This week was another set of reminders that without proprietary software it’s hard to have a profitable business model.

Ubiquiti managed to come public this week and although they are positioned as a wireless hardware company their strategy, business model, profits and high valuation all come from a focus on software. They combine proprietary software with zero incremental cost with commodity hardware to deliver a solution that is low-priced, high function and generates increasing returns to scale. (Check your email if you are a client or wait until the note gets published on Seeking Alpha.)

It should come as no surprise that the founder and CEO of Ubiquiti cut his teeth at Apple. Apple generates the bulk of the revenue from “hardware” but it’s not obvious to everyone that it is the software (and design to be fair) that generates the advantage, the margin and the valuation for Apple.

Amazon leverages software too but in their own way. An online, service-oriented set of systems that is now going to be the main gateway for most consumers to discover, purchase and access real and virtual goods.

Contrast all this with Dell who continues to struggle to find a new positioning in a world where the things they are known for are now commodities. Dell may still have a price/performance edge in delivering commodity hardware but it’s not a ticket to high operating margins.

This week Dell is stressing their power and prowess as an “enterprise” technology company and asserting that Apple is not. Unfortunately for Dell they are wrong on both counts. First of all Apple has been on the rise in terms of enterprise spending and plans for the past two years and that trend is accelerating thanks to the iPhone and the iPad.

Second of all the ability for Dell to add proprietary value is limited. They have made a number of acquisitions but not enough in software. Customers point out there are many sources for low-cost commodity solutions and companies like Red Hat provide excellent software to make those systems perform well. Add into that improvements in virtualization technology (where VMWare dominates) and you end up with hardware vendors simply competing on price/performance.

In terms of innovation in the server space Dell is being outdone with Cisco with their UCS.

Closer to the consumer we’ve been doing some work on a private company called FitBit. They have a little device that goes in your pocket to track your activity but the power and value of the company is completely in their software that brings together multiple aspects of activity, consumption, and health measurements into a goal-driven context. The hardware bit is irrelevant. In fact the one they make has many flaws. As the company grows maybe third parties will emerge with different/better devices that tie into the software. Again it’s the software in the middle that drives all the value.

FourSquare has just introduced some new software features called “Radar” that promise to make a very big difference in the usage and value derived from their service. We see companies every day that forget the simple software lesson and investors wasting time with companies that don’t have it right.

Architecture is important too but we’ll leave that for another post.

I attended a one-day “Think Tank” hosted by Coburn Ventures in November where a hundred or so smart people riffed about a broad range of topics in technology, social networking, the Internet, and investing. The event defies easy encapsulation because ultimately what you take away is based on your own personal thought process and the interaction you have with other ideas and attendees. So with that intro/caveat here are some highlights I came away with:

One-Way Doors

The concept of “one-way doors” for consumers in the technology space is very powerful. It’s a perfect turn of a phrase to describe what we’ve been doing for hundreds of years.  But today the doors seem to be coming faster and realizing just how “one way” they are is instructive.  Recent examples are the iPhone and the Kindle.  Consumers expect simplicity, power, touch screens and the ability to get immediate access to digital content.

Many of us have already had the experience of touching and pinching a device with a non-touch display and wondering what’s wrong.  Now it seems odd to interact with a hand-held device that *doesn’t* have a touch screen.  The advent of mainstream touch screens is only four years old.  iTunes is another good example because it took a very convoluted process and turned it into a plug and a click.  Another instant one-way door.  I think the Kindle (and Kindle software) will do this for a large segment of the book market.  I’ve been crazy for books my whole life (no doubt in part because my dad and my step-mom were both librarians) and I thought the Kindle was a terrible idea when it came out because I love my physical books so much.  But, after using it for a year, I can see that it will be very big for everyone, myself included.  Art books, out of print books, large format books, etc. will continue to need a physical aspect for a while but not forever. A quick look at the interactive Sistine Chapel makes it clear that conventional books will get outmoded quickly.  It will take some time to see a digital edition of “Classic Japanese Joinery Illustrated,” but when it does come out it is likely to offer an enhanced viewing and learning experience that I can’t even get today from the beautiful printed book.  It’s true that for services like Kindle to work we need a way to borrow and lend content more easily.  Remixing need to be easier too. In the meantime, however, a digital version will offer better value than the physical book for many purchases.

Many of these recent innovations have hit the consumer first but are increasingly putting pressure on enterprises.  Most enterprise technologies are very difficult in almost every way possible: hard to buy, hard to install, hard to learn, hard to run.  Many enterprise technology bigots suggest that this is all necessary because these products are secure, they scale, they meet the myriad requirements for compliance, etc.

But enterprise users are still people. Which means they are also consumers who are going through these “one way doors” all the time.  They are coming to expect power and simplicity.  They are beginning to vote with their feet – or finger now that most things are just a click or two away – and enterprise technology providers need to take notice.  One study found that a vast majority (>70%) of people in Fortune 100 companies were using services like Dropbox even though they are prohibited.  It’s hard to prevent the use of simple, free (or cheap) products that work great.

From an investment standpoint I think this means that markets will shift faster and the ability to adapt and scale will continue to be extremely important. It also tends to add to visibility once the door is opened.  For example, the attractiveness of an investment in Apple has not really ebbed much since 2007.  So many people have yet to flow through their one way door (with high margin toll booths) that years of profitable growth are locked in.

Lean Back versus Lean Forward

A little over ten years ago, John Seely Brown gave a presentation at a Warburg IT conference in NYC using a brilliant set of illustrated charts that showed many modes of computing, including leaning forward and leaning back.  Today the idea is very apt given the battle that is going on in the entertainment industry.  Entertainment evokes a “leaned back” view of content.  You are, after all, supposed to be entertained. Which means someone else is doing the work.

Video games blurred the distinction long ago and today we are faced with a very fuzzy set of lines in digital entertainment. The real challenge is that consumers vacillate wildly about leaning forward and leaning back *even in specific genres*. For example, games are lean forward activities but now many gamers are eager to watch others play games on a gaming TV channel to learn more and pick up tips while eating pizza and relaxing with friend in the living room. Some even watch for the entertainment value alone. Millions learned about poker by being captivated watching the Poker Channel on their TV (often while unable to sleep at 2am in their hotel room.) That turned into a desire to play online and “lean forward” into the game. The same is true for Internet radio (last.fm) and eventually Internet video (YouTube/GoogleTV, AppleTV.)

The other sort of crazy new trend is to go from lean back to lean forward based on direct interaction with the artist and the content. Increasingly, consumers are being invited into the creative process and many true fans take advantage and turn passive music consumption back into active engagement and a new level of entertainment.

This is also happening with sports with “helmet cams” seeping into NFL football that allow viewers to select and view their own perspectives of a play. NASCAR implemented “in-car cameras” some time ago.   These are interesting technologies but it’s too soon to know how much consumers will be willing to pay for and engage with these new models.

Multiple consumption modes don’t just apply to the *types* of content but also to the use cases which seem to be mutating and being demanded *simultaneously*. This is a big problem for non-IP architected content solutions like cable companies. It would seem that what is going on here is utterly incomprehensible to cable companies and media networks. Consumers will need to pay for big data pipes, but in return will demand new content models that shift endlessly between “lean forward” and “lean back,” which will make it impossible to succeed without radical retooling.

Is Facebook the Devil?

It hasn’t taken long for Facebook to become a lightning rod for many storms (privacy, valuation, data ownership, games) and it seems, for many, also morals and society.  Clay Shirky has said that Facebook is a new metaphor which defies analogies and prior examples.  As such, everyone is still figuring out how to deal with it and opinions range from “the greatest thing ever” to “it’s the Devil” to “it’s good but like AOL for social networking and a big short.”

Now that technology is so entwined with society, debates about a new “technology” like Facebook are unlikely to go anywhere from an investment standpoint. Mankind has consistently given up things like privacy in exchange for convenience. One way to really understand this is to read a book called “How to be Invisible” which lays it all out for you. The extent to which you would have to change your life not to be fairly easily discovered and known is staggering.

For me the real question is “are we using Facebook or is it using us?” Many of the people in the room no doubt felt they were controlling it, but worried about the less technically savvy and teens/tweens in the world.  Based on a small sample I think young people are learning fairly rapidly how to use these systems and are pretty smart about what information to put where (at least based on their own sensibilities) and which things to avoid.

It’s become pretty clear that most people have multiple and distinct networks (social and professional) so that the idea of having just one, be it Facebook or another, doesn’t really make sense. This means that despite the dominance of Facebook we can probably expect to see many successful networks built and become great investments. We’d point to examples like StockTwits (stock investing), LinkedIn (professionals), and Mendeley (scientists) as three easy examples.

Digitizing our lives opens my myriad opportunities for use and abuse. Which path Facebook will take isn’t yet totally clear.

[Credits: Door image from Fluxxlab.]  [Disclosures: None for this post.]

Related articles

• Twitter and LinkedIn Signal: Lean-Forward and Lean-Back Designs In Action (contentnation.com)
• Amazon Announces Magazines and Newspapers for Kindle Apps (geardiary.com)
• Sorting Books and Digitizing Thought (bigthink.com)

Last week we published our March Thought Leader Interview with Arthur Kroeber, an expert on China and Managing Director at Dragonomics Research & Advisory. It offered some real insights into China from political, economic, technological and practical perspectives.

In addition to several ideas that I expected I found some surprises and excellent long-term considerations including:

1. China already has the cleanest coal burning technology and will extend their lead because that have so much coal.
2. There’s really not much business at stake for Google in China, it dwarfs what they have to lose from a lost of trust if they don’t do the right thing there.
3. A very big looming question is whether or not the government can make the trade-off between control of the financial system (which they rely on to control the country) and greater efficiency and long-term growth.
4. Electric vehicles seem like they would be a natural fit for an increasingly urban China but lack of any garage or home charging space means that most of the growth will be in the form of public vehicles.
5. The real technology know-how continues to exist only in Taiwan and this is likely to be true for a long-time to come.
6. Demographically China will begin to see the number of new workers decline each year. It will still be a big number but it will put upward pressure on wages (increasing consumption) and drive increases in efficiency.

There is plenty more where that came from in the report and as usual the picture of China from afar is way too simplified to be useful. Only by digging in and seeing the details can any useful predictive picture emerge.

R2 Members received this report via email last week and it is available online in our research library.

Research 2.0 basic membership is free subject to approval. Sign up here to join. Additional fee-based research and services are also available.

[Disclosure: None.]

RIMM too sexy to be single?

We wrote about it back in this January post but now bigger, more connected sources like Kara Swisher are writing about the release of Microsoft Windows Mobile 7 and how they might need to do something big. The scuttlebutt is that Ballmer would love to buy RIM at the same time it sounds like they realize that buying PALM, while it is much cheaper, won’t really get them anywhere. We stick to our guns on RIMM both as a fundamental story and a too-sexy-to-be-left-alone technology player.

Is Adobe FLASH an endangered species?

We’re not going to get into the technology pissing contest of HTML 5 versus FLASH here. There are dozens of sites that will numb your brain going over it all. The point however is that lots of things are popping up that developers are getting excited about – the iPhone, Android, the Cloud, Facebook, Twitter and now the iPad. So much opportunity, so few incremental buyers of CS5?

Part of the problem is there is a simmering resentment out there for how fat Adobe has been getting off of $1500 software “suites” and $500 upgrade fees. It’s all great stuff but while technology pricing always feels like it’s coming down Adobe feels like a high tax and it reminds people how proprietary FLASH.

Even if FLASH continues to dominate and Adobe does “just fine” with CS5 and future releases if investors perceive it more like Microsoft which “does just fine” with Windows and all that jazz they will be trading at a multiple closer to the old guard.

The conventional content model implosion picks up steam.

Again we’ve penned on this topic before but over here on the Creative Destruction blog. Thanks to the Amazon/Apple dust up with Macmillan the crowds are gathering around the content pricing ring to watch the fight.

There were some stories out today that cable companies should simply focus back on the broadband and stop trying to be in the media business by packaging and charging for entertainment content. It’s certainly something to worry about for them but given their culture it’s hard to see how they work around that part of their core business.

The issue of “what’s the right price” for an online book is fascinating. Part of the problem the entire industry faces is the “casual user” factor. The picture of one set of people pounding the table that “it has to be $14.99″ and another saying “it has to be $9.99″ is absurd. What about lending books? Right now whatever I pay online I can’t lend it to anyone. Why shouldn’t an online book be $5? Nobody knows. Maybe it should be priced by the chapter? That could work for non-fiction anyway, I’d like that model.

As usual most of the discussion we see appears to ignore the consumer, the typical or newly possible use cases. Instead it focuses on some futile preservation of the old model in an entirely new era.

[Disclosure: The Research 2.0 model portfolio contains shares of Apple and RIM at the time of this writing.]

We didn’t make it. (But we did amplify it here on February 24th.)

The points made by GaveKal in February for technology shares leading the market were indeed compelling and the past month of market action has been nothing short of spectacular.

Technology companies are cash-rich as a group, offer a cheap call option on global growth, are taking an increasing share of consumer spending and used to operating in tough environments where lower prices (and costs) are part of doing business.

Combined with the fact that technology stocks were at very low valuations in Feburary it was easy to get “long and strong” the sector.

At this point it’s tempting to take the chips and go home.  But most of the names we follow are still below our estimates of fair value so while it makes sense to adjust positions it doesn’t feel like this trend is over.    Given that we are so focused on technology we try extra hard to be objective.

We were astonished to read articles like this Why Tech Stocks Won’t Lead The Next Bull Market.  These guys are about 10 years behind the curve because the focus on names like Microsoft, Oracle, Yahoo and GE as the “leadership names.”  What?  People like this should be given a one-way Internet connection! 

These stocks may have to take a breather but most of the ones we look at still look attractive on a fundamental basis.

[Disclosure: Research 2.0 is long many technology stocks.]

Today GaveKal was out with a research note regarding the growth of consumption in Asia.  We won’t regale readers with the entire note but one thing stood out:

Asian consumers generally have space issues and tend to be technology savvy.  These conditions tend to stimulate purchases of technology gadgets as consumers get more disposable income.  

Juxtaposed against the recent market sell-off in technology shares the argument is more compelling.  The fact is that technology companies are generally in much better shape to weather the slow growth since many of them are so cash rich.  (25% of assets in the S&P technology companies are in cash)

So technology stocks look like good medium term call options on global growth and are positioned very well longer term to benefit of increased consumption in Asia. 

The above comments capture the gist of what was said in the note and we would add that a number of very strategic core names like Apple, Adobe, Google and Cisco should probably be bought here on a long term basis.

Overall economic fundamentals and a lack of certainty on future estimates will keep some pressure on these names but owning shares in these franchises when growth and visibility comes back will absolutely be the right thing to do.

Technology innovation and adoption is alive and well.  We are in a short-term pause before what appears to be a major adoption cycle a year or two out.

[Research 2.0 owns shares in the names mentioned above.]

Many of us have heard the quote about "not having lived through the great depression" or even more recent history like the bear markets of the mid-1970′s.  Technology companies and investors however have fairly fresh memories of the "dot com bust" of the early 2000′s.  We have seen that in the past week with a raft of fairly aggressive and swift cuts of staff and burn rates at even very small venture-backed companies. 

Companies are suspending expansion plans, shifting workers from full time to freelance, work from home staff. (Possibly exacerbating an already narrow number of employees who get healthcare benefits from their employers.)  In some cases company managements are preparing their firms for survival through 2012 even if revenue fails to materialize between now and then.  Staff cuts of 10%, 20% and even 40% are common. 

Venture capitalists have also been vocal about the need to clamp down and are restricting their investments.  Besides the weak economic outlook the proceeds from exits are certainly down from where they once were and the IPO market remains virtually non-existent.

To cope with the doom many are pointing out the obvious.  This is pretty good news for the future and getting back to seeing attractive returns again.   We’re just beginning to see examples of private investments that have 10x or better returns as fairly likely outcomes over multiyear periods.  (Of course in this environment it doesn’t mean they will get funded!)

Technology should remain one of the better growth areas coming out of this recession.  Some companies that are cutting staff are simultaneously increasing some of their investments in technology because they can improve productivity and lower operating costs.  There isn’t enough of this type of spending to save us all from a downdraft in overall IT spending but it’s still an instructive example.

So for us and our clients and friends who can look a few years out this is also a time that is sowing the seeds for future wealth creation.  We’re adding to our portfolio of names as we work our way through the crisis.  The good news is that managements in most cases are taking the situation very seriously because they remember the bust of only several years ago.  This will create leaner, more profitable and higher return companies than we would have otherwise.

A healthy subset of the global geeks are settling into Berlin later this month for a stream of web-technology-focused events.  As "obvious" as is the inevitability of cloud computing may be to most of us there are still a huge number of technical and user obstacles to overcome before it can really be called mainstream.

Setting raw bandwidth speed and coverage aside for the moment there will be plenty of discussion of the software and service-based issues facing cloud computing adoption at the Web 2.0 event in Berlin.   In particular we’d highlight the following:

1. Cross platform: There’s been some splintering of client-side technologies like IE, FF, Safari, iTunes/iPhone and now Chrome to name a few.  How will they get harmonized?  What about Adobe Flash, Flex and AIR?

2. Scaling: Amazon and Google have started efforts to try and lead the way here but the ability to create, run and scale cloud applications is particularly difficult given the sheer size of the user population.  The cloud may be "elastic" but how long does it take to stretch and contract?  These companies will be in Berlin to talk about this and how smaller firms like RightScale and Elastra may help.

3. Development Vision: What are the right sets of server-side technologies to build on for the long-term?  Location-based services are increasingly being integrated into applications as the virtual and real world applications meld together.  How is that going to come together over time? 

There’s no doubt that there will be much more to cover in the three days we’ll be in Berlin and for those interested in an even deeper dive their are events like BarCamp that precede the Web 2.0 event and some special after-events aimed at further socializing and human collaboration.

As a reminder feel free to use our Research 2.0 discount code "webeu08gr63" for a substantial discount on registration. 

We’re preparing for a productive Web 2.0 conference in Berlin October 21-23.  Recently Tim O’Reilly was shaken up so much by being in such close proximity to the fires of the financial meltdown at the NYC Web 2.0 Expo that he had to rewrite his whole speech to refocus on doing things that "matter" (instead of mashups that show the correlation between crime in Chicago and milkshake flavor choices at an In-N-Out burger in LA.)

In October we should be able to focus a bit more on technologies and start-ups, particularly more from Europe.  We see Europe as a much more fertile ground for startups for a number of reasons.  While Europe lacks some of the features of Silicon Valley it has some different elements that can be just as effective.  There’s no shortage of talent and technology expertise which makes it a hotbed of activity.  Additionally many large companies still prefer to use and even champion local technology to help small firms get a business foothold and critical real-world feedback. 

We’re also starting to see increasing VC activity in Europe as leading firms like Union Square Ventures have shifted more of their focus to Europe and even started to make some investments. Zemanta being a good recent example and it’s even based in Solvenia.    It’s been a long time coming but we see a sustained upswing of activity here because the environment is becoming more "target rich" every day and the expectations and level of VC competition is less heady than what one finds today in the Valley and even now in Boston and NYC. 

In addition to being at the event we’ll be actively covering the more interesting pieces here and hosting a small group dinner on the nights of the 21st and 22nd.  If you haven’t been to Berlin it’s a great place to be.   We also have a code (webeu08gr63) which gets 35% off the registration.  We’ve distributed to our clients but the conference organizers said we could also post it here. 

Tags: web2expoEU, web2expoEU08, w2e_europe08, eurotech

We’re reminded a little of the admonishment "be careful what you wish for" in this current market.  The financial turmoil, unwinding of high energy and commodity prices and slowdown in global growth are all here as expected.  Why don’t we feel more happy about it?

Obviously a market this bad drags everything down but it also calls into question fundamentals and estimates.  It’s been pointed out by others like Bill Hambrecht recently in an interview that growth rates will slow but balance sheets are in very good shape.  Think of the cash that leading companies like Apple and Google are swimming in. 

But still we know that things "at the margin" often determine direction and sentiment for stocks and it’s clear that lower financial sector IT spending and more careful consumer spending are going to reduce the take up of technology, particularly things that can just wait a while.  Our friends over at MGI put up a post that points out that while about 20% of technology spending comes from the financial sector but even more, close to 30% of "leading edge, advanced technology" comes from there.  To us it means that maybe the expensive uptake of new technology products will just be a bit slower than it was going to be. 

Cautious consumers and slowing global growth will certainly push purchases to lower price points and elongate new product cycles (Adobe releases CS4 next week and no matter how good it is most will probably not be eager to move from CS3 anytime soon.)  No doubt $400 smart phones and $2000 laptops may give way to $150 and $1200 versions respectively.  In many respects the timing of the small and cheap laptop PC will be perfect for this economic backdrop.

Current valuations seem low but of course the key question is how much of the slow down is "in the numbers" right now?  We did a quick and dirty analysis looking at forecasts for the top 100 technology companies by revenue to see where we are right now.

The Top 100 have revenues of just over $1T with a total EBITDA of about $200B.  Based on current estimates revenues are expected to grow 8.2% this year and 8.7% next year.  These numbers are probably close to but could come down a point or so.  Earnings per share growth expectations do look too high though with growth of 24% this year and 18% next.  It feels like the 24% number should be cut in half and the out year would be fine from these lower levels.  Athough we don’t have EBITDA estimates for all 100 companies the ones we do have show growth of 14% this year and 12% next.

Our conclusion is that there are still some negative changes at the margin that may keep valuations and sentiment in check for the near term. Since we use a longer term approach in our Intrinsic Value methodology our targets don’t change much, if at all.   We probably picked a great time (October 1st) to release our model portfolio over at The Creative Destruction Fund.