SITALWeek #205
Stuff I thought about last week 8-11-19

Greetings – Intel is under attack on multiple new fronts; a discussion of four industries being disrupted by a combination of consumer behavior changes and technology: package delivery, prescriptions, food delivery and text books; a top down view of consumer budgets for streaming apps; if we are living in a simulation, let’s not find out; the interesting relationship between interest rates and hope for the future; and, lots more. As always, grab me on Twitter with any feedback.

Click here to SIGN UP for SITALWeek’s Sunday EMAIL (please note some ad blocking software may disrupt the signup form; if you have any issues or questions please email sitalweek@nzscapital.com)

Stuff about Innovation and Technology

The US Postal Service logged its first drop in package deliveries in a decade, falling 3% in Q2 2019. This drop will accelerate going forward as FedEx, UPS, and Amazon will all be handing fewer boxes over to the USPS for last-mile delivery. In related news, FedEx ended the rest of their relationship with Amazon this week. It’s widely expected that Amazon could soon offer a broader delivery service, allowing anyone to use their logistics and delivery network for packages. Although FedEx can still partner to deliver for many other shippers, the reality is that, if FedEx disappeared overnight, within a few months the system would re-equilibrate as competitors hire drivers and lease trucks. In the US, it’s not clear why we need UPS, FedEx, Amazon, USPS, and a host of regional carriers and on-demand couriers all visiting each house every day. 20 years ago, when I covered other sectors alongside the tech industry, I was asked by a portfolio manager if a certain discount retailer “has a reason to exist”? I wasn’t sure, so I flew to New England, rented a car, and drove around with paper maps visiting stores (this was back in the day before smartphones!). It turned out that in very few locations did this chain need to exist, and they later went bankrupt. It’s not clear that every package delivery service today has a reason to exist.

Speaking of other companies that may not have a reason to exist, CVS and Walgreens are denying Amazon’s Pillpack subsidiary requests to transfer patient prescriptions, often times just hanging up on the calls that come in. I’m sure this is further much endearing the legacy pharmacies’ customers to them. The way Pillpack signup works, it’s nearly impossible to think someone doesn’t realize they are asking to have their Rx’s transferred – that’s the entire point of entering the Rx information and signing up for the service as far as I can tell – so the argument that patients haven’t provided consent seems entirely frivolous. No one will celebrate more than me the slow death of the terrible customer experience at the drugstore chains. Amazon is also entering another type of “medicine” market with a coming liquor store in San Francisco – from which they can make deliveries!

We are seeing more signs of delivery-driven disruption in legacy restaurant chains as Pizza Hut closes around 500 locations (7% of of their ~7,500 stores) – largely due to fewer dine-in visitors. Another interesting development in the delivery world this week was Shake Shack’s deal with delivery platform Grubhub, driven in large part by the opportunity for data sharing, which will give the burger chain more information on their customers. What’s happening to the large, incumbent food chains is somewhat analogous to the crisis department stores faced when they lost relevance in the face of changing shopping habits and ecommerce. It’s likely that a large set of current restaurants may become much less relevant to consumers in the years to come. At the very least, it’s increasingly difficult to predict the future eating habits of people as delivery and cloud kitchens accelerate growth.

Pearson, maker of $300 textbooks for schools, has lost $700M in revenues (and multiples of that in stock market value) over the last six years as it faces significant disruption from book-rental platforms like Chegg. Pearson is responding by renting digital versions with over-the-air updates for $40-80. The CEO discussed the challenges and opportunities on Kara Swisher’s podcast. I can’t help but wonder if the real opportunity is for the best teachers out there on each subject to create new interactive learning experiences that have very little to do with traditional textbooks.

x86 processors, the bulk of Intel’s business, continue to experience significant future risks. As workloads in the data center become increasingly heterogeneous, and the x86 processor architectures runs into increasingly insurmountable problems (falling well behind Moore’s Law at this point), alternatives such as GPUs and FPGAs are gaining share. Historically, GPUs still relied on x86 CPUs to function; however, this week NVIDIA announced GPUs directly connected to memory via Mellanox technology (which NVIDIA is acquiring later this year) that can bypass the CPU. Further disrupting Intel, rival AMDshifted production to TSM in Taiwan and has launched a 7nm chip with better performance for half the price of Intel’s. Microsoft, Google, Twitter, and others are already using or plan to use the new AMD chips. Intel’s main response, as they struggle to catch up, could be to cut pricing to maintain market share. However, overall, compute demand is growing, which means Intel isn’t in serious trouble today, but the range of outcomes for the US chip giant have widened dramatically as workloads shift and complexity rises.

Video games in China are set to become extremely boring as the government takes increasing morale control of the industry: “Players of [Tencent’s new game] “Homeland Dream”, for example, will be tasked to develop a city that will need to execute policies like poverty alleviation and tax reduction, which are keygoals of Beijing.” This reminds me of the brilliant protest game called Desert Bus, in which players drive a bus eight hours one way, then turn around and go eight hours in the other direction with the only action being a bug that hits the windshield. The game from Penn & Teller was a response to a 1990s call for video games to emulate real life instead of fantasy. Luckily, it has been re-released on VR to make it even more exciting. Penn accurately described the impetus for the game recently: “What the f***?” That’s like telling Shakespeare, “Don’t have just kings and killing each other and s*** like that. Have just people working at a mead shop. Let’s not have any excitement or art in your plays. Let’s just have the boring.”

American Tower is a company that owns and operates cell phone towers in the US and abroad. Together with companies like Crown Castle, they provide infrastructure for cellular carriers that can be shared (i.e., multiple carriers on one tower). Recently, the resolution of the multi-year Sprint-T-mobile merger saga (which will create a new 4th carrier again if DISH is successful) – along with the pending rollout of 5G connectivity – provides a tailwind for the tower industry. The American Tower CEO discussed these trends recently on CNBC.

This week in open-source semiconductor news, Linux giant Red Hat (owned by IBM) joined the RISC-V consortium to help speed up interoperability of enterprise-grade Linux on open-source processors. And, this article discusses the ongoing efforts and challenges to create open-source-chip-design tools and workflows to help speed up and reduce complexity in the design process. It’s not about replacing Cadence and Synopsys, the leading chip design software, but instead leveraging past knowledge and making the overall design flow faster and easier.

Contrary to the claims in this Hollywood Reporter article, Netflix is not under attack just because other direct-to-consumer content owners are finally starting to get their act together. Generally I favor bottoms up analysis, but this is a case where a top down view gives a better picture: households have $150 +/- a month ($80-$250 range) to spend on video content and fixed broadband (even more with wireless data). Of that amount, video is half or more of the total. Many homes will have traditional TV service for a very long time. Some will drop traditional TV and pick up streaming apps only. Some will have both. But very few are complaining about the value of the new services, and most are watching more and more hours with mobile. And, with implementation on the horizon, 5G will increase video viewing even more. That means you're watching more content per dollar spent. There is also an ongoing value transfer to content owners and creators (including Netflix) away from legacy video distributors like cable and satellite. Consumers will easily be able to carry six or more app subscriptions and pay less than they pay now for video while getting more content with more convenient delivery (and, as soon as someone solves universal search across streaming apps, then we really come out ahead!). That said, I think Netflix likely won’t be able to raise prices in the near future, but they are in no way under attack. Matthew Ball has covered the streaming video sector in much more detail – you can find all of his essays here on REDEF.

Speaking of streaming video apps, CBS reported a 43% increase in direct-to-consumer revenues, including the fast-growing CBS All Access, which I’d guess grew even faster during the now-resolved AT&T blackout (CBS won). The market’s been pretty down on CBS for quite a while. There is surely a mess of issues with the Redstones’ control, but the boards of CBS and Viacom have indicated they have a general operating framework and will announce details of a proposed merger soon. CBS projects their earnings to grow double digit for the next few years and Viacom is showing signs of stabilization. Their combined library would be large enough to reach significant streaming scale globally, and CBS has a large lead over Disney, Warner, and NBC Universal in building a DTC business. CBS, trading at 9x this year’s earnings, could pay a healthy premium for Viacom, which is trading at 7.5x 2020 earnings, while extracting cost savings and creating a powerful streaming platform with significant long-term value creation opportunities. The market does not like “overhangs” or complexity sometimes.

Zillow reported earnings this week (PDF), and since I’ve written in detail on the company recently I can offer a few thoughts on the results. Although the stock dropped 20% since the report, I did not see anything from the release that was particularly supportive of the bear or the bull arguments on the stock. The shift to a success-based revenue model, which Zillow calls “Flex,” over time for their premier agent advertising business seems logical to me. It’s worth wondering if the slow down in the high-end housing market is at play in the slower premier agent results as well (recently Redfin reported prices are up only 1% amid falling unit sales with overall sales of homes over $1.5M down 4.6%). The future is unwritten as real estate shifts to the iBuyer market, and I continue to take a Bayesian approach to analysis, adjusting my credence as I look at new data points objectively. I didn’t see any reason to widen or narrow my views on the range of outcomes for the industry this week. I would like to see much more disclosure from Zillow on the age and seasoning of homes on their balance sheet and attach rate of ancillary services, hopefully they can address that in the future.

Back in SITALWeek #199 I discussed the regulatory issues of whether or not tech companies are publishers. Currently, Section 230 of the US Communications Decency Act says they are not publishers and not responsible for what people post to Facebook or YouTube, etc. The tech companies, especially Facebook, have been calling for more government involvement, specifically, for governments to decide what they should or should not take down. Well they might get what they are asking for, but it’s the opposite of their intention. Instead of the US saying what is acceptable content or not, draft legislation from the White House asks for the FCC/FTC to protect users from the take down of content without prior notification, and weaken the blanket immunity enjoyed by social media platforms under Section 230. This legislation would also create a quagmire of interpretation that would be left to the FTC and FCC to sort out.

Miscellaneous Stuff
Are we living in a simulation? It’s very possible, but it’s best not to ask and answer such a question because we might corrupt the results of the simulation, causing the folks running it to end the experiment!

Google’s AI subsidiary DeepMind is succeeding due to its vigilant efforts to create cross-disciplinary teams and allow them to work efficiently – two attributes that tend to be difficult in traditional academic settings. After a few years of proving out reinforcement learning and AI engineering accomplishments in the games space, the company is now heavily focused on problems of biology and chemistry, including protein folding, which could have implications for many diseases. Academic and industrial research is becoming less productive and less risk taking, so Deepmind’s objective is to not necessarily undertake product-led research, instead they are looking for breakthroughs. Large pharma companies are achieving only a 2-3% rate of return on R&D, and it takes 18 times as many semiconductor engineers today as it did in the 1970s to try and stay on Moore’s Law. This article is one of the better longer reads on the organization that has come out over the last year.

This idea of creating a Hippocratic Oath for engineering and technology inventions is an interesting way to think about the accelerating innovation that, for now, seems to be running largely unchecked. Certainly folks are trying to do this with AI, but a broader pledge to “do no harm” with technological advances seems in order.

Facing the reality that plastic recycling is no longer feasible, California’s largest recycling operator, with 300 locations, has shut down.

Stuff about Geopolitics, Economics, and the Finance Industry
Lending and borrowing grew dramatically after the scientific revolution because humans started to believe in progress. This was fuel to the development of capitalism, which, as originally defined by Adam Smith nearly 250 years ago, broadly depends on two driving forces: productive reinvestment of capital and a growing population. You could say that lending depends on a brighter future where debts can be paid – a future built on progress. In other words, it depends on a growing pie, or something beyond a zero-sum game (Harari has a good discussion of this framework in Sapiens). So, it’s worth exploring the relationship between interest rates and hope for the future. Technology, power laws, and inequality are perhaps shifting pie filling, so to speak, from ‘the many’ to ‘the few’ instead of growing the overall pie. If that’s the case, then it represents a much less hopeful future: a pie that won’t be getting bigger. Moreover, the slower-growing pie combined with lower birth-rate trends would imply a future of less demand and therefore less inflation. A future of lower inflation, combined with technology-driven deflation, and a shift toward an economy that is driven more by information than commodities and hard assets is a prescription for low rates. That sounds like one plausible explanation of the global situation today. Therefore, low rates may be a direct reflection of less hope for growing the pie and the way that pie filling will be distributed. Further, what's more pessimistic than negative interest rates? I'll give you a dollar today and I only want 99 cents back in the future. It's a rather bleak explanation; however, it would suggest, rather speculatively, that redistribution in the form of higher wages, lower consumer debt burdens, and even direct government subsidies would create more hope, more inflation, and higher rates along with a stronger global economy. This FT article discusses the idea of central banks giving citizens money directly instead of lowering rates – both options “print” money, but the former would put it the hands of more people directly. The loss of hope and low rates is a paradox that strikes me as worthy of deep analysis.

Related: this article shows that low rates drive capital toward existing assets – share buybacks and acquisitions – rather than productive investments. Low rates aren’t necessarily the main culprit in my opinion, but a confounding factor as we go from an industrial- to an information-lead economy, which requires fewer hard-asset investments.

I’ve mentioned rent controls as a potential rising political hot topic as more housing stock is purchased by large institutions, private equity, etc. This article in The Week does a good job trying to parse the confusing information both for and against. However, the research seems to all fall short because it’s been completed before the post-financial-crisis world, and, therefore, doesn’t take into account the fact that institutions will be buying more and more properties. For example, one potential negative outcome of rent control is that it would cause owners of rental properties to convert apartments to condos or just sell the properties, thus reducing inventory. Previously, a consumer might buy that condo; however, now, due to their cheaper cost of capital, PE would likely purchase the property to operate as a rental, thus maintaining the status quo.

Ray Dalio is bullish on China despite rising tensions and rising state control: “I think the real question is are we going to go to war. If we go to war, we are in a different world,” Dalio said. “I don’t think we’re going to go to ‘classic war’. I think there is going to be a restructuring of the world order in terms of changes in supply chains. There will be changes in who’s making what technologies, important changes in those sorts of things.” In my opinion the government clamp down widens the range of outcomes for Western investors in China, and the reasons for bullishness are not so straightforward.

Aperture is a new asset manager focused on performance fees that align outcomes in the institutional investor market, including clawbacks when the funds underperform.

Beinhocker and others discuss Complexity Economics and the morale angle of political messages: “...to researchers studying moral psychology, Trumpian narratives on social spending, immigration, trade, and climate change all use a common frame of reciprocity violations that stimulates emotions of moral outrage and motivate collective behavior. The typical progressive strategy of appealing to self-interest (cuts in social spending will hurt you, immigration and trade are good for the economy, climate change is bad, etc.) is thus doomed to fail because people are not processing these issues in narrow self-interested cost-benefit terms, but rather as issues of moral fairness and reciprocity.”
“[Complexity Economics] portrays the environment not as an “externality,” but rather the economy as a complex system embedded within the larger complex system of the environment. And it portrays the shift to a zero-carbon economy not as a marginal problem, but as an epochal system transformation on par with the shift from hunting and gathering to agriculture or the Industrial Revolution. It is a problem that requires extremely rapid responses that go far beyond what the standard optimization models even consider, including major changes in our technologies, institutions, behaviors, and cultures. This is the mother-of-all disequilibrium problems...”
If this strikes your fancy, I highly recommend Brian Arthur’s paper on the topic of complexity economics and his McKinsey article on the “realities of the distributive era.”

-Brad

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.