wiltw june 25_2015

WHAT I LEARNED THIS WEEK ® June 25, 2015

13D Research (340) 775-3330 www.13d.com What I Learned This Week 6/25/15

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If you celebrate what you have now, nothing you get—and I mean nothing; nothing material, nothing experiential, no amount of information, no amount of experience, no amount of material possessions—is going to teach you how to celebrate.

WuDe, The Zen of WuDe

The beginning of worth-while living is thus the confrontation with ourselves.

Harry Emerson Fosdick, On Being a Real Person

He who does not trust enough, will not be trusted.

Lao Tzu

Give a man a mask and he will show his true face.

Oscar Wilde

The humble person understands that experience is a better teacher than pure reason. He understands that wisdom is not knowledge. Wisdom emerges out of a collection of intellectual virtues. It is knowing how to behave when perfect knowledge is lacking.

David Brooks, The Road to Character

Ma’am…I don’t know what it is you are wishful for in this life, but you set down of a night and you pray to God that he’ll let you walk alone across a mountain meadow when the wild flowers are blooming. You pray he’ll let you set by a mountain stream with sunlight falling through the aspens, or that he’ll let you ride across an above-timberline plateau with the strong bare peaks around you and the black thunderheads gathering around them—great, swelling rain clouds ready to turn the meadows into swamp in a minute or two…you let him show you those things, ma’am, and you’ll never miss heaven if you don’t make it.

Louis L’Amour

Out of the crooked timber of humanity, no straight thing was ever made.

Immanuel Kant

Nothing is easier than self-deceit. For what each man wishes, that he also believe to be true.

Diane Arbus

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1. Buy when they give it away. What are they giving away now? (pg 4) In 1977, we were walking uptown in New York City with a friend who worked for a prominent trust company. He told us that the trustees of an estate had just sold a triplex on East End Avenue for $1. The reason? The $3,000 per month maintenance was “depleting the assets of the estate”.

Last week, Glencore sold the Cosmos nickel mine for AU$24.5 million. In 2008, Xstrata Plc paid AU$3.1 billion for Jubilee Mines to gain control of Cosmos—the Perth-based company’s flagship operation.

While full accounting is not so straightforward, in simplest form, the properties were bought and resold 7 years later at a 99% loss.

There is a giant infrastructure investment boom just getting started in Asia and along the Silk Road. Wasn’t the whole commodity boom of the last decade based on infrastructure investment in China? Now, it will expand to all of Asia and beyond.

2. The Shanghai Composite Index has posted its biggest weekly loss in seven years, creating an

excellent opportunity to buy A-shares. The secular asset re-allocation away from savings deposits and the property market has only just begun, as the amount of corporate and household savings, estimated at around 133 trillion yuan, is more than double the total market capitalization of mainland-listed companies, which now approximates 62 trillion yuan—implying huge upside as

capital migrates into equities. (pg 6)

China’s A-shares sold-off hard last week, with the Shanghai Composite Index declining 13%—the largest weekly decline in more than seven years. Sharp declines such as this are a common occurrence during Chinese bull markets. We think the recent selloff represents an excellent buying opportunity for investors, particularly for the many foreign investors who have largely missed out on the rally in Chinese stocks thus far.

3. World War “P” begins. (pg 10)

Hundreds of stars and more than 10,000 people who craft brands around them amassed on the coast of France this week as they do each year for the Cannes Lions International Festival of Creativity—the advertising industry’s biggest celebration. But no longer are the delegates like-minded creative types. The trickle of tech-industry party crashers that began last decade has become an invasion—with battalions from Silicon Valley outnumbering those from Hollywood. The opulent celebration is funded by the $540 billion per year advertising industry—and the new ubiquity of mobile devices and ability to finely target prospects have rapidly grown digital advertising’s share of that to 24%, according to Carat. But new challenges to intrusive advertising techniques are spreading—triggering a war throughout the world that will be fought not for control of land—but for privacy. We will call it World War “P”.

4. “Wi-Fi first” technology represents one more “nail in the coffin” for the traditional big telecom

business model—and will help drive accelerating consolidation in the wireless sector. (pg 15) Numerous startups are now deploying low-cost Wi-Fi calling over wireless technology that is poised to disrupt one of big telecom’s primary cash generators—mobile voice calls. This combined with growth in bandwidth bottlenecks, the need to invest network infrastructure in the face of soaring data demand, and slowing subscriber growth in developed markets will drive accelerating consolidation in both telecom operators and key Wi-Fi network equipment suppliers.




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5. Are bonds oversold or is this the beginning of a sustained increase in interest rates (continued)? (pg 19) We asked this question in WILTW June 4, 2015 when we noted: “Sentiment on bonds has become much more bearish since April. However, it may be prudent to look at other markets in the past few years for guidance. Gold was oversold, yet continued to decline. Last year, oil was very oversold and yet it continued to plunge. The U.S. dollar was very overbought and an enormously one- sided trade for months, yet it continued to advance.”

6. In the run-up to the Fed’s coming interest rate hike, rising bond yields may take the steam out of the

currently-feeble recovery. According to the New York Fed, real consumption expenditures have not shown signs of a significant pickup since the winter slowdown, while real business investment has been trending lower. At 28%, buybacks as a percent of corporate cash use are at their highest since 2007, but this spending is not creating sustainable growth. (pg 22) Although an overwhelming majority of the Fed’s policy-making committee expects the central bank to raise interest rates this year, the inability of the U.S. dollar index to break its March 2015 highs appears to be signaling otherwise. Given the weak first quarter and the slow start to the second quarter, one has to wonder if the current stage of the recovery has enough staying power to last into the fourth quarter, when many expect the first rate rise to occur.

7. The emerging Virtual/Augmented Reality industry represents a new transformational

communications interface that could upend the entertainment, healthcare, and education industries, and disrupt current business models across numerous industries. VR/AR represents an opportunity to invest at the front-end of a new technology era that could have a global impact on the scale of smartphones. Huge new winners could emerge, with makers of key enabling technologies holding compelling risk/reward ratios. (pg 23) Virtual reality (VR) and augmented reality (AR) technologies have the potential to be highly disruptive over the next five years, because the next era of computing will evolve around how the digital and analog worlds intersect. VR/AR are nascent with major transformative power, and providers of key enabling technologies are well-positioned to capitalize on this new emerging industry. Which companies are poised to lead?

8. The reason to maintain short exposure to overleveraged oil and gas companies: interest payments

are consuming a growing portion of cash flow after debt ballooned by 16% over the past year, while companies are spending over $4 for every dollar earned on oil and gas sales. Maintain short positions on Magnum Hunter Resources (MHR, $1.75) due to weak operating metrics. (pg 30) A June 18th Bloomberg story noted the following: “Interest payments are eating up more than 10% of revenue for 27 of the 62 drillers in the Bloomberg Intelligence North America Independent Exploration and Production Index, up from a dozen a year ago…”

9. The Innovation Economy: A Darwinian Fight Between Machine and Human Intelligence. Who

Will Win? What are the economic, social and political implications of this relentless disruption? (pg 32) As we wrote in WILTW May 14, 2015, the Rise of the Robots: Technology and the Threat of a Jobless Future by Martin Ford is one of the most important books we have ever read about disruption and the coming automation that threaten jobs across almost every sector of the economy. “Advances in artificial intelligence may make it even easier to offshore jobs that can’t yet be fully automated…Virtually any occupation that primarily involves manipulating information and is not in some way anchored locally—for example, with a requirement for face-to-face interaction with customers—is potentially at risk from offshoring in the relatively near future and then from full automation somewhat further out.”


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http://www.amazon.com/Rise-Robots-Technology-Threat-Jobless/dp/1480574775



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1. Buy when they give it away. What are they giving away now? In 1977, we were walking uptown in New York City with a friend who worked for a prominent trust company. He told us that the trustees of an estate had just sold a triplex on East End Avenue for $1. The reason? The $3,000 per month maintenance was “depleting the assets of the estate”. We can’t imagine the return on that apartment ever since. Around the same time, top Manhattan townhouses were selling for $40,000—and today are easily worth 1,000 times that. This was also the era when two of the greatest real estate investments in modern American history were made—the purchase of the Uris properties by the Reichmanns’ Olympia & York and the Irvine Ranch by Don Bren.

We were very familiar with both deals. In 1977, the National Kinney Corporation was trying to sell eight Manhattan office buildings known as the Uris portfolio because the city was flirting with bankruptcy and the real estate market was severely depressed. The Reichmanns concluded the Uris land alone was worth more than the $320 million asking price. Within a few years, the glut of office space had turned to a shortage and the Reichmanns were able to triple rents with almost full occupancy. Within five years, their $320 million investment grew to an estimated $3 billion. From intense deflation to double-digit inflation in only a few years. Could it happen again? The Real Deal of March 16, 2015 writes the following on Bren: “Donald Bren, the California-based investor who is the majority owner of Manhattan’s MetLife Building, is worth $15.2 billion, making him the richest real estate investor in the country, according to Forbes. His firm, Irvine Co., owns 500 office properties, 50,000 apartments and more than 40 shopping centers. But how did he get his start?... By 1977, Bren and his investment partners started buying shares of the Irvine Co., a former cattle ranch-turned developer active in Orange County. Bren started with a 35% stake, and armed with a $560 million loan, spent the next few years buying out his partners to become the absolute owner of the firm by 1996.” Fast forward to the collapse in commodities in the early to mid-1980s. A friend of ours was the controller of a major oil company, which had purchased at very high prices, a number of aluminum and base metal assets during the hyperinflation of the late 1970s. By the mid 1980s, these assets were hemorrhaging losses and my




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friend was able to purchase from his employer an aluminum property in the West at zero cost. Within a few years, that aluminum smelter was generating profits of $100 million a year. In 1985, the soaring U.S. dollar was devastating U.S. exports. If you had walked into almost any CAT dealership, they would have given you the keys to a brand new CAT for nothing down and probably the dealership along with it. By the fall of 1985, however, pressure on exports had become so painful that the U.S. orchestrated a major devaluation through the Plaza Accord, which continued until the long dollar basing of 1991-1995. What are they giving away now? Last week, Glencore sold the Cosmos nickel mine for AU$24.5 million. In 2008, Xstrata Plc paid AU$3.1 billion for Jubilee Mines to gain control of Cosmos—the Perth-based company’s flagship operation. Last year, Glencore sold the secondary Sinclair project to Talisman Mining for $8 million plus a $2 million contingency. While full accounting is not so straightforward, in simplest form, the properties were bought and resold 7 years later at a 99% loss. Xstrata, which was purchased by Glencore in 2013, acquired Jubilee when nickel was selling for about $32,000 a metric ton—2.5 times higher than where it now trades. Bloomberg recently noted that Rio Tinto Group similarly sold Mozambique coal assets last year that it bought in 2011 with the AU$3.9 billion takeover of Riversdale Mining. The selling price? $50 million. For what it’s worth, Javier Blas tweeted this week that, based on data from Citi Research, 90% of all M&A that miners did since 2007 has been written off. Makes you wonder about the current M&A boom… It is interesting to note how little is being written in the West about One Belt, One Road (see related themes). China Development Bank notes that the number of cross-border projects underway in the Silk Road effort already amount to $980 billion. Reportedly, Asia’s infrastructure needs are close to $8 trillion by 2020. Last week, the Financial Times’ Investment Management Summit took place in Hong Kong. Zhou Yuan, head of strategy at China Investment Corporation, told the conference: “If you can’t expect a return–that is, if you can’t expect infrastructure projects to pay you a dividend some time down the road, you can’t call that investment any more. You might as well call that a Marshall Plan.”




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Jennifer Hughes of the FT elaborated on this subject, as follows: “Inevitably, comparisons abound between China’s AIIB and the U.S.-financed 1948 Marshall Plan that supported European rebuilding after the second world war, and that deployed its current account surpluses in a way that backed American economic and geopolitical goals. China’s current plans include its Silk Road economic initiative (One Belt, One Road), its interest in a Brics development bank as well as the AIIB and other investments such as those funded by CIC, its sovereign wealth fund.” In other words, there is a giant infrastructure investment boom just getting started in Asia and along the Silk Road. Wasn’t the whole commodity boom of the last decade based on infrastructure investment in China? Now, it will expand to all of Asia and beyond.

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2. The Shanghai Composite Index has posted its biggest weekly loss in seven years, creating an excellent opportunity to buy A-shares. The secular asset re-allocation away from savings deposits and the property market has only just begun, as the amount of corporate and household savings, estimated at around 133 trillion yuan, is more than double the total market capitalization of mainland-listed companies, which now approximates 62 trillion yuan—implying huge upside as capital migrates into equities. China’s A-shares sold-off hard last week, with the Shanghai Composite Index (SHCOMP Index, 4,528) declining 13%—the largest weekly decline in more than seven years. The selloff continued through Tuesday morning’s session, and by midday, the SHCOMP had lost as much as 913 points, or 18%, from its most recent peak of 5,178. However, as we have noted previously, sharp declines such as this are a common occurrence during Chinese bull markets. We think the recent selloff represents an excellent buying opportunity for investors, particularly for the many foreign investors who have largely missed out on the rally in Chinese stocks thus far.

Below, we summarize eight key reasons why we believe the bull market will continue:

Real interest rates are still positive, suggesting that the central bank (PBOC) has ample room to ease monetary policy further. The following chart from Bloomberg indicates that China’s major bull markets have correlated




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strongly with real interest-rate cycles. One may recall that the epic bull market in 2007 was largely driven by household savings leaving the banking system in search of higher returns elsewhere, as deposit accounts were generating record negative real-interest rates (denoted by the red line in the following chart). Therefore, it is understandable that the nadir of the real-interest-rate cycle roughly coincided with the peak of the Shanghai Composite Index in late 2007/early 2008, with a lag of just a few months.

China’s Real Interest Rates (red) versus SHCOMP (blue)

Source: Bloomberg. Note: Real interest rates were calculated using one-year saving deposit rates minus reported CPI.

Given its burgeoning fiscal savings accumulated over the past decade, the Chinese central government also has plenty of leeway to run an accommodative fiscal policy for at least a few more years to support its domestic economy. For further details on this, please refer to our report on Beijing’s sharp turn on fiscal policy in WILTW June 11, 2015.

The secular asset re-allocation away from savings deposits and the property market has only just begun. According to data from the PBOC, the total savings in China, including both corporate and household savings, is estimated at around 133 trillion yuan (or $21 trillion) at the end of May 2015. This number is more than double the total market capitalization of mainland-listed companies, which now approximates 62 trillion yuan (or $10 trillion). Furthermore, this savings figure does not include money invested in trust products (at least 10 trillion yuan) and potential outflow from the property





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market (which could approximate tens of trillions of yuan)—all of which could migrate into equities at some point. Wealthy Chinese households have been buying multiple homes to hedge inflationary risks in recent years, however, as housing oversupply has become increasingly obvious, especially in small cities, more people may find this method of storing wealth ineffective. Domestic equities could therefore become the most logical store of value for these investors.

There are already nascent signs that Chinese households have begun shifting their savings into stock markets. For example, household savings have

declined two months in a row. To our knowledge, this would mark the first time that household savings have declined since early 2007, when the last major bull market in Chinese equities was beginning to take off.

The ongoing transition of the Chinese economy—from central planning to market-orientation—will continue under the leadership of President, Xi Jinping and Premier, Li Keqiang. This could create exceptional opportunities for private investors and foreign investors.

Beijing’s reform of state owned enterprises (SOEs), the most significant reform of the state sector in at least two decades, is an important part of the ongoing reforms. The government needs a bull market in equities to attract interest from private investors and to encourage competition among state-backed companies, which would ultimately boost long-term returns to shareholders, including the government (central and local) and the nation’s pension funds.

The ongoing anti-corruption program, combined with its attempt to rectify income inequality and the wealth gap, ensures that the top leadership will enjoy strong support from the average Chinese citizen. Additionally, the endorsement from Chinese citizens will ensure that economic and SOE reforms can be accomplished.

The secular shift from bank financing (or indirect financing) into direct financing, which is already a major national policy drafted by top officials in Beijing, is set to continue. A bull market in Chinese equities will be needed to ensure this transition takes place.




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Last, but definitely not least, the valuations of the most heavily-weighted Chinese stocks remain attractive despite the recent rally. The average price-to-earnings ratio of the Shanghai Stock Exchange 50 A Share Index (SSE50 Index, 2,944) , a large-cap proxy which includes the country’s biggest banks, brokers and insurance companies, now stands at only 13.0 times, while the index’s average price-to-book ratio is only 2.0 times—roughly in line with Japan’s P/B, which is the lowest of all the major developed markets. Current valuations are far below the 2007 bull market peak, when the SSE350 Index’s average price-to-earnings ratio was over 40.0-times and its average price-to-book ratio peaked at over 5.0-times.

Given that the earnings cycle in China has likely bottomed after a nearly seven-year long bear market, we think the valuation metrics of Chinese companies are

still very reasonable, if not outright cheap. Moreover, we doubt if any major bull market elsewhere in the world ever peaked at such paltry valuations.

All the major bull market drivers listed above are secular in nature, implying that the reasons to buy Chinese stocks are not going to disappear anytime soon. As we have noted previously, there is no bull market like a Chinese bull market—historically, they do not peter out until they run to extremes. We therefore remain bullish on the Chinese stocks, in the belief that the latest selloff has created an excellent opportunity for investors to buy or add to their holdings of Chinese equities. We think investors should take advantage of the current price weakness by buying overseas-listed ETFs tracking Chinese A-shares. These include: the Morgan Stanley China A-share Fund (CAF US, $ 35.66), the db-X Trackers Harvest CSI 300 China A-shares Fund (ASHR, $50.39), and the China AMC CSI 300 Index ETF (3188 HK, HKD 59.60). However, investors should hold off on buying the ChiNext Index (SZ399006 Index, CNY 3,206) , because it might have more downside in the short term. Year-to-date, the ChiNext Index has gained 120%, despite a recent drop of 21% from its all-time record high of 4,038 in early June. We suspect a major investment style-shift might be taking place in mainland-traded equities. Once confirmed, this would suggest that large-cap and value-oriented stocks will very likely outperform growth stocks, at least for the next several months




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to come. For more discussion on the historical rationale behind this thesis, please refer to our related reports in WILTW May 28, 2015 & WILTW March 26, 2015. We will be watching for signs of this potential style-shift in the weeks and months to come, and will look for signs that growth stocks have consolidated enough before recommending them again.

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3. World War “P” begins. Hundreds of stars and more than 10,000 people who craft brands around them amassed on the coast of France this week as they do each year for the Cannes Lions International Festival of Creativity—the advertising industry’s biggest celebration. But no longer are the delegates like-minded creative types. The trickle of tech-industry party crashers that began last decade has become an invasion—with battalions from Silicon Valley outnumbering those from Hollywood. The opulent celebration is funded by the $540 billion per year advertising industry—and the new ubiquity of mobile devices and ability to finely target prospects have rapidly grown digital advertising’s share of that to 24%, according to Carat. But new challenges to intrusive advertising techniques are spreading—triggering a war throughout the world that will be fought not for control of land—but for privacy. We will call it World War “P”. Once the lament of consumers alone, governments and technology companies are joining the battle against unfettered digital intrusion. It is ironic that governments are increasing privacy regulation for companies that they frequently try to mine for intelligence about perceived threats and enemies, yet a growing chorus of consumer concern is commanding their attention. As with World War I and World War II, the first shots of World War P are being fired in Europe—but they will soon engulf the globe. Last week, all nations in the European Union voted to adopt a common defense against technological infringement on privacy—condensing the hodgepodge of competing regulations into what will become a unified enforcement regime. As part of widening anti-trust investigations against powerful technology firms, the E.U. also sent lengthy questionnaires to hundreds of internet commerce firms. But the battles are no longer confined to the borders and governments of Europe. Last week, the U.S. Federal Communications Commission moved to expand consumer protections against “robo-calls” and spam text. Now the frontline is shifting towards an arms race over ad-blocking technology that threatens to upend






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the $130 billion digital advertising market as it has come to be known—and the world’s largest company may be pitted against its competitors. The clamor for digital advertising is a function of explosive growth in the use of mobile devices, and their tactical use in shopping. Ericsson reports that the number of cell phones now in use nearly equals the number of people on this planet, there are more than 3 billion mobile broadband subscriptions, and smartphone penetration will more than double over the next five years to 6.1 billion. A new survey by Retale finds that 85% of millennial parents in the U.S. use smartphones to help them shop while in stores, and 70% are likely to make a purchase with a coupon or deal they receive on their smartphone while in or near a store. Digital advertising is seen as increasingly essential to converting sales. We have chronicled consumer concerns and nascent government response in related reports, and each week, new evidence of conflict emerges and new fronts seem to open. A study released this week by Edelman, one of the world’s-largest public relations firms, found that privacy is the top innovation-related concern for 66% of consumers, and that 87% of consumers will refrain from buying specific products due to concerns about privacy, security, impact on the environment, or other innovation-related apprehensions. The study found that 60% of consumers distrust advertising, and nearly two-thirds of consumers want to be reassured about brands they are considering—twice as many hope to be inspired. “People now ask their friends, use the Internet and their peer-to-peer social networks to get reassurance,” Edelman concludes. “They want to talk to others who’ve had the same experience, made the same mistakes, and found the best answer.” Edelman believes that the key to effective marketing is becoming the use of positive experiences and opinions of peers to reassure consumers about brands—and only then trying to inspire action. “Our study found brands win if they embrace and power the peer conversation.” A Chief Marketing Officer at Cannes told Business Insider this week: “We have a saying at Mondelez: “If you can’t share, we don’t care.” You have to be engaging.” If the advertising industry moves as Edelman suggests, consumers will see increased efforts to collect testimonials from them and to target their connections. That premise would add value for social media firms that are able to monetize


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relationships, including Facebook, Snapchat, Pinterest, and LinkedIn—but further risks disenfranchising consumers. Mobile video ads have become advertising’s new battleground. Although smaller screens limit some of the detail that can be displayed effectively on television, mobile devices allow prospects to be precisely targeted based on scores of factors including their purchase histories and current location. With more than 2 billion consumers using smart phones, eMarketer expects mobile ads to account for more than half of all digital advertising next year—topping $100 billion in spend—up 430% from 2013. Mobile advertising in the U.S. is expected to more than double to $40 billion from 2014 to 2016, while more than tripling in China to $22 billion. While search engines have long been the chief digital advertising medium and continue to grow, eMarketer expects search engines to capture less than half of the $81.6 billion in digital ad spending this year. Google continues to dominate that market with 54.5% of total global search engine advertising revenue—six-times higher than Baidu’s 8.8% share. Google also led net mobile advertising revenue with a 40.5% share—more than double Facebook’s 18.4% share and six times Alibaba’s 6.2% share. Search engine advertising is expected to grow 59% from 2013 through next year, but social media advertising is expected to nearly triple over the same period to almost $30 billion—helping Facebook, Twitter, and Tencent gain share. eMarketer expects advertisers to spend over $50 per social media user in North America this year. Facebook’s share of advertising revenue from mobile devices has soared from 30% in the first quarter of 2013 to 73% this year. Facebook’s Vice President of Global Marketing told CNBC in Cannes this week: “We think mobile video is actually going to be way more significant than even the first mobile revolution was for Facebook. We are seeing such increasing adoption of consumers spending time looking at videos: 4 billion video views a day.” That is a 4-fold increase over the last year. Mobile advertising grew even quicker for Tencent than for Facebook—driving a 131% year-over-year increase in total advertising revenue for the Chinese digital firm. Eager to expand its share of the lucrative mobile advertising market, Twitter rolled out autoplay advertisements last week that it claims are preferred 2.5-to-1 versus thumbnail previews and click-to-view videos. Twitter says that completion rates were seven times greater, and ad recall was 14% higher, Adweek reports. It




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remains to be seen if Twitter will suffer consumer backlash against higher data cost, shorter battery life, slower performance, or perceptions of privacy violations from ad targeting.

Whatever the response to the new advertisements on Twitter, a battle is brewing with mobile advertising that pits the firms hosting digital ads against the consumers they target. Last month, a German court ruled

that it is legal to block online advertising—and legal for companies that sell ad blocking services to charge advertisers to “whitelist” them so that their ads are displayed.

Ad-blocking software has become the world’s most popular browser add-on—and is used on roughly 5% of devices globally and up to 30%

in Germany, according to Adobe and PageFair. The most popular third-party add-on, Adblock Plus, boasts more than 400 million downloads and over 50 million active users. Not surprisingly, millennials are far more likely to use ad blockers than the general population—making it more difficult for advertisers to reach a coveted young segment. PageFair estimates that even with “saving” $3.5 billion in revenue by paying to have ads whitelisted, Google lost $6.6 billion in revenue last year due to ad blocking—more than 11% of its total. Digital advertising has always worked on the supposed understanding that people gain access to content without paying by enabling websites to scavenge unseen bits of information from their devices and allowing advertiser targeting. Yet the transaction has rarely been transparent—with users unsure of what information is being taken, how it is being used, the extent to which it is resold, and how proceeds from their behavior are divided. Advertising Age reports that PageFair has tried asking users to disable ad blocking software or make a donation, but less than 1% turned off the ad blocker, and far fewer than that paid for access.

Now those monetizing digital advertising are fighting back against

what a former Google and AOL executive has termed “an existential crisis”. With the support of 22 unnamed publishers, Ben Barokas launched Sourcepoint last week, with $10 million of pre-funding to develop technologies to conquer ad blockers. Possible approaches include allowing users to pay for ad-free access—perhaps using fractionally-divisible cryptocurrencies (see related reports)—and hiding the content of webpages whenever ad blocking software is detected. A technological arms race is now afoot, with profits precariously accruing both to


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industries that profit from digital advertising, and those that profit by disrupting their ability to do so in the name of protecting privacy. This new World War P will take place on many fronts. The early direct combatants are already attracting allies to join in battle. Advertisers are gaining support from the Interactive Advertising Bureau, which is launching a task force to discuss ad blocking. Ad blockers are partnering with some browser providers to provide seamless access to their software. Others like UC Browser, which is popular in China and India, have empowered hundreds of millions of users by incorporating ad-blocking software into their offerings. While companies like Facebook, Twitter, and Google scramble for new ways to monetize user data, others have begun to market greater privacy protection as a

differential advantage. Apple will apparently support ad-blocking technology on its new Safari web browser for iPhones, iPads, and iPods. Apple seems unlikely to block the app-based advertisements that it sells

itself—which may give it more control over content and pricing power for them. It remains to be seen whether Apple presents itself as a stalwart defender of consumer privacy or allows others to shoulder more burden against unhappy publishers, but an opportunity exists to bolster Apple’s image as a customer-focused anti-establishment firm. Thinking back to the famous Orwellian advertisement for the Macintosh computer in 1984, couldn’t highly-targeted ads be seen as another tool in Big Brother’s arsenal of control? Digital Content Next’s CEO told Advertising Age: “Consumers want a faster web, significantly less tracking by unknown third parties and clean, well-lit media experiences. [Apple’s mobile ad-blocking plan] just accelerates it, and opens up a significant share of the marketplace.” CIO.com notes that the ability to block advertisements may force publishers to be more customer-centric—making the nature, placement, and frequency of ads less objectionable. Snapchat is also intrigued by the opportunity to differentiate itself from social media competitors that bombard their users with highly-targeted ads. “We really care about not being creepy,” Snapchat’s founder told an audience in Cannes this week. “That’s really important to us.”




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World War P is unlikely to end with a clear victory and surrender. It may degrade into one of those poorly-defined, semi-permanent conflicts in which defeat in one battle sows the seeds for another. The fusion of digitally-powered data collection, powerful analytics, and artificial intelligence amount to advertising weapons of mass destruction—and those “A-bombs” allow pinpointed targeting and manipulation of consumers and voters. Commercial growth increasingly relies on the ability to effectively deploy such arsenals against their targets. Yet, within that power may lay the seeds of its own destruction—as consumers feel increasingly oppressed by endless assaults against their defenses. Ironically, as the persuasive power of advertisers and data broker

mercenaries reach new heights, acceptance of their authority may wane—and the global order imposed by “free” content may give way to a new era of subscription services.

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4. “Wi-Fi first” technology represents one more “nail in the coffin” for the traditional big telecom business model—and will help drive accelerating consolidation in the wireless sector. Over the last decade, we have argued that wherever we look on the telecommunication landscape, incumbent service operators are under attack by disruptive technology innovations (see reports). In WILTW January 29, 2015, we made the case that creative destruction in wireless is accelerating and poised to upend current incumbent business models, following news of Google’s Fi service and other developments. Similarly, in WILTW July 10, 2014 we noted global wireless telecom M&A was poised to surge—evidenced this week by Altice’s €10 billion bid for Bouygues Telecom. Enter “Wi-Fi first.” Similar to how big telecoms ignored Skype until it was too late, because they were trapped in their old ways, numerous startups are now deploying low-cost Wi-Fi calling over wireless technology that is poised to disrupt one of big telecom’s primary cash generators—mobile voice calls. Big cable operators may follow suit as well. Several factors are converging to make “Wi-Fi first” disruptive—including the fact that most calls via mobile phones are made within range of a Wi-Fi hotspot. Cellular voice revenue remains important to incumbent profits, and is threatened by plateauing demand and migrating talk minutes to free mobile VoIP applications. These factors combined with growth in bandwidth bottlenecks, the need to invest network infrastructure in the face of soaring data demand, and slowing subscriber growth in developed markets will drive accelerating


http://www.13d.com/setup.php?type=search&values=telecom+AND+%22creative+destruction%22+AND+landscape






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consolidation in both telecom operators and key Wi-Fi network equipment suppliers.

When Skype was first introduced, telecom carriers dismissed Internet-telephony service. However, it has since made a significant dent. Last year, users made 248 billion minutes of international calls on Skype—compared to 569 billion minutes on conventional networks, according to TeleGeogrpahy. Now, numerous wireless startups are aiming to achieve a similar disruption by offering calls, texts and data via Wi-Fi hotspots—relegating the traditional cellular network to backup only. Making calls over Wi-Fi has been possible for over a decade, but only in recent years have the available bandwidth and voice-encoding software become good enough for broadly-acceptable call quality, underscores a recent Economist analysis. “Wi-Fi first” was pioneered in 2012 by Free, a French mobile operator that used it to fill gaps in its cellular network. The technology has since been optimized by U.S. wireless startups, including Republic Wireless, Scratch Wireless and FreedomPop. In April, Google officially announced a similar service called “Fi” that works only with a phone made for Google—the Nexus 6. Google’s basic plan costs $30 per month, including one gigabyte of data, with unused data rolled over to the next month. Several factors are converging to make “Wi-Fi first” highly disruptive. First, data shows that nearly 90% of calls via mobile phones are made from home, workplaces and commercial facilities that often have Wi-Fi. Relatively few are made while actually mobile, and out of range of a Wi-Fi hotspot. Second, public Wi-Fi hotspots have proliferated in recent years— numbering around 6 million in America alone, according to the Economist. Third, technology has now progressed to where calls can seamlessly be transferred between Wi-Fi and cellular networks. Apps and embedded software can also check for Wi-Fi quality before connecting and falling back to cellular only when needed. Sophisticated methods enable traffic streams to be blended from Wi-Fi and cellular based on cost and signal availability. For instance, when FreedomPop’s technology detects a Wi-Fi signal is getting weak, it automatically establishes a second connection and moves the call over as needed.




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Chart source: The Economist

Each startup has a slightly different approach. Republic Wireless has about 350,000 subscribers who have purchased special handsets that can switch calls seamlessly between Wi-Fi and the cellular network (currently two Motorola models). Republic is reportedly growing its subscriber base by about 13% every month. Monthly contracts can be cancelled at any time and range in price from $5 per month for Wi-Fi calls only to $40 per month unlimited—half the level some conventional carriers charge. FreedomPop, which recently raised money from the venture fund of one of Skype’s founders, Niklas Zennstrom, only requires its customers to install an app on any handset, which routes their calls through a Wi-Fi connection when available. The basic free service includes 200 voice minutes, 500 texts and 500 megabytes of data, and an “unlimited” package costs $20 per month. FreedomPop has nearly one million customers, half of whom pay for add-ons, and is doubling its customer base every 4-6 months. Both, Republic Wireless and FreedomPop currently use Sprint’s network, and are trying to sign up a second carrier. Google’s service works with both Sprint and T-Mobile and can seamlessly switch between cell networks and Wi-Fi hotspots, depending on the strongest signal. Big U.S. cable operators like Comcast and Charter may use the technology to offer mobile telephone service. Large cable operators already control millions of hotspots, and several of them have the right to access Verizon’s network under terms of a 2011 sale of wireless spectrum to the operator. Earlier this year, Cablevision announced a low cost Wi-Fi-only mobile service (see WILTW January


https://republicwireless.com/

https://www.freedompop.com/




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29, 2015). U.S. cable operators are also collaborating by granting Wi-Fi access to each others’ high-speed Internet customers, opening up millions of new Wi-Fi hotspots throughout America. Companies like iPass Inc. and Devicescape have also stitched millions of hotspots together globally into a single sign-on network. Big carriers are also beginning to make more use of Wi-Fi. This is partially a driver behind recent telecom mergers in Europe. For instance, BT, Britain’s largest broadband provider acquired EE, the nation’s largest mobile operator, in part as EE will be able to offload calls, texts and data to BT’s numerous Wi-Fi hotspots. However, similar to Skype, efforts by incumbent operators risk being too little too late. Revenue from new customers among U.S. operators is stagnant, with post-paid ARPU declining about 3% (Verizon) to 12% (AT&T) during the last eight quarters (as of yearend 2014), underscores Chetan Sharma Consulting. This, combined with relatively high debt levels, $45 billion spent on new spectrum (AWS-3 licenses) plus $40-$50 billion required to build out the associated networks, will pressure incumbent margins. As a result, consolidation is poised to accelerate as incumbent operators try to reverse slowing revenue growth and compete in an increasingly data-driven wireless app market. Please refer to WILTW July 10, 2014 for telecom operators that could be acquired. Big equipment suppliers, such as Ericsson, or telecom operators could also move to acquire smaller-hardware providers to gain synergy for Wi-Fi network deployments. Candidates with strong fundamentals include:

Juniper Networks (JNPR, $26.88) – a leading provider of Internet infrastructure solutions for ISPs and other telecom service providers. JNPR is valued at 8.5 times consensus EV/EBITDA, below its historical median of 11.8 times. .

Ciena Corp. (CIEN, $25.04, reports) – is a leading provider of communications networking equipment. Ciena’s packet-optical transport, packet-optical switching and carrier Ethernet service delivery products are used by communications service providers worldwide. Ciena is valued at 10.7 times consensus EV/EBITDA, below its historical median of 15.0 times. .

Infinera (INFN, $21.79) – is a leading maker of optical transport networking systems, with its photonic integrated circuits used to create digital optical


http://www.slideshare.net/chetansharma/us-wireless-marketq42014updatefeb2015chetansharmaconsulting?ref=http://www.chetansharma.com/



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networks. INFN is valued at 16.2 times consensus FY2016 EV/EBITDA, below its historical forward median of 20.4 times.

Boingo Wireless (WIFI, $8.77) – provides mobile Internet services, with its back-end system infrastructure detecting and enabling one-click access to its global Wi-Fi network. WIFI is valued at 7.8 times consensus FY2016 EV/EBITDA, below a Bloomberg peer group average of 10.7 times.

Ruckus Wireless (RKUS, $11.08) – is a maker of wireless networking equipment, including high capacity, high-speed gateways, controllers, wireless bridges and gateway and controller software platforms. RKUS is valued at 12.5 times consensus EV/EBITDA, below its historical forward median of 21.0 times.

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5. Are bonds oversold or is this the beginning of a sustained increase in interest rates (continued)? We asked this question in WILTW June 4, 2015 when we noted: “Sentiment on bonds has become much more bearish since April. However, it may be prudent to look at other markets in the past few years for guidance. Gold was oversold, yet continued to decline. Last year, oil was very oversold and yet it continued to plunge. The U.S. dollar was very overbought and an enormously one- sided trade for months, yet it continued to advance.”

As we noted on June 4, and the charts below show, subsequent price-action has resulted in a golden-cross of the 50-day and the 200-day moving averages for thirty-year, ten-year and five-year Treasury yields.

Of the many reflation indicators that we monitor, bond market indicators have continued to provide the most consistent signals regarding the burgeoning reversals in the multi-year downtrends in the relative performance (versus S&P 500) of the reflation-sensitive international equity markets and the numerous commodity-market reflation measures. Notably, since April, when the current surge in rates started––thirty-year Treasury yields have experienced the most-shallow pullbacks and were the first to achieve a golden-cross, compared to ten-year and five-year Treasury yields.

Given the sensitivity of long-term bonds to changes in market-sentiment regarding reflation or deflation, and the price-action in thirty-year yields, are these the proverbial “times that try men’s souls”? It is one of the few markets less susceptible to central bank manipulation—so the answer is most probably yes! We also note that the TIP-to-TLT ratio––which has historically provided valuable





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information regarding trends in deflation or reflation––registered a new recovery-high this week. Meanwhile, the TIP-to-IEF ratio appears to be on the verge of advancing above a six-month basing-pattern.

CHART A: Five-Year, Ten-Year and Thirty-Year U.S. Treasury Yields – Daily. As illustrated in the chart, five-year, ten-year and thirty-year Treasury yields have formed a golden-cross. Another technical clue that thirty-year yields could be leading the rise in rates is indicated by the modest pullback during May when thirty-year yields remained above the 200-day moving average and quickly rallied to new recovery-highs.

Source: Stockcharts.com




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CHART B: Five-Year, Ten-Year and Thirty-Year U.S. Treasury Yields – Weekly. The chart below provides a long-term perspective on the trend in Treasury yields. As we have noted previously, unlike thirty-year yields, five-year and ten-year yields did not achieve new lows in 2015––thereby, registering a potential “bullish-divergence”.

The developing robust rally in thirty-year yields that followed the early-2015 lows––which has been much sharper than the rally in five-year and ten-year yields––could be warning that the new lows in 2015 were a “false-breakdown” and signaled the “capitulation” in market fears regarding global deflationary-pressures. History suggests that real false breaks are often followed by a sharp and sudden move in the opposite direction.


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6. In the run-up to the Fed’s coming interest rate hike, rising bond yields may take the steam out of the currently-feeble recovery. According to the New York Fed, real consumption expenditures have not shown signs of a significant pickup since the winter slowdown, while real business investment has been trending lower. At 28%, buybacks as a percent of corporate cash use are at their highest since 2007, but this spending is not creating sustainable growth. Although an overwhelming majority of the Fed’s policy-making committee expects the central bank to raise interest rates this year, the inability of the U.S. dollar index to break its March 2015 highs appears to be signaling otherwise. Given the weak first quarter and the slow start to the second quarter, one has to wonder if the current stage of the recovery has enough staying power to last into the fourth quarter, when many expect the first rate rise to occur.

The New York Fed recently published a chart book entitled “U.S. Economy in a Snapshot,” dated June 2015. It noted that industrial production declined at a 0.3% annual rate in Q1, and has been losing momentum since late last year. Both durable and non-durable goods consumption declined during the February-to-April period relative to the November-to-January period. Real business investment in new equipment grew an “unimpressive” 6.3% over the four quarters ending in Q1 2015, new orders and shipments of capital goods have been trending lower since last year’s third quarter, and net exports have been a significant drag on growth, as we have discussed previously.

One area that concerns us can be found on page 6 of the Fed report: mortgage lending standards remain tight compared to the levels of the early-2000s. While fence-sitters are now jumping into the housing market to beat the next increase in mortgage rates, as those rates rise, credit availability to first-time home buyers could get tighter. According to the report: “Nearly 72 million people in the population of adults with credit reports currently have scores below 650; the share of originations to borrowers in this range has fallen from 25% to 10% since the recession.” Although the labor market indicators have generally been on an improving trend, the sustainability of that improvement will increasingly be called into question if housing and manufacturing cannot demonstrate a more robust recovery. We also remain concerned that corporations have been neglecting their businesses in favor of share buybacks, as demonstrated by the following chart, which shows that at


http://www.newyorkfed.org/research/snapshot/index.html

http://www.newyorkfed.org/research/snapshot/index.html



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28%, buybacks as a percentage of cash used among the S&P 500 companies is at its highest percentage since 2007.

Source: Compustat and Goldman Sachs Global Investment Research, via Streettalklive.com

More troublesome is the fact that many of these companies are funding their equity buybacks with low cost debt. According to data cited by Bloomberg, a record $58 billion of bond deals over the past three months were supposedly directed toward dividends and share buybacks. Low rates make many of these transactions financially worthwhile, but at some point the piper will have to be paid. As Larry Pitkowsky, co-founder of Goodhaven Capital Management, LLC, recently told Bloomberg: “Low interest rates give you a fictitious hurdle to doing things. It looks accretive, but what happens when those bonds roll over and they’re at 6 percent instead of 3 percent?”

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7. The emerging Virtual/Augmented Reality industry represents a new transformational communications interface that could upend the entertainment, healthcare, and education industries, and disrupt current business models across numerous industries. VR/AR represents an opportunity to invest at the front-end of a new technology era that could have a global impact on the scale of smartphones. Huge new winners could emerge, with makers of key enabling technologies holding compelling risk/reward ratios. Virtual reality (VR) and augmented reality (AR) technologies have the potential to be highly disruptive over the next five years, because the next era of computing will evolve around how the digital and analog worlds intersect. Using special headset goggles, displays, gloves and other feedback devices that




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allow users to directly interact with information, VR provides a life-like, immersive experience in a digital world, while AR places digital objects directly in the real world—augmenting analog objects using virtual information or graphics. While VR may initially be almost entirely used by high-end gamers, a much larger enterprise VR market could soon emerge—with the ability to visually demonstrate concepts and create situational awareness from a distance. Entertainment VR/AR applications are a completely new medium, while applications in healthcare for physical therapy and use by surgeons in the operating room can improve medical outcomes, and education apps can improve learning and provide better situational awareness.

VR/AR systems are at a key inflection point for four primary reasons highlights Peter Diamandis: (1) Recent advancements in enabling technologies—including integrated circuits, IMUs, gyros to track head orientation, high-resolution screens, and high-resolution, high performance cameras—make mass adoption feasible because the underlying technology components are powerful, and cheap enough to mass produce; (2) VR can now provide compelling experiences on consumer hardware; (3) Billions of dollars are being invested by major technology firms, with Google/Magic Leap, Facebook, Sony, and Microsoft all planning to launch VR/AR products next year, while Samsung’s Gear VR and Google’s “Cardboard” headsets—both driven by smartphones—are already on the market; and (4) major players have made long-term commitments to developing better VR technology. By 2020, the combined VR/AR industries could represent a $150 billion annual market, up from zero today—and be 50% bigger than today’s entire global video game industry of $93 billion, according to a recent Digi-Capital study. However, challenges need to be resolved before VR/AR can go mainstream—including minimizing latency in high-resolution pixel VR displays to eliminate the risk of nausea, creating a larger field of view in AR displays, and reducing unit costs. VR/AR are nascent with major transformative power, and providers of key enabling technologies are well-positioned to capitalize on this new emerging industry. Virtual reality has been used as a training tool for fighter pilots for at least three decades. In 1996, we note that Warren Buffett acquired FlightSafety International, a pioneer in using virtual simulators for pilot training. However, the first head-mounted VR display dates back to 1960 and a Harvard University project known as Sword of Damocles. VR entered the consumer consciousness with the 1982 movie “Tron,” and VPL Research was the first to sell VR goggles and gloves in the 1990s, but weak visuals caused the technology to fail. Higher quality VR has


http://singularityhub.com/2015/03/31/signs-virtual-reality-and-crowdfunding-are-going-mainstream/

http://www.digi-capital.com/reports/#augmented-virtual-reality



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become possible with the advent of the smartphone revolution—due to the ability to pack more components into slimmer inexpensive devices. Now, VR systems have become very realistic and have declined in cost to the equivalent of a 40-inch TV. Two years ago, Facebook paid $2 billion to acquire Oculus Rift, which has since shipped over 150,000 development kits for an expected $350 Rift headgear that will come to market next year. Mark Zuckerberg believes VR is a new communication platform—with as an example geographically-dispersed users watching sports together, attending college, and surfing Facebook. Later this year, Taiwanese smartphone producer HTC and video game maker, Valve plan to release a rival device, and Sony’s Morpheus for use with the PlayStation 4 is expected to become available during the first half of 2016. Microsoft is also expected to launch its augmented reality Hololens next year, while Magic Leap’s AR device (Google has invested in Magic Leap) is aiming for commercialization in 2016 as well. Samsung’s $200 Gear VR goggles uses its Galaxy Note 4 smartphone as a screen, but has limited content at the moment—although demos like spaceflight and roller coaster simulators have high “wow” factors. Both VR and AR headsets provide stereo 3D high-definition video and audio. The key difference is that VR is closed and fully immersive, while AR is open and partly immersive—enabling a user to see through and around it. VR puts users inside virtual worlds and AR puts virtual things into users’ real worlds—augmenting them. AR could ultimately gain an edge over VR and the entire smartphone and tablet market—with major implications for Apple, Google, Facebook, Microsoft and others, underscores Digi-Capital. This is because AR is similar to wearing a transparent mobile phone, with applications in voice calls, web browsing, film/TV streaming, enterprise apps, advertising, consumer apps, games, and e-commerce. “VR is a 150 million user audience but it’s not for the whole world,” says Tom Sweeney, CEO of Epic Games. “Whereas AR, if you look out a number of years I bet the majority of mankind will have an AR device—it will redefine interaction with computers and replace computer monitors, tablets, televisions and every kind of play technology. I think it’s the next big development in the history of civilization, if you put it in perspective.” However, AR is at an earlier stage, with the VR market likely to take off first in the gaming market, because development of the technology is more straightforward and users experience strong physical and emotional responses. The VR/AR markets could reach $150 billion in revenue by 2020, based on how the technologies could grow new markets and cannibalize existing ones


http://www.gamesindustry.biz/articles/2015-06-23-vr-not-for-the-whole-world-epic-ceo



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beginning next year. Digi-Capital foresees AR taking the majority of the market at $120 billion, while VR represents $30 billion, with the addressable market primarily games and 3D films plus niche enterprise users. VR has the potential to garner tens of millions of users, with hardware price points similar to game consoles. In contrast, Digi-Capital believes AR’s addressable market is similar to the smartphone/tablet market—equating to potentially hundreds of millions of users, with hardware price points in line with mobile devices. AR could cannibalize and grow the mobile market, with a large AR user base serving as a major revenue source for TV/film, enterprise, advertising and consumer apps. AR could also provide an entirely new platform for Amazon and Alibaba to market products.

Chart source: Digi-Capital

Yet, Digi-Capital’s VR analysis could be conservative, argues Sergio Aguirre, founder and CTO of EchoPixel, a startup whose True3D viewer converts patient anatomy into interactive VR as a tool for doctors, medical students and patients. Digi-Capital’s analysis overlooks two key fundamentals, in his view. First, it assumes VR hardware generally resembles Oculus Rift—a fully immersive, wraparound headset. Second, it does not focus on applications for the enterprise market. A key driver is emerging VR applications that allow a user to experience digital objects without the need for a wraparound headset. For example, zSpace has developed “non-enveloping” VR glasses that enable students to collaborate around a virtual experience—separated from the real world, but not isolated from it. In contrast to wraparound experiences, non-enveloping VR is


http://www.digi-capital.com/news/2015/04/augmentedvirtual-reality-to-hit-150-billion-disrupting-mobile-by-2020/#.VYleNVWqqko

http://recode.net/2015/05/26/were-seriously-underestimating-the-virtual-reality-market/



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highly collaborative, enabling multiple people to view the same images at the same time (see video). The zSpace display uses hardware and stereoscopic 3-D glasses. Next generation displays could have zSpace-type technology built right into consumer electronics—enabling a tablet or smartphone to project a virtual world right on top of its screen. Startups Ostendo Technologies and Leia Inc. are developing prototypes. Apple is also reportedly experimenting with 3-D displays for next generation phones as well. Numerous new enterprise applications could emerge for VR. A multitude of industries could utilize 3D VR to launch, edit and demonstrate designs—particularly if they could be used on widely available smartphones and tablets. VR could be utilized in a wide range of markets, including retail, real estate and adult entertainment. VR could also be useful anywhere a professional needs to examine or control something from a distance. A whole range of jobs that presently require physical presence—such as inspecting infrastructure or managing construction—may eventually shift to VR. Remote video surveillance is already used in some of these applications, but flat video images are a poor substitute for reality, because they don’t provide as much information or situational awareness. EchoPixel believes VR will have broad medical applications. VR has been successfully used for several years to help rehabilitate and ease pain in burn victims—where agony from severe burns can be one of the most intense and prolonged types of pain experienced. Improved VR systems could also help many surgeons and radiologists that struggle through flat images of patient anatomy, when digital 3D representation would be much more effective. Similarly, instead of sending a doctor to look for and treat survivors, a drone with video cameras, ultrasound probes and light field sensors could survey a disaster site (i.e. an earthquake in a remote developing country). By converting the images and data sent back from the drone into VR, world-leading doctors could quickly identify victims, closely examine a patient, and deliver improved medical care to injured victims—all from the other side of the world. A VR/AR tsunami may be coming. This year, the Australian airline Qantas started testing mobile virtual-reality headsets, made by Samsung, in first class cabins on certain flights and in some airport lounges. Filmmaker Chris Milk is bullish about the possibilities of VR (see TedTalk), and makes the case that VR is the next great medium: “Right now it’s this bulky thing that goes over your head and projects pixels, but eventually we’ll get to a system that has no extra weight, you can’t feel it at all, and the resolution is so sharp that you can’t differentiate between


https://vimeo.com/115233170

http://www.wsj.com/articles/new-chip-to-bring-holograms-to-smartphones-1401752938

https://www.leiainc.com/#3

http://appleinsider.com/articles/15/05/21/apple-invents-adaptive-eye-tracking-3d-display-highly-portable-cellular-hotspot

http://singularityhub.com/2015/03/17/disrupting-real-estate/

http://www.theverge.com/2015/3/25/8286921/vr-porn-headset-xxx

http://www.bbc.com/news/health-12297569

http://www.ted.com/talks/chris_milk_how_virtual_reality_can_create_the_ultimate_empathy_machine



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it and reality. If you have that, and you have an AI computer that can adapt and tell a story in a million different ways depending how you react inside it, then you have Total Recall. Then you have The Matrix or Neuromancer. That’s where this goes.” However, VR/AR is vulnerable to hype and challenges remain to be surmounted for the technologies to go mainstream. ARK Invest underscores that current desktop displays and low-end VR systems are only up to about 60 frames per second, whereas Oculus Rift’s headset displays 90 frames per second to reduce latency and the risk of user nausea when using fully immersed VR. The field of view in Microsoft’s Hololens is also only a small rectangle, and images outside of it are not augmented (video). Unit costs are also still relatively high for advanced VR headsets like Oculus Rift, because the devices need to be used with a relatively powerful computer, increasing the all-in cost to about $1,500. Oculus co-founder Palmer Luckey believes VR will follow a cost decline curve similar to cellphones, where a good phone cost $600-$700 unsubsidized in 2008/09 but now costs less than $100 and is much better than any of the prior phones. Luckey argues that VR will make distance irrelevant, but equates the current state of VR as similar to smartphones before the iPhone, which launched the modern smartphone and accelerated broad adoption of the technology. “It’s unlikely that the first things to come out in that range of consumer devices is going to be the iPhone,” says Luckey. “The iPhone moment is going to take longer, and it’s probably not going to be such a huge, radical jump, it’s going to be more gradual. The Rift is not the ‘iPhone of VR.’ Nothing out there is ‘the iPhone of VR.’ They’re almost like the Palm Pilots and the Treos of virtual reality.” Despite the remaining hurdles, VR/AR represents an opportunity to invest at the front-end of a new technology era that could be highly disruptive. The lowest-risk way to invest is via major tech companies working VR/AR systems, such as Facebook, Google, and Microsoft. However, we believe makers of key enabling technologies also have compelling risk/reward ratios and are a more direct play. Compelling companies include:

Nvidia (NVDA, $21.01, reports) – is a leading maker of graphic design processors, including the GeForce GTX 980 and 970 GPUs, both well suited to VR applications. Ark Invest highlights that a basic requirement of using Oculus is a high-end GPU, where Nvidia is the leader. NVDA aims to further reduce


http://ark-invest.com/

http://www.theverge.com/2015/5/1/8527645/microsoft-hololens-build-2015-augmented-reality-headset

http://www.wsj.com/articles/virtual-reality-gets-real-for-sony-1434650475

http://www.13d.com/setup.php?type=search&values=NVDA

http://ark-invest.com/



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VR latency via several technologies including: MFAA (Multi-Frame sampled Anti-Aliasing); Dynamic Super Resolution (DSR) technology; and through the use of JIT WARP (just in time Windows Advanced Rasterization Platform) technology. Nvidia’s multi-resolution shading technology is a more efficient way of making VR games without sacrificing performance or image quality—by tweaking the way images from a user’s PC becomes the images a user sees in the headset. NVDA is valued at 9.3 times FY2016 consensus EV/EBITDA, below a Bloomberg peer group average of 11.3 times.

Qualcomm (QCOM, $65.35, reports) – is a leading maker of wireless chips. In the VR/AR segment, QCOM has introduced the Vuforia Software Development Kit for Digital Eyewear, for creating augmented reality applications for smart glasses and head-mounted displays. The Vuforia platform takes advantage of the company’s Snapdragon processors to reduce the “motion-to-photon” latency. The new software allows interactive 3D content to be visually aligned with the underlying world, which will enable new applications in hybrid VR/AR gaming, shopping and education. QCOM is valued at 8.0 times consensus EV/EBITDA, below its trailing long-term median of 11.4 times.

Himax Technologies (HIMX, $8.14) – makes integrated circuits and produces LCD displays well suited for VR/AR applications. Key products include its Front-Lit LCOS microdisplay, WLO and CMOS display ICs and touch drivers used in VR devices. HIMX supplies LCOS microdisplays for Google Glass, Microsoft Hololens, Oseterhout Design Group (ODG), Optinvent, Lumus and Lenovo. HIMX trades at 14.5 times EV/EBITDA.

KVH Industries (KVHI, $13.46) – is a leading maker of high-performance sensors and integrated inertial systems for defense and commercial guidance and stabilization applications—with direct applications to VR/AR systems. For instance, televised coverage of the recent U.S. Open golf tournament utilized an augmented-reality tracking system that included an inertial measurement unit from KVHI. KVHI is valued at 8.9 times consensus EV/EBITDA, below its historical median of 10.5 times.

InvenSense (INVN, $15.85) – makes semiconductor ICs and provides motion sensor and audio sensor solutions for consumer electronic devices, including smartphones, tablets, and wearable devices. The sensors are based on micro-electro-mechanical systems (MEMS), and have applications to virtual reality,


http://www.geforce.com/hardware/technology/mfaa

http://www.geforce.com/hardware/technology/dsr

http://www.techradar.com/news/computing-components/graphics-cards/nvidia-jumps-into-virtual-reality-with-geforce-gtx-980-and-970-1266191

http://venturebeat.com/2015/05/31/nvidias-multi-resolution-shading-vr/

http://www.13d.com/setup.php?type=search&values=QCOM

http://gpsworld.com/augmented-reality-golf-coverage-uses-kvh-imu/



Founded 1983

holography, consumer robotics, self-driving cars, among others. INVN is valued at 15.2 times FY2017 consensus EV/EBITDA, below a Bloomberg peer group average of 17.8 times.

Vuzix (VUZI, $6.83) – makes augmented reality (AR) eyewear, providing a first-person view of the real world, overlaid with computer-generated data and content. The company’s primary product is its M100 Smart Glasses that are a fully-functioning wearable computer with WiFi, Bluetooth, GPS, motion sensors, HD camera, voice recognition and wearable display, enabling a user to work hands-free. The M100 can be connected to and controlled through nearly any computing device, including both Android and iOS platforms. Intel has invested nearly $25 million, for a roughly 30% interest in VUZI, which is valued at 10.1 times consensus FY2015 sales, below its median of 13.3 times.

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8. The reason to maintain short exposure to overleveraged oil and gas companies: interest payments are consuming a growing portion of cash flow after debt ballooned by 16% over the past year, while companies are spending over $4 for every dollar earned on oil and gas sales. Maintain short positions on Magnum Hunter Resources (MHR, $1.75) due to weak operating metrics. A June 18th Bloomberg story carrying the headline “The Shale Industry Could be Swallowed by Its Own Debt,” showed that little has changed for the over-indebted shale drillers over the past year, other than the fact that they are outspending their cash flow by an even wider margin than before. We quote: “Interest payments are eating up more than 10% of revenue for 27 of the 62 drillers in the Bloomberg Intelligence North America Independent Exploration and Production Index, up from a dozen a year ago. Drillers’ debt ballooned to $235 billion at the end of the first quarter, a 16 percent increase in the past year, even as revenue shrank…The problem for shale drillers is that they’ve consistently spent money faster than they’ve made it, even when oil was $100 a barrel. The companies in the Bloomberg index spent $4.15 for every dollar earned selling oil and gas in the first quarter, up from $2.25 a year earlier, while pushing U.S. oil production to the highest in more than 30 years.”

The oil industry has about $2.5 trillion of debt outstanding, with almost half of this amount as bank loans, according to estimates cited by

the Financial Times. The FT also noted that Moody’s expects default rates for E&P companies to jump from 3% in March 2015 to 7% next year, while UBS thinks the default rate for high yield energy could be 10% to 15%. While the nearly-40% increase in oil prices




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above this year’s lows helps the broad industry a great deal, some of the weaker companies are still going to be under pressure because they have cut back on the spending that is necessary to increase their future production. The pressure on capital spending, which triggered a 60% decline in the oil rig count since last fall, appears to be impacting production alongside the deteriorating finances in the E&P sector. After posting its first sequential monthly decline in more than a year in January 2015, U.S. crude oil output rebounded by more than 160,000 bpd to 9.531 million bpd in March. However, the most recent state-level data for North Dakota indicated that April 2015 production was almost 60,000 bpd below December’s. The state-level data for Texas also signal an increased likelihood of lower output in April. An analysis by the Bentek Energy forecasting unit of Platts recently estimated that May 2015 output in the Bakken and Eagle Ford regions was little changed in May versus April.

Given that North Dakota and Texas accounted for over three-quarters of the U.S. oil production increase since December 2012, these recent datapoints lend credence to the increasingly widespread view that U.S. oil production is not as robust as many believe. Lower drilling costs and greater efficiencies can only go so far. At the end of the day, depleted legacy wells have to be replaced with new ones, and this is where the Saudi’s October 2014 “policy change” appears to have had the desired impact (see WILTW December 11, 2014). As Bentek Energy analyst, Sami Yaha, recently told Oil & Gas Financial Journal, “The steep decline in rig count and the discouraging oil barrel-pricing environment has taken its toll on oil production from the Eagle Ford shale. While producers have been actively making gains in efficiency and high-grading their acreage, the efforts have not been sufficient to prevent oil production from dipping.”

While we have been recommending maintaining exposure to high-quality unconventional oil and gas companies, because their reserves are considered “safe” from geopolitical risk in the Middle East (see our latest discussion of the Sunni-Shiite rivalry in WILTW June 18, 2015), we also think it is prudent to hedge long exposures with select short-sale candidates. Our attention was recently directed toward one of our short-sale calls, Magnum Hunter Resources (MHR, $1.75). The company’s stock has been in a free-fall since we reiterated our short-sale recommendation in WILTW April 16, 2015, at a price of $2.82. It bottomed-out last week at $1.19, then recovered at the end of the week after receiving an extension from creditors.


http://peakoilbarrel.com/texas-oil-and-gas-production-for-april/






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Earlier this year, MHR cut its capital expenditure budget from $400 million in 2014 to $100 million in 2015. Reductions of that magnitude, however, are bound to have an impact on the sustainability of future production. It is easy to see why the markets are anxious about MHR’s relationship with creditors. In 2011, interest expense approximated 24% of adjusted EBITDAX, but this grew to 57% in 2014. Last year, combined interest and exploration expense accounted for 136% of EBITDAX—evidence that the business simply cannot be sustained without continuous borrowing and capital spending. This begs the following question: would U.S. oil production have taken off the way it did without the Fed’s rock-bottom interest rates and quantitative easing? It is little wonder that the stock has been crushed from nearly $9 last year to less than $2. Given the weakness in the balance sheet and operating metrics, MHR remains a good candidate for shorting as a hedge against falling oil prices.

Magnum Hunter Resources stock price


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9. The Innovation Economy: A Darwinian Fight Between Machine and Human Intelligence. Who Will Win? What are the economic, social and political implications of this relentless disruption? As we wrote in WILTW May 14, 2015, the Rise of the Robots: Technology and the Threat of a Jobless Future by Martin Ford is one of the most important books we have ever read about disruption and the coming automation that threaten jobs across almost every sector of the economy. “Advances in artificial intelligence may make it even easier to offshore jobs that can’t yet be fully automated…Virtually any occupation that primarily involves manipulating information and is not in some way anchored locally—for example, with a requirement for face-to-


http://www.amazon.com/Rise-Robots-Technology-Threat-Jobless/dp/1480574775



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face interaction with customers—is potentially at risk from offshoring in the relatively near future and then from full automation somewhat further out.”

We think this book is so important that we continue to excerpt key sections. We quote as follows:

While the trend toward increased automation of white-collar jobs is clear, the most dramatic onslaught—especially for truly skilled professions—still lies in the future. The same cannot necessarily be said for the practice of offshoring, where knowledge jobs are moved electronically to lower-wage countries. Highly educated and skilled professionals such as lawyers, radiologists, and especially computer programmers and information technology workers have already felt a significant impact…

Electronic offshoring, in contrast, is almost completely frictionless and subject to none of these penalties. Jobs are moved to low-wage locations instantly and at minimal cost. If peripheral jobs are created, it is much more likely to be in the country where the workers reside.

I would argue that “free trade” is the wrong lens through which to view offshoring. Instead, it is much more akin to virtual immigration…I find it somewhat ironic that many conservatives in the United States are adamant about securing the border against immigrants who will likely take jobs that few Americans want, while at the same time expressing little concern that the virtual border is left completely open to the higher-skill workers who take jobs that Americans definitely do want.

The argument put forth by economists like Mankiw, of course, measures in the aggregate and glosses over the highly disproportionate impact that offshoring has on the groups of people who either suffer or benefit from the practice. On the other hand, a relatively small but still significant group of people—potentially measured in the millions—may be subjected to a substantial downgrade in their income, quality of life, and future prospects. Many of these people may have made substantial investments in education and training. Some workers may lose their income entirely. Mankiw would likely argue that the aggregate benefit to consumers makes up for these losses. Unfortunately, although consumers may benefit from lower prices as a result of the offshoring, this savings may be spread across a population of tens or even hundreds of millions of people, perhaps resulting in a cost reduction that amounts to mere pennies and has a negligible effect on any one individual’s well-being. And, needless to say, not all the gains will flow to consumers; a significant fraction will end up in the pockets of a few already-wealthy executives, investors, and business owners. This asymmetric impact is, perhaps not surprisingly, intuitively grasped by most average workers but seemingly lost on many economists…




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Full automation is simply the logical next step. As technology advances, we can expect that more and more of the routine tasks now performed by offshore workers will eventually be handled entirely by machines. This has already occurred with respect to some call center workers who have been replaced by voice automation technology. As truly powerful natural language systems like IBM’s Watson move into the customer service arena, huge numbers of offshore call center jobs are poised to be vaporized.

As this process unfolds, it seems likely that those companies—and nations—that have invested heavily in offshoring as a route to profitability and prosperity will have little choice but to move up the value chain. As more routine jobs are automated, higher-skill, professional jobs will be increasingly in the sights of the offshorers. One factor that is, I think, underappreciated is the extent to which advances in artificial intelligence as well as the big data revolution may act as a kind of catalyst, making a much broader range of high-skill jobs potentially offshorable. As we’ve seen, one of the tenets of the big data approach to management is that insights gleaned from algorithmic analysis can increasingly substitute for human judgment and experience. Even before advancing artificial intelligence applications reach the stage where full automation is possible, they will become powerful tools that encapsulate ever more of the analytic intelligence and institutional knowledge that give a business its competitive advantage. A smart young offshore worker wielding such tools might soon be competitive with far more experienced professionals in developed countries who command very high salaries.

When offshoring is viewed in combination with automation, the potential aggregate impact on employment is staggering. In 2013, researchers at the University of Oxford’s Martin School conducted a detailed study of over seven hundred US job types and came to the conclusion that nearly 50 percent of jobs will ultimately be susceptible to full machine automation. Alan Blinder and Alan Krueger of Princeton University conducted a similar analysis with respect to offshoring and found that about 25 percent of US jobs are at risk of eventually being moved to low-wage countries. Let’s hope there’s significant overlap between those two estimates! Indeed, in all likelihood there is plenty of overlap when the estimates are viewed in terms of job titles or descriptions. The story is different along the time dimensions, however. Offshoring will often arrive first; to a significant degree, it will accelerate the impact of automation even as it drags higher-skill jobs into the threat zone.

As powerful AI-based tools make it easier for offshore workers to compete with their higher-paid counterparts in developed countries, advancing technology is also likely to upend many of our most basic




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assumptions about which types of jobs are potentially offshorable. Nearly everyone believes, for example, that occupations that require physical manipulation of the environment will always be safe. Yet, military pilots located in the western United States routinely operate drone aircraft in Afghanistan. By the same token, it is easy to envision remote-controlled machinery being operated by offshore workers who provide the visual perception and dexterity that, for the time being, continues to elude autonomous robots. A need for face-to-face interaction is another factor that is assumed to anchor a job locally. However, telepresence robots are pushing the frontier in this area and have already been used to offshore English language instruction from Korean schools to the Philippines. In the not too distant future, advanced virtual reality environments will likewise make it even easier for workers to move seamlessly across national borders and engage directly with customers or clients.

As offshoring accelerates, college graduates in the United States and other advanced countries may face daunting competition based not just on wages but also on cognitive capability. The combined population of India and China amounts to roughly 2.6 billion people—or over eight times the population on the United States. The top 5 percent in terms of cognitive ability amounts to about 130 million people—or over 40 percent of the entire US population. In other words, the inescapable reality of the bell-curve distribution stipulates that there are far more very smart people in India and China than in the United States. That will not necessarily be a cause for concern, of course, as long as the domestic economies in those countries are capable of creating opportunities for all those smart workers. The evidence so far, however, suggests otherwise. India has built a major, nationally strategic industry specifically geared toward the electronic capture of American and European jobs. And China, even as the growth rate of its economy counties to be the envy of the world, struggles year after year to create significant white-collar jobs for its soaring population of new college graduates. In mid-2013, Chinese authorities acknowledged that only half of the country’s current crop of college graduates had been able to find jobs, while more than 20 percent of the previous year’s graduates remained unemployed—and those figures are inflated when temporary and freelance work, as well as enrollment in graduate school and government-mandated “make work” positions, are regarded as full employment.

Thus far, a lack of proficiency in English and other European languages has largely prevented skilled workers in China from competing aggressively in the offshoring industry. Once again, however, technology seems likely to eventually demolish this barrier. Technologies like deep learning neural networks are poised to transport instantaneous machine voice translation from the realm of science fiction into the real world—




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and this could happen within the next few years. In June 2013, Hugo Barra, Google’s top Android executive, indicated that he expects a workable “universal translator” that could be used either in person or over the phone to be available within several years. Barra also noted that Google already has “near perfect” real-time voice translations between English and Portuguese. As more and more routine white-collar jobs fall to automation in countries throughout the world, it seems inevitable that competition will intensify to land one of the dwindling number of positions that remain beyond the reach of the machines. The very smartest people will have a significant advantage and they won’t hesitate to look beyond national borders. In the absence of barriers to virtual immigration, the employment prospects for nonelite college-educated workers in developed economies could turn out to be pretty grim.

As technology advances and more jobs become susceptible to automation, the conventional solution has always been to offer workers more education and training so that they can step into to new, higher-skill roles. As we saw in Chapter 1, millions of lower-skill jobs in areas like fast food and retail are at risk as robots and self-service technologies begin to enrich aggressively in these areas. We can be sure that more education and training will be the primary proffered solution for these workers. Yet, the message of this chapter has been that the ongoing race between technology and education may well be approaching the endgame: the machines are coming for the higher-skill jobs as well…Collaborating with the machines. Erik Brynjolfsson and Andrew McAfee of the Massachusetts Institute of Technology have been especially strong proponents of this idea, advising workers that they should learn to “race with the machines”—rather than against them.

While that may well be sage advice, it is nothing especially new. Learning to work with the prevailing technology has always been a good career strategy. We used to call it “learning computer skills.” Nevertheless, we should be very skeptical that this latest iteration will prove to be an adequate solution as information technology continues on its relentless exponential path…

In spite of the mottos and slogans that corporations direct at their employees, the reality is that most businesses are not prepared to pay a significant premium for “world-class” performance when it comes to the bulk of the more routine work required in their operations…Businesses will make the investment in areas that are critical to their core competency—in other words, the activities that give the business a competitive advantage…The individuals that businesses are likely to hire and then couple with




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the best available technology are the same people who are largely immune to unemployment today. It is a small population of the elite workers…

There are also good reasons to expect that many machine collaboration jobs will be relatively short-lived. Recall the example of WorkFusion and how the company’s machine learning algorithms incrementally automate the work performed by freelancers. The bottom line is that if you find yourself working with, or under the direction of, a smart software system, it’s probably a pretty good bet that—whether you’re aware of it or not—you are also training the software to ultimately replace you.

Yet another observation is that, in many cases, those workers who seek a machine collaboration job may well be in for a “be careful what you wish for” epiphany. As one example, consider the current trends in legal discovery. When corporations engage in litigation, it becomes necessary to sift through enormous numbers of internal documents and decide which ones are potentially relevant to the case at hand. The rules require these to be provided to the opposing side, and there can be substantial legal penalties for failing to produce anything that might be pertinent. One of the paradoxes of the paperless office is that the sheer number of such documents, especially in the form of emails, has grown dramatically since the days of typewriters and paper. To deal with this overwhelming volume, law firms are employing new techniques.

The first approach involves full automation. So-called e-Discovery software is based on powerful algorithms that can analyze millions of electronic documents and automatically tease out the relevant ones. These algorithms go far beyond simple key-word searches and often incorporate machine learning techniques that can isolate relevant concepts even when specific phrases are not present. One direct result has been the evaporation of large numbers of jobs for lawyers and paralegals who once would have sorted laboriously through cardboard boxes full of paper documents.

There is also a second approach in common use: law firms may outsource this discovery work to specialists who hire legions of recent law school graduates. These graduates are typically victims of the bursting law school enrollment bubble. Unable to find employment as full-fledged lawyers—and often burdened with enormous student loans—they instead work as document reviewers. Each attorney sits in front of a monitor where a continuous stream of documents is displayed. Along with the document, there are two buttons: “Relevant” and “Not Relevant.” The law school graduates scan the document on the screen and click the proper button. A new document then appears. They may be expected to categorize up to eighty documents per hour. For these young attorneys, there are no courtrooms, no opportunity to learn or to grow in their




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profession, and no opportunity for advancement. Instead, there are—hour after hour—the “Relevant” and “Not Relevant” buttons.

One obvious question regarding these two competing approaches is whether the collaboration model is sustainable. Even at the relatively low wages (for attorneys) commanded by these workers, the automated approach seems far more cost-effective. As to the low quality of these jobs, you might assume that I’ve simply cherry-picked a rather dystopian example. After all, won’t most jobs that involve collaboration with machines put people in control—so that workers supervise the machines and engage in rewarding work, rather than simply acting as gears and cogs in a mechanized process?

The problem with this rather wishful assumption is that the data does not support it. In his 2007 book Super Crunchers, Yale University professor Ian Ayres cites study after study showing that algorithmic approaches routinely outperform human experts. When people, rather than computers, are given overall control of the process, the results almost invariably suffer. Even when human experts are given access to the algorithmic results in advance, they still produce outcomes that are inferior to the machines acting autonomously. To the extent that people add value to the process, it is better to have them provide specific inputs to the system instead of giving them overall control. As Ayres says, “Evidence is mounting in favor of a different and much more demeaning, dehumanizing mechanism for combining expert and [algorithmic] expertise.”

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Global 13D Staff

www.13D.com [email protected]


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