Oculus, Are we there yet?

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Are we there yet with virtual reality? HTC and Sony plan deliveries of headsets this year. At the F8, Facebook demoed the VR selfie stick. But Oculus is still to deliver its promised products to all the Kickstarters and in fact is having trouble getting them to customers. Two years year ago, Palmer Luckey and company kick started virtual reality, but will Oculus get there?

To find out if Oculus’ mission is complete, just ask Facebook. Facebook would be the best to know. For example, in the filing released on January 16, 2016, Facebook anticipated product problems; what Facebook called “inventory risk”.

Facebook said “ In addition, when we begin selling or manufacturing a new Oculus product, it may be difficult to establish vendor relationships, determine appropriate product or component selection, and accurately forecast demand.”

Oculus has long way to go; at least based on the financial reports. Facebook purchased Oculus for $2 billion for a company which had not yet to deliver a product. Due to the uncertainty, the deal included an earn-out, which meant that Palmer Luckey and others would get more cash and stock if certain conditions were met; but that has not yet happened.

And early employees of Oculus aren’t leaving just yet or they’ll lose a lot. When the deal closed, Oculus employees received Facebook stock worth $284 million, but the stock vests over a period of four years. Employees must stay until mid 2018 to receive all they are due.

Facebook bought Oculus, among other reasons, to “expand the FB platform”; that explains the reason for VR selfie stick demo at the F8 conference. In the future, Mark Zuckerberg hopes we will all met and “like” each other in virtual reality, the metaverse. And in that space, Facebook wants to sell ads and other stuff.

It is for those reasons that Facebook willingly paid so much for Oculus. By combining Oculus with the FB platform, Zuckerberg expects to get back the more than $2 billion he paid.  In fact Facebook paid a premium of $1.5 billion for Oculus, whose assets were only $320 million when the deal closed in July 2014.

If there perceived synergies do not materialize, then Facebook would need to write-off some of the Oculus acquisition. Normally, tech companies write down acquisitions that do not turn out as expected, such as Yahoo’s recent $230 write off Tumblr. Facebook has not writedown its Oculus acquisition, according to its securities filings. So the mission to use Oculus to expand and further monetize the FB platform is not complete either.

As part of the earnout, Palmer Luckey and others could receive additional cash and stock, valued at $191 million back in 2014. As part of the earn-out, Oculus was entitled to receive $60 million and 3 million shares of Facebook Class B stock after meeting certain milestones. Please note milestone is plural, so the more than one goal needs to be accomplished.

Milestone can be “event” or “market” based. A market milestone could be financial such as hitting a certain sales level.  An “event” milestone could be regulatory approval for drug developed by biotech startup. For Oculus, it could be the delivery of a product. The Oculus milestones are not known. Facebook has not disclosed them, possibility for business reasons.

Facebook did report that the “….milestones have not been met as of December 31, 2015” in its most recent Form 10-K filed in January 2016. In fact, the earn-out amount is now worth $280 million and has been paid. So it appears, Oculus is not there yet.

 

Alphabet, Apple, Salt, and Pepper

 

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Financial ratio just compare different things; an example would be comparing salt and pepper or Kanye and Kim. Entrepreneurs and venture capitalists can use them (ratios) to manage their business. A SaaS business may need to consider its sales efficiency which compares marketing expenses and incremental revenue. The venture capitalist may need to know internal rates of return.

Don’t look there. Look here.  If you read online about financial ratios, you may find textbook explanations. But like sleight of hand, you to need to look another way not to be fooled. Financial ratios just compare two things. For example, a common measure of company profitability is return on equity (ROE). It can be expressed as net income divided by shareholder’s equity.

Another way to think of return on equity, is as a rate of return. For example, an interest rate can be expressed as a rate of return. Assume you deposit $100 into the bank. One year later, you get back $10. If you compare the $10 to the $100, the ratio is 10%. Said another way: you earned a 10% percent interest rate or your rate of return was 10%.

Return on Equity. ROE can also measure how much you will earn if you put your money into a business rather than the bank. ROE compares net income and total shareholder equity.  How do we get shareholder’s equity? An investor gives money to company in exchange for stock. The cash received by the company represents the shareholders equity.

When you buy stock, it’s as if you deposit money into the company.  Now management takes your cash and tries to make more. Stock is more than just a piece of paper; instead it is fractional ownership interest in the company. In theory as an investor, you own a piece of the net income. The net income can be paid to you as a dividend or kept by the company to make money.

Comparing Apple and Alphabet.  For the year ended December 31, 2015, Apple’s return on equity was approximately 43% and Alphabet’s was 15%. So if you give $100 to Tim Cook, he will earn $40, while Larry Page will only return $15 to you. Does this mean Apple is better investment than Google? This post is not meant for investment purposes, but explain to financial ratios.

An investor have many places to put their cash: gold, apartments, land, or under the mattress. Earning the most is the prize. So would rather put you money in a company with ROE of 20% or in the bank with an interest rate of less than zero. The choice is yours, but thinking in terms of rate of returns can be helpful.

SaaSy. Think about sales efficiency in terms of comparing two different things. Here you are comparing marketing and incremental revenue.  If you put $500,000 into marketing and sales and the incremental revenue is $1 million, then sales efficiency is a multiple of two.

For every time you put $1 dollar into marketing you earn $2 dollars of revenue. Is that good or bad? Well like the ROE example, you need to compare it to something else like the sales efficiency of industry. Then you can decide how well you are spending your marketing dollars.

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No So Square Capital

 

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At the LendIt USA 2016 conference on April 12th, Jacqueline Reses was asked how Square Capital manages risk as it scales. After a long answer, she could have just said Square doesn’t manage credit risk, at least for itself. Square started out as credit card processor, but has aspirations to be a bank, offering money to its merchant customers.

Frankenstein. Fin-tech is like Frankenstein, in this case, a combination of finance and technology. The fin-tech business which relies not only on human capital (programmers) but also financial capital (cash). In order to lend money in new ways, the money needs to come from somewhere. In the old days, the money came from depositors. Now it comes from others sources such as investors. For example, Max Levchin’s new startup, Affirm just raised more money to order to make its loans.

Starting in 2014, Square offer a “type of loan” called the merchant cash advance. Merchants could receive money now against future credit card receivables. Rather than own the receivables, Square sold portions of the receivables to Victory Park Capital. So Square stood in the middle between its customer and Victory Park Capital.

A Vampire? Square collects an upfront fee and a fee for servicing the receivables. Square collects payments from the merchant and then sends the payments to Victory Park Capital. By selling a portion of the receivables, Square does not bear any risk of loss, Victory Park Capital does. For the receivables it does keep, Square can have losses from noncollectable amounts. For last year, total merchant cash advances owed to Square were approximately $42 million; of this amount, Square estimated that 14% or $6 million would not be collectible.

In March 2016, Square announced a shift away from merchant cash advances (MCA) to offering loan to its merchants. The cash for the loans will come from Celtic Bank. By offering loans, Square Capital can grow faster, but it might bring higher regulatory costs as predicted in Square’s S-1 from 2015:

As our business continues to develop and expand, additional rules and regulations may become relevant. For example, if our Square Capital program shifts from an MCA model to a loan model, state and federal rules concerning lending could become applicable.

Square does not intend to make loans themselves; instead the money will come from outside investors. Celtic Banks is facilitating the loans, but the loans will be sold to third parties as was done with the merchant cash advances. By selling the loans, Square manages its own credit risk if the the loans go bad. Square says this “allows us to mitigate our balance sheet risk.”

According to Ms. Reses, Square will keep some of the loans to show investors that Square has “put skin in the game”. But Square depends on third party funding to expand Square Capital. In its recent form 10-K, Square said it had enough capital to meet its needs for merchant cash advances and assumed new loan products at least for the next year. Otherwise it would need use its existing capital or raise additional capital, which may not be on the most agreeable terms.

The Real Horror Show. So in many ways, fin-tech is not really that new. In the old days, banks did not keep their loans, but sold them to others. This was certainly the case with home mortgage as loans were package and sold as new securities to investors. Anyone who has seen The Big Short can understand the dangers when the distance between the borrower and lender becomes too great.

Now with technology, fin-tech companies, like Square can know more about their customers and their credit risk. But in terms of credit risk, the person who bears the risk of loss hasn’t change. It is ultimately the person lends the money and this case, it may not be Square Capital.

So Square Capital is not so square. In fact, Square acts like the old fashioned banks, another person in the middle taking their cut.

 

Deja Yahoo

Yahoo is going through yet another sale. April 18, 2016 was the last date for bids from private equity firms, Google, Verizon, and others. In current bidding process, it was reported that Yahoo was in dire straits with decrease revenue and cash flows. Back in the 2011, Yahoo considered something similar: selling itself primarily to private equity firms. So with Yahoo, haven’t we seen all of this before?

In 2011, there was another Wall Street financier pressuring Yahoo: Dan Loeb of Third Point Capital. He wanted to increase Yahoo share price and demanded change at Yahoo. In one letter to the Board, Loeb was critical of Jerry Yang’s failed attempt to sale Yahoo to Microsoft. Dan Loeb eventually left in 2013 after being paid off by Yahoo.

Now the outside investor is Jeffrey Smith of Starboard Value. He also sent many letters to the Board discussing the mismanagement at Yahoo. In September 2014 Mr. Smith wrote that Yahoo had been acquiring…”businesses at massive valuations with seemingly little to no regard for profitability and return on capital”.

Jeffrey Smith is concern, among other things, how Yahoo is using its cash.  For example, since taking over Yahoo, Ms. Mayers has done many acqui-hires: purchasing startups solely for talent, rather than technology. Per CB Insights, Yahoo did thirty seven acqui-hires from 2012 to early 2014. One of famous, must have been the $30 million paid in 2013 for Summly, founded by the then teenager, Nick D’Aloisio.

Google employee and now author, Laszlo Bock, calls the practice of acqui-hiring, “expensive”. After paying many multiples for these startups, Yahoo shut down the startups and talent left. For example, after acquiring Summly, only two employee were kept including the founder, who eventually left in 2015.

Yahoo repeat the practice of overpaying in futile attempts to boost revenues. After failing to push up the its core business, Marissa Mayer purchased Tumblr, Polyvore, Flurry, and Brightroll. One of the most notable acquisition was Tumblr which was purchased for approximately $1 billion in 2013.  Yahoo announced in 2016 that it was writing off $230 million of the Tumblr purchase due less than expected traffic to the site.

What was not announce and did not make make the news: Yahoo also write down the value of Flurry, Brightroll, and Polyvore. Yahoo reported the information in its most recent 10-K, but the amounts were not disclosed.  Flurry and Brightroll were Yahoo’s attempt at programmatic advertising. Yahoo paid over $800 million for both companies together. And the purchase of Polyvore, to expand into e-commerce, was purchased for $161 million.

Marissa Mayer brought the tricks of acquisitions and acqui-hires to Yahoo from Google. At Google, she also pursued the purchase of Zagat for $151 million in 2010. But Zagat was not fully integrated into Google and talent eventually left. Ms. Mayer also left Google after being passed over in favor of Jeff Huber. With the pending sale, new management of Yahoo may not want her there either.

So besides you, is Marissa Mayer having deja vu, too?

Spilling the Beans on the Yale Endowment

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The Yale Endowment had spectacular year in venture capital; in fact many decades worth of happy returns. The 2015 annual report is dedicated to…

“Yale’s successful entrepreneurs, technologists, and investors, who strive to transform markets, develop new products and processes, and change the world”.

But why dedicated a whole report to a subset of an asset class (private equity) to trumpet the Yale Endowment’s grand returns?

Get Lucky.  Since taking over Yale endowment in the early 1980s, David Swensen shifted the endowment away from traditional stocks and bonds towards illiquid securities found in private markets.  Higher returns can be found in private markets since the market is not efficiency: there is a lack of information. This in part lead to the spectacular returns.

Another contributing to Yale’s success is timing or just luck. David Swensen’s change in portfolio allocation paralleled the boom in tech beginning in early 1980s. And given the endowment’s long-term perspective, the fund benefit from internet bubble of the 1990s.

Social Network. Yale’s alumni network also contributed the endowment stellar performance. Of the many Yale alums profiled in annual report, two are pioneers: Leonard Baker and William Draper III.

Mr. Draper besides founding Sutter Hill Partners in 1964 is responsible for Tim Draper of DJF. Tim Draper is also responsible for Valley Girl, Jessie Draper. Leonard Baker became a Sutter partner in 1973. Besides sitting on many boards, Mr. Baker belongs to GIC, Singapore’s Sovereign Wealth Fund.

It’s alumni connections which bring investment ideas and opportunities to Yale.  Yale’s investment office also produces which goes onto to work in venture capital. Profiled in the annual report was Nick Shalek who graduated from Yale in 2005 and when to establish Ribbit Capital. In addition, the current head of Stanford’s endowment, Robert F. Wallace, also work at Yale’s investment office and graduated from Yale.

Spilling the Beans. After two decades, why now is Yale reporting its success in venture capital? The secrets of Yale’s success are well known after the publication of David Swensen’s Pioneering Portfolio Management.

Given the outcry over high college tuition and tax-exempt status of university endowments, the Yale 2015 annual report is more marketing than investing. Yale wants to appear to be doing good, rather than just making lots and lots of tax-free money.

 

The Garage Sales of Silicon Valley

Alphabet joins this month’s garage sales in Silicon Valley. In late March 2016, Bloomberg broke the news that Boston Dynamics was up for sale. The sale comes after Google purchased the robotics company in 2013. Alphabet’s fire sale is matched by Yahoo’s perennial sale of its core business.

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It not faulty technology causing the “for sale” sign at the Googleplex. The reason is finance, New York City style. No one knows when Wall Street invaded Silicon Valley; but for Alphabet, it happened last year with the hiring of new CFO, Ruth Porat. Ms. Port came from Morgan Stanley to provide financial discipline to the newly created Alphabet.

Google became Alphabet to resemble Warren Buffet’s holding company, Berkshire Hathaway. As Berkshire’s head, Buffet’s main job is allocating capital among the many businesses owned by Berkshire. In the same way, Ruth Porat’s job is allocating Google search cash among Alphabet’s other bets.

So Boston Dynamics‘ sale shouldn’t be a surprise. Alphabet’s first 10-K announced the changes in January 2016: now Alphabet’s businesses would be managed according to “resource allocation” and “performance assessment”. Boston Dynamics did mostly research and was far, far away from selling a robot.

So with a dim commercial future, Alphabet must have decided to allocate its capital elsewhere and sell Boston Dynamics.