Monday, October 31, 2016

Valuing Computing Technology - An Update

            It has been a big month for product announcements by major technology companies and I see some valuation implications.  First, Google has now introduced a first rate phone.  I have been using mine for about a week and consider it to be the hardware equivalent of the iPhone 7.  This finally gives Google the platform it needs to showcase its software and update it in a timely fashion.  Android 7 with the Google Assistant is a great combination, but it would fail if the phone were inferior.  For instance, I bought a top of the line Lumia phone when it came out to give Windows Phone 10 a try.  The phone was so bad in terms of both esthetics and build quality that it was on eBay the same day.  The software never had a chance with me because the hardware platform was so bad.  The Google Nexus while superior to the Lumia was not on a par with Apple products.  With the Pixel, Google has not that made that mistake.
            More generally, economic theory highlights the importance of software firms producing first rate hardware.  Michael Spence won the Nobel Prize for his theory of market signaling.  Signaling works because firms with superior technology can signal their superiority by producing products that are too expensive for inferior firms to match.  After Lumia, Microsoft seems to have learned this lesson.  The Surface Studio it introduced last week (and I ordered on the spot) is a ground breaking product.  Even if it is too expensive for most consumers, it signals to the market the Microsoft has the technological talent to compete with, or even surpass, Apple in producing innovative products.  The development of such products is, in my opinion, a critical step for Microsoft and the current news is clearly positive.
            Apple also introduced new MacBooks last week.  While not as innovative as the Microsoft Surface Studio, the new MacBooks have the quality one comes to expect from Apple and the touch bar is a nice added feature.  The big problem for Apple is price.  In the past few months, companies like Asus, Lenovo and HP have introduced innovative new machines with designs that rival Apple at lower price points.  But the real problem for Apple as is at the very low end.  Apple’s least expensive new MacBook is $1,349 even with the educational discount.  This means that Apple has basically handed the K-12 school market to Chromebooks, and to a lesser extent inexpensive Windows machines.  I see that as a huge threat.  Students who grow up with Chrome and Android (or more likely the forthcoming combination) accompanied by Google productivity software are likely to stay in the Google universe, particularly if Google matches Apple’s phone hardware.  If that occurs, Apple is likely to be relegated to the role of a high end backwater – a possibility that has massive implications for the iPhone which is the major source of Apple’s revenue.  In my view, Apple is a bit like the frog in the pot who fails to jump out when the heat is slowly increased.  Apple has been in an enviable position milking the incredibly innovative products introduced under Steve Jobs.  The company needs to take big risks going forward to maintain that position as the competition heats up. 
            The real battle will involve combining hardware and AI software in beautifully designed and functional packages that make it easier and more enjoyable to interact with computers.  In the past Apple was the front runner in that effort, but that lead has vanished.  The future race will be exciting.
            So what are the investment implications of all the foregoing?  While the technological gains by Google and Microsoft are impressive, those gains have not been lost on the market.  The unfortunate fact is that there is no technology so good it cannot be overpriced.  Although it may be going too far to say the Microsoft and Google are overpriced, they certainly are not cheap.  Neither in my view is a particularly good investment.  Apple with its huge hoard of cash and is far less expensive according to any standard valuation ratio such as P/E.  But there is a reason for that too.  Unless Apple can unleash new creativity, I would not recommend purchase of Apple at the current levels.  The bottom line?  Chalk one up for market efficiency.