Google vs. Facebook – AI dividend.

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Google’s AI already paying dividends

  • Both Google and Facebook have a fake news problem but Google’s leadership in AI means that it is likely to have a better solution and will not have to materially impact the financial performance of the company to fix it.
  • Over the last 2 years, Google, Facebook, Twitter and so on have become far more important when it comes to delivering current events to users.
  • This is particularly relevant when certain events occur that result in regular citizens present at these events uploading videos and commentary long before the more established media outlets can arrive on the scene.
  • As a result, important information often appears on Google, Facebook and Twitter first, meaning that the accuracy and veracity of this information is of paramount importance.
  • Unfortunately, during these sorts of events, there is often a scarcity of information available making it the easiest time to successfully propagate fake news.
  • This is the problem with which both Facebook and Google are wrestling, but from looking at how both are dealing with it I think there is a huge gap between these two players.
    • Facebook: To combat this problem, Facebook has announced that the total number of employees working on safety and security will be doubled from 10,000 to 20,000.
    • Given that the total number of employees at the end of June 2017 was 20,658, this implies that 50% – 60% of all Facebook employees will be working in non-revenue producing positions.
    • This will mean that costs will meaningfully outstrip revenues leading to a “significant” decline in profitability.
    • These humans are being shipped in to deal with the problem because Facebook’s AI is not even close to being good enough to deal with it
    • Furthermore, I think that this is a problem that humans cannot really solve given the velocity that is required.
    • Google: to be fair to Facebook, Google’s data tends to be somewhat more structured than Facebook’s making it easier to analyse but this does not come close to explaining the difference in AI ability.
    • Although Google remains reluctant to discuss the methods it is using to combat this problem, this is something that it has been dealing with for many years and there has been no sudden increase in current for forecasted headcount.
    • There has also been no sudden decline in gross margins (current or forecasted) which would indicate that Google had taken on contractors to help fix the problem.
    • While Google does use fact checking services to ascertain the veracity of some of the content that appears in its searches, I think that almost all of its efforts are going into closing the loopholes in its algorithms that allow fake news to surface.
    • This is why there is no financial impact on Google from this problem compared to Facebook.
  • Furthermore, I think that using humans to combat fake news will end in failure.
  • This is because it takes the human system around 2-3 days to reliably label an article or item as fake by which time is has trended and already been seen by millions of users.
  • Consequently, I do not think that having tens of thousands of humans scouring Facebook for fake news will actually solve the problem.
  • Hence, I think that this will result in $1bn+ of shareholders money being wasted in every year that humans are being used.
  • This highlights the gravity of the AI problem that Facebook is trying to deal with and think it is one that Google is much closer to solving.
  • Hence, I see Google being able to far more effectively manage this problem and at a fraction of the cost.
  • From a shareholder value perspective, perhaps it is time to consider switching from Facebook to Google.

Tencent Q3 17 – Time purchase

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Mighty core business buys time.

  • Tencent reported strong results driven mostly by its content offerings which gives the company time to work out how to fully monetise the vast the community it has created.
  • Q3 17 revenues / net income RMB65.2bn ($9.8bn) / RMB18.0bn ($2.7bn) nicely ahead of estimates of RMB61.0bn / RMB15.8bn.
  • Tencent called out smartphone games (especially Honour of Kings) and its online video platform (which it now believes has overtaken Alibaba and Baidu to become China’s No. 1 place for video streaming) as top performers during the quarter.
  • Most revenue streams grew between 45% and 50% YoY but it was the contribution from other businesses such as first-time monetisation of WeChat Pay and cloud services that really drove the numbers above expectations.
  • Overall, these revenues grew by 143% to RMB12.0bn which pushed the corporate average revenue growth rate to a 7 year high of 61% YoY.
  • While the core businesses continue to defy the slowdown I have been expecting, the laggard in the company remains the monetisation of the ecosystem that it has created.
  • This is what Baidu and Google are really good at and what Alibaba has been showing increasing signs of getting to grips with.
  • The vast majority of Tencent’s revenues come from selling content like games, in app purchases or streaming subscriptions making it more like Netflix and Amazon rather than Google or Facebook.
  • Tencent has created a community of 980m users at least half of whom regularly interact with Tencent in multiple Digital Life segments.
  • This creates a substantial revenue opportunity for Tencent but one I think that it has struggled to really get to grips with.
  • Online advertising is still just 18% of revenues which I calculate is between one third to one half of what it should be for an ecosystem with 980m active users.
  • It is here that I still see the real upside for Tencent as it has done little in the last 15 months to address this opportunity.
  • To be fair to the company, management time has been very successfully invested in growing the existing businesses but the time will come when it will need to monetise this opportunity to keep growth going.
  • Here, I think that Tencent has a lot of work to do as its score on RFM’s 8 Laws of Robotics is pretty low, particularly against Laws 5 and 6 which focus on the integration of services and user data.
  • To monetise the ecosystem effectively, I think a good score against these measures is required and Tencent has so far shown little sign of grasping the importance of integration.
  • However, while the core business continues to defy expectations, this is not a problem from a share price perspective and buys management time to get to grips with integrating its assets into a single place where users can live their Digital Lives.
  • This is how I can continue to like Tencent as an investment despite its apparent slowness to move onto the next stage of its development.
  • While the core business continues to deliver, the valuation remains underpinned with the potential further upside coming from monetisation of the ecosystem.
  • This is why Tencent remains my preferred pick globally.

Softbank & Uber – Sellers’ paradise

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At around $70bn, there should be plenty of sellers.

  • Uber has approved a deal where SoftBank will lead a $1bn fund raising and at the same time buy around $9bn from existing shareholders which should give SoftBank a stake in Uber of around 14%.
  • Softbank is investing at a valuation of $70bn and while the purchase of existing shares will be done at a lower valuation, I think that it will have to be pretty close to the price being paid for primary shares to keep sellers happy.
  • The deal also goes hand in hand with agreements to restructure Uber’s corporate governance in a bid to draw a line under the disastrous 2017 that Uber has had.
  • This is badly needed as management turnover, bad press, unhappy drivers and a series of scandals has led to the company focusing on anything but its core business in 2017.
  • This has resulted in a meaningful deterioration of its market position and outlook in my opinion.
    • First, in its home market, lack of focus has led to Lyft being able to confidently expect to improve its market share to 33% from 20% at the beginning of the year.
    • This leaves Uber on 66% which based on my rule of thumb for network based businesses, is enough to eventually win the market, but its margin for error has been substantially reduced.
    • This rule of thumb states that 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.
    • Coming into 2017, Uber had a 20% cushion before Lyft could really start causing it some problems, but this cushion has now been reduced to just 6%.
    • Furthermore, with Google is now backing Lyft as the best way for it to get its self-driving technology (Waymo) to market, this gives Lyft much deeper pockets than it had previously.
    • Second, following its ignominious exit from China (see here), Uber has also lost the Russian market to Yandex (see here).
    • It is increasingly looking like Uber will end up with USA and a host of smaller markets where there has been no particularly strong local competitor.
    • India is still in play and I think could be a source of conflict as when this deal closes, SoftBank will have a meaningful position in both Indian rivals (Ola (see here) and Uber).
    • Third, RFM research concluded that of all the autonomous driving technologies being tested, Uber’s is the worst (see here) where Google’s offering is 5,000x better.
    • Autonomous driving will be critical for the ride sharing companies as when the supply side of their marketplaces disappears, they will become service companies or fleet operators.
    • At that time the quality of their autonomous driving technologies will be a major factor in determining market share and profitability.
    • With Lyft going with market leader Waymo. Uber has everything to do.
  • The net result of this series of misfortunes and own goals is that the outlook for Uber has deteriorated materially over the long-term.
  • I think Uber could easily lose every large market that it is trying for resulting in it ending up being pretty much US only ad even here Lyft is looking increasingly threatening.
  • On this basis, I think that a valuation of $70bn is a big stretch
  • Consequently, if SoftBank is offering around $70bn for secondary shares, I think that there will be plenty of supply as I think many people now have a materially lower valuation in mind.

Tencent – Digital circumnavigation.

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Tencent begins to build on Supercell.

  • Following the most difficult set of results after its IPO, Snap has conveniently announced that Tencent has taken a 12% stake in the company.
  • This has awoken take-over speculation that I thought would not really emerge before the shares dropped below $10 and should provide a badly needed boost to sentiment.
  • In its 10Q Snap stated that it had been notified by Tencent that it has purchased 145.8m shares representing a holding of 12% in Snap Inc.
  • If this had been purchased purely through the exchange it would have consumed 25% of the free float which I think would have been noticed triggering a rally and speculation.
  • Consequently, I suspect that the majority of this stake was accumulated by approaching existing holders directly whom I suspect were only too happy to sell.
  • I do not think that this transaction has anything to do with Tencent’s China business but instead is more about Tencent looking at ways of spreading its wings overseas.
  • RFM research (see here) has concluded that Digital Life services in developed markets do not work well in China (mostly because they are blocked) while Chinese Digital Life services do not work well in developed markets as they do not fit culturally and also are predominantly in Chinese.
  • Consequently, the BATmen have had to seek other ways to develop overseas other than just spreading their Chinese services into developed markets.
  • Alibaba is approaching this using the Trojan horse of Alipay (see here), while Tencent is showing signs of assembling a range of assets that would give it good coverage of Digital Life in developed markets (see here).
  • This process began with the acquisition of Supercell in June 2016 (see here), continued with an attempt on Spotify that failed (see here) and now it seems to be latching onto Snapchat.
  • Tencent is the global market leader when it comes to Digital Life coverage with 77% of the Chinese pie covered and 30% of the developed market pie covered with its position in Supercell.
  • Adding Snapchat would take this coverage to 44% ahead of both Google and Apple (who have 40% each).
  • However, it is one thing to have good Digital Life coverage and quite another to create a vibrant ecosystem that one can effectively monetise.
  • The Digital Life measure is only a measure of opportunity which is why RFM uses its 8 Laws of Robotics to assess the quality of the proposition being made to users.
  • Against these tests both inside China and overseas, Tencent does not score well (see here) which explains why the vast majority of its revenue comes from selling content and games rather than from monetising its community.
  • It increasingly looks as if Tencent is embarking on a circumnavigation of the Digital Life pie in order to build an ecosystem to challenge the established Google, Apple, Amazon, Facebook dominance of consumer digital services.
  • Consequently, I expect Tencent to actively seek investments or acquisitions in Media Consumption, Search, Social Networking and so on in order to build its coverage.
  • This is likely to prove to be expensive and in my opinion the real challenge for Tencent lies ahead.
  • This will be to assemble and integrate these assets into a vibrant and consistent community which is something is has yet to do with the majority of its assets in China.
  • It is at this time that its score against RFM’s 8 Laws of Robotics will begin to improve but so far there is not that much sign of it.
  • I continue to like Tencent as it is the strongest of all the Chinese ecosystems and the share price still does not reflect all of the potential upside.
  • Hence, there is still not much very downside in Tencent if it fails to integrate its assets and improve its score on the 8 Laws.
  • However, should it do so, there is plenty of further upside from here.
  • Tencent, along with Baidu and Microsoft remain my top picks.


Snap Q3 17 – Sixes and sevens.

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Dreadful results reveal a company in disarray.

  • Snap reported weak results that bear all the hallmarks of a small, weak player being ground into the dust by a larger, much more powerful rival (see here).
  • Furthermore, Snap now finds itself being forced to redesign its user experience in a desperate attempt to drive user growth which, by its own admission, puts at risk the usage and revenues it already has.
  • Signs of disarray are everywhere from a sudden desire to redesign its user experience (see below) to a failure to update its mission statement following the failure of Snap Spectacles (see here).
  • Snap still describes itself as a camera company (see here) despite taking a $39m write-off of camera hardware after failing to sell the units.
  • Q3 17 daily active users (DaU) and revenues were 178m / $207.9m falling well short of consensus at 180.5m / $235.5m.
  • Revenues have been depressed by the shift from direct sales to programmatic advertising which has had a significantly negative impact on advertisement pricing.
  • This transition is now largely over as 80% of revenue now comes from this form of advertising meaning that growth should be better going forward.
  • However, the two most important measures of a company’s ability to monetise its users: Digital Life coverage and active users are both stagnant.
  • Snap’s Digital Life coverage remains at 14% and without major traction in another area like Media Consumption or Gaming, it is unlikely to change for the foreseeable future.
  • I think that Snap’s active users are not growing because Instagram has successfully copied all of Snap’s user experience innovations and made them easier to access.
  • The result is that users are no longer leaving Facebook to go to Snapchat but instead simply switch over to Instagram Stories for this type of service.
  • Hence, I think that the end result is that neither its Digital Life coverage nor its user count has any real scope to expand from here.
  • Putting this into the context of RFM’s monetisation analysis (see here), means that once Snap Inc. has monetised its full potential, growth will grind to a halt as it has at Twitter.
  • Furthermore, tinkering with the user experience runs the risk of putting off its existing users which could cause active users to decline which would put a major crimp on the company’s ability to monetise.
  • Snap has a core user base and revenue opportunity which, in my opinion, still values the company at around $12.40 a share.
  • This is not far from where it is now following the 17% after-hours correction on 7th November 2017.
  • However, I still think that the stock needs to dip below $10 before I would consider looking at it as it is at this point that potential acquisition interest may materialise.

Facebook vs. Snap Inc. – Own goal pt. II.

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An unaffordable outage.

  • Snap Inc’s Snapchat service suffered a 4 hour worldwide outage that enraged its users, greatly increasing the risk of defection to Facebook’s more reliable and much larger stories service.
  • Snap Inc. is already having a tough time competing against Instagram Stories and these sorts of events are simply unaffordable if Snap Inc. is to have a chance of succeeding and remaining independent.
  • Snapchat currently has around 173m DaU but despite launching just 14 months ago, Instagram Stories now has over 300m.
  • This is doubly troubling as not only is Stories now twice the size of Snapchat, it is growing much more quickly.
  • This strongly implies that users who like the type of service pioneered by Snapchat can now access a much bigger network without having to leave Facebook’s environment.
  • I think that this has proved to be very successful as evidenced by the fact that Instagram Stories is growing very quickly while Snapchat has stagnated from the day it went public.
  • I suspect that many users, who might have otherwise signed up with Snapchat, have opted to stay with Instagram thereby depriving Snap Inc. of its badly needed growth.
  • This is why an outage is something that Snap Inc can not afford as it meaningfully increases the risk that, on top of not gaining new users, it may begin to lose its those that it already has.
  • Furthermore, Data from Captiv8, the audience tracking service, indicates that influencers are leaving Snap and are finding their way to Instagram.
  • During Q2 17, Snap saw a 20% decline in influencers while Instagram saw an 11% jump.
  • Snap Inc. is already struggling with the loss of key influencers who are defecting to Instagram as Instagram is making it very easy for them to get set up and critically, make money.
  • In many ways influencers are a bit like developers which in order to get going, need lots of love and support.
  • Facebook and Instagram have understood this and acted upon it while Snap’s management does not seem to care that much.
  • Snap badly needs to address this situation as influencers are key for marketing to its key user base.
  • Take this in the context of enraging users with a service outage and the stage is set for very little progress to be made in terms of getting the user base growing again.
  • Consequently, I think that Q3 17 and Q4 17 will continue to see the user numbers and the engagement disappoint leading to more pressure on the share price.
  • I continue to think that while Twitter is also stagnating, it is in a much better strategic position as it remains unopposed in its space.
  • Snap by contrast is under colossal pressure from Facebook which I think could lead to the shares dipping well below my fair value of $12.40 a share.
  • If they were to hit $10 or below, I could see acquirors coming out of the woodwork.
  • Until then, I still see no reason whatsoever to get involved.

Facebook Q3 17– Organic brains.

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Humans are not the answer.

  • Facebook reported strong results but gave disappointing guidance as its shortcomings in AI mean that non-productive headcount is going to skyrocket, materially hurting profitability.
  • Q3 17 revenues / EPS were $10.3bn / $1.59 comfortably above forecasts of $9.8bn / $1.28.
  • Once again this was driven by growing engagement on mobile and users spending more time watching videos that have originated on Facebook.
  • Active users have now reached 2.07bn with 1.37bn using the service every day.
  • This sets Facebook up nicely to become by far the biggest ecosystem outside of China, but it still has a long way to go.
  • Currently Facebook is made up of a few discrete services which need to be migrated into an integrated suite of services where users can spend the majority of their digital lives.
  • This transition is underway and it is still a work in progress, but the commentary for this quarter reveals just how serious the AI problem is.
  • Facebook has a serious fake news problem and it also believes that some countries are using its platform to interfere in the political process of other nations.
  • To combat this, it has announced that the total number of employees working on safety and security will be doubled from 10,000 today to 20,000.
  • Given that the total number of employees at the end of June 2017 was 20,658, this implies that 50% – 60% of all Facebook employees will be working in non-revenue producing positions.
  • This will mean that costs will meaningfully outstrip revenues leading to a “significant” decline in profitability.
  • I strongly believe that there will be no need for a corresponding increase of headcount at Google, Baidu, Yandex, Microsoft, Amazon or Apple to deal with these problems as these companies are much better positioned to create a solution using AI.
  • In contrast it seems that whenever Facebook attempts to automate anything, it inevitably goes awry resulting in the need for more humans to fix the problem. (see here, here and here)
  • Furthermore, humans are ill suited to solve these kinds of problems as it takes far too long to find and remove the relevant content meaning that it will have already trended and been seen long before it is removed.
  • I think that this process has to be automated to be effective and as a result, Facebook’s costs are going to rise and the problem is unlikely to be solved.
  • Consequently, I think that the money would be far better invested in AI rather than in bodies as AI is how the problem will eventually be solved.
  • Until then the financial performance of the company is likely to suffer weakening the case for the shares to trade such a high multiple.
  • Consequently, I think that this is a good time to start thinking about taking some profits and reinvesting the proceeds elsewhere.
  • Long-term there is still upside, but this requires a much deeper Digital Life offering and world class AI both of which are still far from being achieved.
  • There is likely to be a better time and place to build a position in Facebook for the long-term.

Facebook – Lead bullet.

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A problem that humans can’t solve.

  • There is a silver bullet to deal with the fake news issue, but the problem is that Facebook is not even close to being able to produce one and is having to rely on old, ineffective bullets instead.
  • This problem has been around for a while but really came to light in the summer of 2016, following a move to automate the selection of trending stories on Facebook.
  • Simply put, Facebook’s AI is incapable of working out which stories are fake and which are true which led to false stories being highlighted by Facebook as treading.
  • Facebook’s reaction to this problem has been to throw humans at the problem and a Bloomberg investigation has indicated that this is not working well at all.
  • Facebook has outsourced fact checking to PolitiFact, Snopes, ABC News, and the Associated Press for the period of 12 months but this has been problematic.
  • In order to be flagged as disputed on Facebook, two of the contracted organisations have to mark the story as false at which point the number of users seeing the story is cut by around 80%.
  • This manual process takes about three days to complete in many cases, it takes much longer.
  • On Facebook this is effectively useless as many stories will have trended, been seen by millions of users and disappeared again long before the humans can mark the story as false.
  • Consequently, the only way to solve this problem is to have AI that scans stories as they begin trending and can accurately weed out the fake ones.
  • This is where Facebook comes unstuck as RFM research has found that when it comes to AI, Facebook’s position is very weak (see here).
  • This is not because Facebook does not have good employees in this area but merely because it has not been working on it for long enough.
  • I believe that currently, excellence in AI has very little to do with how many big brains one has on the bench but how long one has been crunching the data.
  • This is where Facebook really suffers as it has only been working on AI for a couple of years whereas Google, Baidu and Yandex have all been crunching data for over 20 years.
  • To be fair, Facebook has shown some progress on image and video recognition (see here) but on the recognition and elimination of fake news, I have seen none whatsoever.
  • As a result, I think that Facebook’s contention that there is no silver bullet to deal with the fake news problem is incorrect.
  • There is a silver bullet but the real problem that Facebook has is that it has no idea how to make it.
  • Until it figures this out, it looks to me like the fake news problem is here to stay.
  • This weakness in AI is not limited to fake news but shows up everywhere across Facebook’s services making it the biggest challenge that Facebook is facing.
  • This problem has to be solved properly for Facebook to achieve its long-term potential as a fully-fledged ecosystem offering deep and intuitive services to 2bn+ users.
  • It is based on this that I can make a case for liking Facebook long-term meaning that this has to be fixed at all costs.

Alphabet, Baidu & Amazon – West vs. East.

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US fares far better than China.

  • Alphabet and Amazon reported very strong results while Baidu struggled to deal with the shift in advertising from search to social media.


  • Alphabet reported another very strong quarter but the requirement to share some of the spoils with its partners is putting upward pressure on costs.
  • Q3 17A revenue-ex TAC / EPS were $22.3bn / $9.57 compared to consensus at $22.1bn / $8.32.
  • The better than expected profitability was largely driven by the reduction of losses at Other Bets as costs at the fibre init were cut and other investments were more fiscally prudent.
  • Revenues were once again mainly driven by mobile advertising which carries a much higher traffic acquisition cost (TAC) as Google has to share revenue with its partners.
  • This climbed to 23% of revenues up from 21% a year ago.
  • This combined with many fewer rumblings of dissent coming from Android handset makers these days and automakers saying that Google is being nicer to them, leads me to believe that Google is sharing more of the spoils with its long-suffering partners.
  • Alphabet admitted as much on the call mentioning that some of the agreements with its partners had been changed.
  • I suspect that this also has something to do with the prospect of the EU forcing Google to change its business model which is likely to be less severe if its partners are happy.
  • I suspect that this trend is likely to continue and the outlook for Alphabet going into Q4 17 and 2018 remains healthy.
  • That being said, the valuation has kept largely in step with the fundamental improvement in its business leaving me indifferent to the shares.


  • Amazon’s haphazard approach to making money surprised the market once again but I suspect that investments in Q4 17 will once again depress earnings.
  • Q3 17 revenues / EBIT were $43.7bn / $347m compared to estimates of $41.3bn / $223m.
  • It was the unexpected profit that once again lifted hopes that Amazon has become sustainably profitable.
  • As usual it was AWS that drove profits with revenues of $4.6bn and margins of 25.5%.
  • This masked ongoing massive investments outside of the US where losses mounted to $936m (6.8%) from $541m (5.1%) one year ago.
  • I suspect that the vast majority of this is being spent in India where Amazon is absolutely determined not to lose out to local players following its ignominious defeat at the hands of Alibaba in China.
  • This is why I am extremely cautious on the outlook for Flipkart and Snapdeal as Amazon has the financial resources that its rivals lack despite huge investments from Softbank.
  • Amazon is guiding for strong sales in Q4 17 but I think that it could easily miss its profitability forecasts as has become customary.
  • Q4 17 revenues / EBIT are expected to be $56.0bn – $60.5bn / $300m – $1.65bn slightly ahead of consensus at $55.5bn / $1.5bn.
  • Amazon is continuing to grow its revenue base very successfully but I still can’t get comfortable with investing in shares where one is already paying for profitability that remains random and illusive.


  • Baidu reported poor results that triggered a big sell off creating what is probably the cheapest AI investment on the planet.
  • Q3 17 revenues / net income were RMB23.5bn / RMB7.9bn beating estimates of RMB23.5bn / RMB4.4bn but the better than expected profits were driven by a non-operating gain of RMB4.2bn.
  • Removing this and adjusting for tax reveals a much more sombre picture and the reality that R&D spending is outstripping sales growth as these investments have yet to bear fruit.
  • At the same time, the company guided weakly for Q4 17 with RMB22.2bn – RMB23.4bn of revenues expected, again missing estimates of RMB25.0bn.
  • This weak performance came on top of a 7% fall in the total number of advertisers using Baidu to 486,000 raising legitimate concerns around long-term growth.
  • These advertisers are becoming more interested in spending their money on social networking platforms where the likes of Tencent have woken up to the revenue potential that their services create.
  • Consequently, the short to medium term outlook for Baidu remains uncertain which resulted in the big sell off seen following the numbers.
  • However, it is not all bad news as RFM ranks Baidu as No. 2 globally in AI which is currently the most sort after (and hence the most expensive) skillset in the technology industry today.
  • This capability has been created from 20 years of crunching data which has allowed Baidu to create the best digital assistant in China (Duer) as well as the most advanced Chinese autonomous driving offering.
  • Unfortunately, all of these investments have yet to bear fruit in terms of tangible revenues meaning that short-term minded investors will continue to ignore them.
  • This creates an opportunity for those wanting to invest in AI to get into something at a very reasonable price.
  • The issue is that without any visibility on when these investments will bear fruit and the uncertainty around the core business, the right time to make this investment is clearly not now.
  • I have liked Baidu given is relative valuation to its Chinese peers and leadership in AI but these results indicate that it is likely to be very volatile for the next few quarters.
  • Tencent looks like a safer place to be for now.

Snap – Reality of fad.

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Snap learns a hard lesson.

  • Snap generated plenty of interest around its first hardware product but the fact that more than 50% users wore the spectacles for just 4 weeks indicates that the device was nothing more than a passing fad.
  • To add insult to injury a sizeable number of users got fed up with the glasses after just one week.
  • Snap sold around 150,000 units of the spectacles which was above its initial 100,000 target but the interest that it managed to generate in the first few days fooled it into thinking that it was something more than a fad.
  • When Snap launched the spectacles, it announced that vending machines would pop-up at undisclosed locations a clever strategy that generated long queues to purchase the product.
  • Unfortunately, this development led the hardware-inexperienced Snap to think that it had a hit product on its hands which meant that it ramped up manufacturing orders in anticipation of demand which was never real.
  • Snap has declined to disclose how large its inventories are, but it did say that as of Q2 17, it had irrevocable hardware purchase commitments of $29m related to the spectacles.
  • This will be on top of the inventory that the company already has.
  • I suspect that following launch, the company ramped up its orders to around 500,000 units which assuming 150,000 sold and a bill of materials of $110, would give an unsold inventory of 350,000 units with a total cost of $38.5m.
  • Snap has plenty of cash on its balance sheet ($2.8bn) and so writing down this inventory to $0 will not hurt financially but it is a real black eye for the company’s credibility.
  • Snap has also substantially reduced its resource commitment to hardware which I think spells the end of its efforts to compete in hardware (see here).
  • I have long held the opinion that Snap has no business being a hardware company (which would materially damage its valuation) and should instead concentrate on its core strengths.
  • These strengths are working out innovative ways for users to engage with each other over an instant messaging platform but unfortunately these innovations are very easy to legally copy.
  • Instagram now has a successful habit of copying all of Snap’s best innovations and pushing them out to its much larger user base pretty quickly.
  • This makes it extremely hard for Snap to compete as apps that offer communication are all about the network of users.
  • Metcalf’s Law of Networking states that the utility or value of a network increases by the square of the number of devices attached to it.
  • This would imply that Instagram (4x Snap’s size) should be at least 16x more valuable than Snap meaning that at Snap’s valuation, Instagram makes up more than half of the valuation of Facebook.
  • Instagram is an important part of Facebook, but I don’t think it is contributing more than 50% of Facebook’s value.
  • Hence, I would be inclined to believe that Snap remains meaningfully over-valued.
  • I think that fair value for Snap remains around $12.40 per share which is still 18% below where the shares are today.
  • I still think that negative sentiment could push the shares closer to $10 at which point acquirors could start to take interest.
  • Until then I still see no reason to get involved and would strongly prefer Twitter to Snap Inc.