The Race to a Trillion

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[The companies that are headed toward a trillion dollars in market capitalization are all high tech. *RON*]

Neil Cybart, Above Avalon, 11 July 2018


An arbitrary race that many have been following on Wall Street is, which company will be the first to reach a trillion dollar market capitalization? Currently, there are four legitimate contenders: Apple, Amazon, Alphabet, and Microsoft. However, the race to a trillion dollars ends up hiding a much more interesting development that has been unfolding on Wall Street.

A select group of corporate giants continue to gain influence and investor dollars. Their rise is drawing into question whether or not this time is different. Have these companies found a way to remain at the top indefinitely? Are we seeing the rise of a new breed of corporate giant?

Today's Giants

There are currently five giants on Wall Street:
  • Apple: $924B
  • Amazon: $848B
  • Alphabet: $814B
  • Microsoft: $782B
  • Facebook: $587B
Combined, the five preceding companies total $4.0 trillion of market cap, representing 16.5% of the entire S&P 500. This development has raised concerns that we may be in some kind of tech bubble or, worse, that today's giants are gaining too much power over the broader market.

History offers a different viewpoint. Wall Street has been no stranger to corporate giants. In fact, power was much more centralized at the top in the 1960s and 1970s when the top five companies made up more than 20% of the S&P 500.

Exhibit 1: Market Capitalization of Top Five Companies in S&P 500 (% of Total S&P 500)



During the 1960s and 1970s, the largest company represented 7% to 9% of the overall S&P 500. Today, Apple represents approximately 4% of the S&P 500. As seen in Exhibit 2, no company has been immune from the eventual fall from the top. It seems like the surest way to not be the largest company in the future is to be the largest company today.

Exhibit 2: Market Capitalization of Largest Company in S&P 500 (% of Total S&P 500)


Diversification

Historically, there has been diversification among the largest public companies. For decades, the top five companies have included representatives from different segments of the economy such as the tech, industrial, energy, and financial sectors. Many have looked at today's giants and concluded such diversification has disappeared. However, upon closer examination, a different picture comes into focus. There is still diversity at the top:
  • Apple is a design company selling tools that empower people
  • Amazon is a retailer intently focused on offering the best retail experience imaginable. 
  • Microsoft is an enterprise-focused services company focused on helping people get work done.
  • Google is a services company aimed at delivering data-capturing tools to as many people as possible. 
  • Facebook is a services company providing curated versions of the web (Facebook and Instagram).
The preceding five companies rely on different business models to form unique customer relationships. More impressively, each company has gotten to where it is today without interrupting the others' business models. We see some skirmishes at the edges. (Facebook and Google are both offering prime real estate for advertisers while Amazon has entered Google's search territory.) However, things have remained shockingly benign when it comes to all-out wars among giants.

Narratives

The five giants aren't treated and viewed equally on Wall Street. Along with having different business models, each also possesses unique narratives with some stronger than others. Amazon currently has one of the strongest narratives. Out of the five giants, Amazon is viewed as having the most defensible business model with the company positioning itself as a type of utility that will eventually own the most cost efficient and effective way goods are transferred from merchants to people's homes. One way to verify this strong narrative is to look at the market's reaction to Amazon announcing M&A activity. News of Amazon entering a new industry (grocery and now pharmacy) is accompanied by significant market cap losses among that industry's existing players.

Meanwhile, Facebook and Google are viewed as being more susceptible to competition grabbing users' attention with different kinds of data-capturing services. Nevertheless, the market is still rewarding the two companies for their seemingly more predictable services revenue streams based on delivering ads.

Apple is viewed as the most susceptible of the group. There continues to be a significant amount of doubt regarding Apple's ability to keep coming up with new products that people love. This skepticism has surrounded Apple for decades and is used by the company as a factor motivating employees to surprise the world.

Valuation multiples afforded to each company reflect these different narratives. Amazon shares trade at the highest multiples among the group with Apple bringing up the rear, trading at a 10% discount to the overall market (according to forward P/E multiples).

The following valuation metric is operating cash flow yields (operating cash flow / market cap). The lower the yield, the higher the valuation metric. For example, the market is currently willing to pay 3x more for a dollar of Amazon operating cash flow (and Amazon's future cash flow stream) versus a dollar of Apple operating cash flow.
  • Apple: 7%
  • Microsoft: 5%
  • Alphabet: 5%
  • Facebook: 4%
  • Amazon: 2%
Software

The five largest public U.S. companies do have one thing in common: software prowess. Three of the five were able to harness the power found with software in the mobile era to achieve a type of scale that was once unimaginable. All five relied on software advancements to come up with new customer experiences. Facebook and Alphabet cater to more than two billion customers each. Microsoft and Apple have more than a billion customers each.

Some market observers are wondering if the combination of software prowess and sheer scale has resulted in a different kind of corporate giant. Have today's largest companies gained so much power thanks to their capabilities and loyal customer bases that they will be able to avoid the inevitable fall from grace? Similar questions have been pointed towards non-U.S. companies as well, including Tencent and Alibaba.

Defining Power

Today's corporate giants hold considerable power in two ways:
  • Cash
  • Data
Four of the five largest public U.S. companies have remarkably strong balance sheets. The following totals reflect net cash (excludes debt) positions as of the end of March 2018:
  • Apple: $145B
  • Alphabet: $100B
  • Microsoft: $55B
  • Facebook: $44B
  • Amazon: $6B 
More impressively, each company is kicking off significant amounts of cash flow. The following totals reflect operating cash flow for FY2017:
  • Apple: $64B
  • Microsoft: $40B
  • Alphabet: $37B
  • Facebook: $24B
  • Amazon: $18B
Strong balance sheets and superior cash flows provide management teams flexibility to fund and pursue ambitious ideas. Each company has seen a dramatic rise in R&D expense in recent years. Apple, historically known for its R&D expense frugality, will spend more on R&D in 2018 than it did from 1998 to 2011. The following totals are R&D expense in FY2017.
  • Alphabet: $17B
  • Microsoft: $13B
  • Apple: $12B
  • Amazon: $12B*
  • Facebook: $8B
*Estimated as Amazon includes R&D within its "technology and content" line item.

Add topics like AI and machine learning into the discussion, and some think these giants derive value not from just having many users, but also from users' data. There is a growing number of market observers and pundits that see a new breed of monopoly being born, a "data monopoly." This group views data, or the lack thereof, as a formidable barrier to entry, preventing others from competing with today's giants. In such a scenario, government regulation would be the only thing capable of slowing down the giants.

Nothing Lasts Forever

This may be a controversial statement, but odds are good that today's giants won't be tomorrow's giants. Despite some companies being viewed as more defensible than others, each is fragile. New companies, some of which haven't been founded yet, will rise up and compete with today's leaders for market supremacy. Critics will argue this thinking is too old-school and that today's companies simply hold too much power (via cash and user data) to one day be disrupted. I disagree.

It is easy to think that today's giants are where they are today because of a particular product, feature, or core competency. However, this isn't the case. Instead, each company has developed a culture and process to create value for customers. It is this process, and the sheer level of difficulty found with changing such a process, that will serve as a roadblock for today's giants.

Over time, new forces will rise that will challenge existing processes and require giants to come up with new ways of thinking. The degree to which management teams can respond and adjust to these new forces will determine the amount of success in staying at the top. There is nothing inherently found with today's giants that prevents new companies from leveraging technologies to deliver customer value in new ways. Instead of there being some kind of innovation black hole where advancements can only come from the five giants, tomorrow's giants will likely use today's leaders as stepping stones to reach new heights. An example of this development would be the way companies have used smartphones to rethink transportation via ride sharing.

Start-ups will be able to innovate in the areas of A.I. and machine learning despite not having access to the quantity of data that the giants possess. In essence, too many people are positioning data and scale as moats that will protect today's giants. Neither will prove true.

The five giants are keenly aware of their fragility. No one wants to miss the next big thing and be left behind. Consider the following actions when it comes to avoiding irrelevancy:
  • Apple is sprinting into wearables while continuing to embrace additional vertical integration by owning the core technologies powering its devices. Apple is mapping a post-iPhone path forward. 
  • Google's Alphabet reorganization was designed to better manage the various bets the company had placed. While the reorg doesn't appear to be going terribly well from a management / leadership perspective, Alphabet has become more financially-disciplined when it comes to its long-term bets. 
  • Facebook's annual developers conference has seen Mark Zuckerberg position different initiatives as the company's future. In 2016, VR was said to be Facebook's future. The implication is that the world will increasingly move beyond just text and photos. In 2017, AR was Facebook's future. Today, Facebook finds itself dialing things back to put more resources in cameras and video. 
  • Microsoft's shift away from consumer markets symbolized management's acceptance of missing the mobile revolution and instead staking out a differentiated path forward. 
  • Amazon's vertical integration into product and delivery is upending nearly every part of the legacy retail complex. 
While the giants have become more ambitious and willing to take on challenges, there has been very little change to their cultures or processes.

Case Study: Apple

Apple management is well aware that they are trying to do the seemingly impossible - remain relevant. Aside from a few luxury brands, very few companies have been able to avoid what appears to be the inevitable fall from grace.

Apple's future won't be determined by the iPhone, Apple Watch, or Services. Instead, Apple's future will be based on the company's ability to come up with valuable tools for people. This reality is dependent on a few ingredients:
  • Deep collaboration among teams within Apple. 
  • An intense focus on design (i.e. how Apple products are used). 
  • Correct market positioning and timing (Arguably, these attributes end up being a design offshoot as they relate to how people will use Apple tools.). 
Tim Cook is misunderstood as Apple CEO. Many have been grading Cook as if he is Apple's product visionary. Instead, Cook is tasked with managing something more important than any one product. Cook is looking over the process used to develop products. He has overseen major changes to the way Apple is managed on a day-to-day basis while doubling down on positioning Apple's Industrial Design group as purveyors for the experience found with using Apple products.

As we move into the AI / ML era, it isn't a coincidence that Apple has been making internal changes to foster deeper collaboration between industrial designers (who oversee Apple's product vision) and other teams on the frontline of new technologies. The recent hiring of John Giannandrea as Chief of Machine Learning and AI Strategy emphasizes this last point. Apple's new headquarters house a design studio fostering a greater level of idea dissemination versus what was possible at Apple's old headquarters.

We also see Apple moving deeper into owning core technologies - a bet that will likely give the company a competitive advantage measured in decades. Not only is Apple working on developing the required technologies for new product categories, but management is also waiting for the correct market timing. The transportation industry isn't quite ripe for a company like Apple to enter. However, given the significant amount of change unfolding in the space, an Apple move into transportation is inevitable. Such a move may be associated with Apple relying on different processes to monetize premium experiences. It is this embrace of change that gives Apple the best chance of continuing to build tools for people. Waiting for the right time to move is a freedom that Apple never had twenty years ago.

A Trillion Dollar Reminder

Barring some kind of global slowdown in economic activity, there will likely be at least one trillion dollar company among today's giants. Over the next few years, it is certainly possible that there will be multiple trillion dollar companies.

Instead of this milestone representing the start of a new chapter for these giants, it should serve as a reminder of these companies' fragility and the never-ending supply of new companies coming up with new processes for delivering experiences and value to the world.

While many think there will be growing competition or wars between today's giants, such a scenario is unlikely. Instead, the competition will come from other directions, including new entrants possessing dramatically different business models and processes.

The strongest opponents in the giants' battle to remain relevant end up being themselves. The natural aversion to change will simply be too strong for most giants. Strong balance sheets, billions of users, and access to seemingly unlimited user data will all prove futile in their bids to remain relevant.

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