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Loosing trust in SaaS, at least for startups

Late last month it was announced Facebook would be shutting down Parse.  This came as a surprise from many as there wasn’t any indication Facebook was planning to change direction for Parse.  Looking at the decision in more detail makes sense however as Facebook is moving to consolidate around its own ecosystem instead of enabling other external apps.  This aside, one of the interesting developments is Parse has given users until January 28th 2017 to migrate off their services, an uncharacteristically long amount of time.  Parse even went the next mile and open sourced a Parse compatible API on Github.  This contrasted with news this week that Palantir acquired Kimono.  Instead of giving users a year to migrate to another platform, Kimono announced service would be suspended by the end of the month – just about two weeks before their service would become unavailable.  Furthermore no part of their product was open sourced or alternatives provided for their current customers.

We’ve seen this happen over and over – smaller SaaS startups get acquired or fold leaving their customers searching for an alternative, many times with little time to make a transition.  Their existence is becoming increasingly ephemeral and many times customers have little or no warning before the rug is pulled out from underneath them.  This forces companies who used those services to invest time and energy to find alternative services instead of continuing to develop their core product.  For SaaS products like Kimono and Parse, the advantages they bring has always been being able to leverage SaaS within a technology stack to more quickly develop and implement a product.  This is critical when attempting to scale and develop a product in such a fast pace iterative environment like tech.  However the disadvantages of relying on a SaaS startup is significant and grow as the product matures and user base increases.  Irregardless of industry standard integration modalities and distributed computing, there is never a 1 for 1 SaaS replacement and functionality can vary greatly.  The cost of replacing a specialized SaaS product can be significant especially when attempting to migrate within 2 weeks.

There are about a dozen other services that have similar capabilities that Kimono had. But will companies be willing to invest in a transition, if the same scenario will play out again in 6 months?  Startup SaaS companies are going to have an increasingly difficult time finding new enterprise customers with the current trend, which is ironic since their end goal is most often to be acquired.  Not to mention if not acquired typically these startups have a limited runway, meaning if they don’t reach break even they’ll risk shutting down again abandoning their customers.  The industry is going to start to shift to a position of stability, looking for SaaS services from established companies or leveraging the cloud to host their own technology stacks within their control.

Why Boeing actually cut 747-800 production

This past week Boeing announced they would be cutting their 747-800 production down to .5 frames per month.  For many analysts this came as no surprise – the latest jumbo jet has failed to gain traction since its EIS in 2011.  Even in the cargo market where it seemed to have a sweet spot with its adaptable cargo capabilities, adoption has not been anywhere near where Boeing would like.  In their press release Boeing cited a cooling cargo market for the lack of demand.  According to the Bureau of Transportation Statistics, cargo volumes are up by 1.35% YTD since October 2015.  Additionally the GFC FedEx Cargo index shows high utilization over this past holiday season and continued robust aircraft utilization into early this year. Although this doesn’t suggest significant growth in the air cargo market it suggests there might be more reasons for the 747-800’s poor sales performance.

 

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FedEx Cargo Utilization (min/day/frame)

 

Existing cargo aircraft and low oil prices

This is easily the largest contributor to Boeing’s woes. Although Boeing won’t admit it, with oil at ~$30bbl levels, cargo airlines are flying with their existing fleet longer and foregoing costly upgrades.  Furthermore, there is ample market for used frames, including 747-400F and other variants.  Cargo airlines like Kalitta are even keeping their 747-200s in service longer, along with 747-400BCFs of which there are plenty of used frames available.  As passenger airlines upgrade their fleet, used aircraft such as 767s and 757s are also becoming increasingly abundant.  Boeing recently announced a program for conversion of 737-800 passenger aircraft as well.  Freighter conversion programs allow cargo airlines to take advantage of these used aircraft and provide options for lower capital costs as opposed to newly-built aircraft.  Declining oil prices make this option even more attractive.  With a list price of $378.5 million for a new 747-800F and interest rates now rising, the choice to purchase used aircraft is logical.

Belly cargo is taking up cargo slack

Over the past decade, many passenger airlines which historically had separate cargo operations have consolidated their cargo operations and mostly reduced or eliminated cargo-specific aircraft from their fleet.  A good example of this model was Northwest Airlines, which at its peak had a fleet of 15 747-200Fs.  After Delta merged with Northwest, Delta eliminated these aircraft in 2009 and consolidated all cargo operation to lower deck cargo on passenger aircraft.  Japan Airlines has gone through a similar process and eliminated its dedicated cargo aircraft in 2010.

The reason for this shift is in part due to the increasing capacity of lower level cargo on new airliners.  Aircraft of the 60s, 70s and 80s were not as adept as aircraft are today for carrying ancillary cargo.  The Boeing 707 and DC-8, popular narrow body aircraft of the time, did not have the cargo capacity of today’s long haul aircraft.  These aircraft were designed in a way which did not facilitate the use of Unit Load Device (ULDs) that had been standardized for new larger wide body aircraft such as the 747.  Even as wide body aircraft started to take hold, their cargo capacities were limited and not optimized for carrying additional cargo.  Some airlines did opt for “combi” versions which could carry cargo on the main deck of the aircraft, however none of these aircraft gained wide adoption.  Compounded by the scheduling requirements of passenger aircraft and the cheap price of oil a the time, it was easier for airlines to augment their cargo capabilities with additional cargo specific aircraft.  

 

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Cross section of an A300 with 2 LD3 containers left and a 737 right, similar to a 707 cross section

 

As demand for air freight picked up in the late 80s and 90s, dedicated cargo airlines utilizing jet aircraft started to spring up and passenger airlines continued to add cargo aircraft to their fleet, sometimes using their old passenger aircraft and converting them to freighter use.  The shift to consolidate cargo operations for passenger airlines started with the introduction of aircraft like the 777 in the mid 90s.  The 777-300, the largest twin engine passenger aircraft to date, has the capability to transport 44 LD3 containers in its lower holds.  Compare this to the L-1011, an early wide body aircraft, the 777-300 can carry nearly three times as much cargo.  This capability came with the advantage of only using two engines and a much greater fuel efficiency.  Increased range and other efficiencies also allowed passenger airlines to more fully utilize the aircraft they had by adding more cargo to existing flights.  Today it’s estimated nearly 50% of air cargo is from lower hold cargo.

Air freight is unique

Coinciding with the increased capabilities of newer passenger aircraft was older passenger aircraft that were being replaced.  Aircraft like the MD-11 and the A300 became a popular conversion with cargo airlines as the aircraft were modern and relatively cheap on the used market and provided incredible cargo capabilities.  

Large newly-built freighter aircraft like the Boeing 747 did find their niche in the market.  Dedicated cargo carriers like UPS, Fedex, TNT, and DHL found roles for large wide body aircraft hub to hub routes.  The Boeing 747 especially has dominated the cargo market, with over 200 in service carrying nearly half of the world’s air freight.  Airbus wanted to break into this market of larger freighters and launched the A380F as an option to usurp the 747, promising 7% greater payload capacity over its competitor.  Although the A380F gained 27 orders, they were all canceled or converted by 2007.  This lack of expected growth shows the market for large freighter aircraft simply isn’t that large and highlights the issues with aircraft of this size.

As air freight evolved so did the competition.  Cargo carriers started competing not only on price but also on delivery time, especially as sea cargo drove price down.  Because of this, frequency has become a priority over capacity for most air freight routes.  Air cargo operators can’t afford to sit around and wait until they have enough cargo to fill an aircraft, or only provide air freight services a few days out of the week.  They benefit much more from the flexibility to dynamically route aircraft based on demand than fly half empty aircraft part of the time.  Few point-to-point destinations are large enough in cargo volume to justify volumes that fill a 747 on a daily basis.  Furthermore, new freighter aircraft like the 777F have the same cargo capacity of the older 747-200F.  The dynamics of the air cargo markets today simply doesn’t fit well with large aircraft such as the 747-800F except on very select routes.

The future of air cargo demand still remains unclear, however in the short term its apparent aircraft like the 747-800F have limited application.  With no other large freighter on the drawing board it might be a while until we start to see a “clean sheet” designed cargo aircraft.  As current passenger A380s start being retired it is possible we’ll see a freighter conversion program which involves strengthening the cabin floors for greater cargo flexibility.  But the future for air cargo seems to be centered around medium narrow body aircraft conversions like the 737 and other wide body aircraft like the 767 or 777.

The shadow war for natural resources

It might seem odd that during a time where nearly all commodities have seen double-digit declines in the past year there is an underlying push for investment and consolidation of these resources.  It’s no secret OPEC has fought to drive out US shale oil producers by flooding the market with supply, depressing oil prices down to 12-year lows.  But it seems consolidation is happening for other commodities as well.  As we shift away from fossil fuels, other finite resources are taking their place such as rare earth metals, which are integral in technologies like renewable energy.  Lithium cobalt oxide, derived from lithium carbonate, has become a crucial component in nearly every electronic device we own as it is a primary ingredient in lithium-ion battery technology.  Now lithium-ion batteries are finding their way into durable goods such as cars and home power systems, and even into industrial applications supplying energy storage for renewable energy resources.  Companies and countries are taking note of this shift, and some have already started to move on controlling as much of these resources as possible.

Lithium_triangle

One timely example of this is trend is Lithium carbonate production consolidation.  The Economist recently reported Lithium carbonate spot prices have soared in recent months to over $13,000 a tonne, doubling from 2014 prices.  In 2015 Albemarle, the world’s largest Lithium producer, completed the purchase of Rockwood, which owns Chile’s second largest lithium deposit.  The acquisition valued at $6.2 billion, secured Albemarle as the leading producer of lithium products, including lithium salts and metals critical for lithium-ion battery production.  Recently, shares of Sociedad Química & Minera de Chile SA (SAC) surged after it was reported Citic Securities Co., a Chinese firm, was interested in purchasing a stake in the company.  Just weeks prior, Citic invested $60 million in FDG Electric Vehicles, another Hong Kong-based company planning on expanding its manufacturing capacity of lithium-ion batteries for buses it plans to build.

This news isn’t shaping up well for companies such as Tesla which depend on lithium-ion battery technology. A majority of the cost for Tesla’s cars is the battery pack. A rise in lithium prices makes the manufacturer vulnerable, especially when it does not own a company directly involved in lithium production.  Although Tesla has penned agreements with a number of producers, including a local startup in Nevada, the car maker will still be exposed to fluctuating lithium prices as supplies continue to consolidate.

Although other commodities such as rare earth metals are also on decline, their output is still largely controlled by China.  In 2008 and 2009 prices for raw materials such as polysilicon, used for the manufacture of photovoltaic (PV) cells, skyrocketed.  Other rare earth metals experienced similar trends during this same time period.  These commodities saw such a drastic price increase because China, a primary producer, enforced export controls and other measures in an attempt to encourage manufacturing locally.  This tactic backfired and these export controls were later relaxed after the 2008 recession.  China then tried another tactic: just as OPEC flooded the market with cheap oil to drive out US shale producers, China also began to flood the market with rare earth metals.  The result has successfully depressed commodity prices, incentivised manufacturers to incorporate and become dependent on these cheap resources, and drive out US producers who can’t withstand sustained lower prices making production unprofitable.  Molycorp, which mines rare earth metals in California, filed for bankruptcy in June of 2015 citing lower prices.  Other producers will soon follow as they are unable to sustain unprofitable mining operations over an extended period of time.

With China still controlling about 95% of global rare earth production, this trend continues to be a risk.  As technology continues to become more reliant on these commodities and the US and other countries start to develop and manufacture locally, China might once again step in to curtail its exports once US producers and others are gone, again increasing prices.  Tesla and other manufacturers are incredibly vulnerable when critical components for their products are derived from materials controlled by only a few entities and cartels.  We’re already seeing this play out with Lithium prices.  The consolidation of Lithium producers has coincided with a drastic increase in price.  Despite the US dollar index at all-time highs and other commodities at all-time lows, lithium has defied this trend and producers are positioning themselves to profit and control as much of the rare earth commodities as they can.

A look back at 2015

2015 was an exciting year for GFC and for the financial markets in general.  We covered a number of topics including the following articles which proved to be especially relevant:

Tech fatigue:  As with any new Apple device, analysts were anticipating record sales and the possibility of the next iPhone type device.  However the smartwatch in general never seemed to catch on as widely as analysts had expected.  Apple hasn’t even released sales figures for the apple watch, and by some estimates only comprise %3 of the total iPhone user base.

Valley of the kings:  2015 turned out to be subdued in terms of IPOs, as tech companies looking to cash in on their sky high valuations had to take a second look at their prospects.  Theranos is an excellent example faltering after their blood tests came under the scrutiny of the FDA.  Others are scaling back their valuations as investors take a hard look at the reality of the marketplace and revenue potential.

Rally like its 1999:  Across the board the equities market was either flat or in the red for major indices.  As 2016 kicks off the markets have extended this decline well below the highs of the NASDAQ made in 2015.

Tesla’s numbers don’t add up:  Since our article was published Tesla stock has continued to fall.  Other bad news has come out as well, such as reports suggesting that two-thirds of Tesla Model S owners needed an entire new drivetrain by 60,000 miles.  Consumer reports also revised its original assessment of the Model S, highlighting a number of defects and fixes.  For its new Model X, Tesla came in on the lower end for its own estimated deliveries at 17,400 cars.

High aircraft utilization translates to robust on-line shipping:  As our data showed from our proprietary cargo utilization index, on-line holiday spending was robust while in store spending was stagnant.  Shippers experienced increased volumes from on-line purchases.

Why package delivery drones are a long way off

Amazon announced with much fanfare in 2013 their intention to develop and launch a drone delivery service. Two years later, drones have bumped 3D printers out of the technological limelight. Drones already make scheduled deliveries: DHL employs them to deliver medication to a North Sea island. And now Amazon has released a new video showing their own drone transitioning from vertical to horizontal flight and successfully delivering a much-needed replacement soccer cleat, narrated by Jeremy Clarkson (who is known for his technical prowess).  From all appearances drones are well on their way to populating the skies of our neighborhood, buzzing about delivering our online purchases.  In reality however we are much further off than most would think.

There are a number of reasons the development of drones has taken off so rapidly in the past 5 years or so. Technology needed for drones has become cheaper and more accessible; microcontrollers such as the Raspberry Pi are now inexpensive but powerful. The explosion of the smartphone market has also allowed the mass production of miniature gyroscope devices, critical for drone stabilization and flight. Cameras have become lighter and higher quality, while lithium ion battery technology has become light and cheap enough to produce en masse. All these incremental technological improvements have allowed drone manufacturers to develop and produce consumer drones at a price within the reach of most individuals with some spare cash. The commercial application of drones is a natural progression. But are drones ready for unmanned high volume and large scale operations such as package delivery? Though possible in theory, there are a number of significant hurdles that need to be overcome in order for commercial drone delivery to be successful.

Weather is perhaps the biggest challenge facing commercial drone delivery. Commercial aviation has advanced to the point where aircraft are able to operate in most all weather conditions. Rain, sleet, snow, wind, cold; nearly all weather is safe for flying. But these capabilities are in part due to technology that does not translate to drones – for example, anti-icing capabilities. All commercial aircraft are equipped with ice protection systems of some type: either heating elements, bleed air, or mechanical ice boots which provide protection from ice build-up on critical flight surfaces.

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G450 anti-ice bleed air system, not too complex

Drones do not currently have the capabilities to deal with ice accretion as current drone-sized batteries cannot provide sufficient power. Imagine if there was a snowstorm before the holiday season. Online shoppers relying on last-minute drone delivery would be unable to receive their purchases via drone. Uptime is especially critical for these types of last minute deliveries, if a package fails to be delivered on time customers are much more likely to simply drive to the nearest store rather than risk never getting the item they ordered. Even if a company like Amazon was to offer an alternative form of delivery as a contingency, the additional costs involved in maintaining not only a drone delivery fleet, but a traditional fleet of delivery vehicles as well or contracting with another company for same-day delivery, may prove too expensive.

Another environmental hurdle is wind. At the slow speeds drones can currently manage, sustained winds of 15-20 mph would significantly reduce their range or prohibit them from flying altogether. Current drone designs are optimized for vertical flight; most are not designed for high speed and efficient horizontal movement. Even when configured for horizontal flight, aircraft have complex systems designed to cope with a crosswind component. These systems, though complex, still require a human pilot to intervene in case an issue arises, something an unmanned drone will not have. Imagine a drone attempting to land to deliver a package on a windy day, in a yard covered by trees and flanked by power lines.

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Typical suburban tree covered road

Visibility is frequently an issue with aviation in general. Complex systems of radar have been developed to help guide planes as they navigate the sky and land. Instrument landing systems (ILS) allow planes to hone in on a transponder signal to calculate the appropriate glide slope for a safe landing. CAT III-equipped airports and aircraft even can autoland without any pilot intervention, with visibility as low as 150ft. Delivery drones would have to contend with much more challenging conditions. Residential homes don’t have an ILS or localizer for a drone to track. Even with GPS capabilities, a drone will have to guide itself to a safe landing spot once it arrives on site. Amazon’s drone appears to use picture-type beacon to help guide drones to a safe landing spot. But how many people will know how to properly place these locators, not to mention a situation in typical urban and suburban areas which have tree cover, streetlights and electrical poles? Add in other environmental factors such as inclement weather and low visibility and the difficulties for drone operation seem outsized for their benefit.

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Low visibility landing conditions

Cargo capacity is another obvious issue. Battery technology still limits the amount of cargo a drone can carry due to the power density of lithium ion technology. There is a reason aircraft don’t run on battery power: pound for pound, lithium ion power density comes nowhere near Jet A. This will limit packages to a few pounds or less. A quick survey of my own Amazon purchases in the past year shows only a few packages would qualify. Package dimensions greatly limit drone usage as well. Even if a package remains within the required weight, it still has to fit within the cargo hold of a drone (Amazon’s appears to be about the size of a shoe box).

As drones begin to populate the skies, precautions need to also be put in place to prevent them from interfering with each other and other air traffic. Although the video does briefly reference these capabilities, no details are given. TCAS (Traffic collision avoidance systems) which are required on commercial aircraft, require both radar and transponders to operate. It an incredibly complex, standardized system, which plots the course of surrounding aircraft and calculates if a mid-air collision is imminent. A simple GPS-enabled reference is not effective in these scenarios, nor is a cellular internet connection robust enough for drones to communicate with one another. Equivalent systems need to be tested, standardized, and certified for drones.  Safety, especially when operating in low altitude in highly populated areas is critical.

Many comparisons have been made to commercial aviation, and despite technological advances, this past year 79% of flights arrived on time. Commercial aviation’s systems have taken decades to develop. Would drone delivery service succeed with only 79% of packages ordered delivered on time, not to mention the challenges above?

If all that were not enough, the continued controversy around the FAA and their approach thus far for drone regulation throws another wrench in the works. Policies around pilots needing licenses to operate drones, having drones always be within the operator’s sight, and other requirements seem draconian and uninformed. The simple fact is no one, including the FAA, has had to deal with drones until now. Technology has far surpassed the legislation needed to regulate their use (as is often the case), the FAA’s position is a cautious one which is expected when you’re dealing with aircraft regulation.

All this discussion is moot unless Amazon customers are willing to pay extra for drone delivery, and how much money Amazon is willing to spend to develop, implement, and maintain a fleet of delivery drones (not to mention the lobbying costs to change FAA regulations). It is still unclear how many online shoppers subscribe to Amazon Prime, estimates vary greatly however it’s speculated Amazon loses between $1 and $2 billion in shipping for Prime customers every year. Drone delivery will only increase this overhead. Even then the question remains: would a typical American family use drone delivery for the scenario laid out in Amazon’s most recent promotional video? I find this questionable at best. It would be much easier, less costly, and perhaps even quicker, to run down to the nearest shoe store and pick up another sports shoe rather than sit on your front lawn awkwardly waiting for a drone to perhaps arrive.  Drone delivery may soon go the way of the consumer 3D printer and might serve Amazon as PR stunt rather than a new form of delivery.

High aircraft utilization translates to robust on-line shipping

Many economists have expressed concern over the low peak season shipping levels, especially coming into the holiday season.  We commented on this observation last week and confirmed the downtrend in port activity with our Dry Cargo Index.  However many speculated this import slump might not reflect a poor holiday buying season – instead it might be due to retailers having higher inventory on hand than previous years.  

There is no doubt consumers are feeling the pressure as wages remain stagnant despite increasingly low unemployment.  This pressure however is being offset by record low gas prices and an increasingly strong US Dollar, so how are consumers going to spend their money this holiday season?  The Cass Freight Index for October shows a year-over-year change of -5.3% for shipments with the past several months remaining steadily below 2013 levels.  How these data translates to consumer spending this holiday season remains unclear.  However, shipping companies such as UPS are still predicting an increase in shipping this season.  Retailers seem to be equally uncertain as to how the holiday season will affect them.  Third quarter earnings were mixed for retailers, with good news from brands such as Home Depot and Amazon, while others like Target continue to struggle.  One distinguishing shift in spending is the increasing volume of on-line retailing.  Despite the pressure on retailers to deliver better deals this Black Friday, many consumers are spending their time shopping on-line instead of waiting in long queues this Friday.  comScore reported its official forecast for the November/December holiday season and predicts on-line spending will reach $70.1B, a 14% gain from last year.

FedEx Utillization
Average aircraft utilization for FedEx

This increase in on-line spending and mixed brick-and-mortar performance might be confirmed by the higher volumes expected by shipping companies such as UPS and FedEx. The FedEx Cargo Utilization Index trends the cargo aircraft utilization in real time and can give us some insight on the cargo levels for FedEx, which transports many on-line purchases. The data above shows overall aircraft utilization has been trending upwards since mid-summer, indicating an increase in overall air freight volume for FedEx.  Additionally, we can see aircraft utilization by type, which shows a similar trend (below).  Interestingly, much of the increase in utilization can be seen specifically in 777 and MD-11 utilization.  Typically these aircraft are used on longer international routes, meaning the increase in their utilization might mean retailers stocking up last minute before the holiday rush.  More information on the FedEx Cargo Utilization Index can be found under our Indexes menu.

FedEx Utilization by type
Aircraft utilization by aircraft type

Even though the data points to muted holiday spending, there are a number of indicators that are showing growth in on-line shopping.  This correlates with the data we see from FedEx and their increased aircraft utilization coming into this holiday season.

Global dry cargo slump? Perhaps also beyond the U.S.

The Wall Street Journal recently published an article detailing the slowdown of U.S. port activity for the months of September and October.  These data indicate that during an otherwise typically busy time of the year, imports have declined at each of the three busiest seaports in the U.S.  Economists are insinuating this might indicate a larger global problem and is not limited to buildup in inventory but instead a more systemic global slowdown.  News from China and now from Japan correlate with this sentiment.  However, the U.S. market continues to show strength with consumer spending on the rise and an all time high in equities thanks to continued low interest rates.  

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Total shipping volume in TEUs

 

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Cargo vessel utilization 

Data from our own Dry Cargo Index corroborates this assessment.  For both of these months dry cargo levels on averaged showed a decline.  Additionally, the number of vessels showing they are actively underway have decreased as well indicating lower utilization overall.  However, for the first half of November dry cargo levels have leveled off and are trending slightly upwards.  These data are interesting since the GFC Dry Cargo Index monitors cargo shipping levels globally instead of concentrating on only U.S. shipping activity.  Furthermore, our index concentrates on the largest of the cargo shipping vessels indicating on a global scale dry cargo shipping globally is also seeing a pullback.  Although a slight decline can still be inferred for September and October, the WSJ article references imports in the U.S. are up %4 for the first 10 months this year compared to last.  It is still unclear if this trend will continue past the peak shipping season, however the GFC Cargo Index seems to correlate with the slowdown in U.S. imports.

Tesla’s numbers don’t add up

A recent post in the Wall Street Journal highlighted some of the shortcomings of Tesla Motors, the darling tech startup which has continued to gain traction as its stock soars sky-high.  However, as this article and others point out, there are some deep concerns investors should be aware of in terms of long term sustainable growth.

Highlights:

  • Precipitous cash burn rate for multiple capital intensive initiatives, increasing operating expenses.
  • Model 3 will be competing with other major established manufacturers, and other electric vehicles with similar technology have struggled.
  • Tesla is depended on Li-ion technology, which has potential technology and future supply issues.
  • Tesla Powerwall is simply not competitive in today’s market with cheap reliable electricity.

First and foremost is the issue of cash flow.  With its stock near all-time highs, this summer Tesla was able to secure $750M revolving credit agreements with several banks, which should give it some more flexibility for near-term goals.  It will likely need to tap these finances as costs continue to rise.  2015 Q1 results showed Tesla ending the quarter with $1.5B left on its balance sheets, compared to $2.3B in September of last year.  For its most recent quarter filing this burn rate continued unabated when Tesla showed it had just over $1B of cash and equivalents remaining.  This volcanic burn rate is combined with a number of incredibly capital intensive initiatives.  Tesla is planning on releasing its new Model X later this year and is ramping up development of its upcoming Model 3.  Car production, let alone car development, requires ample cash flow to survive.  Tack on the new residential and commercial storage products announced this year along with the building of the Gigafactory, a new battery factory, and Tesla (and its investors) are leveraging a hefty bet that its new cars will be a hit.  Even with the new Model X selling well by the end of the year, Tesla will continue to burn through cash and will more than likely need to secure additional financing.  With its stock continuing to climb, it is very likely Tesla will look to tap additional funds by issuing additional shares.  This dilution, depending on the size, will most likely have mixed reactions from investors.  Up until now investors have been betting on Tesla based on its ability to deliver an innovative product.  Now investors are starting to take a hard look at the numbers and are anxious for stability, especially for life beyond Models S and X.

Model 3

Announced a little over a year ago, the Model 3 is Tesla’s continuation of the product line and philosophy of starting with luxury cars and moving to more affordable mass market vehicles.  This new model is expected to be priced starting at $35,000 before subsidies, which puts it in competition with the BMW 3 series and Audi A4.  This poses a challenge for Tesla, as they begin to enter a lower price market they also are entering an increasingly crowded one.  Not only do consumers have a wide range of choices, they also tend to be brand loyal and nearly all major car manufacturers are in the process of releasing all electric cars.  In the case of the Nissan Leaf, sales were and continue to be sluggish.  Issues with battery degradation, range, and performance in cold weather climates have hampered sales.  Tesla will have to contend with these same issues as they expand, using the same battery technology as the Leaf.  Furthermore consumers who once had to deal with $4/gallon gas can now fill up for a little over half that.  Oil prices have continued to plunge as output stays steady, and Goldman Sachs and others are predicting continued depressed oil prices into 2016 and longer.  This adds to the decreased attractiveness of electric cars as consumers are still anxious about a vehicle which is still lacking in many categories.

Battery Technology

Tesla states their new Gigafactory would reduce production costs by 30% for their cars and Powerwall products.  The important distinction here is the reduction of production costs rather than an increase in efficiency.  Tesla is making a huge bet by committing itself to the current Lithium Ion battery technology which is in a continual state of refinement and development.  As new Li-ion technology comes on-line, Tesla will need to continually update its manufacturing process.  More concerning is the current world supply of Lithium keeping up with demand.  Lithium is also used in batteries for consumer electronic devices and in a number of other industrial products, such as lubricants.  As Lithium becomes more scarce, increasingly inaccessible sources will need to be tapped, increasing the price of Lithium.  This in turn will increase the price of batteries, which already accounts for a considerable portion of the production costs of Tesla’s cars.  Another reality is Li-ion batteries have a predefined life.  After a number of charging cycles they will no longer hold a charge.  No amount of maintenance can bring them back to life aside from a complete replacement which carries considerable costs.  By contrast, a conventional car can be incrementally repaired depending on the fault, i.e. a damaged head gasket can be replaced without replacing the entire engine.

Tesla Powerwall

Already there has been considerable criticism for the Tesla Powerwall since it was announced. It is worth noting first the device and concept itself is not novel.  Companies have developed similar solutions for residential homes which are partially or fully off the grid, or for other “green” applications tied with a solar/alternative energy source.  The problem is these systems never caught on – they remain a niche market for a simple reason: they are not economically viable and their capacity is limited.  Even with hefty state and federal subsidies, the residential application for this technology will be looked over in favor of cheap and reliable utility power.  Forbes Magazine calculated using the Tesla Powerwall in conjunction with solar panels would incur a cost of $0.30/kWh, compared to an average of $0.125/kWh for U.S. consumers.  This is a steep price gap which will not be filled anytime soon.  Furthermore, the current capacity of the Powerwall, 7kw and 10kw, cannot meet the demand of current U.S. homes even as they become more efficient.  With a typical residential AC unit, fridge, and other large appliances running, it is possible to drain a Powerwall within a matter of 2-3 hours.  Add in electric ranges, dryers, and heaters, and the Powerwall would drain even more quickly.  The Powerwall also has to contend with converting the stored DC electricity into household-usable AC electricity, a conversion which significantly reduces efficiency.  Add in the predefined life cycle, and the Powerwall will remain a toy for the environmentally-conscious rich.  Homeowners will be much better served upgrading their appliances for more energy efficient models and utilizing new energy efficient lighting technology such as LED.

Battery recycling, infrastructure, and alternatives

All of Tesla’s products have one thing in common – they all depend on Li-ion battery technology.  Although Li-ion batteries use less toxic materials than previous rechargeable battery technologies, a comprehensive strategy for recycling batteries needs to be developed, especially in light of a potential Lithium shortage.  Furthermore, the cost of infrastructure is enormous and often overlooked.  Building new charging stations and installing chargers in homes costs thousands of dollars.  The automotive industry would be better off adopting technologies which use existing infrastructure and can be retrofitted onto existing vehicles.  Biofuels can begin to fill this gap and are a cheaper, more reliable, and environmentally renewable technology.  In essence what Li-ion technology in electric cars is trying to replace is the gas tank, which is an obviously more complicated solution that what exists today.  As history has shown with the prospect of Hydrogen cars, technology is limited not only by costs of energy but also the method of storing that energy.  Unfortunately for applications like vehicles, gas is still a more efficient, cheaper, and more stable way to store energy than Li-ion batteries and will be for the foreseeable future.

Rally like its 1999

Despite a rocky start to the year, the NASDAQ and other indices are still trading at or near all-time highs.  Recently, GDP and other data suggest the economy is still struggling however, and despite the apparent recovery the Federal Reserve continues to keep interest rates historically low.  The rationale for this extreme measure – now 6 years and running – is often shadowy at best.  Economic data is inconsistent and notoriously unreliable and seems to be contradicting what the wider equity markets are showing.  However, there seems to be a correlation and the Fed’s plan is at least working to prop up the equity markets. But the reality is that cheap money not only leads to higher markets, but subsequently fuels bubbles.

One of the more memorable bubbles is the tech craze that took over the NASDAQ in the late 90s, producing gems like WebVan and even spilling over and enabling corporations like Enron.  Again, we’ve already seen incredible valuations for technology companies that have very little to no assets or physical goods, instead basing their valuation on IP and source code.  There is legitimate value in IP although that IP must drive operating profitability and this has seemingly become irrelevant – again – as companies like Twitter, LinkedIn, and Amazon have PE ratios measured in generations.  But this isn’t something new; we’ve been living in this environment for at least the past five years (if not longer).  Investors seem to be comfortable with the idea of a perpetually unprofitable company, provided their stock continues to rise based on either their potential or talent.  Many IPOs have come and gone since the financial crisis, and generally most have proven to be a success on the surface.  The Valley is still pumping out startups at a steady rate, but at what point will this growth become unsustainable?

One of the more recent startups that stood out from the rest is Magic, a service that at its core enables lazy people with discretionary income to text a service to get theoretically anything they want (sans illegal activity).  Basically, Magic will Google whatever service you’re looking for that is available in your area, mark up that service, and charge you a premium for the trouble.  Say for example you want milk and eggs.  Text Magic and they’ll contact Instacart or a similar service, charge you a premium and have the goods delivered.

We have trained operators standing by 24/7 to answer every one of your requests. Send us a text message, and we’ll get you what you want. We’ll order what you need from the appropriate service (e.g. DoorDash, Instacart, Postmates, etc.), and deal with them so you just automatically get what you want, like magic

This sounds like a good idea until you realize a similar system could easily be set up within a few hours using Twillio, a stock website template, and a few warm bodies to answer text messages.  Nothing (apparently) innovative was developed, no special AI to answer or fulfill requests, not even a dedicated app was developed.  What is more remarkable however is the funding this startup raised.  After completing Y Combinator and posting on hacker news, Magic received $12M in Series A funding from Sequoia Capital.  We’ve gotten to a point where a company with no assets, and now no substantial or novel IP, has closed VC funding measured in the millions.  It’s telling that Sequoia Capital has enough money to justify a $12M investment in a startup of this nature.  Cash has once again become incredibly cheap, and cheap to the point that investments are flowing into tech companies with little prospects for profitability and sustainability.

NASDAQ1

From a technical perspective the NASDAQ is looking prime for a pullback.  Recently both Twitter and Linkedin have posted less-than-stellar earnings, and cracks are beginning to show as the index tries to break through critical resistance.  The NASDAQ is perilously close to the all-time high set back in the 2000 tech boom and is showing signs of struggling to continue the upward trend.  As shown below, there are two critical resistance and support levels now in place, both at just under the 4800 level as well as the 4200 level. This chart also shows the development of Doji, further indicating resistance as the index remains close to the high set in early 2000.

NASDAQ Daily

Furthermore, the chart above shows trend lines converging to form a rising wedge, which broke through on the downside in early March.  The index then confirmed the lower trendline as resistance and then continued to break down further.  This indicates the trend which has developed since late 2014 is now over, and compounded with the additional resistance as the index reaches all time highs suggests the NASDAQ is starting to run out of steam.  But for this to be a confirmed reversal, sufficient selling volume will need to be seen, which so far has not materialized.  Until this is confirmed, the index may continue to test resistance until a breakout occurs in either direction.

Valley of the kings

The tech world of Silicon Valley is an odd and confusing place that is often hard to put into traditional financial context.  With a resurgence of VC funding and IPOs that rivals the influx seen in the 2000 dotcom bubble, some worry another bubble is starting to form.  Chronically low interest rates and equities at all-time highs mean cash is cheap and plentiful and burning holes the pockets of large tech companies. Not just in new technology and acquisitions, but in something more physical and permanent – lavish new headquarters. But is this the wisest use of capital?  The Economist recently published an article detailing some of the concerns with these new expensive buildings – and also made some cautious parallels with the dotcom boom in the late ’90s.

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Building new headquarters as a symbol of your success isn’t a recent development. One infamous example is the Pan Am building in Manhattan.  Built in the 1960s, Juan Trippe famously signed a $115M 30-year lease which included $1M or 10% equity stake in the property.  At the time it was the largest commercial lease ever signed for a building in Manhattan and in line with Juan Trippe’s massive ego, the building had 30ft “Pan Am” logo erected at the top.  At the time Pan Am seemed poised to dominate the airline world – it had recently purchased a fleet of new jets and was about to take delivery of the largest airliner in the world, the 747. But as deregulation took hold and the company struggled under unionization and poor management, other airlines stepped in and began eating away their business.  In the last days of the airline, Pan Am was forced to sell its stake in the property as it was drowning in red ink and relocated its headquarters to Miami.  Another prominent example is the iconic Sears Tower in Chicago.  Completed in the early 1970s, the Sears Tower was designed to consolidate office space for Sears as well as become an iconic symbol for the retailer.  Unfortunately Sears’ growth did not line up with its forecast. With pressure from other retailers the building remained mostly vacant as other cheap office space flooded Chicago.  Eventually Sears left the building entirely in 1995 and today the building no longer even bears its name.  The is just a sampling of corporations that, at their apex, decided to show their success by putting a stake in the ground and erecting massive monuments in their name – history is littered with many more.

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Recently there has been an eerily similar comeback in headquarters planning. On February 27th, 2015, Google submitted a proposal for permission to build an even larger headquarters than its current “Googleplex” in Mountain View.  Google isn’t the only tech giant looking for new digs. Facebook, Apple, and Amazon all have plans for extravagant new office spaces.  These examples are more of the exception than the norm and firms like Google and Apple have ample amounts of cash on hand to bankroll these large capital investments.  But for other small and medium sized companies and startups looking to keep up with the Joneses, building or moving into a new building just to impress investors or clients can be fatal.  Buildings should always be considered overhead and never an investment, and when a company decides to make a move it’s a good idea to take a hard look at their performance and core business.  Even for Google and Apple, a strong argument could be made this money would be better spent elsewhere, or better yet given back to the shareholders.

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So what does this mean from an investment strategy perspective?  Below are a few examples of tech companies who decided to invest in new expensive headquarters, and the stock price today:

Company Date of Announcement Stock Price at Announcement Stock Price at Writing
Groupon September 12th, 2013 $11.76 $7.60
Twitter June 13th, 2012 $44.90* $48.44
Zynga March 5th, 2012 $13.97 $2.70
*Stock price at close on first day of trading

These data are tertiary market intelligence which are often understandably overlooked despite their usefulness as financial indicators.  Despite the proliferation of free accessible data, much of these data are in disparate forms and in multiple locations.  The task of collecting and normalizing these data can be prohibitive.  One good example of tertiary market intelligence is a study published by Yale Law Journal in which a meaningful correlation was drawn between corporate aircraft movements and future stock price action.  These data sets have been available for some twenty years, but this is the first useful application. This perhaps is another example where data could be leveraged as a corporate barometer, and in conjunction with other market indicators could be a useful and profitable measure.