An interesting piece reprinted from this week’s Barron’s. I think what we discover in reviewing the history of technology is that old technology gets disrupted by newer, better technology. I suspect this is what will disrupt the tech oligarchies built up over the past two decades. Not too long ago, the sector was dominated by IBM, HP, and AOL.
Whether the three can continue to have such a positive effect on the stock market will depend on how they respond to U.S. and European regulators, who are starting to swing a heavier hammer to challenge their dominance. Alphabet’s (ticker: GOOGL) Google, for instance, holds 90% of Europe’s search and mobile operating systems markets, which has drawn the scrutiny of the European Commission. This and inquiries from the U.S.’s Federal Trade Commission have prompted speculation about the breakup of these companies. Former Google Ventures CEO Bill Maris, who now runs venture-capital firm Section 32, told a Wall Street Journal tech conference last week: “It wouldn’t surprise me if the sun is setting on the golden age of Silicon Valley.” He added that he also wouldn’t be shocked if regulators tried to break up companies like Google or Facebook because they have more command of their markets than AT&T (T) did in its heyday.
More than antitrust issues are in play. The huge amounts of personal data that Google, Facebook (FB), and Amazon (AMZN) are amassing is just as troubling to some. Facebook, for one, has been sued in Europe over its transfer of information about users from Europe to the U.S. A case heading for the U.S. Supreme Court could also have significant ramifications. Microsoft (MSFT) is being sued by the U.S. government for refusing to honor a warrant served to it to reveal a customer’s emails. At issue is whether a U.S. company must turn over data even when that data, as in Microsoft’s case, are stored on servers abroad.
Last week Sen. John McCain (R., Ariz.) joined two Democratic senators to co-sponsor a bill that would force Facebook, Google, and other internet providers to disclose who’s buying political ads on their sites, following the recent disclosures that Russians had purchased ads to influence the 2016 presidential election.
Of course, Facebook, Amazon, and Google owe most of their stock-market leadership to their ability to create and supply digital gadgets and services—everything from Amazon’s Alexa virtual assistant to Google’s Android software, the top choice in mobile phones. But the shifts in political and government sentiment have stirred memories of not just AT&T, but IBM (IBM) and Microsoft. Both went through years of antitrust lawsuits that dragged down their stock prices and distracted management. Neither the companies nor their shares recovered quickly, as the nearby charts suggest.
All this has started to catch Wall Street’s attention. The European Commission, under competition watchdog Margrethe Vestager, fined Google 2.4 billion euros ($2.8 billion) on allegations that it gives more prominent placement in search results to its own “comparison shopping” listings versus listings from rival services. The commission alleged Google was manipulating the algorithms used to construct search results. More worrying was an EC case brought against Google in 2015, with formal charges lodged against it in spring 2016. The EC asserted that the company has abused its near-monopoly in both search and mobile operating systems by requiring gadget makers who license Android to install Google’s search bar as their default search mechanism on their devices.
“Of all the cases being brought, this is the one that most stands out as a concern, and it has made us less constructive on Alphabet” as a stock, says RBC Capital internet analyst Mark Mahaney, using Wall Street’s euphemism for being worried.
TAKEN TOGETHER, THESE challenges threaten the stock valuations of the group. To get an idea of the worst-case scenario, take a look at two of tech’s dominant players from previous eras: IBM and Microsoft.
The Department of Justice sued IBM in 1969 under the Sherman Antitrust Act, accusing the company of trying to monopolize the computer business, specifically by abusing its control of disk drives for mainframes. That action ended with the DoJ withdrawing its claims, but it tied up IBM and its management for years. From the time of the suit in January 1969, when the company boasted the largest market value in the S&P 500, till the day it announced it was backing off in January 1982, IBM stock declined 9.3%, versus a 14% gain in the S&P 500. Worse, IBM emerged from the suit in a weakened state to try to lead the personal computer revolution. Ultimately, it lost its dominant tech position to Microsoft, Compaq, and Apple (AAPL). A winning government case isn’t necessary to affect a stock’s price.
Microsoft’s collision with the government occurred in 1998, when the DOJ sued it on antitrust grounds, accusing Microsoft of abusing its monopoly in PC operating systems by “tying” its Internet Explorer browser to Windows. Massachusetts Institute of Technology professor Franklin Fisher, the chief economic witness for the government, showed that Microsoft was giving away its Web browser to destroy a competitor, Netscape, which threatened Windows’ dominance. In Microsoft CEO Bill Gates’ famous phrase, the software giant was “cutting off [Netscape’s] oxygen.”
The judge, Thomas Penfield Jackson, ordered a breakup of Microsoft, but that was rejected by an appeals court, in part because it decided Jackson had violated ethics rules by meeting with reporters to discuss the case. The FTC settled with Microsoft in November 2001. Even though the company avoided the worst fate—a breakup—in the subsequent nearly 13 years, until the appointment of Satya Nadella as CEO, the stock rose a meager 18%, versus 62% for the S&P 500. Microsoft competitors Oracle (ORCL) and SAP (SAP) saw their shares nearly triple in the same period.
Like IBM, Microsoft emerged from the government suit just as the tech world was changing. Google was founded the year of the suit, and its Gmail and Android would, along with Apple’s iPhone—which debuted six years after the settlement—demolish the importance of the PC and the Windows operating system.
Amazon, Facebook, and Google all benefit from the same sort of network effects that snagged Microsoft. The more people use Facebook, the more others feel they must use it, in a self-perpetuating fashion. Ditto for advertising on Google or selling goods on Amazon. Wall Street and investors may love this virtuous cycle, or, as it’s commonly known, the “flywheel” that keeps expanding their businesses.
But others, citing Fisher’s work, see exploitation and unfair leverage. They can argue that Amazon sells its Echo home speaker at roughly break-even prices to bring in more shoppers. It’s conceivable such leverage could be interpreted by regulators as predatory. Another example is Amazon’s bundling of its Amazon Prime membership, which offers free shipping and streaming videos, below Amazon’s cost to provide it. Google’s use of Android to maintain its search engine as pre-eminent on mobile devices has been likened to the kind of “tying” that Microsoft tried with Internet Explorer.
FOR NOW, THE BIGGEST TECH companies don’t face an immediate threat of being broken up. But just the possibility creates a risk factor in the stocks. “We expect increased regulatory scrutiny in the U.S. and EU, which could create an overhang which hinders prospects for further multiple expansion for these companies,” wrote Michael Nathanson, an analyst at MoffettNathanson who covers Alphabet and Facebook.
A regulatory quagmire lasting several years would not just hold back the stocks’ multiple expansion but could substantially contract them, as previous challenges did to Microsoft and IBM. Microsoft’s forward price/earnings multiple declined from 27 to 14 times between late 2001 and 2014, while IBM’s trailing P/E declined from 53 to 10 times from 1969 to 1982.
The current tech giants already sport expensive prices. At 124 times next year’s projected earnings, Amazon’s stock has plenty of room for multiple compression, as they say. But even Alphabet and Facebook, trading at 25 and 27 times, respectively, are up slightly from their year-ago multiples of 20 times and 26 times.
Like IBM and Microsoft, the latest titans run the risk of missing the next big thing. Tim O’Reilly, chief executive of O’Reilly Media, an influential publisher and futurist who has had many conversations with Amazon CEO Jeff Bezos and Google founders Larry Page and Sergey Brin, thinks that will be the symbiosis of human and machine. Human abilities will be amplified by machines as society comes to better understand how data affect the real world. From browsers, it’s already progressed to ride-sharing services from Uber Technologies and Lyft, which in the future will pilot people anywhere without a driver. Likewise, agribusiness giant Monsanto (MON) is looking at how weather data can be used to control robotic farm equipment, putting it on a collision course with its traditional partner, Deere (DE). Will Facebook, Amazon, and Google, possibly preoccupied by government inquiries, miss the boat?
Given tech’s enormous clout in the markets, even a relatively small decline would affect millions of investors. The stocks dominate both active portfolios and passive ones like exchange-traded funds Techology Select Sector SPDR (XLK), which includes Facebook and Google, or Consumer Discretionary Select Sector SPDR (XLY), which includes Amazon. Howard Silverblatt of S&P Dow Jones Indices notes that Apple, which hasn’t been a focus of the government inquiries, is the biggest component of the market-weighted S&P 500, at 7.8%. Facebook is No. 2, at 4.7%, Amazon is fourth at 3.4%, and Alphabet’s A and C classes of stock combined rank as fifth and sixth, with a combined 4%.
CAN FACEBOOK, GOOGLE, and Amazon avoid much tighter regulation or a breakup? Yes, but they’re going to need to change their ways. For every mea culpa from Facebook Chief Operating Officer Sheryl Sandberg about Russian advertising in the 2016 presidential election, there seems to be at least one utterly tone-deaf incident. That would include her boss Mark Zuckerberg’s recent demonstration of his firm’s new virtual-reality gadget by pretending to tour the devastation of Puerto Rico, a move that seemed especially insensitive. Other public-relations low points include Uber founder Travis Kalanick’s parties in Las Vegas and sexist emails circulating at Google about female engineers.
The companies, instead, could be helping the public understand the complexity of their businesses and why things like leveraging a logistics business to lure third-party sellers is justifiable.
“We are at this moment in time, this Facebook moment, when everybody’s talking about these things, and it could be a teachable moment,” says O’Reilly. He thinks the companies need to communicate the economic inputs and outputs of the internet business model, things such as stock options that are a super-currency with which they have financial leverage, but also how many ancillary jobs they create by enabling commerce. [Blogger’s note: I seriously doubt they are going to successfully PR their way to public acceptance of monopoly economic power.]
The internet giants could help in shaping enlightened reforms, suggests O’Reilly. New financial statements could be formulated with the help of the Financial Accounting Standards Board, he says, and stock compensation, one of the worst aspects of Silicon Valley, could be reformed. “They’re aware, but they just don’t get” the need for dialogue with the public, O’Reilly says. “It’s like someone who knows they should quit smoking, but they just don’t.”
The stakes are large, says O’Reilly. “I think there’s huge risk in America that we are going to create a regulatory burden that is going to mean that our companies are less competitive in many markets,” he says.
IF THESE GIANTS GET SIDESWIPED, it could be because of the fatal flaw in large tech companies that’s often drawn social ire and regulation—the will to exploit their dominance. “The biggest thing they’re vulnerable to is that they work too hard to protect their existing businesses,” says O’Reilly. [It’s the capitalist survival instinct, and no company willingly falls on their sword for principles of fairness.]
“That’s always where companies get it wrong—Microsoft got it wrong, IBM before them got it wrong—they basically did things to extract money from customers rather than benefit customers,” he says. How the current tech titans meet this challenge likely will determine how shareholders fare as well. [That would be the far-sighted strategy. Web 3.0 will probably force it upon them. The Golden Rule stated: “Technology disrupts technology.”]