The Bear’s Lair: Toothless FAANGs.

For several years, the stocks of the FAANGs (Facebook, Apple, Amazon, Netflix, Google) have been the way to make money. Over the five years to December 31, 2017, the FAANG stocks returned 41.6% annualized, compared with 18.6% for the S&P 500 Index, to trade at almost 70 times historic earnings by that point. Yet all five of the FAANG stocks have weaknesses in their business models that are becoming increasingly apparent, suggesting that they are just today’s equivalent of the 1999 dot-coms, the 1972 Nifty Fifty, the 1929 Investment Trusts or the 1720 South Sea Company.

To begin with Facebook, we learned last week that Facebook intends to set up its own “Supreme Court” to police ‘hate speech’ on its service. This may suit Mark Zuckerberg’s dreams of world domination, but it in no way represents what a private corporation ought to be doing. Even if Facebook were not a leftist political monoculture, with little or no hope of changing, I would oppose it having that kind of power.

The problem is Facebook’s ability to scoop up private information on people and sell it to third parties, or indeed use it itself in pursuit of some nefarious non-economic goal. When Facebook started, it appeared to be largely a means for teenagers to communicate, which could be monetized through advertising, but as it has grown its sinister potential has more clearly appeared. Dictators in South-East Asia are using their Facebook pages to provide “information” to citizens of countries in which the free press is suppressed but the global danger of this is far less than that of having some PC Zuckerberg clone controlling what the citizens of free democracies can view.

There is no solution to Facebook’s censorship problem. In a traditional media environment, a wide variety of media outlets use the skilled judgement of journalists with decades of experience to decide what to print; if they get it wrong, the outlet lost subscribers and money. But Facebook is effectively a monopoly; there is no way it can censor the news without becoming Pravda. Under Facebook’s current leadership, becoming Pravda appears to be its ambition rather than its fear.

The only solution would be to break up Facebook into half a dozen competing outlets, each with a different political outlook, thereby reproducing a healthy newspaper environment like the U.K. fifty years ago. Alternatively, the de-globalization of the world may result in entities like the EU imposing revenue-based taxes on Facebook, thus over time leading to national equivalents and a dissipation of Facebook’s power by this means. Either way, Facebook’s monopoly power will not last, and its revenue generating capacity will be correspondingly diminished. Its business model is broken.

Amazon, the next of the FAANGS, is really two businesses. One of them, Amazon Web Services, is the leader in providing cloud services to businesses and consumers. It is a sensible business, has a good market position, but in 2017 had only $17.5 billion in revenues and operating profit of $4.3 billion. A nice business, as I say; worth about $150 billion if you give it a generous multiple of 35 times earnings, appropriate given its growth.

The problem is the rest of Amazon’s business, which in 2017 made an operating loss of about $1.3 billion, even though it had revenues of around $160 billion. Even though Amazon has in the past benefited from huge subsidies in not charging state and local taxes (and still has a huge cash flow benefit from paying its state taxes later and not charging local taxes) its entire retailing operation, after 23 years in business, is still not profitable. Yet, given that the web services business is worth around $150 billion, its retail business is valued at $500 billion. For what? It’s no good saying it is valued for its growth potential; retailing is a notoriously low-margin business, and Amazon already represents over 40% of on-line sales – there is nowhere much for it to expand to.

With President Trump threatening the company’s sweetheart crony deal with the Post Office, which gives it postal rate some 40% below market, according to a Citigroup report and comes to an end in October, the company’s margins are unlikely to grow, even if gets another point or two of the retail market. Given that hard reality, its share price is hopelessly over-inflated, and the pains of its deflation may make it difficult for Amazon to sustain its expansion program and its heavy long-term debt. Amazon’s business plan was initially brilliant, but it has failed to mature into a profitable, sustainable economic entity.

Apple is the oldest of the FAANGS and in its early years had an excellent business with Steve Jobs for design and Steve Wozniak pushing the technological envelope, first developing one of the first usable personal computers, then adapting Xerox PARC technology to produce a PC, the Macintosh, that was far easier for non-technical types to master. Then after a lost decade, in which products like the Newton hand-held device failed because of poor design, Jobs returned to Apple and proceeded to produce a series of superbly designed products that in some cases, notably the smartphone, were truly paradigm-altering.

Sadly, Steve Jobs died in 2011, and Apple thereafter has shown itself incapable of more than incremental product improvement. At the same time his successor as CEO, Tim Cook, has concentrated on tax-optimizing Apple’s operations, growing its political influence, and maintaining or increasing margins on each new “generation” of Apple products. His politicization has already run into trouble; Apple was one of the chief targets of Trump’s tax reform, intended to prevent companies piling up hundreds of billions of dollars in offshore tax havens. With product innovation slowed (partly by technological factors such as the senescence of Moore’s Law) and Cook’s creative use of tax havens and intellectual property increasingly under attack, Apple’s rating is far below that of the other FAANGs and its future must be in serious question, although with all that cash its survival at least for the medium term must be assured.

Netflix built itself into a member of the iconic FAANGs by assembling a store of content, including more recently original programing, that made it the “go to” destination for Millennials seeking a cheaper alternative to the overpriced cable TV. In recent years, however, it like the other FAANGs has gone off the rails. Technologically (which I don’t pretend to understand even when it’s explained to me) it pushed through, by cronyism in the industry and government, a new proprietary software that has now become an official industry standard. It also was a major generator of the Obama administration’s “net neutrality” legislation, that brought neutrality between the service providers at the cost of excessive negotiating power for the content providers like Netflix and Google. Finally, it now has George Soros as a major shareholder.

Political neutrality is of no importance in many businesses – who cares what the politics of your auto company are? However, in the entertainment area, because of the ability to produce propaganda disguised as entertainment, political neutrality is extremely important, and thoughtful consumers will avoid companies that violate it. Netflix, by its cronyist design of regulations to benefit it and its increasing political orientation, is both dangerous and alienating to half its customer base. Again, not a good business model.

Finally, Google (controlled by a holding company Alphabet Inc.) startled the world at the time of its 2004 IPO by its slogan “Don’t be evil” which even at the time was pretty obviously a sign that the company had sinister ambitions. (This column said so, but I grant you was laughably wrong in saying the stock was overpriced at $85!) Google shares Netflix’s attempts to design cronyist regulations benefiting it, and its political predilections (with its outgoing executive chairman Eric Schmidt being a major Hillary Clinton friend). However, it also shares Facebook’s strategic problems. First, it is heavily dependent on the digital advertising business, in which Facebook and it hold a duopoly with around a 60% market share – the advertising business is highly cyclical, and it’s unlikely that digital’s share of the total business will grow significantly further.

Second, like Facebook Google relies for much of its profits on scooping up endless information on its consumers, which comprise more or less the entire population, and using that information for legitimate or nefarious purposes. As consumers become more aware of the uses to which their personal information is being put, they will erect more sophisticated defenses against its improper use, devastating Google’s profit potential. Like the other four FAANGs therefore, Google has a fundamentally flawed business model.

In the past decade, because of artificial ultra-low interest rates worldwide, the Schumpeteran process of creative destruction has not operated properly. This has allowed the FAANGs to grow to an enormous size without correcting the flaws in their business models and practices. The next few years are likely to be very much less friendly to them.

Disclosure: I own modest put option positions in Amazon and Alphabet/Google.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)