The next IPOs and M&As

THERE ARE a few companies out there I believe should/could debut on stock exchanges in 2014 or the year after. This post is a short analysis of two of them:

Dropbox (online file storage and sharing; mainly targeted for personal use)

Dropbox works by storing users' data with cloud storage and synchronising files, eradicating the need to carry portable storage devices or storing to your computer. There are now over 200 million users of Dropbox who are mostly individuals rather than enterprises, unlike Dropbox's main competitor, Box. Dropbox nevertheless in the past year has been pushing a version of its storage service for enterprise use, charging a considerable fee. In terms of other monetised/premium services,  individual users can buy more space although not many users have opted for this at the moment. Still, Dropbox have enjoyed strong revenue streams (the figure is a Dropbox secret) and also secured $250m of venture capital recently. Their valuation is around $4 billion  (to grow substantially) and I believe an IPO could help raise a huge amount, most likely to be used for expanding via further acquisition of technologies (also not to mention the acquisition of talent in this process) that are compatible with smartphones and also the technology to store music, sound. The storage of map and app data can be a further area to venture into; either to develop organically or through acquisition.  

So from this latter point, I think such opportunity is also Dropbox's number one challenge affecting valuation and stock performance after an IPO: it is really the ability to innovate storage technology so it copes as new devices, apps and platforms are changed and introduced. Another is the changing scene of cloud storage. When I started using Dropbox a few years ago, there weren't really that many 'well-known' competitors around. Now, there are several: Google, Microsoft and Amazon being the three I can think of at the top of my head. With these places giving space away for free, they could very easily snatch away Dropbox's users and eat into their profit margin. However, there is a lot of scope for growth at Dropbox which hasn't even started. Its clean-cut piece of stand alone technology giving users secure storage, a simple interface and fast software earns everyone's trust. Google and Microsoft for example, have been implicated in privacy breaching. 

Box, valued at $1.2 billion is also poised for an IPO in 2014. 

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Twitter  (microblogging/social media tool, for those unfamiliar with Twitter)

There has been a lot of talk and hype about Twitter's IPO especially in recent days. It has been reported in the financial press that initial talks between Twitter with several investment banks have started. J.P.Morgan, Goldman Sachs, Morgan Stanley, BAML, Credit Suisse and others are vying for a lead role in this prestigious IPO. The social media platform also advertised for a 'Form S-1 preparer with other financial reporting duties' for "when we go public" on Linkedin, although it was later taken down. Reasons for Twitter going public are fairly simple. Twitter is valued at $10 million with its shares valued at around $20 on the private market and increasing in an IPO. Twitter's financial performance ($350 million in revenues in 2012; estimated $500 million in revenues this year; estimated $1 billion next year) and strong user and advertising interest makes it a good time to go public. Future prospects for social media companies like Twitter are good. They can capitalise on digital advertising through its huge user base & user data and channel more links with app developers. I believe that part of the financing raised from the IPO will be spent on a further string of acquisitions, given Twitter's recent track of them. Seeing what happened to Facebook's shares after their IPO, it is no surprise that Twitter is cautious about an IPO. Indeed, there will be a lot of comparisons between the IPOs of these two social media giants. There are a few lessons from the Facebook experience that Twitter can learn from, and hopefully avoid: overvaluation, using a dutch auction and not delaying the IPO too long so that there is no inflation of the market value - ergo a bubble waiting to pop. 

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From the M&A side, I think there are currently a few potential M&As which has the synergy to work well together.

I previously talked about Blackberry's case for a joint venture with Tactus Technology to develop a microfludic keyboard for a touchscreen phone/tablet. (See here). Tactus has the technology while Blackberry already has the credentials to bring such a product to market. Such a radical innovation before anyone else on the mainstream market launches it could just be Blackberry's final life saver before it considers going private. 


TMT aside, in the food sector, I believe Krispy Kreme is a good target for acquisition by a supermarket. The doughnut chain/franchise business had been suffering from a volatile bottom line in a recent years for a number of reasons such as accounting irregularities and aggressive but often unprofitable growth in its USA franchises. Revenues have grown but this has attracted more tax, eating away at profit. Yesterday, Krispy Kreme released their financial results, missing their revenue target and causing their share price to drop 13.3%. 

Krispy Kreme doughnuts are stocked in selected Tesco stores in the UK as well as in Target and Walmart in the USA, but I believe Krispy Kreme could fare better in a supermarket for the increased consumer exposure because at the end of the day, Krispy Kreme is a highly desirable, unique and special brand. One way it has done this is through its designs of doughnuts, the packaging and the fact the chain has managed to keep itself relatively exclusive by having few stores compared to other 'occasion' confectionery and bakery retailers such as Thornton's and Millie's Cookies. 

An acquisition by an international supermarket such as Tesco, Safeway or Kroger could give Krispy Kreme far more consumer exposure through Krispy Kreme doughnuts being sold in more supermarket stores. The theme of making junk food 'healthy' is also an important thing Krispy Kreme cannot ignore. It could be useful to use the cash of a parent company (Safeway for example has considerably more cash than Krispy Kreme) for product development and marketing in this area. 

JH

In the next post: I will be discussing the future of 'Moshi Monsters' and 'Bin Wheevils'

Earnings, earnings, earnings

SO EARNINGS reporting season has just gone by and I am sharing some thoughts on the financial results of a few companies I follow, particularly on companies I haven't blogged about already. Ideally I would have liked to blog about this sooner but travelling and holidays got in the way!

TMT Sector 

Yahoo! announced their Q2 2013 results on 16th July. Revenue dropped by 1% to $1.07 billion while profit was $331m, up 46% compared to Q2 2012. This profit growth was mostly attributed to Yahoo's investment in Alibaba. While on the topic of Alibaba, I want to note that how Alibaba's impending IPO will affect Yahoo!'s fortunes is uncertain; Yahoo! has already promised to sell half its shares but of course it is Alibaba who holds the cards in this IPO and not Yahoo!. I imagine there could be some conflict on interest between Yahoo! and Alibaba as Alibaba will be less concerned about the initial offering price but more about strong stock performance after. (Just think of what happened to Facebook's shares soon after their IPO). A favourable situation for Yahoo! could be to sell its stake in Alibaba but share some future share price gains. On the other hand, Yahoo! could prefer an outright exit. Whatever they choose and given its promise to sell half its stake, the investment of Alibaba won't be propping up Yahoo!'s profit so strongly after Alibaba's IPO.

Another cause for concern is Yahoo!'s falling revenue in advertising and for search, decreasing 13% and 9% respectively. Melissa Mayer however is choosing to concentrate on the offering of new mobile applications and services where Yahoo! is basically offering a new product or service every week - notable mobile apps include Yahoo Mail, weather, sports, news and Flickr. Share price under Mayer has risen by 70% (over the past year) and since Mayer took office, admittedly, Yahoo! has undergone a cultural and structural turnaround. Employee turnover has decreased by 59% and 17 acquisitions including Tumblr have been made to not only acquire the technology but also the talent. Despite this, Mayer's strategy to ignore revenue is not particularly unimpressive in this competitive environment. The lackluster revenue reflects the fact that Yahoo! is failing to make the effort to attract online advertisers who are far more appealed to Google and Facebook instead. It is predicted by eMarketer that Yahoo's share of digital ad spending is to decline from 3.37% to 3.1% of total spending while Google and Facebook will bite more into Yahoo's online ads stake. 

There is also indication that Tumblr won't generate big profits this year and there will be no more big acquisitions like Tumblr either. As a result, Yahoo! really needs to capitalise on making money by appealing to digital advertisers to advertise on what seems like their endless array of apps and mobile services as well as on the jewels of Flickr and Tumblr. The challenge (for all internet companies) however is that it is difficult to display ads on the smaller mobile screen for the ever increasing smartphone app users. Further, Yahoo! is not as attractive to advertisers as Facebook since it does not have as large a user base and user data for targeted/location ads. I think another lucrative but more difficult route to go down is mobile gaming which has a huge opportunity to build in buy-able add-ons and advertising. Designing from scratch and building this area organically is costly and tough in an already filled market. Yahoo! could enter into joint venture with a games developer (the likes of Beeline, King and among others) to build-in such games into its online apps, email and IM. 

Whatever Yahoo! decides to do next, it still will be in a turnaround process into the next 2-3 years. If Mayer is successful in reversing Yahoo!'s fortunes, it will be reflected in the company's fundamentals then. 

Facebook delivered their Q2 2013 results on 25th July which surpassed expectations. Profits reached $333 million, as boosted by mobile ads, sending shares to a 25.6% gain  - the highest since May 2012. In fact, Facebook's revenue from smartphones and tablets constituted almost half of their total advertising revenue to the June quarter; this was $655.6m (or 41%) of the total $1.6 billion advertising revenue. It was only 30% last quarter. Facebook's smartphone users has increased by 51% to 819 million, compared to this time last year. 

It seems that Facebook has finally capitalised on its 1.6 billion users (who spent 20 billion minutes on Facebook in June 2012) to generate business since one year ago, the social media giant had no mobile advertising. Unlike Yahoo!, Facebook is making smart moves to capitalise and focus on advertising. For example, in Q4 this year, Facebook will launch mobile video advertising with 15 second video ads. This could be the next billion dollar revenue generator as Facebook's massive user base, user data, smartphone users are highly desirable to advertisers. 

Compared to Google and certainly to Yahoo! among other internet companies, I would say that Facebook is in the lead with digital advertising. At their conference call, Zuckerberg indicated that mobile revenue will continue to grow and set to overtake its desktop counterpart. I think this is a definite accurate statement since I talked about what is happening in Q4. Also, Facebook will be opening the popular photo sharing platform Instagram to advertisements and possibly adding video ads on Instagram given video sharing is a new feature there. It is predicted that Facebook will generate more than $2 billion in mobile advertising revenue in 2013 and its market share of the digital ad market will increase from 4.11% (in 2012) to 5.04% this year. In essence, Facebook's weapon is simple. Facebook's competitive advantage is its user base and user data; highly attractive to advertisers since there is a huge opportunity to create targeted and location based ads. 

Not many people outside of China are familiar with Tencent but many are familiar with social media platform and instant messenger QQ. QQ is actually run and owned by Tencent who also designs and owns a whole host of other social media platforms  such as WeChat and gaming products.  

China's biggest internet company announced their results for the April to June quarter about two weeks ago. Results this time aren't has golden compared to previous quarters, missing targets by around 3.9 billion Yuan and causing shares to drop ~5%. While Tencent have made a profit (3.7 billion Yuan; $605 million) which is up 18.4% compared to this time last year, profit declined by 9.5% compared to the previous quarter. 

This decline in profit is largely attributed to a more competitive gaming environment,  marketing costs for e-commerce and marketing costs for WeChat. On the topic of WeChat, high marketing costs seems to have paid off as WeChat now has 300 million active users, up 176% from a year ago (the more established Whatsapp has 250 million). For example, Tencent used Messi among other celebrities to promote the app to appeal to users outside of China.  However, I do not think Tencent's slowing profit is a long term concern at all.  Their marketing costs has been offset by the huge surge of users internationally, not just within China. Chinese internet companies have had trouble with breaking out of China (see why in this previous post) but WeChat is proving previous experiences wrong. Further, with a huge user base and user data on smartphones, Tencent can set to monetize the app with targeted and location ads or services. In fact, I updated my WeChat app this month and found that the new version combines online games, stickers and payments for add-ons. I don't buy these things but many people do! It is good to see Tencent moving away from desktop products and into mobile, especially attempting to break borders. 

Tencent's main challenge I would say is the cut-throat competition in China's internet scene right now (which is nothing new, of course). Alibaba recently bought an 18% stake in the well-known Sina Weibo and also suspended sellers’ access to WeChat applications this month. The good news is that IM is highly popular in China with 84% of Chinese internet users regularly using IM. By the end of the year, WeChat is projected to have 400 million users globally, with the biggest foreign market being India and in South East Asia. This provides a golden opportunity to invest and push on with gaming and digital advertising services within WeChat. If Tencent could achieve this, it is predicted that 2.2 billion Yuan will be generated from WeChat. 

Consumer Goods Sector (Retail)

Inditex is the owner of the brands as shown above; most well known brands are Zara and Zara Home. Zara in recent years has won appraise from both the fashion side and the investor side for its huge uninterrupted growth due to its "fast-fashion model" where it replicates designs from the catwalk forthe high street in a short lead time of just two weeks. Inditex released their first quarter figures in June which proved that Inditex is actually not invincible. Lower demand due to cold weather in Europe and a volatile currency market -  particularly in the Yen, Bolivar, Real and Rouble -  has made Inditex's Q1 the weakest set of results in four years. It did make a profit nevertheless where Inditex reported a net profit of 438m Euros, a 1.4% increase compared to this time last year but missed analyst predictions by 2m. After all, it was always going to be difficult to beat last year's bumper results. However, Inditex has experienced slowdowns before and this quarter's results (still strong profit margins and a profit) won't make Inditex unfavorable with investors. 

Inditex's net sales grew by 5.2% to 3.6 billion Euros, mostly attributed to the opening of new stores. In the coming years, the group plans to open 80-100 new stores each year globally but not in Spain due to the difficulties there... Some of the Inditex brands deserve more exposure to our shopping streets, particularly Pull and Bear and Bershka. Their chic fashion pieces and low prices can draw in sales. 

JH

What's the 'deal' with Chinese internet companies?

THE AMOUNT of M&A activity and the increasing value of deals - fuelled by the money making potential in mobile platforms - in the Chinese internet scene makes the sector a very exciting place at the moment. Analysys International, an internet research firm recently reported that the value of China's mobile internet market will rise to 300 billion Yuan (£30 billion) in 2014. It was only worth 150 billion Yuan in 2012. China's internet users stands at 591 million in June 2013, an increase of 41% compared to three years ago.

M&A wise, I believe there will be continued activity here and especially in the mobile internet sector since mobile internet and applications fields are not fully developed in China. There is much scope for growth, organically or by M&A.

I have chosen a few momentous (planned) deals to blog about.

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In the past day, Qihoo, the second most popular search engine by traffic in China (after the almighty Baidu) has announced it is in early talks with Sohu to buy its search engine Sogou (meaning literally 'search dog'). I believe that the acquisition of Sogou, the third most popular search engine by traffic is a well thought out strategic decision for catching up with Baidu who is and still will be (if the acquisition goes ahead), miles ahead in terms of traffic and revenue. Internet research firms CNZZ and Alexa show that Baidu command roughly 69% of search traffic while Qihoo and Sogou only have 15% and 9% respectively. However, Qihoo has still been a serious competitor to Baidu. Their simple interface is more attractive to inexperienced users and at the same time, delivers a better smartphone/tablet experience. Further, Qihoo have an advantage over Baidu in that it is also a software company. This has enabled Qihoo to incorporate search engine bars into their software to boost traffic. 

Market share is important in the internet sector and the fastest way for Qihoo to increase market share is through M&A. With the Sogou buy, Qihoo will reach more than 20% of market share for search engines and can scale it up. This acquisition will also give the company access to the search technologies of music/MP3, videos, maps, shopping, photos, Sogou's online radio station among other features which are popular among younger internet users (who form the bulk of internet users), directly challenging Baidu's products. Further, Qihoo will reap the technology of Sogou's smart input search method which currently has 195 million users. In general, both brands have similar business models and I think there are strong synergies between Sogou and Qihoo search. Not only will they be a dominant challenger to Baidu from a second position, but they will also be dominant in the browser, internet security, software and Chinese language input markets.

Given that it is early days in talks, numbers are unclear. Sogou is valued between $1.2-$1.4 billion. As Qihoo reported $301 million of cash and cash equivalent at year end in March, any offering is more likely to be equity heavy. And since Sogou is in talks with other parties, Qihoo could potentially lose to bidders who can offer more cash, namely Baidu. However, any acquisition by Baidu could be blocked on antittrust grounds. 

The valuation of Sogou is questionable since it was only worth $237 million one year ago. A valuation of over $1 billion only makes sense if Sogou has dramatically optimised and innovated new products in its search and other software in the past year which admittedly it it has done some of...see here and here. Still, a more prudent estimate should be around $800 million maximum.

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The IPO of Alibaba in possibly this year or early next, will be one of the biggest IPOs globally. Alibaba is currently valued at up to $120 billion and could raise $15-$20 billion in this IPO. Alibaba is the biggest e-commerce firm in China and its platforms are the equivalent of eBay, Amazon, Groupon and PayPal. 

I think this IPO is likely to happen sooner than later. Alibaba achieved a profit margin of 48.4% in Q1 2013  - double than that of Apple's in the same period - boosted by the demand for e-commerce services to link businesses and consumers in China. If Alibaba can demonstrate such strong earnings growth again in Q2 2013, an IPO could be ready by the end of 2013. Other financials are also very attractive. Compared to its US counterpart, Amazon, who is the world's largest online retailer, Amazon only achieved a profit margin of 0.51% in the March quarter while it was 18.1% for eBay. Alibaba's net income in Q1 2013 was $669 million compared to only $220 million in Q1 2012. Further, Alibaba constituted 70% of parcel deliveries in China last year and sales alone on its two main platforms reached 1 trillion Yuan in 2012.  

Alibaba is also an attractive company to hold on any investor's portfolio due to the large growth market it operates in. Alibaba is still in its early days also, who has a more vertical growth curve rather than a flatter one. 

Other details of the IPO remain sketchy. But Credit Suisse is expected to take a leading role given its history of working with Alibaba on past transactions. Goldman Sachs and Morgan Stanley are also expected to play a leading role in this prestigious and highly lucrative deal. 

I believe that one problem Alibaba has however, and which could be reflected in valuations, is that Alibaba does not have a strong position in China's social media/mobile market. It is has been unable to monetise on mobile users thus far unlike other Chinese internet giants of Tencent and Baidu among others who all operate rather strong e-commerce platforms or capabilities. The other challenge is choosing which stock market to float on. With many foreign backers, Alibaba may have to float outside of Hong Kong. 

Overall, internet companies are inherently volatile, as are their valuations. I believe any valuation up to $100-120 billion of Alibaba is fair. High performers in this sector are attractive to fierce competitors and creative destruction (in the Schumperterian spirit) is not uncommon, whereby new technologies uproot even the most established ones. It therefore makes sense for Alibaba to take imminent action for an IPO. 

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A few days ago, Baidu, China's Google, has announced it will acquire 91 wireless from NetDragon Websoft for $1.9 billion to further penetrate the mobile applications market. 91 wireless is a platform that distributes Android applications and connects over 90,000 application developers. Baidu is behind the other giant internet companies, namely Tencent and Sina, in terms of targeting mobile internet. So strategically, this acquisition is the correct one for Baidu. Baidu, as a search engine, is really for desktops but since consumers are devoting more time to mobiles/tablets, Baidu cannot continue to rely on online search for revenues. Baidu really needs this acquisition as location based and real-time applications (for maps, business nearby, SatNav for traffic data) are growing popular and consumers no longer need search to find what they're looking for. Using Baidu on smartphones is not particularity user friendly either.  

This acquisition will allow Baidu to generate more traffic from mobile users. Tencent's WeChat has 400 million mobile users and Alibaba is also starting to make headway in mobile applications by investing in Sina Weibo, AutoNavi among others. It is safe to say that Baidu is falling behind in traffic from smartphones. Unlike Google, it also has few applications for smartphones but this acquisition can help Baidu to boost usage experience in mobile apps and help the company to build a mobile ecosystem faster than developing organically. As well as catching up with Alibaba among others, the 91 Wireless acquisition can also shrug off competition from Qihoo who is the market leader in mobile application distribution. 

Although Tencent is a big player in developing, operating and marketing mobile gaming applications, I believe that Baidu and also Alibaba could look into targeting gaming apps in the near future as these are hugely popular with younger Chinese users, who are willing to pay for add-ons within games. 

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All this got me thinking why Chinese internet companies are hugely successful in China but nowhere else. And why, the likes of Google, Yahoo!, eBay or Amazon are hugely successful everywhere else but not in China. So, what is the deal with these Chinese internet companies? There are several answers to my question:

• A large internet/mobile internet market (due to China's population) has been an underlying factor to all Chinese internet companies' success. 

• The rise, growth and later dominance of the main Chinese companies we know today can be attributed to first mover advantage. The companies were founded in circa 1999, a period of mass internet adoption within China. This not only provided the opportunity to enter the internet content market but internet companies also capitalised by emerging as the first movers. Later entrants fail to be as successful since the first movers capture the benefits of dynamic increasing returns, which cause rise and growth. This is true for Baidu for example, as later entrants, whether indigenous firms or foreign firms who enter the search engine market hold significantly less market share.

• Joseph Schumpeter argued that innovation drives economic growth and an organisation forward. Innovation allowed Chinese internet companies to emerge and achieve first mover status but importantly, innovation facilitated their development of new combinations, leading to rise and growth. Baidu contributed little to the general search engine technology having modelled/imitated itself after Google, but the company innovated China’s first Chinese language search engine. Similarly, Tencent QQ is imitated after Mirabilis’ ICQ but Tencent innovated the first Chinese language instant messenger and also technology to send offline messages and store chat history, rapidly increasing QQ’s popularity. Sina’s main innovation lies in being the first to provide comprehensive news and entertainment and lifestyle portals, allowing Sina to diminish its direct competitor Sohu’s market share. Innovating Chinese language platforms in particular, immediately improves ease of use for Chinese users, leading to customer loyalty, brand recognition, other dynamic increasing returns and in turn, rise and growth. Weak IP laws within China have allowed internet firms to do so without much consequence and then reap the benefits of imitating an already successful model.  Just compare: 

Or:

Spot the similarity: Facebook v RenRen; Baidu v Google v Qihoo

• Chinese internet companies' success within China can also be attributed to possessing an excellent understanding of the Chinese market. Chinese search engines' MP3 downloads and games searches are of interest to young Chinese users and Tencent’s QQ and games allow users to purchase items for customising virtual characters, meeting their entertainment needs. Sina provides region-focussed news, relevant adverts and infotainment channels such as automobile information and luxury goods which appeal to China’s ever-growing middle class. The companies also brand themselves strongly as indigenous Chinese firms, further appealing to users.

• Cooperation with the Chinese government’s censorship regulations enabled the companies to emerge and rise. Cooperation is key; Google’s refusal to censor instigated its exits from China in 2010 and several Google services became blocked, allowing Baidu’s market share to increase from 60% to 75.9%. Following Wikipedia’s block in 2005, Baidu also capitalised by developing a Chinese version of Wikipedia, Baiduknows. Sina used the opportunity to launch Weibo in 2009, after the closure of micro-blog Fanfou due to censorship disputes. Thus, censorship regulations and blocks on the main foreign internet companies from Facebook to Youtube to Google reduces competition, grants indigenous companies who comply opportunities to replicate such foreign websites and space to thrive in the Chinese market. 

• Chinese internet companies have been and will be unable to compete globally, I believe. Chinese internet companies cater only to the Chinese market and their niche models cannot succeed abroad. . Mastering an understanding of international markets can also be difficult if management have little experience of the target country. Further, competing abroad is unlikely as well-established or indigenous firms may already operate in the market; Google, Yahoo!, eBay and Amazon serve many regions outside of China. For example, Baidu, who entered the Japanese market in 2008 holds only 0.2% of the market share; the market is divided between first-movers Google and Yahoo!. Moreover, as Chinese internet companies generally will offer no markedly new products, entering foreign markets will generate little success. Similarly for these same reasons, foreign internet brands cannot be successful in China so easily. However, Baidu and Tencent currently operate small-scale foreign ventures - includes multi-language products and establishing partnerships with foreign counterparts - in emerging markets such as Brazil, India and Vietnam. Expanding into developing markets offers Chinese firms an increased chance of success as they benefit from first mover advantage and will experience little competition . Such companies will continue to expand into emerging markets, as their management have expressed a desire to invest in, or acquire foreign firms. For example, Tencent have invested substantially in FAB and KakaoTalk and Qihoo 360 have partnered with Line. 

JH