China VIE trouble for BABA?

That didn’t take long.

Over the past few months I have been writing (also here and here) about Alibaba (Ticker: BABA). I mentioned one of the key risks with buying BABA stock is that when you do you are not really buying a share in Alibaba the company. Instead, you are buying a share in a Cayman Islands-registered Variable Interest Entity (VIE) which is tied to Alibaba through a ream of contracts. But there has always been the risk that this relationship is vulnerable.

One of those risks has now perked up. Last week the Chinese government issued draft legislation overhauling the law covering VIEs. For a good break down on this, check out the China Law Blog (CLB) which has a great overview of the changes and a list of other experts writing on the subject. (Side note: If you are currently or are about to do business in China, save yourself a fortune in legal fees and future headaches and go read the entire China Law Blog now.)

I will leave the details of the changes to those posts, but put simply the announcement last week calls into question the whole basis for the relationship between VIEs and the actual underlying companies to which they are tied. Now some people will say this is just another example of bad faith in Chinese business law, which many see as being increasingly tilted against foreigners. I disagree that sentiment. In particular, the problem is that everyone working around VIEs has always known they were a grey area, at best. It says so in BABA’s S-1 Risk Factors.

The whole VIE structure grew up as something of a hack. Foreigners are not allowed to have equity in Chinese media companies (as well as several other ‘strategic’ industries). Going back to the 1990’s ‘.com’ era, as Chinese Internet companies went public, some clever lawyers (or bankers) stumbled on this VIE structure as a way to separate ‘ownership’ of the companies from ‘economic participation’ in those companies. From a philosophical perspective it is unclear if that is even possible. But from a technical legal standpoint, it has always been a bit shaky. So now the government of China is going to clarify the law. Seemed like this latest news was inevitable, and I have to wonder if the high profile of the BABA IPO did not play a role in catalyzing the matter.

So what happens now? The answer is unclear. It seems possible that BABA and some of the other China Internet names may get some sort of one-time exception, or be ‘grandfather-ed in’. However, as CLB points out, that penalizes any private BABA competitor. Alibaba has raised a lot of money from foreign investors, and can use that to build its business (not least through strengthening its loan book), but anyone coming after them will be prevented from doing so. Leaving them at a permanent disadvantage. At the other extreme, there is a non-zero possibility that Alibaba’s VIE structure is ruled entirely invalid, leaving investors in the lurch. This would be some pretty bad publicity for the Chinese marketplace, but that may not matter to the lawmakers. If I had to guess (and that’s all I can do), I imagine we will end up with some highly pragmatic compromise that further erodes the control that the BABA VIE has over Alibaba the company, but nothing disastrous.

The odd thing is that there has been no affect on BABA’s share price. The stock is down about 5% over the last five days, exactly in line with the broader market. I have not read all the research out there, but as far as I can tell, no one seems terribly worried about this change, or even mildly interested.

From all of this, I imagine that most investors had some earlier warning that a legal change may take place. This may have come up in the IPO roadshow. Or investors may just assume that Alibaba can find some way to a reasonable settlement with the new law. In fact, if they do get an exception, penalizing all the smaller competitors may help the company. Nonetheless, a part of me suspects that many investors outside China are just treating this as a non-event because it falls in the bucket of China Politics, and thus unknowable.

For me, this latest news is just one more example of the uncertainty underlying BABA that keeps me from buying the stock. After my earlier posts, I had a few investors mention to me that they felt the same way (although they put it a little more cynically). The logical interpretation of this is that BABA should trade at a discount to its peers, but little about current Internet stock multiples are ‘logical’.

As much as I like Alibaba’s underlying business, I am staying on the sidelines for now.

Don’t Talk to VCs – A Reply to Paul Graham

Last week Paul Graham posted a note titled “Don’t Talk to Corp Dev”. I have nothing against Paul Graham. It is hard to argue with his track record, and most everything I have heard about how he treats startups is positive. But I do have a problem with sweeping generalizations sitting beneath alarmist headlines.

His post starts off reasonably enough. Young start-ups should not get distracted when corporate development teams from large companies come calling. Fair enough, big companies move at their own pace, and start-up management teams can lose a lot of time dealing with that.

He then goes on to talk about how these conversations can be demoralizing causing management teams to lose faith and give up too soon. That seemed exaggerated. If you are going to start a company, you will face many doubters and haters. If you have gotten to this point, chances are you know how to deal with ‘demoralizing’ outsiders.

Up to this point, I am willing to give Graham the benefit of the doubt. He is talking to a specific audience of start-ups he is close to. And maybe he had a recent, bad experience with someone, and wanted to use that as a teaching moment.

But then he goes off the rails.

Their tactics in pushing you down that slope are usually fairly brutal. Corp dev people’s whole job is to buy companies, and they don’t even get to choose which. The only way their performance is measured is by how cheaply they can buy you, and the more ambitious ones will stop at nothing to achieve that. For example, they’ll almost always start with a lowball offer, just to see if you’ll take it. Even if you don’t, a low initial offer will demoralize you and make you easier to manipulate.

He continues:

I remember once complaining to a friend at Google about some nasty trick their corp dev people had pulled on a YC startup. “What happened to Don’t be Evil?” I asked. “I don’t think corp dev got the memo,” he replied.

Yes, there are ruthless corp dev people out there. But there are ruthless people in every field and every role. And I am not being naive about Corp Dev. I have seen many of the tricks Graham deplores, and seen them recently. Corp Dev professionals can be sharp negotiators, but they have no monopoly on ruthless streaks.

Up to a point I wanted to argue that management teams have many reasons for wanting to talk to Corp Dev. A basic conversation can be a good way to learn about the industry or about competitors. When I was in Corp Dev, I was much less interested in buying companies than in finding strategic partnerships. Even if the Corp Dev people only want to talk about acquiring you, its worth having the conversation. Most start-ups that do not fail end up being acquired. There is nothing wrong with that. And many times, the only way to achieve a small company’s full vision is to do so as part of a larger company. Talking to Corp Dev people can help you understand that avenue better.

But when I got to those paragraphs quoted above, I realized there is a darker interpretation of “Don’t Talk to Corp Dev”. Let’s not pretend that venture capitalists, as a group, are any holier than Corp Dev people. All the ‘tricks’ that Graham mentions in his post have been perpetrated on start-ups by VCs. I am not accusing Graham of that, again, everything I hear about him is quite positive. But he is laying out a blanket accusation in his post. So I think it is fair to turn the spotlight around. Is anyone going to argue that VCs do not have  their own basket of psychological tricks to play on management teams?

VCs like big exits, and Corp Dev M&A processes dampen those exits. No one likes competition.

If you are running a start-up, listen to everyone, but keep your own counsel. You know your business and prospects best. And never let anyone tell you who to talk to.

Semiconductor Consolidation is Coming

As a recent participant in semiconductor consolidation, I think I can safely say that there is going to be a lot more. There are too many chip companies out there chasing too little growth.

The industry still views itself as a growth industry, but really it is big and cyclical, and resembles the steel industry as much as anything else. The growth days are behind most companies, the future is going to be managing cycles and costs. Albeit with the very real risk of facing oblivion if they miss a product cycle. This is going to require a big change in thinking for many management teams.

In many categories, this consolidation has already taken place. There are only four memory companies left. PC CPUs have been what could generously be called a duopoly for over a decade. Mobile basebands – there are really only three vendors left. I think we could still see a lot of growth in semiconductor content in cars. And there is that whole Internet of Things (IoT) . But in autos, there is not likely going to be much disruption to market share for most pieces of semis, the big guys will get much of the share. And as I noted last week, IoT is not guaranteed to bring the riches that many in the industry hope for. Beyond that, what is there? ARM servers? Maybe, but that will also likely bring about a massive deflation in pricing. If it ever happens. Custom silicon for networking? Facebook, Amazon and Google all seem to be designing their own chips, but it is hard to see how big a market that will ultimately be beyond a few web giants, and works against most of the established chip houses.

Now to be clear, I am not forecasting a doom and gloom scenario. Chip companies will still grow, just at a much slower pace than over the past 20 years.

When industries make this kind of transition, strategies change. The power center moves from R&D and sales, to the finance team. Winning market share is less about having the great new technology and more about scale. This leads to M&A as the only way to gain share and bulk up. This is especially true in semiconductors. There are very real cost advantages available to the companies who put in the bigger orders. While few companies have their own fabs or manufacturing lines, the foundry partners tend to give the best service and best pricing to the larger customers. And for those companies that still own their fabs, volume is life.

This leads to the question of who gets consolidated next. Most investors would agree that there are still far too many analog chip companies out there, something like 150 depending on how you count them. These are companies that make decidedly unglamorous products – interfaces, microcontollers, timers, the list goes on. This is big business, but competition is less about technology and more about pricing and distribution.

Despite pullbacks this year, many semiconductor stocks are trading at healthy prices and multiples. My sense is that these will not last, so the time to strike is coming soon, while capital is still ‘cheap’.

I am not going to name specific names here, maybe some other day. However, a few things to look out for. First, companies that know how to integrate acquisitions should do well. Much of the value in a chip company is the talent of its engineering team, and other intangibles. Very few mid-size chip companies have this integration expertise, as very few have done many deals. But having a integration plan in place before the deal closes matters. Let employees of the new company know where they stand right away, even better leave them mostly alone. Most important – communicate clearly as early as possible.

Second, operations will matter tremendously. By operations, I am really referring to general management skills. Well-run companies will prosper. It will not be enough to simply throw engineering resources at a few key customers. The companies that can best balance having the right portfolio of products against a reasonably sized engineering team should do well. Capital allocation will matter.

Offsetting this, companies are going to need to make some big bets, soon. There a half dozen mega cap chip companies out there, but below that there are dozens of companies that risk being swallowed up. Once upon a time, having an $8 billion market cap for a semis company made you untouchable, even a $25 billion market cap. But today even those companies are potential targets. Management teams who want to remain in business ten years from now will have to bulk up quickly. Smartly, but quickly.

None of this is lost on the industry, and my guess is that many potential targets have high expectations for takeover values, which means potential acquirers will need to pay up. Of course, this creates a dilemma. The best acquirers will be the most capital-disciplined companies, but they may not be willing to pay top dollar in an auction.

I am not clear how this will play out. I know a few companies whose stock I would like to buy, because they are good at what they do. But in the back of my head, I am worried that they will have to start paying dilutive prices for good acquisitions to survive.

Good times to be an M&A banker, tougher times for stock pickers.

CES without the Selfie Sticks: The Affiliate Summit

Sitting in McCarran Airport, listening to the slot machines jingle, I feel an odd sense of deja vu. Somehow, I am back in Vegas less than two weeks after CES. I attended the Affiliate Summit West today, as part of my effort to better understand digital economies. It is a much smaller show than CES, but just as crowded. Fewer gadgets, but lots more energy.

For those of you who prefer your technology in some solid form like semiconductors or networking boxes, the Affiliate Summit is a portal into a very strange world. Conversations here have as many, if not more, acronyms than any telecom conference, but the product on sale is always a bit vague.

Let’s start with the basics. Affiliate Marketing is the term for the exchange of online actions for some form of ad dollars. Much of the time, when we talk about online advertising, we are talking about someone paying a website based on the number of times their ad is viewed, or impressions. This is the show where advertisers may for performance. If you have a website, you can run an ad for someone, and if one of your viewers clicks on that ad, and then buys something from the advertiser, you the website owner get paid.

Affiliate Marketing has been around for a long time, but in recent years it has grown very rapidly. I told an old-time Internet-eer that I was attending, and he described the show’s money makers as “a cancer”. Because another word for much of this form of marketing is spam.

Admittedly, there were a very large number of companies selling vitamins, supplements and other “nutraceuticals”. And the number of companies touting their affiliation with payday lenders is probably a red flag too. However, Affiliate Marketing has come a very long way since the 1990’s. This is a big robust industry, where virtually every retailer and product company has some form of affiliate program.

I first got interested in affiliate marketing when the website Wirecutter launched. The Wirecutter was founded by several well-known tech bloggers. It is one of the best product review sites out there, with thorough analysis of every consumer electronics category. They generate all of their revenue by the links from their site to Amazon, which as you can guess, redirect through Amazon’s affiliate program.

So those are the two extremes – Wirecutter with its excellent reviews at one end, and Male Enhancement pills at the other.

I think the real driver of the industry in the past few years has been the rise of mobile, especially mobile gaming. There is a very hot market for buying app downloads or ‘installs’. The amount of money thrown at the category has provided an underpinning for growth across the affiliate market. My opinion is that the mobile install business is very frothy, with too many companies chasing installs with too much venture money. That being said, I think we passed the inflection point for affiliate marketing, that even when the mobile gaming bubble bursts the rest of the industry will largely carry on, albeit on reduced budgets.

I have always assumed that one of the big appeals of online marketing is the vast amount of data the system generates. With TV commercials, advertisers never know exactly how many people see their ads, let alone what the affect those ads have on purchases. On the Internet, advertisers can get a highly precise figure on viewership and performance. It would seem that online advertising should be a very quantitative field.

However, on the ground, this business resembles Hollywood much more than Silicon Valley. There is a strong element of it being a hit-driven business. Right now, apparently, the big money in mobile ads is coming from companies looking to attract users in India. But the pocket of demand moves around. Nine months ago it was China.

As a result, this show has a very personal feel to it. When I talk to people in the industry they often lament how low-tech much of their work is. Signing individual deals and tracking everything in Excel. True, there are companies employing sophisticated Big Data tools on expensive Hadoop clusters, but the big money seems to remain in salesman lining up advertisers.

For part of the day, I walked around with an agent for a US video network. He owns several highly rated, niche YouTube channels that generates a respectable amount of traffic. Vendors were happy to talk to him, but were not that interested in what he was doing. By contrast, I inadvertently followed two agents for a small Indian ad network. In every booth they visited, they were aggressively courted, with repeated requests for follow-on meetings. I do not know this for a fact, but from what I overheard, I am fairly certain the US video agent had at least as much traffic as the gentlemen from India, but numbers are not all of the story.

I chatted with one industry veteran who I have known for a long time. I commented that the industry seems to be maturing, “Not so scammy, but still relationship driven,” was my comment. “No,” he replied “It is extremely scammy still.”

The bottom line is that Affiliate Marketing is firmly established in the marketing stack. But it is far from mature, there are going to be some big opportunities in the future to layer on technology and build very robust, automated markets here. In the mean time, be careful what ads you click.

Qualcomm in China – Some Signs of Progress

Now that I am unemployed, I am a bit less encumbered in topics I can write about. However, I want to be clear, the note below is based entirely on public information and my experience in China. Nothing here comes from my previous employer.

For investors in Qualcomm the past year has been marred by the company’s troubles in China. They are under investigation on multiple fronts, their employees have been held in custody, and then two quarters ago they had to admit (PDF) they were not being paid royalties on a very large number of phones built in China. This matters because a large and growing share of the world’s 3G and 4G smartphones are coming from China – from the branded majors like ZTE, Xiaomi, Lenovo and Huawei to the unbranded ‘shanzhai’. This is also the ‘home base’ of Qualcomm’s largest baseband rivals Mediatek (of Taiwan) and Spreadtrum.

I recently had a chance to talk to a couple contacts in China, and it seems that Qualcomm has turned a corner there. One contact characterized their conversation with the government as no longer being hostile, having moved “from argument to negotiation”.

My first trip to China was almost 30 years ago, and in the years I have been working in or around China, I have seen this situation many times. Companies run afoul of something there, and then slowly work their way out. The typical pattern is the company admits some form of wrong-doing (aka self-criticism), pays a fine and moves on. After a decent interval, they announce a major investment in China – open an R&D center, endow a few university research departments, or roll out a major training program. These are usually on the scale of $1 billion (so this $40 million investment is just a start). Then after some further period of time, we start to hear about a few other headlines that are kept out of the spotlight.

If I had to guess (and this is just a guess), I imagine Qualcomm will have to pay something like a $1 billion fine, and then another multi-hundred million dollar investment (all using offshore cash). Then over time, we will learn that Qualcomm has lowered the royalty rates it charges China companies for their handset royalties.

My sense is that most investors see the situation in a similar light. I wanted to post on this because my telecoms contacts outlined current conditions that sound just like this, confirming my guess to some degree.

So that is the good news, there is an end in sight.

However, there are a few pieces of bad news.

First, the timing of any settlement is still very unclear, it could take months before an announcement. My contacts at Qualcomm all pointed this out. Ultimately, the decision to announce probably rests with domestic China political considerations, which are impossible for outsiders to grasp. (To get a sense of that, go back and look at how long the industry waited for China’s 3G licensing to play out. There is no predicting these things.) So investors hoping for imminent news will likely be disappointed.

Second, one of the key points still being negotiated seems to be the royalty rate Qualcomm can charge. Some people believe their average royalty rate in China will go from 5% to 3%, with everyone getting a new contract. Most people on the Street expect this scenario. It is worth noting that there is another alternative. That Qualcomm will be permitted to keep its 5% rate, but will no longer be able to charge that 5% to the wholesale (transfer) price of the phone, instead they will only be able to charge against the printed circuit board (PCB) on which their chips sit. So in very rough numbers that is 3% of a $200 phone or 5% of a $100 board. The math gets more complicated than that, but the PCB option almost always ends up being worth considerably less. If this happens, it would be below where investors expect. The PCB option also opens up the door to endless wrangling about what goes on the board, with design houses working rapidly to split the phone into multiple boards and take many components off PCB entirely.

Now to be clear, nothing is certain here. The situation is fluid, and highly opaque to most everyone. So conditions could change.

There is also a big open question as to what phones will be covered. I say open in the sense that no one I spoke with was clear as to the status of these negotiations or what proposals are on the table. Will Qualcomm be able to charge a royalty for TDD LTE phones, that is phones using China’s domestic TD standard? Will they be able to charge royalties on phones sold solely for domestic consumption? What audit rights will they have? These are big questions with no clear answer.

In all of this, it is important to remember that Qualcomm has many supporters in China. There are many companies who have benefited from their partnership with Qualcomm. And many will rely on the company as they expand international sales. Overall, I think the big winners here will be the China handset companies who should be able to compete more effectively on the global stage.

Overall, I think this is also good news for Qualcomm, as we will at some point be removing a great big overhang. I would not rush out to buy the stock, because there is still the potential for some ‘disappointing’ conditions being attached to any agreement. Nonetheless, a move to settlement will put the company on a clearer footing.

An Update on my Status

As of last Friday, I am officially unemployed. This is the good kind of unemployment, the kind that comes from working hard to eliminate the need for your own job. Mission accomplished.

I plan to take some time. Work out. And then think hard about what I want to do next. I like working at the intersection of technology, finance, and strategy. So that seems to be a job where I do investing – either at a private buyer or back on the Street.

In the coming weeks, I will be reaching out and hope to see many of you over coffee or further afield, Mobile World Congress is almost upon us. In the mean time, I open to any suggestions and will be available for consulting work.

CES 2015 Follow-up – And my GigaOm Podcast

I am trying to get back in the habit or writing 500 words a day. That was my resolution for 2014. I maintained that pace for a bit, but then I got buried in the Peregrine sale process. I tend to write about what I see every day, and since most of what I saw every day was either: a) confidential or b) the inside of the dumpiest motel rooms San Diego has… well there was not a lot to cover.

I am considerably less encumbered now. (And if you need a hotel recommendation in San Diego, let me know, I have stayed in them all.)

I had some interesting follow-ups to my posts yesterday on CES, IoT and drones.

First, I was on the GigaOm Internet of Things Show podcast with Stacey Higginbotham. Stacey is one of my favorite tech journalists. She has a great understanding of technology, and even more important, she can it explain it well – without being overly simplified or overly technical. She has been writing about IoT devices for a while now, and I think she has tested every gadget on the market. Go back and read her past posts on the subject for a great survey of the landscape (and some solid gift ideas).

In my post, I mentioned a few implications for some of the big investible sectors that could potentially benefit from IoT. So Stacey had me on to talk about An Investor’s Take on IoT. It was a good talk, and a lot more fun than being on Investor Talk Radio.

Second, my take on CES is that there is still a lot of room for hardware innovation, but it has to be hardware with a good User Experience (UX). A few commentors pointed out that ties really well with the Maker movement.  I posted on Makers last year, noting that the Maker movement, with all its Arduino boards and hacker communities resembles the kit computer market of the 1970’s which gave rise to Apple. Bundle a good Arduino prototype and a solid iPhone app as a remote control, and something interesting is bound to emerge. I strongly suggest a visit to the Maker Faire in San Mateo this May or in New York in September.

Finally, just as I was writing my notes I came across this article in the San Jose Mercury News that highlights the drone hardware community that is developing around Boston. There was a similar story in the California Sunday Magazine about Reno. I point this out because I was pretty downbeat for the prospects of US drone companies. I still think the hardware side of this business has already gone to Shenzhen. The FAA is going to take years before it sets on drone regulations, one more reason that the US is going to lag.

That all being said, these stories point out there is a lot of innovation still to come. Someone from one of these communities may rethink drones entirely and surprise me.


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