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Jubak's Journal Recent articles: • 10 under-the-radar blue chips, 3/8/2006 • 10 stocks that win with $60 oil, 3/7/2006 • Oil producers reach for more power, 3/3/2006 More... | Jubak's Journal Google and AT&T: Is bigger better? Investors are betting that profits at Google and AT&T will climb as each company grows, but they may be wrong. Let's look at the scenarios -- and at the case of Amazon.com. By Jim Jubak What do the share prices of Google and AT&T have in common? In each case, investors who own the stocks are betting that bigger is better. In the first instance, I think that's dead wrong. Investors who are buying Google In the second, I think the answer is yes. The purchase of BellSouth And both these stocks have another thing in common. Investors aren't paying enough attention to this question: How do these businesses scale?
Ideally, profit margins go up as companies get bigger and they're able to spread fixed costs over a larger base of sales. Margins also increase as they use their size to wring variable costs out of their business by means such as negotiating lower prices from suppliers (the Wal-Mart Stores But the real world is almost never ideal. The greatest risk that investors are taking now is that profit margins will sink, not climb, with size. Related news and commentary on MSN Money
A peek at the scale Let me use Amazon.com Amazon continues to grow unit volume -- unit growth was 22% in the fourth quarter of 2005. But Amazon just can't seem to hit that magic point where it can reduce investment in the company as a percentage of revenue. For example, in the fourth quarter of 2005, spending on technology and content climbed to 4.1% of sales, an increase of 1.2 percentage points from the fourth quarter of 2004. Even as the company grows in size, operating profit margins are falling. For 2006, the company forecast sales growth of 16% to 23% and a decline in operating margin to 5.1% to 6.2%, down from the 6.6% of 2005. That's especially disappointing because Amazon seemed to be on a profit-margin roll back in 2004, producing the best operating margin, 7.3%, in the company's history. A drop to the neighborhood of 6% in 2006 would be a huge step backward. So what exactly is the problem? In a nutshell, Amazon's business hasn't scaled according to schedule. By this point, for example, Amazon should be able to hold what it calls investment in technology and content relatively stable, even as the company grows in size. Yes, the company will continue to need to invest in its business. But Amazon's brand and its clout in the marketplace should let it reduce that spending as a percentage of revenue as revenue grows. Instead, the company's spending in this category jumped 57% in the fourth quarter of 2005. And Amazon isn't getting any leverage on operating expenses or shipping costs, either. Those two rose by 31% and 17%, respectively, in the quarter. Google looks Amazonian I've spent so much time on Amazon because Google is showing symptoms of the same failure to scale on schedule. Google's hiring rate in 2005 of 88% just trails its revenue-growth rate of 93%. Capital spending was up 163% in 2005 over 2004. Research and development costs rose 115%. Sales and marketing, up 79%. General and administrative costs were up 140%. Maybe Google is still too young for any of this to be an issue. Its 2005 revenue of $6.1 billion was, after all, only about 15% of Microsoft's But when a stock trades at 73 times trailing earnings, I'd argue that these numbers do matter, and that investors shouldn't assume that Google's profit margins will grow as its revenues do. That's especially true when the company starts to talk about paying Dell Phone numbers Let's take the same kind of look at a very different company, AT&T, that's growing by acquisition, a very different model from Google's. I've read all the Wall Street explanations for why AT&T's acquisition of BellSouth makes good business sense. It will increase the company's footprint in both conventional land-line and wireless phone services. It will enable the company to compete more effectively with the cable companies in offering new services such as TV and long-distance telephony over the Internet. And, of course, there's the conventional explanation for why the deal is so great: synergies. The newer, bigger AT&T will be able to cut costs by $2 billion annually in stage one and then increase the savings to $3 billion annually by 2010. Much of that will come from job cuts: 10,000 as a result of the acquisition of BellSouth and 13,000 as a result of November's deal combining SBC and AT&T. I get the job-cut part, but I don't see why AT&T had to acquire BellSouth if all it wanted to do was reduce costs by paying fewer workers. The other stuff? It just doesn't hold up for me. AT&T owned 50 million access lines before the deal and had 7 million DSL (high-speed Internet) lines in place before the merger. BellSouth will bring 20 million access lines and 2 million DSL lines. That's a hefty chunk of customers, but not really to the point if you're talking about the ability to offer new services. And isn't a company with 50 million land-lines already so big that adding 20 million more isn't a significant change in scale? The deal is especially puzzling when you look at the liabilities it brings to AT&T. The company already has one of the 10 largest unfunded pension obligations among the companies in the Standard & Poor's 500 ($INX). A shortfall of $12 billion puts the company just below General Motors Besides pension costs, the other huge drag on phone-company profitability right now is capital spending, which is needed to deliver all the neat stuff that is supposed to win the battle against the cable companies. AT&T isn't as far along in its buildup as Verizon, the industry leader. But it's not far behind, and Wall Street projects that after climbing by another 4.1% in 2006 (after a 7% increase in 2005), AT&T's capital spending will level off in 2007 and then start to decline. Land-line locked BellSouth, on the other hand, has been spending most of its money on its legacy land-line network and on its wireless system, with relatively modest investments in the fiber optics necessary to deliver the brave new world of services to the home that the phone companies are betting on to beat back cable. So in buying BellSouth, AT&T is taking on a high-technology build-out that is less advanced than its own. But if you ignore the high tech razzle-dazzle that Wall Street is using to sell this deal to investors and that AT&T is using to sell it to consumers and Congress, and look instead at the old land-line business, you will see how scale is important. The land-line business -- you know, your Mom and Dad's telephone -- isn't growing. Wireless and Internet telephony are taking their share. Prices are dropping. AT&T projects a 3% drop in wire-line revenue in 2006, followed by a 1% drop in 2007. Yep, in some ways, it's a terrible business. On the other hand, it still generates huge cash flows. In 2005, $40 billion out of AT&T's $65 billion in total revenue came from the land-line segment. That's 62% of revenue. About 57% of earnings before interest, taxes, depreciation and amortization came from the land-line segment. And you know what? Profit margins in this declining business are actually climbing. By cutting customer service and reducing work forces, the phone companies have been increasing the cash this cash cow yields. Now think of the deal not as designed to improve AT&T's position in new technologies, but to defend the old legacy phone business and these climbing margins. If you can remove a competitor, as SBC did when it bought AT&T and AT&T did when it bought BellSouth, a company has more ability to cut costs by reducing customer service without the fear that some competitor, spending slightly more on this business, will poach your customer. So in this one business -- the declining legacy business that no one really wants -- scale does matter, and bigger is better. Adding a percentage point or so to your profit margins adds up pretty quick when you're looking at $40 billion in revenue. And, of course, if you know that you're going to be going head-to-head in an investment war with first the cable industry and then with new WiMax broadband wireless technologies, every extra dollar you can get from that cash cow counts. Updates Sell iShares MSCI Japan I added the iShares MSCI Japan Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For suggestions to help navigate the treacherous interest-rate environment see Jim's new portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio. E-mail Jim Jubak at jjmail@microsoft.com. At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: iShares MSCI Japan and Microsoft. He does not own short positions in any stock mentioned in this column. | |||||||||||||||||||||||||||||
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