Mad Hedge Technology Letter
November 15, 2018
Fiat Lux
Featured Trade:
(AVOID THE HOUSING DATABASE LANDMINES)
(Z), (RDFN)
Stocks that negatively correlate with higher trending interest rates are on a suicide mission as the Fed gradually raises interest rates because of the robust domestic economy hitting on all cylinders.
That is why I am unequivocally bearish on online real estate database companies Zillow (Z) and Redfin (RDFN).
Invest in these stocks at your peril because the short-term path to accelerated EPS growth and higher revenue growth looks treacherous at best.
The last few months has brought forth a massive contraction in mortgage applications as a lack of affordability cripples home buyers around the country.
Buyers are simply waiving the white flag and giving up home searches unable to digest the potential monthly mortgage payments.
As recent as last week, mortgage applications dropped 4% from the previous week and this is only the tip of the iceberg.
Buyers are holding off pulling the trigger and have concluded that housing is about to peak, or the peak is in view.
Why splurge on a big investment when you can buy a house cheap on the next dip?
The supposed silver lining is that inventory is slightly up but that is largely irrelevant because the inching up stems from a dire shortage of inventory that incited vicious bidding wars in the most sought-after metropolitan areas mainly around the east and west coasts.
This is all bad news for Zillow and Redfin who are the main real estate database firms buyers use to do research on the properties and sellers use to advertise housing-related products.
The more buyers drop out of the market altogether, the fewer eyeballs gravitate towards these platforms creating less traffic volume.
Aptly aware of the pitfalls around this business model, both Redfin and Zillow desperately attempted to evolve and fortify their business model.
They decided to get into the business of selling houses and originating mortgage loans when real estate specialists view short-term housing prices in a precarious situation at best.
Zillow preceded this up by purchasing online mortgage lender, Mortgage Lenders of America, which is a dangerous short-term bet as the loan book could sour if the real estate market is crushed by rising rates.
Buy low and sell high, it seems Zillow understood this the other way around.
One bright note was that Zillow shouldn’t face liquidity problems because the purchase was made in cash for $65 million.
Attempts to corner the real estate advertising market was Zillow’s cash cow, and careening into a high-risk part of the real estate market at the wrong time could turn into a painful write-off.
Both of these companies are chronic loss-markers and if the recession graces our shores earlier than expected, it could stick Zillow and Redfin with a hefty inventory of housing units in a downtrodden market.
Pouring fuel on the flames, turning into a mortgage lender could cannibalize 3rd party agent business who could decide to pull the plug on their listings and ads from the database completely.
This could be dreadful for Zillow because the main source of revenue is the advertising revenue they rely on from its platform.
In one fell swoop, Zillow effectively damaged both businesses failing to recognize the disconnection of the synergies between them.
I would argue that this could have been a sublime idea if there was no competition and a monopolistic moat would force customers to search on a single platform.
However, these two companies have minimal product differentiation and the risk of starting a pricing war to zero could be in the fold as shoppers will cherry-pick for the best deal depending on the platform since the products are the same.
Fast food outlets have faced this problem in the last few years as their products have been commoditized.
Prematurely rolling out this new strategy could emasculate these companies.
The time is ripe for an outsider with access to cheap capital to easily roll into town and play nice with the independent broker industry promising to protect future broker’s commission and not step onto their turf.
3rd party brokers would migrate towards this peaceful platform in an instant if they sensed cooperating with Redfin and Zillow hampered business, and it would be game over for Zillow and Redfin in a jiffy.
It would make sense for outliers like Homesnap, Neighborhood Scout, and Realtor.com to summon a batch of capital and surgically target the weakness left gaping open by Zillow and Redfin.
Naturally, investors voted with their wallets and each of these “transformational” moves was met by a cascade of torrential selling in the shares.
As interest rates trend higher, it will automatically ratchet up pressure on these marginal business models.
The coming potential lack of mortgage originations from fewer buying candidates and a slide in internet traffic disrupting ad revenue will quickly erode sales revenue growth.
Zillow is already buying houses from sellers in Denver, Atlanta, Las Vegas and Phoenix with their own capital.
If buyers dry up, Zillow will be on the hook for these houses saddled with a growing inventory of units with a return rate of zero while dealing with a high cost of carry.
All of this shouts lower growth and decelerating revenue.
Management has effectively offered shareholders a difficult path to profits beset by landmines that could potentially blow up a limb or two along the way.
If management stuck with the ad business, they could revisit this risky business at the start of the new cycle with the tailwind of low-interest rates and lower house prices.
Patience is a virtue, and nobody told Zillow’s and Redfin’s management.
That is exactly the type of tech company not to invest in even though Zillow’s 22% sales revenue growth is not bad.
I commend management for seeking fresh levers to stoke growth, but this was a badly calibrated commitment that will cast a pall over its operations for the next few years.
As predicted, these companies blew up its future guidance which is a sign of things to come.
Redfin reduced guidance for profits on the home selling unit by 80%.
Not only did they pull back guidance for the new division, but the core advertising unit was hit with a mild reset in guidance.
Elevated execution risk effectively moving forward to this back end of the economic cycle could turn out to be a genius move. But until management can prove this move could gain traction, investors need to abstain from taking risks with this potential catastrophe.
My bet is that this will end in tears.
Zillow is a far stronger company than Redfin with stronger revenue accumulation while boasting higher revenue growth. But when the industry fundamentals are dictating the weak price action, it’s a great time to sit on the sidelines.
Avoid Zillow and Redfin, the boat is sinking and unfortunately this time, the tide won’t raise all boats and say hello to margin capitulation while you’re at it.
“Facebook used to be a place people felt good going to.” – Said Founder of DoubleLine Capital Jeffrey Gundlach
Mad Hedge Technology Letter
November 14, 2018
Fiat Lux
Featured Trade:
(I NAILED IT)
(AMZN), (GOOGL), (FDX), (UPS), (JCP)
It’s Washington D.C.
That’s what I thought two months ago when I guessed where Amazon (AMZN) would place their new headquarter, please click here to read the story.
It all makes sense and Founder and CEO of Amazon Jeff Bezos clearly has a lot of sense.
Why would you build a second headquarter far away from the home away from home Bezos purchased in the posh Kalorama neighborhood of Washington DC for $23 million in 2016?
The reason Softbank’s CEO Masayoshi Son bought the most expensive home in California was because he hates staying in hotels.
Men of this ilk are beyond hotels and have the resources to recreate a Taj Mahal to recharge their batteries in.
Hotels fail to deliver the same comforting effect, and perpetually feeling like an outsider isn’t the environment that breeds success or high-level inspiration.
Divine inspiration fuels earth-changing ideas to these visionaries.
Bezos’ estate was already the biggest home in Washington DC before he commenced a $12 million expansion last year.
With his wife MacKenzie, the couple has targeted the use of the home for socializing with the global elite just a stone’s throw away from the White House.
The 27,000 square feet reconfigured to wine and dine is about to be the hottest party ticket in Washington.
It’s ideal timing for Amazon as regulation could have gnarly teeth like Dracula and it is entirely logical to place yourself a degree of separation from Capitol Hill to put out any potential legislative fires.
Bezos’s 11th hour decision flipped the script somewhat as he decided to split the headquarter between New York.
The abundance of big data possessed by the richest man in America indicated that finding the necessary technical talent would be a big ask for one place and bifurcating the operation into two would ensure streamlined execution of recruiting the best talent on earth.
Unsurprisingly, Bezos pinpointed New York as the lucky sub-winner and Bezos’s other house is conveniently located in Central Park West purchased in 1999 for $7.7 million from former Sony Music executive Tommy Mottola.
Washington DC and New York were always going to be the first two choices because places like Nashville and Atlanta are bereft of the amount of talent Amazon needs to fill these headquarters up with.
The more than $2 billion in tax incentives from state and local governments is a nice bonus too.
As a side note, Amazon announced a new “Operations Center of Excellence” in downtown Nashville and will fill it up with 5,000 employees, meaning they approved of some of these smaller cities, but not at the grand scale Amazon’s ambitious expansion requires.
It is a consolation prize that is still quite a reward as second-tier cities augment its attempt to morph into legitimate regional tech hubs.
Amazon also threw a bone to the local governments allowing them to brace for a tsunami of gentrification and an affordability crisis at a slower pace.
Real estate prices, standard of living, upheaval of the local lower class, and quality of jobs are about to explode in Long Island, New York and Crystal City, Virginia.
On the back of the Amazon news, Google announced its intentions to expand its New York headcount by up to 14,000.
Consequently, New York real estate and its crumbling infrastructure effectively receive no reprieve from an onslaught of tech capital, high-income jobs, and gentrification about to shower down on its urban core.
The most powerful American tech players have essentially given smaller American cities the middle finger.
This could have the unintended effect of exacerbating income inequality and social division that have been at the forefront of this 10-year economic recovery.
That is basically why Bezos absolutely needs to be in the middle of Washington D.C.
He wants to cut off the snakes of Medusa before his brainchild is venomously bitten.
Make no mistake, one of Amazon’s unintended effects is massive job loss in the retail sector that has caused companies like Sears, Toy “R” Us to shutter and has set up JC Penny (JCP) for a TKO.
What does my crystal ball say next?
Amazon’s gargantuan expansion has its sights set on one thing – the domestic logistics industry.
Bezos wants to become totally vertically integrated to control every movement of the supply chain.
That is his end goal, and nothing will stop him.
To carry this out, he needs headquarters on both coasts and in megacities that can execute his strategic plan to algorithmic precision.
Amazon death star’s next casualties are his logistics competitors FedEx (FDX), UPS (UPS), and the United States Post Service.
They have been a weakness in Amazon’s next-gen supply chain for years.
These services are constantly underperforming, slow to modernize, and worst of all charge too much for their service.
The access to cheap capital and superior talent base means Amazon’s next Christmas list of an in-house logistical service could be plausible.
It certainly would solve the backbiting of the administration criticizing Amazon for manipulating the post service. That argument is nullified if Amazon goes totally in-house which in all likelihood was the premise and roadmap for creating two new headquarters.
Amazon needs to snatch enough delivery capacity to marry it up with the rapid growth of their e-commerce division as Amazon secures a bigger market share of retail sales.
Amazon has already bitten off 50% of domestic e-commerce sales and rising fast.
You don’t need the data in your face, I can tell you right here that USPS, FedEx, and UPS cannot deliver this extra capacity at the low costs Amazon desires.
While building their new logistics arm, they will still be reliant on these current legacy offerings but will start to divert deliveries into their own in-house options as they quickly come on line.
This game plan mirrors the strategy for Amazon Basics brand that learns to crawl before it walks from 3rd party sellers.
Amazon absorbs enough to build a comparable product for half the price then sticks it up at the top of their own website’s product search magically relegating the competition down the product search page.
If you think Amazon doesn’t copy other’s ideas, then you are mistaken. They learn what they can then apply the massive swath of data to do the same for cheaper and with better execution.
Amazon is already in the testing phase for the new Amazon delivery program offering rates that are 50% cheaper than UPS.
This pilot program is being tested in the Los Angeles area and could be a material benefit to 3rd party seller’s cash flow.
One of my favorite Jeff Bezos quotes is “your margin is my opportunity,” and he is set to roll out the same playbook on UPS and FedEx.
FedEx and UPS cannot compete when Amazon is taking a calculative loss delivering products with an in-house service that is focused on grabbing market share and not extracting profits.
Amazon has one priority and that is the end customers who receive their shiny Amazon packages at the front door with an ear to ear smile.
They couldn't care less about the logistics providers they work with and I can guarantee you that upper management has made dominating logistics a focal point of the next step of expansion.
The optics test certainly proves my point as every time I go into a United States post office, the service is slow, inefficient, and coated with a transparent disregard for performance.
Even worse, there are usually two or three customers complaining about misplaced packages off to the side looking to find a manager who is out on a perpetual lunch break. Such is the state of the USPS for better or worse.
Amazon has also introduced its own Amazon-branded delivery vans that partner companies can lease, and the testing phase is swiftly accumulating enough data for Amazon to feel they can go forward with wide-scale adoption.
Management will never vocally concede that they are about to wipe out FedEx, UPS, and the USPS. As usual, the focus is laser-like on the end customer with Amazon management explaining that “to support growth, we went back to our roots to share the opportunity with small- and medium-sized businesses.”
Offering best in class service with unbeatable prices is the formula for customer retention. Amazon knows this, and they don’t care who they wipe the floor with on the way to achieve their ultimate mandate.
“Be stubborn on vision, but flexible on details” – Said Founder and CEO of Amazon Jeff Bezos
Mad Hedge Technology Letter
November 13, 2018
Fiat Lux
Featured Trade:
(NO BIWEEKLY STRATEGY WEBINAR FOR WEDNESDAY NOVEMBER 14)
(WHY I HATE CHIP STOCKS)
(AAPL), (CY), (TXN), (LRCX), (KLAC), (LITE), (QCOM), (MU), (SWKS), (LSCC)
Now that the midterm elections are behind us, Congress will be gridlocked for the next two years portending well for tech stocks as a whole.
However, the gridlock will exacerbate negative sentiment in one small group of technology – the semiconductor chip sector.
I have been staunchly bearish on this cohort since the outset of the trade logjam with China and I recommend readers to avoid these stocks like the plague.
The split Congress could fuel an even more rigid stance towards the complicated tech situation, further clamping down on foreign IP theft and technological forced transfers.
Either way, there is no end in sight and as this administration is concretely in place for the next two years, doubling down on foreign policy wins could be the Republican party’s path to victory heading into the 2020 election.
This could mean the rhetoric towards China could ratchet up a few levels.
Soon enough, the tariffs levied on Chinese imports is set to increase to 25% in January.
Even before January, a planned meeting between Trump and Chairman Xi in Buenos Aires on Nov. 29 will take place and is creating a swirling tornado of uncertainty around chip sentiment that is on tenterhooks.
Any chance to resuscitate the sentiment in the industry could come and go with another gut-churning leg down in chip shares.
Unfortunately, the sword of Damocles hanging over the chip sector could drop in 2019 slashing profit margins, revenue, and damaging the all-important guidance.
Even if individual chip companies determine that the trade friction is too much to stomach, it would be expensive and lengthy to transfer an entire supply chain to Vietnam or Indonesia, hitting current R&D budgets and damaging future innovation affecting the pipeline of fresh products.
Time is not a friend to the chip sector.
If the China leveraged chip companies were to wait out this trade war, they risk further being enveloped into the eye of the trade storm if no quick agreements can be made.
They might have to wait a while as Beijing views waiting out Trump and dealing with the next administration in charge as the ideal option.
Chairman Xi conveniently removed term limits in the last congress, meaning he is in his job until death which could be another 40 years or so.
That is the time horizon the Chinese are playing with.
The timing couldn’t have been worse for the chip sector after a slew of weak guidance from upper management painted a downbeat picture for the sector as we inch towards 2019.
Texas Instruments (TXN) Chief Executive Rich Templeton started off his earnings report admitting, “demand for our products slowed across most markets.”
He later admitted that the semiconductor market is grappling with an imminent “softer” market.
Following up a growing chorus of chip executives flashing dangerous warnings signs, Lattice Semiconductors (LSCC) lamented that it was seeing slowness in the industrial and consumer markets in Asia as a result of macroeconomic conditions and tariffs.
Cypress Semiconductor (CY) also chimed in saying it was coping with “softness across the board.”
Making matters worse, Beijing has been showering capital on the local chip sector aimed at nurturing and developing Chinese chip companies poised to compete on the global stage.
Recently, Chinese state-backed semiconductor maker Fujian Jinhua Integrated Circuit was indicted by the U.S. Justice Department for industrial espionage.
The company allegedly stole trade secrets from Boise-based Micron (MU).
Micron could now become the first piece of collateral damage to the snarky trade war threatening huge swaths of American chip company's revenue.
And with the affected American chip companies waded in a quagmire, and chip market softness on the near horizon, semiconductor equipment firms have borne a good amount of the damage this year with Applied Materials Inc (AMAT), KLA-Tencor Corp (KLAC), and Lam Research Corp (LRCX) getting hammered.
Chips tied to Apple’s (AAPL) iPhone are also in for a drubbing with Apple suddenly announcing in their most recent report they would stop offering the unit sales of iPhones, creating more uncertainty around units sold for a massive end-market for global chip companies, adding to the swirling uncertainties overall Chinese chip revenue face.
Apple proxy chip stocks who lean on Apple for a big chunk of revenue such as Skyworks Solutions (SWKS) are getting crushed.
Skyworks was downgraded last week by Citigroup based on underperforming iPhone XR sales.
The rapid rush of chip downgrades has been fast and furious.
Skyworks will have pockets of strength when 5G is fully rolled out because they will supply critical components installed in this new technology for the new era of internet speed and performance.
But that pocket of strength is not now and will not happen tomorrow.
It’s time to duck out of Skyworks and I have been convincingly downbeat on this particular name since the inception of the trade war.
Today crawled in the next batch up negative chip news from Lumentum Holdings (LITE) who supplies 3D chips for Apple iPhone's facial recognition system.
Management reported that sales would be $20 million lower than originally forecasted because of a sudden reduction in shipments from an unnamed customer.
Another ongoing headache is the Qualcomm (QCOM) versus Apple marriage or divorce, depending on how you look at it.
They have been mired in a prolonged court case against each other, and Qualcomm’s share price has been dismal as of late.
Qualcomm recorded zero licensing revenue in the quarter from Apple who is withholding royalty payments from Qualcomm in a dispute over the company's licensing practices.
The move damaged quarterly licensing sales sliding 6% to $1.14 billion.
Qualcomm has lashed back at Apple pointing the finger at Apple for transferring its intellectual property to Intel (INTC) who is supplying chips for new-model iPhones which is possibly part of the reason they lost this contract.
Losing the iPhone contract to Intel is the main factor in Qualcomm expecting modem chip shipments to decline 22% to about 185 million units.
The fight has no end in sight but like Skyworks Solution, Qualcomm is on the forefront of the 5G revolution and provides a silver lining to embattled revenue growth that has been dragged down with the China mess.
At the end of the day, companies have less resistance when they aren’t belligerently brawling with their biggest purchasers.
Biting the hand that feeds you is a poor strategy that cuts across any industry.
Avoid chip companies for the short term and wait for sentiment to reverse course.
“The path to the CEO's office should not be through the CFO's office, and it should not be through the marketing department. It needs to be through engineering and design.” – Said Co-Founder and CEO of Tesla Elon Musk
Mad Hedge Technology Letter
November 12, 2018
Fiat Lux
Featured Trade:
(THE NEXT OVERHYPED TECH PRODUCT TO BOMB)
(SSNGY), (AAPL), (GOOGL)
