Category: Tech Stocks

Will Bitcoin Make a Good Investment? Phase 2: Economic Uncertainty

Posted on by io-fund

In the previous analysis, we discussed one primary reason that bitcoin will make a good long-term investment, as the price is likely to go up and stabilize once institutions gain SEC-regulated access. Fidelity and the NYSE-founded Bakkt are two examples of platforms that will influence the first phase of bitcoin’s broader adoption. These two platforms have not yet launched, but a new supply-and-demand dynamic will occur when institutional investors can access cryptocurrencies.

The next phase for bitcoin stability and price support will hinge on the eroding trust in fiat currencies – both globally and also from younger generations who are digital natives with good reason to seek alternatives outside of the fiat system.

Global Unrest Sees Bitcoin as Alternative to Fiat Currency

Economists have discussed the effects of going off the gold standard during Nixon’s presidency ad nauseum, yet this has been a futile conversation in the past as there has been no alternate method of transacting other than centralized cash. Gold and precious metals are hard to transport and cannot be used to transact daily in the modern age, despite having a store of value. 

Globally, bitcoin is more attractive than many foreign currencies. Venezuela, for instance, is going through a period of hyperinflation with a cup of coffee costing 2,800 bolivars up from 0.75 bolivars less than a year ago, representing an increase of 373,233%, according to Bloomberg data. Essential goods such as toilet paper and medicine are very expensive, and many Venezuelans are fleeing the country.

Bitcoin has emerged as a solid alternative to Venezuelan bolivars. Even when Bitcoin loses value from $19,000 to $3,000, it’s still out-performing the inflation of Venezuela’s currency. On the flip side, when bitcoin rises in value from $5,000 to $11,000 in one month, it allows global populations to hold an appreciating asset. Despite market volatility, bitcoin makes Venezuelans money, offers them accessible protection, and they are able to escape an autocratic regime.

Although many consider countries with the most dominant GDPs as the countries who set the world’s stage for economic conditions, the emerging markets play an important role as the unrest in these regions can lead to disruption.

In South Africa, the number of new users trading bitcoin rose 671% from January to the end of November in 2018. South Africa, Ghana, and Nigeria are among the top five countries searching for bitcoin according to Google Trends.

Currently, the United States is at debt levels that amount to 78 percent of gross domestic product (GDP) compared to 35 percent of GDP in 2007. This debt-to-GDP ratio could reach 144 percent of GDP by 2049 due to decreased tax revenue and increased spending, especially on health care.

During World War II, the debt-to-GDP ratio was 106 percent, however, we are currently at all-time highs during a decade that is absent of a World War.  The United States is unlikely to see hyperinflation to the level of Venezuela (at least let’s hope not), however, trust in fiat currencies will erode as debt continues to climb.

Japan is an excellent case study for an economy that is struggling due to quantitative easing. As of 2018, the Japanese debt-to-GDP ratio is at an all-time high at 254% due to nearly 15 years of quantitative easing. Government debt to GDP in Japan averaged 137.4% from 1980 to 2017.

Easy money policies from Japan’s central bank harmed domestic asset returns by suppressing local interest rates. Ranking as the world’s third largest economy, Japan resorted to negative interest rates in 2016. In April of 2016, it was reported that a “Japanese bank buying 5-Year U.S. Treasuries with perfectly hedged currency and duration risk would (lose) 0.9% a year.”

Consequently, Japan is a thriving bitcoin market. Over 3.5 million people in Japan trade cryptocurrency with the vast majority (84%) between the ages of 20 and 40. The trading volume in Japan rose from $22 million in March of 2014 to $97 billion in March of 2017. Trading on margins, credit and futures rose from $2 million in 2014 to $543 billion in 2017.

For Millennials, Bitcoin is a Good Investment

Student debt weighs heavily on Millennials in the United States. This digital-native generation faces $1.5 trillion in student debt, rising from 3.5% of gross domestic product in 2006 to 7.5% of gross domestic product in 2016.

Rising interest rates plus booming college prices that outpace inflation has affected the age range that is most likely to use bitcoin, compounding the attractiveness of alternative forms of financial trust for this generation. To not invest in bitcoin would be to bet against Millennials seeking decentralization despite being negatively impacted by the current fiat system and record debt levels.

Source: Wikipedia

Bitcoin and cryptocurrencies have been in existence for most of the Millennial generation’s adult life, having launched in 2008, and when this generation ages another decade, crypto and crypto wallets will be frictionless. Edelman Research published a study of 1,000 millennials with over $100,000 in income and found 25% own cryptocurrency. In addition, another one-third are interested in owning or using cryptocurrency.

According to Avivah Litan, a Gartner vice president, millennials don’t trust banks and the established financial system. “Millennials generally understand cybersecurity issues more than their elder counterparts and many of them trust blockchain data security more than the banks’ security,” Litan said.

Bitcoin was introduced during the last financial crisis of 2008. The next global financial crisis will be phase two for bitcoin’s proliferation. Many critics believe bitcoin will need to seek permission from central banks. Quite the opposite is true. The populations that are negatively impacted by the financial system are the ones driving this forward, and to attempt to contain every geographic unrest, every student in debt, or every libertarian across the globe through regulation will prove nearly impossible.

In the next article of this 3-part analysis, “Will Bitcoin Make a Good Investment,” I discuss how the free market is also contributing to the adoption of bitcoin with many corporations on board. The free market will add to the momentum of institutional trading and economic unrest.

Also Read: Will Bitcoin Make a Good Investment?

Centralized Crypto Investments vs. Decentralized

Many of those on the sidelines of bitcoin are predicting the decentralized coin will lose ground to centralized crypto, such as Facebook’s Libra and JP Morgan’s JPM Coin, which have the backing of centralized financial systems. However, centralized currencies negate some of the primary benefits of decentralized cryptocurrencies and anyone confusing the two will miss out on opportunities around crypto.

For one, centralized coins (Libra, JPM Coin) do not hedge against inflation and are not scarce assets. They function like cashless digital transactions made through online platforms. AliPay functions similarly (although not encrypted) and was launched in 2004 and now serves 5% of the world’s population.

Starbucks, Apple and Google also allow digital transactions without the need for cash or credit cards. Centralized crypto coins have little benefit over a mobile app payment, and may be more cumbersome as the fiat currencies the crypto is based on will have to be exchanged, whereas with Starbucks, Apple Pay and Google Pay, no conversion to a “crypto coin” has to occur.

To put it simply, there is very little benefit to transacting on a blockchain if the crypto is based off fiat currency. Seamless transactions through mobile apps may be more convenient for consumers.

The value that Libra or JP Morgan’s coin provides is lower transfer fees from companies such as Western Union or Paypal, which take a significant-enough percentage of around 5% of the amount being transferred. This is not a big enough demand to justify the launch of new coins, however, as Moneygram has announced a partnership with the cryptocurrency, Ripple, to lower the speed of transfers and fees. In other words, wire transfer companies can easily partner with cryptocurrencies rather than non-financial companies launching entirely new payment networks (like Libra).

Centralized crypto will also act to erode privacy for citizens as every transaction will be tracked and easily mined for transaction history.

The difference between centralized and decentralized cryptocurrency is not lost on bitcoin enthusiasts or the citizens of struggling economies. These parties are seeking a safe haven that is not tied to the central banks, and therefore, it’s doubtful a centralized cryptocurrency will have much of an impact on the long-term potential of bitcoin.

Exploiting the lack of knowledge around the word “cryptocurrency” will be rampant in the coming years as blockchain infiltrates the financial sector. Corporate public relations firms frequently use tactics such as over-generalizing technology terms or exaggerating deployments.  We’ve seen this occur around autonomous vehicles on timing for deployments (promised for many years now) as well as the various levels of autonomy (if a human is in the car; the term is driver-assisted – yet autonomous is used instead).

The parties who are launching centralized cryptocurrencies, such as Facebook and Chase Bank, are not in the business of making crypto investors’ money. Their goal is to lock people into their platform and to collect data on every purchase a consumer makes. This will not make for a good asset, although you are free to buy the company’s stock.

Institutions will not trade Libra or JPM Coin as this would be the equivalent of trading dollars (except with the extra work of converting it on an exchange). Countries with economic uncertainty will not see centralized coins as a safe haven, and thus a crypto boom in Japan, South Korea or Venuzuela will not contribute to the adoption of centralized coins.

Facebook’s Libra will help to normalize crypto, however, for the general population. As pointed out at a recent bitcoin conference, Libra can potentially be a positive thing for introducing crypto wallets to the 2+ billion users across Facebook apps. Normalizing the concept of carrying crypto and transacting in crypto, even if there is little success for the Libra currency, will help accomplish the third and final phase for bitcoin: digital transactions. Follow me for part 3 of this series where I discuss the third phase for mass adoption of bitcoin: digital transactions.

Also Read: Highlights from Bitcoin Conference 2019

Conclusion:

This analysis is not saying bitcoin won’t experience volatility with the introduction of institutional trading, as global economic uncertainty grows, or as the younger generations seek alternatives beyond the debts they are inheriting. Over the next few years, bitcoin will be very volatile as the new technology strives for hockey-stick growth.

With that said, Bitcoin’s support level will rise over time, and therefore a strategic entry is important to withstand volatility and hold the asset over the next 5-10 years. The next article in this series will look at the third phase for bitcoin, which will include the tipping point for digital payments, as well as how the free market is propelling bitcoin forward.

Will Bitcoin Make a Good Investment? Part 1: Institutional Adoption

Posted on by io-fund

The largest bitcoin conference in the world took place last month in San Francisco with many early pioneers discussing why bitcoin has made a good investment for them and why bitcoin investments will do well long-term. You can view highlights from the Bitcoin conference here.

Bitcoin buyers fall into two camps (primarily). Those who trade the cryptocurrency and those who “stack Satoshis,” a term for stockpiling on bitcoin as a means of building long-term wealth. Stacking Satoshis may be the most successful tactic due to a few key iterations that bitcoin will go through to ultimately strengthen its price and reputation as a solid investment choice. Many bitcoin experts expect bitcoin to be at the height of its development in 2025.

There are key reasons as to why bitcoin will make a solid long-term asset over the next five years and may reach its peak as a new technology with mass adoption in seven to ten years. This 3-part series explores why strategically entering the bitcoin market at a good entry price will make a solid investment for the future.

Bitcoin Investment Cycle: Institutions

This is part of a larger 3-part bitcoin series. Subscribe for the next two phases of this series.

Bitcoin’s investment cycle is important to understand as the cryptocurrency has the potential for mass adoption as blockchain is built out. Although many are concerned with being too early to bitcoin investments, it may be more important to not be too late in building a small position with an entry that can withstand volatility.

Technologies go through various phases of adoption as the customers become more open to using the technology and forming new habits. The volatility seen in bitcoin is not uncommon for a startup venture; what is uncommon is that bitcoin is an investment, and you can track the inflow and outflow of money, which causes more uncertainty than usual for the general population who does not see the typical challenges that emerging technologies go through prior to reaching mass adoption. In other words, bitcoin’s volatility as it attempts to find product-market fit is not uncommon and will reduce over time.

We currently see similar volatility in autonomous vehicles and 5G supply and demand. Volatility is inherent in nascent technologies. The smartphone crawled before it could walk, with QWERTY Blackberry and Nokia phones leading to the evolution of touch screens and app stores.

Virtually every technology product on the market today has examples of volatility and early apathy towards the believability of its potential for scale. Relative to the disruption bitcoin seeks to bring to ancient-old financial systems, the volatility has been in-line with high risk/ high reward endeavors.

Bitcoin Investments Hinge on Secure Custody

Most people can imagine a world that runs on digital financial transactions as money today is exchanged digitally and cashless. For instance, China’s Ant Financial currently serves 5% of the world with a cashless application called AliPay. The United States has digital financial apps, such as the Apple Wallet, and Venmo is a popular method to exchange money between friends without fees.

One of the biggest hurdles for institutions, however, is not the idea of a world run on digital currencies, but rather the decentralization concept and the need for cryptocurrency storage. Institutional investors need to know the assets are secure, insured, and under the care of a trusted third party, per SEC rules, which requires advisers to keep client funds with a qualified custodian. 

Custody solutions safeguard cryptocurrency, and go beyond private keys or wallets, which are subject to hacks or the misplacement of hard disk storage. The word “custody” refers to a third-party provider of storage and security services for cryptocurrencies. These services are aimed at institutions and hedge funds, and incorporate a combination of storage online for liquidity and storage that is disconnected from the internet. Vault storage is a popular method which keeps the majority of the crypto in offline storage with a minority in online storage. Upcoming modifications to the Glacier Protocol will strengthen high-security offline storage for bitcoin.

This year, many emerging custody solutions have been introduced to the market. In the first five months, six new custodians entered the market while a number of existing crypto custody providers have announced new features. There has been some M&A in the crypto custodian market, as well, and exchanges such as Coinbase, Gemini and itBit have launched custody solutions in an effort to push more institutional investors towards bitcoin and digital assets.  

Bitcoin Futures to Launch for Institutions in July

Jeff Sprecher, the Chairman of Intercontinental Exchange (ICE) and Founder of the New York Stock Exchange (NYSE) and many other exchanges internationally, aims to create a federally-regulated crypto ecosystem. The consortium includes Microsoft, Starbucks and the Boston Consulting Group, who are working together to help leverage ICE’s trading infrastructure and to cater to retail investors, institutional investors, and consumers. This could help baby boomers put their 401K into bitcoin, and pave the way for bitcoin-backed ETFs or mutual funds.

Bakkt plans to launch its physically-settled bitcoin futures products for testing in July, according to the company’s blog post. At the core of Bakkt is the custody of digital assets for institutional clients. The first solution will be physical-delivery bitcoin futures traded on a federally regulated exchange and clearing house.

The trades will happen on ICE Futures US (IFUS) and will be cleared on ICE Clear US (ICUS). Bakkt will provide regulated custody as the company has filed with the New York Department of Financial Services for approval to become a trust company and to serve as a Qualified Custodian for digital assets.

Bakkt bitcoin investment

The partnership with Starbucks is a core component for success as Starbucks’ mobile app has more users than Google Pay or Apple Pay.

Bakkt will use both warm (online) and cold (offline) wallet architecture to secure customer funds. The majority of assets are stored offline in air-gapped cold wallets and are insured with a $100,000,000 policy underwritten by global insurance carriers.

Security: Bakkt will use FIPS 140-2 level 3 or higher hardware security modules (HSM) to manage and secure its warm wallet cryptographic keys. The cryptographic systems will be secured in bank-grade vaults and datacenters that are protected with physical security.

Security is one area where the NYSE has already gained trust from institutions. Therefore, the barrier to entry is lower for Bakkt and institutions are likely to enter crypto futures with Bakkt being built on the same system as the NYSE.

Bitcoin Investments Will Get a Boost from Fidelity

Abigail Johnson, the CEO of Fidelity, has been a “believer” since 2017 when she introduced bitcoin and Ethereum mining in 2017 at a conference in New York.

“I’m a believer. I’m one of the few standing before you today from a large financial services company that has not given up on digital currencies.” – Abigail Johnson, 2017

In May, the company announced plans to launch a cryptocurrency trading service in the “next few weeks.” The Fidelity Digital Assets platform was created in October of 2018 with select hedge funds and family offices testing the platform for cryptocurrency custody and trade execution over the last few months.

Bitcoin-Investments-Fidelity

Fireblocks, a platform for securing digital assets in transit, announced a $16 million Series A funding round from investors including the proprietary investment arm of Fidelity, Eight Roads. The startup helps to safeguard the transmission of digital assets across exchanges by building a cloud-based security platform as the current process of moving digital assets is susceptible to cyber-attacks and human errors.

Fidelity interviewed 450 institutions and found that 22 percent already own cryptocurrency and those that own crypto plan to double their allocation over the next five years. The long-term interest from institutions stems from the asset being seen as an uncorrelated risk during an economic crisis (more on this in Part 2 of this series “global economic uncertainty” – follow me for updates).

Forty-seven percent of institutions believe digital assets are worth investing in, according to the survey released by Fidelity on May 2nd. Fidelity will only serve institutions for now while Robinhood and E*Trade serve retailers.

Dose of Reality with Bitcoin Investments

Bitcoin is on the inflection point of institutional adoption, but it’s important to remember it has been there for almost two years. Several attempts to launch a Bitcoin-based ETF in 2018 and 2019 have fallen through as the SEC either rejected or delayed the proposals due to market manipulation. 

Reports published on the SEC website claim that up to 95% of crypto volume on unregulated exchanges is fake, legitimizing the concerns from the SEC and regulators that bitcoin is subject to market manipulation. The presentation was prepared by Bitwise in March of 2019.

There was a follow up whitepaper in May of 2019 that concluded the fake volumes do not affect price discovery in the real bitcoin spot market. The new white paper reiterates that a great number of advances and tools, such as the launch of regulated bitcoin futures and algorithmic trading, “dramatically improve the efficiency” of BTC markets.

The ten exchanges which showed 100% real volume include: Binance, Bitfinex, bitFlyer, Bitstamp, Bittrex, Coinbase Pro, Gemini, itBit, Kraken and Poloniex. Meanwhile, 73 exchanges were condemned by the presentation as contributing to high percentages of fake volumes.

Conclusion:

What you know of bitcoin today as an investment choice will change rapidly over the next 5-10 years with a few key phases of adoption and iterations that will strengthen its price and prospect as a good investment. Today, bitcoin’s price is based on retail traders and crypto enthusiasts. To not believe bitcoin will saturate other markets would require acute, bearish incredulousness.  

Investors in bitcoin today need a few things to happen for the currency to achieve price stability and to reach its long-term potential as a good investment for buy and hold portfolios. If you want to swim with the stream, then look for a great entry price where you can hold the cryptocurrency long term until these phases are built out (again, this will take 5-7 years – maybe 10 years). I’ll be expanding on this point in the other parts of this series.  

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Recommended Reading:

Highlights from Bitcoin Conference 2019
Will Facebook Cryptocurrency Have A Long-Term Impact?
Uber Stock Had Disappointing Q1 Earnings: So Why Did the Price Go Up?

Image from Crypto Head

Highlights from Bitcoin Conference 2019

Posted on by io-fund

Last week, the world’s largest bitcoin conference took place in San Francisco. Despite bitcoin holding a $200 billion market cap in Q2 2019, cryptocurrency conferences receive less press than tech conferences from companies with comparable market caps, such as Oracle World, Dream Force or even Oktane, a conference by a company with a fraction of the market cap that receives ample press coverage. 

Despite naysayers, Bitcoin has proven to be a revolutionary, digital asset. Worst case scenario, if you had invested in bitcoin as a long-term investment at the height of each bubble and sold at the bottom of the crash (due to terrible luck and timing), you would have seen 82-fold returns from $39 to $3,200 over the last decade or 3-fold returns from $1,151 to $3,200. There are those who bought at $19,000 who are still licking their wounds, but these were not long-term investors.

Quite a few of the speakers at the conference have been holding bitcoin since its early days as a long-term investment. There are key reasons as to why bitcoin will make a solid long-term asset over the next five years and may reach its peak as a new technology with mass adoption in seven to ten years. Follow me for a three-part series entitled: “Is Bitcoin a Good Investment” with analysis on three important phases to the bitcoin tech cycle: institutional adoption, global economic uncertainty and digital payments.

Privacy and Bitcoin

One of the highlights at the Bitcoin Conference 2019 was a fireside chat with Edward Snowden (yes, that Edward Snowden), who dialed into the conference for a thirty-minute webcast on privacy. The crowd was ecstatic to say the least, as technologists and privacy advocates are usually one and the same. When you work in the industry, you see too much and know too much to be complacent over privacy, and bitcoin technologists are no exception.

Hackers endorsing bitcoin can be a double-edged sword, however, as institutions circle the cryptocurrency with no official adoption just yet (i.e. SEC regulated platform). The cryptocurrency is well adopted in the hacker community and will now require broader adoption to see its full potential.

Onion routing is one method of concealing location and online activity from network surveillance or traffic analysis. Tor Project is a group of developers who offers onion routing to reduce the likelihood of sites tracing actions and data back to a user. Going beyond a Virtual Private Network, onion routing conceals IP addresses although the use of Tor can be traced. 

Isabela Bagueros of Tor Project spoke at the Bitcoin Conference 2019 and her message was clear – that VPNs are centralized and not to be trusted for anonymity. The proliferation of bitcoin and concerns around financial privacy will likely draw more attention in the years to come as Bitcoin has an inherent, anonymity issue as every transaction is public data. Meanwhile, specific solutions that combine full anonymity over a computer network and the use of blockchain and/or bitcoin have not been developed at this time. Bitcoin is a step direction towards financial privacy, but as many of the panelists pointed out, there’s still more to be done.

Bitcoin Vs. Libra

Tim Draper is well-known in the startup scene and is a founding partner of Draper Fisher Jurvetson. He has been an early advocate of bitcoin and one of the more publicized spokespeople on the topic, especially around his first prediction that bitcoin would hit $10,000 (this came true), a second prediction that it will hit $100,000 and his current prediction that bitcoin will hit $250,000 by 2023.

When Draper was asked about the effects of Facebook’s Libra coin, he pointed out that two drawbacks is the coin relies on fiat currencies and is also controlled by Facebook, and therefore, goes against the ideals of decentralized cryptocurrencies.

During a panel that included Max Keiser of the Keiser Report, Bill Barhydt of Abra and Anthony Pompliano of Morgan Creek Digital, Libra was seen as potentially a positive thing for introducing crypto wallets to the 2+ billion users across Facebooks apps. At the very least, Libra will normalize the concept of carrying crypto and transacting in crypto even if there is little success with the Libra currency. 

Dovey Wan, the founding partner of Primitive, expressed on a separate panel that Libra is not much different than AliPay, a digital payments platform used in China that does not require cash or credit cards to transact.

Facebook is not the only company placing large bets on the future of crypto. During the same week as the conference, Hotels.com announced a partnership with Lolli to reward Hotel.com customers with micro units of Bitcoin. Moneygram also recently announced that Ripple will be its main partner for cross-border transactions that use digital assets.

In my upcoming three-part series entitled “Is Bitcoin a Good Investment,” I cover three important phases to the bitcoin tech cycle: adoption by institutions, global economic uncertainty and digital payments.

Recommended Reading:

Will Bitcoin Make a Good Investment? Part 1: Institutional Adoption
Will Facebook’s Cryptocurrency Have a Long-Term Impact?
Uber IPO

Fundamental Stock Analysis Webinar: May 22nd at 4:30 pm EST

Posted on by io-fund

On May 22nd at 4:30 pm Eastern, join four fundamental stock analysts on a webinar where they will discuss stock picks, trends and strategies to help strengthen your personal portfolio. Beth Kindig will discuss how to pick a solid tech growth stock and how to hedge in down market. Specifically, Beth Kindig will discuss the differences between how the financial industry defines growth and how the tech industry defines growth, and why a blend of both is essential for picking stocks in the number one growth sector. Beth predicted the biggest stock drop in history in Q2 2018 with Facebook’s miss and the biggest IPO loss in history with Uber in Q2 2019. She covered Roku from its IPO for a 300% gain and is known for having a crystal ball to predict tech stocks on Twitter. Her experience comes from a decade of analyzing tech companies, tech products and startups resulting in over 700 articles and many enterprise-level analyst reports. She speaks frequently at tech conferences covering macro trends and has a tech podcast in the Top 40 for technology on iTunes and Spotify. 

She joins three other analysts including Bhavneesh Sharma, who will highlight a stock with a unique gene editing approach to fighting cancer; Lyn Alden Schwartzer, who will showcase 2 high-quality value stocks to buy and hold over the next decade; and Kirk Spano, who will focus on solar and other sustainable stocks to watch as the world transitions to alternative energy.

Here are the details for the webinar:

Wed, May 22, 2019 1:30 PM – 2:30 PM PDT

To Register: Click here

Zoom May Be the Best Silicon Valley IPO of the Year

Posted on by io-fund

This post originally appeared on FATrader.com on April 16th, 2019. Beth later appeared on Yahoo Finance discussing this analysis. This post originally appeared on FATrader.com on April 16th, 2019. Beth later appeared on Yahoo Finance discussing this analysis. appeared on Yahoo Finance discussing this analysis. 

This may be hard to believe, but on Thursday, Silicon Valley will have a company go public that is already profitable. If you’ve used Cisco’s Webex for meetings, then you’ll understand Zoom. The company provides web conferencing that is simple for users to join and has a lot of features to assist in virtual meetings.

Zoom has a “bottoms-up” viral customer base, which means junior employees evangelize the service at the company. These are often some of the most loyal customers. For instance, 55% of $100,000 or higher revenue customers were started with a single employee’s free trial.

Financials

Zoom’s financials outperform successful software-as-a-service companies on the public markets today, such as Workday and Okta. Here’s a snapshot of the S-1 Filing showing $60M in revenue in 2017, $151M in revenue in 2018 and $330M in revenue in 2019. The company has been posting 100%+ revenue growth for three years with gross profit margins in the high 70% to low 80% range compared to more mature SaaS companies currently on the public market posting increasing net losses (Okta and Workday).

In the year ending January 31st, 2019, Zoom became profitable with $7.58 million in net income or 3 cents EPS. The year prior, Zoom posted a net loss of $4.8 million. Compare this to Okta’s net loss of $125M on similar revenue this past year or Workday’s net losses of $418M on approx. $2.8B revenue.

Zoom’s IPO price continues to change daily. The shares are now being priced 8 percent higher than previously estimated last week with a valuation around $9 billion. This is up 9x from the company’s most recent private funding round, which was priced at a $1 billion valuation. SalesForce Ventures has agreed to buy $100 million Class A stock at the IPO.

Zoom has disrupted Cisco’s WebEx, which is clunky and more intensive software for video conferencing. Some Wall Street analysts have speculated Cisco and Microsoft are a threat to Zoom, although the opposite is true.

Zoom’s CEO Eric Yuan, owns 19 percent of the stake in the company, and was a former engineer at WebEx before it was acquired by Cisco. On a similar note, I would not be surprised if SalesForce acquired Zoom given its large stake and the loyal customers Zoom could bring to a predominant SaaS platform. Yuan has adamantly stated he would not sell a company after his experience with the WebEx acquisition, although this may be too idealistic for a standalone conferencing product. Long story short, it is likely Zoom will agree to an acquisition in the future.

SaaS Metrics

There is a breakdown of Zoom by venture capitalist Alex Clayton of Spark Capital. It bears mentioning that many of the software-as-a-service VCs support one another in public offerings and Clayton is a little too enthusiastic about Zoom. However, Clayton does a good job of visualizing the data. I’ll summarize some of what he says here and point out a few things you should consider when looking at the data that comes from the VC side.Spark Capital. It bears mentioning that many of the software-as-a-service VCs support one another in public offerings and Clayton is a little too enthusiastic about Zoom. However, Clayton does a good job of visualizing the data. I’ll summarize some of what he says here and point out a few things you should consider when looking at the data that comes from the VC side.

Software-as-a-service (SaaS) has unique key metrics that venture capitalists look for when privately funding a SaaS startup. Subscription revenue run-rate is one metric used, although it can be overly simplistic.

Annual Revenue Run Rate = Monthly Revenue * 12 months

ARR does not account for churn or growth. Zoom’s ARR likely looks better than the more mature companies on the public markets (which are contrasted below) because Zoom is a smaller company and has gone through periods of hyper growth. For this chart to be completely accurate, you would have to compare growth from the same year of a company’s inception as Zoom is going public early compared to the other companies in this chart, and therefore, demonstrates hyper growth compared to a more mature company that files to go public.

Private investors typically calculate the monthly recurring revenue, which calculates the amount of revenue you have in the beginning of the month plus the revenue you gain during the month minus downgrades or customer churn.

Zoom has an advantage over many other public SaaS companies by posting positive net income. Many of the SaaS companies on the market today trading at 30x price to sales are not profitable. Okta, especially, may appear overvalued after Zoom’s IPO as the company posts similar annual income but with staggering net losses. Zoom is not in the same category as Okta, as Zoom is web conferencing and Okta is identity management. However, they share the same SaaS subscription-based business model and more financial clarity for investors in this business model will likely shift perception of how a SaaS company should perform on the public markets. Basically, Zoom’s financials are a safer bet.

Takeaway

Zoom is likely to be a popular IPO due to being a profitable SaaS company. With many companies like Okta, WorkDay, and Twilio trading at 15-30 Price to Sales ratios, and many not profitable, you can image the excitement that will follow Zoom. I am going to allocate a small percentage to Zoom’s IPO, provided it remains at a $9 billion valuation. I am considering a short on Okta as of Zooms’ S-1 Filing as the stock has climbed 80% from December lows.

As many FATrader analysts have pointed out, IPOs are risky.

I am a tech analyst, not a financial advisor.

Alphabet Stock: Keep a Close Eye on Third-Party Ads

Posted on by io-fund

Data privacy will be affecting stocks into the near future and will likely catch Wall Street off guard as the minutiae is hard to sift through. Alphabet’s data machine has the longest tentacles of any company on the public market today, yet Facebook continues to carry the headlines. There are specific reasons that Alphabet has done a much better job at handling data, which in turn, creates a safer stock for investors. Even if some of the Google’s data collection policies are at odds with privacy advocates, Alphabet is being more transparent through SEC filings and offers a disclosure around revenue sources.

Last week, there was an important insider leak reported in Adweek that Google is “contemplating a number of changes to its consumer -and advertiser-facing tools.” Criteo’s stock dropped 30% when the news broke and TradeDesk saw a 15% drop while Alphabet’s stock showed the least impact at 5%. I believe this market reaction, which penalized Alphabet the least, is due to a misunderstanding around the implications of third-party revenue for Alphabet.

This analysis will break down why the intel leaked to the ad industry late last month is important for stock investors to pay attention to.

Overview:

The official list of companies who are in a grey area with how they collect and use data is Google, Facebook, Amazon, Twitter and Snap. You can add Spotify to that list too, although their data is minor compared to the bigger players. The reason these companies are at risk is because there is a conflict of interest in collecting first-party data with people you have a direct business relationship with and brokering this to third-party companies.

Let’s reframe this so it’s easier to picture. For instance, what if your credit card company brokered your data to run ads? They have more information on you than Facebook or Google because Mastercard and Visa knows your every purchase. They would make A LOT of money if they anonymized your data, assigned you an ID number, and let advertisers target you based on what you bought with your credit card. In fact, purchase history is the most valuable data to an advertiser and they would pay much higher amounts for this than social media data or search data. Mastercard and Visa don’t do this because it’s against regulations. This is what the online and mobile industries face who are brokering first-party data to third-party companies to target people and run ads.

Going back to Google. Of the companies listed above, Google is being the most proactive and has the least amount to lose (Amazon is a close second with the least amount to lose). This is because Google makes money from search engine inquiries, with advertisements based on your search criteria, and not targeted to who you are as a person. However, there’s a chance that Google could lose up to $5 billion per quarter if the insider information to AdWeek is accurate. One reason is because if Google prevents ad networks from running ads in the Chrome browser, they will risk anti-trust if they continue to do so themselves. There is also a conflict of interest for first-party data companies to run third-party ads through a demand-side ad platform, where advertisers go online to place ads using proprietary data.

Especially if Google wants to be a leader in artificial intelligence, which will require a privacy adherent company policy, it is my prediction that Google will part with the third-party ad revenue to win big on AI in the coming years.

Intel from the Ad Industry:

Here’s an excerpt from the Adweek article Google Mulls Third-Party Ad-Targeting RestrictionsGoogle Mulls Third-Party Ad-Targeting Restrictions: “According to sources, certain Google teams want to placate the growing zeitgeist around the protection of consumers’ data privacy, which has grown ever louder since the Cambridge Analytica scandal last year. These internal discussions also follow the implementation of third-party tracking restrictions on Apple’s web browser, Safari, and similar moves from Mozilla’s Firefox and Brave’s offering in recent months. Although the various businesses within Google advocate similar measures, the breadth of the company’s interests (i.e., the dominance of its Chrome browser and ad-tech stack) make its decision-making process more complex.”

What you need to know:

There are two issues here. As the article points out, Google will likely cut off third-party ad companies from brokering through the browser on Chrome similar to Safari and Firefox. The issue is that if Google continues to broker ads with first-party data while cutting off competition, there will be antitrust repercussions. Plus, this doesn’t address the grey area as to why Google is using first-party data to broker ads in the first place, as this is against regulations in the EU already and highly contested in the US (with Facebook taking a lot of the blame). This brokering of first-party data is what “ad-tech stack” refers to.

The leak was enough for Criteo to be downgraded from $32 to $24 by financial analysts and TradeDesk dropped from $213 to $185 the day the news broke. Alphabet stock remained relatively stable although I believe this was the market not fully understanding Alphabet’s tech stack.

Disclosure of Third-Party Revenue

In the introduction, I stated that “there are specific reasons that Alphabet has done a much better job at handling data, which in turn, creates a safer stock for investors.” The primary reason Alphabet makes a safer investment is that you can evaluate the stock for risk because the company discloses third-party revenue it makes from this grey area in their SEC filings. Facebook, and the others, do not disclose this as a separate line item, which makes it impossible to quantify the risks.

The line item that the leak refers to is “Google Network Members’ properties revenues,” which is $5.6 billion in revenue, or about 15% of quarterly revenue. The actual net income is much lower as Google pays out 70% to publishers, which is the Total Acquisition Cost, or “TAC to Google Network Members.” This leave the income for third-party sites at $1.7 billion per quarter.

Conclusions

On the Q1 2018 earnings call, analysts asked Sundar Pichai if the GDPR would affect the company. He stressed the importance of search engine revenue which is GDPR compliant, as it does not target people, rather it uses search inquiries. Although Waymo operates cars in the streets, and there have been many other speculative releases such as Google Glass, it’s important to remember that Alphabet’s revenue is 86% advertising.

Google Network Members’ revenue is at risk right now due to privacy regulations in the EU and ongoing scrutiny by regulators in the United States. It is my prediction changes will occur to Google’s third-party member sites revenue, and that the market misunderstood the impact it could have on Alphabet. Although there is no way to time exactly when this will occur, Adweek’s sources said they believe it will roll out by 4th quarter of this year.

Lyft: Risky Valuation and No Intellectual Property

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Who doesn’t love the ease of using a mobile application to order a ride rather than stand awkwardly on a street corner hailing a taxi? Once I downloaded Lyft and Uber, I said goodbye to the rejection of occupied taxis forever. Lyft and Uber represent free market evolution by offering a better service than the outdated competition. The apps shave off valuable time with door-side pickup, and the overall cost is cheaper than taxis too. In San Francisco, these apps have become ubiquitous, but these biases have to take a backseat to investment discipline.

There is a tinge of glam to the upcoming Lyft IPO road show, and the anticipated IPO from Uber in 2019. Silicon Valley produces a lot of winners; however, I believe investors should be careful with both of these IPOs due to exuberant valuations, accelerating net losses, and a lack of geographic expansion opportunities. Yet, another concern is the liquidity event the large cap IPO provides, and the level of PR that can be bought leading up to the IPO, which will likely focus on the growing sales. There is evidence the growing revenue has been subsidized, therefore, revenue is not a safe bet when evaluating these particular stocks, and the prospectus fails to outline a clear path to profitability.

1. Risky Valuation with Accelerating Net Losses

Lyft went from a $7 billion valuation in 2017 to a $15 billion valuation in 2018 and is now seeking a $20-$25 billion valuation on the public markets. The problem with this rising valuation is that losses are progressive with $2.6 billion in revenue in 2018 but a $911.3 million loss. Due to these losses, Lyft may need to borrow or raise more equity after its first year on the public market, which means debt or dilutive stock offerings.

Lyft’s sales, on the other hand, appear positive on the surface with incredible growth year-over-year from $343M in 2016 to $1.05 billion in 2017 and 100%+ growth in 2018 at $2.15 billion. The problem is that the losses are also accelerating.

Lyft’s filing also points to an important issue with growth marketing tactics for user acquisition (UA) and user retention. I’ll copy the paragraph here verbatim from the S-1 Filing and translate my understanding of how ridesharing apps subsidize UA.

“Ability to Cost-Effectively Attract and Retain Riders and Increase Our Share of Their Transportation Spend “Ability to Cost-Effectively Attract and Retain Riders and Increase Our Share of Their Transportation Spend 

We grow our business by attracting new riders to our platform and increasing their usage of our platform over time. To effectively attract riders, we focus on driving organic adoption in our rider base, and do so with investments in brand and growth marketing to increase consumer awareness. We also offer incentives for first time riders to try Lyft, as well as incentives for existing drivers and riders to refer new riders. Once riders start using Lyft, we provide a quality experience and a diverse offering of products to accommodate different transportation use cases, retain riders and encourage repeat usage. We often also provide incentives to existing riders to encourage them to expand their use of our platform. If we fail to continue to attract riders to our platform and grow our rider base, expand riders’ usage of our platform over time or increase our share of riders’ transportation spend, our results of operations would be harmed.”

The translation here is that Lyft and Uber pay incentives to acquire and retain users. In gaming, a company might spend $8 to acquire a user with a lifetime value of $15 per user for a profit of $7. The problem with ride-sharing apps is that the incentives offered do not cover the costs of the ride, and that is one reason we see strong sales growth mired by accelerating losses.

Reuters has some historic information on this dated back to 2015, when Uber passengers paid only 41 percent of the actual cost of their trips. At the time, Reuters reported that this creates an “artificial signal about the size of the market” with Uber releasing limited financial data that showed losses of $708 million per quarter.

Going back to Lyft, the takeaway is that these incentives are creating an artificial signal about revenue, which is ultimately overshadowed by net losses. The problem with subsidizing rides is that public market investors aren’t able to determine what will be required for profitability, how much the cost of the ride will have to increase, and if that will impede the demand to ride share.

2. “Human Resources” Business Model is Not Profitable

Lyft and Uber have scaled their companies but it comes with the variable cost of human labor. Ideally, you want fixed costs for R&D on platforms, software, hardware and other products to create the margins that technology is known for. Lyft and Uber are mobile applications, but the business model is more of a large-cap human resources department with many variables around wages, and potentially regulations due to independent contractor classifications. (There was a recent $20 million settlement due to the misclassification of drivers in California).

As you’ll see below, the mobile app holds very little intellectual property, with the primary value of the product resting in the mobilization of a massive work force of nearly 2 million people, per Lyft’s S-1 Filing. To some regard, Lyft and Uber are not technology companies, rather they are very large human resource departments run through an application.  Whenever you are involved with labor at this level, regulations and wages eat at profits.

3. Autonomous Vehicles 5-10 Years Out

This leads us to the only hope for ride-sharing to become profitable, which would be to remove the human driver through autonomous vehicles. Here’s some information from my autonomous vehicle analysis published in October on AV delays as it pertains to the timeline of when Lyft or Uber could potentially deploy driverless and how investors should exercise caution here:

“The regulation hurdles between Level 2 and Level 3 and delayed deployments will put immense pressure on stocks that are overvalued based on AV speculation. ABI Research, an advisory firm that reports on market-foresight trends, predicts 8 million consumer vehicles with Level 3 to Level 5 autonomy will ship in 2025. Compare this to the 94.5 million vehicles sold in 2017 which equates to 8.5% of sales. This is a small and fairly insignificant percentage of market share to be chasing 7-years ahead of deployment. Yet, investors are pouring cash into hyped up stocks- and the press plays a large role in this. Headlines are a continual churn of autonomous vehicle “moments” – every partnership, every mile driven, every make and model that adds another feature. To be clear, we’ve only gone from a Level 1 to Level 2. We are not able to release Level 3 AV right now – and yes, that includes Tesla.

Note: I was the first to write about the issues around autonomous vehicle deployment and how this will affect stocks (this prediction was before GM announced layoffs and before Tesla reported AV deployment issues, as well).

4. Total Addressable Market & Lack of Intellectual Property

I saved some of the best for last, as a paramount risk to both Uber and Lyft is total addressable market. Room for geographic expansion is limited beyond the United States, other than a few outlier countries like Saudi Arabia. Of course, the underlying issue with TAM is a lack of intellectual property with an easy-to-duplicate mobile application that leverages common app features such as GPS location and SMS/voice. Although it is common to discuss the ridesharing ecosystem as “Lyft Vs. Uber,” the fact is the global competitors in their respective geographies are a serious deterrent to future growth.

Here is a summary of the global ride-sharing market:

Asia: China’s Didi surpassed Uber as the world’s most valuable startup. Both Uber and Didi have something in common too; their investor is SoftBank. Grab is Singapore’s ridesharing service and bought Uber out of the market in Southeast Asia. (Uber was losing money here). India has a domestic ridesharing company named Ola, who can operate for as cheap as 8 cents per kilometer.

Europe: Taxify and MyTaxiApp: I went to MWC in Barcelona about two weeks ago and hailed about thirty rides in one week through a ride-sharing app called MyTaxi. One interesting feature behind the MyTaxiApp is that it leverages unionized cab drivers through the app rather than mobilizing independent contractors. The fares are cheaper than Uber, too, which is why Uber wasn’t able to capture Europe.

Middle East:  The Dubai-based ride-hailing app Careem serves the Middle East and Africa with 33 million users.

Latin America: Uber is doing well in Latin America with 25 million monthly active users, a presence in 200 million metro areas and is in 15 countries. Lyft is unlikely to compete with Uber here. China’s Didi is moving forward on competing in Latin America.

Japan: Japan could be a potential market although the overall sentiment is that Japan has major regulatory hurdles and the high-quality taxi system does not need much improvement.

Takeaway: Due to the reasons I’ve outlined, my concern is that the valuations and late-stage IPO is better for private market liquidity and not a sustained growth story for the public markets. The accelerating losses tell a different story than the 100%+ revenue, and if investors are subsidizing rides, then buying PR focused on sales is cheap. There is also no clear path to geographic expansion for near-term growth. Will Uber and Lyft be around in 5 years? Sure. Yelp, Snap and Zynga are still around …

“Algorithms are not biased; data is biased” – MWC 2019

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Last week at MWC in Barcelona, the session panels focused on the hottest topics in mobile, such as 5G, artificial intelligence and blockchain. The more controversial panels discussed the bias found in data, and how that data goes onto inform algorithms, which results in unethical conclusions. Speakers and panelists pointed out the racial bias in prison sentencing, gender bias in mortgage loans, financial institutions, age-related bias that occurs during job recruitment, and pre-existing conditions in health care coverage.

Danny Guillory, the head of global diversity and inclusion at AutoDesk told Fortune Magazine that by running a search for a professional social network for social engineers, the results were primarily Caucasian men. Guillory pointed out that when you engage or ask for more results, the AI delivers candidates with similar attributes – more Caucasian men. Another example of AI bias is the notorious Microsoft’s Tay AI, when released on Twitter back in March of 2016, the AI quickly became misogynist and racist on social media within a staggering 24 hours.

AI may seem like an auxiliary technology to how we live our daily lives today, however, it will soon be the primary driver across the tech industry. PricewaterhouseCoopers estimates the world economy will reach an additional 15.7 trillion in value by 2030 due to artificial intelligence. To put this into perspective, the top 5 technology companies today have a combined value of about $4 trillion, which includes Apple, Amazon, Microsoft, Google and Facebook. The annual global technology spend is similar – about $3 trillion. Over the next decade, AI will drive a market 5x the size of tech’s current global spend.

Although this growth is exciting on many levels, the panelists at MWC 2019 voiced concerns about the handling of inherent biases that comes from data, as clearly discrimination by age, race, gender, education or other factors within audience segmentation is counterproductive to the advancement of society that AI promises.

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AI algorithms are responsible for making consequential decisions and are trained to find lookalikes or other markers to learn patterns. Some argue that the bias occurs when the computer system reflects the humans who designed it. Proven downsides to artificial intelligence have surfaced in recent years, for instance with fake news allegedly influenced the 2016 Presidential election. These accusations are proof that we have run out of time in addressing these concerns, especially as we near the precipice of a much larger, multi-trillion-dollar AI market.

Provided there is more diversity within the field of artificial intelligence, many of the panelists asked who should regulate the infractions of algorithmic bias – governments or markets? Many felt there should be an international community to establish guidelines for AI. But even then, will the lower classes be invited or what level of inclusivity will an international community realistically provide for, as the world’s most vulnerable and marginalized people are unlikely to be represented. In this way, AI could further the gap between lower class and upper class along socioeconomic lines, if it hasn’t done so already as AI is currently in use by the largest financial funds in capital markets.

The unanimous solution among the panelists and speakers was to broaden the conversation and not limit artificial intelligence jobs only to technical experts. “Requiring someone to know Python in order to work with AI is not democratizing AI,” one panelist pointed out. Along these lines, a more human centric approach is necessary.

MWC 2019: A Dose of Reality on 5G, Those Foldable Phones and Bitcoin Has a Serious Competitor

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The GSMA Mobile World Congress (MWC) is the world’s largest exhibition for the mobile industry and combines influential companies from Asia, Europe and North America in the central location of Barcelona. The grandiose 20,000 square foot booths come with the largest names in mobile, like Samsung, Ericsson, Huawei, Google, Docomo, Telefonica, Orange, Verizon, AT&T, Qualcomm, Xiaomi, and other big names with big marketing budgets.

MCW 2019 Event

5G Loud and Clear

5G, 5G, and more 5G is basically the best way to sum up the news from the event. Every operator, network and manufacturer had some angle on the 5G rollout. However, hold your investment pennies for now on 5G stocks. The capex bill that comes with it may be one of the biggest the tech industry has ever faced. The GSMA trade group, a trade body that counts over 800 telecom and mobile corporate companies as members, stated that carriers will be spending $160 billion on an annual basis to roll out 5G networks. In addition to network costs, trillions will be required to install the infrastructure needed for the content, applications and emerging tech that will rely on the 5G networks (i.e. smart cities, autonomous vehicles, virtual reality, etc). Think 5G makes for a good long trade? Again, don’t count on it for now as the GSMA also stated only 15 percent of all mobile connections will be on 5G by 2025. (As I mentioned, the GSMA is a fairly reliable source as it counts 800 of the world’s top mobile companies as members).

Qualcomm 5G

According to VentureBeat, the financing firm Greensill puts the total cost for 5G at $2.7 trillion through the end of 2020. The issue is that it’ll take a few years to see any returns, which will put networks in the red until applications catch up. This, of course, is the fine print to 5G that the lights, camera and action of the booths at MWC didn’t portray (view my Instagram posts here). In fact, there was a panel where Mike Fries, the CEO of Liberty Global, pointed out that carriers in Europe have not recouped costs on 4G yet. “You’ve had 10 straight years of declining mobile revenues in Europe with the biggest issue being price,’ he said.

Will Foldable Phones Drive Sales?

Foldable phones were the most talked about product at the event. Huawei’s Mate X and Samsung’s Galaxy Fold were both on display behind glass cases. The use-cases for the foldable phone include more productivity while on-the-go and new applications for cameras, such as seeing the photo before you take it due to the second screen. The price tag is high – over $2,000 is the anticipated number when the phone is released later this year. Following MWC, on February 28th, Apple Insider reported that Apple has filed a patent application for “Electronic Devices with Flexible Displays” with sensor and micro-heater technology to keep a foldable screens from becoming too brittle in cold temperatures. No doubt, mobile handsets have stagnated recently with iPhone revenue dropping in Apple’s earnings reports. Will foldable phones deliver enough ingenuity to revive sales? Time will tell, but it does seem like early adopters are taking a risk on the durability of the manufacturing as Samsung’s foldable phone is already reporting issues after being folded 10,000 times. According to Wired and ArsTechnica, the foldable phones from Samsung and Huawei are made of plastic polymers, which can scratch easily and cause the previously mentioned wear from folding the device. In the meantime, glass-maker Corning is “working on an ultrathin, bendable glass that’s 0.1 millimeters thick and can bend to a 5-millimeter radius” that may hit the market in about two years. (Wired’s article is less than obscure and is entitled “Want a Foldable Phone? Hold Out for Real Glass).

SoftBank Becomes Bitcoin Competitor

Blockchain was a more muted theme at MWC, one that was mainly talked about in sessions for Silver, Gold and Platinum pass holders. In one session, SoftBank had an interesting angle on how to transfer payments electronically in order to avoid the drawbacks of bitcoin. Their proposal is cross-carrier identification systems (CCIS) and payment systems (CCPS) technology that runs through telecom carriers. CCIS focuses on enabling identification and authentication, which reduces the need to have different usernames and passwords by using Zero Knowledge Proof cryptography and Distributed Ledger Technology (DLT) to issue, store and authorize for identification purposes without requiring detailed information. The goal is to prevent identify thefts while minimizing the current requirements needed to verify passwords by creating encrypted digital identities.

Presentation on MWC 2019

The second part to SoftBank’s partnership with TBCASoft is a blockchain-based platform for global or cross-border payments. For instance, a user can make purchases in Japan with U.S. dollars through mobile-based Rich Communications Services (RCS). The official press release was in September of 2018. Here is some more information on how it works:

“The PoC enables users to make a variety of in-store, mobile and digital purchases directly from their device. For example, a mobile customer based in Japan can travel to the U.S. and make a purchase supported by SoftBank and Synchronoss via RCS. In addition, the RCS global messaging standard can be used to send a payment, while the CCPS blockchain API enables the recipient to use an RCS-based messaging app or legacy messaging service to receive person-to-person (P2P) money transfers through the RCS wallet app.”

Facebook Stock: Too Good to Be True

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Facebook has financial statements that Wall Street dreams are made of. Profit margins are at 40 percent, free cash flow outperforms due to low capex, and annual growth exceeds 20 percent year-over-year. In fact, FB posted 35 percent growth this past year with lots of runway to go. Meanwhile many of its FAANG peers struggle with high capex (Netflix) and diminishing growth (Apple).

To put it simply, Facebook’s cash flow and profit margins are not only some of the best in the S&P 500, but the best in the world. The ad dollar machine has incredible inertia and advertisers simply can’t turn away.  If you are looking at the income statements, then you have every reason to go all-in on this company.

The more insidious issue at hand is that Facebook is posting meteoric growth of 35% year-over-year in the middle of a tech slump, yet the stock price does not reflect the growth. The current earnings should have caused a rally, instead Facebook is at a PE ratio of 19 while posting better growth than Netflix with a PE ratio of 150, Google at 24 and Microsoft at 23.

In fact, Facebook is growing faster than 95% of the S&P 500 with margins higher than 90% of the S&P, but Facebook stock is hovering at post-Cambridge Analytics levels. If financials and free cash flow “never lie,” then this stock should be at $240 right now (well past the stock price it was when posting $40 billion annual revenue)

In April, I published “Facebook’s Challenges are Much Bigger than Cambridge Analytica.” You’d have to go back in a time machine to remember all of the stock investors insisting Cambridge Analytica was “priced into the stock” and Facebook would be the bull story everyone was betting on. Before the Q2 Facebook stock plunge, I insisted that the GDPR was a much bigger deal than investors realized and I broke down the various ways Facebook illegally (in the EU) takes data from users and non-users outside of Facebook. (Jeffrey Gundlach, the Bond God, may have stated the stock would be hurt by regulations, but he most certainly couldn’t explain why revenue would be affected or why investors should care. Likewise, Citron said Facebook was a long-term short, but has now reversed their recommendation to a buy with a fairly sensational report about Facebook being evil, which drove the price down making it a great opportunity – again, not explaining much in the way of the business model).

The goal of this article is to break down the risk of Facebook stock for any investor who wants to know. I realize a large majority of Facebook investors may not want to know, because, well, numbers don’t lie.

First-party data vs. Third-party data

Data extraction that is done inside the apps of FB, Instagram and Whatsapp is fair use and legal. You’ve given consent to use these apps, and how they use your data, within reason, is within the realm of a first-party relationship. This is very similar to how you engage with every company who you provide information to.

For the rest of this article, we are placing those applications aside. They are not at risk. What is at risk is that Facebook collects data from millions of applications and websites it does not own. This is called third-party data because you are not a party to the customer relationship in order to collect the data. As of May 25th, the European Union made this illegal in those geos.

Take a look at your smartphone right now. Facebook is collecting data from your applications through software called Audience Network. If you have 25 apps on your phone, Facebook’s software is tracking you inside 12 of those applications, for example. (Again, we are not talking about Facebook-owned apps – these are not apps owned by Facebook).

The GDPR is concerned with tracking that occurs outside of a first-party relationship, and Facebook’s revenue will be affected when third-party data collection is cut off.

Don’t believe me? You don’t have to. Facebook has stated they expect single digit losses and they list the GDPR and data regulation as a risk in their SEC filings. The window of opportunity here, if you like to bet against Facebook (like I did and will again), is that Facebook investors are walking towards a mirage of uninterrupted returns. They, again, think Facebook’s problems are in the rear view, and that these privacy issues are within Facebook’s domain, such as FB, Instagram and Whatsapp. Perhaps more concerning, is that investors don’t have a means of determining how third-party sites (that Facebook does not own) contributes to the $55 billion in revenue.

Germany is Hot on the Trail

Despite all of the investigations on privacy this past year, regulators and the press struggle to organize the issues into one clear thesis. Are we worried that Facebook is leaking data to profiling agencies like Cambridge Analytica? Is Facebook politically motivated and censoring posts or is this a free platform for people to express their ideas? Or what about the pixel we keep hearing about? Or that Facebook should censor what teenagers post? What was that thing about George Soros and Sheryl Sandberg? It’s a complete mess.

The FTC is unlikely to understand how a software development kit (SDK) works and what kind of device signals SDKs can extract, and why that threatens privacy[1]. The FTC is still reacting to fairly insignificant data leaks and the accusations of political brainwashing (this is what the FTC is likely to fine Facebook for). It clouds the actual practices that lie beneath, and it’s unintelligible as to why Facebook investors should care about any of this.

Not to fault the FTC. Since I wrote my article in April, hundreds of journalists have covered Facebook’s privacy issues, and not one reporter has clearly described how Facebook’s software extracts data across billions of users the company doesn’t have a relationship with, and why this is illegal in the EU as of May 25th, 2018.

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Germany, however, is hot on Facebook’s trail. Last month, I read an article that spelled out exactly how and why Facebook’s business models are at risk. If you’re an investor in Facebook, you’ll want to read it and follow what Germany is doing. As the article pointed out, Facebook is collecting data off-site from millions of applications and websites it doesn’t own, and Germany most certainly doesn’t want its citizens tracked by a company in the United States with this software.

Therefore, the approaching FTC fine for political issues or fake news is a red herring. The important regulations to watch are from the European Union as their concerns will have the greatest impact on Facebook’s revenue, which I believe is unsustainable in the current regulatory environment.

What is Audience Network and the Pixel Worth?

Hopefully, Facebook bulls have stopped reading the article by this point as they definitely will not want to hear the specifics on how much revenue is generated from the third-party data that Facebook doesn’t have consent to collect. (If bulls are still reading this article, I am sure to hear about it in the comments).

A few stats:

  • Facebook’s “third-party website and application” revenue is not in their SEC filing. Google clearly discloses this and the company makes $17 billion per year off third-party sites. (I think the fact FB didn’t break out this line item is a bit misleading, but that’s up to the SEC and anyone who experienced losses from Facebook stock to determine).
  • The official statistic I have in my research is that Facebook’s software is in approximately 40% of the mobile applications on the market. That exceeds Google’s third-party reach on mobile and would be about 2 million iOS and Android apps. If you look collectively at these 2 million applications, all of the 3-4 billion smartphones in the world today will have at least 1 of these 2 million applications installed.
  • Facebook Audience Network directly monetizes over 2 billion users (off-Facebook and off-Instagram) yet collects data on approximately 3-4 billion users. The value of this exceeds the value of Instagram (which has 1 billion users).
  • The data from the software informs the entire ad machine for higher average revenue per user. (Lookalike modeling is somewhat complicated but that’s the easiest way I can describe it within this article). I wrote about lookalike modeling a few years back. You can read about it here.
  • In 2016, Facebook executives warned of ad load issues. This means that the Facebook properties of FB and IG can only handle so many ads as there is finite inventory. The majority of the revenue made past this date would have relied on the Audience Network 2 million app-reach.

I put the value of Audience Network and third-party data at $20 billion in annual revenue. This is conservative considering Google makes $17 billion and when comparing apples to apples, mobile is worth much more than desktop (mobile can extract location, text/SMS and app activity across the device). You could probably add about $5 billion in brand reputation issues, as well, if/when third-party revenue is cut off. In addition, Facebook has added about $35 billion in revenue since the warning of ad load issues [2] in 2016, and at the time, Audience Network was stating massive user growth of over 1 billion users. Assuming half of this came from the new software with a reach 3-4 billion people is, again, conservative.

Is Facebook still a great stock at $30 billion annual revenue? Yes, in fact, I think it’s priced pretty close for a company with those financials. The adjusted expectations of the market could cause a shock for a year or two, but in the long-run, a $30 billion in annual revenue with low capex is still a solid business.

Takeaway: If you’re one of my readers who is invested in Facebook, keep a close eye on the EU and don’t get a false sense of confidence if the FTC clouds the press with fines for fake news or political ads while Germany and the EU pursues the software that collects third-party data.

The timing of this is probably 2020-2021, maybe even 2022 for all of the third-party data collection to be regulated. My prediction is that 2019 will be the year the European Union cuts off the third-party software and the United States may catch up during the election year or shortly thereafter. I’m watching the EU closely for a put option now. If they go forward, I’ll enter a short position again (as I did when the GDPR went into effect end of May 2018 and was rewarded for that courage).

[1] For reference purposes, an SDK has the capability to track every activity performed on the smartphone across ten device signals and sensors. They track everything you click, say or text inside the apps, and they can track your location whether you are inside the application with the SDK or not.

[2] Ad loads refer to the limited amount of ads social media feeds can show. For instance, one social media user may see a ratio of one ad per seven posts, which restricts the number of ads Facebook can serve within its own properties of Facebook and Instagram, creating finite limitations.