The Tech IPO and M&A Conundrum

M&A and Stock Market Up, But IPOs Way Down

Historically, technology sector IPOs, M&A and stock performance tended to move in tandem. However, this correlation has materially broken down in the past 18 months as technology IPOs have dwindled while the tech stock index approaches new highs and tech M&A surges. This is shown in the following couple of charts. The successful technology IPO of Twilio today (up 92% from the IPO price) was, thus, a sight for sore eyes for technology investors, venture capitalists and employees. In fact, Twilio was the first $1B+ MCAP venture backed IPO since Square went public in November of 2015. While time will tell if Twilio is the beginning of a resurgent tech IPO market, my sense is that the current stock market fundamentals, sentiment and some unique favorable attributes of the Twilio IPO will not make Twilio the beginning of major broad new tech IPO wave in the near term.

ipo techM&A Tech

Low Economic Growth and Bond Rates Driving “Yield” Investing

I would characterize the current overall stock market sentiment and fundamentals driven primarily by the forces of low global bond yields and lack of economic growth in both developed and emerging markets.   Bond yields are now close to zero and even negative in major countries across the world (e.g. Germany, Japan, Switzerland etc.) while economic growth has fallen short of expectations in most of the world including the US, Europe, China, Brazil etc. At the same time, the US stock market is interestingly approaching new highs. This, however, is likely due to the chase for a “safe yield” as returns in cash and bonds are negligible. This is clearly manifested in the S&P sectors of Utilities and Consumer Staples leading the stock market performance in the past 12 months with several of the leading stocks in these sectors (e.g. Procter and Gamble, Coke, Duke Energy etc.) hitting multi-year highs in valuation metrics (e.g. EV/Sales and PE multiples).   When safety and dividend driven sectors lead the stock market, it is typically reflective of low global growth, which is not typically the backdrop for a strong tech IPO market.

Cheap Money and Embolden Activists ==> Surging M&A

At the same time, there are many fundamental and financial forces in the technology sector that are resulting in significant discontinuity and low growth for established public companies but at the same time increased M&A.   The fundamental impact of cloud on traditional technology companies is clearly very disruptive as demand for traditional products is either diminished, as workloads move to the public cloud, and/or technology company business models are transitioning from appliance/hardware sales to lower revenue software based sales. These forces are making public equity investors less enthusiastic about most of public technology companies unless they are high growth, cash flow generative pure plays in this cloud transition.   At the same time, the surge in M&A can be explained by the very low cost of debt (allowing for deals to be more easily accretive) and increased fund raising of private equity and activist investment funds. Over the past 18 months we have witnessed the largest ever technology takeover by a private company (i.e. Dell buying EMC), Microsoft further trying to accelerate its transition to the new enterprise software sales model with its planned acquisition of LinkedIn and activist and private equity investors being more collaborative in taking low growth, but highly profitable tech companies private.

Twilio Was Priced Favorably; Will Other Unicorns Follow or Wait?

For tech IPOs to roar back, I think we will need to see better overall economic growth to encourage an offensive rather than defensive/yield driven investment psychology. Otherwise, there will likely need to be more companies that have the characteristics of the Twilio IPO, namely, high revenue growth rate driven by the transition to the cloud, approaching or already cash flow positive and favorable valuation metrics to the public investor.   This last piece on attractive valuation cannot be overstated. It appears that Twilio was priced very favorably at ~8x sales in the IPO, which for its growth rate and size was likely very compelling to the public investor. I do not recall any other software cloud or SaaS tech IPO in the last few years that went public at a similar revenue scale and growth rate at less than 10x sales. Luckily for Twilio’s private round investors, this compelling public valuation was still higher than the most recent “unicorn” venture round. Twilio was also a relatively small “unicorn” to go public. For the tech IPO market to truly bounce back, we will likely need to see some of the higher profile “unicorn” companies (e.g. Snapchat, Uber etc.) go public.

Is NY Ready for IPO Primetime?

This week two NY tech IPOs are expected to price, namely Etsy and Virtu Financial. Given that there were only six NY venture capital backed tech/healthcare IPOs in 2013 and 2014 combined that I am aware of, having two IPOs in one week is a rare event; at least for now. With NY based On Deck Capital going public only just this past December, the increasing pace of NY IPOs and the potential pipeline of future IPOs raises the question whether NY is ready to break out in terms of generating IPO caliber companies.

As I wrote about in January in my prior post regarding NY’s tech ecosystem, NY’s relatively young tech ecosystem when compared to Silicon Valley or Massachusetts has shown tremendous success in total venture dollar investments and M&A exits, but relatively limited success in IPO exits. It is my view that an increasing number of IPO exits, followed by growing market capitalization companies that can be consolidators in their respective markets will be needed in order for the NY tech ecosystem to maximize its prosperity over the longer term.   While NY’s tech ecosystem is broad based from a vertical perspective, chances are NY will be most successful in producing innovative and disruptive companies in new tech verticals that have roots in traditional NY based industries such as financial services, retail, fashion etc. Thus, it is not surprising that On Deck Capital and Virtu Financial are players in fintech while Etsy is a player in e-commerce/retail.

The following table shows some of the recent NY tech/healthcare IPOs in the past couple of years.   Besides being a somewhat short list, the after market stock performance of these recent IPOs has been mixed with Shutterstock so far being the only tech/non-biopharma company on the list to show robust after market appreciation post the first day of trading.   Time will tell if On Deck, Etsy, Virtu Financial and other NY IPOs in the pipeline will become good public investments. As a homegrown New Yorker and current angel investor in NY start-ups, I am clearly rooting for the home team to be a winner!

IPO Date IPO Price Closing Day of IPO 4/10/15
Varonis 2/28/14 $22 $44 $27
Tremor Video 6/27/13 $10 $8.50 $2.40
Borderfree 3/20/14 $16 $20 $6.72
Shutterstock 10/10/12 $17 $22 $71.14
Everdadyhealth 5/28/14 $14 $13.50 $12.57
Intercept Pharma 10/11/12 $15 $19.05 $179.25
Ophthotech Corporation 9/25/13 $22 $26.30 $50
On Deck Capital 12/17/14 $20 $27.98 $19.53

NY Start-Up Ecosystem: What I Am Keeping An Eye On

While working in the technology and finance industries for 30 years, including eighteen years as a Wall Street technology equity research analyst, I have witnessed dozens of Silicon Valley start-ups go from the seed phase to successful exit. I characterize Silicon Valley as a “well oiled machine” in how it can consistently over multiple decades create, fund and successfully grow the most innovative companies in the technology industry.   As a long time resident of the Greater New York City region, I am truly excited that over the past decade the NY start-up ecosystem has achieved enormous momentum and has the potential of also creating new innovative companies and perhaps even defining new subsectors of the technology and media industries.

Many have opined in the media on whether NY will ever catch up to Silicon Valley or if it is even relevant to compare the two start-up ecosystems. In this regard, I agree that it is not extremely relevant to compare the two regions given the maturity and decades of success of the Silicon Valley start-up ecosystem vs. the relatively young NY ecosystem of roughly only a decade.   NY has a different culture and industry roots than Silicon Valley that will likely result in its own unique ecosystem evolution. For example, the historical entrenchment of industries in NY such as media, fashion and finance make talent in these industries more prevalent in NY than classical technology sectors in Silicon Valley such as semiconductors, enterprise software, data networking etc. These strong industry foundations in NY are evident in two of the few NY start-ups that have actually gone public in the past three years, namely Shutterstock (Media/Content Tech) and On Deck Capital (Financial Tech).

As someone who was educated in both NY and Silicon Valley and is now an angel investor, board member and advisor to companies in NY and California, I read with intrigue the “2014 U.S. Venture Capital Year in Review” by CB Insights as it relates to the topic of NY as a blossoming start-up ecosystem and how it metrically compares to other regions of the US. I wanted to highlight a few key metrics from this report that demonstrate both the momentum and scale of the NY start-up ecosystem, but also the coincident realization that this ecosystem is still relatively young and has more to prove to compete with Silicon Valley and other parts of the US in attracting the absolute best financiers, entrepreneurs, scientists/engineers, students and academics to the region.

Table: 2014 U.S. Venture Activity

Metric Calif. Mass. NY Total US
Number of VC Backed Deals (Growth Over 2013) 1,631 (13%) 346 (9%) 422 (7%) 3,617 (8%)
$B Amount of VC Backed Deals (Growth Over 2013) 26.8 (81%) 4.2 (37%) 4.5 (53%) 47.3 (62%)
VC backed IPOs (vs. 2013 figure) 45 (31) 18 (10) 5 (1) 101 (73)
VC backed M&A Exits (vs. 2013 figure) 265 (188) 70 (33) 59 (49) 637 (440)

Source: CB Insights report “2014 U.S. Venture Capital Year In Review”, January 2015

The CB Insights report shows that NY was 2nd only to California in venture backed funding in 2014 both in terms of number of deals and total dollars funded as it surpassed Massachusetts in both these categories. This clearly reflects the enthusiasm, momentum and scale of the NY start-up ecosystem. However, NY continues to lag in terms of exits as it only generated 5 IPOs in 2014 (and only 1 in 2013) and its M&A exits in 2014 did not keep pace with California, Massachusetts or the US as a whole.

NY will need to improve its exit conversion rate in the next few years or it might be at risk of being viewed as the “gold-rush” region of the current technology and media era. I personally view the talent, innovation and entrepreneurial energy level in NY as too powerful for such a scenario to play out.   Time will tell whether NY will follow its strong growth metrics in deals and funding values with also an improving performance of exits.   While the numbers will ultimately speak for themselves, here are three important dynamics that I will also be following to measure the progression of the NY start-up ecosystem.

Minting Serial Entrepreneurs that VCs Will Follow: As exits grow in absolute numbers and valuations, it will be important for NY to establish its own set of serial entrepreneurs that stay local to the region, come up with the “next big thing” and can easily raise money from VCs given the returns they delivered to them in the past. This profitable cycle will also help drive the best VCs to put better talent in NY.

Fading of The “Trader” Mentality: Perhaps its because NY is the financial capital of the world, or perhaps its because the NY start-up ecosystem is still fairly young that I find many NY entrepreneurs (and NY start-up financiers) think primarily of a quicker M&A exit for their companies rather dreaming of building a company that can go public.   While I stated earlier that I don’t think it is relevant to compare Silicon Valley to NY, this is one big difference between the two regions. Silicon Valley tends to dream relatively more of building big innovative and disruptive companies, while NY tends to dream of the quick exit or “trade”. Perhaps NY first needs to “mint” its serial entrepreneurs through M&A exits to create the stage for more far reaching company goals. Having more public companies I think would make NY even more attractive to the best talent in the nation to come here to work. Achieving an IPO with a valuation of multiple tens of billions of dollars would be a momentous event for the region and also allowing for a NY based consolidator.

Fostering Entrepreneurship At Local Universities: NY has a solid list of universities. These universities historically, however, have not had a culture that has fostered entrepreneurship. This is changing quite rapidly but will need to continue. As a member of the Columbia Engineering Entrepreneurship Advisory Board, I have witnessed how one such university is making such strides and it is a pleasure to be a part of the progress. NY still has more to go in this area including being supportive of professors that want to be more actively engaged with start-ups and being more creative and less bureaucratic in intellectual property ownership rules when dealing with campus-based start-ups.



Is U.S. Telecom Capital Spending Going Up in “Spectrum”?

Over the past couple of months several technology companies with meaningful exposure to telecom capital spending in the United States including Adtran, Ciena, Juniper and Procera have provided cautionary outlooks in their respective businesses. Most of the companies, analyst and press commentary on these earnings warnings primarily point to the impact of the AT&T Domain 2.0 vendor qualification process (including the associated architectural shift and additional pricing pressure it has brought to the industry), the pending consolidation of the some of the larger US telecom/PayTV operators (e.g. the AT&T/DirecTV and Comcast/Time Warner Cable deals) and a more front end loaded capital spending environment in the US than normal in 2014. While all of these factors are likely key contributing factors to the recent disappointing earnings of the technology companies exposed to US telecom capital spending, I also believe that pending wireless spectrum auctions in 2014 and 2015 are factors that have not received as much attention in the press and should be considered.

Wall Street analyst reports have suggested that the wireless spectrum being auctioned by the FCC in the AWS-3 auction in November 2014 is likely to cost the winners in the auction from $10-$15 billion with AT&T and Verizon likely being the major winners in this auction. To put this potential spectrum spending in perspective, AT&T and Verizon combined have an annual capital spending budget (both wireline and wireless capex) of about $36-$37 billion in 2014. Thus, if AT&T and Verizon spend a combined $9 billion in the November spectrum auction, it would represent about 24% of their combined capital spending plans for 2014, which is fairly significant percentage.

Another spectrum factor that potentially may impact capital spending in the short to intermediate term is the planned FCC Broadcast Television Incentive Auction, which the FCC estimates will take place in mid-2015. This spectrum auction is unique as the FCC plans on using free market forces to motivate existing broadcasters that own the spectrum to sell it in an auction format on a voluntary basis. Since the spectrum auction will be on a voluntary basis, its difficult to predict the potential timing, outcome and spending for the spectrum. Wall Street analysts, however, have written that wireless operators could pay as much as $34-$48 billion in the 2015 incentive auction for spectrum with AT&T and Verizon potentially spending a combined $21-$24 billion. Thus, if AT&T and Verizon combined spend about $9 billion and $22.5 billion in 2014 and 2015 respectively for wireless spectrum, this would represent about 43% of their combined overall capital spending budgets for the two years 2014 and 2015.  The following table shows how the potential spectrum costs in 2014 and 2015 compare to the overall US wireless industry capital spending budgets.

Estimates 2014 2015
AWS-3 Auction $10-$15 Billion
US Wireless Capex $34.1 Billion
AWS-3 Auction as a % of Capex 29%-44%
Broadcast Incentive Auction $33.6-$48 Billion
US Wireless Capex $34.5 Billion
Incentive Auction as a % of Capex 97%-140%

Source: Company reports and UBS Investment Research

Wireless operators have many cash pressures on their operating cash flow including network related capital spending, dividends, share buybacks, acquisitions and spectrum purchases.   Given the potential significant amount of spectrum purchases expected in 2014 and 2015 in the US, allocation of funds to spectrum spending by wireless operators may be another key factor that has led to weaker than expected network related capital spending, thus, resulting in weaker than expected earnings outlooks for certain technology companies. If one thinks about competing for cash outlays, deferring capital spending on equipment and allowing the network to run “hot” on a short-term basis, if possible, seems rational and plausible when such a large cash outlay is likely going to be needed for upcoming spectrum auctions. Network planning could also be potentially impacted as wireless operators have some uncertainty as to their spectrum assets pending the outcome of the auctions, which also could be impacting some spending in the network.


Capex Continues To Surprise On the Upside

A key fundamental driver of the communications equipment industry and associated supply chain stock performance is the growth in overall capital spending by service providers, including wireless, fixed and cable TV operators.  Coming into 2014, the general expectation by Wall Street analysts was for 2014 to be a decent year of overall growth in capital spending on the order of 2%-4%, with the wireless component growing much faster in the 6%-9% range. The 2014 growth expectation was due to a ramp in spending in key markets like China given the expectation that LTE would be finally rolled out in earnest, Europe given operators were expected to start growing spending after a period of under-investment in the past few years and the US given wireless operators were expected to continue to grow spending to enhance network quality and expand LTE coverage.

After reviewing some of the key telecom operator 4Q13 results in these regions and their respective comments on capital spending plans for 2014, the general bias on 2014 capital spending by operators was generally to either maintain or raise capex expectations.  In addition to expected capex spending growth in wireless I mentioned above, we also heard better spending plans in fixed networks in the US from the larger three cable TV operators and in Europe by traditional fixed operators.

I continue to view the upward bias on 2014 operator capex as favorably for communications equipment and supply chain companies.  While several companies may benefit from this trend, I continue to favor Alcatel-Lucent (ALU) and Finisar (FNSR) as stocks to benefit from this theme.  Both are beneficiaries of the upward bias on capital spending while Alcatel-Lucent has the added benefit of a restructuring story and Finisar has the added benefits of relatively higher exposure to the optical upgrade in China and ramping deployments of “white box” switches by Web2.0 companies (e.g. Amazon) that utilize their optical sub-systems.  Keep in mind, both ALU and FNSR are very volatile stocks and can have extreme negative reactions to any negative earnings or other negative macro-economic and fundamental news.  In particular, Finisar reports earnings this week and Alcatel-Lucent has exposure to emerging markets.

Here are some key highlights of recent capital spending commentary from key operators in the US, China and Europe from 4Q13 earnings calls that took place in January and February:

China: After a delayed tendering process by China Mobile in 2013 for LTE equipment suppliers, a portion of China Mobile capital spending was delayed into 2014.  This deferral into 2014, combined with all the major operators ramping LTE spending in 2014 is likely to lead to an overall China capex growth of 15% in 2014 vs. prior expectations of about 10% growth.

US – In the US, AT&T, Verizon, T-Mobile, Comcast, Time Warner Cable and Charter all raised their respective 2014 capex plans vs. prior analyst expectations.  In addition, Google announced it is planning to expand its Google Fiber network to 34 additional cities in the future, which may add to the competitive pressure in residential broadband networks in future years.  Specific capex commentary from above mentioned US operators are as follows:

–       AT&T: Announced Project Agile that will result in capex being about $21B in 2014 vs. prior estimates of about $20B

–       Verizon: Guided 2014 capex to $16.5B-$17.0B vs. prior estimates of $16.0B-$16.5B.

–       Time Warner Cable: Guided 2014 capex to $3.7B-$3.8B vs. prior estimates of about $3.2B-$3.3B given new initiatives such as all digital conversion.

–       Comcast: Guided 2014 capex about $800M higher than 2013 given initiatives around digital set top boxes and WiFi routers.

–       Charter: Guided 2014 capex higher than expected by about $400M primarily due to all digital conversion resulting in 2014 capex of about $2.2B vs. prior estimates of about $1.8B.

Europe – In Europe, there continue to be early signs of a need for network operators to upgrade their networks after a period of cautious investment in the past few years.  The two most notable examples were Vodafone and Telefonica.  Vodafone announced Project Spring in 4Q13 that will result in capex of about £7.3B in 2014 vs. £6.2B in 2013.  Telefonica raised its expected capex/sales ratio for 2014 to 15.5-16% compared to 14.5% in 2013 to fund new network upgrade programs.


Juniper Has The “Edge” Over Cisco

I recently wrote an article on Seeking Alpha on my views on why Juniper is currently outpacing Cisco in the router market and how this is likely to continue through most of 2014.  Specifically, Cisco’s relatively older edge routing platforms vs. Juniper and the likelihood that Cisco has confused customers in the core routing market given two different product introductions in 2013 may be reasons for Cisco’s relative underperformance vs. Juniper.  One key data point to watch in 2014 for both Cisco and Juniper in the router market is AT&T’s Domain 2.0 process, which is likely to be completed by mid-year.    Given AT&T’s desire to maximize free cash flow given increasing investor concerns in this area (i.e. AT&T’s stock price fell the day after it reported earnings given a lower free cash flow outlook for 2014 vs. 2013), it is likely that product pricing will be a key factor in the Domain 2.0 vendor selection process, especially if Cisco continues to lose share to Juniper and Alcatel-Lucent in the router market in 2014 and it seeks to stop this trend by being more aggressive in the AT&T opportunity.

Are There Bubbles In The Cloud?

I recently wrote an article on Seeking Alpha on the valuations of disruptive and high growth companies in cloud software and social networking such as FireEye (FEYE), Splunk (SPLLK), Twitter (TWTR) and Workday (WDAY) and whether these valuations suggest we might be in a mini tech bubble in these sub categories within the overall technology sector.  I also was recently interviewed on Bloomberg TV on this topic. Valuations of these and other cloud/social companies are very high (i.e. ranging from 30x-60x trailing EV/Sales) when one looks at the post Tech Bubble era, but they are nowhere near the valuations we saw of high flying disruptive companies in 2000 (e.g. Juniper Networks peaked at around 400x trailing EV/Sales in 2000).  While these current valuations are not even close to the levels we saw in 2000, they are generally higher than the post bubble range of 20x-40x EV/trailing sales for best in class software/Internet companies, VMware and Goggle when they were at similar annualized revenue levels.  A look back at the respective sales growth rates and valuations of these best in class enterprise software and Internet companies, suggests the current class of disruptive enterprise software, Internet and social networking companies may still offer positive stock returns from current levels over the next 3-5 years, but that these new class of companies will likely need to grow at the same historical rate (or better) as the prior best in class group.  Even if this new class of companies can replicate the growth rates of CRM, VMW and GOOG when they were at the same revenue size, large stock corrections of 25%+ are likely and an overall negative return over the next 3-5 years cannot be ruled out (e.g. if one purchased VMware at its peak valuation in October 2007 of ~40x trailing EV/Sales, you would still be underwater on the stock).



Elliot Targets Activist Reforms at Juniper

Today Elliot Management disclosed it owns 6.2% of Juniper Networks and in a very detailed SEC filing, outlined its desire for Juniper to implement 1) $200M in cost reductions, 2) $3.5B in capital returns to shareholders in buybacks and initiating an ongoing dividend, and 3) production optimization including reviews of the security and switching businesses, which have been generally disappointing in the past couple of years.  Given the relative underperformance of Juniper stock over the past few years, its higher relative cost structure as compared to other companies in the networking industry and its strong cash position and cash flow generation, Elliot’s investment and objectives are not that shocking to me.

Elliot’s investment in Juniper is yet another example how activist investors are becoming more emboldened to invest in technology companies and seeking material change in either strategy, management and/or capital returns to shareholders. I wrote about this trend in topic in a prior blog post, and I continue to expect activist investors to increase their investment in the technology sector.  Recent activist investment successes in technology investments (e.g. Microsoft, Apple, Dell, Yahoo, NetApp etc.), increasing fund flows into activist funds, the overall underperformance of mature technology companies vs. the overall market (e.g. the IT sector has under-performed the overall S&P 500 in each of the past four years) and the relative cash rich nature of the technology industry vs. other sectors are all likely to continue to drive activist funds to evaluate and potentially invest in technology companies.

The Juniper situation is also very interesting given the recent changes to the senior management team and the current composition of the board of directors.  The company’s new CEO, Shaygan Kheradpir, officially started in his new role on January 1st and Bob Muglia, prior EVP of Software Solutions and a direct report to the CEO position, left the company in December of 2013 shortly after the new CEO was announced.  It should be noted that Shaygan Kheradpir has not been a CEO in the past.  The departure of Bob Muglia was not a material surprise to me given he was recruited to the company by prior CEO Kevin Johnson as both executives worked together at Microsoft in the past.  I would not be surprised to also see Gerri Elliot, current EVP Chief Customer Officer and a direct report to the CEO, also depart from Juniper in the future, as she was also recruited from Microsoft by prior CEO Kevin Johnson.  Jim Duffy of Network World recently wrote about the “ending of the Microsoft Era” at Juniper in a blog post.

Elliot’s timing on this investment is also interesting when one looks at the current Board structure and the fact that Juniper usually has its annual shareholder meeting where shareholders vote for directors in May of each year.  While the press has written often how the new CEO of Microsoft will have to deal with two former CEOs on the Microsoft board, Shaygan Kheradpir (CEO of Juniper) has two former CEOs (Kevin Johnson and Scott Kriens) and the founder (Pradeep Sindhu) on the Juniper board.  I would not be surprised if Kevin Johnson decides not to seek re-election in the upcoming May board meeting given his recent retirement from the company as CEO.   It will be interesting to see the dynamics between Elliot and Juniper over the next few months leading up to the shareholder meeting.

China: The Elusive Market For US Technology Companies

China ranks as the world’s largest country by population, second in annual GDP and is likely to rank second in terms of total Information Technology (IT) spending in 2013 at about 10% of global IT spending.  It is estimated by industry analysts that China will grow its IT spending by close to 10% per year over the next decade as IT spending only represents about 2% of its GDP which is less than half the level of more developed countries like the US.  While China represents a large and rapidly growing market for US technology companies, the path to success in this market has proven difficult and sometimes impossible due to indigenous suppliers, intellectual property protection and software piracy issues, pricing challenges and other unique market conditions.  China has also grown its own global technology powerhouses in certain industries like communications equipment and personal computers, materially impacting the competitive dynamics for traditional US and European players in not just the China market, but also the entire global technology market.  Finally, China has also developed its own Internet powerhouse companies that have made it difficult for leading US Internet and social media companies to succeed in China.   Is China “friend or foe” for US technology companies, and has history provided technology companies any lessons on sustainable business practices that can be applied to the Chinese market?


Over the past three decades there have been many failures and lackluster successes by US technology companies seeking to enter and profitably grow in the China market.  A high profile example was Google, who decided to exit the China market in 2010 after only about five years of formally entering the market with its own development center in China (and an earlier failed attempt to acquire local competitor Baidu).  Baidu’s market share only increased from the mid 40s to the mid 60s in the five years following Google’s entry, which was significantly higher than the 30%-35% share that Google was able to achieve during that period.   While Google pointed to censorship issues as the main driver to leaving the China market, it was also clearly the case that Baidu did a better job of understating the local market (e.g. Mandarin language searches, music downloads that “crossed” the line on piracy issues etc.) which contributed to Google not being a success in the search engine market in China as it was in other markets around the world. 


Google was not the only US Internet giant that failed to achieve its goals in China, as Yahoo and EBay entered and exited as well.  Both used acquisitions of Chinese-based companies as part of their respective entry strategies, but Yahoo could not effectively compete with Baidu in the search market while eBay lost out to (owned by Alibaba) in the online auction market.  In both cases, both eBay and Yahoo did not do a good job in understanding the local China market nuances for search and on-line auctions. Yahoo at least made a financially smart decision to exit the market and invest in competitor Alibaba, which took over its Internet operations.  It is estimated by some analysts that Yahoo’s investment in Alibaba is worth 50% or much more of Yahoo’s current market capitalization. 


In all the cases above, US Internet companies stopped their efforts in China within about a five-year period.  While the Internet may move a rapid pace of innovation, business success in China, especially in the technology sector, takes a much longer-term commitment.  Google’s former CEO, Eric Schmidt, initially stated that China had 5,000 years of history and Google would have 5,000 years of patience in China.  As it turned out, Google, eBay and Yahoo only had about 5 years of loss-making patience.  Unfortunately for US Internet companies, China continues to grow much faster than the US in on-line sales and is likely to surpass the US within the next couple of years as evident by China “crushing” the on-lines sales record on November 11th, 2013 as part of China’s annual “Single’s Day” national promotion.


The concern over protecting IP and pirating software has been an obstacle for US technology companies seeking to expand their sales business operations in China.  Taking legal action by US technology companies has often backfired.  For example, Cisco Systems’ first-ever corporate lawsuit on IP was against Chinese based Huawei in 2003, which allegedly copied Cisco manuals and software code.  Cisco dropped the lawsuit in 2004 after remedy actions by Huawei, but in my view the lawsuit cost Cisco more in reputational risk than any benefit from the lawsuit.  To this day, China represents less than 5% of Cisco’s total sales in China and the company often highlights China as being “unique” for Cisco when discussing its sub-par performance in the country.  Microsoft has faced software piracy issues around Windows for PCs in China since the company entered the market in 1992.   The issue of piracy in China is still an issue today for Microsoft as evidenced from its recent earnings call where it disclosed for the first time the performance of its Windows business with and without China (i.e. Windows is declining more rapidly in China than the rest of the world).  Microsoft is hoping to reduce piracy of software by selling cloud-based versions of its consumer software, thus, hopefully eliminating over time the availability of pirated software disks sold on the streets.


Cisco’s problems in China have intensified recently as the company’s orders from China fell 18% in its recent October 2013 quarter. Cisco is likely feeling the backlash of Huawei’s years of struggle and ultimate failure in building a US business, which was exacerbated by recent press reports on spying by the US National Security Agency. Other large US technology companies like IBM and HP also reported recent weakness in China and Qualcomm has made public comments that U.S. restrictions on Chinese companies and revelations about surveillance by the NSA are impacting its business in China.  As a result of these and other recent data points, there is now a growing view on Wall Street that US tech firms are seeing slowing sales in China due to the NSA spying claims. It is interesting, however, that Franco-American company Alcatel-Lucent announced the day after Cisco report its poor China results that it had won the largest market share in China Mobile’s network for Enhanced Packet Core (EPC) technology among all vendors (including Chinese based vendors). Alcatel-Lucent sells in China through a joint venture established in 1984. Perhaps Alcatel-Lucent is not feeling the same issues as other large US technology firms because it is technically a French company, but it’s long standing JV and the relationships established by this JV in China also has likely played a role in its ability to so far overcome the political backlash that other large US technology companies have experienced.


While China based Internet companies like Baidu (search engine), Alibaba (e-commerce) and Tencent (social media and gaming), have generally become dominant in their home market, China based IT centric companies Huawei and Lenovo have established global businesses which have led to weakening fundamentals for Western suppliers of communications equipment and personal computers.  Huawei generated sales of $35.4 billion in 2012 and is now comparable in size to Western leaders Ericsson and Cisco.  The dramatic success of Huawei over the past fifteen years contributed to the bankruptcy of Nortel, the failed mergers of Alcatel with Lucent and Nokia with Siemens, and the lackluster stock performance of Ericsson and Cisco.  Lenovo became the world’s largest supplier of personal computers in 2Q13 with both IDC and Gartner estimating their market share at 16.7% surpassing both HP and Dell for the first time.  In 2009, Lenovo ranked fourth in the world in PC shipments with about 7% share.  While HP and Dell continue to suffer from the fundamental shift from PCs to tablets and smartphones, the loss of market share to Lenovo over the past few years intensified this fundamental issue for both companies and was likely a contributing factor to Dell deciding to go private through an LBO to realign the company and pursue a more Enterprise IT and Services strategy.


While US Internet companies and global IT equipment suppliers such as Microsoft, Cisco, HP and others have had either difficulties succeeding in the China market, or face significant competitive pressures from China based IT global competitors such as Huawei and Lenovo, there are examples of US technology companies that have succeeded in selling in China and competing globally against Chinese based competitors over an extended period of time and who so far, have not publicly acknowledged any political pressure on their respective businesses.  Two such companies are Apple and Corning.  Apple currently generates about 15% of total sales from Greater China and its operating margin in China is generally comparable with other regions.  This level of success has been achieved with Apple not yet selling iPhones to China Mobile, the largest mobile operator in the world based on subscribers.  Apple has also been vocal and active on improving working conditions in China among its supply chain companies including conducting annual audits on its suppliers; thus, thus likely helping its reputation in the country.  Corning has been in China for 25 years and competes effectively in catalytic converter substrates, LCD glass display and fiber optic cable.  The Greater China Region represents 26% of Corning total sales and is the company’s largest country by annual sales.  Corning attributes it success in China to having a very long-term perspective, developing relationships with key leaders at the local and national level on important issues such as IP protection, investing in local manufacturing and developing extra checks and balances on potential IP protection issues. 


While there is no magic formula for succeeding in the China market as a technology company, there are some common threads among companies that have shown success in the market.  These include, truly showing (not saying) a long-term commitment to the country, developing key relationships (including JVs) at the local and national level to help support a fair playing field and protection of IP, local manufacturing through long lived assets and R&D, understanding the risks of reputational damage when taking legal or other public action against a local company and enacting unique processes to help ensure IP is maintained.  Having products or a distribution of products that make pirating or copying of your products difficult, is also a big plus.


Note: The above article first appeared in the November 2013 issue of “The Cornerstone Journal of Sustainable Finance & BankingSM


Cisco – What Happened and What Is Next

I recently wrote an article on Seeking Alpha on Cisco, which can be found on this link.  The key points in the article are as follows:

Cisco really surprised Wall Street when it reported last week as its guided to a decline in revenues of 8%-10% year over year. Cisco has never reported such a decline when the US is not in a recession. With US GDP growth improving in the past three quarters, but Cisco’s orders decelerating, the guidance Cisco provided is disturbing.

The weak guidance is likely due to three main points:

1. Cisco is not focused on growing its set top box business, as the company de-emphasizes lower margin solutions/products for the home given the exit of its Consumer business a few years ago and the sale of its Linksys home networking business.

2. Cisco if facing major product transitions in high end switching and routing that are likely to impact year over year sales growth for 2-4 quarters.

3. Cisco is fighting an emerging but significant battle against cloud commoditization as Amazon and other cloud operators deploy lower cost “white box” networking equipment rather than traditional equipment from companies like Cisco.  Of the three issues Cisco is facing, this is the one that investors will focus on the most longer term in determining whether to invest in the stock or not.  Cisco’s recent launch of Insieme/ACI is how the company plans to attack the threat of “white box” networking.

Cisco’s weak guidance and commentary that business slowed at the end of the quarter combined with overall finished goods inventories being slightly up sequentially is likely to lead to Cisco managing down inventories in the next quarter. This may result in lower than expected orders to Cisco’s supply chain.  Suppliers and contract manufacturers that are exposed to Cisco could be impacted by these reduced orders.  Supply chain companies that recently have had high exposure to Cisco include Cavium, EZchip and Finisar, although it is fair to say these stocks have already been hit post Cisco’s results and may be discounting the bad news.