Curated Insights 2019.01.25

Netflix flexes

Netflix has shows it owns completely, shows it own first-run rights to, hybrid shows like Hastings described, second-run shows — it runs the gamut. Critically, while some models are more profitable than others, all make the service more attractive to Netflix’s customers. This will be a particular challenge for a company like Disney: the company is staking a good portion of its future on its own streaming service driven by its own IP, but has not suggested a willingness to scale supply like Netflix has. That, by definition, will limit the company’s upside when it comes to consumer reach and also long-term pricing power.

T. Rowe Price’s Henry Ellenbogen on Gartner

Every company is trying to figure out how to use technology, internally and externally. One play on this is Gartner. Ninety percent of Gartner’s earnings before interest and taxes comes from its research business. It has two parts. Because of the demands that all companies have to use technology better and understand how their competitors are using it, the research product has transitioned from one that was nice to have to one you need to have. You can see it in Gartner’s numbers. Last year, it had over $2 billion of revenue and grew more than 13% organically. It’s a global business. We believe that it is going to continue to be a strong double-digit growth business.

The average customer spends $180,000 for Gartner research. They want to know what technology providers they should look at to answer their key questions. How are other people using technology and on-boarding it? How can they drive technology into a business line to get efficiency?

The other 20% of the research business is where the controversy has been. We have owned the stock since 2010. It has compounded at well over 20% since we’ve owned it. In the past two years, Gartner’s performance has been weaker, because it bought Corporate Executive Board, or CEB, a business best-practices consultant outside of technology that helps functional groups in a business understand issues in their areas.

Gartner instituted a turnaround at CEB. The product was fine, but it had to change the go-to market. They were selling by individual site license, as opposed to role-based pricing, and had to re-energize the sales force. A lot of costs have come into this division, with only modest improvement in growth; that’s where the controversy is. But Gartner now has an excellent franchise in an area that is becoming increasingly important globally.

In addition, Gartner has deleveraged. The leverage was about four times. It is now 2½ times, and the company is deleveraging at more than one time per year. They are back to buying back stock. We see low-$4 earnings per share in 2019. Free cash flow historically has been 130% or greater, because customers pay upfront. Next year, we see low-$5 EPS and close to $7 of free cash flow, and expect the company will return to trading at 20 to 25 times free cash flow, versus 18 times now.


T. Rowe Price’s Henry Ellenbogen on SS&C Technologies

When we think about compounders, the two key factors are ownership’s mentality and the durability of growth. My next pick, SS&C Technologies Holdings, came public for the second time in 2010, and we have been owners since the second IPO. Despite a mediocre 2018, the stock has compounded wealth at 24% since the IPO.

SS&C does fund accounting. It provides the pipes on the technology side and the service side for hedge funds. It’s the leading provider in the country; a lot of people in this room probably use them. And they are also the leader for private equity, and early last year, they bought DST Systems, which provides these services for mutual funds.

Bill Stone started the company in a classic American way, by getting a second mortgage on his house in 1986. He still owns 13% of it. Even in an industry where growth is neutral or negative, when you get into the plumbing, people can’t really take you out. You have a revenue stream, and you have pricing power. People worry about the health of their customers. But even under modest volume, Stone is going to have pricing power. If you change your back office and your accountants, you get all sorts of questions from your customers.

People are very concerned about the capital markets. But 10% of the company’s revenue is tied to market sensitivity; 90% isn’t. That’s about $50 million of Ebitda, if you assume a 30% correction, about 40% incremental margins. On the flip side, we believe that DST could yield an additional $50 million to $100 million of synergies beyond market expectations.

Another concern is that SS&C is 4.7 times leveraged, and the market doesn’t like leverage. This is the only highly levered name I am going to mention, and there are three reasons. First, Stone is investing his own money alongside other people’s, and he is very focused on paying down the debt. Second, the business is a very low capital-intensive one that is very sticky, and we think under normal operating situations, the leverage will be below four times by the end of this year. Third, when Stone bought DST, he got DST Health, which does $100 million of Ebitda and is a noncyclical business. If he wanted to, he could sell it at 12 to 15 times Ebitda, and that would instantly deleverage the company below three times. So he has another road out. We believe that SS&C Technologies will earn about $3.70 a share this year and $4 to $4.10 next year.


Rivulet Capital’s Oscar Schafer on Dollar Tree

Dollar Tree operates 15,000 stores under two distinct banners: Dollar Tree, a chain of variety stores selling a unique assortment of discount merchandise, all priced at a dollar, and Family Dollar, a chain of discount stores offering everyday goods and general merchandise. The Dollar Tree business is doing great, and it continues to execute on a growth model that has worked for three decades. The company acquired Family Dollar in 2015 and strove to really stabilize that business and turn it around. The reasons to be optimistic are that they have paid down debt and started ramping up investment in the Family Dollar stores. Most importantly, the stock price has declined to a point where I feel that I’m buying Dollar Tree for a fair price and getting Family Dollar for free. I like free options.

The Dollar Tree segment is a strong and stable business that will generate over 80% of consolidated operating income this year. A true “dollar” store, Dollar Tree employs a rapidly rotating assortment of merchandise to create a “treasure-hunt” experience. This format has proved to be largely insulated from e-commerce competition. The growth at Dollar Tree has been spectacular over the past 10 years, including during the financial crisis. Since 2006, the store count has more than doubled, from 3,200 to 6,900. Same-store sales growth has averaged 4.1%, and operating income is up by almost five times, with a compound annual growth rate of 15%.

Family Dollar’s business is different. A direct competitor is Dollar General. Family Dollar offers an assortment of everyday necessities in general merchandise, primarily to low-income consumers. Physical stores are much smaller; consumables make up almost 80% of the sales, and, over the past few years, the company has suffered from a litany of issues: food deflation, management turnover, and strategic operational business mishaps.

For many years, Dollar Tree was a stock-market darling, driving a 28% compound annual return from 2006 to 2014. Since acquiring Family Dollar in 2015, Dollar Tree shares have gone almost nowhere. This is due to dramatic multiple compression, not stagnating earnings. In fact, earnings were up by more than 60% in the past three years. On a combined basis, Dollar Tree is now trading at a relatively discounted valuation of less than 16 times forward earnings, and less than 10 times enterprise value to Ebitda.

We see multiple ways to win. First, we estimate that Dollar Tree can grow Ebitda at a mid-single-digit rate, even if we assume continued deterioration at Family Dollar. In this scenario, the company should still generate a billion dollars in excess free cash flow per year over the next few years. Having recently gained investment-grade status, the company can reallocate the cash flow from debt pay-down to share buybacks. This should drive double-digit earnings growth. Assuming a 16-times-earnings multiple on our estimate of 2021 earnings, I see 30% upside over the next two years.

Second, we see an opportunity for value-creating corporate action. In 2014, Dollar General attempted to buy Family Dollar for almost $10 billion. My research suggests that given the chance, Dollar General would again jump at the opportunity to consolidate its nearest rival. I estimate that the market is currently ascribing zero value to Family Dollar within Dollar Tree, so even if they sold Family Dollar at a discount to the 2015 purchase price, this would still unlock substantial value for Dollar Tree holders.

Serving the six-sided teeter totter: 2018 year in review — adventur.es

We often get asked by sellers, “What will adventur.es do for my company? What resources will you provide? What kind of growth can you promise?” Our answer is short and meant to be sweet — plan on adventur.es being a fair, long-term home for the business and its people, and nothing else. The response is almost always met with incredulity and usually leads to a great conversation.

What organizations do is overrated, while what organizations don’t do is highly underrated. It’s easy to make promises and we’ve certainly made plenty over the years that haven’t turned out well. What’s hard is following through — doing what you say you’ll do, when you said you’d do it, and under the terms agreed upon.

What’s even harder than doing what you say is intentionally not doing, and being transparent about it. Our first rule is “do no harm.” Humans are creatures of progress and crave shortcuts. We’ve learned that progress (almost) never comes by prescription, nor pill. Knowledge can light the path, but it can’t walk it for you. Often the right decision is to wait, gather more information, and reassess.

We ask that our sellers and company leadership have low expectations for us around everything except how we treat them. We’re not in the business of interventions, although we have paid for rehab a few times. If we intervene, we must see it through. It’s like a tree branch that is growing in the wrong direction. Merely pulling on it won’t solve the problem. The branch must be pulled and held, almost indefinitely. Sometimes we can help identify a poor direction, but leadership teams are the ones who pull and hold the branches.

The only other way to acquire a skill set is by hiring outside talent, a consultant, or a firm that can perform the difficult task. Again, there’s a nasty selection bias at play. If you’re excellent at a difficult-to-acquire and valuable skill, you typically don’t seek employment opportunities, or consulting gigs, or customers in small business, and especially in non-sexy industries.

Our goal is to find someone who has a range of experiences in successfully generating revenue through varied channels, building teams, and taking ownership of results. We know it’s humanly impossible for one individual to have deep experience in all the revenue disciplines. We expect this leader to build a team, both at the adventur.es level and within the portfolio companies, and draw on some stout resources already here.

Curated Insights 2019.01.18

10 years since BNSF

“It’s a crazy deal. It’s an insane deal. We looked at Burlington Northern at $75 and I’ll give you the exact calculation we did. You don’t have a high earnings return. They are paying 18 times earnings, but it’s really much worse than that. They report maintenance cap-ex very carefully. They report depreciation and amortization, and they report only about 70% of the maintenance cap-ex.”

One very important fact of this transaction, was his level of conviction. In November 2009, there were a ton of cheap opportunities. Buffett picked BNSF, and paid a 30% premium to gain full ownership. Also, 40% of the total consideration was paid with arguably deeply undervalued BRK shares. So, safe to say he really wanted BNSF. The $34bn paid for BNSF, represented almost 25% of Berkshire’s equity! It was a huge bet, with significant repercussions.

Applying similar numbers, we get to an Enterprise Value of $125bn and an equity value of $105bn for Berkshire´s railroad. Once again, Buffett paid $34bn, took out $31bn in dividends and is left with +$100bn in value…Good job Warren.

So we know returns for this massive investment have been impressive, but let´s get to a number. And the number is…~18%. That is massive for an investment many thought at the time would produce mediocre returns. Remember many experts thought he was overpaying for a capital-intensive, regulated and cyclical business.

18% is 1.5x the return of the S&P 500 during a bull market. But it gets better…At the time of the acquisition, Berkshire already owned ~20% of BNSF stock…so he didn´t have to pay the takeout premium on 100% of the shares outstanding. In reality, he had to pay ~$26bn for the shares he didn´t own. Also, Berkshire employed a bit of leverage to fund the acquisition. The company issued $8bn in bonds, so we get, leveraged returns. If we take into account the leverage and the shares of BNSF Berkshire already owned, then the return on the equity would go…way up. But I think we get the point.

Fund manager: Why Amazon could double

The market is not correctly conceptualizing normalized profitability. It seems that the market views AMZN’s profitability primarily through a legacy e-commerce lens, viewing AMZN as a single-digit-margin business. Piecing apart the business, I think this is wrong. First, AMZN has not known the meaning of the word “operating leverage” for the past 10 years, but it is showing through recently with beautiful impact. In Q3 18, fulfillment as a percentage of sales actually declined for the first time time in five years (having gone from 8.5% in 2010 to 15% of sales in 2018). This is a nascent signal, but suggests that the fulfillment infrastructure expansion is nearing its final stages. There are supplementary data points to support this notion, including the slowing in new DCs and headcount. As a result of this operating leverage, operating margins went from 0.8% in Q3 17 to 6.6% in Q3 18, with incremental margins of 26%. Second, there is a real mix shift going on at AMZN that benefits GMs and fundamentally changes the OM outlook for the combined business. Core e-commerce (lower margin) grew revenue only 10% in Q3, but third party seller services grew 31% and AWS grew 46%. As a result of this positive mix shift, gross margins went from 37% Q3 17 to 41.7% in Q3 18, with incremental gross margins coming in at 57.5%. Amazon effectively has a powerful combination of mix-driven GM expansion and operating leverage driven OM expansion in play here, and my view is that this dynamic will hold for at least a number of years to come.

PayPal quietly took over the checkout button

In 2013, PayPal bought Braintree Payment Solutions LLC, which processes the credit card transactions on the mobile apps of Uber, Airbnb, StubHub, and thousands of smaller businesses. The acquisition brought in an influx of programmers and designers, as well as Venmo, which Braintree had acquired the year before. Venmo is a way to quickly settle small debts between friends: a dinner check, a get-well present for a colleague. With Venmo, informal financial interactions formerly governed by social norms about reciprocity, forgiveness, and passive-aggressive hinting could be easily recorded and quickly paid. (“I only have a twenty” is no longer a viable excuse.) You could even “bill” your friends. The app—complete with a feed of the payments your friends have made to each other—has proved enormously popular with millennials.

Over the next six months, Schulman negotiated similar partnerships with Mastercard and Citibank, committing to make it as effortless as possible for customers to use Citibank-issued credit cards and Mastercard’s network. “When PayPal first spun out of EBay, there was a lot of competition and a lot of negative sentiment,” says Heath Terry, an analyst who covers the industry for Goldman Sachs Group Inc. “Basically, in 18 months on the job, Dan was able to completely change that narrative.” As with the Visa deal, PayPal was forgoing some profit but placating powerful and formerly antagonistic payments incumbents. Citi and Mastercard—along with Google, Apple, Amazon, and Samsung, each of which has an eponymous “pay” product—began steering customers to link their accounts with PayPal, seeing it not as a competitor but as a driver of transactions and the fees they generate. In short, as a pal.

The result has been a surge in growth. “It took us 14 years to go from 50 million subscribers to 250 million,” Schulman says. “I mean, it’s impressive, but it’s a long time. We went from 200 million to 250 million in about 18 months,” tripling the rate at which the company added users, or what it calls “net new actives.” PayPal’s stock is up more than 100 percent since the start of 2017. However, PayPal’s most impressive statistic may be its conversion rate. People who design online and mobile shopping apps are obsessed with smoothing and shortening the path from idle browsing to purchase—humans are acquisitive and impulsive creatures, but they’re also easily distracted and bad at remembering their credit card numbers. Too many options hurts conversion, and so does having to type out stuff or wait for a page to load. PayPal’s conversion rate is lights-out: Eighty-nine percent of the time a customer gets to its checkout page, he makes the purchase. For other online credit and debit card transactions, that number sits at about 50 percent.

This differential was cited by the hedge fund Third Point in an investor letter last July: “We see parallels between PayPal and other best-in-class internet platforms like Netflix and Amazon,” it read. It applauded PayPal’s $2.2 billion purchase in May of IZettle, a Swedish payments processor known as the “Square of Europe.” The praise was particularly striking coming from Third Point, whose billionaire founder Dan Loeb, like Icahn, is better known for publicly excoriating the leadership of the companies in which he invests. Built into PayPal’s high share price is the expectation that the company will figure out a way to turn Venmo’s popularity into profit. Third Point’s letter predicted that the app will be contributing $1 billion in additional annual revenue within three years. Disagreements over how to do that, or how much to even try, have led to the departures of two Venmo heads in two years. Employees who have left in recent months describe mounting mutual frustration. According to multiple people familiar with the company’s finances, the app is still losing hundreds of millions of dollars annually. In an interview after the announcement of Venmo’s latest leadership change in late September, Schulman’s deputy, PayPal Chief Operating Officer Bill Ready, downplayed any suggestion of turmoil. “Any startup that goes through rapid growth is going to experience this,” he says. “You evolve, and you have to bring in different skill sets for each stage of the journey.”

Cancer deaths decline 27% over 25 years

Deaths from cancer dropped 27% over a quarter century, meaning an estimated 2.6 million fewer people died of the disease during that period, according to a new report from researchers at the American Cancer Society.

For most of the 20th century, overall cancer deaths rose, driven mainly by men dying from lung cancer, researchers noted. But since the peak in 1991, the death rate has steadily dropped 1.5% a year through 2016, primarily because of long-running efforts to reduce smoking, as well as advances in detection and treatment of cancer at earlier stages, when prognosis for recovery is generally better.

Curated Insights 2019.01.11

Disney’s Bob Iger talks streaming, park plans, and learning from Kodak

In the case of Pixar, Marvel, and Lucas, none of them were for sale. We were the only ones. Us identifying them as acquisition targets and my going out and meeting with Steve Jobs and Ike Perlmutter and George Lucas one on one. Just alone. And broaching the subject and ultimately doing a deal. In looking back, particularly with Marvel and Lucas—Pixar was different—we had an ability to monetize those assets better than anyone else. If someone came along, we would have had a competitive advantage. You can argue that in the Comcast case with Fox, they’re probably the only other company out there that can monetize. Whether they monetize as well as we do, I don’t know. I don’t think they’re quite where we are.

What we looked at there was partly the result of the strategy we’re deploying, which is to be in the direct-to-consumer space in a very serious way. In order to do that, we needed a few things, and one of them, really the most important, was intellectual property. And when we looked at the Fox assets and brands—National Geographic, FX, Searchlight, the movie Avatar, the Marvel properties that they licensed, I could go on, The Simpsons—they had a lot that we could use to feed the beast that we’re taking to the market. And the board has been great at articulating this back to me. Had we not defined this strategy and gone for it, they would not have figured out how the Fox assets would have been of value to us. Because on the surface, you’re buying traditional businesses—cable channels and the like—and what do you need that for?

And then on top of that there was a global element to it that was very important to us. For instance, the Star assets in India. And they have a very successful business across Latin America. Sky was obviously attractive to us too, but it got less attractive as the price went up.

Wiedower Capital 2018 Annual Shareholder Letter: Trupanion

The vast majority of companies would take these increased efficiencies and let them drop to the bottom line. Not Trupanion. Their goal when the business is more mature in a few years is to have an adjusted operating margin of 15% (which equates to a net margin of around 5%). Once they achieve maturity, they want to then share all savings above that with their customers, basically capping their net margin at around 5%. Trupanion’s current loss ratio is ~70%, but their longer-term goal is to increase that to 80% (essentially giving 10% more value back to their customers).

To be clear, even if Trupanion does succeed with the scaled economies shared flywheel, it will not be as effective as Costco’s has been. An insurance company increasing loss ratios is a much less tangible benefit to the consumer vs a retailer decreasing prices. This is because retail prices can easily be compared at Costco vs Walmart or Amazon, whereas insurance policy prices are generally harder to compare apples-to-apples. However, I still believe this will make life harder on other pet insurers if Trupanion is slowly increasing their loss ratios on a yearly basis. That is tough to compete with. Very few companies are willing to pass up higher short-term profits every single year in the hopes that decreasing their prices will increase long-term customer loyalty.

For Healthy Paws (the #3 pet insurer, but the competitor I worry about the most) to have a meaningful effect on Trupanion’s customer acquisition strategy, they would have to hire and train a hundred salespeople all over the country and those people would have to spend years getting inroads into vets. And vets that already have Trupanion Express installed will have an even higher barrier to entry. Over 10% of vets in North America already have Express installed and that number is growing quickly (install growth was 42% in 2017 and over 50% in 2018).

Because of their customer acquisition cost, Trupanion loses money in the first year of all new pets they sign up. However, the average pet stays with Trupanion for over eight years, so that initial loss is made up over time. But because Trupanion is growing so fast, the cost of those new pets every year make the reported financials look worse than the progress of the underlying business. If customer acquisition costs are amortized over the life of a pet, the financials look much better.

This means that for every dollar spent on sales and marketing, Trupanion gets a 30-40% return on that invested capital. Very few businesses can maintain that return on capital for very long. Trupanion has been doing this for years and, given the industry penetration is just over 1%, they may be able to continue achieving this high return for many more years. Trupanion has the best unit economics of any company we own and, just as important, I believe these returns can continue because they are very defensible.

In addition to valuation, I believe the regulatory risks to Trupanion are overblown. The most touted regulatory risk is that many of Trupanion’s territory partners are not licensed to sell insurance—even though they don’t sell insurance and ideally never even interact with potential customers. There are fringe cases where this can be iffy though. For example, an unlicensed territory partner who talks to her friend about the benefits of Trupanion could potentially cross the line. Even in the scenario where regulators rule that all territory partners need to be licensed, I don’t believe the risk is large to Trupanion. From talking to insurance regulators about this, I expect a modest fine at worst.

The regulatory risk that I think is a bigger concern, but that gets discussed less often, is if veterinarians were required to get licensed. The veterinarians are the main conduit that connect pet owners to Trupanion. If veterinarians were required to get licensed, this would kill Trupanion’s current business model as very few vets would go through the effort of getting licensed. Here, it’s important to note that veterinarians who work with Trupanion do not explain the insurance specifics to their pet owner clients. The vets are allowed to recommend the concept of pet insurance broadly, and then discuss their personal experience with Trupanion, but that’s it. The vets do not get into insurance coverage details because that is when they would be required to get licensed.

Dureka Carrasquillo long Ferrari: Sohn London Conference

In 2017 the luxury car market was valued at $570bn. Estimates suggest it will grow at about 9% for the next 5 years. Ferrari sits in the category of luxury goods that is considered an ‘experience’ and that category is projected to grow at an even higher rate.

Special cars have historically been about 2% of sales but they will become a larger part of the business. She estimates that by 2022 special cars will represent 20% of revenues. These cars which are limited editions – often 500 cars – sell for more than $1m each and sometimes sell out on the day they go on sale. Gross margins on special cars are about 3x base cars. If the number of special cars is increased in the way that Carrasquillo predicts EBITDA margins for the whole group could increase from 33% to 38%.

Another hallmark of a luxury goods player is careful management of supply. Current product capacity is about 16,000 cars per year yet only 9000 are made. In comparison, Porsche sells 25,000 to 30,00 911s per year. Carrasquillo thinks that Ferrari could increase production to 16,000 cars per year and still sell them. Ferrari intends to launch 15 new models in the next 5 years – that’s a lot more than in the past. It takes about 40 months to produce and launch a new car.


Luke Newman long Rolls Royce: Sohn London Conference

At its heart Rolls Royce is a razor to razorblade business model – the razors – or the engines in this case – cost billions of dollars to design, deliver and install and come with an obligation to buy razorblades – service contracts – for the next 25 years. The gross margins on the service contracts are high between 50% to 70% but the engines are sold at a loss.

The secular trends in air travel are supportive driven by increasing wealth and emerging markets. Air passenger kilometres over the last 70 years have grown at 6% CAGR. If passenger growth continues at 4.5% and assuming planes have a 25-year life, 425 new wide body planes are required every year to keep up with demand. That’s 37 new wide-bodied planes every month. The production schedules for Boeing and Airbus for next year are slated at 34 per month creating positive pricing dynamics for all participants.

Over the last 20 years what was a 3-player market has become a duopoly. Pratt and Whitney took the rationale decision to concentrate on narrow body engines and ceded their market share to Rolls Royce. That did not come for free because Rolls Royce had to spend billions of dollars developing new engines to take the market share. The good news is that this year is the first year in which most of the revenue will come from the high margin aftermarket business. The company has reached a critical inflection point.

GE, the other member of the duopoly, has been in harvest mode, maintaining share and enjoying good aftermarket revenues. GE has lots of problems, but the engine business has not been one of them. GE’s engine margins have been consistently high.

Curated Insights 2019.01.04

The customer acquisition pricing parade

“One spectator, determined to get a better view, stands on their tiptoes. It works well initially until everyone else does the same. Then, the taxing effort of standing on your toes becomes table stakes to be able to see anything at all. Now, not only is any advantage squandered, but we’re all worse off than we were when we first started.”

“Marketing is increasingly cheap. Trust is increasingly expensive. Attracting eyeballs no longer sets you apart. Building trust among those who have their eyes on you, does. Getting people’s attention is no longer a skill. Keeping people’s attention is.”

To decrease spending and increase profitability, the holding companies of tomorrow will shift their attention from controlling supply to controlling demand — from building around industries to building around audiences.  

Re-marketing to an existing customer is significantly cheaper than trying to persuade a first time customer to buy your product — sometimes nearly 90% cheaper.

Companies who cater to the needs of passionate customers will benefit from lowered customer acquisition costs and higher lifetime value (LTV), reduced churn and increased loyalty. Once a paying customer is acquired, companies can cross-sell and up-sell them into different products, categories, and even brands. The fight to find that customer will be much easier leading to an increase in transaction volume. As they reduce friction in the payment process and increase customer loyalty, they’ll accrue data behind customer cohorts leading to a customer-centric experience.

Companies who cater to their customers and develop direct relationships with them, will own the future.

Working more magic at Disney

Walt Disney has in a sense become more Disney-like in how it earns its profits. After 20 years of being dominated by television, especially cable, the company is returning to its roots in films and theme parks. Seven years ago, for each $1 in operating profit that Disney made from its parks and studios, it generated $3 in TV. During the fiscal year ended September, parks and studios retook the lead.

The coming streaming platform will be reported to Wall Street as a separate Netflix-like division within Disney. Investors will see how much cash the unit is paying for content. New Disney, so to speak, will pay this money to Old Disney. “What I’ve discovered is, businesses in a traditional space that want to innovate and spend money to do so, they park the cost of innovation in their traditional businesses,” Iger says. “Those businesses all kind of suffer from the cost of that innovation, because it’s not typically monetized right away. You can get impatient to the point of losing interest and abandoning innovation, because you don’t have the patience to wait for it to really pay off.”

For decades, Disney was largely a moviemaker with theme parks, although television has long been part of the mix; The Mickey Mouse Club, which began on ABC in 1955, helped finance Disneyland, and the Disney Channel has been a cable mainstay since the 1980s. But in 1995, Disney surprised investors with a $19 billion acquisition of Capital Cities/ABC, gaining a prosperous TV network and a thriving ESPN. As cable spread service across the nation, and TV producers learned how to extract higher fees from cable operators for their content, the small screen became Disney’s big earner.

Iger planted the roots of Disney’s growth spurt in its traditional businesses when he rolled up major story-telling outfits that weren’t for sale. He did that by visiting their bosses one-on-one: Steve Jobs, culminating in the $7.4 billion purchase of Pixar in 2006; Isaac Perlmutter, for a $4 billion acquisition of Marvel Entertainment in 2009; and George Lucas, in a $4 billion deal for Lucasfilm in 2012. What has followed has been a film boom for the ages.

This year, Disney will again become the only studio in history to reap $7 billion in worldwide box office receipts: $4 billion internationally and $3 billion in the U.S. It also did so in 2016. And Disney makes eight to 10 films a year; some big studios make two dozen.

Box office results relate to return on invested capital the way dunking a basketball relates to winning a game: The former gets the crowd’s attention, but people with stakes care mostly about the latter. The broader film industry operates with a single-digit return, Iger says. Yet there are years when Disney’s film returns top 30%. As a result, studio operating income has multiplied more than fourfold since 2011, to nearly $3 billion during the fiscal year ended in September.

Does AI make strong tech companies stronger?

First, though you need a lot of data for machine learning, the data you use is very specific to the problem that you’re trying to solve. GE has lots of telemetry data from gas turbines, Google has lots of search data, and Amex has lots of credit card fraud data. You can’t use the turbine data as examples to spot fraudulent transactions, and you can’t use web searches to spot gas turbines that are about to fail. That is, ML is a generalizable technology – you can use it for fraud detection or face recognition – but applications that you build with it are not generalized. Each thing you build can only do one thing. This is much the same as all previous waves of automation: just as a washing machine can only wash clothes and not wash dishes or cook a meal, and a chess program cannot do your taxes, a machine learning translation system cannot recognise cats. Both the applications you build and the data sets you need are very specific to the task that you’re trying to solve (though again, this is a moving target and there is research to try to make learning more transferable across different data sets).

So: as an industrial company, do you keep your own data and build the ML systems to analyse it (or pay a contractor do do this for you)? Do you buy a finished product from a vendor that’s already trained on other people’s data? Do you co-mingle your data into that, or into the training derived from it? Does the vendor even need your data or do they already have enough? The answer will be different in different parts of your business, in different industries and for different use cases.

This takes me to a metaphor I’ve used elsewhere – we should compare machine learning to SQL. It’s an important building block that allowed new and important things, and will be part of everything. If you don’t use it and your competitors do, you will fall behind. Some people will create entirely new companies with this – part of Wal-Mart’s success came from using databases to manage inventory and logistics more efficiently. But today, if you started a retailer and said “…and we’re going to use databases”, that would not make you different or interesting – SQL became part of everything and then disappeared. The same will happen with machine learning.


One giant step for a chess-playing machine

Most unnerving was that AlphaZero seemed to express insight. It played like no computer ever has, intuitively and beautifully, with a romantic, attacking style. It played gambits and took risks. In some games it paralyzed Stockfish and toyed with it. While conducting its attack in Game 10, AlphaZero retreated its queen back into the corner of the board on its own side, far from Stockfish’s king, not normally where an attacking queen should be placed.

Yet this peculiar retreat was venomous: No matter how Stockfish replied, it was doomed. It was almost as if AlphaZero was waiting for Stockfish to realize, after billions of brutish calculations, how hopeless its position truly was, so that the beast could relax and expire peacefully, like a vanquished bull before a matador. Grandmasters had never seen anything like it. AlphaZero had the finesse of a virtuoso and the power of a machine. It was humankind’s first glimpse of an awesome new kind of intelligence.

Tellingly, AlphaZero won by thinking smarter, not faster; it examined only 60 thousand positions a second, compared to 60 million for Stockfish. It was wiser, knowing what to think about and what to ignore. By discovering the principles of chess on its own, AlphaZero developed a style of play that “reflects the truth” about the game rather than “the priorities and prejudices of programmers,” Mr. Kasparov wrote in a commentary accompanying the Science article.

What is frustrating about machine learning, however, is that the algorithms can’t articulate what they’re thinking. We don’t know why they work, so we don’t know if they can be trusted. AlphaZero gives every appearance of having discovered some important principles about chess, but it can’t share that understanding with us. Not yet, at least. As human beings, we want more than answers. We want insight. This is going to be a source of tension in our interactions with computers from now on.

Maybe eventually our lack of insight would no longer bother us. After all, AlphaInfinity could cure all our diseases, solve all our scientific problems and make all our other intellectual trains run on time. We did pretty well without much insight for the first 300,000 years or so of our existence as Homo sapiens. And we’ll have no shortage of memory: we will recall with pride the golden era of human insight, this glorious interlude, a few thousand years long, between our uncomprehending past and our incomprehensible future.


Evaluating early stage startups — The three metrics that matter

Defining “fast growth” depends on stage, but for early (Seed or Series A), growing 100% YoY is typically pretty solid. Paul Graham (PG) famously looks for 5–7% weekly growth for companies in Y Combinator, and his rationale is pretty simple: “a company that grows at 1% a week will grow 1.7x a year, whereas a company that grows at 5% a week will grow 12.6x.” When you consider the compounding effects of this growth, it means a company starting with $1,000 in revenue and growing at 1% will be at $7,900 per month four years later, whereas the company growing 5% per week will be bringing in more than $25 million per month.


The founder’s guide to understanding investors

When we dig deeper, the degree to which early-stage investing is a grand slam business is shocking. First, amongst early stage investors, the returns are disproportionately distributed. The Kauffman Foundation, an investor in many VC funds, found the top 20 VC firms (~3% of VC firms), generate 95% of all venture returns. Second, outside of the top 20 VC firms, most lose money! A study found the top 29 VC firms made a profit of $64B on $21B invested, while the rest of the VC universe lost $75B on $160B invested.

As early-stage investing operates on a power law, Paul Graham (founder of Y Combinator) mentions “You [as an investor] have to ignore the elephant in front of you, the likelihood they’ll [the startup] succeed, and focus instead on the separate and almost invisibly intangible question of whether they’ll succeed really big.” He highlights there are 10,000x variations (!) in startup investing returns, meaning top investors must have the mindset of willing to strike out in order to hit grand slams.

There needs to be room for your startup to capture a large share of this market. Elad Gil (early investor in Airbnb, Coinbase, Gusto, Instacart, Stripe), explains this means i) the market is structurally set up to support multiple winners, but ii) if the market only supports one winner and customers are currently not served well – there is an opportunity to dominate the market.

At the Series A stage, investors are mainly looking to see if PMF is achieved. This evaluation can be qualitative – Marc Andreessen (co-founder of Netscape and Andreessen Horowitz, an early investor in Facebook, Twitter, Wealthfront, Slack) notes, on the inside, “you can always feel product/market fit when it’s happening. The customers are buying the product just as fast as you can make it — or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can. Reporters are calling…”

When investors are evaluating for PMF, Rachleff notes that the best test is to see if the product is growing exponentially with no marketing, meaning the product is so good it grows through word of mouth. Top investors often don’t want to see marketing spend because it shows care for vanity metrics (things that don’t matter) rather than building an amazing product that people engage with (which does matter).

Not all buzzwords will fulfill their potential and result in a disruptive technology shift though. As a founder, you can reduce this risk by avoid starting a startup on that shift until the technology adoption is growing quickly and reaches a multi-hour per day level of usage. Sam Altman expands, “It’s very hard to differentiate between fake trends and real trends…If you think hard and you really pay attention, sometimes you can. The metric I use to differentiate between a real trend and a fake trend is similar to loving a product. It’s when there is a new platform that people are using many hours every day.”

To believe the startup can fulfill grand slam potential, investors want to see the startup has verified their assumptions on how users find the product in a repeatable and scalable manner. This is also called a go-to-market strategy (GTM).

Bill Gurley (major early investor in Uber, Stitch Fix, Zillow, etc.) called a unique GTM the most under-appreciated part about startups. It’s not about who did it first, but who did it right. Gurley looks to see if the startup has two things: (1) An interesting way to get into the market; (2) A way to establish themselves once in the market. The word ‘unique’ is important here. Replicating existing GTM strategies is often too costly because incumbents have already dried up the channel(s) to market and sell to customers. As a founder, you need to find a unique GTM that is repeatable and scalable. The good news here is that if you succeed, you’ll be able to keep out competitors by saturating the new channels.

Andy Rachleff has a second perspective on how startups can avoid competition. With his adaptation to Clayton Christensen’s (Harvard Business School Professor) disruption theory, startups can compete with reduced competition in either two ways. They can compete via new-market disruption – targeting a new set of users and competing on different characteristics (e.g. instead of price, focus on experience) than competitors, or they can compete via low-end disruption – targeting the same set of users as incumbents, but offering a greatly reduced product at a lower price point.

Along with the above quote, Bill Gurley tests if executives at the startup have a notion of insane curiosity – constantly learning new ways to win. To evaluate this, he asks questions on what information (e.g. books, podcasts) executives learn from, how they engage with it, and then probes if they are trying to use that information to majorly improve themselves or their business.

Curious folks tinker. Obsessively curious folks solve the hardest problems that require endless tinkering. If you are obsessively curious and fail with your original plan, odds are you will use your learnings and pivot into a big market that loves their product.

If a founder is obsessively curious, they can navigate the idea maze. By running a founder through the idea maze, investors evaluate if the founder understands all permutations of their idea, why their plan is superior to all other competitors, and which turns to lead to treasure versus which ones lead to certain death. It’s important for a founder to thoroughly know their idea maze, it can save years by not going down the wrong path, in addition to convincing investors you know can be a grand slam.

Rating citizens – can China’s social credit system fix its trust deficit?

In some Chinese cities, if you have wilfully defaulted on paying your debts, callers to your mobile phone will hear this message instead of the usual ringback tone: “This is a friendly reminder from the people’s court of XX city. The person you have just called has been declared a trust-breaker subject to enforcement by the court …”

Given that 80 per cent of respondents in a 2018 opinion poll conducted across China have approved of the social credit system, it seems that most Chinese, for now, do not consider the drastic surveillance scheme a violation of their privacy. Instead, most see the merit of the system in the perks they may enjoy and its potential in fostering trustworthiness in society.

However, the feasibility of this is highly questionable since the government is simultaneously the enforcer, the appraiser and the appraisee. For instance, many local governments in China have often failed to repay debt ranging from a few thousand to tens of million yuan, including loans, payment to contractors, and compensation for seized land. Since local governments are the ones that assess trustworthiness and mete out punishment, will they themselves be subject to the same penalties as other defaulters?

In this county, slandering others online will take 100 points off your social credit rating, while manufacturing and selling fake products will set you back by merely 35 points. Someone who may be rightfully seeking redress by occupying government offices may be slapped with a 50-point deduction, the same penalty as someone who has given or received bribes.