The Economic Obsolescence Risk to NVIDIA GPU's

The financial press has had a field day in discussing the depreciation risk associated with high end NVIDIA GPU chips. However, lurking beneath the surface is the risk of economic obsolescence. That risk will come from the availability of lower cost chips such as the Google Tensor processor. Moreover, additional competition will come from Amazon and Elon Musk who are developing their own chip sets.

The arithmetic is simple. A high-end NVIDIA GPU chip set costs about $60,000 of that $43,800 represents NVIDIA’s extraordinarily high 73% gross margin. In this example NVIDIA’s cost is $16,200. Herein lies the risk. Lower cost chips produced, at say a more normal, but still high 60% gross margin would yield a price of $40,500. Thus, AI competitors using the newer chips would have a significant 1/3 cost advantage thereby rendering the existing NVIDIA chips economically obsolete. In a way NVIDIA could very well become a victim of its own success.

To be sure, NVIDIA is a technological behemoth, and it has its CUDA software to lock in existing customers. Nevertheless, the mere existence of a 73% gross margin will ultimately bring price competition into the GPU landscape.

My Review of Donald Chew Jr.'s "The Making of Modern Corporate Finance"

An Ode to Modern Financial Theory

As a former professor of finance, I read Donald Chew’s book with great interest. His book is a history of the development of modern financial theory from its early roots in John Burr Williams’ 1938 “Theory of Investment Value” to its beginning in the late 1950’s with the works of Miller and Modigliani on capital structure and dividend irrelevance. He made a mistake in attributing Myron Gordon’s model to Williams. 

Chew writes in a very breezy style by referring to Michael Jensen as Mike and Stewart Myers as Stu. From his post as an editor of Stern Stewart’s “The Journal of Applied Corporate Finance,” he got to know most of the major players in academic finance. I too met many of the academics he discusses, and indeed I was an early adopter of Brealey and Myers textbook he highly praises in my corporate finance class during the 1982-83 academic year. I also met, on several occasions, his mentor, Joel Stern.

Chew makes the case that earnings per share don’t count, but rather it is the ability of a corporation to earn a return above the cost of capital with return measured as net operating profit after taxes. It is with this insight that Stern Stewart pioneered the concept of economic value added. (EVA) Indeed, instead of using earnings to value a corporation, value can be defined as the present value of the cash flow associated with existing assets plus the present value of future growth opportunities. Hence, Amazon for example, can trade at values divorced from current earnings.

However, he oversells his point that earning per share doesn’t count. Corporate management and analysts continue to stress earnings per share and woe to the company that misses its quarterly earning estimates.  In the short run earnings seem to count a great deal.

He also oversells private equity. To be sure private equity posted extraordinary returns in its first twenty years starting in the 1980’s. Since then, returns have eroded, and their risks have been underrated. Put simply, the industry is guilty of what Cliff Asness of AQR, calls “volatility washing.”

This book is of interest to readers who are interested in how modern financial theory evolved and it is helpful in understanding what forces drive stock prices in long run.

 

My Review* of Sergey Radchenko's "To Run the World: The Kremlin's Bd.........."

 The Rise and Fall of Soviet Foreign Policy

 

Johns Hopkins professor Sergey Radchencko has given us a deeply researched and encyclopedic book on Soviet foreign policy from 1944 – 1991 from the point of view of the Soviet leadership. He gets into the heads of Stalin, Khrushchev, Brezhnev, Gorbachev, and their foreign policy minions. The Soviet leadership faced the tension among three incompatible goals of maintaining its revolutionary ideology, the need for security and its search for legitimacy among the nations, especially the United States.

 

He starts off with Stalin as the ultimate European focused leader whose “percentages agreement” with Churchill in late 1944 opened the way for Soviet control over Eastern Europe. He argues that Stalin did not initially want to Sovietize the Eastern Europe economies until he witnessed the failure of the French and Italian Communist parties to win electorally in the mid-1940’s. I don’t really buy that because the hardening of the Soviet position occurred while the war was still going on. Further, Radchenko fails to mention the Duclos letter to the American Communist Party in April 1945 criticizing its softness which signaled a hardening of the Soviet position worldwide.

 

What Stalin envisioned in 1945 was that Russia, as in 1815, would be part of a new Concert Europe that would run the continent. Hence Soviet power would be viewed as legitimate. Russian actions in Poland, Czechoslovakia, and Berlin soon stripped away any sense of legitimacy, and in response NATO was formed. What I found fascinating was that anglophiles in the foreign ministry, Maksim Litvinov (ex-foreign minister and ambassador to the U.S.) and Ivan Maisky (ex-ambassador to the U.K.) played leading roles in developing Stalin’s European policies.

 

In Asia Stalin did not believe that Mao would succeed and for a time played the nationalists off against Mao’s communists. Mao accepted Stalin’s leadership as a junior partner. He would not feel such obedience under Khrushchev. In Iran Stalin was very cautious and he withdrew his forces from northern Iran thereby selling out the local communists who supported him.

 

Khrushchev was far more reckless. In Europe he ignited a Berlin Crisis, n caused a nuclear war over missiles in Cuba, and was an early supporter of Third World revolutionaries. Russian influence had to be reckoned with throughout the world. All the while the Soviets were building up their missile and nuclear capabilities in a direct challenge to the United States. This was crucial to Khrushchev because he sensed the unfairness of the United States having military bases surrounding the Soviet Union while he couldn’t have bases close to the United States. Hence, the big play in Cuba.

 

Khrushchev’s 1956 speech denouncing Stalin sent ripples throughout Communist Parties around the world triggering revolts in Poland and Hungary. While Chairman Mao respected Stalin, he had no such respect for Khrushchev and hence the long simmering Chinese jealousy towards Russia began to boil.

 

The split with China would widen to even include military action and a break in diplomatic relations with the Soviets and the opening of relations with the U.S. after the Nixon visit in 1972.  In 1978 Deng Xiaoping took power and embarked China on a capitalist road to prosperity. His goal was modernization, but as early as 1982, after he realized that the U.S. would stand by Taiwan, China gradually began its drift back towards Russia. In fact, two weeks before the 1989 Tiananmen massacre China resumed diplomatic relations with Russia. Thus, it should not be surprise to see Putin’s Russia and China cozying up in recent years.

 

In 1964 Brezhnev replaced Khrushchev and simultaneously accelerated the nuclear arms race and sought détente with the United States. In making arms deals with Nixon, Brezhnev at once lowered the risk of a nuclear holocaust and achieved the legitimacy he sought from the United States. One of the most powerful vignettes in the book is that Radchenko recounts that at the height of the 1973 Yom Kippur War Nixon was asleep and drunk and Brezhnev was zonked out on sleeping pills. The decision over war and peace was thus made by Kissinger and Andropov.

 

Brezhnev’s failing health later in the 1970’s was emblematic of sclerosis seizing up in the Soviet economy. Even allowing for Soviet gains in Africa, Soviet power was falling under the weight of its weakening economy. That economy would be put to the test with Reagan’s military buildup in the early 1980’s. Simply put the Russian leadership went into panic mode fearing they could not keep up. If you learn one thing from this book, it is that Reagan’s foreign and defense policies brought the Soviets to their knees.

 

Gorbachev tried to turn things around with his glasnost and perestroika, but the Soviets were too far gone. To ease the pressure on the economy he made a series of arms control deals with Reagan and Bush thereby legitimizing his country and he cut loose Eastern Europe because the economy could no longer afford to subsidize its satellites.

 

Gorbachev was a proponent of the Gaullist notion of a Europe from the Atlantic to the Urals. He called it “Our Common European Home.”  It was too late. Radchenko notes that there were discussions about limiting NATO’s reach in Eastern Europe. However, not commitments were reduced to writing and thus under Clinton NATO expanded to the borders of Russia.

 

One last point the Soviet Union had two diplomats who were survivors, and they appear throughout the book. Andrei Gromyko was a power from 1945-1988 and Anastas Mikoyan was a major player from 1935-1966. It was though them that Soviet foreign policy has continuity and historical memory. Radchenko has written an important book, and it will be useful in gaining insights into how Putin’s policies are both a continuation and a departure from the history he has outlined.

*- I am engaged in a dispute with Amazon about my ability to post reviews on their site. Amazon alleges that I have gone afoul of their community guidelines. Amazon is very difficult to communicate with so dear readers if you have a way of weighing in with Amazon, please do.

The Defanging of the Stock Market

 

April has brought with it the defanging of the stock market where the hitherto invulnerable FAANG stocks crashed and burned bringing with it a full-fledged bear market in the NASDAQ Composite Index. FAANG stands for Facebook (now Meta Platforms) Apple, Amazon, Netflix, and Google (now Alphabet). From their respective 52-week highs Meta is down 48%, Apple is down 13%, Amazon is down 33%, Netflix is down an astounding 73% and Alphabet is down 23%. Taken as a whole the NASDAQ Composite is down 23%. The weakness in these five stocks which at one time accounted for nearly a quarter of the market value of the S&P 500 brought that benchmark index down 14%.

 

Market behavior of this type is reminiscent of the 1973-74 and the 2000-02 bear markets. In the 1970s the so-called Nifty-50 group of one-decision growth stocks which were trading at 50-60X earnings experienced declines in excess of 50 -80% during the course of the bear market. In the collapse of the 2000 dot.com bubble such stalwarts as Cisco, Microsoft, Intel, and Oracle (a group of stocks that I then characterized as “The Four Horseman of the NASDAQ”) which traded at multiples in the 80-100X range lost about three quarters of their market value. Indeed, just as today, the stock market was bracing for a tightening of monetary policy. Needless to say, the history is not encouraging.

 

There are, however, two distinct differences between then and now. First, from 1972-74 the 10-year Treasury traded in a 6-8% range and in 2000-02 it traded in a 5-6% range far higher than the current 2.9% yield. Second, with the exception of Netflix valuations are nowhere near as demanding with Alphabet trading less than 20X earnings, Apple at around 25X, Meta at a below market 14X earnings. As a result, even if Treasury yields rise to 4%, my sense is that the worst of the declines in FAANG and the market as whole are behind us.

 

To be sure, we could soon be looking into the teeth of a recession triggered by a very aggressive Fed and continued high inflation which would haircut earnings estimates across the entire market. We are sure to have a recession at some point, but I do not believe it is soon. Simply put the end of the pandemic is fueling a consumer boom and capex remains strong fueled technology and energy related spending of all types. Thus, it will take more than 250 basis points of tightening to break this economy. Of course, if we are in a rerun of “That 70’s Show,” all bets are off. (Shulmaven: Roaring 20's or That 70's Show)

 

As I wrote in February(https://shulmaven.blogspot.com/2022/02/the-unravelling.html), my sense is that we are in a structural bear market in bonds and in for a very volatile stock market. Whether or not the lows are in or not, I do not know, but the world will not look as bad in December as market participants feared last week. Net, net although 2022 will be a down year for stocks, the market will end the year higher than where it is now.

My Amazon Review of Jonathan Haskell's and Stian Westlake's "Capitalism Without Capital: The Rise of the Intangible Economy"

UK economics professor Jonathan Haskell and UK consultant Stian Westlake have written an important book on the ever growing importance of intangible assets in the modern economy. Unfortunately the book is too long and it would have better been written as a long magazine article. Nevertheless they succeed in pointing out that the values of firms are now largely dependent upon intangible capital and that society at large is increasingly being ordered around it. In very simplified terms the mode of production has shifted from hardware to software and we witness that every day with our use of Google, Facebook, Amazon, Netflix, and yes Starbucks. Why Starbucks? In the case of Starbucks it is the managerial software behind their organizational instructions that makes each coffee shop run.

Unlike tangible capital, intangibles are readily scalable, offer huge spillover effects and generally work synergistically with other intangibles. However in order to create intangible capital the sunk costs are unusually high and risky which makes debt finance difficult to obtain. A bank will lend on a machine, but not on in process software code.

This book should be read in conjunction with Baruch Lev and Feng Gu’s “The End of Accounting” where they establish new rules for dealing with intangible capital.( https://shulmaven.blogspot.com/2016/07/my-amazon-review-of-baruch-lev-and-feng_19.html)    In the case of the public sector, national GDP accounting has introduced intellectual capital as a form of investment. That category includes such things as computer software, research and development and filmed entertainment, for example.

On the societal level the growth of intangible capital tend to exacerbate income inequality. Success no longer flows to the tinkerers and mechanics of the 19^th century but rather to the degreed knowledge workers of the 21^st century. I would note one small error in the book. The authors called Robert Reich a future Treasury Secretary when, in fact, he was future Labor Secretary. All told Haskell and Westlake have given us a good overview as to how modern economies are being transformed.

The full Amazon URL appears at: https://www.amazon.com/review/R3JEO64PYDQCJS/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv

Mall Valuations Post GGP/BPY

This is my fifth post on high quality mall REIT valuations in less than a year. Going back to my first post on May 4, 2017 ( https://shulmaven.blogspot.com/2017/05/a-new-look-at-mall-reit-valuations.html) I noted that the 4.5% cap rates used by most REIT analysts were way to low and I argued that a 5.65% cap rate was more appropriate. This analysis did not receive much support when Unibail announced its acquisition of Westfield last fall that implied a cap rate for its U.S. assets in the high 4% range.

However, the Brookfield Property Partners (BPY) acquisition of the 64% of the shares of GGP that it did not own at an implied cap rate estimated to be in 5.8%-6% range validated my thesis. The BPY offer was valued at around $22 per GGP share, 19% below the Street consensus net asset value of $27.28. Warning: take Street estimates of NAV with a grain of salt.

If anything I was too optimistic. I argued then that high quality mall cap rates were under stress because the e-commerce challenge would require significantly high capital expenditures, lower future estimates of rent growth and cause a downgrading of approximately 15% of the those malls considered to be high quality over the next five years.  As of today the first two of my assumptions are now the conventional wisdom. I also argued that higher long term interest rates would pressure cap rates.  Since then the 10 year treasury yield has increased from 2.3% to 2.8%.

Yesterday mall stocks tanked on the GGP news. However, today the mall REIT shares are soaring on reports that President Donald Trump is out to get Amazon, their arch nemesis. As of 3:00 PM EDT AMZN was off by 5% and SPG, for example, was up by 3%. In my view today's stock market action is a transitory phenomena and the mall REITs will be revalued to reflect the GGP transaction. Simply put, AMZN ain't going away, Trump or no Trump.

What that means is that once the Street adjusts net asset values to reflect high quality mall cap rates in the high 5% range, the stocks will settle in to trade at about a 10% discount from the new asset values which implies moderately lower share prices. Why? There is still too much uncertainty in the space and in my view long term interest rates will be significantly higher by year end.

"In the E-Commerce Revolution Brick and Mortar Defenses are Limited and Costly" UCLA Ziman Center for Real Estate Report, October 2017

See the URL below for the full report.

http://www.anderson.ucla.edu/Documents/areas/ctr/ziman/UCLA_Economic_Letter_Shulman_10.10.17.pdf

Amazon, Whole Foods and Shopping Center REITs

Amazon’s proposed takeover of Whole Foods sent shock waves through the grocery, packaged food and shopping center REIT industries. The instant judgement of the market was that the deal is very good for Amazon and bad for the three industries named. Seemingly oblivious to the true import of the deal were stock analysts who cover the REIT industry. To them the deal ratifies the value of what they characterize as high quality real estate. To be sure the 460 or so Whole Foods’ locations mostly sit on some of best shopping center real estate in the country, but that is a tiny segment of the industry.

Nevertheless that really misses the larger point. Amazon’s roll in life is to destroy the gross margins of its competitors. Thus if Amazon succeeds, and it doesn’t always, the 21% gross margin of supermarket operator Kroger will be a relic of the past. My guess is that under Amazon, Whole Foods’ industry high 35% gross margin will give way to something much lower. Although most analysts use sales/square foot as metric for rent paying ability, the true metric is gross margin/square foot and that is about to collapse for most food retailers. As a result rents will fall. Just think of all the grocery stores that will face pricing and market share pressures from the combined behemoth. Trust me, it is not going to be pretty and investors will soon find the safety they sought in grocery anchored centers to be illusory.

What Amazon appears to be doing is to link up the high income consumers who are Amazon Prime customers with the equivalent Whole Foods customer. In fact of all of the supermarket chains in America there is probably the greatest overlap between Whole Foods shoppers and Prime. Simply put Amazon wants to own the high income consumer which will make it easier for the Whole Foods customer to buy goods on Amazon Prime while shopping with the physical store becoming either a delivery point (where the customer takes physical delivery) or a distribution point (where the goods are shipped out to the customer). In essence Amazon will be placing its digitally sophisticated integrated global logistics capabilities at the service of the high income-time constrained consumer.

One last point, to the extent that Amazon will “own” the high income consumer it will be bad news for the operators of A+ regional malls.

A New Look at Mall REIT Valuations

As most REIT practitioners know all too well, the mall sector has been hammered of late by fears of obsolescence engendered by the explosive growth of e-commerce causing the group as a whole to trade at a 30% or so discount to Street net asset value estimates. My explanation is that the estimates of value are way too high. How so?

At the present time the Street seems to be assuming that high quality malls are valued at a 4.5% cap rate, but in my opinion that doesn't take into account the increased capital spending required by mall owners to compete with the likes of Amazon. So instead of using a 4.5% cap rate lets use 5%. There is more though. Simply put some of the high quality malls are going to be degraded over time. My very rough estimate is that about 15% of the high quality malls will be re-rated over the next five years causing a cap rate increase to say 6% for those malls. Thus the weighted average cap rate should be 5.15%.

Now lets add another 50 basis points to allow for higher long term interest rates over the next few years yielding an adjusted cap rate of 5.65%. When you do this exercise you end up with a net asset value approximating current market prices. The arithmetic is below.

Net Operating Income   $45
Cap Rate Today                 4.5%
Firm Value                    $1,000
Debt @30%                       300
Equity Value                      700
Market Value                      490  (30% discount)

New Cap Rate                     5.65%
Firm Value                         $796
Debt                                     300
Pro forma Equity                  496
Market Value                        490

Thus the market might just have it right. You can play with my assumptions to your heart's content, but I think this is a reasonable analytical framework.

Bezos vs. Trump

Today's front page story in the Washington Post (https://www.washingtonpost.com/world/national-security/blackwater-founder-held-secret-seychelles-meeting-to-establish-trump-putin-back-channel/2017/04/03/95908a08-1648-11e7-ada0-1489b735b3a3_story.html?hpid=hp_hp-top-table-main_seychelles-0438pm-1%3Ahomepage%2Fstory&utm_term=.101c69598045) highlighting a meeting with Blackwater founder Erik Prince (brother of Education Secretary Betsy DeVos) and an emissary from Putin in the Seychelles Islands deep in the Indian Ocean signifies the lengths to which the Washington Post is going to investigate the Trump Administration. With sources in the Seychelles and the UAE, which brokered the meeting, a four reporter team pulled together a story that began in December with Trump triumvirate of Flynn, Bannon and Kushner meeting with a UAE representative in New York. The result was a January 11 meeting in the Seychelles.

To do a story like this requires substantial resources and it demonstrates the commitment Post-owner and Amazon founder Jeff Bezos has made to investigative journalism. Put bluntly Trump is in the cross-hairs of a multi-billionaire willing to go after him. However as the rivalry escalates do not be surprised to see Amazon in Trump's cross-hairs.     

Amazon in the Mall: Putting the Fox in the Hen House

Last week General Growth Properties CEO Sandeep Mathrani noted on an earning conference call that Amazon was planning to open up from 300-400 mall stores. He quickly back-tracked by stating that his comment "was not intended to represent Amazon's plans." 

I have no idea whether or not Amazon will embark on such an ambitious plan, but what I do suspect is that Amazon is not going to blow up its business model by opening up a bunch of book stores on very expensive real estate. My guess is that if Amazon is going to go the physical retailing route it will be more than selling books and their proprietary hardware. 

Picture if you will a catalog store that offers the customer the entire Amazon product line in a very easy to use format that goes well beyond today's smart phones. Of a sudden the mall customer would be able to readily comparison shop the entire mall and with that the pricing structure within the mall will crater. This would not be a happy outcome for retailers and their landlords, the giant mall REITs.