May 2010

No one can deny that banks have had a tough time of it when it comes to stock market valuations over the last couple of years. The global financial crisis, massive debt and NPL issues along with punishing public opinion led to a massive collapse in banking stocks and company valuations in recent times. It would be simple to blame the sub-prime and global financial crisis as the sole cause of all the ills of the banking sector, but I have a different theory which explains a large part of the picture. In the last 5 years the S&P 500 has experienced incredible volatility. On October 9, 2007 the S&P 500 hit its all time record of 1,565.15, but it was followed by the biggest annual loss in the S&P’s history, losing 37% in 2008 (the previous record being -22% in 2002 at the end of the dot com boom). As a result you’d expect any participants in the US market to have suffered similarly, and they have. Volatility, or the range/spread of buy and sell trades in the US markets is at an all time high and according to many analysts this volatility is here to stay . The certainty in the market has largely disappeared, and with it, the status quo in respect to valuations. In the last 5 or 6 years, however, a new component has come into valuation metrics for listed companies. We still have revenue, we still have market share, branding and so forth, but innovation is clearly an increasingly significant part of the story. Let me illustrate: Comparative Performance – S&P 500, Tech and Banking Stocks Below is a graph (source: Yahoo Finance , Bloomberg ) showing the comparative performance of a selection of key stocks from the US market, the S&P500 Index being the dotted yellow line. Innovation is being rewarded like never before in market valuations Clearly Apple and Google have differentiated themselves. What has made the difference? Why have Google and Apple performed so much better over the last 5 years in market terms? Let’s examine the facts and see what conclusions we can draw. Microsoft’s Revenue in 2005 exceeded Apple’s by more than 300%, and Google’s by almost 600%. In the last 5 years Microsoft’s Revenue has increased from $39B in 2005 to close to $60B in 2009 , certainly not a bad performance. Google’s revenue certainly has increased, but in the years 2007-2009 it has only jumped from $16.5B to $23.7B. Since 2005 Apple has increased their revenue from $13.9B (2005) to $36.5(2009). Apple has certainly benefited from the popularity of the iPhone (Released June 29th, 2007) and more recently the iPad (Released April, 2010). But if we compare the top 4 US banks we see that their revenue makes the tech companies look fairly ordinary. If revenue was the key driver, then we’d expect to see that the banks would have better comparative valuations. Given that Microsoft’s revenue is still close to double that of Apple’s revenue, and more than double that of Google – if the answer was that ‘tech’ revenue was valued at a premium then we’d expect Microsoft to be fairing better. 2009 data Assets ($B) Revenue ($B) Bank of America (BAC) $2,300 $113 J P Morgan Chase (JPM) $2,000 $101 Citigroup (C) $1,800 $106 Wells Fargo (WFC) $1,200 $51.7 On this basis, revenue, while a critical component of a company’s valuation, would seem to not correlate cleanly with the exceptional performance of Apple and Google recently. Well before the GFC started to impact company valuations, they were already being hurt by something… So is it future revenue potential? P/E Ratios show somewhat the expectation of the market in respect to future revenue potential. For the ‘blue chip’ performers like Microsoft, JP Morgan Chase, Wells Fargo – P/E Ratio (Price/Earnings Ratio) are all performing in the range of 15-17, whereas Apple and Google are at 21.8 and 22.1 respectively. Certainly expectations are that Google and Apple have not yet hit their peak in earnings capability because their valuations show a higher multiple. Indeed, the S&P 500 typically tracks at around 15 – so Google’s and Apple’s performances are something special. Future earnings might account for a higher valuation today, but this is not necessarily the sole factor in their comparative performance which, over the last 5 years, has been much better than Microsoft, the top banks and industrials. In fact, you have to look very hard globally to find better performing stocks in respect to either new or established companies in terms of growth in both revenue and share price over the last 5 years. So future revenue is a factor, but not the sole factor. If it was, then you’d expect Microsoft would get some of the joy too as part of the ‘tech’ clique, but they’ve not received as much optimism as their tech buddies have. What differentiates Apple and Google’s revenue from the rest of the pack? You might attribute Apple’s success in respect to valuations from their great products. But if you compare market share both Google and Apple really still are minority players when compared with Microsoft, purely from a product perspective. While Google’s Android and Apple’s OS-X are taking some share of the mobile market, Windows is still a force to be reckoned with. So where is the differentiation? Google’s strength to date, and Apple’s more recent success with great new device technologies has centered around one key area. Their ability to create great, but simple and intuitive, propositions. Google.com as a search engine is the perfect representation of search (at least for now). When Google launched their search engine in 1997, there was really no one that could touch them in terms of simplicity of experience and validity of results, and today, although many have attempted to copy Google’s formula, (read Bing.com) we still see Google maintaining a 65.6% market share of the SE space. What Google bought to the table, their foundation or core, was innovating the customer experience and making technology really simple to use. The simplicity and user experience differentiate Apple devices Apple has done the same. User Experience is at the heart of why the iPod, iPhone and iPad have captured not only the imagination of the consumer market, but why Apple and its products are increasingly part of the common vernacular. Sure Apple’s stuff looks great, cool and is about as aspirational as branded products get in the Y-Gen/Digital Natives space today. But this stuff just works. Innovating the customer experience is the ‘secret sauce’ Innovating the customer experience is at the heart of why Apple and Google are outperforming the market today. It’s also at the heart of why traditional banks are suffering. As market analysts, consumers and as media commentators we just see more of the same. While there has been pressure on the banking market, bankers seem content to ‘wait it out’ until more sane, normal times return. Banking is an old and traditional industry and it doesn’t take kindly to change. But that is problematic – because right now their lack of adaptability is hurting bank valuations significantly. There’s nowhere for banks to go from here if they can’t innovate around the customer. The lack of innovation means less future revenue and reduced earnings potential. In fact, as of today it’s more likely that a Google, Apple, PayPal or new start up like Square will innovate the customer experience in banking, rather than banks themselves. This is where banks need to take a good hard look at themselves. The lack of capability to innovate the customer experience is costing them, and it’s only going to get worse.