Wednesday Briefs – 24 February 2021

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This week: Facebook Externality; US Infrastructure; Texas Gray Rhino; Market Rotation.

Facebook Externality

Words and actions have consequences. So do 80% gross margins. Very few companies have such profitability. The most profitable industrial companies have gross margins of 20 to 30%. Software companies have gross margins of 40 to 60% because the marginal cost of producing an extra download is relatively low.

Facebook is in rare company at 80% gross margin, in a league occupied by top pharmaceutical companies. The main explanation for this high profitability, we argued previously, is not only Facebook’s uniquely genial execution of its strategy but also the fact that it does not pay for the user data that it mines in order to sell targeted ads. See Tech Giants Should Pay Users.

In 2020, Facebook, Google and Microsoft’s gross margins were 81%, 54% and 68%. One externality of Facebook’s high profits is its willingness to upset for example the government of Australia. That is what it did last week when it suspended all Australian news outlets because of a proposed new law in that country that would make the company pay news companies for their content. Facebook wiped clean the pages of those news outlets and it became impossible even for a non-Australian Facebook user to post their articles on Facebook. Faced with a disastrous PR fallout and ostensibly because this was a battle that it could not win, Facebook made a deal yesterday and reinstated the blacked out news.

Unlike top pharma companies, Facebook’s ability to sustain very high margins does not depend on periodically obtaining new patents while remaining on the good side of regulators. Further misconduct cannot be ruled out.

US Infrastructure

It has been known for decades that US infrastructure is in a state of advanced disrepair. In a 2017 report, the American Society of Civil Engineers (ASCE) graded 16 categories of existing US infrastructure. Rail got a B. Ports got a C+, as did Bridges and Solid Waste management. The remaining 12 categories were graded D+, D or D-. Transit was the sole D-. ASCE averaged all the grades and came up with a GPA of D+ for the entire US infrastructure. At most colleges, that would get a student suspended or put on probation.

From the ASCE’s 2017 Infrastructure Report Card.

The same report estimated that the “cost to improve” all categories stood in 2017 at $4.6 trillion, a sum that it said could be spread over ten years. On the back of weather-related crises suffered in the past fifteen years (hurricanes Katrina, Harvey, Sandy to name only a few) and now the Texas energy debacle, there seems to be a new willingness to lay out some significant dollars for infrastructure.

Infrastructure has been in many ways the neglected child of the investment community. One reason is that returns on infrastructure investments tend to be lower than for most other categories. The very real risks of delays and cost overruns during construction and of new regulations after completion create financial disincentives for investors. See for example the disastrous saga of California’s high speed train link: delayed, over budget, and a fraction of its initial distance.

Other countries, for example France, Spain and the UK, have explored more extensively the concession model by which a private company builds new infrastructure and operates it for profit under oversight and regulation of a government agency. This approach takes the pressure off the taxpayer but is sometimes seen as unfair to lower-income groups when usage fees (tolls, charges etc.) are interpreted as de facto regressive taxes. New technology could resolve this quandary through multi-tiered billing.

Texas Gray Rhino

Texas, better known for longhorns and armadillos, now has to contend with a gray rhino. A gray rhino is author* Michele Wucker’s metaphor for threats that are obvious, highly probable, highly impactful but that are often ignored until it is too late. By then, the cost of a remedy is much higher than that of prevention. Wucker views the power and grid crisis in Texas as a textbook gray rhino event. We reached her last week and she emailed us the following:

“Having been in Houston for the 1989 ice storm and blackouts, I can say first hand that this is not the first time that extreme weather has overcome the Texas power grid and it won’t be the last. And we know that climate change is making weather more and more extreme. So yes, this is a gray rhino that many people saw coming.”

In a subsequent LinkedIn post, Wucker writes:

“[The Texas blackout] followed not just the 1989 blackout but another similar weather-related one in 2011 and many unheeded warnings, including a report published in August 2011 by the Federal Energy Regulatory Commission and the North American Electric Reliability Corporation.”

She recommends a series of questions to deal with similar threats proactively. Among them:

“How much risk is appropriate when it comes to the energy grid? How close is our current setup cutting it to “too much risk”? How much extra capacity do we need to add to prepare for possible future extreme weather events? What kind of measures and redundancies do we need to put in place in case of future equipment or software failures, cyber attacks or human error?”

MORE >>> Listen to our podcast with Michele Wucker discussing The Pandemic as a Gray Rhino Event.

* Michele Wucker is the author of the international bestseller The Gray Rhino and of the upcoming You Are What You Risk.

Market Rotation

This week started with an epic market rotation, out of last year’s high fliers and into the laggards. Tech names and other market favorites sold off hard while depressed sectors rallied strongly. Tesla was down over 10% while Valero was up 6%. We saw it coming in the Wednesday Briefs – 18 November 2020 when we wrote:

“There is considerable upside left in the laggards if the economy holds through the winter surge of the pandemic and if a new stimulus is enacted by Congress. In theory, other things being equal, the latter part of 2021 and the year 2022 could see a very strong recovery in travel, leisure and other sectors that are now depressed. The rush back in spending and socializing will be analogous to a flood after a dam break. According to Citibank analysts quoted in this article, value stocks are priced at only 17x earnings, whereas growth is priced at 38x, an even greater disparity than in early 2000.”

We reproduce here the same table shown in that issue, updated for yesterday’s prices. Companies that are associated with the upper arm of the former K recovery (now looking increasingly like a V recovery) have stagnated since the vaccine news in November, with the notable exception of Alphabet/Google and Tesla. Meanwhile, companies associated with the lower arm have done very well in the past four months.

This rotation will continue for several weeks. The main problem for the major indices is that the combined market cap of the laggards is probably not sufficient to offset declines in the former leaders. On current trends, one way to outperform in 2021 will be to underweight technology.

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