.
  • In my valuation of Snap Inc., I would normally take a 30% discount to my fair value in order to compensate investors for the extra risk taken but to be as generous as possible to Snap Inc., I have not included this here.

Take Home Value.

  • The result of this analysis is an enterprise value for Snap Inc. of between $12.0bn – $16.8bn with the midpoint at $14.4bn.
  • Adding back the $1.0bn of net cash the company has on its balance sheet gives me a fair value, in the best instance, for the equity of the company of $15.4bn.
  • This is some 32% below the midpoint of the range reinforcing my previous opinion (see here) that this is an IPO to be avoided at all costs.
  • I would rather own Microsoft, Tencent or Baidu.

Facebook Q4 16 – In focus

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Facebook intends to kill the YouTube star.

  • Facebook reported good results and highlighted that while 2017 would be much slower, video is the current priority to drive the next leg of growth.
  • Q4 16A revenues / Adj-EPS were $8.81bn / $1.41 nicely ahead of consensus at $8.51bn / $1.31.
  • Mobile was once again the main driver of revenues making up 81% of revenues and growing 61% YoY, echoing the strong numbers reported by Alphabet.
  • Facebook reiterated that growth in 2017 would slow markedly, as it has fully monetised the traffic that it already has, but it is well advanced in seeking other avenues.
  • In the next 3 years, the priority is clearly video and I can see Facebook evolving to become more like YouTube or Netflix.
  • These developments are already underway with the latest innovation being the addition of a tab at the bottom of the Facebook app that has top trending videos as well as recommendations for the user.
  • This makes Facebook video look far more like YouTube which I see as an encyclopaedia of video which Facebook clearly intends to emulate.
  • If Facebook can establish itself as a real rival to YouTube, this will bring its content consumption offering to maturity and I will be comfortable increasing its Digital Live coverage from 36% to 46%.
  • I think that it is still too early to call Facebook a real destination for video, but it is steadily moving in this direction.
  • In Gaming and Facebook M its efforts are far more nascent and I see these two appearing in Facebook’s 5 year strategic horizon.
  • While the long-term outlook for Facebook remains good in terms of Digital Life coverage, artificial intelligence remains a big concern.
  • Facebook has made some big hires in this area but its algorithms remain basic at best and deliver an awful user experience.
  • RFM research indicates that almost every time Facebook tries to use intelligent automation, things go badly wrong leaving Facebook having to fall back on humans.
  • While this is not a huge problem today, if Facebook continues to rely on humans to customise the user experience for its users, OPEX will start growing much more quickly than sales.
  • My concern is not that Facebook can’t fix it but that it will take it a very long time, leaving it still behind its rivals who are already miles ahead and investing heavily.
  • This is why I think that Facebook will end up having to make a lot of acquisitions in this space over the next 3 to 5 years.
  • With a slower outlook for 2017 and the share price back to its all-time high, I can not get excited about the stock as there are challenges that need to be overcome before the next leg of growth materialises.
  • I continue to prefer Microsoft, Tencent and Baidu for capital growth and Apple for income.