Monday, December 4, 2017

Roku, Next Big Tech Flop or Opportunity?

Roku, Next Big Tech Flop or Opportunity?
By: Michael Molman

            Tech stocks are partying like its 1999, the Nasdaq is up nearly 30% this year, billion dollar startups are attracting capital at the greatest rate since the dot com crash and it’s been the busiest year globally for new stock listings since 2007, with 1,450 companies listing shares (mostly in Asia). Amidst this booming market several high-profile companies have opted to go public, some like Snap and Blue Apron were enormous flops but the average new listing in the U.S is up 32%. One company that has been especially volatile since its IPO has been Roku.
            Roku was one of the first companies involved in the now booming streaming business, and is mostly known for selling small plug in boxes allowing people to stream web content like Netflix and Hulu directly on their T.V. When it went public on September 28th, Roku stock surged 68% to $23.50 a share making it the best performing new listing of the year. Unfortunately, the party did not last long, over the course of the next 5 weeks Roku stock was pummeled on concerns that it would not be able to compete with the likes of Amazon and Apple who had entered the hardware streaming business. Shares hit an all-time low of just above $18, leading up to the company’s 1st earnings report on November 8th. However, Roku’s fortunes changed again as soon as its announced its 3rd quarter earnings which showed how the hardware maker was diversifying. Shares surged over 100% in three days to an all-time high of $48.80. Since then the stock cooled off somewhat but remains volatile. Question is, does Roku deserve a place in your portfolio or is it just another overpriced and over hyped tech stock.

Roku Stock since it went public on September 28th to December 4th. Shares surged over 100% post earnings.
Roku has long been an industry leader when it came to selling internet T.V gadgets, the rise of internet streaming and popularity of services like Netflix made Roku a player in an exciting and growing new field. The problem is the rise of internet T.V has attracted some large players. Roku, a company with a current valuation of just over $3 billion, must compete with the likes of Apple worth almost $900 billion and its Apple T.V as well as Amazon and its Fire Stick, not to mention competition from gaming consoles like Microsoft’s Xbox and Sony’s Play station, which also gives people the ability to stream internet content on their T. V’s. Investors and analysts have long been concerned that Roku would not be able to compete against these tech giants.
So, far Roku has been proving analysts wrong, despite the introduction of new competition Roku has maintained its top position in the market place. In its most recent quarter Roku reported that it sold 35% more units then it did in the same period in 2016. The streaming hardware market also has plenty of room to grow, with only a third of U.S households with internet access reporting that they own a streaming video device. The continued growth of web streaming, and the acceleration of cord cutting (people canceling their cable subscriptions in favor of web streaming services) will continue to benefit Roku in the future.
 Chart showing market share of streaming media players in U.S households. Despite the Introduction of new competitors Roku continues to control the largest percentage of the market.

            Despite being able to continue selling streaming devices in the face of stiff competition, the introduction of competing streaming devices has depressed margins in Roku’s hardware business. Despite unit sales increasing 35% in the 3rd quarter hardware revenue increased only 4% and unit gross profit fell 18.6%. This is another major concern for analysts because unlike larger competitors like Apple who have billions in the bank and can withstand lower margins, Roku cannot. In response Roku is changing its business model, from one that focuses on selling hardware to one that focuses on platform sales. Roku’s plan for continued growth involves selling web subscriptions and advertisements to customers through its T.V gadgets.
            On the surface, this is a great idea since Roku simply does not have the size to compete against the larger tech giants. However, switching from being a company reliant on hardware sales to one focused on software and platform sales is not as easy as it sounds. GoPro and Fitbit, both hyped and flashy companies that had great market debuts have tried unsuccessfully to do so. Both companies are languishing due to heavy competition, sound familiar? Even mighty Apple has had difficulty diversifying outside hardware, with attempts to sell iPhone users on various subscriptions through the platform, not contributing much to Apple’s bottom line. (Alternate revenue streams only make up 16% of Apple’s revenue).
            So far Roku’s ambitions to diversify are proving more successful. In its most recent quarter Roku’s platform sales increased more than 137% from the same period last year to $57.5 million (total revenue was $124.8 million). Platform sales now account for 46% of total sales and 89% of gross profit, this makes sense since platform sales have a gross margin of over 75%. Roku’s user base also continues to increase 42% annually and average revenue per user grew 37%. In addition to selling web subscriptions and advertisements on its platform, Roku has also been licensing its software to smart T.V. makers. This is a big deal considering smart T. V. continue to grab a larger percentage of the total T.V. market. All this means that Roku is fulfilling its promise to diversify away from hardware and focus on other revenue streams. It is easy to see why its stock surged so much post earnings.
            The question is where to go from here? More than 1 million shares of Roku have been shorted since November 8th and short positions now compromise 31% of the company’s total float. Clearly many investors still believe Roku cannot possibly compete against the likes of Amazon, Apple or Google and many see the recent stock gains as unsustainable. This is fair, many people think that Roku’s devices are at a disadvantage since consumers will prefer to link their T. V’s to their other devices, like Amazon Echo home assistance or Apple’s iPhone and iPad. Also, a small but growing minority of young people are opting not to buy a T.V at all and instead watch shows and movies from their laptops and tablets, cutting Roku out of the streaming picture completely. Another potential problem could come from the streaming services themselves. Roku’s business model of selling web subscriptions depends on streaming services like Netflix and Hulu sharing a percentage of their streaming revenue they receive from Roku users. Basically, when a Roku user signs up for a Netflix subscription Roku receives a percentage of that subscription revenue. This model could be at risk as more and more companies enter the hardware streaming space allowing streaming services to negotiate better deals when it comes to sharing subscription revenue.
            Despite these negatives, Roku is still one of the only pure play options for investors hoping to gain exposure to the booming business of web T.V. By cutting prices of its signature units and focusing on growing a user base to which it can sell web subscriptions and advertising, Roku has been able to compete against far larger competitors. The market for internet T.V. gadgets still has plenty of room to grow and if Roku can continue selling its devices and continue growing its user base the stock has the potential to defy the bears and continue surging.

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Disclaimer: This material has been written for informational purposes only, it should not be considered as investment advice. Any investment decision should be made after consulting multiple sources and a financial advisor.            

Monday, October 23, 2017

Investing in a Rapidly Changing Diamond Industry

Investing in a Rapidly Changing Diamond Industry
By: Michael Molman

            Diamonds are called “a woman’s best friend”. They can be used to show off your incredible wealth, cut granite, or launder money if you’re an African warlord. In any case diamonds are the physical representation of opulence, and the industry is going through a period of change that provides investors with huge opportunities.
            The diamond trade has traditionally been one of the most secretive industries in the world. De Beers, a diamond cartel, had an almost absolute monopoly on the business for over 100 years, during which it regulated the supply of diamonds and kept prices inflated. A few diamond trading houses located mostly in Antwerp, Belgium, were designated “sight holders” by De Beers and could purchase rough diamonds in bulk (rough diamonds are diamonds yet to be cut and polished). These diamond trading houses were the secret link between diamond mines in African countries like Botswana and premium jewelry outlets in New York, London and Hong Kong. Diamond trading was a largely deregulated affair and deals were often done behind closed doors with little or no paper trail. While other industries modernized, and were transformed by improving technology, diamond trading remained entrenched in its roots.
            This all began to change during the early 2000’s when suddenly people began to notice how diamonds were financing brutal regimes and atrocities in Africa. Movies like “Blood Diamond” and “Lord of War” showed how diamonds illegally sourced in war zones in Africa using slave and child labor, were used to finance war and horror. Amid public uproar governments began to increasingly scrutinize the diamond industry. Under increasing public pressure and government regulations De Beers made the decision to only sell diamonds sourced at its own mines (before De Beers would force independent diamond miners to market and sell their diamonds through them, threatening to flood the diamond market with supply if the independent miner refused.). Free of the De Beers diamond monopoly smaller diamond miners began to grab market share and produce their own diamonds and for the first time there was no single player regulating the supply.
             At the same time as the De Beers monopoly was being taken apart diamond traders began to look to new growth markets. A rise in incomes and a new middle class in large emerging countries like China and India created a whole new class of people who could afford to buy diamonds. This convinced diamond traders that the demand for jewelry was about to explode. To be ready for the increased demand, diamond manufacturers (those who cut and polish diamonds), began to buy up rough diamonds in bulk. Banks, hoping to take advantage of the coming diamond boom themselves, were more than happy to extend large amounts of credit to these diamond manufacturers. The increased demand for rough diamonds allowed diamond miners to raise prices for rough stones. From 2009 to the Spring of 2011 rough diamond prices rose 75%. The expectation of strong demand for diamond jewelry in China and India led to over speculation in the diamond market which created a diamond bubble. In the Spring of 2011 the bubble burst. Demand from China, although growing rapidly, was not enough to meet the expectations of the diamond industry. This caused diamond prices to collapse, from their 2011 highs to 2012 diamond prices crashed 20%. Suddenly an over leveraged diamond manufacturing industry was facing significant losses and was forced to curb rough diamond buying. This has led to a long-term recession in the diamond industry.

IDEX Diamond Index showing cut diamond prices from January 2013 to July 2017. Oversupply and changing consumer tastes have pressured prices.

Six years after the bursting of the diamond bubble the industry still faces significant hurdles, chief amongst which is lack of financing. Diamond trading is a capital-intensive business, traders often borrow hundreds of millions to buy stones, and until recently banks were willing to lend this money to them. However, due to a fall in diamond prices traders are having a harder time paying back loans taken out before the crash. This coupled with new regulations by governments have led banks to make the decision to pull out of the diamond business entirely. Banks like KBC Group and Standard Chartered, formerly the largest lenders to diamond traders have decided to pull out of the business. Standard Chartered alone has already taken over $400 million in losses on its diamond loans and still needs to recoup some $1.7 billion in loans to diamond traders. KBC Group meanwhile has taken more drastic measures in trying to recoup its diamond loans. In August, KBC had the offices of diamond distributor Exelco which owed the bank $30 million, raided. This raid forced Exelco, a De Beers “sight holder” and prominent diamond trader which sold to retailers like Signet Jewelers and Jared Galleria, to declare bankruptcy. Other diamond traders are hardly faring better, fellow Antwerp diamond trading house, Arjav Diamonds, has seen revenue decline over a third from two years ago to $542 million and has had debt increase to over $500 million. Some traders have cash reserves so low they have trouble finding people willing to do business with them.
            While diamond traders suffer under the weight of bad loans and lack of financing, diamond retailers like Signet Jewelers and Tiffany face slower diamond sales in Western markets. Changing consumer preferences and falling marriage rates are taking their toll on companies who derive much of their income from selling expensive diamond engagement rings. Meanwhile diamond miners have seen their stocks crushed after a series of issues including mine setbacks, political fights, and low prices. Shares of smaller diamond producers have on average fallen 30% in 2017, meanwhile the overall mining sector is up by double digits. Every part of the diamond supply chain seems to be in complete turmoil and this has led to investors shunning the industry. However, there is light at the end of the tunnel, certain developments are in the works that could revive and transform the industry and that is where the opportunity is.
            Diamonds have many uses, as the hardest substance found on Earth they have many industrial uses and because of their natural beauty they are popular in jewelry. These features mean that no matter what diamonds will always been a source of value, much like gold. However, while gold was mined in large enough quantities to be used as currency, diamonds are rarer so it was never practical to use them as money. This meant that even when gold currency was disbanded, several gold exchanges popped up to allow traders to invest and trade the metal. Now days over 60% of gold is used for investment purposes and only 40% is used for jewelry. There is now a push to make diamonds the next gold, an investable commodity that can be traded on exchanges around the world allowing investors to hedge risk.
            If diamonds become an exchange traded asset like gold, silver or platinum, it would bring greater liquidity, price transparency and stability to an industry which has been in turmoil for years. This is not a new idea, the diamond industry has been trying to set up diamond based investment derivatives for years, the problem always was, unlike gold, there is no one type of diamond. Diamonds come in different colors, clarity and cut, this makes it incredibly difficult to create a standardized investment grade diamond product.  Also, there has never been a spot price for diamonds, prices usually varied from vendor to vendor. These things meant that to invest in diamonds one needed to be an expert. This is beginning to change as some people are trying to create a modern market for investment grade diamonds.

Diamond Futures
            In August of 2017 The Indian Commodity Exchange (ICEX) launched the world’s first diamond based futures contract, to provide Indian diamond exporters with a way to hedge prices. India is one of the largest centers for diamond trading in the world, 14 out of every 15 rough diamonds that comes out of the ground is cut and polished in India. From March 2016 to March 2017, India imported about 153 million rough diamond, worth about $19 billion and exported over $24 billion in cut and polished stones. Indian banks, unlike their western peers, have been eager to lend to diamond traders, partially filling the financial void left by the exit of other western institutions.
            Those facts have encouraged some in India to launch a diamond futures contract to help deliver greater liquidity and price transparency. Contracts will be for 1 carat with expiration in November, December and January. ICEX’s diamond future gives traders their first opportunity to speculate on diamonds, which opens the industry to the public for the first time.

Diamond Bullion
            Futures contracts are not for everyone, they tend to be too risky and complex for average investors. Therefore, in October of 2017, the Singapore Diamond Exchange (SDiX), launched another exchange traded diamond product, diamond bullion. This bullion will be a credit card sized package of investment grade diamonds, that will be exchange traded, allowing investors to trade it globally similarly to how they trade gold or silver bullion. There will be two different types of diamond bullion, silver; which began trading at $100,000, and gold; which will include higher end stones and be worth $200,000 (begins trading in January). The prices of these two types of bullion are determined by supply and demand, like any other exchange traded asset. The diamonds included in each bullion are authenticated by the Institute of Diamond Grading a Research, a unit of De Beers which makes sure that the diamonds are ethically sourced (that they are not blood diamonds) and are indeed investment grade.
Diamond bullion is meant to open the diamond trade to the public like never before by providing investors a standardized way to invest in diamonds. It also creates a real possibility to make diamonds a whole new asset class onto itself, a safe haven that could compete with gold and have a place in everybody’s portfolio.
The question is, will investors accept diamonds as a new investment product? After all prices have suffered in recent years and investors might be concerned about investing in a commodity as controversial as diamonds. It is true it will take a while for diamond exchange traded products to catch on and go mainstream, but recently the diamond industry has begun to normalize. To support diamond prices large producers like De Beers (no longer a diamond monopoly but still controlling 35% of the market), and ALROSA, a Russian mining giant (20% of the worlds diamonds are sourced in Russia), cut production of rough diamonds. They also made it more difficult for diamond traders to buy in bulk by requiring them to be more corporate and provide financial information, something unheard of previously. Meanwhile new company’s like Dfin (a London based corporate finance firm) have plans to loan the diamond trading industry as much as $250 million to take advantage of the current lack of competition in diamond financing. These efforts to stabilize prices appear to have worked with rough diamond prices up about 5% in 2017. According to diamond analyst Paul Zimnisky prices could rise another 5-10% this year as the global supply glut begins to subside.

Diamond index created by diamond analyst Paul Zimnisky that attempts to track global rough diamond prices. Rough diamond prices have largely stabilized in 2017.

                  While prices for rough diamonds begin to recover prices for polished gems used in jewelry remain under pressure. Demand for diamond jewelry in markets such as the U.S have been stable at best with diamond retailers like Signet Jewelers showing sales declines. However, large diamond producers known for their expert marketing techniques, are increasing their advertising budgets and changing their marketing strategies to connect to a new generation of consumers. Diamond jewelry sales are expected to increase 4% between 2016 and 2021.
            Despite the slowing sales of diamond jewelry, the real opportunity for the diamond industry is for investment diamonds. At the moment 95% of diamonds are used for consumer consumption, the other 5% are used for industrial purposes (this field is mostly controlled by synthetic diamonds) and investment purposes. With diamond trading becoming more open and with new diamond derivatives popping up around the world, the demand for investment diamonds will increase. Especially when you consider the fact that diamond production is expected to slow dramatically in the coming years, with new diamonds being sourced from deeper and more expensive mines.

Chart shows how diamond supply is expected to fall off after 2030 with demand continuing to grow steadily.

            Diamonds have the potential to become the next big publically traded commodity, the industry has already embraced the concept. Large miners such as De Beers and smaller miners like Petra Diamonds have already voiced their support for publically traded derivatives like India’s diamond futures, and Singapore’s diamond bullion. Diamond exchange traded assets will stabilize the diamond industry by opening it up to the public, providing greater price transparency and liquidity. Investors will potentially have a new safe haven asset something that can rival gold and protect them from inflation, geopolitical risk or stock market crashes. People who start to pay attention to the industry now, while it is hurting and transforming, stand to make a fortune when the transformation is finished and the industry is thriving.

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Disclaimer: This material has been written for informational purposes only, it should not be considered as investment advice. Any investment decision should be made after consulting multiple sources and a financial advisor. 

Wednesday, October 4, 2017

The Case for Shorting Apple

The Case for Shorting Apple
By: Michael Molman
             Apple is one of the most recognizable companies on the planet, it has a market cap larger than the GDP of most countries (nearly $800 billion), it brings in revenue of well over $200 billion a year and its cash reserves alone are larger than most Fortune 500 companies (over $250 billion). Investors who bought Apple stock when it went public in December 1980, would have made a 37,878.8% return at Apple’s current price. These facts have made Apple stock a piece of virtually every person’s portfolio, from Warren Buffet’s to the High Schooler who has just opened his first brokerage account. However, many people, including the media and analysts seem to be ignoring several key facts about Apple that could send the stock falling over the next few months.
 For the most part Apple has been a great investment over the years as the stock remains in an upward long-term trend, but there have been periods where the stock has gone through significant corrections of 30-40%. I believe the stock may be nearing one of those corrections now. 
Apple stock from 2011 to September 26th, 2017

By looking at the chart above it easy to notice how Apple stock is at the top of the trend it has kept since 2012, the last two times the stock was at the top of the trend, in 2012 and 2015, the stock proceeded to crash 40% and 30% respectfully. This on its own means little to most people, the stock could continue to rally on fundamental reasons and break the trend. However, Apple’s most recent rally, which has seen the stock surge nearly 70% in the last year and a half, has been powered by the expectation that Apple’s most recent products will be wildly successful and usher the company into a new age of innovation.
 Apple has recently released a new series of products, including 3 new iPhones, a new smart watch, an improved T.V box and a slate of new software features. The most important of these products is the iPhone X, the phone which is meant to mark the 10-year anniversary of the iPhone and represent the innovation that made the company what it is today. The iPhone X is indeed a major upgrade over previous models, with features such as facial recognition (which Apple calls Face I.D) and wireless charging. Unfortunately, Apple’s stock price hangs entirely on the success of this specific model. There have been few fundamental reasons behind Apple’s recent rally meaning markets have mostly priced in the success of the iPhone X so any hiccup whatsoever could have serious consequences.
The question is whether the iPhone X is enough to keep Apple’s stock rally alive. The last two times Apple stock took a serious tumble the main driver was lack of innovation and new products. Apple has increasingly become a one product company, with the iPhone being responsible for two thirds of the company’s revenue. This reliance on one product has made Apple vulnerable in case of a slowdown in smart phone demand, which is happening now. The smart phone market has matured, in markets such as the U.S and Europe smart phone sales have plateaued and in growing regions like China, Apple trails local competitors.

Chart showing forecasted smart phone sales in millions.
Market growth has significantly decreased.

Competition has shrunk the company’s market share forcing Apple to jack up prices for its new phones to maintain growth. The iPhone X will be the most expensive iPhone yet with the cheapest model retailing for nearly $1,000. Analysts say that the price will not hurt sales however early polls show that only 18% of people are willing to pay $1,000 for a new smart phone. There have been concerns that carriers like AT&T and Verizon will be unwilling to finance more expensive smartphones since doing so hurts their already slim margins. Carrier incentives have been one of the key reasons consumers started buying smart phones in the past, which makes sense considering few people have $600-700 to spend on a new phone. Incentives are decreasing while phone prices are increasing that on its own is not a great sign for future sales but there will be no way to truly tell how big of an effect this will be until the phone comes to market on November 3rd.

Chart showing Apple’s market share of the global smartphone market (in percentage)
iPhone’s growth has been stagnating

The importance of the iPhone X becomes even more apparent as reviews come out for Apple’s other devices. The iPhone 8 has received mostly tepid reviews with most people saying that although it is a decent smart phone there is little to distinguish it from the iPhone 7 (which I point out was no one’s favorite iPhone). Demand for the iPhone 8 has also been softer than many expected, the phone managed to capture just .3% of the global IOS market in its 1st week out, which is lower than the iPhone 7 which captured 1% and the iPhone 6 which captured 2%. Although the iPhone 8 plus performed slightly better, the reviews for it were also not extraordinary. The Apple series 3 watch, the 3rd iteration of the company’s first new product in years, also suffered setbacks, with the device having problems with its cellular connectivity feature, which was the devices main selling point. These series of problems led to Apple stock having its worst week since April 2016, with the stock falling over 5%.
            Apple bulls have said that these fears are overblown, pointing out that soft demand for the iPhone 8 is due to strong pent up demand for the iPhone X, which is supposed to lead the way to a 13% surge in sales over the next year. What the bulls are forgetting is that a huge bump in sales from the iPhone X has already been priced into the stock. For over a year investors have been looking forward to this product release, expecting Apple to wow them like they used to be by Steve Jobs. Having a smart watch that doesn’t work well, and 2 mediocre iPhones does not strike me as the beginning of a new “super cycle”. Apple is boosting prices for its newest phone to maintain growth, that would be great if the company was marketing itself as a blue chip, but it hasn’t, it claims to be a growth stock. To be a growth stock Apple must show that it can innovate. Competitors like Microsoft, Google and Samsung have expanded into multiple high growth fields such as Artificial Intelligence and self-driving cars. Meanwhile Apple has been resting on its laurels and although it has begun investing into new technologies it remains behind its competitors. This means Apple’s growth is capped. If anything goes wrong with the launch of the iPhone X or even if demand falls slightly below expectations Apple stock could get crushed. So, with all the growth from its new products already priced into the stock it is possible and even likely that Apple stock could see a significant pullback.

Disclaimer: This material has been written for informational purposes only, it should not be considered as investment advice. Any investment decision should be made after consulting multiple sources and a financial advisor.
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Wall Street Journal