MARKET OVERVIEW

Recently, Japanese company Rakuten acquired communications service provider Viber for $900M. After two consecutive years of missing earnings targets to an increasingly agitated shareholder base, Rakuten hatched the ambitious plan to enter the social media market with the Viber acquisition (they also invested in Pinterest as part of this plan). Though Rakuten will likely do well in its own markets with these investments, it is doubtful that they will be able to scale up to dominate social media on a global basis.

Clearly, Facebook panicked when Viber was taken off the table, which induced them to push their price to unheard levels when it bought WhatsApp for $19 Billion last week. Bear in mind that WhatsApp has virtually no revenue, as they only charge their users $1.00 annually for using their service. Therefore $19B has to be a much more strategic move for Facebook – right?  Let’s take a closer look at that.

Google (NasdaqGS: GOOG) paid $12.5 billion for Motorola’s mobility unit in 2012 – and has since divested most of the unit to Lenovo (see article below in Portfolio Update section). Integrating large units into large companies is extremely difficult. Though Google had the most popular SmartPhone operating system with its Android operating system, even they could not successfully meld the two units together.

Motorola’s mobility unit actually had positive revenue flows, but in the end cost Google $4B after they pared off their losses and sold the remnants (sans patents) to Lenovo. WhatsApp has so little current revenue and even less of a future for revenues that the $19B paid by Facebook for it can never be returned as value to the stockholders.

We at STI admit we were never fans of Facebook, mainly because its economic model was a copy of Google’s advertising revenue-based model. The difference being, of course, is that search has yet to decline. Facebook was the “it” place for social media for several years, but now is seeing the younger crowd move off to other “it” places as the market fractures into many much smaller pieces.

Facebook is defending this acquisition by saying they have recaptured the young people who use WhatsApp.  Really? WhatsApp is not a destination; it is a messaging service popular outside of the US (primarily in economically challenged South America). The reason it is not popular in the US is because messaging is not as expensive here as it is in other parts in the world. Even if messaging rates do not eventually decline in the other markets – and of course, they will – Facebook has at best gained entry into a new market segment only, and not a very strong one for selling ads primarily aimed at mostly unemployed teenagers.

Here’s the problem: Facebook rationalized that it was killing two birds with one stone. First, they say they stopped the decline of the rapidly declining youth segment for Facebook; and second, the acquisition strategically blocked Google from gaining a toehold in that market. We know they didn’t achieve the former, but how about the latter?

Let’s see… Google puts out tools for techies. Not easy or intuitive to use, but they are cheap, and some are even free. Was Google ever going to become an “it” place on the Internet? No. That involves design, and to be honest even Facebook’s user interface is not the greatest after ten years of development. Google has no shot at becoming an “it” hangout joint on the net for young kids, nor does it want to be.

If Facebook did not block Google (since Google was never going there in the first place) and did not get back the youth who are defecting from them, then why would they spend $19 billion? The answer is actually quite simple; because the controlling interest in Facebook is held by a twenty-nine year old kid who is extremely frightened right now.

With Facebook CEO Mark Zuckerberg now married and on the verge of turning thirty, he feels he has lost touch with the youth market segment. Just as HP spent almost $9B for a company that could not help them with their core business problems, Facebook blew $19B essentially to assuage the fears of its founder.

Who your CEO is and what their innogration plan is matters – a lot. When some small Japanese tech company stole Viber for less than $1B, Facebook panicked. The team at Google has to be laughing so hard these days that is must be difficult to stand up straight (btw, we suspect Google made a bogus offer for WhatsApp to get Facebook to blow a pile of their IPO powder on it – it will be interesting to see if that ever comes to light).

If Google is not laughing – expect Viber to get resold for $10B pretty quickly – to Google. But don’t hold your breath waiting for that to happen. Even if Facebook’s acquisition moves them into a new market segment, the revenue is anemic. It is true that Facebook has been adding revenue to their balance sheet in recent quarters, but their new model is still Google’s old model.

The bottom line is this: Facebook has yet to demonstrate it has any new ideas to help it remain the “it” place on the net, simultaneous to their core market fracturing beneath their feet. This happened much faster than STI thought possible, but Facebook is looking more and more like the merger of Time Warner and AOL at the height of the dot.com era. And we all know where that ended up for the stockholders.

We reaffirm our short sell recommendation for Facebook in our Equity Trades Portfolio.

NASDAQ Composite Index:

Friday, February 21 = 4,263.41

Year to Date = + 2.9%

Trailing 7 Days = + 0.5%

Trailing 4 Weeks = + 3.9%

PORTFOLIO UPDATE

Two changes to our portfolios this week:

Ricoh (OTC: RICOY), which is currently a buy recommendation in our Equity Trades portfolio, is being moved over to our Investments Portfolio as we are convinced it offers longer term value to our readers (our Equity Trades Portfolio consists of recommendations that we believe should be closed out within a year, while our Investments Portfolio consists of recommendations that we think should be held for the long term).

In its place, we are adding Lenovo (OTC: LNVGY) as a buy recommendation in the Equity Trades Portfolio.  The stock has taken a hit since it announced a couple of major acquisitions earlier this month, but we think that represents a good short-term buying opportunity – and here’s why.

Lenovo purchased IBM’s PC division back in 2005, and their market share went up to third place among the PC makers. Since then they had grown their worldwide share to move into second place ahead of Dell. This yeoman like work was laudable, but not extremely interesting to the investor.

A few weeks ago Lenovo changed the game completely with two significant purchases. First, they bought out IBM’s PC server business. If IBM made it out of PC technology – Lenovo now owns it all. PC servers – called x86 servers – are still a growing and expanding market, unlike PCs themselves.

The second thing Lenovo bought was Google’s Smartphone unit, which had formerly been Motorola’s. Google had struggled to integrate Motorola’s cellular unit into their business despite the fact that it appeared to be a perfect fit with Google’s Android operating system.

Perhaps the sale from Google to Lenovo informs us more about Google’s inability to branch out of the search business. However, what we can now clearly see is that Lenovo joins Apple, Microsoft and Samsung as a major Smartphone manufacturer.

Apple and Microsoft, of course, make the operating systems for their Smartphones while Samsung and Lenovo will not. Therefore, Lenovo has served notice it intends to take market share from Samsung. This is not trivial, as the majority of Smartphones are the less expensive Android phones from Samsung.

Samsung tripped in its last earnings release where, despite their growing market share, their profits decreased. Apple, on the other hand, had 56% of all profits from the Smartphone market – more than all of the other competitors combined!

Lenovo has demonstrated it can increase share in a commoditizing market as they did against Dell and HP in the OC space. I suspect Lenovo will likely do the same thing to Samsung in the Smartphone market. Keep in mind that the word Lenovo means ‘innovation’ in Chinese, and these guys have proven they can certainly do that.

Now that Lenovo has PCs, tablets, Smartphones and a server business, they have a truly end-to-end business technology model. STI has a renewed interest in seeing where Lenovo is going to take their innogration strategy in 2014 and beyond.

Lenovo is a buy in our Equity Trades Portfolio up to $22.