At the 2011 Sequoia Fund investor day the Sequoia managers were asked about their newest portfolio positions Google (GOOG, Financial) and IBM (IBM, Financial). I thought it would be interesting to revisit since we have also discovered that Buffett was buying IBM around the same time or shortly after.
Question:
I’d like to ask about another area that’s new to you. I see that you’ve picked up IBM and Google. Google in particular — I’m wondering if you feel that unlike Warren Buffett you can predict over ten years how it is going to do. How do you look at a business like that, value it, find your margin of safety and so on?
Chase Sheridan:
You’re right, Google is unusual for us. It first got our attention on a valuation basis because it seemed like an anomaly; the speed at which it was growing relative to the valuation seemed out of whack. But as you know we look for sustainable competitive advantages. So the first thing I concentrated on when I looked at Google was how sustainable its advantage in search was. What we found is that the days of someone coming up with a clever algorithm and competing against Google in search are essentially over. A lot of people may not understand that when you search the internet, first you have to crawl the internet, download the internet, and parse the internet. That takes a tremendous amount of investment and infrastructure.
Google owns more servers than anyone else. It owns a tremendous amount of fiber optic cable. It places its computer servers next to very cheap energy. Google has its systems built literally next to hydroelectric dams. So you’re talking about a business with a tremendous amount of investment required. There’s really only one competitor out there that is trying to compete directly with Google in search and that’s Microsoft. If you look at the numbers — because the media don’t always frame this with the numbers in place; there’s a lot of hype —Google’s revenue last year was a little over $29 billion. Its operating income was a little over $10 billion. Microsoft, in its online services, had revenue of $2.1 billion and it had losses of $2.4 billion. For every dollar it took in as revenue, it lost more than a dollar.
Facebook is the big threat to Google these days in a lot of people’s minds. In display that’s true, but Facebook is not directly competing with Google in search; so there’s room for them both to do very, very well. Facebook will do well in display and Google will do well in display as well. But in search it’s very hard to see a competitor coming up now — it’s tech so I could always be wrong — but I think it will take a long time before anyone threatens Google in this area.
Bob Goldfarb:
Is it $37 billion in cash?
Chase Sheridan:
Yes, probably more by now.
Bob Goldfarb:
Now it may be $40 billion because they just sold $3 billion worth of debt but it would still be net cash of $37 billion. One of our concerns, or reservations, about Google is what it will do with that cash as well as the enormous amount of cash that it generates every year from earnings. How would you assess past acquisitions, Chase?
Chase Sheridan:
It’s hard to assess them because in certain cases I thought management was nuts when it made the acquisition. YouTube is a great example — Google paid $1.65 billion in stock for YouTube when it had sixty-some employees. Eric Schmidt, later in a deposition, said he thought that was about a billion dollars more than the company was actually worth.
But Google wanted to keep it out of Microsoft’s hands. So a cynical value investor might say that Google was crazy to pay that price, but as it turns out that decision has been born out. YouTube is an incredibly valuable property. If I could go back in time and advise Google on whether or not to buy YouTube and invest in it as it has, I would absolutely advise a repeat of the decision. Still one of the worries that we have is that Google, an extremely ambitious company, is headed by brilliant engineers whose goals may not necessarily be to maximize shareholder value. They are out to change the world.
Changing the world can require very long term thinking with very high amounts of invested capital and that may not necessarily benefit shareholders.
The question is do you give Google a discount for that risk and if so, how big a discount? Right now, Google last quarter— grew revenue 27% year over year, which for a company of that size is just remarkable. It is valued at — depending on how much credit you want to give for the cash —anywhere between 15 − 18 times earnings. So you can give Google a discount for uncertainty around how management is going to allocate cash flows and still find that the company looks pretty cheap.
Bob Goldfarb:
We just don’t have any informed opinion on the value of the investment in self-driving cars that Google is experimenting with in Nevada. It’s venture capital and that’s a different game than the one we’re in. Another point that Chase just raised with regard to YouTube is there is a risk, which possibly manifested itself last week with Microsoft’s acquisition of Skype, that for defensive purposes these companies make acquisitions at excessive prices just in order to keep them out of the other guy’s hands.
There’s an arms race, if you will, and it’s possible that unilateral disarmament might be the best outcome for the shareholders. But I wouldn’t necessarily predict that is going to be the most likely course of action.
Will Pan:
On IBM: Just to clarify or add my two cents to what Mr. Buffett said at this year’s annual meeting, he said technology — now we’re talking about information technology — is an extremely fertile area to look for growth because the world does need to get more productive. The problem is that there are so many big winners and big losers. And it is difficult to predict.
The nice thing about IBM is that it’s really a comprehensive portfolio. You’re not betting on one specific technology or one specific company bringing that to fruition. IBM is very comprehensive both in the types of products that it offers and in the ways that it can deliver them to its clients. It has the services functionality for really complex analytical offerings and it has software, which is really high margin, and the hardware as well. So it can really offer a one stop shop to its clients and that is one reason why it has such a valuable brand. Of course, with any portfolio you have to manage it and that is a little bit more difficult in technology than elsewhere. We think that the management team at IBM is extremely capable, one of the smartest in the field. It really has the deck stacked in its favor—and IBM has been staying abreast of technology enterprise IT for generations. That’s something embedded in the culture.
It has the deck stacked in its favor because when IBM sees a trend, it can build on it. IBM has a tremendously productive R&D function that it spends $6 billion a year on, about 6% of revenues. In other situations where the most important work or the most promising work is being done at start-ups where the equity holders have a lot of upside, IBM can afford to pay more than others but still get a good return on investment; its unparalleled global distribution network enables it to generate greater revenues and earnings from the acquired entity.
And IBM has turned into something surprisingly predictable. This is a company whose management team has established a very credible roadmap to almost double operating earnings per share by 2015 with very high returns on invested capital, bolstered by significant share repurchase. We see that IBM has a lot of levers to pull to deliver on its promise and we find it both a compelling and a conservative promise.
Bob Goldfarb:
While we favor an R&D light model in pharmaceuticals, that may not be appropriate in information technology, as evidenced by the problems that Hewlett-Packard is having because of underspending on R&D under Mark Hurd. We like the fact that IBM is devoting a fair percentage of its resources to research and development.
Link to the entire Q&A from the Sequoia Investor day http://www.sequoiafund.com/reports/transcript11.pdf
Question:
I’d like to ask about another area that’s new to you. I see that you’ve picked up IBM and Google. Google in particular — I’m wondering if you feel that unlike Warren Buffett you can predict over ten years how it is going to do. How do you look at a business like that, value it, find your margin of safety and so on?
Chase Sheridan:
You’re right, Google is unusual for us. It first got our attention on a valuation basis because it seemed like an anomaly; the speed at which it was growing relative to the valuation seemed out of whack. But as you know we look for sustainable competitive advantages. So the first thing I concentrated on when I looked at Google was how sustainable its advantage in search was. What we found is that the days of someone coming up with a clever algorithm and competing against Google in search are essentially over. A lot of people may not understand that when you search the internet, first you have to crawl the internet, download the internet, and parse the internet. That takes a tremendous amount of investment and infrastructure.
Google owns more servers than anyone else. It owns a tremendous amount of fiber optic cable. It places its computer servers next to very cheap energy. Google has its systems built literally next to hydroelectric dams. So you’re talking about a business with a tremendous amount of investment required. There’s really only one competitor out there that is trying to compete directly with Google in search and that’s Microsoft. If you look at the numbers — because the media don’t always frame this with the numbers in place; there’s a lot of hype —Google’s revenue last year was a little over $29 billion. Its operating income was a little over $10 billion. Microsoft, in its online services, had revenue of $2.1 billion and it had losses of $2.4 billion. For every dollar it took in as revenue, it lost more than a dollar.
Facebook is the big threat to Google these days in a lot of people’s minds. In display that’s true, but Facebook is not directly competing with Google in search; so there’s room for them both to do very, very well. Facebook will do well in display and Google will do well in display as well. But in search it’s very hard to see a competitor coming up now — it’s tech so I could always be wrong — but I think it will take a long time before anyone threatens Google in this area.
Bob Goldfarb:
Is it $37 billion in cash?
Chase Sheridan:
Yes, probably more by now.
Bob Goldfarb:
Now it may be $40 billion because they just sold $3 billion worth of debt but it would still be net cash of $37 billion. One of our concerns, or reservations, about Google is what it will do with that cash as well as the enormous amount of cash that it generates every year from earnings. How would you assess past acquisitions, Chase?
Chase Sheridan:
It’s hard to assess them because in certain cases I thought management was nuts when it made the acquisition. YouTube is a great example — Google paid $1.65 billion in stock for YouTube when it had sixty-some employees. Eric Schmidt, later in a deposition, said he thought that was about a billion dollars more than the company was actually worth.
But Google wanted to keep it out of Microsoft’s hands. So a cynical value investor might say that Google was crazy to pay that price, but as it turns out that decision has been born out. YouTube is an incredibly valuable property. If I could go back in time and advise Google on whether or not to buy YouTube and invest in it as it has, I would absolutely advise a repeat of the decision. Still one of the worries that we have is that Google, an extremely ambitious company, is headed by brilliant engineers whose goals may not necessarily be to maximize shareholder value. They are out to change the world.
Changing the world can require very long term thinking with very high amounts of invested capital and that may not necessarily benefit shareholders.
The question is do you give Google a discount for that risk and if so, how big a discount? Right now, Google last quarter— grew revenue 27% year over year, which for a company of that size is just remarkable. It is valued at — depending on how much credit you want to give for the cash —anywhere between 15 − 18 times earnings. So you can give Google a discount for uncertainty around how management is going to allocate cash flows and still find that the company looks pretty cheap.
Bob Goldfarb:
We just don’t have any informed opinion on the value of the investment in self-driving cars that Google is experimenting with in Nevada. It’s venture capital and that’s a different game than the one we’re in. Another point that Chase just raised with regard to YouTube is there is a risk, which possibly manifested itself last week with Microsoft’s acquisition of Skype, that for defensive purposes these companies make acquisitions at excessive prices just in order to keep them out of the other guy’s hands.
There’s an arms race, if you will, and it’s possible that unilateral disarmament might be the best outcome for the shareholders. But I wouldn’t necessarily predict that is going to be the most likely course of action.
Will Pan:
On IBM: Just to clarify or add my two cents to what Mr. Buffett said at this year’s annual meeting, he said technology — now we’re talking about information technology — is an extremely fertile area to look for growth because the world does need to get more productive. The problem is that there are so many big winners and big losers. And it is difficult to predict.
The nice thing about IBM is that it’s really a comprehensive portfolio. You’re not betting on one specific technology or one specific company bringing that to fruition. IBM is very comprehensive both in the types of products that it offers and in the ways that it can deliver them to its clients. It has the services functionality for really complex analytical offerings and it has software, which is really high margin, and the hardware as well. So it can really offer a one stop shop to its clients and that is one reason why it has such a valuable brand. Of course, with any portfolio you have to manage it and that is a little bit more difficult in technology than elsewhere. We think that the management team at IBM is extremely capable, one of the smartest in the field. It really has the deck stacked in its favor—and IBM has been staying abreast of technology enterprise IT for generations. That’s something embedded in the culture.
It has the deck stacked in its favor because when IBM sees a trend, it can build on it. IBM has a tremendously productive R&D function that it spends $6 billion a year on, about 6% of revenues. In other situations where the most important work or the most promising work is being done at start-ups where the equity holders have a lot of upside, IBM can afford to pay more than others but still get a good return on investment; its unparalleled global distribution network enables it to generate greater revenues and earnings from the acquired entity.
And IBM has turned into something surprisingly predictable. This is a company whose management team has established a very credible roadmap to almost double operating earnings per share by 2015 with very high returns on invested capital, bolstered by significant share repurchase. We see that IBM has a lot of levers to pull to deliver on its promise and we find it both a compelling and a conservative promise.
Bob Goldfarb:
While we favor an R&D light model in pharmaceuticals, that may not be appropriate in information technology, as evidenced by the problems that Hewlett-Packard is having because of underspending on R&D under Mark Hurd. We like the fact that IBM is devoting a fair percentage of its resources to research and development.
Link to the entire Q&A from the Sequoia Investor day http://www.sequoiafund.com/reports/transcript11.pdf
